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+RISK FACTORS Investing in our common stock involves risks. Before making an investment in our common stock, you should carefully consider the following risks, as well as the other information contained in this prospectus, including our consolidated financial statements and the related notes and the section titled Management s Discussion and Analysis of Financial Condition and Results of Operations. The risks described below are those that we believe are the material risks we face. Any of the risk factors described below could significantly and adversely affect our business, prospects, financial condition and results of operations. As a result, the trading price of our common stock could decline and you may lose all or part of your investment. Risks Relating to Our Business The success of our business is significantly related to general economic conditions and, accordingly, our business could be harmed in the event of an economic slowdown or recession. Periods of economic slowdown or recession, significantly rising interest rates, a declining employment level, a declining demand for real estate or the public perception that any of these events may occur, can reduce volumes for many of our business lines. These economic conditions could result in a general decline in rents, which in turn would reduce revenue from property management fees and brokerage commissions derived from property sales and leases. In addition, these conditions could lead to a decline in sales prices as well as a decline in funds invested in commercial real estate and related assets. An economic downturn or a significant increase in interest rates also may reduce the amount of loan originations and related servicing by our commercial mortgage banking business. If our brokerage and mortgage banking businesses are negatively impacted, it is likely that our other lines of business would also suffer due to the relationship among our various business lines. Further, as a result of our debt level and the terms of our existing debt instruments, our exposure to adverse general economic conditions is heightened. As an example of this risk, during 2002 and 2001, we were adversely affected by the slowdown in the U.S. economy, which negatively impacted the commercial real estate market generally. This caused a decline in our leasing activities within the United States. Moreover, in part because of the terrorist attacks on September 11, 2001 and the subsequent conflict with Iraq, the economic climate in the United States became very uncertain, which had an adverse effect on commercial real estate market conditions and, in turn, our operating results for 2002 and 2001. If the properties that we manage fail to perform, then our financial condition and results of operations could be harmed. The revenue we generate from our asset services and facilities management lines of business is generally a percentage of aggregate rent collections from properties, although many management agreements provide for a specified minimum management fee. Accordingly, our success partially depends upon the performance of the properties we manage. The performance of these properties will depend upon the following factors, among others, many of which are partially or completely outside of our control: our ability to attract and retain creditworthy tenants; the magnitude of defaults by tenants under their respective leases; our ability to control operating expenses; governmental regulations, local rent control or stabilization ordinances which are in, or may be put into, effect; various uninsurable risks; financial conditions prevailing generally and in the areas in which these properties are located; the nature and extent of competitive properties; and the real estate market generally. Table of Contents The information in this prospectus is not complete and may be changed. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell these securities and we are not soliciting an offer to buy these securities in any jurisdiction where the offer or sale is not permitted. SUBJECT TO COMPLETION, DATED NOVEMBER 24, 2004 15,000,000 Shares CB Richard Ellis Group, Inc. Class A Common Stock Table of Contents We have numerous significant competitors, some of which may have greater financial resources than we do. We compete across a variety of business disciplines within the commercial real estate industry, including investment management, tenant representation, corporate services, construction and development management, property management, agency leasing, valuation and mortgage banking. In general, with respect to each of our business disciplines, we cannot give assurance that we will be able to continue to compete effectively or maintain our current fee arrangements or margin levels or that we will not encounter increased competition. Each of the business disciplines in which we compete is highly competitive on an international, national, regional and local level. Although we are the largest commercial real estate services firm in the world in terms of 2003 revenue, our relative competitive position varies significantly across product and service categories and geographic areas. Depending on the product or service, we face competition from other real estate service providers, institutional lenders, insurance companies, investment banking firms, investment managers and accounting firms, some of which may have greater financial resources than we do. Many of our competitors are local or regional firms. Although substantially smaller than us, some of these competitors are larger on a local or regional basis. We are also subject to competition from other large national and multi-national firms that have similar service competencies to ours. Our international operations subject us to social, political and economic risks of doing business in foreign countries. We conduct a significant portion of our business and employ a substantial number of people outside of the United States. During 2003 and the nine months ended September 30, 2004, we generated approximately 30.2% of our revenue from operations outside the United States. Circumstances and developments related to international operations that could negatively affect our business, financial condition or results of operations include, but are not limited to, the following factors: difficulties and costs of staffing and managing international operations; currency restrictions, which may prevent the transfer of capital and profits to the United States; unexpected changes in regulatory requirements; potentially adverse tax consequences; the responsibility of complying with multiple and potentially conflicting laws; the impact of regional or country-specific business cycles and economic instability; the geographic, time zone, language and cultural differences among personnel in different areas of the world; greater difficulty in collecting accounts receivable in some geographic regions such as Asia, where many countries have underdeveloped insolvency laws and clients are often slow to pay, and in some European countries, where clients also tend to delay payments; political instability; and foreign ownership restrictions with respect to operations in countries such as China. We have committed additional resources to expand our worldwide sales and marketing activities, to globalize our service offerings and products in selected markets and to develop local sales and support channels. If we are unable to successfully implement these plans, to maintain adequate long-term strategies that successfully manage the risks associated with our global business or to adequately manage operational fluctuations, our business, financial condition or results of operations could be harmed. In addition, our international operations and, specifically, the ability of our non-U.S. subsidiaries to dividend or otherwise transfer cash among our subsidiaries, including transfers of cash to pay interest and principal on our debt, may be affected by limitations on imports, currency exchange control regulations, transfer pricing regulations and potentially adverse tax consequences, among other things. The selling stockholders named in this prospectus are selling 15,000,000 shares of Class A common stock. We will not receive any of the proceeds from the shares of Class A common stock sold by the selling stockholders. Our Class A common stock is listed on the New York Stock Exchange under the trading symbol CBG. On November 23, 2004, the last reported sale price of our Class A common stock on the New York Stock Exchange was $25.86 per share. The underwriters have an option to purchase a maximum of 2,250,000 additional shares of Class A common stock from some of the selling stockholders to cover over-allotments of shares. Investing in our Class A common stock involves risks. See Risk Factors beginning on page 10. Price to Public Table of Contents Our revenue and earnings may be adversely affected by foreign currency fluctuations. Our revenue from non-U.S. operations is denominated primarily in the local currency where the associated revenue was earned. During 2003 and the nine months ended September 30, 2004, approximately 30.2% of our business was transacted in currencies of foreign countries, the majority of which included the Euro, the British Pound Sterling, the Hong Kong dollar, the Singapore dollar and the Australian dollar. Thus, we may experience fluctuations in revenues and earnings because of corresponding fluctuations in foreign currency exchange rates. For example, during 2003, the U.S. dollar dropped in value against many of the currencies in which we conduct business. We have made significant acquisitions of non-U.S. companies, and we may acquire additional foreign companies in the future. As we increase our foreign operations, fluctuations in the value of the U.S. dollar relative to the other currencies in which we may generate earnings could adversely affect our business, financial condition and operating results. Due to the constantly changing currency exposures to which we will be subject and the volatility of currency exchange rates, we cannot predict the effect of exchange rate fluctuations upon future operating results. In addition, fluctuations in currencies relative to the U.S. dollar may make it more difficult to perform period-to-period comparisons of our reported results of operations. From time to time, our management uses currency hedging instruments, including foreign currency forward and option contracts, and borrows in foreign currencies. Economic risks associated with these hedging instruments include unexpected fluctuations in inflation rates, which impact cash flow relative to paying down debt, and unexpected changes in the underlying net asset position. These hedging activities also may not be effective. Our growth has depended significantly upon acquisitions, which may not be available in the future. A significant component of our growth has occurred through acquisitions, including our acquisition of Insignia on July 23, 2003. Any future growth through acquisitions will be partially dependent upon the continued availability of suitable acquisition candidates at favorable prices and upon advantageous terms and conditions. However, future acquisitions may not be available at advantageous prices or upon favorable terms and conditions. In addition, acquisitions involve risks that the businesses acquired will not perform in accordance with expectations and that business judgments concerning the value, strengths and weaknesses of businesses acquired will prove incorrect. Future acquisitions and any necessary related financings also may involve significant transaction-related expenses. For example, through September 30, 2004, we have incurred approximately $200.9 million of transaction-related expenses in connection with our acquisition of Insignia in 2003. If we acquire companies in the future, we may experience integration costs and the acquired businesses may not perform as we expect. We have had, and may continue to experience, difficulties in integrating operations and accounting systems acquired from other companies. These difficulties include the diversion of management s attention from other business concerns and the potential loss of our key employees or those of the acquired operations. We believe that most acquisitions will initially have an adverse impact on operating and net income. For example, in 2003 we incurred costs associated with integrating Insignia s business into our existing business lines. Acquisitions also frequently involve significant costs related to integrating information technology, accounting and management services and rationalizing personnel levels. In connection with the Insignia acquisition, we recorded significant charges during 2003 and the first nine months of 2004 relating to integration costs. In addition, we have several different accounting systems as a result of acquisitions we have made, including the accounting systems of Insignia. If we are unable to fully integrate the accounting and other systems of the businesses we own, we may not be able to effectively manage our acquired businesses. Moreover, the Underwriting Discounts and Commissions Table of Contents integration process itself may be disruptive to our business as it requires coordination of geographically diverse organizations and implementation of new accounting and information technology systems. A significant portion of our operations are concentrated in California and New York, and our business could be harmed in the event of a future economic downturn in the California or New York real estate markets. During 2003, approximately 23.8% of our revenue was generated from transactions originating in California and approximately 6.9% was generated from transactions originating in the greater New York metropolitan area. Due to our acquisition of Insignia on July 23, 2003, we expect that the percentage of our revenue generated in the New York metropolitan area in future years will increase. As a result of the geographic concentrations in California and New York, any future economic downturn in the California or New York commercial real estate markets and in the local economies in San Diego, Los Angeles, Orange County or the greater New York metropolitan area could harm our results of operations. Our results of operations vary significantly among quarters during each calendar year, which makes comparisons of our quarterly results difficult. A significant portion of our revenue is seasonal. Historically, this seasonality has caused our revenue, operating income, net income and cash flow from operating activities to be lower in the first two quarters and higher in the third and fourth quarters of each year. The concentration of earnings and cash flow in the fourth quarter is due to an industry-wide focus on completing transactions toward the fiscal year-end. This has historically resulted in lower profits or a loss in the first and second quarters, with profits growing (or losses decreasing) in each subsequent quarter. This variance among quarters during each calendar year makes comparison between such quarters difficult, but does not generally affect the comparison of the same quarters during different calendar years. Our substantial leverage and debt service obligations could harm our ability to operate our business, remain in compliance with debt covenants and make payments on our debt. We are highly leveraged and have significant debt service obligations. For 2003, on a pro forma basis, our interest expense was $83.5 million. Our interest expense for the nine months ended September 30, 2004 was $52.1 million. Our substantial level of indebtedness increases the possibility that we may be unable to generate cash sufficient to pay when due the principal of, interest on or other amounts due in respect of our indebtedness. In addition, we may incur additional debt from time to time to finance strategic acquisitions, investments, joint ventures or for other purposes, subject to the restrictions contained in the documents governing our indebtedness. If we incur additional debt, the risks associated with our substantial leverage, including our ability to service our debt, would increase. Our substantial debt could have other important consequences, which include, but are not limited to, the following: we could be required to use a substantial portion, if not all, of our cash flow from operations to pay principal and interest on our debt; our level of debt may restrict us from raising additional financing on satisfactory terms to fund working capital, strategic acquisitions, investments, joint ventures and other general corporate requirements; our interest expense could increase if interest rates increase because the loans under our amended and restated credit agreement governing our senior secured credit facilities bear interest at floating rates; our substantial leverage could increase our vulnerability to general economic downturns and adverse competitive and industry conditions, placing us at a disadvantage compared to those of our competitors that are less leveraged; our debt service obligations could limit our flexibility in planning for, or reacting to, changes in our business and in the commercial real estate services industry; Proceeds to Selling Stockholders Table of Contents our failure to comply with the financial and other restrictive covenants in the documents governing our indebtedness, which, among others, require us to maintain specified financial ratios and limit our ability to incur additional debt and sell assets, could result in an event of default that, if not cured or waived, could harm our business or prospects and could result in our filing for bankruptcy; and from time to time, Moody s Investors Service and Standard & Poor s Ratings Service rate our outstanding senior secured term loan, our 9 3/4% senior notes and our 11 1/4% senior subordinated notes. These ratings may impact our ability to borrow under any new agreements in the future, as well as the interest rates and other terms of any such future borrowings and could also cause a decline in the market price of our common stock. We cannot be certain that our earnings will be sufficient to allow us to pay principal and interest on our debt and meet our other obligations. If we do not have sufficient earnings, we may be required to refinance all or part of our existing debt, sell assets, borrow more money or sell more securities, none of which we can guarantee we will be able to do. We are able to incur more indebtedness, which may intensify the risks associated with our substantial leverage, including our ability to service our indebtedness. Our amended and restated credit agreement governing our senior secured credit facilities and the indentures relating to our 9 3/4% senior notes due 2010 and our 11 1/4% senior subordinated notes due 2011 permit us, subject to specified conditions, to incur a significant amount of additional indebtedness, including up to $150.0 million of additional indebtedness under our revolving credit facility. Our amended and restated credit agreement also permits us to borrow up to $25.0 million of additional term loans under our term loan facility, subject to the satisfaction of customary conditions. If we incur additional debt, the risks associated with our substantial leverage, including our ability to service our debt, would increase. Our debt instruments impose operating and financial restrictions on us, and in the event of a default, all of our borrowings would become immediately due and payable. The indentures governing our 9 3/4% senior notes due 2010 and our 11 1/4% senior subordinated notes due 2011 impose, and the terms of any future debt may impose, operating and other restrictions on us and many of our subsidiaries. These restrictions will affect, and in many respects will limit or prohibit, our ability and our restricted subsidiaries abilities to: incur or guarantee additional indebtedness; pay dividends or make distributions on capital stock or redeem or repurchase capital stock; repurchase equity interests; make investments; create restrictions on the payment of dividends or other amounts to us; sell stock of subsidiaries; transfer or sell assets; create liens; enter into transactions with affiliates; enter into sale/leaseback transactions; and enter into mergers or consolidations. Per Share $ $ $ Total $ $ $ Delivery of the shares of Class A common stock will be made on or about , 2004. Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense. Credit Suisse First Boston Citigroup Table of Contents In addition, the amended and restated credit agreement governing our senior secured credit facilities includes other and more restrictive covenants and prohibits us from prepaying most of our other debt while debt under our senior secured credit facilities is outstanding. The amended and restated credit agreement also requires us to maintain compliance with specified financial ratios. Our ability to comply with these ratios may be affected by events beyond our control. The restrictions contained in our debt instruments could: limit our ability to plan for or react to market conditions or meet capital needs or otherwise restrict our activities or business plans; and adversely affect our ability to finance ongoing operations, strategic acquisitions, investments or other capital needs or to engage in other business activities that would be in our interest. A breach of any of these restrictive covenants or the inability to comply with the required financial ratios could result in a default under our debt instruments. If any such default occurs, the lenders under the senior secured credit facilities and the holders of our 9 3/4% senior notes due 2010 and our 11 1/4% senior subordinated notes due 2011, pursuant to the respective indentures, may elect to declare all outstanding borrowings, together with accrued interest and other fees, to be immediately due and payable. The lenders under our senior secured credit facilities also have the right in these circumstances to terminate any commitments they have to provide further borrowings. If we are unable to repay outstanding borrowings when due, the lenders under the senior secured credit facilities will have the right to proceed against the collateral granted to them to secure the debt, which collateral is described in the immediately following risk factor. If the debt under the senior secured credit facilities, our 9 3/4% senior notes due 2010 or our 11 1/4% senior subordinated notes due 2011 were to be accelerated, we cannot give assurance that these assets would be sufficient to repay our debt. If we fail to meet our payment or other obligations under the senior secured credit facilities, the lenders under the senior secured credit facilities could foreclose on, and acquire control of, substantially all of our assets. In connection with the incurrence of indebtedness under our senior secured credit facilities and the completion of our acquisition of Insignia, the lenders under our senior secured credit facilities received a pledge of all of our equity interests in our significant domestic subsidiaries, including CB Richard Ellis Services, Inc., CB Richard Ellis Investors, L.L.C., L.J. Melody & Company, Insignia and Insignia/ESG, Inc., which was subsequently renamed CB Richard Ellis Real Estate Services, Inc., and 65% of the voting stock of our foreign subsidiaries that is held directly by us or our domestic subsidiaries. Additionally, these lenders generally have a lien on substantially all of our accounts receivable, cash, general intangibles, investment property and future acquired material property. As a result of these pledges and liens, if we fail to meet our payment or other obligations under the senior secured credit facilities, the lenders under the senior secured credit facilities will be entitled to foreclose on substantially all of our assets and liquidate these assets. Our co-investment activities subject us to real estate investment risks which could cause fluctuations in earnings and cash flow. An important part of the strategy for our investment management business involves investing our capital in certain real estate investments with our clients. As of September 30, 2004, we had committed $41.7 million to fund future co-investments and we expect approximately $11.0 million of these commitments will be funded during the fourth quarter of 2004. In addition to required future capital contributions, some of the co-investment entities may request additional capital from us and our subsidiaries holding investments in those assets and the failure to provide these contributions could have adverse consequences to our interests in these investments. These adverse consequences could include damage to our reputation with our co-investment partners and clients, as well as the necessity of obtaining alternative funding from other sources that may be on disadvantageous terms for us and the other co-investors. Providing co-investment financing is also a very important part of CBRE Goldman, Sachs & Co. JPMorgan Lehman Brothers Merrill Lynch & Co. Bear, Stearns & Co. Inc. The date of this prospectus is , 2004. Table of Contents Investor s investment management business, which would suffer if we were unable to make these investments. Although our debt instruments contain restrictions that will limit our ability to provide capital to the entities holding direct or indirect interests in co-investments, we may provide this capital in many instances. Participation in real estate transactions through co-investment activity could increase fluctuations in earnings and cash flow. Other risks associated with these activities include, but are not limited to, the following: losses from investments; difficulties associated with international co-investments described in Our international operations subject us to social, political and economic risks of doing business in foreign countries and Our revenue and earnings may be adversely affected by foreign currency fluctuations; and potential lack of control over the disposition of any co-investments and the timing of the recognition of gains, losses or potential incentive participation fees. Our joint venture activities involve unique risks that are often outside of our control which, if realized, could harm our business. We have utilized joint ventures for commercial investments and local brokerage and other partnerships both in the United States and internationally, and although we currently have no specific plans to do so, we may acquire minority interests in other joint ventures in the future. In many of these joint ventures, we may not have the right or power to direct the management and policies of the joint ventures and other participants may take action contrary to our instructions or requests and against our policies and objectives. In addition, the other participants may become bankrupt or have economic or other business interests or goals that are inconsistent with ours. If a joint venture participant acts contrary to our interest, it could harm our business, results of operations and financial condition. Our success depends upon the retention of our senior management, as well as our ability to attract and retain qualified and experienced employees. Our continued success is highly dependent upon the efforts of our executive officers and other key employees, including Ray Wirta, our Chief Executive Officer; Brett White, our President; Kenneth J. Kay, our Chief Financial Officer; Alan C. Froggatt, our President, EMEA; and Robert Blain, our President, Asia Pacific. In addition, Messrs. Wirta, White and Kay currently are not parties to employment agreements with us. If any of our key employees leave and we are unable to quickly hire and integrate a qualified replacement, our business, financial condition and results of operations may suffer. In addition, the growth of our business is largely dependent upon our ability to attract and retain qualified personnel in all areas of our business, including brokerage and property management personnel. If we are unable to attract and retain these qualified personnel, our growth may be limited and our business and operating results could suffer. If we fail to comply with laws and regulations applicable to real estate brokerage and mortgage transactions and other business lines, we may incur significant financial penalties. Due to the broad geographic scope of our operations and the numerous forms of real estate services performed, we are subject to numerous federal, state and local laws and regulations specific to the services performed. For example, the brokerage of real estate sales and leasing transactions requires us to maintain brokerage licenses in each state in which we operate. If we fail to maintain our licenses or conduct brokerage activities without a license, we may be required to pay fines or return commissions received or have licenses suspended. In addition, because the size and scope of real estate sales transactions have increased significantly during the past several years, both the difficulty of ensuring compliance with the numerous state licensing regimes and the possible loss resulting from non-compliance have increased. Furthermore, the laws and regulations applicable to our business, both in the United States and in foreign countries, also may change in ways that materially increase the costs of compliance. NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 82,810 22,914 43,772 (6,139 ) CASH AND CASH EQUIVALENTS, AT BEGINNING OF PERIOD 79,701 57,450 13,662 20,854 Effect of currency exchange rate changes on cash 1,370 (663 ) Total long-term debt 791,420 499,004 Short-Term Borrowings: Warehouse Line of Credit, with interest at 1.00% over the Residential Funding Corporation base rate with a maturity date of August 31, 2004 230,790 63,140 Non-recourse mortgage debt related to property held for sale with interest at one-month Yen LIBOR plus 3.50% and a maturity date of June 18, 2003 40,005 Insignia acquisition loan notes, with interest ranging from 1.53% to 3.00%, due on demand 12,191 Westmark Senior Notes, with interest ranging from 4.40% to 9.00%, due on demand 12,129 12,129 Euro cash pool loan, with interest at 2.50% over the applicable HSBC base rate and no stated maturity date 11,517 7,904 Other 3,510 NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 3 (28 ) 42,159 1,638 43,772 CASH AND CASH EQUIVALENTS, AT BEGINNING OF PERIOD 959 45 12,658 13,662 Effect of currency exchange rate changes on cash 16 Table of Contents Table of Contents We may have liabilities in connection with real estate brokerage and property management activities. As a licensed real estate broker, we and our licensed employees are subject to statutory due diligence, disclosure and standard-of-care obligations. Failure to fulfill these obligations could subject us or our employees to litigation from parties who purchased, sold or leased properties that we or they brokered or managed. We could become subject to claims by participants in real estate sales claiming that we did not fulfill our statutory obligations as a broker. In addition, in our property management business, we hire and supervise third-party contractors to provide construction and engineering services for our managed properties. While our role is limited to that of a supervisor, we may be subjected to claims for construction defects or other similar actions. Adverse outcomes of property management litigation could negatively impact our business, financial condition or results of operations. We agreed to retain contingent liabilities in connection with Insignia s sale of substantially all of its real estate investment assets in 2003. Immediately prior to the completion of our acquisition of Insignia on July 23, 2003, Insignia completed the sale of substantially all of its real estate investment assets to Island Fund. Under the terms of the purchase agreement, we agreed to retain some contingent liabilities related to these real estate investment assets, including, as of September 30, 2004, approximately $5.2 million of letters of credit support and a guarantee of an approximately $1.3 million repayment obligation. Island Fund is obligated to reimburse us for only 50% of any future draws against these letters of credit or the repayment guarantee, and there can be no assurance that Island Fund will be able to satisfy any future requests for reimbursement. Also in connection with the sale to Island Fund, we agreed to indemnify Island Fund against any losses resulting from the ownership, use or operation of the real estate investment assets prior to the closing of the sale. Although this indemnification obligation to Island Fund is subject to a number of exceptions and limitations, future claims against us pursuant to this indemnification obligation may be material. In addition, a number of the real estate investment assets that we agreed to sell to Island Fund required the consent of one or more third parties in order to transfer such assets to Island Fund, and some of these third party consents were not obtained prior to the closing and have not been obtained since then. As a result, we continue to hold these real estate investment assets pending the receipt of these third party consents. While we continue to hold these assets, we generally have agreed to provide Island Fund with the economic benefits from these assets, and Island Fund generally has agreed to indemnify us with respect to any losses incurred in connection with our continuing to hold these assets. There can be no assurance, however, that Island Fund actually will be able to provide such indemnification if required to do so at any future date. Risks Relating to the Offering and Ownership of Our Common Stock The future price of our common stock may fluctuate significantly, and you could lose all or part of your investment. The future market price of our common stock could fluctuate significantly, in which case you may not be able to resell your shares at or above the offering price. Fluctuations may occur in response to the risk factors listed in this prospectus and for many other reasons, including: our financial performance or the performance of our competitors and similar companies; changes in estimates of our performance or recommendations by securities analysts; failure to meet financial projections for each fiscal quarter; technological innovations or other trends in our industry; CASH AND CASH EQUIVALENTS, AT END OF PERIOD $ 3,008 $ Table of Contents Table of Contents the introduction of new services by us or our competitors; the arrival or departure of key personnel; acquisitions, strategic alliances or joint ventures involving us or our competitors; and market conditions in our industry, the financial markets and the economy as a whole. In addition, the stock market, in general, has historically experienced significant price and volume fluctuations. These fluctuations are often unrelated to the operating performance of particular companies. These broad market fluctuations may cause declines in the market price of our common stock. When the market price of a company s common stock drops significantly, stockholders often institute securities class action lawsuits against the company. A lawsuit against us could cause us to incur substantial costs and could divert the time and attention of our management and other resources from our business. Future sales of common stock by some of our existing stockholders could cause our stock price to decline. Affiliates of Blum Capital Partners, L.P., together with some of the other selling stockholders and our employees, will continue to hold a significant portion of our outstanding common stock after the offering. Sales of the shares in the public market, as well as shares we may issue upon the exercise of outstanding options and in connection with future distributions pursuant to stock fund units under our old deferred compensation plan, could cause the market price of our common stock to decline significantly. The perception among investors that these sales may occur could produce the same effect. Of the outstanding shares after completion of the offering, all of the 15,000,000 shares sold in the offering, all of the 24,229,300 shares issued and sold in our initial public offering and substantially all of our other currently outstanding shares held by our current and former employees and consultants will be freely tradable immediately without further registration under the Securities Act, except that any shares held by our affiliates, as that term is defined under Rule 144 of the Securities Act, may be sold only in compliance with the limitations under Rule 144. In addition, 25,857,558 shares, which are subject to lock-up agreements with the underwriters, will be eligible for sale at various times beginning 90 days after the date of this prospectus pursuant to Rule 144, including 144(k). The underwriters may release all or a portion of these shares subject to lock-up agreements at any time without notice. After the offering, stockholders beneficially owning approximately 28.4 million shares of our common stock, will have rights, subject to conditions, to require us to file registration statements covering their shares or to include their shares in registration statements that we may file. By exercising these registration rights and selling a large number of shares, these holders could cause the price of our common stock to decline. Furthermore, if we were to include their shares in a registration statement, those sales could impair our ability to raise needed capital by depressing the price at which we could sell our common stock. See the information under the heading titled Shares Eligible for Future Sale for a more detailed description of the shares that will be available for future sales upon completion of the offering. TABLE OF CONTENTS Page Table of Contents For so long as affiliates of Blum Capital Partners, L.P. continue to own a significant percentage of our common stock they will have significant influence over our affairs and policies, and their interests may be different from yours. After the completion of the offering, affiliates of Blum Capital Partners will beneficially own approximately 27.0% of our outstanding common stock. In addition, pursuant to a securityholders agreement, these affiliates of Blum Capital Partners, subject to the applicable listing rules of the New York Stock Exchange, are entitled to nominate a percentage of our total number of directors that is equivalent to the percentage of the outstanding common stock beneficially owned by these affiliates, with this percentage of our directors being rounded up to the nearest whole number of directors. Also pursuant to this agreement, some of our other stockholders will be obligated to vote their shares in favor of the directors nominated by these affiliates of Blum Capital Partners. These other stockholders, collectively, will beneficially own approximately 9.4% of our outstanding common stock after completion of the offering. There are no restrictions in the securityholders agreement on the ability of these affiliates of Blum Capital Partners to sell their shares to any third party or to assign their rights under the securityholders agreement in connection with a sale of a majority of their shares to a third party. For so long as these affiliates of Blum Capital Partners continue to beneficially own a significant portion of our outstanding common stock, they will continue to have significant influence over matters submitted to our stockholders for approval and to exercise significant control over our business policies and affairs, including the following: the composition of our board of directors and, as a result, any determinations of our board with respect to our business direction and policy, including the appointment and removal of our officers; determinations with respect to mergers and other business combinations, including those that may result in a change of control; sales and dispositions of our assets; and the amount of debt financing that we incur. The significant ownership position of the affiliates of Blum Capital Partners could have the effect of delaying, deterring or preventing a change of control or other business combination that might otherwise be beneficial to our other stockholders. In addition, we cannot assure you that the interests of the affiliates of Blum Capital Partners will not conflict with yours. For additional information regarding the share ownership of, and our relationships with, these affiliates of Blum Capital Partners, you should read the information under the headings titled Principal and Selling Stockholders and Related Party Transactions. Delaware law and provisions of our restated certificate of incorporation and restated by-laws contain provisions that could delay, deter or prevent a change of control. The anti-takeover provisions of Delaware law impose various impediments to the ability of a third party to acquire control of us, even if a change of control would be beneficial to our existing stockholders. We are currently subject to these Delaware anti-takeover provisions. Additionally, our restated certificate of incorporation and our restated by-laws contain provisions that might enable our management to resist a proposed takeover of our company. These provisions could discourage, delay or prevent a change of control of our company or an acquisition of our company at a price that our stockholders may find attractive. These provisions also may discourage proxy contests and make it more difficult for our stockholders to elect directors and take other corporate actions. The existence of these provisions could limit the price that investors might be willing to pay in the future for shares of our common stock. The provisions include: advance notice requirements for stockholder proposals and nominations; and the authority of our board to issue, without stockholder approval, preferred stock with such terms as our board may determine. Table of Contents For additional information regarding these provisions, you should read the information under the headings titled Description of Capital Stock Anti-Takeover Effects of Certain Provisions of our Restated Certificate of Incorporation and Restated By-Laws and Delaware Anti-Takeover Statute. A portion of the net proceeds of this offering will be received by affiliates of, and some of the selling stockholders are affiliates of, one of our underwriters. This may present a conflict of interest. Affiliates of Credit Suisse First Boston LLC, one of the representatives of the underwriters for the offering, are selling stockholders in the offering. As of October 31, 2004, these affiliates of Credit Suisse First Boston LLC were the beneficial owners of 1,420,656 shares, or approximately 2.0% of our outstanding common stock. These affiliates of Credit Suisse First Boston LLC are selling 640,999 shares (or 1,420,656 shares if the underwriters exercise their over-allotment option in full) in the offering, and will receive net proceeds of approximately $ million (or approximately $ million if the underwriters exercise their over-allotment option in full). After the offering, these affiliates of Credit Suisse First Boston LLC will beneficially own 1.1% of our common stock (or no shares of our common stock if the underwriters exercise their over-allotment option in full). See the information under the heading titled Principal and Selling Stockholders for a more complete description of these affiliates ownership of our common stock. These affiliations may present a conflict of interest since Credit Suisse First Boston LLC may have an interest in the successful completion of the offering in addition to the underwriting discounts and commissions it expects to receive. Your ability to recover from our former auditors, Arthur Andersen LLP, for any potential financial misstatements is limited. On April 23, 2002, at the recommendation of our audit committee, we dismissed Arthur Andersen LLP as our independent public accountants and engaged Deloitte & Touche LLP to serve as our independent public accountants for fiscal year 2002. Our audited consolidated financial statements for the period from February 20 (inception) to December 31, 2001 and the audited consolidated financial statements of CB Richard Ellis Services for the period from January 1, 2001 through July 20, 2001, which are included in this prospectus, have been audited by Arthur Andersen, our former independent public accountants, as set forth in their report, but Arthur Andersen has not consented to our use of their report in this prospectus. Arthur Andersen completed its audit of our consolidated financial statements for the year ended December 31, 2001 and issued its report relating to these consolidated financial statements on February 26, 2002. Subsequently, Arthur Andersen was convicted of obstruction of justice for the activities relating to its previous work for another of its audit clients and has ceased to audit publicly-held companies. We are unable to predict the impact of this conviction or whether other adverse actions may be taken by governmental or private entities against Arthur Andersen. If Arthur Andersen has no assets available for creditors, you may not be able to recover against Arthur Andersen for any claims you may have under securities or other laws as a result of Arthur Andersen s previous role as our independent public accountants and as author of the audit report for some of the audited financial statements included in this prospectus. CASH AND CASH EQUIVALENTS, AT END OF PERIOD $ 20,066 $ Table of Contents FORWARD-LOOKING STATEMENTS This prospectus includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933. The words anticipate, believe, could, should, propose, continue, estimate, expect, intend, may, plan, predict, project, will and similar terms and phrases are used in this prospectus to identify forward-looking statements. The forward-looking statements in this prospectus include, but are not limited to, statements under the captions Prospectus Summary, Risk Factors, Unaudited Pro Forma Financial Information, Management s Discussion and Analysis of Financial Condition and Results of Operations and Business regarding our future financial condition, prospects, developments and business strategies. These statements relate to analyses and other information based on forecasts of future results and estimates of amounts not yet determinable. These statements also relate to our future prospects, developments and business strategies. These forward-looking statements are made based on our management s expectations and beliefs concerning future events affecting us and are subject to uncertainties and factors relating to our operations and business environment, all of which are difficult to predict and many of which are beyond our control. These uncertainties and factors could cause our actual results to differ materially from those matters expressed in or implied by these forward-looking statements. The following factors are among those that may cause actual results to differ materially from the forward-looking statements: changes in general economic and business conditions; the failure of properties managed by us to perform as anticipated; competition; changes in social, political and economic conditions in the foreign countries in which we operate; foreign currency fluctuations; future acquisitions; integration issues relating to acquired businesses; an economic downturn in the California and New York real estate markets; significant variability in our results of operations among quarters; our substantial leverage and debt service obligations; our ability to incur additional indebtedness; our ability to generate a sufficient amount of cash to service our existing and future indebtedness; the success of our co-investment and joint venture activities; our ability to retain our senior management and attract and retain qualified and experienced employees; our ability to comply with the laws and regulations applicable to real estate brokerage and mortgage transactions; our exposure to liabilities in connection with real estate brokerage and property management activities; the significant influence of our largest stockholders; and the other factors described under the heading titled Risk Factors. Forward-looking statements speak only as of the date the statements are made. You should not put undue reliance on any forward-looking statements. We assume no obligation to update forward-looking statements to reflect actual results, changes in assumptions or changes in other factors affecting forward-looking information, except to the extent required by applicable securities laws. If we do update one or more forward-looking statements, no inference should be drawn that we will make additional updates with respect to those or other forward-looking statements. You should rely only on the information contained in this prospectus. We have not authorized anyone to provide you with information that is different. This prospectus may only be used where it is legal to sell these securities. The information in this prospectus may only be accurate on the date of this prospectus. CB Richard Ellis and the CBRE CB Richard Ellis corporate logo set forth on the cover of this prospectus are the registered trademarks of CB Richard Ellis Group, Inc. and its subsidiaries in the United States. All other trademarks or service marks are trademarks or service marks of the companies that use them. Industry and market data used in this prospectus were obtained from our own research, publicly available studies conducted by third parties and publicly available industry and general publications published by third parties and, in some cases, are management estimates based on its industry and other knowledge. While we believe our research and management estimates are reliable, they have not been verified by independent sources. Some figures in this prospectus may not total due to rounding adjustments. Quarter ending June 30, 2004 (commencing June 10, 2004) $ 19.10 $ 18.20 Quarter ending September 30, 2004 $ 23.64 $ 18.78 Quarter ending December 31, 2004 (through November 23, 2004) $ 26.88 $ 23.51 The closing sale price of our Class A common stock, as reported by the New York Stock Exchange on November 23, 2004, was $25.86. As of October 31, 2004, there were 92 holders of record of our common stock. DIVIDEND POLICY We have not declared or paid any cash dividends on any class of our common stock since our inception on February 20, 2001, and we do not anticipate declaring or paying any cash dividends on our common stock for the foreseeable future. We currently intend to retain any future earnings to finance future growth. Any future determination to pay cash dividends will be at the discretion of our board of directors and will depend on our financial condition, results of operations, capital requirements and other factors the board of directors deems relevant. In addition, our ability to declare and pay cash dividends after the offering will be restricted by the amended and restated credit agreement governing our senior secured credit facilities and the indentures relating to our 9 3/4% senior notes due 2010 and our 11 1/4% senior subordinated notes due 2011. As a result, you will need to sell your shares of common stock to realize a return on your investment, and you may not be able to sell your shares at or above the price you paid for them. Table of Contents [THIS PAGE INTENTIONALLY LEFT BLANK] (1) As of September 30, 2004, no revolving credit facility borrowings were outstanding but an aggregate of $24.3 million of letters of credit were outstanding that reduce the amount we may borrow under our revolving credit facility. Borrowings of up to $150.0 million are available at any one time for general corporate purposes under our revolving credit facility. (2) Includes current portion of $11.8 million due and payable on or prior to September 30, 2005. Our amended and restated credit agreement permits us to borrow up to $25.0 million of additional term loans under our term loan facility, subject to the satisfaction of customary conditions. (3) The amount shown is net of unamortized discount of $2.4 million associated with the issuance of our 11 1/4% senior subordinated notes due 2011. (4) The number of shares of Class A common stock excludes as of September 30, 2004: 5,463,525 shares subject to options issued under our 2001 stock incentive plan at a weighted average exercise price of $5.77 per share, of which options to purchase 1,492,219 shares were then exercisable; 1,265,643 shares subject to options issued under our 2004 stock incentive plan at a weighted average exercise price of $22.33 per share, of which options to purchase 1,715 shares were then exercisable; 2,911,915 shares underlying outstanding stock fund units under our deferred compensation plan, which are issuable in connection with future distributions under the plan pursuant to elections made by plan participants and of which 1,752,931 were then vested; and 5,631,263 additional shares available for future grants under our 2004 stock incentive plan. Table of Contents UNAUDITED PRO FORMA FINANCIAL INFORMATION The following unaudited pro forma financial information is based on the historical financial statements of CB Richard Ellis Group and Insignia included elsewhere in this prospectus. The unaudited pro forma statement of operations for the year ended December 31, 2003 gives effect to the following transactions as if they had occurred on January 1, 2003: Disposition of Real Estate Investment Assets by Insignia the disposition by Insignia Financial Group, Inc. to Island Fund I LLC, immediately prior to the completion of the merger described below on July 23, 2003 and for aggregate cash consideration of $36.9 million, of Insignia s real estate investment assets, which consisted of Insignia subsidiaries and joint ventures that held (1) minority investments in office, retail, industrial, apartment and hotel properties, (2) minority investments in office development projects and a related undeveloped parcel of land, (3) wholly owned or consolidated investments in Norman, Oklahoma, New York City and the U.S. Virgin Islands and (4) investments in private equity funds that invest in mortgage-backed debt securities and other real estate-related assets; and Insignia Acquisition and Related Transactions the acquisition of Insignia by our wholly owned subsidiary, CB Richard Ellis Services, Inc., which occurred pursuant to the merger of Apple Acquisition Corp., a wholly owned subsidiary of CB Richard Ellis Services, with and into Insignia on July 23, 2003; the issuance on May 22, 2003 by CBRE Escrow, Inc., a wholly owned subsidiary of CB Richard Ellis Services, of $200.0 million aggregate principal amount of 9 3/4% senior notes due 2010, which notes were assumed by CB Richard Ellis Services on July 23, 2003 in connection with the merger of CBRE Escrow with and into CB Richard Ellis Services on the same day; the term loan borrowing by CB Richard Ellis Services of $75.0 million on July 23, 2003 pursuant to our amended and restated credit agreement dated May 22, 2003; and fees and expenses related to each of the transactions and financings described in the Insignia Acquisition and Related Transactions bullet points above. The unaudited pro forma financial information is presented for informational purposes only and does not purport to represent what our results of operations or financial position actually would have been had the disposition of real estate investment assets by Insignia and the Insignia acquisition and related transactions in fact occurred on the date specified, nor does the information purport to project our results of operations for any future period or at any future date. The unaudited pro forma financial information does not give effect to the refinancing of all outstanding borrowings under our previous amended and restated credit agreement on October 14, 2003 or any financings or debt repayments or redemptions that we completed during 2004, including: the refinancing of all outstanding borrowings under our amended and restated credit agreement on June 15, 2004; the open market purchases by us of $21.6 million in aggregate principal amount of our 11 % senior subordinated notes in May and June 2004, and the payment of $3.1 million in connection with such purchases; and the issuance and sale by us of 7,726,764 shares of Class A common stock in our initial public offering and the application of the net proceeds we received to (1) the prepayment of $15.0 million in principal amount of the senior secured term loan under our amended and restated credit agreement in June 2004, (2) the redemption of the remaining $38.3 million outstanding principal amount of our 16% senior notes due 2011, including payment of a $3.7 million premium in connection with such redemption, in July 2004, and (3) the redemption of $70.0 million in aggregate principal amount of our 9 % senior notes due 2010, including payment of a $6.8 million premium in connection with such redemption, in July 2004. 21** Subsidiaries of CB Richard Ellis Group, Inc. 23.1* Consent of Deloitte & Touche LLP 23.2* Consent of KPMG LLP 23.3* Consent of Ernst & Young LLP 23.4 Consent of Simpson Thacher & Bartlett LLP (included in Exhibit 5) 10.3 2004 Stock Incentive Plan of CB Richard Ellis Group, Inc. (incorporated by reference to Exhibit 10.3 of the CB Richard Ellis Group, Inc. Amendment No. 2 to Registration Statement on Form S-1 filed with the SEC (No. 333-112867) on April 30, 2004) 10.4 CB Richard Ellis Services, Inc. Amended and Restated Deferred Compensation Plan, as amended (incorporated by reference to Exhibit 10.11 of the CB Richard Ellis Group, Inc. Annual Report on Form 10-K filed with the SEC on March 25, 2003) 10.5 CB Richard Ellis Services, Inc. Amended and Restated 401(k) Plan, as amended (incorporated by reference to Exhibit 10.12 of the CB Richard Ellis Group, Inc. Annual Report on Form 10-K filed with the SEC on March 25, 2003) 10.6 Employment Agreement, dated as of July 20, 2001, between CB Richard Ellis Services, Inc. and Ray Wirta (incorporated by reference to Exhibit 10.13 of the CB Richard Ellis Group, Inc. Registration Statement on Form S-4 (No. 333-70980) filed with the SEC on October 4, 2001) 10.7 Termination of Employment Agreement, effective as of February 15, 2004, between CB Richard Ellis Services, Inc. and Ray Wirta (incorporated by reference to Exhibit 10.6 of the CB Richard Ellis Group, Inc. Annual Report on Form 10-K filed with the SEC on March 30, 2004) 10.8 Full Recourse Note, dated as of April 8, 2004, by and between Ray Wirta and CB Richard Ellis Group, Inc. (incorporated by reference to Exhibit 10.9 of the CB Richard Ellis Group, Inc. Amendment No. 2 to Registration Statement on Form S-1 filed with the SEC (No. 333-112867) on April 30, 2004) 10.9 Pledge Agreement, dated as of April 8, 2004, by and between Ray Wirta and CB Richard Ellis Group, Inc. (incorporated by reference to Exhibit 10.10 of the CB Richard Ellis Group, Inc. Amendment No. 2 to Registration Statement on Form S-1 filed with the SEC (No. 333-112867) on April 30, 2004) 10.10 Amended and Restated Executive Service Agreement, dated as of June 4, 2003, between CB Richard Ellis Limited and Alan Charles Froggatt (incorporated by reference to Exhibit 10.11 of the CB Richard Ellis Group, Inc. Amendment No. 2 to Registration Statement on Form S-1 filed with the SEC (No. 333-112867) on April 30, 2004) 10.11 Employment Agreement, dated as of January 23, 2001, between CB Richard Ellis Pty Ltd. and Robert Blain (incorporated by reference to Exhibit 10.12 of the CB Richard Ellis Group, Inc. Amendment No. 2 to Registration Statement on Form S-1 filed with the SEC (No. 333-112867) on April 30, 2004) 10.12 CB Richard Ellis Deferred Compensation Plan effective as of August 1, 2004 (incorporated by reference to Exhibit 4.1 of the CB Richard Ellis Group, Inc. Registration Statement on Form S-8 filed with the SEC (No. 333-119362) on September 29, 2004) 16 Letter from Ernst & Young LLP confirming its concurrence with the statements made by Insignia Financial Group, Inc. in a current report concerning the dismissal as Insignia s principal accountant (incorporated by reference to Exhibit 16.1 to the Insignia Financial Group, Inc. Current Report on Form 8-K filed with the SEC on April 12, 2002) 21** Subsidiaries of CB Richard Ellis Group, Inc. 23.1* Consent of Deloitte & Touche LLP 23.2* Consent of KPMG LLP 23.3* Consent of Ernst & Young LLP 23.4 Consent of Simpson Thacher & Bartlett LLP (included in Exhibit 5) Table of Contents The unaudited pro forma financial information should be read in conjunction with the other information contained in this prospectus under the headings titled Prospectus Summary Summary Historical and Pro Forma Financial Data, Capitalization, Selected Historical Financial Data and Management s Discussion and Analysis of Financial Condition and Results of Operations and the respective financial statements of CB Richard Ellis Group and Insignia and the related notes included elsewhere in this prospectus. The accompanying notes are an integral part of these financial statements. The Americas 139 2 141 Europe, Middle East and Africa 52 1 53 Asia Pacific 25 1 CASH FLOWS (USED IN) PROVIDED BY OPERATING ACTIVITIES: $ (46,824 ) $ 28,930 $ (31,706 ) $ (21,114 ) $ (70,714 ) CASH FLOWS FROM INVESTING ACTIVITIES: Capital expenditures, net of concessions received (9,163 ) 978 (8,185 ) Acquisition of businesses including net assets acquired, intangibles and goodwill, net of cash acquired (243,847 ) (243,847 ) Other investing activities, net CASH FLOWS (USED IN) PROVIDED BY OPERATING ACTIVITIES $ (30,872 ) $ 5,041 $ 59,797 $ 29,975 $ 63,941 CASH FLOWS FROM INVESTING ACTIVITIES: Capital expenditures, net of concessions received (14,182 ) (12,779 ) (26,961 ) Proceeds from sale of properties and servicing rights 3,753 196 3,949 Acquisition of businesses including net assets acquired, intangibles and goodwill, net of cash acquired (276,401 ) 12,718 (263,683 ) Other investing activities, net (e) Per Rule 11-02 of Regulation S-X, pro forma combined statements of operations are required to disclose income (loss) from continuing operations before nonrecurring charges or credits directly attributable to the transaction. Accordingly, this adjustment removes such charges from the pro forma statement of operations. Table of Contents Recent Developments For the three months ended September 30, 2004, our revenue increased 35.8% to $575.0 million from $423.4 million for the corresponding period in 2003. In addition, we had net income of $11.9 million for the three months ended September 30, 2004 as compared to a net loss of $28.4 million for the corresponding period in 2003. The drivers for this increase in revenue and earnings were (1) significant organic revenue growth fueled by generally improved market conditions in the United States, Europe and Asia, as evidenced by a steady recovery of leasing activity and robust investment property sales during the three months ended September 30, 2004, and (2) continued market share gains in these markets. Our results for the three months ended September 30, 2004 were also favorably impacted by the full-quarter contribution from the Insignia acquisition. In addition, the three months ended September 30, 2003 included significantly greater merger-related, integration and revenue backlog amortization expenses related to the Insignia acquisition than the three months ended September 30, 2004. (1) For purposes of the calculations above, LIBOR is based on the average three-month LIBOR for fiscal year 2003. (h) Represents the reversal of the write-off of unamortized deferred financing costs associated with our prior credit agreement, which was replaced in connection with the Insignia acquisition. (i) Represents the tax effect of the pro forma adjustments included in notes (b) through (h) above at the respective statutory rates. (j) The pro forma weighted average shares number gives effect to the 2,363,598 shares of Class A common stock of CB Richard Ellis Group and the 18,421,621 shares of Class B common stock of CB Richard Ellis Group issued in connection with the Insignia acquisition, as though such shares were issued on January 1, 2003. (Dollars in thousands, except share data) Statement of Operations Data: Revenue $ 1,566,907 $ 1,008,817 $ 1,630,074 $ 1,170,277 $ 562,828 $ 607,934 $ 1,323,604 $ 1,213,039 Operating income (loss) 60,772 6,694 25,830 96,736 61,178 (17,048 ) 100,780 71,387 Interest expense, net 49,835 49,115 67,696 57,229 27,290 18,736 39,146 37,438 Loss on extinguishment of debt 21,075 6,840 13,479 Net (loss) income (1,708 ) (24,620 ) (34,704 ) 18,727 17,426 (34,020 ) 33,388 23,282 EPS (3)(4): Basic (0.03 ) (0.52 ) (0.68 ) 0.45 0.80 (1.60 ) 1.60 1.11 Diluted (0.03 ) (0.52 ) (0.68 ) 0.44 0.79 (1.60 ) 1.60 1.10 Weighted average shares (4)(5): Basic 66,006,231 46,995,364 50,918,572 41,640,576 21,741,351 21,306,584 20,931,111 20,998,097 Diluted 66,006,231 46,995,364 50,918,572 42,185,989 21,920,915 21,306,584 21,097,240 21,072,436 Statement of Cash Flow Data: Net cash provided by (used in) operating activities $ 38,605 $ (70,714 ) $ 63,941 $ 64,882 $ 91,334 $ (120,230 ) $ 80,859 $ 70,340 Net cash provided by (used in) investing activities 8,821 (252,684 ) (284,795 ) (24,130 ) (261,393 ) (12,139 ) (32,469 ) (23,096 ) Net cash (used in) provided by financing activities (61,721 ) 328,498 303,664 (17,838 ) 213,831 126,230 (53,523 ) (37,721 ) Other Data: EBITDA (6) $ 110,893 $ 69,447 $ 132,817 $ 130,676 $ 74,930 $ 11,482 $ 150,484 $ 117,369 Note: We and our predecessor have not declared any cash dividends for the periods shown. (1) The actual results for the year ended December 31, 2003 include the activities of Insignia from July 23, 2003, the date Insignia was acquired by our wholly owned subsidiary, CB Richard Ellis Services. (2) The results for the period from February 20 (inception) to December 31, 2001 include the activities of CB Richard Ellis Services from July 20, 2001, the date we acquired CB Richard Ellis Services. (3) EPS represents (loss) earnings per share. See (loss) earnings per share information in note 14 to our unaudited consolidated financial statements and note 16 to our audited consolidated financial statements, both included elsewhere in this prospectus. (4) EPS and weighted average shares for our predecessor company do not reflect the 3-for-1 stock split of our outstanding Class A common stock and Class B common stock effected on May 4, 2004, or the 1-for-1.0825 reverse stock split of our outstanding Class A common stock and Class B common stock effected on June 7, 2004 because our predecessor was a different legal entity. (5) For the period from February 20 (inception) to December 31, 2001, the 21,741,351 and the 21,920,915 shares represent the weighted average shares outstanding for basic and diluted earnings per share, respectively. These balances take into consideration the lower number of shares outstanding prior to July 20, 2001, the date we acquired CB Richard Ellis Services. (6) EBITDA represents earnings before net interest expense, loss on extinguishment of debt, income taxes, depreciation and amortization. Our management believes EBITDA is useful to investors because it is frequently used by securities analysts, investors and other interested parties in the evaluation of companies in our industry. In addition, our management believes that EBITDA is useful in evaluating our operating performance compared to that of other companies in our industry because the calculation of EBITDA generally eliminates the effects of financing and income taxes and the accounting effects of capital spending and acquisitions, which items may vary for different companies for reasons unrelated to overall operating performance. As a result, our management uses EBITDA as a measure to evaluate the performance of our various business lines and for other discretionary purposes, including as a significant component when measuring our performance under our employee incentive programs. However, EBITDA is not a recognized measurement under U.S. generally accepted accounting principles, or GAAP, and when analyzing our operating performance, investors should use EBITDA in addition to, and not as an alternative for, operating income (loss) and net (loss) income, each as determined in accordance with GAAP. Because not all companies use identical calculations, our presentation of EBITDA may not be comparable to similarly titled measures of other companies. Furthermore, EBITDA is not intended to be a measure of free cash flow for our management s discretionary use, as it does not consider certain cash requirements such as tax and debt service payments. The amounts shown for EBITDA also differ from the amounts calculated under similarly titled definitions in our debt instruments, which are further adjusted to reflect certain other cash and non-cash charges and are used to determine compliance with financial covenants and our ability to engage in certain activities, such as incurring additional debt and making certain restricted payments. Table of Contents Summary Historical and Pro Forma Financial Data The following table is a summary of our historical consolidated financial data as of and for the periods presented, as well as pro forma financial data giving effect to our acquisition of Insignia and the related transactions and financings for such acquisition for the period presented. On July 20, 2001, we acquired CB Richard Ellis Services, Inc. Except as otherwise indicated below, the statement of operations data, statement of cash flow data and other data for the period ended July 20, 2001 are derived from the consolidated financial statements of CB Richard Ellis Services, our predecessor company. You should read this data along with the information included under the headings titled Management s Discussion and Analysis of Financial Condition and Results of Operations and Unaudited Pro Forma Financial Information and the financial statements and related notes included elsewhere in this prospectus. The pro forma financial data do not purport to represent what our results of operations would have been if the Insignia acquisition and the related transactions and financings had occurred as of the date indicated or what our results will be for future periods. Pro Forma (1) CB Richard Ellis Group Table of Contents MANAGEMENT S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This prospectus contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in forward-looking statements for many reasons, including the risks described under the heading Risk Factors and elsewhere in this prospectus. You should read the following discussion in conjunction with the information included under the headings titled Unaudited Pro Forma Financial Information and Selected Historical Financial Data and the financial statements and related notes included elsewhere in this prospectus. Overview We are the largest global commercial real estate services firm, based on 2003 revenue, offering a full range of services to occupiers, owners, lenders and investors in office, retail, industrial, multi-family and other commercial real estate assets. As of December 31, 2003 we operated in 220 offices worldwide with over 13,500 employees, excluding affiliate and partner offices, providing commercial real estate services under the CB Richard Ellis brand name. Our business is focused on several service competencies, including strategic advice and execution assistance for property leasing and sales, forecasting, valuations, origination and servicing of commercial mortgage loans, facilities and project management and real estate investment management. We generate revenues both on a per project or transaction basis and from annual management fees. When you read our financial statements and the information included in this section, you should consider that we have experienced, and continue to experience, several material trends and uncertainties that have affected our financial condition and results of operations and make it challenging to predict our future performance based on our historical results. We believe that the following material trends and uncertainties are most crucial to an understanding of the variability in our historical earnings and cash flows and the potential for such variances in the future: Macroeconomic Conditions Economic trends and government policies directly affect our operations as well as global and regional commercial real estate markets generally. These include overall economic activity and employment growth, interest rate levels, the availability of credit to finance transactions and the impact of tax and regulatory policies. Periods of economic slowdown or recession, significantly rising interest rates, a declining employment level, a declining demand for real estate or the public perception that any of these events may occur, can reduce volumes for many of our business lines. Weak economic conditions could result in a general decline in rents, which, in turn, would reduce revenue from property management fees and brokerage commissions derived from property sales and leases. In addition, these conditions could lead to a decline in sales prices as well as a decline in funds invested in commercial real estate and related assets. An economic downturn or a significant increase in interest rates also may reduce the amount of loan originations and related servicing by our commercial mortgage banking business. If our brokerage and mortgage banking businesses are negatively impacted, it is likely that our other lines of business would also suffer due to the relationship among our various business lines. During 2002 and 2001, we were adversely affected by the slowdown in the United States economy, which negatively impacted the commercial real estate market generally. This caused a decline in our leasing activities within the United States. Moreover, in part because of the terrorist attacks on September 11, 2001 and the run-up to the conflict with Iraq, the economic climate in the United States became very uncertain, which had an adverse effect on commercial real estate market conditions and, in turn, our operating results for 2002 and 2001. During 2003 and the first three-quarters of 2004, economic conditions in the United States improved, which positively impacted the commercial real estate market generally. This caused an improvement in our Americas segment s revenue, particularly in sales and leasing activities. We expect this trend to continue in the near term. Predecessor Company Table of Contents Our management team primarily addresses adverse changes in economic conditions through our compensation structure. Compensation is our largest expense, and the sales and leasing professionals in our largest line of business, advisory services, generally are paid on a commission and bonus basis that correlates with our revenue performance. As a result, the negative effect on our operating margins during difficult market conditions is partially mitigated. In addition, in circumstances when economic conditions are particularly severe, our management also has sought to improve operational performance through cost reduction programs. For example, as economic conditions worsened in 2001, our management team made targeted reductions in our workforce, reduced senior management bonuses, streamlined general and administrative operations and cut capital expenditures and other discretionary operating expenses. After our acquisition of CB Richard Ellis Services in 2001, our management also instituted a best practices program branded People, Platform & Performance in order to implement and encourage new business practices that would result in lower operating expenses and enhance revenue and margin growth. We believe this program significantly contributed to the $18.7 million reduction in our operating expenses during 2002 as compared to 2001. Notwithstanding these approaches, adverse global and regional economic changes remain one of the most significant risks to our future financial condition and results of operations. Effects of Prior Acquisitions Our management historically has made significant use of strategic acquisitions to add new service competencies, to increase our scale within existing competencies and to expand our presence in various geographic regions around the world. For example, we enhanced our mortgage banking services through our 1996 acquisition of L.J. Melody & Company and we significantly increased the scale of our investment management business through our 1995 acquisition of Westmark Realty Advisors and our 1997 acquisition of Koll Real Estate Services. An example of a strategic acquisition that increased our geographic coverage was our 1998 acquisition of Hillier Parker May & Rowden in the United Kingdom. Our largest acquisition to date was our July 23, 2003 acquisition of Insignia Financial Group, which not only significantly increased the scale of our real estate services and outsourcing services business lines in the Americas segment but also significantly increased our presence in the New York, London and Paris metropolitan areas. Although our management believes that strategic acquisitions can significantly decrease the cost, time and commitment of management resources necessary to attain a meaningful competitive position within targeted markets or to expand our presence within our current markets, our management also believes that most acquisitions will initially have an adverse impact on our operating and net income, both as a result of transaction-related expenditures and charges and the costs of integrating the acquired business and its financial and accounting systems into our own. For example, through September 30, 2004, we have incurred $200.9 million of transaction-related expenses in connection with our acquisition of Insignia in 2003 and $87.6 million of transaction-related expenses in connection with our acquisition of CB Richard Ellis Services in 2001. Transaction-related expenses include severance costs, lease termination costs, transaction costs, deferred financing costs and merger-related costs, among others. We do not expect to incur any additional transaction-related expenditures after September 30, 2004 with respect to the Insignia Acquisition. In addition, through September 30, 2004, we have incurred approximately $25.4 million of expenses in connection with the integration of Insignia s business lines, as well as accounting and other systems, into our own. We expect to incur additional integration expenses in connection with the Insignia integration of approximately $2.5 million during the fourth quarter of 2004, approximately $6.5 million during 2005 and approximately $4.0 million during 2006. International Operations We have made significant acquisitions of non-U.S. companies, and we may acquire additional foreign companies in the future. As we increase our foreign operations through either acquisitions or organic growth, fluctuations in the value of the U.S. dollar relative to the other currencies in which we may generate earnings could adversely affect our business, financial condition and operating results. Our management team generally Table of Contents seeks to mitigate our exposure by balancing assets and liabilities that are denominated in the same currency and by maintaining cash positions outside the United States only at levels necessary for operating purposes. In addition, from time to time we enter into foreign currency forward exchange contracts to mitigate our exposure to exchange rate changes related to particular transactions. Prior to 2004, our management historically had not entered into agreements to hedge the risks associated with the translation of foreign currencies into U.S. dollars. On April 6, 2004, we entered into an option agreement to purchase an aggregate notional amount of 8.7 million British pounds sterling for a cost of $0.6 million, which would have expired on December 29, 2004. On July 2, 2004, we entered into an option agreement to purchase an aggregate notional amount of 18.8 million euros for a cost of $0.07 million, which also would have expired on December 29, 2004. During October 2004, we sold both of these option agreements and entered into two new option agreements to purchase an aggregate notional amount of 10.2 million British pounds sterling for a cost of $0.3 million and 20.0 million euros for a cost of $0.4 million, both of which expire on December 29, 2004. The net impact on our earnings resulting from gains and/or losses on these option agreements has not been, and is not expected to be, material. Due to the constantly changing currency exposures to which we are subject and the volatility of currency exchange rates, our management cannot predict the effect of exchange rate fluctuations upon future operating results. In addition, fluctuations in currencies relative to the U.S. dollar may make it more difficult to perform period-to-period comparisons of our reported results of operations. Our international operations also are subject to, among other things, political instability and changing regulatory environments, which may adversely affect our future financial condition and results of operations. Our management routinely monitors these risks and costs and evaluates the appropriate amount of resources to allocate towards business activities in foreign countries where such risks and costs are particularly significant. Leverage We are highly leveraged and have significant debt service obligations. Although our management believes that the incurrence of this long-term indebtedness has been important in funding the growth of our business, including facilitating our acquisition of Insignia Financial Group in 2003, the cash flow necessary to service this debt is not available for other general corporate purposes, which may limit our flexibility in planning for, or reacting to, changes in our business and in the commercial real estate services industry. Our management seeks to mitigate this exposure both through the refinancing of debt when available on attractive terms and through selective repayment and retirement of indebtedness. For example, we refinanced our senior secured credit facilities in October 2003 and June 2004 to obtain more attractive interest rates and other terms, redeemed $30.0 million in aggregate principal amount of our 16% senior notes in late 2003 and repurchased $21.6 million in aggregate principal amount of our 11 1/4% senior subordinated notes in the open market during May and June 2004. In addition, on June 15, 2004 we received aggregate net proceeds of approximately $135.0 million, after deducting underwriting discounts and commissions and offering expenses payable by us, in connection with the sale of 7,726,764 shares of our Class A common stock pursuant to the completion of our initial public offering. During June 2004, we used a portion of the net proceeds received from our initial public offering to prepay $15.0 million in principal amount of the term loan under our amended and restated credit agreement, and during July 2004 we used the remaining net proceeds we received from our initial public offering to redeem all $38.3 million in aggregate principal amount of our remaining outstanding 16% senior notes and $70.0 million in aggregate principal amount of our 9 3/4% senior notes. In addition, we amended our amended and restated credit agreement, effective November 16, 2004, to reduce the interest rates applicable to the term loan facility and to modify some of the restrictive covenants in the agreement. Our management expects to continue to look for opportunities to reduce, and improve the terms of, our debt in the future. Notwithstanding the actions described above, however, our level of indebtedness and the operating and financial restrictions in our debt agreements both place constraints on the operation of our business. Nine Months Ended September 30, Table of Contents Basis of Presentation Recent Significant Acquisitions and Dispositions On July 20, 2001, we acquired CB Richard Ellis Services, Inc. pursuant to an amended and restated agreement and plan of merger, dated as of May 31, 2001, among CB Richard Ellis Group (formerly known as CBRE Holding, Inc.), CB Richard Ellis Services and Blum CB Corp., a wholly owned subsidiary of CB Richard Ellis Group. Blum CB was merged with and into CB Richard Ellis Services, with CB Richard Ellis Services being the surviving corporation. At the effective time of such merger, CB Richard Ellis Services became a wholly owned subsidiary of CB Richard Ellis Group. Our results of operations, including our segment operations and cash flows, for the year ended December 31, 2001 have been derived by combining the results of operations and cash flows of CB Richard Ellis Group for the period from February 20 (inception) to December 31, 2001 with the results of operations and cash flows of CB Richard Ellis Services, our predecessor, from January 1, 2001 to July 20, 2001, the date of the merger. The results of operations and cash flows of our predecessor prior to the merger incorporated in the following discussion are the historical results and cash flows of our predecessor. These results of our predecessor do not reflect any purchase accounting adjustments, which are included in our results subsequent to the merger. Due to the effects of purchase accounting applied as a result of the merger and the additional interest expense associated with the debt incurred to finance the merger, our results of operations may not be comparable in all respects to the results of operations for our predecessor prior to the merger. However, our management believes a discussion of our 2001 operations is more meaningful by combining our results with the results of our predecessor. On July 23, 2003, pursuant to an amended and restated agreement and plan of merger, dated as of May 28, 2003, by and among CB Richard Ellis Services, CB Richard Ellis Group, Apple Acquisition Corp., a Delaware corporation and wholly owned subsidiary of CB Richard Ellis Services, and Insignia Financial Group, Inc., Apple Acquisition was merged with and into Insignia Financial Group. Insignia Financial Group was the surviving corporation in the Insignia acquisition and at the effective time of the Insignia acquisition became a wholly owned subsidiary of CB Richard Ellis Services. Segment Reporting We report our operations through three geographically organized segments: (1) the Americas, (2) Europe, Middle East and Africa, or EMEA, and (3) Asia Pacific. The Americas consists of operations located in the United States, Canada, Mexico and South America. EMEA mainly consists of operations in Europe, while Asia Pacific includes operations in Asia, Australia and New Zealand. Year Ended December 31, (Dollars in thousands) Revenue $ 1,630,074 100.0 % $ 1,170,277 100.0 % $ 1,170,762 100.0 % Costs and expenses: Cost of services 796,408 48.8 547,093 46.7 542,804 46.4 Operating, administrative and other 678,397 41.6 501,798 42.9 517,405 44.2 Depreciation and amortization 92,622 5.7 24,614 2.1 37,854 3.2 Merger-related and other nonrecurring charges 36,817 2.3 EBITDA represents earnings before net interest expense, loss on extinguishment of debt, income taxes, depreciation and amortization. Our management believes EBITDA is useful to investors because it is frequently used by securities analysts, investors and other interested parties in the evaluation of companies in our industry. (Dollars in thousands) The Americas Revenue $ 1,197,626 100.0 % $ 896,064 100.0 % $ 928,799 100.0 % Costs and expenses: Cost of services 609,619 50.9 438,842 49.0 448,813 48.3 Operating, administrative and other 474,317 39.6 367,360 41.0 388,645 41.8 Depreciation and amortization 58,216 4.9 16,958 1.9 27,452 3.0 Merger-related and other nonrecurring charges 20,367 1.7 Revenue $ 1,630,074 $ 1,170,277 $ 562,828 $ 607,934 Costs and expenses: Cost of services 796,408 547,093 263,601 279,203 Operating, administrative and other 678,397 501,798 219,409 297,996 Depreciation and amortization 92,622 24,614 12,198 25,656 Merger-related and other nonrecurring charges 36,817 Revenue $ $ $ 849,563 $ 320,714 $ $ 1,170,277 Costs and expenses: Cost of services 413,830 133,263 547,093 Operating, administrative and other 415 1,186 345,279 154,918 501,798 Depreciation and amortization 15,833 8,781 24,614 Merger-related and other nonrecurring charges 36 Period from February 20 (inception) to December 31, 2001 (3) Nine Months Ended September 30, 2004 Compared to Nine Months Ended September 30, 2003 We reported a consolidated net loss of $1.7 million for the nine months ended September 30, 2004 on revenue of $1.6 billion as compared to a consolidated net loss of $24.6 million on revenue of $1.0 billion for the nine months ended September 30, 2003. Table of Contents Our revenue on a consolidated basis increased by $558.1 million, or 55.3%, as compared to the nine months ended September 30, 2003. The increase was primarily driven by the combination of the Insignia acquisition and organic market share growth sustained by the improvement of general economic conditions in the United States. This was evidenced by higher revenues in our Americas and EMEA business segments, particularly relative to sales and lease transaction revenue as well as management and consulting fees. In addition, in our EMEA business segment we experienced an increase in appraisal fees. Also, with the anticipation of rising interest rates in the United States during the first half of the year, we experienced an increase in loan origination fees in our Americas business segment. Foreign currency translation had a $46.8 million positive impact on total revenue during the nine months ended September 30, 2004. Our cost of services on a consolidated basis increased by $313.1 million, or 64.6%, as compared to the nine months ended September 30, 2003. Our sales and leasing professionals generally are paid on a commission and bonus basis, which substantially correlates with our revenue performance. Accordingly, the overall increase was primarily driven by the overall increase in revenue. The Insignia acquisition has contributed to higher payroll-related costs, including bonus accruals, insurance and benefits, producer retention and broker draw amortization. The producer retention expense, which represents amounts paid to the top real estate advisory services professionals that we retained at the time of the acquisition, is being amortized through cost of services over the lives of the related employment agreements. As part of our refinement of the purchase price allocation for the Insignia acquisition, during the three months ended March 31, 2004, we assigned a $6.6 million fair value to a broker draw asset acquired in the Insignia acquisition. Based on our management s estimates, we generally derive benefit from brokers participating in our draw program over two years. Accordingly, we estimated that we would derive benefit from the broker draw asset related to Insignia s brokers over two years from the date of the Insignia acquisition and, accordingly, we are amortizing it on a straight-line basis, which reflects the pattern in which the economic benefits of the broker draw asset are consumed, during that period. During the nine months ended September 30, 2004, we have recorded $3.9 million for the amortization of this broker draw asset, which includes a $1.4 million adjustment to correct the amortization taken for the period from the date of the Insignia Acquisition through December 31, 2003. The producer retention and the broker draw amortization are considered integration costs associated with the Insignia acquisition and together amounted to $8.2 million for the nine months ended September 30, 2004. Foreign currency translation had a $20.8 million negative impact on cost of services during the nine months ended September 30, 2004. Cost of services as a percentage of revenue increased from 48.0% for the nine months ended September 30, 2003 to 50.9% for the nine months ended September 30, 2004, primarily driven by producers reaching higher commission tranches as a result of higher revenue and due to the producer retention and broker draw amortization recorded in 2004 as well as the new mix of compensation structures as a result of compensation plans adopted in the Insignia acquisition. Our operating, administrative and other expenses on a consolidated basis were $643.0 million, an increase of $198.7 million, or 44.7%, for the nine months ended September 30, 2004 as compared to the nine months ended September 30, 2003. The increase was primarily driven by higher costs as a result of the Insignia acquisition, including $3.6 million of integration costs, as well as increased worldwide payroll-related expenses, such as bonuses and insurance and benefits and increased marketing expenses. Higher occupancy expenses, particularly in our EMEA business segment, the write-down of investments of $3.0 million in our Americas business segment as well as professional fees of $2.7 million in the current year related to the ongoing Sarbanes-Oxley compliance work also contributed to the variance. During the nine months ended September 30, 2004, we also incurred one-time compensation expense of $15.0 million related to bonus payments that were triggered by our initial public offering and were payable to several of our non-executive real estate advisory services employees as a result of provisions in their employment agreements. Additionally, during the nine months ended September 30, 2003 total operating expenses were reduced by substantial net foreign transaction gains as the dollar was very weak particularly relative to the Australian and New Zealand dollars, while in the nine months ended September 30, 2004 we experienced only moderate net foreign currency transaction losses. Finally, foreign currency translation had a $22.5 million negative impact on total operating expenses during the nine months ended September 30, 2004. Table of Contents Our depreciation and amortization expense on a consolidated basis decreased by $13.6 million, or 25.3%, for the nine months ended September 30, 2004 as compared to the nine months ended September 30, 2003. The decrease was largely due to lower amortization expense related to intangibles acquired in the Insignia acquisition, including a reduction in amortization expense of $20.7 million related to acquired net revenue backlog. As of September 30, 2004, the net book value of the intangible asset representing the remaining net revenue backlog acquired in the Insignia acquisition was $2.8 million and is expected to be fully amortized by the end of 2004. Partially offsetting the aforementioned decrease in amortization expense was a $5.2 million increase in depreciation expense during 2004 mainly related to depreciation expense associated with fixed assets acquired in the Insignia acquisition. Our merger-related charges on a consolidated basis were $25.6 million and $19.8 million for the nine months ended September 30, 2004 and 2003, respectively. The charges for both years primarily consisted of lease termination costs associated with vacated spaces, consulting costs and severance costs, all of which were attributable to the Insignia acquisition. Our equity income from unconsolidated subsidiaries on a consolidated basis increased $0.9 million, or 10.2%, for the nine months ended September 30, 2004 as compared to the nine months ended September 30, 2003, primarily due to a one-time incentive fee of $0.9 million received from an investment fund as well as improved overall performance of our equity investments in the United States and Japan. These increases were partially offset, on a year over year comparison basis, by the impact of a one-time gain on the sale of owned units in an investment fund recognized in the prior year. Our consolidated interest expense was $52.1 million for the nine months ended September 30, 2004, which was relatively flat in comparison to the nine months ended September 30, 2003. The slight increase was driven by higher interest expense as a result of the additional debt issued in connection with the Insignia acquisition offset by the interest savings realized as a result of debt repayments during the fourth quarter of 2003 and throughout 2004. As a result of our de-leveraging efforts to date in 2004, we expect to achieve annual cash interest savings in 2005 of approximately $16.0 million. Our loss on the extinguishment of debt on a consolidated basis was $21.1 million and $6.8 million for the nine months ended September 30, 2004 and 2003, respectively. The loss incurred during the current year was related to the write-offs of unamortized deferred financing fees and unamortized discount, as well as premiums paid, all in connection with the redemptions of $70.0 million in aggregate principal amount of our 9 3/4% senior notes and $38.3 million in aggregate principal amount of our 16.0% senior notes with the net proceeds received from our initial public offering. Additionally, we incurred a loss of $4.0 million in the second quarter of 2004 related to the write-offs of unamortized deferred financing fees and unamortized discount, as well as premiums paid, in connection with the $21.6 million repurchase of our 11 1/4% senior subordinated notes in the open market during May and June 2004. The loss in the prior year related to the write-off of unamortized deferred financing fees associated with a prior credit facility, which was replaced in connection with the Insignia acquisition. Our provision for income taxes on a consolidated basis was $1.7 million for the nine months ended September 30, 2004 as compared to a benefit for income taxes of $15.5 million for the nine months ended September 30, 2003. The unusual tax rate for the nine months ended September 30, 2004 was primarily related to losses sustained in jurisdictions where no tax benefit can be provided. Year Ended December 31, 2003 Compared to Year Ended December 31, 2002 We reported a consolidated net loss of $34.7 million for the year ended December 31, 2003 on revenue of $1.6 billion as compared to consolidated net income of $18.7 million on revenue of $1.2 billion for the year ended December 31, 2002. Our revenue on a consolidated basis increased $459.8 million, or 39.3%, during the year ended December 31, 2003 as compared to the year ended December 31, 2002. The increase was driven by higher Table of Contents revenue as a result of our capturing a larger market share in our Americas real estate services business line through our acquisition of Insignia, particularly leasing activity in the New York area. Additionally, as a result of the improvement of general economic conditions in the United States, we experienced significantly higher sales transaction revenue as well as increased lease transaction revenue and appraisal fees. Internationally, the Insignia acquisition helped us to expand our reach in Europe as evidenced by increased sales and lease transaction revenue, as well as higher consultation and appraisal fees, particularly in London and Paris. We expect that this increased revenue level will be maintained in the near term. Lastly, foreign currency translation had a $54.4 million positive impact on total revenue during the year ended December 31, 2003. Our cost of services on a consolidated basis totaled $796.4 million, an increase of $249.3 million, or 45.6%, from the year ended December 31, 2002. This increase was mainly due to higher commission expense, bonus accruals and producer retention expense as a result of the Insignia acquisition as well as increased worldwide sales and lease transaction revenue. Our sales and leasing professionals are paid on a commission and bonus basis, which generally correlates with our revenue performance. Accordingly, as revenue increases, cost of services will also increase. Additionally, we paid bonuses to the top advisory services professionals of Insignia that we retained in the acquisition. The producer retention expense represents the amortization of these bonuses, which are being amortized to cost of services over the lives of the related employment agreements. The producer retention expense is considered an integration cost associated with the Insignia acquisition and amounted to $2.7 million for the year ended December 31, 2003. Also contributing to the increase in cost of services over the prior year was increased worldwide payroll related costs, including worldwide insurance and pension expense in the United Kingdom, which were mainly driven by increased headcount resulting from the Insignia acquisition. Finally, foreign currency translation had a $23.9 million negative impact on cost of services during the year ended December 31, 2003. Our operating, administrative and other expenses on a consolidated basis were $678.4 million, an increase of $176.6 million, or 35.2 %, for the year ended December 31, 2003 as compared to the year ended December 31, 2002. The increase was primarily driven by higher costs as a result of the Insignia acquisition, including $10.9 million of integration costs, as well as increased worldwide bonuses and payroll-related expenses, principally in the Americas and Europe. Included in the 2003 bonus amount was an accrual for a one-time performance award of approximately $6.9 million. We expect to pay higher bonuses in 2004 as we will incur a nonrecurring charge of $15.0 million for compensation expenses relating to bonus payments triggered by the offering, which are payable to several of our non-executive real estate services employees as a result of provisions in such employees employment agreements. Also contributing to the variance was a legal settlement in the United States in 2003 as well as higher occupancy expense in the United Kingdom as a result of our relocation to a new facility in 2003. Lastly, foreign currency translation had a $23.4 million negative impact on total operating expenses during the year ended December 31, 2003. These increases were partially offset by net foreign currency translation gains resulting from the weaker U.S. dollar. Over 2003 and 2002, the U.S. dollar has continued to weaken, which has resulted in our recognizing foreign currency translation gains. Due to the volatility of currency exchange rates, there is no way for us to predict if this trend will continue in the future. Our depreciation and amortization expense on a consolidated basis increased by $68.0 million, or 276.3%, for the year ended December 31, 2003 as compared to the year ended December 31, 2002 mainly due to $59.1 million of amortization of the net revenue backlog acquired as part of the Insignia acquisition. As of December 31, 2003, the net book value of the intangible asset representing the remaining net revenue backlog acquired in the Insignia acquisition was $13.4 million, which is expected to be fully amortized by the end of 2004 (see note 8 of our audited consolidated financial statement included elsewhere in this prospectus). The increase over the prior year was also due to a one-time reduction of amortization expense recorded in 2002 related to the adjustment of certain intangible assets to their estimated fair values as of their acquisition date in connection with our acquisition of CB Richard Ellis Services in 2001. Our equity income from unconsolidated subsidiaries on a consolidated basis increased $5.0 million, or 54.0%, for the year ended December 31, 2003 as compared to the year ended December 31, 2002, primarily due 2003 (2) Table of Contents to a one-time gain on sale of owned units in an investment fund. In addition, the trend of improved performance in our other domestic joint ventures continued, but was offset by a decrease in equity income versus the prior year as a result of a one-time disposition fee received in 2002 upon liquidation of one of our U.S. joint ventures in the normal course of business upon completion of the investment strategy set forth in its joint venture agreement. Our merger-related charges on a consolidated basis were $36.8 million for the year ended December 31, 2003. These charges primarily consisted of lease termination costs associated with vacated spaces, change of control payments, consulting costs and severance costs, all of which were attributable to the Insignia acquisition. Our consolidated interest expense was $71.3 million for the year ended December 31, 2003, an increase of $10.8 million, or 17.8%, as compared to the year ended December 31, 2002. This increase was primarily driven by the new debt incurred in connection with the Insignia acquisition. Our loss on extinguishment of debt on a consolidated basis was $13.5 million for the year ended December 31, 2003. The loss resulted from a $6.8 million write-off of unamortized deferred financing fees associated with a prior credit facility, which was replaced in connection with the Insignia acquisition, as well as $6.7 million of write-offs of unamortized deferred financing fees and unamortized discount, as well as premiums paid, in connection with the $30.0 million of redemptions of our 16% senior notes in the fourth quarter of 2003. Our benefit for income tax on a consolidated basis was $6.3 million for the year ended December 31, 2003 as compared to a provision for income tax of $30.1 million for the year ended December 31, 2002. The income tax (benefit) provision and effective tax rate generally were not comparable between periods due to the effects of the Insignia acquisition. Additionally, non-deductible expenses contributed to a lower effective tax benefit rate in 2003 as compared to 2002. Year Ended December 31, 2002 Compared to Year Ended December 31, 2001 We reported consolidated net income of $18.7 million for the year ended December 31, 2002 on revenue of $1.2 billion as compared to a consolidated net loss of $16.6 million on revenue of $1.2 billion for the year ended December 31, 2001. Our revenue on a consolidated basis for the year ended December 31, 2002 was comparable to the year ended December 31, 2001. Overall revenue decreased in our Americas segment primarily caused by declines in lease transaction revenue, which were driven by the continued softness in the leasing industry in the United States as a result of general economic uncertainty, combined with a nonrecurring sale of mortgage fund contracts of $5.6 million in 2001. In Asia Pacific, revenue declined mainly due to the sale of our wholly-owned operations in Thailand, the Philippines and India. These decreases were mostly offset by higher worldwide sales transaction revenue driven by investment property sales and higher investment management fees in Japan as result of the expansion of this business in that region. Foreign currency translation had a $10.5 million positive impact on total revenue during the year ended December 31, 2002. Our cost of services on a consolidated basis totaled $547.1 million for the year ended December 31, 2002, an increase of $4.3 million, or 0.8%, from the year ended December 31, 2001. This increase was primarily due to higher compensation of advisory services professionals within our international operations associated with expanded international activities. These increases were partially offset by lower variable commissions, principally in our Americas segment, driven by lower lease transaction revenue. Foreign currency translation had a $4.2 million negative impact on cost of services during the year ended December 31, 2002. Our operating, administrative and other expenses on a consolidated basis were $501.8 million for the year ended December 31, 2002, a decrease of $15.6 million, or 3.0%, as compared to the year ended December 31, 2001. This decrease was primarily driven by cost reduction measures and operational efficiencies from programs initiated in May 2001, as well as foreign currency transaction and settlement gains resulting from the weaker U.S. dollar. The trend of foreign currency transaction gains resulting from the weakening of the U.S. dollar has Table of Contents continued in 2003. These reductions were partially offset by an increase in bonuses and other incentives, primarily within our international operations, due to improved results. Foreign currency translation also had a $4.1 million negative impact on total operating expenses during the year ended December 31, 2002. Our depreciation and amortization expense on a consolidated basis decreased by $13.2 million, or 35.0%, for the year ended December 31, 2002 as compared to the year ended December 31, 2001 was mainly due to the discontinuation of goodwill amortization after our acquisition of CB Richard Ellis Services in 2001 in accordance with Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets, or SFAS No. 142, and lower depreciation expense, principally due to lower capital expenditures for the year ended December 31, 2002. The lower capital expenditures resulted from cost reduction measures initiated in 2001. Our capital expenditures increased in 2003 primarily as a result of our planned relocation to a new facility in the United Kingdom in 2003. The year ended December 31, 2002 also included a one-time reduction of amortization expense of $2.0 million arising from the adjustment of certain intangible assets to their estimated fair values as of July 20, 2001, the date we acquired CB Richard Ellis Services. Our equity income from unconsolidated subsidiaries increased by $4.9 million, or 110.6%, for the year ended December 31, 2002 as compared to the year ended December 31, 2001, primarily due to a $2.2 million nonrecurring disposition fee received upon liquidation of one of our joint ventures in the United States in the normal course of business, upon completion of the investment strategy set forth in its joint venture agreement, as well as the improved performance from several of our other domestic joint ventures. Earnings from these domestic joint ventures continued to increase during 2003 as general economic conditions improved in the United States. Our merger-related and other nonrecurring charges on a consolidated basis were $28.6 million for the year ended December 31, 2001. These costs primarily consisted of merger-related charges of $18.3 million, the write-off of assets, primarily e-business investments, of $7.2 million as well as severance costs of $3.1 million related to our cost reduction program initiated in May 2001. Our consolidated interest expense was $60.5 million, an increase of $10.5 million, or 21.0%, over the year ended December 31, 2001. This was primarily attributable to our change in debt structure in connection with our acquisition of CB Richard Ellis Services in 2001. Our income tax expense on a consolidated basis was $30.1 million for the year ended December 31, 2002 as compared to $19.1 million for the year ended December 31, 2001. The income tax provision and effective tax rate were not comparable between periods due to effects of our acquisition of CB Richard Ellis Services in 2001 and the adoption of SFAS No. 142, which resulted in the elimination of the amortization of goodwill. In addition, non-deductible losses associated with our deferred compensation plan contributed to an increased effective tax rate. Segment Operations The following tables summarize our revenue, costs and expenses and operating income (loss) by operating segment for the nine months ended September 30, 2004 and 2003 and for the years ended December 31, 2003, 2002 and 2001. Our Americas results for the nine months ended September 30, 2004 and 2003 include merger-related charges of $22.0 million and $15.9 million, respectively, attributable to the Insignia acquisition. Our Americas 2003 results include merger-related charges of $20.4 million attributable to the acquisition of Insignia. Our Americas 2001 results include a nonrecurring sale of mortgage fund contracts of $5.6 million, as well as merger-related and other nonrecurring charges of $26.9 million attributable to our acquisition of CB Richard Ellis Services. Our EMEA results for the nine months ended September 30, 2004 and 2003 include merger-related charges of $3.5 million and $3.9 million, respectively, attributable to the Insignia acquisition. Our EMEA 2003 results include merger-related charges of $16.0 million attributable to the Insignia acquisition. Our Asia Pacific 2001 results include merger-related and other nonrecurring charges of $1.2 million attributable to the acquisition of CB Richard Ellis Services. (Dollars in thousands, except share data) Statement of Operations Data: Revenue $ 1,948,827 $ 1,566,907 $ 1,008,817 $ 1,630,074 $ 1,170,277 $ 562,828 $ 607,934 Operating income (loss) 17,871 60,772 6,694 25,830 96,736 61,178 (17,048 ) Interest expense, net 78,411 49,835 49,115 67,696 57,229 27,290 18,736 Loss on extinguishment of debt 6,639 21,075 6,840 13,479 Net (loss) income (43,923 ) (1,708 ) (24,620 ) (34,704 ) 18,727 17,426 (34,020 ) EPS (4)(5): Basic (0.70 ) (0.03 ) (0.52 ) (0.68 ) 0.45 0.80 (1.60 ) Diluted (0.70 ) (0.03 ) (0.52 ) (0.68 ) 0.44 0.79 (1.60 ) Weighted average shares (5)(6): Basic 62,478,565 66,006,231 46,995,364 50,918,572 41,640,576 21,741,351 21,306,584 Diluted 62,478,565 66,006,231 46,995,364 50,918,572 42,185,989 21,920,915 21,306,584 Statement of Cash Flow Data: Net cash provided by (used in) operating activities $ 38,605 $ (70,714 ) $ 63,941 $ 64,882 $ 91,334 $ (120,230 ) Net cash provided by (used in) investing activities 8,821 (252,684 ) (284,795 ) (24,130 ) (261,393 ) (12,139 ) Net cash (used in) provided by financing activities (61,721 ) 328,498 303,664 (17,838 ) 213,831 126,230 Other Data: EBITDA (7) $ 135,621 $ 110,893 $ 69,447 $ 132,817 $ 130,676 $ 74,930 $ 11,482 CB Richard Ellis Group EBITDA represents earnings before net interest expense, loss on extinguishment of debt, income taxes, depreciation and amortization. Our management believes EBITDA is useful to investors because it is frequently used by securities analysts, investors and other interested parties in the evaluation of companies in our industry. In addition, our management believes that EBITDA is useful in evaluating our operating performance compared to that of other companies in our industry because the calculation of EBITDA generally eliminates the effects of financing and income taxes and the accounting effects of capital spending and acquisitions, which items may vary for different companies for reasons unrelated to overall operating performance. As a result, our management uses EBITDA as a measure to evaluate the performance of our various business lines and for other discretionary purposes, including as a significant component when measuring our performance under our employee incentive programs. However, EBITDA is not a recognized measurement under U.S. generally accepted accounting principles, or GAAP, and when analyzing our operating performance, investors should use EBITDA in addition to, and not as an alternative for, operating income (loss), as determined in accordance with GAAP. Because not all companies use identical calculations, our presentation of EBITDA may not be comparable to similarly titled measures of other companies. Furthermore, EBITDA is not intended to be a measure of free cash flow for our management s discretionary use, as it does not consider certain cash requirements such as tax and debt service payments. As of December 31, CASH AND CASH EQUIVALENTS, AT END OF PERIOD $ 959 $ Table of Contents Nine Months Ended September 30, 2004 Compared to Nine Months Ended September 30, 2003 The Americas Revenue increased by $381.6 million, or 49.8%, for the nine months ended September 30, 2004 as compared to the nine months ended September 30, 2003. The overall increase was primarily driven by the Insignia acquisition, which resulted in the expansion of our market share in the real estate services area of our advisory services line of business. The increase in market share resulted in higher revenues particularly relative to leasing activity, predominately in the New York area. The Insignia acquisition also drove an increase in management fees in the current year. The continued improvement of general economic conditions led to an increase in sales and lease transaction revenue, while the anticipation of higher interest rates resulted in higher loan origination fees primarily during the first part of the year. Cost of services increased by $233.3 million, or 61.2%, for the nine months ended September 30, 2004 as compared to the nine months ended September 30, 2003. The increase was primarily due to higher commission expense, bonus accruals, insurance and benefits, producer retention and broker draw amortization as a result of the overall increase in revenue as well as due to the Insignia acquisition. The producer retention expense, which represents amounts paid to the top real estate advisory services professionals of Insignia that we retained at the time of the acquisition, is being amortized through cost of services over the respective lives of their underlying employment agreements. The broker draw amortization of $3.9 million includes a $1.4 million adjustment to correct the amortization taken for the period from the date of the Insignia acquisition through December 31, 2003. It also reflects the pattern in which the economic benefits of the broker draw asset acquired in the Insignia acquisition are consumed, the fair value of which was refined during the three months ended March 31, 2004. The remaining net broker draw asset of $2.8 million will be amortized on a straight-line basis over the next ten months. Both the producer retention and the broker draw amortization are considered integration costs associated with the Insignia acquisition and together amounted to $6.3 million for the nine months ended September 30, 2004. Cost of services as a percentage of revenue increased from 49.7% in the third quarter of 2003 to 53.5% in the third quarter of 2004, primarily driven by producers reaching higher commission tranches as a result of higher revenue as well as due to the producer retention and broker draw amortization recorded in 2004 and the new mix of compensation structures as a result of compensation plans adopted in the Insignia acquisition. Operating, administrative and other expenses increased $118.8 million, or 37.5%. The increase was primarily driven by higher costs as a result of the Insignia acquisition, including $3.3 million of integration costs, as well as higher payroll-related expenses, including bonuses and insurance and benefits. Additionally, we incurred higher marketing expenses, professional fees, including $2.7 million related to Sarbanes-Oxley compliance work, and a $3.0 million charge for the write-down of investments. The investment write-down primarily related to the write-off of our investment in Workplace IQ, Ltd. in its entirety as a result of a period of negative operating cash flows, brought about by unanticipated product delays during 2004, as well as the restructuring and recapitalization of this entity in 2004, which caused a significant decline in our ownership percentage and preference in equity distributions. During the nine months ended September 30, 2003, we also incurred additional costs as a result of our initial public offering, including one-time compensation expense of $15.0 million related to bonus payments made to several of our non executive real estate advisory services employees as a result of provisions in their employment agreements. Additionally, during the nine months ended September 30, 2003 total operating expenses were reduced by substantial net foreign currency transaction gains as the dollar was very weak particularly relative to the Australian and New Zealand dollars, while in the current year period we experienced only moderate net foreign currency transaction losses. EMEA Revenue increased by $143.5 million, or 85.9%, for the nine months ended September 30, 2004 as compared to the nine months ended September 30, 2003, primarily driven by increased revenue as a result of the Insignia acquisition as well as organic growth. This was evidenced by higher sales and lease transaction revenue, particularly in London and Paris, as well as increased consultation, appraisal and management fees, predominantly in the U.K. Foreign currency translation had a $33.3 million positive impact on total revenue during the nine months ended September 30, 2004. Table of Contents Cost of services increased $62.2 million, or 87.9%, as a result of higher producer compensation expense as well as increased payroll-related costs, including bonuses and insurance and benefits, particularly in the U.K. and France, primarily due to the higher revenue. Also included in producer compensation expense were integration costs of $1.9 million, representing the amortization of bonuses paid to the top producers in the U.K., which are being amortized over the respective lives of the underlying employment agreements. Foreign currency translation had a $14.1 million negative impact on cost of services during the nine months ended September 30, 2004. Operating, administrative and other expenses increased by $71.1 million, or 77.6%, mainly driven by higher payroll-related expenses, including bonuses and insurance and benefits, as well as higher marketing expenses, particularly in the U.K. and France, primarily due to the Insignia acquisition. Also, expenses in the U.K. were higher due to increased occupancy expense as a result of our relocation to a new facility in London in the fourth quarter of 2003 as well as $8.7 million of charges related to an idle facility and a sublease termination in the U.K. Foreign currency translation had a $17.2 million negative impact on total operating expenses during the nine months ended September 30, 2004. Asia Pacific Revenue increased by $33.0 million, or 44.1%, for the nine months ended September 30, 2004 as compared to the nine months ended September 30, 2003. The increase was primarily driven by an overall increase in revenue in Australia and Japan, primarily resulting from our successful efforts to increase incremental market share in the region. Foreign currency translation had a $10.1 million positive impact on total revenue during the nine months ended September 30, 2004. Cost of services increased by $17.5 million, or 53.5%, mainly attributable to higher producer compensation expense due to the increased headcount in Australia and Japan resulting from our efforts to increase our market share in this region, in addition to higher commissions as a result of higher transaction revenue. Foreign currency translation had a $4.9 million negative impact on cost of services for the nine months ended September 30, 2004. Operating, administrative and other expenses increased by $8.9 million, or 24.4%, primarily due to higher payroll-related costs, including bonuses, in Australia and Japan, mainly attributable to the aforementioned increased headcount. Additionally, higher bad debt expense in Japan related to the write-off on an uncollectible receivable during the period, also contributed to the increase. Foreign currency translation had a $4.1 million negative impact on total operating expenses during the nine months ended September 30, 2004. Year Ended December 31, 2003 Compared to Year Ended December 31, 2002 The Americas Revenue increased by $301.6 million, or 33.7%, for the year ended December 31, 2003 as compared to the year ended December 31, 2002 primarily driven by the expansion of our market share in our real estate services business line through our acquisition of Insignia, particularly in the leasing industry in the New York area. Additionally, the improvement of general economic conditions in the United States led to an increase in volume of transactions resulting in significantly higher sales transaction revenue as well as increased lease transaction revenue and appraisal fees. Cost of services increased by $170.8 million, or 38.9%, for the year ended December 31, 2003 as compared to the year ended December 31, 2002 primarily due to higher commission expense, bonus accruals and producer retention expense as a result of the Insignia acquisition as well as the higher sales and lease transaction revenue. The producer retention expense represents bonuses paid to the top advisory services professionals of Insignia that we retained at the time of the acquisition that is being amortized through cost of services over the respective lives of the underlying employment agreements. The producer retention expense is considered an integration cost associated with the Insignia acquisition and amounted to $1.5 million for the year ended December 31, 2003. Operating, administrative and other expenses increased $107.0 million, or 29.1%, mainly caused by higher costs as a result of the Insignia acquisition, including integration expenses of $9.1 Table of Contents million, increased bonuses and payroll related costs mainly resulting from improved operating performance, and a nonrecurring legal settlement in the United States. Included in the 2003 bonus was an accrual for a one-time performance award of approximately $6.9 million. These increases were partially offset by net foreign currency transaction gains resulting from the weakened U.S. dollar, a trend that we have experienced in 2003 and 2002. EMEA Revenue increased by $131.5 million, or 72.1%, for the year ended December 31, 2003 as compared to the year ended December 31, 2002, primarily driven by increased revenue as a result of the Insignia acquisition as evidenced by higher sales and lease transaction revenue as well as increased consultation and appraisal fees, predominantly in the United Kingdom and France. Foreign currency translation had a $35.5 million positive impact on total revenue during the year ended December 31, 2003. Cost of services increased $65.5 million, or 93.2%, as a result of higher producer compensation expense and bonuses as well as increased payroll-related costs, including insurance expense throughout Europe and pension expense in the United Kingdom, primarily due to the Insignia acquisition. Also included in producer compensation expense for 2003 were integration costs of $1.2 million, representing the amortization of bonuses paid to the top producers of Insignia in the United Kingdom, which is being amortized over the respective lives of the underlying employment agreements. Foreign currency translation had a $15.0 million negative impact on cost of services during the current year. Operating, administrative and other expenses increased by $61.0 million, or 67.8%, mainly driven by increased costs as a result of the Insignia acquisition, including integration expenses of $1.8 million, as well as higher bonus, payroll related and consulting expenses. Additionally, occupancy expense was higher in the United Kingdom as a result of our relocation to a new facility. Lastly, foreign currency translation had a $16.4 million negative impact on total operating expenses during the year ended December 31, 2003. Asia Pacific Revenue increased by $26.8 million, or 29.1%, for the year ended December 31, 2003 as compared to the year ended December 31, 2002. The increase was primarily driven by an overall increase in revenue in Australia and New Zealand, primarily resulting from our incremental efforts to increase our market share in the region as well as due to our organic growth. Foreign currency translation had a $13.8 million positive impact on total revenue during the current year. Cost of services increased by $13.0 million, or 34.2%, mainly attributable to increased transaction revenue as well as higher producer compensation expense due to increased headcount in Australia and New Zealand resulting from our incremental efforts to increase our market share in this region. Foreign currency translation had a $6.1 million negative impact on cost of services for the year ended December 31, 2003. Operating, administrative and other expenses increased by $8.6 million, or 19.4%, primarily due to an increased accrual for long-term incentives as well as higher payroll related costs in Australia and New Zealand. The long-term incentive plan term ended in 2003 with payout of approximately $7.8 million anticipated in early 2004. We anticipate implementing a new long-term incentive plan starting in 2004. Foreign currency translation also had a $5.6 million negative impact on total operating expenses during the year ended December 31, 2003. Year Ended December 31, 2002 Compared to Year Ended December 31, 2001 The Americas Revenue decreased by $32.7 million, or 3.5%, for the year ended December 31, 2002 as compared to the year ended December 31, 2001, primarily driven by a lower average value per transaction in lease transaction revenue resulting from the continued softness in the leasing industry in the United States combined with a nonrecurring sale of mortgage fund contracts of $5.6 million in 2001. These decreases were partially offset by higher sales transaction revenue, which was driven by a higher number of transactions as well as a higher average value per transaction, primarily due to investment property sales. The improvement in sales transaction revenue continued in 2003. Cost of services decreased by $10.0 million, or 2.2%, for the year ended December 31, 2002 as compared to the year ended December 31, 2001, caused primarily by lower variable commissions Table of Contents commensurate with lower lease transaction revenue. Operating, administrative and other expenses decreased by $21.3 million, or 5.5%, as a result of cost reduction and efficiency measures, the organizational restructuring implemented after our acquisition of CB Richard Ellis Services in 2001, and foreign currency transaction and settlement gains resulting from the weaker U.S. dollar. The trend of foreign currency transaction gains resulting from the weakening U.S. dollar continued throughout 2003. EMEA Revenue increased by $20.9 million, or 13.0%, for the year ended December 31, 2002 as compared to the year ended December 31, 2001. This was mainly driven by higher sales transaction revenue across Europe as the general economy in this region improved. Foreign currency translation had an $8.9 million positive impact on total revenue during the year ended December 31, 2002. Cost of services increased by $10.0 million, or 16.6%, due to higher producer compensation as a result of increased revenue arising from expanded activities in Europe. Foreign currency translation had a $3.4 million negative impact on cost of services during the year ended December 31, 2002. Operating, administrative and other expenses increased by $5.3 million, or 6.2%, mainly attributable to higher incentives due to improved results, higher occupancy costs and consulting fees. Foreign currency translation also had a $3.7 million negative impact on total operating expenses during the year ended December 31, 2002. Asia Pacific Revenue increased by $11.3 million, or 14.1%, for the year ended December 31, 2002 as compared to the year ended December 31, 2001. This increase was primarily driven by higher investment management fees in Japan and an increase in overall revenue in Australia and New Zealand due to increased efforts to expand our market share in these locations, partially offset by lower revenues as a result of the sale of our wholly owned operations in Thailand, the Philippines and India. Foreign currency translation had a $2.8 million positive impact on total revenue during the year ended December 31, 2002. Cost of services increased by $4.3 million, or 12.6%, primarily driven by higher producer compensation expense due to increased personnel in Australia, New Zealand and China, slightly offset by lower commissions due to conversions to affiliate offices elsewhere in Asia. Foreign currency translation had a $1.3 million negative impact on cost of services for the year ended December 31, 2002. Operating, administrative and other expenses increased by $0.4 million, or 0.9%, primarily due to increased bonuses as a result of improved results in Australia and New Zealand, partially offset by lower expenses as a result of sales of operations in Asia. Foreign currency translation also had a $1.1 million negative impact on total operating expenses during the year ended December 31, 2002. Liquidity and Capital Resources We believe that we can satisfy our working capital requirements and funding of investments with internally generated cash flow and, as necessary, borrowings under the revolving credit facility of our amended and restated credit agreement described below. Included in the capital requirements that we expect to be able to fund during 2004 are approximately $40.0 million of anticipated capital expenditures, net of concessions received, of which $27.5 million has been funded on or prior to September 30, 2004. The capital expenditures for 2004 are primarily composed of information technology costs, which are driven largely by computer replacement costs as well as costs associated with upgrading various servers and systems, and leasehold improvements. During both 2001 and 2003, we required substantial amounts of new equity and debt financing to fund our acquisitions of CB Richard Ellis Services and Insignia Financial Group. Absent extraordinary transactions such as these, we historically have not needed sources of financing other than our internally generated cash flow and our revolving credit facility to fund our working capital, capital expenditures and investment requirements. As a result, our management anticipates that our cash flow from operations and revolving credit facility will be sufficient to meet our anticipated cash requirements for the foreseeable future, but at a minimum for the next twelve months. Table of Contents (footnotes for previous page) (footnotes on following page) (1) Includes capital lease obligations. (2) See note 13 to our audited consolidated financial statements included elsewhere in this prospectus. (3) Because these obligations are related, either wholly or partially, to the future retirement of our employees and such retirement dates are not predictable, an undeterminable portion of this amount will be paid in future years. (4) Excludes letters of credit related to our subsidiaries outstanding indebtedness and operating leases. Historical Cash Flows Operating Activities Net cash provided by operating activities totaled $38.6 million for the nine months ended September 30, 2004, an increase of $109.3 million compared to the nine months ended September 30, 2003. The acquisition of Insignia Financial Group on July 2003 has impacted substantially all components of cash used in our operating activities making comparison against the same period in the prior year not meaningful. Net cash provided by operating activities totaled $63.9 million for the year ended December 31, 2003, a decrease of $0.9 million compared to the year ended December 31, 2002. The acquisition of Insignia in July 2003 has impacted substantially all components of cash provided by our operating activities making comparison against the prior year not meaningful. Net cash provided by operating activities totaled $64.9 million for the year ended December 31, 2002, an increase of $93.8 million compared to the year ended December 31, 2001. This increase was primarily due to our improved 2002 earnings, as well as lower payments made in the year ended December 31, 2002 for 2001 bonus and profit sharing as compared to the 2000 bonus and profit sharing payments made in the year ended December 31, 2001. Investing Activities Net cash provided by investing activities totaled $8.8 million for the nine months ended September 30, 2004, representing an increase of $261.5 million compared to the nine months ended September 30, 2003. This increase was primarily due to the Insignia acquisition. In addition, during the nine months ended September 30, 2004, we received proceeds from the sale of property held for sale related to a real estate investment in Japan. These increases were slightly offset by an increase in capital expenditures, net of landlord concessions received, of $19.3 million, primarily resulting from integration costs related to leasehold improvements in new and combined offices as a result of the Insignia acquisition as well as a decrease in concessions received during the nine months ended September 30, 2004. Net cash used in investing activities totaled $284.8 million for the year ended December 31, 2003, an increase of $260.7 million compared to the year ended December 31, 2002. This increase was primarily due to costs incurred in 2003 associated with the Insignia acquisition. Capital expenditures, net of concessions received, of $27.0 million during the year ended December 31, 2003 were $12.7 million higher than 2002. This increase was mainly driven by net capital expenditures incurred in connection with our relocation to new offices in the United Kingdom in 2003. Table of Contents comparable to similarly titled measures of other companies. Furthermore, EBITDA is not intended to be a measure of free cash flow for our management s discretionary use, as it does not consider certain cash requirements such as tax and debt service payments. The amounts shown for EBITDA also differ from the amounts calculated under similarly titled definitions in our debt instruments, which are further adjusted to reflect certain other cash and non-cash charges and are used to determine compliance with financial covenants and our ability to engage in certain activities, such as incurring additional debt and making certain restricted payments. EBITDA is calculated as follows: Pro Forma Table of Contents We utilized $24.1 million in investing activities during the year ended December 31, 2002, a decrease of $249.4 million compared to the year ended December 31, 2001. This decrease was primarily due to the prior year payment of the purchase price and related expenses associated with our acquisition of CB Richard Ellis Services in July 2001. Capital expenditures, net of concessions received, of $14.3 million during the year ended December 31, 2002 were $7.0 million lower than 2001, driven primarily by efforts to reduce spending and improve cash flows. Financing Activities Net cash used in financing activities totaled $61.7 million for the nine months ended September 30, 2004 as compared to net cash provided by financing activities of $328.5 million for the nine months ended September 30, 2003. The decrease was primarily driven by debt repayments made in 2004 as well as a net increase in debt in the prior year mainly relating to the debt financing required by the Insignia acquisition. The impact of these items was partially offset by the repayment of Insignia notes payable in the prior year as well as higher deferred financing fees paid in the prior year. Net cash provided by financing activities totaled $303.7 million for the year ended December 31, 2003 compared to net cash used in financing activities of $17.8 million for the year ended December 31, 2002. This increase was mainly attributable to the additional net debt and equity financing resulting from the Insignia acquisition. Net cash used in financing activities totaled $17.8 million for the year ended December 31, 2002 compared to cash provided by financing activities of $340.1 million for the year ended December 31, 2001. This decrease was mainly attributable to the debt and equity financing required for our acquisition of CB Richard Ellis Services in 2001. Initial Public Offering On June 15, 2004, we completed our initial public offering of shares of our Class A common stock. In connection with our initial public offering, we issued and sold 7,726,764 shares of our Class A common stock and received aggregate net proceeds of approximately $135.0 million, after deducting underwriting discounts and commissions and offering expenses payable by us. Also in connection with our initial public offering, selling stockholders sold an aggregate of 16,273,236 shares of our Class A common stock and received net proceeds of approximately $290.6 million, after deducting underwriting discounts and commissions. On July 14, 2004, selling stockholders sold an additional 229,300 shares of our Class A common stock to cover over-allotments of shares by the underwriters and received net proceeds of approximately $4.1 million, after deducting underwriting discounts and commissions. We did not receive any of the proceeds from the sale of shares by the selling stockholders on June 15, 2004 and July 14, 2004. Indebtedness Our substantial level of indebtedness increases the possibility that we may be unable to generate cash sufficient to pay when due the principal of, interest on or other amounts due in respect of our indebtedness and other obligations. In addition, we may incur additional debt from time to time to finance strategic acquisitions, investments, joint ventures or for other purposes, subject to the restrictions contained in the documents governing our indebtedness. If we incur additional debt, the risks associated with our substantial leverage, including our ability to service our debt, would increase. For additional information regarding the terms of certain of our long-term indebtedness, see the information under the heading titled Description of Certain Long-Term Indebtedness. Most of our long-term indebtedness was incurred in connection with our acquisition of CB Richard Ellis Services in July 2001 and the Insignia acquisition. The CB Richard Ellis Services acquisition, which was a CB Richard Ellis Group Table of Contents going private transaction involving members of our senior management, affiliates of Blum Capital Partners and Freeman Spogli & Co. and some of our other existing stockholders, was undertaken so that we could take advantage of growth opportunities and focus on improvements in the CB Richard Ellis Services businesses. The Insignia acquisition increased the scale of our real estate services and outsourcing services businesses as well as significantly increasing our presence in the New York, London and Paris metropolitan areas. Since 2001, we have maintained a credit agreement with Credit Suisse First Boston and other lenders to fund strategic acquisitions and to provide for our working capital needs. On April 23, 2004, we entered into an amendment to our previously amended and restated credit agreement that included a waiver generally permitting us to prepay, redeem, repurchase or otherwise retire up to $30.0 million of our existing indebtedness and provided for the refinancing of all outstanding amounts under our previous credit agreement as well as the amendment and restatement of our credit agreement upon the completion of our initial public offering. On June 15, 2004, in connection with the completion of our initial public offering, we completed a refinancing of all amounts outstanding under our amended and restated credit agreement and entered into a new amended and restated credit agreement, which became effective in connection with such refinancing. Our amended and restated credit agreement permitted us, among other things, to use the net proceeds we received from our initial public offering to pay down debt, including the redemptions in July 2004 of all $38.3 million in aggregate principal amount of our 16% senior notes due 2011 and $70.0 million in aggregate principal amount of our 9 3/4% senior notes due 2010, and the prepayment of $15.0 million in principal amount of our term loan under our amended and restated credit agreement, which prepayment occurred on June 15, 2004. Effective November 16, 2004, we amended our amended and restated credit agreement to reduce the interest rates applicable to the term loan facility, as described below, and to modify some of the restrictive covenants in the agreement that are described below. Our amended and restated credit agreement includes the following: (1) a term loan facility of $295.0 million (of which $280.0 million was outstanding as of September 30, 2004), requiring quarterly principal payments of $2.95 million beginning December 31, 2004 through December 31, 2009 with the balance payable on March 31, 2010; and (2) a $150.0 million revolving credit facility, including revolving credit loans, letters of credit and a swingline loan facility, all maturing on March 31, 2009. Our amended and restated credit agreement also permits us to borrow up to $25.0 million of additional term loans under our term loan facility, subject to the satisfaction of customary conditions. Borrowings under the term loan facility bear interest at varying rates based, at our option, on either LIBOR plus 2.00% or the alternate base rate plus 1.00%. The alternate base rate is the higher of (1) Credit Suisse First Boston s prime rate or (2) the Federal Funds Effective Rate plus one-half of one percent. The potential increase of up to $25.0 million for the term loan facility would bear interest either at the same rate as the current rate for the term loan facility or, in some circumstances as described in the amended and restated credit agreement, at a higher or lower rate. During June 2004, we used a portion of the net proceeds we received from our initial public offering to prepay $15.0 million in principal amount of the term loan facility. The total amount outstanding under the term loan facility included in the senior secured term loan and current maturities of long-term debt in the accompanying consolidated balance sheets was $280.0 million and $297.5 million as of September 30, 2004 and December 31, 2003, respectively. Borrowings under the revolving credit facility bear interest at varying rates based, at our option, on either the applicable LIBOR plus 2.00% to 2.50% or the alternate base rate plus 1.00% to 1.50%, in both cases as determined by reference to our ratio of total debt less available cash to EBITDA (as defined in the amended and restated credit agreement). As of September 30, 2004 and December 31, 2003, we had no revolving credit facility principal outstanding. As of September 30, 2004, letters of credit totaling $24.3 million were outstanding, which letters of credit primarily relate to our subsidiaries outstanding indebtedness and operating leases and reduce the amount we may borrow under the revolving credit facility. Predecessor Company Table of Contents Borrowings under our amended and restated credit agreement are jointly and severally guaranteed by us and substantially all of our domestic subsidiaries and are secured by a pledge of substantially all of our assets. Additionally, our amended and restated credit agreement requires us to pay a fee based on the total amount of the unused revolving credit facility commitment. In May 2003, in connection with the Insignia acquisition, CBRE Escrow, Inc., a wholly owned subsidiary of CB Richard Ellis Services, issued $200.0 million in aggregate principal amount of 9 3/4% senior notes, which are due May 15, 2010. CBRE Escrow, Inc. merged with and into CB Richard Ellis Services, and CB Richard Ellis Services assumed all obligations with respect to the 9 3/4% senior notes in connection with the Insignia acquisition. The 9 3/4% senior notes are unsecured obligations of CB Richard Ellis Services, senior to all of its current and future unsecured indebtedness, but subordinated to all of CB Richard Ellis Services current and future secured indebtedness. The 9 3/4% senior notes are jointly and severally guaranteed on a senior basis by us and substantially all of our domestic subsidiaries. Interest accrues at a rate of 9 3/4% per year and is payable semi-annually in arrears on May 15 and November 15. The 9 3/4% senior notes are redeemable at our option, in whole or in part, on or after May 15, 2007 at 104.875% of par on that date and at declining prices thereafter. In addition, before May 15, 2006, we were permitted to redeem up to 35.0% of the originally issued amount of the 9 3/4% senior notes at 109 3/4% of par, plus accrued and unpaid interest, solely with the net cash proceeds from public equity offerings, which we elected to do. During July 2004, we used a portion of the net proceeds we received from our initial public offering to redeem $70.0 million in aggregate principal amount, or 35.0%, of our 9 3/4% senior notes, which also required the payment of a $6.8 million premium and accrued and unpaid interest through the date of redemption. In the event of a change of control (as defined in the indenture governing our 9 3/4% senior notes), we are obligated to make an offer to purchase the 9 3/4% senior notes at a redemption price of 101.0% of the principal amount, plus accrued and unpaid interest. The amount of the 9 3/4% senior notes included in the accompanying consolidated balance sheets was $130.0 million and $200.0 million as of September 30, 2004 and December 31, 2003, respectively. In June 2001, in order to partially finance our acquisition of CB Richard Ellis Services, Blum CB Corp. issued $229.0 million in aggregate principal amount of 11 1/4% senior subordinated notes due June 15, 2011 for approximately $225.6 million, net of discount. CB Richard Ellis Services assumed all obligations with respect to the 11 1/4% senior subordinated notes in connection with the merger of Blum CB Corp. with and into CB Richard Ellis Services on July 20, 2001. The 11 1/4% senior subordinated notes are unsecured senior subordinated obligations of CB Richard Ellis Services and rank equally in right of payment with any of CB Richard Ellis Services existing and future unsecured senior subordinated indebtedness, but are subordinated to any of CB Richard Ellis Services existing and future senior indebtedness. The 11 1/4% senior subordinated notes are jointly and severally guaranteed on a senior subordinated basis by us and substantially all of our domestic subsidiaries. The 11 1/4% senior subordinated notes require semi-annual payments of interest in arrears on June 15 and December 15 and are redeemable in whole or in part on or after June 15, 2006 at 105.625% of par on that date and at declining prices thereafter. In addition, before June 15, 2004, we were permitted to redeem up to 35.0% of the originally issued amount of the notes at 111 1/4% of par, plus accrued and unpaid interest, solely with the net cash proceeds from public equity offerings, which we did not do. In the event of a change of control (as defined in the indenture governing our 11 1/4% senior subordinated notes), we are obligated to make an offer to purchase the 11 1/4% senior subordinated notes at a redemption price of 101.0% of the principal amount, plus accrued and unpaid interest. In May and June 2004, we repurchased $21.6 million in aggregate principal amount of our 11 1/4% senior subordinated notes in the open market. We paid an aggregate of $3.1 million of premiums in connection with these open market purchases. The amount of the 11 1/4% senior subordinated notes included in the accompanying consolidated balance sheets, net of unamortized discount, was $205.0 million and $226.2 million as of September 30, 2004 and December 31, 2003, respectively. Also, to partially fund our acquisition of CB Richard Ellis Services in 2001, we issued $65.0 million in aggregate principal amount of 16% senior notes due July 20, 2011. The 16% senior notes were unsecured obligations, senior to all of our current and future unsecured indebtedness but subordinated to all of our current and future secured indebtedness. Interest accrued at a rate of 16.0% per year and was payable quarterly in arrears. CASH AND CASH EQUIVALENTS, AT END OF PERIOD $ CASH AND CASH EQUIVALENTS, AT END OF PERIOD $ 127 $ Table of Contents Under the terms of the indenture governing the 16% senior notes and subject to the restrictions set forth in our amended and restated credit agreement, the notes were redeemable at our option, in whole or in part, at 116.0% of par commencing on July 20, 2001 and at declining prices thereafter. During July 2004, we used a portion of the net proceeds we received from our initial public offering to redeem the remaining $38.3 million in aggregate principal amount of our 16% senior notes, which also required the payment of a $2.5 million premium and accrued and unpaid interest through the date of redemption. The amount of the 16% senior notes included in the accompanying consolidated balance sheet, net of unamortized discount, was $35.5 million as of December 31, 2003. Our amended and restated credit agreement and the indentures governing our 9 3/4% senior notes and our 11 1/4% senior subordinated notes each contain numerous restrictive covenants that, among other things, limit our ability to incur additional indebtedness, pay dividends or make distributions to stockholders, repurchase capital stock or debt, make investments, sell assets or subsidiary stock, engage in transactions with affiliates, enter into sale/leaseback transactions, issue subsidiary equity and enter into consolidations or mergers. Our amended and restated credit agreement also currently requires us to maintain a minimum coverage ratio of interest and certain fixed charges and a maximum leverage and senior secured leverage ratio of EBITDA (as defined in the amended and restated credit agreement) to funded debt. From time to time, Moody s Investors Service and Standard & Poor s Ratings Service rate our outstanding senior secured term loan, our 9 3/4% senior notes and our 11 1/4% senior subordinated notes. Although neither the Moody s nor the Standard & Poor s ratings impact our ability to borrow, they may affect the applicable interest rate for our senior secured term loan. In addition, these ratings may impact our ability to borrow under new agreements in the future and the interest rates of any such future borrowings. A joint venture that we have consolidated since 2001 incurred non-recourse debt to acquire a real estate investment in Japan in 2001. This debt was secured by a mortgage on the acquired real estate asset. During August 2004, the joint venture completed the sale of this real estate asset and utilized the proceeds from the sale to repay all of the non-recourse debt, plus accrued interest and other fees. In our accompanying consolidated balance sheet, this debt comprised $2.0 million of our other short-term borrowings and $41.8 million of our other long-term debt as of December 31, 2003. Our wholly owned subsidiary, L.J. Melody & Company, has a credit agreement with Residential Funding Corporation, or RFC, for the purpose of funding mortgage loans that will be resold. On August 19, 2004, we entered into a Third Amendment to the Fourth Amended and Restated Warehousing Credit and Security Agreement (warehouse line of credit). The current agreement provides for a warehouse line of credit of up to $250.0 million, bears interest at one-month LIBOR plus 1.0% and expires on December 1, 2004. We expect that prior to December 1, 2004 L.J. Melody will be able to reach a satisfactory amendment to extend the term of the agreement with RFC or to enter into an agreement with another third party to provide substitute financing arrangements for the purpose of funding mortgage loans. However, if L.J. Melody is unable to do so, the business and results of operations of our mortgage loan origination and servicing line of business may be adversely affected. During the quarter ended September 30, 2004, we had a maximum of $244.6 million warehouse line of credit principal outstanding with RFC. As of September 30, 2004 and December 31, 2003, we had a $111.8 million and a $230.8 million warehouse line of credit outstanding, respectively, which are included in short-term borrowings in the accompanying consolidated balance sheets. Additionally, we had $111.8 million and $230.8 million of mortgage loans held for sale (warehouse receivable), which represented mortgage loans funded through the line of credit that, while committed to be purchased, had not yet been purchased as of September 30, 2004 and December 31, 2003, respectively, which are also included in the accompanying consolidated balance sheets included elsewhere in this prospectus. In connection with our acquisition of Westmark Realty Advisors in 1995, which significantly expanded our investment management services business, we issued approximately $20.0 million in aggregate principal amount Nine Months Ended September 30, Table of Contents of senior notes. The Westmark senior notes are secured by letters of credit equal to approximately 50% of the outstanding balance at December 31, 2003. The Westmark senior notes are redeemable at the discretion of the note holders and have final maturity dates of June 30, 2008 and June 30, 2010. During the year ended December 31, 2002, all of the Westmark senior notes bore interest at 9.0%. On January 1, 2003, the interest rate on some of these notes was converted to varying rates equal to the interest rate in effect with respect to amounts outstanding under our credit agreement. On January 1, 2005, the interest rate on all of the other Westmark senior notes will be adjusted to equal the interest rate then in effect with respect to amounts outstanding under our credit agreement. The amount of the Westmark senior notes included in short-term borrowings in our consolidated balance sheets included elsewhere in this prospectus was $12.1 million as of September 30, 2004 and December 31, 2003. Insignia, which we acquired in July 2003, issued loan notes as partial consideration for previous acquisitions of businesses in the United Kingdom, which was part of Insignia s business strategy of increasing its presence in that country. The acquisition loan notes are payable to the sellers of the previously acquired U.K. businesses and are secured by restricted cash deposits in approximately the same amount. The acquisition loan notes are redeemable semi-annually at the discretion of the note holder and have a final maturity date of April 2010. As of September 30, 2004 and December 31, 2003, $9.7 million and $12.2 million, respectively, of the acquisition loan notes were outstanding, which are included in short-term borrowings in our consolidated balance sheets included elsewhere in this prospectus. A significant number of our subsidiaries in Europe have had a Euro cash pool loan since 2001, which is used to fund their short-term liquidity needs. The Euro cash pool loan is an overdraft line for our European operations issued by HSBC Bank. The Euro cash pool loan has no stated maturity date and bears interest at varying rates based on a base rate as defined by HSBC Bank plus 2.5%. The amount of the Euro cash pool loan included in short-term borrowings in our consolidated balance sheets included elsewhere in this prospectus was $3.5 million and $11.5 million as of September 30, 2004 and December 31, 2003, respectively. Deferred Compensation Plan Obligations We have two deferred compensation plans, one of which has been frozen and is no longer accepting deferrals, which we refer to as the Old DCP, and one of which became effective on August 1, 2004 and began accepting deferrals on August 13, 2004, which we refer to as the New DCP. Because a substantial majority of the deferrals under both the Old DCP and the New DCP have a distribution date based upon the end of the relevant participant s employment with us, we have an ongoing obligation to make distributions to these participants as they leave our employment. In addition, participants may receive unscheduled in-service withdrawals subject to a 7.5% penalty. As the level of employee departures or in-service distributions is not predictable, the timing of these obligations also is not predictable. Accordingly, we may face significant unexpected cash funding obligations in the future if a larger number of our employees than we expect take in-service distributions or leave our employment. Old DCP Prior to amending the Old DCP as discussed below, each participant in the Old DCP was allowed to defer a portion of his or her compensation for distribution generally either after his or her employment with us ends or on a future date at least three years after the deferral election date. The investment alternatives available to participants include two interest index funds and an insurance fund in which gains and losses on deferrals are measured by one or more of approximately 80 mutual funds. Distributions with respect to the interest index and insurance fund accounts are made by us in cash. In addition, prior to July 2001, participants were entitled to invest their deferrals in stock fund units that are distributed as shares of our Class A common stock. As of October 31, 2004, there were 2,717,313 outstanding stock fund units under the Old DCP, all of which were vested. The deferred compensation liability in the accompanying consolidated balance sheets was $146.7 million and $138.0 million at September 30, 2004 and December 31, 2003, respectively. Year Ended December 31, Table of Contents Effective January 1, 2004, we closed the Old DCP to new participants. Until January 1, 2005, the Old DCP will continue to accept compensation deferrals from those participants who currently have a balance in the plan, meet the eligibility requirements and elect to participate, in each case up to a maximum annual contribution amount of $250,000 per participant. Effective January 1, 2005, no additional deferrals will be permitted under this plan. Existing account balances under the plan will be paid to participants in the future according to their existing deferral elections. However, all participants may make unscheduled in-service withdrawals of their account balances, including the shares of Class A common stock underlying stock fund units, if they pay a penalty equal to 7.5% and the taxes due on the value of the withdrawal. Prior to our initial public offering, all shares held by our current and former employees and consultants, including any shares that such employees and consultants are entitled to receive as distributions with respect to stock fund units in the Old DCP, were subject to transfer restrictions. In connection with our initial public offering, we waived all of these transfer restrictions. As a result, all of these shares, including any shares received as future distributions with respect to stock fund units in the Old DCP, may be sold, subject to applicable securities law requirements. Shortly after our initial public offering, we filed a registration statement on Form S-8 that registered, among other things, the shares of Class A common stock to be distributed in the future with respect to stock fund units in the Old DCP. We have entered into agreements with participants in the Old DCP holding stock fund units with 2,280,831 underlying shares of Class A common stock pursuant to which these participants have agreed to sell no more than 20% of the shares underlying their current stock fund unit balances during any year over the next five years in exchange for fixed cash payments by us to these participants. New DCP Effective August 1, 2004, we adopted the New DCP, which began accepting deferrals for compensation otherwise earned after August 13, 2004. Under the New DCP, each participant is allowed to defer a portion of his or her compensation for distribution generally either after his or her employment with us ends or on a future date at least three years after the deferral election date. Deferrals are credited at the participant s election to one or more investment alternatives under the New DCP, which include a money-market fund and a mutual fund investment option. There is limited flexibility for participants to change distribution elections once made. However, all participants may make unscheduled in-service withdrawals of their account balances if they pay a penalty equal to 7.5% and the taxes due on the value of the withdrawal. Pension Liability Our subsidiaries based in the United Kingdom maintain two defined benefit pension plans to provide retirement benefits to existing and former employees participating in the plans. With respect to these plans, our historical policy has been to contribute annually an amount to fund pension cost as actuarially determined by an independent pension consulting firm and as required by applicable laws and regulations. Our contributions to these plans are invested and, if these investments do not perform in the future as well as we expect, we will be required to provide additional funding to cover the shortfall. The pension liability in our consolidated balance sheets included elsewhere in this prospectus was $36.6 million and $36.0 million at September 30, 2004 and December 31, 2003, respectively. We expect to contribute a total of $4.9 million to fund our pension plan for the year ended December 31, 2004, of which $3.8 million was funded as of September 30, 2004. Other Obligations and Commitments In connection with the sale of real estate investment assets by Insignia to Island Fund I LLC on July 23, 2003, Insignia agreed to maintain letter of credit support for real estate investment assets that were subject to the purchase agreement until the earlier of (1) the third anniversary of the completion of the sale, (2) the date on which the letter of credit is no longer required pursuant to the applicable real estate investment asset agreement or (3) the completion of a sale of the relevant underlying real estate investment asset. As of September 30, 2004, an aggregate of approximately $5.2 million of this letter of credit support remained outstanding under the Table of Contents purchase agreement. Also in connection with the sale, Insignia agreed to maintain a $1.3 million guarantee of a repayment obligation with respect to one of the real estate investment assets. Island Fund agreed to reimburse us for 50% of any draws against these letters of credit or the repayment guarantee while they are outstanding and delivered a letter of credit to us in the amount of approximately $2.9 million as security for Island Fund s reimbursement obligation. As a result of this reimbursement obligation, we effectively retain potential liability for 50% of any future draws against these letters of credit and the repayment guarantee. However, there can be no assurance that Island Fund will be able to reimburse us in the event of any draws against the letters of credit or the repayment guarantee or that Island Fund s future reimbursement obligations will not exceed the amount of the letter of credit provided to us by Island Fund. L.J. Melody & Company previously executed an agreement with Federal National Mortgage Association, or Fannie Mae, to initially fund the purchase of a commercial mortgage loan portfolio using proceeds from its RFC line of credit. Subsequently, a 100% participation in the loan portfolio was sold to Fannie Mae and L.J. Melody retains the credit risk on the first 2% of losses incurred on the underlying portfolio of commercial mortgage loans. As of September 30, 2004, the loan portfolio balance was $85.8 million and we have collateralized a portion of our obligations to cover the first 1% of losses through a letter of credit in favor of Fannie Mae for a total of approximately $0.9 million. The other 1% is covered in the form of a guarantee to Fannie Mae by L.J. Melody. We had letters of credit totaling $6.1 million as of September 30, 2004, excluding letters of credit related to our subsidiaries outstanding indebtedness and operating leases. Approximately $5.2 million of these letters of credit were issued pursuant to the terms of the purchase agreement with Island Fund described above. The remaining $0.9 million outstanding letter of credit is for the Fannie Mae letter of credit as described above. The outstanding letters of credit as of September 30, 2004 expire at varying dates through July 23, 2005. However, we are obligated to renew the letters of credit related to the Island Fund purchase agreement until as late as July 23, 2006 and the Fannie Mae letter of credit until our obligation to cover potential credit losses is satisfied. We had guarantees totaling $5.1 million as of September 30, 2004, which consisted primarily of guarantees of property debt as well as the obligations to Island Fund and Fannie Mae discussed above. Approximately $1.2 million of the guarantees is related to investment activity that is scheduled to expire on September 1, 2008. The guarantee related to the Island Fund purchase agreement expired on the September 15, 2004 maturity date of the underlying loan agreement, however, similar loan terms are expected to be renewed, modified or extended upon the completion of on-going negotiations. Currently, renewals, modifications and extensions to such loan may be made without our consent in connection with any such renewal, modification or extension. The guarantee obligation related to the agreement with Fannie Mae discussed above will expire in December 2004. An important part of the strategy for our investment management business involves investing our capital in certain real estate investments with our clients. As of September 30, 2004, we had committed $41.7 million to fund future co-investments. We expect that approximately $11.0 million of these commitments will be funded during 2004. In addition to required future capital contributions, some of the co-investment entities may request additional capital from us and our subsidiaries holding investments in those assets and the failure to provide these contributions could have adverse consequences to our interests in these investments. Seasonality A significant portion of our revenue is seasonal, which affects your ability to compare our financial condition and results of operations on a quarter-by-quarter basis. Historically, this seasonality has caused our revenue, operating income, net income and cash flow from operating activities to be lower in the first two quarters and higher in the third and fourth quarters of each year. The concentration of earnings and cash flow in the fourth quarter is due to an industry-wide focus on completing transactions toward the fiscal year-end. This has historically resulted in lower profits or a loss in the first and second quarters, with profits growing or losses decreasing in each subsequent quarter. Table of Contents Inflation Our commissions and other variable costs related to revenue are primarily affected by real estate market supply and demand, which may be affected by general economic conditions including inflation. However, to date, we do not believe that general inflation has had a material impact upon our operations. Application of Critical Accounting Policies Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States, which require management to make estimates and assumptions that affect reported amounts. The estimates and assumptions are based on historical experience and on other factors that management believes to be reasonable. Actual results may differ from those estimates. We believe that the following critical accounting policies represent the areas where more significant judgments and estimates are used in the preparation of our consolidated financial statements: Revenue Recognition We record real estate commissions on sales upon close of escrow or upon transfer of title. Real estate commissions on leases are generally recorded as income once we satisfy all obligations under the commission agreement. A typical commission agreement provides that we earn a portion of the lease commission upon the execution of the lease agreement by the tenant, while the remaining portion(s) of the lease commission is earned at a later date, usually upon tenant occupancy. The existence of any significant future contingencies will result in the delay of recognition of revenue until such contingencies are satisfied. For example, if we do not earn all or a portion of the lease commission until the tenant pays its first month s rent, and the lease agreement provides the tenant with a free rent period, we delay revenue recognition until cash rent is paid by the tenant. Investment management and property management fees are recognized when earned under the provisions of the related agreements. Appraisal fees are recorded after services have been rendered. Loan origination fees are recognized at the time the loan closes and we have no significant remaining obligations for performance in connection with the transaction, while loan servicing fees are recorded to revenue as monthly principal and interest payments are collected from mortgagors. Other commissions, consulting fees and referral fees are recorded as income at the time the related services have been performed unless significant future contingencies exist. In establishing the appropriate provisions for trade receivables, we make assumptions with respect to their future collectibility. Our assumptions are based on an individual assessment of a customer s credit quality as well as subjective factors and trends, including the aging of receivables balances. In addition to these individual assessments, in general, outstanding trade accounts receivable amounts that are more than 180 days overdue are fully provided for. Principles of Consolidation Our consolidated financial statements included elsewhere in this prospectus include our accounts and those of our majority owned subsidiaries. Additionally, the consolidated financial statements included elsewhere in this prospectus include the accounts of CB Richard Ellis Services prior to the date we acquired it in 2001, as CB Richard Ellis Services is considered our predecessor for purposes of Regulation S-X. The equity attributable to minority shareholders interests in subsidiaries is shown separately in our consolidated balance sheets included elsewhere in this prospectus. All significant intercompany accounts and transactions have been eliminated in consolidation. Our investments in unconsolidated subsidiaries in which we have the ability to exercise significant influence over operating and financial policies, but do not control, are accounted for under the equity method. Accordingly, our share of the earnings of these equity-method basis companies is included in consolidated net income. All other investments held on a long-term basis are valued at cost less any impairment in value. Table of Contents Goodwill and Other Intangible Assets Goodwill mainly represents the excess of the purchase price paid by us over the fair value of the tangible and intangible assets and liabilities acquired in our acquisition of CB Richard Ellis Services in 2001 and our acquisition of Insignia Financial Group in 2003. Other intangible assets include trademarks, which were separately identified as a result of the 2001 acquisition, as well as a trade name separately identified as a result of the Insignia acquisition representing the Richard Ellis trade name in the United Kingdom that was owned by Insignia prior to the Insignia acquisition. Both the trademarks and the trade name are not being amortized and have indefinite estimated useful lives. Other intangible assets also include backlog, which represents the fair value of Insignia s net revenue backlog as of July 23, 2003 that was acquired as part of the Insignia acquisition. The net revenue backlog consists of the net commission receivable on Insignia s revenue producing transactions, which were at various stages of completion prior to the Insignia acquisition. Net revenue backlog is being amortized as cash is received or upon final closing of these pending transactions. The remaining other intangible assets primarily include management contracts, loan servicing rights, franchise agreements and a trade name, which are all being amortized on a straight-line basis over estimated useful lives ranging up to 20 years. We fully adopted SFAS No. 142, Goodwill and Other Intangible Assets, effective January 1, 2002. This statement requires us to perform at least annually an assessment of impairment of goodwill and other intangible assets deemed to have indefinite useful lives based on assumptions and estimates of fair value and future cash flow information. We perform an annual assessment of our goodwill and other intangible assets deemed to have indefinite lives for impairment based in part on a third-party valuation as of the beginning of the fourth quarter of each year. We also assess goodwill and other intangible assets deemed to have indefinite useful lives for impairment when events or circumstances indicate that their carrying value may not be recoverable from future cash flows. We completed our required annual impairment tests as of October 1, 2003 and 2002 and determined that no impairment existed as of those dates. We are in the process of completing our annual impairment test for 2004. New Accounting and Tax Pronouncements On March 31, 2004, the Financial Accounting Standards Board, or FASB, issued its Exposure Draft, Share-Based Payment, which is a proposed amendment to Statement of Financial Accounting Standards, or SFAS, No. 123, Accounting for Stock-Based Compensation. The amendment would require all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values, which would include all unvested grants at the time of adoption. The FASB expects to issue a final standard late in 2004. On October 13, 2004, the FASB decided that the final amendment would be effective for public companies for any interim or annual period beginning after June 15, 2005, though early adoption would be encouraged. The adoption of this Exposure Draft is not expected to have a material impact on our financial position or results of operations. In October 2004, the American Jobs Creation Act of 2004 was passed. We are currently assessing the impact of this law on our operations, particularly relative to provisions on repatriation of foreign earnings as well as deferred compensation. We do not expect this act to have a material impact on our financial position or results of operations. Quantitative and Qualitative Disclosures About Market Risk Our exposure to market risk consists of foreign currency exchange rate fluctuations related to our international operations and changes in interest rates on debt obligations. Exchange Rates Approximately 30.2% of our business was transacted in local currencies of foreign countries for the nine months ended September 30, 2004 and the year ended December 31, 2003, the majority of which included the Euro, the British pound sterling, the Hong Kong dollar, the Singapore dollar and the Australian dollar. We attempt to manage our exposure primarily by balancing assets and liabilities, and maintaining cash positions in Table of Contents foreign countries only at levels necessary for operating purposes. However, we do not enter into agreements to hedge the risks associated with translation of foreign currencies into U.S. dollars. As a result, fluctuations in foreign currency exchange rates affect reported amounts of our total assets and liabilities, which are reflected in our financial statements as translated into U.S. dollars for each financial reporting period at the exchange rate in effect on the respective balance sheet dates, and our total revenues and expenses, which are reflected in our financial statements as translated into U.S. dollars for each financial reporting period at the monthly average exchange rate. For example, during 2003, the U.S. dollar dropped against many of the currencies in which we conduct business. During the nine months ended September 30, 2004, foreign currency translation had a $46.8 million positive impact on total revenue and a $43.3 million negative impact on our total costs of services and operating, administrative and other expenses. During the year ended December 31, 2003, foreign currency translation had a $54.4 million positive impact on our total revenue and a $47.3 million negative impact on our total costs of services and operating, administrative and other expenses. We routinely monitor our exposure to currency exchange rate changes in connection with transactions and sometimes enter into foreign currency exchange forward and option contracts to limit our exposure to such transactions, as appropriate. In the normal course of business, we also sometimes utilize derivative financial instruments in the form of foreign currency exchange forward contracts to mitigate foreign currency exchange exposure resulting from intercompany loans. In all cases, we view derivative financial instruments as a risk management tool and, accordingly, do not engage in any speculative activities with respect to foreign currency. At September 30, 2004, we had foreign currency exchange forward contracts with an aggregate notional amount of $12.0 million, which expire on various dates through December 31, 2004. The net impact on our earnings for the nine months ended September 30, 2004 resulting from unrealized gains and/or losses on these foreign currency exchange forward contracts was not significant. On April 6, 2004, we entered into an option agreement to purchase an aggregate notional amount of 8.7 million British pounds sterling, which would have expired on December 29, 2004. On July 2, 2004, we entered into an option agreement to purchase an aggregate notional amount of 18.8 million euros, which also would have expired on December 29, 2004. During October 2004, we sold both of these option agreements and entered into two new option agreements to purchase an aggregate notional amount of 10.2 million British pounds sterling for a cost of $0.3 million and 20.0 million euros for a cost of $0.4 million, both of which expire on December 29, 2004. The net impact on our earnings resulting from gains and/or losses on these option agreements has not been, and is not expected to be, material. We also enter into loan commitments that relate to the origination or acquisition of commercial mortgage loans that will be held for resale. SFAS No. 133 Accounting for Derivative Instruments and Hedging Activities, requires that these commitments be recorded at their relative fair values as derivatives. The net impact on our financial position for the nine months ended September 30, 2004 resulting from these derivative contracts was not significant. (1) Includes $11.8 million relating to our senior secured credit facilities and $2.0 million related to our Westmark senior notes (see note 11 to our unaudited consolidated financial statements included elsewhere in this prospectus). (2) Consists of amounts due under our senior secured credit facilities. (3) Primarily includes our 11 1/4% senior subordinated notes and 9 3/4% senior notes. We utilize sensitivity analyses to assess the potential effect of our variable rate debt. If interest rates were to increase by 40 basis points, which would comprise approximately 10% of the weighted average interest rates of our outstanding variable rate debt at September 30, 2004, the net impact would be a decrease of $1.2 million on pre-tax income and cash provided by operating activities for the nine months ended September 30, 2004. Based on dealers quotes at September 30, 2004, the estimated fair values of our 9 3/4% senior notes and our 11 1/4% senior subordinated notes were $148.2 million and $238.5 million, respectively. Estimated fair values for the term loan under our senior secured credit facilities and our remaining long-term debt are not presented because we believe that they are not materially different from book value, primarily because the majority of our remaining debt is based on variable rates that approximate terms that we believe could be obtained at September 30, 2004. We historically have not entered into agreements with third parties for the purpose of hedging our exposure to changes in interest rates. Although we do not have any current intentions to enter into such agreements in the future, we may do so in connection with our on-going assessment of our interest rate exposure. If we do enter into any such agreements, we would do so for risk management purposes only and not to engage in speculative activities with respect to interest rates. We would apply SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended by SFAS No. 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities, when accounting for any such derivatives. Table of Contents BUSINESS Overview We are the largest global commercial real estate services firm, based on 2003 revenue, offering a full range of services to occupiers, owners, lenders and investors in office, retail, industrial, multi-family and other commercial real estate assets. As of December 31, 2003, we operated in 220 offices worldwide with over 13,500 employees, excluding affiliate and partner offices, providing commercial real estate services under the CB Richard Ellis brand name. Our business is focused on several service competencies, including strategic advice and execution assistance for property leasing and sales, forecasting, valuations, origination and servicing of commercial mortgage loans, facilities and project management and real estate investment management. We generate revenues both on a per project or transaction basis and from annual management fees. For the year ended December 31, 2003, approximately 87.3% of our revenue related to engagements on a per project or transaction basis and approximately 12.7% of our revenue related to ongoing management fee engagements. We have a well-balanced, highly diversified base of clients that includes more than 60% of the Fortune 100. Many of our clients are consolidating their commercial real estate-related expenditures with fewer providers and, as a result, awarding their business to those providers that have a strong presence in important markets and the ability to provide a complete range of services worldwide. As a result of this trend and our ability to deliver comprehensive solutions for our clients needs across a wide range of markets, we believe we are well positioned to capture a growing percentage of our clients commercial real estate services expenditures. Our History We trace our roots to a San Francisco-based firm formed in 1906 that grew to become one of the largest commercial real estate services firms in the western United States during the 1940s. In the 1960s and 70s, the company expanded both its service portfolio and geographic coverage to become a full-service provider with a growing presence throughout the United States. In 1989, employees and third-party investors acquired the company s operations to form CB Commercial. Throughout the 1990s, CB Commercial moved aggressively to accelerate growth and cultivate global capabilities to meet client demands. The company acquired leading firms in investment management (Westmark Realty Advisors now CB Richard Ellis Investors, in 1995), mortgage banking (L.J. Melody & Company, in 1996) and property and corporate facilities management, as well as capital markets and investment management (Koll Real Estate Services, in 1997). In 1996, CB Commercial became a public company. In 1998, the company, then known as CB Commercial Real Estate Services Group, achieved significant global expansion with the acquisition of REI Limited. REI Limited, which traces its roots to London in 1773, was the holding company for all Richard Ellis operations outside of the United Kingdom. Following the REI Limited acquisition, the company changed its name to CB Richard Ellis Services, Inc. and, later in 1998, acquired the London-based firm of Hillier Parker May & Rowden, one of the top property services firms operating in the United Kingdom. With these acquisitions, we believe we became the first real estate services firm with a platform to deliver integrated real estate services across the world s major business capitals through one commonly-owned, commonly-managed company. CB Richard Ellis Group, Inc., which was initially known as Blum CB Holding Corp. and later as CBRE Holding, Inc., was formed by an affiliate of Blum Capital Partners, L.P. as a Delaware corporation on February 20, 2001 for the purpose of acquiring all of the outstanding stock of CB Richard Ellis Services in a going private transaction. This transaction, which involved members of our senior management team and affiliates of Blum Capital Partners and Freeman Spogli & Co., was completed in July 2001. In July 2003, our global position was further solidified as CB Richard Ellis Services and Insignia Financial Group, Inc. were brought together to form a premier, worldwide, full-service real estate company. As a result of (In thousands) Net (loss) income $ (43,923 ) $ (1,708 ) $ (24,620 ) $ (34,704 ) $ 18,727 $ 17,426 $ (34,020 ) Add: Depreciation and amortization 103,385 40,001 53,571 92,622 24,614 12,198 25,656 Interest expense 83,496 52,138 51,739 71,256 60,501 29,717 20,303 Loss on extinguishment of debt 6,639 21,075 6,840 13,479 (Benefit) provision for income taxes (8,891 ) 1,690 (15,459 ) (6,276 ) 30,106 18,016 1,110 Less: Interest income 5,085 2,303 2,624 3,560 3,272 2,427 1,567 Table of Contents the Insignia acquisition, we now operate globally under the CB Richard Ellis brand name, which we believe is a well-recognized brand in virtually all of the world s key business centers. Lastly, in order to enhance our financing flexibility and to provide liquidity for some of our stockholders, in June 2004 we completed the initial public offering of our common stock. Our Corporate Structure We are a holding company and conduct all of our operations through our indirect subsidiaries. Our directly-owned subsidiary CB Richard Ellis Services is also generally a holding company and is the primary obligor or issuer with respect to most of our long-term indebtedness, including our senior secured credit facilities, our 9 3/4% senior notes due 2010 and our 11 1/4% senior subordinated notes due 2011. In our Americas segment described below, substantially all of our advisory services and outsourcing services operations, other than mortgage loan origination and servicing, are conducted through our indirect wholly owned subsidiaries CB Richard Ellis Real Estate Services, Inc., which we acquired in connection with the Insignia acquisition and was formerly known as Insignia/ESG, Inc., and CB Richard Ellis Inc. Our mortgage loan origination and servicing operations are conducted exclusively through our indirect wholly owned subsidiary, L.J. Melody & Company, and its subsidiaries. Our investment management business in our Americas segment is conducted almost entirely through our indirect wholly owned subsidiary CB Richard Ellis Investors, L.L.C. Our operations in Canada are primarily conducted through our indirect wholly owned subsidiary CB Richard Ellis Limited. Our operations outside the Americas segment, including both our Europe, Middle East and Africa, and Asia-Pacific segments described below, are conducted through a number of indirect wholly owned subsidiaries. The most significant of such subsidiaries in Europe, Middle East and Africa include CB Richard Ellis Ltd. and Insignia Richard Ellis Europe Limited (the United Kingdom), CB Richard Ellis SA and Insignia France SARL (France), CB Richard Ellis SA (Spain) and CB Richard Ellis, B.V. (the Netherlands). The most significant of such subsidiaries in Asia Pacific include CB Richard Ellis Pty Ltd. (Australia), CB Richard Ellis (Agency) Ltd. (New Zealand), CB Richard Ellis Ltd. (Hong Kong) and CB Richard Ellis Pte Ltd. (Singapore). Industry Overview Our business covers all the various segments that compose the commercial real estate services industry, which includes leasing, sales, property management, facilities management, consulting, mortgage origination and servicing, valuation and appraisal services and investment management. Based upon our experience in these various segments and our management s ongoing, internally-generated assessment of the size of the addressable market within each such segment, we believe that the U.S. commercial real estate services industry, excluding investment management, generated approximately $22 billion in revenues during 2003. In addition, we review on a quarterly basis various internally-generated statistics and estimates regarding both office and industrial space within the U.S. commercial real estate services industry, including the total available stock of rentable space and the average rent per square foot of space. Our management believes that changes in the addressable commercial rental market represented by the product of available stock and rent per square foot provide a reliable estimate of changes in the overall commercial real estate services industry because nearly all segments within the industry are affected by changes in these two measurements. We estimate that the product of available stock and rent per square foot grew at a compound annual growth rate of approximately 4.8% from 1993 through 2003. During the next few years, we believe the key drivers of revenue growth for the largest commercial real estate services companies will be: (1) the continued outsourcing of commercial real estate services, (2) the consolidation of clients activities with fewer providers and (3) the increasing institutional ownership of commercial real estate. Table of Contents Outsourcing Motivated by reduced costs, lower overhead, improved execution across markets, increased operational efficiency and a desire to focus on their core competencies, property owners and occupiers have increasingly contracted out for commercial real estate services, including the following: Transaction management oversight of purchase and sale of properties, execution of lease transactions, renewal of leases, expansions and relocation of offices and disposition of surplus space; Facilities management oversight of all the operations associated with the functioning of occupied real estate, whether owned and leased, including engineering services, janitorial services, security services, landscaping and capital improvements and directing and monitoring of various subcontractors; Project management oversight of the design and construction of interior space (as distinct from building design and construction), including assembling and coordinating contracting teams, and creating and managing budgets; Lease administration analysis of all real estate leases of a client to ensure that it is in compliance with all terms and maintenance of reports on all lease data, including critical dates such as renewal options, expansion options and termination options, performance of required services and proper charging or payment for costs; Property management oversight of the daily operation of a single property or portfolio of properties, including tenant service/relations and bidding, awarding and administering subcontracts for maintenance, landscaping, security, parking, capital and tenant improvements to implement the owner s specific property value enhancement objectives through maximization of cash flow; and Property accounting performance of all of the accounting and financial reporting associated with a property or portfolio, including operating budget and expenses, rent collection and other accounts receivable, accounts payable, capital and tenant improvements and tenant lease administration. According to an Ernst & Young study of major corporations published in the Fall of 2002, 57% of the subject corporations retained third-party service providers for transaction management services, 46% outsourced their lease administration functions and 37% outsourced their facilities management functions. We believe this represents an increase from historical outsourcing of these functions, and we expect this outsourcing trend to continue. Consolidation Despite recent consolidation, the commercial real estate services industry remains highly fragmented. Other than the limited number of national and international real estate services firms with whom we compete in a number of service competencies, most firms within the industry are local or regional firms that are substantially smaller than us on an overall basis, although in some cases have a larger local presence in certain competencies. We believe that major property owners and corporate users are motivated to consolidate their service provider relationships on a regional, national and global basis to obtain more consistent execution across markets, to achieve economies of scale and enhanced purchasing power and to benefit from streamlined management oversight and the efficiency of single point of contact service delivery. As a result, we believe large owners and occupiers are awarding a disproportionate share of this business to the larger real estate services providers, particularly those that provide a full suite of services across geographical boundaries. Institutional Ownership of Commercial Real Estate Institutional owners, such as real estate investment trusts, or REITs, pension funds, foreign institutions and other financial entities, increasingly are acquiring more real estate assets and financing them in the capital markets. Total U.S. real estate assets held by institutional owners increased to $423 billion in 2003 from $223 Table of Contents billion in 1994. REITs were the main drivers of this growth, with a portfolio increase of more than 400% over this time period. Pension fund assets also grew by 48% and foreign institutions augmented their U.S. real estate investments by 77%. We believe it is likely that these owners will outsource management of their portfolios and consolidate their use of commercial real estate services vendors. Our Regions of Operation and Principal Services We have organized our business into, and report our results of operations through, three geographically organized segments: (1) the Americas, (2) Europe, Middle East and Africa, or EMEA, and (3) Asia Pacific. Within our Americas segment, we organize our services into the following business areas in order to maximize synergies and cross-selling opportunities among our clients: (a) advisory services, (b) outsourcing services and (c) investment management services. Information regarding revenue and operating income or loss, attributable to each of our segments, is included in Segment Operations within the Management s Discussion and Analysis of Financial Condition and Results of Operations section of this prospectus and within note 21 to our audited consolidated financial statements included elsewhere in this prospectus. Information concerning the identifiable assets of each of our business segments is set forth in note 21 to our audited consolidated financial statements included elsewhere in this prospectus. The Americas The Americas is our largest segment of operations and provides a comprehensive range of services throughout the United States and in the largest metropolitan regions in Canada, Mexico and other selected parts of Latin America. Our Americas segment accounted for 73.3% of our revenue for the nine months ended September 30, 2004, 73.5% of our 2003 revenue, 76.6% of our 2002 revenue and 79.3% of our 2001 revenue. Advisory Services Corporations, institutions and other users of real estate services have been increasingly consolidating their relationships with fewer service providers that have depth of resources, full array of services and broad geographic reach. We believe our advisory services businesses have been at the vanguard of this trend, offering occupier/tenant and investor/owner services that meet the full spectrum of marketplace needs, including (1) real estate services, (2) mortgage loan origination and servicing and (3) valuation. Our advisory services business line accounted for 61.9% of our revenue for the nine months ended September 30, 2004, 59.7% of our 2003 revenue, 60.5% of our 2002 revenue and 61.3% of our 2001 revenue. Within advisory services, our major service lines are the following: Real Estate Services. We provide strategic advice and execution assistance to owners, investors and occupiers of real estate in connection with leasing, disposition and acquisition of property. These businesses are built upon strong client relationships that frequently lead to recurring revenue opportunities over many years. Our real estate services professionals are particularly adept at aligning real estate strategies with client business objectives, serving as an advisor as well as transaction executor. During 2003, on a pro forma basis, we advised on nearly 23,000 lease transactions involving aggregate rents of approximately $27.3 billion and more than 4,700 real estate sales transactions with an aggregate value of approximately $27.6 billion. We believe we are a market leader for the provision of sales and leasing real estate services in many of the top U.S. metropolitan statistical areas (as defined by the U.S. Census Bureau), including New York, Philadelphia, Washington, D.C., Los Angeles, Atlanta, Chicago, Boston and Dallas. Our advice and execution assistance professionals are compensated primarily through commission-based programs, which are payable upon completion of the assignment. Therefore, as compensation is our 111,447 138,037 Cash of discontinued operations 72,245 39,202 111,447 Cash of discontinued operations 66 Table of Contents largest expense, this flexible cost structure permits us to mitigate the negative effect on our operating margins during difficult market conditions. Due to the low barriers to entry and significant competition for quality employees, we strive to retain top professionals through an attractive compensation program tied to productivity. We further strengthen our relationships with our real estate services clients by offering proprietary research to clients through our Torto Wheaton Research unit, a leading provider of commercial real estate market information, forecasting and consulting services. Torto Wheaton Research provides data and analysis to its clients in various formats, including TWR Outlook reports for office, industrial, hotel, retail and multi-housing sectors covering 56 U.S. metropolitan areas and TWR Select office and industrial database coverage of over 210,000 commercial properties. Mortgage Loan Origination and Servicing. Our wholly owned subsidiary, L.J. Melody & Company, originates and services commercial mortgage loans primarily through relationships established with investment banking firms, national banks, credit companies, insurance companies, pension funds and government agencies. During 2003, L.J. Melody originated $11.0 billion in mortgage loans and, through a joint venture with GE Capital Real Estate, serviced approximately $61.0 billion in mortgage loans, $23.2 billion of which relates to servicing rights of L.J. Melody. Also during 2003, approximately $1.4 billion in loans were originated for federal government sponsored entities using a revolving credit line dedicated exclusively for this purpose. These loan originations generally occur without principal risk because L.J. Melody obtains a legally binding purchase commitment from the government sponsored entity before it actually originates the loan. Valuation. We provide valuation services that include market value appraisals, litigation support, discounted cash flow analyses and feasibility and fairness opinions. Our valuation business has developed proprietary technology for preparing and delivering valuation reports to its clients, which we believe provides it with a competitive advantage over its rivals. We believe that our valuation business is one of the largest in our industry. During 2003, on a pro forma basis, we completed over 11,500 valuation, appraisal and advisory assignments. Outsourcing Services Outsourcing is a long-term trend in commercial real estate, with corporations, institutions and others seeking to achieve improved efficiency, better execution and lower costs by relying on the expertise of third-party real estate specialists. Our outsourcing services business includes two business lines that seek to capitalize on this trend: (1) asset services and (2) corporate services. Although our management agreements with our outsourcing clients generally may be terminated on relatively short notice ranging between 30 days to a year, we have developed long-term relationships with many of these clients and we continue to work closely with them to implement their specific goals and objectives and to preserve and expand upon these relationships. As of December 31, 2003, we managed approximately 422.8 million square feet of commercial space for property owners and occupiers, which we believe represents one of the largest portfolios in the Americas. Our outsourcing services business line accounted for 9.5% of our revenue for the nine months ended September 30, 2004, 11.2% of our 2003 revenue, 13.1% of our 2002 revenue and 14.7% of our 2001 revenue. Asset Services. We provide property management, construction management, marketing, leasing, accounting and financial services on a contractual basis for income-producing office, industrial and retail properties owned by local, regional and institutional investors. We believe our contractual relationships with these clients put us in an advantageous position to provide other services for them, including refinancing, disposition and appraisal. Corporate Services. We provide a comprehensive set of portfolio management, transaction management, project management, strategic consulting, facilities management and other corporate real estate services to leading global companies and public sector institutions with large, geographically-diverse real estate portfolios. Corporate facilities under management in the Americas region include headquarters buildings, Table of Contents regional offices, administrative offices and manufacturing and distribution facilities. Corporate services clients are typically companies or public sector institutions with large, distributed real estate portfolios. We enter into long-term, contractual relationships with these organizations with the goal of ensuring that our clients real estate strategies support their overall business strategies. Investment Management Services Our wholly owned subsidiary, CB Richard Ellis Investors, L.L.C., provides investment management services to clients that include pension plans, investment funds, insurance companies and other organizations seeking to generate returns and diversification through investment in real estate and sponsors funds and investment programs that span the risk/return spectrum. In higher yield strategies, CBRE Investors co-invests with its clients/partners. Our investment management services business line accounted for 1.9% of our revenue for the nine months ended September 30, 2004, 2.6% of our 2003 revenue, 3.0% of our 2002 revenue and 3.3% of our 2001 revenue. CBRE Investors is organized into three general client-focused groups according to investment strategy, which include managed accounts group (low risk), strategic partners (value added funds) and special situations (higher yield and highly focused strategies). Operationally, a dedicated investment team with the requisite skill sets executes each investment strategy, with the team s compensation being driven largely by the investment performance of its particular strategy/fund. This organizational structure is designed to align the interests of team members with those of the firm and its investor clients/partners and to enhance accountability and performance. Dedicated teams share resources such as accounting, financial controls, information technology, investor services and research. In addition to the research provided by our advisory services group, which focuses primarily on market conditions and forecasts, CBRE Investors has an in-house team of research professionals who focus on investment strategy and underwriting. CBRE Investors closed over $1.2 billion of new acquisitions in the Americas in each of 2002 and 2003, and it has increased its assets under management in the Americas from $3.5 billion in 1998 to $5.7 billion in 2003, representing a 10.2% compound annual growth rate. Europe, Middle East and Africa As of December 31, 2003, our EMEA segment had offices in 28 countries, with its largest operations located in the United Kingdom, France, Spain, the Netherlands and Germany. Operations within the EMEA countries generally include brokerage, investment properties, corporate services, valuation/appraisal services, asset management services, facilities management and other services similar to our Americas segment. Our EMEA segment accounted for 19.8% of our revenue for the nine months ended September 30, 2004, 19.2% of our 2003 revenue, 15.6% of our 2002 revenue and 13.8% of our 2001 revenue. We are one of the leading commercial real estate services companies in the United Kingdom. We hold the leading market position in London in terms of 2003 leased square footage and provide a broad range of commercial property real estate services to investment, commercial and corporate clients located in London. We also have eight regional offices in Birmingham, Bristol, Jersey, Leeds, Liverpool, Manchester, Edinburgh and Glasgow. In France, we believe we are a market leader in Paris and we provide a complete range of services to the commercial property sector, as well as some services to the residential property market. In Spain, we provide expansive coverage operating through our offices in Madrid, Barcelona, Valencia, Malaga, Marbella and Palma de Mallorca. Our business in the Netherlands is based in Amsterdam, while our German operations are located in Frankfurt, Munich, Berlin and Hamburg. Our operations in these countries generally provide a full range of services to the commercial property sector, along with some residential property services. We also have affiliated offices that provide commercial real estate services under our brand name in the Middle East and Africa, including the countries of Bostwana, Israel, Kenya, South Africa, Uganda and Table of Contents Zimbabwe. Our agreements with these independent offices include licenses to use the CB Richard Ellis name in the relevant territory in return for payments to us of annual royalty fees. In addition, these agreements also include business cross-referral arrangements between us and the affiliates. We do not have any ownership interests with respect to these affiliated offices. Asia Pacific As of December 31, 2003, our Asia Pacific segment had offices in 11 countries. We believe that we are one of only a few companies that can provide a full range of real estate services to large corporations throughout the region, including the similar broad range of services provided by our Americas and EMEA segments. Our principal operations in Asia are located in China (including Hong Kong), Singapore, South Korea and Japan. In addition, we have agreements with affiliated offices in India, the Philippines, Thailand and other countries within the region that include licensing, royalty and cross-referral arrangements on terms similar to those with our affiliated offices in our EMEA segment, as described above. The Pacific region includes Australia and New Zealand, with principal offices located in Brisbane, Melbourne, Sydney, Perth, Auckland and Wellington. The Asia Pacific segment accounted for 6.9% of our revenue for the nine months ended September 30, 2004, 7.3% of our 2003 revenue, 7.8% of our 2002 revenue and 6.9% of our 2001 revenue. Our Competitive Position We believe we possess several competitive strengths that position us to capitalize on the positive outsourcing, consolidation and globalization trends in the commercial real estate services industry. Our strengths include the following: Global Brand and Market Leading Positions. For nearly a century, we and our predecessors have built the CB Richard Ellis brand into the largest commercial real estate services provider in the world, based on 2003 revenue, and one of only two commercial real estate services companies with a global brand. As a result of our global brand recognition and geographic reach, large corporations, institutional owners and users of real estate recognize us as a leading provider of world-class, comprehensive real estate services. Operating under the global CB Richard Ellis brand name, we are a leader in many of the local markets in which we operate, including New York, Los Angeles, Chicago, London and Paris. Full Service Capabilities. We provide a full range of commercial real estate services to meet the needs of our clients, and we believe this suite of services represents a broader range globally than those of many of our competitors. When combined with our extensive global reach and localized knowledge, this full range of real estate services enables us to provide world-class service to our multi-regional and multi-national clients, as well as to maximize our revenue per client. Strong Client Relationships and Client-tailored Service. We have forged long-term relationships with many of our clients. Our clients include more than 60% of the Fortune 100, with nearly half of these clients purchasing more than one service from us. In order to better satisfy the needs of our largest clients and to capture cross-selling opportunities, we have organized fully integrated client coverage teams comprised of senior management, a global relationship manager and regional and product specialists. We believe that this client-tailored approach contributed significantly to our 38.6% increase in revenues from the 50 largest clients of our U.S. investment sales group within our real estate services line of business during the period from 1999 to 2003. Attractive Business Model. Our business model features a diversified client base, recurring revenue streams, a variable cost structure, low capital requirements and strong cash flow generation. Diversified Client Base. Our global operations, multiple service lines and extensive client relationships provide us with a diversified revenue base. For 2003, on a pro forma basis, we estimate that corporations accounted for approximately 25% of our global revenues, insurance companies and banks accounted for approximately 23% of our revenue, pension funds and their advisors Table of Contents accounted for approximately 14% of our revenue, individuals and partnerships accounted for approximately 11% of our revenue, REITs accounted for approximately 10% of our revenue and other types of clients accounted for the remainder of our revenues. Recurring Revenue Streams. Our years of strong local market presence have allowed us to develop significant repeat client relationships, which along with the turnover of leases and properties for which we have previously acted as transaction manager we estimate accounted for approximately 65% of our 2003 revenue. This includes our contractual, annual fee-for-services businesses, which generally involve facilities management, property management, mortgage loan servicing provided by L.J. Melody & Company and asset management provided by CBRE Investors. Our contractual, fee-for-service business represented 12.7% of our 2003 revenue. Variable Cost Structure. Compensation is our largest expense, and our sales and leasing professionals are generally paid on a commission and bonus basis, which correlates with our revenue performance. This flexible cost structure mitigates the negative effect on our operating margins during difficult market conditions. However, our cost structure also includes significant other operating expenses that may not correlate to our revenue performance, including office lease and information technology maintenance expenses along with insurance premiums. Low Capital Requirements. Our business model is structured to provide value-added services with low capital intensity. During 2003, our net capital expenditures were 1.7% of our revenue. Strong Cash Flow Generation. Our strong brand name, full-service capabilities, and global presence enable us to generate significant revenues which, when combined with our flexible cost structure and low capital requirements, have allowed us historically to generate significant cash flow in a variety of economic conditions. Strong Management Team and Workforce. Our most important asset is our people. We have recruited a talented and motivated workforce of over 13,500 employees worldwide, excluding affiliate and partner offices, who are supported by a strong and deep senior management team consisting of a number of highly-respected executives, most of whom have over 20 years of broad experience in the real estate industry. In addition, we use equity compensation to align the interests of our senior management team with the interests of our stockholders. Our executive officers beneficially owned approximately 3.8% of our common stock as of October 31, 2004. Although we believe these strengths will create significant opportunities for our business, you should also be aware of the risks that may impact our competitive position, which include the following: Significant Leverage. We are highly leveraged and have debt service obligations. For the year ended December 31, 2003, on a pro forma basis, our interest expense was $83.5 million. For the nine months ended September 30, 2004, our interest expense was $52.1 million. In addition, the instruments governing our indebtedness impose operating and financial restrictions on the conduct of our business. Geographic Concentration. During 2003, approximately 23.8% of our revenue was generated from transactions originating in California and approximately 6.9% of our revenue was generated from transactions originating in the greater New York metropolitan area. In addition, a significant portion of our European operations is concentrated in London and Paris. As a result, future adverse economic effects in these regions may affect us more than our competitors. Exposure to Risks of International Operations. We conduct a significant portion of our business and employ a substantial number of people outside of the United States. During 2003 and the nine months ended September 30, 2004, we generated approximately 30.2% of our revenue from operations outside the United States. Because a significant portion of our revenues are derived from operations outside the United States, we are exposed to adverse changes in exchange rates and social, political and economic risks of doing business in foreign countries. Table of Contents Smaller Presence in Some Markets than our Local Competitors. Although we are the largest commercial real estate services firm in the world in terms of 2003 revenue, our relative competitive position varies significantly across service categories and geographic areas. Depending on the service, we face competition from other real estate service providers, institutional lenders, insurance companies, investment banking firms, investment managers and accounting firms, some of which may have greater financial resources than we do. Many of our competitors are local or regional firms. Although substantially smaller than we are, some of these competitors are larger on a local or regional basis. Our Growth Strategy We believe we have built the premier integrated global services platform in our industry. In developing this integrated global platform, we acquired such entities as The Koll Company, Westmark Realty Advisors, L.J. Melody, Richard Ellis International and Hillier Parker May & Rowden during the 1990s and, in 2003, we acquired Insignia. Today, we believe we offer the commercial real estate services industry s most complete suite of service offerings and that we have a leadership position in many of the top business centers around the world. Our primary business objective is to leverage this platform in order to garner an increasing share of industry revenues relative to our competitors. We believe this will enable us to maximize and sustain our long-term cash flow and increase long-term stockholder value. Our strategy to achieve these business objectives consists of several elements: Increase Revenue from Large Clients. We plan to capitalize on our client management strategy for our large clients, which is designed to provide them with a full range of services globally while maximizing our revenue per client. We deliver these services through relationship management teams that are charged with thoroughly understanding our customer s business and real estate strategies and matching our services to the customers requirements. The global relationship manager is a highly seasoned professional who is focused on maximizing revenue per client and compensated with a salary and a performance-based bonus and is supported by salaried professionals with specialized expertise, such as marketing, financial analysis and construction. The team leader also taps into our field-level transaction professionals, as necessary, for execution of client strategies. We believe this approach to client management will lead to stronger client relationships and enable us to maximize cross-selling opportunities and capture a larger share of our clients commercial real estate services expenditures. For example: we generated repeat business in 2003 from approximately 60% of our U.S. real estate sales and leasing clients; more than 40% of our corporate services clients today purchase more than one service and, in many cases, more than two; the square footage we manage for our 15 largest asset services clients has grown by 55% in three years; and the 50 largest clients of the investment sales group within our real estate services line of business generated $52.6 million in revenues in 2003 up 38.6% from $37.9 million for these same 50 clients four years earlier. Capitalize on Cross-selling Opportunities. Because we believe cross-selling represents a large growth opportunity within the commercial real estate services industry, we are committed to emphasizing this opportunity across all of our clients, services and regions. We have dedicated substantial resources and implemented several management initiatives to better enable our workforce to capitalize on these opportunities among our various lines of business, including our CBRE University outside Chicago that provides intensive training for sales and management professionals, a customer relationship management database and sales management principles and incentives designed to improve individual productivity. We believe the combination of these initiatives will enable us to further penetrate local markets and better capitalize on our worldwide platform. Table of Contents Continue to Grow our Investment Management Business. Our growing investment management business provides us with an attractive revenue source through fees on assets under management and gains on the sales of assets. We also expect to achieve strong growth in this business by continuing to harness the vast resources of the entire CB Richard Ellis organization for the benefit of our investment management clients. CBRE Investors independent structure creates an alignment of interests with its investors, while permitting its portfolio companies to use the broad range of services provided by our other business lines. As a result, we historically have received significant revenue from the provision of services on an arm s length basis to these portfolio companies, and we believe this will continue in the future. Focus on Best Practices to Improve Operating Efficiency. In 2001, we launched a best practices initiative, branded People, Platform & Performance, and we believe the process and operational improvements associated with this initiative contributed to operating cost reductions. We believe our focus on best practices has enabled us to generate industry-leading operating margins. We remain keenly focused on this strategic initiative and continue to strive for efficiency improvements and cost savings in order to maximize our operating margins and cash flow. Competition We compete across a variety of business disciplines within the commercial real estate services industry, including investment management, tenant representation, corporate services, construction and development management, property management, agency leasing, valuation and mortgage banking. Each of the business disciplines in which we compete is highly competitive on an international, national, regional and local level. Although we are the largest commercial real estate services firm in the world in terms of 2003 revenue, our relative competitive position varies significantly across product and service categories and geographic areas. Depending on the product or service, we face competition from other commercial real estate service providers, institutional lenders, insurance companies, investment banking firms, investment managers and accounting firms, some of which may have greater financial resources than we do. Many of our competitors are local or regional firms. Although substantially smaller than we are, some of these competitors are larger on a local or regional basis. We are also subject to competition from other large national and multi-national firms that have similar service competencies to ours, including Cushman & Wakefield, Grubb & Ellis, Jones Lang LaSalle and Trammell Crow. Different factors weigh heavily in the competition for clients. In advisory services, key differentiating factors include quality service, resource depth, demonstrated track record, analytical skills, market knowledge, strategic thinking and creative problem-solving. These factors are also vital in outsourcing services, and are supplemented by consistency of execution across markets, economies of scale, enhanced efficiency and cost reduction strategies. In investment management the ability to enhance asset value and produce solid, consistent returns on invested capital are keys to success. Seasonality A significant portion of our revenue is seasonal. Historically, this seasonality has caused our revenue, operating income, net income and cash flow from operating activities to be lower in the first two calendar quarters and higher in the third and fourth calendar quarters of each year. The concentration of earnings and cash flow in the fourth quarter is due to an industry-wide focus on completing transactions by year-end. Employees As of December 31, 2003, we had more than 13,500 employees worldwide, excluding affiliate and partner offices. As of December 31, 2003, approximately 245 of our employees were subject to collective bargaining agreements, the substantial majority of whom are employees in our asset services business in the New York/New Jersey area. We believe that our relations with our employees are satisfactory. Table of Contents Intellectual Property We hold various trademarks and trade names worldwide, which include the CB Richard Ellis name. Although we believe our intellectual property plays a role in maintaining our competitive position in a number of the markets that we serve, we do not believe we would be materially adversely affected by expiration or termination of our trademarks or trade names or the loss of any of our other intellectual property rights other than the CB Richard Ellis name and the L.J. Melody name. With respect to the CB Richard Ellis and L.J. Melody names, we have processed and continuously maintain trademark registrations for these trade names in the United States and, solely with respect to the CB Richard Ellis name, in most foreign jurisdictions where we conduct significant business. We obtained our most recent U.S. trademark registrations for the CB Richard Ellis name and related trade names in 2001, and these registrations would expire in 2007 if we failed to renew them. We obtained our most recent U.S. trademark registration for the L.J. Melody name in 1997, and this registration would expire in 2007 if we failed to renew it. In addition to trade names, we have developed proprietary technology for preparing and developing valuation reports to our clients through our valuation business and we offer proprietary research to clients through our Torto Wheaton research unit. We also offer proprietary investment structures through CB Richard Ellis Investors. While we seek to secure our rights under applicable intellectual property protection laws in these and any other proprietary assets that we use in our business, we do not believe any of these other items of intellectual property are material to our business. Environmental Matters Federal, state and local laws and regulations impose environmental controls, disclosure rules and zoning restrictions that impact the management, development, use, or sale of commercial real estate. We are not aware of any material noncompliance with the environmental laws or regulations currently applicable to us, and we are not the subject of any material claim for liability with respect to contamination at any location. However, these laws and regulations may discourage sales and leasing activities and mortgage lending with respect to some properties, which may adversely affect both us and the commercial real estate services industry in general. In addition, if we fail to disclose environmental issues in connection with a real estate transaction, we may become liable to a buyer or lessee of property. Environmental contamination or other environmental liabilities may also negatively affect the value of commercial real estate assets held by entities that are managed by our investment management business, which could adversely impact the result of operations of that business line. Applicable laws and contractual obligations to property owners could also subject us to environmental liabilities through our provision of management services. Environmental laws and regulations impose liability on current or previous real property owners or operators for the cost of investigating, cleaning up or removing contamination caused by hazardous or toxic substances at the property. As a result, we may be held liable as an operator for such costs in our role as an on-site property manager. This liability may result even if the original actions were legal and we had no knowledge of, or were not responsible for, the presence of the hazardous or toxic substances. Similarly, environmental laws and regulations impose liability for the investigation or cleanup of off-site locations upon parties that disposed or arranged for disposal of hazardous wastes at such locations. As a result, we may be held liable for such costs at landfills or other hazardous waste sites where wastes from our managed properties were sent for disposal. Under certain environmental laws, we could also be held responsible for the entire amount of the liability if other responsible parties are unable to pay. We may also be liable under common law to third parties for property damages and personal injuries resulting from environmental contamination at our sites, including the presence of asbestos-containing materials. Insurance coverage for such matters may be unavailable or inadequate to cover our liabilities. Additionally, liabilities incurred to comply with more stringent future environmental requirements could adversely affect any or all of our lines of business. In general, these leased offices are fully utilized. The most significant terms of the leasing arrangements for our offices are the term of the lease and the rent. Our leases have terms varying in duration. The rent payable under our office leases varies significantly from location to location as a result of differences in prevailing commercial real estate rates in different geographic locations. Our management believes that no single office lease is material to our business, results of operations or financial condition. In addition, we believe there is adequate alternative office space available at acceptable rental rates to meet our needs, although adverse movements in rental rates in some markets may negatively affect our profits in those markets when we enter into new leases. We do not own any offices, which is consistent with our strategy to lease instead of own. Legal Proceedings We are party to a number of pending or threatened lawsuits arising out of, or incident to, our ordinary course of business. Our management believes that any liability imposed on us that may result from disposition of these lawsuits will not have a material effect on our consolidated financial position or results of operations. Ray Wirta 60 Chief Executive Officer and Director Brett White 44 President and Director Kenneth J. Kay 49 Chief Financial Officer Alan C. Froggatt 55 President, EMEA Robert Blain 49 President, Asia Pacific Richard C. Blum 69 Chairman of the Board of Directors Jeffrey A. Cozad 40 Director Patrice Marie Daniels 44 Director Bradford M. Freeman 62 Director Michael Kantor 65 Director Frederic V. Malek 67 Director Jeffrey S. Pion 43 Director Gary L. Wilson 64 Director Ray Wirta. Mr. Wirta has been Chief Executive Officer of CB Richard Ellis Group since July 2001 and a director of CB Richard Ellis Group since September 2001. He has been Chief Executive Officer of CB Richard Ellis Services since May 1999. He served as its Chief Operating Officer from May 1998 to May 1999. Mr. Wirta holds a B.A. from California State University, Long Beach and an M.B.A. in International Management from Golden Gate University. Brett White. Mr. White has been President and a director of CB Richard Ellis Group since September 2001. He was Chairman of the Americas of CB Richard Ellis Services from May 1999 to September 2001 and was its President of Brokerage Services from August 1997 to May 1999. Previously, he was its Executive Vice President from March 1994 to July 1997 and Managing Officer of its Newport Beach, California office from May 1993 to March 1994. Mr. White is a member of the board of directors of Mossimo, Inc. Mr. White received his B.A. from the University of California, Santa Barbara. Kenneth J. Kay. Mr. Kay has been Chief Financial Officer of CB Richard Ellis Group since July 2002. He previously served as Vice President and Chief Financial Officer of Dole Food Company, Inc. from December 1999 to June 2002. Mr. Kay served as Executive Vice President and Chief Financial Officer for the consumer products group of Universal Studios, Inc. from December 1997 to December 1999. Mr. Kay is a certified public accountant in the State of California and holds a B.A. and an M.B.A. from the University of Southern California. Alan C. Froggatt. Mr. Froggatt has been President of CB Richard Ellis Ltd. EMEA since July 2003, when CB Richard Ellis Group acquired Insignia. He previously served as Chief Executive Officer of Insignia s European Operations and as Chief Executive of Richard Ellis Group Limited from the date it was acquired by Insignia in February 1998. Mr. Froggatt holds a B.S. from the College of Estate Management, University of Reading. Robert Blain. Mr. Blain has been President of CB Richard Ellis Asia Pacific since February 2002. Prior to such time, he was employed by Colliers International Property Consultants, Inc., and served as a Regional Investment Director from 1995 to 1998, its Australia Director from 1999 to 2000 and as its Chief Executive South Wales from 2000 to February 2002. Mr. Blain holds a diploma in Land Economy from the Real Estate Institute of New South Wales. Table of Contents Richard C. Blum. Mr. Blum has been Chairman of the Board of Directors of CB Richard Ellis Group since September 2001 and a director of CB Richard Ellis Group since July 2001. He is the Chairman and President of Richard C. Blum & Associates, Inc., the general partner of Blum Capital Partners, L.P., a long-term strategic equity investment management firm that acts as general partner for various investment partnerships and provides investment advisory services, which he founded in 1975. Mr. Blum is a member of the boards of directors of Northwest Airlines Corporation and Glenborough Realty Trust Incorporated and is Vice Chairman of the Board of URS Corporation. Mr. Blum also serves as co-chairman of Newbridge Capital, LLC, an investment management firm that invests in Asia and Latin America. Mr. Blum holds a B.A. and an M.B.A. from the University of California, Berkeley. Jeffrey A. Cozad. Mr. Cozad has been a director of CB Richard Ellis Group since September 2001. Mr. Cozad has been a partner of Blum Capital Partners, L.P. since 2000. Prior to joining Blum Capital Partners, Mr. Cozad was a managing director of Security Capital Group Incorporated, a global real estate research, investment and operating management company from 1991 to 2000. Mr. Cozad holds a B.A. from DePauw University and an M.B.A. from the University of Chicago Graduate School of Business. Patrice Marie Daniels. Ms. Daniels has been a director of CB Richard Ellis Group since February 2004. Ms. Daniels is a founding partner of Onyx Capital Ventures, L.P., a private equity investment firm, which was founded in October 2001. She previously served as Managing Director, Corporate and Leveraged Finance for CIBC World Markets, an investment banking firm, from March 1997 to October 2001. Ms. Daniels holds a B.S. from the University of California, Berkeley and an M.B.A. from the University of Chicago Graduate School of Business. Bradford M. Freeman. Mr. Freeman has been a director of CB Richard Ellis Group since July 2001. Mr. Freeman is a founding partner of Freeman Spogli & Co. Incorporated, a private investment company founded in 1983. Mr. Freeman is also a member of the board of directors of Edison International. Mr. Freeman holds a B.A. from Stanford University and an M.B.A. from Harvard Business School. Michael Kantor. Mr. Kantor has been a director of CB Richard Ellis Group since February 2004. Mr. Kantor has been a partner with the law firm of Mayer, Brown, Rowe & Maw LLP since March 1997. From 1993 to 1996, he served as the U.S. Trade Representative and from 1996 to 1997 as U.S. Secretary of Commerce. Mr. Kantor holds a B.A. from Vanderbilt University and a J.D. from Georgetown University. Frederic V. Malek. Mr. Malek has been a director of CB Richard Ellis Group since September 2001. He has served as Chairman of Thayer Capital Partners, a merchant banking firm he founded, since 1993. He also serves on the boards of directors of Automatic Data Processing Corp., Federal National Mortgage Association, FPL Group, Inc., Manor Care, Inc. and Northwest Airlines Corporation. Mr. Malek recently retired as director of American Management Systems, Inc., effective March 31, 2004. Mr. Malek holds a B.S. degree from the United States Military Academy at West Point and an M.B.A. from Harvard Business School. Jeffrey S. Pion. Mr. Pion has been a director of CB Richard Ellis Group since October 2003. Mr. Pion has been an Executive Vice President of CB Richard Ellis Group since January 2003. For the last 18 years, Mr. Pion has been a broker at our subsidiary CB Richard Ellis, Inc., focusing on the sale and leasing of office and commercial properties. Prior to joining CB Richard Ellis, Inc., Mr. Pion worked at Central Real Estate Corp., a real estate development and investment company based in Los Angeles. Mr. Pion holds a B.A. degree from the University of California, Santa Barbara. Gary L. Wilson. Mr. Wilson has been a director of CB Richard Ellis Group since September 2001. He previously served as a director of our company from 1989 to July 2001. Since April 1997, Mr. Wilson has been Chairman of Northwest Airlines Corporation, for which he served as Co-Chairman from January 1991 to April 1997. Mr. Wilson also serves on the boards of directors of The Walt Disney Company, On Command Table of Contents Corporation, Veritas Holdings GmbH and Yahoo! Inc. Mr. Wilson holds a B.A. from Duke University and an M.B.A. from the Wharton Graduate School of Business and Commerce at the University of Pennsylvania. Each executive officer serves at the discretion of our board of directors and holds office until his successor is elected and qualified or until his earlier resignation or removal. There are no family relationships among any of our directors or executive officers. Board Structure Our board of directors currently consists of ten directors. Our board of directors has determined that each of Ms. Daniels and Messrs. Blum, Cozad, Freeman, Kantor, Malek and Wilson is independent, as defined under and required by the federal securities laws and the rules of the New York Stock Exchange. All of our directors stand for election at each annual meeting of our stockholders. As described in greater detail under the heading titled Related Party Transactions Securityholders Agreement, pursuant to a securityholders agreement, our stockholders affiliated with Blum Capital Partners, L.P. are entitled to nominate a percentage of our total number of directors that is equivalent to the percentage of the outstanding common stock beneficially owned by these affiliates, with this percentage of our directors being rounded up to the nearest whole number of directors. Accordingly, these affiliates of Blum Capital Partners have nominated Messrs. Blum and Cozad to our board of directors. In addition to Messrs. Blum and Cozad, assuming our board of directors continues to consist of ten directors in the future, these affiliates will be entitled to nominate one additional director in future board elections based upon their percentage ownership of our common stock immediately after completion of the offering. Also pursuant to the securityholders agreement, our stockholders affiliated with Freeman Spogli & Co. Incorporated are entitled to nominate one of our directors, and they have nominated Mr. Freeman. After completion of the offering, our stockholders affiliated with Freeman Spogli & Co. Incorporated will no longer be entitled to nominate a director pursuant to the securityholders agreement. Committees of the Board The standing committees of our board of directors currently consist of an audit committee, a corporate governance and nominating committee, a compensation committee and an executive committee. Audit Committee The principal duties of our audit committee are as follows: to retain, compensate, oversee and terminate any registered public accounting firm in connection with the preparation or issuance of an audit report, and to approve all audit services and any permissible non-audit services provided by the independent auditors; to receive the direct reports from any registered public accounting firm engaged to prepare or issue an audit report; to review and discuss annual audited and quarterly unaudited financial statements with management and the independent auditors; to review with the independent auditor any audit problems and management s response; to discuss earnings releases, financial information and earnings guidance provided to analysts and rating agencies; to periodically meet separately with management, internal auditors and the independent auditors; to establish procedures to receive, retain and treat complaints regarding accounting, internal accounting controls or auditing matters; Table of Contents to obtain and review, at least annually, an independent auditors report describing the independent auditors internal quality-control procedures and any material issues raised by the most recent internal quality-control review of the independent auditors or any inquiry by governmental authorities; to set hiring policies for employees or former employees of the independent auditors; to retain independent counselor and other outside advisors, including experts in the area of accounting, as it determines necessary to carry out its duties; and to report regularly to our full board of directors with respect to any issues raised by the foregoing. Our audit committee is composed of Ms. Daniels and Messrs. Malek and Wilson, and our board of directors has determined that each of the members of our audit committee is independent, as defined under and required by the federal securities laws and the rules of the New York Stock Exchange, or NYSE, including Rule 10A-3(b)(i) under the Securities Exchange Act of 1934. Our board of directors has determined that Ms. Daniels qualifies as an audit committee financial expert, as this term has been defined by the SEC in Item 401(h)(2) of Regulation S-K. Our board of directors determined that Ms. Daniels acquired the required attributes for such designation as a result of the following relevant experience, which forms of experience are not listed in any order of importance and were not assigned any relative weights or values by our board of directors in making such determination: Ms. Daniels received a B.S. degree in Business Administration at the University of California, Berkeley and an M.B.A. degree in Finance at the University of Chicago Graduate School of Business. Ms. Daniels served in several capacities, including as a Managing Director, with Bankers Trust from July 1987 to March 1997, which included arranging private and public senior and subordinated debt financing and equity capital for leveraged buyout transactions and for restructuring or acquisitions for non-investment grade companies. Ms. Daniels served as a Managing Director with CIBC World Markets from March 1997 to October 2001, which included providing investment and commercial banking products to non-investment grade companies and leveraged buyout firms. Ms. Daniels is a founding partner of Onyx Capital Ventures, L.P., a private equity investment firm, which was founded in October 2001. Ms. Daniels served on the audit committee of the board of directors of World Color Press, Inc., a diversified commercial printing company that was publicly traded on the NYSE until it was acquired by Quebec or Printing Inc. in 1999, from January 1998 to October 1999. Our board of directors has adopted a written charter for the audit committee, which is available on our website. Corporate Governance and Nominating Committee The principal duties of the corporate governance and nominating committee are as follows: subject to the provisions of the securityholders agreement described in further detail under the heading titled Related Party Transactions Securityholders Agreement, to recommend to our board of directors proposed nominees for election to the board of directors by the stockholders at annual meetings, including an annual review as to the renominations of incumbents and proposed nominees for election by the board of directors to fill vacancies that occur between stockholder meetings; and to make recommendations to the board of directors regarding corporate governance matters and practices. Table of Contents Our corporate governance and nominating committee is composed of Messrs. Blum, Malek and Kantor, and our board of directors has determined that each of the members of our corporate governance and nominating committee is independent, as defined under and required by the federal securities laws and the rules of the NYSE. Our board of directors has adopted a written charter for the corporate governance and nominating committee, which is available on our website. Compensation Committee The principal duties of the compensation committee are as follows: to review key employee compensation policies, plans and programs; to review and approve the compensation of our chief executive officer and the other executive officers of the company and its subsidiaries; to review and approve any employment contracts or similar arrangement between the company and any executive officer of the company; to review and consult with our chief executive officer concerning selection of officers, management succession planning, performance of individual executives and related matters; and to administer our stock plans, incentive compensation plans and any such plans that the board may from time to time adopt and to exercise all the powers, duties and responsibilities of the board of directors with respect to such plans. Our compensation committee currently is composed of Messrs. Malek, Freeman and Cozad, and our board of directors has determined that each of the members of our compensation committee is independent, as defined under and required by the federal securities laws and the rules of the NYSE. Our board of directors has adopted a written charter for the compensation committee, which is available on our website. Executive Committee Our board of directors has delegated to the executive committee the authority to act for the board on most matters during intervals between board meetings, except with respect to issuances of stock, declarations of dividends and other matters that, under Delaware law, may not be delegated to a committee of the board of directors. The principal duties of the executive committee are as follows: to develop and implement our Company s policies, plans and strategies; and to approve, modify or reject certain acquisitions or investments. The executive committee currently is composed of Messrs. Wirta, White and Blum. Compensation Committee Interlocks and Insider Participation During the fiscal year ended December 31, 2003, the members of our compensation committee were Frederic V. Malek and Bradford Freeman. Neither Mr. Malek nor Mr. Freeman has ever been an officer or employee of our company or any of our subsidiaries. During 2003, none of our executive officers served on the compensation committee (or equivalent), or the board of directors, of another entity whose executive officer(s) served on our compensation committee or board of directors. Additional information concerning transactions between us and the members of our compensation committee or entities affiliated with such members is described under the heading titled Related Party Transactions. Table of Contents Codes of Conduct and Ethics and Corporate Governance Guidelines Our board of directors has adopted (1) a code of business conduct and ethics applicable to our directors, officers and employees, (2) a code of ethics applicable to our chief executive officer, chief financial officer and global controller and (3) corporate governance guidelines, each in accordance with applicable rules and regulations of the SEC and the NYSE. Each of these codes of ethics and conduct and the corporate governance guidelines is available on our website. Compensation of Directors On November 5, 2003, we granted Gary Wilson options to acquire 27,714 shares of our Class A common stock for $5.77 per share in connection with his agreement to serve on the audit committee of our board of directors. On February 9, 2004, we granted Michael Kantor options to acquire 13,857 shares of our Class A common stock for $5.77 per share in connection with his agreement to serve on our board of directors. The options of Messrs. Wilson and Kantor were granted pursuant to our 2001 stock incentive plan, vest 20% per anniversary of their respective grant dates and expire on the earlier of the tenth anniversary of the grant date or the one-year anniversary after such director ceases to be a member of our board of directors. In addition, our director compensation policy provides for the following annual compensation for each of our non-employee directors: a $20,000 annual cash retainer; a grant of a number of unrestricted shares of our common stock with a fair market value equal to $10,000 on the date of grant; a stock option grant for a number of shares equal to $50,000 divided by the fair market value of our common stock on the date of grant; and a restricted stock grant for a number of shares equal to $25,000 divided by the fair market value of our common stock on the date of grant. Pursuant to this policy, our directors also receive an additional payment of $1,000 per meeting attended and $1,000 per committee meeting attended that was not scheduled in conjunction with a meeting of our board of directors. The chairman of the audit committee receives an additional annual cash retainer of $10,000, and the chairmen of all other committees receive additional annual cash retainers of $5,000 each. The annual cash retainer, the additional payments per meeting attended and the additional annual cash retainers for committee chairmanships became effective under this policy as of March 11, 2004. With respect to the equity compensation components of our director compensation policy, on June 10, 2004, automatic grants of stock options and unrestricted and restricted stock, as described above, were made to our current outside directors pursuant to our 2004 stock incentive plan, the terms of which are described below. These grants were pro-rated to cover only the period from the date the registration statement for our initial public offering was declared effective by the SEC to the following May 15, the end date of the annual pro-ration cycle as determined by the 2004 stock incentive plan. We also reimburse our non-employee directors for all out-of-pocket expenses incurred in the performance of their duties as directors. Our employee directors do not receive any fees for attendance at meetings or for their service on our board of directors. (1) Bonuses for each year are paid in the first quarter of the following year pursuant to our Annual Management Bonus Plan. For example, the bonus shown for 2003 represents the 2002 annual bonus that was paid in the first quarter of 2003. (2) Pursuant to the 1996 Equity Incentive Plan, or EIP, Mr. White purchased 25,000 shares of CB Richard Ellis Services common stock in 1998 at a purchase price of $38.50 per share and 20,000 shares of CB Richard Ellis Services common stock in 2000 at a purchase price of $12.875 per share. These purchases were paid for by the delivery of full-recourse promissory notes. A First Amendment to Mr. White s 1998 promissory note provided that the portion of the then outstanding principal in excess of the fair market value of the shares would be forgiven in the event that Mr. White was an employee of ours or of our subsidiaries on November 16, 2002 and the fair market value of our common stock was at least $13.89 per share on November 16, 2002. As part of our acquisition of CB Richard Ellis Services in 2001, the 25,000 shares of CB Richard Ellis Services common stock purchased by Mr. White were exchanged for 69,284 shares of our Class B common stock, which shares were substituted for CB Richard Ellis Services shares as security for the note. Mr. White s promissory note was subsequently amended in 2001, terminating the First Amendment and adjusting the original 1998 Stock Purchase Agreement by reducing the purchase price from $13.89 to $5.77. The 25,000 shares held as security for the Second Amended Promissory Note were tendered as full payment for this note. The remaining note delivered by Mr. White accrues interest at 7.40% per year and all principal and accrued interest is payable on August 31, 2010. As part of our acquisition of CB Richard Ellis Services in 2001, the 20,000 shares of CB Richard Ellis Services common stock purchased by Mr. White were exchanged for 55,427 shares of our Class B common stock, which shares were substituted for CB Richard Ellis Services shares as security for the note. Pursuant to the EIP, Mr. Wirta Table of Contents purchased 30,000 shares of CB Richard Ellis Services common stock in 2000 at a purchase price of $12.875 that was paid for by the delivery of a full-recourse promissory note. The note accrues interest at 7.40% per year and all principal and accrued interest is payable on August 31, 2010. As part of the acquisition, the 30,000 shares of CB Richard Ellis Services common stock were exchanged for 83,140 shares of our Class B common stock, which shares were substituted for the CB Richard Ellis Services shares as security for the note. All interest charged on the outstanding promissory note balances for any year is forgiven if the executive s performance produces a high enough level of bonus, with approximately $7,500 of interest forgiven for each $10,000 of bonus. In 2003, our board of directors forgave all 2002 interest on Mr. White s and Mr. Wirta s notes. Based on the 2003 bonuses paid to Messrs. Wirta and White in the first quarter of 2004, we expect all interest charged on their outstanding promissory notes in 2003 to be forgiven in 2004. (3) Pursuant to Mr. Blain s employment agreement, he received a schooling and housing allowance of $120,000 in 2002 and $157,692 in 2003. (4) In connection with our acquisition of CB Richard Ellis Services in 2001, we offered and sold shares of our Class A common stock for $5.77 per share to certain of our employees, including 177,541 shares to Mr. Wirta and 73,615 shares to Mr. White. If the employment of the owner of such shares is terminated, we have the right to repurchase a portion of the shares at either fair market value or the amount paid for such shares by the owner, which depends upon whether the owner was terminated for cause or voluntarily left for a good reason, as such terms are defined in the owner s subscription agreement. On each of the first five anniversaries of the July 20, 2001 purchase date of the shares, 20% of the shares initially subject to repurchase cease to be subject to the right of repurchase. Accordingly, at December 31, 2003, 60% of such shares acquired by Mr. Wirta and Mr. White remain subject to repurchase. The per share consideration paid for these shares was the same as the per share consideration paid by certain of our stockholders to acquire shares of our Class A common stock and Class B common stock on July 20, 2001, which consideration was used to partially finance our acquisition of CB Richard Ellis Services. Our shares of Class A common stock were not publicly traded at such time. Accordingly, the Summary Compensation Table reflects a valuation of $0 for these restricted stock awards. (5) In connection with our acquisition of CB Richard Ellis Services in 2001, we awarded cash retention bonuses to Messrs. Wirta, White and Leonetti to provide an incentive and reward for continued service up to and including the date of the acquisition. At the effective time of the acquisition, Messrs. Wirta, White and Leonetti also received for each of their options to purchase shares of CB Richard Ellis Services common stock the greater of (a) the amount by which $16.00 exceeded the exercise price of the option, if any, and (b) $1.00. (6) As described in greater detail in footnote (2) above, the promissory note delivered by Mr. White in 1998 as consideration for his purchase of 25,000 shares of CB Richard Ellis Services common stock for $38.50 per share, or a total of $962,500, was amended to adjust the principal amount of such promissory note to $400,000. The $562,500 difference is included as other compensation for Mr. White. (7) Mr. Kay joined us effective June 13, 2002. (8) Pursuant to Mr. Kay s former employment agreement, he received a sign-on bonus of $300,000. (9) Mr. Leonetti ceased to be an executive officer and an employee of ours on July 19, 2002. (10) In connection with the termination of Mr. Leonetti s employment, he received a severance payment of $170,000. (11) Pursuant to a separation agreement executed on November 19, 2001, Mr. Leonetti received a payment of $300,000. (12) Mr. Froggatt joined us, effective July 23, 2003, when we acquired Insignia. (13) Mr. Froggatt received a car allowance of $20,777 in 2003. (14) Mr. Froggatt received a benefit of $566 under our life insurance program. (15) Mr. Blain joined us effective January 23, 2002. (16) Pursuant to Mr. Blain s employment agreement, he received a one-time transfer allowance of $15,000. EBITDA $ 135,621 $ 110,893 $ 69,447 $ 132,817 $ 130,676 $ 74,930 $ 11,482 Ray Wirta 195,273 525,705 Brett White 157,172 468,552 Kenneth J. Kay 34,365 237,229 Alan C. Froggatt 83,141 Robert Blain 69,284 The table above does not include the options granted to our executive officers on September 22, 2004. Incentive Plans 2001 Stock Incentive Plan Our 2001 stock incentive plan was adopted by our board of directors, and approved by our stockholders, on June 7, 2001. However, our 2001 stock incentive plan was terminated in June 2004, in connection with the adoption of our 2004 stock incentive plan, which is described below. The 2001 stock incentive plan permitted the grant of nonqualified stock options, incentive stock options, stock appreciation rights, restricted stock, restricted stock units and other stock-based awards to our employees, directors or independent contractors. Since our 2001 stock incentive plan has been terminated, no shares remain available for issuance under the 2001 stock incentive plan. However, as of October 31, 2004, outstanding stock awards granted under the 2001 stock incentive plan to acquire 5,394,949 shares of our Class A common stock remain outstanding according to their terms, and we will Loss from continuing operations before income taxes (14,881 ) (185 ) Income tax benefit 5,208 (Loss) income from continuing operations before income taxes (21,197 ) 8,799 12,213 (185 ) Income tax benefit (expense) 3,594 (3,511 ) Table of Contents continue to issue shares to the extent required under the terms of such outstanding awards. The 2001 stock incentive plan is administered by our board of directors, which may delegate its duties and powers in whole or in part to any committee of the board of directors. Unless otherwise determined by our board of directors, awards granted under the 2001 stock incentive plan are not transferable other than by will or by the laws of descent and distribution. In the event of a change of control, which is defined in the 2001 stock incentive plan, (1) any outstanding awards then held by participants, including executive officers, which are unvested or otherwise unexercisable will automatically be deemed exercisable or otherwise vested, as the case may be, as of immediately prior to the change of control and (2) our board of directors may (a) provide for a cash payment to the holder of an award in consideration for the cancellation of the award and/or (b) provide for substitute or adjusted awards. 2004 Stock Incentive Plan Our 2004 stock incentive plan was adopted by our board of directors on April 1, 2004, and approved by our stockholders, on April 21, 2004. The 2004 stock incentive plan authorizes the grant of stock-based awards to our employees, directors and consultants. A total of 6,928,406 shares of our Class A common stock have been reserved for issuance under the 2004 stock incentive plan. This share reserve will be reduced by one share upon exercise or redemption of an option or stock appreciation right, and reduced by 2.25 shares upon issuance of stock pursuant to other stock-based awards. Shares of our common stock covered by awards that expire, terminate, lapse, are reacquired by us or are redeemed for cash rather than shares will again be available for grant under the stock incentive plan. No employee will be eligible to be granted options or stock appreciation rights covering more than 2,078,522 shares during any calendar year. In addition, our board of directors has adopted a policy stating that no person will be eligible to be granted options, stock appreciation rights, or restricted stock purchase rights covering more than 692,841 shares during any calendar year and to be granted any other form of stock award permitted under the 2004 stock incentive plan covering more than 346,420 shares during any calendar year. As of October 31, 2004, 1,265,643 shares were subject to options issued under our 2004 stock incentive plan and 5,631,263 shares remained available for future grants under the 2004 stock incentive plan. The number of shares issued or reserved pursuant to the 2004 stock incentive plan, or pursuant to outstanding awards, is subject to adjustment on account of mergers, consolidations, reorganizations, stock splits, stock dividends and other dilutive changes in our common stock. In addition, our board of directors may adjust outstanding awards to preserve the awards benefits or potential benefits. Our board of directors has delegated administration of the 2004 stock incentive plan to the compensation committee. The compensation committee, or our board of directors if the delegation of authority to the compensation committee is terminated in the future, has the authority to: designate participants in the plan; determine the type(s), number, terms and conditions of awards, as well as the timing and manner of grant; interpret the plan; establish, adopt or revise any rules and regulations to administer the plan; and make all other decisions and determinations that may be required under the plan. Incentive stock options must have an exercise price that is at least equal to, and nonstatutory stock options an exercise price at least 85% of, the fair market value of our Class A common stock on the date the option is granted. An option holder may exercise an option by payment of the exercise price (1) in cash, (2) according to a deferred payment or similar arrangement, (3) pursuant to a same day sale program, (4) by the surrender of a number of shares of Class A common stock already owned by the option holder for at least six months with a fair Table of Contents market value equal to the exercise price or (5) by a combination approved by the board. In the event of the option holder s termination, the option holder will generally have up to three months (up to one year if due to disability or 18 months if due to death) from termination to exercise his/her vested options. Directors who are neither employed by us nor receive a management fee from us will each automatically receive an annual grant of stock options with a per share exercise price equal to the fair market value of our Class A common stock and an aggregate exercise price equal to $50,000. They will also each automatically receive an annual grant of restricted stock worth a total of $25,000 on the date of grant. Our board of directors may award restricted stock bonuses. Our board may also award restricted stock units, which entitle the participant the right to receive one share of common stock per unit at the time the unit vests, with delivery of such common stock on a date chosen by the participant. For both restricted stock bonuses and units, vesting will generally be based on the participant s continuous service. In the event a participant s continuous service terminates, all unvested common stock as of the date of termination will be subject to our reacquisition. Our board of directors may grant stock appreciation rights independent of or in connection with an option. The base price per share of a stock appreciation right may be no less than 85% of the fair market value of our Class A common stock. Generally, each stock appreciation right will entitle a participant upon redemption to an amount equal to (a) the excess of (1) the fair market value on the redemption date of one share of common stock over (2) the base price, times (b) the number of shares of common stock covered by the stock appreciation right. To the extent a stock appreciation right is granted concurrently with an option, the redemption of the stock appreciation right will proportionately reduce the number of shares of common stock subject to the concurrently granted option. Payment shall be made in common stock or in cash, or a combination of both, as determined by the board. The plan also allows for grants of other stock-based awards such as restricted stock purchase rights, phantom stock units, performance shares and performance share units. Unless otherwise determined by our board of directors or provided for in a written agreement evidencing an award, awards granted under the 2004 stock incentive plan are not transferable other than by will or by the laws of descent and distribution. In the event of a change of control, as defined in the stock incentive plan, other than dissolution, the board may provide for the (1) assumption or continuation of any stock awards outstanding under the plan, (2) issuance of substitute awards that will substantially preserve the terms of any awards, (3) payment in exchange for the cancellation of an award or (4) termination of an award upon the consummation of the change of control, but only if the participant has been permitted to exercise or redeem an option or stock appreciation right prior to the change of control. Furthermore, at any time the board may provide for the acceleration of exercisability and/or vesting of an award. Our board of directors may amend, suspend, or terminate the stock incentive plan in any respect at any time, but no amendment may materially impair any of the rights of a participant under any awards previously granted, without his/her consent. Deferred Compensation Plans We have two deferred compensation plans, one of which has been frozen and is no longer accepting deferrals, which we refer to as the Old DCP, and one of which became effective on August 1, 2004 and began accepting deferrals on August 13, 2004, which we refer to as the New DCP. Old DCP Prior to amending the Old DCP as discussed below, each participant in the Old DCP was allowed to defer a portion of his or her compensation for distribution generally either after his or her employment with us ends or Table of Contents on a future date at least three years after the deferral election date. The investment alternatives available to participants include two interest index funds and an insurance fund in which gains and losses on deferrals are measured by one or more of approximately 80 mutual funds. Distributions with respect to the interest index and insurance fund accounts are made by us in cash. In addition, prior to July 2001, participants were entitled to invest their deferrals in stock fund units that are distributed as shares of our Class A common stock. As of October 31, 2004, there were 2,717,313 outstanding stock fund units under the Old DCP, all of which were vested. Effective January 1, 2004, we closed the Old DCP to new participants. Until January 1, 2005, the Old DCP will continue to accept compensation deferrals from those participants who currently have a balance in the plan, meet the eligibility requirements and elect to participate, in each case up to a maximum annual contribution amount of $250,000 per participant. Effective January 1, 2005, no additional deferrals will be permitted under this plan. Existing account balances under the plan will be paid to participants in the future according to their existing deferral elections. However, all participants may make unscheduled in-service withdrawals of their account balances, including the shares of Class A common stock underlying stock fund units, if they pay a penalty equal to 7.5% and the taxes due on the value of the withdrawal. Prior to our initial public offering, all shares held by our current and former employees and consultants, including any shares that such employees and consultants are entitled to receive as distributions with respect to stock fund units in the Old DCP, were subject to transfer restrictions. In connection with our initial public offering, we waived all of these transfer restrictions. As a result, all of these shares, including any shares received as future distributions with respect to stock fund units in the Old DCP, may be sold, subject to applicable securities law requirements. Shortly after our initial public offering, we filed a registration statement on Form S-8 that registered, among other things, the shares of Class A common stock to be distributed in the future with respect to stock fund units in the Old DCP. We have entered into agreements with participants in the Old DCP holding stock fund units with 2,280,831 underlying shares of Class A common stock pursuant to which these participants have agreed to sell no more than 20% of the shares underlying their current stock fund unit balances during any year over the next five years in exchange for fixed cash payments by us to these participants. New DCP Effective August 1, 2004, we adopted the New DCP, which began accepting deferrals for compensation otherwise earned after August 13, 2004. Under the New DCP, each participant is allowed to defer a portion of his or her compensation for distribution generally either after his or her employment with us ends or on a future date at least three years after the deferral election date. Deferrals are credited at the participant s election to one or more investment alternatives under the New DCP, which include a money-market fund and a mutual fund investment option. There is limited flexibility for participants to change distribution elections once made. However, all participants may make unscheduled in-service withdrawals of their account balances if they pay a penalty equal to 7.5% and the taxes due on the value of the withdrawal. 401(k) Plan We maintain a tax qualified 401(k) retirement plan. Generally, our employees are eligible to participate in the plan if they are at least 21 years old. The plan provides for participant contributions, as well as discretionary contributions by us. A participant is allowed to contribute to the plan from 1% to 50% of his or her compensation, subject to limits imposed by applicable law. Each year, we determine an amount of employer contributions that we will contribute, if any, to the plan based on the performance and profitability of our consolidated U.S. operations. Our contributions for a year are allocated to participants who are actively employed on the last day of the plan year in proportion to each participant s pre-tax contributions for that year, up to 5% of the participant s compensation. Participants are entitled to invest up to 25% their 401(k) account balance in shares of our common stock. As of October 31, 2004, 274,136 shares of our common stock were held as investments by participants in our 401(k) plan. A participant may elect to receive a distribution from the plan in a single lump sum payment of his or her account balance following termination of the participant s employment with us. However, if the participant has Table of Contents an account balance in our common stock fund, the participant may receive all or a portion of his or her balance in that fund either in shares or in cash. We amended the plan on April 23, 2004 to provide that participants thereafter may only receive their account balances in the common stock fund in cash. Employment Agreements with Executive Officers Alan C. Froggatt In connection with our acquisition of Insignia in 2003, Mr. Froggatt, our President, EMEA, entered into an amended and restated executive service agreement with us, which became effective upon the date of the closing of the acquisition on July 23, 2003 and superseded his prior employment agreement with Richard Ellis Group Limited. This agreement provides that Mr. Froggatt s employment may be terminated by us at any time. This agreement also provides that Mr. Froggatt will have a fixed salary at the rate of 250,000 per year and the opportunity to earn an annual target bonus of 250,000 under our management bonus plan. For calendar year 2003, we agreed that Mr. Froggatt s annual bonus under the management bonus plan would be no less than 150,000. Also under the agreement, Mr. Froggatt is entitled to reimbursement of business-related expenses and to certain benefits and perquisites, including health insurance and life insurance benefits maintained by us from time to time. The agreement further provides that if Mr. Froggatt s employment is terminated by us prior to December 31, 2004, he will be entitled to continue to receive his fixed salary, bonus and contractual benefits through December 31, 2005. If Mr. Froggatt s employment is terminated by us on or subsequent to December 31, 2004, he will be entitled to continue to receive his fixed salary, bonus and contractual benefits for (1) twelve months following the date of termination of his employment if we previously have not provided Mr. Froggatt with a twelve-month notice of our intention to terminate the employment agreement, or (2) if we have provided Mr. Froggatt with a twelve-month notice of our intention to terminate the employment agreement, for the remaining term of the twelve-month notice period. Mr. Froggatt s agreement generally provides that (1) he will not engage, assist or have an interest in any undertaking which provides services similar to those provided by us or our affiliates in the United Kingdom for a period of one year following termination of his employment, (2) he will not employ, solicit or engage any person who was a senior executive or consultant of us or our affiliates for a period of one year following termination of his employment and (3) he will not solicit or interfere with or endeavor to entice away from us or our affiliates any person, firm, company or entity in the United Kingdom who was a client of us or our affiliates for a period of one year following termination of his employment. Robert Blain On January 23, 2002, Mr. Blain, our President, Asia Pacific, entered into an employment agreement with us which extends for an indefinite term, subject to termination by either Mr. Blain or by us for any reason. Under the terms of his employment agreement, Mr. Blain receives an annual base salary of $300,000, subject to annual review and adjustment. Mr. Blain also is eligible to earn an annual bonus based upon the level of profitability achieved by us in the greater China region during the applicable fiscal year. If Mr. Blain s employment terminates for any reason other than his voluntary resignation or on account of his misconduct, he will be entitled to receive a payment of his annual bonus, calculated at the end of the year during which the termination occurs and pro-rated based on the date of termination. If Mr. Blain voluntarily resigns or is terminated by us due to misconduct, he will not be eligible to receive a pro-rated bonus for the year in which his employment terminates. Mr. Blain s employment agreement also contains a provision regarding confidentiality during and following termination of his employment with us, as well as a non-competition and non-solicitation provision for terms of three months and six months, respectively, following the termination of his employment. PROSPECTUS SUMMARY 1 RISK FACTORS 10 FORWARD-LOOKING STATEMENTS 21 USE OF PROCEEDS 22 PRICE RANGE OF COMMON STOCK 22 DIVIDEND POLICY 22 CAPITALIZATION 23 UNAUDITED PRO FORMA FINANCIAL INFORMATION 24 SELECTED HISTORICAL FINANCIAL DATA 29 MANAGEMENT S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 32 BUSINESS 63 MANAGEMENT 75 RELATED PARTY TRANSACTIONS Table of Contents RELATED PARTY TRANSACTIONS Securityholders Agreement In connection with our acquisition of CB Richard Ellis Services in 2001, we and CB Richard Ellis Services entered into a securityholders agreement with our stockholders listed below: our stockholders affiliated with Blum Capital Partners, L.P.; our stockholders affiliated with Freeman Spogli & Co. Incorporated; Ray Wirta, who is our Chief Executive Officer; Brett White, who is our President; Frederic V. Malek, who is one of our directors; The Koll Holding Company; California Public Employees Retirement System; and our stockholders that purchased shares of our Class A common stock in connection with the issuance on July 20, 2001 of our 16% senior notes due 2011, some of whom are affiliates of Credit Suisse First Boston LLC. The securityholders agreement defines various rights of the stockholders that are parties to the agreement related to their ownership of common stock. Nomination of Directors and Voting. Our stockholders affiliated with Blum Capital Partners are entitled to nominate a percentage of our total number of directors that is equivalent to the percentage of the outstanding common stock beneficially owned by these affiliates, with this percentage of our directors being rounded up to the nearest whole number of directors. Our stockholders affiliated with Freeman Spogli are entitled to nominate one person to our board of directors for so long as these stockholders, collectively, beneficially own at least 7.5% of our outstanding common stock. The stockholders that are parties to the securityholders agreement that owned shares of our Class B common stock, other than Mr. Malek, are obligated to vote their shares in favor of the directors nominated by these affiliates of Blum Capital Partners and Freeman Spogli. As of October 31, 2004, these stockholders, collectively, beneficially owned approximately 54.7% of our outstanding common stock. Registration Rights. Each of the stockholders that are parties to this agreement has registration rights, which are described in further detail under the heading titled Description of Capital Stock Registration Rights. Indemnification. We are obligated to indemnify the stockholders that are parties to the securityholders agreement and each of their respective affiliates, controlling persons, directors, officers, employees and agents from and against any and all damages, claims, losses, expenses, costs, obligations and liabilities, including all reasonable attorneys fees and expenses but excluding special or consequential damages, arising from, relating to or otherwise in respect of, any governmental or other third party claim against these indemnified persons that arises from, relates to or is otherwise in respect of (1) our business, operations, liabilities or obligations or (2) the ownership by the stockholders or any of their respective affiliates of any of our equity securities, except to the extent these losses and expenses (x) arise from any claim that the indemnified person s investment decision relating to the purchase or sale of these equity securities violated a duty or other obligation of the indemnified person to the claimant or (y) are finally determined in a judicial action by a court of competent jurisdiction to have resulted from the gross negligence or willful misconduct of the stockholder or its affiliates. Table of Contents Loans to Our Executive Officers Currently Outstanding Loans Loan Related to Acquisition of Common Stock by Ray Wirta. At the time of our acquisition of CB Richard Ellis Services in 2001, Mr. Wirta delivered a full-recourse note in the amount of $512,504 as payment for a portion of our shares of Class A common stock purchased in connection with an offering of shares of our Class A common stock to our employees in 2001. Mr. Wirta s promissory note is repayable upon the earliest to occur of the following: (1) July 20, 2010, (2) 180 days following Mr. Wirta s termination of employment if terminated by us without cause, by him for good reason or as a result of his death or disability and (3) 90 days following Mr. Wirta s termination of employment if terminated for any reason not described in clause (2) above. This note bears interest at 10.0% per year. During 2002 and 2003, Mr. Wirta paid down his loan amount by $40,004 and $70,597, respectively. As of September 30, 2004 and December 31, 2003, Mr. Wirta had an outstanding loan balance of $401,903, which is included in notes receivable from the sale of common stock in our consolidated balance sheet included elsewhere in this prospectus. 1996 Equity Incentive Plan Loans to Ray Wirta and Brett White. Each of Mr. Wirta and Mr. White has an outstanding loan pursuant to the CB Richard Ellis Services 1996 Equity Incentive Plan, which loans are described in further detail under the heading Management Compensation of Executive Officers. Loan to Ray Wirta Pursuant to Former Employment Agreement. Pursuant to the terms of Mr. Wirta s former employment agreement with us that he entered into in 2001, we agreed to loan Mr. Wirta up to $3.0 million on a full-recourse basis to enable him to exercise an existing option to acquire shares held by The Koll Holding Company if Mr. Wirta were employed by us at the time of exercise, were terminated without cause or resigned for good reason and the shares he would receive upon such exercise would not be freely tradable on a national securities exchange or an over-the-counter market by June 2004. Mr. Wirta exercised his option on April 8, 2004 and, pursuant to the terms of his former employment agreement, we loaned Mr. Wirta $3.0 million on that date. Mr. Wirta s shares would not have been freely tradable on a national securities exchange or on an over-the-counter market by June 2004 as a result of transfer restrictions applicable to Mr. Wirta s shares. This loan is repayable upon the earliest to occur of the following: (1) 90 days following termination of his employment, other than by us without cause or by him for good reason, (2) seven months following the date Mr. Wirta s shares of common stock are freely tradable as described above and (3) the receipt of proceeds from the sale of the pledged shares described below. This loan bears interest at 4% per year, which was the prime rate in effect on the date of the loan, compounded annually, and is repayable to the extent of any net proceeds received by Mr. Wirta upon the sale of any shares of our common stock. Mr. Wirta pledged the shares received upon exercise of the option as security for the loan. Previously Outstanding Loans Retention and Recruitment Award Loans. In the past we have made loans to our employees that represent prepaid retention and recruitment awards at varying principal amounts, bearing interest at rates up to 10.0% per annum and maturing on various dates through 2007. As of December 31, 2003, the outstanding employee loan balances included a $0.3 million loan to Ray Wirta and a $0.2 million loan to Brett White. These non-interest-bearing loans to Mr. Wirta and Mr. White were issued during 2002 and were due and payable on December 31, 2003. The compensation committee of our board of directors forgave these loans to Messrs. Wirta and White in full, effective January 1, 2004. Loans Related to Acquisitions of Common Stock. In the past, we have made full recourse loans to employees, officers and certain of our stockholders for the purchase of shares of our commons stock. These loans are secured by shares of our common stock that are owned by the borrowers. As of December 31, 2003, Mr. White had an outstanding loan of $179,886, which amount is included in notes receivable from sale of common stock in the accompanying consolidated balance sheets included elsewhere in this prospectus. This loan relates to the acquisition of 12,500 shares of CB Richard Ellis Services common stock prior to our acquisition of CB Richard Ellis Services in 2001. Subsequent to the 2001 acquisition, these shares were converted into shares of our common stock and the Table of Contents related loan amount was carried forward. As amended, this loan accrued interest at 6.0% and the principal and all accrued interest was payable on or before April 23, 2010. Mr. White repaid this loan in full on February 10, 2004. At the time of our acquisition of CB Richard Ellis Services, Mr. Wirta delivered to us an $80,000 promissory note as payment for the purchase of 13,856 shares of our Class B common stock. Mr. Wirta repaid this promissory note in full in April of 2002. Additionally, Mr. White delivered a full-recourse note in the amount of $209,734 as payment for a portion of our shares of Class A common stock purchased in connection with an offering of shares of our Class A common stock to our employees in 2001. This note bore interest at 10.0% per year. During 2002, Mr. White paid off his note in its entirety. 1996 Equity Incentive Plan Loans to Ray Wirta and Brett White. In addition to the currently outstanding loan referenced above, Mr. White had an outstanding loan pursuant to the CB Richard Ellis Services 1996 Equity Incentive Plan that was repaid in full, which loan is described in further detail under the heading titled Management Compensation of Executive Officers. Transactions Related to Our Acquisition of CB Richard Ellis Services in 2001 Purchases of Common Stock and Grants of Stock Options. In connection with our acquisition of CB Richard Ellis Services in 2001, our stockholders that previously owned shares of our Class B common stock, collectively, contributed 7,967,774 shares of CB Richard Ellis Services common stock to us in exchange for 22,081,590 shares of our Class B common stock. Also in connection with the acquisition, our stockholders affiliated with Blum Capital Partners made aggregate cash contributions to us of approximately $71.0 million in exchange for an aggregate of 12,291,419 shares of our Class B common stock. Also in connection with the acquisition, we offered and sold shares of our Class A common stock to certain of our employees at the time that were designated by our board of directors in consultation with Ray Wirta and Brett White. If each of these designated employees subscribed for a specified number of shares that was determined by our board of directors, they were entitled to receive a grant of options to acquire our Class A common stock. These options have an exercise price of $5.77 per share and a term of 10 years, with 20% of the options vesting on each of the first five anniversaries of the completion of the acquisition and all vesting if there is a change in control of us. In connection with this offering, Ray Wirta purchased 177,541 shares of our Class A common stock and received a grant of 488,184 options to acquire Class A common stock and Brett White purchased 73,615 shares of our Class A common stock and received a grant of 392,929 shares of our Class A common stock. As described in greater detail above, Mr. Wirta delivered a full-recourse note to us in the aggregate principal amount of $512,504 as payment for a portion of his shares and Mr. White delivered a full-recourse note in the aggregate principal amount of $209,734 as payment for a portion of his shares. Each of Mr. Wirta and Mr. White pledged as security for his full-recourse note a number of shares having an offering price equal to 200% of the amount of his note. Transaction Fees. In connection with advisory services related to our acquisition of CB Richard Ellis Services in 2001, we paid a fee of $3.0 million to an affiliate of Blum Capital Partners and $2.0 million to an affiliate of Freeman Spogli. These advisory services included, among other things, transaction and structuring analysis, financing analysis and the arrangement and negotiation of debt and equity financing. The amounts of these fees were the result of negotiations among the affiliates of Blum Capital Partners and Freeman Spogli and the other parties that provided equity financing in connection with our acquisition of CB Richard Ellis Services. We also reimbursed certain expenses of our stockholders affiliated with Blum Capital Partners and Freeman Spogli. Treatment of Warrants to Acquire Shares of CB Richard Ellis Services Common Stock. Pursuant to an agreement entered into in connection with the acquisition of CB Richard Ellis Services, we issued to our stockholders affiliated with Freeman Spogli a warrant to acquire 708,019 shares of our Class B common stock at an exercise price of $10.825 per share in exchange for the cancellation of previously outstanding warrants to Table of Contents acquire 364,884 shares of CB Richard Ellis Services common stock. These warrants were automatically exercised on a cashless basis in connection with our initial public offering in June 2004. Also pursuant to the same agreement, previously outstanding warrants to acquire 84,988 shares of CB Richard Ellis Services common stock beneficially owned by Ray Wirta and The Koll Holding Company were cancelled and Mr. Wirta and The Koll Holding Company received $1.00 per share underlying these warrants in connection with the closing of the 2001 acquisition. Transactions Related to Our Acquisition of Insignia in 2003 In connection with our acquisition of Insignia, our stockholders affiliated with Blum Capital Partners made aggregate cash contributions to us of $105,394,160 in exchange for an aggregate of 18,255,338 shares of our Class B common stock and Frederic V. Malek made a cash contribution to us of $960,000 in exchange for 166,281 shares of our Class B common stock. Other Business Relationships with Our Directors CBRE Investors and certain investment funds managed by it retained the law firm of Mayer, Brown, Rowe & Maw LLP, including its predecessors, to provide legal services during each of 2003, 2002 and 2001. Michael Kantor, who has been a member of our board of directors since February 2004, currently is a partner at Mayer, Brown, Rowe & Maw LLP. Greater than 5% Stockholders: Blum Strategic Partners, L.P. Blum Strategic Partners II, L.P. Blum Strategic Partners II GmbH & Co. KG (2)(3) 29,048,352 41.2 % 10,000,000 19,048,352 27.0 % FS Equity Partners III, L.P. FS Equity Partners International, L.P. (2)(4) 6,946,390 9.9 3,134,203 3,812,187 5.4 Executive Officers and Directors: Ray Wirta (2)(5) 2,059,523 2.9 2,059,523 2.9 Brett White (2)(6) 515,284 * 515,284 * Kenneth J. Kay (7) 88,683 * 88,683 * Alan C. Froggatt (8) 16,628 * 16,628 * Robert Blain (9) 13,856 * 13,856 * Richard C. Blum (2)(3)(10) 29,050,843 41.2 10,000,000 19,050,843 27.0 Jeffrey A. Cozad (2)(3)(10) 29,050,843 41.2 10,000,000 19,050,843 27.0 Patrice Marie Daniels (10) 2,491 * 2,491 * Bradford M. Freeman (2)(4)(10) 6,948,881 9.9 3,134,203 3,814,678 5.4 Michael Kantor (10) 2,491 * 2,491 * Frederic V. Malek (10) 908,019 1.3 311,731 596,288 * Jeffrey S. Pion (11) 28,592 * 28,592 * Gary L. Wilson (12) 8,033 * 8,033 * All directors and executive officers as a group 39,645,815 55.7 13,445,934 26,199,881 36.8 * less than 1.0% (1) If the underwriters exercise in full their over-allotment option, some of the selling stockholders will sell 2,250,000 additional shares of Class A common stock, which sale is not reflected in the table above. Assuming the over-allotment option is exercised in full, these selling stockholders will sell the following additional shares: Blum Strategic Partners, L.P. 247,796; Blum Strategic Partners II, L.P. 287,843; Blum Strategic Partners II GmbH & Co. KG 5,935; FS Equity Partners III, L.P. 834,240; FS Equity Partners International, L.P. 31,557; Frederic V. Malek 16,882; California Public Employees Retirement System 46,090; DLJ Investment Partners II, L.P. 443,070; DLJ Investment Partners, L.P. 196,897; and DLJIP II Holdings, L.P. 139,690. (2) As a result of the voting provisions set forth in the securityholders agreement described in greater detail in this prospectus under the heading Related Party Transactions Securityholders Agreement, this stockholder, together with our other stockholders that owned shares of Class B common stock prior to our initial public offering, other than Frederic V. Malek, may be deemed to constitute a group, within the meaning of Section 13(d)(3) of the Securities Exchange Act of 1934, after the offering. Accordingly, the group formed by these stockholders may be deemed to beneficially own 25,701,710 shares of our Class A common stock after the offering. (3) Prior to the offering, consists of 13,291,018 shares of our Class A common stock owned by Blum Strategic Partners, L.P., 15,439,006 shares of our Class A common stock owned by Blum Strategic Partners II, L.P. and 318,328 shares of our Class A common stock owned by Blum Strategic Partners II GmbH & Co. KG. In connection with the offering, Blum Strategic Partners will sell 4,575,481 shares, Blum Strategic Partners II, L.P. will sell 5,314,933 shares and Blum Strategic Partners II GmbH & Co. KG will sell 109,586 shares. The sole general partner of Blum Strategic Partners, L.P. is Blum Strategic GP, L.L.C., and the sole general partner of Blum Strategic Partners II, L.P. and the managing limited partner of Blum Strategic Partners II GmbH & Co. KG is Blum Strategic GP II, L.L.C. Richard C. Blum is a managing member of Blum Strategic GP, L.L.C. and each of Messrs. Blum and Cozad is a managing member of Blum Strategic GP II, L.L.C. Except as to any pecuniary interest, each of Messrs. Blum and Cozad disclaims beneficial interest in all of these shares. The business address of Blum Strategic Partners, L.P., Blum Strategic Partners II, L.P., Blum Strategic Partners II GmbH & Co. KG, Blum Strategic GP, L.L.C., Blum Strategic GP II, L.L.C., Richard C. Blum and Jeffrey A. Cozad is 909 Montgomery Street, Suite 400, San Francisco, California 94133. As a result of the securityholders agreement, Blum Strategic Partners, L.P., Blum Strategic Partners II, L.P. and Blum Strategic Partners II GmbH & Co. KG share voting power over the indicated shares with our other stockholders that owned shares of Class B common stock prior to their conversion to shares of Class A common stock in June 2004. (4) Prior to the offering, consists of 6,693,205 shares of our Class A common stock held by FS Equity Partners III, L.P., or FSEP III, and 253,185 shares of our Class A common stock held by FS Equity Partners Table of Contents International, L.P., or FSEP International. In connection with the offering, FSEP III will sell 3,019,966 shares and FSEP International will sell 114,237 shares. As general partner of FS Capital Partners, L.P., which is the general partner of FSEP III, FS Holdings, Inc. has the power to vote and dispose of the shares owned by FSEP III. As general partner of FS&Co. International, L.P., which is the general partner of FSEP International, FS International Holdings Limited has the power to vote and dispose of the shares owned by FSEP International. Bradford Freeman, who is one of our directors, Ronald Spogli, Frederick Simmons, William Wardlaw, John Roth and Charles Rullman, Jr. are the directors, officers and shareholders of FS Holdings, Inc. and FS International Holdings Limited, and may be deemed to be the beneficial owners of the shares of common stock, and rights to acquire common stock, owned by FSEP III and FSEP International. Brad Freeman is a director and owner of less than 10% of the securities of, and Ronald Spogli is the owner of less than 10% of the securities of, a registered broker-dealer. Both FSEP III and FSEP International acquired the shares of our common stock beneficially owned by them in the ordinary course of business and, at the times they acquired such shares, had no agreements or understandings, directly or indirectly, with any person to distribute them publicly. The business address of FSEP III, FS Capital Partners, L.P. and FS Holdings, Inc. and their directors, officers and beneficial owners is 11100 Santa Monica Boulevard, Suite 1900, Los Angeles, California 90025. The business address of FSEP International, FS&Co. International, L.P. and FS International Holdings Limited is c/o Paget-Brown & Company, Ltd., West Winds Building, Third Floor, Grand Cayman, Cayman Islands, British West Indies. As a result of the securityholders agreement, FSEP III and FSEP International share voting power over the indicated shares with our other stockholders that owned shares of Class B common stock prior to their conversion to shares of Class A common stock in June 2004. (5) Includes 339,470 shares of Class A common stock subject to options that are exercisable or will be exercisable within 60 days. As a result of the securityholders agreement, Mr. Wirta shares voting power over 1,720,053 of the indicated shares with our other stockholders that owned shares of Class B common stock prior to their conversion to shares of Class A common stock in June 2004. (6) Mr. White is co-trustee and, together with his wife Danielle, is the beneficiary of The White Family Trust, which owns 273,730 of the indicated shares. Includes 172,270 shares of Class A common stock subject to options that are exercisable or will be exercisable within 60 days. Also includes 69,284 shares of Class A common stock underlying vested stock fund units in our deferred compensation plan. In connection with any voluntary or involuntary termination of his employment with us, Mr. White may be entitled to receive an issuance of some or all of the shares underlying the stock fund units within 60 days of such termination, depending upon the date of such termination and the current terms of the election he has made under the plan. As a result of the securityholders agreement, Mr. White shares voting power over 273,730 of the indicated shares with our other stockholders that owned shares of Class B common stock prior to their conversion to shares of Class A common stock in June 2004. (7) Includes 88,683 shares of Class A common stock subject to options that are exercisable or will be exercisable within 60 days. (8) Includes 16,628 shares of Class A common stock subject to options that are exercisable or will be exercisable within 60 days. (9) Includes 13,856 shares of Class A common stock subject to options that are exercisable or will be exercisable within 60 days. (10) Includes 491 shares of Class A common stock subject to options that are exercisable or will be exercisable within 60 days. (11) Includes 28,592 shares of Class A common stock underlying vested stock fund units in our deferred compensation plan. In connection with any voluntary or involuntary termination of his employment with us, Mr. Pion may be entitled to receive a distribution of some or all of the shares underlying the stock fund units within 60 days of such termination, depending upon the date of such termination and the current terms of the election he has made under the plan. (12) Includes 6,033 shares of Class A common stock subject to options that are exercisable or will be exercisable within 60 days. Table of Contents (13) CalPERS owns a less than 10% non-managing member interest in a registered broker-dealer. CalPERS acquired the shares of our common stock beneficially owned by it in the ordinary course of business and, at the times it acquired such shares, had no agreements or understandings, directly or indirectly, with any person to distribute them publicly. The business address of CalPERS is 400 P Street, Suite 3492, Sacramento, California 95814. (14) The shares beneficially owned include 807,342 shares of Class A common stock owned by DLJ Investment Partners II, L.P., 358,777 shares of Class A common stock owned by DLJ Investment Partners, L.P. and 254,537 shares of Class A common stock owned by DLJIP II Holdings, L.P. (collectively, the DLJIP Entities ). In connection with the offering, DLJ Investment Partners II, L.P. will sell 364,272 shares, DLJ Investment Partners, L.P. will sell 161,880 shares and DLJIP II Holdings, L.P. will sell 114,847 shares. Credit Suisse First Boston, a Swiss bank, owns a majority of the voting stock of Credit Suisse First Boston, Inc., which in turn owns all the voting stock of Credit Suisse First Boston (USA), Inc. ( CSFB-USA ). The DLJIP Entities are private equity funds advised by subsidiaries of CSFB-USA. Credit Suisse First Boston LLC, one of the underwriters in this offering, is a direct subsidiary of CSFB-USA. Credit Suisse First Boston Capital LLC ( CSFB Capital ), an indirect wholly owned subsidiary of CSFB-USA, is a registered broker-dealer. Neither CSFB-USA nor CSFB Capital holds any ownership interest in the DLJIP Entities. The DLJIP Entities acquired the shares of our common stock beneficially owned by them in the ordinary course of business and, at the times they acquired such shares, had no agreements or understandings, directly or indirectly, with any person to distribute them publicly. The business address for each of the DLJIP Entities is 11 Madison Avenue, 16th Floor, New York, NY 10010. (15) The shares beneficially owned consist of 18,094 shares of Class A common stock owned by Stanfield Arbitrage CDO, Ltd., 18,094 shares of Class A common stock owned by Stanfield CLO, Ltd. and 15,509 shares of Class A common stock owned by Stanfield/RMF Transatlantic CDO, Ltd. In connection with the offering, each of Stanfield Arbitrage CDO, Ltd., Stanfield CLO, Ltd. and Stanfield/RMF Transatlantic CDO, Ltd. will sell all of its shares. Stanfield Arbitrage CDO, Ltd., Stanfield CLO, Ltd. and Stanfield/RMF Transatlantic CDO, Ltd. are structured finance vehicles (collectively, the Stanfield Funds ) and Stanfield Capital Partners LLC is the collateral manager to each of the Stanfield Funds. Stanfield Capital Partners LLC, in its capacity as collateral manager to such funds, is able to direct the voting and disposition of the indicated shares. As such, it may be deemed to be the beneficial owner of the shares owned by the Stanfield Funds. Stanfield Capital Partners LLC disclaims any such beneficial ownership. The business address for each of the Stanfield Funds is Hemisphere House, 9 Church Street, Third Floor, Harbour Centre, Hamilton, Bermuda HM11, British West Indies. A copy of any correspondence to any of the Stanfield Funds should also be sent to Stanfield Capital Partners LLC, 430 Park Avenue, 12th Floor, New York, NY 10022. (16) National City Corporation owns 100% of a registered broker-dealer. Provident Financial Group, Inc., the predecessor by merger to National City Corporation, purchased the shares of our common stock beneficially owned by National City Corporation in the ordinary course of business and, at the time it acquired such shares, had no agreements or understandings, directly or indirectly, with any person to distribute them publicly. The business address of National City Corporation is 1900 East Ninth Street, Cleveland, OH 44114. Table of Contents DESCRIPTION OF CAPITAL STOCK The following description summarizes information regarding our capital stock. This information does not purport to be complete and is subject in all respects to the applicable provisions, of the Delaware General Corporation Law, and our restated certificate of incorporation and restated by-laws, which are included as exhibits to the registration statement of which this prospectus forms a part. Common Stock Generally. We are authorized to issue 325,000,000 shares of Class A common stock, $0.01 par value per share. On May 4, 2004, we completed a 3-for-1 stock split of our outstanding Class A common stock and Class B common stock, which was effected by a stock dividend. On June 7, 2004, we amended our certificate of incorporation to effect a 1-for-1.0825 reverse stock split. In June 2004, in connection with our initial public offering, all of the previously outstanding shares of our Class B common stock were converted into shares of Class A common stock at a 1-for-1 ratio. As of October 31, 2004, we had 70,438,865 shares of Class A common stock outstanding. Voting Rights. Holders of our Class A common stock generally are entitled to one vote per share on all matters on which our stockholders are entitled to vote. Our directors are elected by a plurality of the votes of the shares of Class A common stock present in person or represented by proxy at a stockholder meeting called for such election. The holders of Class A common stock do not have cumulative voting rights in the election of directors. Dividends. Holders of our Class A common stock are entitled to receive ratably dividends if, as and when declared from time to time by our board of directors out of funds legally available for that purpose, after payment of dividends required to be paid on any outstanding preferred stock, as described below. Our senior credit facilities and indentures impose restrictions on our ability to declare dividends with respect to our Class A common stock. Liquidation Rights. Upon our dissolution, liquidation or winding up, the holders of our Class A common stock are entitled to receive ratably the assets available for distribution to our stockholders after payment of liabilities and accrued but unpaid dividends and liquidation preferences on any outstanding preferred stock. Other Matters. Our Class A common stock does not have preemptive or conversion rights and is not subject to further calls or assessment by us. There are no redemption or sinking fund provisions applicable to our Class A common stock. Preferred Stock Our board of directors is authorized, subject to any limitations imposed by law, without the approval of our stockholders, to issue from time to time up to a total of 25,000,000 shares of our preferred stock, in one or more series, with each such series having rights and preferences, including voting rights, dividend rights, conversion rights, redemption privileges and liquidation preferences, as our board of directors may determine. The issuance of our preferred stock, while potentially providing us with flexibility in connection with possible acquisitions and other corporate purposes, could have the effect of making it more difficult for a third party to acquire, or discourage a third party from attempting to acquire, a majority of our outstanding voting stock. We have no present plans to issue any shares of preferred stock. Registration Rights Pursuant to a securityholders agreement, the other terms of which are described under the heading Related Party Transactions Securityholders Agreement, we have granted registration rights to our stockholders that are parties to that agreement. Table of Contents Demand Registrations. As a result of these registration rights, after we have completed this offering and upon the expiration or earlier waiver of the lock-up period imposed by the underwriters, we can be required by some of our stockholders to effect additional registration statements, or demand registrations, registering the securities held by the stockholder for sale under the Securities Act of 1933. Under this agreement, our stockholders affiliated with Blum Capital Partners may request six demand registrations and our stockholders affiliated with Freeman Spogli may request three demand registrations. After completion of the offering, these stockholders will beneficially own 22,860,539 shares of our common stock. Our stockholders affiliated with Blum Capital Partners have used one of their demand registrations in connection with the offering being made by this prospectus and will have five remaining demand registrations after completion of the offering. If a demand registration is underwritten and the managing underwriter advises us that marketing factors require a limitation on the number of shares to be underwritten, priority of inclusion in the demand registration generally is such that the stockholder initiating the demand registration receives first priority. Piggyback Registrations. In addition to our obligations with respect to demand registrations, if we propose to register any of our securities, other than a registration relating to our employee benefit plans or a corporate reorganization or other transaction under Rule 145 of the Securities Act, whether or not the registration is for our own account, we are required to give each of our stockholders that is party to the securityholders agreement the opportunity to participate, or piggyback, in the registration. These piggyback registration rights apply in the offering because affiliates of Blum Capital Partners are selling shares in the offering. If a piggyback registration is underwritten and the managing underwriter advises us that marketing factors require a limitation on the number of shares to be underwritten, priority of inclusion in the demand registration generally is such that we receive first priority with respect to the shares we are issuing and selling. Other Registration Provisions. The registration rights are subject to conditions and limitations, among them the right of the underwriters of an offering subject to the registration to limit the number of shares included in the offering. We generally are required to pay the registration expenses in connection with both demand and piggyback registrations. A stockholder s registration rights will terminate if we have completed an initial public offering of our common stock, the stockholder holds less than 0.5% of our outstanding common stock and the stockholder is entitled to sell all of its shares in any 90-day period under Rule 144 of the Securities Act. For additional information regarding sales under Rule 144, see the description under the heading titled Shares Eligible for Future Sale Sale of Restricted Shares. Anti-Dilution Agreement In connection with the 2001 issuance and sale of our 16% senior notes due 2011, we issued an aggregate of 941,764 shares of our Class A common stock to the purchasers of the senior notes. On July 20, 2001, we also issued 504,462 shares of our Class A common stock to the affiliate of Credit Suisse First Boston LLC that originally committed to purchase our 16% senior notes. In connection with these issuances, we entered into an anti-dilution agreement pursuant to which these stockholders have the right to purchase additional shares of our Class A common stock for $0.01 per share upon the occurrence of specified events. These specified events include any issuance of shares of our common stock or options, warrants or other securities convertible into, or exchangeable or exercisable for, shares of our common stock, in each case, at a price that is less than the current market price per share of our common stock. The current market price per share of any class of our common stock at any date generally is the average of the quoted price of our common stock on a securities exchange for 30 consecutive trading days commencing 45 trading days before the date in question. If our shares are not listed on a securities exchange on the date in question, then the current market price would be determined by our board of directors, which determination in some cases must based upon a valuation by an unaffiliated nationally-recognized investment banking or appraisal firm. With respect to issuances of stock options by us, the current market price following our initial public offering is determined based upon the quoted price of our common stock on the trading day immediately preceding the date of grant of the option. Table of Contents The right of these stockholders to purchase additional shares of our Class A common stock pursuant to the anti-dilution agreement is subject to important exceptions, which include issuances of common stock pursuant to bona fide public offerings and issuances of common stock pursuant to certain employee stock purchase programs. If we consolidate or merge with or into, or transfer or lease all or substantially all of our assets to, any person, and in connection with such transaction the holders receive common stock of another entity or option, warrants or other securities convertible into or exchange for common stock of another entity, then upon consummation of such transaction, the right to purchase additional shares of our common stock under this agreement will automatically become applicable to the common stock of the other entity. No adjustment in the number of shares held by these stockholders is required to be made unless the adjustment would require an increase or decrease of at least 1% in the number of shares held by these stockholders. Any such adjustments that are not made are carried forward and taken into account in determining any subsequent adjustments. The anti-dilution agreement terminates on July 20, 2011 and, with respect to each of the shares of our Class A common stock subject to such agreement, the agreement also terminates at such time as such share has been transferred pursuant to a registration statement filed with the SEC or pursuant to Rule 144 of the rules and regulations promulgated by the SEC under the Securities Act of 1933. Anti-Takeover Effects of Certain Provisions of Our Restated Certificate of Incorporation and Restated By-Laws Certain provisions of our restated certificate of incorporation and restated by-laws may have an anti-takeover effect and may delay, defer or prevent a tender offer or takeover attempt that a stockholder might consider in its best interest, including those attempts that might result in a premium over the market price for the shares held by stockholders. Advance Notice Requirements for Stockholder Proposals and Director Nominations Our restated by-laws provide that stockholders seeking to nominate candidates for election as directors or to bring business before a meeting of stockholders must provide timely notice of their proposal in writing to the corporate secretary. Generally, to be timely, a stockholder s notice will need to be received at our principal executive offices not less than 90 days nor more than 120 days prior to, in the case of annual meetings, the first anniversary date of the previous year s annual meeting and, in the case of special meetings, the date of such special meeting. Our restated by-laws also specify requirements as to the form and content of a stockholder s notice. These provisions may impede stockholders ability to bring matters before an annual meeting of stockholders or make nominations for directors at an annual meeting of stockholders. Amendments Our restated certificate of incorporation grants our board of directors the authority to amend and repeal our by-laws without a stockholder vote in any manner not inconsistent with the laws of the State of Delaware or our certificate of incorporation. Limitations on Liability and Indemnification of Officers and Directors Our certificate of incorporation provides that our directors may not be held liable to us or our stockholders for monetary damages for breach of their fiduciary duties as directors, except to the extent the exemption from, or limitation of, liability is not permitted under Delaware law. Table of Contents Our certificate of incorporation also provides that we must indemnify our directors and officers to the fullest extent authorized by Delaware law. We are also expressly authorized to carry directors and officers insurance providing indemnification for our directors, officers and certain employees for some liabilities. We believe that these indemnification provisions and insurance are useful to attract and retain qualified directors and executive officers. The limitation of liability and indemnification provisions in our certificate of incorporation may discourage stockholders from bringing a lawsuit against directors for breach of their fiduciary duty. These provisions may also have the effect of reducing the likelihood of derivative litigation against directors and officers, even though such an action, if successful, might otherwise benefit us and our stockholders. In addition, your investment may be adversely affective to the extent we pay the costs of settlement and damage awards against directors and officers pursuant to these indemnification provisions. There is currently no pending material litigation or proceeding involving any of our directors, officers or employees for which indemnification is sought. Delaware Anti-Takeover Statute Pursuant to our certificate of incorporation prior to May 4, 2004, we had opted out of the protections of Section 203 of the Delaware General Corporation Law. In our restated certificate of incorporation that we filed, and that became effective, on May 4, 2004, we opted in to Section 203. Subject to specified exceptions, Section 203 prohibits a publicly held Delaware corporation from engaging in a business combination with an interested stockholder for a period of three years after the date of the transaction in which the person became an interested stockholder. Business combinations include mergers, asset sales and other transactions resulting in a financial benefit to the interested stockholder. Subject to various exceptions, an interested stockholder is a person who together with his or her affiliates and associates, owns, or within three years did own, 15% or more of the corporation s outstanding voting stock. These restrictions generally prohibit or delay the accomplishment of mergers or other takeover or change-in control attempts. However, in connection with our opt in, our stockholders that currently own 15% or more of our outstanding voting stock, including affiliates of Blum Capital Partners, L.P. and affiliates of Freeman Spogli & Co. Incorporated, are not considered interested stockholders under Section 203. Transfer Agent The transfer agent for our Class A common stock is The Bank of New York located at 101 Barclay Street, New York, New York, 10286 and its telephone number is (212) 815-3776. Table of Contents SHARES ELIGIBLE FOR FUTURE SALE We can make no predictions as to the effect, if any, that sales of shares or the availability of shares for sale will have on the market price prevailing from time to time. Nevertheless, sales of significant amounts of our common stock in the public market, or the perception that those sales may occur, could adversely affect prevailing market prices and impair our future ability to raise capital through the sale of our equity at a time and price we deem appropriate. Sale of Restricted Shares and Shares Held by Affiliates As of October 31, 2004, we had 70,438,865 shares of common stock outstanding. In addition, as of October 31, 2004, 9,377,905 shares of common stock were issuable upon the exercise of outstanding stock options or in connection with distributions pursuant to our old deferred compensation plan. Of the outstanding shares after completion of the offering, all of the 15,000,000 shares sold in the offering, all of the 24,229,300 shares issued and sold in our initial public offering and substantially all of our other currently outstanding shares held by our current and former employees and consultants immediately will be freely tradable without further registration under the Securities Act, except that any shares held by our affiliates, as that term is defined under Rule 144 of the Securities Act, may be sold only in compliance with the limitations under Rule 144 as described below. In addition, 25,857,558 shares subject to the lock-up agreements described below will be eligible for sale at various times beginning 90 days after the date of this prospectus pursuant to Rule 144, including 144(k). Rule 144 In general, under Rule 144 as currently in effect, any person (or persons whose shares must be aggregated), including an affiliate of ours, who has beneficially owned restricted shares of our common stock for at least one year is entitled to sell in any three-month period a number of shares that does not exceed the greater of the following: 1% of the then-outstanding shares of common stock, which, as of October 31, 2004 was approximately 704,000 shares; and the average weekly reported volume of trading of our common stock on the New York Stock Exchange during the four calendar weeks preceding the date on which notice of the sale is filed pursuant to Rule 144, subject to restrictions. Sales under Rule 144 also must be sold only through brokers transactions or in transactions directly with a market maker, as those terms are defined in Rule 144. In addition, sales under Rule 144 are subject to notice requirements and the availability of current public information concerning us for at least 90 days after completion of the offering. Rule 144(k) A person (or persons whose shares must be aggregated) who is not deemed to have been an affiliate of ours at any time during the 90 days preceding a sale and who has beneficially owned the shares proposed to be sold for at least two years would be entitled to sell those shares under Rule 144(k) without regard to the volume, manner of sale, notice or public information requirements of Rule 144 described above. Table of Contents Registrations on Form S-8 On June 10, 2004, we filed a registration statement on Form S-8 under the Securities Act of 1933 to register shares of common stock issuable under our 2001 stock incentive plan, our old deferred compensation plan and our 2004 stock incentive plan. As a result, shares issued pursuant to our 2001 stock incentive plan and our 2004 stock incentive plan, including upon the exercise of stock options, and shares issued pursuant to our old deferred compensation plan are eligible for resale in the public market without restriction, subject to Rule 144 limitations applicable to affiliates described above and the lock-up and other agreements described below. As of October 31, 2004: 5,394,949 shares subject to options issued under our 2001 stock incentive plan at a weighted average exercise price of $5.77 per share, of which options to purchase 1,463,498 shares were then exercisable; 1,265,643 shares subject to options issued under our 2004 stock incentive plan at a weighted average exercise price of $22.33 per share, of which options to purchase 1,715 shares were then exercisable; 2,717,313 shares underlying outstanding stock fund units under our old deferred compensation plan, which are issuable in connection with future distributions under the plan pursuant to elections made by plan participants and all of which were vested; and 5,631,263 additional shares available for future grants under our 2004 stock incentive plan. We have entered into agreements with participants in the old deferred compensation plan holding stock fund units with 2,280,831 underlying shares of common stock pursuant to which these participants have agreed to sell no more than 20% of the shares underlying their current stock fund unit balances during any year over the next five years in exchange for fixed cash payments by us to these participants. Lock-Up Agreements For a description of the lock-up agreements with the underwriters that restrict sales of shares by us and the selling stockholders, see the information under the heading Underwriting. Registration Rights For a description of registration rights with respect to our common stock, see the information under the heading titled Description of Capital Stock Registration Rights. Table of Contents DESCRIPTION OF CERTAIN LONG-TERM INDEBTEDNESS CB Richard Ellis Services Senior Secured Credit Facilities In connection with our acquisition of CB Richard Ellis Services in 2001, CB Richard Ellis Services entered into a credit agreement with a syndicate of lenders for which Credit Suisse First Boston, or CSFB, serves as the administrative agent and collateral agent. The credit agreement was amended as of the closing of the offering of our 9 3/4% senior notes on May 22, 2003 to permit the issuance of the 9 3/4% senior notes and was amended and restated upon the consummation of the Insignia acquisition on July 23, 2003. On October 14, 2003, CB Richard Ellis Services amended and restated the credit agreement a second time. On April 23, 2004, we entered into an amendment to the amended and restated credit agreement that included a waiver generally permitting us to prepay, redeem, repurchase or otherwise retire up to $30.0 million of our existing indebtedness and provided for the amendment and restatement of our credit agreement upon the completion of our initial public offering. On June 15, 2004, we amended and restated the credit agreement a third time in connection with the completion of our initial public offering. Effective November 16, 2004, we amended our amended and restated credit agreement to reduce the interest rates applicable to the term loan facility, as described below, and to modify some of the restrictive covenants in the agreement that are described below. CB Richard Ellis Services senior secured credit facilities, as set forth in our amended and restated credit agreement, consists of a $295.0 million term loan facility and a $150.0 million revolving credit facility. Our amended and restated credit agreement also permits us to borrow up to $25.0 million of additional term loans under the term loan facility, subject to the satisfaction of customary conditions. The senior secured credit facilities are jointly and severally guaranteed by us and substantially all of CB Richard Ellis Services domestic subsidiaries, including future domestic subsidiaries. The senior secured credit facilities are secured by a pledge of all of the equity interests of CB Richard Ellis Services and its significant domestic subsidiaries, including CB Richard Ellis, Inc., CBRE Investors, L.L.C., L.J. Melody & Company, Insignia Financial Group, Inc. and Insignia/ESG, Inc., which was renamed CB Richard Ellis Real Estate Services, Inc., and 65% of the voting stock of its foreign subsidiaries that are held directly by it or its domestic subsidiaries. Additionally, these lenders generally have a lien on substantially all of our accounts receivable, cash, general intangibles, investment property and future acquired property. Pursuant to our amended and restated credit agreement, the term loan facility matures on March 31, 2010 and amortizes in equal quarterly installments of $2.95 million through December 31, 2009, with the balance payable on the maturity date. The revolving credit facility terminates on March 31, 2009. In the event of an increase in the term loan facility, the increased amount of such facility will mature at the same time or later as the remainder of the facility, depending upon the agreement we reach with the lenders for such increased facility. Pursuant to our amended and restated credit agreement, borrowings under the senior secured credit facilities bear interest at the following rates: Term loan facility at CB Richard Ellis Services option, either LIBOR plus 2.00% or the alternate base rate, as defined below, plus 1.00%; Revolving credit facility at CB Richard Ellis Services option, either LIBOR plus 2.00% to 2.50% or the alternate base rate plus 1.00% to 1.50%, in each case as determined by reference to our ratio of total debt less available cash to EBITDA, as such terms are defined in the credit agreement; and Up to $25.0 million incremental term loan facility depending upon the agreement we reach with the lenders for any such facility, either the rate for the term loan facility described above or a higher or lower rate. The alternate base rate is the higher of (1) Credit Suisse First Boston s prime rate or (2) the Federal Funds Effective Rate plus one-half of one percent. Table of Contents We are required to pay to the lenders under the senior secured credit facilities a commitment fee on the unused portion of the revolving credit facility and a letter of credit fee on each letter of credit outstanding. We are also required to apply certain proceeds of sales of assets, issuances of equity, incurrences of debt and excess cash flow to the prepayment of the term loan. The amended and restated credit agreement for the senior secured credit facilities contains customary restrictive covenants, including, among others, limitations on the ability of us and our subsidiaries to pay dividends on, redeem and repurchase capital stock; prepay, redeem and repurchase debt; incur liens; enter into sale/leaseback transactions; make loans and investments; incur indebtedness; enter into mergers, acquisitions and asset sales; enter into transactions with affiliates; change lines of business; and make capital expenditures. In addition, the amended and restated credit agreement contains covenants that require us to maintain specified financial ratios, which include the following ratios: total debt less available cash to EBITDA; total senior secured debt less available cash to EBITDA; EBITDA to interest expense and EBITDA less capital expenditures and co-investments to interest expense. The amended and restated credit agreement also includes customary events of default, including nonpayment of principal, interest, fees or reimbursement obligations with respect to letters of credit, violation of covenants, inaccuracy of representations and warranties in any material respect, cross default and cross-acceleration to certain other indebtedness and agreements, bankruptcy and insolvency events, material judgments and liabilities, defaults or judgments under ERISA and change of control. The occurrence of any of the events of default could result in acceleration of our obligations under the amended and restated credit agreement and foreclosure on the collateral securing the obligations. This summary of the material provisions of the amended and restated credit agreement is qualified in its entirety by reference to all of the provisions of the amended and restated credit agreement, which is filed as an exhibit to the registration statement of which this prospectus is a part. CB Richard Ellis Services 9 3/4% Senior Notes Due 2010 On May 22, 2003, CBRE Escrow, Inc. issued $200.0 million in aggregate principal amount of 9 3/4% senior notes due 2010 for $200.0 million. In connection with our acquisition of Insignia on July 23, 2003, CBRE Escrow merged into CB Richard Ellis Services, Inc., which assumed the 9 3/4% senior notes, and we and substantially all of our domestic subsidiaries guaranteed the 9 3/4% senior notes. CB Richard Ellis Services 9 3/4% senior notes are its unsecured senior obligations and rank equally in right of payment with any of our existing and future senior unsecured indebtedness but are effectively subordinated to all of our secured debt to the extent of the value of the assets securing such debt. They are also structurally subordinated to all of the existing and future liabilities of CB Richard Ellis Services subsidiaries that do not guarantee the notes. The 9 3/4% senior notes are governed by an indenture among CB Richard Ellis Services, us, the other guarantors and U.S. Bank National Association, as trustee. Interest accrues at a rate of 9 3/4% per year and is payable semiannually in arrears. Interest is computed on the basis of a 360-day year comprised of twelve 30-day months. There are no mandatory sinking fund payments for our 9 3/4% senior notes. We may at any time, and from time to time, purchase our 9 3/4% senior notes in the open market or otherwise. We and certain of our subsidiaries guaranteed our 9 3/4% senior notes on a senior unsecured basis. These guarantees by the guarantors of the notes are pari passu to all of such guarantors existing and future indebtedness. 2007 104.875 % 2008 102.438 2009 and thereafter 100.000 In the event of a change of control, which is defined in the indenture governing the 9 3/4% senior notes, we will be obligated to make an offer to purchase all outstanding 9 3/4% senior notes at a redemption price of 101% of the principal amount plus accrued interest, subject to certain conditions. The indenture governing our 9 3/4% senior notes contains customary restrictive covenants for high yield securities, including, among others, limitations on our ability and the ability of our subsidiaries to incur or guarantee additional indebtedness; pay dividends or distributions on capital stock or redeem or repurchase capital stock; make investments; create restrictions on the payment of dividends or other amounts to us; sell stock of our subsidiaries; transfer or sell assets; enter into transactions with affiliates; and enter into mergers and consolidations. This summary of the material provisions of our 9 3/4% senior notes is qualified in its entirety by reference to all of the provisions of the indenture governing our 9 3/4% senior notes, which is filed as an exhibit to the registration statement of which this prospectus is a part. CB Richard Ellis Services 11 1/4% Senior Subordinated Notes Due 2011 On June 7, 2001, Blum CB Corp. issued $229.0 million in aggregate principal amount of 11 1/4% senior subordinated notes due 2011 for $225.6 million. In connection with our acquisition of CB Richard Ellis Services in 2001, CB Richard Ellis Services assumed the 11 1/4% senior subordinated notes and we and substantially all of our domestic subsidiaries guaranteed the 11 1/4% senior subordinated notes. CB Richard Ellis Services 11 1/4% senior subordinated notes are our unsecured senior subordinated obligations and rank equally in right of payment with any of our existing and future senior subordinated unsecured indebtedness but are subordinated to any of our existing and future senior indebtedness. The 11 1/4% senior subordinated notes are governed by an indenture among CB Richard Ellis Services, us, the other guarantors and U.S. Bank National Association (as successor to State Street Bank and Trust Company of California, N.A.), as trustee. 2006 105.625 % 2007 103.750 2008 101.875 2009 and thereafter 100.000 In the event of a change of control, which is defined in the indenture governing the 11 1/4% senior subordinated notes, we will be obligated to make an offer to purchase all outstanding 11 1/4% senior subordinated notes at a redemption price of 101% of the principal amount plus accrued interest. The indenture governing our 11 1/4% senior subordinated notes contains customary restrictive covenants for high yield securities, which covenants are substantially the same as the covenants in the indenture governing our 9 3/4% senior notes. In May and June 2004, we purchased $21.6 million in aggregate principal amount of our 11 1/4% senior subordinated notes in the open market. We paid an aggregate of $3.1 million of premiums in connection with such purchases. This summary of the material provisions of our 11 1/4% senior subordinated notes is qualified in its entirety by reference to all of the provisions of the indenture governing our 11 1/4% senior subordinated notes, which is filed as an exhibit to the registration statement of which this prospectus is a part. Table of Contents CERTAIN U.S. TAX CONSEQUENCES TO NON-U.S. HOLDERS The following summary describes certain U.S. federal income and estate tax consequences of the ownership of our Class A common stock by a non-U.S. holder, as defined below, as of the date of this prospectus. This discussion does not address all aspects of U.S. federal income and estate taxes and does not deal with foreign, state and local consequences that may be relevant to non-U.S. holders in light of their personal circumstances. Special rules may apply to certain non-U.S. holders, such as U.S. expatriates, controlled foreign corporations, passive foreign investment companies, and investors in pass-through entities that are subject to special treatment under the Internal Revenue Code of 1986, or the Code. These non-U.S. holders should consult their own tax advisors to determine the U.S. federal, state, local and other tax consequences that may be relevant to them. Furthermore, the discussion below is based upon the provisions of the Code, and U.S. Treasury regulations, rulings and judicial decisions under the Code as of the date of this prospectus, and these authorities may be repealed, revoked or modified, perhaps retroactively, so as to result in U.S. federal income and estate tax consequences different from those discussed below. Persons considering the ownership of our Class A common stock should consult their own tax advisors concerning the U.S. federal income and estate tax consequences in light of their particular situations as well as any consequences arising under the laws of any other taxing jurisdiction. If a partnership holds our Class A common stock, the tax treatment of a partner will generally depend upon the status of the partner and the activities of the partnership. Persons who are partners of partnerships holding our Class A common stock should consult their tax advisors. As used in this section of the prospectus, a non-U.S. holder of our Class A common stock means a beneficial owner, other than an entity treated as a partnership, that is not any of the following for U.S. federal income tax purposes: an individual citizen or resident of the United States, a corporation, or entity treated as a corporation for U.S. federal income tax purposes, created or organized in or under the laws of the United States, any of its states or the District of Columbia, an estate the income of which is subject to U.S. federal income taxation regardless of its source, or a trust if it (1) is subject to the primary supervision of a court within the United States and one or more U.S. persons have the authority to control all substantial decisions of the trust or (2) has a valid election in effect under applicable U.S. Treasury regulations to be treated as a U.S. person. Dividends Dividends paid to a non-U.S. holder of our Class A common stock generally will be subject to withholding of U.S. federal income tax at a 30% rate or such lower rate as may be specified by an applicable income tax treaty. However, dividends that are effectively connected with the conduct of a trade or business by the non-U.S. holder within the United States and, where a tax treaty applies, are attributable to a U.S. permanent establishment of the non-U.S. holder, are not subject to the withholding tax, provided certain certification and disclosure requirements are satisfied. Instead, such dividends are subject to U.S. federal income tax on a net income basis in the same manner as if the non-U.S. holder were a U.S. person as defined under the Code. Any such effectively connected dividends received by a foreign corporation may be subject to an additional branch profits tax at a 30% rate or such lower rate as may be specified by an applicable income tax treaty. A non-U.S. holder of our Class A common stock who wishes to claim the benefit of an applicable treaty rate and avoid backup withholding, as discussed below, for dividends, will be required to (a) complete Internal Revenue Service Form W-8BEN or other applicable form and certify under penalty of perjury that such holder is not a U.S. person or (b) if the Class A common stock is held through certain foreign intermediaries, satisfy the Table of Contents relevant certification requirements of applicable U.S. Treasury regulations. Special certification and other requirements apply to certain non-U.S. holders that are entities rather than individuals. A non-U.S. holder of our Class A common stock eligible for a reduced rate of U.S. withholding tax pursuant to an income tax treaty may obtain a refund of any excess amounts withheld by filing an appropriate claim for refund with the Internal Revenue Service. Gain on Disposition of Our Class A Common Stock A non-U.S. holder generally will not be subject to U.S. federal income tax with respect to gain recognized on a sale or other disposition of our Class A common stock unless one of the following applies: the gain is effectively connected with a trade or business of the non-U.S. holder in the United States, and, where a tax treaty applies, is attributable to a U.S. permanent establishment of the non-U.S. holder, in the case of a non-U.S. holder who is an individual and holds the Class A common stock as a capital asset, such holder is present in the United States for 183 or more days in the taxable year of the sale or other disposition and certain other conditions are met, or we are or have been a United States real property holding corporation for U.S. federal income tax purposes. An individual non-U.S. holder described in the first bullet point immediately above will be subject to tax on the net gain derived from the sale under regular graduated U.S. federal income tax rates. An individual non-U.S. holder described in the second bullet point immediately above will be subject to a flat 30% tax on the gain derived from the sale, which may be offset by U.S. source capital losses, even though the individual is not considered a resident of the United States. If a non-U.S. holder that is a foreign corporation falls under the first bullet point immediately above, it will be subject to tax on its net gain in the same manner as if it were a U.S. person as defined under the Code and, in addition, may be subject to the branch profits tax equal to 30% of its effectively connected earnings and profits or at such lower rate as may be specified by an applicable income tax treaty. We believe we are not, and do not anticipate becoming, a United States real property holding corporation for U.S. federal income tax purposes. Federal Estate Tax Class A common stock held by an individual non-U.S. holder at the time of death will be included in such holder s gross estate for U.S. federal estate tax purposes, unless an applicable estate tax treaty provides otherwise. Information Reporting and Backup Withholding We must report annually to the Internal Revenue Service and to each non-U.S. holder the amount of dividends paid to such holder and the tax withheld with respect to such dividends, regardless of whether withholding was required. Copies of the information returns reporting such dividends and withholding may also be made available to the tax authorities in the country in which the non-U.S. holder resides under the provisions of an applicable income tax treaty. A non-U.S. holder will be subject to backup withholding for dividends paid to such holder unless such holder certifies under penalty of perjury that it is a non-U.S. holder, and the payor does not have actual knowledge or reason to know that such holder is a U.S. person, or such holder otherwise establishes an exemption. Table of Contents Information reporting and, depending on the circumstances, backup withholding will apply to the proceeds of a sale of our Class A common stock within the United States or conducted through U.S.-related financial intermediaries unless the beneficial owner certifies under penalty of perjury that it is a non-U.S. holder, and the payor does not have actual knowledge or reason to know that the beneficial owner is a U.S. person, or such owner otherwise establishes an exemption. Any amounts withheld under the backup withholding rules may be allowed as a refund or a credit against such holder s U.S. federal income tax liability provided the required information is furnished to the Internal Revenue Service. Underwriting discounts and commissions paid by the selling stockholders $ $ $ $ Expenses payable by us $ $ $ $ The expenses of the offering, not including the underwriting discounts and commissions, are estimated at $750,000 and are payable by us. We have agreed that we will not offer, sell, contract to sell, pledge or otherwise dispose of, directly or indirectly, or file with the Securities and Exchange Commission a registration statement under the Securities Act of 1933, relating to any shares of our common stock or securities convertible into or exchangeable or exercisable for any shares of our common stock, or publicly disclose the intention to make any offer, sale, pledge, disposition or filing, without the prior written consent of Credit Suisse First Boston LLC for a period of 90 days after the date of this prospectus, subject to specified exemptions. Table of Contents The selling stockholders, which together will beneficially own approximately 36.7% of our outstanding Class A common stock immediately after the offering, have agreed, subject to certain exceptions, that they will not offer, sell, contract to sell, pledge or otherwise dispose of, directly or indirectly, any shares of our common stock or securities convertible into or exchangeable or exercisable for any shares of our common stock, enter into a transaction that would have the same effect, or enter into any swap, hedge or other arrangement that transfers, in whole or in part, any of the economic consequences of ownership of our common stock, whether any of these transactions are to be settled by delivery of our common stock or other securities, in cash or otherwise, or publicly disclose the intention to make any offer, sale, pledge or disposition, or to enter into any transaction, swap, hedge or other arrangement, without, in each case, the prior written consent of Credit Suisse First Boston LLC for a period of 90 days after the date of this prospectus. Each of the underwriters has represented to us and agreed that it has not offered, sold or delivered and will not offer, sell or deliver any of the shares of our common stock directly or indirectly, or distribute this prospectus or any other offering material relating to such shares, in or from any jurisdiction except under circumstances that will result in compliance with the applicable laws and regulations thereof and that will not impose any obligations on us except as set forth in the underwriting agreement. In particular, each underwriter has represented to us and agreed that: it has not offered or sold, and, prior to the expiration of the period of six months from the closing date for the issue of the shares of our common stock, will not offer or sell any shares of our common stock to persons in the United Kingdom, except to those persons whose ordinary activities involve them in acquiring, holding, managing or disposing of investments (as principal or agent) for the purpose of their businesses or otherwise in circumstances which have not resulted and will not result in an offer to the public in the United Kingdom within the meaning of the Public Offers of Securities Regulations 1995; it has complied, and will comply, with all applicable provisions of the Financial Services Act 1986 and all applicable provisions of the Financial Services and Markets Act 2000, or the FSMA, with respect to anything done by it in relation to the shares of our common stock in, from or otherwise involving the United Kingdom; it has only communicated or caused to be communicated, and will only communicate or cause to be communicated, any invitation or inducement to engage in investment activity, within the meaning of the FSMA, received by it in connection with the issue or sale of the shares of our common stock in circumstances in which Section 21(1) of the FSMA does not apply to us; and the shares of our common stock may not be offered, sold, transferred or delivered in or from the Netherlands as part of their initial distribution, or at any time thereafter, directly or indirectly, other than to banks, pension funds, insurance companies, securities firms, investment institutions, central governments, large international and supranational institutions and other comparable entities, including, among others, treasuries and finance companies of large enterprises, which trade or invest in securities in the course of a profession or trade. Individuals or legal entities who or which do not trade or invest in securities in the course of their profession or trade may not participate in the offering, and this prospectus or any other offering material relating to the shares may not be considered an offer or the prospect of an offer to sell or exchange the shares of common stock. We and the selling stockholders have agreed to indemnify the underwriters against liabilities under the Securities Act, or contribute to payments that the underwriters may be required to make in that respect. Our common stock is listed on the New York Stock Exchange under the symbol CBG. Certain of the underwriters and their respective affiliates have from time to time performed, and may in the future perform, various financial advisory, commercial banking and investment banking services for us and our affiliates in the ordinary course of business, for which they received, or will receive, customary fees and CASH FLOWS USED IN OPERATING ACTIVITIES $ (37,633 ) $ (53,363 ) $ (29,234 ) $ (120,230 ) CASH FLOWS FROM INVESTING ACTIVITIES: Capital expenditures, net of concessions received (11,309 ) (3,505 ) (14,814 ) Proceeds from sale of properties and servicing rights 9,105 439 9,544 Investment in property held for sale (2,282 ) (2,282 ) Acquisition of businesses including net assets acquired, intangibles and goodwill, net of cash acquired (31 ) (1,893 ) (1,924 ) Other investing activities, net 251 (3,024 ) Table of Contents expenses. In particular, Credit Suisse First Boston, an affiliate of Credit Suisse First Boston LLC, serves as the administrative agent and collateral agent for, and is a lender under, our senior secured credit facilities. See the information under the heading titled Description of Certain Long-Term Indebtedness for additional information regarding the terms of this indebtedness. As of October 31, 2004, affiliates of Credit Suisse First Boston LLC also are the lenders with respect to 5.37% of the term loan under our amended and restated credit agreement. In addition, as of October 31, 2004, affiliates of Credit Suisse First Boston LLC were the beneficial owners of 1,420,656 shares, or approximately 2.0%, of our outstanding common stock. These affiliates of Credit Suisse First Boston LLC are selling a portion of their shares in the offering and will beneficially own approximately 1.1% of our common stock after the offering. See the information under the heading titled Principal and Selling Stockholders for additional information regarding their beneficial ownership. Bear, Stearns & Co. Inc. acted as financial advisor to the special committee of Insignia s board of directors in connection with our acquisition of Insignia in July 2003 and received customary fees and expenses from Insignia in such capacity. In connection with the offering the underwriters may engage in stabilizing transactions, over-allotment transactions, syndicate covering transactions and penalty bids in accordance with Regulation M under the Securities Exchange Act of 1934. Stabilizing transactions permit bids to purchase the underlying security so long as the stabilizing bids do not exceed a specified maximum. Over-allotment involves sales by the underwriters of shares in excess of the number of shares the underwriters are obligated to purchase, which creates a syndicate short position. The short position may be either a covered short position or a naked short position. In a covered short position, the number of shares over-allotted by the underwriters is not greater than the number of shares that they may purchase in the over-allotment option. In a naked short position, the number of shares involved is greater than the number of shares in the over-allotment option. The underwriters may close out any covered short position by either exercising their over-allotment option and/or purchasing shares in the open market. Syndicate covering transactions involve purchases of the common stock in the open market after the distribution has been completed in order to cover syndicate short positions. In determining the source of shares to close out the short position, the underwriters will consider, among other things, the price of shares available for purchase in the open market as compared to the price at which they may purchase shares through the over-allotment option. If the underwriters sell more shares than could be covered by the over-allotment option, a naked short position, the position can only be closed out by buying shares in the open market. A naked short position is more likely to be created if the underwriters are concerned that there could be downward pressure on the price of the shares in the open market after pricing that could adversely affect investors who purchase shares in the offering. Penalty bids permit the representatives to reclaim a selling concession from a syndicate member when the common stock originally sold by the syndicate member is purchased in a stabilizing or syndicate covering transaction to cover syndicate short positions. These stabilizing transactions, syndicate covering transactions and penalty bids may have the effect of raising or maintaining the market price of our common stock or preventing or retarding a decline in the market price of the common stock. As a result, the price of our common stock may be higher than the price that might otherwise exist in the open market. These transactions may be effected on the New York Stock Exchange or otherwise and, if commenced, may be discontinued at any time. A prospectus in electronic format may be made available on the web sites maintained by one or more of the underwriters, or selling group members, if any, participating in the offering and one or more of the underwriters participating in this offering may distribute prospectuses electronically by e-mail. The representatives may agree to allocate a number of shares to underwriters and selling group members for sale to their online brokerage account holders. Internet distributions will be allocated by the underwriters and selling group members that will make internet distributions on the same basis as other allocations. Table of Contents LEGAL MATTERS The validity of the shares of common stock being offered by the selling stockholders in the offering will be passed upon for us by Simpson Thacher & Bartlett LLP, Palo Alto, California. Selected legal matters in connection with the offering will be passed upon for the underwriters by Cravath, Swaine & Moore LLP, New York, New York. EXPERTS The consolidated financial statements and the related financial statement schedules of CB Richard Ellis Group, Inc. as of and for the years ended December 31, 2003 and 2002 included in this prospectus have been audited by Deloitte & Touche LLP, an independent registered public accounting firm, as stated in their report appearing herein (which report expresses an unqualified opinion and includes explanatory paragraphs referring to the adoption of Statement of Financial Accounting Standards No. 142 effective January 1, 2002 and concerning the application of procedures relating to certain disclosures and revisions of financial statement amounts related to the 2001 financial statements that were audited by other auditors who have ceased operations and for which Deloitte & Touche LLP expressed no opinion or other form of assurance other than with respect to such disclosures and revisions), and have been so included in reliance upon the report of such firm given upon their authority as experts in accounting and auditing. The consolidated financial statements of CB Richard Ellis Group, Inc. for the period from February 20 (inception) to December 31, 2001 and the financial statements of CB Richard Ellis Services, Inc. for the period from January 1, 2001 through July 20, 2001 included in this prospectus were audited by Arthur Andersen LLP, independent public accountants. See the information under the heading titled Risk Factors Risks Relating to the Offering and Ownership of Our Common Stock Your ability to recover from our former auditors, Arthur Andersen LLP, for any potential financial misstatements is limited. The consolidated financial statements of Insignia Financial Group, Inc. as of and for the year ended December 31, 2002 have been included herein and in the registration statement in reliance upon the report of KPMG LLP, independent accountants, appearing elsewhere herein, which report refers to changes in accounting principles relating to the adoption of the fair value recognition provisions of Statement of Financial Accounting Standards No. 123 and the adoption of the accounting principles set forth in Statements of Financial Accounting Standards Nos. 141 and 142 effective January 1, 2002, and upon the authority of said firm as experts in accounting and auditing. The consolidated statements of operations, stockholders equity and cash flows of Insignia Financial Group, Inc. for the year ended December 31, 2001 appearing in this prospectus and the registration statement to which it forms a part have been audited by Ernst & Young LLP, independent registered public accounting firm, as set forth in their report thereon appearing elsewhere herein and is included in reliance upon such report given on the authority of such firm as experts in accounting and auditing. CHANGE IN ACCOUNTANTS On April 23, 2002, we dismissed our independent auditors, Arthur Andersen LLP, and engaged the services of Deloitte & Touche LLP as our new independent auditors for the fiscal year ended December 31, 2002. Our board of directors and our audit committee authorized the dismissal of Arthur Andersen LLP and the engagement of Deloitte & Touche LLP. Arthur Andersen LLP s reports on CB Richard Ellis Group s consolidated financial statements for the fiscal years ended December 31, 2001 and 2000 and for the period from CB Richard Ellis Group s inception through the date of Arthur Andersen LLP s dismissal did not contain an adverse opinion or disclaimer of opinion, nor were such reports qualified or modified as to uncertainty, audit scope or accounting principles. Table of Contents During the period from CB Richard Ellis Group s inception through the date of Arthur Andersen s dismissal, there were no (1) disagreements with Arthur Andersen LLP on any matters of accounting principles or practices, financial statement disclosure or auditing scope or procedure which disagreements, if not resolved to Arthur Andersen LLP s satisfaction, would have caused it to make reference to the subject matter of the disagreements in connection with its report on CB Richard Ellis Group s consolidated financial statements or (2) reportable events as defined in Item 304(a)(1)(v) of Regulation S-K. On April 8, 2002, Ernst & Young was dismissed as Insignia s principal independent accountant and, effective April 11, 2002, KPMG was retained as its principal independent accountant. The reports of Ernst & Young on Insignia s financial statements for the years ended December 31, 2001 and December 31, 2000 did not contain an adverse opinion or a disclaimer of opinion and were not qualified or modified as to uncertainty, audit scope or accounting principles. The decision to change accountants was recommended by Insignia s audit committee and approved by Insignia s board of directors. During the years ended December 31, 2001 and December 31, 2000 and through April 8, 2002, there were no disagreements with Ernst & Young on any matter of accounting principles or practices, financial statement disclosure or auditing scope or procedure, which disagreements, if not resolved to the satisfaction of Ernst & Young, would have caused it to make reference thereto in its reports on the financial statements for such periods. WHERE YOU CAN FIND MORE INFORMATION We have filed with the Securities and Exchange Commission a registration statement on Form S-1, which includes amendments and exhibits, under the Securities Act of 1933 and the rules and regulations under the Securities Act, for the registration of the common stock being offered by this prospectus. Although this prospectus, which forms a part of the registration statement, contains all material information included in the registration statement, parts of the registration statement have been omitted from this prospectus as permitted by the rules and regulations of the SEC. For further information with respect to us and the common stock offered by this prospectus, please refer to the registration statement. We file annual, quarterly and current reports, proxy statements and other information with the SEC. The registration statements and other reports, proxy statements and other information can be inspected, and copies may be obtained, at the Public Reference Room of the SEC, 450 Fifth Street, N.W., Washington, D.C. 20549, at prescribed rates. Information on the operation of the Public Reference Room of the SEC may be obtained by calling the SEC at 1-800-SEC-0330. The SEC also maintains a website at http://www.sec.gov that contains reports, proxy and information statements and other information that we have filed electronically with the SEC. CASH FLOWS (USED IN) PROVIDED BY OPERATING ACTIVITIES: $ (10,948 ) $ (1,049 ) $ 55,910 $ (5,308 ) $ 38,605 CASH FLOWS FROM INVESTING ACTIVITIES: Proceeds from sale of servicing rights and other assets 5,435 172 5,607 Proceeds from sale of property held for sale 50,401 50,401 Capital expenditures, net of concessions received (20,204 ) (7,251 ) (27,455 ) Acquisition of businesses including net assets acquired, intangibles and goodwill, net of cash acquired (8,586 ) (8,198 ) (16,784 ) Other investing activities, net Table of Contents USE OF PROCEEDS We will not receive any of the proceeds from the sale of shares of our common stock in the offering. The selling stockholders will receive all of the net proceeds from the offering. PRICE RANGE OF COMMON STOCK Our Class A common stock has traded on the New York Stock Exchange under the symbol CBG since June 10, 2004. The high and low closing prices of our Class A common stock, as reported by the New York Stock Exchange, are set forth below for the periods indicated. Price Range Fiscal Year 2004 High Low Table of Contents CAPITALIZATION The following table sets forth our cash and cash equivalents and capitalization as of September 30, 2004. As of September 30, 2004 (In thousands) Cash and cash equivalents $ 147,925 Long-term debt, including current portion: Revolving credit facility (1) $ Senior secured term loan (2) 280,000 9 3/4% senior notes due 2010 130,000 11 1/4% senior subordinated notes due 2011 (3) 204,972 Other long-term debt 2,098 Total long-term debt, including current portion 617,070 Stockholders equity: Class A common stock, $0.01 par value per share; 325,000,000 shares authorized, 70,195,909 shares issued and outstanding; preferred stock, 25,000,000 shares authorized, no shares issued or outstanding (4) 702 Additional paid-in capital 509,288 Notes receivable from sale of stock (5,058 ) Accumulated deficit (259 ) Accumulated other comprehensive loss (26,425 ) Total stockholders equity 478,248 Total capitalization $ 1,095,318 Table of Contents CB RICHARD ELLIS GROUP, INC. UNAUDITED PRO FORMA STATEMENT OF OPERATIONS For the Year Ended December 31, 2003 (In thousands, except share data) Historical Pro Forma Adjustments Pro Forma As Adjusted Exercise of stock options and warrants 113,519 shares of Common Stock issued 1 673 674 Issuance of 111,840 shares of Common Stock under Employee Stock Purchase Program 1 902 903 Issuance of 131,480 shares of Common Stock in connection with Insignia Bourdais acquisition 1 1,305 1,306 Restricted stock awards 87,155 shares of Common Stock issued 1 706 707 Preferred stock issuance 125,000 shares 1 12,269 12,270 Preferred stock dividend (1,829 ) (1,829 ) Cancellation of notes receivable for 47,786 shares of Common Stock (1 ) (542 ) 543 Payments on notes receivable for shares of Common Stock 146 Insignia from January 1, 2003 to July 23, 2003 Disposition of Real Estate Investment Assets by Insignia (a) Insignia Acquisition and Related Transactions Revenue $ 1,630,074 $ 325,600 $ (6,847 ) $ $ 1,948,827 Costs and expenses: Cost of services 796,408 796,408 Operating, administrative and other 678,397 678,397 Cost and expenses Insignia 320,319 (8,039 ) 3,669 (b) 315,949 Depreciation and amortization 92,622 10,148 (792 ) (2,134 )(c) 103,385 3,541 (d) Merger-related charges 36,817 21,627 (12,832 ) (8,795 )(e) 36,817 Table of Contents INSIGNIA FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) deployment of committed capital (totaling $71.0 million) in 2002, of which $10.0 million was invested by Insignia and the remainder by third-party investors. Insignia has an aggregate ownership interest of approximately 13% in IOT and IOP and also has a 10% non-subordinated promoted interest in IOP. In September 2001, Insignia closed the capital-raising phase for a second real estate investment fund, Insignia Opportunity Partners II ( IOP II ), with $48.5 million of equity capital commitments from Insignia and third-party investors. IOP II invests primarily in secured real estate debt instruments, similar to the investment initiatives of IOT. IOP II had called $28.2 million of its total capital commitments at December 31, 2002. Insignia holds a 10% ownership in IOP II and serves as its day-to-day advisor. Insignia realized total earnings from both funds of approximately $4.0 million (2002) and $2.6 million (2001). Such earnings are included in equity earnings in unconsolidated ventures. At December 31, 2002, Insignia held investments totaling $16.1 million in IOT, IOP and IOP II and had commitments to invest an additional $2.1 million in IOP II. The following table summarizes financial information of IOT and IOP II as of December 31, 2002 (in thousands): Total assets $ 150,139 Total liabilities 36,358 Total revenues 25,992 Apart from its real estate investments, Insignia had obligations totaling $14.0 million to all real estate entities at December 31, 2002, which consisted of the following (in thousands): Letters of credit partially backing construction loans $ 8,900 Other partial guarantees of property debt 2,825 Future capital contributions for capital improvements (In thousands) Cash acquired $ 8,856 Receivables 5,469 Property and equipment 415 Property management contracts 1,008 Non-compete agreements Net income (loss) $ 11,895 $ (28,445 ) $ (1,708 ) $ (24,620 ) Foreign currency translation gain (loss) Asia Pacific Operating income $ 9,470 $ 3,298 Add: Depreciation and amortization 2,901 2,438 Equity income (loss) from unconsolidated subsidiaries 796 44,682 (22,676 ) 60,772 6,694 Equity income (loss) from unconsolidated subsidiaries Americas 4,302 2,536 9,601 9,379 EMEA (60 ) (253 ) (277 ) (361 ) Asia Pacific 584 35 796 1,604,244 352,094 (21,663 ) (3,719 ) 1,930,956 $ 1,200 $ Exercise of stock options and warrants 381,241 shares of Common Stock issued 4 2,139 2,143 Issuance of 159,520 shares of Common Stock under Employee Stock Purchase Program 2 1,470 1,472 Issuance of 402,645 shares of Common Stock in connection with Insignia Bourdais acquisition 4 3,995 3,999 Restricted stock awards 30,330 shares of Common Stock issued 627 627 Restricted stock 279,370 shares issued 3 (3 ) Preferred stock dividend 25,000 shares of Common Stock issued 250 (1,250 ) (1,000 ) Payments on notes receivable for shares of Common Stock 169 Long-Term Debt: Senior secured term loans, with interest ranging from 4.40% to 7.50%, due from 2003 through 2008 $ 297,500 $ 220,975 11 1/4% Senior Subordinated Notes, net of unamortized discount of $2.8 million and $3.1 million at December 31, 2003 and 2002, respectively, due in 2011 226,173 225,943 9 3/4% Senior Notes due in 2010 200,000 16% Senior Notes, net of unamortized discount of $2.8 million and $5.1 million at December 31, 2003 and 2002, respectively, due in 2011 35,472 61,863 Non-recourse mortgage debt related to property held for sale with interest at one-month Yen LIBOR plus 3.50% and a maturity date of July 31, 2008 41,753 Capital lease obligations, mainly for automobiles and telephone equipment, with interest ranging from 6.50% to 9.74%, due through 2007 259 763 Other 1,548 7. Receivables At December 31, 2002, receivables consisted of the following (in thousands): Commissions and accounts receivable, net of allowance $ 140,589 Notes receivable: Broker signing bonuses and advances 7,111 Brokerage and other employees 3,483 Executive officers, with interest at the Company s cost of debt capital (approximately 5.25%) 3,269 Reimbursement due from Chairman (collected on February 28, 2003) 691 Other Operating income (loss) 25,830 (26,494 ) 14,816 3,719 17,871 Equity income (loss) from unconsolidated subsidiaries 14,365 (4,439 ) 4,439 14,365 Interest income 3,560 1,924 (399 )(f) 5,085 Interest expense 71,256 6,045 (841 ) 7,036 (g) 83,496 Loss on extinguishment of debt 13,479 (6,840 )(h) 6,639 Interest on $200.0 million in aggregate principal amount senior notes at 9 3/4% per annum $ 19,500 Incremental interest on $75.0 million in additional tranche B term loan borrowings at LIBOR plus 4.25% (1) 2,355 Additional 0.50% interest rate margin on existing senior secured term loan facilities 649 Incremental amortization of deferred financing costs over the term of each respective debt instrument 1,688 Incremental commitment and administration fees CASH FLOWS PROVIDED BY (USED IN) OPERATING ACTIVITIES: $ 509 $ (7,905 ) $ 42,090 $ 30,188 $ 64,882 CASH FLOWS FROM INVESTING ACTIVITIES Capital expenditures, net of concessions received (10,049 ) (4,217 ) (14,266 ) Proceeds from sale of properties and servicing rights 2,515 3,863 6,378 Acquisition of businesses including net assets acquired, intangibles and goodwill, net of cash acquired (11,588 ) (35 ) (3,188 ) (14,811 ) Other investing activities, net 44 Total current liabilities 833,417 431,087 Long-Term Debt: 11 1/4% senior subordinated notes, net of unamortized discount of $2,827 and $3,057 at December 31, 2003 and 2002, respectively 226,173 225,943 Senior secured term loans 287,500 211,000 9 3/4% senior notes 200,000 16% senior notes, net of unamortized discount of $2,844 and $5,107 at December 31, 2003 and 2002, respectively 35,472 61,863 Other long-term debt 42,275 590,810 (Loss) income from continuing operations $ (34,704 ) $ (22,950 ) $ 11,857 $ 1,874 $ (43,923 ) Total 216 4 Basic and diluted loss per share from continuing operations $ (0.68 ) $ (0.70 ) Weighted average shares outstanding for basic and diluted loss per share 50,918,572 62,478,565 (j) Table of Contents Notes to Unaudited Pro Forma Statement of Operations For the Year Ended December 31, 2003 (a) Reflects the elimination of the historical results of the real estate investment assets that were sold by Insignia to Island Fund immediately prior to the closing of the Insignia acquisition. For purposes of the unaudited pro forma combined statement of operations, these dispositions were assumed to have occurred prior to January 1, 2003. (b) This adjustment mainly relates to the $6.6 million estimated fair value of the broker draw asset acquired in the Insignia acquisition. Based on our management s estimates, we generally derive benefit from brokers participating in our draw program over two years. Accordingly, we estimated that we will derive benefit from the broker draw asset related to Insignia s brokers over two years from the date of the Insignia acquisition and, accordingly, we are amortizing it on a straight-line basis, which reflects the pattern in which the economic benefits of the broker draw asset are consumed, during that period. For purposes of the unaudited pro forma combined statement of operations, the Insignia acquisition is assumed to have occurred on January 1, 2003. Accordingly, the adjustment for pro forma broker draw expense represents twelve months of amortization expense of the broker draw asset acquired. Additionally, the adjustment includes incremental pro forma deferred rent expense resulting from the recalculation of deferred rent expense from the Insignia acquisition, assumed to have closed on January 1, 2003 for purposes of the unaudited pro forma combined statement of operations. (c) Represents a reduction to depreciation expense as a result of fair value adjustments to property and equipment. (d) Represents an adjustment to amortization expense resulting from the recalculation of amortization expense relating to intangible assets acquired in the Insignia acquisition. For purposes of the unaudited pro forma combined statement of operations, the Insignia acquisition is assumed to have occurred on January 1, 2003. The largest intangible asset acquired in the Insignia acquisition relates to net revenue backlog. The net revenue backlog consists of net commissions receivable on Insignia s revenue producing transactions, which were at various stages of completion prior to the Insignia acquisition, for which Insignia recognized no revenue. The net revenue backlog is amortized as cash is received or upon final closing of these pending transactions, a large portion of which is expected to occur within twelve months after the date of the Insignia acquisition. The pro forma amortization adjustment can be summarized as follows (in thousands): Insignia historical intangible amortization January 1 to July 23, 2003 $ (1,447 ) Adjustment to CB Richard Ellis Group amortization of intangibles acquired in the Insignia acquisition: Amortization Period Cost Historical CB Richard Ellis Group Amortization 7/23-12/31/03 Pro forma Amortization Adjustment Required Total 82,568 65,407 60,419 4,988 4,988 Pro forma adjustment to amortization expense $ 3,541 Table of Contents Insignia s historical merger costs primarily include the loss on the sale of the real estate investment assets to Island Fund prior to the closing of the Insignia acquisition and legal fees incurred related to the Insignia acquisition. (f) Represents the reversal of historical interest income earned by us on the net proceeds from the $200.0 million in aggregate principal amount of our 9 3/4% senior notes held in escrow from May 22, 2003 through July 23, 2003, the date of the closing of the Insignia acquisition. The net proceeds held in escrow were released to us upon consummation of the Insignia acquisition. (g) The increase in pro forma interest expense as a result of the Insignia acquisition is summarized as follows: (In thousands) (In thousands) As of June 30, 2003 Property management contracts 5 years $ 52,679 $ 51,895 $ 784 Favorable premises leases 11 years 2,666 Subtotal 24,388 Less: historical interest expense of CB Richard Ellis Group for $200.0 million in aggregate principal amount of 9 3/4% senior notes (11,918 ) Less: historical interest expense of Insignia (1,978 ) Less: historical amortization of deferred financing costs of CB Richard Ellis Group (primarily the credit facility in effect prior to Insignia acquisition) (1,110 ) Less: historical amortization of deferred financing costs of Insignia (2,346 ) Subtotal (17,352 ) Loss from continuing operations (9,673 ) (102 ) Discontinued operations, net of applicable taxes: (Loss) income from operations (360 ) 2,869 Income on disposal 3,763 (Loss) income from operations, net of tax benefit of $248 (2003) and tax expense of $2,347 (2002) (360 ) 2,869 Income on disposal, net of tax expense of $4,741 (2003) and $1,809 (2002) 3,763 (Loss) income from continuing operations (17,603 ) 5,288 12,213 (102 ) Discontinued operations, net of applicable taxes: Income from operations 2,869 2,869 Income on disposal 265 Net increase in interest expense $ 7,036 Table of Contents SELECTED HISTORICAL FINANCIAL DATA The following table sets forth our selected historical consolidated financial information for each of the five years in the period ended December 31, 2003 and for the nine months ended September 30, 2004 and 2003. On July 20, 2001, we acquired CB Richard Ellis Services, Inc. Except as otherwise indicated below, the selected historical financial data for the dates and periods ended prior to July 20, 2001 are derived from the consolidated financial statements of CB Richard Ellis Services, our predecessor company. The statement of operations data, statement of cash flow data and other data for the nine months ended September 30, 2004 and 2003 and the balance sheet data as of September 30, 2004 were derived from our unaudited consolidated financial statements included elsewhere in this prospectus. The statement of operations data, statement of cash flow data and other data for the year ended December 31, 2003 and 2002, for the period from February 20 (inception) to December 31, 2001 and for the period from January 1 to July 20, 2001 and the balance sheet data as of December 31, 2003 and 2002 were derived from our or our predecessor s audited consolidated financial statements included elsewhere in this prospectus. The statement of operations data, statement of cash flow data and other data for the year ended December 31, 2000 and 1999 and the balance sheet data as of December 31, 2001, 2000 and 1999 were derived from our predecessor s audited consolidated financial statements that are not included in this prospectus. The selected financial data presented below are not necessarily indicative of results of future operations and should be read in conjunction with our consolidated financial statements and the information included under the headings Management s Discussion and Analysis of Financial Condition and Results of Operations and Unaudited Pro Forma Financial Information included elsewhere in this prospectus. CB Richard Ellis Group Predecessor Company Nine Months Ended September 30, Year Ended December 31, Period From February 20 (inception) to December 31, Period From January 1 to July 20, Year Ended December 31, Revenue $ $ $ 406,679 $ 168,320 $ $ 574,999 Costs and expenses: Cost of services 222,991 77,720 300,711 Operating, administrative and other 529 2,842 132,714 77,141 213,226 Depreciation and amortization 8,683 3,657 12,340 Merger-related charges 3,761 2003(1) 2001(2) Table of Contents CB Richard Ellis Group Predecessor Company As of December 31, As of December 31, Balance, February 20, 2001 $ $ $ $ $ $ $ $ $ Net income 17,426 17,426 Contribution of deferred compensation plan stock fund units 18,771 18,771 Contribution of shares by certain shareholders of CB Richard Ellis Services, Inc. 222 121,590 121,812 Net issuance of Class A common stock 50 27,639 27,689 Issuance of Class B common stock 128 72,285 72,413 Notes receivable from sale of stock (5,884 ) (5,884 ) Foreign currency translation gain 296 Net (loss) income $ (34,704 ) $ 18,727 $ 17,426 $ (34,020 ) Other comprehensive (loss) income: Foreign currency translation (loss) gain (6,712 ) (2,255 ) Total other comprehensive (loss) income (4,782 ) (19,294 ) (In thousands) Balance Sheet Data: Cash and cash equivalents $ 147,925 $ 163,881 $ 79,701 $ 57,450 $ 20,854 $ 27,844 Total assets 2,007,347 2,213,481 1,324,876 1,354,512 963,105 929,483 Long-term debt, including current portion 617,070 802,705 509,715 517,423 289,447 348,135 Total liabilities 1,522,432 1,873,896 1,067,920 1,097,693 724,018 715,874 Total stockholders equity 478,248 332,929 251,341 252,523 235,339 209,737 Table of Contents EBITDA is calculated as follows: CB Richard Ellis Group Predecessor Company Nine Months Ended September 30, Year Ended December 31, Year Ended December 31, (In thousands) Net (loss) income $ (1,708 ) $ (24,620 ) $ (34,704 ) $ 18,727 $ 17,426 $ (34,020 ) $ 33,388 $ 23,282 Add: Depreciation and amortization 40,001 53,571 92,622 24,614 12,198 25,656 43,199 40,470 Interest expense 52,138 51,739 71,256 60,501 29,717 20,303 41,700 39,368 Loss on extinguishment of debt 21,075 6,840 13,479 (Benefit) provision for income taxes 1,690 (15,459 ) (6,276 ) 30,106 18,016 1,110 34,751 16,179 Less: Interest income 2,303 2,624 3,560 3,272 2,427 1,567 2,554 1,930 (In thousands) Current: Federal $ (324 ) $ 1,080 Foreign 8,279 4,868 State and local (299 ) Total Current Liabilities 54,376 17,614 532,216 269,878 (40,667 ) 833,417 Long-Term Debt: 11 1/4% senior subordinated notes, net of unamortized discount 226,173 226,173 Senior secured term loan 287,500 287,500 9 3/4% senior notes 200,000 200,000 16% senior notes, net of unamortized discount 35,472 35,472 Inter-company loan payable 726,844 60,165 (787,009 ) Other long-term debt Revenues Real estate services $ 613,253 $ $ $ $ 613,253 Property operations 3,969 3,969 Equity earnings in unconsolidated ventures 13,911 13,911 Other income, net 1,765 632,898 EBITDA $ 110,893 $ 69,447 $ 132,817 $ 130,676 $ 74,930 $ 11,482 $ 150,484 $ 117,369 Table of Contents Results of Operations The following tables set forth items derived from the consolidated statements of operations for the nine months ended September 30, 2004 and 2003 and for the years ended December 31, 2003, 2002 and 2001, presented in dollars and as a percentage of revenue: Nine Months Ended September 30, EBITDA $ 10,956 3.5 % $ EBITDA $ 10,956 $ (Dollars in thousands) Revenue $ 1,566,907 100.0 % $ 1,008,817 100.0 % Costs and expenses: Cost of services 797,544 50.9 484,485 48.0 Operating, administrative and other 643,016 41.0 444,272 44.0 Depreciation and amortization 40,001 2.6 53,571 5.3 Merger-related charges 25,574 1.6 19,795 2.0 Investing activities Additions to property and equipment, net (4,982 ) (2,197 ) Proceeds from real estate investments 4,154 30,940 Payments made for acquisitions of businesses (4,071 ) (6,155 ) Proceeds from sale of discontinued operations 66,750 23,250 Investment in real estate (4,732 ) (4,897 ) Decrease in restricted cash Investing activities Additions to property and equipment, net (1,294 ) (3,688 ) (4,982 ) Proceeds from real estate investments 4,154 4,154 Payments made for acquisitions of businesses (4,071 ) (4,071 ) Proceeds from sale of discontinued operation 66,750 66,750 Investment in real estate (4,732 ) (4,732 ) Decrease (increase) in restricted cash 2,977 (2,612 ) Net cash used in investing activities (11,544 ) (7,373 ) (5,213 ) (24,130 ) CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from revolver and swingline credit facility 238,000 238,000 Repayment of revolver and swingline credit facility (238,000 ) (238,000 ) Repayment of senior secured term loans (9,351 ) (9,351 ) Repayment of senior notes and other loans, net (189 ) (3,116 ) (4,900 ) (8,205 ) Decrease (increase) in intercompany receivables, net 28,284 462 (28,746 ) Other financing activities, net (385 ) (172 ) (94 ) Operating income 60,772 3.9 6,694 0.7 Equity income from unconsolidated subsidiaries 10,120 0.6 9,182 0.9 Interest income 2,303 0.2 2,624 0.2 Interest expense 52,138 3.4 51,739 5.1 Loss on extinguishment of debt 21,075 1.3 6,840 0.7 (In thousands, except per share data) Revenues $ 633,229 $ 228,981 $ 115,949 $ 140,747 $ 147,552 Income (loss) from continuing operations 6,352 13,534 (5,561 ) (1,821 ) 200 Discontinued operations (19,860 ) (18,593 ) 1,091 (11,972 ) 16,436 9,291 (911 ) State: Current 1,824 3,173 1,600 Deferred (1,613 ) Loss before (benefit) provision for income taxes (18 ) 0.0 (40,079 ) (4.0 ) Provision (benefit) for income taxes 1,690 0.1 (15,459 ) (1.6 ) Net loss $ (1,708 ) (0.1 )% $ (24,620 ) (2.4 )% EBITDA $ 110,893 7.1 % $ 69,447 6.9 % Year Ended December 31, Operating income 25,830 1.6 96,736 8.3 44,130 3.8 Equity income from unconsolidated subsidiaries 14,365 0.9 9,326 0.8 4,428 0.4 Interest income 3,560 0.2 3,272 0.3 3,994 0.4 Interest expense 71,256 4.4 60,501 5.2 50,020 4.3 Loss on extinguishment of debt 13,479 0.8 25,830 96,736 61,178 (17,048 ) Equity income (loss) from unconsolidated subsidiaries Americas $ 14,180 $ 8,425 $ 1,343 $ 2,465 EMEA (188 ) 82 22 (20 ) Asia Pacific 373 819 189 (In thousands) 2003 $ 6,369 2004 2,865 2005 3,860 2006 1,205 2007 Loss from continuing operations before income taxes (11,038 ) (1,632 ) (2,211 ) (14,881 ) Income tax benefit 4,768 (Loss) income before (benefit) provision for income taxes (40,980 ) (2.5 ) 48,833 4.2 2,532 0.2 (Benefit) provision for income taxes (6,276 ) (0.4 ) 30,106 2.6 19,126 1.6 (Dollars in thousands) EMEA Revenue $ 313,686 100.0 % $ 182,222 100.0 % $ 161,306 100.0 % Costs and expenses: Cost of services 135,854 43.3 70,309 38.6 60,309 37.4 Operating, administrative and other 151,077 48.1 90,047 49.4 84,762 52.5 Depreciation and amortization 31,287 10.0 4,579 2.5 6,492 4.0 Merger-related and other nonrecurring charges 15,958 5.1 Net (loss) income $ (34,704 ) (2.1 )% $ 18,727 1.6 % $ (16,594 ) (1.4 )% Total short-term borrowings 256,270 13,867 270,137 Current maturities of long-term debt 10,000 1,029 256 11,285 Other current liabilities 12,522 Total short-term borrowings 256,270 13,867 270,137 Current maturities of long-term debt 10,000 1,029 256 11,285 Other current liabilities 12,522 EBITDA $ 132,817 8.1 % $ 130,676 11.2 % $ 86,412 7.4 % Table of Contents In addition, our management believes that EBITDA is useful in evaluating our performance compared to that of other companies in our industry because the calculation of EBITDA generally eliminates the effects of financing and income taxes and the accounting effects of capital spending and acquisitions, which items may vary for different companies for reasons unrelated to overall operating performance. As a result, our management uses EBITDA as a measure to evaluate the performance of our various business lines and for other discretionary purposes, including as a significant component when measuring our performance under our employee incentive programs. However, EBITDA is not a recognized measurement under U.S. generally accepted accounting principles or GAAP, and when analyzing our operating performance, investors should use EBITDA in addition to, and not as an alternative for, operating income (loss) and net income (loss), each as determined in accordance with GAAP. Because not all companies use identical calculations, our presentation of EBITDA may not be comparable to similarly titled measures of other companies. Furthermore, EBITDA is not intended to be a measure of free cash flow for our management s discretionary use, as it does not consider certain cash requirements such as tax and debt service payments. The amounts shown for EBITDA also differ from the amounts calculated under similarly titled definitions in our debt instruments, which are further adjusted to reflect certain other cash and non-cash charges and are used to determine compliance with financial covenants and our ability to engage in certain activities, such as incurring additional debt and making certain restricted payments. EBITDA is calculated as follows: Nine Months Ended September 30, (In thousands) Net loss $ (1,708 ) $ (24,620 ) Add: Depreciation and amortization 40,001 53,571 Interest expense 52,138 51,739 Loss on extinguishment of debt 21,075 6,840 Provision (benefit) for income taxes 1,690 (15,459 ) Less: Interest income 2,303 2,624 Asia Pacific Revenue $ 118,762 100.0 % $ 91,991 100.0 % $ 80,657 100.0 % Costs and expenses: Cost of services 50,935 42.9 37,942 41.2 33,682 41.7 Operating, administrative and other 53,003 44.6 44,391 48.3 43,998 54.5 Depreciation and amortization 3,119 2.6 3,077 3.3 3,910 4.9 Merger-related and other nonrecurring charges EBITDA $ 110,893 $ 69,447 Year Ended December 31, (In thousands) Net (loss) income $ (34,704 ) $ 18,727 $ (16,594 ) Add: Depreciation and amortization 92,622 24,614 37,854 Interest expense 71,256 60,501 50,020 Loss on extinguishment of debt 13,479 (Benefit) provision for income taxes (6,276 ) 30,106 19,126 Less: Interest income 3,560 3,272 3,994 Service cost $ 1,808 $ 1,672 $ 4,938 $ 4,510 Interest cost 2,791 2,230 8,409 5,014 Expected return on plan assets (3,170 ) (2,246 ) (9,477 ) (5,421 ) Amortization of prior service costs (85 ) (191 ) Amortization of unrecognized net gain 274 EBITDA $ 132,817 $ 130,676 $ 86,412 Table of Contents Nine Months Ended September 30, (Dollars in thousands) The Americas Revenue $ 1,148,577 100.0 % $ 766,995 100.0 % Costs and expenses: Cost of services 614,254 53.5 380,942 49.7 Operating, administrative and other 435,117 37.9 316,352 41.2 Depreciation and amortization 27,007 2.3 37,277 4.8 Merger-related charges 22,037 1.9 15,891 2.1 Funded status $ (44,228 ) $ (20,304 ) Unrecognized net actuarial loss 29,331 33,350 Company contributions in the post-measurement period 485 Tax at U.S. statutory rates $ 5,617 35.0 % $ 3,456 35.0 % Effect of different tax rates in foreign jurisdictions (387 ) (2.4 ) (424 ) (4.3 ) State income taxes, net of federal tax benefit (2,571 ) (16.0 ) (1,521 ) (15.4 ) Effect of nondeductible meals and entertainment expenses 479 3.0 1,075 10.9 Effect of nondeductible goodwill amortization 1,386 14.0 Change in valuation allowances for continuing operations 1,913 11.9 1,468 14.9 Effect of settlement of IRS exam (73 ) (0.4 ) (1,961 ) (19.9 ) Effect of executive compensation limitation 1,504 9.3 351 3.6 Other Operating income $ 50,162 4.4 % $ 16,533 2.2 % Total $ 352,421 $ 111,840 $ 282,006 $ 4,320 $ EBITDA $ 86,770 7.6 % $ 63,189 8.2 % EMEA Revenue $ 310,511 100.0 % $ 167,020 100.0 % Costs and expenses: Cost of services 133,001 42.8 70,782 42.4 Operating, administrative and other 162,740 52.4 91,615 54.9 Depreciation and amortization 10,093 3.3 13,856 8.3 Merger-related charges 3,537 1.1 3,904 2.3 Operating income (loss) $ 1,140 0.4 % $ (13,137 ) (7.9 )% Denominator: Denominator for basic earnings per share weighted average common shares 23,122 22,056 Effect of dilutive securities: Stock options, warrants and unvested restricted stock Asia Pacific Revenue $ 107,819 100.0 % $ 74,802 100.0 % Costs and expenses: Cost of services 50,289 46.6 32,761 43.8 Operating, administrative and other 45,159 41.9 36,305 48.5 Depreciation and amortization 2,901 2.7 2,438 3.3 Operating income $ 9,470 8.8 % $ 3,298 4.4 % (In thousands) 2003 $ 16,889 $ 412 $ 17,301 2004 95,000 8,786 103,786 2005 20,518 20,518 2006 556 556 2007 598 EBITDA $ 13,167 12.2 % $ 5,900 7.9 % Balance at December 31, 2002 467,668 106,063 3,406 577,137 Purchase accounting adjustments related to acquisitions 130,771 111,043 Year Ended December 31, Asia Pacific Operating income (loss) $ 11,213 $ 6,581 $ (2,128 ) Add: Depreciation and amortization 3,119 3,077 3,910 Equity income from unconsolidated subsidiaries 373 819 CASH FLOWS FROM OPERATING ACTIVITIES: Net (loss) income $ (34,704 ) $ 18,727 $ 17,426 $ (34,020 ) Adjustments to reconcile net (loss) income to net cash provided by (used in) operating activities: Depreciation and amortization 92,622 24,614 12,198 25,656 Amortization and write-off of deferred financing costs 13,276 3,322 1,316 1,152 Amortization and write-off of long-term debt discount 2,493 444 201 136 Deferred compensation deferrals 13,715 15,925 16,151 16,447 Gain on sale of properties and servicing rights (5,321 ) (6,287 ) (2,868 ) (10,009 ) Equity income from unconsolidated subsidiaries (14,365 ) (9,326 ) (1,554 ) (2,874 ) Provision for doubtful accounts 3,436 3,415 1,317 3,387 Deferred income tax (benefit) provision (12,750 ) 5,158 (1,948 ) (1,569 ) (Increase) decrease in receivables (43,011 ) (4,770 ) (18,379 ) 26,970 (Increase) decrease in deferred compensation assets (12,747 ) 5,743 (4,517 ) (11,665 ) Increase (decrease) in accounts payable and accrued expenses 14,448 7,912 (4,749 ) (5,491 ) Increase (decrease) in compensation and employee benefits payable and accrued bonus and profit sharing 42,634 17,541 64,677 (101,312 ) (Decrease) increase in income taxes payable (15,197 ) 3,225 13,578 (16,357 ) Increase (decrease) in other liabilities 16,021 (15,203 ) (9,260 ) (11,305 ) Other operating activities, net 3,391 (5,558 ) 7,745 Operating income $ 35,107 2.9 % $ 72,868 8.1 % $ 36,966 4.0 % EBITDA $ 107,503 9.0 % $ 98,251 11.0 % $ 68,226 7.3 % Table of Contents Year Ended December 31, (1,613 ) 2,202 2,679 942 Foreign: Current 6,642 12,920 10,137 1,079 Deferred Operating (loss) income $ (20,490 ) (6.5 )% $ 17,287 9.5 % $ 9,292 5.8 % EBITDA $ 10,609 3.4 % $ 21,948 12.0 % $ 15,786 9.8 % Net cash (used in) provided by financing activities (61,721 ) 328,498 NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS (14,295 ) 5,100 CASH AND CASH EQUIVALENTS, AT BEGINNING OF PERIOD 163,881 79,701 Effect of currency exchange rate changes on cash (1,661 ) NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 19,939 (34 ) (14,871 ) 66 5,100 CASH AND CASH EQUIVALENTS, AT BEGINNING OF PERIOD 127 54 74,173 5,347 79,701 Effect of currency exchange rate changes on cash 693 Operating income (loss) $ 11,213 9.4 % $ 6,581 7.2 % $ (2,128 ) (2.6 )% EBITDA $ 14,705 12.4 % $ 10,477 11.4 % $ 2,400 3.0 % Table of Contents We do not allocate net interest expense or provision (benefit) for income taxes among our segments. Accordingly, EBITDA for our segments is calculated as follows: Nine Months Ended September 30, (In thousands) The Americas Operating income $ 50,162 $ 16,533 Add: Depreciation and amortization 27,007 37,277 Equity income from unconsolidated subsidiaries 9,601 9,379 EBITDA $ 86,770 $ 63,189 Costs and expenses Real estate services 271,908 239,960 Property operations 3,664 3,165 Administrative 10,192 6,583 Depreciation 6,971 6,744 Property depreciation Costs and expenses Real estate services 187,672 84,236 271,908 Property operations 3,664 3,664 Administrative 10,192 10,192 Depreciation and amortization 6,271 1,922 8,193 Property depreciation 753 EMEA Operating income (loss) $ 1,140 $ (13,137 ) Add: Depreciation and amortization 10,093 13,856 Equity loss from unconsolidated subsidiaries (277 ) (361 ) (In thousands, except per share data) Revenues $ 591,014 $ 172,332 $ 155,414 $ 139,225 $ 124,043 Income (loss) from continuing operations 9,037 6,254 2,779 905 (901 ) Discontinued operations 9,098 80 5,990 2,270 Revenue $ $ $ 416,446 $ 146,382 $ $ 562,828 Costs and expenses: Cost of services 207,019 56,582 263,601 Operating, administrative and other 500 3,589 145,145 70,175 219,409 Depreciation and amortization 8,523 3,675 12,198 Merger-related and other nonrecurring charges 2,144 3,530 EBITDA $ 13,167 $ 5,900 Long-Lived Assets United States $ 277,262 $ 261,741 United Kingdom 120,334 112,138 France 31,794 25,013 Other Europe 8,471 5,637 Asia and Latin America 939 Year Ended December 31, (In thousands) The Americas Operating income $ 35,107 $ 72,868 $ 36,966 Add: Depreciation and amortization 58,216 16,958 27,452 Equity income from unconsolidated subsidiaries 14,180 8,425 3,808 Liabilities Accounts payable 2,535 Commissions payable 564 Accrued incentives 3,027 Accrued and sundry liabilities 3,256 Deferred taxes EBITDA $ 107,503 $ 98,251 $ 68,226 Net cash used in investing activities (284,795 ) (24,130 ) (261,393 ) (12,139 ) CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from revolver and swingline credit facility 152,850 238,000 113,750 Repayment of revolver and swingline credit facility (152,850 ) (238,000 ) (113,750 ) Proceeds from senior secured term loans 375,000 235,000 Repayment of senior secured term loans (298,475 ) (9,351 ) (4,675 ) Proceeds from 9 3/4% senior notes 200,000 Repayment of notes payable (43,000 ) Proceeds from 16% senior notes 65,000 Repayment of 16% senior notes (30,000 ) Proceeds from (repayment of) senior notes and other loans, net 3,029 (8,205 ) (1,188 ) 446 Proceeds from 11 1/4% senior subordinated notes 225,629 Repayment of 8 7/8% senior subordinated notes (175,000 ) Proceeds from non-recourse debt related to property held for sale 37,179 Proceeds from revolving credit facility 195,000 Repayment of revolving credit facility (235,000 ) (70,000 ) Payment of deferred financing fees (22,707 ) (443 ) (21,750 ) (8 ) Proceeds from issuance of common stock 120,980 180 92,156 Other financing activities, net (1,163 ) (19 ) (3,520 ) Net cash provided by (used in) investing activities 251 (5,259 ) (7,131 ) (12,139 ) CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from revolving credit facility 195,000 195,000 Repayment of revolving credit facility (70,000 ) (70,000 ) (Repayment of) proceeds from senior notes and other loans, net (2,490 ) (1,656 ) 4,592 446 Payment of deferred financing fees (8 ) (8 ) (Increase) decrease in intercompany receivables, net (85,712 ) 52,846 32,866 Other financing activities, net 1,489 (81 ) (616 ) (In thousands) Revenues Real estate services $ 577,544 $ 613,253 Property operations 9,195 3,969 Equity earnings in unconsolidated ventures 3,482 13,911 Other income, net (In thousands) Revenues Real estate services $ 577,544 $ $ $ 577,544 Property operations 9,195 9,195 Equity earnings in unconsolidated ventures 3,482 3,482 Other income, net 589 204 Federal: Current $ (5,335 ) $ 10,204 $ 11,747 $ Deferred (6,637 ) 6,232 (3,252 ) (911 ) Change in valuation allowances Current Assets: Cash and cash equivalents $ 54 $ 2,315 $ 126,066 $ 19,490 $ $ 147,925 Restricted cash 10,162 452 10,614 Receivables, less allowance for doubtful accounts 20 6 115,451 160,866 276,343 Warehouse receivable (a) 111,840 111,840 Prepaid expenses and other current assets 84,273 EBITDA $ 10,609 $ 21,948 $ 15,786 Backlog Various $ 72,149 $ 62,431 $ 59,108 $ 3,323 Management contracts Various 4,611 1,115 490 625 Other Various 5,808 1,861 EBITDA $ 14,705 $ 10,477 $ 2,400 Table of Contents From time to time, we consider potential strategic acquisitions. Our management believes that any future significant acquisitions that we make most likely would require us to obtain additional debt or equity financing. In the past, we have been able to obtain such financing for other material transactions on terms that our management believed to be reasonable. However, it is possible that we may not be able to find acquisition financing on favorable terms in the future, if we decide to make any material acquisitions. Our current long-term liquidity needs, other than those related to ordinary course obligations and commitments such as operating leases, generally are comprised of two parts. The first is the repayment of the outstanding principal amounts of our long-term indebtedness, including our senior secured term loan in 2010, our 9 3/4% senior notes in 2010 and our 11 1/4% senior subordinated notes in 2011. During June 2004, we used a portion of the net proceeds we received from our June 15, 2004 initial public offering to prepay $15.0 million in principal amount of the senior secured term loan under our amended and restated credit agreement. During July 2004, we used the remaining net proceeds received from the initial public offering to redeem all $38.3 million in aggregate principal amount of the remaining outstanding 16% senior notes and $70.0 million in aggregate principal amount of our 9 3/4% senior notes. In the future, we will continue to look for opportunities to reduce debt, which is consistent with our de-leveraging efforts thus far in 2004. Our management is unable to project with certainty whether our long-term cash flow from operations will be sufficient to repay our long-term debt when it comes due. If this cash flow is insufficient, then our management expects that we would need to refinance such indebtedness or otherwise amend its terms to extend the maturity dates. Our management cannot make any assurances that such refinancings or amendments, if necessary, would be available on attractive terms, if at all. The other primary component of our long-term liquidity needs, other than those related to ordinary course obligations and commitments such as operating leases, are our obligations related to our deferred compensation plan and our U.K. pension plans. Pursuant to our deferred compensation plans, a select group of our management and other highly-compensated employees have been permitted to defer receipt of some or all of their compensation until future distribution dates and have the deferred amount credited towards specified investment alternatives. Except for deferrals into stock fund units that provide for future issuances of our common stock, the deferrals under the deferred compensation plans represent future cash payment obligations for us. We currently have invested in insurance funds for the purpose of funding approximately half of our future cash deferred compensation obligations. In addition, upon each distribution under the plans, we receive a corresponding tax deduction for such compensation payment. Our U.K. subsidiaries maintain pension plans with respect to which a limited number of our U.K. employees are participants. Our historical policy has been to fund pension costs as actuarially determined and as required by applicable law and regulations. As of December 31, 2003, based upon actuarial calculations of future benefit obligations under these plans, these plans were in the aggregate approximately $44.2 million underfunded. Our management expects that any future obligations under our deferred compensation plans and pension plans that are not currently funded will be funded out of our future cash flow from operations. Summary of Contractual Obligations and Other Commitments The following is a summary of our various contractual obligations and other commitments as of September 30, 2004, except for operating leases which are as of December 31, 2003: Payments Due by Period Contractual Obligations Total Less Than 1 Year 1-3 Years 4-5 Years More Than 5 Years (In thousands) Total debt (1) $ 755,306 $ 151,257 $ 24,342 $ 244,634 $ 335,073 Operating leases (2) 710,262 96,123 167,164 134,094 312,881 Deferred compensation plan liability (3) 146,709 6,048 15,702 17,470 107,489 Pension liability (3) 36,565 36,565 Total Contractual Obligations $ 1,648,842 $ 253,428 $ 207,208 $ 396,198 $ 792,008 Total Table of Contents Amount of Commitments Expected by Period Other Commitments Total Less Than 1 Year 1-3 Years 4-5 Years More Than 5 Years (In thousands) Letters of credit (4) $ 6,070 $ 6,070 $ $ $ Guarantees 5,100 3,900 1,200 Co-investment commitments 41,700 35,091 6,609 Total Current Liabilities 634,675 833,417 Long-Term Debt: 11 1/4% senior subordinated notes, net of unamortized discount of $2,397 and $2,827 at September 30, 2004 and December 31, 2003, respectively 204,972 226,173 Senior secured term loan 268,200 287,500 9 3/4% senior notes 130,000 200,000 16% senior notes, net of unamortized discount of $2,844 at December 31, 2003 35,472 Other long-term debt Total Current Liabilities 13,470 26,769 401,774 192,662 634,675 Long-Term Debt: 11 1/4% senior subordinated notes, net of unamortized discount 204,972 204,972 Senior secured term loan 268,200 268,200 9 3/4% senior notes 130,000 130,000 Inter-company loan payable 748,699 134,974 (883,673 ) Other long-term debt 330 547 Total Commitments $ 52,870 $ 45,061 $ 6,609 $ 1,200 $ Change in Plan Assets Fair value of plan assets at beginning of year 44,131 Actual return on plan assets (6,198 ) Employer contributions Table of Contents Interest Rates We manage our interest expense by using a combination of fixed and variable rate debt. Our fixed and variable rate long-term debt at September 30, 2004 consisted of the following: Year of Maturity Fixed Rate One- Month LIBOR +1.0% Three to Six-Month LIBOR +2.5% Interest Rate Range of 1.0% to 6.25% Six- Month Yen LIBOR +3.75% Six- Month GBP LIBOR 2.0% Total (Dollars in thousands) 2004 $ 16,936 $ 111,840 $ 13,806 (1) $ 4,320 $ 182 $ 4,173 151,257 2005 361 11,800 364 12,525 2006 17 11,800 11,817 2007 17 11,800 11,817 2008 17 232,800 (2) 232,817 Thereafter (3) 335,073 335,073 CASH AND CASH EQUIVALENTS, AT END OF PERIOD $ 3 $ Net periodic pension cost $ 7,822 $ 3,575 $ 1,439 $ Weighted average interest rate 10.5 % 2.8 % 4.5 % 5.5 % 3.8 % 1.5 % 7.0 % Total current 7,656 6,276 Deferred: Federal 2,053 (1,662 ) Foreign Table of Contents Facilities We occupied the following offices as of December 31, 2003: Location Sales Offices Corporate Offices Total Costs and expenses Real estate services 526,076 554,744 Property operations 7,264 1,145 Administrative 14,344 13,439 Depreciation 13,915 12,509 Property depreciation 1,920 Table of Contents MANAGEMENT Executive Officers and Directors The following table sets forth information about our executive officers and directors as of October 31, 2004: Name Age Position Table of Contents Compensation of Executive Officers Summary Compensation Table The following table sets forth information concerning the compensation of our chief executive officer and our other executive officers for the three years ended December 31, 2003: Annual Compensation Long-Term Compensation All Other Compensation (5) Name and Principal Position Year Salary Bonus (1) Other Annual Compensation (2)(3) Restricted Stock Awards (2)(4) Securities Underlying Stock Options Ray Wirta Chief Executive Officer 2003 2002 2001 $ 573,129 518,511 518,510 $ 521,310 $ 28,560 27,359 8,092 232,794 488,184 $ 489,375 Brett White President 2003 2002 2001 506,156 450,501 415,883 355,481 15,284 71,897 62,552 232,794 392,929 971,000 (6) Kenneth J. Kay (7) Current Senior Executive Vice President and Chief Financial Officer 2003 2002 450,000 207,692 300,000 99,769 171,824 300,000 (8) James H. Leonetti (9) Former Senior Executive Vice President and Chief Financial Officer 2002 2001 147,138 254,458 47,629 170,000 453,500 (10) (11) Alan C. Froggatt (12) President, EMEA 2003 337,351 536,190 20,777 (13) 83,141 566 (14) Robert Blain (15) President, Asia Pacific 2003 2002 302,308 225,000 344,506 100,000 157,692 120,000 69,284 15,000 (16) Table of Contents Option Grants Table The following table sets forth information concerning stock option grants to our executive officers during the year ended December 31, 2003, each of which was granted pursuant to our 2001 stock incentive plan: Name Number of Securities Underlying Options Granted Percentage of Total Options Granted to Employees in 2003 Exercise Price Per Shares Expiration Date Potential Realizable Value at Assumed Annual Rates of Stock Price Appreciation for Option Term 5% 10% Ray Wirta 232,794 7.9 % $ 5.77 9/16/13 $ 845,234 $ 2,141,990 Brett White 232,794 7.9 5.77 9/16/13 845,234 2,141,990 Kenneth J. Kay 99,769 3.4 5.77 9/16/13 362,243 917,996 Alan C. Froggatt 83,141 2.8 5.77 9/16/13 301,869 764,996 Robert Blain 69,284 2.4 5.77 9/16/13 251,558 637,497 Each of the options disclosed in the option grant table above vests 20% per anniversary of the September 16, 2003 grant date. On September 22, 2004, we granted to our executive officers options to acquire the following numbers of shares of our Class A common stock: Ray Wirta 100,000; Brett White 100,000; Kenneth J. Kay 50,000; Robert Blain 30,000; and Alan C. Froggatt 20,000. Each of these options has an exercise price of $22.39 per share, expires on September 22, 2009 and vests in 25% increments on each anniversary of the initial grant. Aggregated Options Table The following table sets forth information concerning unexercised options held as of December 31, 2003 by the persons named in the table under Summary Compensation Table. No options were exercised by our executive officers during 2003. Name Shares Acquired on Exercise Value Realized ($) Number of Securities Underlying Unexercised Options at December 31, 2003 Value of Unexercised In-the- Money Options at December 31, 2003 Exercisable Unexercisable Exercisable Unexercisable Table of Contents PRINCIPAL AND SELLING STOCKHOLDERS The table below sets forth the number of shares of our Class A common stock beneficially owned, and the percentage ownership of our common stock, as of October 31, 2004 for the following persons: each person that beneficially owns 5% or more of our Class A common stock; each of our directors; each of our executive officers; all of our directors and executive officers as a group; and each selling stockholder. Except as otherwise noted below, the address for each person listed on the table is c/o CB Richard Ellis Group, Inc., 865 South Figueroa Street, Suite 3400, Los Angeles, California 90017. Beneficial ownership is determined in accordance with the federal securities rules that generally attribute beneficial ownership of securities to persons who possess sole or shared voting power or investment power with respect to those securities. Unless otherwise indicated, the persons or entities identified in this table have sole voting and investment power with respect to all shares shown as beneficially owned by them, subject to applicable community property laws. In computing the number of shares beneficially owned by a person and the percentage ownership of that person, shares subject to options or warrants held by that person that are or will become exercisable within 60 days of October 31, 2004 are deemed outstanding, although the shares are not deemed outstanding for purposes of computing percentage ownership of any person. Shares Beneficially Owned Prior to the Offering Shares to be Sold in the Offering (1) Shares Beneficially Owned After the Offering Number Percent Number Percent Table of Contents Shares Beneficially Owned Prior to the Offering Shares to be Sold in the Offering (1) Shares Beneficially Owned After the Offering Number Percent Number Percent Other Selling Stockholders: California Public Employees Retirement System (13) 2,472,105 3.5 % 851,031 1,621,074 2.3 DLJ Investment Partners II, L.P. DLJ Investment Partners, L.P. DLJIP II Holdings, L.P. (14) 1,420,656 2.0 640,999 779,657 1.1 Stanfield Arbitrage CDO, Ltd. Stanfield CLO, Ltd. Stanfield/RMF Transatlantic CDO, Ltd. (15) 51,697 * 51,697 National City Corporation (16) 10,339 * 10,339 Table of Contents Until May 15, 2006, our 9 3/4% senior notes may be redeemed on one or more occasions in an amount not to exceed 35% of the principal amount of all issued 9 3/4% senior notes at a redemption price of 109 3/4%, plus accrued and unpaid interest to the redemption date, with cash proceeds raised in certain public equity offerings, as long as: at least 65% of the aggregate principal amount of our 9 3/4% senior notes, including any additional 9 3/4% senior notes, remains outstanding after each redemption; if the money is raised in an equity offering by us, we contribute to CB Richard Ellis Services an amount sufficient to redeem the 9 3/4% senior notes; and the 9 3/4% senior notes are redeemed within 90 days after the completion of the related equity offering. Pursuant to this provision of the indenture, we used a portion of the net proceeds we received from our initial public offering to redeem $70.0 million in aggregate principal amount of our 9 3/4% senior notes due 2010 in July 2004, which also required payment of a $6.8 million premium and accrued and unpaid interest through the date of redemption. On and after May 15, 2007, all or a portion of our 9 3/4% senior notes will be redeemable at our option upon not less than 30 nor more than 60 days notice. The notes are redeemable at the redemption prices, expressed as a percentage of the principal amount on the redemption date, set forth in the table below, plus accrued and unpaid interest, if redeemed during the twelve-month period commencing May 15 of the years below: Year Percentage Table of Contents Interest accrues at a rate of 11 1/4% per year and is payable semiannually in arrears. Interest is computed on the basis of a 360-day year comprised of twelve 30-day months. There are no mandatory sinking fund payments for our 11 1/4% senior subordinated notes. We may at any time and from time to time purchase our 11 1/4% senior subordinated notes in the open market or otherwise. We and substantially all of our domestic subsidiaries guaranteed the 11 1/4% senior subordinated notes on a senior subordinated basis. These guarantees are subordinated to all of such guarantors existing and future senior indebtedness, including guarantees by them of the senior secured credit facilities. On and after June 15, 2006, all or a portion of our 11 1/4% senior subordinated notes will be redeemable at our option upon not less than 30 nor more than 60 days notice. The notes are redeemable at the redemption prices, expressed as a percentage of the principal amount on the redemption date, set forth in the table below, plus accrued and unpaid interest, if redeemed during the twelve-month period commencing June 15 of the years below: Year Percentage Table of Contents UNDERWRITING Under the terms and subject to the conditions contained in an underwriting agreement dated , 2004, the selling stockholders have agreed to sell to the underwriters named below, for whom Credit Suisse First Boston LLC and Citigroup Global Markets Inc. are acting as representatives, the following respective numbers of shares of common stock: Underwriter Number of Shares Credit Suisse First Boston LLC Citigroup Global Markets Inc. Goldman, Sachs & Co. J.P. Morgan Securities Inc. Lehman Brothers Inc. Merrill Lynch, Pierce, Fenner & Smith Incorporated Bear, Stearns & Co. Inc. Total 15,000,000 The underwriting agreement provides that the underwriters are obligated to purchase all the shares of common stock in the offering if any are purchased, other than those shares covered by the over-allotment option described below. The underwriting agreement also provides that if an underwriter defaults, the purchase commitments of non-defaulting underwriters may be increased or the offering may be terminated. Some of the selling stockholders have granted to the underwriters a 30-day option to purchase on a pro rata basis up to 2,250,000 additional outstanding shares from them at the offering price less the underwriting discounts and commissions. The option may be exercised only to cover any over-allotments of common stock. The underwriters propose to offer the shares of common stock initially at the offering price on the cover page of this prospectus and to selling group members at that price less a selling concession of $ per share. The underwriters and selling group members may allow a discount of $ per share on sales to other broker/dealers. After the offering, the representatives may change the offering price and concession and discount to broker/dealers. The following table summarizes the compensation the selling stockholders will pay and estimated expenses we will pay: Per Share Total Without Over- allotment With Over- allotment Without Over- allotment With Over- allotment Table of Contents INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Page (Unaudited) ASSETS Current Assets: Cash and cash equivalents $ 147,925 $ 163,881 Restricted cash 10,614 14,899 Receivables, less allowance for doubtful accounts of $15,557 and $16,181 at September 30, 2004 and December 31, 2003, respectively 276,343 322,416 Warehouse receivable 111,840 230,790 Prepaid expenses 24,308 22,854 Deferred tax assets, net 62,832 57,681 Other current assets 41,539 26,461 Total Current Assets 675,401 838,982 Property and equipment, net 128,076 113,569 Goodwill 830,723 819,558 Other intangible assets, net of accumulated amortization of $89,113 and $73,449 at September 30, 2004 and December 31, 2003, respectively 117,295 131,731 Deferred compensation assets 79,461 76,389 Investments in and advances to unconsolidated subsidiaries 83,537 68,361 Deferred tax assets, net 30,636 32,179 Other assets, net 62,218 132,712 Total Assets $ 2,007,347 $ 2,213,481 LIABILITIES AND STOCKHOLDERS EQUITY Current Liabilities: Accounts payable and accrued expenses $ 170,130 $ 189,787 Compensation and employee benefits payable 156,233 148,874 Accrued bonus and profit sharing 143,585 200,343 Short-term borrowings: Warehouse line of credit 111,840 230,790 Other 26,396 39,347 Total short-term borrowings 138,236 270,137 Current maturities of long-term debt 13,021 11,285 Other current liabilities 13,470 12,991 Total Long-Term Debt 604,049 791,420 Deferred compensation liability 146,709 138,037 Pension liability 36,565 35,998 Other liabilities 100,434 75,024 Total Liabilities 1,522,432 1,873,896 Minority interest 6,667 6,656 Commitments and contingencies Stockholders Equity: Class A common stock; $0.01 par value; 325,000,000 shares authorized; 70,195,909 and 7,176,396 shares issued and outstanding at September 30, 2004 and December 31, 2003, respectively 702 72 Class B common stock; $0.01 par value; 100,000,000 shares authorized; 53,409,556 shares issued and outstanding at December 31, 2003; no shares authorized, issued or outstanding at September 30, 2004 534 Additional paid-in capital 509,288 359,334 Notes receivable from sale of stock (5,058 ) (4,680 ) Accumulated (deficit) earnings (259 ) 1,449 Accumulated other comprehensive loss (26,425 ) (23,780 ) Total Stockholders Equity 478,248 332,929 Total Liabilities and Stockholders Equity $ 2,007,347 $ 2,213,481 Table of Contents CB RICHARD ELLIS GROUP, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited) (Dollars in thousands, except share data) Three Months Ended September 30, Nine Months Ended September 30, Revenue $ 574,999 $ 423,376 $ 1,566,907 $ 1,008,817 Costs and expenses: Cost of services 300,711 207,820 797,544 484,485 Operating, administrative and other 213,226 180,676 643,016 444,272 Depreciation and amortization 12,340 41,071 40,001 53,571 Merger-related charges 4,040 16,485 25,574 19,795 Operating income (loss) 44,682 (22,676 ) 60,772 6,694 Equity income from unconsolidated subsidiaries 4,826 2,318 10,120 9,182 Interest income 672 1,373 2,303 2,624 Interest expense 14,919 21,000 52,138 51,739 Loss on extinguishment of debt 17,066 6,840 21,075 6,840 Income (loss) before provision (benefit) for income taxes 18,195 (46,825 ) (18 ) (40,079 ) Provision (benefit) for income taxes 6,300 (18,380 ) 1,690 (15,459 ) Net income (loss) $ 11,895 $ (28,445 ) $ (1,708 ) $ (24,620 ) Basic income (loss) per share $ 0.17 $ (0.49 ) $ (0.03 ) $ (0.52 ) Weighted average shares outstanding for basic income (loss) per share 71,446,359 57,486,405 66,006,231 46,995,364 Diluted income (loss) per share $ 0.16 $ (0.49 ) $ (0.03 ) $ (0.52 ) Weighted average shares outstanding for diluted income (loss) per share 75,184,418 57,486,405 66,006,231 46,995,364 Table of Contents CB RICHARD ELLIS GROUP, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) (Dollars in thousands) Nine Months Ended September 30, CASH FLOWS FROM OPERATING ACTIVITIES: Net loss $ (1,708 ) $ (24,620 ) Adjustments to reconcile net loss to net cash provided by (used in) operating activities: Depreciation and amortization 40,001 53,571 Amortization and write-off of deferred financing costs 10,094 10,176 Amortization and write-off of long-term debt discount 3,274 378 Deferred compensation deferrals 12,764 7,836 Write-off of impaired investments 2,990 Gain on sale of servicing rights, property held for sale and other assets (5,789 ) (3,417 ) Equity income from unconsolidated subsidiaries (10,120 ) (9,182 ) Provision for doubtful accounts 2,304 3,598 Deferred income tax benefit (190 ) (13,600 ) Decrease in receivables 37,465 23,253 Increase in deferred compensation assets (3,072 ) (6,435 ) Decrease (increase) in prepaid expenses and other assets 14,172 (14,237 ) Decrease in compensation and employee benefits payable and accrued bonus and profit sharing (41,843 ) (45,269 ) Decrease in accounts payable and accrued expenses (22,185 ) (22,089 ) Decrease in income tax payable (7,861 ) (29,134 ) Increase (decrease) in other liabilities 6,946 (1,540 ) Other operating activities, net 1,363 (3 ) Net cash provided by (used in) operating activities 38,605 (70,714 ) CASH FLOWS FROM INVESTING ACTIVITIES: Proceeds from sale of servicing rights and other assets 5,607 1,922 Proceeds from sale of property held for sale 50,401 Capital expenditures, net of concessions received (27,455 ) (8,185 ) Acquisition of businesses including net assets acquired, intangibles and goodwill, net of cash acquired (16,784 ) (243,847 ) Other investing activities, net (2,948 ) (2,574 ) Net cash provided by (used in) investing activities 8,821 (252,684 ) CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from revolver and swingline credit facility 186,750 152,850 Repayment of revolver and swingline credit facility (186,750 ) (152,850 ) Proceeds from senior secured term loan 75,000 Repayment of senior secured term loan (17,500 ) (7,513 ) Repayment of non-recourse debt related to property held for sale (42,048 ) Repayment of notes payable (43,000 ) (Repayment of) proceeds from euro cash pool loan and other loans, net (9,809 ) 3,732 Proceeds from 9 3/4% senior notes 200,000 Repayment of 9 3/4% senior notes (70,000 ) Repayment of 11 1/4% senior subordinated notes (21,631 ) Repayment of 16% senior notes (38,316 ) Proceeds from issuance of common stock, net 135,000 120,580 Proceeds from exercise of stock options 7,991 Payment of deferred financing fees (3,942 ) (19,774 ) Other financing activities, net (1,466 ) (527 ) CASH AND CASH EQUIVALENTS, AT END OF PERIOD $ 147,925 $ 85,494 SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: Cash paid during the period for: Interest, net of amount capitalized $ 56,846 $ 31,694 Income taxes, net of refunds $ 11,462 $ 25,533 Utilized To Date To be Utilized Severance $ 30,706 $ (19 ) $ (23,653 ) $ 7,034 Lease termination costs 28,922 8,923 (10,152 ) 27,693 Change of control payments 10,451 (10,451 ) Costs associated with exiting contracts 8,921 1,519 (9,016 ) 1,424 Legal settlements anticipated 8,739 3,770 (3,122 ) 9,387 $ 87,739 $ 14,193 $ (56,394 ) $ 45,538 4. Basis of Presentation The consolidated statements of operations and cash flows for the three and nine months ended September 30, 2004 include full periods of activity for Insignia. However, the consolidated statements of operations and cash flows for the three and nine months ended September 30, 2003 include the activity of Insignia from July 23, 2003, the date of the Insignia Acquisition. As such, our consolidated financial statements after the Insignia Acquisition are not directly comparable to our consolidated financial statements prior to the Insignia Acquisition. Pro forma results for the three and nine months ended September 30, 2003, assuming the Insignia Acquisition had occurred as of January 1, 2003, are presented below. These pro forma results have been prepared for comparative purposes only and include adjustments, such as increased amortization expense as a result of intangible assets acquired in the Insignia Acquisition as well as higher interest expense as a result of debt incurred to finance the Insignia Acquisition. These pro forma results do not purport to be indicative of what operating results would have been had the Insignia Acquisition occurred on January 1, 2003, and may not be indicative of future operating results (dollars in thousands, except share data). September 30, 2003 Three Months Ended Nine Months Ended Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Unaudited) In accordance with SFAS No. 123, we estimate the fair value of our options using the Black-Scholes option-pricing model, which takes into account assumptions such as the dividend yield, the risk-free interest rate, the expected stock price volatility and the expected life of the options. As our Class A common stock was not freely tradeable on a national securities exchange or an over-the-counter market prior to the completion of the IPO, an effectively zero percent volatility was utilized for all periods ending prior to the IPO. The dividend yield is excluded from the calculation, as it is our present intention to retain all earnings. The following table illustrates the effect on net income (loss) and income (loss) per share if the fair value based method had been applied to all outstanding and unvested awards in each period (dollars in thousands, except share data): Three Months Ended September 30, Nine Months Ended September 30, Net income (loss) as reported $ 11,895 $ (28,445 ) $ (1,708 ) $ (24,620 ) Add: Stock-based employee compensation expense included in reported net income (loss), net of the related tax effect 114 220 Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of the related tax effect (310 ) (205 ) (697 ) (498 ) Pro forma net income (loss) $ 11,699 $ (28,650 ) $ (2,185 ) $ (25,118 ) Basic income (loss) per share: As reported $ 0.17 $ (0.49 ) $ (0.03 ) $ (0.52 ) Pro forma $ 0.16 $ (0.50 ) $ (0.03 ) $ (0.53 ) Diluted income (loss) per share: As reported $ 0.16 $ (0.49 ) $ (0.03 ) $ (0.52 ) Pro forma $ 0.16 $ (0.50 ) $ (0.03 ) $ (0.53 ) The weighted average fair value of options granted by us was $8.07 and $0.53 for the three months ended September 30, 2004 and 2003, respectively, and $8.05 and $0.58 for the nine months ended September 30, 2004 and 2003, respectively. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model, utilizing the following weighted average assumptions: Three Months Ended September 30, Nine Months Ended September 30, Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Unaudited) 8. Goodwill and Other Intangible Assets The changes in the carrying amount of goodwill for us and each of our segments (See Note 19 for a description of our segments) for the nine months ended September 30, 2004 are as follows (dollars in thousands): Americas EMEA Asia Pacific Total Balance at January 1, 2004 $ 598,439 $ 217,106 $ 4,013 $ 819,558 Purchase accounting adjustments related to acquisitions 6,177 1,124 3,864 11,165 Balance at September 30, 2004 $ 604,616 $ 218,230 $ 7,877 $ 830,723 Other intangible assets totaled $117.3 million and $131.7 million, net of accumulated amortization of $89.1million and $73.4 million, as of September 30, 2004 and December 31, 2003, respectively, and are comprised of the following (dollars in thousands): As of September 30, 2004 As of December 31, 2003 Gross Carrying Amount Accumulated Amortization Gross Carrying Amount Accumulated Amortization Unamortizable intangible assets Trademarks $ 63,700 $ 63,700 Trade name 19,826 19,826 $ 83,526 $ 83,526 Amortizable intangible assets Backlog $ 72,149 $ (69,355 ) $ 72,503 $ (59,108 ) Management contracts 25,731 (12,287 ) 25,649 (9,708 ) Loan servicing rights 19,194 (5,254 ) 17,694 (3,812 ) Other 5,808 (2,217 ) 5,808 (821 ) $ 122,882 $ (89,113 ) $ 121,654 $ (73,449 ) Total intangible assets $ 206,408 $ (89,113 ) $ 205,180 $ (73,449 ) Current assets $ 211,151 $ 208,743 Non current assets $ 2,845,552 $ 2,040,138 Current liabilities $ 284,151 $ 154,778 Non current liabilities $ 1,309,935 $ 969,993 Minority interest $ 6,783 $ 4,600 Condensed Statements of Operations Information: Three Months Ended September 30, Nine Months Ended September 30, Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Unaudited) $0.9 million outstanding letter of credit is the Fannie Mae letter of credit described above. The outstanding letters of credit as of September 30, 2004 expire at varying dates through July 23, 2005. However, we are obligated to renew the letters of credit related to the Island purchase agreement until as late as July 23, 2006 and the Fannie Mae letter of credit until our obligation to cover potential credit losses is satisfied. We had guarantees totaling $5.1 million as of September 30, 2004, which consisted primarily of guarantees of property debt as well as the obligations to Island and Fannie Mae discussed above. Approximately $1.2 million of the guarantees are related to investment activity that is scheduled to expire on September 1, 2008. The guarantee related to the Island purchase agreement expired on the September 15, 2004 maturity date of the underlying loan agreement, however, similar loan terms are expected to be renewed, modified or extended upon the completion of on-going negotiations. Currently, renewals, modifications and extensions of such loan may be made without our consent, but the Insignia $1.3 million amount of our guarantee related to such loan may not be increased without our consent in connection with any such renewal, modification or extension. The guarantee obligation related to the agreement with Fannie Mae discussed above will expire in December 2004. An important part of the strategy for our investment management business involves investing our capital in certain real estate investments with our clients. As of September 30, 2004 we had committed $41.7 million to fund future co-investments. In addition to required future capital contributions, some of the co-investment entities may request additional capital from us and our subsidiaries holding investments in those assets and the failure to provide these contributions could have adverse consequences to our interests in these investments. 13. Comprehensive Income (Loss) Comprehensive income (loss) consists of net income (loss) and other comprehensive income (loss). In the accompanying consolidated balance sheets, accumulated other comprehensive loss consists of foreign currency translation adjustments and minimum pension liability adjustments. Foreign currency translation adjustments exclude any income tax effect given that the earnings of non-U.S. subsidiaries are deemed to be reinvested for an indefinite period of time. The following table provides a summary of comprehensive income (loss) (dollars in thousands): Three Months Ended September 30, Nine Months Ended September 30, Comprehensive income (loss) $ 12,051 $ (23,897 ) $ (4,353 ) $ (23,346 ) Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Unaudited) 14. Earnings (Loss) Per Share Information Earnings (loss) per share (EPS) is accounted for in accordance with SFAS No. 128, Earnings Per Share. Basic EPS is computed by dividing net income (loss) by the weighted average number of common shares outstanding during each period. Where appropriate, the computation of diluted EPS further assumes the dilutive effect of potential common shares, which include stock options, stock warrants and certain contingently issuable shares. Contingently issuable shares represent unvested stock fund units in the deferred compensation plan. The following is a calculation of the earnings (loss) per share (dollars in thousands, except share data): Three Months Ended September 30, Income Shares Per Share Amount Loss Shares Per Share Amount Basic earnings (loss) per share: Net income (loss) applicable to common stockholders $ 11,895 71,446,359 $ 0.17 $ (28,445 ) 57,486,405 $ (0.49 ) Diluted earnings (loss) per share: Net income (loss) applicable to common stockholders $ 11,895 71,446,359 $ (28,445 ) 57,486,405 Dilutive effect of contingently issuable shares 1,184,170 Dilutive effect of incremental stock options 2,553,889 Net income (loss) applicable to common stockholders $ 11,895 75,184,418 $ 0.16 $ (28,445 ) 57,486,405 $ (0.49 ) Nine Months Ended September 30, Loss Shares Per Share Amount Loss Shares Per Share Amount Basic and diluted loss per share: Net loss applicable to common stockholders $ (1,708 ) 66,006,231 $ (0.03 ) $ (24,620 ) 46,995,364 $ (0.52 ) Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Unaudited) 16. Pensions Net periodic pension cost consisted of the following (dollars in thousands): Three Months Ended September 30, Nine Months Ended September 30, Net periodic pension cost $ 1,618 $ 2,160 $ 4,788 $ 5,601 Utilized To Date To be Utilized Lease termination costs $ 15,805 $ 19,643 $ (6,625 ) $ 28,823 Severance 7,042 2,215 (9,257 ) Change of control payments 6,525 (6,525 ) Consulting costs 2,738 1,888 (4,626 ) Other 4,707 1,828 (6,535 ) Total merger-related charges $ 36,817 $ 25,574 $ (33,568 ) $ 28,823 Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Unaudited) CONDENSED CONSOLIDATING BALANCE SHEET AS OF SEPTEMBER 30, 2004 (Dollars in thousands) Parent CBRE Guarantor Subsidiaries Nonguarantor Subsidiaries Elimination Consolidated Total Total Current Assets 84,347 3,125 384,583 203,346 675,401 Property and equipment, net 81,512 46,564 128,076 Goodwill 578,539 252,184 830,723 Other intangible assets, net 91,779 25,516 117,295 Deferred compensation assets 79,461 79,461 Investments in and advances to unconsolidated subsidiaries 5,551 62,068 15,918 83,537 Investments in consolidated subsidiaries 306,782 154,734 146,379 (607,895 ) Inter-company loan receivable 69,953 813,720 (883,673 ) Deferred tax assets, net 30,636 30,636 Other assets, net 26,841 29,095 6,282 62,218 Total Assets $ 491,718 $ 1,083,432 $ 1,373,955 $ 549,810 $ (1,491,568 ) $ 2,007,347 Current Liabilities: Accounts payable and accrued expenses $ $ 14,969 $ 77,180 $ 77,981 $ $ 170,130 Compensation and employee benefits payable 102,464 53,769 156,233 Accrued bonus and profit sharing 86,508 57,077 143,585 Short-term borrowings: Warehouse line of credit (a) 111,840 111,840 Other 22,754 3,642 26,396 Total short-term borrowings 134,594 3,642 138,236 Current maturities of long-term debt 11,800 1,028 193 13,021 Other current liabilities 13,470 13,470 Total Long-Term Debt 603,172 749,029 135,521 (883,673 ) 604,049 Deferred compensation liability 146,709 146,709 Other liabilities 68,418 68,581 136,999 Total Liabilities 13,470 776,650 1,219,221 396,764 (883,673 ) 1,522,432 Minority interest 6,667 6,667 Commitments and contingencies Stockholders Equity 478,248 306,782 154,734 146,379 (607,895 ) 478,248 Total Liabilities and Stockholders Equity $ 491,718 $ 1,083,432 $ 1,373,955 $ 549,810 $ (1,491,568 ) $ 2,007,347 Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Unaudited) CONDENSED CONSOLIDATING BALANCE SHEET AS OF DECEMBER 31, 2003 (Dollars in thousands) Parent CBRE Guarantor Subsidiaries Nonguarantor Subsidiaries Elimination Consolidated Total Current Assets: Cash and cash equivalents $ 3,008 $ 17 $ 148,752 $ 12,104 $ $ 163,881 Restricted cash 12,545 2,354 14,899 Receivables, less allowance for doubtful accounts 27 18 114,215 208,156 322,416 Warehouse receivable (a) 230,790 230,790 Prepaid expenses and other current assets 63,557 42,151 18,957 22,998 (40,667 ) 106,996 Total Current Assets 66,592 42,186 525,259 245,612 (40,667 ) 838,982 Property and equipment, net 66,280 47,289 113,569 Goodwill 572,376 247,182 819,558 Other intangible assets, net 101,326 30,405 131,731 Deferred compensation assets 76,389 76,389 Investments in and advances to unconsolidated subsidiaries 4,973 50,732 12,656 68,361 Investments in consolidated subsidiaries 321,451 252,399 199,393 (773,243 ) Inter-company loan receivable 787,009 (787,009 ) Deferred tax assets, net 32,179 32,179 Other assets, net 2,555 27,819 44,779 57,559 132,712 Total Assets $ 422,777 $ 1,190,775 $ 1,560,145 $ 640,703 $ (1,600,919 ) $ 2,213,481 Current Liabilities: Accounts payable and accrued expenses $ 1,187 $ 7,614 $ 64,392 $ 116,594 $ $ 189,787 Inter-company payable 40,667 (40,667 ) Compensation and employee benefits payable 98,160 50,714 148,874 Accrued bonus and profit sharing 112,365 87,978 200,343 Short-term borrowings: Warehouse line of credit (a) 230,790 230,790 Other 25,480 13,867 39,347 Total Long-Term Debt 35,472 713,673 727,174 102,110 (787,009 ) 791,420 Deferred compensation liability 138,037 138,037 Other liabilities 48,356 62,666 111,022 Total Liabilities 89,848 869,324 1,307,746 434,654 (827,676 ) 1,873,896 Minority interest 6,656 6,656 Commitments and contingencies Stockholders Equity 332,929 321,451 252,399 199,393 (773,243 ) 332,929 Total Liabilities and Stockholders Equity $ 422,777 $ 1,190,775 $ 1,560,145 $ 640,703 $ (1,600,919 ) $ 2,213,481 Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Unaudited) CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2004 (Dollars in thousands) Parent CBRE Guarantor Subsidiaries Nonguarantor Subsidiaries Elimination Consolidated Total Operating (loss) income (529 ) (2,842 ) 38,530 9,523 44,682 Equity income from unconsolidated subsidiaries 294 4,368 164 4,826 Interest income 20 8,403 470 177 (8,398 ) 672 Interest expense 368 13,540 7,320 2,089 (8,398 ) 14,919 Loss on extinguishment of debt 7,166 9,900 17,066 Equity income from consolidated subsidiaries 17,209 28,770 4,752 (50,731 ) Income before (benefit) provision for income taxes 9,166 11,185 40,800 7,775 (50,731 ) 18,195 (Benefit) provision for income taxes (2,729 ) (6,024 ) 12,030 3,023 6,300 Net income $ 11,895 $ 17,209 $ 28,770 $ 4,752 $ (50,731 ) $ 11,895 CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2003 (Dollars in thousands) Parent CBRE Guarantor Subsidiaries Nonguarantor Subsidiaries Elimination Consolidated Total Revenue $ $ $ 309,075 $ 114,301 $ $ 423,376 Costs and expenses: Cost of services 156,972 50,848 207,820 Operating, administrative and other 88 (1,994 ) 125,412 57,170 180,676 Depreciation and amortization 38,162 2,909 41,071 Merger-related charges 14,151 2,334 16,485 Operating (loss) income (88 ) 1,994 (25,622 ) 1,040 (22,676 ) Equity income (loss) from unconsolidated subsidiaries 60 2,539 (281 ) 2,318 Interest income 67 10,596 832 56 (10,178 ) 1,373 Interest expense 2,947 18,826 8,389 1,016 (10,178 ) 21,000 Loss on extinguishment of debt 6,840 6,840 Equity (loss) income from consolidated subsidiaries (26,924 ) (20,315 ) 1,813 45,426 Period from January 1 to July 20, Period from February 20 (inception) to December 31, Period from January 1 to July 20, Period From February 20 (inception) to December 31, Period From January 1 to July 20, Period From February 20 (inception) to December 31, Period From January 1 to July 20, Period From February 20 (inception) to December 31, Period From January 1 to July 20, Period From February 20 (inception) to December 31, Period From January 1 to July 20, Period From February 20 (inception) to December 31, Period From January 1 to July 20, Period From February 20 (inception) to December 31, Period From February 20 (inception) to December 31, Period From January 1 to July 20, Period From February 20 (inception) to December 31, Period From January 1 to July 20, Period From February 20 (inception) to December 31, Period From January 1 to July 20, Period From February 20 (inception) to December 31, Period From January 1 to July 20, Period From February 20 (inception) to December 31, Period From January 1 to July 20, Period From February 20 (inception) to December 31, Period From January 1 to July 20, Period From February 20 (inception) to December 31, Period From January 1 to July 20, Period From February 20 (inception) to December 31, Period From January 1 to July 20, Period From February 20 (inception) to December 31, Period From January 1 to July 20, Table of Contents INSIGNIA FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) $10.3 million (net of applicable taxes) for 2001. The following table provides pro forma information to reflect the effect of adoption of SFAS No. 142 on earnings for 2001. Table of Contents INSIGNIA FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) These pro forma results do not purport to represent the operations of the Company nor are they necessarily indicative of the results that actually would have been realized by the Company if the purchase of these businesses had occurred at the beginning of the periods specified. Except for the Bourdais acquisition, the financial operations of the acquired businesses were not significant to those of the Company. The base purchase consideration for the Bourdais and Baker acquisitions and other individually insignificant acquisitions is summarized as follows: The base purchase consideration was allocated as follows: Table of Contents INSIGNIA FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (1) EPS is defined as earnings (loss) per share Three Months Ended December 31, Three Months Ended September 30, Three Months Ended June 30, Three Months Ended March 31, Table of Contents INSIGNIA FINANCIAL GROUP, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) During the six months ended June 30, 2003, Insignia recognized a net gain of approximately $3.8 million (net of $4.7 million of applicable income taxes) in connection with the sale of its residential businesses. These businesses also generated an operating loss of $360,000 on revenues of $20.5 million during the 2003 period. The gain on sale and operating loss are reported as discontinued operations for financial reporting purposes. During the first quarter of 2002, Insignia recognized income on disposal of $265,000 (net of applicable taxes of $1.8 million) related to the sale of Realty One, the Company s former single-family home brokerage business. The following tables summarize the aggregate assets and liabilities of Insignia Douglas Elliman and Insignia Residential Group at December 31, 2002 and the results of operations and income on disposal attributed to Insignia Douglas Elliman (2003), Insignia Residential Group (2003) and Realty One (2002) during the six months ended June 30, 2003 and 2002, respectively. December 31, Table of Contents INSIGNIA FINANCIAL GROUP, INC. CONSOLIDATED BALANCE SHEET December 31, Table of Contents INSIGNIA FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) The Company s pro forma information follows: (In thousands, except per share data) Pro forma: Income from continuing operations $ 6,556 $ 4,014 Net loss (4,981 ) (15,846 ) Per share amounts: Pro forma earnings per share basic Income from continuing operations $ 0.19 $ 0.14 Net loss (0.31 ) (0.76 ) Pro forma earnings per share assuming dilution Income from continuing operations 0.19 0.13 Net loss (0.30 ) (0.72 ) The pro forma information has been determined as if the Company had accounted for its employee stock options, warrants and unvested restricted stock awards granted under the fair value method with fair values estimated at the date of grant using a Black-Scholes option-pricing model with the following weighted-average assumptions: Years ended December 31 All intangible assets are being amortized over their estimated useful lives with no residual value. Intangibles included in Other consist of customer backlog, non-compete agreements, franchise agreements and trade names. The aggregate reported acquired intangible amortization expense for 2002 and 2001 totaled approximately $4.4 million and $5.6 million, respectively. Amortization of favorable premises leases, totaling approximately $157,000 for 2002 is included in rental expense (included in real estate services expenses) in the Company s consolidated statements of operations. The estimated acquired intangible assets amortization expense, including amounts reflected in rental expense, for the subsequent five fiscal years through December 31, 2007 approximates $2.0 million, $941,000, $550,000, $523,000 and $370,000, respectively. 5. Earnings Per Share The following table sets forth the computation of the numerator and denominator used for the computation of basic and diluted earnings per share for the periods indicated. Equity earnings in unconsolidated ventures included pre-tax gains on dispositions of minority-owned investments totaling $4.2 million and $11.0 million in 2002 and 2001, respectively. December 31, Table of Contents INSIGNIA FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) The terms of all options assumed in connection with acquisitions remained subject to continued vesting over their original terms. These options have been accounted for as additional purchase consideration for each respective business combination. During 2000, Insignia granted 1,493,000 warrants to purchase Insignia common stock to certain key executives, non-employee directors and other employees under Warrant Agreements. Such warrants had five-year terms at the date of grant. At December 31, 2002, 1,432,500 warrants remained outstanding. Pursuant to the Company s Supplemental Stock Purchase and Loan Program, Insignia has loans outstanding to seven employees, including three executive officers, of the Company. These loans were originally made in 1998 and 1999 for the purchase of 158,663 newly issued shares of Insignia s common stock at an average share price of approximately $12.18. The loans require principal and interest payments, at a fixed rate of 7.5%, in 40 equal quarterly installments ending December 31, 2009. The notes are secured by the common shares and are non-recourse to the employee except to the extent of 25% of the outstanding amount. The outstanding principal balances of these notes totaled $1,193,000 at December 31, 2002. The notes receivable are classified as a reduction of stockholders equity in the Company s consolidated balance sheet. The Company s 1998 Employee Stock Purchase Plan (the Employee Plan ) was adopted to provide employees with an opportunity to purchase common stock through payroll deductions at a price not less than 85% of the fair market value of the Company s common stock. The Employee Plan was developed to qualify under Section 423 of the Internal Revenue Code of 1986. In connection with the Company s spin-off in September 1998, 1,196,000 warrants to purchase shares of common stock of the Company (at $14.50 per share) were issued to holders of the Convertible Preferred Securities of the Company s former parent. The term of each warrant is five years. The Company s former parent purchased the warrants from Insignia in 1998 for approximately $8.5 million. At December 31, 2002, all warrants remained outstanding and were fully exercisable. The Company s common stock reserved for future issuance in connection with stock compensation plans totaled 5,751,373 shares at December 31, 2002. Summaries of the Company s stock option, warrant and unvested restricted stock activity, and related information for the years ended December 31, 2002 and 2001 are as follows: 15. Income Taxes For financial reporting purposes, income (loss) from continuing operations before income taxes includes the following components: Significant components of the income tax expense from continuing operations are as follows: Table of Contents INSIGNIA FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Components of income tax expense (benefit) reported other than in continuing operations are as follows: The reconciliation of income tax attributable to continuing operations computed at the U.S. statutory rate to income tax expense is shown below (In thousands): Table of Contents INSIGNIA FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 21. Quarterly Financial Data (unaudited) Year Ended December 31, Year Ended December 31, CB Richard Ellis Group for the Year Ended December 31, Pro forma December 31, Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Unaudited) The Insignia Acquisition gave rise to the consolidation and elimination of some Insignia duplicate facilities and redundant employees as well as the termination of certain contracts as a result of a change of control of Insignia. As a result, we have accrued certain liabilities in accordance with EITF Issue No. 95-3. These liabilities assumed in connection with the Insignia Acquisition consist of the following and are included in other liabilities on the consolidated balance sheets (dollars in thousands): December 31, We contributed an additional $1.5 million and $3.8 million to fund our pension plans during the three and nine months ended September 30, 2004. We expect to contribute a total of $4.9 million to fund our pension plans for the year ended December 31, 2004. 17. Merger-Related Charges We recorded merger-related charges of $4.0 million and $25.6 million for the three and nine months ended September 30, 2004, respectively, and $16.5 million and $19.8 million for the three and nine months ended September 30, 2003, all in connection with the Insignia Acquisition. These charges primarily related to the exit of facilities that were occupied by us prior to the Insignia Acquisition as well as the termination of employees, both of which became duplicative as a result of the Insignia Acquisition. We recorded charges for the exit of these facilities as premises were vacated and for redundant employees as these employees were terminated, both in accordance with SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities. Additionally, we recorded consulting costs, which represented fees paid to outside parties for nonrecurring services relating to the combination of Insignia s financial systems and businesses with ours. Our merger-related charges consisted of the following (dollars in thousands): Loss before benefit for income taxes (29,892 ) (33,331 ) (28,827 ) (201 ) 45,426 (46,825 ) Benefit for income taxes (1,447 ) (6,407 ) (8,512 ) (2,014 ) (18,380 ) Period From February 20 (inception) to December 31, Period From January 1 to July 20, Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) 17. Fiduciary Funds The accompanying consolidated balance sheets do not include the net assets of escrow, agency and fiduciary funds, which are held by us on behalf of clients and which amounted to $626.3 million and $414.6 million at December 31, 2003 and 2002, respectively. 18. Fair Value of Financial Instruments SFAS No. 107, Disclosures about Fair Value of Financial Instruments, requires disclosure of fair value information about financial instruments, whether or not recognized in the accompanying consolidated balance sheets. Value is defined as the amount at which an instrument could be exchanged in a current transaction between willing parties other than in a forced or liquidation sale. The fair value estimates of financial instruments are not necessarily indicative of the amounts we might pay or receive in actual market transactions. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts. Cash and Cash Equivalents: This balance includes cash and cash equivalents with maturities of less than three months. The carrying amount approximates fair value due to the short maturity of these instruments. Short-Term Borrowings: The majority of this balance represents the warehouse line of credit. Due to their short-term maturities and variable interest rates, fair value approximates carrying value (See Note 12). 11 1/4% Senior Subordinated Notes: Based on dealers quotes, the estimated fair value of the 11 1/4% Senior Subordinated Notes is $256.5 million and $208.4 million at December 31, 2003 and 2002, respectively. Their actual carrying value totaled $226.2 million and $225.9 million at December 31, 2003 and 2002, respectively (See Note 12). 9 3/4% Senior Notes: Based on dealers quotes, the estimated fair value of the 9 3/4% Senior Notes is $222.0 million at December 31, 2003. Their actual carrying value totaled $200.0 million at December 31, 2003 (See Note 12). 16% Senior Notes: There was no trading activity for the 16% Senior Notes, which are due in 2011. Their carrying value totaled $35.5 million and $61.9 million at December 31, 2003 and 2002, respectively (see Note 12). Senior Secured Terms Loans & Other Long-Term Debt: Estimated fair values approximate respective carrying values because the majority of these instruments are based on variable interest rates (see Note 12). 19. Merger-Related and Other Nonrecurring Charges We recorded merger-related charges of $36.8 million for the year ended December 31, 2003 in connection with the Insignia Acquisition. The charges consisted of the following (dollars in thousands): (1) EPS is defined as earnings (loss) per share Three Months Ended December 31, Three Months Ended September 30, Three Months Ended June 30, Three Months Ended March 31, Table of Contents INSIGNIA FINANCIAL GROUP, INC. CONDENSED CONSOLIDATED BALANCE SHEET (In thousands, except share data) (Unaudited) June 30, Table of Contents INSIGNIA FINANCIAL GROUP, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) and (v) $15.1 million in minority-owned private investment funds owning debt securities. The properties owned by the consolidated investment entities are subject to mortgage debt of $72.0 million and Insignia s investment in the properties totaled $22.3 million at June 30, 2003. Insignia s investment in consolidated properties includes $19.2 million invested in a marina-based development property in the U.S. Virgin Islands. Insignia s minority-owned investments in operating real estate assets include office, retail, industrial, apartment and hotel properties. At June 30, 2003, these real estate assets consisted of over 5.8 million square feet of commercial property and 1,967 multi-family apartment units and hotel rooms. The Company s minority ownership interests in co-investment property range from 1% to 33%. Gains realized from sales of real estate by minority owned entities for the six months ended June 30, 2003 and 2002 totaled $734,000 and $1.6 million, respectively. During the six months ended June 30, 2003, the Company recorded impairment against its real estate investments of $3.9 million on five property assets. The Company evaluates its real estate investments on a quarterly basis for evidence of impairment. Impairment losses are recognized whenever events or changes in circumstances indicate declines in value of such investments below carrying value and the related undiscounted cash flows are not sufficient to recover the asset s carrying amount. The impairments were based on changes in factors including increased vacancies, lower market rental rates and decreased projections of operating cash flows which diminished prospects for recovery of the Company s full investment upon final disposition. The gains realized from real estate sales and the losses taken on impairments are included in the caption equity (loss) earnings in unconsolidated ventures in the Company s condensed consolidated statements of operations. The Company s only financial obligations with respect to its real estate investments, beyond its investment, are (i) partial construction financing guarantees, backed by letters of credit, totaling $8.9 million; (ii) other letters of credit and guarantees of property debt totaling $2.8 million; and (iii) future capital commitments for capital improvements and additional asset purchases totaling $2.3 million. 9. Debt At June 30, 2003, Insignia s debt consisted of the following: June 30, As of September 30, As of September 30, Table of Contents CB RICHARD ELLIS GROUP, INC. CONSOLIDATED BALANCE SHEETS (Dollars in thousands, except share data) September 30, Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Unaudited) Other amortizable intangible assets represent other intangible assets acquired as a result of the Insignia Acquisition including an intangible asset recognized for other non-contractual revenue acquired in the U.S. as well as franchise agreements and a trade name in France. These other intangible assets are being amortized over estimated useful lives of up to 20 years. Amortization expense related to intangible assets was $4.3 million and $32.5 million for the three months ended September 30, 2004 and 2003, respectively, and $15.6 million and $34.4 million for the nine months ended September 30, 2004 and 2003, respectively. The estimated annual amortization expense for each of the years ended December 31, 2004 through December 31, 2008 approximates $20.7 million, $6.7 million, $5.3 million, $4.5 million and $3.8 million, respectively. 9. Investments in and Advances to Unconsolidated Subsidiaries Investments in and advances to unconsolidated subsidiaries are accounted for under the equity method of accounting. Combined condensed financial information for these entities is as follows (dollars in thousands): Condensed Balance Sheets Information: September 30, Table of Contents CB RICHARD ELLIS GROUP, INC. QUARTERLY RESULTS OF OPERATIONS (Unaudited) Three Months Ended September 30, Three Months Ended June 30, Three Months Ended March 31, Table of Contents INSIGNIA FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Environmental Under various federal and state environmental laws and regulations, a current or previous owner or operator of real estate may be required to investigate and remediate certain hazardous or toxic substances or petroleum-product releases at the property, and may be held liable to a governmental entity or to third parties for property damage and for investigation and cleanup costs incurred by such parties in connection with contamination. In addition, some environmental laws create a lien on the contaminated site in favor of the government for damages and costs it incurs in connection with the contamination. The owner or operator of a site may be liable under common law to third parties for damages and injuries resulting from environmental contamination emanating from or at the site, including the presence of asbestos containing materials. Insurance for such matters may not be available. The presence of contamination or the failure to remediate contamination may adversely affect the owner s ability to sell or lease real estate or to borrow using the real estate as collateral. There can be no assurance that Insignia, or any assets owned or controlled by Insignia (as on-site property manager), currently are in compliance with all of such laws and regulations or that Insignia will not become subject to liabilities that arise in whole or in part out of any such laws, rules or regulations. The liability may be imposed even if the original actions were legal and Insignia did not know of, or was not responsible for, the presence of such hazardous or toxic substances. Insignia may also be solely responsible for the entire payment of any liability if it is subject to joint and several liability with other responsible parties who are unable to pay. Insignia may be subject to additional liability if it fails to disclose environmental issues to a buyer or lessee of property. Management is not currently aware of any environmental liabilities that are expected to have a material adverse effect upon the operations or financial condition of the Company. Operating Leases The Company leases office space and equipment under noncancelable operating leases. Minimum annual rentals under operating leases for the five years ending after December 31, 2002 and thereafter are as follows (in thousands): 2003 $ 27,276 2004 25,878 2005 24,105 2006 22,306 Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) acquisition loan notes are redeemable semi-annually at the discretion of the note holder and have a final maturity date of April 2010. At December 31, 2003, $12.2 million of the acquisition loan notes were outstanding and are included in short-term borrowings in the accompanying consolidated balance sheet. In connection with our acquisition of Westmark Realty Advisors in 1995, one of our subsidiaries issued approximately $20.0 million in aggregate principal amount of Senior Notes (Westmark Senior Notes). The Westmark Senior Notes are secured by letters of credit equal to approximately 50% of the outstanding balance at December 31, 2003. The Westmark Senior Notes are redeemable at the discretion of the note holders and have final maturity dates of June 30, 2008 and June 30, 2010. During the year ended December 31, 2002, all of the Westmark Senior Notes bore interest at 9.0%. On January 1, 2003 the interest rate on some of these notes was converted to varying rates equal to the interest rate in effect with respect to amounts outstanding under our credit agreement. On January 1, 2005, the interest rate on all of the other Westmark Senior Notes will be adjusted to equal the interest rate then in effect with respect to amounts outstanding under our credit agreement. The amount of the Westmark Senior Notes included in short-term borrowings in the accompanying consolidated balance sheets was $12.1 million as of December 31, 2003 and 2002. Our subsidiaries in Europe have had a Euro cash pool loan since 2001. The Euro cash pool loan is an overdraft line for our European operations issued by HSBC Bank. The Euro cash pool loan has no stated maturity date and bears interest at varying rates based on a base rate as defined by the bank plus 2.5%. The amount of the Euro cash pool loan included in short-term borrowings in the accompanying consolidated balance sheets was $11.5 million and $7.9 million as of December 31, 2003 and 2002, respectively. One of our subsidiaries has a credit agreement with JP Morgan Chase. The credit agreement provides for a revolving line of credit of up to $20.0 million, bears interest at 1.0% in excess of the bank s cost of funds and expires on May 28, 2004. At December 31, 2003 and 2002, no amounts were outstanding under this line of credit. In connection with the Insignia Acquisition, on July 23, 2003, we immediately repaid Insignia s outstanding revolving credit facility of $28.0 million and subordinated credit facility of $15.0 million. 13. Commitments and Contingencies We are a party to a number of pending or threatened lawsuits arising out of, or incident to, our ordinary course of business. Our management believes that any liability imposed upon us that may result from disposition of these lawsuits will not have a material effect on our consolidated financial position or results of operations. The following is a schedule by year of future minimum lease payments for noncancellable operating leases as of December 31, 2003 (dollars in thousands): 2004 $ 96,123 2005 89,961 2006 77,203 2007 69,539 Net (loss) income $ (28,445 ) $ (26,924 ) $ (20,315 ) $ 1,813 $ 45,426 $ (28,445 ) Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Unaudited) CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2004 (Dollars in thousands) Parent CBRE Guarantor Subsidiaries Nonguarantor Subsidiaries Elimination Consolidated Total Revenue $ $ $ 1,093,752 $ 473,155 $ $ 1,566,907 Costs and expenses: Cost of services 584,862 212,682 797,544 Operating, administrative and other 1,179 7,532 406,943 227,362 643,016 Depreciation and amortization 25,974 14,027 40,001 Merger-related charges 22,038 3,536 25,574 Operating (loss) income (1,179 ) (7,532 ) 53,935 15,548 60,772 Equity income (loss) from unconsolidated subsidiaries 728 9,634 (242 ) 10,120 Interest income 81 35,521 1,680 501 (35,480 ) 2,303 Interest expense 4,084 45,480 31,848 6,206 (35,480 ) 52,138 Loss on extinguishment of debt 7,166 13,909 21,075 Equity income from consolidated subsidiaries 6,196 25,347 2,511 (34,054 ) (Loss) income before (benefit) provision for income taxes (6,152 ) (5,325 ) 35,912 9,601 (34,054 ) (18 ) (Benefit) provision for income taxes (4,444 ) (11,521 ) 10,565 7,090 1,690 Net (loss) income $ (1,708 ) $ 6,196 $ 25,347 $ 2,511 $ (34,054 ) $ (1,708 ) CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2003 (Dollars in thousands) Parent CBRE Guarantor Subsidiaries Nonguarantor Subsidiaries Elimination Consolidated Total Revenue $ $ $ 727,394 $ 281,423 $ $ 1,008,817 Costs and expenses: Cost of services 359,672 124,813 484,485 Operating, administrative and other 244 2,716 298,302 143,010 444,272 Depreciation and amortization 46,704 6,867 53,571 Merger-related charges 15,890 3,905 19,795 Operating (loss) income (244 ) (2,716 ) 6,826 2,828 6,694 Equity income (loss) from unconsolidated subsidiaries 84 9,461 (363 ) 9,182 Interest income 136 29,380 1,916 132 (28,940 ) 2,624 Interest expense 8,800 39,096 28,491 4,292 (28,940 ) 51,739 Loss on extinguishment of debt 6,840 6,840 Equity loss from consolidated subsidiaries (19,371 ) (10,044 ) (957 ) 30,372 Loss before benefit for income taxes (28,279 ) (29,232 ) (11,245 ) (1,695 ) 30,372 (40,079 ) Benefit for income taxes (3,659 ) (9,861 ) (1,201 ) (738 ) (15,459 ) Net loss $ (24,620 ) $ (19,371 ) $ (10,044 ) $ (957 ) $ 30,372 $ (24,620 ) Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Unaudited) CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2004 (Dollars in thousands) Parent CBRE Guarantor Subsidiaries Nonguarantor Subsidiaries Consolidated Total Net cash provided by (used in) investing activities 113 (25,612 ) 34,320 8,821 CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from the revolver and swingline credit facility 186,750 186,750 Repayment of revolver and swingline credit facility (186,750 ) (186,750 ) Repayment of senior secured term loan (17,500 ) (17,500 ) Repayment of non-recourse debt related to property held for sale (42,048 ) (42,048 ) Repayment of euro cash pool and other loans, net (3,146 ) (6,663 ) (9,809 ) Repayment of 9 3/4% senior notes (70,000 ) (70,000 ) Repayment of 11 1/4% senior subordinated notes (21,631 ) (21,631 ) Repayment of 16% senior notes (38,316 ) (38,316 ) Proceeds from issuance of common stock, net 135,000 135,000 Proceeds from exercise of stock options 7,991 7,991 Payment of deferred financing fees (3,942 ) (3,942 ) (Increase) decrease in inter-company receivables, net (96,182 ) 116,307 (49,838 ) 29,713 Other financing activities, net (499 ) (967 ) (1,466 ) Net cash provided by (used in) financing activities 7,994 3,234 (52,984 ) (19,965 ) (61,721 ) NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS (2,954 ) 2,298 (22,686 ) 9,047 (14,295 ) CASH AND CASH EQUIVALENTS, AT BEGINNING OF PERIOD 3,008 17 148,752 12,104 163,881 Effect of currency exchange rate changes on cash (1,661 ) (1,661 ) SUPPLEMENTAL DATA: Cash paid during the period for: Interest, net of amount capitalized $ 7,050 $ 45,695 $ 1,156 $ 2,945 $ 56,846 Income taxes, net of refunds $ 11,462 $ $ $ $ 11,462 Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Unaudited) CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2003 (Dollars in thousands) Parent CBRE Guarantor Subsidiaries Nonguarantor Subsidiaries Consolidated Total Net cash provided by (used in) investing activities 26 (250,372 ) (2,338 ) (252,684 ) CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from revolver and swingline credit facility 152,850 152,850 Repayment of revolver and swingline credit facility (152,850 ) (152,850 ) Proceeds from senior secured term loans 75,000 75,000 Repayment of senior secured term loans (7,513 ) (7,513 ) Repayment of notes payable (43,000 ) (43,000 ) Proceeds from 9 3/4% senior notes 200,000 200,000 Proceeds from short-term borrowings and other loans, net 3,732 3,732 Proceeds from issuance of common stock, net 120,580 120,580 (Increase) decrease in inter-company receivables, net (53,623 ) (233,711 ) 267,207 20,127 Other financing activities, net (194 ) (19,766 ) (341 ) (20,301 ) Net cash provided by (used in) financing activities 66,763 (28,990 ) 267,207 23,518 328,498 SUPPLEMENTAL DATA: Cash paid during the period for: Interest, net of amount capitalized $ 4,038 $ 21,949 $ 1,371 $ 4,336 $ 31,694 Income taxes, net of refunds $ 25,533 $ $ $ $ 25,533 Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Unaudited) 19. Industry Segments We report our operations through three geographically organized segments: (1) Americas, (2) Europe, Middle East and Africa (EMEA) and (3) Asia Pacific. The Americas consist of operations in the U.S., Canada, Mexico and South America. EMEA mainly consists of operations in Europe, while Asia Pacific includes operations in Asia, Australia and New Zealand. Summarized financial information by operating segment is as follows (dollars in thousands): Three Months Ended September 30, Nine Months Ended September 30, Revenue Americas $ 425,194 $ 324,508 $ 1,148,577 $ 766,995 EMEA 110,000 69,390 310,511 167,020 Asia Pacific 39,805 29,478 107,819 74,802 $ 574,999 $ 423,376 $ 1,566,907 $ 1,008,817 Operating income (loss) Americas $ 35,837 $ (11,914 ) $ 50,162 $ 16,533 EMEA 4,649 (13,844 ) 1,140 (13,137 ) Asia Pacific 4,196 3,082 9,470 3,298 4,826 2,318 10,120 9,182 Interest income 672 1,373 2,303 2,624 Interest expense 14,919 21,000 52,138 51,739 Loss on extinguishment of debt 17,066 6,840 21,075 6,840 Income (loss) before provision (benefit) for income taxes $ 18,195 $ (46,825 ) $ (18 ) $ (40,079 ) Table of Contents CB RICHARD ELLIS GROUP, INC. CONSOLIDATED BALANCE SHEETS (Dollars in thousands, except share data) December 31, ASSETS Current Assets: Cash and cash equivalents $ 163,881 $ 79,701 Restricted cash 14,899 Receivables, less allowance for doubtful accounts of $16,181 and $10,892 at December 31, 2003 and 2002, respectively 322,416 166,213 Warehouse receivable 230,790 63,140 Prepaid expenses 22,854 9,748 Deferred tax assets, net 57,681 18,723 Other current assets 26,461 8,415 Total current assets 838,982 345,940 Property and equipment, net 113,569 66,634 Goodwill 819,558 577,137 Other intangible assets, net of accumulated amortization of $73,449 and $7,739 at December 31, 2003 and 2002, respectively 131,731 91,082 Deferred compensation assets 76,389 63,642 Investments in and advances to unconsolidated subsidiaries 68,361 50,208 Deferred tax assets, net 32,179 36,376 Other assets, net 132,712 93,857 Total assets $ 2,213,481 $ 1,324,876 LIABILITIES AND STOCKHOLDERS EQUITY Current Liabilities: Accounts payable and accrued expenses $ 189,787 $ 102,415 Compensation and employee benefits payable 148,874 63,734 Accrued bonus and profit sharing 200,343 103,858 Income taxes payable 15,451 Short-term borrowings: Warehouse line of credit 230,790 63,140 Other 39,347 60,054 Total short-term borrowings 270,137 123,194 Current maturities of long-term debt 11,285 10,711 Other current liabilities 12,991 11,724 Total long-term debt 791,420 499,004 Deferred compensation liability 138,037 106,252 Pension liability 35,998 10,766 Other liabilities 75,024 20,811 Total liabilities 1,873,896 1,067,920 Minority interest 6,656 5,615 Commitments and contingencies Stockholders Equity: Class A common stock; $0.01 par value; 325,000,000 shares authorized; 7,561,499 and 4,969,757 shares issued and outstanding (including treasury shares) at December 31, 2003 and 2002, respectively 76 50 Class B common stock; $0.01 par value; 100,000,000 shares authorized; 53,409,556 and 34,987,934 shares issued and outstanding at December 31, 2003 and 2002, respectively 534 350 Additional paid-in capital 361,522 240,318 Notes receivable from sale of stock (4,680 ) (4,800 ) Accumulated earnings 1,449 36,153 Accumulated other comprehensive loss (23,780 ) (18,998 ) Treasury stock at cost, 385,103 and 305,332 shares at December 31, 2003 and 2002, respectively (2,192 ) (1,732 ) Total stockholders equity 332,929 251,341 Total liabilities and stockholders equity $ 2,213,481 $ 1,324,876 Table of Contents CB RICHARD ELLIS GROUP, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (Dollars in thousands, except share data) CB Richard Ellis Group Predecessor Company Year Ended December 31, Operating income (loss) 25,830 96,736 61,178 (17,048 ) Equity income from unconsolidated subsidiaries 14,365 9,326 1,554 2,874 Interest income 6,041 3,272 2,427 1,567 Interest expense 87,216 60,501 29,717 20,303 (Loss) income before (benefit) provision for income taxes (40,980 ) 48,833 35,442 (32,910 ) (Benefit) provision for income taxes (6,276 ) 30,106 18,016 1,110 Net (loss) income $ (34,704 ) $ 18,727 $ 17,426 $ (34,020 ) Basic (loss) earnings per share $ (0.68 ) $ 0.45 $ 0.80 $ (1.60 ) Weighted average shares outstanding for basic (loss) earnings per share 50,918,572 41,640,576 21,741,351 21,306,584 Diluted (loss) earnings per share $ (0.68 ) $ 0.44 $ 0.79 $ (1.60 ) Weighted average shares outstanding for diluted (loss) earnings per share 50,918,572 42,185,989 21,920,915 21,306,584 Table of Contents CB RICHARD ELLIS GROUP, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollars in thousands) CB Richard Ellis Group Predecessor Company Year Ended December 31, Net cash provided by (used in) operating activities 63,941 64,882 91,334 (120,230 ) CASH FLOWS FROM INVESTING ACTIVITIES: Capital expenditures, net of concessions received (26,961 ) (14,266 ) (6,501 ) (14,814 ) Proceeds from sale of properties and servicing rights 3,949 6,378 2,108 9,544 Investment in property held for sale (40,174 ) (2,282 ) Acquisition of businesses including net assets acquired, intangibles and goodwill, net of cash acquired (263,683 ) (14,811 ) (214,702 ) (1,924 ) Other investing activities, net 1,900 (1,431 ) (2,124 ) (2,663 ) Net cash provided by (used in) financing activities 303,664 (17,838 ) 213,831 126,230 CASH AND CASH EQUIVALENTS, AT END OF PERIOD $ 163,881 $ 79,701 $ 57,450 $ 13,662 SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: Cash paid during the period for: Interest, net of amount capitalized $ 63,718 $ 52,647 $ 26,126 $ 18,457 Income taxes, net of refunds $ 17,783 $ 19,142 $ 5,061 $ 19,083 Table of Contents CB RICHARD ELLIS GROUP, INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY (Dollars in thousands, except share data) CB Richard Ellis Group Class A common stock Class B common stock Additional paid-in capital Notes receivable from sale of stock Accumulated earnings Accumulated other comprehensive income (loss) Treasury stock Total Minimum pension liability Foreign currency translation Balance, December 31, 2001 50 350 240,285 (5,884 ) 17,426 296 252,523 Net income 18,727 18,727 Issuance of Class A common stock 460 (180 ) 280 Net cancellation of deferred compensation stock fund units (427 ) (427 ) Net collection on notes receivable from sale of stock 1,264 1,264 Purchase of common stock (1,732 ) (1,732 ) Minimum pension liability adjustment, net of tax (17,039 ) (17,039 ) Foreign currency translation loss (2,255 ) (2,255 ) Balance, December 31, 2002 50 350 240,318 (4,800 ) 36,153 (17,039 ) (1,959 ) (1,732 ) 251,341 Net loss (34,704 ) (34,704 ) Issuance of Class A common stock 26 14,681 14,707 Issuance of Class B common stock 184 106,169 106,353 Issuance of deferred compensation stock fund units, net of cancellations 195 195 Net collection on notes receivable from sale of stock 120 120 Purchase of common stock (460 ) (460 ) Minimum pension liability adjustment, net of tax 1,930 1,930 Compensation expense for stock options 159 159 Foreign currency translation loss (6,712 ) (6,712 ) Balance, December 31, 2003 $ 76 $ 534 $ 361,522 $ (4,680 ) $ 1,449 $ (15,109 ) $ (8,671 ) $ (2,192 ) $ 332,929 Predecessor Company Common stock Additional paid-in capital Notes receivable from sale of stock Accumulated deficit Accumulated other comprehensive loss Treasury stock Total Balance, December 31, 2000 $ 217 $ 364,168 $ (11,847 ) $ (89,097 ) $ (12,258 ) $ (15,844 ) $ 235,339 Net loss (34,020 ) (34,020 ) Common stock issued for incentive plans 360 360 Contributions, deferred compensation plan 1,004 1,004 Deferred compensation plan co-match 492 492 Net collection on notes receivable from sale of stock (742 ) 1,001 259 Amortization of cheap and restricted stock 1 210 211 Tax deduction from issuance of stock 1,479 1,479 Foreign currency translation loss (7,106 ) (7,106 ) Cancellation of common stock (54 ) (54 ) Cancellation of common stock and elimination of historical equity due to the merger (218 ) (366,917 ) 10,846 123,117 19,364 15,844 (197,964 ) Balance, July 20, 2001 $ $ $ $ $ $ $ Table of Contents CB RICHARD ELLIS GROUP, INC. CONSOLIDATED STATEMENTS OF COMPREHENSIVE (LOSS) INCOME (Dollars in thousands) CB Richard Ellis Group Predecessor Company Year Ended December 31, Comprehensive (loss) income $ (39,486 ) $ (567 ) $ 17,722 $ (41,126 ) Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) after January 1, 2003, as permitted by SFAS No. 148, Accounting for Stock-Based Compensation Transition and Disclosure An Amendment of FASB Statement No. 123. Awards under our stock-based compensation plans vest over five-year periods. Therefore, the cost related to stock-based employee compensation included in the determination of net loss for the year ended December 31, 2003 is less than that which would have been recognized if the fair value based method had been applied to all awards since the original effective date of SFAS No. 123. In accordance with SFAS No. 123, we estimate the value of our options based upon the Minimum Value method. Option valuation models require the input of assumptions such as the expected stock price volatility. As our common stock is not freely tradable on a national securities exchange or an over-the-counter market, an effectively zero percent volatility was utilized. The dividend yield is also excluded from the calculation, as it is our present intention to retain all earnings. The following table illustrates the effect on net (loss) income and (loss) earnings per share if the minimum value based method had been applied to all outstanding and unvested awards in each period (dollars in thousands, except share data): CB Richard Ellis Group Predecessor Company Year Ended December 31, Net (loss) income as reported $ (34,704 ) $ 18,727 $ 17,426 $ (34,020 ) Add: Stock-based employee compensation expense included in reported net (loss) income, net of related tax effect 98 Deduct: Total stock-based employee compensation expense determined under the minimum value method for all awards, net of related tax effect (648 ) (523 ) (272 ) (2,758 ) Pro Forma net (loss) income $ (35,254 ) $ 18,204 $ 17,154 $ (36,778 ) Basic EPS: As Reported $ (0.68 ) $ 0.45 $ 0.80 $ (1.60 ) Pro Forma $ (0.69 ) $ 0.44 $ 0.79 $ (1.73 ) Diluted EPS: As Reported $ (0.68 ) $ 0.44 $ 0.79 $ (1.60 ) Pro Forma $ (0.69 ) $ 0.43 $ 0.78 $ (1.73 ) Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) The minimum value of each option grant and warrant is estimated on the date of grant utilizing the following weighted average assumptions: Year Ended December 31, Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) The preliminary purchase accounting adjustments related to the Insignia Acquisition have been recorded in the accompanying consolidated financial statements as of, and for periods subsequent to, July 23, 2003. The final valuation of the net assets acquired is expected to be completed as soon as practicable, but no later than one year from the acquisition date. Given the size and complexity of the acquisition, the fair valuation of certain assets acquired, primarily net deferred tax assets, is still preliminary. Additionally, adjustments to the estimated liabilities assumed in connection with the Insignia Acquisition may still be required. The following table summarizes the estimated fair values of the assets acquired and the liabilities assumed at the date of acquisition (in thousands): Fair Value of Assets Acquired and Liabilities Assumed At July 23, 2003 Current assets $ 270,641 Property and equipment, net 32,532 Goodwill 237,569 Other intangible assets, net 102,748 Other assets 30,776 Total assets acquired 674,266 Current liabilities 168,574 Liabilities assumed in connection with the Insignia Acquisition 87,739 Notes payable 43,000 Other liabilities 46,994 Total liabilities assumed 346,307 Net assets acquired $ 327,959 The following is a summary of the intangible assets acquired in connection with the Insignia Acquisition (dollars in thousands): Weighted Average Amortization Period July 23, 2003 December 31, 2003 Gross Carrying Amount Accumulated Amortization Net Carrying Amount Backlog (1) $ 72,503 $ (59,108 ) $ 13,395 Trade name n/a 19,826 19,826 Management contracts 5 years 4,611 (490 ) 4,121 Other 6 years 5,808 (821 ) 4,987 Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) The Insignia Acquisition gave rise to the consolidation and elimination of some Insignia duplicate facilities and Insignia redundant employees as well as the termination of certain contracts as a result of a change of control of Insignia. As a result, we have accrued certain liabilities in accordance with Emerging Issues Task Force Issue No. 95-3, Recognition of Liabilities in Connection with a Purchase Business Combination. These liabilities assumed in connection with the Insignia Acquisition consist of the following (dollars in thousands): 2003 Charge to Goodwill Utilized to Date To be Utilized Severance $ 30,706 $ 13,676 $ 17,030 Lease termination costs 28,922 3,065 25,857 Change of control payments 10,451 10,451 Costs associated with exiting contracts 8,921 7,632 1,289 Legal settlements anticipated 8,739 2,900 5,839 $ 87,739 $ 37,724 $ 50,015 Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) well as higher interest expense as a result of debt incurred to finance the Insignia Acquisition. These unaudited pro forma results do not purport to be indicative of what operating results would have been had the Insignia Acquisition occurred on January 1, 2003 or 2002, respectively, and may not be indicative of future operating results (dollars in thousands, except share data): Year Ended December 31, (Unaudited) Revenue $ 1,948,827 $ 1,744,162 Operating income $ 17,871 $ 59,380 Net loss $ (43,923 ) $ (20,443 ) Basic and diluted loss per share $ (0.70 ) $ (0.33 ) Weighted average shares outstanding for basic and diluted loss per share 62,478,565 62,425,796 6. Restricted Cash Included in the accompanying consolidated balance sheet as of December 31, 2003 is restricted cash of $14.9 million, which primarily consists of cash pledged to secure the guarantee of notes issued in connection with previous acquisitions by Insignia in the U.K. The acquisitions include the 1999 acquisition of St. Quintin Holdings Limited and the 1998 acquisition of Richard Ellis Group Limited. 7. Property and Equipment Property and equipment consists of the following (dollars in thousands): December 31, Leasehold improvements $ 48,741 $ 20,000 Furniture and equipment 162,157 116,268 Equipment under capital leases 12,820 13,925 223,718 150,193 Accumulated depreciation (110,149 ) (83,559 ) Property and equipment, net $ 113,569 $ 66,634 Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) 8. Goodwill and Other Intangible Assets In June 2001, the FASB issued SFAS No. 142, Goodwill and Other Intangible Assets. Under SFAS No. 142, goodwill and other intangible assets deemed to have indefinite useful lives are no longer amortized but are subject to impairment tests on an annual basis, at a minimum, or whenever events or circumstances occur indicating that those assets might be impaired. We adopted the non-amortization provisions of SFAS No. 142 on July 20, 2001, the effective date of the 2001 Merger. The following table presents the impact of SFAS No. 142 on, our net (loss) income and net (loss) earnings per share had the standard been in effect for the period from January 1 to July 20, 2001 (dollars in thousands, except share data): CB Richard Ellis Group Predecessor Company Year Ended December 31, Reported net (loss) income $ (34,704 ) $ 18,727 $ 17,426 $ (34,020 ) Add back amortization of goodwill, net of taxes 7,701 Adjusted net (loss) income $ (34,704 ) $ 18,727 $ 17,426 $ (26,319 ) Basic (loss) earnings per share: Reported (loss) earnings per share $ (0.68 ) $ 0.45 $ 0.80 $ (1.60 ) Add back goodwill amortization per share 0.36 Adjusted basic (loss) earnings per share $ (0.68 ) $ 0.45 $ 0.80 $ (1.24 ) Diluted (loss) earnings per share: Reported (loss) earnings per share $ (0.68 ) $ 0.44 $ 0.79 $ (1.60 ) Add back goodwill amortization per share 0.36 Adjusted diluted (loss) earnings per share $ (0.68 ) $ 0.44 $ 0.79 $ (1.24 ) The preliminary purchase accounting adjustments associated with the Insignia Acquisition have been recorded in the accompanying consolidated financial statements. We are in the process of finalizing the fair value of all assets acquired and liabilities assumed as of July 23, 2003, the effective date of the Insignia Acquisition (See Note 3 for additional information). The following table summarizes the estimated goodwill allocated to our operating segments in connection with the Insignia Acquisition as well as other changes in the carrying amount of goodwill for the years ended December 31, 2003 and 2002 (dollars in thousands): Americas EMEA Asia Pacific Total Balance at January 1, 2002 $ 510,188 $ 96,637 $ 2,718 $ 609,543 Purchase accounting adjustments related to acquisitions 15,321 5,809 688 21,818 Reclassed (to) from intangibles assets (57,841 ) 3,617 (54,224 ) Balance at December 31, 2003 $ 598,439 $ 217,106 $ 4,013 $ 819,558 Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Other intangible assets totaled $131.7 million and $91.1 million, net of accumulated amortization of $73.5 million and $7.7 million, as of December 31, 2003 and 2002, respectively, and are comprised of the following (dollars in thousands): December 31, Gross Carrying Amount Accumulated Amortization Gross Carrying Amount Accumulated Amortization Unamortizable intangible assets Trademarks $ 63,700 $ 63,700 Trade name 19,826 Total $ 83,526 $ 63,700 Amortizable intangible assets Backlog $ 72,503 $ (59,108 ) $ $ Management contracts 25,649 (9,708 ) 18,887 (5,605 ) Loan servicing rights 17,694 (3,812 ) 16,234 (2,134 ) Other 5,808 (821 ) Total $ 121,654 $ (73,449 ) $ 35,121 $ (7,739 ) Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) 9. Investments in and Advances to Unconsolidated Subsidiaries Investments in and advances to unconsolidated subsidiaries are accounted for under the equity method of accounting and as of December 31, 2003 and 2002 include the following (dollars in thousands): December 31, Interest Global Innovation Partners, L.L.C. 4.9 % $ 14,037 $ 6,228 CB Richard Ellis Strategic Partners, L.P. 2.9 % 10,353 10,690 CB Commercial/Whittier Partners, L.P. 50.0 % 8,590 8,816 CB Richard Ellis Strategic Partners II, L.P. 3.4 % 7,322 5,965 Ikoma CB Richard Ellis KK 22.8 % 4,973 4,782 Building Technology Engineers 49.9 % 2,553 1,931 Glades Plaza, L.P. 20.0 % 2,451 KB Opportunity Investors 45.0 % 1,723 1,857 CB Richard Ellis/Pittsburgh, L.P. 50.0 % 1,221 1,461 Other * 15,138 8,478 Total $ 68,361 $ 50,208 * Various interests with varying ownership rates. Combined condensed financial information for our investments in and advances to unconsolidated subsidiaries are as follows (dollars in thousands): Condensed Balance Sheets Information: December 31, Current assets $ 208,743 $ 127,635 Noncurrent assets $ 2,040,138 $ 1,552,546 Current liabilities $ 154,778 $ 108,463 Noncurrent liabilities $ 969,993 $ 664,241 Minority interest $ 4,600 $ 3,938 Condensed Statements of Operations Information: Year Ended December 31, Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) professional services to these equity investees and earned revenues from these co-investments of $21.6 million, $22.4 million and $15.4 million during the years ended December 31, 2003, 2002 and 2001, respectively. In March 2001, our wholly owned subsidiary, CB Richard Ellis Investors, L.L.C. (CBRE Investors), entered into a joint venture, Global Innovation Partners, with CalPERS. This joint venture targets real estate and private equity investments and expected opportunities created by the convergence of technology and real estate. The managing member of the joint venture is 50% owned by one of our subsidiaries. In connection with formation of the joint venture, CBRE Investors, CalPERS and some of our employees entered into an aggregate of $526.0 million of capital commitments to Global Innovations Partners, of which CalPERS committed an aggregate of $500.0 million. 10. Other Assets The following table summarizes the items included in other assets (dollars in thousands): December 31, Property held for sale $ 50,615 $ 45,883 Deferred financing costs, net 29,898 20,467 Employee loans (1) 17,622 4,089 Property investments held pursuant to the Island Purchase Agreement (2) 7,457 Cost investments 7,096 6,524 Long-term trade receivables, net 6,542 1,128 Notes receivable 5,640 4,943 Deposits 4,621 8,714 Miscellaneous 3,221 2,109 Total $ 132,712 $ 93,857 Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) A summary of the status of our option plans and warrants, as well as our Predecessor s, is presented in the tables below: CB Richard Ellis Group Shares Weighted Average Exercise Price Exercisable Shares Weighted Average Exercise Price Outstanding at February 20, 2001 (Inception) $ Granted 4,921,064 6.50 Forfeited (47,629 ) 5.77 Outstanding at December 31, 2001 4,873,435 6.51 Granted 343,297 5.77 Forfeited (485,806 ) 5.77 Outstanding at December 31, 2002 4,730,926 6.53 769,261 $ 5.77 Granted 2,931,905 5.77 Forfeited (58,107 ) 5.77 Outstanding at December 31, 2003 7,604,724 $ 6.24 1,538,575 $ 5.77 Predecessor Company Shares Weighted Average Exercise Price Exercisable Shares Weighted Average Exercise Price Outstanding at December 31, 2000 3,340,010 $ 21.25 1,824,665 $ 23.90 Exercised (86,521 ) 12.89 Forfeited/Expired (93,370 ) 20.27 Paid and/or cancelled as a result of the 2001 Merger (3,160,119 ) 21.50 Outstanding at July 20, 2001 $ Option plans and warrants outstanding at December 31, 2003 and their related weighted average exercise price and life information is presented below: Outstanding Options and Warrants Exercisable Options and Warrants Exercise Prices Number Outstanding Weighted Average Remaining Contractual Life Weighted Average Exercise Price Number Exercisable Weighted Average Exercise Price $5.77 6,896,705 8.49 $ 5.77 1,538,575 $ 5.77 $10.825 708,019 3.66 10.825 7,604,724 $ 6.24 1,538,575 $ 5.77 Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Pension Plans. The London-based firm of Hillier Parker May & Rowden, which we acquired in 1998, had a contributory defined benefit pension plan. A subsidiary of Insignia, which we acquired in connection with the Insignia Acquisition in 2003, had a contributory defined benefit pension plan in the U.K. Our subsidiaries based in the U.K. maintain these plans to provide retirement benefits to existing and former employees participating in the plans. With respect to these plans, our historical policy has been to contribute annually an amount to fund pension cost as actuarially determined and as required by applicable laws and regulations. Pension expense totaled $7.8 million for the year ended December 31, 2003, $3.6 million for the year ended December 31, 2002, $1.4 million for the period February 20 (inception) to December 31, 2001, and $0.9 million for the period from January 1 to July 20, 2001. The following table sets forth a reconciliation of the benefit obligation, plan assets, plan s funded status and amounts recognized in the accompanying consolidated balance sheets for our defined benefit pension plans (in thousands): Year Ended December 31, Change in benefit obligation Benefit obligation at beginning of period $ 96,734 $ 74,418 Service cost 6,248 5,578 Interest cost 7,573 4,764 Actuarial loss 7,472 3,997 Insignia Acquisition 64,392 Benefits paid, net of plan participants contributions (1,942 ) (713 ) Foreign currency translation 19,709 8,690 Benefit obligation at end of period $ 200,186 $ 96,734 Change in plan assets Fair value of plan assets at beginning of period $ 76,430 $ 80,950 Actual return on plan assets 18,317 (13,777 ) Company contributions 2,850 2,299 Insignia Acquisition 45,295 Benefits paid, net of plan participants contributions (1,942 ) (713 ) Foreign currency translation 15,008 7,671 Fair value of plan assets at end of period $ 155,958 $ 76,430 Net amount recognized $ (14,412 ) $ 13,576 Net amount recognized in the consolidated balance sheets Accrued benefit liability $ (35,998 ) $ (10,766 ) Accumulated other comprehensive loss 21,586 24,342 $ (14,412 ) $ 13,576 Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Weighted average assumptions used to determine our projected benefit obligation were as follows: Year Ended December 31, Discount rate 5.60 % 5.60 % Expected return on plan assets 7.90 % 8.20 % Rate of compensation increase 4.40 % 4.30 % Weighted average assumptions used to determine our net periodic pension cost were as follows: CB Richard Ellis Group Predecessor Company Year Ended December 31, Discount rate 5.56 % 6.00 % 6.00 % 6.00 % Expected return on plan assets 7.88 % 8.00 % 7.50 % 7.75 % Rate of compensation increase 4.24 % 4.50 % 4.75 % 5.00 % Net periodic pension cost consisted of the following (in thousands): CB Richard Ellis Group Predecessor Company Year Ended December 31, Service cost $ 6,248 $ 5,578 $ 2,325 $ 2,875 Interest cost 7,573 4,764 2,059 2,316 Expected return on plan assets (8,023 ) (6,767 ) (2,945 ) (4,257 ) Amortization of unrecognized net gain 2,024 Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) 12. Debt Total debt consists of the following (dollars in thousands): December 31, Subtotal 802,705 509,715 Less current maturities of long-term debt 11,285 10,711 Total short-term borrowings 270,137 123,194 Add current maturities of long-term debt 11,285 10,711 Total current debt 281,422 133,905 Total debt $ 1,072,842 $ 632,909 Total minimum payments required $ 710,262 Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Substantially all leases require us to pay maintenance costs, insurance and property taxes. The composition of total rental expense under noncancellable operating leases consisted of the following (dollars in thousands): CB Richard Ellis Group Predecessor Company Year Ended December 31, Minimum rentals $ 81,361 $ 68,711 $ 27,203 $ 32,831 Less sublease rentals (2,134 ) (1,157 ) (500 ) (551 ) $ 79,227 $ 67,554 $ 26,703 $ 32,280 Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) August 31, 2004. However, we are obligated to renew the letters of credit related to certain office leases until 2023, the letters of credit related to the Island Purchase Agreement until as late as July 23, 2006 and the Fannie Mae letter of credit until our obligation to cover potential credit losses is satisfied. We had guarantees totaling $9.0 million as of December 31, 2003, which consisted primarily of guarantees of property debt as well as the obligations to Island and Fannie Mae discussed above. Approximately $4.8 million of the guarantees are related to investment activity that is scheduled to expire in October 2008. Approximately $1.7 million of the guarantees are related to office leases in Europe and Asia. These guarantees will expire at the end of the lease terms. The guarantee obligation related to the agreement with Fannie Mae discussed above will expire in December 2004. The guarantee related to the Island Purchase Agreement will expire on the May 30, 2004 maturity date of the underlying loan agreement, unless such loan is renewed, modified or extended prior to such date to provide for a later maturity date. An important part of the strategy for our investment management business involves investing our capital in certain real estate investments with our clients. These co-investments typically range from 2% to 5% of the equity in a particular fund. As of December 31, 2003, we had committed $26.6 million to fund future co-investments. 14. Income Taxes Our tax (benefit) provision consisted of the following (in thousands): CB Richard Ellis Group Predecessor Company Year Ended December 31, 7,309 11,468 6,046 1,079 $ (6,276 ) $ 30,106 $ 18,016 $ 1,110 Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) The following is a reconciliation, stated as a percentage of pre-tax income, of the U.S. statutory federal income tax rate to our effective tax rate on income from operations: CB Richard Ellis Group Predecessor Company Year Ended December 31, The domestic component of (loss) income before (benefit) provision for income taxes included in the accompanying consolidated statements of operations was $(31.6) million for the year ended December 31, 2003, $32.3 million for the year ended December 31, 2002, $22.6 million for the period from February 20 (inception) to December 31, 2001 and $(21.5) million for the period from January 1 to July 20, 2001. The international component of (loss) income before (benefit) provision for income taxes was $(9.4) million for the year ended December 31, 2003, $16.5 million for the year ended December 31, 2002, $12.8 million for the period from February 20 (inception) to December 31, 2001 and $(11.4) million for the period from January 1 through July 20, 2001. Cumulative tax effects of temporary differences are shown below at December 31, 2003 and 2002 (in thousands): December 31, Asset (Liability) Property and equipment $ 6,738 $ 10,960 Bad debts and other reserves (17,768 ) (14,228 ) Capitalized costs and intangibles (4,113 ) (7,003 ) Bonus, unexercised restricted stock, deferred compensation 80,048 57,780 Investment 5,622 4,189 Net operating loss (NOL), alternative minimum tax credit and charitable contribution carryforwards 36,200 5 Unconsolidated affiliates 5,266 5,283 Pension obligation 14,492 7,303 Acquisitions 3,237 All other 18,892 4,702 Net deferred tax assets before valuation allowances 148,614 68,991 Valuation allowances (58,754 ) (13,892 ) Net deferred tax assets $ 89,860 $ 55,099 Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Total deferred tax assets and deferred tax liabilities at December 31, 2003 and 2002 were as follows (in thousands): December 31, Total deferred tax assets $ 213,164 $ 103,302 Deferred tax asset valuation allowances (58,754 ) (13,892 ) 154,410 89,410 Total deferred tax liabilities (64,550 ) (34,311 ) Net deferred tax assets $ 89,860 $ 55,099 Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) 16. (Loss) Earnings Per Share Information The following is a calculation of (loss) earnings per share (dollars in thousands, except share data): CB Richard Ellis Group Predecessor Company Year Ended December 31, Loss Shares Per Share Amount Income Shares Per Share Amount Income Shares Per Share Amount Loss Shares Per Share Amount Basic (loss) earnings per share: Net (loss) income applicable to common stockholders $ (34,704 ) 50,918,572 $ (0.68 ) $ 18,727 41,640,576 $ 0.45 $ 17,426 21,741,351 $ 0.80 $ (34,020 ) 21,306,584 $ (1.60 ) Diluted (loss) earnings per share: Net (loss) income applicable to common stockholders $ (34,704 ) 50,918,572 $ 18,727 41,640,576 $ 17,426 21,741,351 $ (34,020 ) 21,306,584 Dilutive effect of contingently issuable shares 545,413 179,564 Net (loss) income applicable to common stockholders $ (34,704 ) 50,918,572 $ (0.68 ) $ 18,727 42,185,989 $ 0.44 $ 17,426 21,920,915 $ 0.79 $ (34,020 ) 21,306,584 $ (1.60 ) The following items were not included in the computation of diluted (loss) earnings per share because their exercise price was at or above fair market value during such periods: CB Richard Ellis Group Predecessor Company Year Ended December 31, Utilized to Date To be Utilized Lease termination costs $ 15,805 $ 977 $ 14,828 Severance 7,042 7,042 Change of control payments 6,525 6,525 Consulting costs 2,738 2,738 Other 4,707 4,707 Total merger-related charges $ 36,817 $ 21,989 $ 14,828 Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) CB RICHARD ELLIS GROUP, INC. CONDENSED CONSOLIDATING BALANCE SHEET AS OF DECEMBER 31, 2003 (Dollars in thousands) Parent CBRE Guarantor Subsidiaries Nonguarantor Subsidiaries Elimination Consolidated Total Current Assets: Cash and cash equivalents $ 3,008 $ 17 $ 148,752 $ 12,104 $ $ 163,881 Restricted cash 12,545 2,354 14,899 Receivables, less allowance for doubtful accounts 27 18 114,215 208,156 322,416 Warehouse receivable 230,790 230,790 Prepaid expenses and other current assets 63,557 42,151 18,957 22,998 (40,667 ) 106,996 Total current assets 66,592 42,186 525,259 245,612 (40,667 ) 838,982 Property and equipment, net 66,280 47,289 113,569 Goodwill 572,376 247,182 819,558 Other intangible assets, net 101,326 30,405 131,731 Deferred compensation assets 76,389 76,389 Investment in and advances to unconsolidated subsidiaries 4,973 50,732 12,656 68,361 Investment in consolidated subsidiaries 321,451 252,399 199,393 (773,243 ) Intercompany loan receivable 787,009 (787,009 ) Deferred tax assets, net 32,179 32,179 Other assets, net 2,555 27,819 44,779 57,559 132,712 Total assets $ 422,777 $ 1,190,775 $ 1,560,145 $ 640,703 $ (1,600,919 ) $ 2,213,481 Current Liabilities: Accounts payable and accrued expenses $ 1,187 $ 7,614 $ 64,392 $ 116,594 $ $ 189,787 Inter-company payable 40,667 (40,667 ) Compensation and employee benefits payable 98,160 50,714 148,874 Accrued bonus and profit sharing 112,365 87,978 200,343 Short-term borrowings: Warehouse line of credit 230,790 230,790 Other 25,480 13,867 39,347 Total current liabilities 54,376 17,614 532,216 269,878 (40,667 ) 833,417 Long-Term Debt: 11 1/4% senior subordinated notes, net of unamortized discount 226,173 226,173 Senior secured term loans 287,500 287,500 9 3/4% senior notes 200,000 200,000 16% senior notes, net of unamortized discount 35,472 35,472 Other long-term debt 330 41,945 42,275 Intercompany loan payable 726,844 60,165 (787,009 ) Total long-term debt 35,472 713,673 727,174 102,110 (787,009 ) 791,420 Deferred compensation liability 138,037 138,037 Other liabilities 48,356 62,666 111,022 Total liabilities 89,848 869,324 1,307,746 434,654 (827,676 ) 1,873,896 Minority interest 6,656 6,656 Commitments and contingencies Stockholders equity 332,929 321,451 252,399 199,393 (773,243 ) 332,929 Total liabilities and stockholders equity $ 422,777 $ 1,190,775 $ 1,560,145 $ 640,703 $ (1,600,919 ) $ 2,213,481 Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) CB RICHARD ELLIS GROUP, INC. CONDENSED CONSOLIDATING BALANCE SHEET AS OF DECEMBER 31, 2002 (Dollars in thousands) Parent CBRE Guarantor Subsidiaries Nonguarantor Subsidiaries Elimination Consolidated Total Current Assets: Cash and cash equivalents $ 127 $ 54 $ 74,173 $ 5,347 $ $ 79,701 Receivables, less allowance for doubtful accounts 40 61,624 104,549 166,213 Warehouse receivable 63,140 63,140 Prepaid expenses and other current assets 18,723 22,201 8,432 7,729 (20,199 ) 36,886 Total current assets 18,850 22,295 207,369 117,625 (20,199 ) 345,940 Property and equipment, net 51,419 15,215 66,634 Goodwill 442,965 134,172 577,137 Other intangible assets, net 89,075 2,007 91,082 Deferred compensation assets 63,642 63,642 Investment in and advances to unconsolidated subsidiaries 4,782 39,205 6,221 50,208 Investment in consolidated subsidiaries 302,593 322,794 66,162 (691,549 ) Intercompany loan receivable 429,396 (429,396 ) Deferred tax assets, net 36,376 36,376 Other assets, net 4,896 17,464 20,453 51,044 93,857 Total assets $ 362,715 $ 860,373 $ 916,648 $ 326,284 $ (1,141,144 ) $ 1,324,876 Current Liabilities: Accounts payable and accrued expenses $ 2,137 $ 4,610 $ 36,895 $ 58,773 $ $ 102,415 Intercompany payable 20,199 (20,199 ) Compensation and employee benefits payable 40,938 22,796 63,734 Accrued bonus and profit sharing 59,942 43,916 103,858 Income taxes payable 15,451 15,451 Short-term borrowings: Warehouse line of credit 63,140 63,140 Other 12,145 47,909 60,054 Total short-term borrowings 75,285 47,909 123,194 Current maturities of long-term debt 9,975 736 10,711 Other current liabilities 11,724 11,724 Total current liabilities 49,511 14,585 213,060 174,130 (20,199 ) 431,087 Long-Term Debt: 11 1/4% senior subordinated notes, net of unamortized discount 225,943 225,943 Senior secured term loans 211,000 211,000 16% senior notes, net of unamortized discount 61,863 61,863 Other long-term debt 198 198 Intercompany loan payable 362,344 67,052 (429,396 ) Total long-term debt 61,863 436,943 362,344 67,250 (429,396 ) 499,004 Deferred compensation liability 106,252 106,252 Other liabilities 18,450 13,127 31,577 Total liabilities 111,374 557,780 593,854 254,507 (449,595 ) 1,067,920 Minority interest 5,615 5,615 Commitments and contingencies Stockholders equity 251,341 302,593 322,794 66,162 (691,549 ) 251,341 Total liabilities and stockholders equity $ 362,715 $ 860,373 $ 916,648 $ 326,284 $ (1,141,144 ) $ 1,324,876 Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) CB RICHARD ELLIS GROUP, INC. CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS FOR THE YEAR ENDED DECEMBER 31, 2003 (Dollars in thousands) Parent CBRE Guarantor Subsidiaries Nonguarantor Subsidiaries Elimination Consolidated Total Revenue $ $ $ 1,137,987 $ 492,087 $ $ 1,630,074 Costs and expenses: Cost of services 577,808 218,600 796,408 Operating, administrative and other 426 4,973 447,447 225,551 678,397 Depreciation and amortization 56,853 35,769 92,622 Merger-related and other nonrecurring charges 20,367 16,450 36,817 Operating (loss) income (426 ) (4,973 ) 35,512 (4,283 ) 25,830 Equity income from unconsolidated subsidiaries 132 13,818 415 14,365 Interest income 185 39,312 2,659 2,738 (38,853 ) 6,041 Interest expense 17,815 61,907 38,046 8,301 (38,853 ) 87,216 Equity losses from consolidated subsidiaries (21,214 ) (8,432 ) (16,739 ) 46,385 Loss before (benefit) provision for income taxes (39,270 ) (35,868 ) (2,796 ) (9,431 ) 46,385 (40,980 ) (Benefit) provision for income taxes (4,566 ) (14,654 ) 5,636 7,308 (6,276 ) Net loss $ (34,704 ) $ (21,214 ) $ (8,432 ) $ (16,739 ) $ 46,385 $ (34,704 ) Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) CB RICHARD ELLIS GROUP, INC. CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS FOR THE YEAR ENDED DECEMBER 31, 2002 (Dollars in thousands) Parent CBRE Guarantor Subsidiaries Nonguarantor Subsidiaries Elimination Consolidated Total Operating (loss) income (415 ) (1,222 ) 74,621 23,752 96,736 Equity income from unconsolidated subsidiaries 662 7,449 1,215 9,326 Interest income 158 42,845 2,079 916 (42,726 ) 3,272 Interest expense 11,344 42,731 39,742 9,410 (42,726 ) 60,501 Equity income from consolidated subsidiaries 27,306 32,898 5,005 (65,209 ) Income before (benefit) provision for income taxes 15,705 32,452 49,412 16,473 (65,209 ) 48,833 (Benefit) provision for income taxes (3,022 ) 5,146 16,514 11,468 30,106 Net income $ 18,727 $ 27,306 $ 32,898 $ 5,005 $ (65,209 ) $ 18,727 Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) CB RICHARD ELLIS GROUP, INC. CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS FOR THE PERIOD FROM FEBRUARY 20 (INCEPTION) TO DECEMBER 31, 2001 (Dollars in thousands) Parent CBRE Guarantor Subsidiaries Nonguarantor Subsidiaries Elimination Consolidated Total Operating (loss) income (500 ) (5,733 ) 52,229 15,182 61,178 Equity income from unconsolidated subsidiaries 198 1,290 66 1,554 Interest income 1,135 19,270 370 561 (18,909 ) 2,427 Interest expense 8,199 20,353 17,091 2,983 (18,909 ) 29,717 Equity income from consolidated subsidiaries 22,721 27,713 8,605 (59,039 ) Income before (benefit) provision for income taxes 15,157 21,095 45,403 12,826 (59,039 ) 35,442 (Benefit) provision for income taxes (2,269 ) (1,626 ) 17,690 4,221 18,016 Net income $ 17,426 $ 22,721 $ 27,713 $ 8,605 $ (59,039 ) $ 17,426 Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) CB RICHARD ELLIS GROUP, INC. CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS FOR THE PERIOD FROM JANUARY 1 TO JULY 20, 2001 (Predecessor Company) (Dollars in thousands) CBRE Guarantor Subsidiaries Nonguarantor Subsidiaries Elimination Consolidated Total Revenue $ $ 465,280 $ 142,654 $ $ 607,934 Costs and expenses: Cost of services 217,799 61,404 279,203 Operating, administrative and other 1,155 216,063 80,778 297,996 Depreciation and amortization 17,021 8,635 25,656 Merger-related and other nonrecurring charges 19,260 2,867 22,127 Operating (loss) income (20,415 ) 11,530 (8,163 ) (17,048 ) Equity income from unconsolidated subsidiaries 492 2,141 241 2,874 Interest income 16,757 952 615 (16,757 ) 1,567 Interest expense 18,014 14,952 4,094 (16,757 ) 20,303 Equity losses from consolidated subsidiaries (14,587 ) (12,480 ) 27,067 Loss before (benefit) provision for income taxes (35,767 ) (12,809 ) (11,401 ) 27,067 (32,910 ) (Benefit) provision for income taxes (1,747 ) 1,778 1,079 1,110 Net loss $ (34,020 ) $ (14,587 ) $ (12,480 ) $ 27,067 $ (34,020 ) Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) CB RICHARD ELLIS GROUP, INC. CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS FOR THE YEAR ENDED DECEMBER 31, 2003 (Dollars in thousands) Parent CBRE Guarantor Subsidiaries Nonguarantor Subsidiaries Consolidated Total Net cash provided by (used in) investing activities 26 (280,415 ) (4,406 ) (284,795 ) CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from revolver and swingline credit facility 152,580 152,580 Repayment of revolver and swingline credit facility (152,580 ) (152,580 ) Proceeds from senior secured term loans 375,000 375,000 Repayment of senior secured term loans (298,475 ) (298,475 ) Proceeds from 9 3/4% senior notes 200,000 200,000 Repayment of notes payable (43,000 ) (43,000 ) Repayment of 16% senior notes (30,000 ) (30,000 ) (Repayment of) proceeds from senior notes and other loans, net (914 ) 3,943 3,029 Proceeds from issuance of common stock 120,980 120,980 (Increase) decrease in intercompany receivables, net (56,894 ) (215,929 ) 296,111 (23,288 ) Other financing activities, net (333 ) (22,700 ) (837 ) (23,870 ) Net cash provided by (used in) financing activities 33,753 (5,104 ) 295,197 (20,182 ) 303,664 NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 2,881 (37 ) 74,579 5,387 82,810 CASH AND CASH EQUIVALENTS, AT BEGINNING OF PERIOD 127 54 74,173 5,347 79,701 Effect of currency exchange rate changes on cash 1,370 1,370 Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) CB RICHARD ELLIS GROUP, INC. CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS FOR THE YEAR ENDED DECEMBER 31, 2002 (Dollars in thousands) Parent CBRE Guarantor Subsidiaries Nonguarantor Subsidiaries Consolidated Total Net cash (used in) provided by financing activities (385 ) 18,572 (2,748 ) (33,277 ) (17,838 ) NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 124 (877 ) 31,969 (8,302 ) 22,914 CASH AND CASH EQUIVALENTS, AT BEGINNING OF PERIOD 3 931 42,204 14,312 57,450 Effect of currency exchange rate changes on cash (663 ) (663 ) Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) CB RICHARD ELLIS GROUP, INC. CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS FOR THE PERIOD FROM FEBRUARY 20 (INCEPTION) TO DECEMBER 31, 2001 (Dollars in thousands) Parent CBRE Guarantor Subsidiaries Nonguarantor Subsidiaries Elimination Consolidated Total CASH FLOWS PROVIDED BY OPERATING ACTIVITIES $ 310 $ 5,947 $ 56,478 $ 28,599 $ $ 91,334 CASH FLOWS FROM INVESTING ACTIVITIES: Capital expenditures, net of concessions received (4,246 ) (2,255 ) (6,501 ) Proceeds from sale of properties and servicing rights 1,996 112 2,108 Investment in property held for sale (40,174 ) (40,174 ) Contribution to CBRE (154,881 ) 154,881 Acquisition of businesses including net assets acquired, intangibles and goodwill, net of cash acquired (212,369 ) (1,850 ) (483 ) (214,702 ) Other investing activities, net (1 ) (1,950 ) (173 ) (2,124 ) Net cash used in investing activities (154,881 ) (212,370 ) (6,050 ) (42,973 ) 154,881 (261,393 ) CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from revolver and swingline credit facility 113,750 113,750 Repayment of revolver and swingline credit facility (113,750 ) (113,750 ) Proceeds from senior secured term loans 235,000 235,000 Repayment of senior secured term loans (4,675 ) (4,675 ) Proceeds from 16% senior notes 65,000 65,000 Repayment of senior notes and other loans, net (1,185 ) (3 ) (1,188 ) Proceeds from 11 1/4% senior subordinated notes 225,629 225,629 Repayment of 8 7/8% senior subordinated notes (175,000 ) (175,000 ) Proceeds from non recourse debt related to property held for sale 37,179 37,179 Repayment of revolving credit facility (235,000 ) (235,000 ) Payment of deferred financing fees (2,582 ) (19,168 ) (21,750 ) Proceeds from issuance of stock 92,156 154,881 (154,881 ) 92,156 Decrease (increase) in intercompany receivables, net 30,263 (6,981 ) (23,282 ) Other financing activities, net (5,535 ) (103 ) 2,118 (3,520 ) Net cash provided by (used in) financing activities 154,574 206,395 (8,269 ) 16,012 (154,881 ) 213,831 Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) CB RICHARD ELLIS GROUP, INC. CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS FOR THE PERIOD FROM JANUARY 1 TO JULY 20, 2001 (Predecessor Company) (Dollars in thousands) CBRE Guarantor Subsidiaries Nonguarantor Subsidiaries Consolidated Total Net cash provided by financing activities 38,279 51,109 36,842 126,230 NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 897 (7,513 ) 477 (6,139 ) CASH AND CASH EQUIVALENTS, AT BEGINNING OF PERIOD 62 7,558 13,234 20,854 Effect of currency exchange rate changes on cash (1,053 ) (1,053 ) Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) 21. Industry Segments We report our operations through three geographically organized segments: (1) Americas, (2) Europe, Middle East and Africa (EMEA) and (3) Asia Pacific. Summarized financial information by operating segment is as follows (dollars in thousands): CB Richard Ellis Group Predecessor Company Year Ended December 31, Revenue Americas $ 1,197,626 $ 896,064 $ 440,349 $ 488,450 EMEA 313,686 182,222 83,012 78,294 Asia Pacific 118,762 91,991 39,467 41,190 $ 1,630,074 $ 1,170,277 $ 562,828 $ 607,934 Operating income (loss) Americas $ 35,107 $ 72,868 $ 47,767 $ (10,801 ) EMEA (20,490 ) 17,287 11,441 (2,149 ) Asia Pacific 11,213 6,581 1,970 (4,098 ) $ 14,365 $ 9,326 $ 1,554 $ 2,874 Interest income 6,041 3,272 2,427 1,567 Interest expense 87,216 60,501 29,717 20,303 (Loss) income before (benefit) provision for income taxes $ (40,980 ) $ 48,833 $ 35,442 $ (32,910 ) Depreciation and amortization Americas $ 58,216 $ 16,958 $ 9,221 $ 18,231 EMEA 31,287 4,579 1,763 4,729 Asia Pacific 3,119 3,077 1,214 2,696 $ 92,622 $ 24,614 $ 12,198 $ 25,656 Capital expenditures, net of concessions received Americas $ 14,960 $ 10,999 $ 4,692 $ 12,237 EMEA 10,353 2,018 694 1,557 Asia Pacific 1,648 1,249 1,115 1,020 $ 26,961 $ 14,266 $ 6,501 $ 14,814 Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, (Dollars in thousands) Identifiable assets Americas $ 1,426,525 $ 868,990 $ 941,732 EMEA 409,087 198,027 171,621 Asia Pacific 124,128 123,059 97,552 Corporate 253,741 134,800 143,607 $ 2,213,481 $ 1,324,876 $ 1,354,512 Identifiable assets by industry segment are those assets used in our operations in each segment. Corporate identifiable assets include cash and cash equivalents and net deferred tax assets. December 31, (Dollars in thousands) Investments in and advances to unconsolidated subsidiaries Americas $ 56,774 $ 44,294 EMEA 6,494 1,058 Asia Pacific 5,093 4,856 $ 68,361 $ 50,208 Geographic Information: CB Richard Ellis Group Predecessor Company Year Ended December 31, (Dollars in thousands) Revenue U.S. $ 1,137,986 $ 849,563 $ 416,445 $ 465,281 U.K. 179,792 95,947 48,206 48,210 All other countries 312,296 224,767 98,177 94,443 $ 1,630,074 $ 1,170,277 $ 562,828 $ 607,934 The revenue shown in the table above is allocated based upon the country in which services are performed. December 31, (Dollars in thousands) Long-lived assets U.S. $ 66,280 $ 51,419 U.K. 31,707 3,297 All other countries 15,582 11,918 $ 113,569 $ 66,634 (Dollars in thousands, except share data) Revenue $ 574,999 $ 550,916 $ 440,992 Operating income (loss) 44,682 25,362 (9,272 ) Net income (loss) 11,895 2,965 (16,568 ) Basic EPS (1) 0.17 0.05 (0.26 ) Weighted average shares outstanding for basic EPS (1) 71,446,359 63,990,494 62,522,176 Diluted EPS (1) $ 0.16 $ 0.04 $ (0.26 ) Weighted average shares outstanding for diluted EPS (1) 75,184,418 69,375,929 62,522,176 (Dollars in thousands, except share data) Revenue $ 621,257 $ 423,376 $ 321,717 $ 263,724 Operating income (loss) 19,136 (22,676 ) 21,591 7,779 Net (loss) income (10,084 ) (28,445 ) 5,172 (1,347 ) Basic EPS (1) (0.16 ) (0.49 ) 0.12 (0.03 ) Weighted average shares outstanding for basic EPS (1) 62,532,166 57,486,405 41,683,699 41,651,415 Diluted EPS (1) $ (0.16 ) $ (0.49 ) $ 0.12 $ (0.03 ) Weighted average shares outstanding for diluted EPS (1) 62,532,166 57,486,405 42,523,893 41,651,415 (Dollars in thousands, except share data) Revenue $ 376,466 $ 284,928 $ 284,893 $ 223,990 Operating income 49,264 18,384 27,624 1,464 Net income (loss) 15,097 1,881 7,289 (5,540 ) Basic EPS (1) 0.36 0.05 0.17 (0.13 ) Weighted average shares outstanding for basic EPS (1) 41,572,035 41,614,903 41,666,372 41,710,761 Diluted EPS (1) $ 0.36 $ 0.05 $ 0.17 $ (0.13 ) Weighted average shares outstanding for diluted EPS (1) 42,230,128 42,196,179 42,172,340 41,710,761 Table of Contents CB RICHARD ELLIS GROUP, INC. SCHEDULE II VALUATION AND QUALIFYING ACCOUNTS (in thousands) CB Richard Ellis Group Allowance For Bad Debts Balance, February 20, 2001 (inception) $ Acquired in connection with the 2001 Merger 12,074 Charges to expense 1,317 Write-offs, payments and other (1,643 ) Balance, December 31, 2001 11,748 Charges to expense 3,415 Write-offs, payments and other (4,271 ) Balance, December 31, 2002 10,892 Acquired in connection with the Insignia Acquisition 5,061 Charges to expense 3,436 Write-offs, payments and other (3,208 ) Balance, December 31, 2003 $ 16,181 Predecessor Company Allowance For Bad Debts Balance, December 31, 2000 $ 12,631 Charges to expense 3,387 Write-offs, payments and other (3,944 ) Balance, July 20, 2001 $ 12,074 Assets Cash and cash equivalents $ 55,991 Receivables, net 137,566 Restricted cash 21,153 Property and equipment, net 42,140 Real estate investments, net 131,411 Goodwill 260,565 Acquired intangible assets, less accumulated amortization of $56,025 4,684 Deferred taxes 62,086 Other assets, net 18,653 Total assets $ 734,249 Liabilities and Stockholders Equity Liabilities: Accounts payable $ 8,999 Commissions payable 45,744 Accrued incentives 13,958 Accrued and sundry 92,886 Deferred taxes 23,396 Notes payable 56,785 Real estate mortgage notes 71,986 Total liabilities 313,754 Stockholders Equity: Common stock, par value $.01 per share authorized 80,000,000 shares, 24,082,121 issued and outstanding shares, net of 1,502,600 shares held in treasury 241 Preferred stock, par value $.01 per share authorized 20,000,000 shares, Series A, 250,000 and Series B, 125,000 issued and outstanding shares 4 Additional paid-in capital 443,101 Notes receivable for common stock (1,006 ) Accumulated deficit (24,104 ) Accumulated other comprehensive income 2,259 Total stockholders equity 420,495 Total liabilities and stockholders equity $ 734,249 Table of Contents INSIGNIA FINANCIAL GROUP, INC. CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (In thousands) (Unaudited) Six Months Ended June 30, Revenues Real estate services $ 281,280 $ 255,446 Property operations 4,326 4,550 Equity (loss) earnings in unconsolidated ventures (3,318 ) 3,259 282,288 263,255 294,710 260,245 Operating (loss) income (12,422 ) 3,010 Other income and expenses: Interest income 1,646 2,081 Other income 29 13 Interest expense (3,293 ) (4,338 ) Property interest expense (841 ) (951 ) (Loss) income before cumulative effect of a change in accounting principle (6,270 ) 3,032 Cumulative effect of a change in accounting principle, net of applicable taxes (20,635 ) Net loss (6,270 ) (17,603 ) Preferred stock dividends (1,594 ) (573 ) Net loss available to common shareholders $ (7,864 ) $ (18,176 ) Table of Contents INSIGNIA FINANCIAL GROUP, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) (Unaudited) Six Months Ended June 30, Operating activities Loss from continuing operations $ (9,673 ) $ (102 ) Adjustments to reconcile loss from continuing operations to net cash used in operating activities: Depreciation and amortization 8,946 10,537 Equity loss (earnings) in unconsolidated ventures 3,318 (3,259 ) Changes in operating assets and liabilities: Accounts receivable 16,441 36,386 Other assets (7,752 ) 3,158 Accrued incentives (35,339 ) (44,039 ) Accounts payable and accrued expenses (9,136 ) (23,526 ) Commissions payable (17,543 ) (33,747 ) Net cash used in operating activities (50,738 ) (54,592 ) Net cash provided by investing activities 57,484 43,882 Financing activities Proceeds from issuance of common stock 5,488 1,127 Proceeds from issuance of preferred stock, net 12,325 Preferred stock dividends (1,593 ) (633 ) Payment on notes payable (70,104 ) (36,722 ) Payments on real estate mortgage notes (20,915 ) Proceeds from real estate mortgage notes 5,191 Debt issuance costs (866 ) Net cash used in financing activities (61,018 ) (45,684 ) Net cash (used in) provided by discontinued operations (3,002 ) 5,209 Effect of exchange rate changes on cash 1,818 1,641 Net decrease in cash and cash equivalents (55,456 ) (49,544 ) Cash and cash equivalents at beginning of period 111,447 131,770 Cash and cash equivalents at end of period $ 55,991 $ 82,226 (In thousands) Assets Cash and cash equivalents $ 66 Receivables 2,479 Property and equipment 11,766 Goodwill 34,117 Acquired intangible assets 11,999 Deferred taxes 3,365 Other assets 2,177 Assets of discontinued operations 65,969 Liabilities of discontinued operations 10,171 Net assets $ 55,798 Six Months Ended June 30, (In thousands) Revenues $ 20,517 $ 69,009 Net income $ 3,403 $ 3,134 Table of Contents INSIGNIA FINANCIAL GROUP, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 7. Goodwill and Intangible Assets The table below reconciles the change in the carrying amount of goodwill, by operating segment, for the period from December 31, 2002 to June 30, 2003. Commercial Residential Total (In thousands) Balance as of December 31, 2002 $ 255,444 $ 34,117 $ 289,561 Adjustment for discontinued operations (34,117 ) (34,117 ) 255,444 255,444 Other adjustments to purchase consideration (877 ) (877 ) Foreign currency translation 5,998 5,998 Balance as of June 30, 2003 $ 260,565 $ $ 260,565 The following tables present certain information on the Company s acquired intangible assets as of June 30, 2003. Acquired Intangible Assets Weighted Average Amortization Period Gross Carrying Amount Accumulated Amortization Net Balance Total $ 60,709 $ 56,025 $ 4,684 (In thousands) Notes Payable Senior revolving credit facility $ 28,000 Subordinated credit facility 15,000 Acquisition loan notes 13,785 56,785 Real Estate Mortgage Notes 71,986 Total $ 128,771 Table of Contents INSIGNIA FINANCIAL GROUP, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) sale of its residential businesses, lowering its outstanding balance to $28.0 million. In conjunction with the pay-down, the commitment under the senior credit facility was reduced from $230.0 million to $165.0 million. The senior revolving credit facility matures in May 2004. The subordinated credit facility borrowings, which are subordinate to Insignia s senior credit facility, bear interest at an annual rate of 11.25%, payable quarterly. Insignia may borrow the remaining $22.5 million available under this credit facility through the period ending in December 2003. The subordinated debt matures in June 2009. The acquisition loan notes are payable to sellers of the acquired U.K. businesses and are backed by restricted cash deposits in approximately the same amount. The loan notes are redeemable semi-annually at the discretion of the note holder and have a final maturity date of April 2010. The real estate mortgage notes are secured by property assets owned by consolidated subsidiaries. Maturities on the real estate mortgage notes range from December 2004 to October 2023. 10. Comprehensive Income (Loss) The following table presents a calculation of comprehensive income (loss) for the periods indicated. Six Months Ended June 30, (In thousands) Net loss $ (6,270 ) $ (17,603 ) Other comprehensive income (loss): Foreign currency translation 7,354 5,967 Reclassification adjustment for realized gain (50 ) Minimum pension liability (61 ) Total other comprehensive income (loss) 7,354 5,856 Total comprehensive income (loss) $ 1,084 $ (11,747 ) Table of Contents INSIGNIA FINANCIAL GROUP, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 11. Industry Segment Data In 2003, Insignia s operating activities from continuing operations encompass only one reportable segment, commercial real estate services. The Company s residential real estate service businesses were disposed of in the first quarter of 2003 and are reported as discontinued operations. The Company s commercial service businesses offer similar products and services and are managed collectively because of the similarities between such services. These businesses provide services including tenant representation, property and asset management, agency leasing and brokerage, investment sales, development and re-development, consulting and other real estate financial services. Insignia s commercial businesses include Insignia/ESG in the United States, Insignia Richard Ellis in the United Kingdom, Insignia Bourdais in France and other businesses in continental Europe, Asia and Latin America. The following table summarizes certain geographic financial information for the periods indicated. Six Months Ended June 30, (In thousands) Total Revenues United States $ 194,341 $ 187,644 United Kingdom 54,462 49,939 France 22,032 18,082 Other Europe 7,468 4,866 Asia and Latin America 3,985 2,724 $ 282,288 $ 263,255 $ 438,800 $ 405,302 Table of Contents INSIGNIA FINANCIAL GROUP, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Condensed Consolidating Balance Sheet June 30, 2003 Domestic Commercial Service Operations Other Operations Eliminations Consolidated Total (In thousands) Assets Cash and cash equivalents $ 38,386 $ 17,605 $ $ 55,991 Receivables, net 98,651 38,915 137,566 Restricted cash 14,300 6,853 21,153 Intercompany receivables 43,978 (43,978 ) Investment in consolidated subsidiaries 129,895 (129,895 ) Property and equipment, net 32,220 9,920 42,140 Real estate investments, net 131,411 131,411 Goodwill 112,662 147,903 260,565 Acquired intangible assets, net 426 4,258 4,684 Deferred taxes 54,501 7,585 62,086 Other assets, net 8,160 10,493 18,653 Total assets $ 533,179 $ 374,943 $ (173,873 ) $ 734,249 Liabilities and Stockholders Equity Liabilities: Accounts payable $ 6,288 $ 2,711 $ $ 8,999 Commissions payable 43,548 2,196 45,744 Accrued incentives 10,704 3,254 13,958 Accrued and sundry 44,707 48,179 92,886 Deferred taxes 21,182 2,214 23,396 Intercompany payables 43,978 (43,978 ) Notes payable 56,785 56,785 Real estate mortgage notes 71,986 71,986 Total liabilities 183,214 174,518 (43,978 ) 313,754 Total stockholders equity 349,965 200,425 (129,895 ) 420,495 Total liabilities and stockholders equity $ 533,179 $ 374,943 $ (173,873 ) $ 734,249 Table of Contents INSIGNIA FINANCIAL GROUP, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Condensed Consolidating Statement of Operations For the Six Months Ended June 30, 2003 Domestic Commercial Service Operations Other Operations Eliminations Consolidated Total (In thousands) Revenues $ 193,333 $ 88,955 $ $ 282,288 204,135 90,575 294,710 Operating loss (10,802 ) (1,620 ) (12,422 ) Other income and expenses: Interest income 593 1,053 1,646 Other income (expense) 41 (12 ) 29 Interest expense (3,081 ) (212 ) (3,293 ) Property interest expense (841 ) (841 ) Equity earnings in consolidated subsidiaries 2,211 (2,211 ) Loss from continuing operations (6,270 ) (1,192 ) (2,211 ) (9,673 ) Discontinued operations, net of applicable taxes: Loss from operations (360 ) (360 ) Income on disposal 3,763 3,763 Net loss $ (6,270 ) $ 2,211 $ (2,211 ) $ (6,270 ) Table of Contents INSIGNIA FINANCIAL GROUP, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Condensed Consolidating Statement of Operations For the Six Months Ended June 30, 2002 Domestic Commercial Service Operations Other Operations Eliminations Consolidated Total (In thousands) Revenues $ 179,835 $ 83,420 $ $ 263,255 Costs and expenses Real estate services 171,590 68,370 239,960 Property operations 3,165 3,165 Administrative 6,583 6,583 Depreciation and amortization 7,585 1,894 9,479 Property depreciation 1,058 1,058 185,758 74,487 260,245 Operating (loss) income (5,923 ) 8,933 3,010 Other income and expenses: Interest income 946 1,135 2,081 Other income (expense) 53 (40 ) 13 Interest expense (4,060 ) (278 ) (4,338 ) Property interest expense (951 ) (951 ) Equity losses in consolidated subsidiaries (12,213 ) 12,213 Income (loss) before cumulative effect of a change in accounting principle (17,603 ) 8,422 12,213 3,032 Cumulative effect of a change in accounting principle, net of applicable taxes (20,635 ) (20,635 ) Net loss $ (17,603 ) $ (12,213 ) $ 12,213 $ (17,603 ) Table of Contents INSIGNIA FINANCIAL GROUP, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Condensed Consolidating Statement of Cash Flows For the Six Months Ended June 30, 2003 Domestic Commercial Service Operations Other Operations Consolidated Total (In thousands) Net cash used in operating activities $ (22,851 ) $ (27,887 ) $ (50,738 ) Net cash provided by investing activities 1,683 55,801 57,484 Financing activities Decrease (increase) in intercompany receivables, net 53,518 (53,518 ) Proceeds from issuance of common stock 5,488 5,488 Preferred stock dividends (1,593 ) (1,593 ) Payments on notes payable (70,104 ) (70,104 ) Proceeds from real estate mortgage notes 5,191 5,191 Net cash used in financing activities (12,691 ) (48,327 ) (61,018 ) Net cash used in discontinued operations (3,002 ) (3,002 ) Effect of exchange rate changes on cash 1,818 1,818 Net decrease in cash and cash equivalents (33,859 ) (21,597 ) (55,456 ) Cash and cash equivalents at beginning of period 72,245 39,202 111,447 Cash and cash equivalents at end of period $ 38,386 $ 17,605 $ 55,991 Table of Contents INSIGNIA FINANCIAL GROUP, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Condensed Consolidating Statement of Cash Flows For the Six Months Ended June 30, 2002 Domestic Commercial Service Operations Other Operations Consolidated Total (In thousands) Net cash (used in) provided by operating activities $ (63,181 ) $ 8,589 $ (54,592 ) Investing activities Additions to property and equipment, net (1,878 ) (319 ) (2,197 ) Proceeds from real estate investments 30,940 30,940 Payments made for acquisitions of businesses (804 ) (5,351 ) (6,155 ) Proceeds from sale of discontinued operation 23,250 23,250 Investment in real estate (4,897 ) (4,897 ) Decrease (increase) in restricted cash 3,932 (991 ) 2,941 Net cash provided by investing activities 1,250 42,632 43,882 Financing activities Decrease (increase) in intercompany receivables, net 35,275 (35,275 ) Proceeds from issuance of common stock 1,127 1,127 Proceeds from issuance of preferred stock, net 12,325 12,325 Preferred stock dividends (633 ) (633 ) Payments on notes payable (36,722 ) (36,722 ) Payments on real estate mortgage notes (20,915 ) (20,915 ) Debt issuance costs (866 ) (866 ) Net cash provided by (used in) financing activities 10,506 (56,190 ) (45,684 ) Net cash provided by discontinued operations 5,209 5,209 Effect of exchange rate changes on cash 1,641 1,641 Net (decrease) increase in cash and cash equivalents (51,425 ) 1,881 (49,544 ) Cash and cash equivalents at beginning of period 106,954 24,816 131,770 Cash and cash equivalents at end of period $ 55,529 $ 26,697 $ 82,226 (In thousands) Assets Cash and cash equivalents $ 111,513 Receivables, net of allowance of $6,684 155,321 Restricted cash 21,518 Property and equipment, net 55,614 Real estate investments, net 134,135 Goodwill 289,561 Acquired intangible assets, less accumulated amortization of $65,276 17,611 Deferred taxes 47,609 Other assets, net 39,957 Assets of discontinued operation Total assets $ 872,839 Liabilities and Stockholders Equity Liabilities: Accounts payable $ 13,743 Commissions payable 63,974 Accrued incentives 52,324 Accrued and sundry 117,990 Deferred taxes 15,795 Notes payable 126,889 Real estate mortgage notes 66,795 Liabilities of discontinued operation Total liabilities 457,510 Stockholders Equity: Preferred stock, par value $.01 per share authorized 20,000,000 shares, Series A, 250,000 and Series B, 125,000 issued and outstanding shares 4 Common Stock, par value $.01 per share authorized 80,000,000 shares 23,248,242 issued and outstanding shares, net of 1,502,600 shares held in treasury 232 Additional paid-in capital 437,622 Notes receivable for common stock (1,193 ) Accumulated deficit (16,241 ) Accumulated other comprehensive loss (5,095 ) Total stockholders equity 415,329 Total liabilities and stockholders equity $ 872,839 Table of Contents INSIGNIA FINANCIAL GROUP, INC. CONSOLIDATED STATEMENTS OF OPERATIONS Years Ended December 31 591,014 633,229 567,925 603,171 Operating income 23,089 30,058 Other income and expenses: Interest income 3,936 4,853 Interest expense (8,854 ) (12,369 ) Property interest expense (2,122 ) (1,744 ) Losses from internet investments, net (10,263 ) Other expense (661 ) Income from continuing operations before income taxes 16,049 9,874 Income tax expense (7,012 ) (3,522 ) Income from continuing operations 9,037 6,352 Discontinued operations, net of applicable tax Income (loss) from operations 4,180 (2,231 ) Income (loss) on disposal 4,918 (17,629 ) 9,098 (19,860 ) Income (loss) before cumulative effect of a change in accounting principle 18,135 (13,508 ) Cumulative effect of a change in accounting principle, net of applicable taxes (20,635 ) Net loss (2,500 ) (13,508 ) Preferred stock dividends (2,173 ) (1,000 ) Net loss available to common shareholders $ (4,673 ) $ (14,508 ) Table of Contents INSIGNIA FINANCIAL GROUP, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (CONTINUED) Years Ended December 31 (In thousands, except per share data) Per share amounts: Earnings per common share basic Income from continuing operations $ 0.30 $ 0.24 Income (loss) from discontinued operations 0.39 (0.90 ) Income (loss) before cumulative effect of a change in accounting principle 0.69 (0.66 ) Cumulative effect of a change in accounting principle (0.89 ) Net loss $ (0.20 ) $ (0.66 ) Earnings per common share assuming dilution: Income from continuing operations $ 0.29 $ 0.23 Income (loss) from discontinued operations 0.38 (0.85 ) Income (loss) before cumulative effect of a change in accounting principle 0.67 (0.62 ) Cumulative effect of a change in accounting principle (0.87 ) Net loss $ (0.20 ) $ (0.62 ) Weighted average common shares and assumed conversions: Basic 23,122 22,056 Assuming dilution 23,691 23,398 Table of Contents INSIGNIA FINANCIAL GROUP, INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY Common Stock Preferred Stock Additional Paid-in Capital Notes Receivable for Common Stock Accumulated Deficit Accumulated Other Comprehensive Loss Comprehensive Loss Total (In thousands, except share data) Balances at December 31, 2000 $ 216 $ 3 $ 413,831 $ (2,051 ) $ 2,846 $ (5,964 ) $ 408,881 Net loss (13,508 ) $ (13,508 ) (13,508 ) Other comprehensive income (loss): Foreign currency translation, net of tax benefit of $1,769 (2,033 ) (2,033 ) (2,033 ) Unrealized gain on securities, net of tax of $7 7 7 7 Minimum pension liability, net of tax benefit of $696 (900 ) (900 ) (900 ) Total comprehensive loss $ (16,434 ) Balances at December 31, 2001 $ 229 $ 3 $ 422,309 $ (1,882 ) $ (11,912 ) $ (8,890 ) $ 399,857 Table of Contents INSIGNIA FINANCIAL GROUP, INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY (CONTINUED) Common Stock Preferred Stock Additional Paid-in Capital Notes Receivable for Common Stock Accumulated Deficit Accumulated Other Comprehensive Loss Comprehensive (Loss) Income Total (In thousands, except share data) Balance at December 31, 2001 (from previous page) $ 229 $ 3 $ 422,309 $ (1,882 ) $ (11,912 ) $ (8,890 ) $ 399,857 Net loss (2,500 ) $ (2,500 ) (2,500 ) Other comprehensive income (loss) Foreign currency translation, net of tax of $6,215 12,383 12,383 12,383 Reclassification adjustment for realized gain, net of tax of $39 (50 ) (50 ) (50 ) Unrealized gain on securities, net of tax of $752 1,128 1,128 1,128 Minimum pension liability, net of tax benefit of $3,832 (9,666 ) (9,666 ) (9,666 ) Total comprehensive income $ 1,295 Balance at December 31, 2002 $ 232 $ 4 $ 437,622 $ (1,193 ) $ (16,241 ) $ (5,095 ) $ 415,329 Table of Contents INSIGNIA FINANCIAL GROUP, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS Years Ended December 31 (In thousands) Operating activities Income from continuing operations $ 9,037 $ 6,352 Adjustments to reconcile income from continuing operations to net cash provided by operating activities: Depreciation and amortization 20,241 33,843 Other expenses 661 Equity earnings in real estate ventures (3,482 ) (10,381 ) Gain on sale of consolidated real estate property (1,306 ) Foreign currency transaction gains (331 ) Losses from internet investments 10,263 Deferred income taxes (644 ) (2,754 ) Changes in operating assets and liabilities, net of effects of acquired businesses: Receivables 24,184 23,486 Other assets (9,610 ) 5,656 Accrued incentives (16,002 ) (22,194 ) Accounts payable and accrued expenses 1,157 (34,344 ) Commissions payable (21,893 ) 18,616 Cash provided by operating activities 1,682 28,873 Investing activities Additions to property and equipment (8,388 ) (11,789 ) Investment in internet-based businesses (4,010 ) Distribution proceeds from real estate investments 44,648 63,787 Proceeds from sale of discontinued operations 23,250 Payments made for acquisition of businesses, net of acquired cash (8,918 ) (18,983 ) Investments in real estate (46,684 ) (33,905 ) Decrease (increase) in restricted cash 3,964 (14,879 ) Table of Contents INSIGNIA FINANCIAL GROUP, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED) Years Ended December 31 (In thousands) Financing activities Proceeds from issuance of common stock $ 903 $ 1,472 Proceeds from issuance of preferred stock 12,270 Proceeds from exercise of stock options 674 2,143 Preferred stock dividends (1,829 ) (1,000 ) Payments on notes payable (59,785 ) (138,350 ) Proceeds from notes payable 15,000 158,999 Payments on real estate mortgage notes (28,361 ) (33,086 ) Proceeds from real estate mortgage notes 20,000 21,987 Debt issuance costs (1,415 ) (2,130 ) Cash (used in) provided by financing activities (42,543 ) 10,035 Net cash provided by (used in) discontinued operation 8,787 (4,402 ) Effect of exchange rate changes in cash 3,789 (1,217 ) Net (decrease) increase in cash and cash equivalents (20,413 ) 13,510 Cash and cash equivalents at beginning of year 131,860 124,527 Cash and cash equivalents at end of year $ 111,513 $ 131,860 Table of Contents INSIGNIA FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) The results of operations of Insignia Douglas Elliman, Insignia Residential Group and Realty One are reported separately as discontinued operations for the years ended December 31, 2002 and 2001. The following tables summarize the aggregate assets and liabilities of Insignia Douglas Elliman and Insignia Residential Group at December 31, 2002 and the results of operations and income (loss) on disposal of Insignia Douglas Elliman, Insignia Residential Group and Realty One for the periods presented (in thousands): Assets Cash and cash equivalents $ 66 Receivables 2,479 Mortgage loans held for sale Property and equipment 11,766 Goodwill 34,117 Acquired intangible assets 11,999 Other assets 5,542 65,969 Liabilities Accounts payable 2,535 Commissions payable 564 Accrued incentives 3,027 Accrued and sundry liabilities 4,045 Mortgage warehouse line of credit Notes payable 10,171 Net assets of discontinued operations $ 55,798 (In thousands) Revenues $ 133,691 $ 222,043 Income (loss) from operations, net of tax expense of $3,707 (2002) and tax benefit of $1,123 (2001) 4,180 (2,231 ) Income (loss) on disposal, net of applicable tax benefits of $2,844 (2002) and $4,000 (2001) 4,918 (17,629 ) Net income (loss) $ 9,098 $ (19,860 ) (In thousands) Reported income from continuing operations $ 6,352 Less: Preferred stock dividend (1,000 ) Income from continuing operations available to common shareholders 5,352 Add: Goodwill amortization, net of tax benefit of $4,520 10,260 Adjusted income from continuing operations available to common shareholders $ 15,612 Earnings per common share basic: Reported income from continuing operations $ 0.24 Add: Goodwill amortization, net of tax benefit of $0.20 0.47 Adjusted income from continuing operations $ 0.71 Earnings per common share assuming dilution: Reported income from continuing operations $ 0.25 Add: Goodwill amortization, net of tax benefit of $0.18 0.41 Adjusted income from continuing operations $ 0.66 Additional contingent purchase price of acquired businesses totaling $17.9 million was recorded as additional goodwill during 2002. Such additional purchase price included: (i) Insignia Bourdais earnout of $10.3 million (paid by issuance of 131,480 shares of Insignia common stock, a cash payment of $4.7 million and $4.3 million accrued at December 31, 2002); (ii) a $4.0 million earnout with respect to the prior Boston acquisition by Insignia/ESG; (iii) a $2.0 million earnout related to Insignia Douglas Elliman; and (iv) $1.6 million of payments related to other acquisitions. The table below reconciles the change in the carrying amount of goodwill, by operating segment, for the period from December 31, 2001 to December 31, 2002. Commercial Residential Total (In thousands) Balance as of December 31, 2001 $ 228,967 $ 59,386 $ 288,353 Effect of adoption of SFAS 142 (3,201 ) (26,822 ) (30,023 ) Balance as of January 1, 2002 225,766 32,564 258,330 Additional purchase consideration 15,922 2,000 17,922 Other reclassifications (143 ) (143 ) Goodwill related to partial sale of business unit (447 ) (447 ) Foreign currency translation 13,899 13,899 Balance as of December 31, 2002 $ 255,444 $ 34,117 $ 289,561 Table of Contents INSIGNIA FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) The following table presents certain information on the Company s acquired intangible assets as of December 31, 2002 (in thousands): Acquired Intangible Assets Weighted Average Amortization Period Gross Carrying Amount Accumulated Amortization Net Balance Property management contracts 7 years $ 72,883 $ 60,081 $ 12,802 Favorable premises leases 8 years 4,831 1,667 3,164 Other 3 years 5,173 3,528 1,645 Total $ 82,887 $ 65,276 $ 17,611 (In thousands) Numerator: Numerator for basic and diluted earnings per share income available to common stockholders after assumed conversions (before discontinued operations and cumulative effect) $ 6,864 $ 5,352 Denominator for diluted earnings per share weighted average common shares and assumed conversions 23,691 23,398 (In thousands) Common stock $ 4,000 Accrued and sundry liabilities 10,990 Cash paid at the closing dates 20,508 $ 35,498 $ 35,498 14,732 $ 155,321 Table of Contents INSIGNIA FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Long-term commissions receivable totaling $8.4 million at December 31, 2002 have been discounted to their present value based on an estimated discount rate of 5.25%. Broker signing bonuses and advances are generally forgiven over the terms of employment, subject to potential repayment based on certain specific conditions. Principal collections on brokerage, employee and executive notes receivable and scheduled forgiveness of Broker signing bonuses and advances are as follows: Amount $ 14,732 8. Property and Equipment At December 31, 2002, property and equipment consisted of the following (in thousands): Data processing equipment $ 32,010 Computer software 34,291 Furniture and fixtures 17,466 Leasehold improvements 19,805 Other equipment 7,436 111,008 Less: Accumulated depreciation (55,394 ) $ 55,614 Table of Contents INSIGNIA FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) At December 31, 2002, the Company s real estate investments totaled $134.1 million and consisted of the following (in thousands): Minority interests in operating properties $ 21,109 Consolidated properties 85,205 Minority owned development properties 10,014 Land held for future development 1,726 Minority interests in real estate debt investment funds 16,081 Total Real Estate Investments $ 134,135 Total Obligations $ 13,980 Table of Contents INSIGNIA FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Summarized financial information of unconsolidated real estate entities is as follows: Year ended December 31 Condensed Statements of Operations Information (In thousands) Revenues $ 197,255 $ 222,502 Total operating expenses (190,543 ) (208,556 ) Income before gains on sales of properties 6,712 13,946 Gains on sales of properties 41,252 107,025 Net income $ 47,964 $ 120,971 Company s share of net income: Included in equity earnings in unconsolidated ventures $ 3,482 $ 13,911 Condensed Balance Sheet Information (In thousands) Cash and investments $ 46,068 Receivables and deposits 25,946 Investments in commercial mortgage backed securities 127,116 Investments in mezzanine loans 1,731 Other assets 31,573 Real estate 1,056,037 Less accumulated depreciation (95,891 ) Net real estate 960,146 Total assets $ 1,192,581 Mortgage notes payable $ 712,601 Other liabilities 27,435 PRINCIPAL AND SELLING STOCKHOLDERS 92 DESCRIPTION OF CAPITAL STOCK 96 SHARES ELIGIBLE FOR FUTURE SALE 100 DESCRIPTION OF CERTAIN LONG-TERM INDEBTEDNESS 102 CERTAIN U.S. TAX CONSEQUENCES TO NON-U.S. HOLDERS 106 UNDERWRITING 109 LEGAL MATTERS 112 EXPERTS 112 CHANGE IN ACCOUNTANTS 112 WHERE YOU CAN FIND MORE INFORMATION 113 INDEX TO CONSOLIDATED FINANCIAL STATEMENTS CB Richard Ellis Group, Inc. Consolidated Balance Sheets at September 30, 2004 (Unaudited) and December 31, 2003 F-2 Consolidated Statements of Operations for the three months ended and the nine months ended September 30, 2004 and 2003 (Unaudited) F-3 Consolidated Statements of Cash Flows for the three months ended and the nine months ended September 30, 2004 and 2003 (Unaudited) F-4 Notes to Consolidated Financial Statements (Unaudited) F-5 Report of Independent Registered Public Accounting Firm F-28 Report of Independent Public Accountants F-30 Consolidated Balance Sheets at December 31, 2003 and 2002 F-31 Consolidated Statements of Operations for the years ended December 31, 2003 and 2002, for the period from February 20 (inception) through December 31, 2001 and for the period from January 1, 2001 through July 20, 2001 (predecessor) F-32 Consolidated Statements of Cash Flows for the years ended December 31, 2003 and 2002, for the period from February 20 (inception) through December 31, 2001 and for the period from January 1 through July 20, 2001 (predecessor) F-33 Consolidated Statements of Stockholders Equity for the years ended December 31, 2003 and 2002, for the period from February 20 (inception) through December 31, 2001 and for the period from January 1, 2001 through July 20, 2001 (predecessor) F-34 Consolidated Statements of Comprehensive (Loss) Income for the years ended December 31, 2003 and 2002, for the period from February 20 (inception) through December 31, 2001 and for the period from January 1 through July 20, 2001 (predecessor) F-35 Notes to Consolidated Financial Statements F-36 Quarterly Results of Operations (Unaudited) F-84 Schedule II Valuation and Qualifying Accounts F-85 Insignia Financial Group, Inc. Condensed Consolidated Balance Sheet at June 30, 2003 (Unaudited) F-86 Condensed Consolidated Statements of Operations for the six months ended June 30, 2003 and 2002 (Unaudited) F-87 Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2003 and 2002 (Unaudited) F-88 Notes to Condensed Consolidated Financial Statements (Unaudited) F-89 Independent Auditors Report F-102 Report of Independent Registered Public Accounting Firm F-103 Consolidated Balance Sheet December 31, 2002 F-104 Consolidated Statements of Operations Years ended December 31, 2002 and 2001 F-105 Consolidated Statements of Stockholders Equity Years ended December 31, 2002 and 2001 F-107 Consolidated Statements of Cash Flows Years ended December 31, 2002 and 2001 F-109 Notes to Consolidated Financial Statements F-111 The accompanying notes are an integral part of these consolidated financial statements. The accompanying notes are an integral part of these consolidated financial statements. Total liabilities 740,036 Partners capital 452,545 The accompanying notes are an integral part of these consolidated financial statements. Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 1. Nature of Operations CB Richard Ellis Group, Inc., formerly known as CBRE Holding, Inc. (which may be referred to in this Form 10-Q as we, us, and our ), offers a full range of services to occupiers, owners, lenders and investors in office, retail, industrial, multi-family and other commercial real estate markets globally under the CB Richard Ellis brand name. Our business is focused on several service competencies, including strategic advice and execution assistance for property leasing and sales; property valuation; commercial mortgage loan origination and servicing, facilities and property management; real estate investment management and real estate econometric forecasting. We generate revenues both on a per project or transaction basis and from annual management fees. CB Richard Ellis Group, Inc. was incorporated on February 20, 2001 and was created to acquire all of the outstanding shares of CB Richard Ellis Services, Inc. (CBRE), an international real estate services firm. Prior to July 20, 2001, we were a wholly owned subsidiary of Blum Strategic Partners, L.P., which is an affiliate of Richard C. Blum, a director of CBRE and our Company. On July 20, 2001, we acquired all of the outstanding stock of CBRE pursuant to an Amended and Restated Agreement and Plan of Merger, dated May 31, 2001, among CBRE, Blum CB Corp. (Blum CB) and us. Blum CB was merged with and into CBRE with CBRE being the surviving corporation (the 2001 Merger). On July 23, 2003, our global position in the commercial real estate services industry was further solidified as CBRE acquired Insignia Financial Group, Inc. 2. Initial Public Offering On June 15, 2004, we completed the initial public offering of shares of our Class A common stock (the IPO). In connection with the IPO, we issued and sold 7,726,764 shares of our Class A common stock and received aggregate net proceeds of approximately $135.0 million, after deducting underwriting discounts and commissions and offering expenses payable by us. Also in connection with the IPO, selling stockholders sold an aggregate of 16,273,236 shares of our Class A common stock and received net proceeds of approximately $290.6 million, after deducting underwriting discounts and commissions. On July 14, 2004, selling stockholders sold an additional 229,300 shares of our Class A common stock to cover over-allotments of shares by the underwriters and received net proceeds of approximately $4.1 million, after deducting underwriting discounts and commissions. We did not receive any of the proceeds from the sales of shares by the selling stockholders on June 15, 2004 and July 14, 2004. 3. Insignia Acquisition On July 23, 2003, pursuant to an Amended and Restated Agreement and Plan of Merger, dated May 28, 2003 (the Insignia Acquisition Agreement), by and among us, CBRE, Apple Acquisition Corp. (Apple Acquisition), a Delaware corporation and wholly owned subsidiary of CBRE, and Insignia Financial Group, Inc. (Insignia), Apple Acquisition was merged with and into Insignia (the Insignia Acquisition). Insignia was the surviving corporation in the Insignia Acquisition and at the effective time of the Insignia Acquisition became a wholly owned subsidiary of CBRE. The aggregate purchase price for the acquisition of Insignia was approximately $329.5 million, which includes: (1) $267.9 million in cash paid for shares of Insignia s outstanding common stock, at $11.156 per share, (2) $38.2 million in cash paid for Insignia s outstanding Series A preferred stock and Series B preferred stock at $100.00 per share plus accrued and unpaid dividends, (3) cash payments of $7.9 million to holders of Insignia s vested and unvested warrants and options and (4) $15.5 million of direct costs incurred in connection with the acquisition, consisting mostly of legal and accounting fees. Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Unaudited) Purchase accounting adjustments related to the Insignia Acquisition have been recorded in the accompanying consolidated financial statements as of, and for periods subsequent to, July 23, 2003. The final valuation of the net assets acquired was completed during the third quarter of 2004 and did not result in any significant adjustments when compared to the preliminary valuation, other than those noted below. During the nine months ended September 30, 2004, we made the following significant adjustments to goodwill: In the first quarter of 2004, we assigned a $6.6 million estimated fair value to a broker draw asset acquired from Insignia. Based on our management s estimates, we generally derive benefit from brokers participating in our draw program over two years. Accordingly, we estimate that we will derive benefit from the broker draw asset related to Insignia s brokers over two years from the date of the Insignia Acquisition and, accordingly, we are amortizing it on a straight-line basis, which best reflects the pattern in which the economic benefits of the broker draw asset are consumed, during that period. The allocation of purchase price to the broker draw asset, net of related tax impact, resulted in a $3.8 million decrease in goodwill and a related $2.4 million increase in net loss during the nine months ended September 30, 2004, which includes a $0.8 million first quarter 2004 adjustment to correct the amortization taken for the period from the date of the Insignia Acquisition through December 31, 2003. During the nine months ended September 30, 2004, we recorded a $14.2 million increase to goodwill due to an increase in liabilities primarily related to additional lease termination costs, contract termination costs and costs associated with anticipated legal settlements. All such adjustments were recorded in accordance with the requirements of Emerging Issues Task Force (EITF) Issue No. 95-3, Recognition of Liabilities in Connection with a Purchase Business Combination. As of the consummation date of the acquisition of Insignia, our management began to assess and formulate a plan to close certain Insignia locations. Due to the size of this acquisition and the dispersed nature of Insignia s operations, a significant amount of time and effort was required to finalize plans with respect to closures, analyze the provisions of contracts to be terminated and estimate the total exit costs. The adjustment during the nine months ended September 30, 2004 represents a change in estimate as we completed our assessments and finalized our plans with respect to certain of the locations. In the first quarter of 2004, we recorded a $4.2 million increase to goodwill related to the sale of certain assets acquired in connection with the Insignia Acquisition. Of this amount, $3.7 million represented a receivable due from a buyer, which was collected in the second quarter of 2004. During the second and third quarter of 2004, we received additional cash for the sale of such assets as well as finalized the fair value assigned to such assets in the purchase price allocation. This resulted in a overall increase to goodwill of approximately $2.9 million, which reflects the sale of assets at an amount less than the value assigned in the preliminary purchase price allocation. As no event occurred during the period from the acquisition date to the sale date that would have impacted the value of these assets, our management concluded that the amount at which these assets were ultimately sold represents the best estimate of the fair value of these assets at the date of the Insignia Acquisition. During the second quarter of 2004, we finalized the fair value of liabilities assumed relating to annuities due to former equity partners of Richard Ellis Group Limited that are payable by Insignia until the times of their deaths. Our valuations of these annuities was based in part on a third-party valuation and resulted in a $4.2 million increase in goodwill in 2004. During the nine months ended September 30, 2004, we recorded a reduction of $9.2 million to goodwill related to the deferred tax impact of all purchase accounting adjustments recorded in 2004, excluding the deferred tax impact previously mentioned related to the broker draw asset. Total liabilities and partners capital $ 1,192,581 Revenue $ 462,004 $ 1,327,570 Operating income (loss) $ 1,968 $ (25,238 ) Net loss $ (15,115 ) $ (52,326 ) Basic and diluted loss per share $ (0.24 ) $ (0.84 ) The accompanying consolidated financial statements have been prepared in accordance with the rules applicable to Form 10-Q and include all information and footnotes required for interim financial statement presentation. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Unaudited) to make estimates and assumptions that affect reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting periods. Actual results could differ materially from those estimates. All significant inter-company transactions and balances have been eliminated, and certain reclassifications have been made to prior periods consolidated financial statements to conform with the current period presentation. The results of operations for the three and nine months ended September 30, 2004 are not necessarily indicative of the results of operations to be expected for the year ending December 31, 2004. The consolidated financial statements and notes to consolidated financial statements should be read in conjunction with our 2003 Annual Report on Form 10-K/A, which contains the latest available audited consolidated financial statements and notes thereto, which are as of and for the year ended December 31, 2003. On May 4, 2004, we amended our Certificate of Incorporation increasing the authorized shares of Class A common stock to 325,000,000 and the authorized shares of Class B common stock to 100,000,000. Also, on May 4, 2004, we effected a three-for-one split of our outstanding Class A common stock and Class B common stock, which split was effected by a stock dividend. In addition, on June 7, 2004, we effected a 1-for-1.0825 reverse stock split of our outstanding Class A common stock and Class B common stock. The applicable share and per share data for all periods included herein have been restated to give effect to these stock splits. In connection with the completion of the IPO, all outstanding shares of Class B common stock were converted into an equal number of shares of Class A common stock. On June 16, 2004, we amended our Certificate of Incorporation to eliminate the authorized shares of Class B common stock. 5. Stock-Based Compensation Prior to the fourth quarter of 2003, we accounted for our employee stock-based compensation plans under the recognition and measurement provisions of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees and related Financial Accounting Standards Board (FASB) interpretations. Accordingly, compensation cost for employee stock options was measured as the excess, if any, of the estimated market price of our Class A common stock at the date of grant over the amount an employee was required to pay to acquire the stock. During the fourth quarter of 2003, we adopted the fair value recognition provisions of Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation prospectively to all employee awards granted, modified or settled after January 1, 2003, as permitted by SFAS No. 148, Accounting for Stock-Based Compensation Transition and Disclosure An Amendment of FASB Statement No. 123. Risk-free interest rate 3.20 % 2.74 % 3.20 % 3.03 % Expected volatility 40.00 % 0.00 % 30.00 % 0.00 % Expected life 4 years 5 years 4 years 5 years Option valuation models require the input of subjective assumptions including the expected stock price volatility. Because our employee stock options have characteristics significantly different from those of traded options and because changes in the subjective input assumptions can materially affect the fair value estimate, we do not believe that the Black-Scholes model necessarily provides a reliable single measure of the fair value of our employee stock options. Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Unaudited) 6. Fair Value of Financial Instruments SFAS No. 107, Disclosures about Fair Value of Financial Instruments, requires disclosure of fair value information about financial instruments, whether or not recognized in the accompanying consolidated balance sheets. Value is defined as the amount at which an instrument could be exchanged in a current transaction between willing parties other than in a forced or liquidation sale. The fair value estimates of financial instruments are not necessarily indicative of the amounts we might pay or receive in actual market transactions. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts. Cash and Cash Equivalents and Restricted Cash: This balance includes cash and cash equivalents with maturities of less than three months. The carrying amount approximates fair value due to the short-term maturities of these instruments. Receivables: Due to their short-term nature, fair value approximates carrying value. Warehouse Receivable: Due to their short-term nature, fair value approximates carrying value. Fair value is determined based on the terms and conditions of the funded mortgage loans and generally reflects the value of the Residential Funding Corporation (RFC) warehouse line of credit outstanding (see Note 11). Short-Term Borrowings: The majority of this balance represents the warehouse line of credit. Due to their short-term maturities and variable interest rates, fair value approximates carrying value (See Note 11). 11 1/4% Senior Subordinated Notes: Based on dealers quotes, the estimated fair value of the 11 1/4% senior subordinated notes is $238.5 million and $256.5 million at September 30, 2004 and December 31, 2003, respectively. Their actual carrying value totaled $205.0 million and $226.2 million at September 30, 2004 and December 31, 2003, respectively (See Note 11). 9 3/4% Senior Notes: Based on dealers quotes, the estimated fair value of the 9 3/4% senior notes is $148.2 million and $222.0 million at September 30, 2004 and December 31, 2003, respectively. Their actual carrying value totaled $130.0 million and $200.0 million at September 30, 2004 and December 31, 2003, respectively. (See Note 11). Senior Secured Terms Loans & Other Long-Term Debt: Estimated fair values approximate respective carrying values because a substantial majority of these instruments are based on variable interest rates (see Note 11). 7. Restricted Cash Included in the accompanying consolidated balance sheets as of September 30, 2004 and December 31, 2003, is restricted cash of $10.6 million and $14.9 million, respectively, which primarily consists of cash pledged to secure the guarantee of certain short-term notes issued in connection with previous acquisitions by Insignia in the United Kingdom (U.K.). The acquisitions include the 1999 acquisition of St. Quintin Holdings Limited and the 1998 acquisition of Richard Ellis Group Limited. Table of Contents INSIGNIA FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 10. Other Assets At December 31, 2002, other assets consisted of the following (in thousands): Loan costs, net $ 2,412 Amount receivable in connection with disposition 2,693 Federal tax refund receivable (domestic) 3,966 Prepaid taxes 5,246 Other prepaid expenses 12,088 Real estate sales proceeds 7,865 Other 5,687 In accordance with SFAS No. 141, Business Combinations, trademarks of $63.7 million were separately identified as a result of the 2001 Merger. As a result of the Insignia Acquisition, a $19.8 million trade name was separately identified, which represents the Richard Ellis trade name in the U.K. that is owned by Insignia. Both the trademarks and the trade name have indefinite useful lives and accordingly are not being amortized. Backlog represents the fair value of Insignia s net revenue backlog as of July 23, 2003, which was acquired as part of the Insignia Acquisition. The backlog consists of the net commissions receivable on Insignia s revenue producing transactions, which were at various stages of completion prior to the Insignia Acquisition. This intangible asset is being amortized as cash is received or upon final closing of these pending transactions. Management contracts are primarily comprised of property management contracts in the United States (U.S.), the U.K., France and other European operations, as well as valuation services and fund management contracts in the U.K. These management contracts are being amortized over estimated useful lives of up to ten years. Loan servicing rights represent the fair value of servicing assets in our mortgage banking line of business in the U.S., the majority of which were acquired as part of the 2001 Merger. The loan servicing rights are being amortized over estimated useful lives of up to ten years. Net revenue $ 168,126 $ 116,516 $ 404,460 $ 319,328 Operating income $ 37,601 $ 31,296 $ 93,136 $ 87,046 Net income $ 51,039 $ 31,135 $ 125,138 $ 78,922 Our investment management business involves investing our own capital in certain real estate investments with clients. We have provided investment management, property management, brokerage and other professional services to these equity investees on an arm s length basis and earned revenues from these unconsolidated subsidiaries of $4.8 million and $6.8 million for the three months ended September 30, 2004 and 2003, respectively, and $16.8 million and $17.3 million for the nine months ended September 30, 2004 and 2003, respectively. 10. Employee Benefit Plans On September 22, 2004, pursuant to our 2004 Stock Incentive Plan, certain employees were granted 1,245,000 options to acquire Class A common stock at an exercise price of $22.39 per share. These options vest and are exercisable in 25% increments over a four-year period and expire on September 22, 2009. $ 39,957 Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Unaudited) 11. Debt Since 2001, we have maintained a credit agreement with Credit Suisse First Boston (CSFB) and other lenders to fund strategic acquisitions and to provide for our working capital needs. On April 23, 2004, we entered into an amendment to our previously amended and restated credit agreement that included a waiver generally permitting us to prepay, redeem, repurchase or otherwise retire up to $30.0 million of our existing indebtedness and provided for the refinancing of all outstanding amounts under our previous credit agreement as well as the amendment and restatement of our credit agreement upon the completion of our initial public offering. On June 15, 2004, in connection with the completion of our IPO, we completed the refinancing of all amounts outstanding under our amended and restated credit agreement and entered into a new amended and restated credit agreement (the Credit Agreement), which became effective in connection with such refinancing. Our Credit Agreement permitted us, among other things, to use the net proceeds received from our IPO to pay down debt, including the redemptions in July 2004 of all $38.3 million in aggregate principal amount of our 16% senior notes due 2011 and $70.0 million in aggregate principal amount of our 9 3/4% senior notes due 2010, and the prepayment of $15.0 million in principal amount of our term loan under our Credit Agreement, which prepayment occurred on June 15, 2004. Our Credit Agreement includes the following: (1) a term loan facility of $295.0 million (of which $280.0 million was outstanding as of September 30, 2004), requiring quarterly principal payments of $2.95 million beginning December 31, 2004 through December 31, 2009 with the balance payable on March 31, 2010; and (2) a $150.0 million revolving credit facility, including revolving credit loans, letters of credit and a swingline loan facility, all maturing on March 31, 2009. Our Credit Agreement also permits us to make additional borrowings under the term loan facility of up to $25.0 million, subject to the satisfaction of customary conditions. Borrowings under the term loan facility bear interest at varying rates based, at our option, on either LIBOR plus 2.25% to 2.50% or the alternate base rate plus 1.25% to 1.50%, in both cases as determined by reference to the credit rating assigned to the term facility by Moody s Investors Service and Standard & Poor s. The alternate base rate is the higher of (1) CSFB s prime rate or (2) the Federal Funds Effective Rate plus one-half of one percent. The potential increase of up to $25.0 million for the term loan facility would bear interest either at the same rate as the current rate for the term loan facility or, in some circumstances as described in the Credit Agreement, at a higher or lower rate. During June 2004, we used a portion of the net proceeds we received from the IPO to prepay $15.0 million in principal amount of our term loan facility. The total amount outstanding under the term loan facility included in the senior secured term loan and current maturities of long-term debt in the accompanying consolidated balance sheets was $280.0 million and $297.5 million as of September 30, 2004 and December 31, 2003, respectively. Borrowings under the revolving credit facility bear interest at varying rates based at our option, on either the applicable LIBOR plus 2.00% to 2.50% or the alternate base rate plus 1.00% to 1.50%, in both cases as determined by reference to our ratio of total debt less available cash to EBITDA (as defined in the Credit Agreement). As of September 30, 2004 and December 31, 2003 we had no revolving credit facility principal outstanding. As of September 30, 2004, letters of credit totaling $24.3 million were outstanding, which letters of credit primarily relate to our subsidiaries outstanding indebtedness and operating leases and reduce the amount we may borrow under the revolving credit facility. Borrowings under the Credit Agreement are jointly and severally guaranteed by us and substantially all of our domestic subsidiaries and are secured by a pledge of substantially all of our assets. Additionally, the Credit Agreement requires us to pay a fee based on the total amount of the unused revolving credit facility commitment. Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Unaudited) In May 2003, in connection with the Insignia Acquisition, CBRE Escrow, Inc. (CBRE Escrow), a wholly owned subsidiary of CBRE, issued $200.0 million in aggregate principal amount of 9 3/4% senior notes, which are due May 15, 2010. CBRE Escrow merged with and into CBRE, and CBRE assumed all obligations with respect to the 9 3/4% senior notes in connection with the Insignia Acquisition. The 9 3/4% senior notes are unsecured obligations of CBRE, senior to all of its current and future unsecured indebtedness, but subordinated to all of CBRE s current and future secured indebtedness. The 9 3/4% senior notes are jointly and severally guaranteed on a senior basis by us and substantially all of our domestic subsidiaries. Interest accrues at a rate of 9 3/4% per year and is payable semi-annually in arrears on May 15 and November 15. The 9 3/4% senior notes are redeemable at our option, in whole or in part, on or after May 15, 2007 at 104.875% of par on that date and at declining prices thereafter. In addition, before May 15, 2006, we were permitted to redeem up to 35.0% of the originally issued amount of the 9 3/4% senior notes at 109 3/4% of par, plus accrued and unpaid interest, solely with the net cash proceeds from public equity offerings, which we elected to do. During July 2004, we used a portion of the net proceeds we received from our IPO to redeem $70.0 million in aggregate principal amount, or 35%, of our 9 3/4% senior notes, which also required the payment of a $6.8 million premium and accrued and unpaid interest through the date of redemption. Additionally, we wrote off $3.1 million of unamortized deferred financing costs in connection with this redemption. In the event of a change of control (as defined in the indenture governing our 9 3/4% senior notes), we are obligated to make an offer to purchase the 9 3/4% senior notes at a redemption price of 101.0% of the principal amount, plus accrued and unpaid interest. The amount of the 9 3/4% senior notes included in the accompanying consolidated balance sheets was $130.0 million and $200.0 million as of September 30, 2004 and December 31, 2003, respectively. In June 2001, in connection with the 2001 Merger, Blum CB issued $229.0 million in aggregate principal amount of 11 1/4% senior subordinated notes due June 15, 2011 for approximately $225.6 million, net of discount. CBRE assumed all obligations with respect to the 11 1/4% senior subordinated notes in connection with the 2001 Merger. The 11 1/4% senior subordinated notes are unsecured senior subordinated obligations of CBRE and rank equally in right of payment with any of CBRE s existing and future unsecured senior subordinated indebtedness but are subordinated to any of CBRE s existing and future senior indebtedness. The 11 1/4% senior subordinated notes are jointly and severally guaranteed on a senior subordinated basis by us and substantially all of our domestic subsidiaries. The 11 1/4% senior subordinated notes require semi-annual payments of interest in arrears on June 15 and December 15 and are redeemable in whole or in part on or after June 15, 2006 at 105.625% of par on that date and at declining prices thereafter. In addition, before June 15, 2004, we were permitted to redeem up to 35.0% of the originally issued amount of the notes at 111 1/4% of par, plus accrued and unpaid interest, solely with the net cash proceeds from public equity offerings, which we did not do. In the event of a change of control (as defined in the indenture governing our 11 1/4% senior subordinated notes), we are obligated to make an offer to purchase the 11 1/4% senior subordinated notes at a redemption price of 101.0% of the principal amount, plus accrued and unpaid interest. In May and June 2004, we repurchased $21.6 million in aggregate principal amount of our 11 1/4% senior subordinated notes in the open market. We paid an aggregate of $3.1 million of premiums and wrote off $0.9 million of unamortized deferred financing costs and unamortized discount in connection with these open market purchases. The amount of the 11 1/4% senior subordinated notes included in the accompanying consolidated balance sheets, net of unamortized discount, was $205.0 million and $226.2 million as of September 30, 2004 and December 31, 2003, respectively. Also, to partially fund the acquisition of CBRE in 2001, we issued $65.0 million in aggregate principal amount of 16% senior notes due July 20, 2011. The 16% senior notes were unsecured obligations, senior to all of our current and future unsecured indebtedness but subordinated to all of our current and future secured indebtedness. Interest accrued at a rate of 16.0% per year and was payable quarterly in arrears. Under the terms of the indenture governing the 16% senior notes and subject to the restrictions set forth in the Credit Agreement, the notes were redeemable at our option, in whole or in part, at 116.0% of par commencing on July 20, 2001 and Real estate sales proceeds of $7.9 million represents sale proceeds from a minority owned real estate property received in December 2002 and payable to a third party investor in 2003. The corresponding payable is included in the Company s accrued and sundry liabilities at December 31, 2002. 11. Accrued and Sundry Liabilities At December 31, 2002, accrued and sundry liabilities consisted of the following (in thousands): Employee compensation and benefits $ 13,791 Acquisition related lease and annuity liabilities 6,379 Amounts payable in connection with acquisitions 6,450 Deferred compensation 21,192 Deferred revenue 13,948 Current taxes payable 7,175 Value added taxes 6,312 Minimum pension liability 14,571 Real estate sales proceeds payable 7,865 Liabilities of consolidated real estate entities 3,136 Other 17,171 Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Unaudited) at declining prices thereafter. During July 2004, we used a portion of the net proceeds we received from our IPO to redeem the remaining $38.3 million in aggregate principal amount of our 16% senior notes, which also required the payment of a $2.5 million premium and accrued and unpaid interest through the date of redemption. Additionally, we wrote off $4.8 million of unamortized deferred financing costs and unamortized discount in connection with this redemption. The amount of the 16% senior notes included in the accompanying consolidated balance sheet, net of unamortized discount was $35.5 million as of December 31, 2003. Our Credit Agreement and the indentures governing our 9 3/4% senior notes and our 11 1/4% senior subordinated notes each contain numerous restrictive covenants that, among other things, limit our ability to incur additional indebtedness, pay dividends or make distributions to stockholders, repurchase capital stock or debt, make investments, sell assets or subsidiary stock, engage in transactions with affiliates, enter into sale/leaseback transactions, issue subsidiary equity and enter into consolidations or mergers. Our Credit Agreement also currently requires us to maintain a minimum coverage ratio of interest and certain fixed charges and a maximum leverage and senior secured leverage ratio of EBITDA (as defined in the Credit Agreement) to funded debt. A joint venture that we have consolidated since 2001 incurred non-recourse debt to acquire a real estate investment in Japan in 2001. This debt was secured by a mortgage on the acquired real estate asset. During August 2004, the joint venture completed the sale of this real estate asset and utilized the proceeds from the sale to repay all of the related non-recourse debt, plus accrued interest and other fees. In our accompanying consolidated balance sheet, this debt comprised $2.0 million of our other short-term borrowings and $41.8 million of our other long-term debt as of December 31, 2003. We had short-term borrowings of $138.2 million and $270.1 million with weighted average interest rates of 3.4% and 2.7% as of September 30, 2004 and December 31, 2003, respectively. Our wholly owned subsidiary, L.J. Melody & Company (L.J. Melody), has a credit agreement with RFC for the purpose of funding mortgage loans that will be resold. On August 19, 2004, we entered into a Third Amendment to the Fourth Amended and Restated Warehousing Credit and Security Agreement (warehouse line of credit). The current agreement provides for a warehouse line of credit of up to $250.0 million, bears interest at one-month LIBOR plus 1.0% and expires on December 1, 2004. During the quarter ended September 30, 2004, we had a maximum of $244.6 million warehouse line of credit principal outstanding with RFC. As of September 30, 2004 and December 31, 2003, we had a $111.8 million and a $230.8 million warehouse line of credit outstanding, respectively, which are included in short-term borrowings in the accompanying consolidated balance sheets. Additionally, we had $111.8 million and $230.8 million of mortgage loans held for sale (warehouse receivable), which represented mortgage loans funded through the line of credit that, while committed to be purchased, had not yet been purchased, as of September 30, 2004 and December 31, 2003, respectively, which are also included in the accompanying consolidated balance sheets. In connection with our acquisition of Westmark Realty Advisors in 1995, we issued approximately $20.0 million in aggregate principal amount of senior notes. The Westmark senior notes are secured by letters of credit equal to approximately 50% of the outstanding balance at December 31, 2003. The Westmark senior notes are redeemable at the discretion of the note holders and have final maturity dates of June 30, 2008 and June 30, 2010. During the year ended December 31, 2002, all of the Westmark senior notes bore interest at 9.0%. On January 1, 2003, the interest rate on some of these notes was converted to varying rates equal to the interest rate in effect with respect to amounts outstanding under our Credit Agreement. On January 1, 2005, the interest rate on all of the other Westmark senior notes will be adjusted to equal the interest rate then in effect with respect to amounts outstanding under our Credit Agreement. The amount of the Westmark senior notes included in short-term borrowings in the accompanying consolidated balance sheets was $12.1 million as of September 30, 2004 and December 31, 2003. Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Unaudited) Insignia, which we acquired in July 2003, issued loan notes as partial consideration for previous acquisitions of businesses in the U.K. The acquisition loan notes are payable to the sellers of the previously acquired U.K. businesses and are secured by restricted cash deposits in approximately the same amount. The acquisition loan notes are redeemable semi-annually at the discretion of the note holder and have a final maturity date of April 2010. As of September 30, 2004 and December 31, 2003, $9.7 million and $12.2 million, respectively, of the acquisition loan notes were outstanding and are included in short-term borrowings in the accompanying consolidated balance sheets. A significant number of our subsidiaries in Europe have had a Euro cash pool loan since 2001, which is used to fund their short-term liquidity needs. The Euro cash pool loan is an overdraft line for our European operations issued by HSBC Bank. The Euro cash pool loan has no stated maturity date and bears interest at varying rates based on a base rate as defined by HSBC Bank plus 2.5%. The amount of the Euro cash pool loan included in short-term borrowings in the accompanying consolidated balance sheets was $3.5 million and $11.5 million as of September 30, 2004 and December 31, 2003, respectively. 12. Commitments and Contingencies We are a party to a number of pending or threatened lawsuits arising out of, or incident to, our ordinary course of business. Our management believes that any liability imposed upon us that may result from disposition of these lawsuits will not have a material effect on our consolidated financial position or results of operations. In connection with the sale of real estate investment assets by Insignia to Island Fund I LLC (Island) on July 23, 2003, Insignia agreed to maintain letter of credit support for real estate investment assets that were subject to the purchase agreement until the earlier of (1) the third anniversary of the completion of the sale, (2) the date on which the letter of credit is no longer required pursuant to the applicable real estate investment asset agreement or (3) the completion of a sale of the relevant underlying real estate investment asset. As of September 30, 2004, an aggregate of approximately $5.2 million of this letter of credit support remained outstanding under the purchase agreement. Also in connection with the sale, Insignia agreed to maintain a $1.3 million guarantee of a repayment obligation with respect to one of the real estate investment assets. Island agreed to reimburse us for 50% of any draws against these letters of credit or the repayment guarantee while they are outstanding and delivered a letter of credit to us in the amount of approximately $2.9 million as security for Island s reimbursement obligation. As a result of this reimbursement obligation, we effectively retain potential liability for 50% of any future draws against these letters of credit and the repayment guarantee. However, there can be no assurance that Island will be able to reimburse us in the event of any draws against the letters of credit or the repayment guarantee or that Island s future reimbursement obligations will not exceed the amount of the letter of credit provided to us by Island. L.J. Melody previously executed an agreement with the Federal National Mortgage Association (Fannie Mae) to initially fund the purchase of a commercial mortgage loan portfolio using proceeds from its RFC line of credit. Subsequently, a 100% participation in the loan portfolio was sold to Fannie Mae and L.J. Melody retains the credit risk on the first 2% of losses incurred on the underlying portfolio of commercial mortgage loans. The current loan portfolio balance is $85.8 million and we have collateralized a portion of our obligations to cover the first 1% of losses through a letter of credit in favor of Fannie Mae for a total of approximately $0.9 million. The other 1% is covered in the form of a guarantee to Fannie Mae by L.J. Melody. We had letters of credit totaling $6.1 million as of September 30, 2004, excluding letters of credit related to our subsidiaries outstanding indebtedness and operating leases. Approximately $5.2 million of these letters of credit were issued pursuant to the terms of the purchase agreement with Island described above. The remaining $ 117,990 Options to purchase 1,245,000 shares of Class A common stock granted during the three months ended September 30, 2004, however, were not included in the computation of diluted EPS for the three months ended September 30, 2004 as the options exercise price was greater than the average market price of the Class A common shares during the period. As a result of operating losses incurred for the three months ended September 30, 2003 and the nine months ended September 30, 2004 and 2003, dilutive weighted average shares outstanding did not give effect to potential common shares, as to do so would have been anti-dilutive. 15. Fiduciary Funds The accompanying consolidated balance sheets do not include the net assets of escrow, agency and fiduciary funds, which amounted to $661.7 million and $626.3 million at September 30, 2004 and December 31, 2003, respectively. Table of Contents INSIGNIA FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) million in newly issued shares of Series B convertible preferred stock and a commitment to provide $37.5 million of subordinated debt. The preferred stock carries an 8.5% annual dividend, payable quarterly at Insignia s option in cash or in kind, and is convertible into Insignia common stock at a price of $15.40 per share, subject to adjustment. The preferred stock has a perpetual term, although Insignia may call the preferred stock, at stated value, after June 7, 2005. In February 2000, Blackacre purchased $25.0 million of convertible preferred stock, which has now been exchanged for a Series A convertible preferred stock with an 8.5% annual dividend and a conversion price of $14.00 per share. The Blackacre credit facility, which is subordinate to Insignia s senior credit facility, bears interest at an annual rate of 11.25% to 12.25%, payable quarterly, depending on the amount borrowed. In July 2002, Insignia borrowed $15.0 million under the credit facility. The proceeds were used to finance the purchase of the development property and related leasehold rights in St. Thomas, United States Virgin Islands (discussed under Real Estate Principal Investment Activities above). Insignia may draw down the remaining $22.5 million of availability at any time until December 2003. Any further borrowings will bear interest at 12.25%. The subordinated debt has a final maturity of June 2009. 13. Long-Term Debt Total long-term debt consists of notes payable of the Company and real estate mortgage notes of consolidated real estate entities. Notes Payable At December 31, 2002, notes payable consisted of the following (in thousands): Senior revolving credit facility with interest due quarterly at LIBOR plus 2.0 to 2.5% (totaling approximately 4.3%). Final payment due date is May 8, 2004 $ 95,000 Senior subordinated credit facility with interest due quarterly at 11.25% and a final maturity of June 2009 15,000 Acquisition loan notes with an interest rate of approximately 3.0% and a final maturity of April 2010 16,889 Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Unaudited) 18. Guarantor and Nonguarantor Financial Statements The 9 3/4% senior notes are jointly and severally guaranteed on a senior basis by us and substantially all of our domestic subsidiaries. In addition, the 11 1/4% senior subordinated notes are jointly and severally guaranteed on a senior subordinated basis by us and substantially all of our domestic subsidiaries. (See Note 11 to the consolidated financial statements for additional information on the 9 3/4% senior notes and the 11 1/4% senior subordinated notes). The following condensed consolidating financial information includes: (1) Condensed consolidating balance sheets as of September 30, 2004 and December 31, 2003; condensed consolidating statements of operations for the three and nine months ended September 30, 2004 and 2003; and condensed consolidating statements of cash flows for the nine months ended September 30, 2004 and 2003, of (a) CB Richard Ellis Group as the parent, (b) CBRE as the subsidiary issuer, (c) the guarantor subsidiaries, (d) the nonguarantor subsidiaries and (e) CB Richard Ellis Group on a consolidated basis; and (2) Elimination entries necessary to consolidate CB Richard Ellis Group as the parent, with CBRE and its guarantor and nonguarantor subsidiaries. Investments in consolidated subsidiaries are presented using the equity method of accounting. The principal elimination entries eliminate investments in consolidated subsidiaries and inter-company balances and transactions. The purchase accounting adjustments associated with the Insignia Acquisition have been recorded in the accompanying consolidated financial statements. The condensed consolidated balance sheet as of September 30, 2004 reflects the allocation of goodwill based upon the final valuation of the net assets acquired, which valuation was completed during the third quarter of 2004. As a result, the condensed consolidated balance sheet as of December 31, 2003, reflects the allocation of goodwill based upon the estimated fair value of Insignia s acquired reporting units as of that date (See Note 3 to the consolidated financial statements for additional information). (a) Although L.J. Melody is included among our domestic subsidiaries, which jointly and severally guarantee our 9 3/4% senior notes and 11 1/4% senior subordinated notes, all warehouse receivables funded under the RFC line of credit are pledged to RFC, and accordingly are not included as collateral for these notes or our other outstanding debt. $ 126,889 (a) Although L.J. Melody is included among our domestic subsidiaries, which jointly and severally guarantee our 9 3/4% senior notes and 11 1/4% senior subordinated notes, all warehouse receivables funded under the RFC line of credit are pledged to RFC, and accordingly are not included as collateral for these notes or our other outstanding debt. Table of Contents INSIGNIA FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) The senior credit facility provides for foreign denominated borrowings up to an aggregate $75 million. No foreign denominated borrowings were outstanding at December 31, 2002. The senior facility is collateralized by a pledge of the stock of domestic subsidiaries and material foreign subsidiaries. The Company also maintains a 5 million line of credit in the UK for short term working capital purposes in Europe. The Company has not borrowed on this line of credit during the past two years. The U.K. acquisition loan notes outstanding at December 31, 2002 are guaranteed by a bank, as required by the terms of the respective purchase agreements. The bank holds restricted cash deposits sufficient to repay the notes in full when due. These loan notes are redeemable semi-annually at the discretion of the note holder. In March 2003, the Company repaid $67.0 million on the senior credit facility as a result of the sale of its residential businesses Insignia Douglas Elliman and Insignia Residential Group. In conjunction with the pay-down, the commitment under the senior credit facility was reduced from $230.0 million to $165.0 million. The Company s credit agreements and other debt agreements contain various restrictive covenants requiring, among other things, minimum consolidated net worth and certain other financial ratios. The Company s revolving credit facility restricts the payment of cash dividends to an amount not to exceed twenty-five percent of net income for the immediately preceding fiscal quarter. At December 31, 2002, Insignia had approximately $80.0 million of availability on its credit facilities under these covenants. At December 31, 2002, the Company was in compliance with all covenants. Real Estate Mortgage Notes At December 31, 2002, real estate mortgage notes represented non-recourse loans collateralized by real estate properties and consisted of the following (in thousands): Brookhaven Village, mortgage loan bearing interest at 6.24% with a final maturity in December 2004 $ 8,305 U.S. Virgin Islands development loan bearing interest at LIBOR plus 5.0% with a floor of 8.0% (8% at December 31, 2002). The note matures in August 2005 20,000 West Village, FHA loan bearing interest at 7.25%. The loan matures in October 2013 7,064 West Village, HPD note bearing interest at 8.5% and maturing in October 2023 (loan amount plus unpaid accrued interest) 29,897 West Village, non-interest bearing residual receipt note maturing in October 2023 1,529 $ 66,795 20. New Accounting and Tax Pronouncements On March 31, 2004, the FASB issued its Exposure Draft, Share-Based Payment , which is a proposed amendment to SFAS No. 123, Accounting for Stock-Based Compensation. The amendment would require all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values, which would include all unvested grants at the time of adoption. The FASB expects to issue a final standard late in 2004. On October 13, 2004, the FASB decided that the final amendment would be effective for public companies for any interim or annual period beginning after June 15, 2005, although early adoption would be encouraged. The adoption of this exposure draft is not expected to have a material impact on our financial position or results of operations. In October 2004, the American Jobs Creation Act of 2004 was passed. We are currently assessing the impact of this law on our operations, particularly relative to provisions on repatriation of foreign earnings as well as deferred compensation. We do not expect this act to have a material impact on our financial position or results of operations. Table of Contents REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Stockholders of CB Richard Ellis Group, Inc.: We have audited the accompanying consolidated balance sheets of CB Richard Ellis Group, Inc., a Delaware corporation, and subsidiaries (the Company ) as of December 31, 2003 and 2002 and the related consolidated statements of operations, cash flows, stockholders equity and comprehensive (loss) income for each of the two years in the period ended December 31, 2003. Our audits also included the 2003 and 2002 financial statement schedules listed in the Index to Consolidated Financial Statements. These financial statements and the financial statement schedules are the responsibility of the Company s management. Our responsibility is to express an opinion on the 2003 and 2002 financial statements and the financial statement schedules based on our audits. The consolidated financial statements and the financial statement schedule of the Company for the period from February 20 (inception) to December 31, 2001 and the consolidated financial statements and financial statement schedule of CB Richard Ellis Services, Inc. (the Predecessor ) for the period from January 1 to July 20, 2001 were audited by other auditors who have ceased operations. Those auditors expressed an unqualified opinion on those financial statements and stated that such 2001 financial statement schedules, when considered in relation to the 2001 basic financial statements taken as a whole, presented fairly, in all material respects, the information set forth therein, in their report dated February 26, 2002. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such 2003 and 2002 consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2003 and 2002 and the results of its operations and its cash flows for each of the two years in the period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the 2003 and 2002 financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note 8 to the Consolidated Financial Statements, the Company changed its method of accounting for goodwill and other intangible assets in 2002 to conform to Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets ( SFAS 142 ). As discussed above, the consolidated financial statements of the Company for the period from February 20 (inception) to December 31, 2001 and the consolidated financial statements of the Predecessor for the period from January 1 to July 20, 2001 were audited by other auditors who have ceased operations. As described in Note 8, these consolidated financial statements have been revised to include the transitional disclosures required by SFAS 142, which was adopted by the Company as of January 1, 2002. Our audit procedures with respect to the disclosures in Note 8 with respect to 2001 included (i) comparing the previously reported net income (loss) to the previously issued consolidated financial statements and the adjustments to reported net income (loss) representing amortization expense (including any related tax effects) recognized in those periods relating to goodwill that is no longer being amortized as a result of initially applying SFAS 142 to the Company s and the Predecessor s underlying analysis obtained from management, and (ii) testing the mathematical accuracy of the reconciliation of adjusted net income (loss) to reported net income (loss), and the related earnings (loss)-per-share amounts. In our opinion, the disclosures for 2001 in Note 8 are appropriate. However, we were not engaged to audit, review, or apply any procedures to the 2001 consolidated financial statements of the Company and the Predecessor other than with respect to such disclosures, and accordingly, we do not express an opinion or any other form of assurance on the 2001 consolidated financial statements taken as a whole. Table of Contents As discussed above, the consolidated financial statements of the Company for the period from February 20 (inception) to December 31, 2001 were audited by other auditors who have ceased operations. As described in Note 23, those consolidated financial statements have been revised to give effect to the stock split on May 4, 2004 and the reverse stock split on June 7, 2004 discussed in Note 23. We audited the adjustments described in Note 23 that were applied to revise the Company s 2001 consolidated financial statements for such stock split and reverse stock split. Our audit procedures included (1) comparing the amounts shown in the earnings per share disclosures for 2001 to the Company s underlying accounting analysis obtained from management, (2) comparing the previously reported shares outstanding and income statement amounts per the Company s accounting analysis to the previously issued consolidated financial statements, and (3) recalculating the additional shares to give effect to the stock split and reverse stock split and testing the mathematical accuracy of the underlying analysis. In our opinion, such adjustments have been properly applied. However, we were not engaged to audit, review, or apply any procedures to the 2001 consolidated financial statements of the Company other than with respect to such stock split and reverse stock split adjustments and, accordingly, we do not express an opinion or any form of assurance on the Company s 2001 consolidated financial statements taken as a whole. DELOITTE & TOUCHE LLP Los Angeles, California March 30, 2004 (June 7, 2004 as to the effects of the stock split and reverse stock split described in Note 23) Table of Contents INSIGNIA FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Scheduled principal maturities on all long-term debt payable after December 31, 2002 are as follows: Notes Payable Table of Contents REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Stockholders and Board of Directors of CBRE Holding, Inc.: We have audited the accompanying consolidated balance sheet of CBRE Holding, Inc., a Delaware corporation, (the Company) as of December 31, 2001 and related consolidated statements of operations, cash flows, stockholders equity and comprehensive income for the period from February 20, 2001 (inception) through December 31, 2001. We have also audited the accompanying consolidated balance sheet of CB Richard Ellis Services, Inc. (Predecessor) as of December 31, 2000, and the related consolidated statements of operations, cash flows, stockholders equity and comprehensive (loss) income for the period from January 1, 2001 to July 20, 2001, and the twelve months ended December 31, 2000 and 1999. These financial statements and the schedule referred to below are the responsibility of the Company s and the Predecessor s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of CBRE Holding, Inc. as of December 31, 2001 and the results of their operations and their cash flows for the period from February 20, 2001 (inception) through December 31, 2001 and the financial position of CB Richard Ellis Services, Inc. (the Predecessor) as of December, 31 2000 and the results of their operations and their cash flows for the period from January 1, 2001 to July 20, 2001, and the twelve months ended December 31, 2000 and 1999, in conformity with accounting principles generally accepted in the United States. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedule listed in the index to consolidated financial statements is presented for purposes of complying with the Securities and Exchange Commission s rules and is not a required part of the basic financial statements. This schedule has been subjected to the auditing procedures applied in our audits of the basic financial statements and, in our opinion, is fairly stated in all material respects in relation to the basic financial statements taken as a whole. ARTHUR ANDERSEN LLP Los Angeles, California February 26, 2002 NOTE: The report of Arthur Andersen LLP presented above is a copy of a previously issued Arthur Andersen LLP report. This report has not been reissued by Arthur Andersen LLP nor has Arthur Andersen LLP provided a consent to the inclusion of its report in this Form 10-K. NOTE: The consolidated financial statements for the period from February 20 (inception) to December 31, 2001 and for the period from January 1 to July 20, 2001 have been revised to include the transitional disclosures required by Statement of Financial Accounting Standards No. 142. Goodwill and Other Intangible Assets (see Note 8) and the stock splits (see Note 23). The report of Arthur Andersen LLP presented above does not extend to these revisions. NOTE: On February 13, 2004, CBRE Holding, Inc. changed its name to CB Richard Ellis Group, Inc. Real Estate Mortgage Notes The accompanying notes are an integral part of these consolidated financial statements. Total The accompanying notes are an integral part of these consolidated financial statements. The accompanying notes are an integral part of these consolidated financial statements. The accompanying notes are an integral part of these consolidated financial statements. The accompanying notes are an integral part of these consolidated financial statements. Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Nature of Operations CB Richard Ellis Group, Inc. (formerly known as CBRE Holding, Inc.), a Delaware corporation, was incorporated on February 20, 2001 and was created to acquire all of the outstanding shares of CB Richard Ellis Services, Inc. (CBRE), an international commercial real estate services firm. Prior to July 20, 2001, we were a wholly owned subsidiary of Blum Strategic Partners, L.P. (Blum Strategic), formerly known as RCBA Strategic Partners, L.P., which is an affiliate of Richard C. Blum, a director of CBRE and our company. On July 20, 2001, we acquired all of the outstanding stock of CBRE pursuant to an Amended and Restated Agreement and Plan of Merger, dated May 31, 2001, among CBRE, Blum CB Corp. (Blum CB) and us. Blum CB was merged with and into CBRE with CBRE being the surviving corporation (the 2001 Merger). In July 2003, our global position in the commercial real estate services industry was further solidified as CBRE acquired Insignia Financial Group, Inc. (Insignia Acquisition). We have no substantive operations other than our investment in CBRE. We offer a full range of services to occupiers, owners, lenders and investors in office, retail, industrial, multi-family and other commercial real estate assets globally under the CB Richard Ellis brand name. Our business is focused on several service competencies, including strategic advice and execution assistance for property leasing and sales, forecasting, valuations, origination and servicing of commercial mortgage loans, facilities and project management and real estate investment management. We generate revenues both on a per project or transaction basis and from annual management fees. 2. Significant Accounting Policies Principles of Consolidation The accompanying consolidated financial statements include our accounts and those of our majority-owned subsidiaries. Additionally, the consolidated financial statements for the period from January 1 to July 20, 2001 include the accounts of CBRE prior to the 2001 Merger as CBRE is considered our predecessor for purposes of Regulation S-X. The equity attributable to minority shareholders interests in subsidiaries is shown separately in the accompanying consolidated balance sheets. All significant intercompany accounts and transactions have been eliminated in consolidation. Our investments in unconsolidated subsidiaries in which we have the ability to exercise significant influence over operating and financial policies, but do not control, are accounted for under the equity method. Accordingly, our share of the earnings of these equity-method basis companies is included in consolidated net income. All other investments held on a long-term basis are valued at cost less any impairment in value. Use of Estimates Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America, which require management to make estimates and assumptions that affect the reported amounts in the financial statements. Actual results may differ from these estimates. Management believes that these estimates provide a reasonable basis for the fair presentation of our financial condition and results of operations. Cash and Cash Equivalents Cash and cash equivalents generally consist of cash and highly liquid investments with an original maturity of less than three months. We control certain cash and cash equivalents as an agent for our investment and property management clients. These amounts are not included in the accompanying consolidated balance sheets (See Note 17). Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Property and Equipment Property and equipment is stated at cost, net of accumulated depreciation, or in the case of capitalized leases, at the present value of the future minimum lease payments. Depreciation and amortization of property and equipment is computed primarily using the straight-line method over estimated useful lives ranging up to ten years. Leasehold improvements are amortized over the term of the respective leases, excluding options to renew. We capitalize expenditures that materially increase the life of the related assets and expense the costs of maintenance and repairs. We periodically review property and equipment for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. If any of the significant assumptions inherent in this assessment materially change due to market, economic, and/or other factors, the recoverability is assessed based on the revised assumptions. If this analysis indicates that such assets are considered to be impaired, the impairment is recognized in the period the changes occur and represents the amount by which the carrying value exceeds the fair value of the asset. Goodwill and Other Intangible Assets Goodwill mainly represents the excess of the purchase price paid by us over the fair value of the tangible and intangible assets and liabilities acquired in the 2001 Merger and in the Insignia Acquisition. Other intangible assets include trademarks, which were separately identified as a result of the 2001 Merger, as well as a trade name separately identified as a result of the Insignia Acquisition representing the Richard Ellis trade name in the United Kingdom (U.K.) that was owned by Insignia prior to the Insignia Acquisition. Both the trademarks and the trade name are not being amortized and have indefinite estimated useful lives. Other intangible assets also include backlog, which represents the fair value of Insignia s net revenue backlog as of July 23, 2003 that was acquired as part of the Insignia Acquisition. The backlog consists of the net commission receivable on Insignia s revenue producing transactions, which were at various stages of completion prior to the Insignia Acquisition. Backlog is being amortized as cash is received or upon final closing of these pending transactions. The remaining other intangible assets primarily include management contracts, loan servicing rights, franchise agreements and a trade name, which are all being amortized on a straight-line basis over estimated useful lives ranging up to 20 years. We fully adopted Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible Assets, effective January 1, 2002. This statement requires us to perform at least an annual assessment of impairment of goodwill and other intangible assets deemed to have indefinite useful lives based on assumptions and estimates of fair value and future cash flow information. We perform an annual assessment of our goodwill and other intangible assets deemed to have indefinite lives for impairment based in part on a third-party valuation as of the beginning of the fourth quarter of each year. We also assess our goodwill and other intangible assets deemed to have indefinite useful lives for impairment when events or circumstances indicate that our carrying value may not be recoverable from future cash flows. We completed our required annual impairment tests as of October 1, 2003 and 2002, and determined that no impairment existed as of those dates. Deferred Financing Costs Costs incurred in connection with financing activities are deferred and amortized using the straight-line method over the terms of the related debt agreements ranging up to ten years. Amortization of these costs is charged to interest expense in the accompanying consolidated statements of operations. In the third quarter of 2003, in connection with the Insignia Acquisition, we entered into an amended and restated credit facility and wrote off $6.8 million of unamortized deferred financing costs associated with our prior credit facility. In the Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) fourth quarter of 2003, we wrote off $1.8 million of unamortized deferred financing costs associated with the $20.0 million and $10.0 million redemptions of our 16% senior notes on October 27, 2003 and December 29, 2003, respectively. Total deferred costs, net of accumulated amortization, included in other assets in the accompanying consolidated balance sheets were $29.9 million and $20.5 million, as of December 31, 2003 and 2002, respectively. Revenue Recognition Real estate commissions on sales are recorded as income upon close of escrow or upon transfer of title. Real estate commissions on leases are generally recorded as income once we satisfy all obligations under the commission agreement. A typical commission agreement provides that we earn a portion of the lease commission upon the execution of the lease agreement by the tenant, while the remaining portion(s) of the lease commission is earned at a later date, usually upon tenant occupancy. The existence of any significant future contingencies will result in the delay of recognition of revenue until such contingencies are satisfied. For example, if we do not earn all or a portion of the lease commission until the tenant pays their first month s rent and the lease agreement provides the tenant with a free rent period, we delay revenue recognition until cash rent is paid by the tenant. Investment management and property management fees are recognized when earned under the provisions of the related agreements. Appraisal fees are recorded after services have been rendered. Loan origination fees are recognized at the time the loan closes and we have no significant remaining obligations for performance in connection with the transaction, while loan servicing fees are recorded to revenue as monthly principal and interest payments are collected from mortgagors. Other commissions, consulting fees and referral fees are recorded as income at the time the related services have been performed unless significant future contingencies exist. In establishing the appropriate provisions for trade receivables, we make assumptions with respect to their future collectibility. Our assumptions are based on an individual assessment of a customer s credit quality as well as subjective factors and trends, including the aging of receivables balances. In addition to these individual assessments, in general, outstanding trade accounts receivable amounts that are greater than 180 days are fully provided for. Business Promotion and Advertising Costs The costs of business promotion and advertising are expensed as incurred in accordance with Statement of Position 93-7, Reporting on Advertising Costs. Business promotion and advertising costs of $23.5 million, $16.8 million, $6.1 million and $12.5 million were included in operating, administrative and other expenses for the years ended December 31, 2003 and 2002, the period from February 20 (inception) to December 31, 2001 and the period from January 1 to July 20, 2001, respectively. Foreign Currencies The financial statements of subsidiaries located outside the United States (U.S.) are generally measured using the local currency as the functional currency. The assets and liabilities of these subsidiaries are translated at the rates of exchange at the balance sheet date, and income and expenses are translated at the average monthly rate. The resulting translation adjustments are included in the accumulated other comprehensive (loss) income component of stockholders equity. Gains and losses resulting from foreign currency transactions are included in the results of operations. The aggregate transaction gains and losses included in the accompanying consolidated statements of operations are a $9.8 million gain, a $6.4 million gain, a $0.2 million loss and a $0.3 million gain for the years ended December 31, 2003 and 2002, the period from February 20 (inception) to December 31, 2001 and the period from January 1 to July 20, 2001, respectively. $ 126,889 $ 66,795 $ 193,684 Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Comprehensive (Loss) Income Comprehensive (loss) income consists of net (loss) income and other comprehensive (loss) income. Accumulated other comprehensive (loss) income consists of foreign currency translation adjustments and minimum pension liability adjustments. Foreign currency translation adjustments exclude income tax expense (benefit) given that earnings of non-U.S. subsidiaries are deemed to be reinvested for an indefinite period of time. The income tax benefit associated with the minimum pension liability adjustments is $6.5 million and $7.3 million as of December 31, 2003 and 2002, respectively. Accounting for Transfers and Servicing We follow SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities in accounting for loan sales and acquisition of servicing rights. SFAS No. 140 provides accounting and reporting standards for transfers and servicing of financial assets and extinguishments of liabilities. Those standards are based on consistent application of a financial-components approach that focuses on control. Under the approach, after a transfer of financial assets, an entity recognizes the financial and servicing assets it controls and the liabilities it has incurred at fair value. Servicing assets are amortized over the period of estimated servicing income with a write-off required when control is surrendered. Our recording of servicing rights at their fair value resulted in gains, which have been reflected in the accompanying consolidated statements of operations. Corresponding servicing assets of approximately $1.8 million and $2.1 million, for the years ended December 31, 2003 and 2002, respectively, are included in other intangible assets reflected in the accompanying consolidated balance sheets. Accounting for Broker Draws As part of our recruitment efforts relative to new U.S. brokers, we offer a transitional broker draw arrangement. Our broker draw arrangements generally last until such time as a broker s pipeline of business is sufficient to allow him or her to earn sustainable commissions. This program is intended to provide the broker with a minimal amount of cash flow to allow adequate time for his or her training as well as time for him or her to develop business relationships. Similar to traditional salaries, the broker draws are paid irrespective of the actual revenues generated by the broker. Often these broker draws represent the only form of compensation received by the broker. Furthermore, it is not our policy to pursue collection of unearned broker draws paid under this arrangement. As a result, we have concluded that broker draws are economically equivalent to salaries paid and accordingly charge them to compensation as incurred. The broker is also entitled to earn a commission on completed revenue transactions. This amount is calculated as the commission that would have been payable under our full commission program, less any amounts previously paid to the broker in the form of a draw. Stock-Based Compensation Prior to 2003, we accounted for stock-based compensation plans under the recognition and measurement provisions of Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees. No stock-based employee compensation cost is reflected in net income (loss) for the year ended December 31, 2002, for the period from February 20 (inception) to December 31, 2001 or for the period from January 1 to July 20, 2001, as all options granted during those periods had an exercise price equal to or greater than the market value of the underlying common stock on the date of grant. In the fourth quarter of 2003, we adopted the fair value recognition provisions of SFAS No. 123, Accounting for Stock-Based Compensation prospectively to all employee awards granted, modified or settled The weighted average minimum value of options and warrants granted by us was $0.58 for the year ended December 31, 2003, $0.84 for the year ended December 31, 2002 and $0.67 for the period from February 20 (inception) to December 31, 2001. There were no stock options or warrants granted by CBRE for the period from January 1 to July 20, 2001 that remained outstanding as of December 31, 2001. Risk-free interest rate 3.02 % 4.06 % 4.69 % Expected volatility 0.00 % 0.00 % 0.00 % Expected life 5 years 5 years 5 years (Loss) Earnings Per Share Basic (loss) earnings per share is computed by dividing net (loss) income by the weighted average number of common shares outstanding during each period. The computation of diluted earnings per share further assumes the dilutive effect of stock options, stock warrants and contingently issuable shares. Contingently issuable shares represent unvested stock fund units in the deferred compensation plan. In accordance with SFAS No. 128, Earnings Per Share these shares are included in the dilutive earnings per share calculation under the treasury stock method (see Note 16). Income Taxes Income taxes are accounted for under the asset and liability method in accordance with SFAS No. 109, Accounting for Income Taxes. Deferred tax assets and liabilities are determined based on temporary differences between the financial reporting and the tax basis of assets and liabilities and operating loss and tax credit carry forwards. Deferred tax assets and liabilities are measured by applying enacted tax rates and laws to taxable income in the years in which the temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Valuation allowances are provided against deferred tax assets when it is more likely than not that some portion or all of the deferred tax asset will not be realized. New Accounting Pronouncements In January 2003, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 46 (FIN 46), Consolidation of Variable Interest Entities. This standard clarifies the application of Accounting Research Bulletin No. 51, Consolidated Financial Statements, and addresses consolidation by business enterprises of variable interest entities. FIN 46 requires existing unconsolidated variable interest entities to be consolidated by their primary beneficiaries if the entities do not effectively disperse risk among the parties involved. This statement is immediately effective for variable interest entities created or in which an enterprise obtains an interest after January 31, 2003. In December 2003, the FASB issued a revised version of FIN 46 (FIN 46R). Among other things, the revision clarifies the definition of a variable interest entity, exempts most entities that are businesses from the scope of FIN 46R and delays the effective date of the revised standard to no later than the end of the first reporting period ending after December 15, 2003 for special purpose entities and March 15, 2004 for all other types of entities. The adoption of this interpretation has not had, and is not expected to have, a material impact on our financial position or results of operations. Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) In April 2003, the FASB issued SFAS No. 149, Amendment to Statement 133 on Derivative Instruments and Hedging Activities. SFAS No. 149 amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under SFAS No. 133. SFAS No. 149 is applied prospectively and is effective for contracts entered into or modified after June 30, 2003, except for SFAS No. 133 implementation issues that have been effective for fiscal quarters that began prior to June 15, 2003 and certain provisions relating to forward purchases and sales on securities that do not yet exist. The adoption of this statement has not had a material impact on our financial position or results of operations. In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. SFAS No. 150 establishes standards for the classification and measurement of financial instruments with characteristics of both liabilities and equity. The financial instruments affected include mandatorily redeemable stock, certain financial instruments that require or may require the issuer to buy back some of its shares in exchange for cash or other assets and certain obligations that can be settled with shares of stock. SFAS No. 150 is effective for all financial instruments entered into or modified after May 31, 2003 and must be applied to our existing financial instruments effective July 1, 2003. On October 29, 2003, the FASB deferred indefinitely the provisions of paragraphs 9 and 10 and related guidance in the appendices of this pronouncement as they apply to mandatorily redeemable noncontrolling interests. The adoption of the effective provisions of SFAS No. 150 have not had a material impact on our financial position or results of operations. In December 2003, the FASB issued a revised version of SFAS No. 132, Employers Disclosures about Pensions and Other Postretirement Benefits. The revised statement retains the disclosure requirements contained in SFAS No. 132 and requires additional disclosures about the assets, obligations, cash flows and net periodic benefit cost of defined benefit pension plans and other defined benefit postretirement plans. We have adopted this statement for the year ended December 31, 2003. In addition, we expect to adopt additional disclosures for our U.K. pension plans during 2004. Reclassifications Certain reclassifications, which do not have an effect on net income or equity, have been made to the 2002 and 2001 financial statements to conform to the 2003 presentation. 3. Insignia Acquisition On July 23, 2003, pursuant to an Amended and Restated Agreement and Plan of Merger, dated May 28, 2003 (the Insignia Acquisition Agreement), by and among us, CBRE, Apple Acquisition Corp. (Apple Acquisition), a Delaware corporation and wholly owned subsidiary of CBRE, and Insignia Financial Group, Inc. (Insignia), Apple Acquisition was merged with and into Insignia (the Insignia Acquisition). Insignia was the surviving corporation in the Insignia Acquisition and at the effective time of the Insignia Acquisition became a wholly owned subsidiary of CBRE. We acquired Insignia to solidify our position as the market leader in the commercial real estate services industry. In conjunction with and immediately prior to the Insignia Acquisition, Island Fund I LLC (Island), a Delaware limited liability company, which is affiliated with Andrew L. Farkas (Insignia s former Chairman and Chief Executive Officer) and some of Insignia s other former officers, completed the purchase of specified real estate investment assets of Insignia, pursuant to a Purchase Agreement, dated May 28, 2003 (the Island Purchase Agreement), by and among Insignia, us, CBRE, Apple Acquisition and Island. A number of the real estate investment assets that were sold to Island required the consent of one or more third parties in order to transfer such assets. Some of these third party consents were not obtained prior to or since the closing of the Insignia Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Acquisition. As a result, we continue to hold these real estate investment assets pending the receipt of these third party consents. While we hold these assets, we have generally agreed to provide Island with the economic benefits from these assets and Island generally has agreed to indemnify us with respect to any losses incurred in connection with continuing to hold these assets. Pursuant to the terms of the Insignia Acquisition Agreement, (1) each issued and outstanding share of Insignia Common Stock (other than treasury shares), par value $0.01 per share, was converted into the right to receive $11.156 in cash, without interest (the Insignia Common Stock Merger Consideration), (2) each issued and outstanding share of Insignia s Series A Preferred Stock, par value $0.01 per share, and Series B Preferred Stock, par value $0.01 per share, was converted into the right to receive $100.00 per share, plus accrued and unpaid dividends, (3) all outstanding warrants and options to acquire Insignia common stock other than as described below, whether vested or unvested, were canceled and represented the right to receive a cash payment, without interest, equal to the excess, if any, of the Insignia Common Stock Merger Consideration over the per share exercise price of the option or warrant, multiplied by the number of shares of Insignia Common Stock subject to the option or warrant less any applicable withholding taxes and (4) outstanding options to purchase Insignia Common Stock granted pursuant to Insignia s 1998 Stock Investment Plan, whether vested or unvested, were canceled and represented the right to receive a cash payment, without interest, equal to the excess, if any, of (a) the higher of (x) the Insignia Common Stock Merger Consideration, or (y) the highest final sale price per share of the Insignia Common Stock as reported on the New York Stock Exchange (NYSE) at any time during the 60-day period preceding the closing of the Insignia Acquisition (which was $11.20), over (b) the exercise price of the options, multiplied by the number of shares of Insignia Common Stock subject to the options, less any applicable withholding taxes. Following the Insignia Acquisition, the Insignia Common Stock was delisted from the NYSE and deregistered under the Securities Exchange Act of 1934. The funding to complete the Insignia Acquisition, as well as the refinancing of substantially all of the outstanding indebtedness of Insignia, was obtained through (a) the sale of 18,255,338 shares of our Class B Common Stock, par value $0.01 per share, to Blum Strategic, a Delaware limited partnership, Blum Strategic Partners II, L.P., a Delaware limited partnership and Blum Strategic Partners II GmbH & Co. KG, a German limited partnership, for an aggregate cash purchase price of $105,394,160; (b) the sale of 631,496 shares of our Class A Common Stock, par value $.01 per share, to DLJ Investment Partners, L.P., a Delaware limited partnership, DLJ Investment Partners II, L.P., a Delaware limited partnership and DLJIP II Holdings, L.P., a Delaware limited partnership, for an aggregate cash purchase price of $3,645,840; (c) the sale of 1,732,101 shares of our Class A Common Stock to California Public Employees Retirement System (CalPERS) for an aggregate cash purchase price of $10,000,000; (d) the sale of 166,281 shares of our Class B Common Stock to Frederic V. Malek, a director of our company, for an aggregate cash purchase price of $960,000; (e) the release from escrow of the net proceeds from the offering by CBRE Escrow, Inc. (CBRE Escrow), a wholly owned subsidiary of CBRE that merged with and into CBRE in connection with the Insignia Acquisition, of $200.0 million of the 9 3/4% Senior Notes due May 15, 2010 (see Note 12), issued and sold by CBRE Escrow on May 22, 2003; (f) $75.0 million of term loan borrowings under the Amended and Restated Credit Agreement (see Note 12), dated as of May 22, 2003, by and among CBRE, Credit Suisse First Boston (CSFB) as Administrative Agent and Collateral Agent, the other lenders named in the credit agreement, us and the guarantors named in the credit agreement and (g) $36,870,230 of cash proceeds from the completion of the sale to Island. The aggregate preliminary purchase price for the Insignia Acquisition was approximately $328.0 million, which includes: (1) $267.9 million in cash paid for shares of Insignia s outstanding common stock, valued at $11.156 per share, (2) $100.00 per share plus accrued and unpaid dividends paid to the owners of Insignia s outstanding Series A preferred stock and Series B preferred stock totaling $38.2 million, (3) cash payments of $7.9 million to holders of Insignia s vested and unvested warrants and options and (4) $14.0 million of direct costs incurred in connection with the acquisition, consisting mostly of legal and accounting fees. (1) Weighted average amortization period is not determinable. See Note 8 for additional information. The liability for severance covers approximately 450 employees with the bulk of the terminations occurring in the U.S. A majority of the amount unpaid as of December 31, 2003 represents future payments required as per severance agreements for the top six former senior executives of Insignia. These amounts will be paid as required by their severance agreements up through their expiration dates of December 31, 2004 and December 31, 2005. All other outstanding liabilities for severance are expected to be paid in 2004. We identified approximately 50 redundant facilities consisting of both sales and corporate offices. A total accrual for lease termination costs of $28.9 million was established for office closures, the majority of which were located in the U.S. The liability for lease termination costs will be paid over the remaining contract periods through 2012. The change of control payments represented amounts paid to the top six former senior executives of Insignia as a direct result of the Insignia Acquisition as stipulated in their employment contracts. In connection with the Insignia Acquisition, we incurred costs associated with the termination of contracts that Insignia entered into prior to the Insignia Acquisition. We expect to pay all remaining costs relating to exiting these contracts in 2004. We have accrued approximately $8.7 million to cover our exposure in various lawsuits involving Insignia that were pending prior to the Insignia Acquisition. These liabilities will be paid as each case is settled. 4. 2001 Merger On July 20, 2001, we acquired CBRE pursuant to an Amended and Restated Agreement and Plan of Merger dated May 31, 2001 (the 2001 Merger Agreement) among us, CBRE and Blum CB. At the effective time of the 2001 Merger, CBRE became our wholly owned subsidiary. Pursuant to the terms of the 2001 Merger Agreement, each issued and outstanding share of common stock of CBRE was converted into the right to receive $16.00 in cash, except for: (i) shares of common stock of CBRE owned by us and Blum CB immediately prior to the 2001 Merger, totaling 7,967,774 shares, which were cancelled, (ii) treasury shares and shares of common stock of CBRE owned by any of its subsidiaries, which were cancelled and (iii) shares of CBRE held by stockholders who perfected appraisal rights for such shares in accordance with Delaware law. All shares of common stock of CBRE outstanding prior to the 2001 Merger were acquired by us and subsequently cancelled. Immediately prior to the 2001 Merger, the following, collectively referred to as the buying group, contributed to us all the shares of CBRE s common stock that he or it directly owned in exchange for three shares of our Class B common stock: Blum Strategic, FS Equity Partners III, L.P. (FSEP III), a Delaware limited partnership, FS Equity Partners International, L.P. (FSEP International), a Delaware limited partnership, The Koll Holding Company, a California corporation, Frederic V. Malek, a director of our company and CBRE, Raymond E. Wirta, the Chief Executive Officer and a director of our company and CBRE, and Brett White, the President and a director of our company and CBRE. Such shares of common stock of CBRE, which totaled 7,967,774 shares of common stock, Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) were then cancelled. In addition, we offered to purchase for cash, options outstanding to acquire common stock of CBRE at a purchase price per option equal to the greater of the amount by which $16.00 exceeded the exercise price of the option, if at all, or $1.00. In connection with the 2001 Merger, CBRE purchased its outstanding options on our behalf, which were recorded as merger-related and other nonrecurring charges by CBRE in the period from January 1 to July 20, 2001. The funding to complete the 2001 Merger, as well as the refinancing of substantially all of the outstanding indebtedness of CBRE, was obtained through: (i) a cash contribution of $74.8 million from the sale of our Class B common stock for $5.77 per share, (ii) sale of shares of our Class A common stock for $5.77 per share to employees and independent contractors of CBRE, (iii) sale of 1,732,102 shares of our Class A common stock to CalPERS for $5.77 per share, (iv) issuance and sale of 65,000 units for $65.0 million to DLJ Investment Funding, Inc. and other purchasers, which units consisted of $65.0 million in aggregate principal amount of 16% Senior Notes due July 20, 2011 and 941,764 shares of our Class A common stock, (v) issuance and sale by Blum CB of $229.0 million in aggregate principal amount of 11 1/4% Senior Subordinated Notes due June 15, 2011 for $225.6 million (which were assumed by CBRE in connection with the 2001 Merger) and (vi) borrowings by CBRE under a new $325.0 million senior credit facility with CSFB and other lenders. Following the 2001 Merger, the common stock of CBRE was delisted from the NYSE. CBRE also successfully completed a tender offer and consent solicitation for all of the outstanding principal amount of its 8 7/8% Senior Subordinated Notes due 2006 (the Subordinated Notes). The Subordinated Notes were purchased at $1,079.14 for each $1,000 principal amount of Subordinated Notes, which included a consent payment of $30.00 per $1,000 principal amount of Subordinated Notes. We also repaid the outstanding balance of CBRE s existing revolving credit facility. We entered into the 2001 Merger in order to enhance the flexibility to operate CBRE s existing businesses and to develop new ones. 5. Basis of Preparation The accompanying consolidated balance sheets as of December 31, 2003 and 2002, and the consolidated statements of operations, cash flows and stockholders equity for the years ended December 31, 2003 and 2002 and for the period from February 20 (inception) to December 31, 2001, reflect our consolidated balance sheets, results of operations, cash flows and stockholders equity from our company s inception and also include the consolidated financial statements of CBRE from the date of the 2001 Merger, including all material adjustments required under the purchase method of accounting. For purposes of Regulation S-X, CBRE is considered our predecessor. As such, the historical financial statements of CBRE prior to the 2001 Merger are included in the accompanying consolidated financial statements, including the consolidated statements of operations, cash flows and stockholders equity for the period from January 1 to July 20, 2001 (the Predecessor financial statements). The Predecessor financial statements have not been adjusted to reflect our acquisition of CBRE. As such, our consolidated financial statements after the 2001 Merger are not directly comparable to the Predecessor financial statements prior to the 2001 Merger. Additionally, the accompanying consolidated balance sheet as of December 31, 2003 and the consolidated statements of operations and cash flows for the year ended December 31, 2003 include the consolidated financial statements of Insignia from July 23, 2003, the date of the Insignia Acquisition, including all material adjustments required under the purchase method of accounting. As such, our consolidated financial statements after the Insignia Acquisition are not directly comparable to our financial statements prior to the Insignia Acquisition. Unaudited pro forma results, assuming the Insignia Acquisition had occurred as of January 1, 2003 and 2002 for purposes of the 2003 and 2002 pro forma disclosures, respectively, are presented below. These unaudited pro forma results have been prepared for comparative purposes only and include certain adjustments, such as increased amortization expense as a result of intangible assets acquired in the Insignia Acquisition as Depreciation expense was $28.3 million for the year ended December 31, 2003, $20.8 million for the year ended December 31, 2002, $9.1 million for the period from February 20 (inception) to December 31, 2001 and $12.6 million for the period from January 1 to July 20, 2001. Shares Weighted Average Exercise Price In accordance with SFAS No. 141, Business Combinations, trademarks of $63.7 million were separately identified as a result of the 2001 Merger. As a result of the Insignia Acquisition, a $19.8 million trade name was separately identified, which represents the Richard Ellis trade name in the U.K. that was owned by Insignia prior to the Insignia Acquisition. Both the trademarks and the trade name have indefinite useful lives and accordingly are not being amortized. Backlog represents the fair value of Insignia s net revenue backlog as of July 23, 2003, which was acquired as part of the Insignia Acquisition. The backlog consists of the net commissions receivable on Insignia s revenue producing transactions, which were at various stages of completion prior to the Insignia Acquisition. This intangible asset is being amortized as cash is received or upon final closing of these pending transactions. Management contracts are primarily comprised of property management contracts in the U.S., the U.K., France and other European operations, as well as valuation services and fund management contracts in the U.K. These management contracts are being amortized over estimated useful lives of up to ten years. Loan servicing rights represent the fair value of servicing assets in our mortgage banking line of business in the U.S., the majority of which were acquired as part of the 2001 Merger. The loan servicing rights are being amortized over estimated useful lives of up to ten years. Other amortizable intangible assets represent other intangible assets acquired as a result of the Insignia Acquisition, including an intangible asset recognized for other non-contractual revenue acquired in the U.S. as well as franchise agreements and a trade name in France. These other intangible assets are being amortized over estimated useful lives of up to 20 years. Amortization expense related to intangible assets was $64.3 million for the year ended December 31, 2003, $3.8 million for the year ended December 31, 2002, $3.1 million for the period from February 20 (inception) to December 31, 2001 and $13.1 million for the period from January 1 to July 20, 2001. The estimated amortization expense for the five years ending December 31, 2008 approximates $20.3 million, $6.5 million, $5.1 million, $4.2 million and $3.4 million, respectively. Shares Net revenue $ 450,542 $ 349,121 $ 286,138 Income from operations $ 111,585 $ 78,171 $ 60,259 Net income $ 174,629 $ 81,498 $ 30,098 Included in other current assets in the accompanying consolidated balance sheet was a note receivable from our equity investment in Investor 1031, L.L.C. in the amount of $1.2 million as of December 31, 2002. This note was issued on June 20, 2002, bore interest at 20.0% per annum and was due for repayment on July 15, 2003. This note and related interest were paid in full during the second quarter of 2003. Our investment management business involves investing our own capital in certain real estate investments with clients. We have provided investment management, property management, brokerage, appraisal and other Weighted Average Exercise Price (1) See Note 22 for additional information. (2) Represents property investments held for the benefit of Island Fund pursuant to the Island Purchase Agreement pending the receipt of third party consents (see Note 3 for additional information). 11. Employee Benefit Plans Stock Incentive Plans and Warrants. 2001 Stock Incentive Plan. Our 2001 stock incentive plan was adopted by our board of directors and our stockholders on June 7, 2001. The stock incentive plan permits the grant of nonqualified stock options, incentive stock options, stock appreciation rights, restricted stock, restricted stock units and other stock-based awards to our employees, directors or independent contractors. A total of 18,013,857 shares of Class A common stock have been reserved for issuance under the stock incentive plan, and 9,698,289 shares remained available for future issuance as of December 31, 2003. The number of shares issued or reserved pursuant to the stock incentive plan, or pursuant to outstanding awards, is subject to adjustment on account of stock splits, stock dividends and other dilutive changes in our Class A common stock. Class A common stock covered by awards that expire, terminate or lapse will again be available for option or grant under the stock incentive plan. No award may be granted under the stock incentive plan after June 7, 2011, but awards granted prior to June 7, 2011 may extend beyond that date. In the event of a change of control of our company, all outstanding options will become fully vested and exercisable. Outstanding at beginning of year 6,616,404 $ 10.32 8,304,155 $ 10.06 Options and warrants granted 290,000 10.33 30,000 11.70 Options granted in connection with a prior acquisition 20,000 10.80 Exercised (200,674 ) 3.48 (690,941 ) 6.64 Forfeited/canceled (954,357 ) 11.95 (1,046,810 ) 9.40 Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) In connection with the 2001 Merger, we offered and sold shares of our Class A common stock to certain of our employees that were designated by our board of directors in consultation with Ray Wirta, our Chief Executive Officer, and Brett White, our President. If each of these designated employees subscribed for a specified number of shares that was determined by our board of directors, they were then entitled to receive a grant of options to acquire our Class A common stock. As part of the 2001 Merger, we issued and sold 1,172,904 shares of our Class A common stock and granted 4,213,045 options to acquire our Class A common stock at an exercise price of $5.77 per share and a term of ten years. These options vest and are exercisable in 20% annual increments over a five-year period ending on July 20, 2006. On September 16, 2003, we issued to employees 2,427,714 options to acquire our Class A common stock at an exercise price of $5.77 per share and a term of ten years. These options vest and are exercisable in 20% annual increments over a five-year period ending September 16, 2008. Since the 2001 Merger, there have been instances where employees have forfeited their options as a result of the termination of their employment with our company. In these instances, we have generally issued individual grants to replacement hires made as well as to retain certain key employees. Additionally, individual grants of options and issuances and sales of shares of Class A common stock have been made from time to time to key new hires. As of December 31, 2003, a total of 245,958 shares of our Class A common stock had been issued and sold and 847,488 options to acquire our Class A common stock had been granted to individuals under the instances described above since the 2001 Merger. These options have exercise prices of $5.77 per share, terms of ten years and vest and are exercisable in 20% annual increments over various five-year periods through November 2008. Warrants. Pursuant to an agreement entered into in connection with the 2001 Merger, we issued to FSEP III and FSEP International warrants to acquire 708,019 shares of our Class B common stock at an exercise price of $10.825 per share in exchange for the cancellation of previously outstanding warrants to acquire 364,884 shares of CBRE common stock. Subject to limited exceptions, these warrants do not vest until August 26, 2007, expire on August 27, 2007 and will become fully vested and exercisable upon a change in control of our company. Option Plans and Warrants of CBRE, our Predecessor. The options and warrants outstanding prior to the 2001 Merger were issued in connection with various acquisitions and employee stock-based compensation plans and had exercise prices that ranged from $10.00 to $36.75 with vesting periods that ranged up to 5 years and expired at various dates through August 2010. At the effective time of the 2001 Merger, each holder of an option to acquire CBRE s common stock, whether or not vested, had the right to receive, in consideration for the cancellation of his or her options, an amount per share of common stock equal to the greater of (i) the amount by which $16.00 exceeded the exercise price of the option, if any, or (ii) $1.00, reduced in each case by applicable withholding taxes. Warrants to acquire 84,988 shares of CBRE beneficially owned by Ray Wirta and one of the other members of the CBRE board of directors prior to the 2001 Merger were cancelled in exchange for a cash payment of $1.00 per share of common stock underlying the warrants. Warrants held by non-employees, other than FS Equity Partners III, L.P. and FS Equity Partners International, L.P. who received warrants to acquire shares of CBRE s Class B common stock, were cancelled and no payments were made to such shareholders. As of December 31, 2001, there were no options or warrants outstanding to acquire CBRE s stock. Deferred Compensation Plan. Our deferred compensation plan (the DCP) historically has permitted a select group of management employees, as well as other highly compensated employees, to elect, immediately prior to the beginning of each calendar year, to defer receipt of some or all of their compensation for the next year until a Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) future distribution date and have it credited to one or more of several funds in the DCP. The DCP permits participants to elect in-service distributions, which may not begin less than three years following the election and post-employment distributions. There is limited flexibility to change distribution elections once made. A participant may elect to receive a distribution of his or her vested accounts at any time subject to a charge equal to 7.5% of the amount to be distributed. The investment alternatives available to participants in connection with their deferrals include two interest index funds and an insurance fund in which gains or losses on deferrals are measured by one or more of approximately 30 mutual funds. In addition, prior to the 2001 Merger, participants were entitled to invest their deferrals in stock fund units that entitled the participants to receive future distributions of shares of CBRE common stock, which stock fund units now represent the right to receive future distributions of shares of our common stock. Each stock fund unit that was unvested prior to the 2001 Merger remained in participants accounts, but after the 2001 Merger was converted to the right to receive three shares of our Class A common stock. Subsequent to our reverse stock split which is expected to occur during May 2004, each stock fund unit will be converted to the right to receive 0.9238 shares of our Class A common stock. These unvested stock fund units have been accounted for as a deferred compensation asset and are being amortized as compensation expense over the remaining vesting period for such stock fund units in accordance with FASB Interpretation No. 44, Accounting for Certain Transactions Involving Stock Compensation, with $1.8 million charged to compensation expense for the years ended December 31, 2003 and 2002, and $0.9 million charged to compensation expense for the period from February 20 (inception) to December 31, 2001. The accompanying consolidated balance sheets include the unamortized balances totaling $1.4 million and $1.9 million in other current assets as of December 31, 2003 and 2002, respectively, and $1.4 million in other assets as of December 31, 2002. Subsequent to the 2001 Merger, no new deferrals have been allowed in stock fund units. In 2001, we announced a match for the Plan Year 2000, effective July 2001, in the amount of $8.0 million to be invested in an interest bearing account on behalf of participants. The 2000 Company Match vests at 20% per year and will be fully vested by December 2005. The related compensation expense is being amortized over the vesting period. The amounts charged to expense for the 2000 Company match were $1.7 million for the years ended December 31, 2003 and 2002, $0.7 million for the period from February 20 (inception) to December 31, 2001 and $0.2 million for the period from January 1 to July 20, 2001. Included in our accompanying consolidated balance sheets is an accumulated non-stock liability of $138.0 million and $106.3 million at December 31, 2003 and 2002, respectively, and the assets (in the form of insurance) set aside to cover the liability of $76.4 million and $63.6 million as of December 31, 2003 and 2002, respectively. In addition, our stock fund unit deferrals included in additional paid-in capital totaled $18.1 million and $18.2 million at December 31, 2003 and 2002, respectively. Early in the fourth quarter of 2003, we announced that effective January 1, 2004, we will close the DCP to new participants. Currently, the DCP is accepting compensation deferrals from participants who have a balance, meet the eligibility requirements and elect to participate, up to a maximum annual contribution amount of $250,000 per participant. We are currently reviewing the future status of this plan. Stock Purchase Plans. Prior to the 2001 Merger, CBRE had restricted stock purchase plans covering select key executives including senior management. A total of 500,000 and 550,000 shares of common stock were reserved for issuance under CBRE s 1999 and 1996 Equity Incentive Plans, respectively. The shares were issued to senior executives for a purchase price equal to the greater of $18.00 and $10.00 per share or fair market value, respectively. The purchase price for these shares was paid either in cash or by delivery of a full recourse promissory note. All promissory notes related to the 1999 Equity Incentive Plan were repaid as part of the 2001 Merger. The majority of the notes related to the 1996 Equity Incentive Plan were also repaid, with the remaining unpaid outstanding balance of $0.6 million as of December 31, 2003 and 2002, included in notes receivable from Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) sale of stock in the accompanying consolidated statements of stockholders equity. As part of the 2001 Merger, the CBRE shares related to these outstanding promissory notes were exchanged for three shares of our Class B common stock. Bonuses. We have bonus programs covering select key employees, including senior management. Awards are based on the position and performance of the employee and the achievement of pre-established financial, operating and strategic objectives. The amounts charged to expense for bonuses were $51.8 million for the year ended December 31, 2003, $40.2 million for the year ended December 31, 2002, $18.0 million for the period from February 20 (inception) to December 31, 2001 and $16.5 million for the period from January 1 to July 20, 2001. 401(k) Plans. Our CB Richard Ellis 401(k) Plan (401(k) Plan) is defined contribution profit sharing plan under Section 401(k) of the Internal Revenue Code. Generally, our U.S. employees are eligible to participate in the plan if the employee is at least 21 years old. The 401(k) Plan provides for participant contributions as well as discretionary employer contributions. A participant is allowed to contribute to the 401(k) Plan from 1% to 15%, in whole percentages, of his or her compensation, subject to limits imposed by the U.S. Internal Revenue Code. Each year, we determine the amount of employer contributions, if any, we will contribute to the 401 (k) Plan based on the performance and profitability of our consolidated U.S. operations. Our contributions for the year are allocated to participants who are actively employed on the last day of the plan year in proportion to each participant s pre-tax contributions for that year, up to 5% of the participant s compensation. In connection with the 401(k) Plan, we incurred $2.2 million for the year ended December 31, 2003, no expense for the year ended December 31, 2002, $0.8 million for the period from February 20 (inception) to December 31, 2001 and no expense for the period from January 1 to July 20, 2001. In connection with the 2001 Merger, each share of common stock of CBRE formerly held by the 401(k) Plan and credited to participant accounts was exchanged for $16.00 in cash. In addition, the 401(k) Plan was amended to eliminate the common stock of CBRE as an investment option within the 401(k) Plan after July 20, 2001. The cash received for the shares of CBRE common stock was available for reinvestment in one or more of the investment alternatives available within the 401(k) Plan in accordance with the terms of the plan, including a new company stock fund in which employees could invest on a one-time basis in our Class A shares of common stock. Subsequent to the 2001 Merger, participants are no longer entitled to purchase additional shares of our Class A or Class B common stock for allocation to their account balances. In connection with the Insignia Acquisition, we assumed Insignia s existing 401(k) Retirement Savings Plan (Insignia 401(k) Plan) and its 401(k) Restoration Plan. The Insignia 401(k) Plan covered substantially all Insignia employees in the U.S. Insignia made contributions equal to 25% of the employees contributions up to a maximum of 6% of the employees compensation and participants fully vested in employees contributions after five years. Insignia s contribution was discontinued effective July 23, 2003. Upon the close of the Insignia Acquisition, participants in the Insignia 401(k) Plan were required, instead, to join our 401(k) Plan. Currently, only loan payments are being accepted into the former Insignia 401(k) Plan until we receive IRS approval to terminate the plan and transfer plan balances into our 401(k) Plan. The 401(k) Restoration Plan allowed designated executives of Insignia and certain participating affiliated employees in the Insignia 401(k) Plan to defer the receipt of a portion of their compensation in excess of the amount of compensation that was permitted to be contributed to the Insignia 401(k) Plan. This plan ceased to accept deferrals on July 23, 2003. Future annual aggregate maturities of total consolidated debt at December 31, 2003 are as follows (dollars in thousands): 2004 $281,422; 2005 $10,367; 2006 $10,017; 2007 $10,017; 2008 $299,270; and $461,749 thereafter. In connection with the 2001 Merger, we entered into a credit agreement (the Credit Facility) with CSFB and other lenders. In connection with the Insignia Acquisition, we entered into an amended and restated credit agreement with CSFB and other lenders. On October 14, 2003, we refinanced all of the outstanding loans under that agreement. As part of this refinancing, we entered into a new amended and restated credit agreement. The Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) prior credit facilities were, and the current amended and restated credit facilities continue to be, jointly and severally guaranteed by us and each of our domestic subsidiaries and are secured by a pledge of substantially all of our assets. The Credit Facility entered into in connection with the 2001 Merger included the following: (1) a Tranche A term facility of $50.0 million maturing on July 20, 2007, which was fully drawn in connection with the 2001 Merger; (2) a Tranche B term facility of $185.0 million maturing on July 18, 2008, which was fully drawn in connection with the 2001 Merger; and (3) a revolving line of credit of $90.0 million, including revolving credit loans, letters of credit and a swingline loan facility, maturing on July 20, 2007. Borrowings under the Tranche A term facility and revolving facility bore interest at varying rates based on our option, at either the applicable LIBOR rate plus 2.50% to 3.25% or the alternate base rate plus 1.50% to 2.25%, in both cases as determined by reference to our ratio of total debt less available cash to EBITDA, which was defined in the credit agreement. The alternate base rate is higher of (1) CSFB s prime rate or (2) the Federal Funds Effective Rate plus one-half of one percent. Borrowings under the Tranche B term facility bore interest at varying rates based on our option at either the applicable LIBOR plus 3.75% or the alternate base rate plus 2.75%. The amended and restated credit facilities entered into in connection with the Insignia Acquisition included the following: (1) a Tranche A term facility of $50.0 million maturing on July 20, 2007; (2) a Tranche B term facility of $260.0 million maturing on July 18, 2008, $75.0 million of which was drawn in connection with the Insignia Acquisition; and (3) a revolving line of credit of $90.0 million, including revolving credit loans, letters of credit and a swingline loan facility, maturing on July 20, 2007. After the amendment and restatement in connection with the Insignia Acquisition, borrowings under the Tranche A term facility and revolving facility bore interest at varying rates based on our option, at either the applicable LIBOR plus 3.00% to 3.75% or the alternate base rate plus 2.00% to 2.75%, in both cases as determined by reference to our ratio of total debt less available cash to EBITDA, which is defined in the amended and restated credit agreement. After the amendment and restatement in connection with the Insignia Acquisition, borrowings under the Tranche B term facility bore interest at varying rates based on our option at either the applicable LIBOR plus 4.25% or the alternate base rate plus 3.25%. In connection with the October 14, 2003 refinancing of our credit facilities and the signing of a new amended and restated credit agreement, the former Tranche A term facility and Tranche B term facility were combined into a new single term loan facility. The new term loan facility, of which $300.0 million was drawn on October 14, 2003, requires quarterly principal payments of $2.5 million through September 30, 2008 and matures on December 31, 2008. Borrowings under the new term loan facility bear interest at varying rates based on our option at either LIBOR plus 3.25% or the alternate base rate plus 2.25%. The maturity date and interest rate for borrowings under the revolving credit facility remain unchanged in the new amended and restated credit agreement. The revolving line of credit requires the repayment of any outstanding balance for a period of 45 consecutive days commencing on any day in the month of December of each year as determined by us. We repaid our revolving credit facility as of July 23, 2003 and November 5, 2002, and at December 31, 2003 and 2002, we had no revolving line of credit principal outstanding. At December 31, 2003, we had an aggregate of $10.8 million in letters of credit outstanding under the revolving credit facility, which reduces the amount we may borrow under the revolving credit facility. The total amounts outstanding under the senior secured credit facilities included in senior secured term loans and current maturities of long-term debt in the accompanying consolidated balance sheets were $297.5 million and $221.0 million as of December 31, 2003 and 2002, respectively. On May 22, 2003, CBRE Escrow, Inc. (CBRE Escrow), a wholly owned subsidiary of CBRE, issued $200.0 million in aggregate principal amount of 9 3/4% Senior Notes due May 15, 2010 The proceeds of this issuance were placed in escrow pending the completion of the Insignia Acquisition on July 23, 2003, on which date the Outstanding at end of year 5,751,373 10.30 6,616,404 $ 10.32 Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) proceeds were released from escrow in order to partially fund the acquisition. CBRE Escrow merged with and into CBRE, and CBRE assumed all obligations with respect to the 9 3/4% Senior Notes. The 9 3/4% Senior Notes are unsecured obligations of CBRE, senior to all of its current and future unsecured indebtedness, but subordinated to all of CBRE s current and future secured indebtedness. The 9 3/4% Senior Notes are jointly and severally guaranteed on a senior basis by us and substantially all our domestic subsidiaries. Interest accrues at a rate of 9 3/4% per year and is payable semi-annually in arrears on May 15 and November 15. The 9 3/4% Senior Notes are redeemable at our option, in whole or in part, on or after May 15, 2007 at 104.875% of par on that date and at declining prices thereafter. In addition, before May 15, 2006, we may redeem up to 35.0% of the originally issued amount of the 9 3/4% Senior Notes at 109 3/4% of par, plus accrued and unpaid interest, solely with the net cash proceeds from public equity offerings. In the event of a change of control, we are obligated to make an offer to purchase the 9 3/4% Senior Notes at a redemption price of 101.0% of the principal amount, plus accrued and unpaid interest. The amount of the 9 3/4% Senior Notes included in the accompanying consolidated balance sheet was $200.0 million as of December 31, 2003. In order to partially finance the 2001 Merger, Blum CB issued $229.0 million in aggregate principal amount of 11 1/4% Senior Subordinated Notes due June 15, 2011 for approximately $225.6 million, net of discount, on June 7, 2001. CBRE assumed all obligations with respect to the 11 1/4% Senior Subordinated Notes in connection with the 2001 Merger on July 20, 2001. The 11 1/4% Senior Subordinated Notes are jointly and severally guaranteed on a senior subordinated basis by us and substantially all of our domestic subsidiaries. The 11 1/4% Senior Subordinated Notes require semi-annual payments of interest in arrears on June 15 and December 15 and are redeemable in whole or in part on or after June 15, 2006 at 105.625% of par on that date and at declining prices thereafter. In addition, before June 15, 2004, we may redeem up to 35.0% of the originally issued amount of the notes at 111 1/4% of par, plus accrued and unpaid interest, solely with the net cash proceeds from public equity offerings. In the event of a change of control, we are obligated to make an offer to purchase the 11 1/4% Senior Subordinated Notes at a redemption price of 101.0% of the principal amount, plus accrued and unpaid interest. The amount of the 11 1/4% Senior Subordinated Notes included in the accompanying consolidated balance sheets, net of unamortized discount, was $226.2 million and $225.9 million as of December 31, 2003 and 2002, respectively. Also in connection with the 2001 Merger, we issued $65.0 million in aggregate principal amount of 16% Senior Notes due July 20, 2011. The 16% Senior Notes are unsecured obligations, senior to all of our current and future unsecured indebtedness but subordinated to all of our current and future secured indebtedness. Interest accrues at a rate of 16% per year and is payable quarterly in arrears. Interest may be paid in kind to the extent our ability to pay cash dividends is restricted by the terms of our amended and restated credit agreement. Additionally, interest in excess of 12.0% may, at our option, be paid in kind through July 2006. We elected to pay in kind interest in excess of 12.0% or 4.0%, that was payable on April 20, 2002, July 20, 2002, October 20, 2002, January 20, 2003 and April 20, 2003. The 16% Senior Notes are redeemable at our option, in whole or in part, at 116.0% of par commencing on July 20, 2001 and at declining prices thereafter. On October 27, 2003 and December 29, 2003, we redeemed $20.0 million and $10.0 million, respectively, in aggregate principal amount of the 16% Senior Notes and paid $2.9 million of premiums in connection with these redemptions. In the event of a change in control, we are obligated to make an offer to purchase all of the outstanding 16% Senior Notes at 101.0% of par. The amount of the 16% Senior Notes included in the accompanying consolidated balance sheets, net of unamortized discount, was $35.5 million and $61.9 million as of December 31, 2003 and 2002, respectively. The 16% Senior Notes are solely our obligation to repay. CBRE has neither guaranteed nor pledged any of its assets as collateral for the 16% Senior Notes and is not obligated to provide cash flow to us for repayment of these 16% Senior Notes. However, we have no substantive assets or operations other than our investment in CBRE to meet any required principal and interest payments on the 16% Senior Notes. We will depend on CBRE s cash flows to fund principal and interest payments as they come due. Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Our amended and restated credit agreement and the indentures governing our 9 3/4% Senior Notes, our 11 1/4% Senior Subordinated Notes and our 16% Senior Notes each contain numerous restrictive covenants that, among other things, limit our ability to incur additional indebtedness, pay dividends or distributions to stockholders, repurchase capital stock or debt, make investments, sell assets or subsidiary stock, engage in transactions with affiliates, enter into sale/leaseback transactions, issue subsidiary equity and enter into consolidations or mergers. The amendment and restatement of the credit agreement modified the financial covenant ratios to provide a greater degree of flexibility than the prior credit agreement. The amended and restated credit agreement requires us to maintain a minimum coverage ratio of interest and certain fixed charges and a maximum leverage and senior secured leverage ratio of earnings before interest, taxes, depreciation and amortization to funded debt. The credit agreement required, and after the amendment and restatement continues to require, us to pay a facility fee based on the total amount of the unused commitment. During 2001, a joint venture that we consolidate incurred $37.2 million of non-recourse mortgage debt secured by a real estate investment. During the third quarter of 2003, the maturity date on this non-recourse debt was extended to July 31, 2008. In our accompanying consolidated balance sheets, this debt comprised $41.8 million of our other long-term debt at December 31, 2003 and $40.0 million of our other short-term borrowings at December 31, 2002. Additionally, during the third quarter of 2003, this joint venture incurred an additional $1.9 million of non-recourse mortgage debt with a maturity date of June 15, 2004. At December 31, 2003, $2.0 million of this non-recourse debt is included in short-term borrowings in the accompanying consolidated balance sheet. We had short-term borrowings of $270.1 million and $123.2 million with related average interest rates of 2.7% and 4.3% as of December 31, 2003 and 2002, respectively. One of our subsidiaries has a credit agreement with Residential Funding Corporation (RFC) for the purpose of funding mortgage loans that will be resold. On December 16, 2002, we entered into a Third Amended and Restated Warehousing Credit and Security Agreement effective December 20, 2002. The agreement provided for a revolving warehouse line of credit of $200.0 million, bore interest at the lower of one-month LIBOR or 2.0% (RFC Base Rate) plus 1.0% and expired on August 31, 2003. On June 25, 2003, the agreement was modified to provide a temporary revolving line of credit increase of $200.0 million that resulted in a total line of credit equaling $400.0 million, which expired on August 30, 2003 and changed the RFC Base Rate to one-month LIBOR. By amendment on August 29, 2003, the expiration date of the agreement was extended to September 25, 2003. On September 26, 2003, we entered into a Fourth Amended and Restated Warehousing Credit and Security Agreement. The agreement provides for a revolving line of credit of up to $200.0 million, bears interest at one-month LIBOR plus 1.0% and expires on August 31, 2004. By amendment on November 14, 2003, the agreement was further modified to provide a revolving line of credit increase of $50.0 million that resulted in a total line of credit equaling $250.0 million. During the years ended December 31, 2003 and 2002, respectively, we had a maximum of $272.5 million and $309.0 million revolving line of credit principal outstanding with RFC. At December 31, 2003 and 2002, respectively, we had a $230.8 million and a $63.1 million warehouse line of credit outstanding, which are included in short-term borrowings in the accompanying consolidated balance sheets. Additionally, we had a $230.8 million and a $63.1 million warehouse receivable, representing mortgage loans funded through the line of credit that had not been purchased as of December 31, 2003 and 2002, respectively, which are also included in the accompanying consolidated balance sheets. Insignia, which we acquired in July 2003, issued acquisition loan notes in connection with previous acquisitions of businesses in the U.K. The acquisition loan notes are payable to the sellers of the previously acquired U.K. businesses and are secured by restricted cash deposits in approximately the same amount. The The total minimum payments for noncancellable operating leases were not reduced by the minimum sublease rental income of $4.7 million due in the future under noncancellable subleases. In connection with the sale of real estate investment assets by Insignia to Island on July 23, 2003 (See Note 3), Insignia agreed to maintain letter of credit support for real estate investment assets that were subject to the purchase agreement until the earlier of (1) the third anniversary of the completion of the sale, (2) the date on which the letter of credit is no longer required pursuant to the applicable real estate investment asset agreement or (3) the completion of a sale of the relevant underlying real estate investment asset. As of December 31, 2003, an aggregate of approximately $10.2 million of this letter of credit support remained outstanding under the purchase agreement. Also in connection with the sale, Insignia agreed to maintain a $1.3 million guarantee of a repayment obligation with respect to one of the real estate investment assets. Island agreed to reimburse us for 50% of any draws against these letters of credit or the repayment guarantee while they are outstanding and delivered a letter of credit to us in the amount of approximately $2.9 million as security for Island s reimbursement obligation. As a result of this reimbursement obligation, we effectively retain potential liability for 50% of any future draws against these letters of credit and the repayment guarantee. However, there can be no assurance that Island will be able to reimburse us in the event of any draws against the letters of credit or the repayment guarantee or that Island s future reimbursement obligations will not exceed the amount of the letter of credit provided to us by Island. One of our subsidiaries previously executed an agreement with Fannie Mae to initially fund the purchase of a commercial mortgage loan portfolio using proceeds from its RFC line of credit. Subsequently, a 100% participation in the loan portfolio was sold to Fannie Mae and we retained the credit risk on the first 2% of losses incurred on the underlying portfolio of commercial mortgage loans. The current loan portfolio balance is $98.6 million and we have collateralized a portion of our obligations to cover the first 1% of losses through a letter of credit in favor of Fannie Mae for a total of approximately $1.0 million. The other 1% is covered in the form of a guarantee to Fannie Mae. We had outstanding letters of credit totaling $22.6 million as of December 31, 2003, excluding letters of credit related to our outstanding indebtedness. Approximately $10.8 million of these letters of credit secure certain office leases and are outstanding pursuant to the revolving credit facility under our amended and restated credit agreement. An additional $10.8 million of these letters of credit were issued pursuant to the terms of the purchase agreement with Island described above and are outstanding pursuant to a reimbursement agreement with the Bank of Nova Scotia. Under this agreement, we may issue up to a maximum of approximately $11.0 million of letters of credit outstanding at any one time and the outstanding letters of credit are secured by the same assets of ours that secure our amended and restated credit agreement. The remaining outstanding letters of credit have been issued pursuant to a credit agreement with Wells Fargo Bank for the Fannie Mae letter of credit described above. The outstanding letters of credit as of December 31, 2003 expire at varying dates through As a result of the Insignia Acquisition and the current year s tax loss, at December 31, 2003, we had U.S. federal NOL carryforwards of approximately $67.7 million, translating to a deferred tax asset before valuation allowance of $23.7 million. Approximately $3.8 million of these NOLs begin to expire in 2010 and the remainder begins to expire in 2019. There were also deferred tax assets of approximately $9.8 million related to state NOLs. The utilization of NOLs may be subject to certain limitations under U.S. federal and state laws. Management determined that as of December 31, 2003, $58.8 million of deferred tax assets do not satisfy the recognition criteria set forth in SFAS No. 109. Accordingly, a valuation allowance has been recorded for this amount. The valuation allowance was recorded against deferred tax assets during the 2001 Merger and the Insignia Acquisition, with the offset to goodwill. Accordingly, any tax benefits subsequently recognized will reduce goodwill. A deferred U.S. tax liability has not been provided on the unremitted earnings of foreign subsidiaries because it is our intent to permanently reinvest these earnings. Unremitted earnings of foreign subsidiaries, which have been, or are intended to be, permanently invested in accordance with APB No. 23, Accounting for Income Taxes Special Areas, aggregated $79.0 million at December 31, 2003. The determination of the tax liability upon repatriation is not practicable. 15. Stockholders Equity We are authorized to issue 425,000,000 shares of common stock, including 325,000,000 shares of Class A common stock and 100,000,000 shares of Class B common stock, both with $0.01 par value per share. The holders of Class A common stock are entitled to one vote for each share. Holders of Class B common stock are entitled to ten votes for each share. There are no differences between the two classes of common stock other than the number of votes. The holders of Class A and Class B common stock shall share equally on a per-share basis all dividends and other cash, stock or property distributions. Upon written request of any holder of Class B common stock, any shares will be automatically converted on a share-for-share basis into the same number of shares of Class A common stock. In addition, upon any transfer, sale or other disposition of shares of Class B common stock, other than transfers to certain permitted transferees, such shares shall be converted into shares of Class A common stock on a share-for-share basis. Also, upon completion of an underwritten public offering in which we become listed on a national securities exchange, all outstanding shares of Class B common stock shall automatically be converted into shares of Class A common stock on a share-for-share basis. As long as Class B common stock is outstanding, if a holder of Class B common stock purchases any shares of Class A common stock, the holder may convert the Class A common shares on a share-for-share basis into the same number of shares of Class B common stock. Stock options Outstanding 6,896,705 4,022,907 4,165,416 2,562,150 Price ranges $5.77 $5.77 $5.77 $0.38 - $36.75 Expiration ranges 7/20/11 - 11/5/13 7/20/11 - 7/31/12 7/20/11 6/8/04 - 8/31/10 Stock warrants Outstanding 708,019 708,019 708,019 597,969 Price $10.825 $10.825 $10.825 $30.00 Expiration date 8/27/07 8/27/07 8/27/07 8/28/04 All options and warrants for the year ended December 31, 2003 and for the period from January 1 to July 20, 2001 were anti-dilutive since we reported a net loss in these periods. Any assumed exercise of options or warrants would have been anti-dilutive as they would have resulted in a lower loss per share. Exercisable at end of year 4,501,359 $ 10.66 4,233,299 $ 11.31 Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) During the period from February 20 (inception) to December 31, 2001, we recorded nonrecurring pre-tax charges totaling $6.4 million, which mainly related to the write-off of e-business investments. During the period from January 1 to July 20, 2001, CBRE recorded merger-related and other nonrecurring charges of $22.1 million, which included merger-related costs incurred of $16.4 million, severance costs incurred of $2.8 million related to CBRE s cost reduction program implemented in May 2001, as well as the write-off of an e-business investment of $2.9 million. 20. Guarantor and Nonguarantor Financial Statements The 9 3/4% Senior Notes are jointly and severally guaranteed on a senior basis by us and substantially all of our domestic subsidiaries. In addition, the 11 1/4% Senior Subordinated Notes are jointly and severally guaranteed on a senior subordinated basis by us and substantially all of our domestic subsidiaries. See Note 12 for additional information on the 9 3/4% Senior Notes and the 11 1/4% Senior Subordinated Notes. The following condensed consolidating financial information includes: (1) Condensed consolidating balance sheets as of December 31, 2003 and 2002; condensed consolidating statements of operations for the years ended December 31, 2003 and 2002, the period from February 20 (inception) to December 31, 2001 and the period from January 1 to July 20, 2001, and condensed consolidating statements of cash flows for the years ended December 31, 2003 and 2002, the period from February 20 (inception) to December 31, 2001 and the period from January 1 to July 20, 2001 of (a) CB Richard Ellis Group as the parent, (b) CBRE as the subsidiary issuer, (c) the guarantor subsidiaries, (d) the nonguarantor subsidiaries and (e) CB Richard Ellis Group on a consolidated basis; and (2) Elimination entries necessary to consolidate CB Richard Ellis Group as the parent, with CBRE and its guarantor and nonguarantor subsidiaries. Investments in consolidated subsidiaries are presented using the equity method of accounting. The principal elimination entries eliminate investments in consolidated subsidiaries and intercompany balances and transactions. The preliminary purchase accounting adjustments associated with the Insignia Acquisition have been recorded in the accompanying consolidated financial statements. The condensed consolidated balance sheet as of December 31, 2003 reflects the allocation of goodwill based upon the estimated fair value of Insignia s acquired reporting units (See Note 3 for additional information). Weighted-average fair value of grants during the year $ 2.90 $ 5.32 SUPPLEMENTAL DATA: Cash paid during the period for: Interest, net of amount capitalized $ 15,823 $ 44,201 $ 1,491 $ 2,203 $ 63,718 Income taxes, net of refunds 17,783 17,783 SUPPLEMENTAL DATA: Cash paid during the period for: Interest, net of amount capitalized $ 8,509 $ 38,751 $ 1,635 $ 3,752 $ 52,647 Income taxes, net of refunds 19,142 19,142 SUPPLEMENTAL DATA: Cash paid during the period for: Interest, net of amount capitalized $ 2,600 $ 22,562 $ 874 $ 90 $ $ 26,126 Income taxes, net of refunds 5,061 5,061 SUPPLEMENTAL DATA: Cash paid during the period for: Interest, net of amount capitalized $ 17,194 $ 1,165 $ 98 $ 18,457 Income taxes, net of refunds 19,083 19,083 Table of Contents INSIGNIA FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Significant option, warrant and unvested restricted stock groups outstanding at December 31, 2002 and related weighted average price and life information follows: Outstanding The long-lived assets shown in the table above include property and equipment. Exercisable Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) 22. Related Party Transactions Included in other current and other assets in the accompanying consolidated balance sheets are employee loans of $31.7 million and $5.9 million as of December 31, 2003 and 2002, respectively. The majority of these loans represent sign-on and retention bonuses issued or assumed in connection with the Insignia Acquisition as well as prepaid retention and recruitment awards issued to employees. These loans are at varying principal amounts, bear interest at rates up to 10% per annum and mature on various dates through 2008. As of December 31, 2002, the outstanding employee loan balances included a $0.3 million loan to Ray Wirta, our Chief Executive Officer, and a $0.2 million loan to Brett White, our President. These non-interest bearing loans to Mr. Wirta and Mr. White were issued during 2002 and were due and payable on December 31, 2003. The compensation committee of our board of directors forgave Mr. Wirta s and Mr. White s loans in full, effective January 1, 2004. The accompanying consolidated balance sheets also include $4.7 million and $4.8 million of notes receivable from sale of stock as of December 31, 2003 and 2002, respectively. These notes are primarily comprised of full recourse loans to our employees, officers and certain shareholders, and are secured by our common stock that is owned by the borrowers. These recourse loans are at varying principal amounts, require quarterly interest payments, bear interest at rates up to 10.0% per annum and mature on various dates through 2010. Pursuant to the Equity Incentive Plan (EIP), Mr. Wirta purchased 30,000 shares of CBRE common stock in 2000 at a purchase price of $12.875 per share that was paid for by the delivery of a full recourse promissory note bearing interest at 7.40%. As part of the 2001 Merger, the 30,000 shares of CBRE common stock were exchanged for 83,141 shares of our Class B common stock, which shares were substituted for the CBRE shares as security for the note. All interest charged on the outstanding promissory note balance for any year is forgiven if Mr. Wirta s performance produces a high enough level of bonus, with approximately $7,500 of interest forgiven for each $10,000 of bonus. In 2003, our board of directors forgave all 2002 interest on Mr. Wirta s promissory note. As of December 31, 2003 and 2002, Mr. Wirta had an outstanding loan balance of $385,950, which is included in notes receivable from sale of stock in the accompanying consolidated balance sheets. Pursuant to the EIP, Mr. White purchased 25,000 shares of CBRE common stock in 1998 at a purchase price of $38.50 per share and 20,000 shares of CBRE common stock in 2000 at a purchase price of $12.875 per share. These purchases were paid for by the delivery of full recourse promissory notes. A First Amendment to Mr. White s 1998 promissory note provided that the portion of the then outstanding principal in excess of the fair market value of the shares would be forgiven in the event that Mr. White was an employee of ours or of our subsidiaries on November 16, 2002 and the fair market value of our common stock was at least $38.50 per share on November 16, 2002. Mr. White s promissory note was subsequently amended, terminating the First Amendment and adjusting the original 1998 Stock Purchase Agreement by reducing the purchase price from $13.89 to $5.77. During 2002, the 69,284 shares held as security for the Second Amended Promissory Note were tendered as full payment for this note. The remaining note delivered by Mr. White bears interest at 7.40%. As part of the 2001 Merger, the 20,000 shares of CBRE common stock purchased by Mr. White were exchanged for 55,427 shares of our common Class B common stock, which shares were substituted for CBRE shares as security for the note. All interest charged on the outstanding promissory note balances for any year is forgiven if Mr. White s performance produces a high enough level of bonus, with approximately $7,500 of interest forgiven for each $10,000 of bonus. In 2003, our board of directors forgave all 2002 interest on Mr. White s promissory note. As of December 31, 2003 and 2002, Mr. White had an outstanding loan balance $257,300, which is included in notes receivable from the sale of stock in the accompanying consolidated balance sheets. Range of Exercise Prices Table of Contents CB RICHARD ELLIS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) As of December 31, 2003 and 2002, Mr. White also had an outstanding loan balance of $179,886 and $164,832, respectively, which is included in notes receivable from the sale of stock in the accompanying consolidated balance sheets. This outstanding loan relates to the acquisition of 12,500 shares of CBRE s common stock prior to the 2001 Merger. Subsequent to the 2001 Merger, these shares were converted into 34,642 shares of our common stock and the related loan amount was carried forward. As amended, this loan accrues interest at 6.0%, and the principal and all accrued interest is payable on or before April 23, 2010. Mr. White repaid this loan in full on February 10, 2004. At the time of the 2001 Merger, Mr. Wirta delivered to us an $80,000 promissory note, which bore interest at 10% per year, as payment for the purchase of 13,857 shares of our Class B common stock. Mr. Wirta repaid this promissory note in full in April of 2002. Additionally, Mr. Wirta and Mr. White delivered full-recourse notes in the amounts of $512,504 and $209,734, respectively, as payment for a portion of the shares of Class A common stock purchased in connection with the 2001 Merger. These notes bear interest at 10% per year. During the year ended December 31, 2002, Mr. Wirta paid down his loan amount by $40,004 and Mr. White paid off his note in its entirety. During the year ended December 31, 2003, Mr. Wirta paid down his loan amount by $70,597. As of December 31, 2003 and 2002, Mr. Wirta has an outstanding loan balance of $401,903 and $472,500, respectively, which is included in notes receivable from sale of stock in the accompanying consolidated balance sheets. In the event that our common stock is not freely tradable on a national securities exchange or an over-the-counter market by May 30, 2004, we agreed in 2001 to loan Mr. Wirta up to $3.0 million on a full-recourse basis to enable him to exercise an existing option to acquire shares held by the Koll Holding Company if Mr. Wirta is employed by us at the time of exercise, was terminated without cause or resigned for good reason. This loan will become repayable upon the earliest to occur of the following: (1) 90 days following termination of his employment, other than without cause or by him for good reason, (2) seven months following the date our common stock becomes freely tradable as described above or (3) the receipt of proceeds from the sale of the pledged shares. This loan will bear interest at the prime rate in effect on the date of the loan, compounded annually, and will be repayable to the extent of any net proceeds received by Mr. Wirta upon sale of any shares of our common stock. Mr. Wirta is required to pledge the shares received upon exercise of the option as security for the loan. 23. Subsequent Event On May 4, 2004, we amended our Certificate of Incorporation increasing the authorized Class A common shares to 325,000,000 and the authorized Class B common shares to 100,000,000. Additionally, on May 4, 2004, we effected a three-for-one split of our outstanding Class A common stock and Class B common stock, which split was effected by a stock dividend. In addition, on June 7, 2004, we effected a 1-for-1.0825 reverse stock split of our outstanding Class A common stock and Class B common stock. The applicable share and per share data for all periods included herein have been restated to give effect to these stock splits. Number Outstanding (1) EPS is defined as earnings (loss) per share Weighted Average Remaining Contractual Life Weighted Average Exercise Price See Notes to Condensed Consolidated Financial Statements. Number Exercisable See Notes to Condensed Consolidated Financial Statements. Weighted Average Exercise Price See Notes to Condensed Consolidated Financial Statements. $0.00 - $7.50 1,017,526 1.9 years $5.82 560,066 $6.41 $7.51 - $11.00 2,108,000 2.5 years $8.40 1,723,330 $8.06 $11.01 - $14.00 1,308,965 1.7 years $12.61 901,081 $12.65 $14.01 - $15.69 1,316,882 0.8 years $14.51 1,316,882 $14.51 Table of Contents INSIGNIA FINANCIAL GROUP, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 1. Business Insignia Financial Group, Inc. ( Insignia or the Company ), a Delaware corporation headquartered in New York, New York, is a leading provider of international real estate and real estate financial services, with operations in the United States, United Kingdom, France, continental Europe, Asia and Latin America. Insignia s real estate service businesses offer a diversified array of services including commercial leasing, sales brokerage, corporate real estate consulting, property management, property development, re-development and real estate oriented financial services. In addition to traditional real estate services, Insignia has historically deployed its own capital, together with the capital of third party investors, in principal real estate investments, including co-investment in existing property assets, real estate development and managed private investment funds. The Company s real estate service operations and real estate investments are more fully described below. Insignia s primary real estate service businesses include the following: Insignia/ESG (United States, commercial real estate services), Insignia Richard Ellis (United Kingdom, commercial real estate services) and Insignia Bourdais (France, commercial real estate services; acquired in December 2001). Insignia also offers commercial real estate services throughout continental Europe, Asia and Latin America. Insignia s other businesses in continental Europe include operations in Germany, Italy, Spain, Holland and Belgium. Insignia s New York-based residential businesses Insignia Douglas Elliman and Insignia Residential Group were sold on March 14, 2003 (see further discussion under the caption Discontinued Operations in Note 6). 2. Interim Financial Information The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States ( GAAP ) for interim financial information. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the six months ended June 30, 2003 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2003. For further information, refer to the consolidated financial statements and footnotes thereto included in the Company s Annual Report on Form 10-K for the year ended December 31, 2002. 3. Reclassifications Certain amounts for the prior year have been reclassified to conform to the 2003 presentation. These reclassifications have no effect on reported net loss. 4. Seasonality The Company s revenues are substantially derived from tenant representation, agency leasing, investment sales and consulting services. Revenues generated by these services are transactional in nature and therefore affected by seasonality, availability of space, competition in the market place and changes in business and capital market conditions. A significant portion of the expenses associated with these transactional activities are directly correlated to revenue. Also, certain conditions to revenue recognition for leasing commissions are outside of the Company s control. Consistent with the industry in general, the Company s revenues and operating income have historically been lower during the first three calendar quarters than in the fourth quarter. The reasons for the concentration of earnings in the fourth quarter include a general, industry-wide focus on completing transactions by calendar year Table of Contents INSIGNIA FINANCIAL GROUP, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) end, as well as the constant nature of the Company s non-variable expenses throughout the year versus the seasonality of its revenues. This phenomenon has generally produced a historical pattern of higher revenues and income in the last half of the year and a gradual slowdown in transactional activity and corresponding operating results during the first quarter. This tendency notwithstanding, it is possible that any fourth quarter may not be the best performing quarter of a particular year. Insignia s quarterly earnings are also susceptible to the potential adverse effects of unforeseen market disruptions like that of the third quarter of 2001 caused by the events of September 11. Consequently, future revenue production and earnings may be difficult to predict and comparisons from period to period may be difficult to interpret. 5. Foreign Currency The financial statements of the Company s foreign subsidiaries are measured using the local currency as the functional currency. The British pound and euro represent the only foreign currencies of material operations, which collectively generated approximately 30% of the Company s service revenues for the six months ended June 30, 2003. Revenues and expenses of all foreign subsidiaries have been translated into U.S. dollars at the average exchange rates prevailing during the periods. Assets and liabilities have been translated at the rates of exchange at the balance sheet date. Translation gains and losses are deferred as a separate component of stockholders equity in accumulated other comprehensive income (loss), unless there is a sale or complete liquidation of the underlying foreign investment. Gains and losses from foreign currency transactions, such as those resulting from the settlement of foreign receivables or payables, are included in the consolidated statements of operations in determining net income. For the six months ended June 30, 2003, European operations were translated to U.S. dollars at average exchange rates of $1.61 to the British pound and $1.10 to the euro. The assets and liabilities of the Company s European operations have been translated at exchange rates of $1.65 to the British pound and $1.14 to the euro at June 30, 2003. 6. Discontinued Operations On March 14, 2003, Insignia completed the sale of its New York-based residential businesses, Insignia Residential Group and Insignia Douglas Elliman, to Montauk Battery Realty. Montauk Battery Realty is located on Long Island, New York and its principal owners are New Valley Corp. and Dorothy Herman, chief executive officer of Prudential Long Island Realty. The total purchase price of $71.75 million was paid or is payable as follows: (i) $66.75 million paid in cash to Insignia at the closing of the transaction; (ii) $500,000 in cash held in escrow on the closing date and up to another $500,000 held in escrow pending receipt of specified commissions; and (iii) the assumption by the buyer of up to $4.0 million in existing contingent earn-out payment obligations of Insignia Douglas Elliman. The escrowed amounts are available to secure Insignia s indemnity obligations under the purchase and sale agreement. Any amounts remaining in escrow on March 14, 2004 and not securing previously made indemnity claims will be released to Insignia. Insignia Douglas Elliman, acquired by Insignia in June 1999, provides sales and rental services in the New York City residential cooperative, condominium and rental apartment market and also operates in upscale suburban markets in Long Island (Manhasset, Locust Valley and Port Washington/Sands Point). Insignia Residential Group is the largest manager of cooperative, condominium and rental apartments in the New York metropolitan area, providing full service third-party fee management for more than 250 properties, comprising approximately 60,000 residential units. These residential businesses collectively produced service revenues in 2002 and 2001 of $133.7 million and $119.2 million, respectively. All intangible assets are being amortized over their estimated useful lives with no residual value. Intangibles included in Other consist of customer backlog, non-compete agreements, franchise agreements and trade names. The aggregate acquired intangible amortization expense for the six months ended June 30, 2003 and 2002 totaled $1.2 million and $2.7 million, respectively. The decline in amortization expense in 2003 is attributed to property management contracts and customer backlog that were fully amortized in 2002. 8. Real Estate Investments Insignia has historically invested in real estate assets and real estate debt securities. Insignia has engaged in real estate investment generally through: (i) investment in operating properties through co-investments with various clients or, in limited instances, by itself; (ii) investment in and development of commercial real estate on its own behalf and through co-investments; and (iii) minority ownership in and management of private investment funds, whose investments primarily consist of securitized real estate debt. At June 30, 2003, the Company s real estate investments totaled $131.4 million, consisting of the following: (i) $19.3 million in minority-owned operating properties; (ii) $87.2 million of real estate carrying value attributed to three real estate investment entities consolidated by Insignia for financial reporting purposes; (iii) $8.1 million in four minority owned office development properties; (iv) $1.7 million in a land parcel held for development; 5,751,373 $10.30 4,501,359 $10.66 The Company s debt includes borrowings under its $165.0 million senior revolving credit facility (as amended), borrowings under a $37.5 million subordinated credit facility entered into in June 2002, acquisition loan notes issued in connection with previous acquisitions in the United Kingdom and real estate mortgage notes collateralized by real estate properties. The senior credit facility bears interest at a margin above LIBOR, which was 2.0% at June 30, 2003. In March 2003, Insignia repaid $67.0 million on the senior revolving credit facility as a result of the March 14, 2003 Long-lived assets are comprised of property and equipment, real estate investments, goodwill and acquired intangible assets. 12. Contingencies Insignia and certain subsidiaries are defendants in lawsuits arising in the ordinary course of business. Management does not expect that the results of any such lawsuits will have a significant adverse effect on the financial condition, results of operations or cash flows of the Company. All contingencies, including unasserted claims or assessments, which are probable and the amount of loss can be reasonably estimated are accrued in accordance with Statement of Accounting Standards ( SFAS ) No. 5, Accounting for Contingencies. 13. CB Richard Ellis Merger and Related Transactions On February 17, 2003, Insignia entered into an Agreement and Plan of Merger with CB Richard Ellis Group, Inc., CB Richard Ellis Services, Inc. ( CB ) and Apple Acquisition Corp., a wholly owned subsidiary of CB, pursuant to which, upon the terms and subject to the conditions set forth therein, including the approval of Insignia s stockholders, Apple Acquisition Corp. would be merged with and into Insignia (the Merger ), with Table of Contents INSIGNIA FINANCIAL GROUP, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Insignia being the surviving corporation in the Merger and becoming a wholly owned subsidiary of CB. The Merger closed on July 23, 2003 and Insignia s common shareholders received cash consideration of $11.156 per share. Insignia incurred approximately $4.9 million of expenses for legal and other services in connection with the Merger during the first six months of 2003. Such expenses are included in administrative expenses in the Company s statement of operations for the six months ended June 30, 2003. Separately, on July 23, 2003, Insignia sold substantially all of its real estate investment assets to Island Fund I LLC prior to the closing of the Merger. The purchase price in the sale aggregated $44.8 million and included $36.9 million paid in cash to Insignia at closing and the assumption by the buyer of $7.9 million in contractual obligations to certain executive officers, including the Company s Chairman, who are also officers of Island Fund. The Company recognized a loss of approximately $12.8 million (before income tax effects) in connection with the sale. 14. Supplemental Information The following supplemental information includes: (i) condensed consolidating balance sheet as of June 30, 2003; and (ii) condensed consolidating statements of operations and cash flows for the six months ended June 30, 2003 and 2002, respectively, of the Company s domestic commercial service operations (including operations of Insignia/ESG, Inc. and unallocated administrative expenses and corporate assets of Insignia), all other operations (comprised of international service operations and real estate investment operations) and the Company on a consolidated basis. Investments in consolidated subsidiaries are presented using the equity method of accounting. The principal elimination entries eliminate investments in consolidated subsidiaries and intercompany balances and transactions. (In thousands) United States $ (3,583 ) $ 4,200 Foreign 19,632 5,674 Table of Contents INDEPENDENT AUDITORS REPORT The Stockholders Insignia Financial Group, Inc.: We have audited the accompanying consolidated balance sheet of Insignia Financial Group, Inc. and subsidiaries as of December 31, 2002, and the related consolidated statements of operations, stockholders equity, and cash flows for the year then ended. These consolidated financial statements are the responsibility of the Company s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audit. We conducted our audit in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Insignia Financial Group, Inc. and subsidiaries as of December 31, 2002, and the results of their operations and their cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America. As discussed in Notes 2 and 4 to the consolidated financial statements, the Company adopted the fair value recognition provisions of Financial Accounting Standards Board Statement No. 123, Accounting for Stock-Based Compensation, and the provisions of Statement No. 141, Business Combinations, and Statement No. 142, Goodwill and Other Intangible Assets effective January 1, 2002. /S/ KPMG LLP New York, New York October 15, 2003 Table of Contents REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM Board of Directors Insignia Financial Group, Inc. We have audited the accompanying consolidated statements of operations, stockholders equity and cash flows of Insignia Financial Group, Inc. for the year ended December 31, 2001. These financial statements are the responsibility of the Company s management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated results of operations, changes in stockholders equity and cash flows of Insignia Financial Group, Inc. for the year ended December 31, 2001 in conformity with U.S. generally accepted accounting principles. /S/ ERNST & YOUNG LLP New York, New York February 8, 2002, except Notes 3, 4, 5, 15 and 19, as to which the date is October 15, 2003 $ 16,049 $ 9,874 See accompanying notes to the consolidated financial statements. See accompanying notes to the consolidated financial statements. See accompanying notes to consolidated financial statements. Cash provided by (used in) investing activities $ 7,872 $ (19,779 ) Supplemental disclosure of cash flow information: Cash paid for interest $ 8,956 $ 11,036 Cash paid for income taxes 9,527 7,714 See accompanying notes to consolidated financial statements. Table of Contents INSIGNIA FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2002 1. Business Insignia Financial Group, Inc. ( Insignia or the Company ), a Delaware corporation headquartered in New York, New York, is a leading provider of international real estate and real estate financial services, with operations in the United States, the United Kingdom, France, continental Europe, Asia and Latin America. Insignia s principal executive offices are located at 200 Park Avenue in New York. Insignia s real estate service businesses specialize in commercial leasing, sales brokerage, corporate real estate consulting, property management, property development and re-development, apartment brokerage and leasing, condominium and cooperative apartment management, real estate-oriented financial services, equity co-investment and other services. In 2002, Insignia s primary real estate service businesses include the following: Insignia/ESG (U.S. commercial real estate services), Insignia Richard Ellis (U.K. commercial real estate services), Insignia Bourdais (French commercial real estate services; acquired in December 2001), Insignia Douglas Elliman (New York apartment brokerage and leasing) and Insignia Residential Group (New York condominium, cooperative and rental apartment management). Insignia s commercial real estate service operations in continental Europe, Asia and Latin America include the following locations: Madrid and Barcelona, Spain; Frankfurt, Germany; Milan and Bologna, Italy; Brussels, Belgium; Amsterdam, The Netherlands; Tokyo, Japan; Hong Kong; Beijing and Shanghai, China; Bangkok, Thailand; Mumbai, Hyderabad, Bangalore, Chennai and Delhi, India; Manila, Philippines; and Mexico City, Mexico. The Company also owns 10% of an Irish commercial services company with offices in Dublin, the Republic of Ireland and Belfast, Northern Ireland. In addition to traditional real estate services, Insignia has historically deployed its own capital, together with the capital of third party investors, in principal real estate investments, including co-investment in existing property assets, real estate development and managed private investment funds. 2. Summary of Significant Accounting Policies Basis of Presentation These consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States ( GAAP ). Principles of Consolidation Insignia s consolidated financial statements include the accounts of all majority-owned subsidiaries and all entities over which the Company exercises voting control. All significant intercompany balances and transactions have been eliminated. Entities in which the Company owns less than a majority interest and has substantial influence are recorded on the equity method of accounting (net of payments to certain employees in respect of equity grants or rights to proceeds). In one instance, a minority-owned partnership (with additional promotional interests in profits depending on performance) is consolidated by virtue of general partner control. Since the cumulative losses of the partnership have exceeded the limited partners original investment, the partnership is consolidated into Insignia s financial statements and no minority interest is reflected, even though Insignia holds a minority economic interest. Use of Estimates The preparation of financial statements in conformity with GAAP requires that management make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Estimates and assumptions are used in the evaluation and financial reporting for, among other things, bad debts, self-insurance Table of Contents INSIGNIA FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) liabilities, intangibles and investment valuations, deferred taxes and pension costs. Actual results could differ from those estimates under different assumptions or conditions. Reclassifications Certain amounts for 2001 have been reclassified to conform to the 2002 presentation. These reclassifications had no effect on the net loss or total stockholders equity previously reported. Cash and Cash Equivalents The amount of cash on deposit in federally insured institutions generally exceeds the limit on insured deposits. The Company considers all highly liquid investments with original maturities of three months or less at date of purchase to be cash equivalents. Restricted Cash At December 31, 2002 restricted cash consisted of approximately $17.3 million in cash pledged to secure the bond guarantee of notes issued in connection with the Richard Ellis Group Limited ( REGL ) and St. Quintin Holdings Limited ( St. Quintin ) acquisitions and approximately $4.2 million related to accounts of the consolidated real estate entities. Real Estate Investments Insignia has invested in real estate assets and real estate related debt securities. Generally, the Company s investment strategy involves identifying investment opportunities and investing as a minority owner in entities formed to acquire such assets. The Company s minority-owned investments are generally accounted for under the equity method of accounting due to the Company s influence over the operational decisions made with respect to the real estate entities. The Company s portion of earnings in these real estate entities is reported in equity earnings in unconsolidated ventures in its consolidated statements of operations, including gains on sales of property and net of impairments. The Company s share of unrealized gains on marketable equity and debt securities available for sale is reported as a component of other comprehensive income (loss), net of tax. Income from dispositions of minority-owned development assets is reported in real estate services revenues in the Company s consolidated statements of operations. The Company s policy with respect to the timing of recognition of promoted profit participation interests in its real estate investments is to record such amounts upon collection. Each entity in which the Company holds a real estate investment is a special purpose entity, the assets of which are subject to the obligations only of that entity. Each entity s debt, except for limited and specific guarantees and other commitments aggregating $14.0 million, is either (i) non-recourse except to the real estate assets of the subject entity (subject to limited exceptions standard in such non-recourse financing, including the misapplication of rents or environmental liabilities), or (ii) an obligation solely of such limited liability entity and thus having no recourse to other assets of the Company. The Company provides real estate services to and receives real estate service fees from the entities comprising its principal investment activities. Such fees are generally derived from the following services: (i) property management, (ii) asset management, (iii) development management, (iv) investment management, (v) leasing, (vi) acquisition, (vii) sales and (viii) financings. With respect to fees that are currently recorded as expense by the entities, the Company includes the fees in current income, while its share as owner of such fee is Table of Contents INSIGNIA FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) reflected in the income or loss from the investment entity. If the fee is capitalized by the investment entity, the Company records as income only the portion of the fee attributable to third party ownership and defers the portion attributable to its ownership. The Company evaluates all real estate investments on a quarterly basis for evidence of impairment. Impairment losses are recognized whenever events or changes in circumstances indicate declines in value of such investments below carrying value and the related undiscounted cash flows are not sufficient to recover the asset s carrying amount. Generally, Insignia relies upon the expertise of its own property professionals to assess real estate values; however, in certain circumstances where Insignia considers its expertise limited with respect to a particular investment, third party valuations may also be obtained. Property valuations and estimates of related future cash flows are by nature subjective and will vary from actual results. In October 2001, the Financial Accounting Standards Board ( FASB ) issued Statement of Financial Accounting Standards ( SFAS ) No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, which provides accounting guidance for financial accounting and reporting for the impairment or disposal of long-lived assets. Insignia early adopted SFAS No. 144 as of January 1, 2001. SFAS No. 144 requires, in most cases, that gains/losses from dispositions of investment properties and all earnings from such properties be reported as discontinued operations. SFAS No. 144 is silent with respect to treatment of gains or losses from sales of investment property held in a joint venture. The Company has concluded that, as a matter of policy, all gains and losses realized from sales of minority owned property in its real estate co-investment program constitute earnings from a continuing line of business. Therefore, operating activity related to that investment program will continue to be included in income (loss) from continuing operations. However, SFAS No. 144 requires that gains or losses from sales of consolidated properties, if material, be reported as discontinued operations. As a result, the Company s earnings from dispositions of consolidated properties would be excluded from reported income from continuing operations and included in discontinued operations, if material. Consolidated Real Estate At December 31, 2002, the Company consolidated three investment entities owning real estate property. These consolidated properties include a wholly owned retail property; a wholly owned marine development property and a minority owned residential property consolidated due to general partner control. Rental revenue attributable to the Company s consolidated property operations are recognized when earned. Real estate is stated at depreciated cost. The cost of buildings and improvements include the purchase price of property, legal fees and acquisitions costs. Costs directly related to the development property are capitalized. Capitalized development costs include interest, property taxes, insurance, and other direct project costs incurred during the period of development. The Company periodically reviews its properties to determine if its carrying amounts will be recovered from future operating cash flows. The evaluation of anticipated cash flows is highly subjective and is based in part on assumptions regarding future occupancy, rental rates and capital requirements, which could differ materially from actual results in future periods. Development Activities At December 31, 2002, the Company held minority investments in four office properties whose development the Company has directed. A variety of costs have been incurred in the development and leasing of these properties. Capitalized development costs include interest, internal wages, property taxes, insurance, and other project costs incurred during the period of development. Table of Contents INSIGNIA FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) After determination is made to capitalize a cost, it is allocated to the specific component of a project that is benefited. Determination of when a development project is substantially complete and capitalization must cease involves a degree of judgment. The Company s capitalization policy on its development properties is guided by SFAS No. 34, Capitalization of Interest Costs, and SFAS No. 67, Accounting for Costs and the Initial Rental Operations of Real Estate Properties. The Company ceases capitalization when a property is held available for occupancy upon substantial completion of tenant improvements. Revenue Recognition The Company s real estate services revenues are generally recorded when the related services are performed or at closing in the case of real estate sales. Leasing commissions that are payable upon tenant occupancy, payment of rent or other events beyond the Company s control are recognized upon the occurrence of such events. As certain conditions to revenue recognition for leasing commissions are outside of the Company s control and are not clearly defined, judgment must be exercised in determining when such events have occurred. Revenues from tenant representation, agency leasing, investment sales and residential brokerage, which collectively comprise a substantial portion of Insignia s service revenues, are transactional in nature and therefore subject to seasonality and changes in business and capital market conditions. As a consequence, the timing of transactions and resulting revenue recognition is difficult to predict. Insignia s revenue from property management services is generally based upon percentages of the revenue generated by the properties that it manages. In conjunction with the provision of management services, the Company customarily employs personnel (either directly or on behalf of the property owner) to provide services solely to the properties managed. In most instances, Insignia is reimbursed by the owners of managed properties for direct payroll related costs incurred in the employment of property personnel. The aggregate amount of such payroll cost reimbursements has ranged from $50.0 million to $60.0 million annually. Such payroll reimbursements are generally characterized in the Company s consolidated statements of operations as a reduction of actual expenses incurred. This characterization is based on the following factors: (i) the property owner generally has authority over hiring practices and the approval of payroll prior to payment by the Company; (ii) Insignia is the primary obligor with respect to the property personnel, but bears little or no credit risk under the terms of the management contract; (iii) reimbursement to the Company is generally completed simultaneously with payment of payroll or soon thereafter; and (iv) the Company generally earns no margin in the arrangement, obtaining reimbursement only for actual cost incurred. Advertising Expense The cost of advertising is expensed as incurred. The Company incurred approximately $8,327,000 and $8,926,000 in advertising costs during 2002 and 2001, respectively. Acquired Intangible Assets The Company s acquired intangible assets consist of property management contracts, favorable leases, non-competitive agreements, trademarks and franchises. Acquired intangible assets are stated at cost, less accumulated amortization. These assets are amortized using the straight-line method over 3 to 20 years, and are reviewed when indicators of impairment exist. Intangible assets are reviewed for impairment when indicators of impairment exist. Property and Equipment Property and equipment is stated at cost, less accumulated depreciation. Depreciation is computed principally by the straight-line method over the estimated useful lives of the assets, typically ranging from 3 to 10 years. Table of Contents INSIGNIA FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Foreign Currency The financial statements of the Company s foreign subsidiaries are measured using the local currency as the functional currency. The British pound and euro represent the only foreign currencies of material operations, which collectively generate approximately 25% of the Company s annual revenues. All currencies other than the British pound, euro and dollar have comprised less than 1% of annual revenues. Revenues and expenses of all foreign subsidiaries have been translated into U.S. dollars at the average exchange rates prevailing during the periods. Assets and liabilities have been translated at the rates of exchange at the balance sheet date. Translation gains and losses are deferred as a separate component of stockholders equity in accumulated other comprehensive income (loss), unless there is a sale or complete liquidation of the underlying foreign investment. Gains and losses from foreign currency transactions, such as those resulting from the settlement of foreign receivables or payables, are included in the consolidated statements of operations in determining net income. For the twelve months ended December 31, 2002, the Company s European operations have been translated into U.S. dollars at average exchange rates of $1.51 to the pound and $0.95 to the euro. For the twelve months of 2001, European operations were translated to U.S. dollars at average exchange rates of $1.44 and $0.90 to the pound and euro, respectively. The assets and liabilities of the Company s European operations have been translated at exchange rates of $1.60 to the pound and $1.05 to the euro at December 31, 2002. Accumulated Other Comprehensive Income (Loss) Other comprehensive income (loss) consists of unrealized gains (losses) on marketable equity securities, foreign currency translation and minimum pension liability adjustments. At December 31, 2002, accumulated other comprehensive losses totaled $5.1 million (net of applicable taxes), comprised of unrealized gains on marketable securities of $1.1 million and foreign currency translation gains of $4.4 million and a minimum pension liability of $10.6 million. Minority Interest During the first half of 2000, Insignia consolidated EdificeRex.com, Inc. ( EdificeRex ), the Company s internally developed internet-based business that launched in February 2000, and recorded net operating losses of approximately $9.3 million, or $3.2 million in excess of the Company s investment. EdificeRex was de-consolidated in the third quarter of 2000, due to an equity restructuring that reduced the Company s voting interest to approximately 47%. The $3.2 million excess loss was carried as a deferred credit on the Company s balance sheet until EdificeRex disposed of all of its operating divisions and liquidated during the fourth quarter of 2001. At liquidation, the Company recognized the deferred credit of $3.2 million in earnings, which is included in losses from internet investments. Income Taxes Deferred income tax assets and liabilities are recorded to reflect the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective income tax bases and operating loss and tax credit carry forwards. Valuation allowances are provided against deferred tax assets that are unlikely to be realized. Federal income taxes are not provided on the unremitted earnings of foreign subsidiaries because it has been the practice of the Company to reinvest those earnings in the businesses outside the United States. Table of Contents INSIGNIA FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Impairment In October 2001, the FASB issued SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. SFAS No. 144 provides guidance for accounting and financial reporting for the impairment or disposal of long-lived assets. While SFAS No. 144 supersedes SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of, it retains the fundamental provisions of that Statement. It also supersedes the accounting and reporting of APB Opinion No. 30, Reporting the Results of Operations Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions related to the disposal of a segment of a business. However, it retains the requirement in Opinion 30 to report separately discontinued operations and extends that reporting to a component of an entity either disposed of or classified as held for sale. SFAS No. 144 is effective for fiscal years beginning after December 15, 2001. Insignia early adopted SFAS No. 144 as of January 1, 2001. Impairment losses are recognized for long-lived assets held and used when indicators of impairment are present and the undiscounted cash flows are not sufficient to recover the assets carrying amount. Impairment losses are measured for assets held for sale by comparing the fair value of assets (less costs to dispose) to their respective carrying amounts. Goodwill and Other Intangible Assets Goodwill represents the excess of costs over fair value of assets of businesses acquired. As described in Note 4, the Company adopted the provisions of SFAS No. 142, Goodwill and Other Intangible Assets, as of January 1, 2002. Goodwill and intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized, but instead tested for impairment at least annually in accordance with the provisions of SFAS No. 142. Prior to the adoption of SFAS No. 142, goodwill was amortized on a straight-line basis over the expected periods to be benefited, generally 5 to 25 years, and evaluated for potential impairment by determining whether the underlying undiscounted cash flows of the acquired business were sufficient to recover the carrying value of the asset. Stock-Based Compensation At December 31, 2002, the Company had four stock-based employee compensation plans that are described more fully in Note 14. Prior to 2002, the Company accounted for those plans under the recognition and measurement provisions of APB Opinion No. 25, Accounting for Stock Issued to Employees and related interpretations. Effective January 1, 2002 the Company adopted the fair value recognition provisions of SFAS 123, Accounting for Stock-Based Compensation, prospectively to all employee awards granted, modified or settled after January 1, 2002. Awards under the Company s plans vest over five years. The cost related to stock-based employee compensation included in the determination of net income for 2002 is less than that which would have been recognized if the fair value based method had been applied to all awards since the original effective date of SFAS 123. The following table illustrates the pro forma effect on net income and earnings per share if the fair value based method had been applied to all outstanding awards in each period. Risk-free interest rate 2.5 % 3.7 % Dividend yield N/A N/A Volatility factors of the expected market price 0.45 0.49 Weighted-average expected life of the options 3.9 4.3 The Black-Scholes option valuation model was developed for use in estimating the fair value of transferable options and warrants with no vesting restrictions. This method requires the input of subjective assumptions including the expected stock price volatility and weighted average expected life of the options. The Company s employee stock options have characteristics significantly different from those of transferable options and changes in the subjective input assumptions can materially affect the value estimate. The Black-Scholes model is not the only reliable measure that could be used to determine the fair value of employee stock options. The Company believes that any and all valuations of employee stock options will necessarily be estimates. Risks and Uncertainties The Company s future results could be adversely affected by a number of factors, including (i) a general economic downturn in the Company s principal markets, most notably New York, London and Paris; (ii) unfavorable foreign currency fluctuations; (iii) changes in interest rates; and (iv) fluctuations in rental rates and real estate values. Earnings Per Share Basic earnings per share is calculated using income available to common shareholders divided by the weighted average number of common shares outstanding during the year. Diluted earnings per share is similar to basic earnings per share except that the weighted average number of common shares outstanding is increased to include the number of additional common shares that would have been outstanding if the potentially dilutive securities, such as preferred stock, options and warrants, had been issued or exercised. Table of Contents INSIGNIA FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Recent Accounting Pronouncements In January 2003, the Financial Accounting Standards Board (FASB ) issued Interpretation No. 46, Consolidation of Variable Interest Entities, an interpretation of ARB No. 51. This Interpretation addresses the consolidation by business enterprises of variable interest entities as defined in the Interpretation. The Interpretation applies immediately to variable interests in variable interest entities created after January 31, 2003, and to variable interests in variable interest entities obtained after January 31, 2003. The Interpretation requires certain disclosures in financial statements issued after January 31, 2003 if it is reasonably possible that the Company will consolidate or disclose information about variable interest entities when the Interpretation becomes effective. A public enterprise with a variable interest in a variable interest entity created before February 1, 2003, shall apply this guidance (other than the required disclosures prior to the effective date) to that entity as of the beginning of the first interim or annual reporting period beginning after December 15, 2003. The application of this Interpretation is not expected to have a material effect on the Company s consolidated financial statements. In November 2002, the FASB issued Interpretation No. 45, Guarantor s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness to Others, an interpretation of FASB Statements No. 5, 57 and 107 and a rescission of FASB Interpretation No. 34. This Interpretation elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under guarantees issued. The Interpretation also clarifies that a guarantor is required to recognize, at inception of a guarantee, a liability for the fair value of the obligation undertaken. The initial recognition and measurement provisions of the Interpretation are applicable to guarantees issued or modified after December 31, 2002 and are not expected to have a material effect on the Company s consolidated financial statements. In June 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities. SFAS No. 146 provides guidance for accounting and financial reporting for costs associated with exit or disposal activities and supersedes Emerging Issues Task Force (EITF) Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity. SFAS No. 146 requires the recognition of a liability for costs associated with an exit or disposal activity when the liability is incurred and establishes fair value as the initial measurement of a liability. Under EITF Issue No. 94-3, a liability for an exit cost is recognized at the date of a commitment to an exit plan. SFAS No. 146 is effective for exit or disposal activities initiated after December 31, 2002. 3. Discontinued Operations Sale of Insignia Douglas Elliman and Insignia Residential Group On March 14, 2003, Insignia completed the sale of its New York-based residential businesses, Insignia Douglas Elliman and Insignia Residential Group, to Montauk Battery Realty, LLC. Montauk Battery Realty is located on Long Island, New York and its principal owners are New Valley Corp. and Dorothy Herman, chief executive officer of Prudential Long Island Realty. Insignia Douglas Elliman, acquired by Insignia in June 1999, provides sales and rental services in the New York City residential cooperative, condominium and rental apartment market and also operates in upscale suburban markets in Long Island (Manhasset, Locust Valley and Port Washington/Sands Point). Insignia Residential Group is the largest manager of cooperative, condominium and rental apartments in the New York metropolitan area. The financial terms of the sale included the payment of $66.75 million in cash to Insignia at closing of the transaction, $500,000 in cash held in escrow on the closing date and up to another $500,000 held in escrow pending receipt of specified commissions. In addition, the buyer acceded to existing contingent earn-out obligations of Insignia Douglas Elliman totaling up to $4.0 million, depending on the future of the business. The Table of Contents INSIGNIA FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) escrowed amounts are available to secure Insignia s indemnity obligations under the purchase and sale agreement. Any amounts remaining in escrow on March 14, 2004 and not securing previously made indemnity claims will be released to Insignia. Simultaneous with closing, Insignia paid down $67.0 million on its senior revolving credit facility, decreasing outstanding borrowings to $28.0 million. Insignia recognized a net gain of approximately $3.8 million (net of $4.7 million of applicable income taxes) during the first quarter of 2003 in connection with the sale of these residential businesses. The operations of Insignia Douglas Elliman and Insignia Residential Group were discontinued in the first quarter of 2003. The Company s statements of operations and statements of cash flows for the years ended December 31, 2002 and 2001 have been restated to classify the operations and cash flows of these residential businesses as discontinued operations for financial reporting purposes. Sale of Realty One In December 2001, Insignia entered into a contract to sell its Realty One single-family home brokerage business and affiliated companies to Real Living, Inc., effective as of December 31, 2001. Real Living, Inc. is a privately held company formed by HER Realtors of Columbus, Ohio and Huff Realty of Cincinnati, Ohio. The sale closed on January 31, 2002. Proceeds from the sale potentially total $33.0 million, including approximately $29.0 million in cash received at closing (before extinguishment of $5.5 million of Realty One debt) and additional receipts aggregating as much as $4.0 million. The additional receipts include the following: (i) a $1.0 million reimbursement, collected in February 2002, for Realty One operating losses in January 2002; (ii) a potential earn-out of as much as $2 million receivable through 2003 (depending on the performance of the Realty One business); and (iii) a $1 million operating lease receivable over four years for the use of proprietary software developed by Insignia for an internet-based residential brokerage model. The $2.0 million earnout is receivable in increments of $1.0 million each for the 2002 and 2003 fiscal years. The first $1.0 million earnout for the 2002 fiscal year was achieved in full and be received by the Company in May 2003, as required by the terms of the sale. Remaining amounts due to Insignia under the terms of the sale totaling $2.7 million were included in other assets in the Company s consolidated balance sheet at December 31, 2002. Insignia recognized a loss in connection with the sale of Realty One of $17.6 million (net of applicable tax benefit of $4.0 million) for the year ended December 31, 2001. During the twelve months ended December 31, 2002, the Company recognized net income of $4.9 million from discontinued operations, including $265,000 (net of tax), in post-closing adjustments in the first quarter and $4.7 million in the third quarter from the reduction of a valuation allowance on the tax benefit on the capital portion of the loss on sale. This capital loss was fully reserved in 2001 because of uncertainty of its deductibility due to loss disallowance rules in the Treasury Regulations and insufficient income of the appropriate character. In the third quarter of 2002, it was determined that the loss would be fully deductible for tax purposes, resulting in the realization of a tax benefit for financial reporting purposes. 4. Changes in Accounting Principles Stock-Based Compensation In September 2002, the Company adopted the fair value expense recognition provisions of SFAS No. 123, Accounting for Stock-Based Compensation, in accounting for employee stock options. The accounting change results in the expensing of the estimated fair value of employee stock options granted by the Company, applied on a prospective basis for all stock options granted on or after January 1, 2002. The Company previously followed Accounting Principles Board ( APB ) Opinion No. 25, Accounting for Stock Issued to Employees. Under APB Opinion No. 25, no compensation expense is recognized when the exercise price of an employee stock option equals or exceeds the market price at issuance. Table of Contents INSIGNIA FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) The Company issued 290,000 employee options during 2002. The fair value of these options has been estimated as of the date of grant using the Black-Scholes option pricing model with the following assumptions: (i) estimated stock price volatility of 40%; (ii) risk free interest rate of 2.5%; (iii) weighted average option life of 3.9 years; and (iv) a forfeiture rate of 3%. Under these assumptions, the aggregate value of the options totaled approximately $384,000, which is amortizable to expense over the vesting periods of six years. For 2002, stock compensation expense recognized totaled approximately $102,000. The ultimate impact of the accounting change on the Company s future earnings will depend on the number of options issued in the future, as to which the Company has no specific plan, and the estimated value of each option. Insignia does not expense the value of outstanding options issued before January 1, 2002. Goodwill and Intangible Assets In June 2001, the FASB issued SFAS No. 141, Business Combinations, and No. 142, Goodwill and Other Intangible Assets. SFAS 141 replaced APB 16 and requires the use of the purchase method for all business combinations initiated after June 30, 2001. It also provides guidance on purchase accounting related to the recognition of intangible assets. Under SFAS 142, goodwill and other intangible assets deemed to have indefinite lives are no longer amortized but are subject to impairment tests on an annual basis, at a minimum, or whenever events or circumstances occur indicating goodwill or indefinite-lived intangibles might be impaired. Other acquired intangible assets with finite lives continue to be amortized over their estimated useful lives. The Company adopted SFAS No. 141 for all business combinations completed after June 30, 2001 and fully implemented SFAS No. 141 and SFAS No. 142 effective January 1, 2002. The Company identified its reporting units and determined the carrying value of each reporting unit by assigning assets and liabilities, including the existing goodwill and intangible assets, to those units as of January 1, 2002 for purposes of performing a required transitional goodwill impairment assessment within six months of adoption. In early 2002, the Company performed internal analyses on its reporting units based on estimated industry multiples and the carrying values of tangible and intangible assets which demonstrated that the value of the Company s U.S. commercial operation significantly exceeded its carrying value and that goodwill of the Asian operation was fully impaired. These analyses also indicated potential impairment in the Company s European operations and Insignia Douglas Elliman. The Company engaged Standard & Poor s to value the European and Insignia Douglas Elliman operations and those appraisals indicated no impairment in the Company s European operations and partial impairment in Insignia Douglas Elliman. As a result of this evaluation, Insignia measured impairment for Insignia Douglas Elliman and the Asian business of an aggregate $30.0 million, before applicable taxes. The Company recorded a $20.6 million (net of tax benefit of $9.4 million) transitional goodwill impairment charge in earnings as the cumulative effect of a change in accounting principle, effective January 1, 2002. The Company concluded its annual impairment test as of December 31, 2002, and that test did not demonstrate further goodwill impairment. The estimation of business values for measuring goodwill impairment is highly subjective and selections of different projected income levels and valuation multiples within observed ranges can yield different results. Amortization of goodwill (from continuing operations) totaled approximately $14.8 million for 2001. Elimination of goodwill amortization would have improved income from continuing operations by approximately Total deferred (644 ) (2,754 ) The potential dilutive shares from the conversion of preferred stock is not assumed for the year ended December 31, 2002 or 2001, because the inclusion of such shares would be antidilutive. Table of Contents INSIGNIA FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 6. Acquisitions The Company s significant acquisitions during the last two years are discussed below. All acquisitions were accounted for as purchases and the results of operations have been included in Insignia s statement of operations from the respective date of acquisition. Contingent purchase consideration is generally accounted for as additional costs in excess of net assets of acquired businesses when incurred. Groupe Bourdais In late December 2001, Insignia completed the acquisition of Groupe Bourdais, one of France s premier commercial real estate services companies. Groupe Bourdais now operates under the Insignia Bourdais name. The Insignia Bourdais purchase price consists of total potential consideration of approximately $50.2 million. Amounts paid and or accrued in cash or stock (534,125 common shares) at December 31, 2002 total approximately $31.7 million. Additional consideration up to approximately $18.5 million may be paid over the two years ending December 31, 2004, depending on the performance of the Insignia Bourdais operation. The acquisition consisted substantially of specifically identified intangible assets and goodwill. Identified intangible assets, included customer backlog, property management contracts, a non-compete agreement, franchise agreements, trademarks and a favorable premises lease. The results of Insignia Bourdais have been included in the Company s financial statements since January 1, 2002. Baker Commercial In October 2001, Insignia acquired Baker Commercial Real Estate ( Baker ), a leading provider of commercial real estate services in the greater Dallas area. Baker provides tenant representation, land and investment property sales, and strategic real estate planning. The Baker acquisition augments Insignia s existing regional tenant representation and investment sales capabilities in the greater Dallas area. The base purchase price was approximately $2.2 million and was paid in cash. Additional purchase consideration of up to $1.0 million payable over 2003 and 2004 is contingent on the future performance of the Dallas operations. Other Information (Unaudited) Pro forma unaudited results of operations for the year ended December 31, 2001, assuming consummation of the Bourdais acquisition at January 1, 2001, is as follows (in thousands, except per share data): Revenues $ 672,115 Income from continuing operations 9,012 Net loss (11,053 ) Pro forma per share amounts: Net loss basic $ (0.50 ) Net loss assuming dilution (0.47 ) Accounts receivable consists primarily of property management fees and cost reimbursements. Commissions receivable consists primarily of brokerage and leasing commissions from users of the Company s real estate services. The Company s receivables are not collateralized; however, credit losses have been insignificant. The Company s bad debt expense totaled approximately $5.0 million and $1.9 million in 2002 and 2001, respectively. The useful life of each property and equipment category is listed below: Data processing equipment, 3 years; Computer software, 2-10 years; Furniture and fixtures, 7-10 years; Leasehold improvements, generally 5-10 years; Other equipment, 3-7 years. 9. Real Estate Investments The Company has engaged in real estate investment generally through: (i) investment in operating properties through co-investments with various clients or, in limited instances, by itself; (ii) investment in and development of commercial real estate on its own behalf and through co-investments; and (iii) minority ownership in and management of private investment funds, whose investments primarily consist of securitized real estate debt. The Company is currently not engaged in new investments although, is continuing its investment in existing real estate entities as needed or required by current business plans. The real estate carrying amounts of the three consolidated properties at December 31, 2002 were financed by real estate mortgage notes encumbering the assets totaling $66.8 million. At December 31, 2002, Insignia had equity investments of approximately $21.7 million in these consolidated properties and has no further obligations to the subsidiaries or their creditors. Insignia maintains an incentive compensation program pursuant to which certain employees, including executive officers, participate in the profits generated by its real estate investments, through grants of either equity interests (at the time investments are made) or contractual right to participate in proceeds from successful investments. Such grants generally consist of an aggregate of 50% to 63.5% of the cash proceeds paid to Insignia after Insignia has recovered its full investment plus a 10% per annum return thereon. In addition, upon disposition, the Company generally makes discretionary incentive payments of 5% to 10% to certain employees who directly contributed to the success of an investment. With respect to the private investment funds, employees are collectively entitled to share 55% to 60% of proceeds received by Insignia in respect of its promoted profits participation in those funds. Employees share only in promoted profits and are not entitled to any portion of earnings on the Company s actual investment. Gains on sales of real estate and equity earnings for 2002 and 2001 are recorded net of employee entitlements and discretionary incentives of approximately $8.1 million and $10.8 million, respectively. The Company s principal investment programs are more fully described below. Property Investment The Company maintains minority investments in operating real estate assets including office, retail, industrial, apartment and hotel properties. As of December 31, 2002, Insignia held equity investments totaling $21.1 million in 30 minority owned property assets. These properties consist of approximately 6.0 million square feet of commercial property and 1,967 multi-family apartment units and hotel rooms. The Company s minority ownership interests in co-investment property range from 1% to 33%. Gains realized from sales of real estate by minority owned ventures totaled $4.2 million in 2002 and $11.0 million in 2001. Such amounts are included in the caption equity earnings in unconsolidated ventures in the Company s consolidated statements of operations. Insignia also consolidates two operating properties, a wholly owned retail property located in Norman, Oklahoma and a New York City apartment complex owned by a limited partnership in which the Company owns a 1% controlling general partner interest. These properties contain approximately 155,000 square feet of commercial space and 420 multi-family apartment units. With respect to the New York City apartment complex, in addition to its 1% interest, Insignia is entitled to approximately $1.3 million of the first $7.3 million distributed and approximately 45% of all additional distributions. In July 2002, Insignia invested approximately $1.3 million in the limited partnership as a new limited partner pursuant to a $1.5 million equity financing and the purchase of an existing partners interest. The remaining equity financing was invested in June 2002 by existing limited partners. Certain executives and other employees of Insignia have the right to acquire from the Company, at its Table of Contents INSIGNIA FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) cost, approximately 50% of the $1.3 million limited partner investment made in July 2002. Such executives and employees have no other incentive grants or participation rights with respect to this investment. Although Insignia s economic interest in the New York City apartment complex at its initial investment was nominal (until the limited partners received a return of all invested capital), the Company commenced consolidating this property in its financial statements as of January 1, 2002 because (i) the partnership agreement for the property-owning partnership grants the general partner complete authority over the management and affairs of the partnership, including any sale or refinancing of its sole asset without limited partner approval, and (ii) accounting principle s generally accepted in the United States require consolidation on the basis of voting control (regardless of the level of equity ownership). At December 31, 2002, the carrying amounts of these two consolidated properties totaled $46.4 million, and non-recourse real estate mortgage debt totaled $46.8 million. In September 2002, a consolidated retail property was sold for a $1.3 million net gain. The gain is included under the caption other income, net in the Company s consolidated statements of operations. Development The Company s development program includes minority-owned office developments and a wholly owned marina based development located in the U.S. Virgin Islands. In July 2002, a subsidiary of the Company acquired three contiguous parcels of property and related leasehold rights in St. Thomas, U.S. Virgin Islands, which comprise 32.3 acres of property, including 18 submerged acres with full water rights. The initial purchase price was approximately $35.0 million, paid with $18.5 million in cash and $20.0 million borrowed by the subsidiary under a non-recourse $40.0 million mortgage loan facility. The property is currently undergoing predevelopment activities together with operating activities of an existing marina. The property and its debt are consolidated in the Company s consolidated financial statements. Insignia s equity investment in the property totaled $19.3 million at December 31, 2002. Insignia also has minority ownership in four office projects whose development is directed by the Company and owns a parcel of land in Denver, located adjacent to one of the office developments, that is held for future development. Development activities on all four office buildings have been completed other than tenant improvements associated with additional leasing. Insignia s ownership in the four office developments ranges from 25% to 33% and all have commenced operations. The Company s only financial obligations with respect to the office developments, beyond its investment, are partial construction financing guarantees, backed by letters of credit, totaling $8.9 million. The Company s investment in the office development assets and land parcel totaled $11.7 million at December 31, 2002. The Company has not initiated any new office developments since September 2000 and does not currently intend to further expand this development program. Interest capitalized in connection with development properties totaled approximately $1,673,000 and $500,000 in 2002 and 2001, respectively. Private Investment Funds Insignia Opportunity Trust ( IOT ) is an Insignia-sponsored private real estate investment fund formed in late 1999. IOT, through its subsidiary operating partnership, Insignia Opportunity Partners ( IOP ), invests primarily in secured real estate debt instruments and, to a lesser extent, in other real estate debt and equity instruments, with a focus on below investment grade commercial mortgage-backed securities. IOT completed its $ 7,012 $ 3,522 Outstanding letters of credit generally have one-year terms to maturity and bear standard renewal provisions. Other letters of credit and guarantees of property debt do not bear formal maturity dates and remain outstanding until certain conditions (such as final sale of property and funding of capital commitments) have been satisfied. The future capital contributions represent contractual equity commitments for specified activities of the respective real estate entities. Insignia, as a matter of policy, would consider advancing funds to real estate entities beyond its legal obligation as a new capital contribution subject to normal investment returns. Real Estate Impairment During 2002, the Company recorded impairment against its real estate investments of $3.5 million on eight property assets. The impairment charge includes $560,000 for a owned land parcel in Denver, held for future development, based on a third party appraisal. The Company recorded an impairment charge during 2001 of $824,000. Deferred revenue consists of lease commissions collected but deferred due to contingencies and the Company s ownership portion of acquisition and development fees in certain real estate partnerships. Deferred acquisition and development fees are realized in income upon disposal of the Company s ownership, generally from property sales, and deferred leasing commissions are recognized upon the fulfillment of all conditions to commission payment, such as tenant occupancy or payment of rent. 12. Private Financing In June 2002, Insignia executed agreements for $50.0 million of new capital through a private investment by funds affiliated with Blackacre Capital Management, LLC ( Blackacre ). The investment consists of $12.5 The Company s debt includes outstanding borrowings under its $230.0 million senior revolving credit facility and a $37.5 million subordinated credit facility entered into in June 2002 with Blackacre. The margin above LIBOR on the senior facility was 2.50% at December 31, 2002. The Company also had outstanding letters of credit of $11.0 million at December 31, 2002. At December 31, 2002 the unused commitment on the senior revolving credit facility was approximately $124.0 million. The $37.5 million Blackacre credit facility is subordinate to Insignia s senior credit facility and bears interest, payable quarterly, at an annual rate of 11.25% to 12.25%, depending on the amount borrowed. At December 31, 2002, the Company had borrowings of $15.0 million outstanding on the subordinated credit facility at an interest rate of 11.25%. Any further borrowings bear interest at 12.25%. Insignia may draw down the remaining $22.5 million of availability at any time until December 2003. The subordinated debt has a final maturity of June 2009. The mortgage note encumbering Brookhaven Village includes a participation feature whereby the lender is entitled to 35% of the net cash flow, net refinancing proceeds or net sales proceeds after the Company has achieved a 10% annual return on equity. The projected participation liability to the lender equaled approximately $715,000 at December 31, 2002. This amount is substantially contingent upon a sale of the asset. The U.S. Virgin Island development loan includes a one time deferred financing fee of 4.35% to 17% of the loan proceeds, depending of the length of financing. This deferred financing fee is payable at loan maturity or the early repayment of the loan. 14. Stock Compensation Plans The Company s 1998 Stock Incentive Plan, as amended and restated (the 1998 Plan ), authorized the grant of options and restricted stock awards to management personnel totaling up to 4,500,000 shares of the Company s common stock. The term of each option is determined by the Company s Board of Directors but will in no event exceed ten years from the date of grant. Options granted typically have five-year terms and are granted at prices not less than 100% of the fair market value of the Company s common stock on the date of grant. The 1998 Plan may be terminated by the Board of Directors at any time. In September 1998, the Company was spun-off from its former parent, a company also named Insignia Financial Group, Inc. At the spin-off date, the Company assumed, under the 1998 Plan, approximately 1,787,000 options issued by the former parent to employees of the businesses included in the spin-off. At December 31, 2002, 1,926,583 options were outstanding under the 1998 Plan. At December 31, 2002, approximately 96,000 unvested restricted stock awards to acquire shares of the Company s common stock were outstanding under the 1998 Plan. These awards, which have a five-year vesting period, were granted to executive officers and other employees of the Company. Compensation expense recognized by the Company for these awards totaled approximately $706,000 and $627,000 for 2002 and 2001, respectively. During 2002, the Company granted 150,000 nonqualified options to the president of Insignia Douglas Elliman, pursuant to his employment agreement. These options were issued outside of the 1998 Plan and have a five-year vesting period. The Company assumed 1,289,329 options under Non-Qualified Stock Option Agreements in connection with the acquisition of REGL. The options had five-year terms at the date of grant and the terms remained unchanged at the date of assumption. At December 31, 2002, 654,806 options remained outstanding. The Company assumed approximately 612,000 options under Non-Qualified Stock Option Agreements in connection with the acquisition of St. Quintin. The options had five-year terms at the date of grant and the terms remained unchanged at the date of assumption. At December 31, 2002, 266,484 options remained outstanding. The Company assumed 110,000 options under a Non-Qualified Stock Option Plan in connection with a prior acquisition. At December 31, 2002, 65,000 options remained outstanding under the plan. The options had five and one half-year terms at the date of grant and the terms remained unchanged at the date of assumption. (In thousands) Discontinued Operations: Income (loss) from operations $ 3,707 $ (1,123 ) Income (loss) on disposal (2,844 ) (4,000 ) In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment. In order to realize fully the deferred assets, the Company will need to generate future taxable income of approximately $58.1 million, principally for U.S. purposes. The Company has generated losses and has created other net deferred assets in prior years. Based upon the level of historical taxable income and projections for future taxable income over the periods in which the deferred tax assets are deductible, management believes it is more likely than not that the Company will realize the benefits of these deductible differences, net of the existing valuation allowances. The amount of the deferred tax asset considered realizable, however, could be reduced in the near term if estimates of future income during the carryforward period are reduced. Net operating losses in the U.S. were carried forward from 2001 for federal income tax purposes. At December 31, 2002, approximately $12.6 million and $41.1 million of net operating losses will carry forward to 2003 for federal, state and local income tax purposes respectively. These amounts expire between 2015 and 2022. Table of Contents INSIGNIA FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) In 2001, the Company entered into an agreement to sell Realty One and its affiliated companies. In connection with the Realty One sale, the Company incurred a pre-tax loss of approximately $21.6 million. Under the tax law existing at December 31, 2001, approximately $12.5 million of the loss could not be deducted for income tax purposes and no income tax benefit has been provided on this portion of the loss in 2001. Subsequent to 2001, the U.S. Treasury Department issued new legislative regulations that allowed for the deduction of the loss for income tax purposes. Sufficient capital gains were generated to offset the loss. Undistributed earnings of the Company s foreign operations amounted to approximately $39.0 million in aggregate as of December 31, 2002. Deferred income taxes are not provided at U.S. tax rates on these earnings as it is intended that the earnings will be permanently reinvested outside of the U.S. Any such taxes should not be significant, since U.S. tax rates are no more than 5% in excess of U.K. and French tax rates and goodwill, with respect to the U.K. and French operations, are amortizable for U.S. tax purposes. During 2002, certain of the Company s foreign operations generated operating losses in aggregate of approximately $8.1 million. All potential tax benefits pertaining to such losses have been fully reserved due to absence of profits. In 2000, the Internal Revenue Service ( IRS ) commenced an examination of the income tax returns for the 1998 (January 1, 1998 through September 30, 1998), 1997 and 1996 tax years. In November 2001, the IRS made a final determination to which the Company agreed. The agreed assessment paid by the Company was approximately $1.1 million, including taxes and interest. The examination will have final resolution when the U. S. Treasury Department issues a determination letter resulting from the review by the Joint Committee on Taxation. The statute of limitations expired on March 31, 2003 and the Company does not anticipate any additional assessments. 16. Employee Benefit Plans 401(k) Retirement Plan The Company established a 401(k) savings plan covering substantially all U.S. employees. The Company may make a contribution equal to 25% of the employees contribution up to a maximum of 6% of the employees compensation and participants fully vest in employer contributions after 5 years. All contributions to the 401(k) plan are expensed currently in earnings. The Company expensed approximately $1,026,000 and $1,201,000 in contributions to the 401(k) plan during 2002 and 2001, respectively. Defined Contribution Plan Insignia Richard Ellis maintains a defined contribution plan that is available to all of its employees at their option after the completion of six months of service and the attainment of 25 years of age. Insignia Richard Ellis contributions are 3.5% of salary for ages 25 to 30, 4.5% of salary for ages 31 to 35 and 5.5% to 7% of salary for ages 36 and over. Insignia Richard Ellis expensed approximately $1,598,000 and $1,430,000 in contributions to the plan during 2002 and 2001, respectively. Defined Benefit Plans Insignia Richard Ellis maintains two defined benefit plans for certain of its employees. The plans provide for benefits based upon the final salary of participating employees. The funding policy is to contribute annually an amount to fund pension cost as actuarially determined by an independent pension consulting firm. Assumptions used in determining accounting: Discount rate 5.5 % 6.0 % Weighted average increase in compensation levels 4.3 % 4.5 % Rate of return on plan assets 6.5 % 6.5 % The adjustment to accumulated other comprehensive income in 2002 pertaining to the minimum pension liability was approximately $9.7 million (net of tax benefit of $3.8 million). Table of Contents INSIGNIA FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 17. Related Party Transactions In May 2002, Insignia made a loan in the amount of $270,000 to an Executive Vice President of the Company. The variable interest rate on the loan is the same as the average cost of funds borrowed by Insignia, which was approximately 5.25% at December 31, 2002. Interest on the loan is payable to Insignia in cash on June 30 and December 31 of each year; provided, however, that until December 31, 2004 all interest accrued and payable may, at the discretion of the executive (but subject to Insignia s right of offset as more fully described below), be added to the outstanding principal balance of the loan instead of paid in cash. The loan is repayable on the earlier of (i) June 30, 2005 or (ii) 30 days following a termination of the executive s employment with Insignia for any reason. Pursuant to its rights under the note, beginning on August 1, 2002, Insignia began withholding 50% of any distribution payable to the executive, in respect of the executive s equity interest in the Company s profits interest in IOP, to be applied as a payment of accrued interest first and then outstanding principal. The outstanding balance on the loan was $269,083 at December 31, 2002. In March 2002, Insignia made a loan in the amount of $1.5 million to its Chairman and Chief Executive Officer. The variable interest rate on the loan is the same as the average cost of funds borrowed by Insignia, which was approximately 5.25% at December 31, 2002. The loan is payable on or before March 5, 2005. The Company deducts quarterly interest payments due on the loan from certain bonuses payable to the Chairman. To the extent such bonuses are not paid, all accrued and unpaid interest is payable at maturity. The loan and any accrued interest thereon would be forgiven in limited circumstances, such as a significant transaction or change of control. The outstanding balance on the loan at December 31, 2002 was $1.5 million. In June 2001, Insignia made a loan in the amount of $1.5 million to its President. The variable interest rate on the loan is the same as the average cost of funds borrowed by Insignia, which was approximately 5.25% at December 31, 2002. The loan becomes due upon the earliest of (i) voluntary termination of the President s employment with Insignia, (ii) the termination of the President s employment with Insignia for cause or (iii) March 15, 2006. Insignia will forgive $375,000 of the principal amount of the loan and accrued interest thereon on March 15 of the year following each of 2002, 2003, 2004 and 2005 to the extent that actual Net EBITDA equals or exceeds 75% of annual budgeted Net EBITDA for any such year, as approved by the Board of Directors. In addition, if aggregate actual Net EBITDA for fiscal 2002, 2003, 2004 and 2005 equals or exceeds aggregate annual budgeted EBITDA for such years, any outstanding principal amount of the loan and accrued interest thereon, will be forgiven as of March 15, 2006. The outstanding balance on the loan at December 31, 2002 was $1.5 million. Pursuant to the Company s Supplemental Stock Purchase and Loan Program, Insignia has loans outstanding to seven employees, including three executive officers, of the Company. These loans were originally made in 1998 and 1999 for the purchase of 158,663 newly issued shares of Insignia s common stock at an average share price of approximately $12.18. The loans require principal and interest payments, at a fixed rate of 7.5%, in 40 equal quarterly installments ending December 31, 2009. The notes are secured by the common shares and are non-recourse to the employee except to the extent of 25% of the outstanding amount. At December 31, 2002, the loans outstanding totaled $1,193,000 and are presented as a reduction of stockholders equity in the Company s consolidated balance sheet. A director of Insignia is a partner in a law firm that represents Insignia or certain of its affiliates from time to time. The amount of fees paid by the Company to the firm during 2002 and 2001 totaled $1,363,000 and $59,000, respectively. Table of Contents INSIGNIA FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 18. Commitments, Contingencies and Other Matters Ordinary Course of Business Claims Insignia and certain subsidiaries are defendants in lawsuits arising in the ordinary course of business. Management does not expect that the results of any such lawsuits will have a significant adverse effect on the financial condition, results of operations or cash flows of the Company. All contingencies including unasserted claims or assessments, which are probable and for which the amount of loss can be reasonably estimated, are accrued in accordance with SFAS No. 5, Accounting for Contingencies. Indemnification In 1998, the Company s former parent entered into a Merger Agreement with Apartment Investment and Management Company ( AIMCO ), and one of AIMCO s subsidiaries, pursuant to which the former parent was merged into AIMCO. Shortly before the merger, the former parent distributed the stock of Insignia to its shareholders in a spin-off transaction. As a requirement of the Merger Agreement, Insignia entered into an Indemnification Agreement with AIMCO. In the Indemnification Agreement, Insignia agreed generally to indemnify AIMCO against all losses exceeding $9.1 million that result from: (i) breaches by the Company or former parent of representations, warranties or covenants in the Merger Agreement; (ii) actions taken by or on behalf of former parent prior to the merger; and (iii) the spin-off. In December 2001, the Company entered into a stock purchase agreement with Real Living, Inc., the purchaser, that provided for the sale of 100% of the stock of Realty One and its affiliated companies. Such affiliated companies included First Ohio Mortgage Corporation, Inc., First Ohio Escrow Corporation, Inc. and Insignia Relocation Management, Inc. As a part of the sale, the Company agreed generally to indemnify the purchaser against all losses up to the purchase price (subject to certain deductible amounts), resulting from the following: (i) breaches by the Company of any representations, warranties or covenants in the stock purchase agreement; (ii) pre-disposition obligations for goods, services, taxes or indebtedness except for those assumed by Real Living, Inc.; (iii) change of control payments made to employees of Realty One; and (iv) any third party losses arising or related to the period prior to the disposition. In addition, the Company provided an indemnification for losses incurred by Wells Fargo Home Mortgage, Inc. ( Wells Fargo ) and/or the purchaser in respect of (i) mortgage loan files existing on the date of closing; (ii) fraud in the conduct of its home mortgage business; and (iii) the failure to follow standard industry practices in the home mortgage business. The aggregate loss for which the Company is potentially liable to Wells Fargo is limited to $10 million and the aggregate of any claims made by the purchaser and Wells Fargo shall not exceed the purchase price. In March 2003, Insignia completed the sale of its New York-based residential real estate service businesses, Insignia Douglas Elliman and Insignia Residential Group, to Montauk Battery Realty, LLC. In connection with the sale, Insignia agreed generally to indemnify the purchaser for the amount of any loss, liability, claim, damage, cost or expense up to the aggregate purchase price (subject to certain deductible amounts) arising, directly or indirectly, from or in connection with the following: (i) breaches by the Company of any representations, warranties, covenants or obligations in the purchase and sale agreement; (ii) claims pending or threatened on the date of sale; (iii) any conduct, action or inaction or circumstances related to the operation, management or ownership of the businesses arising or related to the period prior to the sale; and (iv) any liabilities or obligations arising or related to the period prior to the sale. As of December 31, 2002, the Company was not aware of any matters that would give rise to a material claim under any indemnities and warranties. Rental expense, which is recorded on a straight-line basis, was approximately $29,705,000 (2002) and $24,496,000 (2001). Certain of the leases are subject to renewal options and annual escalation based on the Consumer Price Index or annual increases in operating expenses. Convertible Preferred Stock Insignia has 375,000 shares, or $37.5 million, of convertible preferred stock outstanding to investment funds affiliated with Blackacre Capital Management. The convertible preferred stock includes 250,000 shares, or $25.0 million, of Series A, initially purchased in February 2000, and 125,000 shares, or $12.5 million, of Series B purchased in June 2002. The initial preferred originally carried a 4% annual dividend and was exchanged in June 2002 for Series A convertible preferred stock. The convertible preferred stock carries an 8.5% annual dividend (totaling approximately $3.2 million), payable quarterly at Insignia s option in cash or in kind. The Company paid cash dividends of approximately $1.8 million in 2002. Table of Contents INSIGNIA FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) The convertible preferred stock has a perpetual term, although Insignia may call the preferred stock, at stated value, after June 7, 2005. Upon the dissolution, liquidation or winding up of the Company, the holders of Series A and Series B convertible preferred stock are entitled to receive the stated value of $100.00 per share (totaling $37.5 million) plus accrued and unpaid dividends. Stock Repurchase At December 31, 2002, Insignia held in treasury 1,502,600 repurchased shares of its Common Stock. Such shares were repurchased at an aggregate cost of approximately $16.2 million and are reserved for issuance upon the exercise of warrants granted in 2001 to certain executive officers, non-employee directors and other employees of the Company. In July 2002, the Company authorized a stock repurchase program of up to $5.0 million, subject to compliance with all covenants contained within the Company s existing debt agreements. As of December 31, 2002, the Company had not initiated any stock repurchases under this authorization. 19. Industry Segments As of December 31 2002, Insignia s operating activities encompassed two segments that include (i) commercial real estate services, including principal investment activities, and (ii) residential real estate services. The Company s New York-based residential real estate service businesses were sold in March 2003; therefore, operating activities from continuing operations exclude the operations of these businesses. Residential operations are reported as discontinued operations in the Company s consolidated statements of operations. In 2001, the Company s operating activities included internet-based initiatives as a segment. The Company s segments include businesses that offer similar products and services and are managed separately because of the distinction between such services. The accounting policies of the segments are the same as those used in the preparation of the consolidated financial statements. The commercial segment provides services including tenant representation, property and asset management, agency leasing and brokerage, investment sales, development and re-development, consulting and other services. The commercial segment also includes the Company s principal real estate investment activities and fund management. Insignia s commercial segment is comprised of the operations of Insignia/ESG in the U.S., Insignia Richard Ellis in the U.K., Insignia Bourdais in France and other businesses in continental Europe, Asia and Latin America. The Company s unallocated administrative expenses and corporate assets, consisting primarily of cash and property and equipment, are included in Other in the segment reporting. The Company s internet-based initiatives launched in 1999 were terminated in 2001. Total assets $ 678,091 $ 147,654 $ 1,007 $ 91,630 $ 918,382 Real estate investments, net 95,710 95,710 Capital expenditures, net 11,704 85 11,789 Long-lived assets are comprised of property and equipment, real estate investments, goodwill and acquired intangibles. 20. Fair Values of Financial Instruments The fair value estimates of financial instruments are not necessarily indicative of the amounts the Company might pay or receive in actual market transactions. The carrying amount reported on the balance sheet for cash and cash equivalents approximates its fair value. Receivables reported on the balance sheet generally consist of property and lease commission receivables and various note receivables. The property and note receivables approximate their fair values. Lease commission receivables are carried at their discounted present value; therefore the carrying amount and fair value amount are the same. The carrying amounts for notes payable and real estate mortgage notes payable approximate their respective fair value because the interest rates generally approximate current market interest rates for similar instruments. Fourth quarter earnings included a gain of approximately $10.4 million from the sale of a real estate property in which the Company held a 17.5% profits interest. In addition, the fourth quarter included impairment write-downs of $4.6 million in remaining internet investments and income of $3.2 million in connection with the liquidation of EdificeRex. 22. Subsequent Events CB Richard Ellis Merger On February 17, 2003, Insignia entered into an Agreement and Plan of Merger (the Merger Agreement ) with CB Richard Ellis Group, Inc., CB Richard Ellis Services, Inc. ( CB ) and Apple Acquisition Corp., a wholly owned subsidiary of CB, pursuant to which, upon the terms and subject to the conditions set forth therein, Apple Acquisition Corp. will be merged with and into Insignia (the Merger ), with Insignia being the surviving corporation in the Merger and becoming a wholly owned subsidiary of CB. The Merger Agreement provides that Insignia s Certificate of Incorporation and the Bylaws of Apple Acquisition Corp. will be the Certificate of Incorporation and the Bylaws, respectively, of the surviving corporation. Under the Merger Agreement, at closing each share of common stock, par value $0.01 per share, of Insignia (the Common Stock ) will be converted into the right to receive $11.00 per share in cash (the Common Merger Consideration ), subject to adjustment based on the potential sale of certain real estate assets (excluding assets of the service businesses) prior to the closing of the Merger. The Merger Agreement provides that if Insignia receives more than a specified amount of cash net proceeds for these assets, the excess net cash proceeds will be paid to holders of Common Stock, options, warrants and unvested restricted stock as additional Common Merger Consideration, up to an additional $1.00 per share of Common Stock. The Merger closed on July 23, 2003 and Insignia s common shareholders received cash consideration of $11.156 per share. Separately, on July 23, 2003, Insignia sold substantially all of its real estate investment assets to Island Fund I LLC prior to the closing of the Merger. The purchase price in the sale aggregated $44.8 million and included $36.9 million paid in cash to Insignia at closing and the assumption by the buyer of $7.9 million in contractual Table of Contents INSIGNIA FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) obligations to certain executive officers, including the Company s Chairman, who are also officers of Island Fund. The Company recognized a loss of approximately $12.8 million (before applicable income taxes) in connection with the sale. When Insignia entered into the Merger Agreement it considered whether the right to sell certain of its real estate investment assets had any effect on the evaluation of such investments for purposes of determining impairment and discontinuance for financial reporting purposes. Insignia concluded that the investment assets did not qualify for classification as assets held for sale based on the following factors: (i) management had not committed to a formal plan to sell the asset (or disposal group); (ii) an active program to locate a buyer and other actions required to complete the sell the assets had not been initiated; (iii) the sale of any investment assets below book value was not considered probable; and (iv) the Company would not sell assets below book value unless the merger closed and such sales produced additional incremental share consideration above $11.00 per share. Supplemental Information: Cash paid for interest $ 7,238 $ 1,718 $ 8,956 Cash paid for income taxes 2,784 6,743 9,527 Total 3,135 (2,458 ) Cumulative Change in Accounting Principles: Goodwill impairment (9,388 ) Amount Percent Amount Percent $ 7,012 43.7 % $ 3,522 35.7 % Table of Contents INSIGNIA FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the deferred tax liabilities and assets as of December 31, 2002 are as follows (in thousands): Deferred tax liabilities: Acquisition related intangibles $ (1,799 ) Tax over book depreciation (6,149 ) Partnership earnings differences Compensation (5,415 ) Accumulated comprehensive income unrealized gains (752 ) Other, net (1,680 ) Total deferred tax liabilities (15,795 ) Deferred tax assets: Net operating losses 13,494 Acquisition related items 4,082 Book over tax depreciation Commission income receivable (net) 1,499 Alternative minimum tax credit 1,234 Partnership earnings differences 3,897 Bad debt reserves 2,400 Reserve for asset impairments 2,540 Compensation and benefits 17,261 Accumulated comprehensive income minimum pension liability 4,528 Accumulated comprehensive income currency translation Other, net 2,250 Total deferred tax assets 53,185 Valuation allowance for deferred tax assets (5,576 ) Deferred tax assets, net of valuation allowance 47,609 Net deferred tax assets $ 31,814 Table of Contents INSIGNIA FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) The following table summarizes the accumulated benefit obligation, projected benefit obligation, funded status and net periodic pension cost of the Insignia Richard Ellis defined benefit plans as of December 31, 2002 (in thousands): Accumulated Benefit Obligation $ 57,089 Projected Benefit Obligation ( PBO ) PBO Beginning of year $ 48,355 Service cost 1,158 Interest cost 3,017 Benefits paid net of participant contributions (566 ) Net actuarial loss 4,023 Foreign currency exchange rate changes 5,593 PBO End of year 61,580 Fair value of plan assets at end of year 42,518 Funded status of the plans (19,062 ) Unrecognized net actuarial loss 19,585 Adjustment required to recognize minimum liability (15,094 ) Net pension liability recognized in the Company s consolidated balance sheets $ (14,571 ) Years Ended December 31 (In thousands) Net Periodic Pension Cost Service cost $ 1,158 $ 909 Interest cost 3,017 2,657 Return on plan assets (2,975 ) (3,398 ) Total minimum payments $ 185,032 Table of Contents INSIGNIA FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) The following tables summarize certain financial information by industry segment. Year ended December 31, 2002 Commercial Residential Other Total Operating income (loss) 37,318 (14,229 ) 23,089 Other income and expense: Interest income 2,300 1,636 3,936 Interest expense (474 ) (8,380 ) (8,854 ) Property interest expense (2,122 ) (2,122 ) Income (loss) from continuing operations before income taxes $ 37,022 $ $ (20,973 ) $ 16,049 Total assets $ 724,330 $ 62,604 $ 85,905 $ 872,839 Real estate investments, net 134,135 134,135 Capital expenditures, net 8,388 8,388 Year ended December 31, 2001 Commercial Residential Internet Other Total Operating income (loss) 43,244 (13,186 ) 30,058 Other income and expenses: Interest income 2,084 2,769 4,853 Interest expense (639 ) (11,730 ) (12,369 ) Property interest expense (1,744 ) (1,744 ) Losses from internet investments (10,263 ) (10,263 ) Other expenses (661 ) (661 ) Income (loss) from continuing operations before income taxes $ 42,284 $ $ (10,263 ) $ (22,147 ) $ 9,874 Table of Contents INSIGNIA FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Certain geographic information is as follows: Year ended December 31, 2002 Year ended December 31, 2001 Revenues Long-Lived Assets Revenues Long-Lived Assets United States $ 406,198 $ 343,072 $ 512,754 $ 339,619 United Kingdom 121,746 115,029 105,896 106,701 France 43,058 30,189 12,800 Other countries 20,012 8,631 14,579 8,603 $ 591,014 $ 496,921 $ 633,229 $ 467,723 Total Fourth Quarter Third Quarter Second Quarter First Quarter Income (loss) before cumulative effect of a change in accounting principle 18,135 6,334 8,769 3,175 (143 ) Cumulative effect of a change in accounting principle (20,635 ) (20,635 ) Net (loss) income $ (2,500 ) $ 6,334 $ 8,769 $ 3,175 $ (20,778 ) Per share amounts: Earnings per share basic Income (loss) from continuing operations $ 0.30 $ 0.23 $ 0.09 $ 0.03 $ (0.05 ) Discontinued operations 0.39 0.01 0.25 0.09 0.03 Income (loss) before cumulative effect of a change in accounting principle 0.69 0.24 0.34 0.12 (0.02 ) Cumulative effect of a change in accounting change in accounting principle (0.89 ) (0.90 ) Net (loss) income (0.20 ) $ 0.24 0.34 0.12 (0.92 ) Earnings per share assuming dilution Income (loss) from continuing operations 0.29 0.23 0.09 0.03 (0.05 ) Discontinued operations 0.38 0.01 0.25 0.09 0.03 Income (loss) before cumulative effect of a change in accounting principle 0.67 0.24 0.34 0.12 (0.02 ) Cumulative effect of a change in accounting principle (0.87 ) (0.90 ) Net (loss) income $ (0.20 ) $ 0.24 $ 0.34 $ 0.12 $ (0.92 ) Total Fourth Quarter Third Quarter Second Quarter First Quarter Net loss $ (13,508 ) $ (5,059 ) $ (4,470 ) $ (1,445 ) $ (2,534 ) Per share amounts: Earnings per share basic Income (loss) from continuing operations $ 0.24 $ 0.59 $ (0.26 ) $ (0.09 ) $ 0.00 Discontinued operations (0.90 ) (0.83 ) 0.05 0.01 (0.13 ) Net loss (0.66 ) (0.24 ) (0.21 ) (0.08 ) (0.13 ) Earnings per share assuming dilution Income (loss) from continuing operations 0.23 0.50 (0.26 ) (0.09 ) 0.00 Discontinued operations (0.85 ) (0.70 ) 0.05 0.01 (0.13 ) Net loss $ (0.62 ) $ (0.20 ) $ (0.21 ) $ (0.08 ) $ (0.13 ) Table of Contents INSIGNIA FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 23. Supplemental Information The following supplemental information includes: (i) condensed consolidating balance sheet as of December 31, 2002; (ii) condensed consolidating statement of operations for the year ended December 31, 2002 and (iii) condensed consolidating statement of cash flows for the year ended December 31, 2002 of the Company s domestic commercial service operations (including operations of Insignia/ESG, Inc. and unallocated administrative expenses and corporate assets of Insignia), all other operations (comprised of residential service operations, international service operations and real estate investment operations) and the Company on a consolidated basis. Investments in consolidated subsidiaries are presented using the equity method of accounting. The principal elimination entries eliminate investments in consolidated subsidiaries and intercompany balances and transactions. Condensed Consolidating Balance Sheet As of December 31, 2002 Domestic Commercial Service Operations Other Operations Eliminations Consolidated Total (In thousands) Assets Cash and cash equivalents $ 72,245 $ 39,268 $ $ 111,513 Receivables, net of allowance 103,780 51,541 155,321 Restricted cash 17,277 4,241 21,518 Intercompany receivables 44,196 (44,196 ) Investment in consolidated subsidiaries 246,184 (246,184 ) Property and equipment, net 36,271 19,343 55,614 Real estate investments, net 134,135 134,135 Goodwill, net 112,662 176,899 289,561 Acquired intangible assets, net 1,345 16,266 17,611 Deferred taxes 42,805 4,804 47,609 Other assets, net 26,922 13,035 39,957 Total assets $ 703,687 $ 459,532 $ (290,380 ) $ 872,839 Liabilities and Stockholders Equity Liabilities: Accounts payable $ 5,510 $ 8,233 $ $ 13,743 Commissions payable 63,380 594 63,974 Accrued incentives 23,720 28,604 52,324 Accrued and sundry 54,560 63,430 117,990 Deferred taxes 14,299 1,496 15,795 Intercompany payables 44,196 (44,196 ) Notes payable 126,889 126,889 Real estate mortgage notes 66,795 66,795 Total liabilities 288,358 213,348 (44,196 ) 457,510 Total stockholders equity 415,329 246,184 (246,184 ) 415,329 Total liabilities and stockholders equity $ 703,687 $ 459,532 $ (290,380 ) $ 872,839 Table of Contents INSIGNIA FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Condensed Consolidating Statement of Operations For the Year Ended December 31, 2002 Domestic Commercial Service Operations Other Operations Eliminations Consolidated Total (In thousands) Revenues $ 392,935 $ 198,079 $ $ 591,014 Costs and expenses Real estate services 366,904 159,172 526,076 Property operations 7,264 7,264 Administrative 14,344 14,344 Depreciation and amortization 14,292 4,029 18,321 Property depreciation 1,920 1,920 395,540 172,385 567,925 Operating income (loss) (2,605 ) 25,694 23,089 Other income and expenses: Interest income 1,678 2,258 3,936 Interest expense (8,380 ) (474 ) (8,854 ) Property interest expense (2,122 ) (2,122 ) Equity earnings in consolidated subsidiaries 2,438 (2,438 ) Income (loss) from continuing operations before income taxes (6,869 ) 25,356 (2,438 ) 16,049 Income tax (expense) benefit 4,369 (11,381 ) (7,012 ) Income (loss) from continuing operations (2,500 ) 13,975 (2,438 ) 9,037 Discontinued operations, net of applicable tax Income from operations 4,180 4,180 Income on disposal 4,918 4,918 Income (loss) before cumulative effect of a change in accounting principle (2,500 ) 23,073 (2,438 ) 18,135 Cumulative effect of a change in accounting principle, net of applicable taxes (20,635 ) (20,635 ) Net loss $ (2,500 ) $ 2,438 $ (2,438 ) $ (2,500 ) Table of Contents INSIGNIA FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Condensed Consolidating Statement of Cash Flows For the Year Ended December 31, 2002 Domestic Commercial Service Operations Other Operations Consolidated Total (In thousands) Cash (used in) provided by operating activities $ (52,231 ) $ 53,913 $ 1,682 Investing activities Additions to property and equipment, net (6,315 ) (2,073 ) (8,388 ) Proceeds from real estate investments 44,648 44,648 Proceeds from sale of discontinued operation 23,250 23,250 Payments made for acquisition of businesses (3,650 ) (5,268 ) (8,918 ) Investment in real estate (46,684 ) (46,684 ) Decrease (increase) in restricted cash 5,496 (1,532 ) 3,964 Cash (used in) provided by investing activities (4,469 ) 12,341 7,872 Financing activities Decrease (increase) in intercompany receivables 56,173 (56,173 ) Proceeds from issuance of common stock 903 903 Proceeds from issuance of preferred stock 12,270 12,270 Proceeds from exercise of stock options 674 674 Preferred stock dividends (1,829 ) (1,829 ) Payments on notes payable (59,785 ) (59,785 ) Proceeds from notes payable 15,000 15,000 Payments on real estate mortgage notes (28,361 ) (28,361 ) Proceeds from real estate mortgage notes 20,000 20,000 Debt issuance costs (1,415 ) (1,415 ) Cash provided by (used in) financing activities 21,991 (64,534 ) (42,543 ) Net cash provided by discontinued operations 8,787 8,787 Effect of exchange rate changes in cash 3,789 3,789 Net (decrease) increase in cash and cash equivalents (34,709 ) 14,296 (20,413 ) Cash and cash equivalents at beginning of year 106,954 24,906 131,860 Cash and cash equivalents at end of year $ 72,245 $ 39,268 $ 111,513 Table of Contents Table of Contents PART II INFORMATION NOT REQUIRED IN PROSPECTUS Item 13. Other Expenses of Issuance and Distribution. The following table sets forth the fees and expenses in connection with the issuance and distribution for the securities being registered hereunder, which fees and expenses will be borne solely by the registrant. Except for the Securities and Exchange Commission registration fee and the NASD fee, all amounts are estimates. Description Amount Securities and Exchange Commission registration fee $ 56,858 NASD filing fee 30,500 Legal fees and expenses 300,000 Accounting fees and expenses 100,000 Printing fees and expenses 150,000 Blue Sky fees and expenses 5,000 Transfer agent fees and expenses 5,000 Miscellaneous expenses 102,642 Total $ 750,000 Item 14. Indemnification of Directors and Officers. Section 102 of the Delaware General Corporation Law, or the DGCL, as amended, allows a corporation to eliminate the personal liability of directors of a corporation to the corporation or its stockholders for monetary damage for a breach of fiduciary duty as a director, except where the director breached his duty of loyalty, failed to act in good faith, engaged in intentional misconduct or knowingly violated a law, authorized the payment of a dividend or approved a stock repurchase in violation of Delaware corporate law or obtained an improper personal benefit. Section 145 of the DGCL provides, among other things, that a Delaware corporation may indemnify any person who was or is a party or is threatened to be made a party to any threatened, pending or completed action, suit or proceeding (other than an action by or in the right of such corporation) by reason of the fact that the person is or was a director, officer, agent or employee of such corporation or is or was serving at our request as a director, officer, agent, or employee of another corporation, partnership, joint venture, trust or other enterprise against expenses, including attorneys fees, judgment, fines and amounts paid in settlement actually and reasonably incurred by the person in connection with the action, suit or proceeding. The power to indemnify applies (1) if the person is successful on the merits or otherwise in defense of any action, suit or proceeding or (2) if the person acted in good faith and in a manner he reasonably believed to be in the best interest, or not opposed to the best interest, of the Delaware corporation, and with respect to any criminal action or proceeding, had no reasonable cause to believe his conduct was unlawful. The power to indemnify applies to actions brought by or in the right of the Delaware corporation as well, but only to the extent of defense expenses (including attorneys fees but excluding amounts paid in settlement) actually and reasonably incurred and not to any satisfaction of judgment or settlement of the claim itself, and with the further limitation that in these actions no indemnification shall be made in the event of any adjudication of negligence or misconduct in the performance of his duties to the Delaware corporation, unless the court believes that in light of all the circumstances indemnification should apply. Section 174 of the DGCL provides, among other things, that a director, who willfully or negligently approves of an unlawful payment of dividends or an unlawful stock purchase or redemption, may be held liable II-1 Table of Contents for these actions. A director who was either absent when the unlawful actions were approved or dissented at the time, may avoid liability by causing his or her dissent to these actions to be entered in the books containing the minutes of the meetings of the board of directors at the time the action occurred or immediately after the absent director receives notice of the unlawful acts. Our restated certificate of incorporation includes a provision that limits the personal liability of our directors for monetary damages for breach of fiduciary duty as a director, except to the extent such exemption from liability or limitation is not permitted under the Delaware General Corporation Law. Our restated certificate of incorporation provides that we must indemnify our current or former directors and officers to the fullest extent permitted by Delaware law. Our restated certificate of incorporation provides that each person (and the heirs, executors or administrators of such person) who was or is a party or is threatened to be made a party to, or is involved in any threatened, pending or completed action, suit or proceeding (brought in the right of CB Richard Ellis Group or otherwise), whether civil, criminal, administrative or investigative, and whether formal or informal, including appeals, by reason of the fact that such person is or was a director or officer of CB Richard Ellis Group or, while a director or officer, is or was serving at the request of CB Richard Ellis Group as a director, officer, partner, member, fiduciary, trustee, employee or agent of another corporation, partnership, joint venture, trust, limited liability company or other enterprise, must be indemnified and held harmless by CB Richard Ellis Group to the fullest extent permitted by Delaware law. Our restated certificate of incorporation also provides that each person (and the heirs, executors or administrators of such person) who was or is a party or is threatened to be made a party to any threatened, pending or completed action, suit or proceeding (brought in the right of CB Richard Ellis Group or otherwise), whether civil, criminal, administrative or investigative, and whether formal or informal, including appeals, by reason of the fact that such person is or was an employee or agent of CB Richard Ellis Group or, while an employee or agent, is or was serving at the request of CB Richard Ellis Group as a director, officer, partner, member, fiduciary, trustee, employee or agent of another corporation, partnership, joint venture, trust, limited liability company or other enterprise, may be indemnified and held harmless by CB Richard Ellis Group to the fullest extent permitted by Delaware law. Our restated certificate of incorporation provides that we must advance expenses, as incurred, to our directors and executive officers in connection with a legal proceeding to the fullest extent permitted by Delaware law. In addition, we maintain insurance on behalf of our directors and executive officers insuring them against any liability asserted against them in their capacities as directors or officers or arising out of this status. We must indemnify and hold harmless (1) each holder of our common stock and the warrants to acquire our common stock (and the shares of common stock received upon exercise of the warrants) acquired by the persons defined as Securityholders pursuant to the Securityholders Agreement, dated as of July 20, 2001, by and among, CB Richard Ellis Group, CB Richard Ellis Services, Blum Strategic Partners, L.P., Blum Strategic Partners II, L.P., Blum Strategic Partners II GmbH & Co. KG, FS Equity Partners III, L.P., FS Equity Partners International, L.P., Credit Suisse First Boston Corporation, DLJ Investment Funding, Inc., The Koll Holding Company, Frederic V. Malek, the management investors named therein and the other persons from time to time party thereto and each of their respective affiliates and any controlling person of any of such holders and (2) each of such holder s respective directors, officers, employees and agents from and against any and all damages, claims, losses, expenses, costs, obligations and liabilities (including all reasonable attorneys fees and expenses), but excluding special or consequential damages, arising from, relating to or otherwise in respect of, any governmental or other third party claim against such indemnified person that arises from, relates to or is otherwise in respect of (i) the business, operations, liabilities or obligations of CB Richard Ellis Group or its subsidiaries or (ii) the ownership by such holder or any of their respective affiliates of any equity securities of CB Richard Ellis Group (except to the extent such losses and expenses (x) arise from any claim that such indemnified person s investment decision relating to the purchase or sale of such securities violated a duty or other obligation of the indemnified person to the claimant or (y) are finally determined in a judicial action by a II-2 Table of Contents court of competent jurisdiction to have resulted from the gross negligence or willful misconduct of such holder or its affiliates). The indemnification provided by CB Richard Ellis Group is separate from and in addition to any other indemnification by CB Richard Ellis Group to which the indemnified person may be entitled. Item 15. Recent Sales of Unregistered Securities. Except as otherwise indicated, all information in this Item 15 of Part II gives effect to the 3-for-1 stock split of the registrant s outstanding Class A common stock and Class B common stock on May 4, 2004, which split was effected by a stock dividend, and the 1-for-1.0825 reverse stock split of our outstanding Class A common stock and Class B common stock on June 7, 2004. In the three years prior to October 31, 2004, the registrant issued the following unregistered securities in private placements conducted pursuant to Section 4(2) of the Securities Act of 1933, as amended, as transactions not involving public offerings: (1) The registrant has, in recruiting various key employees, offered such employees the right to purchase shares of its Class A common stock, in each case at $5.77 per share: Number of Shares Date of Purchase Consideration 6,928 January 13, 2002 $20,000 cash $20,000 note 20,785 February 21, 2002 $60,000 cash $60,000 note 34,642 May 31, 2002 $100,000 cash $100,000 note 27,713 January 15, 2003 $80,000 cash $80,000 note 69,284 January 15, 2003 $400,000 cash 8,661 January 27, 2003 $50,000 cash 8,661 January 27, 2003 $50,000 cash 69,284 October 2, 2003 $400,000 cash Such stock was issued pursuant to the registrant s 2001 Stock Incentive Plan in transactions exempt from registration under Rule 701 promulgated pursuant to the Securities Act of 1933, as amended. (2) On May 22, 2003, CBRE Escrow, Inc., an indirect wholly owned subsidiary of registrant, issued and sold to Credit Suisse First Boston LLC, Credit Lyonnais Securities (USA) Inc. and HSBC Securities (USA) Inc. $200.0 million in aggregate principal amount of its 9 3/4% senior notes due May 15, 2010 at a cash price equal to 100% of the aggregate principal amount of such notes. In connection with the merger of CBRE Escrow with and into the registrant s wholly owned subsidiary, CB Richard Ellis Services, Inc., on July 23, 2003, CB Richard Ellis Services assumed the obligations of CBRE Escrow with respect to its 9 3/4% senior notes due May 15, 2010 and the registrant guaranteed such securities on a senior basis. On January 7, 2004, CB Richard Ellis Services, Inc., the registrant and the other guarantors of such unregistered securities exchanged such securities for 9 3/4% senior notes due May 15, 2010 and related guarantees that had been registered under the Securities Act of 1933, as amended, pursuant to a Registration Statement on Form S-4 (No. 333-109841) that had been declared effective by the Securities and Exchange Commission on December 5, 2003. (3) On July 23, 2003, the registrant issued and sold the following unregistered securities: an aggregate of 18,421,619 shares of its Class B common stock to Blum Strategic Partners, L.P., Blum Strategic Partners II, L.P., Blum Strategic Partners II GmbH & Co. KG and Frederic V. Malek for a cash price of $5.77 per share; and an aggregate of 2,363,597 shares of its Class A common stock to DLJ Investment Partners, L.P., DLJ Investment Partners II, L.P., DLJIP II Holdings, L.P. and California Public Employees Retirement System for a cash price of $5.77 per share. II-3 Table of Contents (4) Prior to June 10, 2004, the registrant issued an aggregate of 70,372 shares of its Class A common stock in connection with distributions related to stock fund units under the deferred compensation plan of its wholly owned subsidiary, CB Richard Ellis Services, Inc. The plan participants receiving such shares previously had made aggregate deferrals of $335,296 under the plan with respect to such stock fund units. The issuances of such shares in connection with distributions under such plan were pursuant to Rule 701 promulgated by the Securities and Exchange Commission under Section 3(b) of the Securities Act of 1933, as amended, with respect to transactions pursuant to compensation benefit plans and contracts relating to compensation. (5) Prior to June 10, 2004, current and former employees of the registrant had exercised options to acquire an aggregate of 17,321 shares of the registrant s Class A common stock for $5.77 per share. The issuance of such shares in connection with the exercise of such options was pursuant to the registrant s 2001 Stock Incentive Plan and exempt from registration under Rule 701 promulgated pursuant to the Securities Act of 1933, as amended. Item 16. Exhibits and Financial Statement Schedules. Exhibit Description 1* Form of Underwriting Agreement 2.1 Amended and Restated Agreement and Plan of Merger, dated as of May 28, 2003, by and among Insignia Financial Group, Inc., CB Richard Ellis Group, Inc., CB Richard Ellis Services, Inc. and Apple Acquisition Corp. (incorporated by reference to Exhibit 2.2 of the CB Richard Ellis Services, Inc. Registration Statement on Form S-4 filed with the SEC on October 20, 2003) 2.2 Purchase Agreement, dated as of May 28, 2003, by and among Insignia Financial Group, Inc., CB Richard Ellis Group, Inc., CB Richard Ellis Services, Inc., Apple Acquisition Corp. and Island Fund I LLC (incorporated by reference to Exhibit 2.3 of the CB Richard Ellis Services, Inc. Registration Statement on Form S-4 filed with the SEC (No. 333-190841) on October 20, 2003) 3.1 Form of Restated Certificate of Incorporation of CB Richard Ellis Group, Inc. filed on June 15, 2004 (incorporated by reference to Exhibit 3.3 of the CB Richard Ellis Group, Inc. Amendment No. 4 to Registration Statement on Form S-1 filed with the SEC (No. 333-112867) on June 2, 2004) 3.2 Form of Restated By-laws of CB Richard Ellis Group, Inc. (incorporated by reference to Exhibit 3.5 of the CB Richard Ellis Group, Inc. Amendment No. 4 to Registration Statement on Form S-1 filed with the SEC (No. 333-112867) on June 2, 2004) 4.1 Form of Class A common stock certificate of CB Richard Ellis Group, Inc. (incorporated by reference to Exhibit 4.1 of the CB Richard Ellis Group, Inc. Amendment No. 2 to Registration Statement on Form S-1 filed with the SEC (No. 333-112867) on April 30, 2004) 4.2(a) Securityholders Agreement, dated as of July 20, 2001 ( Securityholders Agreement ), by and among, CB Richard Ellis Group, Inc., CB Richard Ellis Services, Inc., Blum Strategic Partners, L.P., Blum Strategic Partners II, L.P., Blum Strategic Partners II GmbH & Co. KG, FS Equity Partners III, L.P., FS Equity Partners International, L.P., Credit Suisse First Boston Corporation, DLJ Investment Funding, Inc., The Koll Holding Company, Frederic V. Malek, the management investors named therein and the other persons from time to time party thereto (incorporated by reference to Exhibit 25 to Amendment No. 9 to Schedule 13D with respect to CB Richard Ellis Services, Inc. filed with the SEC on July 25, 2001) 4.2(b) Amendment and Waiver to Securityholders Agreement, dated as of April 14, 2004, by and among, CB Richard Ellis Group, Inc., CB Richard Ellis Services, Inc. and the other parties to the Securityholders Agreement (incorporated by reference to Exhibit 4.2(b) of the CB Richard Ellis Group, Inc. Amendment No. 2 to Registration Statement on Form S-1 filed with the SEC (No. 333-112867) on April 30, 2004) 4.2(c)* Second Amendment and Waiver to Securityholders Agreement, dated as of November 24, 2004, by and among CB Richard Ellis Group, Inc., CB Richard Ellis Services, Inc. and certain of the other parties to the Securityholders Agreement II-4 Table of Contents Exhibit Description 4.3 Anti-Dilution Agreement, dated as of July 20, 2001, by and between CB Richard Ellis Group, Inc. and Credit Suisse First Boston Corporation (incorporated by reference to Exhibit 20 to Amendment No. 9 to Schedule 13D with respect to CB Richard Ellis Services, Inc. filed with the SEC on July 25, 2001) 4.4 Warrant Agreement, dated as of July 20, 2001, by and between CB Richard Ellis Group, Inc., and FS Equity Partners III, L.P. and FS Equity Partners International, L.P. (incorporated by reference to Exhibit 26 to Amendment No. 9 to Schedule 13D with respect to CB Richard Ellis Services, Inc. filed with the SEC on July 25, 2001) 4.5(a) Indenture, dated as of May 22, 2003, between CBRE Escrow, Inc., and U.S. Bank National Association, as Trustee, for 9 3/4% Senior Notes Due May 15, 2010 (incorporated by reference to Exhibit 4.1 of the CB Richard Ellis Services, Inc. Registration Statement on Form S-4 filed with the SEC (No. 333-190841) on October 20, 2003) 4.5(b) First Supplemental Indenture, dated as of July 23, 2003, among CB Richard Ellis Services, Inc., CB Richard Ellis Group, Inc., the Subsidiary Guarantors and U.S. Bank National Association (incorporated by reference to Exhibit 4.1(b) of the CB Richard Ellis Services, Inc. Registration Statement on Form S-4 filed with the SEC (No. 333-190841) on December 5, 2003) 4.5(c) Second Supplemental Indenture, dated as of December 4, 2003, among CB Richard Ellis Services, Inc., Investors 1031, LLC and U.S. Bank National Association (incorporated by reference to Exhibit 4.1(c) of the CB Richard Ellis Services, Inc. Registration Statement on Form S-4 filed with the SEC (No. 333-190841) on December 5, 2003) 4.6(a) Indenture, dated as of June 7, 2001, among CB Richard Ellis Services, Inc., BLUM CB Corp., CB Richard Ellis Group, Inc., the Subsidiary Guarantors named therein and State Street Bank and Trust Company of California, N.A., as Trustee, for 11 1/4% Senior Subordinated Notes due 2011 (incorporated by reference to Exhibit 17 of the CB Richard Ellis Services, Inc. Schedule 13D filed with the SEC (No. 005-46943) on July 30, 2001) 4.6(b) First Supplemental Indenture, dated as of July 20, 2001, among CB Richard Ellis Services, Inc., the Subsidiary Guarantors and State Street Bank and Trust Company of California, N.A. (incorporated by reference to Exhibit 10.17(b) of the CB Richard Ellis Services, Inc. Registration Statement on Form S-4 filed with the SEC (No. 333-190841) on December 5, 2003) 4.6(c) Second Supplemental Indenture, dated as of July 23, 2003, among CB Richard Ellis Services, Inc., CB Richard Ellis Group, Inc., the Subsidiary Guarantors and U.S. Bank National Association as successor to Street Bank and Trust Company of California, N.A (incorporated by reference to Exhibit 10.17(c) of the CB Richard Ellis Services, Inc. Registration Statement on Form S-4 filed with the SEC (No. 333-190841) on December 5, 2003) 4.6(d) Third Supplemental Indenture, dated as of December 4, 2003 among CB Richard Ellis Services, Inc., Investors 1031, LLC, and U.S. Bank National Association (incorporated by reference to Exhibit 10.17(d) of the CB Richard Ellis Services, Inc. Registration Statement on Form S-4 filed with the SEC (No. 333-190841) on December 5, 2003) 4.7 Indenture, dated as of July 20, 2001, among CB Richard Ellis Group, Inc., and State Street Bank and Trust Company, N.A., as Trustee, for 16% Senior Notes due 2011 (incorporated by reference to Exhibit 21 to Amendment No. 9 to Schedule 13D with respect to CB Richard Ellis Services, Inc. filed with the SEC on July 25, 2001) 5** Opinion of Simpson Thacher & Bartlett LLP 10.1(a) Amendment Agreement and Waiver, dated as of April 23, 2004, among CB Richard Ellis Services, Inc., CB Richard Ellis Group, Inc., the Lenders named therein and Credit Suisse First Boston, as Administrative Agent (incorporated by reference to Exhibit 10.1(a) of the CB Richard Ellis Group, Inc. Amendment No. 2 to Registration Statement on Form S-1 filed with the SEC (No. 333-112867) on April 30, 2004) II-5 Table of Contents Exhibit Description 10.1(b) Amended and Restated Credit Agreement, dated as of April 23, 2004 ( Credit Agreement ), by and among CB Richard Ellis Services, Inc., CB Richard Ellis Group, Inc., the Lenders named therein and Credit Suisse First Boston, as Administrative Agent (incorporated by reference to Exhibit 10.1(b) of the CB Richard Ellis Group, Inc. Amendment No. 2 to Registration Statement on Form S-1 filed with the SEC (No. 333-112867) on April 30, 2004) 10.1(c)* Amendment to Credit Agreement, dated as of November 15, 2004, by and among CB Richard Ellis Services, Inc., CB Richard Ellis Group, Inc., the Lenders named therein and Credit Suisse First Boston, as Administrative Agent 10.2 CB Richard Ellis Group, Inc. 2001 Stock Incentive Plan, as amended (incorporated by reference to Exhibit 10.1 of the CB Richard Ellis Group, Inc. Annual Report on Form 10-K filed with the SEC on March 25, 2003) 10.3 2004 Stock Incentive Plan of CB Richard Ellis Group, Inc. (incorporated by reference to Exhibit 10.3 of the CB Richard Ellis Group, Inc. Amendment No. 2 to Registration Statement on Form S-1 filed with the SEC (No. 333-112867) on April 30, 2004) 10.4 CB Richard Ellis Services, Inc. Amended and Restated Deferred Compensation Plan, as amended (incorporated by reference to Exhibit 10.11 of the CB Richard Ellis Group, Inc. Annual Report on Form 10-K filed with the SEC on March 25, 2003) 10.5 CB Richard Ellis Services, Inc. Amended and Restated 401(k) Plan, as amended (incorporated by reference to Exhibit 10.12 of the CB Richard Ellis Group, Inc. Annual Report on Form 10-K filed with the SEC on March 25, 2003) 10.6 Employment Agreement, dated as of July 20, 2001, between CB Richard Ellis Services, Inc. and Ray Wirta (incorporated by reference to Exhibit 10.13 of the CB Richard Ellis Group, Inc. Registration Statement on Form S-4 (No. 333-70980) filed with the SEC on October 4, 2001) 10.7 Termination of Employment Agreement, effective as of February 15, 2004, between CB Richard Ellis Services, Inc. and Ray Wirta (incorporated by reference to Exhibit 10.6 of the CB Richard Ellis Group, Inc. Annual Report on Form 10-K filed with the SEC on March 30, 2004) 10.8 Full Recourse Note, dated as of April 8, 2004, by and between Ray Wirta and CB Richard Ellis Group, Inc. (incorporated by reference to Exhibit 10.9 of the CB Richard Ellis Group, Inc. Amendment No. 2 to Registration Statement on Form S-1 filed with the SEC (No. 333-112867) on April 30, 2004) 10.9 Pledge Agreement, dated as of April 8, 2004, by and between Ray Wirta and CB Richard Ellis Group, Inc. (incorporated by reference to Exhibit 10.10 of the CB Richard Ellis Group, Inc. Amendment No. 2 to Registration Statement on Form S-1 filed with the SEC (No. 333-112867) on April 30, 2004) 10.10 Amended and Restated Executive Service Agreement, dated as of June 4, 2003, between CB Richard Ellis Limited and Alan Charles Froggatt (incorporated by reference to Exhibit 10.11 of the CB Richard Ellis Group, Inc. Amendment No. 2 to Registration Statement on Form S-1 filed with the SEC (No. 333-112867) on April 30, 2004) 10.11 Employment Agreement, dated as of January 23, 2001, between CB Richard Ellis Pty Ltd. and Robert Blain (incorporated by reference to Exhibit 10.12 of the CB Richard Ellis Group, Inc. Amendment No. 2 to Registration Statement on Form S-1 filed with the SEC (No. 333-112867) on April 30, 2004) 10.12 CB Richard Ellis Deferred Compensation Plan effective as of August 1, 2004 (incorporated by reference to Exhibit 4.1 of the CB Richard Ellis Group, Inc. Registration Statement on Form S-8 filed with the SEC (No. 333-119362) on September 29, 2004) 16 Letter from Ernst & Young LLP confirming its concurrence with the statements made by Insignia Financial Group, Inc. in a current report concerning the dismissal as Insignia s principal accountant (incorporated by reference to Exhibit 16.1 to the Insignia Financial Group, Inc. Current Report on Form 8-K filed with the SEC on April 12, 2002) II-6 Table of Contents Exhibit Description * Filed herewith. ** Previously filed. Item 17. Undertakings. (a) The undersigned registrant hereby undertakes to provide to the underwriters at the closing specified in the underwriting agreement, certificates in such denominations and registered in such names as required by the underwriters to permit prompt delivery to each purchaser. (b) Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers and controlling persons of the registrant pursuant to the provisions described under Item 14 above, or otherwise, the registrant has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Securities Act and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the registrants of expenses incurred or paid by the director, officer or controlling person of the registrants in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, the registrant will, unless in the opinion of their counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Securities Act and will be governed by the final adjudication of such issue. (c) The undersigned registrant hereby undertakes that: (1) For purposes of determining any liability under the Securities Act of 1933, the information omitted from the form of prospectus filed as part of this registration statement in reliance upon Rule 430A and contained in a form of prospectus filed by the registrant pursuant to Rule 424(b)(1) or (4) or 497(h) under the Securities Act shall be deemed to be part of this registration statement as of the time it was declared effective. (2) For the purpose of determining any liability under the Securities Act of 1933, each post-effective amendment that contains a form of prospectus shall be deemed to be a new registration statement relating to the securities offered therein, and the offering of such securities at that time shall be deemed to be the initial bona fide offering thereof. II-7 Table of Contents SIGNATURES Pursuant to the requirements of the Securities Act of 1933, the registrant has duly caused this registration statement to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Los Angeles, State of California, on November 24, 2004. CB RICHARD ELLIS GROUP, INC. By: /s/ KENNETH J. KAY Name: Kenneth J. Kay Title: Chief Financial Officer Pursuant to the requirements of the Securities Act of 1933, this registration statement has been signed on November 24, 2004 by the following persons in the capacities indicated. Signature Title * Ray Wirta Director and Chief Executive Officer (Principal Executive Officer) /s/ KENNETH J. KAY Kenneth J. Kay Chief Financial Officer (Principal Financial Officer) * Gil Borok Executive Vice President, Global Controller (Principal Accounting Officer) * Brett White Director and President * Richard C. Blum Chairman of the Board * Jeffrey A. Cozad Director * Patrice Marie Daniels Director * Bradford M. Freeman Director * Michael Kantor Director * Frederic V. Malek Director * Jeffrey S. Pion Director * Gary L. Wilson Director *By: /s/ KENNETH J. KAY Attorney-in-fact II-8 Table of Contents EXHIBIT INDEX Exhibit Description 1* Form of Underwriting Agreement 2.1 Amended and Restated Agreement and Plan of Merger, dated as of May 28, 2003, by and among Insignia Financial Group, Inc., CB Richard Ellis Group, Inc., CB Richard Ellis Services, Inc. and Apple Acquisition Corp. (incorporated by reference to Exhibit 2.2 of the CB Richard Ellis Services, Inc. Registration Statement on Form S-4 filed with the SEC on October 20, 2003) 2.2 Purchase Agreement, dated as of May 28, 2003, by and among Insignia Financial Group, Inc., CB Richard Ellis Group, Inc., CB Richard Ellis Services, Inc., Apple Acquisition Corp. and Island Fund I LLC (incorporated by reference to Exhibit 2.3 of the CB Richard Ellis Services, Inc. Registration Statement on Form S-4 filed with the SEC (No. 333-190841) on October 20, 2003) 3.1 Form of Restated Certificate of Incorporation of CB Richard Ellis Group, Inc. filed on June 15, 2004 (incorporated by reference to Exhibit 3.3 of the CB Richard Ellis Group, Inc. Amendment No. 4 to Registration Statement on Form S-1 filed with the SEC (No. 333-112867) on June 2, 2004) 3.2 Form of Restated By-laws of CB Richard Ellis Group, Inc. (incorporated by reference to Exhibit 3.5 of the CB Richard Ellis Group, Inc. Amendment No. 4 to Registration Statement on Form S-1 filed with the SEC (No. 333-112867) on June 2, 2004) 4.1 Form of Class A common stock certificate of CB Richard Ellis Group, Inc. (incorporated by reference to Exhibit 4.1 of the CB Richard Ellis Group, Inc. Amendment No. 2 to Registration Statement on Form S-1 filed with the SEC (No. 333-112867) on April 30, 2004) 4.2(a) Securityholders Agreement, dated as of July 20, 2001 ( Securityholders Agreement ), by and among, CB Richard Ellis Group, Inc., CB Richard Ellis Services, Inc., Blum Strategic Partners, L.P., Blum Strategic Partners II, L.P., Blum Strategic Partners II GmbH & Co. KG, FS Equity Partners III, L.P., FS Equity Partners International, L.P., Credit Suisse First Boston Corporation, DLJ Investment Funding, Inc., The Koll Holding Company, Frederic V. Malek, the management investors named therein and the other persons from time to time party thereto (incorporated by reference to Exhibit 25 to Amendment No. 9 to Schedule 13D with respect to CB Richard Ellis Services, Inc. filed with the SEC on July 25, 2001) 4.2(b) Amendment and Waiver to Securityholders Agreement, dated as of April 14, 2004, by and among, CB Richard Ellis Group, Inc., CB Richard Ellis Services, Inc. and the other parties to the Securityholders Agreement (incorporated by reference to Exhibit 4.2(b) of the CB Richard Ellis Group, Inc. Amendment No. 2 to Registration Statement on Form S-1 filed with the SEC (No. 333-112867) on April 30, 2004) 4.2(c)* Second Amendment and Waiver to Securityholders Agreement, dated as of November 24, 2004, by and among CB Richard Ellis Group, Inc., CB Richard Ellis Services, Inc. and certain of the other parties to the Securityholders Agreement 4.3 Anti-Dilution Agreement, dated as of July 20, 2001, by and between CB Richard Ellis Group, Inc. and Credit Suisse First Boston Corporation (incorporated by reference to Exhibit 20 to Amendment No. 9 to Schedule 13D with respect to CB Richard Ellis Services, Inc. filed with the SEC on July 25, 2001) 4.4 Warrant Agreement, dated as of July 20, 2001, by and between CB Richard Ellis Group, Inc., and FS Equity Partners III, L.P. and FS Equity Partners International, L.P. (incorporated by reference to Exhibit 26 to Amendment No. 9 to Schedule 13D with respect to CB Richard Ellis Services, Inc. filed with the SEC on July 25, 2001) 4.5(a) Indenture, dated as of May 22, 2003, between CBRE Escrow, Inc., and U.S. Bank National Association, as Trustee, for 9 3/4% Senior Notes Due May 15, 2010 (incorporated by reference to Exhibit 4.1 of the CB Richard Ellis Services, Inc. Registration Statement on Form S-4 filed with the SEC (No. 333-190841) on October 20, 2003) Table of Contents Exhibit Description 4.5(b) First Supplemental Indenture, dated as of July 23, 2003, among CB Richard Ellis Services, Inc., CB Richard Ellis Group, Inc., the Subsidiary Guarantors and U.S. Bank National Association (incorporated by reference to Exhibit 4.1(b) of the CB Richard Ellis Services, Inc. Registration Statement on Form S-4 filed with the SEC (No. 333-190841) on December 5, 2003) 4.5(c) Second Supplemental Indenture, dated as of December 4, 2003, among CB Richard Ellis Services, Inc., Investors 1031, LLC and U.S. Bank National Association (incorporated by reference to Exhibit 4.1(c) of the CB Richard Ellis Services, Inc. Registration Statement on Form S-4 filed with the SEC (No. 333-190841) on December 5, 2003) 4.6(a) Indenture, dated as of June 7, 2001, among CB Richard Ellis Services, Inc., BLUM CB Corp., CB Richard Ellis Group, Inc., the Subsidiary Guarantors named therein and State Street Bank and Trust Company of California, N.A., as Trustee, for 11 1/4% Senior Subordinated Notes due 2011 (incorporated by reference to Exhibit 17 of the CB Richard Ellis Services, Inc. Schedule 13D filed with the SEC (No. 005-46943) on July 30, 2001) 4.6(b) First Supplemental Indenture, dated as of July 20, 2001, among CB Richard Ellis Services, Inc., the Subsidiary Guarantors and State Street Bank and Trust Company of California, N.A. (incorporated by reference to Exhibit 10.17(b) of the CB Richard Ellis Services, Inc. Registration Statement on Form S-4 filed with the SEC (No. 333-190841) on December 5, 2003) 4.6(c) Second Supplemental Indenture, dated as of July 23, 2003, among CB Richard Ellis Services, Inc., CB Richard Ellis Group, Inc., the Subsidiary Guarantors and U.S. Bank National Association as successor to Street Bank and Trust Company of California, N.A (incorporated by reference to Exhibit 10.17(c) of the CB Richard Ellis Services, Inc. Registration Statement on Form S-4 filed with the SEC (No. 333-190841) on December 5, 2003) 4.6(d) Third Supplemental Indenture, dated as of December 4, 2003 among CB Richard Ellis Services, Inc., Investors 1031, LLC, and U.S. Bank National Association (incorporated by reference to Exhibit 10.17(d) of the CB Richard Ellis Services, Inc. Registration Statement on Form S-4 filed with the SEC (No. 333-190841) on December 5, 2003) 4.7 Indenture, dated as of July 20, 2001, among CB Richard Ellis Group, Inc., and State Street Bank and Trust Company, N.A., as Trustee, for 16% Senior Notes due 2011 (incorporated by reference to Exhibit 21 to Amendment No. 9 to Schedule 13D with respect to CB Richard Ellis Services, Inc. filed with the SEC on July 25, 2001) 5** Opinion of Simpson Thacher & Bartlett LLP 10.1(a) Amendment Agreement and Waiver, dated as of April 23, 2004, among CB Richard Ellis Services, Inc., CB Richard Ellis Group, Inc., the Lenders named therein and Credit Suisse First Boston, as Administrative Agent (incorporated by reference to Exhibit 10.1(a) of the CB Richard Ellis Group, Inc. Amendment No. 2 to Registration Statement on Form S-1 filed with the SEC (No. 333-112867) on April 30, 2004) 10.1(b) Amended and Restated Credit Agreement, dated as of April 23, 2004 ( Credit Agreement ), by and among CB Richard Ellis Services, Inc., CB Richard Ellis Group, Inc., the Lenders named therein and Credit Suisse First Boston, as Administrative Agent (incorporated by reference to Exhibit 10.1(b) of the CB Richard Ellis Group, Inc. Amendment No. 2 to Registration Statement on Form S-1 filed with the SEC (No. 333-112867) on April 30, 2004) 10.1(c)* Amendment to Credit Agreement, dated as of November 15, 2004, by and among CB Richard Ellis Services, Inc., CB Richard Ellis Group, Inc., the Lenders named therein and Credit Suisse First Boston, as Administrative Agent 10.2 CB Richard Ellis Group, Inc. 2001 Stock Incentive Plan, as amended (incorporated by reference to Exhibit 10.1 of the CB Richard Ellis Group, Inc. Annual Report on Form 10-K filed with the SEC on March 25, 2003) Table of Contents Exhibit Description * Filed herewith. ** Previously filed.
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+RISK FACTORS You should carefully consider the following factors, as well as other information appearing elsewhere in this prospectus, before you decide to purchase our common stock. We may not have sufficient resources to continue as a going concern Our consolidated financial statements have been prepared assuming that we will continue as a going concern. However, because of continuing negative cash flow and operating losses, there is no certainty that we will have the financial resources to continue in business. During fiscal 2003, we prepared and executed a plan to address our financial needs. Our plan included the sale of additional equity. We consummated private placements in September 2003, February 2004 and July 2004. It also included the replacement of our existing revolving line of credit with a larger facility, which we completed on November 26, 2003 and amended to further expand the line on June 25, 2004. In addition, our plan includes restoring our businesses to positive cash flow and, thereafter, to profitability. Ultimately, we believe it is in our interest to sell our Semiconductor Equipment Group ( SEG ). On June 18, 2004, we announced that we have selected William Blair Company LLC to research the level of interest, timing and valuation of a sale of the SEG business. The sale of the Semiconductor Equipment Group, if completed, should be sufficient to pay down our debt, reduce accounts payable and provide working capital for our remaining businesses. However, because the proceeds of the prospective sale are uncertain, and because there will inevitably be a delay between the reaching of a definitive agreement and the completion of a sale of the division, we recognize that we must also continue actions to control operating expenses, inventory levels, and capital expenses; as well as to manage accounts payable and accounts receivable to enhance cash flow. Any significant downturn in the highly cyclical semiconductor industry or in general economic conditions would likely result in a reduction in demand for our products and would be detrimental to our business Our Semiconductor Equipment Group sells capital equipment to companies that design, manufacture, assemble and test semiconductor devices. The semiconductor industry is highly cyclical, causing in turn a cyclical impact on our financial results. Historically, any significant downturns in the markets for our customers semiconductor devices, or in general economic conditions, has resulted in a reduction in demand for our products and has been detrimental to our business. We define bookings during a fiscal period as incoming orders deliverable to customers in the next eighteen months, less cancellations. Our bookings levels decreased each quarter from the third quarter of fiscal 2000 when they were $61.5 million through the second quarter of fiscal 2003 when they were $8.1 million. This decline mirrored the steep decline in the industry, where reports were that bookings rates were down significantly for manufacturers of test, assembly, and packaging. Our level of bookings has subsequently improved. For the quarter ended June 30, 2004, we recorded bookings of $17.0 million. As was the case in both the 1998-1999 and 2001-2002 downturns and the most recent economic downturn, our revenue and operating results declined as a result of a sudden and severe downturn in the semiconductor capital equipment industry. Downturns in the semiconductor capital equipment industry have been characterized by diminished product demand, excess production capacity and accelerated erosion of selling prices. In the past, we have experienced delays in commitments, delays in collecting accounts receivable and significant declines in demand for our product during these downturns, and we have experienced similar delays and declines in this downturn. Additionally, as a capital equipment provider, our revenues are driven by the spending patterns of our customers who often delay expenditures or cancel orders in reaction to variations in their businesses. Because a high proportion of our costs are fixed, we are limited in our ability to reduce expenses quickly in response to severe revenue shortfalls. In a contraction, we may not be able to reduce our significant fixed costs, such as our infrastructure and our continued investment in research and development. Proposed Proposed Maximum Maximum Amount to be Aggregate Price Aggregate Amount of Title of Securities to be Registered(1)(2) Registered Per Share Offering Price Registration Fee Table of Contents During a downturn, we may experience delays in collecting receivables, which may impose constraints on our working capital. In addition, a downturn in industry demand for our products may place us in a position of excessive inventories, which would further constrain cash flow. By way of illustration, we recorded provisions for excess and obsolete inventory of approximately $3.7 million, $4.9 million and $17.3 million during fiscal 2003, 2002 and 2001, respectively, as a consequence of an unexpected industry downturn. Our Acuity CiMatrix business faces significant competition Our machine vision business, Acuity CiMatrix, competes against both larger companies and specialized smaller organizations in its chosen markets. Our larger competitors are able to field more sales personnel and they offer customers greater financial strength. The smaller, specialized organizations against which we compete are generally private companies that may price their equipment at lesser profit. To win and hold customers in the machine vision market, we must show customers that our products are demonstrably superior in performance and offer features not found on competitors offerings. There can be no assurance that customers will recognize our products as distinctive or offering superior performance for price. We will be unable to achieve profitable operations unless we increase quarterly revenue or make further reductions in our costs We incurred net losses of $11.5 million, $30.1 million, $41.8 million and $104.4 million for the nine months ended June 30, 2004 and for fiscal years ended September 30, 2003, 2002 and 2001, respectively, primarily attributable to the worldwide downturn in demand for semiconductor capital equipment. Our ability to achieve profitable operations will depend upon our ability to increase quarterly revenue levels or make further reductions in our costs. There can be no assurance that we will reduce our costs sufficiently in anticipation of declines in demand to return to profitability. A loss of or decrease in purchases by one of our significant customers could materially and adversely affect our revenues and profitability The semiconductor industry is highly concentrated, and a small number of semiconductor device manufacturers and contract assemblers account for a substantial portion of purchases of semiconductor capital equipment. Sales to our ten largest customers accounted for 43.1%, 34.4% and 30.0% of total revenues in fiscal years ended September 30, 2003, 2002 and 2001, respectively. One customer accounted for 10% of our revenues in fiscal years 2002 and 2001. A loss of or decrease in purchases by one of these customers could materially and adversely affect our revenues and profitability. Economic difficulties encountered by certain of our foreign customers may result in order cancellations and reduce collections of outstanding receivables International sales, primarily to Asia and Western Europe, accounted for approximately 55.7%, 54.5% and 61.0% of our revenues for the fiscal years ended September 30, 2003, 2002 and 2001, respectively. In particular, sales to Taiwan, Korea and other Asian countries accounted for approximately 40.4%, 44.6% and 51.0% of our revenues for the fiscal years ended September 30, 2003, 2002 and 2001, respectively. While our sales in Asia are generally denominated in U.S. dollars, our international business may be affected by changes in demand resulting from fluctuations in currency exchange rates, trade restrictions, duties and other political and economic factors. By way of illustration, the Asian economic crisis in 1998 led to significant order cancellations from customers in Taiwan, Korea, Malaysia and the Philippines as currency devaluations prevented these customers from acquiring U.S. dollars at favorable exchange rates, thereby adversely affecting revenue, collections and profitability. Common Stock, par value $0.01 per share(3) 3,173,685 shs. $1.88(4) $5,966,527.80 $755.96(5) Table of Contents Development of our products requires significant lead time and we may fail to correctly anticipate the technical needs of our markets We must anticipate industry trends and develop products in advance of the commercialization of semiconductor capital equipment. We are required to make capital investments to develop new products before our customers commercially accept them. In addition, if we are not successful in developing enhancements or new generations of products, we may not be able to recover the costs of these investments or may incur significant losses. If we were not able to develop new products that meet the needs of our markets, our competitive position in our industries may be diminished and our relationships with our customers may be impaired. Inadequate cash flow and restrictions in our banking arrangements may impede our production and prevent us from investing sufficient funds in research and development The markets for our products are extremely competitive. Our near-term competitive position is dependent upon our ability to satisfy orders received in a timely manner. To do so, we need access to capital to rapidly increase our production capabilities. Maintaining our long-term competitive position will require our continued investment in research and product development. Our ability to satisfy orders received in a timely manner and to invest in research and product development may be limited by our cash flow availability and by our need to comply with covenants in our banking arrangements that may limit our production, research and product development expenditures. We did not meet the fixed charge covenant as of March 31, 2004, and we received a waiver from the lender for the covenant violation. At June 30, 2004, we were in compliance with our financial covenants, including the fixed charge covenant under the amended facility. The loss of key personnel could have a material adverse effect on our business Our success depends in large part upon our ability to hire and retain qualified personnel in technical and managerial positions. We have a limited number of employment agreements with our technical and managerial personnel. The market for employees with the combination of skills and attributes required to carry out our needs is extremely competitive. Our inability to hire and retain such personnel could adversely affect our growth and profitability. Our common stock is quoted on the OTC bulletin board Our common stock has been delisted from the Nasdaq SmallCap Market since October 2003, and now trades over-the-counter via the OTC Bulletin Board. The delisting of common stock could adversely affect (a) the liquidity and marketability of our common stock; (b) the trading price of our common stock; and (c) our relationships with vendors and customers. Shares traded over-the-counter generally are quoted with greater spreads between bid and ask and may be more expensive to buy or sell. We will not be eligible to re-apply to the Nasdaq Stock Market until we have positive shareholders equity and a higher share price. The large number of shares available for future sale could adversely affect the price of our common stock As of July 30, 2004, 273,750 shares of common stock were issuable upon conversion of convertible debt, and 1,810,675 shares of common stock were issuable upon exercise of outstanding stock options with a weighted average exercise price of $6.58 per share, and 4,346,040 shares of common stock were issuable upon exercise of outstanding warrants with substantially all of these warrants having an exercise price of $0.01 to $25.00 per share. Substantially all of the shares underlying these options and warrants have been registered for resale, and none of them is subject to any contractual restrictions on resale. Future sales of any of these shares, or the anticipation of such sales, could adversely affect the market price of our common stock and could materially impair our future ability to raise capital through an offering of equity securities. Further, any issuance of a substantial number of these shares could result in increased volatility in the price of our common stock. Table of Contents The volatility of our stock price could adversely affect the value of an investment in our common stock During the twelve month period ended June 30, 2004, the closing price of our common stock has ranged from a low of $1.80 to a high of $6.65. The price of our common stock has been and likely will continue to be subject to wide fluctuations in response to a number of events and factors, such as: quarterly variations in operating results; differences between our quarterly results of operations and securities analysts estimates; announcements of technological innovations, new products or strategic alliances; the announcement of the results of existing or new litigation; and news reports relating to companies or trends in our markets. (1) Pursuant to Rule 416 under the Securities Act of 1933, this registration statement also covers any additional securities that may be offered or issued in connection with any stock split, stock dividend or similar transaction. (2) Each share of common stock includes one common stock purchase right pursuant to the terms of a Rights Agreement, dated as of May 14, 1998, between the Registrant and American Stock Transfer Trust Company. (3) Represents Common Stock being offered for resale by certain selling stockholders. (4) Estimated solely for the purpose of calculating the registration fee pursuant to Rule 457(c). (5) Amount of registration fee previously paid. Pursuant to Rule 429 promulgated under the Securities Act of 1933, the Prospectus forming a part of this Registration Statement also relates to the Registrant s Registration Statement on Form S-3 (File No. 333-97359), effective on August 13, 2002, and the Registrant s Registration Statement on Form S-3 (File No. 333-88046), effective on July 22, 2002. The Registrant hereby amends this Registration Statement on such date or dates as may be necessary to delay its effective date until the Registrant shall file a further amendment which specifically states that this Registration Statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933 or until the Registration Statement shall become effective on such date as the Commission, acting pursuant to said Section 8(a), may determine. June 30, 2004 $ 4.27 $ 2.50 March 31, 2004 4.50 3.15 December 31, 2003 4.05 2.75 September 30, 2003 6.65 1.80 June 30, 2003 3.20 0.80 March 31, 2003 1.30 0.55 December 31, 2002 2.75 1.05 September 30, 2002 4.45 1.25 June 30, 2002 8.60 4.30 March 31, 2002 7.50 5.00 December 31, 2001 6.80 3.50 This table gives effect to a one-for-five reverse stock split of our common stock, which was effected on November 26, 2003. The above quotations represent prices between dealers and do not include retail markup, markdown or commission. They do not necessarily represent actual transactions. As of August 4, 2004, there were approximately 3,050 holders of record of our common stock and the closing price of our common stock was $1.73 per share. We have never paid any cash dividends and intend, for the foreseeable future, to retain any future earnings for the development of our business. Our bank credit agreement restricts our ability to pay dividends. Our future dividend policy will be determined by our board of directors on the basis of various factors, including our results of operations and financial condition. Expenditures for plant and equipment, net Semiconductor Equipment $ 1,952 $ 173 Acuity CiMatrix 114 24 Other (1) The effect of adopting Staff Accounting Bulletin No. 101 (SAB 101) was to increase fiscal 2001 revenues by $15,197,000 and to reduce the loss before cumulative effect of the accounting change by $8,107,000 (or $1.14 per share). (Unaudited) (In thousands) Selected Balance Sheet Data: Current assets $ 22,424 $ 37,855 $ 55,353 $ 143,564 $ 77,636 $ 25,574 $ 25,361 Total assets $ 33,993 $ 56,889 $ 87,947 $ 195,484 $ 123,201 $ 43,811 $ 39,476 Long term debt and other liabilities $ 1,285 $ 3,076 $ 7,240 $ 2,499 $ 2,855 $ 4,015 $ 1,253 Total liabilities $ 44,443 $ 43,652 $ 47,448 $ 49,924 $ 76,106 $ 50,864 $ 52,199 Prepaid warrants $ 7,067 $ 8,644 $ 9,105 Stockholders equity (deficit) $ (10,450 ) $ 13,327 $ 33,432 $ 136,916 $ 37,990 $ (7,053 ) $ (12,723 ) Working capital (deficit) $ (20,734 ) $ (2,721 ) $ 15,145 $ 96,139 $ 4,385 $ (21,275 ) $ (25,585 ) 2 .1 Purchase and Sales Agreement By and Among Robotic Vision Systems, Inc. and RVSI Europe Ltd. Sellers and Sick, Inc. and Erwin Sick Ltd. Buyers Dated as of December 18, 2001(1) 3 .1 Registrant s Restated Certificate of Incorporation(2) 3 .2 Amendments to Registrant s Restated Certificate of Incorporation(3) 3 .3 Amendment to Registrant s Restated Certificate of Incorporation, filed with the Delaware Secretary of State on November 26, 2003(4) 3 .4 Registrant s Bylaws, as amended(5) 4 .1 Rights Agreement, dated as of May 14, 1998, between Registrant and American Stock Transfer Trust Company(5) 5 .1 Opinion of Sonnenschein Nath Rosenthal LLP 10 .1 Revolving Credit and Security Agreement, dated April 28, 2000 between PNC Bank, National Association (as lender and agent), Registrant and certain of Registrant s subsidiaries (as borrower)and other lenders identified therein(6) 10 .2 First Amendment to the Revolving Credit and Security Agreement, dated September 10, 2001 between PNC Bank, National Association (as lender and agent), Registrant and certain of Registrant s subsidiaries (as borrower)(1) 10 .3 Second Amendment and Restated Revolving Credit Note, dated September 10, 2001 between PNC Bank, National Association (as lender and agent), Registrant and certain of Registrant s subsidiaries (as borrower)(1) 10 .4 Second Amendment to the Revolving Credit and Security Agreement, dated December 19, 2001 between PNC Bank, National Association (as lender and agent) and Registrant (as borrower)(1) 10 .5 Third Amendment to the Revolving Credit and Security Agreement, dated April 23, 2002, between PNC Bank, National Association (as lender and agent) and Registrant (as borrower)(7) 10 .6 Extension to the Revolving Credit and Security Agreement, dated May 16, 2003, between PNC Bank, National Association (as lender and agent) and Registrant (as borrower)(8) 10 .7 Extension to the Revolving Credit and Security Agreement, dated May 30, 2003, between PNC Bank, National Association (as lender and agent) and Registrant (as borrower)(9) 10 .8 Extension to the Revolving Credit and Security Agreement, dated August 14, 2003, between PNC Bank, National Association (as lender and agent) and Registrant (as borrower)(9) Table of Contents MANAGEMENT S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion should be read in conjunction with Selected Consolidated Historical Financial Data and our consolidated financial statements and related notes appearing elsewhere in this prospectus. Our business involves the development, manufacture, marketing and servicing of machine vision equipment for a variety of industries, including the global semiconductor industry. Our business operates in two primary segments within the machine vision industry, the Semiconductor Equipment Group ( SEG ) and the Acuity CiMatrix division. SEG, which is comprised of the Electronics subdivision, including Abante Automation, supplies inspection equipment to the semiconductor industry. The Acuity CiMatrix division designs, manufactures and markets 2-D data collection products and barcode reading systems, as well as 2-D machine vision systems and lighting products for use in industrial automation. Demand for products can change significantly from period to period as a result of numerous factors including, but not limited to, changes in global economic conditions, supply and demand for semiconductors, changes in semiconductor manufacturing capacity and processes and competitive product offerings. Due to these and other factors, our historical results of operations including the periods described herein may not be indicative of future operating results. Our consolidated financial statements have been prepared assuming that we will continue as a going concern. We have incurred operating losses in the nine months ended June 30, 2004 and the twelve months ended September 30, 2003, 2002 and 2001 amounting to $8.0 million, $31.5 million, $40.5 million, and $83.2 million, respectively. Net cash used in operating activities amounted to $12.9 million, $2.9 million, $25.9 million and $12.6 million in the nine months ended June 30, 2004 and the twelve months ended September 30, 2003, 2002 and 2001, respectively. For the quarter ended June 30, 2004, we incurred an operating loss of $1.4 million and used net cash of $2.4 million in operating activities, compared with $3.9 million and $4.1 million, respectively, for the quarter ended March 31, 2004. Further, we have certain past due debt payments. These conditions among others, raise doubt about the Company s ability to continue as a going concern. However, we continue to implement plans to control operating expenses, inventory levels, and capital expenditures as well as plans to manage accounts payable and accounts receivable to enhance cash flows. The Company has prepared and is executing a plan to meet its financial needs. The Company has undertaken several measures during fiscal 2003 and subsequently to reduce its losses, strengthen its working capital position and provide additional liquidity. During fiscal 2003 it pared its fixed costs significantly, reduced its operating losses and lowered its breakeven level of revenues. On December 4, 2002, the Company received $500,000 from the issuance of a convertible note. On April 11, 2003, the Company received a $1.0 million settlement payment and a $2.0 million loan from a major customer. On September 26, 2003, the Company completed a private placement of its common stock which, along with the exercise on December 1, 2003 of an option to purchase additional shares by its lead investor, raised gross proceeds of $6.0 million. On November 26, 2003, the Company replaced its existing revolving credit facility with a new facility, which increased its maximum borrowing availability to $13.0 million. In February 2004, the Company completed private placements of its common stock and warrants, which raised $4.4 million in gross proceeds ($4.1 million, net of offering expenses). A total of approximately 1.5 million shares of common stock were sold to accredited investors at $3.00 per share. The Company also issued to these accredited investors warrants to purchase up to approximately 1.4 million shares at $3.10 per share. On June 25, 2004, the Company amended its revolving credit facility to increase the maximum borrowing availability from $13.0 million to $16.0 million. To increase the availability to the full $16.0 million, the agreement with the lender required the Company to separately add at least $2.0 million of additional working capital. On July 23, 2004 the Company raised an additional $2.4 million ($2.2 million, net of offering expenses) in equity in the form of a private placement for 1,175,605 shares at $2.05 per share. The buyers of the shares also acquired warrants to purchase up to an additional 529,023 shares of common stock. In connection with the June 2004 revolving credit facility amendment, the TABLE OF CONTENTS Page Table of Contents Company issued to the lender a warrant to purchase up to 450,000 shares of common stock, at an exercise price of $0.01 per share through November 30, 2008. As of June 25, 2004, the warrant was exercisable for 200,000 shares of common stock. Additional shares will become available for exercise if the maximum amount of borrowings outstanding under the Company s credit facility reaches certain thresholds specified in the warrant. The lender exercised the warrant with respect to 200,000 shares on June 28, 2004 and the shares were issued on July 1, 2004. Critical Accounting Policies and Estimates Management s Discussion and Analysis of Financial Condition and Results of Operations discusses our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Management believes the following critical accounting policies affect the more significant judgments and estimates used in the preparation of the consolidated financial statements. On an on-going basis, management evaluates its estimates and judgments, including those related to going concern considerations, the allowance for doubtful accounts, inventories, intangible assets, income taxes, warranty obligations, restructuring costs, and contingencies and litigation. Management bases its estimates and judgments on historical experience and on various other factors that are believed to be reasonable under the circumstances. These estimates form the basis for making judgments about the carrying values of assets and liabilities. Actual results may differ from these estimates. We have identified certain critical accounting policies, which are described below: Revenue Recognition In fiscal 2001, we changed our method of accounting for revenue on certain semiconductor equipment sales to comply with Securities and Exchange Commission ( SEC ) Staff Accounting Bulletin ( SAB ) No. 101, Revenue Recognition in Financial Statements. Previously, we generally recognized revenue upon shipment to the customer, and accrued the cost of providing any undelivered services associated with the equipment at the time of revenue recognition. Under the new accounting method, adopted as of October 1, 2000, we now recognize revenue based on the type of equipment that is sold and the terms and conditions of the underlying sales contracts including acceptance provisions. We defer all or a portion of the gross profit on revenue transactions that include acceptance provisions. If the amount due upon acceptance is 20% or less of the total sales amount, we recognize as revenue the amount due upon shipment. We record a receivable for 100% of the sales amount and the entire cost of the product upon shipment. The portion of the receivable that is due upon acceptance is recorded as deferred gross profit until such time as final acceptance is received. When client acceptance is received, the deferred gross profit is recognized in the statement of operations. If the amount due upon acceptance is more than 20% of the total sales amount, we recognize no revenue on the transaction. We record a receivable for 100% of the sales amount and remove 100% of the cost from inventory. The entire receivable and entire inventory balance is then recorded with an offsetting adjustment to deferred gross profit. When client acceptance is received, deferred gross profit is relieved and total sales and cost of sales are recognized in the statement of operations. In December 2003, the SEC issued SAB No. 104, Revenue Recognition, which codifies, revises and rescinds certain sections of SAB No. 101, in order to make this interpretive guidance consistent with current authoritative accounting and auditing guidance and SEC rules and regulations. The changes noted in SAB No. 104 did not have a material effect on our financial position, results of operations, or cash flows. Table of Contents Provision for Doubtful Accounts We maintain an allowance for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. These estimated allowances are periodically reviewed, on a case-by-case basis, analyzing customers payment histories and information regarding customers creditworthiness known to us. In addition, we record a provision based on the size and age of all receivable balances against which we do not have specific provisions. If the financial condition of our customers deteriorate, resulting in their inability to make payments, additional allowances may be required. Inventory Valuation We reduce the carrying value of our inventory for estimated obsolescence or excess inventory by the difference between the cost of inventory and its estimated net realizable value based upon assumptions about future demand and market conditions. There can be no assurance that we will not have to take additional inventory provisions in the future, based upon a number of factors including: changing business conditions; shortened product life cycles; the introduction of new products and the effect of new technology. Goodwill And Other Long-Lived Asset Valuations In accordance with Statement of Financial Accounting Standards ( SFAS ) No. 142, Goodwill and Other Intangible Assets, we conduct a periodic assessment, annually or more frequently, if impairment indicators exist, on the carrying value of our goodwill. The assessment is based on estimates of future income from the reporting units and estimates of the market value of the units. These estimates of future income are based upon historical results, adjusted to reflect our best estimate of future operating conditions and market opportunities, and are continuously reviewed based on actual operating trends. Actual results may differ materially from these estimates. In accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, we review the carrying value of long-lived assets when circumstances dictate that they should be reevaluated, based upon the expected future operating cash flows of our business. These future cash flow estimates are based on historical results, adjusted to reflect Management s best estimate of future operating conditions and market opportunities, and are continuously reviewed based on actual operating trends. Actual results may differ materially from these estimates. Software development costs are capitalized in accordance with SFAS No. 86, Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed. Such costs are capitalized only to the extent of costs of producing product masters subsequent to the establishment of their technological feasibility and capitalization ends when the product is available for general release to customers. Capitalized software development costs are amortized over the estimated useful lives (generally five years) on a straight-line basis or the ratio of current revenues to total expected revenues in a product s expected life, if greater. Amortization begins in the period in which the related product is available for general release to customers. We review the unamortized capitalized costs of our underlying products compared to the net realizable value of these products. An impairment loss is recorded in an amount by which the unamortized capitalized costs of a computer software product exceeds the net realizable value of that asset. Actual results may differ materially from these estimates. Income Tax Provision We record a valuation allowance against deferred tax assets when we believe that it is more likely than not that these assets will not be realized. Because of our recurring losses and negative cash flows, we have provided a valuation allowance against all net deferred tax assets as of June 30, 2004 and September 30, 2003. Table of Contents Restructuring Provisions In July 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities , which nullifies Emerging Issues Task Force ( EITF ) Issue No. 94-3. SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred, whereas EITF No. 94-3 had recognized the liability at the commitment date to an exit plan. We adopted the provisions of SFAS No. 146 effective for exit or disposal activities initiated after December 31, 2002. The effect of adopting SFAS No. 146 is recognized in the consolidated financial statements. Provision for Litigation We periodically assess our exposure to pending litigation and possible unasserted claims against us in order to establish appropriate litigation reserves. In establishing such reserves, we work with our counsel to consider the availability of insurance coverage, the likelihood of prevailing on a claim, the probable costs of defending the claim, and the prospects for, and costs of, resolution of the matter. It is possible that the litigation reserves established by us will not be sufficient to cover our actual liability and future results of operations for any particular quarterly or annual period could be materially adversely affected by the outcome of certain litigation or claims. Results of Operations Nine Months Ended June 30, 2004 and 2003 Bookings and revenues in the nine-month period ended June 30, 2004 were $48.3 million and $39.5 million, respectively, as compared to $28.4 million and $29.9 million in the nine-month period ended June 30, 2003. The increase in bookings reflects growth in our markets and increasing demand for our products. Revenues for our Semiconductor Equipment Group were $20.4 million for the nine-month period ended June 30, 2004 which represented 51.6% of our total revenues, compared to $16.1 million, or 53.8% of revenues, in the nine-month period ended June 30, 2003. Revenues increased as a result of increased demand for our products and improved lead times to procure inventory necessary to satisfy customer orders. Revenues for our Acuity CiMatrix division were $19.1 million for the nine-month period ended June 30, 2004, which represented 48.4% of our total revenues, compared to $13.8 million, or 46.2% of revenues, in the nine-month period ended June 30, 2003. The increase in revenues is a result of increased demand for our products. Our gross profits in the nine-month period ended June 30, 2004 increased by approximately $10.1 million in comparison to the same period of the prior year. The gross profit improvement reflects higher gross margins, as a percentage of revenues. Our gross margin in the nine-month period ended June 30, 2004 was 45.1% compared to 25.8% in the prior year period. The increase in gross profit during the nine-month period ended June 30, 2004 is largely attributable to higher revenues compared to the prior year period, a $3.7 million inventory provision recorded in the second quarter of fiscal 2003 and a lower level of manufacturing overhead expenses in fiscal 2004 as a result of cost reduction measures initiated during fiscal 2003. The increase was partially offset by higher expenses associated with the launch of a new lead scanner product at the Semiconductor Equipment Group during the March 2004 quarter. Research and development expenses were $7.9 million, or 20.0% of revenues, in the nine-month period ended June 30, 2004 compared to $8.0 million, or 26.7% of revenues, in the nine-month period ended June 30, 2003. We intend to continue to invest in new wafer scanning systems and enhanced capabilities for our lead scanning systems in our Semiconductor Equipment Group and to enhance our machine vision and two-dimensional bar code reading products in our Acuity CiMatrix division. Table of Contents borrowings under the guaranteed portion of the credit facility remained unchanged at $10 million. The entire credit facility will now expire on November 30, 2005. In connection with this amendment, we granted the lender a warrant to purchase up to 450,000 shares of our common stock, at an exercise price of $.01 per share through November 30, 2008. As of June 25, 2004, the warrant was exercisable for 200,000 shares of common stock. Additional shares will become available for exercise if the maximum amount of borrowings outstanding under our credit facility reaches thresholds specified in the warrant. In July 2004 we sold 1,175,605 shares of our common stock at a price of $2.05 per share, or an aggregate of $2.4 million ($2.2 million, net of offering expenses) and warrants to purchase 529,023 shares of our common stock, exercisable at $2.50 per share until January 31, 2005 and exercisable at $3.05 per share from February 1, 2005 until July 31, 2007. The proceeds of such sales are expected to be used for general corporate purposes. Barrington Research Associates, Inc., the placement agent for the transactions, received fees of $144,600 and warrants to purchase 40,000 shares of our common stock. On May 1, 2004, approximately $4.2 million of principal and $162,000 of interest was due in connection with notes issued to former shareholders of Auto Image ID, Inc. ( AIID ). In April and July 2004, noteholders representing approximately $4.1 million of the total principal owed agreed to forbear on taking action to enforce their notes until the earlier of December 1, 2005, or the occurrence of certain events. We agreed to issue to these noteholders warrants to purchase a total of approximately 217,000 shares of our common stock at an exercise price of $0.01 per share, pay interest on the outstanding balance at a 7% annual rate, make periodic principal and interest payments and increase the principal amount on the notes by approximately $543,000. Noteholders representing approximately $98,000 of the total principal did not respond to the forbearance offer and therefore retain their rights under the note. The Offering Common stock offered for sale by the selling stockholders 6,017,590 shares (1) Common stock to be outstanding after offering 23,300,894 shares (2) Table of Contents On October 20, 2003 we entered into an agreement to sell certain assets of our Systemation Business consisting primarily of inventory and intellectual property. Under the terms of the sale agreement, we received $40,000 in cash and a promissory note for the nominal amount of approximately $3.6 million. The note was repayable in increasing periodic payments through November 15, 2008. We reflected the note at its estimated fair value of approximately $2.3 million at an estimated effective interest rate of 15%. We made certain assumptions in valuing the promissory note, including existing market conditions, marketability of the note, and other market variables affecting the realization of the note during the long period involved. We concluded that collection of the note could not be reasonably assured on the basis that the buyer was a new entity with limited financial history upon which to make a determination. Therefore, we deferred the gain on this sale of approximately $1.9 million, which was being recognized as payments were received on the note. Prior to June 2004, the Company received principal payments of $149,000 and recognized $79,000 of the deferred gain. The Company also recorded during the period interest income of $59,000 and accretion income on the note of $190,000. In May 2004, the Company entered into a new agreement with the buyer of the assets, whereby in June 2004 the Company received $1.8 million in cash in full satisfaction of the note. As a result of this payment, the Company recorded a net gain of $1.2 million, consisting of the recognition of the remaining deferred gain of $1.8 million, partially offset by a loss on the payment of $0.6 million. Other gains for the nine month period ended June 30, 2003 included a gain relating to a settlement with a major customer in the amount of $1.0 million. On April 11, 2003, we entered into a settlement and release agreement with this customer, which provided for the release of certain claims among the parties and the $1.0 million payment to us. Net interest expense was $3.3 million and $1.0 million in the nine-month periods ended June 30, 2004 and 2003, respectively. The greater interest expense in fiscal 2004 primarily results from the non-cash amortization of deferred financing costs relating to the new facility entered into on November 26, 2003. There were no tax provisions in the nine-month periods ended June 30, 2004 and 2003, due to the losses incurred and the full valuation allowance provided against net operating loss carryforwards. Fiscal Years Ended September 30, 2003 and 2002 Bookings and revenues in the fiscal year ended September 30, 2003 were $39.6 million and $43.4 million, respectively, as compared to $58.1 million and $59.2 million in the fiscal year ended September 30, 2002. The bookings and revenues in the fiscal year ended September 30, 2002, included $1.7 million and $2.8 million, respectively, associated with our material handling business. Excluding the material handling business, bookings and revenues were each $56.4 million in the fiscal year ended September 30, 2002. The decline in our bookings and revenues in the current fiscal year is a reflection of a general industry slowdown, as a result of which our customers have decreased demand for our products, the uncertainty surrounding the potential sale of SEG as well as our financial constraints impacting our ability to procure inventory necessary to satisfy customer orders. Revenues for our Semiconductor Equipment Group were $25.4 million for the fiscal year ended September 30, 2003, which represented 58.6% of our total revenues, compared to $34.2 million or 57.8% of revenues in fiscal 2002. This decline in revenues of 25.6% versus fiscal 2002 is a result of decreased demand for our products, the uncertainty surrounding the potential sale of SEG as well as our financial constraints impacting our ability to procure inventory necessary to satisfy customer orders. Revenues for our Acuity CiMatrix division were $18.0 million for the fiscal year ended September 30, 2003, which represented 41.4% of our total revenues, compared to $25.1 million or 42.2% of total revenues in fiscal 2002. This decline in revenues of 28.4% versus fiscal 2002 is a result of decreased demand for our products as well as our financial constraints impacting our ability to procure inventory necessary to satisfy customer orders. Excluding the material handling business revenues of $2.8 million in fiscal 2002, the decline in revenues during fiscal 2003 was 19.3%. Table of Contents Summary Consolidated Financial Information The following tables set forth our summary consolidated financial results for the years ended September 30, 2003, 2002 and 2001 and for the nine months ended June 30, 2004 and 2003 and should be read in conjunction with Selected Consolidated Financial Data, Management s Discussion and Analysis of Financial Condition and Results of Operations and our consolidated financial statements and related notes appearing elsewhere in this prospectus. The accompanying financial data for fiscal years ended September 30, 2003 and 2002 and for the nine months ended June 30, 2004 and 2003 have been prepared assuming we will continue as a going concern (see Note 1 to the Consolidated Financial Statements). Nine Months Ended Fiscal Year Ended September 30, June 30, Table of Contents Our gross profits in fiscal 2003 declined by approximately $1.2 million from fiscal 2002. The decrease is due to the lower level of revenues in fiscal 2003. Offsetting the lower level of revenues is an increase in our gross margins, as a percentage of revenues, in fiscal 2003 in comparison to fiscal 2002. Our gross margins in fiscal 2003 were 30.2% compared to 24.1% in fiscal 2002. The increase is largely attributable to a lower level of manufacturing overhead expenses in fiscal 2003 as a result of cost reduction measures initiated during fiscal 2003. The improvement in gross margins also reflects greater charges of $4.7 million recorded in fiscal 2002 in comparison with $3.7 million in fiscal 2003 for excess and obsolete inventory reserves. Research and development expenses were $10.2 million, or 23.5% of revenues, in the fiscal year ended September 30, 2003, compared to $18.6 million, or 31.4% of revenues, in the fiscal year ended September 30, 2002. Excluding the effects of the material handling business, research and development expenses were $18.2 million or 30.7% of revenues in the fiscal year ended September 30, 2002. The lower level of expenses reflects a lower level of fixed costs as a result of cost reductions taken in fiscal years 2002 and 2003. We intend to continue to invest in new wafer scanning systems and enhanced capabilities for our lead scanning systems in our Semiconductor Equipment Group and to enhance our machine vision and two-dimensional barcode reading products in our Acuity CiMatrix division. In the fiscal year ended September 30, 2003, we capitalized approximately $1.2 million in software development costs under SFAS 86, Accounting for the Costs of Software to be Sold, Leased, or Otherwise Marketed , as compared with $1.4 million in the fiscal year ended September 30, 2002. The related amortization expense was $2.8 million during fiscal 2003 compared to $3.4 million during fiscal 2002. The amortization costs are included in cost of sales. Selling, general and administrative expenses were $30.9 million, or 71.1% of revenues, in the fiscal year ended September 30, 2003, compared to $36.9 million, or 62.3% of revenues, in the fiscal year ended September 30, 2002. Excluding the effects of the material handling business, selling, general and administrative expenses in fiscal 2002 were $36.2 million, or 61.0% of revenues. The lower level of expenses in fiscal 2003 reflects a combination of lower levels of variable selling expenses associated with the decrease in revenues and the lower level of fixed costs, as a result of the many cost reductions taken. Also, as a result of the slowdown experienced by SEG, we identified certain purchase commitments for products that have been discontinued. We have recorded a $1.1 million charge to selling, general and administrative expenses related to these commitments during fiscal 2003. Restructuring In February 2003, we closed our New Berlin, Wisconsin and Tucson, Arizona facilities, and consolidated these SEG operations into our Hauppauge, New York facility. This restructuring included costs related to the closing of these facilities, writing off tangible and intangible assets and a reduction of approximately 50 employees. The charge for this restructuring totaling $3.5 million was comprised of facility exit costs of $2.5 million, property plant and equipment write-offs of $0.4 million, severance charges of $0.2 million, and other asset write-offs of $0.4 million. As of September 30, 2003, we had substantially reached an agreement pertaining to our lease for the New Berlin, Wisconsin facility and on October 31, 2003, we reached a settlement. In exchange for the release of all past and future obligations, we issued the landlord a $1.0 million note payable in 36 equal payments of approximately $31,000 each. The note reflects an effective interest rate of approximately 8.7% and is payable in full upon the occurrence of certain events, including the sale of SEG. In addition to the note, we issued a three-year warrant to purchase 20,000 shares of common stock at an exercise price of $0.05 per share. The effect of this settlement was to reduce the facility exit costs recorded in February 2003 of $2.5 million by $1.1 million, resulting in a facility exit cost charge of $1.4 million for the fiscal year ended September 30, 2003. Also during the fiscal year period ended September 30, 2003, we took additional steps in order to reduce our costs, including a reduction of approximately 25 employees at our Hauppauge, New York and Canton, Massachusetts facilities, resulting in severance costs of approximately $0.2 million. In November 2002, certain SEG senior management and technical employees were granted retention agreements. These agreements allow for employees to receive cash and stock benefits for remaining with During the fiscal year ended September 30, 2003, we issued 439,785 shares of our common stock to certain suppliers in exchange for the cancellation of approximately $2.8 million of indebtedness owed to such suppliers. This debt restructuring also included the cancellation of certain of our purchase order commitments totaling approximately $2.8 million. We have reported a gain from debt restructuring of $1.5 million in other gains for the fiscal year ended September 30, 2003. Other gains for the fiscal year ended September 30, 2003, also included a gain relating to a settlement with a major customer in the amount of $1.0 million. On April 11, 2003, we entered into a Settlement and Table of Contents Release Agreement with this customer, which provided for the release of certain claims among the parties and the $1.0 million payment to us. Net interest expense was $1.3 million in the fiscal year ended September 30, 2003, as compared to $1.2 million in the fiscal year ended September 30, 2002. The applicable interest rate under the revolving credit facility is prime plus 2% as of September 30, 2003. There were no tax provisions in the fiscal years ended September 30, 2003 and 2002, due to the losses incurred and full valuation allowance provided against net operating loss carryforwards. In fiscal 2003, we had a net loss of $30.1 million or a loss of $2.44 per share. For fiscal 2002, we had a net loss of $41.8 million, or a loss of $4.19 per share. Fiscal Years Ended September 30, 2002 and 2001 The following discussion of results of operations includes the operations of the material handling business in the prior periods as the basis of the analysis, unless otherwise noted. Our bookings and revenues are inevitably tied to the growth or contraction of the overall semiconductor industry and the changes in capital spending by semiconductor companies. We define bookings during a fiscal period as incoming orders deliverable to customers in the next eighteen months less known cancellations. In fiscal 2002, bookings were $58.1 million compared to $71.4 million for fiscal 2001, a decrease of 18.6%. Bookings associated with the material handling business during fiscal 2002 and fiscal 2001 were $1.7 million and $15.7 million, respectively. Excluding the material handling business, bookings during fiscal 2002 were $56.4 million compared to $55.7 million during fiscal 2001, an increase of 1.3%. For the three month period ended September 30, 2002, bookings were $14.2 million compared to $15.7 million for the three month period ended June 30, 2002, to $18.4 million for the three month period ended March 31, 2002, $9.8 million for the three month period ended December 31, 2001 and $15.0 million for the three month period ended September 30, 2001. For the three month periods ended September 30, 2002, June 30, 2002, March 31, 2002, December 31, 2001 and September 30, 2001, bookings associated with the material handling business were none, none, none, $1.7 million and $2.7 million, respectively. The slight increase in our bookings in the last year, excluding the material handling business, was a result of increased demand for our two-dimensional bar code reading systems and related products, offset by a continued decrease in demand for our semiconductor inspection and handling equipment products. Our revenues were $59.2 million for the fiscal year ended September 30, 2002, compared to $107.8 million for the fiscal year ended September 30, 2001, a decrease of 45.1%. Revenues associated with the material handling business during the fiscal years ended September 30, 2002 and September 30, 2001 were $2.8 million and $16.1 million, respectively. Our revenues excluding the material handling business for the fiscal year ended September 30, 2002 were $56.4 million compared to $91.7 million for the fiscal year ended September 30, 2001, a decrease of 38.5%. For the three month period ended September 30, 2002, revenues were $14.9 million compared to $15.3 million for the three month period ended June 30, 2002, to $14.0 million for the three month period ended March 31, 2002, $15.0 million for the three month period ended December 31, 2001 and $16.5 million for the three month period ended September 30, 2001. For the three month periods ended September 30, 2002, June 30, 2002, March 31, 2002, December 31, 2001 and September 30, 2001, revenues associated with the material handling business were none, none, none, $2.8 million and $3.6 million, respectively. The reason for the decline in our revenues in the last year excluding the material handling business, is due to the continued slowdown in demand for our Semiconductor Equipment Group products, offset in part by the increased demand for our two-dimensional bar code reading systems and related products. In fiscal 2002, revenues for our Semiconductor Equipment Group were $34.2 million, which represented 57.8% of total revenues, compared to $71.8 million or 66.6% of revenues in fiscal 2001. Table of Contents Overall, revenues declined 52.4% in our Semiconductor Equipment Group during fiscal 2002. For the three month period ended September 30, 2002, revenues were $10.0 million in comparison to revenues of $10.5 million for the three months ended June 30, 2002 to $7.3 million for the three months ended March 31, 2002 and $6.4 million for the three months ended December 31, 2001. The decrease in our revenues in fiscal 2002 reflects a continued dramatic slowdown in demand from the semiconductor capital equipment industry. In fiscal 2002, revenues for our Acuity CiMatrix division were $25.1 million, representing 42.2% of total revenue, compared to $36.0 million or 33.4% of revenues in fiscal 2001. The decline in fiscal 2002 revenues compared to fiscal 2001 revenues of 30.4%, is attributable to the loss of revenues resulting from the sale of the material handling business. Revenues associated with the material handling business during the fiscal years ended September 30, 2002 and September 30, 2001 were $2.8 million and $16.1 million, respectively. Excluding the material handling business, revenues during fiscal 2002 were $22.3 million compared to $19.8 million during fiscal 2001, an increase of 12.6%. This increase was a result of increased sales of two-dimensional bar code reading systems and related products. The Acuity CiMatrix division revenues were $4.9 million for the three months ended September 30, 2002, which compares to revenues of $4.9 million in the three months ended June 30, 2002, $6.8 million in the three months ended March 31, 2002 and $5.7 million in the three months ended December 31, 2001, excluding revenues associated with the material handling business. We review and evaluate the excess, obsolescence and net realizable value of inventories on a quarterly basis. The carrying value of the inventory is compared to the future realizable value of such products given sales prices and revenue projections. Substantially all inventory provisions recorded during fiscal 2002 and 2001 related to excess inventories. We believe that these provisions have reduced the inventories to their appropriate net realizable value. However, there can be no assurance that we will not have to take additional inventory provisions in the future, based upon a number of factors including: changing business conditions; shortened product life cycles; the introduction of new products and the effect of new technology. Our gross profit margins, as a percentage of revenues, increased to 24.1% for fiscal 2002 compared to 16.5% for fiscal 2001. As a result of the quarterly analyses mentioned above, we recorded inventory provisions, which reduced our gross profit during fiscal 2002, of $4.7 million or 7.9% of revenue and $17.3 million or 16.0% of revenue during fiscal 2001, primarily relating to excess inventories. The reduction in inventory provisions in fiscal 2002 versus fiscal 2001 led to the margin improvement in fiscal 2002. Exclusive of inventory provisions, gross profit was 32.1% of revenues during fiscal 2002 compared to 32.6% during fiscal 2001. The gross profit margin percentage, exclusive of inventory provisions, for the Semiconductor Equipment Group decreased to 20.8% for fiscal 2002 as compared to 29.4% of revenues for fiscal 2001, primarily due to the lower level of sales compared to the prior year and fixed costs spread over fewer units, partially offset by the cost reductions. Gross profit margin, as a percentage of revenues, increased for the Acuity CiMatrix division to 47.1% in fiscal 2002, as compared to 38.9% for fiscal 2001, attributable to cost reductions and the impact of the sale of the lower margin material handling business that was included in fiscal year 2001. Our research and development expenses were $18.6 million, or 31.4% of revenues, in fiscal 2002, compared to $28.4 million, or 26.3% of revenues, in fiscal 2001. The decline in spending relates primarily to our cost cutting efforts during fiscal 2002 in addition to less cost incurred due to the sale of the material handling business. Research and development expenses associated with the material handling business during fiscal 2002 and fiscal 2001 were $0.4 million and $2.0 million, respectively. The current level of research and development expense reflects spending associated with our continued efforts to maintain our market position and ensure we have the appropriate products for our customers when demand returns. In our Semiconductor Equipment Group, the research and development projects included work on the new wafer scanning inspection systems and enhanced capabilities for our lead scanning systems. At Acuity CiMatrix, we continued to invest in enhancing our two-dimensional barcode reading products and expanding our machine vision platform, Visionscape. During fiscal 2002, we capitalized $1.4 million of software development costs, in accordance with SFAS No. 86, compared to $3.4 million in fiscal 2001. Restructuring We experienced a decline in orders and revenues during fiscal 2002. Our response was to develop and implement headcount reduction plans designed to reduce costs and expenses. As the downturn in the economy worsened, management reviewed its operational plan and made further headcount reductions. During the quarters ended December 31, 2001, March 31, 2002 and June 30, 2002, management made decisions to terminate employees in response to lower revenues. In addition to headcount reductions, we incurred costs related to the closing of a foreign office. Certain tangible and intangible assets were also abandoned in connection with the restructuring efforts. Restructuring charges, totaling approximately $1.7 million after reversals, were recorded during fiscal 2002. The charges can be summarized as follows: During the quarter ended December 31, 2001, approximately $0.2 million of employee severance was recorded. Headcount reductions were made in the Semiconductor Equipment Group and the Acuity CiMatrix division. Approximately 30 employees were terminated throughout all functions of these operations. In the quarter ended March 31, 2002, approximately $0.5 million of severance was recorded. Approximately 30 employees were terminated throughout all functions of the Semiconductor Equipment Group. Also, approximately $0.3 million of severance and facility cost restructuring charges was reversed during the quarter. The reversal of charges was due to a change in operating plans by management, which abandoned plans to close a facility. Severance for employees at that facility and facility exit costs previously accrued were reversed. In the quarter ended June 30, 2002, approximately $1.3 million of severance and other charges was recorded. Approximately 100 employees were terminated throughout all functions of the Semiconductor Equipment Group, the Acuity CiMatrix division as well as within the Corporate Table of Contents staff. The restructuring also included costs related to closing a foreign office, which included the write-off of tangible assets of $0.3 million. In the quarter ended September 30, 2002, approximately $0.1 million of severance and other charges in the Semiconductor Equipment Group were recorded, relating primarily to the finalization of a foreign office closing, which included the write-off of certain tangible property totaling $85 thousand. Also, approximately $0.1 million of severance was reversed during the quarter, relating to the Acuity CiMatrix division, an adjustment to an estimated amount accrued in the prior quarter. All charges were paid within our fiscal year ended September 30, 2003. Impairments Because of the continued decline in revenues in 2002, we reviewed our long-lived assets, including capitalized software, purchased technologies and goodwill for impairment. To evaluate and measure the impairment of capitalized software we considered the estimated future gross revenues reduced by estimated future costs, including costs of performing maintenance and customer support. To evaluate the impairment of purchased technologies and goodwill, we compared the carrying amount to estimated undiscounted net future cash flows. If an impairment was indicated, the amount was measured as the excess of the carrying amount over the fair market value of the asset, which we generally estimated using a discounted cash flow model. This model assumed future revenue growth commensurate with industry projections, a level of costs consistent with past experience, a discount rate based on our incremental borrowing rate and cash flows over the remaining useful life of the intangible asset being tested. As a result of this review, we recorded in fiscal 2002 impairment charges relating to capitalized software, goodwill and other non-current assets totaling $0.3 million, $2.3 million and $2.0 million, respectively. Net interest expense was $1.2 million for fiscal 2002 and fiscal 2001. The interest expense relates to borrowings on our line of credit and acquisition debt. We had $7.1 million of borrowings on our line of credit at the end of fiscal 2002. There was no tax provision in fiscal 2002, due to the operating losses incurred and the valuation allowances provided on those deferred tax assets. During fiscal 2001, based on the losses and the inability to project a return to profitability until there is a sustained upturn in the semiconductor capital equipment sector, we recorded $9.2 million of additional valuation allowance and a corresponding tax expense in fiscal 2001. In fiscal 2002, we had a net loss of $41.8 million, or a loss of $4.19 per share. For fiscal 2001, we had a net loss of $104.4 million, or $14.72 per diluted share. Liquidity and Capital Resources Our cash balance decreased $0.3 million to $30,000 in the nine months ended June 30, 2004, largely as a result of $13.0 million of net cash provided by financing activities, offset by $12.9 million of net cash used in operating activities and $0.5 million of net cash used in investing activities. The $12.9 million of net cash used in operating activities was largely a result of the $11.5 million loss in the nine-month period ended June 30, 2004, partially offset by $4.5 million in non-cash net expenses, and $5.9 million used as a result of changes in operating assets and liabilities. Additions to plant and equipment were $2.1 million in the nine months ended June 30, 2004, as compared to $0.2 million in the nine months ended June 30, 2003. Capitalized software development costs in the nine months ended June 30, 2004, were $0.6 million as compared with $1.0 million in the nine months ended June 30, 2003. We did not capitalize software development expenditures incurred at the Semiconductor Equipment Group during the nine months ended June 30, 2004 as the work performed during this period did not qualify for capitalization under SFAS No. 86. Funds from financing activities were $13.0 million in the nine months ended June 30, 2004, as compared to $5.1 million in the nine months ended June 30, 2003. During the nine months ended June 30, 2004, we received net proceeds from various financing activities of $4.7 million, our revolving line of credit Table of Contents borrowings increased by $9.0 million and our net repayment of long-term borrowings totaled approximately $0.7 million. Our consolidated financial statements have been prepared assuming that we will continue as a going concern. However, because of continuing negative cash flow from operations, limited credit facilities, and the uncertainty of the sale of SEG, there is no certainty that we will have the financial resources to continue in business. We have incurred operating losses in the nine months ended June 30, 2004 and the years ended September 30, 2003, 2002, and 2001 amounting to $8.0 million, $31.5 million, $40.5 million, and $83.2 million, respectively. Net cash used in operating activities amounted to $12.9 million, $2.9 million, $25.9 million and $12.6 million in the nine months ended June 30, 2004 and the years ended September 30, 2003, 2002 and 2001, respectively. In November 2002, we adopted a formal plan to sell the SEG business. In the period since the formal plan was adopted, the semiconductor equipment industry has entered the early stages of a growth cycle driven by rising semiconductor industry sales. Also, during this period the SEG business has a) lowered its fixed costs and breakeven level of revenues, b) reduced its liabilities through a series of debt-for-equity exchanges, and c) recruited an experienced high technology executive to run the operations and oversee its eventual sale. While there can be no assurance of a successful outcome, we believe that given these changes in the business and the concurrent improvement in the semiconductor capital spending environment, the SEG business has the potential to generate positive cash flow from operations and return to profitability. We have not changed our belief that the sale of the SEG business is in the best interests of shareholders, nor have we changed our desire to consummate a sale of the SEG business at the earliest practical time. On June 18, 2004, we announced that we have selected William Blair Company LLC to research the level of interest, timing and valuation of a sale of the SEG business. On December 4, 2002, Pat V. Costa, our Chief Executive Officer, loaned us $0.5 million and we issued a 9% Convertible Senior Note in the amount of $0.5 million. Under the terms of this note, we are required to make semiannual interest payments in cash on May 15 and November 15 of each year commencing May 2003 and pay the principal amount on December 4, 2005. This note allows Mr. Costa to require earlier redemption by us in certain circumstances including the sale of a division at a purchase price at least equal to the amounts then due under this note. Thus, Mr. Costa may require redemption at the time of the sale of SEG. This note also allows for conversion into shares of common stock. The note is convertible at the option of Mr. Costa into approximately 238,000 shares of our common stock at a conversion price of $2.10 per share. As an inducement to make this loan, Mr. Costa received a warrant to purchase approximately 60,000 shares of our common stock at an exercise price of $3.15 per share. We did not make the semiannual interest payments due on May 15, 2003, November 15, 2003 and May 15, 2004. Mr. Costa has agreed to forbear from exercising his rights with respect to these interest payments until January 14, 2005. On April 11, 2003, we entered into a settlement and release agreement with a major customer which provided for the release of certain claims among the parties and the payment of $1.0 million to us. On the same date, we entered into a loan agreement with this customer and we delivered a secured promissory note in the amount of $2.0 million with a maturity date of April 11, 2004, bearing an interest rate of 10%. We did not pay the amount due on April 11, 2004 and are in default on the loan. The customer has not formally declared the loan to be in default and we are in discussions with them regarding the indebtedness. On September 26, 2003, we closed a private placement of our securities raising $5.0 million in gross proceeds, $4.6 million of which was received by September 30, 2003 and the balance in early October 2003. In December 2003, the lead investor exercised an option to invest an additional $1.0 million on the same terms and conditions as the original funding, including warrants to purchase up to 0.2 million shares, increasing the total gross proceeds to $6.0 million. The net proceeds of the financing will be used for general corporate purposes, including working capital to support growth. A total of 2.4 million shares of common stock were sold in the private placement at $2.50 per share. The private placement also included warrants to purchase up to 1.2 million shares at $3.05 per share on or before September 26, 2008. 10 .10 Extension to the Revolving Credit and Security Agreement, dated October 10, 2003, between PNC Bank, National Association (as lender and agent) and Registrant (as borrower)(10) 10 .11 Securities Purchase Agreement, dated as of April 23, 2002, by and among Registrant and the purchasers listed therein(7) 10 .12 Form of Registrant s Common Stock Purchase Warrant expiring May 1,2005 to purchase in the aggregate up to 513,861 shares of common stock(7) 10 .13 Registrant s Common Stock Purchase Warrant expiring May 1, 2005 to purchase in the aggregate up to 113,049 shares of common stock(7) 10 .14 Employment, Retention and Severance Agreement, dated November 13, 2002, between Registrant and Earl Rideout (11) 10 .15 Amended and Restated Convertible Senior Note Agreement, dated as of December 4, 2002, between Registrant and Pat V. Costa(4) 10 .16 Common Stock Warrant Agreement, dated December 4, 2002, between Registrant and Pat V. Costa(11) 10 .17 Security Agreement, dated December 4, 2002, between Registrant and Pat V. Costa(11) 10 .18 Indemnification Agreement, dated April 2, 2002, between Registrant and Pat V. Costa(11) 10 .19 Asset Purchase Agreement, dated October 20, 2003, between International Product Technology, Inc. (as buyer) and Registrant (as seller)(10) 10 .20 Securities Purchase Agreement, dated as of September 24, 2003, by and among Registrant and the purchasers listed therein(4) 10 .21 Form of Registrant s Common Stock Purchase Warrant expiring September 26, 2008 to purchase in the aggregate 1,200,000 shares of common stock(4) 10 .22 Registrant s Common Stock Purchase Warrant expiring September 26, 2007 to purchase in the aggregate 40,000 shares of common stock(4) 10 .23 Registration Rights Agreement, dated as of September 26, 2003, by and among the Registrant and the purchasers listed therein(4) 10 .24 Amended and Restated Revolving Credit and Security Agreement dated as of November 26, 2003 among the Registrant, RVSI Investors, L.L.C. and other lenders party thereto, and PNC Bank, National Association, as Agent(12) 10 .25 Loan Agreement, dated April 11, 2003(4) 10 .26 Form of Registrant s Common Stock Purchase Warrant expiring August 19, 2004 to purchase in the aggregate 1,419,355 shares of common stock(13) 10 .27 First Amendment to Amended and Restated Revolving Credit and Security Agreement dated as of June 26, 2004, among the Registrant, RVSI Investors, L.L.C. and other lenders party thereto, and PNC Bank National Association, as Agent(14) 10 .28 Warrant issued to RVSI Investors, L.L.C. on June 25, 2004(14) 10 .29 Registration Rights Agreement dated as of June 25, 2004 between the Registrant and RVSI Investors, L.L.C.(14) 10 .30* Form of Subscription Agreement dated as of July 23, 2004 10 .31 Second Amendment to Amended and Restated Revolving Credit and Security Agreement, dated as of August 6, 2004 among the Registrant, RVSI Investors, L.L.C. and other lenders party thereto, and PNC Bank, National Association, as Agent 21 .1 Subsidiaries of Registrant(4) 23 .1 Consent of Grant Thornton LLP (Unaudited) (In thousands, except per share amounts) Statement of Operations Data: Revenues $ 43,400 $ 59,243 $ 107,845 $ 39,540 $ 29,901 Loss before income taxes $ (30,104 ) $ (41,774 ) $ (84,406 ) $ (11,460 ) $ (26,618 ) Provision for income taxes $ $ $ 9,220 $ $ Loss before cumulative effect of accounting change $ (30,104 ) $ (41,774 ) $ (93,626 ) $ (11,460 ) $ (26,618 ) Cumulative effect of accounting change(1) $ $ $ (10,747 ) Net loss $ (30,104 ) $ (41,774 ) $ (104,373 ) $ (11,460 ) $ (26,618 ) Net loss per share, before cumulative effect of accounting change: Basic and diluted $ (2.44 ) $ (4.19 ) $ (13.22 ) $ (0.66 ) $ (2.17 ) Cumulative effect of accounting change:(1) Basic and diluted $ $ $ (1.50 ) $ $ Net loss: Basic and diluted $ (2.44 ) $ (4.19 ) $ (14.72 ) $ (0.66 ) $ (2.17 ) Weighted average shares: Basic and diluted 12,337 10,019 7,137 17,325 12,240 Table of Contents Warrants were also issued to the placement agent to purchase up to 40,000 shares of common stock at $2.50 per share on or before September 26, 2007. All of such warrants may be exercised six months after September 26, 2003. Additionally, we were required to file a registration statement by November 26, 2003, and to cause such registration statement to become effective by January 25, 2004, or, in each case, to pay each investor 1% of the purchase price paid by such investor, as liquidated damages for each of the next two months and 2% per month thereafter. The completed registration statement became effective on April 6, 2004. As of March 31, 2004, we incurred and accrued liquidated damages of approximately $356,000 in connection with this obligation. In complete satisfaction of this obligation, we entered into a settlement agreement effective March 31, 2004, whereby in the third quarter of fiscal 2004 we issued 102,579 shares of RVSI common stock and paid $42,000 in cash to the investors. In February 2004, we completed private placements of our common stock and warrants which raised $4.4 million in gross proceeds ($4.1 million, net of offering expenses). A total of approximately 1.5 million shares of common stock were sold to accredited investors at $3.00 per share. We also issued to these accredited investors warrants to purchase up to approximately 1.4 million shares at $3.10 per share. We had a $10.0 million revolving credit facility which was due to expire on April 28, 2003. The termination date had been extended several times by the lender. This credit facility allowed for borrowings of up to 90% of eligible foreign receivables up to $10.0 million of availability provided under the Export-Import Bank of the United States guarantee of certain foreign receivables and inventories, less the aggregate amount of drawings under letters of credit and any bank reserves. On November 26, 2003, we replaced the $10.0 million revolving credit line with a $13.0 million facility. On June 25, 2004, we amended the facility to increase the maximum borrowing availability from $13.0 million to $16.0 million. To increase the availability to the full $16.0 million, the agreement with the lender required us to separately add at least $2.0 million of additional working capital. On July 23, 2004 we raised an additional $2.4 million in equity in the form of a private placement for 1,175,605 shares at $2.05 per share. The buyers of the shares also acquired warrants to purchase up to an additional 529,023 shares of common stock, exercisable at $2.50 per share until January 31, 2005 and exercisable at $3.05 per share from February 1, 2005 until July 31, 2007. The amended facility has two revolving credit lines and expires on November 30, 2005. The first accords us a maximum of $10.0 million and is collateralized by certain foreign receivables and inventory with availability subject to a borrowing base formula. This line is guaranteed by the Export-Import Bank of the United States and has a 7% interest rate. The second line is for a maximum of $6.0 million and is collateralized by certain domestic and foreign receivables. Availability under this line is subject to a borrowing base formula, which, as defined in the credit agreement, includes a $1.5 million over advance feature. It has a 17% interest rate of which 5% can be capitalized at our option (as defined in the agreement). The facility contains covenants pertaining to our net worth and to fixed charge coverage (as defined). We can prepay the facility at our discretion. Any sale of assets not in the ordinary course of business would require the use of proceeds to pay down the principal of both lines. The facility also includes an annual commitment fee of 0.5% based on the unused portion of the facility. At June 30, 2004, the aggregate amount available under the lines was approximately $14.0 million, against which we had $13.6 million of borrowings. At March 31, 2004, we did not meet the fixed charge covenant related to the facility and received a waiver from the lender for the covenant violation. At June 30, 2004, we were in compliance with our financial covenants, including the fixed charge covenant under the amended facility. In connection with the facility, during the first quarter of fiscal 2004 we issued a warrant to purchase 2.2 million shares of our common stock at an exercise price of $0.01 per share to the lender and a warrant to purchase 60,000 shares of our common stock at an exercise price of $0.01 per share to the placement agent. We recorded a deferred financing cost asset for the fair value of the warrants (determined using the Black-Scholes pricing model), of approximately $7.4 million, which is being amortized and charged to interest expense over the life of the facility. The lender exercised its warrant on December 18, 2003. In addition, we incurred costs in connection with the financing of approximately $465,000 which are being amortized and charged to interest expense over the life of the facility. Upon the 23 .3 Consent of Sonnenschein Nath Rosenthal LLP (contained in their opinion included under Exhibit 5.1) (1) The effect of adopting Staff Accounting Bulletin No. 101 (SAB 101) was to increase fiscal 2001 revenues by $15,197,000 and to reduce the loss before cumulative effect of the accounting change by $8,107,000 (or $1.14 per share). September 30, June 30, Table of Contents maturity or payoff of the facility we will also be obligated to pay $400,000 reflecting deferred interest and closing costs and which are being amortized and charged to interest expense over the life of the facility. In connection with the June 2004 amendment, the Company issued to the lender a warrant to purchase up to 450,000 shares of common stock, at an exercise price of $0.01 per share through November 30, 2008. As of June 25, 2004, the warrant was exercisable for 200,000 shares of common stock. Additional shares will become available for exercise if the maximum amount of borrowings outstanding under the Company s credit facility reaches certain thresholds specified in the warrant. The lender exercised the warrant with respect to 200,000 shares on June 28, 2004 and the shares were issued on July 1, 2004. The Company recorded a deferred financing cost asset for the fair value of the 200,000 exercisable warrants of approximately $0.5 million using the Black-Scholes valuation model with the following assumptions: volatility of 143% and risk-free interest rate of 1.52%. The deferred financing cost is being amortized and charged to interest expense over the life of the facility. In addition, the Company incurred costs in connection with the financing of approximately $0.1 million which are being amortized and charged to interest expense over the life of the facility. During the nine months ended June 30, 2004, we issued 60,000 shares of our common stock to suppliers in exchange for the cancellation of approximately $50,000 of trade indebtedness owed to such suppliers and forgiveness of $703,000 of purchase order commitments. As of June 30, 2004, we were in default on an aggregate of $2.7 million of our borrowings. On November 21, 2001, the $1.5 million note payable issued to the former principals of Abante Automation Inc. ( Abante ) came due, together with 8% interest thereon from November 29, 2000. In connection with the acquisition of Abante, we agreed to make post-closing installment payments to the selling shareholders of Abante. These non-interest bearing payments were payable in annual installments of not less than $0.5 million through November 2005. On November 21, 2001, the first of five annual installments on the Abante payable also became due, in the amount of $0.5 million. Pursuant to an oral agreement with the former principals of Abante, we paid on November 21, 2001 the interest, $250 thousand of note principal and approximately $112 thousand of the first annual installment. The balance of the sums originally due on November 21, 2001 were rescheduled for payment in installments through the first quarter of fiscal 2003. We continued to make certain payments in accordance with the terms of that agreement, paying the interest, $250 thousand of note principal and approximately $150 thousand of the first annual installment on February 21, 2002, and paying approximately $238 thousand of the first annual installment on May 21, 2002. We did not make either the November 2002 note principal payment of $1.0 million or a significant portion of the November 2002 annual installment payment of $0.5 million. In addition, we did not make a significant portion of the November 2003 annual installment payment of $0.5 million. On December 19, 2003, we entered into a settlement agreement with the former principals of Abante, who agreed to forbear from taking action against us for fifteen months. Pursuant to this agreement, we paid $0.3 million in January 2004, agreed to make additional monthly payments of at least $35,000, and agreed to pay the remaining balance due upon the sale of SEG, subject to certain conditions. As of June 30, 2004, the remaining outstanding balances on the note payable and post-closing installment payments were $0.2 million and $1.8 million, respectively. In connection with the acquisition of Auto Image ID, Inc. in January 2001, we issued notes having an initial principal amount of approximately $5.6 million. We did not make all payments on the notes as scheduled. Beginning in January 2002, we entered into a series of forbearance agreements with some of the noteholders. These noteholders agreed to forbear from taking action to enforce their notes until May 1, 2004 or the earlier occurrence of certain events. On October 29, 2003, additional noteholders agreed to forbear from taking action until May 1, 2004. We agreed to issue these noteholders warrants to purchase approximately 59,000 shares of our common stock at exercise prices ranging from $2.50 per share to $3.60 per share and paid these noteholders the outstanding interest that had accrued through June 1, 2003. In the third quarter of fiscal 2004, noteholders representing approximately $4.1 million of the total principal owed agreed to forbear on taking action to enforce their notes until the earlier of December 1, 2005, or the occurrence of certain events. We agreed to issue to these noteholders warrants to purchase a total of Purchase Commitments As of June 30, 2004, we had approximately $18.6 million of purchase commitments with vendors. Approximately $16.9 million were for the Semiconductor Equipment Group, and included computers and manufactured components for the division s lead and wafer scanning product lines. Approximately $1.7 million were for the Acuity CiMatrix division and included computers, PC boards, cameras, and manufactured components for the division s machine vision and two-dimensional inspection product lines. We are required to take delivery of this inventory over the next three years. Substantially all deliveries are expected to be taken in the next eighteen months. Effect of Inflation Management believes that during the nine months ended June 30, 2004 and the years ended September 30, 2003, 2002 and 2001 the effect of inflation was not material. Recent Accounting Pronouncements In December 2003, the FASB issued SFAS No. 132 (Revised 2003): Employers Disclosures about Pensions and Other Postretirement Benefits An Amendment of FASB Statements No. 87, 88, and 106. This Statement revises employers disclosures about pension plans and other postretirement benefit plans. It does not change the measurement or recognition of those plans required by FASB Statements No. 87, Employers Accounting for Pensions, No. 88, Employers Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits, and No. 106, Employers Accounting for Postretirement Benefits Other Than Pensions. This Statement retains the disclosure requirements contained in FASB Statement No. 132, Employers Disclosures about Pensions and Other Postretirement Benefits, which it replaces. It requires additional disclosures to those in the original Statement 132 about the assets, obligations, cash flows, and net periodic benefit cost of defined benefit pension plans and other defined benefit postretirement plans. We adopted this statement on January 1, 2004, as required. However, the adoption of this pronouncement did not have a material effect on our financial position, results of operations, or cash flows. Table of Contents In December 2003, the SEC issued SAB No. 104, Revenue Recognition, which codifies, revises and rescinds certain sections of SAB No. 101, Revenue Recognition in Financial Statements , in order to make this interpretive guidance consistent with current authoritative accounting and auditing guidance and SEC rules and regulations. The changes noted in SAB No. 104 did not have a material effect on our financial position, results of operations, or cash flows. Table of Contents BUSINESS General Robotic Vision Systems, Inc. designs, manufactures and markets machine vision, automatic identification and related products for the semiconductor capital equipment, electronics, automotive, aerospace, pharmaceutical and other industries. Founded in 1976, we use advanced technology including vision-enabled process equipment, high-performance optics, lighting and advanced hardware and software to offer a full range of automation solutions. In 1991, we introduced the first generation of our current principal product, the lead scanner, a three-dimensional machine vision system, which inspects the physical characteristics of packaged semiconductors. We believe we have installed more than 1800 of the 2300 lead scanners used by the semiconductor industry since we entered that market. More recently, we have become a leader in designing and manufacturing products that utilize machine vision technology to read two-dimensional bar codes. We operate through two divisions: the Semiconductor Equipment Group, based in Hauppauge, New York, and the Acuity CiMatrix division, located in Nashua, New Hampshire. The Semiconductor Equipment Group s primary business is the design, manufacture and marketing of systems that employ lasers to provide three-dimensional measurement and inspection of solder connection bumps on semiconductor wafers and leads and ball-grid-arrays on assembled chip packages. This group serves the semiconductor capital equipment market. The Acuity CiMatrix division designs, manufactures and markets two primary product lines: board-level vision systems used in the general purpose machine vision market for a variety of industrial applications; and two-dimensional bar code reading systems and related products used in the automatic identification and data collection market to provide unit-level traceability of products and components for the semiconductor, aerospace, automotive, printed circuit board, pharmaceutical, and consumer products businesses. We were pioneers in the development of machine vision and have utilized our technology to enter the emerging market for two-dimensional bar code readers. We developed the technology and own the patents to Data Matrix, a two-dimensional bar code symbology that can be marked directly onto parts and components. We placed the Data Matrix symbology into the public domain to the extent necessary to enable compliance with standards promulgated for various industries. We retain patent rights for the use of Data Matrix in certain applications, including biometrics. Industry Overview Machine vision refers to the technology using optical sensors and digital image processing hardware and software to identify, guide, inspect and measure objects. Machine vision is important for applications in which human vision is inadequate due to fatigue, visual acuity or speed. In addition, machine vision is increasingly used to achieve substantial cost savings and improve product quality. Many types of manufacturing equipment require machine vision because of the increasing demands for speed and accuracy in manufacturing processes, as well as the decreasing size and increasing complexity of items being manufactured. The semiconductor capital equipment market represents the largest application for machine vision products. Machine vision is also extensively used in general industrial applications such as the manufacture of electronics, automotive, aerospace, pharmaceutical and consumer products. Increasingly, machine vision is being utilized in the automatic identification and data collection market as a complementary or alternative technology to traditional laser scanning devices for reading bar codes. Table of Contents Semiconductor Capital Equipment Market Semiconductor capital equipment is sold primarily to companies engaged in the manufacture of semiconductor devices in order to expand the capacity of existing facilities as well as to enable the production of more complex, higher density and smaller designs. Semiconductors, which are also known as chips, ICs, or integrated circuits, are critical components used to create an increasing variety of electronic products and systems. The semiconductor manufacturing process is divided into the front-end fabrication of semiconductor wafers and the back-end packaging process that involves the assembly, test, packaging and inspection of the integrated circuits. Our semiconductor capital equipment is used primarily in the back-end of the semiconductor manufacturing process. According to the Semiconductor Industry Association ( SIA ), the semiconductor market expanded from approximately $50.5 billion in 1990 to $204.4 billion in 2000, representing a compound annual growth rate of approximately 15% during this period. We believe that this growth resulted primarily from two factors. The first factor is the proliferation of semiconductor applications due to the rapidly expanding end-user demand for faster, smaller and more efficient electronic devices with greater functionality and reliability coupled with an increasingly broad range of applications. The second factor is the increasing importance of semiconductors in electronic systems. We believe that these trends will continue to drive the long-term growth of semiconductors. However, the semiconductor market can be cyclical as a result of periodic oversupply of integrated circuits, resulting in reduction in demand for the capital equipment used to fabricate, assemble, and inspect chips. This was evident in 2001 as a combination of lower-than-expected end-user demand and over-production in 2000 resulted in a decrease in semiconductor industry sales of 32%, to $138.4 billion in 2001. The industry grew by a very modest 1.8% in 2002, but growth accelerated by 18.3%, to $166.4 billion in 2003, according to the SIA. In February 2004, the SIA predicted growth in excess of 19% for the industry in the current year. Growth at these rates, which we cannot assure, would result in semiconductor industry revenues of $194.6 billion in 2004, still slightly lower than the industry s 2000 peak. In December 2000, the Semiconductor Equipment and Materials Institute ( SEMI ), the trade association for suppliers of capital equipment to the semiconductor industry, predicted growth of 22% in 2001 on top of the record 83% growth reported in 2000. In reality, equipment shipments declined 41%. In December 2001, the SEMI predicted flat revenues in 2002 for equipment manufacturers. By December 2002, that same group had revised its expectations for 2002 to show an expectation of a further 31% decline in shipments. Thus, from 2000 revenues of $47.7 billion, industry shipments declined 60% to $19.8 billion in 2002. SEMI s most recent prediction, issued in December 2003, is for industry growth of 8% in 2003 (to $21.4 billion), 39% in 2004, and 18% in 2005. If these predictions prove accurate, which we cannot assure, industry revenues in 2005 will be approximately $35 billion, still 31% below the 2000 peak. Two forces generally drive the demand for semiconductor capital equipment. The first is the need for additional capacity. As more chips are produced, there is a commensurate need for more equipment to fabricate, test, package, and inspect those devices. The second force influencing demand for semiconductor capital equipment is technology change. As new generations of chips are designed, they call for production of ever smaller, lighter, and lower-profile packages. Sale of inspection equipment, of the kind we manufacture, is driven by many factors, including, among others: the general proliferation of advanced package types, such as ball grid array and chip-scale packages, and the trend towards miniaturization of semiconductor devices; the desire of semiconductor manufacturers to replace slower, older inspection technology with newer, faster generations of equipment; Table of Contents the desire to maximize capacity and improve efficiencies by minimizing floor space requirements and reducing the total number of systems employed; the emerging need to inspect previously uninspected classes of semiconductor devices, such as memory chips, due to their increasing package complexity; and the requirement to inspect semiconductors at additional steps within the manufacturing process, most notably wafer-scale inspection during the application of solder balls for flip-chip packages and package visual inspection during the transfer of assembled chips from trays to tubes or tape prior to shipment. Semiconductor manufacturers are increasingly outsourcing their packaging requirements to subcontractors. Subcontractors account for an increasing percentage of semiconductor capital equipment orders as they establish new and expand existing packaging facilities. General Purpose Machine Vision Market A general-purpose machine vision system usually consists of a personal computer equipped with special vision processing software and a vision board connected to a solid-state video camera. The camera is used to acquire a digital image of the subject in computer memory. The vision processing hardware and software is used to extract features from the image, verify the identity of the subject, detect its location or orientation, inspect for surface defects and perform non-contact measurements. The semiconductor industry is the largest market for machine vision systems, followed by the electronics industry, including board-level manufacturing. General-purpose machine vision is also actively employed in the automotive, aerospace, pharmaceutical and consumer products markets. Growth in the general-purpose machine vision market is driven by the need to guide high-speed automated assembly equipment and inspect manufactured products. For example, in pharmaceutical manufacturing, machine vision is employed to inspect and verify packaging, labeling and quantities. In the automotive industry, machine vision is used in parts identification, component inspection, assembly verification and robot guidance. We believe that the utilization of general-purpose machine vision products will continue to increase as products become smaller and more complex, requiring more accurate measurements. According to a November 2003 report by the ARC Advisory Group, the worldwide market for general-purpose machine vision in 2002 (including machine vision as applied to the semiconductor industry) was approximately $1.0 billion, and is forecast to grow at a compound annual rate of 10% through 2006, reaching $1.3 billion in that year. Automatic Identification and Data Collection Market There is also a broader market known as the automatic identification and data collection ( AIDC ) market. This market encompasses products that read bar codes, print bar codes, and collect data from bar code readers; and the labels on which bar codes are printed. According to a 2002 study by Venture Development Corporation ( VDC ), the total market for AIDC in 2001 was $7.6 billion, representing a 14.5% decrease in revenues from 2000. However, the same VDC report forecasts 2005 revenues for the industry of $12.0 billion. For our company, the automatic identification and data collection market encompasses products that mark, read and interpret two-dimensional bar codes, through either a stationary or hand-held machine-vision-based imager. The 2002 VDC study reported the total market for stationary and hand-held scanners in 2000 was $1.66 billion, with a projected growth to $2.22 billion in 2005. The vast majority of this market is for linear, or one-dimensional, bar code scanners. The two-dimensional bar-code imaging segment of this market is not the subject of any current studies. We believe that the scanning portion of the automated identification and data collection market will be increasingly penetrated by machine vision manufacturers, especially in high-density applications such as printed circuit board manufacturing and parts marking and tracking. Table of Contents A traditional linear bar code consists of lines of varying width and spacing. A laser interprets that width and spacing with the result that a typical bar code an inch on a side can contain eight to twelve digits. Two dimensional bar codes represent an important technology improvement in that they store substantially more information in the same or a smaller space. Two dimensional bar codes, in turn, can be divided into analog codes and digital codes. Analog codes, such as Symbol Technologies Inc. s PDF 417, stack bar codes on top of one another. Digital bar codes such as our Data Matrix encode information in binary form. The latter approach stores a significantly greater volume of information in the same space, but the code must be read using machine vision imagers. The use of machine vision to read binary codes frees the user of the code from the constraints of high-contrast paper labels or precise offset printing. Codes can be marked directly onto products via ink-jet printing, pin stamping, or laser etching. Because each code is made uniquely, each code can contain unique information; the serial number of an individual component, for example. This creates a solution to a problem that has become increasingly important in commerce: how to individually identify manufactured items that appear identical, but which have vastly different manufacturing histories. The industry s name for this concept is unit level traceability. The requirement for unit level traceability has evolved over time. For example, microprocessors are extremely valuable and highly portable objects. They are manufactured by the tens of millions each year, yet most appear identical to the unaided eye. Several major microprocessor manufacturers inscribe each processor with a machine readable, two dimensional bar code containing the serial number of the microprocessor. This program has helped prevent theft of microprocessors, as well as trace processors that are illegally re-sold by distributors. The use of two-dimensional bar codes is not limited to high-value-added electronics items. The turbine blades of a jet engine, for example, appear identical but, because they are individually machined, each has a slightly different weight and center of gravity. These tolerances can be captured in a two-dimensional bar code and marked on the completed blade. When a jet engine is being assembled, blades of the proper specification can be identified and placed in the engine to ensure a perfectly balanced turbine. Another two dimensional bar code can capture the date of manufacture and installation, so that blades can be retired upon expiration of their mandated service life. We invented and patented Data Matrix, but have placed it into the public domain to the extent necessary to allow its adoption as an internationally recognized standard. By 2002, Data Matrix was accepted and recognized for use by nine standards-setting organizations. While basic camera-based scanners are capable of reading high contrast and high quality Data Matrix images, we believe that the broad application of Data Matrix symbology on parts and components requires the imaging and processing technology typically associated with machine vision. We believe our long history with Data Matrix gives us a competitive advantage in reading the code under adverse conditions, as well as in understanding the needs of organizations implementing unit level traceability programs. Strategy Our goal is to grow by continuing to work with leaders in each of our served markets, anticipating their needs and offering them the most advanced products and technology. To accomplish this objective, we intend to: Offer the industry s broadest spectrum of machine-vision-based imagers. While most competitors have a single two dimensional bar code reader as part of their product offering, we have a complete family. We cover a wide range of price points with fixed-mount and hand-held readers. Treat two dimensional bar code imagers as one part of a broader system solution that begins with identification of a customer s unit-level traceability requirement and continues through working with the customer to implement programs to mark product, read marks, verify that marks will remain readable, and communicate data collected from imagers over networks. Table of Contents Continually work with customers on pilot programs that can grow into major sales opportunities. Each of our customers with an installed base of more than a million dollars in machine vision imagers began as a small pilot program. Concentrate on a handful of high growth markets. We have focused our sales and marketing efforts on industries such as pharmaceutical, medical devices, electronics manufacturing services, and automotive. This has allowed us to become specialists in critical industry segments rather than generalists, and also allowed us to leverage off of success with one customer in the industry to develop others. Semiconductor Equipment Group Our Semiconductor Equipment Group supplies inspection equipment to the semiconductor industry. Our lead scanning systems, which can be found in most back-end semiconductor manufacturing lines, generally perform the final inspection of semiconductor packages prior to their preparation for shipment to the end-user. Our lead scanning systems offer automated, high-speed, three-dimensional semiconductor package lead inspection with the added feature of non-contact scanning of the packages in their shipping trays, which is known as in-tray scanning. The systems use a laser-based, non-contact, three-dimensional measurement technique to inspect and sort a wide variety of semiconductor package types, such as quad flat packs, thin quad flat packs, chip scale packages, wafer scaled products, ball grid arrays and thin small outline packs in their carrying trays. The system measurements captured by our systems include coplanarity, total package height, true position spread and span, as well as lead angle, width, pitch and gap. The development of a new kind of integrated circuit, used primarily in high performance and small form factor applications, has created a new requirement for high-speed wafer inspection equipment. These ICs, called flip chips, necessitate ball grid arrays to be applied and inspected at the end of the front-end fabrication process, and then re-inspected during the back-end packaging process. Recognizing this need, in 2000 we introduced the WS-series, a two and three-dimensional machine vision-based inspection system. We believe that for metrology applications, our WS-2510, WS-2500 and WS-3000 are the most widely employed bumped wafer inspection equipment in use today, and provide the semiconductor industry with the broadest range of products for bumped wafer inspection. Acuity CiMatrix Division The Acuity CiMatrix division designs, manufactures and markets two-dimensional machine vision systems and lighting products as well as two-dimensional data collection products and bar code reading systems. These products are used by a broad range of businesses, including customers in the semiconductor, electronics, automotive, pharmaceutical and consumer products industries. The Acuity CiMatrix division also supplies certain machine vision products to our Semiconductor Equipment Group. Our Acuity CiMatrix machine vision systems use processor chips optimized for vision, software and solid-state video cameras to perform functions such as measurement, flaw detection and inspection of manufactured products. These products examine an image of a manufactured product in order to ascertain physical characteristics, identify deviations and check for identification. For the general-purpose machine vision market, our Acuity CiMatrix division offers single-board machine vision systems, which can be tailored to the needs of specific industries via software modules. The vertical industries currently served include semiconductor, electronics, automotive and packaging/ pharmaceutical. Acuity CiMatrix s principal board-level machine vision product, Visionscape, was first introduced in 1998 and today encompasses a family of board-level machine vision systems. Visionscape is designed to meet the needs of original equipment manufacturers, which incorporate vision products into their systems, as well as for direct use by manufacturers on their factory floor. Acuity CiMatrix has also developed the HawkEye family of integrated products incorporating cameras and machine vision circuit boards. The HawkEye family is used both as a fixed-station Data Matrix imaging system and as a smart-camera solution for industrial machine vision applications. Total $ 7,062 $ Table of Contents Our Acuity CiMatrix data collection and bar code reading systems use machine vision to read and collect data from two-dimensional bar codes for purposes such as process control, traceability and security. Our product offerings also include both fixed and hand-held two-dimensional camera-based readers. In two-dimensional applications, we have concentrated our efforts on scanning systems compatible with Data Matrix, a symbology that we believe has a number of advantages over other two-dimensional bar codes in the public domain. The smaller size of the Data Matrix symbology enables it to be used in miniaturized applications. Data Matrix is read using machine vision as compared to traditional laser scanning systems. The machine vision scanning process enables Data Matrix to exhibit a wider span of character integrity and, hence, enables Data Matrix to be applied to a variety of surfaces. We believe that these characteristics make Data Matrix the preferred symbology for applications in which components need to be marked directly, such as in parts identification. For example, as part of a move to a paperless manufacturing process, one of our customers, an aircraft engine manufacturer, is now applying two-dimensional bar codes to critical engine components. We believe that on part marking will become increasingly common due to the trend toward reducing electronic component sizes and the desire to improve the traceability of each component. By incorporating our expertise in machine vision with our innovations in bar code technologies, we are uniquely positioned to offer integrated solutions to manufacturers in our served markets. Manufacturing Our manufacturing strategy is to produce internally only those components that possess a critical technology and to subcontract all other components. Our production facilities are capable of fabricating and assembling total electronic and electromechanical systems and subsystems. Facilities include assembly and wiring operations that have the ability to produce intricate electronic subassemblies, as well as complex wiring harnesses. We manufacture products for the Semiconductor Equipment Group in Hauppauge, New York. We manufacture products for the Acuity CiMatrix division in Nashua and Weare, New Hampshire. We maintain comprehensive test and inspection programs to ensure that all systems meet exacting customer requirements for performance and quality workmanship prior to delivery. Marketing and Sales Our Semiconductor Equipment Group s marketing strategy focuses on cultivating long-term relationships with the leading manufacturers of electronic and semiconductor inspection and quality control equipment. Its marketing efforts rely heavily on direct sales. The selling cycle for products, generally, is between six to nine months from initial customer contact to closure. A lengthier process is often the case in the purchase of an initial unit. Subsequent purchases require less time and often result in multiple orders. Direct sales personnel handle group sales activities in the domestic market. The Semiconductor Equipment Group also maintains sales capabilities in both Europe and the Far East through independent sales representatives and distributors, providing access to all major markets for electronic and semiconductor test equipment. Sales and technical support offices are maintained in Singapore. The Acuity CiMatrix division markets its products through a combination of direct sales personnel, value-added distributors, original equipment manufacturers and system integrators. For sales made through distributors, the Acuity CiMatrix division supports these activities with direct sales management and technical support personnel. The Acuity CiMatrix division maintains sales and technical support offices in various locations in the United States, Asia, as well as in the United Kingdom. Engineering, Product Development and Research We believe that our engineering, product development and research functions are critical to our ability to maintain our leadership position in our current markets and to develop new products. As of June 30, Table of Contents 2004 we employed over 90 people who are dedicated to engineering, product development and research functions. Our research and development efforts over recent years have been largely devoted to continued development of advanced two-dimensional and three-dimensional vision technology and applications software for use in various inspection and process control automation. Research and development expenditures, net of capitalized software development costs, were $7.9 million, $10.2 million, $18.6 million and $28.4 million for the nine months ended June 30, 2004 and the years ended September 30, 2003, 2002 and 2001, respectively. In the nine months ended June 30, 2004 and the fiscal years ended September 30, 2003, 2002, and 2001, we capitalized $0.6 million, $1.2 million, $1.4 million and $3.4 million, respectively, of our software development costs in accordance with the provisions of Statement of Financial Accounting Standards No. 86. Sources of Supply To support our internal operations and to extend our overall capacity, we purchase a wide variety of components, assemblies and services from proven outside manufacturers, distributors and service organizations. We have experienced some difficulty in obtaining adequate supplies to perform under our contracts as a result of our limited cash availability. A number of our components and sub-systems are purchased from single sources. We believe that alternative sources of supply could be obtained, if necessary, without major interruption in production. In addition, certain products or sub-systems developed and marketed by the Acuity CiMatrix division are incorporated into the Semiconductor Equipment Group s product offerings. Proprietary Protection At June 30, 2004, we owned over 110 issued U.S. patents, with expiration dates ranging from September 2004 to July 2020 and we owned more than 50 foreign patents. We also have various U.S. and foreign registered trademarks. We do not believe that our present operations are materially dependent upon the proprietary protection that may be available to us by reason of any one or more of such patents. Moreover, as our patent position is largely untested, we can give no assurance as to the effectiveness of the protection afforded by our patent rights. Customers No customer accounted for more than 10% of sales during the fiscal year ended September 30, 2003 and the nine months ended June 30, 2004. Intel Corporation accounted for 10% of our revenues during the fiscal years ended September 30, 2002 and 2001. Bookings and Backlog We define our bookings during a fiscal period as incoming orders deliverable to customers in the next eighteen months less cancellations. For the twelve months ended September 30, 2003, bookings were $39.6 million. This compares to bookings of $58.1 million for the twelve months ended September 30, 2002. The decline in our bookings in fiscal 2003 was a reflection of reduced demand by semiconductor industry customers, coupled with a generally uncertain climate for capital equipment expenditures for all industries. For the nine months ended June 30, 2004, bookings were $48.3 million. This compares to bookings of $28.4 million for the nine months ended June 30,2003. This increase in bookings reflects growth in our markets and increasing demand for our products. As a general rule, we ship most products in the quarter in which orders are received. At September 30, 2003, our backlog was $9.0 million, as compared to $12.9 million at September 30, 2002. At June 30, 2004 backlog was $16.0 million, as compared to $9.0 million at June 30, 2003. We believe that most of our backlog at June 30, 2004 will be delivered in the next 12 months. The change in Table of Contents our backlog in these periods is a reflection of short-term business levels and customer lead times. Because orders in backlog are subject to cancellation or indefinite delay, we do not believe that our backlog at any particular time is necessarily indicative of our long-term future business. Competition We believe that machine vision has evolved over the past several years into a new industry, in which a number of machine vision-based firms have developed successful industrial applications for the technology. We are aware that a large number of companies, estimated to be upward of 100 firms, entered the industry in the 1980 s and that most of these were small private concerns. Over the last several years the number of competitors has narrowed to fewer than 25. We believe this is attributable, to a large extent, to consolidation within the industry. Our principal competitors are ICOS Vision Systems NV in semiconductor inspection, August Technology, Inc. in bumped wafer inspection and Cognex in machine vision. We believe that we are a significant competitor in the machine vision industry based upon the breadth of our product lines and our customer base. The pricing of our semiconductor inspection systems is somewhat higher, generally, than that of our competitors, but we do not regard this factor as a significant competitive disadvantage as customers have historically demonstrated their willingness to pay our asking prices to obtain features that are unavailable in our competitors product offerings or result in lower cost of ownership over the life of the product. Employees At June 30, 2004 we employed 237 persons, of whom 95 were engineering and other technical personnel. None of our employees is a member of a labor union. Properties Our executive offices, as well as our Acuity CiMatrix division, are located in a 34,000 square foot facility in Nashua, New Hampshire and its Northeast Robotics operations are located in an 18,000 square foot facility in Weare, New Hampshire. The Symbology Research Center of our Acuity CiMatrix division is located in a 5,415 square foot facility in Huntsville, Alabama. Our Semiconductor Equipment Group is located in a 65,000 square foot facility in Hauppauge, New York. We maintain a 13,820 square foot satellite office in Canton, Massachusetts that provides offices for certain corporate functions as well as for other company employees. We also maintain sales and service offices across the United States to support our various operations. The Acuity CiMatrix division has sales and service offices in the United Kingdom and Shanghai. We maintain a sales and service office in Singapore to support our Semiconductor Equipment Group s operations. All of our facilities are leased, with annual rental payments of approximately $1.8 million and lease expiration dates ranging from 2004 to 2011. Legal Proceedings In March 2002, we learned that the staff of the Securities and Exchange Commission had commenced a formal investigation into the statements that preceded, and the accounting practices that led to, our May 2001 restatement of our financial results for fiscal year 2000 and for the first quarter of fiscal 2001. We are cooperating in the investigation. We are presently involved in other litigation matters in the normal course of business. Based upon discussion with our legal counsel, management does not expect that these matters will have a material adverse impact on our consolidated financial statements. Remuneration 15 20 25 30 Table of Contents
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+RISK FACTORS THE PURCHASE OF OUR SHARES INVOLVES A HIGH DEGREE OF RISK. YOU SHOULD CAREFULLY CONSIDER THE RISKS DESCRIBED BELOW BEFORE MAKING A DECISION TO BUY OUR COMMON STOCK. IF ANY OF THE FOLLOWING RISKS ACTUALLY OCCURS, OUR BUSINESS COULD BE HARMED. IN THAT CASE, THE TRADING PRICE OF OUR COMMON STOCK COULD DECLINE, AND YOU MAY LOSE ALL OR PART OF YOUR INVESTMENT. YOU SHOULD ALSO REFER TO THE OTHER INFORMATION IN THIS PROSPECTUS, INCLUDING OUR FINANCIAL STATEMENTS AND THE RELATED NOTES. EXCEPT FOR HISTORICAL INFORMATION, THE INFORMATION IN THIS PROSPECTUS CONTAINS "FORWARD-LOOKING" STATEMENTS ABOUT OUR EXPECTED FUTURE BUSINESS AND PERFORMANCE. OUR ACTUAL OPERATING RESULTS AND FINANCIAL PERFORMANCE MAY PROVE TO BE VERY DIFFERENT FROM WHAT WE MIGHT HAVE PREDICTED AS OF THE DATE OF THIS PROSPECTUS. THE RISKS DESCRIBED BELOW ADDRESS SOME OF THE FACTORS THAT MAY AFFECT OUR FUTURE OPERATING RESULTS AND FINANCIAL PERFORMANCE. BUSINESS RISKS WE INCURRED LOSSES FOR FISCAL YEARS 2003, 2002, 2001 AND 2000. We incurred losses of $2.7 million, $14.7 million, $28.9 million and $4.1 million in the fiscal years ended March 31, 2003, 2002, 2001, and 2000 respectively. The losses in the past four years have generally been due to difficulties completing sales for new application software licenses, the resulting change in sales mix toward lower margin services, and debt service expenses. We will need to generate additional revenue to achieve profitability in future periods. If we are unable to achieve profitability, or maintain profitability if achieved, may have a material adverse effect on our business and stock price and we may be unable to continue operations at current levels, if at all. WE HAD NEGATIVE WORKING CAPITAL IN PRIOR FISCAL YEARS, AND WE HAVE EXTENDED PAYMENT TERMS WITH A NUMBER OF OUR SUPPLIERS. At March 31, 2003, 2002 and 2001, we had negative working capital of $4.1 million, $5.3 million and $2.8 million, respectively. We have had difficulty meeting operating expenses, including interest payments on debt, lease payments and supplier obligations. We have at times deferred payroll for our executive officers, and borrowed from related parties to meet payroll obligations. We have extended payment terms with our trade creditors wherever possible. As a result of extended payment arrangements with suppliers, we may be unable to secure products and services necessary to continue operations at current levels from these suppliers. In that event, we will have to obtain these products and services from other parties, which could result in adverse consequences to our business, operations and financial condition, and we may be unable to obtain these products from other parties on terms acceptable to us, if at all. OUR NET SALES HAVE DECLINED IN RECENT FISCAL YEARS. WE EXPERIENCED A SUBSTANTIAL DECREASE IN APPLICATION SOFTWARE LICENSE SALES. OUR GROWTH AND PROFITABILITY IS DEPENDENT ON THE SALE OF HIGHER MARGIN LICENSES. Our net sales decreased by 16% in the fiscal year ended March 31, 2003, compared to the fiscal year ended March 31, 2002. Our net sales decreased by 5% in the fiscal year ended March 31, 2002 compared to the fiscal year ended March 31, 2001. We experienced a substantial decrease in application license software sales, which typically carry a much higher margin than other revenue sources. We must improve new application license sales to become profitable. We have taken steps to refocus our sales strategy on core historic competencies, but our typically long sales cycles make it difficult to evaluate whether and when sales will improve. We cannot be sure that the decline in sales has not been due to factors which might continue to negatively affect sales. OUR FINANCIAL CONDITION MAY INTERFERE WITH OUR ABILITY TO SELL NEW APPLICATION SOFTWARE LICENSES. Future sales growth may depend on our ability to improve our financial condition. Our past financial condition has made it difficult for us to complete sales of new application software licenses. Because our applications typically require lengthy implementation and extended servicing arrangements, potential customers require assurance that these services will be available for the expected life of the application. These potential customers may defer buying decisions until our financial condition improves, or may choose the products of our competitors whose financial condition is or is perceived to be stronger. Customer deferrals or lost sales will adversely affect our business, financial conditions and results of operations. OUR SALES CYCLES ARE LONG AND PROSPECTS ARE UNCERTAIN. THIS MAKES IT DIFFICULT FOR US TO PREDICT REVENUES AND BUDGET EXPENSES. The length of sales cycles in our business makes it difficult to evaluate the effectiveness of our sales strategies. Our sales cycles historically have ranged from three to twelve months, which has caused significant fluctuations in revenues from period to period. Due to our difficulties in completing new application software sales in recent periods and our refocused sales strategy, it is difficult to predict revenues and properly budget expenses. Our software applications are complex and perform or directly affect mission-critical functions across many different functional and geographic areas of the retail enterprise. In many cases, our customers must change established business practices when they install our software. Our sales staff must dedicate significant time consulting with a potential customer concerning the substantial technical and business concerns associated with implementing our products. The purchase of our products is often discretionary, so lengthy sales efforts may not result in a sale. Moreover, it is difficult to predict when a license sale will occur. All of these factors can adversely affect our business, financial condition and results of operations. OUR OPERATING RESULTS HAVE FLUCTUATED SIGNIFICANTLY IN THE PAST, AND THEY MAY CONTINUE TO DO SO IN THE FUTURE, WHICH COULD ADVERSELY AFFECT OUR STOCK PRICE. Our quarterly operating results have fluctuated significantly in the past and may fluctuate in the future as a result of several factors, many of which are outside of our control. If revenue declines in a quarter, our operating results will be adversely affected because many of our expenses are relatively fixed. In particular, sales and marketing, application development and general and administrative expenses do not change significantly with variations in revenue in a quarter. It is likely that in some future quarter our net sales or operating results will be below the expectations of public market analysts or investors. If that happens, our stock price will likely decline. OUR REVENUE MAY VARY FROM PERIOD TO PERIOD, WHICH MAKES IT DIFFICULT TO PREDICT FUTURE RESULTS. Factors outside our control that could cause our revenue to fluctuate significantly from period to period include: o The size and timing of individual orders, particularly with respect to our larger customers; o General health of the retail industry and the overall economy; o Technological changes in platforms supporting our software products; and o Market acceptance of new applications and related services. In particular, we usually deliver our software applications when contracts are signed, so order backlog at the beginning of any quarter may represent only a portion of that quarter's expected revenues. Application license revenues in any quarter are substantially dependent on orders booked and delivered in that quarter. Additionally, we have experienced, and we expect to continue to experience, quarters or periods where individual application license or services orders are significantly larger than our typical application license or service orders. Because of the nature of our offerings, we may get one or more large orders in one quarter from a customer and then no orders the next quarter. As a result of these factors, it is difficult for us to predict revenues and adjust costs as necessary. OUR EXPENSES MAY VARY FROM PERIOD TO PERIOD, WHICH COULD AFFECT QUARTERLY RESULTS AND OUR STOCK PRICE. If we incur additional expenses in a quarter in which we do not experience increased revenue, our results of operations would be adversely affected and we may incur losses for that quarter. Factors that could cause our expenses to fluctuate from period to period include: o The extent of marketing and sales efforts necessary to promote and sell our applications and services; o The timing and extent of our development efforts; and o The timing of personnel hiring. IT IS DIFFICULT TO EVALUATE OUR PERFORMANCE BASED ON PERIOD TO PERIOD COMPARISONS OF OUR RESULTS. The many factors which can cause revenues and expenses to vary make meaningful period to period comparisons of our results difficult. We do not believe period to period comparisons of our financial performance are necessarily meaningful, and you cannot rely on them as an indication of our future performance. WE MAY EXPERIENCE SEASONAL DECLINES IN SALES, WHICH COULD CAUSE OUR OPERATING RESULTS TO FALL SHORT OF EXPECTATIONS IN SOME QUARTERS. We may experience slower sales of our applications and services from October through December of each year as a result of retailers' focus on the holiday retail-shopping season. This can negatively affect revenues in our third fiscal quarter and in other quarters, depending on our sales cycles. WE HAVE RELIED ON CAPITAL CONTRIBUTED BY RELATED PARTIES, AND SUCH CAPITAL MAY NOT BE AVAILABLE IN THE FUTURE. Our cash from operations has not been sufficient to meet our operational needs, and we have relied on capital from related parties. A company affiliated with Donald S. Radcliffe, our former director, made short-term loans to us in fiscal 2002 and in fiscal 2003 to meet payroll when cash on hand was not sufficient. Softline Limited ("Softline") loaned us $10 million to make a required principal payment on our Union Bank term loan in July 2000. A subsidiary of Softline loaned us an additional $600,000 in November 2000 to meet working capital needs. This loan was repaid in February 2001, in part with $400,000 we borrowed from Barry M. Schechter, our former Chairman. We borrowed an additional $164,000 from Mr. Schechter in March 2001, which was repaid in July 2001, for operational needs related to our Australian subsidiary. We may not be able to obtain capital from related parties in the future. No officer, director, stockholder or related party is under any obligation to continue to provide cash to meet our future liquidity needs. WE MAY NEED TO RAISE CAPITAL TO GROW OUR BUSINESS. OBTAINING THIS CAPITAL COULD IMPAIR THE VALUE OF YOUR INVESTMENT. We may need to raise capital to: o Support unanticipated capital requirements; o Take advantage of acquisition or expansion opportunities; o Continue our current development efforts; o Develop new applications or services; or o Address working capital needs. Our future capital requirements depend on many factors including our application development, sales and marketing activities. We do not know whether additional financing will be available when needed, or available on terms acceptable to us. If we cannot raise needed funds for the above purposes on acceptable terms, we may be forced to curtail some or all of the above activities and we may not be able to grow our business or respond to competitive pressures or unanticipated developments. We may raise capital through public or private equity offerings or debt financings. To the extent we raise additional capital by issuing equity securities or convertible debt securities, our stockholders may experience substantial dilution and the new securities may have greater rights, preferences or privileges than our existing common stock. INTANGIBLE ASSETS MAY BE IMPAIRED MAKING IT MORE DIFFICULT TO OBTAIN FINANCING. Goodwill, capitalized software, non-compete agreements and other intangible assets represent approximately 73% of our total assets as of September 30, 2003. We may have to impair or write-off these assets, which will cause a charge to earnings and could cause our stock price to decline. Any such impairments will also reduce our assets, as well as the ratio of our assets to our liabilities. These balance sheet effects could make it more difficult for us to obtain capital, and could make the terms of capital we do obtain more unfavorable to our existing stockholders. FOREIGN CURRENCY FLUCTUATIONS MAY IMPAIR OUR COMPETITIVE POSITION AND AFFECT OUR OPERATING RESULTS. Fluctuations in currency exchange rates affect the prices of our applications and services and our expenses, and foreign currency losses will negatively affect profitability or increase losses. Approximately 12%, 9% and 8% of our net sales from continuing operations were outside North America, principally in Australia and the United Kingdom, in the fiscal years ended March 31, 2003, 2002 and 2001, respectively. Many of our expenses related to foreign sales, such as corporate level administrative overhead and development, are denominated in U.S. dollars. When accounts receivable and accounts payable arising from international sales and services are converted to U.S. dollars, the resulting gain or loss contributes to fluctuations in our operating results. We do not hedge against foreign currency exchange rate risks. HISTORICALLY WE HAVE BEEN DEPENDENT ON A SMALL NUMBER OF CUSTOMERS FOR A SIGNIFICANT AMOUNT OF OUR BUSINESS. Toys "R" Us ("Toys") accounted for 13% of our net sales for the six month period ended September 30, 2003, and 31%, 47% and 33% of our net sales for the fiscal years ended March 31, 2003, 2002 and 2001, respectively. QQQ Systems Ltd. ("QQQ Systems") accounted for 32% of our net sales for the six months ended September 30, 2003. In November 2003, Toys terminated their software development and services agreement with us. We cannot provide any assurances that QQQ Systems or any of our current customers will continue at current or historical levels or that we will be able to obtain orders from new customers. IF WE LOSE THE SERVICES OF ANY MEMBER OF OUR SENIOR MANAGEMENT OR KEY TECHNICAL AND SALES PERSONNEL, OR IF WE ARE UNABLE TO RETAIN OR ATTRACT ADDITIONAL TECHNICAL PERSONNEL, OUR ABILITY TO CONDUCT AND EXPAND OUR BUSINESS WILL BE IMPAIRED. We are heavily dependent on our Chairman and Chief Executive Officer, Harvey Braun, and our President and Chief Operating Officer, Steven Beck. We do not have any written employment agreements with Mr. Braun or Mr. Beck. We are also heavily dependent on our former Chairman, Barry Schechter, who remains a consultant to us. We do not have a written consulting agreement with Mr. Schechter. We also believe our future success will depend largely upon our ability to attract and retain highly-skilled software programmers, managers, and sales and marketing personnel. Competition for personnel is intense, particularly in international markets. The software industry is characterized by a high level of employee mobility and aggressive recruiting of skilled personnel. We compete against numerous companies, including larger, more established companies, for our personnel. We may not be successful in attracting or retaining skilled sales, technical and managerial personnel. The loss of key employees or our inability to attract and retain other qualified employees could negatively affect our financial performance and cause our stock price to decline. WE ARE DEPENDENT ON THE RETAIL INDUSTRY, AND IF ECONOMIC CONDITIONS IN THE RETAIL INDUSTRY FURTHER DECLINE, OUR REVENUES MAY ALSO DECLINE. RETAIL SALES HAVE BEEN AND MAY CONTINUE TO BE SLOW. Our future growth is critically dependent on increased sales to the retail industry. We derive the substantial majority of our revenues from the licensing of software applications and the performance of related professional and consulting services to the retail industry. Demand for our applications and services could decline in the event of consolidation, instability or more downturns in the retail industry. This decline would likely cause reduced sales and could impair our ability to collect accounts receivable. The result would be reduced earnings and weakened financial condition, each or both of which would likely cause our stock price to decline. The success of our customers is directly linked to economic conditions in the retail industry, which in turn are subject to intense competitive pressures and are affected by overall economic conditions. In addition, the retail industry may be consolidating, and it is uncertain how consolidation will affect the industry. The retail industry as a whole is currently experiencing increased competition and weakening economic conditions that could negatively impact the industry and our customers' ability to pay for our products and services. Such consolidation and weakening economic conditions have in the past, and may in the future, negatively impact our revenues, reduce the demand for our products and may negatively impact our business, operating results and financial condition. Uncertain economic conditions and the specter of terrorist activities have adversely impacted sales of our software applications, and we believe mid-tier specialty retailers may be reluctant during the current economic climate to make the substantial infrastructure investment that generally accompanies the implementation of our software applications, which may adversely impact our business. THERE MAY BE AN INCREASE IN CUSTOMER BANKRUPTCIES DUE TO WEAK ECONOMIC CONDITIONS. We have in the past and may in the future be impacted by customer bankruptcies. During weak economic conditions, such as those currently being experienced in many geographic regions around the world, there is an increased risk that certain of our customers will file bankruptcy. When our customers file bankruptcy, we may be required to forego collection of pre-petition amounts owed, and to repay amounts remitted to us during the 90-day preference period preceding the filing. Accounts receivable balances related to pre-petition amounts may in certain of these instances be large due to extended payment terms for software license fees, and significant billings for consulting and implementation services on large projects. The bankruptcy laws, as well as the specific circumstances of each bankruptcy, may severely limit our ability to collect pre-petition amounts, and may force us to disgorge payments made during the 90-day preference period. We also face risk from international customers who file for bankruptcy protection in foreign jurisdictions, in that the application of foreign bankruptcy laws may be less certain or harder to predict. Although we believe that we have sufficient reserves to cover anticipated customer bankruptcies, there can be no assurance that such reserves will be adequate, and if they are not adequate, our business, operating results and financial condition would be adversely affected. WE MAY NOT BE ABLE TO MAINTAIN OR IMPROVE OUR COMPETITIVE POSITION BECAUSE OF THE INTENSE COMPETITION IN THE RETAIL SOFTWARE INDUSTRY. We conduct business in an industry characterized by intense competition. Most of our competitors are very large companies with an international presence. We must also compete with smaller companies which have been able to develop strong local or regional customer bases. Many of our competitors and potential competitors are more established, benefit from greater name recognition and have significantly greater resources than us. Our competitors may also have lower cost structures and better access to the capital markets than us. As a result, our competitors may be able to respond more quickly than we can to new or emerging technologies and changes in customer requirements. Our competitors may: o Introduce new technologies that render our existing or future products obsolete, unmarketable or less competitive; o Make strategic acquisitions or establish cooperative relationships among themselves or with other solution providers, which would increase the ability of their products to address the needs of our customers; and o Establish or strengthen cooperative relationships with our current or future strategic partners, which would limit our ability to compete through these channels. We could be forced to reduce prices and suffer reduced margins and market share due to increased competition from providers of offerings similar to, or competitive with, our applications, or from service providers that provide services similar to our services. Competition could also render our technology obsolete. For a further discussion of competitive factors in our industry, see "Business" under the heading "Competition." OUR MARKETS ARE SUBJECT TO RAPID TECHNOLOGICAL CHANGE, SO OUR SUCCESS DEPENDS HEAVILY ON OUR ABILITY TO DEVELOP AND INTRODUCE NEW APPLICATIONS AND RELATED SERVICES. The retail software industry is characterized by rapid technological change, evolving standards and wide fluctuations in supply and demand. We must cost-effectively develop and introduce new applications and related services that keep pace with technological developments to compete. If we do not gain market acceptance for our existing or new offerings or if we fail to introduce progressive new offerings in a timely or cost-effective manner, our financial performance will suffer. The success of application enhancements and new applications depends on a variety of factors, including technology selection and specification, timely and efficient completion of design, and effective sales and marketing efforts. In developing new applications and services, we may: o Fail to respond to technological changes in a timely or cost-effective manner; o Encounter applications, capabilities or technologies developed by others that render our applications and services obsolete or non-competitive or that shorten the life cycles of our existing applications and services; o Experience difficulties that could delay or prevent the successful development, introduction and marketing of these new applications and services; or o Fail to achieve market acceptance of our applications and services. The life cycles of our applications are difficult to estimate, particularly in the emerging electronic commerce market. As a result, new applications and enhancements, even if successful, may become obsolete before we recoup our investment. OUR PROPRIETARY RIGHTS OFFER ONLY LIMITED PROTECTION AND OUR COMPETITORS MAY DEVELOP APPLICATIONS SUBSTANTIALLY SIMILAR TO OUR APPLICATIONS AND USE SIMILAR TECHNOLOGIES WHICH MAY RESULT IN THE LOSS OF CUSTOMERS. WE MAY HAVE TO INITIATE COSTLY LITIGATION TO PROTECT OUR PROPRIETARY RIGHTS. Our success and competitive position is dependent in part upon our ability to develop and maintain the proprietary aspects of our intellectual property. Our intellectual property includes our trademarks, trade secrets, copyrights and other proprietary information. Our efforts to protect our intellectual property may not be successful. Effective copyright and trade secret protection may be unavailable or limited in some foreign countries. We hold no patents. Consequently, others may develop, market and sell applications substantially equivalent to ours or utilize technologies similar to those used by us, so long as they do not directly copy our applications or otherwise infringe our intellectual property rights. We may find it necessary to bring claims or initiate litigation against third parties for infringement of our proprietary rights or to protect our trade secrets. These actions would likely be costly and divert management resources. These actions could also result in counterclaims challenging the validity of our proprietary rights or alleging infringement on our part. The ultimate outcome of any litigation will be difficult to predict. OUR APPLICATIONS MAY BE SUBJECT TO CLAIMS THEY INFRINGE ON THE PROPRIETARY RIGHTS OF THIRD PARTIES, WHICH MAY EXPOSE US TO LITIGATION. We may become subject to litigation involving patents or proprietary rights. Patent and proprietary rights litigation entails substantial legal and other costs, and we do not know if we will have the necessary financial resources to defend or prosecute our rights in connection with any such litigation. Responding to and defending claims related to our intellectual property rights, even ones without merit, can be time consuming and expensive and can divert management's attention from other business matters. In addition, these actions could cause application delivery delays or require us to enter into royalty or license agreements. Royalty or license agreements, if required, may not be available on terms acceptable to us, if they are available at all. Any or all of these outcomes could have a material adverse effect on our business, operating results and financial condition. DEVELOPMENT AND MARKETING OF OUR OFFERINGS DEPENDS ON STRATEGIC RELATIONSHIPS WITH OTHER COMPANIES. OUR EXISTING STRATEGIC RELATIONSHIPS MAY NOT ENDURE AND MAY NOT DELIVER THE INTENDED BENEFITS, AND WE MAY NOT BE ABLE TO ENTER INTO FUTURE STRATEGIC RELATIONSHIPS. Since we do not possess all of the technical and marketing resources necessary to develop and market our offerings to their target markets, our business strategy substantially depends on our strategic relationships. While some of these relationships are governed by contracts, most are non-exclusive and all may be terminated on short notice by either party. If these relationships terminate or fail to deliver the intended benefits, our development and marketing efforts will be impaired and our revenues may decline. We may not be able to enter into new strategic relationships, which could put us at a disadvantage to those of our competitors which do successfully exploit strategic relationships. OUR PRIMARY COMPUTER AND TELECOMMUNICATIONS SYSTEMS ARE IN A LIMITED NUMBER OF GEOGRAPHIC LOCATIONS, WHICH MAKES THEM MORE VULNERABLE TO DAMAGE OR INTERRUPTION. THIS DAMAGE OR INTERRUPTION COULD HARM OUR BUSINESS. Substantially all of our primary computer and telecommunications systems are located in two geographic areas, and these systems are vulnerable to damage or interruption from fire, earthquake, water damage, sabotage, flood, power loss, technical or telecommunications failure or break-ins. Our insurance may not adequately compensate us for our lost business and will not compensate us for any liability we incur due to our inability to provide services to our customers. Although we have implemented network security measures, our systems are vulnerable to computer viruses, physical or electronic break-ins and similar disruptions. These disruptions could lead to interruptions, delays, loss of data or the inability to service our customers. Any of these occurrences could impair our ability to serve our customers and harm our business. IF PRODUCT LIABILITY LAWSUITS ARE SUCCESSFULLY BROUGHT AGAINST US, WE MAY INCUR SUBSTANTIAL LIABILITIES AND MAY BE REQUIRED TO LIMIT COMMERCIALIZATION OF OUR APPLICATIONS. Our business exposes us to product liability risks. Any product liability or other claims brought against us, if successful and of sufficient magnitude, could negatively affect our financial performance and cause our stock price to decline. Our applications are highly complex and sophisticated and they may occasionally contain design defects or software errors that could be difficult to detect and correct. In addition, implementation of our applications may involve customer-specific customization by us or third parties, and may involve integration with systems developed by third parties. These aspects of our business create additional opportunities for errors and defects in our applications and services. Problems in the initial release may be discovered only after the application has been implemented and used over time with different computer systems and in a variety of other applications and environments. Our applications have in the past contained errors that were discovered after they were sold. Our customers have also occasionally experienced difficulties integrating our applications with other hardware or software in their enterprise. We are not currently aware of any material defects in our applications that might give rise to future lawsuits. However, errors or integration problems may be discovered in the future. Such defects, errors or difficulties could result in loss of sales, delays in or elimination of market acceptance, damage to our brand or to our reputation, returns, increased costs and diversion of development resources, redesigns and increased warranty and servicing costs. In addition, third-party products, upon which our applications are dependent, may contain defects which could reduce or undermine entirely the performance of our applications. Our customers typically use our applications to perform mission-critical functions. As a result, the defects and problems discussed above could result in significant financial or other damage to our customers. Although our sales agreements with our customers typically contain provisions designed to limit our exposure to potential product liability claims, we do not know if these limitations of liability are enforceable or would otherwise protect us from liability for damages to a customer resulting from a defect in one of our applications or the performance of our services. Our product liability insurance may not cover all claims brought against us. THE SAGE GROUP PLC (THE "SAGE GROUP") HAS THE RIGHT TO ACQUIRE A SIGNIFICANT PERCENTAGE OF OUR COMMON STOCK, WHICH IF ACQUIRED BY THE SAGE GROUP, MAY ENABLE THE SAGE GROUP TO EXERCISE EFFECTIVE CONTROL OF US. On November 14, 2003, the Sage Group acquired substantially all of the assets of Softline, including Softline's 141,000 shares of our Series A Convertible Preferred Stock, which are convertible into 18,700,185 shares of our common stock within 60 days of January 8, 2004 (the 18,700,185 shares consist of 18,478,789 shares issuable as of January 8, 2004 and 221,396 shares that will be issuable within 60 days of January 8, 2004 on account of accrued and unpaid dividends during that 60 day period), 8,923,915 shares of our common stock and options to purchase 71,812 shares of our common stock. The Sage Group beneficially owns approximately 41.7% of our outstanding common stock, including shares the Sage Group has the right to acquire upon conversion of its Series A Convertible Preferred Stock and exercise of its outstanding options. Although the Series A Convertible Preferred Stock is redeemable by us and 25,125,000 shares of common stock beneficially owned by the Sage Group are subject to an option held by Steven Beck, as trustee of a certain management group of the Company, if the Sage Group converts its Series A Convertible Preferred Stock, it may have effective control over all matters affecting us, including: o The election of all of our directors; o The allocation of business opportunities that may be suitable for the Sage Group and us; o Any determinations with respect to mergers or other business combinations involving us; o The acquisition or disposition of assets or businesses by us; o Debt and equity financing, including future issuance of our common stock or other securities; o Amendments to our charter documents; o The payment of dividends on our common stock; and o Determinations with respect to our tax returns. THE SAGE GROUP'S POTENTIAL INFLUENCE ON OUR COMPANY COULD MAKE IT DIFFICULT FOR ANOTHER COMPANY TO ACQUIRE US, WHICH COULD DEPRESS OUR STOCK PRICE. The Sage Group beneficially owns a significant percentage of our common stock. In addition, two of the current members of our board of directors are employed by a subsidiary of the Sage Group. The Sage Group's potential effective voting control could discourage others from initiating any potential merger, takeover or other change of control transaction that may otherwise be beneficial to our business or our stockholders. As a result, the Sage Group's potential effective control could reduce the price that investors may be willing to pay in the future for shares of our stock, or could prevent any party from attempting to acquire us at any price. OUR STOCK PRICE HAS BEEN HIGHLY VOLATILE. The market price of our common stock has been, and is likely to continue to be, volatile. When we or our competitors announce new customer orders or services, change pricing policies, experience quarterly fluctuations in operating results, announce strategic relationships or acquisitions, change earnings estimates, experience government regulatory actions or suffer from generally adverse economic conditions, our stock price could be affected. Some of the volatility in our stock price may be unrelated to our performance. Recently, companies similar to ours have experienced extreme price fluctuations, often for reasons unrelated to their performance. For further information on our stock price trends, see "Price Range of Common Stock." WE HAVE NEVER PAID A DIVIDEND ON OUR COMMON STOCK AND WE DO NOT INTEND TO PAY DIVIDENDS ON OUR COMMON STOCK IN THE FORESEEABLE FUTURE. We have not previously paid any cash or other dividend on our common stock. We anticipate that we will use our earnings and cash flow for repayment of indebtedness, to support our operations, and for future growth, and we do not have any plans to pay dividends in the foreseeable future. Holders of our Series A Convertible Preferred Stock are entitled to dividends in preference and priority to common stockholders. Future equity financing(s) may further restrict our ability to pay dividends. THE TERMS OF OUR PREFERRED STOCK MAY REDUCE THE VALUE OF YOUR COMMON STOCK. We are authorized to issue up to 5,000,000 shares of preferred stock in one or more series. We issued 141,000 shares of Series A Convertible Preferred Stock in May 2002. Our board of directors may determine the terms of subsequent series of preferred stock without further action by our stockholders. If we issue additional preferred stock, it could affect your rights or reduce the value of your common stock. In particular, specific rights granted to future holders of preferred stock could be used to restrict our ability to merge with or sell our assets to a third party. These terms may include voting rights, preferences as to dividends and liquidation, conversion and redemption rights, and sinking fund provisions. We are actively seeking capital, and some of the arrangements we are considering may involve the issuance of preferred stock. FAILURE TO COMPLY WITH THE AMERICAN STOCK EXCHANGE'S LISTING STANDARDS COULD RESULT IN OUR DELISTING FROM THAT EXCHANGE AND LIMIT THE ABILITY TO SELL ANY OF OUR COMMON STOCK. Our stock is currently traded on the American Stock Exchange. The Exchange has published certain guidelines it uses in determining whether a security warrants continued listing. These guidelines include financial, market capitalization and other criteria, and as a result of our financial condition or other factors, the American Stock Exchange could in the future determine that our stock does not merit continued listing. If our stock were delisted from the American Stock Exchange, the ability of our stockholders to sell our common stock could become limited, and we would lose the advantage of some state and federal securities regulations imposing lower regulatory burdens on exchange-traded issuers. DELAWARE LAW AND SOME PROVISIONS OF OUR CHARTER AND BYLAWS MAY ADVERSELY AFFECT THE PRICE OF YOUR STOCK. Special meetings of our stockholders may be called only by the Chairman of the Board, the Chief Executive Officer or the Board of Directors. Stockholders have no right to call a meeting. Stockholders must also comply with advance notice provisions in our bylaws in order to nominate directors or propose matters for stockholder action. These provisions of our charter documents, as well as certain provisions of Delaware law, could delay or make more difficult certain types of transactions involving a change in control of the Company or our management. Delaware law also contains provisions that could delay or make more difficult change in control transactions. As a result, the price of our common stock may be adversely affected. SHARES ISSUABLE UPON THE EXERCISE OF OPTIONS, WARRANTS, DEBENTURES AND CONVERTIBLE NOTES OR UNDER ANTI-DILUTION PROVISIONS IN CERTAIN AGREEMENTS COULD DILUTE YOUR STOCK HOLDINGS AND ADVERSELY AFFECT OUR STOCK PRICE. We have issued options and warrants to acquire common stock to our employees and certain other persons at various prices, some of which are or may in the future have exercise prices at below the market price of our stock. We currently have outstanding options and warrants for 14,254,228 shares. Of these options and warrants, as of January 8, 2004, 1,446,257 have exercise prices above the recent market price of $1.92 per share (as of January 8, 2004), and 12,807,971 have exercise prices at or below that recent market price. If exercised, these options and warrants will cause immediate and possibly substantial dilution to our stockholders. Our existing stock option plan currently has approximately 2,284,217 shares available for issuance as of January 8, 2004. Future options issued under the plan may have further dilutive effects. We issued to Union Bank of California, N.A. an unsecured note that is convertible into shares of common stock at a price per share of eighty percent (80%) of the average share closing price of our common stock for the ten trading day period immediately preceding the payoff date of the note, which is March 31, 2004. This note will have a dilutive effect on stockholders if converted. As of September 30, 2003, the bank assigned this note to Roth Capital Partners, LLC. Under a securities purchase agreement dated November 7, 2003 between the Company and various institutional investors, for a six-month period the Company is obligated to issue the investors additional shares of common stock, if the Company or any subsidiary or affiliate of the Company sells any of the Company's common stock for an aggregate purchase price of $1 million for a per share price that is less than 120% of the then current per share purchase price paid by such investors. The number of shares issued pursuant to the anti-dilution provision when aggregated with all prior issuances pursuant to the November 7, 2003 securities purchase agreement can not exceed 7,600,000 without stockholder approval. Sales of shares issued pursuant to exercisable options, warrants, convertible notes or anti-dilution provisions could lead to subsequent sales of the shares in the public market, and could depress the market price of our stock by creating an excess in supply of shares for sale. Issuance of these shares and sale of these shares in the public market could also impair our ability to raise capital by selling equity securities. WE MAY BE UNABLE TO SUCCESSFULLY INTEGRATE OUR OPERATIONS WITH PAGE DIGITAL INCORPORATED ("PAGE DIGITAL") OR RETAIL TECHNOLOGIES INTERNATIONAL, INC. ("RTI") OR REALIZE ALL OF THE ANTICIPATED BENEFITS OF THESE ACQUISITIONS. On January 30, 2004, we acquired Page Digital (see "Recent Transactions" below). On January 6, 2004, we executed a Letter of Intent/Term Sheet pursuant to which we intend to acquire RTI., subject to securing financing, due diligence, the execution of a definitive agreement, the approval of the board of directors of the Company and the approvals of the board of directors and shareholders of RTI. These acquisitions involve integrating two companies that previously operated independently into Island Pacific. These integrations will be complex, costly and time-consuming processes. The difficulties of combining these companies' operations include, among other things: o Coordinating geographically disparate organizations, systems and facilities; o Strain on management resources due to integration demands; o Integrating personnel with diverse business backgrounds; o Consolidating corporate and administrative functions; o Coordinating product development; o Coordinating sales and marketing functions; o Retaining key employees; and o Preserving relationships with key customers. SATISFYING CLOSING CONDITIONS MAY DELAY OR PREVENT THE COMPLETION OF THE RTI TRANSACTION. The closing of the RTI acquisition is conditioned, among other things, upon our securing financing, completion of due diligence, executing definitive agreements and securing the approval of the board of directors of Island Pacific and the approvals of the board of directors and the shareholders of RTI. Satisfying all these conditions is a complicated and time consuming process. We will have to dedicate significant financial and managerial resources to completing this transaction. It is possible that one of these conditions may become difficult or impossible to satisfy delaying or frustrating the consummation of the acquisition. There can be no assurance that the Company will be able to secure the necessary financing to complete the acquisition of RTI. BUSINESS RISKS FACED BY PAGE DIGITAL COULD DISADVANTAGE OUR BUSINESS. Page Digital is a developer of multi-channel commerce software and faces several business risks that could disadvantage our business if the proposed transaction is consummated. These risks include many of the risks that we face, described above, as well as: o LONG AND VARIABLE SALES CYCLES MAKE IT DIFFICULT TO PREDICT OPERATING RESULTS - Historically, the period between initial contact with a prospective customer and the licensing of Page Digital's products has ranged from one to twelve months. Page Digital's average sales cycle is currently three months. The licensing of Page Digital's products is often an enterprise wide decision by customers that involves a significant commitment of resources by Page Digital and its prospective customer. Customers generally consider a wide range of issues before committing to purchase Page Digital's products, including product benefits, cost and time of implementation, ability to operate with existing and future computer systems, ability to accommodate increased transaction volume and product reliability. As a part of the sales process, Page Digital spends a significant amount of resources informing prospective customers about the use and benefits of Page Digital products, which may not result in a sale, therefore increasing operating expenses. As a result of this sales cycle, Page Digital's revenues are unpredictable and could vary significantly from quarter to quarter causing our operating results to vary significantly from quarter to quarter. o DEFECTS IN PRODUCTS COULD DIMINISH DEMAND FOR PRODUCTS AND RESULT IN LOSS OF REVENUES - From time to time errors or defects may be found in Page Digital's existing, new or enhanced products, resulting in delays in shipping, loss of revenues or injury to Page Digital's reputation. Page Digital's customers use its products for business critical applications. Any defects, errors or other performance problems could result in damage to Page Digital's customers' businesses. These customers could seek significant compensation from Page Digital for any losses. Further, errors or defects in Page Digital's products may be caused by defects in third-party software incorporated into Page Digital products. If so, Page Digital may not be able to fix these defects without the assistance of the software providers. o FAILURE TO FORMALIZE AND MAINTAIN RELATIONSHIPS WITH SYSTEMS INTEGRATORS COULD REDUCE REVENUES AND HARM PAGE DIGITAL'S ABILITY TO IMPLEMENT PRODUCTS - A significant portion of Page Digital's sales are influenced by the recommendations of systems integrators, consulting firms and other third parties who assist with the implementation and maintenance of Page Digital's products. These third parties are under no obligation to recommend or support Page Digital's products. Failing to maintain strong relationships with these third parties could result in a shift by these third parties toward favoring competing products, which could negatively affect Page Digital's software license and service revenues. o PAGE DIGITAL'S PRODUCT MARKETS ARE SUBJECT TO RAPID TECHNOLOGICAL CHANGE, SO PAGE DIGITAL'S SUCCESS DEPENDS HEAVILY ON ITS ABILITY TO DEVELOP AND INTRODUCE NEW APPLICATIONS AND RELATED SERVICES - The retail software industry is characterized by rapid technological change, evolving standards and wide fluctuations in supply and demand. Page Digital must cost-effectively develop and introduce new applications and related services that keep pace with technological developments to compete. If Page Digital fails to gain market acceptance for its existing or new offerings or if Page Digital fails to introduce progressive new offerings in a timely or cost-effective manner, our financial performance may suffer. o FAILURE TO PROTECT PROPRIETARY RIGHTS OR INTELLECTUAL PROPERTY, OR INTELLECTUAL PROPERTY INFRINGEMENT CLAIMS AGAINST PAGE DIGITAL COULD RESULT IN PAGE DIGITAL LOSING VALUABLE ASSETS OR BECOMING SUBJECT TO COSTLY AND TIME-CONSUMING LITIGATION - Page Digital's success and ability to compete depend on its proprietary rights and intellectual property. Page Digital relies on trademark, trade secret and copyright laws to protect its proprietary rights and intellectual property. Page Digital also has one issued patent. Despite Page Digital's efforts to protect intellectual property, a third party could obtain access to Page Digital's software source code or other proprietary information without authorization, or could independently duplicate Page Digital's software. Page Digital may need to litigate to enforce intellectual property rights. If Page Digital is unable to protect its intellectual property it may lose a valuable asset. Further, third parties could claim Page Digital has infringed their intellectual property rights. Any claims, regardless of merit, could be costly and time-consuming to defend. o COMPETITION IN THE SOFTWARE MARKET IS INTENSE AND COULD REDUCE PAGE DIGITAL'S SALES OR PREVENT THEM FROM ACHIEVING PROFITABILITY - The market for Page Digital's products is intensely competitive and subject to rapid technological change. Competition is likely to result in price reductions, reduced gross margins and loss of Page Digital's market share, any one of which could reduce future revenues or earnings. Further, most of Page Digital's competitors are large companies with greater resources, broader customer relationships, greater name recognition and an international presence. As a result, Page Digital's competitors may be able to better respond to new and emerging technologies and customer demands.
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+RISK FACTORS An investment in the EISs, shares of our Class A common stock and/or our senior subordinated notes involves a number of risks. In addition to the other information contained in this prospectus, prospective investors should give careful consideration to the following factors. Risks Relating to the EISs, shares of Class A Common Stock and/or Senior Subordinated Notes You may not receive interest or dividends in the amounts contemplated in this prospectus. The terms of our new credit facility will restrict our ability to pay principal and interest on our senior subordinated notes and to pay dividends on shares of our Class A and Class B common stock. The terms of our senior subordinated notes and our franchise agreements with Wendy's International restrict our ability to pay dividends on shares of our Class A and Class B common stock. Our ability to make payments of principal and interest on our senior subordinated notes, pay dividends on our Class A and Class B common stock or make other distributions will be subject to applicable law and contractual restrictions contained in the instruments governing our indebtedness, including the terms of our new credit facility, the indenture governing our senior subordinated notes and our franchise agreements with Wendy's International. The terms of our new credit facility will prevent us from paying principal or interest on our senior subordinated notes during the existence of a payment default thereunder and for 179 days following a default thereunder, other than a payment default. Our new credit facility will also prevent us from paying dividends on our shares of Class A and Class B common stock if an event of default exists thereunder or if certain financial covenant ratios are not met. See "Description of Certain Indebtedness New Credit Facility." The indenture governing our senior subordinated notes contains significant restrictions on our ability to pay dividends on shares of our Class A and Class B common stock based upon meeting certain fixed charge coverage ratios and other conditions, as described under "Description of Senior Subordinated Notes" and prohibits the payment of dividends during the existence of an event of default (including the non-payment of interest on our senior subordinated notes, when due) thereunder. Under the terms of our franchise agreements with Wendy's, we are restricted from paying dividends on our Class A and Class B common stock if at the time of such payment we are not current in our capital expenditure obligations or our royalty fee, advertising contribution or other payment obligations to Wendy's, or if such payment would prevent us from making required payments to Wendy's under our agreements with Wendy's. See "Business Relationship with Wendy's International Ownership and Other Requirements of Wendy's International Dividend restrictions." Accordingly, you may not receive interest or dividends in the amounts contemplated by the senior subordinated notes or the dividend policy to be adopted by our board of directors upon the closing of this offering. You may not receive the level of dividends provided for in the dividend policy our board of directors will adopt upon the closing of this offering or any dividends at all. Dividend payments are not mandatory or guaranteed, and holders of our common stock do not have any legal right to receive, or require us to pay, dividends. Furthermore, our board of directors may, in its sole discretion, amend or repeal the dividend policy to be adopted upon the closing of this offering. Our board of directors may decrease the level of dividends provided for in this dividend policy or entirely discontinue the payment of dividends. Future dividends with respect to shares of our capital stock, if any, will depend on, among other things, our results of operations, cash requirements, financial condition, contractual restrictions, business opportunities, provisions of applicable law and other factors that our board of directors may deem relevant. Under state law, our board of directors may declare DavCo Restaurants Inc. [GRAPHIC OMITTED] dividends only to the extent of our "surplus" (which is defined as total assets at fair market value minus total liabilities, minus statutory capital), or, if there is no surplus, out of the current or immediately preceding fiscal year's earnings. Further, the new credit facility, the indenture governing our senior subordinated notes and our franchise agreements with Wendy's contain significant restrictions on our ability to make dividend payments on our shares of common stock. The reduction or elimination of dividends may negatively affect the market price of the EISs. If we have insufficient cash flow to cover the expected dividend payments under the dividend policy to be adopted by our board of directors we would need to reduce or eliminate dividends or, to the extent permitted under our debt agreements, fund a portion of our dividends with additional borrowings. If our cash flows from operations for future periods were to fall below our minimum expectations (or if our assumptions as to capital expenditures, interest expense or tax expense were too low or our assumptions as to the sufficiency of our new credit facility to finance our new restaurant capital expenditures and any of our seasonal working capital needs and other assumptions were to prove incorrect), we would need either to reduce or eliminate dividends or, to the extent we were permitted to do so under the terms of our new credit facility and the indenture governing our senior subordinated notes, fund a portion of our dividends with borrowings or from other sources. If we were to use our new credit facility or other borrowings to fund dividends, we would have less cash or borrowing capacity available for future dividends and other purposes, which could negatively impact our financial condition, our results of operations and our ability to maintain or expand our business. The degree to which we are leveraged on a consolidated basis may impact our financing options and liquidity position. Following the closing, we will have an aggregate $66.3 million of our senior subordinated notes outstanding (or $75.1 million if the underwriters' over-allotment option is exercised in full) and have entered into the new credit facility. Under certain circumstances, our new credit facility and the indenture governing our senior subordinated notes will permit us to incur additional indebtedness. The degree to which we are leveraged on a consolidated basis could have important consequences to the holders of the EISs or senior subordinated notes, including: it may be more difficult to satisfy our obligations under our new credit facility and the senior subordinated notes and pay dividends on our common stock; our ability in the future to obtain additional financing for working capital, capital expenditures or acquisitions may be limited; we may not be able to refinance our indebtedness on terms acceptable to us or at all; a significant portion of our cash flow from operations is likely to be dedicated to the payment of the principal of and interest on our indebtedness, thereby reducing funds available for future operations, capital expenditures and/or dividends on our common stock; and we may be more vulnerable to economic downturns and be limited in our ability to withstand competitive pressures. We are subject to restrictive debt covenants that limit our business flexibility by imposing operating and financial restrictions on our operations. The agreements governing our indebtedness, including the new credit facility and the indenture governing our senior subordinated notes, impose significant operating and financial restrictions on us. These restrictions prohibit or limit, among other things: the payment of principal and interest on our senior subordinated notes, dividends and distributions on, and purchase or redemption of, capital stock; TABLE OF CONTENTS Page the incurrence of additional indebtedness and the issuance of preferred stock and certain redeemable capital stock; a number of other restricted payments, including the making of certain investments; specified sales of assets; specified sale-leaseback transactions; the creation of a number of liens; specified transactions with affiliates; and consolidations, mergers and transfers of all or substantially all of our assets. These restrictions could limit our ability to obtain future financing, make acquisitions or needed capital expenditures, withstand downturns in our business or take advantage of business opportunities. The terms of the new credit facility include other restrictive covenants and prohibit us from prepaying our other indebtedness, including the senior subordinated notes, while indebtedness under the new credit facility is outstanding. The new credit facility also requires us to maintain certain financial ratios (as defined therein) including, without limitation, the following: a minimum Fixed Charge Coverage Ratio, a maximum Funded Indebtedness to EBITDA ratio, a maximum Adjusted Funded Indebtedness to EBITDAR ratio and a minimum of Adjusted EBITDA. Our ability to comply with the ratios or tests may be affected by events beyond our control, including prevailing economic, financial and industry conditions. A breach of any of these covenants, ratios or tests could result in a default under the new credit facility and/or the indenture. Certain events of default under the new credit facility would prohibit us from making payments on our senior subordinated notes, including payment of interest when due. In addition, upon the occurrence of an event of default under the new credit facility, the lender could elect to declare all amounts outstanding under the new credit facility, together with accrued interest, to be immediately due and payable. If we were unable to repay those amounts, the lender could proceed against the security granted to them to secure that indebtedness. If the lenders accelerate the payment of the indebtedness, our assets may not be sufficient to repay in full this indebtedness and our other indebtedness, including the senior subordinated notes. We are a holding company and rely on dividends, interest and other payments, advances and transfers of funds from our subsidiaries to meet our debt service and other obligations. We are a holding company and conduct all of our operations through our subsidiaries and currently have no significant assets other than the capital stock of DavCo Operations. As a result, we will rely on dividends and other payments or distributions from DavCo Operations and its subsidiaries to meet our debt service obligations and enable us to pay dividends. The ability of DavCo Operations and its subsidiaries to pay dividends or make other payments or distributions to us will depend on their respective operating results and will be restricted by, among other things, the laws of their jurisdiction of organization (which may limit the amount of funds available for the payment of dividends), agreements of those subsidiaries, the terms of the new credit facility and the covenants of any future outstanding indebtedness we or our subsidiaries incur. You may not be able to immediately accelerate the principal amount of the senior subordinated notes prior to their maturity which may delay your right, as a holder of senior subordinated notes, to enforce your remedies and receive payment. The maturity of the principal amount of the senior subordinated notes may not be immediately accelerated and the principal amount will not become due and payable, prior to the scheduled maturity date, for a period beginning on the date notice is provided to Wendy's with respect to the occurrence of certain events of default and ending 45 days after such date, as described in "Description of Senior Subordinated Notes Acceleration Forbearance Periods." This acceleration forbearance period may delay your right, as a holder of senior subordinated notes, to enforce your remedies and receive payments on the senior subordinated notes. Holders of Class B common stock may have conflicting interests from yours. Pursuant to a recapitalization to be effected concurrent with this offering, the management investors and Citicorp Venture Capital will own all of the shares of our Class B common stock. Pursuant to the stockholders agreement, so long as the existing equity investors hold at least 8% or more of the total economic value of the total outstanding equity interests in our company and 8% or more of the total outstanding voting interests in our company, they will be entitled to nominate two individuals for election to our board of directors. As a result, through their director designation right, the management investors and Citicorp Venture Capital will, collectively, exercise influence over matters requiring board approval, including decisions about our capital structure and the payment of dividends on our Class A and Class B common stock. As holders of our Class B common stock, which provide for dividends to be subordinated to the dividends payable to holders of our Class A common stock, their interests may conflict with your interests as a holder of EISs and Class A common stock. You will be immediately diluted by $12.45 per share of Class A common stock if you purchase EISs in this offering. If you purchase EISs in this offering, based on the book value of the assets and liabilities reflected on our balance sheet, you will experience an immediate dilution of $12.45 per share of Class A common stock represented by the EISs which exceeds the entire price allocated to each share of common stock represented by the EISs in this offering because there will be a net tangible book deficit for each share of Class A common stock outstanding immediately after this offering. Our net tangible book deficiency as of June 27, 2004, after giving effect to this offering, was approximately $60.1 million, or $4.80 per share of common stock. Our expansion is dependent on our continued ability to borrow under our new credit facility and our interest expense thereunder may significantly increase and could cause our net income and distributable cash to decline significantly. Our ability to continue to expand our business, including to make new restaurant expenditures, will be dependent upon our ability to borrow funds under our new credit facility and to obtain other third-party financing, including through the sale of EISs or any sale of securities. We cannot assure you that such financing will be available to us on favorable terms or at all. The new credit facility will be subject to periodic renewal or must otherwise be refinanced. We may not be able to renew or refinance the new credit facility, or if renewed or refinanced, the renewal or refinancing may occur on less favorable terms. Any future borrowings under our new credit facility will be made at a floating rate of interest. In the event of an increase in the base reference interest rates, our interest expense will increase and could have a material adverse effect on our ability to make cash dividend payments to our stockholders. We may not generate sufficient funds from operations to pay our indebtedness at maturity or upon the exercise by holders of our senior subordinated notes of their rights upon a change of control. A significant portion of our cash flow from operations will be dedicated to maintaining our restaurants and servicing our debt requirements. In addition, we currently expect to distribute a significant portion of any remaining available cash to our stockholders in the form of quarterly dividends. Moreover, prior to the maturity of our senior subordinated notes, we will not be required to make any payments of principal on our senior subordinated notes. We may not generate sufficient funds from operations to repay the principal amount of our indebtedness at maturity or in case you exercise your right to require us to purchase your senior subordinated notes upon a change of control. In making your investment decision, you should rely only on the information contained in this prospectus or to which we have referred you. We have not authorized anyone to provide you with information that is different. If anyone provided you with different or inconsistent information, you should not rely on it. This prospectus may only be used where it is legal to sell these securities. We may therefore need to refinance our debt or raise additional capital. These alternatives may not be available to us when needed or on satisfactory terms due to prevailing market conditions, a decline in our business or restrictions contained in our senior debt obligations. Your right to receive payments on the senior subordinated notes and the senior subordinated note guarantees is junior to all senior debt of our company and its subsidiaries. We are a holding company and conduct all of our operations through our subsidiaries. The senior subordinated notes and the senior subordinated note guarantees issued by our subsidiary guarantors will be unsecured senior subordinated obligations, junior in right of payment to our senior debt and that of each of our subsidiary guarantors, respectively. As a result of the subordinated nature of our senior subordinated notes and related guarantees, upon any distribution to our creditors or the creditors of the subsidiary guarantors in bankruptcy, liquidation or reorganization or similar proceeding relating to us or the subsidiary guarantors or our or their property, the holders of our senior indebtedness and senior indebtedness of the subsidiary guarantors will be entitled to be paid in full in cash before any payment may be made with respect to our senior subordinated notes or the subsidiary guarantees. In the event of a bankruptcy, liquidation or reorganization or similar proceeding relating to us or the subsidiary guarantors, holders of our senior subordinated notes will participate with all other holders of unsecured indebtedness of ours or the subsidiary guarantors similarly subordinated in the assets remaining after we and the subsidiary guarantors have paid all senior indebtedness. In any of these cases, we and the subsidiary guarantors may not have sufficient funds to pay all of our creditors, and holders of our senior subordinated notes may receive less, ratably, than the holders of senior indebtedness. In such event, we and our subsidiary guarantors would not be able to make all principal payments on our senior subordinated notes. The subordination provisions of the indenture governing the senior subordinated notes will also provide that payments to you under the subsidiary guarantees may be blocked for up to 179 days by holders of designated senior indebtedness (at the closing of this offering, the lenders under the new credit facility) if a default other than a payment default exists under such senior indebtedness. During any period in which payments to you are blocked in this manner, any amounts received by you with respect to the subsidiary guarantees, including as a result of any legal action to enforce such subsidiary guarantees, would be required to be turned over to the holders of senior indebtedness. See "Description of Senior Subordinated Notes Ranking." On a pro forma basis as of June 27, 2004, we would have had approximately $28.0 million of outstanding senior indebtedness, plus approximately $4.6 million of letters of credit and the subsidiary guarantors would have had approximately $28.0 million of outstanding senior indebtedness. In addition, as of June 27, 2004, on a pro forma basis, DavCo Operations would have had the ability to borrow up to an additional amount of $9.1 million under the new credit facility (less amounts reserved for letters of credit), which would have ranked senior in right of payment to our senior subordinated notes. The guarantees of the senior subordinated notes by our subsidiaries may not be enforceable. Under federal bankruptcy law and comparable provisions of state fraudulent transfer laws, a guarantee could be voided, or claims in respect of a guarantee could be subordinated to all other debt of the guarantor, if, among other things, the guarantor, at the time that it assumed the guarantee: issued the guarantee to delay, hinder or defraud present or future creditors; or INDUSTRY AND MARKET DATA Unless otherwise indicated, all United States restaurant industry data in this prospectus is from the Technomic Information Services ("Technomic") 2003 report entitled "Technomic Top 100: Update and Analysis of the Largest U.S. Chain Restaurant Companies" (the "Technomic Report"). received less than reasonably equivalent value or fair consideration for issuing the guarantee and, at the time it issued the guarantee: was insolvent or rendered insolvent by reason of issuing the guarantee and the application of the proceeds of the guarantee; was engaged or about to engage in a business or a transaction for which the guarantor's remaining assets available to carry on its business constituted unreasonably small capital; intended to incur, or believed that it would incur, debts beyond its ability to pay the debts as they mature; or was a defendant in an action for money damages, or had a judgment for money damages docketed against it if, in either case, after final judgment, the judgment is unsatisfied. In addition, any payment by the guarantor under its guarantee could be voided and required to be returned to the guarantor or to a fund for the benefit of the creditors of the guarantor or the guarantee could be subordinated to other debt of the guarantor. The measures of insolvency for the purposes of fraudulent transfer laws vary depending upon the law applied in any proceeding to determine whether a fraudulent transfer has occurred. Generally, however, a person would be considered insolvent if, at the time it incurred the debt: the sum of its debts, including contingent liabilities, was greater than the fair saleable value of its assets; the present fair saleable value of its assets was less than the amount that would be required to pay its probable liability on its existing debts, including contingent liabilities, as they become absolute and mature; or it could not pay its debts as they become due. We believe that immediately after the issuance of the senior subordinated notes and the guarantees, we and each of the subsidiary guarantors will be solvent, will have sufficient capital to carry on our respective businesses and will be able to pay our respective debts as they mature. However, we cannot be sure what standard a court would apply to determine whether the subsidiary guarantors are solvent or that a court would reach the same conclusions with regard to these issues. Regardless of the standard that the court uses, we cannot be sure that the issuance by the subsidiary guarantors of the subsidiary guarantees would not be voided or the subsidiary guarantees would not be subordinated to their other debt. The guarantee of our senior subordinated notes by any subsidiary guarantor could be subject to the claim that, since the guarantee was incurred for the benefit of DavCo Restaurants, and only indirectly for the benefit of the subsidiary guarantor, the obligations of the subsidiary guarantor were incurred for less than fair consideration. If such a claim were successful and it was proven that the subsidiary guarantor was insolvent at the time the guarantee was issued, a court could void the obligations of the subsidiary guarantor under the guarantee or subordinate these obligations to the subsidiary guarantor's other debt or take action detrimental to holders of the senior subordinated notes. If the guarantee of any subsidiary guarantor were voided, our senior subordinated notes would be effectively subordinated to the indebtedness of that subsidiary guarantor. Seasonality and variability of our businesses may cause volatility in the market value of your investment and may hinder our ability to make timely distributions on the EISs. Our business is seasonal in nature, and our net sales and operating results vary significantly from quarter to quarter. This variability results from several factors, including consumer habits driven by changes in the seasons and weather. Consequently, results of operations for any particular quarter may not be indicative of the results of operations of future periods, which make it difficult to forecast our results for an entire year. This variability may cause volatility in the market price of the EISs. In addition, the seasonality and variability of our business means that at certain times of the year our cash receipts are significantly higher than at other times. Given that we are required to make equal quarterly interest payments and expect to pay equal quarterly dividends to EIS holders throughout the year, there is a risk that we will experience cash shortages, which could hinder our ability to make timely distributions to EIS holders. Interest on the senior subordinated notes may not be deductible by us for U.S. federal income tax purposes, which could significantly reduce our future cash flow and impact our ability to make interest and dividend payments. If all or a portion of the senior subordinated notes were treated as equity rather than debt (including if the EISs were treated as an indivisible equity security) for U.S. federal income tax purposes, then a corresponding portion of the interest on the senior subordinated notes would not be deductible by us for U.S. federal income tax purposes. In addition, we would be subject to liability for U.S. withholding taxes on interest payments to non-U.S. holders if such payments were determined to be dividends. Our inability to deduct interest on the senior subordinated notes could materially increase our taxable income and, thus, our U.S. federal and applicable state income tax liability. If the senior subordinated notes were determined to be equity for income tax purposes, our liability for income taxes (and withholding taxes) would materially reduce our after-tax cash flow and would materially and adversely impact our ability to make interest and/or dividend payments. In the case of foreign holders, treatment of the senior subordinated notes as equity for U.S. federal income tax purposes would subject such holders in respect of the senior subordinated notes to withholding or estate taxes in the same manner as with regard to common stock and could subject us to liability for withholding taxes that were not collected on payments of interest. Therefore, foreign holders would receive any such payments net of the tax withheld. Even if the IRS does not challenge the tax treatment of the senior subordinated notes, it is possible that as a result of changes in circumstances, IRS interpretations or the law or other facts that come to light after this offering (including facts indicating the inaccuracy of the representations given by the initial purchasers of the senior subordinated notes not in the form of EISs), we may need to establish an accrual for contingent tax liabilities associated with a potential disallowance of all or part of the interest deductions on the senior subordinated notes, although our present view is that no such accrual is necessary or appropriate. If we were required to maintain a material accrual, our income tax provision, and related income tax liability, could be materially impacted. As a result, our ability to make dividend payments on our common stock could be impaired, due to restrictions under the terms of our new credit facility, in the indenture governing our senior subordinated notes, in our franchise agreements with Wendy's or under applicable law, and the market price or liquidity for the EISs or Class A common stock could be adversely affected. If we subsequently issue senior subordinated notes with significant original issue discount, we may not be able to deduct all of the interest on those senior subordinated notes, which may adversely affect our cash flow available for interest payments and distributions to our equityholders. It is possible that the senior subordinated notes we issue in a subsequent issuance will be issued at a discount to their face value and, accordingly, may have "significant original issue discount" and thus be classified as "applicable high yield discount obligations," or AHYDOs. If any such senior subordinated notes were so treated, a portion of the original issue discount on such senior subordinated notes could be nondeductible by us and the remainder would be deductible only when paid. This treatment would have the effect of increasing our taxable income and may adversely affect our cash flow available for interest payments and distributions to our equityholders. The allocation of the purchase price of the EISs may not be respected, which may adversely affect your tax position. The purchase price of each EIS must be allocated between the share of Class A common stock and senior subordinated notes represented thereby in proportion to their respective fair market values at the time of purchase. We expect to report the initial fair market value of each share of Class A common stock as $7.65 and the initial fair market value of the principal amount of our senior subordinated notes as $7.35 and, by purchasing EISs, under the terms of the indenture, you will agree to and be bound by such allocation, assuming an initial public offering price of $15.00 per EIS, which represents the midpoint of the range set forth on the cover page of this prospectus. If this allocation is not respected, it is possible that the senior subordinated notes will be treated as having been issued with original issue discount (if the allocation to the senior subordinated notes were determined to be too high) or amortizable bond premium (if the allocation to the senior subordinated notes were determined to be too low). You generally would have to include original issue discount in income in advance of the receipt of cash attributable to that income. If the IRS successfully asserts that the senior subordinated notes have a fair market value greater than that which we allocate to such notes, it is possible that the senior subordinated notes will be treated as having amortizable bond premium. If the senior subordinated notes were treated as having amortizable bond premium, you would be able to elect to amortize bond premium over the term of the senior subordinated note. We intend to treat the acquisition of an EIS as an acquisition of the share of Class A common stock and the senior subordinated note represented by the EISs. However, there are no directly applicable legal authorities governing the issue of whether EISs will be treated for U.S. federal income tax purposes as the acquisition of a share of common stock and a separate debt instrument or whether EISs will instead be treated as an indivisible security that is solely an equity security. Consequently, our counsel is unable to opine definitely whether the EISs will be treated for U.S. federal income tax purposes as the acquisition of a share of common stock and a separate debt instrument, although counsel believes they should be so treated. For additional information on the U.S. federal income tax consequences if the EISs were treated as an indivisible equity security, see " Interest on the senior subordinated notes may not be deductible by us for U.S. federal income tax purposes, which could significantly reduce our future cash flow and impact our ability to make interest and dividend payments." Subsequent issuances of senior subordinated notes may cause you to recognize original issue discount and have other adverse consequences. The indenture governing our senior subordinated notes will provide that, in the event there is a subsequent issuance of senior subordinated notes with a new CUSIP number having terms that are substantially identical to the senior subordinated notes (or any issuance of senior subordinated notes thereafter), each holder of EISs or separately held senior subordinated notes (not in the form of EISs), as the case may be, agrees that a portion of such holder's senior subordinated notes will be automatically exchanged for a portion of the senior subordinated notes acquired by the holders of such subsequently issued senior subordinated notes. Consequently, immediately following each such subsequent issuance and exchange, each holder of senior subordinated notes, held either as part of EISs or separately, will own an inseparable unit composed of a proportionate percentage of senior subordinated notes of each separate issuance. Therefore, subsequent issuances of senior subordinated notes with original issue discount pursuant to an EIS offering by us or following exchange by our existing equity investors of Class B common stock for EISs may adversely affect your tax treatment by increasing the original issue discount, if any, that you were previously accruing with respect to your senior subordinated notes. Furthermore, due to the lack of applicable authority, it is unclear whether the exchange of senior subordinated notes for subsequently issued senior subordinated notes will result in a taxable exchange for U.S. federal income tax purposes and our counsel is not able to opine on this issue. It is possible that the IRS might successfully assert that such an exchange should be treated as a taxable exchange. Following any subsequent issuance of senior subordinated notes with original issue discount and exchange, we (and our agents) will report any original issue discount on the subsequently issued senior subordinated notes ratably among all holders of EISs and separately held senior subordinated notes, and each holder of EISs and separately held senior subordinated notes will, by purchasing EISs or senior subordinated notes, agree to report original issue discount in a manner consistent with this approach. However, the Internal Revenue Service may assert that any original issue discount should be reported only to the persons that initially acquired such subsequently issued senior subordinated notes (and their transferees) and thus may challenge the holders' reporting of OID on their tax returns. In such case, the Internal Revenue Service might further assert that, unless a holder can establish that it is not a person that initially acquired such subsequently issued senior subordinated notes (or a transferee thereof), all of the senior subordinated notes held by such holder have original issue discount. Any of these assertions by the Internal Revenue Service could create significant uncertainties in the pricing of EISs and senior subordinated notes and could adversely affect the market for EISs and senior subordinated notes. For a discussion of these and additional tax related risks, see "Material U.S. Federal Income Tax Consequences." Subsequent issuances of senior subordinated notes may adversely affect your treatment in a bankruptcy. The aggregate stated principal amount of the senior subordinated notes owned by each holder will not change as a result of such subsequent issuances of senior subordinated notes or exchanges into EISs. However, under New York and federal bankruptcy law, holders of subsequently issued senior subordinated notes having original issue discount may not be able to collect the portion of their principal face amount that represents unamortized original issue discount as at the acceleration or filing date in the event of an acceleration of the senior subordinated notes or a bankruptcy of DavCo Restaurants prior to the maturity date of the senior subordinated notes. As a result, an automatic exchange that results in a holder receiving a senior subordinated note with original issue discount could have the effect of ultimately reducing the amount such holder can recover from us in the event of an acceleration or bankruptcy. Before this offering, there has not been a public market for our EISs, Class A common stock or senior subordinated notes. The price of the EISs or separately held senior subordinated notes may fluctuate substantially, which could negatively affect EIS holders or holders of senior subordinated notes. None of our EISs, shares of common stock or senior subordinated notes has a relevant public market history. Our shares of common stock were publicly traded from August 13, 1993 to April 1, 1998 but have not publicly traded since that time. In addition, there has not been an active market in the United States for securities similar to the EISs. We cannot assure you that an active trading market for the EISs or our senior subordinated notes will develop in the future, and we currently do not expect that an active trading market for the shares of our Class A common stock will develop, if at all, which may cause the price of EISs to fluctuate substantially. If the senior subordinated notes represented by your EISs are redeemed or mature, the EISs will automatically separate and you will then hold the shares of our Class A common stock. We do not intend to list our senior subordinated notes on any securities exchange. Our Class A common stock initially will not be separately listed on the American Stock Exchange and, until a sufficient number of shares of our Class A common stock are held separately and not in the form of EISs as may be necessary to satisfy applicable listing requirements, we will not apply for such listing. If our senior subordinated notes and shares of our Class A common stock are not listed separately on any securities exchange, the trading market for these securities may be limited, which could adversely affect the trading price of these securities and your ability to transfer these securities. Even if the Class A common stock is listed for separate trading, an active trading market may not develop, or even if it develops, may not last, in which case the trading price of the Class A common stock could be adversely affected and your ability to transfer your shares will be limited. The initial public offering prices of the EISs and senior subordinated notes sold separately in this offering have been determined by negotiations among us, the existing equity investors and the representatives of the underwriters and may not be indicative of the market prices of the EISs and senior subordinated notes after this offering. Factors such as quarterly variations in our financial results, announcements by us or others, developments affecting us or the industry in which we operate, our customers and our suppliers, general interest rate levels and general market volatility could cause the market prices of the EISs and senior subordinated notes sold separately in this offering to fluctuate significantly. In addition, to the extent a market develops for shares of our Class A common stock or our senior subordinated notes, or both, separate from the EISs, the price of your EISs may be affected. The limited liquidity of the trading market for the senior subordinated notes sold separately (not represented by EISs) may adversely affect the trading price of the separate senior subordinated notes. We are separately selling $7.5 million aggregate principal amount of senior subordinated notes (not represented by EISs), representing approximately 10% of the total outstanding senior subordinated notes (including those senior subordinated notes represented by EISs and assuming the underwriters exercise their over-allotment option in full). While the senior subordinated notes sold separately (not represented by EISs) are part of the same series of notes as, and are identical to, the senior subordinated notes represented by the EISs, at the time of the issuance of the separate senior subordinated notes, the senior subordinated notes represented by the EISs will not be separable for at least 45 days and will not be separately tradeable until separated. As a result, the initial trading market for the senior subordinated notes sold separately (not represented by EISs) will be very limited. After the holders of the EISs are permitted to separate their EISs, a sufficient number of holders of EISs may not separate their EISs into shares of our Class A common stock and senior subordinated notes so that a sizable and more liquid trading market for the senior subordinated notes not represented by EISs may not develop or may not develop in a timely manner. Trading markets for debt securities have generally treated debt securities issued in larger aggregate principal amounts more favorably than similar securities issued in smaller aggregate principal amounts because of the increased liquidity created by potentially higher trading volumes associated with larger debt issuances. Given that approximately 90% of the senior subordinated notes will initially be represented by EISs, it is likely that the senior subordinated notes sold separately (not represented by EISs) will not trade at prices reflecting the aggregate principal amount of the combined issuance of senior subordinated notes included in the EIS offering and the separate senior subordinated notes offering. Therefore, a liquid market for the senior subordinated notes sold separately (not represented by EISs) may not develop or may not develop in a timely manner, which may adversely affect the ability of the holders of the separate senior subordinated notes to sell any of their separate senior subordinated notes and the price at which these holders would be able to sell any of the senior subordinated notes sold separately (not represented by EISs). Future sales or the possibility of future sales of a substantial amount of EISs, shares of our Class A common stock or our senior subordinated notes may depress the price of these securities. Future sales or the availability for sale of substantial amounts of EISs or shares of our Class A common stock or a significant principal amount of our senior subordinated notes in the public market could adversely affect the prevailing market price of the EISs, the shares of our Class A common stock and our senior subordinated notes, as applicable, and could impair our ability to raise capital through future sales of our securities. Beginning on the 366th day after the consummation of this offering, holders of shares of our Class B common stock will have certain rights to exchange their shares of our Class B common stock for EISs pursuant to the stockholders agreement. Until the second anniversary of the consummation of this offering, our franchise agreements with Wendy's will prohibit the management investors from exercising this exchange right with respect to all of their shares of our Class B common stock, and our stockholders agreement will restrict the holders of shares of our Class B common stock from exercising this exchange right if, following the exchange, the holders of shares of our Class B common stock would hold less than 1,250,860 shares of our Class B common stock, representing 10% of our common stock equity at the closing of this offering (or less than 1,135,578 shares assuming full exercise of the underwriters' over-allotment option). Any exchange is subject to the terms of our new credit facility, the indenture governing our senior subordinated notes and our franchise agreements with Wendy's. In addition, any issuance of EISs upon exchange must occur pursuant to an effective registration statement under the Securities Act. For a complete description of this exchange right and the terms of our Class A and Class B common stock, see "Related Party Transactions Amendment and Restatement of Stockholders Agreement" and "Description of Capital Stock." We may issue shares of our Class A common stock and senior subordinated notes, which may be in the form of EISs, or other securities from time to time as consideration for future acquisitions and investments. In the event any such acquisition or investment is significant, the number of shares of our Class A common stock and the aggregate principal amount of senior subordinated notes, which may be in the form of EISs, or the number or aggregate principal amount, as the case may be, of other securities that we may issue may in turn be significant. In addition, we may also grant registration rights covering those EISs, shares of our Class A common stock, senior subordinated notes or other securities in connection with any such acquisitions and investments. You may be required to sell your EISs or Class A common stock and may be deprived of an opportunity to obtain a takeover premium for your securities as a result of the 20% ownership limitations imposed on us by Wendy's. Our franchise agreements with Wendy's provide that, if at any time, any person or group acting together (other than the management investors) directly or indirectly owns, controls or exercises control or direction over or is the beneficial owner of more than 20% the total economic value of the total outstanding equity interests in our company or more than 20% of the total outstanding voting interests in our company and we do not within ten days of the date that we first have knowledge of such ownership or control, take steps as may be permitted under our amended and restated certificate of incorporation to reduce such interest to 20% or lower or if such ownership or control remains at more than a 20% of ownership level for more than 90 days after the date we first have knowledge of such ownership or control, such ownership or control shall constitute a default under the franchise agreements with Wendy's International. In such event, Wendy's International has, among other things, the right to terminate any and all of the franchise agreements or exercise its purchase option. Pursuant to our amended and restated certificate of incorporation, in the event that either of the foregoing limitations is or may be contravened, we may take such action with respect to such ownership level over the 20% ownership level as we deem advisable, including refusing to give effect thereto on the stock transfer books, instituting proceedings, redeeming such interest or requiring the sale of such interest in order to reduce the ownership level to or below a 20% ownership level. Upon taking any such action, the affected holders will cease to be holders of that portion of their interest over the 20% ownership level. For the purpose of the foregoing, the 20% ownership limitations will be applicable to holdings of outstanding shares of our Class A common stock, as components of EISs or held separately, as well as all other classes of our capital stock. Our amended and restated certificate of incorporation and amended and restated by-laws contain provisions that could result in adverse consequences to holders of our common stock. Our amended and restated certificate of incorporation authorizes the issuance of preferred stock and Class C common stock without stockholder approval and, in the case of the preferred stock, upon such terms applicable to the preferred stock as the board of directors may determine. The rights of the holders of shares of our common stock will be subject to, and may be adversely affected by, the rights of holders of any class or series of preferred stock that may be issued in the future. If interest rates rise, the trading value of our EISs and senior subordinated notes may decline. Should interest rates rise further or should the threat of rising interest rates continue to develop, debt markets may be adversely affected. As a result, the trading value of our EISs and senior subordinated notes may decline. Risks Related to our Business and Industry The competitive nature of the quick service restaurant market and the effect of fluctuating demographics and consumer trends may harm our business. The restaurant industry generally, and, the quick service restaurant market in particular, is intensely competitive with respect to price, service, location, type and quality of food and personnel. We compete with other well-established companies with extensive financial, technological, marketing and personnel resources and high brand name recognition and awareness. Some of those competitors have been in existence substantially longer than us, have substantially greater financial and other resources than us and have substantially more restaurants or may be better established in the markets where our restaurants are or may be located. McDonald's and Burger King restaurants are our principal competitors in the hamburger segment of the quick service restaurant market and both have substantially more restaurants in our exclusive franchise territory than we do. We also compete with other national and regional restaurant franchises and with non-franchise restaurants. Some of our quick service restaurant competitors have from time to time attempted to draw customer traffic through deep discounting. While we do not believe that this is a profitable long-term strategy, these changes in pricing and other marketing strategies have at times had, and in the future could have, a negative impact on our financial performance. The quick service restaurant market is also affected by changes in demographic trends, traffic patterns, and the type, number and proximity of competing quick service restaurants. In addition, factors such as inflation, increased food, labor and benefits costs, and the availability of experienced management and hourly-paid employees may also adversely affect the financial performance of the quick service restaurant industry in general and the financial performance of our restaurants in particular. Our success also depends on numerous factors affecting discretionary consumer spending, including economic conditions, disposable consumer income and consumer confidence. Adverse changes in these factors could reduce customer traffic or impose limits on pricing, either of which would negatively affect our financial performance. Public health concerns about the safety of beef products and our other menu items could adversely impact our financial performance. Certain events such as the recent report of bovine spongiform encephalopathy, also known as BSE or "mad cow disease," could reduce consumption of our beef products. For the fiscal year 2003, approximately 32% of our sales were derived from beef products. Until now, we have not experienced any decrease in sales that we can trace to public health concerns regarding "mad cow disease" or the safety of the nation's beef supply, however, there can be no assurances that we will not be adversely affected in the future. Changes in the regulation of the beef industry as a result of the discovery of "mad cow disease" in the U.S. may affect the supply of beef or significantly increase the price of beef, which may in turn have a material adverse impact on our financial performance. Other public health concerns about "foot/mouth disease," salmonella or avian flu in chicken also may reduce the consumption of our food products and adversely affect our financial performance. Changes in consumer preferences could adversely affect our financial performance. Our success depends, in part, upon the continued popularity of our hamburgers, chicken breast sandwiches, salads, chili, French fries and soft drinks. In recent years, numerous companies in the quick service restaurant industry have introduced food items positioned to capitalize on the growing consumer preference for food items that are, or are perceived to be, healthy, nutritious or low in calories, carbohydrates or fat content. Shifts in consumer preferences could be based on health concerns related to the cholesterol, carbohydrate or fat content of certain food items, including items featured on our menu. Negative publicity over the health aspects of such food items may adversely affect consumer demand for our menu items and could adversely affect our financial performance. We rely on the availability and quality of raw materials, which, if unavailable, may have a material adverse effect on our financial performance. Our financial performance is dependent on our continuing ability to offer fresh, premium quality food at competitive prices. Various factors beyond our control may affect the availability, quality and price of the raw materials such as fresh beef, chicken or bacon, used in our products. A significant reduction in the availability or quality of the raw materials purchased by us, or an increase in price that cannot be passed on to our customers could have a material adverse effect on our financial performance. We are highly dependent on Wendy's International and our success is tied to the success of Wendy's International. We are a franchisee of Wendy's International and are highly dependent on Wendy's International for our operations. Due to the nature of franchising and our agreements with Wendy's International, our success is, to a large extent, directly related to the success of the Wendy's International restaurant system, including the financial condition, management and marketing success of Wendy's International and the successful operation of Wendy's restaurants owned by other franchisees. In turn, the ability of the Wendy's system to compete effectively depends upon the success of the management of the Wendy's system by Wendy's International. There can be no assurance that Wendy's International will be able to compete effectively with other quick service restaurants. Under our franchise agreements with Wendy's International, we are required to comply with operational programs and standards established by Wendy's International. In particular, Wendy's (Unaudited) Operating activities Net (loss) income $ (18,152 ) $ 5,058 $ 2,735 $ 719 $ (3,291 ) Adjustments to reconcile net (loss) income to net cash provided by operating activities: Depreciation 4,020 3,646 3,676 2,832 2,741 Amortization of leased properties 2,729 2,616 2,866 2,044 2,274 Amortization of franchise rights 180 189 190 143 142 Amortization of goodwill 1,497 Net loss (gain) on disposal of assets held for sale and write-down of impaired long-lived assets 10,784 (757 ) (963 ) (181 ) (455 ) Amortization of deferred financing costs 731 1,497 1,536 1,152 1,152 Write-off of deferred offering and related costs 6,041 Net loss on disposition of fixed assets 2,035 54 55 94 Deferred income taxes 734 307 307 Other 122 Changes in operating assets and liabilities: Receivables 297 99 (420 ) 357 588 Inventories 138 259 34 (42 ) (18 ) Income tax receivable 77 (1,958 ) 1,958 1,958 Prepaid expenses and other assets (192 ) (329 ) 74 658 879 Accounts payable and other accrued expenses 4,119 (76 ) (376 ) (2,321 ) 149 Accrued advertising and royalty fees 2 472 777 800 172 Accrued salaries and wages 17 1,654 International maintains discretion over the menu items that we can offer in our restaurants. We may be under market pressure to adopt price discount promotions that may be unprofitable. We are also required to pay Wendy's International a technical assistance fee upon the opening of each new restaurant, a monthly royalty and a national advertising fee. If we fail to comply with any of the agreements that govern our relationship with Wendy's International for restaurants within our exclusive franchise territory, Wendy's International could terminate the exclusive nature of our franchise rights in such territory or the franchise rights for the restaurant governed by the new unit franchise agreement. The termination of the exclusive nature of our franchise rights in such territory or of franchise rights for the restaurant governed by the new unit franchise agreement could have a material and adverse impact on our operations and would have a material and adverse impact on our future development plans. Wendy's International must approve our opening of any new restaurant, including restaurants opened within our exclusive franchise territory, and the closing of any of our existing restaurants. Wendy's International has a right of first refusal to acquire existing Wendy's restaurants which we may seek to acquire. Although Wendy's International has historically granted its approval for most of our acquisition requests, we cannot be assured that they will continue to do so. Upon their expiration, we may renew the new unit franchise agreements for additional periods equal to the term in Wendy's International's standard form of franchise agreement being executed by other franchisees renewing their franchises on the renewal date, provided that, among other things, we are not in default under any of the franchise agreements, we are up to date on our payments to Wendy's International and we pay a renewal fee. The terms of the new unit franchise agreements are renegotiated upon renewal and we cannot be assured that we will successfully negotiate the terms of the renewal with Wendy's International or that the terms of the new unit franchise agreements we negotiate upon renewal will not differ materially from those in effect during the initial term. See "Business Relationship with Wendy's International." Wendy's International is not selling, offering for sale nor underwriting all or any part of this offering. Wendy's International is not receiving the proceeds of this offering. Wendy's International does not endorse or make any recommendations with respect to this offering or the EISs offered hereby. Wendy's International is not an obligor under the senior subordinated notes which are part of this offering and has no obligation with respect to the payment of principal or interest under the senior subordinated notes. If we fail to comply with the terms of our development agreement or other agreements with Wendy's International, Wendy's International has the right, among other things, to terminate our franchise agreements or exercise its remedies under leasehold mortgages we have granted to Wendy's to secure our obligations under the franchise agreements. Under our development letter with Wendy's International relating to our exclusive franchise territory, we commit to operate a total of 240 restaurants in our franchise territory by December 31, 2015. Should we fail to comply with the development letter or default under any franchise agreement or any other agreement with Wendy's International, its affiliates or its advertising co-operative, or the material provisions of its restaurant supply agreements, Wendy's International could, among other things, terminate the development letter and the exclusive nature of our franchises in our franchise territory. The termination of the exclusive nature of our franchise rights in our territory or the franchise rights for any of our restaurants governed by the new unit franchise agreements could have a material and adverse impact on our operations and our future development plans. See "Business Relationship with Wendy's International." In addition, we have agreed to secure our obligations under the franchise agreements by granting Wendy's International continuing first priority leasehold mortgages on a limited number of our Allocated to Class A common stock $ 4,959 $ (687 ) Allocated to Class B common stock 2,141 restaurants with a value in the aggregate of not less than $10 million. This value is based on a multiple of EBITDA for our most recently completed fiscal year attributable to the restaurants subject to such leasehold mortgages. In the event that we are in default under our franchise agreements and Wendy's or its designees determines to succeed to the leasehold interests pursuant to the leasehold mortgages, Wendy's or its designees will have the right to operate these restaurants. See "Business Relationship with Wendy's International Operating Requirements of Wendy's International Security for our obligations." Finally, Wendy's International is entitled to a right of first refusal, a purchase option and a right of consent in respect of certain transactions described in "Business Relationship with Wendy's International Ownership and Other Requirements of Wendy's International." These entitlements may restrict our ability to undertake certain transactions. We face substantial risks with regard to our plans for growth and development. We intend to grow our business by opening new Wendy's restaurants. Our development letter with Wendy's International requires us to open or commence construction of a prescribed minimum number of restaurants in each year through 2015, and to operate a total of 240 restaurants in our franchise territory by December 31, 2015. Although we currently have no plans to explore other restaurant concepts, subject to obtaining Wendy's prior consent, we may do so in the future. Our growth and development plans involve substantial risks, including the following: our inability to obtain the necessary approvals of Wendy's International; our inability to obtain or self-fund adequate development financing; that our development costs may exceed budgeted amounts; the unavailability of suitable sites; our inability to obtain suitable sites on acceptable lease or purchase terms; our inability to obtain all necessary zoning, construction and other permits; our inability to adequately supervise construction and delays in completion of construction; the incurrence of substantial unrecoverable costs in the event we abandon a development project prior to completion; our inability to recruit, train and retain managers and other employees necessary to staff each new restaurant; that new restaurants may not perform in accordance with targeted sales or cash flow levels or match the performance of our other restaurants; that new restaurants may result in reduced sales at our existing restaurants near newly opened restaurants; changes in governmental rules, regulations and interpretations; and changes in general economic and business conditions. We cannot assure that our growth and development plans can be achieved. If the management investors fail to hold a prescribed interest in us, Wendy's International has the right to, among other things, terminate our franchise agreements. The franchise agreements with Wendy's International require that as of, and at all times following, the closing of this offering, the management investors who, immediately after the recapitalization will be Ronald D. Kirstien, Harvey Rothstein, David J. Norman, Joseph F. Cunnane, III and Richard H. Borchers, own, in the aggregate and free and clear of liens, encumbrances or other restrictions, a prescribed interest in our company. Until the second anniversary of the closing of this offering, the management investors are required to own not less than 10% of the total economic value of the total outstanding equity interests and not less than 10% of the total outstanding voting interests in our company, determined at the closing of this offering. After the second anniversary of the closing of this offering, the management investors are required to own not less than 10% of the outstanding total economic value of the total outstanding equity interests and not less than 10% of the total outstanding voting interests determined at that time. If the management investors' interest level changes solely as a result of the exchange by one or more of the management investors of their shares of our Class B common stock for EISs after the second anniversary of the closing of this offering, the management investors may own less than such 10% interest provided that Citicorp Venture Capital, together with the management investors, own not less than such 10% interest and provided further that the management investors own not less than the greater of the initial 10% interest determined at the closing of this offering or 5% of the total outstanding economic value of the total outstanding equity interests and not less than 5% of the total outstanding voting interests determined at that time. The franchise agreements also impose restrictions on transfer of the interest in our company held by the management investors, and in certain circumstances, provide Wendy's International with a right to consent and a right of first refusal on proposed transfers of such interest. If the management investors fail to hold the prescribed interest, directly or indirectly, in our company, Wendy's International is entitled, among other things, to terminate the franchise agreements. See "Business Relationship with Wendy's International Ownership and Other Requirements of Wendy's International Ownership requirements for management investors." Wendy's International has certain rights of first refusal, purchase rights and consent rights in connection with a change in our ownership, transfers of assets, future offerings of EISs and other securities and certain other events affecting the EISs. Pursuant to the franchise agreements, Wendy's International also has, subject to certain exceptions, a right of first refusal to acquire the interests or assets proposed to be transferred or issued and a right to consent to any such transfer, including on: a proposed transfer by us of any ownership or equity interest in our operating subsidiary, DavCo Operations; a proposed transfer of any portion of the shares of our common stock owned by the management investors; a proposed issuance of securities in any public or private sale of any ownership or equity interest in DavCo Restaurants (other than this offering, as to which Wendy's has consented) or DavCo Operations; a proposed transfer of one or more Wendy's restaurants or any of the franchise agreements; or a proposed direct or indirect transfer of all or substantially all of the Wendy's business or the assets of the Wendy's business or of any part of the Wendy's business or assets such that the assets proposed to be transferred comprise all or substantially all of the assets of one or more Wendy's restaurants; except that, after this offering, this right of first refusal will not be applicable to, among other things, a transfer of outstanding EISs (and the shares of Class A common stock and senior subordinated notes outstanding upon any future separation of any EISs), shares of Class A common stock and/or senior subordinated notes. Failure to comply with the right of first refusal constitutes a default under the franchise agreements, permitting Wendy's International to, among other things, terminate such agreements, as well as to exercise its purchase option. The franchise agreements provide Wendy's International with an option to purchase: (i) all of the equity interests in DavCo Operations; and/or (ii) all of the assets of DavCo Restaurants and all of the assets of DavCo Operations relating to the business, ownership and operation of Wendy's restaurants, at fair market value in the event that, among other things: our company transfers, permits the transfer or suffers a transfer of any direct or indirect interest in DavCo Restaurants or DavCo Operations in violation of any terms and conditions of any right of first refusal held by Wendy's International; any transfer of any direct or indirect interest by or in our company or DavCo Operations in violation of the consent requirements of Wendy's International occurs; any transfer pursuant to, or demand for payment made under, any guarantee by DavCo Restaurants or DavCo Operations, including the guarantee of the senior subordinated notes occurs; any person or group acting together (other than the management investors and Citicorp Venture Capital) acquires more than 20% of the total economic value of the total outstanding equity interests or more than 20% of the total outstanding voting interests in our company in violation of the terms of Wendy's consent; or the terms of the indenture governing our senior subordinated notes are amended in a manner which would be in violation or inconsistent with the provisions of Wendy's consent without the prior written consent of Wendy's International. See "Business Relationship with Wendy's International Ownership and Other Requirements of Wendy's International." We are required to obtain Wendy's consent for certain future public or private offerings of our securities which may affect our ability to raise capital. If, solely as a result of the dilutive effects of the issuance of shares of our Class A common stock or EISs in a proposed follow-on offering, the management investors would own less than 10% of the total economic value of the total outstanding equity interests or total outstanding voting interests in our company, the franchise agreements provide that such reduction in ownership requires the prior consent of Wendy's. As a condition of such consent, Wendy's may require that the management investors own, after giving effect to the proposed follow-on offering, not less than a prescribed interest in our company and that at all times following the second anniversary of the closing of the follow-on offering, the management investors own, together with the holdings of Citicorp Venture Capital, no less than 10% of the total economic value of the total outstanding equity interests or total outstanding voting interests in our company. We are not required to obtain Wendy's consent for future public or private offerings of our senior subordinated notes. Except as described above, Wendy's International has agreed that its right of first refusal will not apply and, subject to the fulfillment of certain conditions (including the condition that subsequent offerings will not materially and adversely affect the rights of Wendy's International under the franchise agreements), its consent will not be required should we undertake offerings of shares of our Class A common stock or EISs to the public in the United States (which offerings may include private placements of shares of our Class A common stock or EISs in the United States in accordance with Rule 144A of the Securities Act) which are consummated not later than December 31, 2015 and all of the net proceeds of which are used in connection with the Wendy's business. The requirement to obtain Wendy's prior consent to certain follow-on offerings of our Class A common stock or EISs and the requirement that the management investors own not less than a prescribed interest in our company may affect our ability to effect follow-on offerings to raise capital. Changes in geographic concentration and regional conditions may negatively impact our operations. All of our restaurants are located in the same region. As a result, a severe or prolonged economic recession or changes in demographic mix, employment levels, population density, weather patterns, real estate market conditions or other factors unique to our geographic region may adversely affect us more than some of our competitors that are more geographically diverse. Increased costs beyond our control may negatively affect our operations and have a material adverse affect on our financial performance. Our labor costs are substantial and we may not be able to offset increased labor costs with increased sales. Our operations are subject to federal and/or state minimum wage laws governing matters such as working conditions and overtime. Significant numbers of our restaurant employees are paid at rates related to the minimum wage and, accordingly, further increases in the minimum wage or mandatory health insurance coverage requirements could increase our labor costs and adversely affect our financial performance. Our success depends on a number of key personnel, the loss of whom could have an adverse effect on our financial performance. Our success depends on the personal efforts of a small group of skilled employees and experienced senior management. Although we believe we will be able to replace key employees within a reasonable time should the need arise, the loss of key personnel could have a material short-term adverse effect on our financial performance. We believe that it would be difficult to replace members of the senior management team with individuals having comparable experience. Consequently, the loss of the services of any member of the senior management team could have a material adverse effect on our financial performance. In addition, under our franchise agreements with Wendy's International, Ronald D. Kirstien, our President and Chief Executive Officer, Harvey Rothstein, our Senior Executive Vice President, and Joseph F. Cunnane, III, our Executive Vice President of Operations, have each been designated by Wendy's International as the individuals responsible for the development and management of our restaurants. If Mr. Kirstien, Mr. Rothstein or Mr. Cunnane (or any other successor approved by Wendy's International) leaves us, any replacement operator must first be approved by Wendy's International. There can be no assurance that Wendy's International will approve the replacement operator we propose. See "Business Relationship with Wendy's International." We may experience labor shortages which may affect the quality level of customer service and lead to reduced customer traffic which could have an adverse effect on our financial performance. In times of high demand for employees, such as during the period of robust economic growth in the U.S. in 2000 and 2001, we experienced labor shortages. A labor shortage may affect the quality level of customer service and lead to reduced customer traffic and can adversely affect our financial performance. There can be no assurance we will not experience labor shortages in the future. We are subject to government regulation and changes to those regulations may affect our operations. We are subject to various federal, state and local laws affecting our business. See "Business Government Regulation." The laws that affect our business include those relating to the preparation and sale of food, employment and discrimination, zoning, building restrictions, and design and operation of our restaurants. Difficulties obtaining or failure to obtain the required licenses or approvals could delay or prevent our development of new restaurants in a particular area and have an adverse impact on our operations and future development plans. We may be subject to significant environmental liabilities. In certain cases, we have agreed to indemnify the purchasers of our former properties for liabilities arising thereon or have agreed to remain liable for certain potential liabilities that were not assumed by the purchaser. Environmental contamination of soil and groundwater by petroleum constituents have been identified at eight properties we currently or formerly operated, although we believe further remedial action will not be required at these properties. Several additional restaurant properties had previous petroleum distribution or industrial uses which may have resulted in contamination, and the prior uses and potential for contamination at a number of additional restaurant properties are unknown. We were one of several defendants in two related lawsuits filed in federal and state court in Missouri in 1995 seeking recovery of petroleum cleanup costs at a former gasoline service station property that we leased in St. Charles, Missouri. The lawsuit was dismissed without prejudice in May 2002 but can be re-filed. Although no specified amount of damages was sought, based on our understanding of the claims in the lawsuits, the total estimated damages would have been expected to be less than $100,000 and the damages sought would be proportionate to the number of the defendants in the chain of title prior to the plaintiffs for restitution of legal and remediation expenses. The parties recently entered into an extension of their standstill agreement to facilitate a potential resolution of the cleanup costs and a determination to what extent such costs would be reimbursed by the state Petroleum Storage Tank Insurance Fund, which the parties believe may pay all or a substantial portion of the cleanup costs. Potential litigation resulting in a significant judgment and/or adverse publicity could have a material adverse affect on our performance. We may be subject to complaints, regulatory proceedings or litigation from customers or other persons alleging food-related illness, injuries suffered on our premises or other food quality, health or operational concerns, including improper handling and preparation in food items and environmental claims. Adverse publicity resulting from such allegations or alleged discrimination or other operating issues stemming from one Wendy's location or a limited number of Wendy's locations could adversely affect our business, regardless of whether the allegations are true, or whether or not our company or another Wendy's restaurant franchisee is ultimately held liable. A significant judgment against us could have a material adverse effect on our financial performance.
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+RISK FACTORS You should carefully consider the following risks and all other information contained in this prospectus before you decide to buy our common stock. We have included a discussion of each material risk that we have identified as of the date of this prospectus. If any of the following risks actually occur, our business, financial condition or operating results could suffer. If this occurs, the trading price of our common stock could decline, and you could lose all or part of the money you paid to buy our common stock. Risks Relating to this Offering Economic conditions beyond our control may keep the price of our stock low. Numerous factors, many of which are beyond our control, may cause the market price of our common stock to fluctuate significantly. These factors include, but are not limited to, the following: o continued losses; o announcements concerning us, our competitors or our customers; o market conditions in the electric vehicle and the hybrid electric vehicle industry and the general state of the securities markets. General economic, political and market conditions, including recession, international instability or military tension or conflicts may adversely affect the market price of our common stock. If we are named as a defendant in any securities-related litigation as a result of decreases in the market price of our shares, we may incur substantial costs, and our management's attention may be diverted, for lengthy periods of time. The market price of our common stock may not increase above the offering price or maintain its price at or above any particular level. Securities traded on the OTC Bulletin Board are generally thinly traded and an active market may never develop. Our common stock trades on the OTC Bulletin Board. Shares traded in the OTC market are generally bought and sold in small amounts, highly volatile and not usually followed by analysts. You may therefore have difficulty selling your shares in the resale market. "Penny stock" regulations may impose restrictions on marketability of our stock. The Securities and Exchange Commission has adopted regulations which generally define "penny stock" to be any equity security that is not traded on a national securities exchange or NASDAQ and that has a market price of less than $5.00 per share or an exercise price of less than $5.00 per share, subject to certain exceptions. Since our securities that are currently included on the OTC Bulletin Board are trading at less than $5.00 per share at any time, our stock may become subject to rules that impose additional sales practice requirements on broker-dealers who sell such securities to persons other than established customers and accredited investors. Accredited investors generally include investors that have assets in excess of $1,000,000 or an individual annual income exceeding $200,000, or together with the investor's spouse, a joint income of $300,000. For transactions covered by these rules, the broker-dealer must make a special suitability determination for the purchase of the securities and must receive the purchaser's written consent to the transaction prior to the purchase. Additionally, for any transaction involving penny stock, unless exempt, the rules require, among other things, the delivery, prior to the transaction, of a risk disclosure document mandated by the SEC relating to the penny stock market and the risks associated therewith. The broker-dealer must also disclose the commission payable to both the broker-dealer and the registered representative, current quotations for the securities and, if the broker-dealer is the sole market maker, the broker dealer must disclose this fact and the broker-dealer's presumed control over the market. Finally, monthly statements must be sent disclosing recent price information for the penny stock held in the account and information on the limited market in penny stocks. Consequently, the penny stock rules may restrict the ability of broker-dealers to sell our securities and may affect your ability to sell your shares in the secondary market. We do not expect to pay dividends in the foreseeable future. We have not declared or paid any cash dividends in the past and do not expect to pay cash dividends in the foreseeable future. We intend to retain our future earnings, if any, to finance the development of our business. We are required to pay dividends on our Series A Stock and our Series B Stock before we may pay dividends on our common stock. At March 31, 2004, we had an accumulated deficit of approximately $97,238,000 and, until this deficit is eliminated, we are prohibited from paying dividends on any class of our stock except out of net profits unless we can meet certain assets and other tests under Sections 500 through 511 of the California Corporations Code. Our board of directors will determine any future dividend policy in light of the all of the foregoing information and then existing conditions, including our earnings, financial condition and financial requirements. You may never receive dividend payments from us. The market price of our Common Stock could be adversely affected by sales of a substantial number of shares of our Common Stock As of the date of this prospectus, we have outstanding 401,853,232 shares of common stock, 2,790,136 shares of Series A Stock, each of which is convertible into one share of common stock, and 1,217,196 shares of Series B Stock, each of which is convertible into two shares of common stock. Sales of a substantial number of shares of our common stock in the public market following this offering could cause our stock price to decline. All the shares sold in this offering will be freely tradable. Currently 154,180,500 shares of common stock are freely tradable and an additional 5,224,500 shares of Series A Stock or Series B Stock would be freely tradable upon conversion to common stock. Approximately an additional 247,672,700 shares of common stock are eligible for sale in the public market subject to volume restrictions of Rule 144 and 15,594,288 shares of common stock issuable upon exercise of outstanding options will become freely tradable upon issuance. In addition, the sale of these shares could cause our stock price to decline and impair our ability to raise capital through the sale of additional stock. See "Shares Eligible for Future Sale." Our principal shareholders, executive officers and directors have substantial control over most matters submitted to a vote of the shareholders, thereby limiting your power to influence corporate action. Our officers, directors and principal shareholders beneficially own approximately 60% of our common stock (including in that percentage shares of our Series A Stock and Series B Stock). As a result, these shareholders have the power to control the outcome of most matters submitted to a vote of shareholders, including the election of members of our board, and the approval of significant corporate transactions. The shareholders purchasing shares in this offering will have little influence on these matters. This concentration of ownership may also have the effect of making it more difficult to obtain the needed approval for some types of transactions that these shareholders oppose, and may result in delaying, deferring or preventing a change in control of our company. The effects of anti-takeover provisions in our charter and bylaws could inhibit the acquisition of us by others. Several provisions of our articles of incorporation and bylaws could discourage potential acquisition proposals and could delay or prevent a change in control of our company. Risks Related to Our Business Our industry is new and is subject to technological changes. The mobile and stationary power markets including electric vehicle and hybrid electric vehicles continue to be subject to rapid technological change. Most of the major domestic and foreign automobile manufacturers: (1) have already produced electric and hybrid vehicles, and/or (2) have developed improved electric storage, propulsion and control systems, and/or (3) are now entering or have entered into production, while continuing to improve technology or incorporate newer technology. Various companies are also developing improved electric storage, propulsion and control systems. In addition, the stationary power market is still in its infancy. A number of established energy companies are developing new technologies. Cost-effective methods to reduce price per kilowatt have yet to be established and the stationary power market is not yet viable. Our current products are designed for use with, and are dependent upon, existing technology. As technologies change, and subject to our limited available resources, we plan to upgrade or adapt our products in order to continue to provide products with the latest technology. We cannot assure you, however, that we will be able to avoid technological obsolescence, that the market for our products will not ultimately be dominated by technologies other than ours, or that we will be able to adapt to changes in or create "leading-edge" technology. In addition, further proprietary technological development by others could prohibit us from using our own technology. There are substantial risks involved in the development of unproven products. In order to remain competitive, we must adapt existing products as well as develop new products and technologies. In fiscal years 2003 and 2002 we spent $799,000 and $1,152,000 respectively on research and development of new products and technology. Despite our best efforts, a new product or technology may prove to be unworkable, not cost effective, or otherwise unmarketable. We can give you no assurance that any new product or technology we may develop will be successful or that an adequate market for such product or technology will ever develop. We may be unable to effectively compete with other companies who have significantly greater resources than we have. Many of our competitors, in the automotive, electronic and other industries, are larger, more established companies that have substantially greater financial, personnel, and other resources than we do. These companies may be actively engaged in the research and development of power management and conversion systems. Because of their greater resources, some of our competitors may be able to adapt more quickly to new or emerging technologies and changes in customer requirements, or to devote greater resources to the promotion and sales of their products than we can. We believe that developing and maintaining a competitive advantage will require continued investment in product development, manufacturing capability and sales and marketing. We cannot assure you that we will have sufficient resources to make the necessary investments to do so. In addition, current and potential competitors may establish collaborative relationships among themselves or with third parties, including third parties with whom we have relationships. Accordingly, new competitors or alliances may emerge and rapidly acquire significant market share. We have continued losses. We have experienced recurring losses from operations and have been profitable in only one year, fiscal 1986. For the three months ended March 31, 2004, we had a net loss of $161,000 on sales of $1,108,000 and an accumulated deficit of $97,238,000. For the twelve months ended December 31, 2003, we had a net loss of $3,186,000 on sales of $4,310,000. For the twelve months ended December 31, 2002, we had a net loss of $3,598,000 on sales of $4,455,000. For the twelve months ended December 31, 2001, we had a net loss of $3,428,000 on sales of $3,780,000. There can be no assurance that we will achieve profitability in the near or foreseeable future or that any net operating losses will be available to us in the future as an offset against future profits for income tax purposes. If we do not raise significant additional capital, we will be unable to fund continuing operations and will likely be forced to reduce or even cease operations. We need substantial working capital to fund our operations. As of March 31, 2004, we had cash, cash equivalents and short-term investment balances of approximately $587,000. Our internal projections show that cash on hand as of March 31, 2004, together with anticipated revenues should be sufficient to fund operations at the current level for at least the next 12 months December 2004. We are currently negotiating to correct a payment default with respect to a $120,000 unsecured note to Jeann Schulz. Unless we are successful in our efforts to raise additional funds, our cash resources will be used to satisfy our existing liabilities, such as that of Ms. Schulz, and we will be unable to fund our current operations, which may result in the reduction of operations. Even if we are successful in these efforts to raise funds, such funds may not be adequate to fund our operations on a long-term basis. Future equity financings may dilute your holdings in our company. We need to obtain additional funding through public or private equity or debt financing, collaborative agreements or from other sources. If we raise additional funds by issuing equity securities, current shareholders may experience significant dilution of their holdings. We may be unable to obtain adequate financing on acceptable terms, if at all. If we are unable to obtain adequate funds, we may be required to reduce significantly our spending and delay, scale back or eliminate research, development or marketing programs, or cease operations altogether. Potential intellectual property, shareholder or other litigation could adversely impact our business. Because of the nature of our business, we may face litigation relating to intellectual property matters, labor matters, product liability or shareholder disputes. Any litigation could be costly, divert management attention or result in increased costs of doing business. Although we intend to vigorously defend any future lawsuits, we cannot assure you that we would ultimately prevail in these efforts. An adverse judgment could negatively impact the price of our common stock and our ability to obtain future financing on favorable terms or at all. We may be exposed to product liability or tort claims if our products fail, which could adversely impact our results of operations. A malfunction or the inadequate design of our products could result in product liability or other tort claims. Accidents involving our products could lead to personal injury or physical damage. Any liability for damages resulting from malfunctions could be substantial and could materially adversely affect our business and results of operations. In addition, a well-publicized actual or perceived problem could adversely affect the market's perception of our products. This could result in a decline in demand for our products, which would materially adversely affect our financial condition and results of operations. We are highly subject to general economic conditions. The financial success of our company is sensitive to adverse changes in general economic conditions, such as inflation, unemployment, and consumer demand for our products. These changes could cause the cost of supplies, labor, and other expenses to rise faster than we can raise prices. Such changing conditions also could significantly reduce demand in the marketplace for our products. We have no control over any of these changes. We are an early growth stage company. Although our company was originally founded in 1976, many aspects of our business are still in the early growth stage development, and our proposed operations are subject to all of the risks inherent in a start-up or growing business enterprise, including the likelihood of continued operating losses. We are relatively new in focusing our efforts on electric systems, hybrid systems and fuel cell managed systems. The likelihood of our success must be considered in light of the problems, expenses, difficulties, complications, and delays frequently encountered in connection with the growth of an existing business, the development of new products and channels of distribution, and current and future development in several key technical fields, as well as the competitive and regulatory environment in which we operate. We operate in a highly regulated business environment and changes in regulation could impose costs on us or make our products less economical. Our products are subject to federal, state, local and foreign laws and regulations, governing, among other things, emissions as well as laws covering occupational health and safety. Regulatory agencies may impose special requirements for implementation and operation of our products or may significantly impact or even eliminate some of our target markets. We may incur material costs or liabilities in complying with government regulations. In addition, potentially significant expenditures could be required in order to comply with evolving environmental and health and safety laws, regulations and requirements that may be adopted or imposed in the future. We are highly dependent on a few key personnel and will need to retain and attract such personnel in a labor competitive market. Our success is largely dependent on the performance of our key management and technical personnel, including Carl Perry, our Chief Executive Officer, Larry Lombard, our Acting Chief Financial Officer, Edward Moore, our Chief Operating Officer and Don Kang, our Vice President of Engineering, the loss of one or more of whom could adversely affect our business. Additionally, in order to successfully implement our anticipated growth, we will be dependent on our ability to hire additional qualified personnel. There can be no assurance that we will be able to retain or hire other necessary personnel. We do not maintain key man life insurance on any of our key personnel. We believe that our future success will depend in part upon our continued ability to attract, retain, and motivate additional highly skilled personnel in an increasingly competitive market. There are minimal barriers to entry in our market. We presently license or own a limited amount of proprietary technology and, therefore, have created little or no barrier to entry for competitors other than the time and significant expense required to assemble and develop similar production and design capabilities. Our competitors may enter into exclusive arrangements with our current or potential suppliers, thereby giving them a competitive edge which we may not be able to overcome, and which may exclude us from similar relationships. Our industry is affected by political and legislative changes. In recent years there has been significant public pressure to enact legislation in the United States and abroad to reduce or eliminate automobile pollution. Although states such as California have enacted such legislation, we cannot assure you that there will not be further legislation enacted changing current requirements or that current legislation or state mandates will not be repealed or amended, or that a different form of zero emission or low emission vehicle will not be invented, developed and produced, and achieve greater market acceptance than electric or hybrid electric vehicles. Extensions, modifications or reductions of current federal and state legislation, mandates and potential tax incentives could also adversely affect our business prospects if implemented. CAUTIONARY NOTE ON FORWARD-LOOKING STATEMENTS Some of the matters discussed under the captions "Prospectus Summary," "Risk Factors," "Management's Discussion and Analysis of Financial Condition and Results of Operations," "Business" and elsewhere in this prospectus include forward-looking statements. We have based these forward-looking statements on our current expectations and projections about future events. In some cases, you can identify forward-looking statements by terminology such as "may," "will," "should," "could," "predicts," "potential," "continue," "expects," "anticipates," "future," "intends," "plans," "believes," "estimates" and similar expressions. These statements are based on our current beliefs, expectations and assumptions and are subject to a number of risks and uncertainties. Actual results, levels of activity, performance, achievements and events may vary significantly from those implied by the forward-looking statements. A description of risks that could cause our results to vary appears under the caption "Risk Factors" and elsewhere in this prospectus. These forward-looking statements are made as of the date of this prospectus, and, except as required under applicable securities law, we assume no obligation to update them or to explain the reasons why actual results may differ.
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+Risk factors An investment in our common stock involves a high degree of risk. You should carefully consider the following risk factors, which we believe are the most significant risk factors we face, before you decide to buy our common stock. Risks relating to our business Because we have a history of losses and our future profitability is uncertain, our common stock is a highly speculative investment. We have experienced significant operating losses since our inception in 1992. For the nine-month period ended September 30, 2004, we had a net loss of $20.1 million. As of September 30, 2004, we had an accumulated deficit of approximately $126.9 million. We expect that we will continue to incur substantial losses and that our cumulative losses will increase as our commercialization, research and development efforts expand. We expect that the losses that we incur will fluctuate from quarter to quarter and that these fluctuations may be substantial. To date, we have not recorded any revenue from the sale of products, and we will not be able to do so unless and until one of our products completes clinical trials and receives regulatory approval. BiDil is our only product candidate that has advanced into late-stage clinical trials, and we do not anticipate receiving revenues from BiDil until at least 2005, if ever. All of our other product candidates are in research or pre-clinical development, will require significant additional testing prior to submission of any regulatory applications and, as such, are not expected to be commercially available for many years, if at all. A large portion of our expenses is fixed, including expenses related to facilities, equipment and personnel. In addition, we expect to spend significant amounts to fund commercialization, research and development of our product candidates and to enhance our core technologies. As a result, we expect that our operating expenses will continue to increase significantly in the near term and, consequently, we will need to generate significant revenue to achieve profitability. At the present time we are unable to estimate the level of revenues, if any, that we will realize from the commercialization of our product candidates, including BiDil. We are therefore unable to estimate when we will achieve profitability, if at all. Even if we do achieve profitability, we may not be able to sustain or increase profitability on a quarterly or annual basis. Our failure to become and remain profitable could depress the market price of our common stock and could impair our ability to raise capital, expand our business, diversify our product offerings or continue our operations. We are heavily dependent on obtaining regulatory approval for and successfully commercializing BiDil, our most advanced drug candidate. Our financial, operational and management resources are primarily dedicated to our most advanced drug candidate, BiDil, which has not been approved by the FDA. In July 2004, we halted our phase III confirmatory clinical trial of BiDil on the recommendation of the independent Data and Safety Monitoring Board and the trial's steering committee due to a significant survival benefit seen in African American patients taking the drug. We submitted the clinical dataset from the trial to the FDA on November 1, 2004 and expect to file an amendment to our NDA with the FDA by the end of 2004. We will need to receive FDA Michael D. Loberg, Ph.D. Chief Executive Officer NitroMed, Inc. 125 Spring Street Lexington, Massachusetts 02421 (781) 266-4000 (Name, address, including zip code, and telephone number, including area code, of agent for service) approval of our amended NDA before we can market and sell BiDil in the United States. We cannot predict whether or when we may receive FDA approval of BiDil. In particular, while we expect to have available by the end of first quarter of 2005 the sales force and quantities of finished product required to support the launch of BiDil, we do not expect that the FDA will act on our application by that time. Even if we obtain FDA approval, we may not be able to launch BiDil prior to the end of 2005, if at all. Our BiDil clinical trial was performed exclusively on subjects who are self-identified as African American. To our knowledge, the FDA has never approved a drug product for use in a particular ethnic population. The FDA's receptiveness to drugs that are approved and marketed on the basis of different ethnicity-based therapeutic outcomes is untested and may be adversely affected by contrary scientific or public health evidence or political or legal factors. For example, scientific evidence could emerge that suggests that there is no physiological basis to support pharmaceutical development of drugs based upon ethnicity. Moreover, others may express the view that ethnicity is only a sociological concept and, accordingly, there is not a valid basis for the commercialization of medicines based on ethnicity. These factors or others may significantly delay FDA approval of our BiDil application beyond the time normally required for the FDA to act and could prevent us from obtaining FDA approval of BiDil. If we fail to achieve regulatory approval or market acceptance of BiDil, our near-term ability to generate product revenue, our reputation and our ability to raise additional capital will be materially impaired, and the value of an investment in our stock will decline. We will require substantial additional funds and, if additional capital is not available, we may need to limit, scale back or cease our operations. We have used and will continue to require substantial funds to conduct research and development, including pre-clinical testing and clinical trials of our product candidates, and to market and manufacture any products that are approved for commercial sale. For example, we estimate that we will incur significant expenses in the last quarter of 2004 and during 2005 as we develop sales and marketing capabilities and prepare for the anticipated 2005 launch of BiDil, assuming FDA approval. Moreover, we may incur significant additional expenditures to conduct pre-clinical testing of our nitric-oxide stents, nitric oxide-enhancing COX-2 inhibitors, and other early-stage development programs. Because the successful development of these programs is uncertain, we are unable to estimate the actual funds we will require to complete research and development of our product candidates and commercialization of our products. We believe that our existing cash and marketable securities, together with the proceeds of this offering and cash we expect to receive under our collaborations with Boston Scientific and Merck, will be sufficient to support our current operating plan for at least the next 15 months. However, our future capital requirements, and the period in which we expect our current cash to support our operations, may vary from what we expect due to a number of factors, including the following: the time and costs involved in obtaining regulatory approvals for BiDil and our other product candidates; the costs of manufacturing, distributing, marketing and selling BiDil, if and when approved by regulatory authorities; Copies to: Steven D. Singer, Esq. Cynthia T. Mazareas, Esq. Wilmer Cutler Pickering Hale and Dorr LLP 60 State Street Boston, Massachusetts 02109 Telephone: (617) 526-6000 Telecopy: (617) 526-5000 Geoffrey B. Davis, Esq. Ropes & Gray LLP One International Place Boston, Massachusetts 02110 Telephone: (617) 951-7000 Telecopy: (617) 951-7050 the timing, receipt and amount of milestone and other payments, if any, from collaborators; the timing, receipt and amount of sales and royalties, if any, from our potential candidates; the resources required to successfully complete our clinical trials; continued progress in our research and development programs, as well as the magnitude of these programs; the costs involved in preparing, filing, prosecuting, maintaining and enforcing patent claims; costs related to acquiring or in-licensing new technologies; and our ability to establish and maintain additional collaborative arrangements. We may be required to seek additional funding in the future and may do so through collaborative arrangements and public or private financings. Additional financing may not be available to us on acceptable terms, or at all. In addition, the terms of the financing may adversely affect the holdings or the rights of our stockholders. For example, if we raise additional funds by issuing equity securities, further dilution to our then-existing stockholders will result. If we are unable to obtain funding on a timely basis, we may be required to significantly curtail one or more of our research or development programs. We also could be required to seek funds through arrangements with collaborators or others that may require us to relinquish rights to some of our technologies, product candidates or products which we would otherwise pursue on our own. If we do not successfully market and sell BiDil or our other product candidates, either directly or through third parties, our future revenue will be limited. We currently have limited sales, marketing and distribution experience. If BiDil is approved, we intend to launch and market BiDil in North America ourselves, using a contract sales force, and, in the future, we may also seek to market other products ourselves which are not already subject to marketing agreements where we believe the target physician market can be effectively reached by the sales force we intend to establish directly or by contract. In order to develop or contract for sales and marketing capabilities, we will have to invest significant amounts of money and management resources. Because we minimized these expenditures prior to obtaining the results of our BiDil clinical trial, we may have insufficient time to build our sales and marketing capabilities in advance of BiDil's expected launch. Moreover, if the approval of BiDil is delayed substantially, or BiDil is not approved, we will have incurred significant unrecoverable expenses. For BiDil and any other product candidates for which we decide to perform for sales, marketing and distribution functions ourselves or through a third party, we could face a number of additional risks, including: we may not be able to attract, build and retain or contract for a significant and qualified marketing or sales force; the cost of establishing or contracting for a marketing or sales force may not be justifiable in light of the revenues generated by any particular product; and our direct sales and marketing efforts may not be successful. Approximate date of commencement of proposed sale to the public: As soon as practicable after the effective date of this registration statement. If the only securities being registered on this form are being offered pursuant to dividend or interest reinvestment plans, please check the following box. If any of the securities being registered on this form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, other than securities offered only in connection with dividend or interest reinvestment plans check the following box. If this form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, please check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. If this form is a post-effective amendment filed pursuant to rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. If delivery of the prospectus is expected to be made pursuant to Rule 434, please check the following box. For products with larger target physician markets, we plan to rely significantly on sales, marketing and distribution arrangements with third parties. For example, we plan to rely on our existing collaboration for the commercialization of stents coated with nitric oxide-releasing compounds if development is successful and such products are approved by the FDA. We may have to enter into additional marketing arrangements in the future. We may not be able to successfully enter into sales, marketing and/or distribution agreements with any other third parties in the future, on terms which are favorable to us, if at all. In addition, we may have limited or no control over the sales, marketing and distribution activities of these third parties. Our future revenues for any products for which we rely on third-party sales, marketing and distribution support will depend heavily on the success of the efforts of these third parties. If our third-party contract sales organization does not devote sufficient resources to our BiDil project, our ability to achieve near-term revenue could be harmed. We recently executed a definitive agreement with Publicis Selling Solutions, Inc., or Publicis, a contract sales organization, pursuant to which, on our behalf, Publicis will recruit, hire, train and employ a specialty sales force of 175 to 200 sales representatives to sell BiDil to our target prescriber markets. If BiDil is approved, our near-term revenue for BiDil will depend heavily upon the success and efforts of Publicis. If Publicis does not devote the resources, time and training required to establish an effective and qualified sales force, our ability to achieve revenue from sales of BiDil will be harmed. Physicians, payors and patients may not be receptive to BiDil or our other product candidiates, if approved, which could prevent us from achieving and maintaining profitability. BiDil and the other product candidates that we are developing are based upon technologies or therapeutic approaches that are not currently in the marketplace. Assuming we receive FDA approval, we plan to market BiDil only in the United States. Key participants in the U.S. pharmaceutical marketplace, such as physicians, payors and patients, may not accept a product intended to improve therapeutic results based on ethnicity. As a result, it may be more difficult for us to convince the medical community and third-party payors and patients to accept and use our products. Our business is substantially dependent on market acceptance of BiDil. If we are unable to launch and commercialize BiDil, we will not generate revenue, and our stock price may decline. Other factors that we believe will materially affect market acceptance of BiDil and our other product candidates under development include: the timing of our receipt of any marketing approvals, the terms of any approval (including labeling requirements and/or limitations), and the countries in which approvals are obtained, if any; the safety, efficacy and ease of administration of BiDil; the success of our physician education programs; and the availability of government and third-party payor reimbursement. Total 97,063 31 (6) 97,088 Less amounts classified as cash and cash equivalents 67,605 THE REGISTRANT HEREBY AMENDS THIS REGISTRATION STATEMENT ON SUCH DATE OR DATES AS MAY BE NECESSARY TO DELAY ITS EFFECTIVE DATE UNTIL THE REGISTRANT SHALL FILE A FURTHER AMENDMENT WHICH SPECIFICALLY STATES THAT THIS REGISTRATION STATEMENT SHALL THEREAFTER BECOME EFFECTIVE IN ACCORDANCE WITH SECTION 8(A) OF THE SECURITIES ACT OF 1933, AS AMENDED, OR UNTIL THE REGISTRATION STATEMENT SHALL BECOME EFFECTIVE ON SUCH DATE AS THE COMMISSION, ACTING PURSUANT TO SAID SECTION 8(A), MAY DETERMINE. The application of our nitric oxide technology is unproven in humans and, as a result, we may not be able to successfully develop and commercialize any products based upon this technology. A component of our strategy is to seek to improve existing medicines with our proprietary nitric oxide technology. Our product candidates include nitric oxide enhancements of existing drugs. Thus, we are modifying compounds whose chemical and pharmacological profiles are well-documented and understood. However, many of our potential product candidates are new molecules with chemical and pharmacological profiles that differ from that of the existing drugs. These compounds may not demonstrate in patients the chemical and pharmacological properties ascribed to them in laboratory studies, and they may interact with human biological systems in unforeseen, ineffective or harmful ways. In addition, it is possible that existing drugs or newly-discovered drugs may not benefit from the application of our nitric oxide technology. If we are not able to successfully develop and commercialize drugs based upon our technological approaches, we will not generate revenue based on these drugs, and the value of our stock will decline. If our clinical trials for any product candidates we advance into clinical testing are not successful, we may not be able to successfully develop and commercialize our products. In order to obtain regulatory approvals for the commercial sale of our product candidates, we or our collaborators will be required to complete extensive clinical trials in humans to demonstrate the safety and efficacy of our product candidates. We may not be able to obtain authority from the FDA or other regulatory agencies to commence or complete these clinical trials. If permitted, such clinical testing may not prove that our drug candidates are safe and effective to the extent necessary to permit us to obtain marketing approvals from regulatory authorities. Moreover, positive results demonstrated in pre-clinical studies and clinical trials that we complete may not be indicative of results obtained in future clinical trials. Furthermore, we, one of our collaborators, institutional review boards or regulatory agencies may suspend clinical trials at any time if it is believed that the subjects or patients participating in such trials are being exposed to unacceptable health risks. Adverse or inconclusive clinical trial results concerning any of our drug candidates could require us to conduct additional clinical trials, result in increased costs and significantly delay the filing for marketing approval for those drug candidates with the FDA or result in a filing for a narrower indication than was originally sought or result in a decision to discontinue development of those drug candidates. The successful completion of our clinical trials will depend on, among other things, the rate of patient enrollment. Patient enrollment is a function of many factors, including the size of the patient population, the nature of the clinical protocol, the availability of alternative treatments, the proximity of patients to clinical sites and the eligibility criteria for the study. We may be unable to enroll the number of patients we need to complete a trial on a timely basis. Moreover, delays in planned patient enrollment for clinical trials may cause us to incur increased costs and delay commercialization. We have relied on academic institutions or clinical research organizations to supervise or monitor some or all aspects of our BiDil trial, and we expect to rely on academic institutions and clinical research organizations for other product candidates we advance into clinical testing. Accordingly, we have less control over the timing and other aspects of these clinical trials than if we conducted them entirely on our own. Balance at December 31, 2001 30,770 $ 80,187 963 $ Balance at December 31, 2002 30,770 $ 82,884 985 $ As a result of these factors, we or third parties on whom we rely may not successfully begin or complete our clinical trials in the time periods we have forecasted, if at all. Moreover, if we incur costs and delays in our programs or if we do not successfully develop and commercialize our products, our stock price could decline. If we and our partners do not obtain and maintain the regulatory approvals required to market and sell BiDil and our other product candidates, then our business will be unsuccessful, and the market price of our stock will substantially decline. We and our partners will not be able to market any of our products in the United States, Europe or in any other country without marketing approval from the FDA or equivalent foreign regulatory agency. The regulatory process to obtain market approval for a new drug or medical device takes many years and requires expenditures of substantial resources. We have had only limited experience in preparing applications and obtaining regulatory approvals. If we do not receive required regulatory approval or clearance to market BiDil or any of our other product candidates, we will not be able to develop and commercialize these products, which will affect our ability to achieve profitability and cause the value of our common stock to substantially decline. If we, our third-party manufacturers or our service providers fail to comply with applicable laws and regulations, we or they could be subject to enforcement actions, which could affect our ability to market and sell our products and harm our reputation. If we or our third-party manufacturers or service providers fail to comply with applicable federal, state or foreign laws or regulations, we could be subject to enforcement actions which could affect our ability to develop, market and sell our products successfully and could harm our reputation and lead to less acceptance of our products by the market. These enforcement actions include: product seizures; voluntary or mandatory recalls; voluntary or mandatory patient or physician notification; withdrawal of product approvals; restrictions on, or prohibitions against, marketing our products; fines; restrictions on importation of our products; injunctions; debarment; civil and criminal penalties; and suspension of review of, or refusal to approve, pending applications. Assuming BiDil is approved for commercial sale, if the third-party manufacturer of BiDil encounters delays or difficulties in production, we may not be able to meet demand for the product, and we may lose potential revenue. We do not manufacture BiDil and have no plans to do so. We engaged Schwarz Pharma Manufacturing, Inc., or Schwarz Pharma, for the manufacture of batches of BiDil for clinical trials and are negotiating a definitive agreement for the manufacture and supply of commercial quantities of BiDil, assuming it receives FDA approval. Although we are currently negotiating the terms of a definitive commercial manufacture and supply agreement for BiDil with Schwarz Pharma, to date we have not secured a long-term commercial supply arrangement for BiDil. We cannot assure you that we will be able to enter into a commercial manufacturing and supply agreement with Schwarz Pharma or any other contract manufacturer for BiDil on a timely basis or on terms that are favorable to us. If we are unable to establish or maintain a commercially reasonable manufacturing agreement for the production of BiDil, if approved, we may not be able to successfully develop and commercialize BiDil and our stock price will decline. Furthermore, Schwarz Pharma, if engaged, may encounter difficulties in production. These problems may include: difficulties with production costs and yields; quality control and assurance; shortages of qualified personnel; compliance with strictly enforced federal, state and foreign regulations; and lack of capital funding. Schwarz Pharma may not perform as agreed or may terminate its engagement with us, which would adversely impact our ability to produce and sell BiDil. The number of third-party manufacturers with the manufacturing and regulatory expertise and facilities necessary to manufacture finished drug products for us on a commercial scale is limited, and it would take a significant amount of time to arrange, qualify, and receive necessary regulatory approval for alternative arrangements. We may not be able to contract for manufacturing on acceptable terms, if at all. Any of these factors could increase our costs and result in our being unable to effectively commercialize BiDil. Furthermore, if Schwarz Pharma or any other third-party manufacturer of BiDil fails to deliver the required commercial quantities of finished product on a timely basis and at commercially reasonable prices, we may be unable to meet the demand for our product, and we may lose potential revenues. The information in this preliminary prospectus is not complete and may be changed. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This preliminary prospectus is not an offer to sell these securities and it is not soliciting an offer to buy these securities in any jurisdiction where the offer or sale is not permitted. Subject to Completion, dated November 26, 2004 Prospectus 3,247,878 shares Common stock We are offering 3,247,878 shares of our common stock. Our common stock is traded on the NASDAQ National Market under the symbol "NTMD." The last reported sale of our common stock on November 23, 2004 was $20.08. The development and commercialization of our product candidates may be terminated or delayed, and the cost of development and commercialization may increase, if third parties on whom we rely to manufacture our products do not fulfill their obligations. We do not manufacture any of our other product candidates and have no current plan to develop any capacity to do so in the future. In order to continue to develop products, apply for regulatory approvals and commercialize our products, we plan to rely on third parties for the production of clinical and commercial quantities of our product candidates. We will depend upon these third parties to perform their obligations in a timely manner and in accordance with applicable laws and regulations. To the extent that third-party manufacturers with whom we contract fail to perform their obligations in accordance with applicable laws and regulations, we may be adversely affected in a number of ways, including: we may not be able to initiate or continue clinical trials of our product candidates; we may be delayed in submitting applications for regulatory approvals for our products; we may be required to cease distribution and/or recall some or all batches of our products; and we may not be able to meet commercial demands for our products or achieve profitability. We rely on a single source supplier for one of the two active ingredients in BiDil, and the loss of this supplier could prevent us from selling BiDil, which would materially harm our business. We rely on Sumitomo for our supply of hydralazine, one of the two active ingredients in BiDil. Sumitomo is currently the only supplier of hydralazine worldwide. We do not have any agreement with Sumitomo regarding the supply of hydralazine. If Sumitomo stops manufacturing or is unable to manufacture hydralazine, or if we are unable to procure hydralazine from Sumitomo on commercially favorable terms, we may be unable to continue to sell BiDil on commercially viable terms, if at all. Furthermore, because Sumitomo is currently the sole supplier of hydralazine, Sumitomo has unilateral control over the price of hydralazine. Any increase in the price for hydralazine may reduce our gross margins. The termination of our collaboration agreement with Merck, resulting from Merck's recent decision to withdraw its COX-2 inhibitor, Vioxx, from worldwide markets, will result in the loss of anticipated milestone and royalty based revenue from the collaboration and may indicate that the development of nitric oxide-enhancing COX-2 inhibitors is not viable. In December 2002, we entered into an exclusive, worldwide research, collaboration and licensing agreement with Merck pursuant to which we granted Merck marketing and sales rights to our technology for nitric oxide-enhancing COX-2 inhibitors. On September 30, 2004, Merck halted the phase II trial of our lead candidate in nitric oxide-enhancing COX-2 inhibitors. This lead nitric oxide candidate is composed of a derivative of rofecoxib. Rofecoxib is the active ingredient in Vioxx, a COX-2 inhibitor which Merck voluntarily withdrew from worldwide markets on September 30, 2004. We have agreed with Merck to terminate our collaboration agreement, which will result in the loss of any potential milestone or royalty revenue from the sale of products that may have resulted from the collaboration as well as any research and development funding that we may have received beyond the end of the initial research term in December 2005. If the FDA imposes additional regulatory burdens for the approval of new Per share Total COX-2 inhibitors, if COX-2 inhibitors continue to pose safety concerns, or if the market for COX-2 inhibitors contracts, then we may lose any investment made in the development of, and any potential revenue that may have resulted from, the development, sale or licensing of nitric oxide-enhancing COX-2 inhibitors. We currently depend on collaborative partners for a significant portion of our revenues and to develop, conduct clinical trials with, obtain regulatory approvals for, and manufacture, market and sell some of our product candidates, and these collaborations may not be successful. We are relying on Boston Scientific to fund the development of and to commercialize nitric oxide-enhancing stents using our technology to prevent the re-closure of arteries, or restenosis, following balloon angioplasty, a treatment to widen blocked arteries. In addition, Merck has funded the development of products based upon our nitric oxide-enhancing COX-2 inhibitor technologies. All of our $12.8 million of revenues for 2003 and our $7.0 million of revenues for the nine months ended September 30, 2004 were derived from licensing, research and development and milestone payments paid to us by Boston Scientific and Merck. We have agreed with Merck to terminate our collaboration on nitric oxide-enhancing COX-2 inhibitor technologies. Please see "Risk Factors The termination of our collaboration agreement with Merck, stemming from Merck's recent decision to withdraw its COX-2 inhibitor, Vioxx, from worldwide markets, will result in the loss of anticipated milestone and royalty based revenue from the collaboration and may indicate that the development of nitric oxide-enhancing COX-2 inhibitors is not viable." for additional risks relating to our agreement with Merck. Our agreement with Boston Scientific provides us research and development funding for our nitric oxide-enhancing stent program, and additional payments due to us under the collaboration agreement are generally based on the achievement of specific development and commercialization milestones that may not be met. The agreement with Boston Scientific can be terminated at any time upon 30 days' prior written notice. We are also entitled to royalty payments that are based on the sales of products developed and marketed through the collaboration. These future royalty payments may not materialize or may be less than expected if the related product candidates are not successfully developed or marketed, or if we or our collaborator is forced to license intellectual property from third parties. Accordingly, we cannot predict with certainty whether this collaboration will continue to generate revenues for us and if so, for how long. The loss of the Boston Scientific collaboration could decrease our revenues. We intend to enter into collaborative agreements with other parties in the future relating to other product candidates, and we are likely to have similar risks with regard to any such future collaborations. In addition, our existing collaboration and any future collaborative arrangements that we seek to enter into with third parties may not be scientifically or commercially successful. Factors that may affect the success of our collaborations include the following: our collaborators may be pursuing alternative technologies or developing alternative product candidates, either on their own or in collaboration with others, that may be competitive with the product on which they are collaborating with us and which could affect their commitment to our collaboration; Price to public $ $ Underwriting discounts and commissions $ $ Proceeds to NitroMed $ $ reductions in marketing or sales efforts or a discontinuation of marketing or sales of our products by our collaborators would reduce our revenues, which will be based on a percentage of net sales by the collaborator; our collaborators may terminate their collaborations with us, which could make it difficult for us to attract new collaborators or adversely affect how we are perceived in the business and financial communities; and our collaborators may pursue higher-priority programs or change the focus of their development programs, which could affect the collaborators' commitment to us. Our failure to successfully acquire, develop and market additional drug candidates or approved drugs would impair our ability to grow. As part of our strategy, we intend to acquire, develop and market additional drugs and drug candidates to treat African Americans with cardiovascular, metabolic and other diseases that affect this population. The success of this strategy depends upon our ability to identify, select and acquire appropriate pharmaceutical drug candidates and drugs. Any drug candidate we license or acquire may require additional development efforts prior to commercial sale, including extensive clinical testing and approval by the FDA and applicable foreign regulatory authorities. All drug candidates are prone to the risks of failure inherent in pharmaceutical product development, including the possibility that the drug candidate will not be shown to be sufficiently safe and effective for approval by regulatory authorities. In addition, we cannot assure you that any drugs that we develop or acquire that are approved will be manufactured or produced economically, successfully commercialized or widely accepted in the marketplace. Proposing, negotiating and implementing an economically viable acquisition of a drug or drug candidate is a lengthy and complex process. Other companies, including those with substantially greater financial, marketing and sales resources, may compete with us for the acquisition of product candidates and approved products. We may not be able to acquire the rights to additional drug candidates and approved drugs on terms that we find acceptable, if at all. Risks relating to our intellectual property rights Our patent protection for BiDil, which is a combination of two generic drugs, is limited, and we may be subject to generic substitution or competition and resulting pricing pressure. We have no composition of matter patent covering our lead product candidate, BiDil, which we intend to market for the treatment of heart failure in African Americans. BiDil is a fixed-dose combination of two generic drugs, isosorbide dinitrate and hydralazine, which are approved and separately marketed, in dosages similar to those we include in BiDil, for indications other than heart failure, at prices below the prices we expect to charge for BiDil. We have three issued method-of-use patents, one of which covers the use of the combination of isosorbide dinitrate and hydralazine to reduce the incidence of mortality associated with chronic congestive heart failure, expiring in 2007, and the others covering the treatment of heart failure in black patients, expiring in 2020. As a practical matter, we may not be able to enforce these method-of-use patents to prevent physicians from prescribing isosorbide dinitrate We have granted the underwriters the right to purchase up to 487,181 additional shares of common stock to cover over-allotments. Investing in our common stock involves a high degree of risk. See "Risk Factors" beginning on page 6. Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or passed upon the adequacy of accuracy of this prospectus. Any representation to the contrary is a criminal offense. JPMorgan Pacific Growth Equities, LLC Deutsche Bank Securities Bear, Stearns & Co. Inc. November , 2004 and hydralazine separately for the treatment of heart failure in African Americans, even though neither drug is approved for such use. Other factors may also adversely affect our patent protection for BiDil. The combination therapy of isosorbide dinitrate and hydralazine for use in heart failure was developed through lengthy, publicly-sponsored clinical trials conducted during the 1980s, prior to the filing of the patent application that resulted in the 2007 patent. The U.S. Patent and Trademark Office, or U.S. patent office, considered published reports on these clinical trials and concluded that they did not constitute prior art that would prevent the issuance of the 2007 patent. The U.S. patent office also considered the question of whether the 2007 patent constituted prior art with respect to the 2020 patents, but determined that the claims of the 2020 patents were non-obvious and patentable. A court considering the validity of the 2007 or 2020 patents with respect to questions of prior art might be presented with other alleged prior art or might reach conclusions different from those reached by the U.S. patent office. If the 2007 or 2020 patents were to be invalidated or if physicians were to prescribe isosorbide dinitrate and hydralazine separately for heart failure in African Americans, our BiDil revenue could be significantly reduced, we could fail to recover the cost of developing BiDil and BiDil might not be a viable product. If we are not able to obtain and enforce patent protection for our discoveries, our ability to develop and commercialize our product candidates will be harmed, and we may not be able to operate our business profitably. Our success depends, in part, on our ability to protect proprietary methods and technologies that we develop under the patent and other intellectual property laws of the United States and other countries, in order to prevent others from using our inventions and proprietary information. Because certain United States patent applications are confidential until patents issue, such as applications filed prior to November 29, 2000 or applications filed after such date which will not be filed in foreign countries, third parties may have filed patent applications for technology covered by our pending patent applications without our being aware of those applications, and our patent applications may not have priority over any patent applications of others. Our strategy depends on our ability to rapidly identify and seek patent protection for our discoveries. This process is expensive and time consuming, and we may not be able to file and prosecute all necessary or desirable patent applications at a reasonable cost or in a timely manner. Despite our efforts to protect our proprietary rights, unauthorized parties may be able to obtain and use information that we regard as proprietary. The mere issuance of a patent does not guarantee that it is valid or enforceable, so even if we obtain patents, they may not be valid or enforceable against third parties. The issued patents and patent applications for our product candidates and nitric oxide technology include claims with respect to both the composition of specific drugs or compounds and specific methods of using these drugs or compounds in therapeutic areas. In some cases, like BiDil, our only patent protection is with respect to the method of using a drug or compound, and we do not have patent claims covering the underlying composition of the drug or compound. Method-of-use patents may provide less protection for our product candidates because it may be more difficult to prove direct infringement against a pharmaceutical manufacturer or distributor once they have gained approval for an alternative indication. In addition, if any other company gains FDA approval for an indication separate from the one we are pursuing and markets a drug that we expect to market under the protection of a method-of-use patent, physicians will be able to prescribe that drug for use in the indication for which we have obtained approval, even though the drug is not approved for such indication. As a practical matter, we may not be able to enforce our method-of-use patents against physicians prescribing drugs for such off-label use. Off-label use and any resulting off-label sales could make it more difficult to obtain the price we would otherwise wish to achieve for, or to successfully commercialize, our product. In addition, in those situations where we have only method-of-use patent coverage for a product candidate, it may be more difficult to find a pharmaceutical company partner to license or support development of our product candidate. Our pending patent applications may not result in issued patents. The patent position of pharmaceutical or biotechnology companies, including ours, is generally uncertain and involves complex legal and factual considerations. The standards which the U.S. patent office and its foreign counterparts use to grant patents are not always applied predictably or uniformly and can change. There is also no uniform, worldwide policy regarding the subject matter and scope of claims granted or allowable in pharmaceutical or biotechnology patents. Accordingly, we do not know the degree of future protection for our proprietary rights or the breadth of claims allowed in any patents issued to us or to others. We also rely on trade secrets, know-how and technology, which are not protected by patents, to maintain our competitive position. If any trade secret, know-how or other technology not protected by a patent were to be disclosed to or independently developed by a competitor, our business and financial condition could be materially adversely affected. If we become involved in patent litigation or other proceedings to enforce our patent rights, we would incur substantial costs and expenses, substantial liability for damages or be required to stop our product development and commercialization efforts. A third party may sue us for infringing on its patent rights. Likewise, we may need to resort to litigation to enforce a patent issued to us or to determine the scope and validity of third-party proprietary rights. The cost to us of any litigation or other proceeding relating to intellectual property rights, even if resolved in our favor, could be substantial, and the litigation would divert our management's efforts. Some of our competitors may be able to sustain the costs of complex patent litigation more effectively than we can because they have substantially greater resources. In addition, our strategy of providing nitric oxide-enhancing versions of existing medicines could lead to more patent litigation as the markets for these existing medicines are very large and competitive. Uncertainties resulting from the initiation and continuation of any litigation could limit our ability to continue our operations. For example, we have filed an opposition in the European Patent Office, or EPO, to revoke NicOx S.A.'s European Patent No. 904 110, which we refer to as EP '110. This patent is directed to the use of organic compounds containing a nitrate group or inorganic compounds containing a nitric oxide group to reduce the toxicity caused by certain drugs, including non-steroidal anti-inflammatory drugs, or NSAIDs. The basis for our opposition, in part, is that the claims in EP '110 are anticipated and therefore invalid if they are construed to cover a single compound chemically linked to a nitrate. While we believe that the claims in EP '110 will be invalidated, or be narrowed, we cannot predict with certainty the outcome of the opposition. If the EPO finds that there are valid claims in EP '110 that cover compounds chemically linked to nitrates, we may be adversely affected in our ability to market our product candidates for reducing gastrointestinal toxicity without first obtaining a license from NicOx, which may not be available on favorable terms, if at all. We do not know whether NicOx has filed claims of similar scope to the EP '110 patent in the United States. If any parties are able to successfully claim that our creation or use of proprietary technologies infringes upon their intellectual property rights, we might be forced to pay damages, potentially including treble damages, if we are found to have willfully infringed on such parties' patent rights. In addition to any damages we might have to pay, a court could require us to stop the infringing activity or obtain a license on unfavorable terms. Moreover, any legal action against us or our partners claiming damages and seeking to enjoin commercial activities relating to the affected products and processes could, in addition to subjecting us to potential liability for damages, require us or our partners to obtain a license in order to continue to manufacture or market the affected products and processes. Any license required under any patent may not be made available on commercially-acceptable terms, if at all. In addition, some licenses may be non-exclusive, and therefore our competitors may have access to the same technology licensed to us. If we fail to obtain a required license or are unable to design around a patent, we may be unable to effectively market some of our technology and product candidates, which could limit our ability to generate revenues or achieve profitability and possibly prevent us from generating revenue sufficient to sustain our operations. In addition, a number of our collaborations provide that royalties payable to us for licenses to our intellectual property may be offset by amounts paid by our collaboration partners to third parties who have competing or superior intellectual property positions in the relevant fields, which could result in significant reductions in our revenues from products developed through collaborations. We in-license a significant portion of our principal proprietary technologies, and if we fail to comply with our obligations under any of the related agreements, we could lose license rights that are necessary to developing BiDil and our other product candidates. We are a party to a number of licenses that give us rights to third-party intellectual property that is necessary for our business. In particular, we have obtained the exclusive right to develop and commercialize BiDil pursuant to a license agreement with Dr. Jay N. Cohn, and some of our intellectual property rights relating to nitric oxide compounds have been obtained pursuant to license agreements with the Brigham and Women's Hospital and Boston University. We expect to enter into additional licenses in the future. These licenses impose various development, commercialization, funding, royalty, diligence, and other obligations on us. If we breach these obligations, the licensor may have the right to terminate the license or render the license non-exclusive, which would result in us being unable to develop, manufacture and sell products that are covered by the licensed technology. Risks relating to our industry We face significant competition, which may result in others discovering, developing or commercializing products before or more successfully than we do. The pharmaceutical and medical device industries are highly competitive and characterized by rapid and significant technological change. Our principal competitors in the markets we have targeted, such as cardiovascular disease and inflammation, are large, multinational pharmaceutical and medical device companies that have substantially greater financial and other resources than we do and are conducting extensive research and development activities on technologies and product candidates similar to or competitive with ours. There are a number of companies currently marketing and selling products to treat heart failure in the general population that will compete with BiDil, if it is approved. These include GlaxoSmithKline, plc, which currently markets Coreg, Merck & Co., Inc., which currently markets Vasotec, Pfizer Inc., which currently markets Inspra, and Astra Zeneca, plc, which currently markets Toprol XL. We also face competition from other pharmaceutical companies seeking to develop drugs using nitric oxide technology. For example, we are aware of at least four companies working in the area of nitric oxide based therapeutics. These companies are GB Therapeutics, NicOx S.A., OxoN Medica, and Vasopharm BIOTECH GmbH. Many of our competitors are more experienced than we are in drug development and commercialization, obtaining regulatory approvals and product marketing and manufacturing. As a result, our competitors may develop and commercialize pharmaceutical products before we do. In addition, our competitors may develop and commercialize products that render our products obsolete or non-competitive or that block or delay approval of our products as a result of patent or non-patent exclusivity. We may be exposed to product liability claims and may not be able to obtain or maintain adequate product liability insurance. Our business exposes us to the risk of product liability claims that is inherent in the manufacturing, testing, and marketing of human therapeutic products. Our clinical trial liability insurance is subject to deductibles and coverage limitations. We do not currently have any commercial product liability insurance. We may not be able to obtain or maintain insurance on acceptable terms, or at all. Moreover, any insurance that we do obtain may not provide adequate protection against potential liabilities. If third-party payors do not reimburse customers for BiDil or any of our product candidates that are approved for marketing, they might not be used or purchased, and our revenues and profits might be adversely affected. Our revenues and profits depend heavily upon the availability of coverage and reimbursement for the use of BiDil, and any of our product candidates that are approved for marketing, from third-party healthcare and state and federal government payors, both in the United States and in foreign markets. Reimbursement by a third-party payor may depend upon a number of factors, including the third-party payor's determination that use of a product is: safe, effective and medically necessary; appropriate for the specific patient; cost-effective; and neither experimental nor investigational. Since reimbursement approval for a product is required from third-party and government payors, seeking this approval, particularly when seeking approval for a preferred form of reimbursement over other competitive products, is a time-consuming and costly process. Third-party payors may require cost-benefit analysis data from us in order to demonstrate the cost-effectiveness of any product we might bring to market. For any individual third-party payor, we may not be able to provide data sufficient to gain reimbursement on a similar or preferred basis to competitive products or at all. Once reimbursement at an agreed level is approved by a third-party payor, we may lose that reimbursement entirely or we may lose the similar or better reimbursement we receive compared to competitive products. As reimbursement is often approved for a period of time, this risk is greater at the end of the time period, if any, for which the reimbursement was approved. Risks relating to our common stock Our stock price is subject to fluctuation, which may cause an investment in our stock to suffer a decline in value. The market price of our common stock may fluctuate significantly in response to factors that are beyond our control. The stock market in general has recently experienced extreme price and volume fluctuations. The market prices of securities of pharmaceutical, biotechnology and other life sciences companies have been extremely volatile, and have experienced fluctuations that often have been unrelated or disproportionate to the operating performance of these companies. For example, our stock price could be adversely affected if product candidates by others that utilize nitric oxide technology are not successful in clinical testing, fail to achieve regulatory approval or are not accepted in the marketplace, even though these failures may not be related to our product candidates or technology. These broad market fluctuations could result in extreme fluctuations in the price of our common stock, which could cause a decline in the value of our common stock. We may incur significant costs and suffer management distraction and reputational damage from class action litigation and regulatory or government investigations and actions due to trading in our common stock. Our stock price has been, and is likely to continue to be, volatile. Our stock price may fluctuate for many reasons, including as a result of public announcements regarding the progress of our development and marketing efforts, the addition or departure of key personnel, variations in our quarterly operating results and changes in market valuations of pharmaceutical, biotechnology or other life sciences companies. When the market price of a company's stock is volatile, holders of that company's stock may bring securities class action litigation against the company that issued the stock. If any of our stockholders were to bring a lawsuit of this type against us, even if the lawsuit was without merit, we could incur substantial costs defending the lawsuit. On July 20, 2004, the Market Regulation Department of the National Association of Securities Dealers, Inc. advised us that it is conducting a review of trading activity in our common stock surrounding our July 19, 2004 announcement that we had halted our phase III confirmatory clinical trial of BiDil due to the significant survival benefit seen with BiDil. The NASD is reviewing, among other things, information on relationships between our officers, directors Loss from operations (12,326 ) (17,914 ) (9,246 ) (10,039 ) (20,989 ) Non-operating income (expense): Interest expense (48 ) (10 ) (4 ) (3 ) (1 ) Interest income 557 387 399 212 913 Other income 188 195 82 82 and service providers and individuals and institutions who may have traded in our common stock prior to the July 19, 2004 announcement. We are cooperating with this review and have identified certain persons on the list provided to us by the NASD as having a relationship with our chief executive officer and others at NitroMed. We have established a special committee of our board of directors to oversee our response to this review. The NASD may refer this matter to the SEC once it completes its review. The SEC or other securities regulators may investigate trading activity of insiders and others around events that result in stock price volatility, such as our July 19 announcement, and we may incur substantial costs in connection with any such government investigation or related action. A stockholder lawsuit, SEC or other investigation or action could also damage our reputation or that of our officers or directors and divert their time and attention away from management of NitroMed. Substantially all of our outstanding common stock may be sold into the market at any time. This could cause the market price of our common stock to drop significantly. Sales of a substantial number of shares of our common stock in the public market could occur at any time. These sales, or the perception in the market that the holders of a large number of shares intend to sell shares, could reduce the market price of our common stock. As of September 30, 2004, we had outstanding 26,356,630 shares of common stock. Subject to lock up agreements which will restrict the sale of approximately 5,489,333 of these shares for a period of 45 days after this offering, 6,367,228 of these shares for a period of 60 days after this offering, and 1,920,176 of these shares for a period of 90 days after this offering, substantially all of these shares may also be resold in the public market at any time. In addition, we have a significant number of shares that are subject to outstanding options. The exercise of these options and the subsequent sale of the underlying common stock could cause a further decline in our stock price. These sales also might make it difficult for us to sell equity securities in the future at a time and at a price that we deem appropriate. Insiders have substantial control over us and could delay or prevent a change in corporate control. As of September 30, 2004, our directors, executive officers and principal stockholders, together with their affiliates, own, in the aggregate, approximately 53% of our outstanding common stock. As a result, these stockholders, if acting together, will have the ability to determine the outcome of matters submitted to our stockholders for approval, including the election and removal of directors and any merger, consolidation or sale of all or substantially all of our assets. In addition, these persons, if acting together, will have the ability to control the management and affairs of our company. Accordingly, this concentration of ownership may harm the market price of our common stock by: delaying, deferring or preventing a change in control of our company; impeding a merger, consolidation, takeover or other business combination involving our company; or discouraging a potential acquirer from making a tender offer or otherwise attempting to obtain control of our company. Summary financial data You should read the following summary financial data in conjunction with "Selected financial data," "Management's discussion and analysis of financial condition and results of operations" and our financial statements and related notes, all included elsewhere in this prospectus. The summary financial data for the three years ended December 31, 2003 are derived from our audited financial statements, which are included elsewhere in this prospectus. The summary financial data for the nine months ended September 30, 2003 and 2004 and as of September 30, 2004 are derived from our unaudited financial statements included elsewhere in this prospectus. The unaudited financial statements include, in the opinion of management, all adjustments, consisting only of normal recurring accruals, that management considers necessary for a fair presentation of our results of operations for these periods and financial position at that date. The historical results are not necessarily indicative of results to be expected in any future period, and the results for the nine months ended September 30, 2004 should not be considered indicative of results expected for the full fiscal year. Provisions in our charter documents and under Delaware law may prevent or frustrate attempts by stockholders to change current management and hinder efforts to acquire a controlling interest in us. Provisions of our restated certificate of incorporation and bylaws may discourage, delay or prevent a merger, acquisition or other change in control that stockholders may consider favorable, including transactions in which stockholders might otherwise receive a premium for their shares. These provisions may prevent or frustrate attempts by stockholders to replace or remove our current management. These provisions include: a prohibition on stockholder action through written consent; a requirement that special meetings of stockholders be called only by a majority of the board of directors, the chairman of the board or the chief executive officer; advance notice requirements for stockholder proposals and nominations; limitations on the ability of stockholders to amend, alter or repeal our certificate of incorporation or bylaws; and the authority of the board of directors to issue preferred stock with such terms as the board of directors may determine. In addition, Section 203 of the Delaware General Corporation Law prohibits a publicly-held Delaware corporation from engaging in a business combination with an interested stockholder, generally defined as a person or entity which together with its affiliates owns or within the last three years has owned 15% of our voting stock, for a period of three years after the date of the transaction in which the person became an interested stockholder, unless the business combination is approved in a prescribed manner. Accordingly, Section 203 may discourage, delay or prevent a change in control of our company. Total current liabilities 6,272 10,446 15,680 Deferred revenue, long term 6,667 6,925 1,731 Notes payable, less current portion Total marketable securities $ 29,458 $ Note payable in monthly payments of $4 through June 30, 2004, including interest at 8% per annum $ 64 $ Long term portion $ Year ended December 31,
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+RISK FACTORS An investment in our common stock involves a high degree of risk. You should carefully consider the risks described below before deciding to invest in our common stock. In assessing these risks, you should also refer to the other information in this prospectus, including our financial statements and the related notes. Various statements in this prospectus, including some of the following risk factors, constitute forward-looking statements. Risks Related to Our Company We recently emerged from a Chapter 11 Bankruptcy Reorganization and have a history of losses. We sought protection under Chapter 11 of the Bankruptcy Code in October 2002. We incurred net losses of approximately $360 million and $170 million during the fiscal years ended December 31, 2002 and December 31, 2001, respectively. See "Management's Discussion and Analysis of Financial Condition and Results of Operations." On November 10, 2003, we emerged from Chapter 11 protection pursuant to the Plan , under which our equity ownership and capital structure changed and our board of directors was replaced. Our return to profitability is not assured and we cannot assure you that we will grow or achieve profitability in the near future, or at all. Our business is capital intensive and we cannot assure you that we will have sufficient liquidity to fund our working capital and capital expenditures and to meet our obligations under our existing debt instruments. Our business is very capital intensive and has always required significant amounts of cash. We cannot be certain that we will achieve sufficient cash flow in the future. Failure to maintain profitability and generate sufficient cash flow could diminish our ability to sustain operations, meet financial covenants, obtain additional required funds and make required payments on any indebtedness we have incurred or may incur. If we do not comply with the covenants in our credit agreements or otherwise default under them, we may not have access to borrowings under our Revolving Credit Facility or the funds necessary to pay all amounts that could become due. Although we believe that our current levels of cash and cash equivalents, along with available borrowings on our Revolving Credit Facility, will be sufficient for our cash requirements during the next twelve months, it is possible that these sources of cash will be insufficient resulting in our having to raise additional funds for liquidity. There can be no assurance we will have the requisite access to new funding if the need arises. The industries in which we operate are highly competitive. This competition may prevent us from raising prices at the same pace as our costs increase, making it difficult for us to maintain existing business and win new business. We face significant competition from established and new competitors in each of our businesses. Certain of these competitors have very large market shares and may have substantially greater financial and technical resources than we do. Moreover, we may also be required to reduce prices if our competitors reduce prices, or as a result of any other downward pressure on prices for our products and services, which could have an adverse effect on us. In each of our business segments, we operate in competitive markets. Our manufacturing segment competes with numerous international and North American companies, including various captive operations of original equipment manufacturers (OEMs) and Tier 1 suppliers to automotive manufacturers. Competition in the manufacturing segment's markets is based on a number of factors, including design and engineering capabilities, price, quality and the ability to meet customer delivery requirements. Most of the markets in which our performance products segment does business are highly competitive. The major competitors of our performance products segment are typically segregated by end market and include international, regional and, in some cases, small independent producers. Competition in the performance products segment's markets is based on a number of factors, including price, freight economics, product quality and technical support. Due to the level of competition faced by our performance products segment, our customers have regularly requested price decreases and maintaining or raising prices has been difficult over the past several years and will likely continue to be so in the near future. Our communications segment also operates in highly competitive markets, with many of our competitors being large, international and technologically sophisticated companies. Competition in our communications segment is based on a number of factors, including technological advancements, price, product line breadth, technical support and service and product quality. The ability to achieve and maintain successful performance in this segment is also dependent on our ability to develop products cost effectively which meet the changing requirements of our customers that are driven by rapid advances in technology. If we are unable to compete successfully, our financial condition and results of operations could be adversely affected. We are a holding company that is dependent upon cash flow from our subsidiaries to meet our obligations; our ability to access that cash flow may be limited in some circumstances. We are a holding company with no independent operations or significant operating assets other than our investments in and advances to our subsidiaries. We depend upon the receipt of sufficient funds from our subsidiaries to meet our obligations. In addition, the terms of our existing and future indebtedness and that of our subsidiaries and the laws of the jurisdictions under which our subsidiaries are organized limit the payment of dividends, loan repayments and other distributions to us under many circumstances. Our current amount of leverage could adversely affect our financial health and diminish shareholder value. We may find that we are over-leveraged, which could have significant negative consequences, including: o it may become more difficult for us to satisfy our obligations with respect to all of our indebtedness; o we may be vulnerable to a downturn in the industries in which we operate or a downturn in the economy in general; o we may be required to dedicate a substantial portion of our cash flow from operations to fund working capital, capital expenditures and other general corporate requirements; o we may be limited in our flexibility to plan for, or react to, changes in our businesses and the industries in which we operate; o we may be placed at a competitive disadvantage compared to our competitors that have less debt; o we may determine it to be necessary to dispose of certain assets or one or more of our businesses to reduce our debt; and o our ability to borrow additional funds may be limited. Additionally, there may be factors beyond our control that could impact our ability to meet debt service requirements. Our ability to meet debt service requirements will depend on our future performance, which, in turn, will depend on a number of factors, including conditions in the global markets for our products, the global economy generally, the behavior of our competitors, the financial condition and sourcing decisions made by our customers, our future cash funding requirements for environmental and pension liabilities, the impact of current and future tax regulations on our cash flows and financial condition and other factors that are beyond our control. We can provide no assurance that our businesses will generate sufficient cash flow from operations or that future borrowings will be available in amounts sufficient to enable us to pay our indebtedness or to fund our other liquidity needs. Moreover, we may need to refinance all or a portion of our indebtedness on or before maturity. We cannot make assurances that we will be able to refinance any of our indebtedness on commercially reasonable terms or at all. If we are unable to make scheduled debt payments or comply with the other provisions of our debt instruments, our various lenders will be permitted under certain circumstances to accelerate the maturity of the indebtedness owing to them and exercise other remedies provided for in those instruments and under applicable law. We are subject to restrictive debt covenants pursuant to our indebtedness. These covenants may restrict our ability to finance our business and, if we do not comply with the covenants or otherwise default under them, we may not have the funds necessary to pay all amounts that could become due and the lenders could foreclose on substantially all of our assets. As part of our implementation of the Plan, we issued $250 million principal amount of senior term debt under the terms of a new credit agreement (referred to herein as the Senior Term Loan Credit Agreement). In addition, we entered into our $125 million Revolving Credit Facility which matures on November 10, 2008. Both facilities are secured by substantially all of our assets. The Revolving Credit Facility, among other things, significantly restricts and, in some cases, effectively eliminates our ability and the ability of most of our subsidiaries to: o incur additional debt; o create or incur liens; o pay dividends or make other equity distributions; o purchase or redeem share capital; o make investments; o sell assets; o issue or sell share capital of certain subsidiaries; o engage in transactions with affiliates; o issue or become liable on a guarantee; o voluntarily prepay, repurchase or redeem debt; o create or acquire new subsidiaries; and o effect a merger or consolidation of, or sell all or substantially all of our assets. Similar restrictive covenants are contained in the Senior Term Loan Credit Agreement which are applicable to us and most of our subsidiaries. In addition, under our Revolving Credit Facility, we and our subsidiaries must comply with certain financial covenants. In the event we were to fail to meet any of such covenants and were unable to cure such breach or otherwise renegotiate such covenants, the lenders under those facilities would have significant rights to seize control of substantially all of our assets. Such a default, or a breach of any of the other obligations in the Senior Term Loan Credit Agreement, could also trigger a default under our Revolving Credit Facility and vice versa. The covenants in our Revolving Credit Facility and the Senior Term Loan Credit Agreement and any credit agreement governing future debt may significantly restrict our future operations. Furthermore, upon the occurrence of any event of default under the Senior Term Loan Credit Agreement, our Revolving Credit Facility or the agreements governing any other debt of our subsidiaries, the lenders could elect to declare all amounts outstanding under such indentures, credit facilities or agreements, together with accrued interest, to be immediately due and payable. If those lenders were to accelerate the payment of those amounts, we cannot assure you that our assets and the assets of our subsidiaries would be sufficient to repay in full those amounts. We are also subject to interest rate risk due to our indebtedness at variable interest rates. Our Revolving Credit Facility and our senior term debt bear interest at variable rates based on a base rate or LIBOR plus an applicable margin. We cannot assure you that shifts in interest rates will not have a material adverse effect on us. We may be required to prepay our indebtedness prior to its stated maturity, which may limit our ability to pursue business opportunities. Pursuant to the terms of our Revolving Credit Facility and Senior Term Loan Credit Agreement, in certain instances we are required to prepay this indebtedness prior to their stated maturity dates, even if we are otherwise in compliance with the covenants contained in the agreements. Specifically, (i) certain asset sale proceeds must be used to pay down indebtedness and can therefore not be reborrowed; and (ii) the Senior Term Loan Credit Agreement provides that, beginning in 2005, we must apply the majority of any "excess cash flow" generated in the prior year to the prepayment of the senior term debt. These prepayment provisions may limit our ability to utilize this excess cash flow to pursue business opportunities. Our Chapter 11 reorganization and uncertainty over our financial condition may harm our businesses and our brand names. Any adverse publicity or news coverage regarding our recent Chapter 11 reorganization and financial condition could have an adverse effect on parts of our business. Due to the potential effect of that publicity, we may find it difficult to maintain relationships with existing customers or obtain new customers. Although we have successfully consummated the Plan, there is no assurance that any such negative publicity will not adversely impact our results of operations or have a long-term negative effect on our businesses and brand names in the future. In addition, uncertainty during our recapitalization process and losses experienced by certain of our unsecured creditors may have adversely affected our relationships with our suppliers. If suppliers become increasingly concerned about our financial condition, they may demand faster payments or refuse to extend normal trade credit, both of which could further adversely affect our cash flow and our results of operations. We may not be successful in obtaining alternative suppliers if the need arises and this would adversely affect our results of operations. In accordance with our Plan, potential preference rights of actions under Section 547 of the Bankruptcy Code against non-insider creditors who received payments within the ninety (90) days prior to our petition date have been assigned to a Preference Claim Litigation Trust (referred to herein as the "Trust"). This Trust, subject to certain limitations, is authorized to prosecute, settle or waive, in its sole discretion, these preference rights. Although this Trust is separate and distinct from the Company and the Company will not receive any significant recoveries from the Trust, its activities may aggravate certain of our suppliers, customers and employees, and could potentially disrupt the flow of necessary raw materials and services, negatively impact our sales and increase our costs, and thereby adversely affect our results of operations. Material changes in pension and other post-retirement benefit costs may occur in the future. In addition, investment returns on pension assets may be lower than assumed, which could result in larger cash funding requirements for our pension plans, which could have an adverse impact on us. We maintain several defined benefit pension plans covering certain employees in Canada, Germany, Ireland and the United States. We record pension and post retirement benefit costs in amounts developed from actuarial valuations. Inherent in these valuations are key assumptions including the discount rate and expected long-term rate of return on plan assets. We believe that material changes in pension and other post retirement benefit costs may occur in the future due to changes in these assumptions, differences between actual experience and the assumptions used, and changes in the benefit plans. Amounts we pay are also dependant upon interest rates. Due to current interest rates and investment returns, some of our plans are substantially underfunded and will require substantial cash contributions over the next several years. Moreover, if investment returns on pension assets are lower than assumed, we may have substantially larger cash funding requirements for our pension plans, which may have a material adverse impact on our liquidity. For a further discussion of our defined benefit pension plans, see "Management's Discussion and Analysis - Financial Condition, Liquidity and Capital Resources" and "Management and Executive Compensation - Pension Plans." We cannot predict the impact of any asset or business disposition or acquisition. From time to time we consider dispositions and acquisitions of assets or businesses. We cannot predict the types of dispositions or acquisitions we may undertake in the future or the financial impact of such actions. For example, any after-tax cash proceeds that we would receive in connection with any disposition would be dependent on levels of interest from potential purchasers, the structure of the transaction and the transaction's tax complexity. As a result, there can be no assurance as to the terms of any such disposition or acquisition, the level of any disruption to the operations of the Company caused by such transaction, or the long-term effect of such transaction on the Company or its financial condition. Our prospects will depend in part on our ability to control our costs while maintaining and improving our service levels. We have been engaged in a process of reducing expenditures in a variety of areas, including by way of a reduction in the number of our employees, the closure of certain facilities, negotiated price reductions on certain raw materials and purchased components, and the outsourcing of some functions. Our prospects will depend in part on our ability to continue to control costs and operate more efficiently, while maintaining and improving our existing service levels. There can be no assurance that the cost reduction efforts listed above will not negatively impact our service levels, quality and employee morale, which would, in turn, adversely affect our results of operations and financial condition. We are highly dependent upon skilled employees and a number of key personnel. We operate businesses that are highly dependent on skilled employees. A loss of a significant number of key professionals or skilled employees could have a material adverse effect on us. We believe that our future success will depend in large part on our continued ability to attract and retain highly skilled and qualified personnel. There can be no assurance that we will be able to retain and employ qualified management and technical personnel. While we maintained a severance and retention plan designed to retain certain of our key employees during the Chapter 11 process, the final retention bonus payment under the plan was made on December 31, 2003. Future compensation and other benefits provided to employees will be determined under the direction of our new board of directors. There can be no assurance that key employees will not seek other employment following the final retention bonus payment or in response to any future changes in employee compensation or benefit programs. Moreover, there is no guarantee that the post-bankruptcy environment will not introduce new risks to employee retention. In addition, certain administrative functions and corporate support services have historically been provided to us by the management company Latona Associates Inc. (Latona). After the Effective Date, we entered into a new one-year agreement with Latona which expires in the fourth quarter of 2004. By the expiration of this agreement, we intend to internally perform, or outsource to other third parties in certain circumstances, the services previously provided by Latona. As a result, unless otherwise agreed to, we will also no longer have access to the services of Latona. Successful operation of our businesses depends on our ability to assume or otherwise provide for these responsibilities and may result in increased costs to us. We may continue to pursue new acquisitions and joint ventures, and any such transaction could adversely affect our operating results or result in increased costs or other operating or management problems. We remain subject to the ongoing risks of successfully integrating and managing the acquisitions and joint ventures through which we have historically grown our business. We have historically grown our business through acquisitions and joint ventures. These transactions expose us to the risk of successfully integrating those acquisitions. Such integration impacts various areas of our business, including our workforce, management, decision making, production facilities, information systems, accounting and financial reporting, and customer service. Disruption to any of these areas of our business could materially harm our financial condition or results of operations. We may continue to pursue new acquisitions and joint ventures in the future, a pursuit which will consume substantial time and resources. Identifying appropriate acquisition candidates and negotiating and consummating acquisitions can be a lengthy and costly process. The successful implementation of our operating strategy at current and future acquisitions and joint ventures may require substantial attention from our management team, which could divert management attention from our existing businesses. The businesses we acquire, or the joint ventures we enter into, may not generate the cash flow and earnings, or yield the other benefits, we anticipated at the time of their acquisition or formation. Furthermore, we may also encounter substantial unanticipated costs or other problems associated with the acquired businesses. The risks inherent in our strategy could have an adverse impact on our results of operation or financial condition. Our principal businesses are subject to government regulation, including environmental regulation, and changes in current regulations may adversely affect us. Our principal business activities are regulated and supervised by various governmental bodies. Changes in laws, regulations or governmental policy or the interpretations of those laws or regulations affecting our activities and those of our competitors could have a material adverse effect on us. For example, our various manufacturing operations, which have been conducted at a number of facilities for many years, are subject to numerous laws and regulations relating to the protection of human health and the environment in the U.S., Canada, Australia, China, Germany, Great Britain, India, Mexico and other countries. We believe that we are in substantial compliance with such laws and regulations. However, as a result of our operations, from time to time we are involved in administrative and judicial proceedings and inquiries relating to environmental matters. Based on information available to us at this time with respect to potential liability involving these facilities, we believe that any such liability will not have a material adverse effect on our financial condition, cash flows or results of operations. However, modifications of existing laws and regulations or the adoption of new laws and regulations in the future, particularly with respect to environmental and safety standards, could require us to make expenditures which may be material or otherwise adversely impact our operations. In addition, the Comprehensive Environmental Response Compensation and Liability Act of 1980 (CERCLA) and similar statutes have been construed as imposing joint and several liability, under certain circumstances, on present and former owners and operators of contaminated sites, and transporters and generators of hazardous substances, regardless of fault. Our facilities have been operated for many years by us or prior owners and operators, and adverse environmental conditions of which we are not aware may exist. Modifications of existing laws and regulations, and the discovery of additional or unknown environmental contamination at any of our current or former facilities, could have a material adverse effect on our financial condition, cash flows and/or results of operations. We may experience increased costs and production delays if suppliers fail to deliver materials to us or if prices increase for raw materials and other goods and services that we purchase from third parties. We purchase raw materials from a number of domestic and foreign suppliers. Although we believe that the raw materials needed for our businesses will be available in sufficient supply on a competitive basis for the foreseeable future, increases in the cost of raw materials, including energy and other inputs used to make our products, could affect future sale volumes, prices and margins for our products. If a supplier should cease to deliver goods or services to us, we would probably find other sources, however, this disruption could result in added cost and manufacturing delays. In addition, political instability, war, terrorism and other unexpected disruptions to international transit routes that are beyond our control could adversely impact our ability to obtain key raw materials in a timely fashion, or at all. Our revenues are dependent on the continued operation of our manufacturing facilities, and breakdowns or other problems in their operation could adversely affect our results of operations. Our revenues are dependent on the continued operation of our various manufacturing facilities. In particular, the operation of chemical manufacturing plants involves many risks, including the breakdown, failure or substandard performance of equipment, natural disasters, power outages, the need to comply with directives of government agencies, and dependence on the ability of railroads and other shippers to transport raw materials and finished products in a timely manner. The occurrence of material operational problems, including but not limited to these events, at one or more of our facilities could have a material adverse effect on our results of operations or financial condition. Certain facilities within each of our business segments account for a significant share of our profits. Disruption to operations at one of these facilities could have a material adverse impact on segment financial performance and our overall financial condition. In addition, in certain circumstances we could also be affected by a disruption or closure of a customer's plant or facility to which we supply our products. The production of chemicals is associated with a variety of hazards which could create significant liabilities or cause our facilities to suspend their operations. Our operations are also subject to various hazards incident to the production of chemicals, including the use, handling, processing, storage and transportation of certain hazardous materials. These hazards, which include the risk of explosions, fires and chemical spills or releases, can cause personal injury and loss of life, severe damage to and destruction of property and equipment, environmental damage, suspension of operations and potentially subject us to lawsuits relating to personal injury and property damages. Any such event or circumstance could have a material adverse effect on our results of operations or financial condition. Due to the nature of our business, we are, from time to time, involved in administrative and judicial proceedings relating to environmental matters which could have a material adverse effect on our results of operations, cash flow and financial condition. As a result of our operations, we may be involved from time to time in proceedings with various regulatory authorities which could require us to pay various fines and penalties due to violations of environmental laws and regulations at our sites, remediate contamination at some of these sites, comply with applicable standards or other requirements or incur capital expenditures to modify certain pollution control equipment or processes at our sites. Although the amount of any liability that could arise with respect to these matters cannot be accurately predicted, we believe that the ultimate resolution of these matters will have no material adverse effect on our results of operations, cash flows or financial condition. On September 7, 2000, the U.S. Environmental Protection Agency issued to us an IAO pursuant to Section 3008(h) of the Resource Conservation and Recovery Act, which requires that we conduct an environmental investigation of certain portions of our Delaware Valley Facility and, if necessary, propose and implement corrective measures to address any historical environmental contamination at the facility. Depending on the scope of any investigation and any remedial activity required as a result, additional costs above those currently estimated could be incurred over a period of the next several years. We are currently unable to estimate the nature and extent of these potential additional costs. As such, it is possible that the final outcome could have a material adverse effect on our results of operations, cash flow and financial condition. We may not be able to obtain insurance at our historical rates and our insurance coverage may not cover all claims and losses. We maintain insurance coverage on our properties, machines, supplies and other elements integral to our business and against certain third party litigation, environmental matters and similar events . Due to recent changes in market conditions in the insurance industry and other factors, we may not be able to secure insurance at a similar cost to what we have previously paid, if at all. In addition, there are certain types of losses, generally of a catastrophic nature, such as earthquakes, floods, hurricanes, terrorism or acts of war, that may be uninsurable or not economically insurable. Inflation, changes in building codes and ordinances, environmental considerations, and other factors, including terrorism or acts of war, also might make the insurance proceeds insufficient to repair or replace a property if it is damaged or destroyed. Under such circumstances, the insurance proceeds received might not be adequate to restore our economic position with respect to the affected real property. In addition, as a result of the events of September 11, 2001, insurance companies are limiting and/or excluding coverage for acts of terrorism in insurance policies. As a result, we may suffer losses from acts of terrorism that are not covered by insurance. We are subject to risks relating to our foreign operations. We have significant manufacturing and sales activities outside of the U.S. and we also export products from the U.S. to various foreign countries. These international operations and exports to foreign markets make us subject to a number of risks such as: currency exchange rate fluctuations; foreign economic conditions; trade barriers; exchange controls; national and regional labor strikes; political instability; risks of increases in duties; taxes; governmental royalties; war; and changes in laws and policies governing operations of foreign-based companies. The occurrence of any one or a combination of these factors may increase our costs or have other negative effects on us. The seasonal nature of the environmental services business could increase our costs or have other negative effects. The businesses of the communications and manufacturing segments are generally not seasonal. However, within the performance products segment, the environmental services business has higher volumes in the second and third quarters of the year, owing to higher spring and summer demand for sulfuric acid regeneration services from gasoline refinery customers to meet peak summer driving season demand and higher spring and summer demand from water treatment chemical customers to manage seasonally high and low water conditions. The seasonal degree of peaks and declines in the volumes of our environmental services business could increase our costs, negatively impact our manufacturing efficiency, require further capital investments or have other negative effects on our operations, customer service or financial performance. We are dependent upon many critical systems and processes, many of which are dependent upon hardware that is concentrated in a limited number of locations. If a catastrophe were to occur at one or more of those locations, it could have a material adverse effect on our business. Our business is dependent on many sophisticated critical systems, which support various aspects of our operations, from our computer network to our billing and customer service systems. The hardware supporting a large number of critical systems is housed in a relatively small number of locations. If one or more of these locations were to be subject to fire, natural disaster, terrorism, power loss, or other catastrophe, it could have a material adverse effect on our business. While we believe that we maintain reasonable disaster recovery programs, there can be no assurance that, despite these efforts, any disaster recovery, security and service continuity protection measures we have or may take in the future will be sufficient. In addition, computer viruses, electronic break-ins or other similar disruptive problems could also adversely affect our operations. Our insurance policies may not adequately compensate us for any losses that may occur due to any failures or interruptions in our computer systems. Risks Related to Our Common Stock The market price of our common stock is subject to volatility as well as trends in our industries in general. We recently emerged from Chapter 11 and the current market price of our common stock may not be indicative of prices that will prevail in the trading markets in the future. The market price of our common stock could be subject to wide fluctuations in response to numerous factors, many of which are beyond our control. These factors include, among other things, actual or anticipated variations in our operating results and cash flow, the nature and content of our earnings releases and our competitors' earnings releases, announcements of technological innovations that impact our products, customers, competitors or markets, changes in financial estimates by securities analysts, business conditions in our markets and the general state of the securities markets and the market for similar stocks, changes in capital markets that affect the perceived availability of capital to companies in our industries, governmental legislation or regulation, currency and exchange rate fluctuations, as well as general economic and market conditions, such as recessions. In addition, in the short period since the issuance of our common stock on the Effective Date, the price of our common stock has been somewhat volatile and remains subject to volatility. Trends in the industries in which we compete are likely to have a corresponding impact on the price of our common stock. Specifically, in our manufacturing segment, the loss of any individual engine line or model contract would not be material to our overall financial condition. However, an economic downturn in the automotive industry as a whole or other events (e.g., labor disruptions) resulting in significantly reduced operations at any of DaimlerChrysler, Ford or General Motors, or at certain of our manufacturing plants, could have a material adverse impact on the results of our manufacturing segment. In addition, in the appliance and electronic and industrial markets, risks include softening of appliance demand, continued price pressure from major customers and continued competition from lower-cost Asian sources. For our performance products business, the continued weakness in the pulp and paper, electronics or chemical processing industries could have an adverse effect on our results of operations. In our communications segment, a loss of key contracts with current customers and vendors in addition to weakness in economic conditions in the communications market and competitive pricing driven by overcapacity could have a material adverse effect on the price of our stock. Sales of large amounts of our common stock or the perception that sales could occur may depress our stock price. On the Effective Date, we issued an aggregate of 10,000,000 shares of our common stock to former holders of our debt securities and other claimants. These shares represented all of our outstanding common stock as of the Effective Date and may be sold at any time, subject to compliance with applicable law, including the Securities Act, and certain provisions of our certificate of incorporation, bylaws and the Registration Rights Agreement (as defined herein). Sales in the public market of large blocks of shares of our common stock acquired pursuant to the Plan could lower our stock price and impair our ability to raise funds in future stock offerings. We may in the future seek to raise funds through equity offerings, or there may be other events which would have a dilutive effect on our common stock. In the future we may determine to raise capital through offerings of our common stock, securities convertible into our common stock, or rights to acquire such securities or our common stock. In any such case, the result would ultimately be dilutive to our common stock by increasing the number of shares outstanding. In addition, if options or warrants to purchase our common stock are exercised or other equity interests are granted under our management and directors incentive plan or under other plans adopted in the future, such equity interests will also have a dilutive effect on our common stock. Additional shares of our common stock and additional warrants may be issued pursuant to the Plan to certain claimants, subject to the resolution of certain claims. In the event that the holders of California Tort Claims (as defined in the Plan) prevail on their asserted claims against us and our insurance does not cover such claims, stock and warrants would be issued to holders of such claims and dilution of any outstanding shares of our common stock would occur. Although we believe we have meritorious defenses to the California Tort Claims and, if our insurance covers this liability, that we have sufficient insurance coverage to satisfy any liquidated amounts relating to such claims, there can be no assurance this will be the case. Under the Plan, holders of California Tort Claims, to the extent they are determined to hold allowable claims not covered by insurance, will receive additional shares of our common stock and warrants beyond those reserved for general unsecured creditors, in an amount that will provide the same percentage recovery as received by general unsecured creditors. We cannot predict the effect any such dilution may have on the price of our common stock. We may be unable to list our stock on a national securities exchange. We are currently traded on the Over the Counter Bulletin Board. Pursuant to the Plan, we are obligated to use our best efforts to list our common stock on a national securities exchange. Despite our efforts, we may not be able to meet the applicable listing requirements of any national securities exchange and, therefore, our common stock may not become listed on a national securities exchange. If our stock is not traded through a market system, it may not be liquid and we may be unable to obtain future equity financing, or use our common stock as consideration for mergers or other business combinations on favorable terms or at all. We do not expect to pay dividends on our common stock in the foreseeable future. We do not expect to pay dividends on our common stock in the foreseeable future. The payment of any dividends by us in the future will be at the discretion of our board of directors and will depend upon, among other things, future earnings, operations, capital requirements, our general financial condition and the general financial condition of our subsidiaries. In addition, under Delaware law, unless a corporation has available surplus or earnings it cannot declare or pay dividends on its capital stock. Furthermore, the terms of our Revolving Credit Facility and our Senior Term Loan Credit Agreement impose limitations on the payment of dividends to us by our subsidiaries and the distribution of earnings or making of other payments to us by our subsidiaries, which consequently limits amounts available for us to pay dividends on our common stock. Additionally, the Senior Term Loan Credit Agreement directly limits our ability to pay dividends on our common stock. The terms of any future indebtedness of our subsidiaries may generally restrict the ability of some of our subsidiaries to distribute earnings or make other payments to us. Certain transfer restrictions on our common stock imposed by our charter may inhibit market activity in our common stock. Our common stock is subject to certain transfer restrictions imposed by our charter. These restrictions generally prohibit the following transfers of our equity securities without the prior written consent of our board of directors, which consent can be withheld only if our board of directors, in its sole discretion, determines that the transfer creates a material risk of limiting certain tax benefits: (i) transfers to a person (including any group of persons making a coordinated acquisition) who beneficially owns, or would beneficially own after the transfer, more than 4.75% of the total value of our outstanding equity securities, to the extent that the transfer would increase such person's beneficial ownership above 4.75% of the total value of our outstanding equity securities and (ii) transfers by a person (or group of persons having made a coordinated acquisition) who beneficially owns more than 4.75% of the total value of our outstanding equity securities. The restrictions are not applicable to transfers pursuant to a tender offer to purchase 100% of our common stock for cash or marketable securities so long as such tender offer results in the tender of at least 50% of our common stock then outstanding. The restrictions begin only at such time that 25% of the our common stock has been transferred, for tax purposes (which generally takes into consideration only transfers to or from shareholders who beneficially own 5% of the value of our common stock), and will remain in effect until the earlier of: (i) the second anniversary of the Effective Date or (ii) such date as the board of directors determines, in its sole discretion, that such restrictions are no longer necessary to protect tax benefits. These transfer restrictions may inhibit market activity in our common stock. Some provisions of the agreements governing our indebtedness and certain provisions of our certificate of incorporation could delay or prevent transactions involving a change of control of GenTek. We may, under some circumstances involving a change of control, be obligated to offer to repay substantially all of our outstanding indebtedness, and repay other indebtedness (including our Revolving Credit Facility and senior term debt). We cannot assure you that we will have available financial resources necessary to repay this indebtedness in those circumstances. If we cannot repay this indebtedness in the event of a change of control, the failure to do so would constitute an event of default under the agreements under which that indebtedness was incurred and could result in a cross-default under other indebtedness. The threat of this default could have the effect of delaying or preventing transactions involving a change of control of GenTek, including transactions in which stockholders might otherwise receive a substantial premium for their shares over then current market prices, and may limit the ability of our stockholders to approve transactions that they may deem to be in their best interest. Certain provisions of our certificate of incorporation, including the provision restricting transfer of shares in order to assist in the preservation of certain tax benefits, may have the effect, alone or in combination with each other or with the existence of authorized but unissued common stock and preferred stock, of preventing or making more difficult transactions involving a change of control of GenTek.
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+RISK FACTORS Investing in our common stock will provide you with an equity ownership in Gasco. As one of our stockholders, you will be subject to risks inherent in our business. The trading price of your shares will be affected by the performance of our business relative to, among other things, competition, market conditions and general economic and industry conditions. The value of your investment may decrease, resulting in a loss. You should carefully consider the following factors as well as other information contained in this prospectus before deciding to invest in shares of our common stock. We have incurred losses since our inception and will continue to incur losses in the future. To date our operations have not generated sufficient operating cash flows to provide working capital for our ongoing overhead, the funding of our lease acquisitions and the exploration and development of our properties. Without adequate financing, we may not be able to successfully develop any prospects that we have or acquire and we may not achieve profitability from operations in the near future or at all. During the year ended December 31, 2002 and during the nine months ended September 30, 2003, we incurred losses of $5,649,682 and $1,890,166, respectively. We have an accumulated deficit of $24,655,402 from our inception through September 30, 2003, including the Series A Convertible Redeemable Preferred Stock deemed distribution of $11,400,000 as further described in Note 11 of our accompanying financial statements. Our oil and gas reserve information is estimated and may not reflect our actual reserves. Estimating accumulations of gas and oil is complex and is not exact because of the numerous uncertainties inherent in the process. The process relies on interpretations of available geological, geophysical, engineering and production data. The extent, quality and reliability of this technical data can vary. The process also requires certain economic assumptions, some of which are mandated by the SEC, such as gas and oil prices, drilling and operating expenses, capital expenditures, taxes and availability of funds. The accuracy of a reserve estimate is a function of: .the quality and quantity of available data; .the interpretation of that data; .the accuracy of various mandated economic assumptions; and .the judgment of the persons preparing the estimate. The proved reserve information included in this prospectus is based on estimates prepared by James R. Stell, independent petroleum engineer. Estimates prepared by others could differ materially from these estimates. The most accurate method of determining proved reserve estimates is based upon a decline analysis method, which consists of extrapolating future reservoir pressure and production from historical pressure decline and production data. The accuracy of the decline analysis method generally increases with the length of the production history. Since most of our wells had been producing less than two months, their production history was relatively short, so other (generally less accurate) methods such as volumetric analysis and analogy to the production history of wells of other operators in the same reservoir were used in conjunction with the decline analysis method to determine our estimates of proved reserves. As our wells are produced over time and more data is available, the estimated proved reserves will be redetermined on an annual basis and may be adjusted based on that data. Actual future production, gas and oil prices, revenues, taxes, development expenditures, operating expenses and quantities of recoverable gas and oil reserves most likely will vary from our estimates. Any significant variance could materially affect the quantities and present value of our reserves. In addition, we may adjust estimates of proved reserves to reflect production history, results of exploration and development and prevailing gas and oil prices. Our reserves may also be susceptible to drainage by operators on adjacent properties. It should not be assumed that the present value of future net cash flows included herein is the current market value of our estimated proved gas and oil reserves. In accordance with SEC requirements, we generally base the estimated discounted future net cash flows from proved reserves on prices and costs on the date of the estimate. Actual future prices and costs may be materially higher or lower than the prices and costs as of the date of the estimate. Future changes in commodity prices or our estimates and operational developments may result in impairment charges to our reserves. We may be required to writedown the carrying value of our gas and oil properties when gas and oil prices are low or if there is substantial downward adjustments to the estimated proved reserves, increases in the estimates of development costs or deterioration in the exploration results. We follow the full cost method of accounting, under which, capitalized gas and oil property costs less accumulated depletion and net of deferred income taxes may not exceed an amount equal to the present value, discounted at 10%, of estimated future net revenues from proved gas and oil reserves plus the cost, or estimated fair value, if lower of unproved properties. Should capitalized costs exceed this ceiling, an impairment is recognized. The present value of estimated future net revenues is computed by applying current prices of gas and oil to estimated future production of proved gas and oil reserves as of period-end, less estimated future expenditures to be incurred in developing and producing the proved reserves assuming the continuation of existing economic conditions. Once an impairment of gas and oil properties is recognized, is not reversible at a later date even if oil or gas prices increase. Our common stock does not trade in a mature market and therefore has limited liquidity. Our common stock is highly speculative and has only been trading in the public markets since January 2001. Our common stock trades on the over-the-counter market. Holders of our common stock may not be able to liquidate their investment in a short time period or at the market prices that currently exist at the time a holder decides to sell. Because of this limited liquidity, it is unlikely that shares of our common stock will be accepted by lenders as collateral for loans. The development of oil and gas properties involves substantial risks that may result in a total loss of investment. The business of exploring for and producing oil and gas involves a substantial risk of investment loss that even a combination of experience, knowledge and careful evaluation may not be able to overcome. Drilling oil and gas wells involves the risk that the wells will be unproductive or that, although productive, the wells do not produce oil and/or gas in economic quantities. Other hazards, such as unusual or unexpected geological formations, pressures, fires, blowouts, loss of circulation of drilling fluids or other conditions may substantially delay or prevent completion of any well. Adverse weather conditions can also hinder drilling operations. A productive well may become uneconomic in the event water or other deleterious substances are encountered, which impair or prevent the production of oil and/or gas from the well. In addition, production from any well may be unmarketable if it is contaminated with water or other deleterious substances. We may not be able to obtain adequate financing to continue our operations. We have relied in the past primarily on the sale of equity capital and farm-out and other similar types of transactions to fund working capital and the acquisition of its prospects and related leases. Failure to generate operating cash flow or to obtain additional financing could result in substantial dilution of our property interests, or delay or cause indefinite postponement of further exploration and development of our prospects with the possible loss of our properties. For example, we are party to an agreement with ConocoPhillips Petroleum to conduct drilling operations on approximately 30,000 acres within the Riverbend project. ConocoPhillips will fund its share of drilling and completion costs of wells that it drills within that area. In order to maximize our interests in any future Riverbend wells drilled by ConocoPhillips, we must fund our proportionate share of the drilling and completion costs of such wells. Generally, if we fund our proportionate share of drilling and completion costs in a well drilled by ConocoPhillips, we will retain a 14% working interest (which becomes a 10.5% working interest after payout) in the well drilled by ConocoPhillips and the spacing unit surrounding the well. If we do not fund our proportionate shares of drilling and completion costs in a well drilled by ConocoPhillips, our interests will be reduced to a 0.35% overriding interest in the well and spacing unit before payout, which will convert to a 2.10% working interest after such well reaches payout. This project and our other projects will require significant new funding. We have not yet secured specific sources of adequate funding for this and other projects, and we may be unable to timely secure financing on terms that are favorable to us or at all. Any future financing through the issuance of our common stock will likely result in a substantial dilution to our stockholders. We may suffer losses or incur liability for events that we or the operator of a property have chosen not to obtain insurance. Although management believes the operator of any property in which we may acquire interests will acquire and maintain appropriate insurance coverage in accordance with standard industry practice, we may suffer losses from uninsurable hazards or from hazards, which we or the operator have chosen not to insure against because of high premium costs or other reasons. We may become subject to liability for pollution, fire, explosion, blowouts, cratering and oil spills against which we cannot insure or against which we may elect not to insure. Such events could result in substantial damage to oil and gas wells, producing facilities and other property and personal injury. The payment of any such liabilities may have a material, adverse effect on our financial position. We may incur losses as a result of title deficiencies in the properties in which we invest. If an examination of the title history of a property that we have purchased reveals a petroleum and natural gas lease that has been purchased in error from a person who is not the owner of the mineral interest desired, our interest would be worthless. In such an instance, the amount paid for such petroleum and natural gas lease or leases would be lost. It is our practice, in acquiring petroleum and natural gas leases, or undivided interests in petroleum and natural gas leases, not to undergo the expense of retaining lawyers to examine the title to the mineral interest to be placed under lease or already placed under lease. Rather, we will rely upon the judgment of petroleum and natural gas lease brokers or landmen who perform the fieldwork in examining records in the appropriate governmental office before attempting to acquire a lease in a specific mineral interest. Prior to the drilling of a petroleum and natural gas well, however, it is the normal practice in the petroleum and natural gas industry for the person or company acting as the operator of the well to obtain a preliminary title review of the spacing unit within which the proposed petroleum and natural gas well is to be drilled to ensure there are no obvious deficiencies in title to the well. Frequently, as a result of such examinations, certain curative work must be done to correct deficiencies in the marketability of the title, and such curative work entails expense. The work might include obtaining affidavits of heirship or causing an estate to be administered. The volatility of natural gas and oil prices could have a material adverse effect on our business. A sharp decline in the price of natural gas and oil prices would result in a commensurate reduction in our income from the production of oil and gas. In the event prices fall substantially, we may not be able to realize a profit from our production and would continue to operate at a loss. In recent decades, there have been periods of both worldwide overproduction and underproduction of hydrocarbons and periods of both increased and relaxed energy conservation efforts. Such conditions have resulted in periods of excess supply of, and reduced demand for, crude oil on a worldwide basis and for natural gas on a domestic basis. These periods have been followed by periods of short supply of, and increased demand for, crude oil and natural gas. The excess or short supply of crude oil has placed pressures on process and has resulted in dramatic price fluctuations even during relatively short periods of seasonal market demand. Among the factors that can cause the price volatility are: - Worldwide or regional demand for energy, which is affected by economic conditions; - The domestic and foreign supply of natural gas and oil; - Weather conditions; - Domestic and foreign governmental regulations; - Political conditions in natural gas or oil producing regions; - The ability of members of the Organization of Petroleum Exporting Countries to agree upon and maintain oil prices and production levels; and - The price and availability of alternative fuels. All of our production is currently located in, and all of our future production is anticipated to be located in, the Rocky Mountain Region of the United States. The gas prices that the Company and other operators in the Rocky Mountain region have received and are currently receiving are at a steep discount to gas prices in other parts of the country. Factors that can cause price volatility for crude oil and natural gas within this region are: - The availability of gathering systems with sufficient capacity to handle local production; - Seasonal fluctuations in local demand for production; - Local and national gas storage capacity; - Interstate pipeline capacity; and - The availability and cost of gas transportation facilities from the Rocky Mountain region. In addition, because of our size we do not own or lease firm capacity on any interstate pipelines. As a result, our transportation costs are particularly subject to short-term fluctuations in the availability of transportation facilities. Our management believes that the steep discount in the prices it receives may be due to pipeline constraints out of the region, but there is no assurance that increased capacity will improve the prices to levels seen in other parts of the country in the future. Even if we acquire additional pipeline capacity, conditions may not improve due to other factors listed above. It is impossible to predict natural gas and oil price movements with certainty. Lower natural gas and oil prices may not only decrease our revenues on a per unit basis but also may reduce the amount of natural gas and oil that we can produce economically. A substantial or extended decline in natural gas and oil prices may materially and adversely affect our future business, financial condition, results of operations, liquidity and ability to finance planned capital expenditures. Further, oil prices and natural gas prices do not necessarily move together. Our ability to market the oil and gas that we produce is essential to our business. Several factors beyond our control may adversely affect our ability to market the oil and gas that we discover. These factors include the proximity, capacity and availability of oil and gas pipelines and processing equipment, market fluctuations of prices, taxes, royalties, land tenure, allowable production and environmental protection. The extent of these factors cannot be accurately predicted, but any one or a combination of these factors may result in our inability to sell our oil and gas at prices that would result in an adequate return on our invested capital. For example, we currently distribute the gas that we produce through a single pipeline. If this pipeline were to become unavailable, we would incur additional costs to secure a substitute facility in order to deliver the gas that we produce. We rely upon the services of third party gathering companies to transport our natural gas to market. A disruption in this service could materially limit our ability to move our natural gas to market until alternative transportation can be arranged which may take an extended period of time. We are subject to environmental regulation that can adversely affect the timing and cost of our operations. Our exploration and proposed production activities are subject to certain federal, state and local laws and regulations relating to environmental quality and pollution control. These laws and regulations increase the costs of these activities and may prevent or delay the commencement or continuance of a given operation. Specifically, we are subject to legislation regarding emissions into the environment, water discharges, and storage and disposition of hazardous wastes. In addition, legislation has been enacted which requires well and facility sites to be abandoned and reclaimed to the satisfaction of state authorities. However, such laws and regulations have been frequently changed in the past, and we are unable to predict the ultimate cost of compliance as a result of future changes. It is anticipated that before full field development can occur we will be required to conduct Environmental Assessments and/or Environmental Impact Statements which may result in material delays and/or limitations to developing all or part of our leasehold interests. We are subject to complex governmental regulations which may adversely affect the cost of our business. Petroleum and natural gas exploration, development and production are subject to various types of regulation by local, state and federal agencies. We may be required to make large expenditures to comply with these regulatory requirements. Legislation affecting the petroleum and natural gas industry is under constant review for amendment and expansion. Also, numerous departments and agencies, both federal and state, are authorized by statute to issue and have issued rules and regulations binding on the petroleum and natural gas industry and its individual members, some of which carry substantial penalties for failure to comply. Any increases in the regulatory burden on the petroleum and natural gas industry created by new legislation would increase our cost of doing business and, consequently, adversely affect our profitability. A major risk inherent in drilling is the need to obtain drilling permits from local authorities. Delays in obtaining drilling permits, the failure to obtain a drilling permit for a well or a permit with unreasonable conditions or costs could have a materially adverse effect on our ability to effectively develop our properties. Our competitors may have greater resources which could enable them to pay a higher price for properties and to better withstand periods of low market prices for hydrocarbons. The petroleum and natural gas industry is intensely competitive, and we compete with other companies, which have greater resources. Many of these companies not only explore for and produce crude petroleum and natural gas but also carry on refining operations and market petroleum and other products on a regional, national or worldwide basis. Such companies may be able to pay more for productive petroleum and natural gas properties and exploratory prospects or define, evaluate, bid for and purchase a greater number of properties and prospects than our financial or human resources permit. In addition, such companies may have a greater ability to continue exploration activities during periods of low hydrocarbon market prices. Our ability to acquire additional properties and to discover reserves in the future will be dependent upon our ability to evaluate and select suitable properties and to consummate transactions in a highly competitive environment. We may have difficulty managing growth in our business. Because of our small size, growth in accordance with our business plans, if achieved, will place a significant strain on our financial, technical, operational and management resources. As we expand our activities and increase the number of projects we are evaluating or in which we participate, there will be additional demands on our financial, technical and management resources. The failure to continue to upgrade our technical, administrative, operating and financial control systems or the occurrence of unexpected expansion difficulties, including the recruitment and retention of experienced managers, geoscientists and engineers, could have a material adverse effect on our business, financial condition and results of operations and our ability to timely execute our business plan. Our success depends on our key management personnel, the loss of any of whom could disrupt our business. The success of our operations and activities is dependent to a significant extent on the efforts and abilities of our management. The loss of services of any of our key managers could have a material adverse effect on our business. We have not obtained "key man" insurance for any of our management. Mr. Erickson is the Chief Executive Officer and Mr. Decker is an executive vice president and Chief Operating Officer of Gasco. The loss of their services may adversely affect our business and prospects. Our officers and directors are engaged in other businesses which may result in conflicts of interest Certain of our officers and directors also serve as directors of other companies or have significant shareholdings in other companies. To the extent that such other companies participate in ventures in which we may participate, or compete for prospects or financial resources with us, these officers and directors will have a conflict of interest in negotiating and concluding terms relating to the extent of such participation. In the event that such a conflict of interest arises at a meeting of the board of directors, a director who has such a conflict must disclose the nature and extent of his interest to the board of directors and abstain from voting for or against the approval of such participation or such terms. In accordance with the laws of the State of Nevada, our directors are required to act honestly and in good faith with a view to the best interests of Gasco. In determining whether or not we will participate in a particular program and the interest therein to be acquired by it, the directors will primarily consider the degree of risk to which we may be exposed and its financial position at that time. It may be difficult to enforce judgments predicated on the federal securities laws on some of our board members who are not U.S. residents. Two of our directors reside outside the United States and maintain a substantial portion of their assets outside the United States. As a result it may be difficult or impossible to effect service of process within the United States upon such persons, to bring suit in the United States or to enforce, in the U.S. courts, any judgment obtained there against such persons predicated upon any civil liability provisions of the U.S. federal securities laws. Foreign courts may not entertain original actions against our directors or officers predicated solely upon U.S. federal securities laws. Furthermore, judgments predicated upon any civil liability provisions of the U.S. federal securities laws may not be directly enforceable in foreign countries. CAUTIONARY STATEMENT ABOUT FORWARD-LOOKING STATEMENTS Some of the information in this prospectus, contains forward-looking statements within the meanings of Section 27A of the Securities Exchange Act of 1934. These statements express, or are based on, our expectations about future events. These include such matters as: - financial position; - business strategy; - budgets; - amount, nature and timing of capital expenditures; - estimated reserves of natural gas and oil; - drilling of wells; - acquisition and development of oil and gas properties; - timing and amount of future production of natural gas and oil; - operating costs and other expenses; and - cash flow and anticipated liquidity. There are many factors that could cause these forward-looking statements to be incorrect including, but not limited to, the risks described under "Risk Factors" and "Management's Discussion and Analysis of Financial Condition and Results of Operations." These factors include, among others: - our ability to generate sufficient cash flow to operate; - the lack of liquidity of our common stock; - the risks associated with exploration; - natural gas and oil price volatility; - uncertainties in the projection of future rates of production and timing of development expenditures; - operating hazards attendant to the natural gas and oil business; - downhole drilling and completion risks that are generally not recoverable from third parties or insurance; - potential mechanical failure or under-performance of significant wells; - climatic conditions; - availability and cost of material and equipment; - delays in anticipated start-up dates; - actions or inactions of third-party operators of our properties; - our ability to find and retain skilled personnel; - availability of capital; - the strength and financial resources of our competitors; - regulatory developments; - environmental risks; and - general economic conditions. Any of the factors listed above and other factors contained in this prospectus could cause our actual results to differ materially from the results implied by these or any other forward-looking statements made by us or on our behalf. We cannot assure you that our future results will meet our expectations. You should pay particular attention to the risk factors and cautionary statements described under "Risk Factors" and "Management's Discussion and Analysis of Financial Condition and Results of Operations." When you consider these forward-looking statements, you should keep in mind these risk factors and the other cautionary statements in this prospectus. Our forward-looking statements speak only as of the date made.
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+RISK FACTORS An investment in the IDSs, our Class A common stock and the notes involves a high degree of risk. You should read and consider carefully each of the following factors, as well as the other information contained in this prospectus, before making a decision to invest in the IDSs, our Class A common stock and/or the notes. The risks described below are not the only risks facing us. Additional risks and uncertainties not currently known to us or those we currently deem to be immaterial may also materially and adversely affect our business operations. Any of the following risks could materially adversely affect our business, financial condition, liquidity or results of operations. In such case, you may lose all or part of your original investment. Risks Relating to the IDSs, Including the Class A Common Stock and Notes Represented by the IDSs, and the Separate Notes Our substantial indebtedness could adversely affect our financial health and restrict our ability to pay interest and principal on the notes and to pay dividends with respect to our Class A common stock, represented by the IDSs and adversely affect our financing options and liquidity position. We have now and, following the closing of this offering and the other Transactions, will continue to have a substantial amount of indebtedness. After giving effect to this offering, the other Transactions, and the redemption of our senior discount debentures, which we expect to complete on June 14, 2004, as of March 31, 2004 we would have had total long-term obligations of $ million and a deficiency of earnings to fixed charges for the three months ended March 31, 2004 of $ . Our substantial level of indebtedness could have important consequences for you as a holder of an IDS or the separate notes. For example, our substantial indebtedness could: make it more difficult for us to satisfy our obligations with respect to the notes and our other indebtedness and/or pay dividends on our Class A common stock and Class B common stock; limit our flexibility to plan, adjust or react to changing economic, market or industry conditions, reduce our ability to withstand competitive pressures, and increase our vulnerability to general adverse economic and industry conditions; place us at a competitive disadvantage to many of our competitors who are less leveraged than we are; limit our ability to issue new IDSs or other equity; limit our ability to borrow additional amounts for working capital, capital expenditures, future business opportunities, including strategic acquisitions and other general corporate requirements or hinder us from obtaining such financing on terms favorable to us or at all; require us to seek additional financing or sell certain of our assets if we cannot generate sufficient cash flow to meet our debt service obligations and fund our working capital requirements; require us to dedicate a substantial portion of our cash flow from operations to payments on our indebtedness, thereby reducing the availability of our cash flow to fund working capital, capital expenditures, future business opportunities and other general corporate purposes; and limit our ability to refinance our indebtedness. Despite our substantial indebtedness, we and our subsidiaries may be able to incur substantial additional indebtedness in the future that would make it more difficult for us to satisfy obligations on the notes and our other indebtedness and pay dividends on our Class A common stock and Class B common stock and further reduce the cash we have available to invest in our operations. If we do not Primary Standard Industrial Classification Code Number generate sufficient cash flow to meet our debt service obligations and to fund our working capital requirements, we may need to seek additional financing or sell certain of our assets. The terms of the indenture governing the notes, the terms of our new revolving credit facility and the terms of our other indebtedness, including the indentures governing the ACSH notes, allow us and our subsidiaries to incur additional indebtedness upon the satisfaction of certain conditions. See "Description of Notes" and "Description of Other Indebtedness." As of March 31, 2004, after giving effect to this offering, the other Transactions and the redemption of our senior discount debentures, which we expect to complete on June 14, 2004, we would have had $50 million available for additional borrowings under the new revolving credit facility. If new indebtedness is added to current levels of indebtedness, the related risks described above could intensify. We will require a significant amount of cash to service our indebtedness. Our ability to generate cash depends on many factors beyond our control. Our ability to make payments on and to refinance our indebtedness, including the notes and amounts borrowed under the new revolving credit facility, and to fund planned capital expenditures and any strategic acquisitions we may make, if any, will depend on our ability to generate cash in the future. Based on our current level of operations, we believe our cash flow from operations, together with available cash and available borrowings under the revolving credit facility, will be adequate to meet our future liquidity needs for at least the next twelve months. However, we cannot assure you that our business will generate sufficient cash flow from operations in the future, that our currently anticipated growth in revenues and cash flow will be realized on schedule or that future borrowings will be available to us in an amount sufficient to enable the repayment of our indebtedness, or to fund our other liquidity needs. We may need to refinance all or a portion of our indebtedness, including the notes, on or before maturity. We cannot assure you that we will be able to refinance any of our debt, including the ACSH notes, the new revolving credit facility and the notes, on commercially reasonable terms or at all. Your right to receive payments on the notes is junior to our existing senior indebtedness and possibly all of our future borrowings. Further, the guarantees of these notes are junior to all of the guarantors' existing senior indebtedness and possibly to all their future borrowings. These notes and the guarantees are unsecured and rank junior to all of our and the guarantors' existing senior indebtedness, including our borrowings and the related guarantees by guarantors under the ACSH senior notes and the new revolving credit facility, and all of our and the guarantors' future senior indebtedness. As of March 31, 2004, after giving effect to this offering, the other Transactions and the redemption of our senior discount debentures, which we expect to complete on June 14, 2004, the notes would have been subordinated to approximately $189.7 million of our senior debt, of which $182 million would have consisted of indebtedness under ACSH's 97/8% senior notes due 2011. In addition, approximately $50.0 million would have been available to us for borrowing as additional senior debt on a secured basis under the new revolving credit facility. We would also be permitted to borrow substantial additional indebtedness, including senior debt, in the future. As a result of such subordination, upon any distribution to our creditors or the creditors of the guarantors in a bankruptcy, liquidation, reorganization or similar proceeding relating to us, the guarantors, our property or the guarantors' property, the holders our of senior debt and the senior debt of the guarantors will be entitled to be paid in full before any payment may be made with respect to the notes or the guarantees. In addition, all payments on the notes and the guarantees will be blocked in the event of a payment default on certain designated senior debt, which will include debt under the new revolving credit facility, and may be blocked for up to 179 consecutive days in the event of certain non-payment defaults on such designated senior debt. In the event of a bankruptcy, liquidation or reorganization or similar proceeding relating to us or the guarantors, the indenture relating to the I.R.S. Employer Identification Number notes will require that amounts otherwise payable to holders of the notes in a bankruptcy or similar proceeding instead be paid to holders of senior debt until the holders of the senior debt are paid in full. As a result, holders of the notes may not receive all amounts owed to them and may receive ratably less than holders of trade payables and other unsubordinated indebtedness in any such proceeding. Our secured creditors will be entitled to be paid in full from the proceeds from the sale of our pledged assets before such proceeds will be available for payments on the IDSs and the separate notes. In addition to being contractually subordinated to all its existing and future senior debt, our obligations under the notes will be unsecured while our obligations under the new revolving credit facility will be secured by substantially all of our assets and those of our subsidiaries. We also have other secured indebtedness. As of March 31, 2004, after giving effect to this offering and the other Transactions, we would have had $7.7 million of secured indebtedness. As of March 31, 2004, on the same pro forma basis, we would have had $50.0 million available for borrowing on a secured basis under the new revolving credit facility. The new revolving credit facility and the indentures governing the ACSH notes permit, and the indenture governing the notes will also permit, us to incur additional secured indebtedness provided certain conditions are met. If we become insolvent or are liquidated, or if payment under the new revolving credit facility is accelerated, the lenders under the new revolving credit facility will be entitled to exercise the remedies available to a secured lender under applicable law. These lenders will have a claim on all assets securing the new revolving credit facility before those proceeds would be available for distribution to our other creditors, including holders of the notes represented by IDSs and holders of the separate notes, or our equity holders, including holders of the Class A common stock represented by IDSs. We may not have sufficient assets remaining to pay amounts due on any or all of the notes then outstanding, including the notes represented by IDSs and the separate notes, or to make payments to our equity holders, including holders of the Class A common stock represented by IDSs. Our debt instruments include restrictive and financial covenants that limit our operating flexibility. Our new revolving credit facility will require us to maintain certain financial ratios and the new revolving credit facility, the indenture governing the notes and the indentures governing the ACSH notes contain covenants that, among other things, restrict our ability to take specific actions, even if we believe such actions are in our best interest. These include restrictions on our ability to: issue certain preferred or redeemable capital stock or IDSs; incur debt; create liens; pay dividends or distributions on, redeem or repurchase our capital stock; make certain types of investments, loans, advances or other forms of payments; issue, sell or allow distributions on capital stock of specified subsidiaries; prepay or defease specified indebtedness, including the notes; enter into transactions with affiliates; or merge, consolidate or sell our assets. If we do not comply with the covenants in our debt agreements, our debt obligations may be accelerated. Our ability to comply with the ratios in the new revolving credit facility may be affected by events beyond our control, including prevailing economic, financial and industry conditions. Any failure to comply with the restrictions of the new revolving credit facility, the indenture governing the notes, the indentures governing the ACSH notes, or certain other current or future financing agreements may result in an event of default. Such default may allow our creditors to accelerate the related debt and may result in the acceleration of any other debt to which a cross-acceleration or cross-default provision applies. Under such circumstances terms of the new revolving credit facility may prohibit us from making payments on the notes or paying dividends on our Class A common stock. These creditors may also be able to terminate any commitments they had made to provide us with additional funds. See "Description of Notes" and "Description of Other Indebtedness," for more information on our restrictive and financial covenants. You may not receive the level of dividends provided for in the dividend policy our board of directors is expected to adopt upon the closing of this offering or any dividends at all. Our board of directors may, in its discretion, amend or repeal the dividend policy it is expected to adopt upon the closing of this offering which may result in the decrease or discontinuation of dividends. Future dividends with respect to shares of our capital stock, if any, will depend on, among other things, our results of operations, cash requirements, financial condition, contractual restrictions, business opportunities, provisions of applicable law and other factors that our board of directors may deem relevant. Additionally, Delaware law and the terms of the indentures governing the notes and the ACSH notes may limit or completely restrict our ability to pay dividends. See "Dividend Policy and Restrictions." Dividends on the Class A common stock and Class B common stock will rank equally, based on their respective dividend rates. As the annual dividend rate on the Class B common stock is expected to be equal to the total annual payments on the IDS, the dividend rate on the Class B common stock will be higher than the dividend rate on the Class A common stock. If there is a limited amount of surplus or net profits available to make dividend distributions, because of the different dividend rates, the pro rata portion of the amount available to make dividend distributions distributed to the Class B common stockholders will be greater than that distributed to the Class A common stockholders. We may not declare dividends on our Class A common stock unless at such time the corresponding proportionate dividend is declared on our Class B common stock. A reduction, or a perceived reduction, in the funds available for dividends resulting from nondeductability of the interest on the notes may negatively affect the market price of the IDSs and the Class A common stock. Funds available for dividend and interest payments would be reduced if the notes were treated as equity rather than debt for U.S. federal income tax purposes. In that event, the stated interest on the notes could be treated as a dividend, and interest on the notes would not be deductible by us for U.S. federal income tax purposes. Our inability to deduct interest on the notes could materially increase our taxable income and, thus, our U.S. federal and applicable state income tax liability thereby reducing the funds available to pay interest on the notes and for dividends. The reduction or elimination of dividends may negatively affect the market price of the IDSs or the Class A common stock represented thereby. We may amend the terms of our new revolving credit facility, or we may enter into new financing agreements that govern our senior indebtedness, and the amended or new agreements may significantly affect our ability to pay dividends on our Class A common stock and interest on the notes. As a result of general economic conditions, conditions in the lending markets, the results of our business or for any other reason, we may elect or be required to amend or refinance our new revolving credit facility, at or prior to maturity, or enter into additional agreements relating to senior indebtedness. Regardless of any protection you have in the indenture governing the notes, any such amendment, refinancing or additional agreement may contain covenants which could limit in a *The address, including zip code and telephone number, including area code, of the principal executive offices of these additional registrants is 600 Telephone Avenue, Anchorage, Alaska 99503, (907) 297-3000. significant way our ability to make interest payments on the notes and make dividend payments on our Class A common stock. The indenture governing the notes, our new revolving credit facility and the terms of our other indebtedness permit us to pay a significant portion of our available funds to stockholders in the form of dividends. Although the indenture governing the notes, the indentures governing the ACSH notes and our new revolving credit facility contain limitations on the payment of dividends on our Class A common stock and our Class B common stock, these agreements permit us to pay a significant portion of our available funds to our stockholders in the form of dividends. For example, in the indenture governing the notes, the covenant that restricts our ability to pay dividends and make other "restricted payments" will contain an initial basket in the amount of $ million, which would enable us to pay substantial dividends after the closing of this offering. Following the closing of this offering, we intend to pay a quarterly dividend on our Class A common stock and our Class B common stock, as described in this prospectus, see "Dividend Policy and Restrictions" and "Summary Pro Forma Interest and Dividend Distributions to IDS Holders." Any amounts paid by us in the form of dividends will not be available in the future to satisfy our obligations under the notes. The realizable value of our assets upon liquidation may be insufficient to satisfy claims. As of March 31, 2004, our assets included intangible assets in the amount of $78.6 million, representing approximately 11.8% of our total consolidated assets and consisting primarily of goodwill, wireless spectrum licenses and debt issuance costs. The value of these intangible assets depends significantly upon the success of our business as a going concern and our ability to manage the operations of businesses we acquire. If we are unable to manage our business successfully and integrate future acquisitions, the realizable value of these intangible assets may be substantially lower and may be insufficient to satisfy the claims of our creditors. The U.S. federal income tax consequences of the purchase, ownership and disposition of IDSs are unclear. No statutory, judicial or administrative authority directly addresses the treatment of the IDSs or instruments similar to the IDSs for U.S. federal income tax purposes. As a result, the U.S. federal income tax consequences of the purchase, ownership and disposition of IDSs are unclear. We will receive an opinion from our counsel, Skadden, Arps, Slate, Meagher & Flom LLP, that an IDS should be treated as a unit representing a share of Class A common stock and $ principal amount of notes and that the notes should be treated as debt for U.S. federal income tax purposes. However, the Internal Revenue Service or the courts may take the position that the notes included in the IDSs are equity, which could adversely affect the amount, timing and character of income, gain or loss in respect of your investment in IDSs, and materially increase our taxable income and, thus, our U.S. federal and applicable state income tax liability. This would reduce our after-tax cash flow and materially and adversely affect our ability to make interest and dividend payments on the notes, including the separate notes, and the Class A common stock. In addition, non-U.S. holders could be subject to withholding or estate taxes with regard to the notes included in the IDSs in the same manner as they will be with regard to the Class A common stock and it could subject us to liability for withholding taxes that were not collected on payments of interest. Payments to non-U.S. holders would not be grossed-up for any such taxes. For discussion of these tax-related risks, see "Material U.S. Federal Income Tax Considerations." Subsequent issuances of notes may cause you to recognize original issue discount and may reduce your recovery in the event of bankruptcy. The indenture governing the notes and the related agreements with the trustee for the notes will provide that, in the event there is a subsequent issuance by us of notes of the same series having terms SUBJECT TO COMPLETION, DATED JUNE , 2004. The information in this prospectus is not complete and may be changed. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell these securities and it is not soliciting an offer to buy these securities in any state where the offer or sale is not permitted. PROSPECTUS Income Deposit Securities (IDSs) and $ % Senior Subordinated Notes due 2019 Alaska Communications Systems Group, Inc. identical (except for the issuance date) to the notes, and such subsequently issued notes are treated as issued with original issue discount for U.S. federal income tax purposes or are issued subsequent to an automatic exchange of notes or if we otherwise determine that such notes need to have a new CUSIP number, each holder of notes or IDSs, as the case may be, agrees that a portion of such holder's notes will be automatically exchanged for a portion of the notes acquired by the holders of such subsequently issued notes. Consequently, immediately following each such subsequent issuance and exchange, each holder of notes or IDSs, will own an inseparable unit composed of a proportionate percentage of both the old notes and the newly issued notes equal to the aggregate stated principal amount of notes owned by the holder. Therefore, subsequent issuances of notes with original issue discount, including as part of IDSs issued in exchange for Class B common stock, may adversely affect your tax treatment by increasing the original issue discount, if any, that you were previously accruing with respect to your notes. Due to the lack of applicable authority, it is unclear whether the exchange of notes for subsequently issued notes will result in a taxable exchange for U.S. federal income tax purposes, and our counsel is unable to opine on this issue. It is possible that the Internal Revenue Service might successfully assert that such an exchange should be treated as a taxable exchange, resulting in the recognition of gain or loss. It is also possible that the Internal Revenue Service might successfully assert that any such loss should be disallowed under the "wash sale" rules. Regardless of whether a subsequent issuance results in a taxable exchange, such exchange may result in holders having to include original issue discount in taxable income prior to the receipt of cash and may have other potentially adverse U.S. federal income tax consequences. Following any subsequent issuance and exchange of notes, we (and our agents) and each holder of notes will report any original issue discount on the subsequently issued notes ratably among all holders of notes and IDSs. However, there can be no assurance that the Internal Revenue Service will not assert that any original issue discount should be reported only to the persons that initially acquired such subsequently issued notes (and their transferees). In this case, the Internal Revenue Service might further assert that all of the notes held by such holder have original issue discount. Any of these assertions by the Internal Revenue Service could create significant uncertainties in the pricing of IDSs and the notes and could adversely affect the market and trading rate for the IDSs and notes. Holders of subsequently issued notes having any amount of discount may not be able under New York and federal bankruptcy law to collect the portion of their principal amount that represents unaccrued discount in the event of an acceleration of the notes or our bankruptcy prior to the maturity date of the notes. As a result, an automatic exchange that results in a holder receiving a note with discount could have the effect of ultimately reducing the amount such holder can recover from us in the event of an acceleration or bankruptcy. The indenture governing the notes will contain no limit on the pricing of any additional notes or IDSs or the discount at which such notes may be sold upon issue. Accordingly, additional notes issued in the future may be issued at a very deep discount, which could cause the tax and bankruptcy risks described above to be very material to you as an investor in notes or IDSs in the event that we issue such additional notes or IDSs. For a discussion of these and additional tax related risks, see "Material U.S. Federal Income Tax Considerations." If we subsequently issue notes with significant original issue discount, we may not be able to deduct all of the interest on those notes. It is possible that notes we issue in a subsequent issuance will be issued at a discount to their face value and, accordingly, may have "significant original issue discount" and thus be classified as "applicable high yield discount obligations" for U.S. federal income tax purposes. If any such notes were so treated, a portion of the original issue discount on such notes may be nondeductible by us and the remainder would be deductible only when paid. This treatment would have the effect of increasing We are offering IDSs. The IDSs being offered by this prospectus represent shares of our Class A common stock and $ million aggregate principal amount of our % senior subordinated notes due 2019. Each IDS initially represents: one share of our Class A common stock, and $ principal amount of our % senior subordinated notes due 2019. We have granted the underwriters an option to purchase up to additional IDSs to cover overallotments. We are also separately offering $ million aggregate principal amount of our % senior subordinated notes due 2019, not as part of the IDSs. These separate notes and the notes included in the IDSs are identical in all respects and will be issued under the same indenture as part of a single series. This is the first offering of our IDSs and the separate notes. We currently expect the offering price of the IDSs will be between $ and $ per IDS and the offering price of the separate notes will be % of the stated principal amount of $ per separate note. We will apply to have the IDSs listed on the under the symbol " ." The Class A common stock will not be listed for separate trading until the minimum listing criteria on the are satisfied by our outstanding shares of Class A common stock not held in the form of IDSs for a period of 30 consecutive trading days. We do not anticipate that the notes will be separately listed on any exchange. The notes mature on , 2019 (assuming that they do not mature earlier under their terms). The notes will bear interest at the rate of % per year. The notes will be our unsecured senior subordinated obligations, guaranteed on an unsecured senior subordinated basis by each of our direct and indirect domestic subsidiaries (other than unrestricted subsidiaries). Investing in the IDSs, Class A common stock and notes, including the separate notes, involves risks. See "Risk Factors" beginning on page 22. The Class A common stock offered as part of the IDSs is different from our existing common stock, which is quoted on the Nasdaq National Market under the symbol "ALSK." The last reported sale price of our existing common stock on May 28, 2004 was $6.47. Our existing common stock will be reclassified concurrently with the closing of this offering, as further described in "The Transactions." Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense. our taxable income and may adversely affect our cash flow available for interest payments on the notes and distributions to holders of our IDSs and our Class A common stock. The allocation of the purchase price of the IDSs may not be respected. The purchase price of each IDS will be allocated between the Class A common stock and notes in proportion to their respective fair market values at the time of purchase. By purchasing the IDSs you will agree to and be bound by the allocations we make. If our allocation is not respected, it is possible that the notes will be treated as having been issued with original issue discount (if the allocation to the notes were determined to be too high) or amortizable bond premium (if the allocation to the notes were determined to be too low) for U.S. federal income tax purposes. You generally would have to include original issue discount in income in advance of the receipt of cash attributable to that income and would be able to elect to amortize bond premium over the term of the notes. Ownership change will limit our ability to use certain losses for U.S. federal income tax purposes and may increase our tax liability. The Transactions will result in an "ownership change" within the meaning of the U.S. federal income tax laws addressing net operating loss carryforwards, alternative minimum tax credits and other similar tax attributes. As a result of such ownership change, there will be specific limitations on our ability to use our net operating loss carryforwards and other tax attributes from periods prior to the Transactions. It is possible in the future that such limitations could limit our ability to utilize such tax attributes and, therefore, result in an increase in our U.S. federal income tax liability. Such an increase would reduce the funds available for the payment of dividends and might require us to reduce or eliminate the dividends on our IDSs and Class A common stock. You will be immediately diluted by $ per share of Class A common stock if you purchase IDSs in this offering. If you purchase IDSs in this offering, you will experience an immediate dilution of $ per share of Class A common stock represented by the IDSs, which exceeds the entire price allocated to each share of Class A common stock represented by the IDSs in this offering because there will be a net tangible book deficit for each share of Class A common stock outstanding immediately after this offering. Our net tangible book deficiency as of March 31, 2004, after giving effect to this offering and the Transactions, would have been approximately $ million, or $ per share of Class A common stock. Our capital structure after closing of this offering may limit our ability to market and issue equity-only securities. As a result of the restrictions in the indenture governing the notes and the restrictions in the other agreements governing our indebtedness, we may be prevented from issuing additional IDSs in the future. In particular, we may only issue additional IDSs if we satisfy certain financial tests under the new revolving credit facility and the indenture governing the notes. Therefore, we may be forced to rely on equity-only securities as an additional source of capital. However, as a result of this offering and the reclassification, most of our equity holders will hold their investment in us in the form of IDSs, and consequently equity-only securities may be a comparatively less attractive investment. Therefore, we cannot assure you that we will be able to issue equity-only securities on commercially reasonable terms, or at all. Per IDS(1) We may not have the ability to raise the funds necessary to fulfill our obligations under the notes following a change of control. This would place us in default under the indenture governing the notes. Upon the occurrence of certain specific kinds of change of control events, we will be required to offer to repurchase all of the outstanding notes. However, it is possible that we will not have sufficient funds at the time of the change of control to make the required repurchase or that restrictions in the new revolving credit facility will not allow such repurchases. Our ability to repurchase these notes upon certain specific kinds of change of control events may be limited by the terms of our senior indebtedness and the subordination provisions of the indenture governing the notes. For example, the new revolving credit facility will prohibit us from repurchasing these notes after certain specific kinds of change of control events until we first repay debt under the new revolving credit facility in full or obtain a waiver from the lenders under our new revolving credit facility. If we fail to repurchase these notes in that circumstance, we will be in default under the indenture related to the notes and under the new revolving credit facility. Any future debt that we incur may also contain restrictions on repayment which come into effect upon certain specific kinds of change of control events. If a change of control occurs, we cannot assure you that we will have sufficient funds to repay other debt obligations which we will be required to repay in addition to the notes. See "Description of Notes Change of Control" and "Description of Other Indebtedness." Federal and state statutes allow courts, under specific circumstances, to void the notes or the guarantees and require noteholders to return payments received from us or the guarantors. If unpaid creditors of us or any guarantor initiate a bankruptcy case or lawsuit, the debt represented by the notes or the guarantees may be reviewed under the federal bankruptcy law and comparable provisions of state fraudulent transfer laws. Under these laws, the notes or the guarantees could be voided, or claims in respect of the notes or the guarantees could be subordinated to our or the applicable guarantor's other debt. To the extent that the claims of the holders of these notes against us or any guarantor were subordinated in favor of other creditors of ours or such guarantor, such other creditors would be entitled to be paid in full before any payment could be made on these notes or the guarantees. If one or more of the guarantees is voided or subordinated, we cannot assure you that, after providing for all prior claims, there would be sufficient assets remaining to satisfy the claims of the holders of these notes. In addition, any payment by us or a guarantor pursuant to the notes or the guarantees, as the case may be, could be voided and required to be returned to us or such guarantor, or to a fund for the benefit of the creditors of us or such guarantor. If a guarantee were voided as a fraudulent conveyance or held unenforceable for any other reason, holders of these notes would be simply our creditors and creditors of our other subsidiaries that have validly guaranteed these notes. These notes then would be effectively subordinated to all obligations of the subsidiary whose guarantee was voided. For more information, see "Description of Notes Overview of the Notes and the Guarantees The Guarantees." Certain transactions related to the enforceability of the guarantees of the notes by certain of our subsidiaries may require the Federal Communications Commission, or FCC, or the Regulatory Commission of Alaska, or RCA, approval, which may not be granted or which may be subject to delays or conditions that could affect your ability to enforce the guarantees. The FCC and RCA may need to approve certain transactions related to the enforceability of the guarantees of the notes provided by certain of our subsidiaries, including the transfer of control of various radio licenses held by our operating subsidiaries or the transfer of control over or sale of the assets of our operating subsidiaries. Such approvals may not be obtained, in which case such guarantees may be unenforceable, or may be subject to delays or conditions that could affect your ability to enforce the guarantees. The total assets of these subsidiaries as of March 31, 2004 was $391.6 million. Total In the event of bankruptcy or insolvency, the notes and guarantees could be adversely affected by principles of equitable subordination or recharacterization. In the event of bankruptcy or insolvency affecting us or our subsidiaries, a party in interest may seek to subordinate the notes or the guarantees under principles of equitable subordination or to recharacterize the notes as equity. There can be no assurance as to the outcome of such proceedings. In the event a court subordinates the notes or the guarantees, or recharacterizes the notes as equity, we cannot assure you that you would recover any amounts owed on the notes or the guarantees and you may be required to return to us any payments we made to you within six years before the bankruptcy on account of the notes or the guarantees. In addition, should the court equitably subordinate the notes or the guarantees, or recharacterize the notes as equity, you may not be able to enforce the guarantees. Before this offering, there has not been a public market for our IDSs, the notes or shares of our Class A common stock and there has only been a limited market for our existing common stock. The IDSs have no public market history. In addition, as the IDS is a new security there has not been an active market in the United States for securities similar to the IDSs. Our existing common stock is currently publicly traded and listed on the Nasdaq National Market, however, as a result of the IDS offering our existing common stock will be delisted from Nasdaq. Furthermore, prior to this offering, there has been limited trading volume in our existing common stock, averaging 7,007 shares per day from January 1, 2004 to March 31, 2004 and, prior to this offering, only approximately 30% of our existing common stock was held by stockholders other than management and affiliates of Fox Paine. Therefore, we cannot predict whether an active public market will develop for our IDSs following this offering. We currently do not expect that an active trading market for our Class A common stock will develop after this offering or that an active trading market for the notes will develop. If a trading market for the IDSs or the Class A common stock represented thereby does develop, the market price will not be correlated to the market price of our current common stock. We do not expect to list our Class A common stock on any securities exchange until a sufficient number of our shares are no longer held in the form of IDSs to satisfy the minimum listing criteria of the , as described in "Description of Capital Stock Class A Common Stock Listing." We currently do not intend to list our notes on any securities exchange. The automatic separation of IDSs may negatively affect holders of IDSs. If the notes are redeemed or mature or certain payment defaults or bankruptcy events affecting us occur, the IDSs will automatically separate and you will then hold our Class A common stock and notes, separate from an IDS. Upon separation, an active trading market may not develop or be sustained for the Class A common stock or the notes. As a result, you may not be able to sell your Class A common stock or notes at a value derived from the market price of the IDS prior to separation. If, upon separation of the IDSs, a trading market for the IDSs or the Class A common stock does not develop, the trading value of the Class A common stock and the notes may not reflect the market price of the IDSs prior to the separation. See "Description of the IDSs Automatic Separation." The price of the IDSs may fluctuate substantially, which could negatively affect holders of IDSs. The initial public offering price of the IDSs and the offering price of the separate notes will be determined by negotiations among us and the representatives of the underwriters and may not be indicative of the market price of the IDSs or the separate notes after the offering. Factors such as quarterly variations in our financial results, announcements by us or others, developments affecting us, Per Separate Note our customers, general interest rate levels and general market volatility could cause the market price of the IDSs or the separate notes to fluctuate significantly. The limited liquidity of the trading market for the separate notes may affect the trading price of the separate notes. We are separately offering $ million principal amount of the notes that will not be represented by the IDSs, reflecting % of the total outstanding notes (assuming the underwriters do not exercise their overallotment option). While the separate notes are part of the same series of notes as, and identical to, the notes represented by the IDSs, the notes represented by the IDSs will not be separable from the IDSs for 45 days following the closing of this offering and will not be separately tradeable until separated and, as a result, the trading market for the separate notes initially will be very limited. There can be no assurance that, after holders of the IDSs are permitted to separate their IDSs, a sufficient number of holders of IDSs will separate their IDSs into Class A common stock and notes to create a liquid trading market for the notes. It is more likely for debt securities issued in larger aggregate principal amounts to trade more favorably than similar securities issued in smaller aggregate principal amounts because of the increased liquidity created by higher trading volumes resulting from larger issuances. Therefore, because approximately 90% of the notes will initially be represented by the IDSs, it is likely that the separate notes will not trade at prices reflecting the aggregate principal amount of the combined issuance of notes included in the IDS offering and the separate notes offering. There can be no assurance as to the liquidity of any market for the separate notes that may develop, the ability of the holders of the separate notes to sell any of their separate notes and the price at which the holders of separate notes would be able to sell any of their separate notes. If interest rates rise, the trading value of our IDSs may decline. We cannot predict the interest rate environment or guarantee that interest rates will not rise in the near future. Should interest rates rise or should the threat of rising interest rates develop, the trading value of the IDS may be adversely affected. As the IDSs are composed of both Class A common stock and notes, the trading price of the IDSs will be based, in part, on whether the interest rate on the notes is comparable to the then current interest rates on indebtedness of companies similar to us. To the extent prevailing interest rates for indebtedness with similar characteristics as the notes are higher than the interest rate on the notes, the trading price of the IDSs will be negatively affected. Future sales or the possibility of future sales of a substantial amount of IDSs, shares of our Class A common stock or notes, or sales or exchanges of our Class B common stock or Class C common stock, may depress the price of the IDSs and of our Class A common stock and the notes. Future sales or the availability for sale of substantial amounts of IDSs or shares of our Class A common stock or a significant principal amount of the notes in the public market could adversely affect the prevailing market price of the IDSs, our Class A common stock and the notes. We may issue shares of our Class A common stock and notes, which may be in the form of IDSs, or we may issue notes or Class B common stock or Class C common stock separately, or other securities from time to time as consideration for future acquisitions and investments. In addition, we may also grant registration rights covering those IDSs, shares of our Class A common stock, Class B common stock, Class C common stock, notes or other securities in connection with any such acquisitions and investments. See "Description of Capital Stock" for a summary of the material terms of our capital stock. If the underwriters exercise their overallotment option in full, there will be additional IDSs outstanding. In addition, 12 days after the completion of the reclassification, a substantial portion of the Class B common stock that we issue in the reclassification will be exchanged for IDSs. These additional outstanding IDSs and any additional IDSs or Class A Net cash provided by operating activities 50,249 64,827 75,263 Cash Flows from Investing Activities: Construction and capital expenditures, net of capitalized interest (48,404 ) (67,277 ) (87,582 ) Net proceeds from sale of business unit 155,269 Release of funds from escrow 3,539 3,706 Placement of funds in escrow (3,725 ) (6,932 ) Issuance of note receivable (15,000 ) Other investing activities Net cash provided (used) by operating activities $ 88,111 $ (11,474 ) $ (1,374 ) $ $ 75,263 Cash Flows from Investing Activities: Construction and capital expenditures (87,548 ) (34 ) (87,582 ) Placement of funds in escrow (6,932 ) (6,932 ) Other investing activities 31 Total common stock or any new Class B common stock or Class C common stock could further adversely affect prevailing market prices of the IDSs or the Class A common stock. Subject to certain limitations, on the second anniversary of the closing this offering all of our outstanding shares of our Class B common stock will be automatically exchanged into either IDSs or, if the IDSs have automatically separated or are otherwise not outstanding at such time, the applicable number of shares of Class A common stock and a note having a principal amount equal to each note which was represented by an IDS, which could adversely affect prevailing market prices and could impair our ability to raise capital through future sales of our securities. IDSs eligible for future sale may depress the trading price of the IDSs. We, all our executive officers and directors and Fox Paine and some of its affiliates have agreed that, for a period of 180 days from the date of this prospectus (other than in connection with the redemption or exchange of shares of Class B common stock described under "Description of Capital Stock Class B Common Stock Redemption; Exchange") we and they will not, without the prior written consent of each of the representatives of the underwriters, dispose of or hedge any IDSs, our Class A common stock, our Class B common stock or the notes, including the separate notes. The representatives of the underwriters, may release any of the securities subject to these lock-up agreements at any time without notice. We will at the time of this offering enter into a registration rights agreement with Fox Paine and some of their affiliates. The registration rights agreement provides, among other things, that Fox Paine may require us, subject to certain limitations, to register with the SEC all or a portion of their IDSs, Class A common stock, notes or Class B common stock that they hold. If Fox Paine exercises these or other similar rights under the registration rights agreement to sell substantial amounts of IDSs, Class A common stock, notes or Class B common stock in the public market, or if it is perceived that such exercise or sale could occur, the market price of our IDSs, Class A common stock, notes or Class B common stock, as the case may be, may fall. See "Certain Relationships and Related Party Transactions Registration Rights" for a summary of the terms of the registration rights agreement. Holders of our existing common stock will hold all of our Class B common stock after the offering and the interests of such holders may conflict with your interests as holders of our IDSs or Class A common stock. In connection with the reclassification, holders of our existing common stock will be receiving shares of Class B common stock. After giving effect to the Transactions, the Class B common stock will represent % of our total outstanding equity. Holders of our existing common stock, including Fox Paine, will beneficially own 100% of the outstanding shares of our Class B common stock and % of the outstanding shares of our voting capital stock ( % if the underwriters' overallotment option is exercised in full). Fox Paine will beneficially own % of the outstanding shares of Class B common stock and % of the outstanding shares of our voting capital stock ( % of our outstanding shares of Class B common stock and % of the outstanding shares of our voting capital stock if the underwriters' overallotment option is exercised in full). Shares of the Class A common stock represented by the IDSs and the Class B common stock issued in connection with the reclassification will vote as a class on all matters presented to the stockholders for a vote. However, the interest of the holders of the Class B common stock may be different than the interests of the holders of the Class A common stock and the holders of IDSs. As a result, the holders of our Class B common stock, including Fox Paine, will have the ability to exert significant influence over the outcome of matters requiring stockholder approval, including: the election of directors and the directors of our subsidiaries; the amendment of our charter or by-laws; and Public Offering Price $ $ % $ Underwriting Discount $ $ % $ Proceeds to Alaska Communications Systems Group, Inc. (before expenses) $ $ % $ the adoption or prevention of mergers, consolidations or the sale of all or substantially all of our assets or our subsidiaries' assets. Finally, Fox Paine may in the future make significant investments in other telecommunications companies. Some of these companies may compete with us. Fox Paine and its affiliates are not obligated to advise us of any investment or business opportunities of which they are aware, and they are not restricted or prohibited from competing with us. Our organizational documents could limit another party's ability to acquire us and deprive our investors of the opportunity to obtain a takeover premium for their securities. A number of provisions in our Amended and Restated Certificate of Incorporation and amended and restated by-laws will make it difficult for another company to acquire us and for you to receive any related takeover premium for your securities. For example, our organizational documents provide that stockholders generally may not act by written consent and require advance notice of stockholder proposals and nominations. In addition, our Amended and Restated Certificate of Incorporation provides that directors can be removed without cause only upon the affirmative vote of 80% of the then outstanding shares of our capital stock generally entitled to vote in the election of directors. Our organizational documents also authorize the issuance of common stock and preferred stock without stockholder approval and upon such terms as the board of directors may determine. The rights of the holders of shares of our common stock will be subject to, and may be adversely affected by, the rights of holders of shares of preferred stock that may be issued in the future. The settlement date for the offerings of the IDSs and the separate notes will extend beyond the standard settlement period. The IDSs and separate notes sold in this offering will be ready for delivery, subject to payment, on or about the closing date noted on the cover page of the prospectus, for the offering of the IDSs and the separate notes. The closing date for the offering of IDSs and the separate notes is expected to be the fifth business day following the date of pricing of this offering. Under SEC rules, trades in the secondary market are generally required to settle in three business days, unless the parties to any such trade expressly agree otherwise. Therefore, investors who purchase IDSs or separate notes in the offering who wish to immediately trade the IDSs or separate notes on the date of pricing or the next succeeding business day will be required to specify an alternate settlement cycle at the time of any such trade to ensure that when the subsequent resale of IDSs or separate notes is settled the investor has the IDSs or separate notes to deliver to the subsequent purchaser. The laws of some jurisdictions may restrict the ability of a holder of the IDSs to transfer beneficial ownership of IDSs. Ownership of the beneficial interests in the IDSs will be shown, and the transfer of that ownership will only be effected through, the facilities of The Depository Trust Company, or DTC. The laws of some jurisdictions may require that, in connection with transactions relating to the transfer of the IDSs, physical delivery of IDSs in definitive form be taken. These laws may impair the ability to transfer or pledge beneficial interests in the IDSs. As DTC can only act on behalf of its participant members which in turn act on behalf of owners of beneficial interests held through such participants, including financial institutions, the ability of a person having a beneficial interest in an IDS to pledge or transfer such interest to persons or entities that do not participate in the DTC system may be limited. (1)Comprised of $ allocated to each share of Class A common stock and $ allocated to each note, representing 100% of its stated principal amount. The underwriters expect to deliver the securities to purchasers on or about , 2004. Risks Related to Our Business Our business is subject to extensive governmental legislation and regulation. Applicable federal and state legislation and regulations and changes to them could adversely affect our business. We operate in a heavily regulated industry, and most of our revenues come from the provision of services regulated by the FCC and the RCA. Laws and regulations applicable to us and our competitors may be, and have been, challenged in the courts, and could be changed by legislation or regulatory orders at any time. We cannot predict the impact of future developments or changes to the regulatory environment or the impact such developments or changes would have on us. See "Regulation." There are a number of FCC and RCA rules under review that could have a significant impact on us. For example, many of the FCC's rules with regard to the provisioning of unbundled network elements, or UNEs, and other LEC interconnection rules were revised by the FCC in 2003 and are subject to further proceedings at the FCC and RCA. An appellate court recently vacated, remanded and upheld different portions of the FCC's order. This decision may be subject to further judicial review as well as regulatory proceedings. Rulings in this area could affect our obligation to provide UNEs and the prices we receive for the UNEs. Changes to intercarrier compensation that could affect our access revenues are also likely over the next few years. The FCC is also looking at universal service fund contribution and disbursement rules that are likely to affect the amount and timing of our contributions to and receipt of universal service funds; our obligations may increase and/or our revenue may decline, and our competitors may receive greater payments. Further, most FCC and RCA telecommunications decisions are subject to substantial delay and judicial review. These delays and related litigation create risk associated with uncertainty over the final direction of federal and state policies. As the ILEC in our service areas, we are subject to legislation and regulation that are not applicable to our competitors. Existing federal and state rules impose obligations and limitations on us, as the incumbent local telephone company, or ILEC, that are not imposed on our competitors. Federal obligations to share facilities, file and justify tariffs, maintain certain types of accounts, and file certain types of reports are all examples of disparate regulation. Similarly, state regulators impose limitations on bundling, require structural separations between affiliated entities, and impose accounting and reporting requirements and service obligations on us that do not exist for our competitors. In addition, state regulators have imposed greater tariffing standards and obligations on us than on our competitors, have required us to operate our business segments separately, and have prohibited our ILECs from promoting our long distance services more favorably than our competitors. The requirement to disclose proposed tariffs six to 12 months before they go into effect has enabled our competitors to plan competitive responses before we are able to implement new rates, diminishing our ability to compete in the marketplace. As our business becomes increasingly competitive, the continued regulatory disparity could impede our ability to compete in the marketplace, which could have a material adverse effect on our business. A reduction by the RCA or the FCC of the rates we charge our customers would reduce our revenues and earnings. The rates we charge our local telephone customers are based, in part, on a rate of return authorized by the RCA on capital invested in our LECs' networks. These authorized rates, as well as allowable investment and expenses, are subject to review and change by the RCA at any time. If the RCA orders us to reduce our rates, both our revenues and our earnings will be reduced. We presently have retail rate filings pending before or due to the RCA. There can be no assurance that new rates will be implemented at these times. Additionally, in this competitive market, we are not sure we would be able to implement higher rates even if approved by the RCA. Further, the rate increases, if any, may not be large enough to recover the revenue deficiencies. Citigroup CIBC World Markets JPMorgan State regulators may rebalance our planned rates or set new rates closer to costs, and refuse to keep sensitive business information confidential, continuing our competitive disadvantage in the marketplace. Our local exchange service competitors may also gain a competitive advantage as a result of the state regulators permitting our competitors to intervene in rate-setting proceedings. See "Regulation State Regulation." FCC regulations also affect rates that are charged to customers. The FCC regulates tariffs for interstate access and subscriber line charges, both of which are components of our network service revenue. The FCC currently is considering proposals to reduce interstate access charges for carriers like us. If the FCC lowers interstate access charges without adopting an adequate revenue replacement mechanism, we may be required to recover more revenue through subscriber line charges and universal service funds or forego this revenue altogether. This could reduce our revenue or impair our competitive position. The rates, terms and conditions for the leasing of facilities and resale of services in Anchorage are subject to regulatory review and may be adjusted in a manner adverse to us. The rates for the leasing of facilities in Anchorage by competitors, including General Communication, Inc., or GCI, has been at issue since January 2000. An RCA hearing was held in November 2003 and a decision is pending. There is risk that the rates will remain unresolved for a substantial period of time. There is also risk that the RCA may continue the practice of setting facility lease rates below what we believe to be compensatory levels. Conversely, if the RCA sets lease rates that are more favorable to us, there is a risk that doing so will encourage GCI to provide service over its own facilities, further reducing our revenues. There is also a risk that, aside from rates, the RCA could order us to enter into an agreement with unfavorable contract terms. Finally, there is the risk that the entire matter may be subject to judicial appeal, which would result in an extended period of uncertainty and additional cost associated with the proceedings. Loss of the exemption from certain forms of competition granted to our rural LECs under the Federal Telecommunications Act of 1996 exposes us to increased competition. Historically, our rural LECs (which do not include ACS of Anchorage, Inc. (or ACSA)) operated under a federal statutory exemption under which they were not required to offer UNEs and wholesale discounted resale services to competitors. On June 30, 1999, the APUC issued an order revoking these rural exemptions. In July 1999 we sought reconsideration of this order from the RCA, and on October 11, 1999, the RCA issued an order sustaining the APUC decision. In December 2003, the Alaska Supreme Court issued a decision reversing the RCA's order as to ACS of Northland, Inc. (or ACSN), and remanding the matter back to the RCA for further proceedings as to ACS of Fairbanks, Inc., or ACSF, and ACS of Alaska, Inc, or ACSAK. On April 18, 2004, ACSF and ACSAK entered into a settlement agreement with GCI in which ACSF and ACSAK waive their claim to the rural exemption with regards to GCI's requests to lease UNEs. Due to the loss of the regulatory exemptions, ACSF and ACSAK will continue to face local exchange service competition, which may reduce revenues and returns. Interconnection duties are governed by telecommunications rules and regulations related to the UNEs that must be provided. These rules and regulations remain subject to ongoing modifications. In addition, to the extent that rural exemptions are terminated, other carriers are entitled to obtain interconnection agreements with us on the basis of picking and choosing elements from the GCI agreements. Finally, to the extent the new rates are higher than the previous rates, that may encourage GCI or other competitors to provide service over their own facilities, further depriving us of revenue. ACSA, ACSF and ACSAK have responded to a formal complaint brought by GCI at the FCC involving order processing and provisioning performance metrics, and have proposed prospective and Banc of America Securities LLC RBC Capital Markets retrospective remedies. The parties have reached a settlement, and requests for approval of revised interconnection agreements are pending at the RCA. Our results of operations could be materially harmed if GCI develops its own network facilities and stops leasing capacity on our network elements. GCI has announced plans to deploy cable telephony by the end of 2004 and migrate its customers served using our UNEs off of our network and onto its own cable system. While we are unable to confirm GCI's plans, GCI has made similar claims in prior years without decreasing its reliance on our network. Nevertheless, we believe GCI has now migrated a small group of its customers onto its own network. Significant migration of customers could result in a significant reduction of revenue for us, as GCI would no longer be leasing our facilities to serve those customers, which could materially harm our results of operations. The telecommunications industry is extremely competitive, and we may have difficulty competing effectively. The telecommunications industry is extremely competitive and we face competition in local voice, local high-speed data, wireless, Internet and long distance services. Competition in the markets in which we operate could: reduce our customer base; require us to lower rates and other prices in order to compete; require us to invest in new facilities and capabilities; increase marketing expenditures and the use of discounting and promotional campaigns that would adversely affect our margins; or otherwise lead to reduced revenues, margins, and returns. New competitors in local services may be encouraged by FCC and RCA rules regarding interconnection agreements and universal service supports. We face competition from wireless service providers for local, long distance and wireless customers. Existing and emerging wireless technologies are increasingly competitive with local exchange services in some or all of our service areas. We and a competitor of ours are deploying a new generation of wireless technologies which will provide wireless data in addition to wireless voice services, and the FCC has ordered wireline-to-wireless and wireless-to-wireless number portability. As a consequence, we anticipate increased risk of wireless substitution for traditional local telephone services and increased competition among wireless carriers. In addition, new carriers offering voice over Internet Protocol, or VoIP, services may also lead to a reduction in traditional local and long distance telephone service customers and revenues as well as our network access revenues. Some of our competitors may have financial and technical resources greater than ours. See "Business Competition" for more information. Revenues from our retail local telephone access lines may be reduced or lost. As the ILEC, we face stiff competition mainly from resellers, local providers who lease UNEs from us, and, to a lesser degree, facilities-based providers of local telephone services. Seven years ago the two largest long distance carriers in Alaska began providing competitive local telephone services in Anchorage through UNE interconnection with our facilities and resale of our services. Interconnection agreements have since been executed with several other competitors. As a result, since 1996 when the industry was opened to competition through March 31, 2004, we have lost approximately 30% of our retail local telephone lines. In our largest market, Anchorage, which opened to competition in 1996, we have lost approximately 50% of our retail local telephone access lines. Similarly, in Fairbanks and Juneau, where competition began only a few years ago, we have lost more than 25% of our retail local telephone access lines. While we generally continue to enjoy revenues for these lines from our competitors, albeit at reduced rates compared to retail customers, our competitors may, in the future, bypass or remove these customers from our network completely, which would eliminate our revenue from those lines altogether. Additionally, although we plan to reacquire customers previously lost to competitors, there can be no assurance that we will be successful in this regard. Revenues from access charges may be reduced or lost. We received 26.5% of our 2003 pro forma operating revenues from access charges paid by interstate and intrastate interexchange carriers and subscriber line charges paid end users for the use of our network to connect the customer premises to the interexchange network. The amount of revenue that we receive from access charges and subscriber line charges is calculated in accordance with requirements set by the FCC and the RCA. Any change in these requirements may reduce our revenues and earnings. Generally, access charges have decreased since our inception in 1999. Under the regulatory rules that exist today, we receive access revenue related to the calls made by all of our retail customers as well as our competitors' customers who are served via wholesale resale service. Access revenue related to our competitors' retail customers that are served by UNEs or by the competitors' own facilities flows to our competitors. To the extent that competitors shift the form in which they provide service away from wholesale resale to UNEs or their own facilities, our access revenue will be reduced. The FCC is reviewing mechanisms for intercarrier compensation, and some parties have suggested terminating all interstate access charge payments by interexchange carriers. If such a proposal is adopted, it could have a material impact on our revenue and earnings. In any event, the FCC has stated its intent to adopt some form of access charge reform soon, which more likely than not will reduce this source of revenue. Similarly, the RCA has issued draft regulations phasing out intra-state access charges over five years. Adoption of this intrastate access charge proposal may reduce our revenue. In addition, both GCI and AT&T alleged that we collected excess interstate access revenue during the years 1997 through 2000. While those claims have been resolved, we cannot assure you that claims alleging excess charges in subsequent years will not be made, nor that we will be able to defeat all such claims. A reduction in the universal service support currently received by some of our subsidiaries would reduce our revenues and earnings. We received 4.9% of our 2003 pro forma operating revenues from the Universal Service Fund, or USF, which was established under the direction of the FCC to compensate carriers for the high cost of providing universal telecommunications services in rural, insular, and high-cost areas. If the support received from the USF is materially reduced or discontinued, some of our rural LECs might not be able to operate profitably. Also, because we provide interstate and international services, we are required to contribute to the USF a percentage of our revenue earned from such services. Although our rural LECs receive support from the USF, we cannot be certain of how, in the future, our contributions to the USF will compare to the support we receive from the USF. Various reform proceedings are under way at the FCC to change the method of calculating the amount of contributions paid into the USF by all carriers and the amount of contributions or support rural carriers like ACSF, ACSAK and ACSN receive from the USF, as well as the amount of support received by our competitors. Already the FCC has imposed caps or limits on the amount of USF distributed and has explored opportunities to obtain contributions from providers of services not currently contributing to USF. We cannot predict at this time whether or when any change in the method of calculating contributions and support may affect our business. You should rely only on the information contained in this prospectus. We have not authorized anyone to provide you with different information. We are not making an offer of these securities in any state where the offer is not permitted. You should not assume that the information contained in this prospectus is accurate as of any date other than the date on the front of this prospectus. The RCA has granted Eligible Telecommunications Carrier, or ETC, status to GCI in Fairbanks and Juneau. Under current FCC rules, this entitles GCI to the same amount of per-line USF support that we are entitled to receive regardless of GCI's costs, and may reduce the amount of USF payments we receive. To the extent that any competitive ETC, such as GCI, has lower costs than us, but receives the same amount of financial support, the competitor gains a competitive cost advantage over us. We cannot say when or how these rules may change. There has been a trend toward granting ETC status to wireless carriers. Alaska DigiTel LLC, or DigiTel, ACS Wireless, Inc., or ACSW, Dobson, and MTA Wireless have petitioned for ETC status. Further, Dobson has asked the RCA to redefine our rural service areas to permit Dobson to receive support on a wire-center basis, but without having to serve the entire area that we are currently required to serve. Redefining ACS's rural service areas requires the approval of both the RCA and the FCC. Creating additional service areas may impose a costly regulatory burden on us for which we may not be compensated. On August 28, 2003, the RCA granted DigiTel's request for ETC status. The ACSW, Dobson and Matanuska-Kenai, Inc. d/b/a MTA Wireless petitions are still pending. We cannot predict whether these pending petitions will be granted or when a decision will be rendered. Granting another carrier's petition would provide it with a competitive cost advantage. The granting of Dobson's request to redefine service areas could materially reduce our revenues from USF, in addition to increasing competition. Revenues from wireless services may be reduced. Market prices for wireless voice and data services have declined over the last several years and may continue to decline in the future due to increased competition. We cannot assure you that we will be able to maintain or improve our average revenue per user, or ARPU. We expect significant competition among wireless providers, which has been intensified by wireless number portability scheduled for May 2004, to continue to drive service and equipment prices lower, which may lead to increased turnover of customers. If market prices continue to decline it could adversely affect our ability to grow revenue, which would have an adverse effect on our financial condition and results of operation. We may not be able to offer long distance and Internet services on a profitable basis. Our long distance operations have historically been modest in relation to the long distance businesses of our competitors and have generated operating losses of $2.0 million in 2001, $1.6 million in 2002 and $21.2 million in 2003. Our Internet operations generated operating losses of $9.6 million in 2001, $21.6 million in 2002, and $60.5 million in 2003. We have, over the last several years, failed to achieve various plans to increase sales and revenue for these businesses. There is, therefore, no assurance that our operating losses from long distance and Internet services will not increase in the future, even after taking account of any additional revenue from complementary or advanced services. If we substantially underestimate or overestimate the demand for our long distance services, our cost of providing these services could increase. We expect to continue to enter into resale agreements for a portion of our long distance services. In connection with these agreements, we must estimate future demand for our long distance service. If we overestimate this demand, we may be forced to pay for services we do not need, and if we underestimate this demand, we may need to lease additional capacity on a short-term basis at unfavorable prices, assuming additional capacity is available. If additional capacity is not available, we will not be able to meet this demand. TABLE OF CONTENTS Page Our investment in an advanced network may prove unprofitable if the network becomes subject to regulation or if we cannot increase the customer base using the network. We have recently invested approximately $20 million in an advanced Multi Protocol Label Switching (MPLS) network. The service we provide over this network currently is not subject to regulation as a telecommunications service. If the FCC or the RCA subject this type of service to increased regulation, it could materially increase our costs and/or reduce our revenues. To date, we have not added sufficient customers for the services this network allows us to offer to generate enough revenues to operate it profitably and as a result, recorded an impairment charge reducing the carrying value of these assets in the third quarter of 2003. If we are unable to increase our customer base in this network, we may not recover our investment in the network. We may not be able to profitably take advantage of future fiber-optic capacity that we may purchase. In anticipation of our obligations under the Telecommunications Services Partnering Agreement, or TPA, we entered with the State of Alaska, we entered an agreement that enables us to purchase additional fiber-optic capacity in future years from Neptune Communications, L.L.C., or Neptune, the expenditures for which are expected to be significant and may exceed $25 million over the next four years. The subsequent termination of our contract with the State of Alaska has reduced our utilization of the additional fiber-optic capacity purchased from Neptune and may reduce the profitability of the agreement with Neptune. As part of the agreement, we made a $15 million loan to Neptune Communications. In connection with this loan, Neptune has granted us an option to purchase certain of its network assets no later than January 2, 2006 at a price equal to the then-outstanding loan balance. Certain material terms of the agreement with Neptune remain subject to continued negotiation, including with respect to the structure and terms of the loans, and it is impossible to determine the ultimate outcome of these negotiations at this time. We cannot assure you that we will successfully resolve any open issues nor can we assure you of the consequences of our inability to resolve any open issues. In addition, even if we are able to resolve the issues, we cannot assure you that we will generate sufficient revenue from these future acquisitions of fiber-optic capacity to provide satisfactory returns on our investment. If we do not adapt to technological changes in the telecommunications industry, we could lose customers or market share. Our success may depend on our ability to adapt to rapid technological changes in the telecommunications industry. Our failure to adopt a new technology, or our choice of one technological innovation over another, may have an adverse impact on our ability to compete or meet the demands of our customers. Technological change could, among other things, reduce the capital required by a competitor to provide local service in our service areas. As we cannot predict with precision the pace of technology change, our ability to deploy new technologies may be constrained by insufficient capital and/or the need to generate sufficient cash to make quarterly distributions on our IDSs or interest payments on the separate notes or our other indebtedness. New products and services may arise out of technological developments and our inability to keep pace with these developments may reduce the attractiveness of our services. If we fail to adapt successfully to technological changes or fail to obtain access to important new technologies, we could lose customers and be limited in our ability to attract new customers and/or sell new services to our existing customers. The successful delivery of new products and services is uncertain and dependent on many factors, and we may not generate anticipated revenues from such services. New governmental regulations may impose obligations on us to upgrade our existing technology or adopt new technology that may require additional capital and we may not be able to comply with these new regulations on a timely basis. We cannot predict the extent to which the government will impose new unfunded mandates such as those related to emergency location, law enforcement assistance and local number portability. Each of these government obligations has imposed new requirements for capital that could not have been predicted with any precision. Along with these obligations the FCC has imposed deadlines for compliance with these mandates. We may not be able to provide services that comply with these mandates in time to meet the imposed deadlines or our petitions for extensions of the deadlines may be denied. We cannot predict whether other mandates, from the FCC or other regulatory authorities, will occur in the future or the demands they will place on capital expenditures. Our network capacity and customer service system may not be adequate and may not expand quickly enough to support our anticipated customer growth. Our financial and operational success depends on ensuring that we have adequate network capacity, sufficient infrastructure equipment and a sufficient customer support system to accommodate anticipated new customers and the related increase in usage of our network. Our failure to expand and upgrade our networks, including through obtaining and constructing additional cell sites, obtaining wireless telephones of the appropriate model and type to meet the demands and preferences of our customers and obtaining additional spectrum, if required, to meet the increased usage could have a material adverse effect on our business. Our failure to complete the build-out of our new wireless network, or a delay in the build-out and launch could have an adverse effect on our wireless operations and we may not be able to recover the costs of deploying the new wireless network. ACS Wireless, Inc. is currently commencing the deployment of a new packet-switched digital network. Substantial costs are involved in the hardware and software necessary to implement this network. Customers may not immediately receive the full benefits of this network's enhanced capabilities, as we expect network deployment to occur in stages over time. If we are not able to successfully deploy the technology, we may lose customers to other carriers. In addition, there is no assurance that this network will work as we expect. The size of the Alaska customer base being served by this new network is also small, and we cannot assure you that we will fully recover all costs related to this network within a reasonable period of time, or at all. There is also no assurance that even if the new network is fully built out and performs as expected that it will be or will become the technology preferred by a substantial number of people. We will have to implement a new billing and customer service system in connection with the launch of our new wireless network, which may result in disruptions in our billing systems and other business processes which could have an adverse affect on our business. Additionally, new billing and customer service arrangements are being implemented by us to service customers on the new wireless network. The process of migrating existing customers from the existing wireless network to the new network involves risks related to the business process changes. During the process of switching billing systems, it is possible that we may experience a disruption in our billing cycle and that customers may be dropped from our database. Any prolonged disruption of our billing function or loss of customers from our database could have an adverse effect on our business, financial condition and results of operations. The changes to our businesses processes have not been proven to work consistently and efficiently, and the failure of these processes could delay or disrupt the deployment of the new network and have an adverse affect on our business and customer satisfaction. Indenture EBITDA $ 63,549 $ 116,710 $ 128,535 $ 119,782 $ 112,522 $ 30,097 $ 26,038 $ $ Adjustments to Indenture EBITDA: Directories Business operations(ii) (9,200 ) (15,822 ) (19,186 ) (19,434 ) (7,153 ) (4,829 ) State of Alaska contract operations(i) 5,783 5,726 529 Fox Paine management fees and expenses(iii) 542 975 1,106 1,117 1,019 257 220 Cash charges included in loss from discontinued operations 141 407 1,015 649 41 Wireless number portability may increase the competitiveness of the wireless industry and increase customer turnover. The wireless industry is extremely competitive and characterized by a high rate of customer turnover. Customer turnover results from different factors, including pricing, service offerings, network coverage and customer service. Efforts to reduce customer turnover and retain customers through various incentives may involve increased costs and reduced pricing. Local number portability allows a customer to retain his or her telephone number when changing telecommunications carriers within the same local market. The FCC requires local number portability for CMRS carriers under rules that distinguish between carriers operating in the largest 100 metropolitan statistical areas and those operating outside the top 100 markets. None of the cities in which we provide wireless service is among the top 100 markets. Under the FCC's rules, ACSW must be capable of allowing number portability by May 24, 2004 or within 6 months of a bona fide request, whichever is later. ACSW has already been successfully porting numbers on a daily basis. The FCC, however, is still clarifying its rules regarding wireline to wireless number portability. While most of our wireline customers have full portability, we may not be able to comply with the porting requirements in some of our small wireline exchanges. Our failure to comply with the local number portability requirements could result in fines, other penalties or enforcement actions against us. The successful operation and growth of our businesses are dependent on economic conditions in Alaska. Substantially all of our customers and operations are located in Alaska. Due to our geographical concentration, the successful operation and growth of our businesses is dependent on economic conditions in Alaska. The Alaskan economy, in turn, is dependent upon many factors, including: the strength of the natural resources industries, particularly oil production; the strength of the Alaskan tourism industry; the level of government and military spending; and the continued growth in services industries. The customer base for telecommunications services in Alaska is small and geographically concentrated. According to the U.S. Census Bureau estimates, the population of Alaska is approximately 649,000, over 60% of whom live in Anchorage, Fairbanks and Juneau. There can be no assurance that Alaska's economy will grow or even be stable. We have a new senior management team with no prior experience in the Alaskan telecommunications market. In connection with our disposition of a controlling interest in our Directories Business in May 2003, our then-president and chief operating officer, Wesley E. Carson, departed to run that business. On October 6, 2003, Charles E. Robinson retired as our chief executive officer. Liane Pelletier joined us, effective October 6, 2003, as our president and chief executive officer in a position that consolidates the day-to-day responsibilities of Mr. Robinson and Mr. Carson. We cannot assure you that the transition in leadership will be seamless and without disruption to our businesses. Although Ms. Pelletier has extensive telecommunications experience, she has limited history running our company. In addition, Mr. David C. Eisenberg joined us as Senior Vice President, Corporate Strategy and Development on November 3, 2003; Mr. Sheldon Fisher joined us as Senior Vice President, Sales and Product Marketing on February 23, 2004, and Mr. David Wilson joined us as Chief Financial Officer on March 1, 2004. Each of Ms. Pelletier, Mr. Wilson, Mr. Eisenberg and Mr. Fisher have experience in the telecommunications industry, but none have experience in the Alaskan telecommunications market and it may be a substantial amount of time before they are familiar with the Alaskan market. The lack of Alaskan telecommunications market experience may place us at a competitive disadvantage. We depend on key members of our senior management team. Our success depends largely on the skills, experience and performance of key members of our senior management team, as well as our ability to attract and retain other highly qualified management and technical personnel. There is intense competition for qualified personnel in our industry, and we cannot assure you that we will be able to attract and retain the personnel necessary for the development of our business. If we lose one or more of our key employees, or the transition in leadership is not successful, our ability to successfully implement our business plan could be materially adversely affected. We do not maintain any "key person" insurance on any of our personnel. We rely on a limited number of key suppliers and vendors for timely supply of equipment and services relating to our network infrastructure. If these suppliers or vendors experience problems or favor our competitors, we could fail to obtain sufficient quantities of the products and services we require to operate our business successfully. We depend on a limited number of suppliers and vendors for equipment and services relating to our network infrastructure. If these suppliers experience interruptions or other problems delivering these network components on a timely basis, subscriber growth and our operating results could suffer significantly. Our initial choice of a network infrastructure supplier can, where proprietary technology of the supplier is an integral component of the network, cause us to be effectively locked into one of a few suppliers for key network components. As a result we have become reliant upon a limited number of network equipment manufacturers, including Nortel Networks Corporation. In the event it becomes necessary to seek alternative suppliers and vendors, we may be unable to obtain satisfactory replacement suppliers or vendors on economically attractive terms, on a timely basis, or at all, which could increase costs and may cause disruption in service. Wireless devices may pose health and safety risk, and driving while using a wireless phone may be prohibited; as a result, we may be subject to new regulations, and demand for our services may decrease. Media reports have suggested that, and studies have been undertaken to determine whether, certain radio frequency emissions from wireless handsets and cell sites may be linked to various health concerns, including cancer, and may interfere with various electronic medical devices, including hearing aids and pacemakers. In addition, lawsuits have been filed against other participants in the wireless industry alleging various adverse health consequences as a result of wireless phone usage. If consumers' health concerns over radio frequency emission increase, they may be discouraged from using wireless handsets, regulators may impose or increase restrictions on the location and operation of cell sites or increase regulation on handsets and wireless providers may be exposed to litigation, which, even if not successful, can be costly to defend. The actual or perceived risk of radio frequency emissions could also adversely affect us through a reduced subscriber growth rate, a reduction in our subscribers, reduced network usage per subscriber or reduced financing available to the wireless communications industry. In addition, the use of a wireless device while driving may also adversely affect our results of operations. Studies have indicated that using wireless devices while driving may impair a driver's attention. The U.S. Congress has proposed legislation that would seek to withhold a portion of federal funds from any state that does not enact legislation prohibiting an individual from using a wireless telephone while driving motor vehicles. In addition, many state and local legislative bodies have passed and proposed legislation to restrict the use of wireless telephones while driving motor vehicles. Concerns over safety risks and the effect of future legislation, if adopted and enforced in the areas we serve, could limit our ability to market and sell our wireless services and may discourage use of our wireless devices and decrease our revenue from customers who now use their wireless telephones while driving. Further, litigation relating to accidents, deaths or serious bodily injuries allegedly injured as a result of wireless telephone use while driving could result in damage awards against telecommunications providers, adverse publicity and further governmental regulation. Any or all of these results, if they occur, could have a material adverse effect on our results of operations and financial condition. We are subject to environmental regulation and environmental compliance expenditures and liabilities. Our business is subject to many environmental laws and regulations, particularly with respect to owned or leased real property relating to our network equipment and underlying our tower sites. Compliance with these laws and regulations is a factor in our business. Some or all of the environmental laws and regulations to which we are subject could become more stringent or more stringently enforced in the future. Our failure to comply with applicable environmental laws and regulations and permit requirements could result in civil or criminal fines or penalties or enforcement actions, including regulatory or judicial orders enjoining or curtailing operations or requiring corrective measures, installation of pollution control equipment or remedial actions. In addition to operational standards, environmental laws also impose obligations to clean up contaminated properties or to pay for the cost of such remediation. We could become liable, either contractually or by operation of law, for such remediation costs even if the contaminated property is not presently owned or operated by us, or if the contamination was caused by third parties during or prior to our ownership or operation of the property. Moreover, future events, such as changes in existing laws or policies or their enforcement, or the discovery of currently unknown contamination, may give rise to material remediation costs. A system failure could cause delays or interruptions of service, which could cause us to lose customers. To be successful, we will need to continue to provide our customers reliable service over our network. Some of the risks to our network and infrastructure include: physical damage to access lines; power surges or outages; software defects; and disruptions beyond our control. We rely heavily on our networks, network equipment, data and software and the networks of other telecommunications providers to support all of our functions and for substantially all of our revenues. We are able to deliver services only to the extent that we can protect our network systems against damage from power or telecommunication failures, computer viruses, natural disasters, unauthorized access and other disruptions. While we endeavor to provide for failures in the network by providing back-up systems and procedures, we cannot guarantee that these back-up systems and procedures will operate satisfactorily in an emergency. Should we experience a prolonged system failure or a significant service interruption, our ongoing customers may choose a different provider and our reputation may be damaged. We cannot assure you that we will be able to successfully integrate any acquisitions we may make in the future. We continually explore acquisitions. However, any future acquisitions we make may involve some or all of the following risks: diversion of management attention from operating matters; financial flexibility. This recapitalization and refinancing will consist of the following transactions which will be completed concurrently: This Offering. This offering includes the offering of both the IDSs and the separate notes. Reclassification of Our Common Stock. We will reclassify each outstanding share of our existing common stock into the right to receive $ in cash and shares of our Class B common stock. We refer to this as the reclassification. New Revolving Credit Facility. ACSH will enter into a new $50.0 million revolving credit facility. Repayment of the Existing Credit Facility. We will terminate and repay all outstanding borrowings under our existing credit facility. Interest Rate Swap Arrangements. We will enter into certain interest rate swap arrangements relating to ACSH's outstanding notes. For more information, see "The Transactions". The closing of this offering, the reclassification, the entering into of the new revolving credit facility and the entering into the interest rate swap arrangements are each conditioned on the completion of the others. The completion of the reclassification and the closing of this offering will occur on the same day. A portion of the shares of Class B common stock issued in the reclassification to the holders of our existing common stock is subject to pro rata redemption with the net proceeds received by us from any sale of IDSs in connection with the exercise of the underwriters' overallotment option. On the 12th day after the completion of the reclassification and pro rata redemption, any remaining outstanding shares of Class B common stock in excess of 10% of the overall value of our equity capitalization will be exchanged for IDSs. We refer to this offering, the reclassification, including the subsequent redemption and exchange of Class B common stock in the 12 days after completion of the reclassification, entering into of the new revolving credit facility, the repayment of the existing credit facility and the entering into of the interest rate swap arrangements, collectively, as the Transactions. unanticipated liabilities or contingencies of acquired businesses; failure to achieve projected cost savings or cash flow from acquired businesses; inability to retain key personnel of the acquired business or maintain relationships with its customers; inability to successfully integrate acquired businesses with our existing businesses, including information-technology systems, personnel, products and financial, computer, payroll and other systems of the acquired businesses; difficulties in enhancing our customer support resources to adequately service our existing customers and the customers of the acquired businesses; and difficulty in maintaining uniform standards, controls, procedures, and policies. In addition, our ability to make acquisitions may be constrained by our inability to use equity as an acquisition currency and by our need to ensure cash for quarterly distributions on our IDSs. Acquisition targets that fail to generate a positive cash flow are probably excluded from consideration under our proposed capital structure. As to targets that do generate positive cash flows, we may not have sufficient available cash or access to sufficient capital resources necessary to complete a transaction for such targets. Estimated Timeline of the Offering and Reclassification
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+RISK FACTORS Investing in our common stock involves risks. Before you invest in our common stock, you should carefully consider the following risks as well as the other information included in this prospectus. These risks set out below are not the only risks we face. If any of the following risks occur, our business, financial condition and results of operations could be materially and adversely affected. In that case, the value of our common stock could decline and you may lose all or part of your investment. RISKS RELATING TO OUR BUSINESS GENERALLY Our business focuses on the investment in and acquisition of small businesses, which typically have a high rate of failure, may take some time to become profitable and may never become profitable. We place primary emphasis on the investment in and acquisition of small businesses with the objective of developing a network of profitable businesses, most of which will principally serve the small and medium-sized business market. Early stage businesses historically have a higher rate of failure than larger businesses, and many that do not fail will have only limited profitability. Moreover, profit generated by any of our majority-owned companies or other investments could be offset by losses generated by others. Our profitability resulting from the operations of our businesses may be delayed for the foreseeable future. For example, our consolidated subsidiaries experienced aggregate net losses of approximately $2,700,000 for the year ended December 31, 2003, aggregate net losses of approximately $3,591,000 for the year ended December 31, 2002, and aggregate net losses of approximately $215,000 for the first quarter ended March 31, 2004. We recorded no net losses from equity method investees in 2003 and approximately $729,000 in 2002. In addition, during 2003 we wrote off approximately $1,996,000 of investments in small businesses, compared to approximately $1,602,000 in 2002, representing management s best estimate as to the amount of the other than temporary decline in the value of the investments. During the first quarter of 2004 we had $0 in write offs. We have generated and carry goodwill as an asset resulting from some of our acquisition transactions and expect to do so as well in the CrystalTech transaction. In 2003, we determined to write down the value of our goodwill by approximately $1,435,000. We can make no assurance that our current or future additional goodwill will not be written down pursuant to applicable accounting standards. A significant write down of a major asset, such as goodwill, could have a material adverse effect on our business, a negative impact on earnings and the value of our common stock. Each of our major investments and affiliated companies may be impacted by a variety of adverse economic, governmental, industrial and internal company factors unique to that business and outside our control. If our investments and affiliated companies do not succeed in overcoming these adverse factors, the value of our assets and the price of our stock would fall. In the past few years we have increasingly concentrated our investments in companies participating in small business lending and electronic payment processing, and we plan to make significant investments in a new insurance agency, the Newtek Insurance Agency, and CrystalTech, following its acquisition by us, in the near future. Each of these businesses has numerous risks associated with them and you should read the specific risk factors set forth below with respect to each of these businesses. As we have concentrated our investments, typically made through the capco programs, in companies which are part of our nationwide marketing strategy of providing a variety of services to small and medium-sized businesses, our exposure and that of our affiliated companies to risks specific to these business lines has increased. We discuss below some of the risks of our significant operations in government-guaranteed small business lending and acting as an independent sales organization in the electronic card processing business. If we are not successful in implementing this business strategy and developing and marketing our new products and services, our results of operations will be negatively impacted. Approximate date of commencement of proposed sale of securities to the public: As soon as practicable after the effective date of this Registration Statement. If any of the securities being registered on this Form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act, check the following box. If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. If the delivery of the prospectus is expected to be made pursuant to Rule 434, please check the following box. Table of Contents We rely on our capcos to fund our investments and our capcos are limited by regulations in the types of investments they can make. Our ability to invest in or acquire companies has in the past and is expected to be in the future significantly reliant on investments permissible under the capco programs in which we participate. In the programs under which the capcos operate, investments by a capco may only be made in the state in which the particular capco operates and the target company must meet certain requirements as to size, employment of state residents and possible restrictions on the ability to relocate. These limitations may require us to forego attractive or desirable investments, which could adversely affect or prevent implementation of our business strategy. If we do not manage our growth effectively, our financial performance could be harmed. Our rapid revenue growth has placed, and will continue to place, certain pressures on our management, administrative, operational and financial infrastructure. As we continue to grow our business, such growth could require capital, systems development and human resources beyond current capacities. As evidence of our internal growth, on December 31, 2001, we and all of our consolidated and majority-owned affiliates had approximately 20 employees, and on December 31, 2003 we had approximately 100 employees, without consideration of independent contractors. The increase in the size of our operations may make it more difficult for us to ensure that we execute our present businesses and future strategies. The failure to manage our growth effectively could have a material adverse effect on our financial condition and results of operations. Because expenses are expected to increase as we build an infrastructure and implement our business strategy, we may incur additional losses in the future. Because our expenses are expected to increase more quickly than our revenue as we build our infrastructure and implement our business strategy, we will likely incur additional losses in the near future. We expect the additional expenses to result primarily from our plans to: expand existing systems; broaden affiliated company support capabilities; continue to explore acquisition opportunities and alliances; and facilitate business arrangements among affiliated companies. If we are unable to obtain the resources required for the growth and development of our affiliated companies, they will be highly susceptible to failure, which would directly affect our profitability and value. Early-stage businesses often fail due to their limited capital and human resources. The effective implementation of our business model is dependent upon the ability of the affiliated companies, with assistance from us, to arrange for the managerial, capital and other resources which they usually require in order to become and remain profitable. We may not be able to integrate acquired companies into our company and, as we acquire more and larger interests in affiliated companies, our resources available to assist our affiliated companies may be insufficient. We have made strategic acquisitions and we intend to continue to make acquisitions in accordance with our business plan. Each acquisition involves a number of risks, including: the diversion of our management s attention to the assimilation and ongoing assistance with the operations and personnel of the acquired business, which could strain the management resources we have available; the potential for our affiliated companies to grow rapidly and adversely affect our ability to assist our affiliated companies as intended; CALCULATION OF REGISTRATION FEE Table of Contents possible adverse effects on our results of operations and cash flows; and possible inability by us to achieve the intended objective of the acquisition. Any strain on our ability to assist our affiliated companies as intended or to acquire and integrate businesses under our business plan could have a negative impact on our operations, financial results and cash flows. Our business may be adversely affected by the highly regulated industries in which we operate. Many of the industries in which we operate are highly regulated and we cannot assure you that we or our affiliated companies are, or that we will continue to be, in full compliance with current laws, rules and regulations. If we or our affiliated companies are unable to comply with applicable laws or regulations or if new laws limit or eliminate some of the benefits of our business lines, our financial condition, results of operations and our cash flows could be materially adversely affected. If we lose our key personnel, we may not be able to find and hire experienced replacements. Our business relies heavily on the expertise of our senior management, particularly Messrs. Barry Sloane, Brian A. Wasserman and Jeffrey G. Rubin, our CEO, CFO and President, respectively. These individuals currently serve pursuant to employment agreements which expire on June 30, 2005. The loss of the services of these individuals could have a material adverse effect on our financial condition, results of operations and cash flows and it is likely that it will be difficult to find adequate replacements. We and our affiliated companies depend on our ability to attract and retain key personnel and any loss of ability to attract these personnel could adversely affect us. Our success depends upon the ability of our affiliated companies and other investments to attract and retain qualified personnel and our ability to supplement those capabilities with our senior management personnel. Competition for qualified employees is intense. If our affiliated companies lose the services of key personnel, or are unable to attract additional qualified personnel, the business, financial condition, results of operations and cash flows of us or one or more of our affiliated companies could be materially adversely affected. It can take a significant period of time to identify and hire personnel with the combination of skills and attributes required in carrying out our strategy. Our success depends on our ability to compete effectively in the highly competitive industries in which we operate. We face intense competition in organizing capcos, originating SBA loans, processing electronic payments and offering insurance, as well as in the other industries in which we or our affiliated companies operate. Low barriers to entry often result in a steady stream of new competitors entering certain of these businesses. Current and potential competitors are or may be better established, substantially larger and have more capital and other resources than we do. If we expand into additional geographical markets, we will face competition from others in those markets as well. A major feature of our business strategy is the development of opportunities for our service and product provider businesses to market to the customers of our other business lines and to the customer bases of our alliance partners. Although the business strategy of management contemplates the referring of prospects between wholly-owned and partially owned companies in our network, there is no history of such cross-selling and there can be no assurances that any effort to make referrals across our network of affiliated companies will result in additional revenue opportunities. In order for our referral network to achieve the desired result, each of the constituent Title of each class of securities to be registered Amount to be registered(1) Proposed maximum offering price per share Proposed maximum aggregate offering price Amount of registration fee (2) Common stock, $.02 par value 7,026,477 shares $ 4.91 $ 34,500,000 $ 4,372 (1) Includes 916,497 shares of common stock that may be sold by the registrant and the selling shareholders upon exercise of the underwriters over-allotment option. (2) Calculated pursuant to Rule 457(o) under the Securities Act of 1933. Such amount was previously paid. Table of Contents companies must have proper incentives and feel comfortable making such introduction, and furthermore, the service provider receiving such referral must properly service such referred client. Instituting a corporate culture conducive to sending and receiving referrals is difficult and may not yield the results anticipated by us. In addition, our marketing alliances are terminable and, if we make serious errors or fail to produce sufficient revenues for our alliance partners, we are at risk of losing these relationships. The inability of any one of our business segments to service customers adequately referred to it from within our other companies could impair our overall relationship with such customers. A significant benefit of our structure and strategy is the ability to cross market between our SBA, electronic payment processing and other business customers, including potentially those of CrystalTech. However, should the business relationship between one of our business segments and customers deteriorate for any reason, such customers may opt to withdraw their business from our other businesses. Such a loss of business could negatively impact our results of operations and cash flows. We rely on information processing systems, and our strategy of cross marketing to customers among our majority-owned subsidiaries will increase this reliance; the interruption, loss or failure of which would materially and adversely affect our business. Our ability to provide business services depends, and will increasingly depend, on our capacity to store, retrieve, process and manage significant amounts of data and expand and upgrade our information processing capabilities. Interruption or loss of our information processing capabilities through loss of stored data, breakdown or malfunctioning of computer equipment and software systems, telecommunications failure or damage caused by acts of god or other disruption, could have a material adverse effect on our business, financial condition and results of operations. Although we have disaster recovery procedures in place and insurance to protect against such contingencies, we cannot be certain that our disaster recovery systems or insurance will continue to be available at reasonable prices, cover all our losses or compensate us for the possible loss of clients occurring during any period that we are unable to provide outsourced business services. We are attempting to build a national Newtek brand for services and products marketed to small and medium-sized businesses, but we are unable to obtain a significantly high level of protection for the brand name due to its previous usage in other contexts. The current and past usage by others of names similar to Newtek may make obtaining a significant level of protection for the use of such name very costly. We cannot assure you that we will be able to prevent competitors from using the name Newtek in other contexts or even in competition with us. In the event of such an infringement, we would attempt to vigorously defend our rights to the name, but we can give no assurance that we will be successful in doing so. We have not registered the mark Newtek with the United States Patent and Trademark Office. RISKS RELATED TO OUR CAPCO BUSINESS Because our capcos are subject to minimum investment and other requirements under state law, a failure of any of them to meet these requirements could subject the capco and our shareholders to the loss of one or more capcos and would preclude participation in future capco programs. Involuntary decertification of all or substantially all of our capcos would result in material loss to us and our shareholders. In general, capcos issue debt and equity instruments, such as warrants, to insurance company investors and the capcos then acquire interests in companies in accordance with applicable state statutes. In return, the states issue tax credits to the capcos, which are available to and used by the insurance company investors to reduce their state tax liabilities. In order to maintain its status as a capco and to avoid the recapture of the tax credits granted, each capco must meet a number of state requirements. A key requirement in order to maintain capco certification is The registrant hereby amends this registration statement on such date or dates as maybe necessary to delay its effective date until the registrant shall file a further amendment which specifically states that this registration statement shall there after become effective in accordance with section 8(a) of the Securities Act of 1933 or until the registration statement shall become effective on such date as the Commission, acting pursuant to said section 8(a), may determine. Table of Contents that a capco must comply with minimum investment schedules that benchmark both the timing and type of required investments. Although to date we have met all applicable benchmarks, we may not do so in the future. A final involuntary loss of capco status, referred to as a decertification as a capco, will result in a loss of the tax credits for us and our insurance company investors; it would also enable the capco insurer, which has the obligation to make compensatory payments to offset the lost tax credits, to take control of one or more capcos and manage or liquidate the capco investments to offset its losses. This would deprive us of the value of the investments and make participation in future capco programs highly unlikely. The ability of our capcos to meet minimum investment requirements is materially and adversely affected by the cost of capco insurance. Each of our capcos, following its organization and payment for capco insurance, begins operations with cash approximately equal to 50% of its initial funding (inclusive of any funds obtained from the capco insurer as premium financing), or certified capital, the amount on which the minimum investment requirement is based. In order to avoid decertification and remain in compliance with applicable rules, each capco must invest an amount equal to at least 50% of certified capital in qualified investments. The capcos receive full credit in the minimum investment calculation for the reinvestment of funds returned to the capco by the repayment, sale or liquidation of investments. However, each capco s ability to meet its minimum investment requirement could be adversely effected by: the cost of insurance at the beginning of the capco s investment cycle; the ability to obtain the premium financing from the capco insurer; the transfer of 2.5% of certified capital per year as management fees to us; the direct costs and expenses of operating the capco, including legal and accounting fees; the payment of taxes due by the capco; and losses by the capco, which are common on investments in riskier early-stage, start up and potentially high growth businesses. As of March 31, 2004 seven of our eleven operating capcos have met the minimum investment requirements (the capco managed by Exponential Business Development, Inc., or Exponential, is not included as we only manage but do not own it). The eleventh capco, in Alabama, was funded and began operations in January, 2004 and is at the beginning of its business cycle, with the entire amount of its certified capital yet to be invested. However, the remaining four capcos must invest an aggregate of approximately $14,000,000 within the varying time frames prescribed by the capcos respective states. Failure of one of these capcos to make the minimum investments within the prescribed time frames would lead to decertification of a capco. The capco programs and the tax credits they provide are created by state legislation, and such laws are subject to possible action to repeal or retroactively revise the programs for political, economic or other reasons. Such an attempted repeal would create substantial difficulty for the capco programs and could, if ultimately successful, cause us material financial harm. The tax credits associated with the capco programs and provided to our capcos investors are to be utilized by the investors over a period of time, typically ten years. Much can change during such a period and it is possible that one or more states may revise or eliminate the tax credits. Any such revision or repeal could have a material adverse economic impact on our capco, either directly or as a result of the capco s insurer s actions. During 2002 a single legislator in Louisiana did introduce such a proposed bill, on which no action was taken, and in Colorado in 2003 and 2004 bills to modify (not repeal) its capco program were introduced; the 2002 legislation was defeated in a legislative committee. The 2004 Colorado legislation could have a material and adverse impact on the potential profitability of our Colorado capco if some of the proposed provisions are adopted. Table of Contents In the event of a threat of decertification by a state, the capco insurer is authorized to assume partial or complete control of a capco which would likely result in financial loss to the capco and possibly us and our shareholders. Under the terms of insurance policies purchased by all but one of our capcos for the benefit of the investors, the capco insurer is authorized, in the event of a formal written threat of decertification by a state and absent appropriate corrective action by the capco, to assume partial or complete control of a capco in order to avoid final decertification and the requirement to pay compensatory interest to the certified investors under the policies. While avoiding final decertification, control by the insurer would result in significant disruption of the capco s business and likely result in financial loss to the capco and our business. In the absence of the adoption of new capco programs, we will be unable to derive any new income from tax credits, which to date represents substantially all of our income. Virtually all of our net income for each of the years since inception was derived from the recognition of income related to tax credits available under current capco programs. We will recognize additional income related to tax credits from the current capco programs over the next ten years. Thereafter, unless additional capco programs are adopted and we are able to participate in them, we will derive no income from additional capco programs. The adoption of new state capco programs could be materially and adversely affected by adverse economic conditions or a change in the political acceptability of economic development or capco programs. Our method of income recognition derived from the capco tax credits causes most of such income to be received in the first five years of the programs. In the absence of income from our investments or other sources, we would sustain material losses in later years. In our capco programs we recognize the majority of our income from the tax credits in the early years of the programs because income recognition is tied to the schedule by which the tax credits become irrevocable and beyond recapture (approximately five years). We recognize the majority of our income from ten year capco programs in the first five years. In the absence of income from other sources, such as our investments in small businesses and affiliated companies, our income would decrease materially and we would likely sustain material losses in later years. Although we will not be recognizing significant tax credit income in the latter part of the program, we will continue to incur costs for the administration of the capcos, insurance expenses for the capcos and interest expenses on the capco notes. In the absence of our participation in new capco programs, income from tax credits will remain stagnant or decrease as the capcos reach maturity beginning in 2004. If we are deemed to be an investment company under the Investment Company Act of 1940, we will not be able to execute our business strategy. Because capcos can operate in a manner similar to venture capital funds, there is a risk that the Securities and Exchange Commission, or the SEC, or a court might conclude that we fall within the definition of investment company, and unless an exemption is available, we would be required to register under the Investment Company Act of 1940. Compliance with the Investment Company Act as a registered investment company would cause us to alter significantly our business strategy of participating in the management and development of affiliated companies, impair our ability to operate as planned and seriously harm our business. In addition, our contracts would be voidable and a court could appoint a receiver to take control of and liquidate our business. The SEC has adopted Rule 3a-1 that provides an exemption from registration as an investment company if a company meets both an asset and an income test and is not otherwise primarily engaged in an investment company business by, among other things, holding itself out to the public as such or by taking controlling interests in companies with a view to realizing profits through subsequent sales of these interests. A company satisfies the asset test of Rule 3a-1 if it has no more than 45% of the value of its total assets (adjusted to exclude U.S. Government securities and cash) in the form of securities other than interests in majority-owned subsidiaries and companies which it primarily and actively controls. A company satisfies the income test of Rule 3a-1 if it has derived no more than 45% of its net income for its last four fiscal quarters combined from securities other than interests in majority owned subsidiaries and primarily and actively controlled companies. Table of Contents The information in this prospectus is not complete and may be changed. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell these securities and is not soliciting an offer to buy these securities in any state where the offer or sale is not permitted. PRELIMINARY PROSPECTUS SUBJECT TO COMPLETION, DATED JUNE 25, 2004 6,000,000 Shares Common Stock Table of Contents RISKS RELATING TO OUR SBA LENDING BUSINESS We have specific risks associated with small business administration loans. We have generally sold the guaranteed portion of SBA loans in the secondary market. There can be no assurance that we will be able to continue originating these loans, or that a secondary market will exist for, or that we will continue to realize premiums upon the sale of, the guaranteed portions of the SBA loans. We believe that our SBA loan portfolio does not involve more than a normal risk of collection. However, since we have sold the guaranteed portion of substantially all of our SBA loan portfolio, we incur a pro rata credit risk on the non-guaranteed portion of the SBA loans since we share pro rata with the SBA in any recoveries. In the event of default on an SBA loan, our pursuit of remedies against a borrower is subject to SBA approval, and where the SBA establishes that its loss is attributable to deficiencies in the manner in which the loan application has been prepared and submitted, the SBA may decline to honor its guarantee with respect to our SBA loans or it may seek the recovery of damages from us. If we should experience significant problems with our underwriting of SBA loans, such failure to honor a guarantee or the cost to correct the problems could have a material adverse effect on us. Although the SBA has never declined to honor its guarantees with respect to SBA loans made by us since our acquisition of the lender, no assurance can be given that the SBA would not attempt to do so in the future. Curtailment of the government guaranteed loan programs could cut off an important segment of our business. There can be no assurance that the federal government will maintain the SBA program, or that it will continue to guarantee loans at current levels. If we cannot continue making and selling government guaranteed loans, we will generate fewer origination fees and our ability to generate gains on sale of loans will decrease. From time to time, the government agencies that guarantee these loans reach their internal budgeted limits and cease to guarantee loans for a stated time period. In addition, these agencies may change their rules for loans. Also, Congress may adopt legislation that would have the effect of discontinuing or changing the programs. Non-governmental programs could replace government programs for some borrowers, but the terms might not be equally acceptable. If these changes occur, the volume of loans to small business and industrial borrowers of the types that now qualify for government guaranteed loans could decline, as could the profitability of these loans. Changing interest rates may reduce our income from lending. Fluctuations in interest rates may affect customer demand for our loans and other products and services. Our lending business will likely increase during times of falling interest rates and, conversely, decrease during times of significantly higher interest rates. Significant fluctuations in interest rates and loan demand could have a potentially adverse effect on our results of operations and cash flows. Our ability to participate in the SBA government-guaranteed loan program depends on our ability to obtain sufficient warehouse or similar lending facilities, on sufficiently attractive terms, to enable us to make profitable loans. In conjunction with the acquisition of our SBA lending affiliate, we were able to assist in the renegotiation and extension of a major warehouse loan facility from an affiliate of Deutsche Bank. This warehouse line enables NSBF to fund loans and repay the line at the time all or a portion of the loan is sold, as is typically the case. On June 22, 2004, NSBF executed an amendment to such warehouse facility to provide for an extension of the warehouse credit line to June 30, 2005 and a possible increase of such line from the current $75 million up to $100 million under certain conditions. The credit facility had been scheduled to terminate on June 30, 2004. We are offering 6,000,000 shares of our common stock. Our common stock is traded on the Nasdaq National Market under the symbol NKBS. On June 24, 2004, the last reported sale price of our common stock was $4.14 per share. This prospectus contains important information that you should know before investing. Please read it before you invest and keep it for future reference. Investing in our common stock involves risks. See Risk Factors beginning on page 7. Per Share Table of Contents The amended warehouse line contains adjustments to the terms of the advances and required reserves, additional financial and non-financial covenants and a commitment from NSBF to obtain $10 million in additional funding by August 2, 2004. In addition, the amended agreement requires, among other terms and conditions, that: (1) Newtek continue its previous guaranty of all of NSBF s obligations under the credit line (including the possible expanded facility), (2) Newtek conform to maximum debt and minimum equity requirements, (3) Newtek not pay dividends for the one year term of the facility and (4) in the absence of funding from other sources, Newtek make a debt or equity infusion of at least $10 million to support the lending activities of NSBF. While there can be no assurance that the additional third party funding will be available, NSBF has had numerous discussions with additional lenders and has signed a non-binding letter of intent with one possible lender for $12 million. The failure to arrange the additional funding would be treated as a default under the credit line. However Newtek currently anticipates that NSBF will be able to enter into a third party loan agreement on or before August 2, 2004 or , alternatively, secure from Newtek the required debt or equity infusion by that date, the funds for which may come, in whole or in part, from the proceeds of this offering. In the absence of NSBF s warehouse line of credit, or some other comparable credit facility, NSBF would be unable to make any material number of loans without finding a replacement lending facility. Furthermore, our interest spread and net earnings from this segment of our business would be directly effected by the terms and conditions of the replacement lending facilities. An increase in non-performing assets would reduce our income and increase our expenses. If our level of non-performing assets in our SBA lending business rises in the future, it could adversely affect our revenue and earnings. Non-performing assets are primarily loans on which borrowers are not making their required payments. Non-performing assets also include loans that have been restructured to permit the borrower to have smaller payments and real estate that has been acquired through foreclosure of unpaid loans. To the extent that our loan assets are non-performing, we will have less cash available for lending and other activities. RISKS RELATING TO OUR ELECTRONIC PAYMENT PROCESSING BUSINESS We rely currently on a single bank sponsor, which has substantial discretion with respect to certain elements of our business practices, in order to process bankcard transactions. If this sponsorship is terminated and we are not able to secure or migrate merchant portfolios to new bank sponsors, we will not be able to conduct our electronic payment processing business. Because we are not a bank, we are unable to belong to and directly access the Visa and MasterCard bankcard associations. The Visa and MasterCard operating regulations require us to be sponsored by a bank in order to process bankcard transactions. We are currently registered with Visa and MasterCard through the sponsorship of one bank that is a member of the card associations. If this sponsorship is terminated and we are unable to secure a bank sponsor, we will not be able to process bankcard transactions. Furthermore, our agreement with our sponsoring bank gives the sponsoring bank substantial discretion in approving certain elements of our business practices, including our solicitation, application and qualification procedures for merchants, the terms of our agreements with merchants, the processing fees that we charge, our customer service levels and our use of independent sales organizations. We cannot guarantee that our sponsoring bank s actions under these agreements will not be detrimental to us. If we or our bank sponsor fail to adhere to the standards of the Visa and MasterCard credit card associations, our registrations with these associations could be terminated and we could be required to stop providing payment processing services for Visa and MasterCard. Substantially all of the transactions we process involve Visa or MasterCard. If we or our bank sponsor fail to comply with the applicable requirements of the Visa and MasterCard credit card associations, Visa or MasterCard could suspend or terminate our registration. The termination of our registration or any changes in the Total (1) Table of Contents Visa or MasterCard rules that would impair our registration could require us to stop providing payment processing services, which would have a material adverse effect on our business. We and our electronic payment processing subsidiaries rely on other card payment processors and service providers. If they no longer agree to, or are unable to, provide their services, our merchant relationships could be adversely affected and we could lose business. Our electronic payment processing business relies on agreements with several other large payment processing organizations to enable us to provide card authorization, data capture, settlement and merchant accounting services and access to various reporting tools for the merchants we serve. We also rely on third parties to whom we outsource specific services, such as reorganizing and accumulating daily transaction data on a merchant-by-merchant and card issuer-by-card issuer basis and forwarding the accumulated data to the relevant bankcard associations. Many of these organizations and service providers are our competitors. The termination by our service providers of these arrangements with us or their failure to perform these services efficiently and effectively may adversely affect our relationships with the merchants whose accounts we serve and may cause those merchants to terminate their processing agreements with us. On occasion, we experience increases in interchange and sponsorship fees. If we cannot pass these increases along to our merchants, our profit margins will be reduced. Our electronic payment processing subsidiaries pay interchange fees or assessments to card associations for each transaction we process using their credit, debit and gift cards. From time to time, the card associations increase the interchange fees that they charge processors and the sponsoring banks. At their sole discretion, our sponsoring banks have the right to pass any increases in interchange fees on to us. In addition, our sponsoring banks may increase their Visa and MasterCard sponsorship fees, all of which are based upon the dollar amount of the payment transactions we process. If we are not able to pass these fee increases along to merchants through corresponding increases in our processing fees, our profit margins in this line of business will be reduced. Unauthorized disclosure of merchant or cardholder data, whether through breach of our computer systems or otherwise, could expose us to liability and business losses. Through our electronic payment processing subsidiaries, we collect and store sensitive data about merchants and cardholders and we maintain a database of cardholder data relating to specific transactions, including payment, card numbers and cardholder addresses, in order to process the transactions and for fraud prevention and other internal processes. If anyone penetrates our network security or otherwise misappropriates sensitive merchant or cardholder data, we could be subject to liability or business interruption. We cannot guarantee that our systems will not be penetrated in the future. If a breach of our system occurs, we may be subject to liability, including claims for unauthorized purchases with misappropriated card information, impersonation or other similar fraud claims. We have potential liability if our merchants refuse or cannot reimburse charge-backs resolved in favor of their customers. If a billing dispute between a merchant and a cardholder is not ultimately resolved in favor of the merchant, the disputed transaction is charged back to the merchant s bank and credited to the account of the cardholder. If we or our processing banks are unable to collect the charge-back from the merchant s account, or if the merchant refuses or is financially unable due to bankruptcy or other reasons to reimburse the merchant s bank for the charge-back, we bear the loss for the amount of the refund paid to the cardholder s bank. We face potential liability for customer or merchant fraud. Credit card fraud occurs when a merchant s customer uses a stolen card (or a stolen card number in a card-not-present transaction) to purchase merchandise or services. In a traditional card-present transaction, if the Public offering price $ $ Underwriting discount $ $ Proceeds, before expenses, to us(2) $ $ (1) We and the selling shareholders named in this prospectus have granted the underwriters a 45-day option to purchase up to an additional 900,000 shares of our common stock at the public offering price, less the underwriting discount. If this over-allotment option is exercised in full, the total public offering price will be $ , the total underwriting discount will be $ and the total proceeds, before expenses, to us would be $ . For all shares sold pursuant to the over-allotment option, 50% will be sold by us on a first priority basis; and 50% will be sold by three of our principal shareholders, all of whom are executive officers, on the same terms and conditions as us, but on a second priority basis. (2) We estimate that we will incur approximately $ in offering expenses in connection with this offering. This is a firm commitment underwriting. The underwriters have the option to purchase up to 450,000 shares of common stock from us and thereafter an additional 450,000 shares from the three selling shareholders on the same basis as the shares sold by us within 45 days from the date of this prospectus to cover over-allotments, if any. The underwriters expect to deliver the shares on or about , 2004. Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense. Roth Capital Partners Maxim Group LLC The date of this prospectus is , 2004. Table of Contents merchant swipes the card, receives authorization for the transaction from the card issuing bank and verifies the signature on the back of the card against the paper receipt signed by the customer, the card issuing bank remains liable for any loss. In a fraudulent card-not-present transaction, even if the merchant receives authorization for the transaction, the merchant is liable for any loss arising from the transaction. Many of our business customers are small and transact a substantial percentage of their sales over the Internet or by telephone or mail orders. Because their sales are card-not-present transactions, these merchants are more vulnerable to customer fraud than larger merchants and we could experience charge-backs arising from cardholder fraud more frequently with these merchants. Merchant fraud occurs when a merchant, rather than a customer, knowingly uses a stolen or counterfeit card or card number to record a false sales transaction or intentionally fails to deliver the merchandise or services sold in an otherwise valid transaction. Anytime a merchant is unable to satisfy a charge-back, we are responsible for that charge-back. We have established systems and procedures to detect and reduce the impact of merchant fraud, but we cannot assure you that these measures are or will be effective. Failure to effectively manage risk and prevent fraud could increase our charge-back liability. RISKS RELATING TO OUR ACQUISITION AND OPERATION OF A WEBSITE HOSTING BUSINESS The closing of the CrystalTech acquisition is contingent on our receiving net proceeds from this offering or a similar financing. Even if this offering is completed, we may still not be able to consummate the acquisition. In such a case, we would not be able to acquire the website hosting business. Under the terms of our agreement with CrystalTech, our obligation to consummate this acquisition is conditioned upon our receiving sufficient financing to fund the cash portion of the purchase price of $10,000,000 plus an additional amount of $2,000,000. Moreover, some of the other closing conditions are not within our control, such as obtaining the consent of CrystalTech s landlord. Absent fulfillment of all material conditions, we may be unable to complete the transaction. In addition, we have agreed with the underwriters for this offering that we will use our commercially reasonable best efforts to consummate the transaction with CrystalTech within eight days of closing this offering. CrystalTech operates in a competitive industry where technological change can be rapid. The website hosting business and its related technology involve a broad range of rapidly changing technologies. CrystalTech s equipment and the technologies on which it is based may not remain competitive over time, and others may develop superior technologies that render CrystalTech s products non-competitive without significant additional capital expenditures. CrystalTech s website hosting business depends on the efficient and uninterrupted operation of its computer and communications hardware systems and infrastructure. Despite precautions taken by CrystalTech against possible failure of its systems, interruptions could result from natural disasters, power loss, the inability to acquire fuel for our backup generators, telecommunications failure, terrorist attacks and similar events. CrystalTech also leases telecommunications lines from local, regional and national carriers whose service may be interrupted. Our business, financial condition and results of operations could be harmed after our acquisition of CrystalTech by any damage or failure that interrupts or delays our operations. Of primary importance to CrystalTech s website hosting customers is the integrity of its infrastructure and the privacy of confidential information. CrystalTech s infrastructure is potentially vulnerable to physical or electronic break-ins, viruses or similar problems. If a person circumvents CrystalTech s security measures, he or she could jeopardize the security of confidential information stored on CrystalTech s systems, misappropriate proprietary information or cause interruptions in CrystalTech s operations. We may be required to make significant additional investments and Table of Contents You should rely only on the information contained in this prospectus or any supplement. We have not authorized anyone to provide you with any different information. You should not consider any statement modified or superceded, except as so modified or superceded by any supplement to this prospectus, to constitute a part of this prospectus. Unless otherwise indicated, all information in this prospectus assumes that the underwriters will not exercise their option to purchase shares to cover over-allotments. To understand this offering fully, you should read this entire document carefully, including, in particular, the Risk Factors section beginning on page 7 as well as the documents identified in the section entitled Where You Can Find More Information on page 85. [remainder of page intentionally left blank] Table of Contents efforts to protect against or remedy security breaches. Security breaches that result in access to confidential information could damage our reputation and expose us to a risk of loss or liability. The security services that CrystalTech offers in connection with customers networks cannot assure complete protection from computer viruses, break-ins and other disruptive problems. Although CrystalTech attempts to limit contractually its liability in such instances, the occurrence of these problems may result in claims against CrystalTech or us or liability on our part. These claims, regardless of their ultimate outcome, could result in costly litigation and could harm our business and reputation and impair CrystalTech s ability to attract and retain customers. CrystalTech s business depends on Microsoft Corporation for the license to use software as well as other intellectual property in its website hosting business. CrystalTech s website hosting business is built on a technological platform relying on the Microsoft Windows products that CrystalTech currently licenses. As a result, if we are unable to continue to have the benefit of that licensing arrangement or if the Microsoft Windows products upon which CrystalTech s platform is built become obsolete, our business could be materially and adversely affected. CrystalTech depends on the services of a few key personnel in managing its website hosting business, and the loss of one or more of them could materially impair its ability to maintain current levels of customer service and the proper technical operations of its business. After we acquire CrystalTech we will depend upon the continued management by Tim Uzzanti of the operations of CrystalTech s website hosting business, along with two or three other individuals to supervise CrystalTech s technical operations and the customer technical service response. If we were to lose the services of one or more of these persons, our website hosting business could be significantly diminished. RISKS RELATING TO OUR NEW BUSINESSES The new businesses we plan to develop or organize, namely insurance sales, tax preparation services and financial information services will be businesses which are new to us and we may incur significant losses prior to becoming profitable if ever. We do not have any experience in conducting our proposed new businesses in any meaningful manner in the past. Our investment in and operation of these businesses may result in losses due to our lack of knowledge and experience. We cannot assure that the insurance, tax preparation or financial information services we plan to offer will be price competitive or accepted by our customers. Despite our efforts to design, market and deliver integrated services to our customers, our proposed new services may not be widely accepted and we may not be able to compete with other larger and better capitalized providers of such services. We will depend on third parties, particularly property and casualty insurance companies, to supply the products marketed by our agents. Our future contracts with property and casualty insurance companies typically will provide that the contracts can be terminated by the supplier without cause. Our inability to enter into satisfactory arrangements with these suppliers or the loss of these relationships for any reason would adversely affect the results of our new insurance business. Termination of our professional liability insurance policy may adversely impact our financial prospects and our ability to continue our relationships with insurance companies. We will need to obtain professional liability insurance in connection with the operation of this business. If we are unable to obtain or if we lose such insurance after we obtain it, it is unlikely that our relationships with Table of Contents insurance companies would continue. We are currently in the process of obtaining professional liability insurance to cover the operations of the insurance agency and meet applicable state licensing requirements but no assurances can be given that we will be able to obtain such insurance. Once obtained, our failure to maintain this insurance would have a material adverse impact on the business. If we fail to comply with government regulations, our insurance agency business could be adversely affected. Our insurance agency business will be subject to comprehensive regulation in the various states in which we plan to conduct business. Our success will depend in part upon our ability to satisfy these regulations and to obtain and maintain all required licenses and permits. Our failure to comply with any statutes and regulations could have a material adverse effect on us. Furthermore, the adoption of additional statutes and regulations, changes in the interpretation and enforcement of current statutes and regulations or the expansion of our business into jurisdictions that have adopted more stringent regulatory requirements than those in which we currently conduct business could have a material adverse effect on us. We do not have any control over the commissions our insurance agency expects to earn on the sale of insurance products which are based on premiums and commission rates set by insurers and the conditions prevalent in the insurance market. Our insurance agency expects to earn commissions on the sale of insurance products. Commission rates and premiums can change based on the prevailing economic and competitive factors that affect insurance underwriters. In addition, the insurance industry has been characterized by periods of intense price competition due to excessive underwriting capacity and periods of favorable premium levels due to shortages of capacity. We cannot predict the timing or extent of future changes in commission rates or premiums or the effect any of these changes will have on the operations of our insurance agency. RISKS RELATING TO OUR COMMON STOCK AND THIS OFFERING Three of our shareholders, all of whom are executive officers and directors, will beneficially own approximately 42% of our common stock after completion of this offering (including the exercise of the over-allotment option) and the acquisition of Crystal Tech (assuming all contingent share payments are earned and issued), and will be able to control the outcome of most shareholder actions. Because of their ownership of our stock, Messrs. Sloane, Wasserman and Rubin will be able to control or have significant influence over all actions requiring shareholder approval, including the election of directors, the adoption of amendments to the certificate of incorporation, approval of stock incentive plans and approval of major transactions such as a merger or sale of assets. This could delay or prevent a change in control of our company, deprive our shareholders of an opportunity to receive a premium for their shares of common stock as part of a change in control and have a negative effect on the market price of our common stock. There is a limited trading market for our common stock, and you may not be able to resell your shares at or above the price you pay for them. The price of our common stock is subject to fluctuations based on, among other things, economic and market conditions for companies in similar industries to ours and the stock market in general, as well as changes in investor perceptions of us. While we are a publicly-traded company, the volume of trading activity in our stock is relatively small. The current public float of our common stock is approximately 11,600,000 shares, and the average daily trading volume of our common stock from January 1, 2004 through March 31, 2004 was approximately 63,000 shares. Even if a more active market develops, there can be no assurance that such a market will continue or that our shareholders will be able to sell their shares at or above the offering price. Table of Contents Our management will have broad discretion over the use of the net proceeds of this offering, and you may not agree with the way the proceeds are used. While we currently intend to use the net proceeds of this offering for the CrystalTech acquisition, capital or liquidity in connection with NSBF s warehouse credit facility, potential future acquisitions, working capital and other general purposes, we may subsequently choose to use the net offering proceeds for different purposes or not at all. In addition, the CrystalTech acquisition may fail to close for a reason or reasons which we cannot now contemplate. The effect of the offering will be to increase capital resources available to our management, and our management will allocate these capital resources as it determines is necessary. You will be relying on the judgment of our management with regard to the use of the net proceeds of this offering. See Use of Proceeds. Future issuances of our common stock or other securities, including preferred stock, may dilute the per share book value of our common stock or have other adverse consequences to our common shareholders. Following the completion of this offering, our board of directors has the authority, without the action or vote of our shareholders, to issue all or part of the approximately 5,800,000 authorized but unissued shares of our common stock. If issued, these common shares would represent approximately 17% of our outstanding common stock. Our business strategy relies upon investment in and acquisition of businesses using the resources available to us, including our common stock. We have made acquisitions during 2002 and 2003 involving the issuance of our common stock, and we expect to make additional acquisitions in the future using our common stock. Additionally, we anticipate granting additional options or restricted stock awards to our employees and directors in the future. We may also issue additional securities, through public or private offerings, in order to raise capital to support our growth, including in connection with possible acquisitions or in connection with purchases of minority interests in affiliated companies or capcos. Future issuances of our common stock will dilute the percentage of ownership interest of current shareholders and could decrease the per share book value of our common stock. In addition, option holders may exercise their options at a time when we would otherwise be able to obtain additional equity capital on more favorable terms. Pursuant to our certificate of incorporation, our board of directors is authorized to issue, without action or vote of our shareholders, up to 1,000,000 shares of blank check preferred stock, meaning that our board of directors may, in its discretion, cause the issuance of one or more series of preferred stock and fix the designations, preferences, powers and relative participating, optional and other rights, qualifications, limitations and restrictions thereof, including the dividend rate, conversion rights, voting rights, redemption rights and liquidation preference, and to fix the number of shares to be included in any such series. The preferred stock so issued may rank superior to the common stock with respect to the payment of dividends or amounts upon liquidation, dissolution or winding-up, or both. In addition, the shares of preferred stock may have class or series voting rights. The authorization and issuance of blank check preferred stock could have an anti-takeover effect detrimental to the interests of our shareholders. Our certificate of incorporation allows our board of directors to issue preferred stock with rights and preferences set by the board without further shareholder approval. The issuance of shares of this blank check preferred stock could have an anti-takeover effect detrimental to the interests of our shareholders. For example, in the event of a hostile takeover attempt, it may be possible for management and the board to impede the attempt by issuing the preferred shares, thereby diluting or impairing the voting power of the other outstanding shares of common stock and increasing the potential costs to acquire control of us. Our board has the right to issue any new shares, including preferred shares, without first offering them to the holders of common stock as they have no preemptive rights. Table of Contents We know of no other publicly-held company that sponsors and operates capcos as a material part of its business. As such, there are, to our knowledge, no other companies against which investors may compare our capco business, operations, results of operations and financial and accounting structures. In the absence of any meaningful peer group comparisons for our capco business, investors may have a difficult time understanding and judging the strength of our business. This, in turn, may have a depressing effect on the value of our stock. Substantial sales of shares may impact the market price of our common stock. If our shareholders sell substantial amounts of our common stock, the market price of our common stock may decline. These sales also might make it more difficult for us to sell equity or equity-related securities in the future at a time and price that we deem appropriate. We are unable to predict the effect that sales may have on the then prevailing market price of our common stock. This risk is compounded by the fact that three of our executive officers and directors will own approximately 42% of our common stock after completion of this offering (including the exercise of the over-allotment option) and the acquisition of CrystalTech (assuming all contingent share payments are earned and issued), and sales by any one of them of substantial numbers of shares, or the perception that such sales could occur, could adversely affect the market price. Further, these three shareholders, as well as all of our other directors, have entered into lock-up agreements with the underwriters in which they have agreed to refrain from selling their shares for a period of 180 days after the date of this prospectus. Increased sales of our common stock in the market after the expiration of these lock up agreements could exert significant downward pressure on our stock price. Provisions of our certificate of incorporation and New York law place restrictions on our shareholders ability to recover from our directors. As permitted by New York law, our amended and restated certificate of incorporation limits the liability of our directors for monetary damages for breach of a director s fiduciary duty except for liability in certain instances. As a result of these provisions and New York law, shareholders have restrictions and limitations upon their rights to recover from directors for breaches of their duties. In addition, our certificate of incorporation provides that we must indemnify our directors and officers to the fullest extent permitted by law. We may not be able to comply in a timely manner with all of the recently enacted or proposed corporate governance requirements. Beginning with the enactment of the Sarbanes-Oxley Act of 2002, in July 2002, a significant number of new corporate governance requirements have been adopted or proposed by the SEC and the Nasdaq Stock Market. Although we currently expect to comply with all current and future requirements, we may not be successful in complying with these requirements in the future. In addition, certain of these requirements may require us to make changes to our corporate governance. There are risks associated with one of our underwriter s lack of recent experience in public offerings. Although certain principals of Maxim Group LLC have extensive experience in the securities industry, Maxim Group LLC itself is newly formed and has acted as an underwriter in only one prior public offering. This lack of operating history may have an adverse effect on this offering. Maxim Group LLC was formed in October 2002 and is a member of the National Association of Securities Dealers and the Securities Investor Protection Corporation. Table of Contents The Offering Common stock offered by us 6,000,000 shares Common stock to be outstanding after this offering 33,246,433 shares Over-Allotment Option We have granted to the underwriters an option for 45 days to purchase up to 450,000 additional shares of common stock to cover over-allotments, if any. In addition, three of our principal shareholders, who are all executive officers, have also granted a similar option to the underwriters to cover over-allotments and will sell up to an aggregate of 450,000 shares of their respective common stock subsequent to our shares being sold. Nasdaq National Market symbol NKBS Use of proceeds We intend to use the net proceeds of this offering to pay the cash portion of the purchase price of CrystalTech and, whether or not the CrystalTech transaction closes, for working capital and general corporate purposes, including potential future acquisitions of complementary businesses and technologies and providing additional capital or liquidity to our current or future operating subsidiaries. Risk Factors See Risk Factors beginning on page 7 for a discussion of factors you should carefully consider before deciding to invest in our common stock. Table of Contents
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+RISK FACTORS Investing in our common stock involves a high degree of risk. You should carefully consider the following risk factors and all other information contained in this prospectus before purchasing our common stock. If any of the following risks occur, our business, financial condition or results of operations could be materially and adversely affected. In these circumstances, the market price of our common stock could decline, and you may lose some or all of your investment. Risks Related to Our Intellectual Property Intellectual property rights, including in particular patent rights, play a critical role in the drug eluting stent sector of the medical device industry, and therefore in our business. We face significant risks relating to patents, both as to our own patent position as well as to patents held by third parties. These risks are summarized below. We describe in greater detail our patent position, and patents held by third parties that could impact our business, under the caption Business Patents and Proprietary Rights. You should consider carefully the matters discussed under that caption and in the risk factors below in considering an investment in our common stock. We believe that it is highly likely that one or more third parties will assert a patent infringement claim against us. If any such claim is successful, we could be enjoined, or prevented, from commercializing our COSTAR stent or other product candidates, and you should assume that a lawsuit asserting such a claim has been or will be filed against us. There are numerous U.S. and foreign issued patents and pending patent applications owned by third parties with patent claims in areas that are the focus of our product development efforts. We are aware of patents owned by third parties, to which we do not have licenses, that relate to, among other things: use of paclitaxel (in general or on a stent) to treat restenosis; stent structure; catheters used to deliver stents; and stent manufacturing processes. Based on the prolific litigation that has occurred in the stent industry and the fact that we may pose a competitive threat to some large and well-capitalized companies who own or control patents relating to stents and their use, manufacture and delivery, we believe that it is highly likely that one or more third parties will assert a patent infringement claim against the manufacture, use or sale of our COSTAR stent based on one or more of these patents. It is not unlikely that a lawsuit asserting patent infringement and related claims will be filed against us prior to the completion of this offering, and it is possible that a lawsuit may have already been filed against us of which we are not aware. Any lawsuit could seek to enjoin, or prevent, us from commercializing our COSTAR stent and may seek damages from us, and would likely be expensive for us to defend against. In particular, it has been reported that Boston Scientific plans to initiate litigation asserting patent infringement claims against us prior to commercialization of our COSTAR stent in the United States. We cannot predict when this lawsuit will be filed, and investors should assume that a lawsuit alleging that we have infringed or are infringing one or more patents controlled by Boston Scientific has been filed by Boston Scientific at or prior to the time of this offering. Although we have not otherwise received any definitive communications from third parties indicating that they intend to pursue patent infringement claims against us, we have received letters from third parties who have intellectual property rights in, or who have been actively involved in litigation or oppositions relating to, coronary stents, asserting that they may have rights to patents that are relevant to our operations or our stent platform and requesting the initiation of discussions. A court may determine that these patents are valid and infringed by us. A number of these patents are owned by very large and well-capitalized companies that are active participants in the stent market, such as Boston Scientific Corporation and Guidant Corporation. Several of these third party patents have been or are being asserted in litigation against purported infringers, demonstrating The Registrant hereby amends this Registration Statement on such date or dates as may be necessary to delay its effective date until the Registrant shall file a further amendment that specifically states that this Registration Statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933, as amended, or until the Registration Statement shall become effective on such date as the Commission, acting pursuant to said Section 8(a), may determine. Table of Contents a willingness by the patent owners to litigate their claims. For a description of patents that we consider to pose a material litigation risk to us, see the discussion under the caption Business Patents and Proprietary Rights Third-Party Patent Rights. There may be patents in addition to those described under that caption that relate to aspects of our technology and that may materially and adversely affect our business. Moreover, because patent applications can take many years to issue, there may be currently pending applications, unknown to us, which may later result in issued patents that pose a material risk to us. The stent and related markets have experienced rapid technological change and obsolescence in the past, and our competitors have strong incentives to stop or delay the introduction of new products and technologies. Some of the companies in these markets, such as Boston Scientific and Guidant Corporation, have been able to capture significant market share by introducing new technologies. These companies have maintained their position in the market by, among other things, establishing intellectual property rights relating to their products and enforcing these rights aggressively against their competitors and potential new entrants into the market. All of the major companies in the stent and related markets, including Boston Scientific Corporation, Johnson & Johnson, Guidant Corporation and Medtronic, have been repeatedly involved in patent litigation relating to stents since at least 1997. Recently filed patent litigation includes litigation between Boston Scientific and Johnson & Johnson relating to Boston Scientific s drug eluting and bare metal stents and Johnson & Johnson s drug eluting stent, as well as patent litigation by Advanced Cardiovascular Systems, a subsidiary of Guidant, against Boston Scientific relating to stent structure. Each company is claiming that the other company infringes its intellectual property. We may pose a competitive threat to many of the companies in the stent and related markets. Accordingly, many of these companies, especially Boston Scientific and others against which we would compete directly, will have a strong incentive to take steps, through patent litigation or otherwise, to prevent us from commercializing our COSTAR stent. For example, Boston Scientific owns a series of patents, known as the Kunz patents, which cover the use of paclitaxel to treat restenosis generally and also to treat restenosis via a stent. Boston Scientific is currently asserting two of the Kunz patents in a patent infringement lawsuit in the Federal District Court in Delaware against Johnson & Johnson and Cordis Corporation, a subsidiary of Johnson & Johnson. In addition, Angiotech Pharmaceuticals, Inc. is the owner of a number of patents, sometimes referred to as the Hunter patents, and has licensed from the U.S. government a number of other patents, sometimes referred to as the Kinsella patents, that also cover the use of paclitaxel coated stents to treat angiogenesis and restenosis. We understand that, in a 1997 license agreement, Angiotech granted co-exclusive sublicenses to Boston Scientific and Cook Inc. under these patents. On September 24, 2004, Angiotech announced that Cook elected to exit the coronary vascular field and focus on the development of paclitaxel-eluting peripheral vascular and gastrointestinal stents. Angiotech also announced that Cook returned all of its rights in the coronary vascular field under the 1997 license agreement to Angiotech. On November 23, 2004, Boston Scientific announced that they had become the only license holder of these rights in the coronary vascular field of use and had obtained the right to sublicense these rights. Angiotech announced that Cook will maintain its rights in the Angiotech patents in the field of paclitaxel-eluting peripheral vascular and gastrointestinal stents. Boston Scientific owns other patents that may have a material adverse affect on us. These include a stent structure patent with claims covering an expanded stent with a plurality of cavities which are micro-holes or micro-slits that extend from the outer surface through the inner surface and which act as reservoirs for a substance. In addition, Guidant owns a number of patents that could have a material adverse effect on us. These include the Yock family of patents that are directed to rapid exchange catheters, the Lau family of patents which claim rapid exchange catheters for stent delivery, another Lau family of patents directed to stent structures and the Castro patents, which are directed to a manufacturing process involving the application of a material to a stent. While our products are in clinical trials, and prior to commercialization, we believe our activities in the United States related to the submission of data to the FDA fall within the scope of the exemptions that cover Table of Contents activities related to developing information for submission to the FDA and fall under general investigational use or similar laws in other countries. However, the U.S. exemptions would not cover our stent manufacturing or other activities in the United States that support overseas clinical trials if those activities are not also reasonably related to developing information for submission to the FDA. In any event, the fact that no third party has asserted a patent infringement claim against us to date should not be taken as an indication, or a level of comfort, that a patent infringement claim will not be asserted against us prior to or upon commercialization. Whether we would, upon commercialization, infringe any patent claim will not be known with certainty unless and until a court interprets the patent claim in the context of litigation. If an infringement allegation is made against us, we may seek to invalidate the asserted patent claim and/or to allege non-infringement of the asserted patent claim. In order for us to invalidate a U.S. patent claim, we would need to rebut the presumption of validity afforded to issued patents in the United States with clear and convincing evidence of invalidity, which is a high burden of proof. In the event that we are found to infringe any valid claim in a patent held by a third party, we may, among other things, be required to: pay damages, including up to treble damages and the other party s attorneys fees, which may be substantial; cease the development, manufacture, use and sale of products that infringe the patent rights of others, including our COSTAR stent, through a court-imposed sanction called an injunction; expend significant resources to redesign our technology so that it does not infringe others patent rights, or to develop or acquire non-infringing intellectual property, which may not be possible; discontinue manufacturing or other processes incorporating infringing technology; and/or obtain licenses to the infringed intellectual property, which may not be available to us on acceptable terms, or at all. Any development or acquisition of non-infringing products or technology or licenses could require the expenditure of substantial time and other resources and could have a material adverse effect on our business and financial results. If we are required to, but cannot, obtain a license to valid patent rights held by a third party, we would likely be prevented from commercializing the relevant product. We believe that it is unlikely that we would be able to obtain a license to any necessary patent rights controlled by companies, like Boston Scientific, against which we would compete directly. This would include, for example, a license to the Kunz, Hunter or Kinsella patents. If we need to redesign products to avoid third-party patents, we may suffer significant regulatory delays associated with conducting additional studies or submitting technical, manufacturing or other information related to the redesigned product and, ultimately, in obtaining approval. In addition, some of our agreements, including our agreement with Phytogen International LLC for the supply of paclitaxel, our distribution agreements with Biotronik AG and the St. Jude Medical affiliates and our supply agreements for laser-cut stents and catheters, require us to indemnify the other party in certain circumstances where our products have been found to infringe a patent or other proprietary rights of others. An indemnification claim against us may require us to pay substantial sums to our supplier, including its attorneys fees. If we are unable to obtain and maintain intellectual property protection covering our products, others may be able to make, use or sell our products, which would adversely affect our market share, and, therefore, our revenues. Our ability to protect our drug eluting stent technology from unauthorized or infringing use by third parties depends substantially on our ability to obtain and maintain valid and enforceable patents. Due to evolving legal standards relating to the patentability, validity and enforceability of patents covering medical devices and pharmaceutical inventions and the scope of claims made under these patents, our ability to obtain and enforce patents is uncertain and involves complex legal and factual questions. Accordingly, rights under any of our issued patents may not provide us with commercially meaningful protection for our drug eluting stents or afford us a commercial advantage against our competitors or their competitive products or processes. In addition, Paclitaxel dose (mcg/17mm stent) 10 10 10 10 30 30 Estimated duration of elution (days) 5 10 10 30 30 Table of Contents The information in this prospectus is not complete and may be changed. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell these securities and it is not soliciting an offer to buy these securities in any state where the offer or sale is not permitted. SUBJECT TO COMPLETION, DATED DECEMBER 10, 2004 PROSPECTUS 5,000,000 Shares Common Stock $ per share Table of Contents patents may not issue from any pending or future patent applications owned by or licensed to us, and moreover, patents that have issued to us or may issue in the future may not be valid or enforceable. Further, even if valid and enforceable, our patents may not be sufficiently broad to prevent others from marketing stents like ours, despite our patent rights. The validity of our patent claims depends, in part, on whether prior art references described or rendered obvious our inventions as of the filing date of our patent applications. We may not have identified all prior art, such as U.S. and foreign patents or published applications or published scientific literature, that could adversely affect the validity of our issued patents or the patentability of our pending patent applications. For example, patent applications in the United States are maintained in confidence for up to 18 months after their filing. In some cases, however, patent applications remain confidential in the U.S. Patent and Trademark Office, which we refer to as the U.S. Patent Office, for the entire time prior to issuance as a U.S. patent. Patent applications filed in countries outside the United States are not typically published until at least 18 months from their first filing date. Similarly, publication of discoveries in the scientific or patent literature often lags behind actual discoveries. Therefore, we cannot be certain that we were the first to invent, or the first to file patent applications relating to, our stent technologies. In the event that a third party has also filed a U.S. patent application covering our stents or a similar invention, we may have to participate in an adversarial proceeding, known as an interference, declared by the U.S. Patent Office to determine priority of invention in the United States. It is possible that we may be unsuccessful in the interference, resulting in a loss of some portion or all of our U.S. position. The laws of some foreign jurisdictions do not protect intellectual property rights to the same extent as in the United States, and many companies have encountered significant difficulties in protecting and defending such rights in foreign jurisdictions. If we encounter such difficulties or we are otherwise precluded from effectively protecting our intellectual property rights in foreign jurisdictions, our business prospects could be substantially harmed. We may initiate litigation to enforce our patent rights, which may prompt our adversaries in such litigation to challenge the validity, scope or enforceability of our patents. If a court decides that our patents are not valid, not enforceable or of a limited scope, we will not have the right to stop others from using our inventions. We also rely on trade secret protection to protect our interests in proprietary know-how and for processes for which patents are difficult to obtain or enforce. We may not be able to protect our trade secrets adequately. In addition, we rely on non-disclosure and confidentiality agreements with employees, consultants and other parties to protect, in part, trade secrets and other proprietary technology. These agreements may be breached, and we may not have adequate remedies for any breach. Moreover, others may independently develop equivalent proprietary information, and third parties may otherwise gain access to our trade secrets and proprietary knowledge. Any disclosure of confidential data into the public domain or to third parties could allow our competitors to learn our trade secrets and use the information in competition against us. We may incur substantial costs as a result of litigation or other proceedings relating to patent and other intellectual property rights. There has been substantial litigation and other proceedings regarding patent and intellectual property rights in the medical device industry generally and the drug eluting stent industry in particular. We may be forced to defend claims of infringement brought by our competitors and others, and we may institute litigation against others who we believe are infringing our intellectual property rights. The outcome of patent litigation is subject to substantial uncertainties, especially in medical device-related patent cases that may, for example, turn on the interpretation of claim language by the court which may not be to our advantage, and also the testimony of experts as to technical facts upon which experts may reasonably disagree. Our involvement in intellectual property litigation could result in significant expense. Some of our competitors, such as Boston Scientific and Guidant, have considerable resources available to them and a strong economic incentive to undertake substantial efforts to stop or delay us from bringing our COSTAR stent to market and achieving market acceptance. We, on the other hand, are a development stage company with comparatively few resources available to us to engage in costly and protracted litigation. Moreover, regardless of the outcome, intellectual property litigation against or by We are selling 5,000,000 shares of our common stock. We and the selling stockholder named in this prospectus have granted the underwriters an option to purchase up to 750,000 additional shares of common stock to cover over-allotments. We will not receive any proceeds from the sale of shares by the selling stockholder. This is the initial public offering of our common stock. We currently expect the initial public offering price to be between $11.00 and $13.00 per share. We have applied to have our common stock approved for quotation on the Nasdaq National Market under the symbol CONR. Table of Contents us could significantly disrupt our development and commercialization efforts, divert our management s attention and quickly consume our financial resources. If third parties file patent applications or are issued patents claiming technology also claimed by us in pending applications, we may be required to participate in interference proceedings with the U.S. Patent Office or in other proceedings outside the United States, including oppositions, to determine priority of invention or patentability. Even if we are successful in these proceedings, we may incur substantial costs, and the time and attention of our management and scientific personnel will be diverted in pursuit of these proceedings. Risks Related to Our Business We will depend heavily on the success of our lead product candidate, our COSTAR stent, which is still in development. If we are unable to commercialize our COSTAR stent or experience significant delays in doing so, our ability to generate revenue will be significantly delayed and our business will be harmed. We have invested all of our product development time and resources in our drug eluting stent technology, which we intend to commercialize initially in the form of our COSTAR stent. We anticipate that in the near term our ability to generate revenues will depend solely on the successful development, regulatory approval and commercialization of our COSTAR stent. If we are not successful in the completion of clinical trials for the development, approval and commercialization of our COSTAR stent, we may never generate any revenues and may be forced to cease operations. Although we are investigating the potential applicability of our stent technology to the treatment of an acute myocardial infarction, or AMI, we do not expect to seek regulatory approval of this product candidate for many years, if at all. The commercial success of our COSTAR stent will depend upon successful completion of clinical trials, manufacturing commercial supplies, obtaining marketing approval, successfully launching the product and acceptance of the product by the medical community and third party payors as clinically useful, cost-effective and safe. If the data from our clinical trials is not satisfactory, we may not proceed with our planned filing of applications for regulatory approvals or we may be forced to delay the filings. Even if we file an application for approval with satisfactory clinical data, the FDA or foreign regulatory authorities may not accept our filing, or may request additional information, including data from additional clinical trials. The FDA or foreign regulatory authorities may also approve our COSTAR stent for very limited purposes with many restrictions on its use, may delay approval, or ultimately, may not grant marketing approval for our COSTAR stent. Even if we do receive FDA or foreign regulatory approval, we may be unable to gain market acceptance by the medical community and third party payors. We do not have the necessary regulatory approvals to market our COSTAR stent or other product candidates, and we may never obtain regulatory approval. We do not have the necessary regulatory approvals to market our COSTAR stent or any other product in the United States or in any foreign market. The regulatory approval process for our COSTAR stent involves, among other things, successfully completing clinical trials and obtaining FDA approval of a premarket approval application, or PMA, and obtaining equivalent foreign market approvals, including taking the steps necessary for our COSTAR stent to bear CE marking in the European Community. We cannot assure you that we will obtain the necessary regulatory approvals to market our COSTAR stent in the United States or abroad. Our COSTAR stent is a combination product that will be regulated primarily as a class III medical device in the United States, which cannot be commercially distributed until the FDA approves our PMA. The premarket approval process can be expensive and uncertain, requires detailed and comprehensive scientific and other data, generally takes several years and may never result in the FDA granting premarket approval. We will also have to obtain similar, or in some cases more stringent, foreign marketing approval in order to commercialize our product candidates outside of the United States. If we do not obtain the requisite regulatory or marketing Investing in our common stock involves risks. See Risk Factors beginning on page 8. Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense. Table of Contents approvals, we will be unable to market our COSTAR stent and may never recover any of the substantial costs we have invested in the development of our COSTAR stent. If our pre-clinical tests or clinical trials for our COSTAR stent or other product candidates do not meet safety or efficacy endpoints, or if we experience significant delays in these tests or trials, our ability to commercialize our COSTAR stent or other product candidates and our financial position will be impaired. Before marketing our COSTAR stent or any other product candidate, we must successfully complete pre-clinical studies and clinical trials that demonstrate that the product is safe and effective. Product development, including pre-clinical studies and clinical testing, is a long, expensive and uncertain process and is subject to delays. It may take us several years to complete our testing, if at all, and a trial may fail at any stage. For example, we discovered that the dosage formulations for our SCEPTER trial were not ideal, and we decided not to complete the data analysis from this trial. The results of pre-clinical or clinical studies do not necessarily predict future clinical trial results, and acceptable results in early studies might not be seen in later studies. For example, the four-month follow-up data from our PISCES study may not be sustained in later follow-up of patients in the trial, and we may discover unanticipated side effects. Any pre-clinical or clinical test may fail to produce results satisfactory to the FDA or foreign regulatory authorities. Pre-clinical and clinical data can be interpreted in different ways, which could delay, limit or prevent regulatory approval. We intend to design the protocol of our planned pivotal U.S. clinical trial for our COSTAR stent based in part on prior clinical trials that used different stents. The results of these prior clinical trials may not be indicative of the clinical results we would obtain for our U.S. pivotal clinical trial. We intend to commercialize our drug eluting stent technology in the form of our COSTAR stent, which is a cobalt chromium, paclitaxel eluting stent. We have only limited clinical data on our COSTAR stent, which we derived from the COSTAR I study. Our other prior clinical trials used either a bare metal stainless steel stent or a stainless steel, paclitaxel eluting stent. In addition to using a different metal than used in our COSTAR stent, the stainless steel stent had slightly different dimensions than our COSTAR stent. We intend to design the protocol, including the dosage formulations, for our planned U.S. pivotal clinical trial based on the results of these prior clinical trials. This trial is being designed in large part based on the results of our PISCES study, which used a stainless steel, paclitaxel eluting form of our stent technology, as well as on the results of our COSTAR I study. Currently, we have only four-month follow-up data from these studies. The results of these prior trials may not be indicative of the behavior of, and therefore the clinical results we will obtain with, our COSTAR stent. If results at least as favorable as the four-month results in our PISCES and COSTAR I studies are not observed in subsequent clinical trials, our development efforts will be delayed or halted and our business may be harmed. The clinical results we have reported to date are after four-month follow-up, and may not be indicative of future clinical results. The clinical results we have reported to date are limited to four-month follow-up data from our PISCES study and our COSTAR I study. The pivotal trial we are conducting for marketing approval in the European Community, EuroSTAR, will report six-month follow-up data, and our planned U.S. pivotal clinical trial, COSTAR II, will require at least eight-month follow-up data. The four-month results from our PISCES and COSTAR I studies may not be indicative of the clinical results obtained when we examine the patients at a later date. While the stainless steel, paclitaxel eluting stent has shown favorable results after four months in our PISCES study, it is possible that the results are not durable, and that the long-term results we obtain with our COSTAR stent may not show similar effectiveness. Per Share Table of Contents Our current and planned clinical trials may not begin on time, or at all, and may not be completed on schedule, or at all. The commencement or completion of any of our clinical trials may be delayed or halted for numerous reasons, including, but not limited to, the following: the FDA or other regulatory authorities do not approve a clinical trial protocol or a clinical trial, or place a clinical trial on hold; patients do not enroll in clinical trials at the rate we expect; patients are not followed-up at the rate we expect; patients experience adverse side effects; patients die during a clinical trial for a variety of reasons, including the advanced stage of their disease and medical problems, which may not be related to our product candidates; third party clinical investigators do not perform our clinical trials on our anticipated schedule or consistent with the clinical trial protocol and good clinical practices, or other third party organizations do not perform data collection and analysis in a timely or accurate manner; regulatory inspections of our clinical trials or manufacturing facilities, which may, among other things, require us to undertake corrective action or suspend or terminate our clinical trials if investigators find us not to be in compliance with regulatory requirements; changes in governmental regulations or administrative actions; the interim results of the clinical trial are inconclusive or negative; or our trial design, although approved, is inadequate to demonstrate safety and/or efficacy. Before we can commence our planned U.S. pivotal clinical trial for our COSTAR stent, an investigational device exemption, or IDE, application must be approved by the FDA. Although we currently anticipate submitting an IDE application to the FDA in 2005, the timing of our IDE submission or the FDA s approval may be delayed for a number of reasons. For example, in animal studies, we observed evidence of small cracks in the previous design of our COSTAR stent. Accordingly, we modified the design of our COSTAR stent in mid-2004, which we believe eliminated the potential for the small cracks we observed in the animal studies. We anticipate our IDE submission will be based, in part, on data from trials conducted with the previous stent design. The FDA may require us to conduct additional studies with the modified stent, which could delay the timing of our IDE submission and/or FDA approval to commence the trial. The FDA may also require us to conduct additional studies of our COSTAR stent since a significant percentage of the patients evaluated in our clinical trials to date were treated with our paclitaxel eluting stainless steel stent. Additionally, the FDA may require us to conduct additional studies of our COSTAR stent at the paclitaxel dose to be used in our planned U.S. pivotal clinical trial. Discussions with the FDA regarding other aspects of our planned clinical trial may also delay the submission of our IDE application or the FDA s approval of the application. Clinical trials may require the enrollment of large numbers of patients, and suitable patients may be difficult to identify and recruit. For example, the FDA may require that we enroll 2,000 or more patients for our U.S. pivotal clinical trial for our COSTAR stent. Patient enrollment in clinical trials and completion of patient follow-up in clinical trials depend on many factors, including the size of the patient population, the nature of the trial protocol, the proximity of patients to clinical sites and the eligibility criteria for the study and patient compliance. For example, patients may be discouraged from enrolling in our clinical trials if the trial protocol requires them to undergo extensive post-treatment procedures to assess the safety and effectiveness of our COSTAR stent, or they may be persuaded to participate in contemporaneous trials of competitive products. In addition, patients participating in our clinical trials may die before completion of the trial or suffer adverse medical effects unrelated to our COSTAR stent. Delays in patient enrollment or failure of patients to continue to participate in a study may cause an increase in costs and delays or result in the failure of the trial. Total Table of Contents Our development costs will increase if we have material delays in our clinical trials or if we need to perform more or larger clinical trials than planned. Adverse events during a clinical trial could cause us to repeat a trial, terminate a trial or cancel the entire program. Problems with the stent to be used in the control group could adversely affect our planned U.S. pivotal clinical trial for our COSTAR stent. Our planned U.S. pivotal clinical trial of our COSTAR stent could be significantly delayed or harmed if we experience problems with the stent to be used in the control group for this trial. We plan to use one of the two currently marketed drug eluting stents, Johnson & Johnson s CYPHER stent and Boston Scientific s TAXUS Express2 stent, as the control stent in our planned U.S. pivotal clinical trial. In July 2004, Boston Scientific announced the recall of approximately 85,000 TAXUS Express2 stent systems and approximately 11,000 Express2 stent systems due to characteristics in the delivery catheters that have the potential to impede balloon deflation during a coronary angioplasty procedure. In August 2004, Boston Scientific announced that it would recall an additional 3,000 TAXUS Express2 stents. If prior to or during the enrollment and treatment period for our planned U.S. pivotal clinical trial, there is a recall of the control stent or the control stent is removed from the market, our trial would likely be substantially delayed. The FDA could also require us to redesign the trial based on an alternative control stent. Any significant delay or redesign would significantly delay and potentially impair our ability to commercialize our COSTAR stent. We may not be successful in our efforts to expand our portfolio of products and develop additional drug delivery technologies. A key element of our strategy is to discover, develop and commercialize a portfolio of new products in addition to our COSTAR stent. We are seeking to do so through our internal research programs and intend to explore strategic collaborations for the development of new products utilizing our stent technology. Research programs to identify new disease targets, product candidates and delivery techniques require substantial technical, financial and human resources, whether or not any product candidates are ultimately identified. Our research programs may initially show promise in identifying potential product candidates, yet fail to yield product candidates for clinical development for many reasons, including the following: the research methodology used may not be successful in identifying potential product candidates; competitors may develop alternatives that render our product candidates obsolete; our delivery technologies may not safely or efficiently deliver the drugs; and product candidates may on further study be shown to have harmful side effects or other characteristics that indicate they are unlikely to be effective. Our strategy also includes exploring the use of compounds and drugs other than paclitaxel for the treatment of restenosis and other indications. We may not be able obtain any necessary licenses to promising compounds or drugs on reasonable terms, if at all. In addition, our strategy includes substantial reliance on strategic collaborations with others to develop new products. If these collaborators do not prioritize and commit substantial resources to these collaborations, or if we are unable to secure successful collaborations on acceptable business terms, we may be unable to discover suitable potential product candidates or develop additional delivery technologies and our business prospects will suffer. Pre-clinical development is a long, expensive and uncertain process, and we may terminate one or more of our pre-clinical development programs. We may determine that certain pre-clinical product candidates or programs do not have sufficient potential to warrant the allocation of resources, such as the potential development of our stent technology for the treatment of AMI. Accordingly, we may elect to terminate our programs for such product candidates. If we terminate a pre- Public Offering Price $ $ Underwriting Discounts $ $ Proceeds to Conor Medsystems, Inc. (before expenses) $ $ The underwriters expect to deliver the shares to purchasers on or about , 2004. Citigroup Table of Contents clinical program in which we have invested significant resources, our prospects will suffer, as we will have expended resources on a program that will not provide a return on our investment and will have missed the opportunity to have allocated those resources to potentially more productive uses. We depend on single source suppliers for our COSTAR stent components, manufacturing components, and the active drug used in our COSTAR stent. The loss of these suppliers could delay our clinical trials or prevent or delay commercialization of our COSTAR stent. We rely on third parties to supply us with the critical components and the active drug, paclitaxel, used in our COSTAR stent. Phytogen International LLC is our sole supplier of paclitaxel. Our agreement with Phytogen restricts our ability to commercialize products that incorporate paclitaxel we purchase from third parties, and there is a limited number of alternative suppliers that are capable of manufacturing paclitaxel and are willing, or legally able, to do so. In addition, the agreement permits Phytogen to manufacture and supply paclitaxel to others. If Phytogen is unable or refuses to meet our demand for paclitaxel, if Phytogen terminates its agreement with us or if Phytogen s supplies do not meet quality and other specifications, the development and commercialization of our COSTAR stent could be prevented or delayed. To date, our paclitaxel requirements have consisted of quantities that we need to conduct our pre-clinical and clinical trials. If we obtain market approval for our COSTAR stent, we anticipate that we will require substantially larger quantities of paclitaxel. Phytogen may not provide us with sufficient quantities of paclitaxel that meet quality and other specifications, and we may not be able to locate an alternative supplier of paclitaxel in a timely manner or on commercially reasonable terms, if at all. We do not have long-term contracts with our third party suppliers of stent delivery catheters or the cobalt chromium tubing and laser-precision cutting process required to produce our COSTAR stent. In addition, we do not have long-term contracts with our third party suppliers of some of the equipment and components that are used in our manufacturing process. Except for the suppliers of our laser-cut stents and stent delivery catheters, none of our suppliers have agreed to maintain a guaranteed level of production capacity. Furthermore, suppliers that have guaranteed a level of production capacity may still be unable to satisfy our supply needs. Establishing additional or replacement suppliers for these components may take a substantial amount of time. We may also have difficulty obtaining similar components from other suppliers that are acceptable to the FDA or foreign regulatory authorities. Furthermore, since some of these suppliers are located outside of the United States, we are subject to foreign export laws and U.S. import and customs regulations, which complicate and could delay shipments to us. Some of the manufacturers of stent components are also our competitors and may be reluctant to supply components to us on favorable terms, if at all. If we have to switch to replacement suppliers, we may face additional regulatory delays and the manufacture and delivery of our COSTAR stent could be interrupted for an extended period of time, which may delay completion of our clinical trials or commercialization of our COSTAR stent. In addition, we will be required to obtain regulatory clearance from the FDA or foreign regulatory authorities to use different suppliers or components that may not be as safe or as effective. As a result, regulatory approval of our COSTAR stent may not be received on a timely basis or at all. We have limited manufacturing capabilities and manufacturing personnel, and if our manufacturing facilities are unable to provide an adequate supply of products, our growth could be limited and our business could be harmed. We currently manufacture our COSTAR stent at our facilities in Menlo Park, California, and we are currently establishing manufacturing capacity in Ireland to manufacture our COSTAR stent for sale outside of the United States. If there were a disruption to our existing manufacturing facility, we would have no other means of manufacturing our COSTAR stent until we were able to restore the manufacturing capability at our facility or develop alternative manufacturing facilities. If we were unable to produce sufficient quantities of our COSTAR stent for use in our current and planned clinical trials, or if our manufacturing process yields substandard stents, our development and commercialization efforts would be delayed. CIBC World Markets SG Cowen & Co. A.G. Edwards , 2004 Table of Contents We currently have limited resources, facilities and experience to commercially manufacture our product candidates. In order to produce our COSTAR stent in the quantities that we anticipate will be required to meet anticipated market demand, we will need to increase, or scale up, the production process by a significant factor over the current level of production. There are technical challenges to scaling-up manufacturing capacity, and developing commercial-scale manufacturing facilities would require the investment of substantial additional funds and hiring and retaining additional management and technical personnel who have the necessary manufacturing experience. We may not successfully complete any required scale-up in a timely manner or at all. If we are unable to do so, we may not be able to produce our COSTAR stent in sufficient quantities to meet the requirements for the launch of the product or to meet future demand, if at all. If we develop and obtain regulatory approval for our COSTAR stent and are unable to manufacture a sufficient supply of our COSTAR stent, our revenues, business and financial prospects would be adversely affected. In addition, if the scaled-up production process is not efficient or produces stents that do not meet quality and other standards, our future gross margins may decline. In addition, while we have validated our manufacturing process for consistency, we have experienced drug release kinetic variability within and between manufacturing lots, and we may experience similar issues in the future. Manufacturing lot variability may result in unfavorable clinical trial results. Additionally, any damage to or destruction of our Menlo Park facilities or our equipment, prolonged power outage or contamination at our facility would significantly impair our ability to produce our COSTAR stents. For example, because our Menlo Park facilities are located in a seismic zone, we face the risk that an earthquake may damage our facilities and disrupt our operations. Our manufacturing facilities and the manufacturing facilities of our suppliers must comply with applicable regulatory requirements. If we fail to achieve regulatory approval for these manufacturing facilities, our business and our results of operations would be harmed. Completion of our clinical trials and commercialization of our product candidates require access to, or the development of, manufacturing facilities that meet applicable regulatory standards to manufacture a sufficient supply of our products. Although we are currently in the process of establishing a manufacturing facility in Ireland for products to be sold outside of the United States, our manufacturing facility may not meet applicable foreign regulatory requirements or standards at acceptable cost and on a timely basis. In addition, the FDA must approve facilities that manufacture our products for U.S. commercial purposes, as well as the manufacturing processes and specifications for the product. Suppliers of components of, and products used to manufacture, our products must also comply with FDA and foreign regulatory requirements, which often require significant time, money and record-keeping and quality assurance efforts and subject us and our suppliers to potential regulatory inspections and stoppages. Our suppliers may not satisfy these requirements. If we or our suppliers do not achieve required regulatory approval for our manufacturing operations, our commercialization efforts could be delayed, which would harm our business and our results of operations. Quality issues in our manufacturing processes could delay our clinical development and commercialization efforts. The production of our COSTAR stent must occur in a highly controlled, clean environment to minimize particles and other yield- and quality-limiting contaminants. In spite of stringent quality controls, weaknesses in process control or minute impurities in materials may cause a substantial percentage of defective products in a lot. If we are not able to maintain stringent quality controls, or if contamination problems arise, our clinical development and commercialization efforts could be delayed, which would harm our business and our results of operations. Table of Contents Table of Contents Our COSTAR stent may never achieve market acceptance even if we obtain regulatory approvals. Even if we obtain regulatory approval, our COSTAR stent, or any other drug delivery device that we may develop, may not gain market acceptance among physicians, patients, health care payors and the medical community. The degree of market acceptance of any of our drug delivery devices that we may develop will depend on a number of factors, including: the perceived effectiveness of the product; the prevalence and severity of any side effects; potential advantages over alternative treatments; the strength of marketing and distribution support; and sufficient third party coverage or reimbursement. If our COSTAR stent, or any other drug delivery device that we may develop, is approved but does not achieve an adequate level of acceptance by physicians, healthcare payors and patients, we may not generate product revenue and we may not become profitable. If we fail to obtain an adequate level of reimbursement for our products by third party payors, there may be no commercially viable markets for our product candidates or the markets may be much smaller than expected. The availability and levels of reimbursement by governmental and other third party payors affect the market for our product candidates. The efficacy, safety, performance and cost-effectiveness of our product candidates and of any competing products will determine the availability and level of reimbursement. Reimbursement and healthcare payment systems in international markets vary significantly by country, and include both government sponsored healthcare and private insurance. To obtain reimbursement or pricing approval in some countries, we may be required to produce clinical data, which may involve one or more clinical trials, that compares the cost-effectiveness of our products to other available therapies. We may not obtain international reimbursement or pricing approvals in a timely manner, if at all. Our failure to receive international reimbursement or pricing approvals would negatively impact market acceptance of our products in the international markets in which those approvals are sought. Although we intend to commercialize our COSTAR stent in India, India does not currently have a reimbursement infrastructure, and we do not anticipate that the commercialization of our COSTAR stent in India will provide us with any significant revenues. We believe that future reimbursement may be subject to increased restrictions both in the United States and in international markets. Future legislation, regulation or reimbursement policies of third party payors may adversely affect the demand for our products currently under development and limit our ability to sell our product candidates on a profitable basis. In addition, third party payors continually attempt to contain or reduce the costs of healthcare by challenging the prices charged for healthcare products and services. If reimbursement for our products is unavailable or limited in scope or amount or if pricing is set at unsatisfactory levels, market acceptance of our products would be impaired and our future revenues, if any, would be adversely affected. If we are unable to establish sales and marketing capabilities or enter into and maintain arrangements with third parties to sell and market our COSTAR stent, our business may be harmed. We do not have a sales organization and have no experience as a company in the sales, marketing and distribution of drug eluting stents or other medical devices. To market and sell our COSTAR stent internationally, we have entered into distribution agreements with third parties and anticipate that we will have to enter into additional distribution arrangements. Our existing distribution agreements are generally short-term in duration, and we will have to pursue alternative distributors if the other parties to these distribution agreements terminate or elect not to renew their agreements with us. If our relationships with our distributors do not progress Table of Contents TABLE OF CONTENTS Page Table of Contents as anticipated, or if their sales and marketing strategies fail to generate sales of our products in the future, our business, financial condition and results of operations would be harmed. If our COSTAR stent is approved for commercial sale in the United States, we currently plan to establish our own sales force to market it in the United States. If we develop our own marketing and sales capabilities, our sales force will be competing with the experienced and well-funded marketing and sales operations of our competitors. Developing a sales force is expensive and time consuming and could delay or limit the success of any product launch. We may not be able to develop this capacity on a timely basis or at all. If we are unable to establish sales and marketing capabilities, we will need to contract with third parties to market and sell our COSTAR stent in the United States. To the extent that we enter into arrangements with third parties to perform sales, marketing and distribution services in the United States, our product revenues could be lower than if we directly marketed and sold our COSTAR stent, or any other drug delivery device that we may develop. Furthermore, to the extent that we enter into co-promotion or other marketing and sales arrangements with other companies, any revenues received will depend on the skills and efforts of others, and we do not know whether these efforts will be successful. Some of our existing or future distributors may have products or product candidates that compete with ours, and they may have an incentive not to devote sufficient efforts to marketing our products. For example, Biotronik AG, with whom we have an agreement that primarily covers European distribution, is developing an absorbable magnesium alloy stent. If we are unable to establish and maintain adequate sales, marketing and distribution capabilities, independently or with others, we may not be able to generate product revenue and may not become profitable. The medical device industry is highly competitive and subject to rapid technological change. If our competitors are better able to develop and market products that are safer and more effective than any products that we may develop, our commercial opportunity will be reduced or eliminated. The medical device industry is highly competitive and subject to rapid and profound technological change. Our success depends, in part, upon our ability to maintain a competitive position in the development of technologies and products in the drug delivery field. We face competition from established pharmaceutical and biotechnology companies, as well as from academic institutions, government agencies and private and public research institutions in the United States and abroad. Our principal competitors have significantly greater financial resources and expertise in research and development, manufacturing, pre-clinical testing, conducting clinical trials, obtaining regulatory approvals and marketing approved products than we do. For example, Johnson & Johnson and Boston Scientific, two companies with far greater financial and marketing resources than we possess, have both developed, and are actively marketing, drug eluting stents which have been approved by the FDA. We may be unable to demonstrate that our COSTAR stent offers any advantages over Johnson & Johnson s CYPHER stent or Boston Scientific s TAXUS Express2 stent. In addition, in August 2004, Boston Scientific announced that it had begun enrolling patients in a pivotal study to support commercialization of its new TAXUS Liberte coronary stent as a platform for its paclitaxel eluting coronary stent system. Boston Scientific has stated that the trial is designed to assess the safety and efficacy of a slow-release dose formulation for the treatment of coronary disease and that the TAXUS Liberte stent system is designed to further enhance deliverability and conformability, particularly in challenging lesions. Many other large companies, including Guidant Corporation, Medtronic Inc. and Abbott Laboratories, among others, are reportedly developing drug eluting stents. Smaller or early-stage companies may also prove to be significant competitors, particularly through collaborative arrangements with, or mergers with or acquisitions by, large and established companies or through the development of novel products and technologies. Our competitors may: develop and patent processes or products earlier than us; obtain regulatory approvals for competing products more rapidly than us; and develop more effective or less expensive products or technologies that render our technology or product candidates obsolete or non-competitive. Summary 1 Risk Factors 8
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+RISK FACTORS Investing in our ordinary shares involves a high degree of risk. You should carefully consider the following risks, as well as the other information in this prospectus, before deciding whether to invest in our ordinary shares. If any of the following risks actually occur, our business, financial condition, results of operations and liquidity could suffer. In that event, the trading price of our ordinary shares could decline and you might lose all or part of your investment. Risks Related to Our Business The rapid evolution of our industry makes it difficult for investors to evaluate our business prospects, and may result in significant declines in our share price. Our service has been available since 1998. Since that time, Internet commerce has grown rapidly and consumer usage patterns have continually evolved. During this period, many businesses related to Internet commerce have failed, and many new comparison shopping services have been introduced and some have failed. Because Internet commerce is a young industry and comparison shopping is a new business sector, we have made frequent changes in our websites and other aspects of our business operations. Some of the special risks we face in our rapidly-evolving industry are: the new and unproven nature of our Shopping.com brand; delays and obstacles to enhancing our service to meet evolving demands; difficulties in forecasting trends that may affect our operations; challenges in attracting and retaining consumers and merchants; significant dependence on a small number of revenue sources; evolving industry demands that require us to adapt our pricing model from time to time; and adverse technological changes and regulatory developments. If we are unable to meet these risks and difficulties as we encounter them, our business, financial condition, results of operations and liquidity may suffer. Our financial results are likely to fluctuate significantly from quarter to quarter, which makes them difficult to predict and could result in significant variations in our share price. Our quarterly financial results have fluctuated significantly in the past and are likely to fluctuate significantly in the future. As a result, you should not rely upon our quarterly financial results as indicators of future performance. Our financial results depend on numerous factors, many of which are outside of our control, including: seasonal fluctuations in consumer shopping and merchant advertising; the number of consumer visits to our service and subsequent lead referrals; changes in the lead referral fees that merchants are willing to pay; the costs of attracting consumers and merchants to our service, including advertising costs; the timing and amount of international expansion costs; the introduction of new consumer and merchant offerings; the loss of one or more of our merchants or other listings providers; system failures, security breaches or Internet downtime; The Registrant hereby amends this Registration Statement on such date or dates as may be necessary to delay its effective date until the Registrant shall file a further amendment that specifically states that this Registration Statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933 or until the Registration Statement shall become effective on such date as the Commission, acting pursuant to said Section 8(a), may determine. Table of Contents difficulty in upgrading our information technology systems and infrastructure; fluctuations in currency exchange rates; and the costs of acquisitions and risks of integration of acquired businesses. Many of our expenses are fixed in the short term and determined based on our investment plans and estimates of future revenues. We expect to incur significant new expenses in developing our technology and service offerings, as well as in advertising and promotion to attract and retain consumers and merchants, before generating associated revenues. We may be unable to adjust our expenditures quickly enough to compensate for any unexpected revenue shortfall. For these or other reasons, our financial results in future quarters may fall below the expectations of management or investors and the price of, and long-term demand for, our ordinary shares could decline. We typically generate a disproportionately high amount of our revenues in the fourth quarter of each year. If that seasonal pattern were to be disrupted for any reason, our revenues and financial results for that year could be harmed, resulting in a decline in our share price. We may incur losses in future periods, which could reduce investor confidence and cause our share price to decline. We had a history of losses prior to 2003, and we may incur losses again. We had net losses of $72.9 million in 2001 and $5.1 million in 2002. We expect to continue to increase our sales and marketing expenses, research and development expenses, and general and administrative expenses, and we cannot be certain that our revenues will continue to grow at the same pace, if at all. If our revenue growth does not continue, we may experience a loss in future periods, which could cause our share price to decline. We have incurred a deemed dividend, and expect to incur additional deemed dividend amounts in connection with this offering, which would reduce our earnings per share or increase our net loss per share, for the period in which this offering occurs and could reduce the trading price of our ordinary shares. In June 2004 we amended our articles of association to increase the conversion ratios of certain classes of our preferred shares. We have recorded a non-cash deemed dividend representing the estimated value of the modification of the conversion ratios as of the date of the shareholder approval, in the amount of $10.5 million. We expect to record an additional amount as a deemed dividend upon the closing of this offering, in an amount equal to the excess of the fair value of the ordinary shares that will be issued upon conversion of the preferred shares over the fair value of the ordinary shares that would have been issued pursuant to the original conversion terms and the $10.5 million that was recorded in June 2004. The fair value will be based upon our actual initial public offering price. The amount of this additional deemed dividend is estimated to be approximately $6.2 million if our initial offering price is $17.00 per share, $7.2 million if it is $18.00 per share and $5.2 million if it is $16.00 per share. We believe that as a result of this deemed dividend, we are likely to report a net loss attributable to ordinary shareholders, and a net loss per share, for 2004 even if we report net income in accordance with GAAP. If we otherwise report a net loss in the period in which we recognize this deemed dividend, the deemed dividend would increase our net loss attributable to ordinary shareholders, and our net loss per share. This could result in a decline in the trading price of our ordinary shares. Table of Contents If we fail to grow the number of consumers and merchants that use our service, our financial results will suffer. Our relationships with consumers and merchants are mutually dependent. We believe consumers will not use our service unless we offer extensive product listings from merchants and that merchants will not use our service unless consumers actively use it to purchase products from them. It is difficult to predict the degree to which consumers and merchants will use our service in the future. Consumers who dislike changes to our service may stop using it, and merchants who dislike the quality of lead referrals that we send to them may cease to use our service or reduce overall spending for our service. Additionally, merchant attrition or reductions in merchant spending could reduce the comprehensiveness of the listings presented on our service, which could lead to fewer consumers using our service. The top three relevant merchant listings that we display in our response to a consumer query in some product categories are selected based on the amount paid by these merchants to us. As a result, consumers may perceive our service to be less objective than those provided by other online shopping solutions. Failure to achieve and maintain a large and active base of consumers and merchants using our service could reduce our revenues and profitability. We face intense competition that could harm our financial performance. The business of providing comparison shopping services is highly competitive. Any service that helps consumers find, compare or buy products or services is a competitor to us. Our competitors may be categorized as focused comparison shopping websites, search engines and portals, online retailers, and other specialized shopping services and publications, such as the following: Focused comparison shopping websites. Several companies focus exclusively on providing comparison shopping services. In this group, our principal competitors are BizRate, mySimon, NexTag and PriceGrabber in the United States, and Kelkoo in Europe (which was recently acquired by Yahoo!). We believe that many of these companies have specific competitive advantages over us. For example, BizRate specializes in merchant reviews and PriceGrabber specializes in computers and consumer electronics categories. Search engines and portals. Search engines and portals serve as origination websites for consumers to find products. Many have large audiences of visitors, consumers and merchants, established brand recognition, loyal users, and significant financial resources and personnel at their disposal. We rely on search engines for a substantial portion of the consumers visiting our websites. Yahoo! provides a service similar to ours, and Google, Inc., or Google, has developed a search engine for finding products for sale online. If these search engines were to change their algorithms or otherwise restrict the flow of consumers visiting our websites, our financial results would suffer. Online retailers. Online retailers serve as destination websites from which consumers directly buy products. They are skilled at building customer loyalty and generating repeat business. Consumers may bypass our service in favor of going straight to retailer websites. This risk is compounded because several of these online retailers, such as Amazon.com and eBay, are also our customers. Competition may limit our growth and increase our costs of doing business. Many of our competitors have significantly longer operating histories, larger and broader customer bases, and greater technical expertise, brand recognition and online commerce experience. Many of our competitors have greater financial resources than we do to invest in marketing and promotional campaigns, attracting consumers and merchants, and hiring and retaining key employees. If we are to remain competitive, we must invest substantial resources in our business with no assurance of any additional revenues. If consumers and merchants forego the use of our service for those of our competitors, our revenues and financial results would suffer. (Loss) income from operations (7,332 ) (60 ) (767 ) 1,025 Interest income 324 118 31 43 (Loss) gain on disposal of fixed assets (322 ) 11 Table of Contents The information in this preliminary prospectus is not complete and may be changed. These securities may not be sold until the registration statement filed with the Securities and Exchange Commission is effective. This preliminary prospectus is not an offer to sell nor does it seek an offer to buy these securities in any jurisdiction where the offer or sale is not permitted. Subject to Completion. Dated October 25, 2004. 6,871,160 Shares Ordinary Shares Table of Contents Approximately 38% of our revenues in 2003 came from Google, which also competes with us, and a change in this relationship could harm our business. In August 2002, we entered into the first of three agreements with Google to participate in its sponsored links program. Under each of these agreements, we display merchant listings from Google s advertisers on the Featured Resources section of our service, and we generate revenues when consumers click through these listings to the Google advertisers websites. In 2003, we derived approximately 38% of our revenues under these agreements. In the first six months of 2004, we derived approximately 43% of our revenues under these agreements. The agreement under which most of our revenues from Google are derived accounted for 27% of our 2003 revenues and expires in April 2006. Under this agreement, we were guaranteed payments totaling $16.0 million during each of the 12-month periods ended April 30, 2003 and 2004. We have a second agreement with Google relating to our U.K. subsidiary, which expires in April 2005 but can be terminated by either party as of October 31, 2004, and which accounted for 2% of our 2003 revenues. We have a third agreement with Google, originally entered into by Epinions, Inc., that expires in February 2005 and accounted for 9% of our 2003 revenues. We are guaranteed payments of $500,000 per month under this agreement. If these contracts end unexpectedly, fail to be renewed or are renewed on less favorable economic terms, our results of operations will suffer. Google operates a search engine for finding products for sale online, called Froogle, that competes with Shopping.com. Google could decide in the future that it prefers not to do business with us due to the competitive nature of our services. In that event, Google could decide not to renew its current agreements with us when they expire, or it could decide to offer renewal terms that are less favorable to us than the terms of our current agreements with Google. In either case, we could experience a significant decline in our revenues and the value of your investment could decline. The recent resignation of our chief operating officer may make it more difficult for us to run our business and may make our prospects more difficult to predict. On June 30, 2004, Nirav Tolia, who had been our chief operating officer, resigned as a member of our board of directors, executive officer and employee, following an investigation by an independent committee of our board of directors into the accuracy of his representations about his educational background and work history that he made during the course of his employment by us. The investigation commenced after counsel to a group of former Epinions stockholders that has made claims associated with our acquisition of Epinions asserted that Mr. Tolia, the chief executive officer of Epinions at the time we acquired it, had made untrue statements about his background. The absence of Mr. Tolia may make it more difficult to run our business, because he was a key contributor to our strategic and marketing efforts after our April 2003 acquisition of Epinions. His departure may place additional burdens on our executive management resources, as existing personnel will assume his management responsibilities. We may also find it necessary to recruit additional personnel to perform some of his responsibilities. Because Mr. Tolia was highly regarded by many employees and by many contributors of our Epinions reviews, his departure could adversely affect employee morale and the level of activity and loyalty among our review contributors. All of these consequences have the potential to harm our business and financial results. The loss of a significant number of merchants could harm our business by reducing our revenues and by making our service less attractive to users. Although merchants enter into contracts with us when they enroll in our service, they are not required to pay us any minimum amounts, or to list a minimum number of products. Merchants are entitled to a refund of any unused prepaid amounts, which amounted to $1.2 million as of June 30, 2004, and they may terminate their agreements with us at any time. If a large number of our merchants Series F Shares 3,000,000 3,000,000 $ 3,060 $ 6 Series E Shares 4,750,000 3,943,098 40,371 8 Series D Shares 10,200,000 8,940,867 64,591 22 Series C Shares 12,500,000 9,817,935 28,131 25 Series B Shares 4,457,150 4,314,293 3,020 11 Series A Shares 4,738,080 4,738,080 1,490 This is an initial public offering of ordinary shares of Shopping.com Ltd. Shopping.com Ltd. is offering 5,060,084 ordinary shares, and the selling shareholders identified in this prospectus are offering an additional 1,811,076 ordinary shares, to be sold in this offering. These amounts are based on an assumed initial public offering price of $17.00 per share. It is currently estimated that the initial public offering price per share will be between $16.00 and $18.00. Shopping.com will not receive any proceeds from the sale of ordinary shares being sold by the selling shareholders. Prior to this offering, there has been no public market for the ordinary shares. Our ordinary shares have been approved for quotation on the Nasdaq National Market under the symbol SHOP. See Risk Factors beginning on page 9 to read about factors you should consider before buying the ordinary shares. (In thousands) Net (loss) income $ (72,854 ) $ (5,082 ) $ 6,922 $ 3,788 $ 3,852 Interest expense 242 386 32 19 3 Interest and other (income) expense, net (972 ) (38 ) (672 ) (141 ) (188 ) Provision for income taxes 158 25 18 Depreciation and amortization 2,361 2,396 2,310 1,135 1,141 Amortization of goodwill and other purchased intangibles 42,336 500 164 353 Restructuring and other charges 9,517 1,019 617 Stock-based compensation 114 Table of Contents were to cancel or significantly reduce the number of their product listings, the quality of the shopping experience we offer consumers would decline, leading to a reduction in the number of consumers using our service, harming our business and financial results. Spending to develop and maintain the Shopping.com brand is costly and does not assure future revenues. Many competing online shopping services have well-established brands. If we do not build brand recognition and loyalty with consumers and merchants quickly, we may lose the opportunity to build the large base of loyal consumers and merchants that we believe is essential to our success. In September 2003, we launched our new website, www.shopping.com, and we have had only a short time to develop recognition of the Shopping.com brand. During the fourth quarter of 2003, we spent approximately $3.8 million on a television advertising campaign to promote our new brand. We may make significant expenditures for similar promotions in the future, but we have not yet determined the timing or amount of these expenditures. There is no guarantee that this strategy will increase the recognition of our brand. In addition, even if our brand recognition increases, this may not result in increased use of our service or higher revenues. We depend on search engines to attract a substantial portion of the consumers who visit our service, and losing these consumers would adversely affect our revenues and financial results. Many consumers access our service by clicking through on search results displayed by search engines, such as Google and Yahoo! Search engines typically provide two types of search results, algorithmic listings and purchased listings. Algorithmic listings cannot be purchased, and instead are determined and displayed solely by a set of formulas designed by the search engine. Purchased listings can be purchased by advertisers in order to attract users to their websites. We rely on both algorithmic and purchased listings to attract and direct a substantial portion of consumers to our service. Search engines revise their algorithms from time to time in an attempt to optimize their search result listings. When search engines on which we rely for algorithmic listings modify their algorithms, this has, on occasion, resulted in fewer consumers clicking through to our website, requiring us to resort to other costly resources to replace this traffic, which, in turn, reduces our operating and net income or our revenues, which harms our business. If one or more search engines on which we rely for purchased listings modifies or terminates its relationship with us, our expenses could rise, or our revenues could decline and our business may suffer. Recent changes to our pricing model might not succeed in increasing our revenues or might cause our revenues to decrease, which would harm our results of operations. Because Internet commerce is a relatively new and rapidly evolving industry, we have occasionally adjusted, and may in the future adjust, our pricing model in an attempt to maximize our profitability. For example, in April 2004, for many of our product categories, we modified the pricing model for lead referral payments by merchants and the system for prioritizing the display of merchant listings on our service. Under this new model, the first three relevant merchant listings are selected for display solely based on the amount of lead referral fees paid to us. All remaining relevant merchant offers are ordered based on a combination of product price and trustworthiness of store, with the first of these merchant listings designated a Smart Buy. The lead referral fees the merchants are willing to pay us for these remaining merchant listings do not affect the order of presentation on our service. For the first four merchant listings displayed, we charge the lead referral fee that each merchant has indicated it is willing to pay us. For the remaining merchant listings displayed, we charge the minimum category listing fee, without regard to the listing fee the merchants may be willing to pay. Before this change, we prioritized relevant merchant listings in all product categories according to a variety of factors, principally the amount paid to us, and charged each merchant the amount that merchant had (In thousands) Net (loss) income $ (72,854 ) $ (5,082 ) $ 6,922 $ 3,788 $ 3,852 Interest expense 242 386 32 19 3 Interest and other (income) expense, net (972 ) (38 ) (672 ) (141 ) (188 ) Provision for income taxes 158 25 18 Depreciation and amortization 2,361 2,396 2,310 1,135 1,141 Amortization of goodwill and other purchased intangibles 42,336 500 164 353 Restructuring and other charges 9,517 1,019 617 Stock-based compensation 114 Total non-cash stock compensation $ 114 $ Phase I Preference Series F Shares 3,000,000 3,000,000 $ 3,060 $ 6 Series E Shares 3,943,098 3,943,098 40,283 8 Series D Shares 9,167,944 8,940,867 63,963 22 Series C Shares 9,817,935 9,817,935 27,795 25 Series B Shares 4,389,293 4,389,293 3,073 11 Series A Shares 4,738,080 4,738,080 2,331 12 Phase II Preference Series I Shares 10,803,587 10,803,587 11,811 24 Series G Shares 10,972,748 10,972,748 8,126 24 Series H Shares 6,171,510 6,171,510 25,000 Neither the Securities and Exchange Commission nor any other regulatory body has approved or disapproved of these securities or passed upon the accuracy or adequacy of this prospectus. Any representation to the contrary is a criminal offense. Table of Contents indicated it was willing to pay us for its listing, regardless of the placement of the merchant s listing on our service. We still apply this method to those product categories not affected by the new pricing model. If these changes to our pricing model do not succeed in increasing our revenues or cause our revenues to decrease, and if we are not able to revise our pricing model in time to reverse this trend, our results of operations would be harmed and our stock price could suffer. If members of the Epinions community cease to provide us with reviews or remove their content from our service, the number of consumers using our service and our revenues could decline. Our service contains a significant amount of consumer-generated content, primarily reviews of products, services and merchants. This content is created for us by members of our Epinions community, many of whom receive nominal payments from us for our use of this content. Our user agreement with Epinions members provides that the member retains the intellectual property rights to this content. Epinions members may modify or remove their content from our service at any time, and some have done so in the past. A small number of reviewers have produced a substantial portion of the Epinions content. If a large amount of content were to be removed from our service, it could lower the value of our service to consumers and harm our business. In addition, though we provide tools to allow the community to rate the helpfulness of reviews, we do not approve, edit or modify any consumer-generated content on our service. Epinions members have, in the past, submitted profane or other undesirable content, which could offend our consumers or merchants. If Epinions members cease authoring reviews or if the quality of their reviews deteriorates, the number of consumers using our service could decline, which could result in a decrease in revenues, adversely impacting our results of operations. Our plans for international expansion could fail as a result of risks associated with international operations. Although our service can be accessed around the world, most of our consumers and merchants are located in the United States. International expansion is a key element of our strategy, but we have limited experience developing or customizing our service to conform to currencies, languages, cultures, standards and regulations outside the United States. We have operated a website in the United Kingdom since December 1999. We previously operated websites in Germany and Japan, but discontinued them in 2001 due to a lack of local market acceptance. Expanding our international operations will require management attention and resources, and will engage us in competition with local companies that are better established and more familiar with the preferences of consumers and merchants in those markets than we are. In addition, the risks we will face in expanding our business internationally include: online shopping might not be sufficiently popular with consumers and merchants in different countries; we might be unable to customize our website to conform to local market preferences; costs required to customize our product catalog for different countries might be high; regulatory requirements in different countries might restrict some product offerings; governments might impose taxes, tariffs or other limitations on Internet access or transactions; foreign operations could require significant management attention; foreign currency exchange rates will fluctuate; protection of intellectual property rights may be weaker in some countries; (Unaudited) Computers, software and peripheral equipment $ 5,962 $ 8,569 $ 12,107 Office furniture and equipment 905 895 913 Leasehold improvements 532 524 536 Motor vehicles Per Share Table of Contents technological infrastructures, such as access to broadband, might be less developed in some countries; we might experience longer payment cycles and greater collection problems; and political instability in some countries might disrupt our business. Any of these risks could have a material adverse effect on our international operations and could affect the profitability of those operations or even cause their total failure, resulting in the loss of our investment. In such events, our business, results of operations, financial condition and liquidity would suffer. Our transfer pricing procedures may be challenged, which may subject us to higher taxes or penalties and adversely affect our earnings. Transfer prices are prices that one company in a group of related companies charges to another member of the group for goods, services or use of property. If two or more affiliated companies are located in different countries, the tax laws or regulations of each country generally will require that transfer prices be the same as those between unrelated companies dealing at arms length. We have operated pursuant to oral and, as of May 2004 with respect to some arrangements with our U.S. subsidiary and as of September 2004 with respect to some arrangements with our U.K. subsidiary, written transfer-pricing agreements that establish the transfer prices for transactions between Shopping.com Ltd. and our U.S. and U.K. subsidiaries. However, our transfer pricing procedures are not binding on applicable tax authorities. No official authority in any country has made a determination as to whether or not we are operating in compliance with its transfer pricing laws. If tax authorities in any of these countries were to challenge our transfer prices successfully, they could require us to adjust our transfer prices and thereby reallocate our income to reflect these transfer prices. A reallocation of income from a lower tax jurisdiction to a higher tax jurisdiction would result in a higher tax liability for us. In addition, if the country from which the income is reallocated does not agree with the reallocation, both countries could tax the same income, resulting in double taxation. Changes in laws and regulations may require us to change our transfer prices or operating procedures. If tax authorities were to allocate income to a higher tax jurisdiction, subject our income to double taxation or assess penalties, it would result in a higher tax liability for us, which would adversely affect our earnings and liquidity. Non-Israeli tax authorities may tax some or all of Shopping.com Ltd. s income, which would adversely affect our earnings. Shopping.com Ltd. is incorporated in Israel and conducts business operations within Israel. Its income is subject to Israeli income tax. The majority of Shopping.com Ltd. s management is based in the United States. We have endeavored to structure our business so that all of our U.S. operations are carried out by our U.S. subsidiaries and all of our U.K. operations are carried out by our U.K. subsidiary. Our U.S. subsidiaries are subject to U.S. income tax and our U.K. subsidiary is subject to U.K. income tax. Under tax treaties between Israel and the United States and between Israel and the United Kingdom, Shopping.com Ltd. s business income is not subject to tax in either the United States or the United Kingdom to the extent that it is not attributable to a permanent establishment located in either of these countries. Shopping.com Ltd. has filed its tax returns on the basis that it does not have a permanent establishment for tax purposes in the United States or in the United Kingdom and that it is not engaged in a U.S. business. U.S. tax law does not clearly define activities that constitute being engaged in a U.S. business or a permanent establishment. The Internal Revenue Service could contend that some or all of Shopping.com Ltd. s income should be subject to U.S. income tax (at the regular corporate rates, plus additional branch profits taxes) or subject to U.S. withholding tax. Similarly, tax authorities in other jurisdictions could contend that some or all of Shopping.com Ltd. s Balance at December 31, 2001 31,754,273 78 4,038,715 84,764 10 172,977 (1,201 ) (163,167 ) 8,697 Net loss (5,082 ) (5,082 ) Comprehensive income (loss) Translation differences 15 Total Table of Contents income should be subject to income tax in those other jurisdictions. If Shopping.com Ltd. s income is subject to taxes in jurisdictions outside of Israel, it will adversely affect our net income. The Israeli Approved Enterprise tax benefits for which we qualify require us to meet specific conditions; if we fail to meet these conditions or if the programs are modified or terminated, these tax benefits could be terminated or reduced, which would increase our taxes and lower our net income. To maintain our qualification as an Approved Enterprise under Israeli tax law, we must continue to meet conditions set forth in Israeli law and regulations, including making specified investments in property and equipment and financing a percentage of our investments with share capital. If we fail to comply with these conditions in the future, the benefits we receive could be cancelled or reduced and we could be required to pay increased taxes or refund the amounts of the tax benefits we received, together with interest and penalties. The Israeli government may terminate these programs or modify the conditions for qualifications at any time. The Law for the Encouragement of Capital Investments, 1959, under which the Approved Enterprise program and its benefits are administered, will expire on October 31, 2004, unless it is extended. Accordingly, requests for new programs or expansions of existing programs that are not approved on or before October 31, 2004, will not confer any tax benefits, unless the term of the law is extended. In addition, from time to time, we may submit requests for expansion of our Approved Enterprise programs or for new programs to be designated as Approved Enterprises. These requests might not be approved. The termination or reduction of these tax benefits, or our inability to get approvals for expanded or new programs, could increase our taxes, thereby reducing our profits or increasing our losses. Additionally, as we increase our activities outside of Israel, our increased activities will not be eligible for inclusion in Israeli tax benefit programs. We recorded taxable income in Israel for the first time in 2003, but that income was offset by tax loss carryforwards. Accordingly, we have received no tax benefits to date under the Approved Enterprise tax program. Capacity constraints and system failures or security breaches could prevent access to our service, which could affect our revenues and harm our reputation. Our service goals of performance, reliability and availability require that we have adequate capacity in our computer systems to cope with the volume of visits to our websites. As our operations grow in size and scope, we will need to improve and upgrade our systems and infrastructure to offer consumers and merchants enhanced services, capacity, features and functionality. The expansion of our systems and infrastructure will require us to commit substantial financial, operational and technical resources before the volume of our business increases, with no assurance that our revenues will increase. If our systems cannot be expanded in a timely manner to cope with increased website traffic, we could experience disruptions in service, slower response times, lower consumer and merchant satisfaction, and delays in the introduction of new products and services. Any of these problems could impair our reputation and cause our revenues to decline. Our ability to provide high-quality service depends on the efficient and uninterrupted operation of our computer and communications systems. Our service has experienced system interruptions from time to time and could experience periodic system interruptions in the future. Our systems and operations also are vulnerable to damage or interruption from human error, natural disasters, power loss, telecommunication failures, break-ins, sabotage, computer viruses, design defects, vandalism, denial-of-service attacks and similar events. Some of our facilities are located in the San Francisco Bay area, a major earthquake zone. We do not have full second-site redundancy, a formal disaster recovery plan or alternative providers of hosting services, and outages at our data centers could mean Initial public offering price $ $ Underwriting discount $ $ Proceeds, before expenses, to Shopping.com $ $ Proceeds, before expenses, to the selling shareholders $ $ To the extent that the underwriters sell more than 6,871,160 ordinary shares, the underwriters have the option to purchase up to an additional 1,030,674 shares from us at the initial public offering price less the underwriting discount. Table of Contents the loss of some or all of our website functionality. Our business interruption insurance may not adequately compensate us for losses that may occur. Any system failure that causes an interruption in service or decreases the responsiveness of our service could impair our reputation and cause our revenues to decline. We may not be able to hire and retain the personnel we need to support and expand our business, which could cause our business to shrink, or slow any expansion. Our future success depends on our ability to identify, hire, train, retain and motivate highly-skilled executive, technical, sales, marketing and business development personnel. Our existing key personnel include all of our executive officers and management team. The loss of any member of this team could disrupt our operations until a suitable replacement is found. Competition for highly-skilled personnel is intense in the technology and Internet markets. The process of locating, training and successfully integrating highly-skilled personnel into our operations can be lengthy and expensive. If we fail to attract, integrate and retain highly-skilled personnel, our ability to support, expand and manage our business could suffer. We may be subject to costly litigation arising out of our acquisition of Epinions, Inc., and that litigation could have a material adverse effect on our business, and the trading price of our ordinary shares, if decided adversely. On May 28 and June 7, 2004, we received letters on behalf of a group of former holders of Epinions, Inc. common stock claiming that they were damaged by alleged misrepresentations and failures to disclose material information, as well as breaches of fiduciary duty, in connection with our April 2003 acquisition of Epinions. That acquisition, following a fairness hearing before the California Department of Corporations and approval by substantial majorities of the Epinions preferred and common stockholders, resulted in holders of Epinions preferred stock receiving shares of our preferred stock and the Epinions common stock being cancelled. In addition, some Epinions employees were hired and granted options to purchase our ordinary shares. The letters claim that the holders of Epinions common stock were not properly informed (or were misled) about financial results and projections of Epinions and about the terms and amounts of stock options to be granted to Epinions employees who were hired by Shopping.com. The letters also claim that a group of controlling stockholders and directors of Epinions improperly increased their ownership interest by agreeing to a merger in which the valuation of Epinions was too low. The alleged controlling group referred to in the letters appears to include Nirav Tolia, our former chief operating officer and director, who was the chief executive officer of Epinions at the time of the acquisition, J. William Gurley and John R. Johnston, who are current members of our board of directors, and some or all of the former holders of Epinions preferred stock, some of which are among our significant shareholders. The letters assert that the former common stockholders of Epinions have suffered damages of over $30 million and that such former stockholders are entitled to between approximately 1.8 million and 2.4 million Shopping.com ordinary shares. The letters further state that the former stockholders may seek punitive damages, or to impose a constructive trust on misappropriated property and possibly other remedies, such as rescission and restitution. The former stockholders may hold us responsible for some or all of these claims. These former Epinions stockholders may choose to commence litigation against us, our directors and officers, and some of our shareholders. If that were to happen, the plaintiffs could claim additional damages and seek additional remedies. In any such litigation, the credibility of Mr. Tolia would likely be an issue, and that credibility may be adversely affected by his recent resignation following an investigation by our board of directors into the accuracy of his representations about his educational background and work history. Dealing with any such claims or litigation could be costly and our insurance, if any, may not cover costs and losses we might suffer. In addition, our management could be required to spend a considerable amount of time attending to these claims, whether or not they result in litigation. Any damages for which we may be liable as a result of such litigation, or any (Loss) income from operations (3,182 ) (2,545 ) (518 ) 1,511 564 3,127 943 1,806 2,083 1,602 Income taxes (25 ) (25 ) (108 ) (6 ) (12 ) Interest (expense) income, net (241 ) (57 ) (56 ) 6 (72 ) 194 147 371 168 Assets and liabilities of the subsidiary at the disposal date: Working capital (excluding cash and cash equivalents) $ (416 ) Fixed assets 9 Other assets 204 Lease liabilities (72 ) Capital gain from the sale of the subsidiary 8,997 Minority interest The underwriters expect to deliver the shares against payment in New York, New York on October , 2004. Goldman, Sachs & Co. Credit Suisse First Boston Deutsche Bank Securities Piper Jaffray Table of Contents settlement, which we may enter into in order to resolve the claims, may require us to spend a material amount of funds or issue new securities. If we were to issue any new shares as compensation to the claimants, there would be an immediate dilution in the value of other outstanding ordinary shares, including any shares sold in this offering, and that dilution could be significant. As a result, these claims and any related litigation could have a material adverse effect on our business, results of operations, financial condition and liquidity and upon the value of your investment in us. We may be subject to costly litigation arising out of information presented on or collected in connection with our service, and the litigation could have a material adverse effect on our business if decided adversely. Claims could be made against us under U.S. and foreign law for defamation, libel, invasion of privacy, deceptive or unfair practices, fraud, negligence, copyright or trademark infringement, or other theories based on the nature and content of the materials disseminated through our service or based on our collection and use of information. The law relating to the liability of online companies for information carried on, disseminated through or collected by their services is currently unsettled. Our service includes consumer-generated reviews from our Epinions website, which includes information regarding the quality of goods, and the reliability of merchants that sell those goods. Similar claims could be made against us for that content. We may be required to reduce exposure to liability for information disseminated through our service, which could require substantial expenditures and discontinuation of some service offerings. Any such response could materially increase our expenses or reduce our revenues. Our liability insurance may not be adequate to indemnify us if we become liable for information disseminated through our service. Any costs incurred as a result of such liability that are not covered by insurance could reduce our profitability or cause us to sustain losses, which could have a material adverse effect on our business, results of operations, financial condition and liquidity. We may also be subject to claims or regulatory action arising out of the collection or dissemination of personal, non-public information of users of our service. We may be subject to costly intellectual property litigation that could have a material adverse effect on our business if decided adversely. We could face claims that we have infringed the patent, trademark, copyright or other intellectual property rights of others. From time to time we receive such claims and we are ordinarily involved in litigation over such claims. Intellectual property litigation is often extremely costly, unpredictable and disruptive to business operations. It may not be possible to obtain or maintain insurance covering these risks. Any adverse decision, including an injunction or damage award entered against us, could subject us to significant liabilities, require us to seek to obtain licenses from others, make changes to our brand, prevent us from operating our business, or cause severe disruptions to our operations or the markets in which we compete. Any of these developments could harm our reputation, our business and our results of operations. We may not be able to protect intellectual property rights upon which our business relies, and if we lose intellectual property protection, we may lose valuable assets. Our business depends on our intellectual property, including internally-developed technology and data resources and brand identification by the public, which we attempt to protect through a combination of copyright, trade secret, patent and trademark law and contractual restrictions, such as confidentiality and proprietary rights agreements. We also depend on our trade names and domain names. We have no patents. Applications we have filed for patent and other intellectual property registration may not result in the issuance of patents, registered trademarks, service marks or other intellectual property registrations. In particular, if we are not able to obtain a registered trademark for the name Shopping.com, and as a result are not able to protect our brand, our business could suffer from possible (Unaudited) Company A 19 % 11 % Company B 19 % 11 % 13 % Company C 14 % Company D 11 % Company E Prospectus dated , 2004. Table of Contents confusion among consumers and merchants, among other things. In addition, our use of unregistered trade names and service marks may not protect us from the use of similar marks by third parties. Intellectual property laws vary from country to country, and it may be more difficult to protect and enforce our intellectual property rights in some foreign jurisdictions. We have had experiences with other companies using or planning to use a name similar to ours as part of a company name, domain name, trademark or service mark. In the future, we may need to litigate in the United States or elsewhere to enforce our intellectual property rights or determine the validity and scope of the proprietary rights of others. This litigation would be expensive and would likely divert the attention of our management. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy or otherwise obtain and use our service, technology and other intellectual property, and we cannot be certain that the steps we have taken will prevent any misappropriation or confusion among consumers and merchants, or unauthorized use of these rights. If we are unable to procure, protect and enforce our intellectual property rights, then we may not realize the full value of these assets, and our business may suffer. We may be unable to protect our Internet domain names, which could decrease the value of our brand. We have the right to use domain names for website destinations that we use in our business. If we are unable to protect our rights in these domain names, our competitors could capitalize on our brand recognition by using these domain names for their own benefit. Domain names similar to Shopping.com have been registered in the United States and elsewhere and in most countries the top- level domain name shopping is owned by other parties. We might not acquire or maintain country- specific versions of the shopping domain name, such as shopping.co.uk in the United Kingdom, shopping.de in Germany or shopping.fr in France. Furthermore, the relationship between regulations governing domain names and laws protecting trademarks and similar proprietary rights is unclear and varies from jurisdiction to jurisdiction. We may be unable to prevent third parties from acquiring domain names that infringe on, or otherwise decrease the value of, our brand, or our trademarks, service marks or other proprietary rights. Protecting and enforcing our intellectual property rights and determining the proprietary rights of others may require litigation, which could result in substantial costs and divert management attention. We may not prevail if litigation is initiated. Exchange rate fluctuations between the U.S. Dollar and the New Israeli Shekel or the British Pound may decrease our earnings. A portion of our revenues and a portion of our costs, including personnel and some marketing, facilities and other expenses, are incurred in New Israeli Shekels and British Pounds. Inflation in Israel or the United Kingdom may have the effect of increasing the U.S. Dollar cost of our operations in that country. If the U.S. Dollar declines in value in relation to one or more of these currencies, it will become more expensive for us to fund our operations in the countries that use those other currencies. From April 2003 to February 2004 the U.S. Dollar to the British Pound, and from February 2003 to July 2003 the U.S. Dollar to the New Israeli Shekel, declined significantly. We do not hedge any of our foreign currency risk. Our acquisitions have been and could be difficult to integrate, disrupt our business, dilute shareholder value and have a material adverse effect on our operating results. We have entered into business combinations with other companies in the past, including our April 2003 acquisition of Epinions, Inc., and we may make additional acquisitions in the future. Acquisitions involve significant risks, including difficulties in the integration of the operations, internal controls, business strategy, services, technologies and corporate culture of the acquired companies, diversion of Table of Contents Table of Contents management s attention from other business concerns, overvaluation of the acquired companies, the rejection of the acquired companies products and services by our customers and the potential impairment of acquired assets. We have experienced many of these risks in connection with the acquisitions that we completed in the past. For example, we realized an impairment of intangible assets of $6.4 million in 2001 relating to the acquisition of Digital Jones, Inc. In addition, future acquisitions would likely result in dilution to existing shareholders, if securities are issued. Additionally, the expenditure of cash or the assumption of debt or contingent liabilities in connection with these acquisitions could have a material adverse effect on our financial condition, results of operations and liquidity. Accordingly, any future acquisitions could result in a material adverse effect on our business. If we cannot adequately manage any future growth, our results of operations will suffer. We have experienced rapid growth in our operations, and our anticipated future growth, if such growth occurs at all, may place a significant strain on our managerial, operational and financial resources. We have made, and may continue to make, inadequate estimates for the costs and risks associated with our expansion, and our systems, procedures and managerial controls may not be adequate to support our operations. Any delay in implementing, or transitioning to, new or enhanced systems, procedures or controls may adversely affect our ability to manage our product listings and record and report financial and management information on a timely and accurate basis. If we are unable to manage any such expansion successfully, our revenues may not grow, our expenses may increase and our results of operations may be adversely affected. Risks Related to Our Industry If Internet usage and infrastructure do not continue to grow rapidly, our business prospects and share price could decline. Our revenues and profits depend on the continued acceptance and use of the Internet and online services as a medium for commerce. The failure of the Internet to continue to develop as a commercial medium could have a material adverse effect on our business and financial results. Consequently, the growth of the market for our service depends upon improvements being made to the entire Internet, as well as to the networking infrastructures of our merchant customers to alleviate overloading and response time delays. We believe that growth in the market for our service also depends upon growth in the utilization of broadband connections. If this growth fails to continue or slows, our financial results and the trading price of our ordinary shares could be adversely affected. Government regulation and legal uncertainties may damage our business. The laws and regulations applicable to the Internet and our service in the countries where we operate are evolving. Governments may adopt new laws and regulations governing the Internet or the conduct of business on the Internet that could increase our costs of doing business or limit the attractiveness of online shopping. In addition, we might be required to comply with existing laws regulating or requiring licenses for certain businesses of our merchants, such as the distribution of alcohol or firearms. These laws and regulations could expose us to substantial compliance costs and liability. In response to these laws and regulations, whether proposed or enacted, as well as public opinion, we may also elect to limit the types of merchants or products we display on our service, which could in turn decrease the desirability of our service and reduce our revenues. The Federal Trade Commission, or FTC, issued guidance in 2002 regarding what disclosures are desirable in order to avoid misleading users about the effect that purchased listings may have on the inclusion or ranking of listings in search results in Internet search engines. This guidance may differ from the existing practices of the industry, including our practices. If the FTC brings enforcement Table of Contents Table of Contents actions against firms not complying with the guidance, and our business practices are covered by and not complaint with the guidelines, we could be subject to litigation by the FTC, as well as State Attorneys General and private litigants, potentially resulting in the payment of significant sums of money for consumer restitution, penalties and fines. Imposition of sales and other taxes may damage our business. Current law does not require merchants to collect sales or other similar taxes with respect to goods sold by them over the Internet in many cases. As a result, consumers are able to buy goods on the Internet without paying sales taxes required by law. Some states may seek to impose sales tax collection obligations on online retailers, or may seek to collect sales tax directly from online consumers. The Internet Tax Freedom Act, which limited the ability of states to impose taxes on access to the Internet, expired on November 1, 2003. A proposal to extend this moratorium has been made, but there can be no assurance that it will be enacted. Failure to extend the moratorium could allow any state to impose taxes on Internet access or online commerce. The imposition of Internet usage taxes or enhanced enforcement of sales tax laws could make online shopping less attractive to consumers, which would have a material adverse effect on our business. Increased security risks to us in particular and online commerce in general may deter future use of our service. Concerns over the security of transactions conducted on the Internet and the privacy of Internet users may inhibit use of the Internet and other online services, including online commerce. Any misappropriation of third-party information collected by an Internet provider, security breach or a change in industry standards, regulations or laws or an adverse judicial determination could deter people from using the Internet to conduct transactions that involve transmitting confidential information such as online commerce, which would harm our business. Our market may undergo rapid technological change and any inability to meet the changing needs of our industry could harm our financial performance. The markets in which we compete are characterized by rapidly changing technology, evolving industry standards, frequent new service announcements, introductions and enhancements, and changing consumer demands. We may not be able to keep up with these rapid changes. As a result, our future success depends on our ability to adapt to rapidly changing technologies, to respond to evolving industry standards and to improve the performance, features and reliability of our service. In addition, the widespread adoption of new Internet, networking or telecommunications technologies or other technological changes may require us to incur substantial expenditures to modify or adapt our service and infrastructure, which could harm our financial performance and liquidity. Risks Related to Our Operations in Israel Because we maintain operations in Israel, political, economic or military instability there could disrupt our operations. We maintain a portion of our research and development facilities and personnel in Israel, and as a result, political, economic and military conditions in Israel affect our operations there. Over the past several decades, a number of armed conflicts have taken place between Israel and its Arab neighbors. Since 2000, hostilities between Israel and the Palestinians have increased in intensity. Continued or increased hostility with Palestinians, military hostilities with other states, or other terrorism could make it more difficult for us to continue our operations in Israel, which could increase our costs and adversely affect our financial results. Table of Contents Table of Contents Israeli courts might not enforce judgments rendered outside of Israel, which may make it difficult to collect on judgments rendered against us. We are incorporated in Israel, and some of our assets are located outside the United States; accordingly, enforcement of judgments obtained in the United States against us, including by our shareholders, may be difficult to obtain within the United States. In addition, some of our directors are not residents of the United States, and service of process and enforcement of judgments obtained in the United States against them also may be difficult to obtain within the United States. We have been informed by our legal counsel that there is doubt as to the enforceability of civil liabilities under U.S. securities laws in original actions instituted in Israel. Our personnel in Israel are required to perform military service, which could disrupt our operations or increase our costs. Many of our employees in Israel are obligated to perform up to 36 days of military reserve duty each year, and are subject to being called for active duty under emergency circumstances. If a military conflict or war arises, these individuals could be required to serve in the military for extended periods of time. Our Israeli operations could be disrupted by the absence of employees due to military service, which could adversely affect our business. Your rights and responsibilities as a shareholder will be governed by Israeli law and differ in some respects from the rights and responsibilities of shareholders under U.S. law. We are incorporated under Israeli law. The rights and responsibilities of holders of our ordinary shares are governed by our articles of association and by Israeli law. These rights and responsibilities differ in some respects from the rights and responsibilities of shareholders in typical U.S. corporations. In particular, a shareholder of an Israeli company has a duty to act in good faith toward the company and other shareholders and to refrain from abusing his power in the company, including, among other things, in voting at the general meeting of shareholders on certain matters. Israeli law provides that these duties are applicable in shareholder votes on, among other things, amendments to a company s articles of association, increases in a company s authorized share capital, mergers and interested party transactions requiring shareholder approval. In addition, a shareholder who knows that it possesses the power to determine the outcome of a shareholder vote or to appoint or prevent the appointment of a director or executive officer in the company has a duty of fairness toward the company. However, Israeli law does not define the substance of this duty of fairness. Because Israeli corporate law has undergone extensive revision in recent years, there is little case law available to assist in understanding the implications of these provisions that govern shareholder behavior. Risks Related to Our Ordinary Shares and This Offering There is no established trading market for our ordinary shares, and the market price of our ordinary shares may be highly volatile or may decline regardless of our operating performance. There has not been a public market for our ordinary shares prior to this offering. A trading market in our ordinary shares may not develop. If you purchase ordinary shares in this offering, you will pay a price that was not established in the public trading markets. The initial public offering price will be determined by negotiations between the underwriters and us. You may not be able to resell your shares at or above the initial public offering price and may suffer a loss of some or all of your investment. The market prices of the securities of Internet companies have been volatile, and have been known to decline rapidly. Broad market and industry conditions and trends may cause fluctuations in (Unaudited) Cash flows from operating activities: Net (loss) income $ (7,330 ) $ 69 $ (725 ) $ 1,068 Adjustments to reconcile net (loss) income to net cash (used in) provided by operating activities: Depreciation and amortization 2,036 1,830 469 342 Stock-based compensation 69 Loss (gain) on disposal of fixed assets 322 (11 ) (11 ) Changes in assets and liabilities: Accounts receivable (239 ) (1,331 ) 94 878 Prepaid expenses and other current assets 105 (43 ) (32 ) 4 Accounts payable (526 ) 334 (89 ) 13 Accrued liabilities (677 ) (295 ) (65 ) Table of Contents the market price of our ordinary shares, regardless of our actual operating performance. Additional factors that could cause fluctuation in the price of our ordinary shares include, among other things: actual or anticipated variations in quarterly operating results; changes in financial estimates by us or by any securities analysts who may cover our shares; conditions or trends affecting our merchants or other listings providers; changes in the market valuations of other online commerce companies; announcements by us or our competitors of significant acquisitions, strategic partnerships or divestitures; announcements concerning the commencement, progress or resolution of investigations or regulatory scrutiny of our operations or lawsuits filed or other claims alleged against us; capital commitments; introduction of new products and service offerings by us or our competitors; entry of new competitors into our market; and additions or departures of key personnel. In the past, securities class action litigation has often been brought against companies following periods of volatility in the market prices of their securities. Such litigation could result in significant costs and divert management attention and resources, which could seriously harm our business and operating results. If the ownership of our ordinary shares continues to be highly concentrated, it may prevent you and other shareholders from influencing significant corporate decisions. Our current executive officers, directors and their affiliates will own or control approximately 40% of our outstanding ordinary shares following the completion of this offering at an assumed public offering price of $17.00 per share, the mid-point of the estimated price range shown on the cover of this prospectus. Accordingly, these executive officers, directors and their affiliates, acting as a group, will have substantial influence over the outcome of corporate actions requiring shareholder approval, including the election of directors, any merger, consolidation or sale of all or substantially all of our assets and any other significant corporate transaction. These shareholders may also delay or prevent a change of control of us, even if such a change of control would benefit our other shareholders. Future sales of ordinary shares by our existing shareholders may cause our share price to fall. The market price of our ordinary shares could decline as a result of sales of ordinary shares by our existing shareholders, including by our directors, officers or their affiliates, or the perception that these sales could occur. These sales might also make it more difficult for us to sell equity securities at a time and price that we deem appropriate. The lock-up agreements delivered by shareholders, including our directors and executive officers, provide that Goldman, Sachs & Co., in its sole discretion, may release any of those parties, at any time or from time to time and without notice, from obligations under these agreements, including the obligation not to dispose of ordinary shares for a period of 180 days or 15 days, as applicable, after the date of this prospectus. We may be treated as a passive foreign investment company, which may subject U.S. shareholders to additional taxes. If our passive income, or our assets that produce passive income, exceed levels provided by law for any taxable year, we may be characterized as a passive foreign investment company for U.S. Table of Contents federal income tax purposes. If we are treated as a passive foreign investment company, U.S. holders of our ordinary shares may be subject to additional taxes based on our taxable income and may be taxed at ordinary U.S. federal income tax rates (rather than at capital gains rates) when our ordinary shares are sold. Whether we are treated as a passive foreign investment company depends on questions of fact as to our assets and revenues that can only be determined at the end of each fiscal year. Accordingly, we cannot be certain that we will not be treated as a passive foreign investment company for 2004 or for any subsequent year. We may need to raise additional capital, which we may not be able to obtain on favorable terms, or at all, which could adversely affect your investment in our company, harm our financial and operating results, and cause our share price to decline. We require substantial working capital to fund our business. We cannot be certain that additional financing will be available to us on favorable terms when required, or at all. We have in the past experienced negative cash flow from operations and may experience negative cash flow from operations in the future. We currently anticipate that the net proceeds of this offering, together with our available funds, will be sufficient to meet our anticipated needs for working capital and capital expenditures through at least the next 12 months. However, we may need to raise additional funds prior to the expiration of this period or at a later date. In addition, if we raise additional funds through the issuance of equity, equity-related or convertible debt securities, these securities may have rights, preferences or privileges senior to those of the rights of our ordinary shares and our shareholders may experience additional dilution. Any such developments can adversely affect your investment in our company, harm our financial and operating results, and cause our share price to decline. You will suffer an immediate and substantial dilution in the net tangible book value of the ordinary shares you purchase. On average, prior investors have paid substantially less per share than the price in this offering. The initial public offering price is substantially higher than the pro forma net tangible book value per share of the outstanding ordinary shares immediately after this offering. As a result, based on pro forma net tangible book value and pro forma ordinary shares issued and outstanding as of June 30, 2004, investors purchasing ordinary shares in this offering will incur immediate dilution of $12.93 per share at an assumed public offering price of $17.00 per share, the mid-point of the estimated price range shown on the cover of this prospectus. The exercise of outstanding stock options will result in further dilution to investors. If the initial public offering price of our ordinary shares in this offering is less than $16.00 per share, the conversion ratios of some of our preferred shares will be adjusted according to a formula, increasing the number of ordinary shares into which they convert. As a result, you would suffer additional dilution. The number of ordinary shares to be outstanding after this offering assumes the initial public offering price is $17.00 per share, the mid-point of the estimated price range shown on the cover of this prospectus. If the initial public offering price in this offering is less than $16.00 per share, the conversion ratios of our Series D, Series E, Series G, Series H and Series I preferred shares will be adjusted, each according to a formula. The number of ordinary shares into which each such series of preferred share would convert upon the closing of this offering would increase as the price per share at which we sell ordinary shares in this offering declines below $16.00. For instance, all 62,777,118 outstanding preferred shares would convert upon the closing of this offering into 17,237,967 ordinary shares if the initial public offering price is $15.00 per share, 17,672,697 ordinary shares if the initial public offering price is $14.00 per share and 16,857,911 ordinary shares if the initial public offering price is $16.00 per share or higher. Table of Contents The amendment of the conversion ratios of the Series D and Series E preferred shares after the filing of the registration statement for this offering may give holders of those shares rescission rights under federal or state securities laws, and could expose us to penalties or fines. After the initial filing of the registration statement for this offering, the conversion ratios of our Series D and Series E preferred shares were changed. The largest holder of Series D preferred shares and the principal holder of Series E preferred shares offered to release us from our agreement not to consummate an initial public offering at a price per share below $16.00 without the consent of those two holders, if we agreed to modify the conversion ratios of the Series D and Series E preferred shares to cause the issuance of more ordinary shares to all holders of those series of preferred shares upon their automatic conversion in this offering at prices below $16.00 per share. That amendment was implemented with the approval of our board of directors and shareholders. It is possible that this amendment was a new offer and sale of securities involving a new investment decision by the holders of Series D and Series E preferred shares. If the amendment was an offer and sale of securities and it was not exempt from the registration requirements of federal or state securities laws, then those holders have rights to bring claims against us for rescission or damages. For example, for a period of one year after the violation, a holder of any of the 8,940,867 Series D preferred shares currently outstanding, or any of the 3,943,098 Series E preferred shares currently outstanding, could bring a claim against us for rescission to recover the consideration the holder paid to us in the amendment, with interest, or for damages. Since the amendment did not involve any issuance of securities for cash, it is uncertain how rescission would be valued or damages would be determined. The value of the consideration surrendered by the shareholders in the amendment, and therefore the magnitude of any related claim for rescission or damages, is uncertain. One measure of rescission or damages may be the value of the consideration surrendered by the former holders of the Series D or Series E preferred shares; assuming that value is equivalent to the value of the additional ordinary shares ultimately issued as a result of the amendment, we estimate that value would be up to approximately $4.1 million (based on an assumed initial public offering price of $15.00 per share), or up to approximately $8.2 million (based on an assumed initial public offering price of $14.00 per share), plus interest. We cannot offer any assurance that the extent of our exposure to damages would be limited to these amounts, or calculated according to these assumptions. We would contest any such claim, but any such litigation would be costly to defend and could harm our results of operations, financial condition and liquidity. We may commence a rescission offer to the holders of these shares in connection with our initial public offering if the initial public offering price is below $16.00 per share, but we cannot offer any assurance that doing so will limit any future claims relating to these shares. In addition, we may be subject to penalties or fines relating to these issuances, and such penalties or fines could harm our results of operations, financial condition and liquidity. If we fail to implement changes in our system of internal controls to address reportable conditions, we may not be able to report our financial results accurately or detect fraud. As a result, we could be subject to costly litigation, and current and potential shareholders could lose confidence in our financial reporting, which could harm our business and the trading price of our ordinary shares. Effective internal controls are required for us to provide reliable financial reports and to detect and prevent fraud. We are currently assessing our system of internal controls and potential areas of improvement. We expect that enhancements, modifications and changes to our internal controls will be necessary. We have in the past discovered, and may in the future discover, areas of our internal controls that need improvement. For example, during our 2003 audit, our independent registered public accounting firm brought to our attention a need to limit employee access to our revenue tracking system, to retain certain electronic records, to automate more of our financial processes that are currently performed manually, and to prepare timely reconciliations between our general ledger and certain subledgers. The independent registered public accounting firm identified these items as reportable conditions, which means that they were matters that in the independent registered public Table of Contents accounting firm s judgment could adversely affect our ability to record, process, summarize and report financial data consistent with the assertions of management in the financial statements. We are in the process of implementing changes to address these reportable conditions, but have not yet completed implementing them. As a result, we have not yet fully remedied these reportable conditions. Completing our assessment of internal controls, implementing changes to address the identified reportable conditions and any other changes that are necessary, and maintaining an effective system of internal controls will be expensive and require considerable management attention. However, if we fail to implement and maintain an effective system of internal controls or prevent fraud, we could be subject to costly litigation, investors could lose confidence in our reported financial information and our brand and operating results could be harmed, which could have a negative effect on the trading price of our ordinary shares. We will have broad discretion over the use of the proceeds to us from this offering. We will have broad discretion to use the net proceeds to us from this offering, and you will be relying on the judgment of our board of directors and management regarding the application of these proceeds. Although we expect to use the net proceeds from this offering for general corporate purposes, including working capital, we may also use a portion of the net proceeds for investments or acquisitions. We have not allocated these net proceeds for specific purposes. We have never paid cash dividends on our share capital, and we do not anticipate paying any cash dividends in the foreseeable future. We have never paid cash dividends on any class of our share capital to date and we currently intend to retain any future earnings to fund the development and growth of our business. Furthermore, Israeli law limits the distribution of dividends to the greater of retained earnings or earnings generated over the two most recent fiscal years, provided that we reasonably believe that the dividend will not render us unable to meet our current or foreseeable obligations when due. As of June 30, 2004, our accumulated deficit amounted to $157.5 million. Accordingly, investors must rely on sales of their ordinary shares after price appreciation, which may never occur, as the only way to realize any future gains on their investment. Investors seeking cash dividends should not purchase our ordinary shares. Provisions of our articles of association and Israeli law may prevent or delay an acquisition of Shopping.com, which could depress the price of our shares. Upon the closing of this offering, our articles of association will be amended and restated. Our amended and restated articles of association will contain provisions that could make it more difficult for a third party to acquire control of us, even if that change in control would be beneficial to our shareholders. Specifically, our board of directors will be divided into three classes, each serving staggered three-year terms, there will be advance notice requirements for shareholder proposals and nominations of directors, and approval of mergers will require an absolute majority of the voting power in our company. In addition, provisions of Israeli law may have the effect of delaying, preventing or making more difficult a merger with, or other acquisition of, our company. As a result of these provisions of our articles of association and Israeli law, our ordinary shares may trade at prices below the price that third parties might be willing or able to pay to gain control of us. Table of Contents
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+RISK FACTORS You should carefully consider the following risk factors in addition to other information contained in this prospectus before investing in our common stock. Risks Related to Our Business, Strategy and Operations Our substantial leverage could adversely affect our ability to incur additional indebtedness if needed and could negatively affect our ability to service our debt. We are highly leveraged. As of June 30, 2004, after giving effect to the reorganization, our total outstanding debt, including capital lease obligations, would have been approximately $165.4 million. As of that date, such indebtedness represented approximately 63.5% of our total pro forma capitalization. The indenture that governs our 111/2% senior notes due 2012 permits us and our subsidiaries to incur additional indebtedness subject to certain limitations, which could further exacerbate the risks associated with our leverage. If we incur additional indebtedness that ranks equally with the senior notes, the holders of that debt will be entitled to share ratably with the holders of the senior notes, respectively, in any proceeds distributed in connection with any insolvency, liquidation, reorganization, dissolution or other winding-up of us. Our substantial indebtedness could adversely affect our financial health by, among other things: increasing our vulnerability to adverse economic conditions; limiting our ability to obtain any additional financing we may need to operate, develop and expand our business; limiting our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate; requiring us to dedicate a substantial portion of any cash flow from our operating activities to service our debt, which reduces the funds available for operations and future business opportunities; and potentially making us more highly leveraged than our competitors, which could decrease our ability to compete in our industry. The ability to make payments on our debt will depend upon our future operating performance, which is subject to general economic and competitive conditions and to financial, business and other factors, many of which we cannot control. If the cash flow from our operating activities is insufficient, we may take actions, such as delaying or reducing capital expenditures, attempting to restructure or refinance our debt, selling assets or operations or seeking additional equity capital. Any or all of these actions may not be sufficient to allow us to service our debt obligations. Further, we may be unable to take any of these actions on satisfactory terms in a timely manner or at all. The indenture that governs the senior notes limits our ability to take several of these actions. Our failure to generate sufficient funds to pay our debts or to successfully undertake any of these actions could, among other things, materially adversely affect the market value of the senior notes and our ability to repay our obligations under such notes. We recently emerged from bankruptcy and we have a history of net losses. We may incur additional losses in the future, and our operating results could fluctuate significantly on a quarterly and annual basis which could negatively affect our stock price. We emerged from bankruptcy on July 20, 2004. We sustained net losses of $21.1 million for the nine months ended June 30, 2004 and $72.9 million for the year ended September 30, 2003. Our earnings were insufficient to cover our fixed charges by $19.6 million for the nine months ended June 30, 2004 and $71.1 million for the year ended September 30, 2003. Our future operating profitability and cash flows from operating activities will depend upon many factors, including, among others, our ability to market Sprint PCS products and services, achieve projected market penetration and manage subscriber turnover rates. If we do not achieve and maintain operating profitability and positive cash flows from operating activities, we may be unable to make interest or principal payments on the senior notes. Our inability to satisfy our obligations may result in our restructuring or bankruptcy, in which case you could lose all or part of your investment. In addition, our future operating results and cash flows will be subject to quarterly and annual fluctuations due to many factors, some of which are outside our control. These factors include increased costs we may incur in connection with the further development, expansion and upgrade of our wireless network and fluctuations in the demands for our services. We may not achieve or sustain profitability. To the extent our quarterly or annual results of operations fluctuate significantly, we will be unable to pay amounts due under the senior notes. Our inability to satisfy our obligations may result in our restructuring or bankruptcy, in which case you could lose all or part of your investment. It is our strategy to accelerate our subscriber growth, which may negatively affect our near term profitability. During the year ended September 30, 2003 and the nine months ended June 30, 2004, we experienced overall declining net subscriber growth compared to periods prior to fiscal year 2003. We limited new subscriber activation volume to ensure adequate liquidity to meet our financial obligations. As a means to conserve cash in fiscal 2003, we closed 15 company-owned retail stores and cancelled 21 agreements with local third-party distributors, thereby reducing our retail presence in a number of our markets. Now that we have completed the reorganization, we intend to accelerate the growth of our subscriber base by expanding our sales distribution channels, particularly the number of local third-party distributors and our company-owned retail stores, and by increasing our sales and marketing activities in order to maximize revenues from our third generation network and advanced product offerings. As we seek to accelerate our subscriber growth, we will incur significant up-front subscriber acquisition expenses, which initially will result in reduced levels of cash flows from operating activities as compared to our most recent prior periods. In addition, to the extent our subscriber growth includes a higher percentage of sub-prime credit subscribers, our churn and bad debt expense may increase, which would impair our ability to maintain and increase our revenues and cause a deterioration in our operating margin. Potential mergers and acquisitions or territory expansions may require us to incur substantial additional debt and integrate new technologies, operations and services, which may be costly, time consuming and negatively affect our operating results. We may evaluate expansion opportunities and, subject to the availability of financing, may strategically expand our territory. In addition, a number of similarly situated PCS Affiliates of Sprint may benefit from combined operations. Accordingly, we expect to continually evaluate opportunities for mergers or the acquisition of businesses that are intended to complement or extend our existing operations. If we acquire additional businesses or territories the market value of our common stock may be adversely effected and we may encounter difficulties that may be costly and time-consuming and slow our growth. For example, we may have to: assume and/or incur substantial additional debt to finance the acquisitions and fund the ongoing operations of the acquired companies; integrate new operations with our existing operations; or divert the attention of our management from other business concerns. Our ability to obtain any additional financing that we may need in order to finance any such acquisitions or fund the ongoing operations of such acquired companies or integrate such new operations could be limited by our substantial existing indebtedness, as well as our recent emergence from bankruptcy which would negatively affect our liquidity. Our financial condition or results of operations will not be comparable to the financial condition or results of operations reflected in our historical financial statements which may negatively affect our share price. As a result of our emergence from bankruptcy, we are operating our business with a new capital structure, and are subject to the fresh-start accounting prescribed by generally accepted accounting principles. As required by fresh-start accounting, assets and liabilities will be recorded at fair value, with the enterprise value being determined in connection with the reorganization. Certain reported assets do not yet give effect to the adjustments that may result from the adoption of fresh-start accounting and, as a result, could change materially. Accordingly, our financial condition and results of operations from and after the effective date of the plan of reorganization will not be comparable to the financial condition or results of operations reflected in our historical consolidated financial statements included elsewhere in this prospectus. In addition, in preparing the unaudited pro forma condensed consolidated financial information included in this prospectus, we have made certain assumptions regarding the application of fresh-start accounting principles to our historical financial information. For example, we have made certain assumptions regarding the reorganization enterprise value and the fair values of identifiable assets and liabilities. When a detailed valuation of our business and all of our identifiable assets and liabilities is completed following the effective date of the plan of reorganization, it is possible that such valuation may result in our final reorganization enterprise value and the final fair value of our identifiable assets and liabilities being different from the amounts used in the preparation of the pro forma consolidated financial statements contained in this prospectus. Therefore, actual amounts of identifiable assets, liabilities and revalued intangibles will differ from the amounts reflected in our pro forma consolidated financial statements. The fair value adjustment to these assets and liabilities may also be amortized to income in different amounts than reflected in the pro forma condensed consolidated financial statements, although this amortization would have no impact on our cash flows. As a result, our consolidated financial statements prepared after we emerge from bankruptcy may be materially different in these respects from those set forth in this prospectus which may negatively affect our share price. The bankruptcy proceeding may adversely affect our ability to engage in transactions. Our past inability to meet our obligations that resulted in our bankruptcy filing, or the perception that we may not be able to meet our obligations following the reorganization, could adversely affect our relationships with third parties, as well as our ability to retain or attract high-quality employees. For example, we may have difficulty entering into leases and other agreements related to our operations because of our bankruptcy filing which may negatively affect our operating results. If we receive lower revenues or incur more fees than we anticipate for PCS roaming from Sprint PCS, our results of operations may be negatively affected. We are paid a fee from Sprint PCS or a PCS Affiliate of Sprint for every minute and kilobyte that Sprint PCS or that affiliate's subscribers use the Sprint PCS network in our territory. Similarly, we pay a fee to Sprint or another PCS Affiliate of Sprint for every minute and kilobyte that our subscribers use the Sprint PCS network outside our territory. The per-minute and per-kilobyte rates that we receive from Sprint PCS and that we pay to Sprint PCS or another PCS Affiliate of Sprint are the same and are fixed until the end of December 2006. Thereafter, the rate will change, based on an agreed-upon formula that may have an adverse effect on us. In addition, Sprint PCS subscribers based The information in this prospectus is not complete and may be changed. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell these securities and it is not soliciting an offer to buy these securities in any state where the offer or sale is not permitted. Subject to Completion, dated November 23, 2004 PROSPECTUS iPCS, INC. 5,007,237 Shares of Common Stock in our territory may spend more time outside our territory than we anticipate, and wireless subscribers from outside our territory may spend less time in our territory or may use our services less than we anticipate. Our ratio of inbound to outbound roaming with Sprint PCS was approximately 1.3 to 1 for the nine months ended June 30, 2004. We expect this ratio to decline over time as our subscriber base continues to grow, resulting in us receiving less Sprint PCS roaming revenue and/or having to pay more in Sprint PCS roaming fees than we collect in Sprint PCS roaming revenue which will negatively affect our operating results. Roaming revenue from subscribers of wireless communications providers other than Sprint PCS and PCS Affiliates of Sprint may decline in the future which may negatively affect our operating results. We derive a significant amount of roaming revenue from wireless communications providers other than Sprint PCS and PCS Affiliates of Sprint for permitting their subscribers to roam on our network when they are in our territory. For fiscal year 2003 and the nine months ended June 30, 2004, approximately 19% and 14%, respectively, of our roaming revenue was attributable to revenue derived from these other wireless communications providers. We do not have agreements directly with these providers. Instead, we rely on roaming arrangements that Sprint PCS has negotiated. Sprint PCS may negotiate roaming arrangements with other wireless communications providers at rates that are lower than current rates, resulting in a decrease in our roaming revenue. If the rates offered by Sprint PCS are not attractive, these other wireless communications providers may decide to build out their own networks in our territory and compete with us directly or enter into roaming arrangements with our competitors who also already have networks in our territory, resulting in a decrease in our roaming revenue. Roaming revenue from subscribers of wireless communications providers other than Sprint PCS and PCS Affiliates of Sprint may also decline as a result of decreased roaming traffic in our territory if our quality of service does not continue to meet designated technical and quality standards or if we are unable to control fraudulent use. Our roaming arrangements may not be competitive with other wireless communications providers, which may restrict our ability to attract and retain subscribers which may negatively affect our operating results. We do not have agreements directly with other wireless service providers for roaming coverage outside our territory. Instead, we rely on roaming arrangements that Sprint PCS has negotiated with other wireless communications providers for coverage in these areas. Some risks related to these arrangements are as follows: the arrangements may not benefit us in the same manner that they benefit Sprint PCS; the quality of the service provided by another provider during a roaming call may not approximate the quality of the service provided by Sprint PCS; the price of a roaming call may not be competitive with prices charged by other wireless companies for roaming calls; customers must end a call in progress and initiate a new call when leaving the Sprint PCS network and entering another wireless network; Sprint PCS subscribers may not be able to use advanced PCS features from Sprint PCS, such as PCS Vision, while roaming; Sprint PCS or the carriers providing the service may not be able to provide us with accurate billing information on a timely basis; and if Sprint PCS subscribers do not have a similar wireless experience as when they are on the PCS network of Sprint PCS, we may lose current subscribers and Sprint PCS products and services may be less attractive to potential new subscribers. This prospectus relates to the offer and sale from time to time by each of the selling stockholders identified in this prospectus of up to 5,007,237 shares of our common stock. These selling stockholders obtained their shares of common stock as part of our recent reorganization. We will not receive any of the proceeds from the sale of our shares being sold by the selling stockholders. Our common stock is quoted on the National Quotation Bureau's Pink Sheets under the ticker symbol "IPCX". On November 22, 2004, the last reported sale price of one share of our common stock was $25.75. If we are unable to attract and retain customers for any reason, our ability to maintain and increase revenues will be impaired and our operating margin will deteriorate. Unauthorized use of, or interference with, the Sprint PCS network in our territory could disrupt our service and increase our costs. We may incur costs associated with the unauthorized use of the Sprint PCS network in our territory, including administrative and capital costs associated with detecting, monitoring and reducing the incidence of fraud. Fraudulent use of the Sprint PCS network in our territory may impact interconnection costs, capacity costs, administrative costs, fraud prevention costs and payments to other carriers for fraudulent roaming. As these costs increase, our operating performance may decline which could adversely affect our ability to make payments on our debt and operate our business. If we lose the right to install our equipment on wireless towers or are unable to renew expiring leases for wireless towers on favorable terms or at all, our business and results of operations could be adversely impacted. Approximately 86% of our base stations are installed on leased tower facilities that may be shared with one or more other wireless communications providers. We expect this percentage to increase to nearly 100% if we are successful in selling our remaining currently owned towers for which we have entered into a sale agreement. In addition, a large portion of these leased tower sites are owned by a few tower companies. If a master agreement with one of these tower companies were to terminate, or if one of these tower companies were unable to support the use of its tower sites by us, we would have to find new sites or may be required to rebuild the affected portion of our network. In addition, the concentration of our tower leases with a limited number of tower companies could adversely affect our results of operations and financial condition if any of our operating subsidiaries is unable to renew its expiring leases with these tower companies either on favorable terms or at all. If any of the tower leasing companies that we do business with should experience severe financial difficulties, or file for bankruptcy protection, our ability to use our towers could be adversely affected. That, in turn, would adversely affect our revenues and financial condition if a material number of towers were involved. The technology that we use may become obsolete, which would limit our ability to compete effectively within the wireless telecommunications industry which would negatively affect our operating results and share price. The wireless telecommunications industry is experiencing significant technological change. We employ CDMA (a digital spread-spectrum wireless technology that allows a large number of users to access a single frequency band by assigning a code to all transmission bits, sending a scrambled transmission of the encoded information over the air and reassembling the speech and data into its original format), the digital wireless communications technology selected by Sprint PCS and certain other carriers for their nationwide networks. Other carriers employ other technologies, such as TDMA (time division multiple access, a technology used in digital cellular telephone communication that divides each cellular channel into three time slots in order to increase the amount of data that can be carried), GSM (global system for mobile communication, a technology that digitizes and compresses data, then sends it down a channel with two other streams of user data, each in its own time slot) and iDEN (integrated digital enhanced network, a technology containing the capabilities of a digital cellular telephone, two-way radio, alphanumeric pager, and data/fax modem in a single network), for their nationwide networks. If another technology becomes the preferred industry standard, we would be at a competitive disadvantage and competitive pressures may require Sprint PCS to change its digital technology, which in turn could require us to make changes to our network at substantial cost. We may be unable to respond to these pressures and implement new technology on a timely basis or at an acceptable cost. Additionally, our substantial indebtedness, coupled with our recent emergence from bankruptcy, could limit our ability to obtain any additional financing that we may need in order to Investing in our common stock involves a high degree of risk. See "Risk Factors" beginning on page 9 to read about factors you should consider before buying the shares of common stock. Neither the SEC nor any state securities commission has approved or disapproved of these securities or determined if this prospectus is truthful and complete. Any representation to the contrary is a criminal offense. The date of this prospectus is November , 2004. make changes to our network, which may require us to dedicate a substantial portion of any cash flow from our operating activities to make such changes, thereby reducing funds available for future marketing activities and debt repayment. We may also lose subscribers if we fail to implement significant technological changes evidenced by the development and commercial acceptance of advanced wireless data services, shorter development cycles for new products and enhancements and changes in end-user requirements and preferences. If we lose subscribers, our ability to maintain and increase revenues will be impaired and our operating margin will deteriorate. Additionally, we may be required to make additional capital expenditures to upgrade base stations on certain towers in our Michigan markets as a result of the expected obsolescence of the Lucent Technologies mini-cell technology we employ on the towers. The loss of the officers and skilled employees upon whom we depend to operate our business could adversely affect our operating results and share price. Our business is managed by a small number of executive officers on whom we depend to operate our business. We believe that our future success will depend in part on our continued ability to retain these executive officers and to attract and retain other highly qualified technical and management personnel. Notwithstanding our employment agreements with certain of our executives, we may not be successful in retaining key personnel or in attracting and retaining other highly qualified technical and management personnel. Moreover, our past inability to meet our obligations that resulted in our bankruptcy filing, or the perception that we may not be able to meet our obligations following the reorganization, could adversely affect our ability to retain or attract high-quality personnel. The loss of the officers and skilled employees upon whom we depend to operate our business could adversely affect operating results and share price. Risks Related to Our Relationship with Sprint PCS Our ability to conduct our business would be severely restricted if Sprint PCS terminates our affiliation agreements and our share price would be negatively affected. Our relationship with Sprint PCS is governed by our affiliation agreements with it. As we do not own any licenses to operate a wireless network, our business depends on the continued effectiveness of these affiliation agreements. Sprint PCS may be able to terminate our affiliation agreements with it if we materially breach the terms of the agreements. These terms include operational and network requirements that are extremely technical and detailed and apply to each retail store, cell site and switch site. Many of these operational and network requirements can be changed by Sprint PCS, in certain cases, with little notice. As a result, we may not always be in compliance with all requirements of our affiliation agreements with Sprint PCS. Sprint PCS conducts periodic audits of compliance with various aspects of its program guidelines and identifies issues it believes need to be addressed. We may need to incur substantial costs to remedy any noncompliance. The fact that we are not in compliance with our affiliation agreements could limit our ability to obtain any additional financing that we may need in order to remedy such noncompliance. Additionally, our substantial indebtedness and our recent emergence from bankruptcy could further limit our ability to obtain additional financing. If we cannot obtain additional financing, we may be unable to remedy such noncompliance, thereby resulting in a material breach of our affiliation agreements which could lead to their termination by Sprint. If Sprint PCS terminates or fails to renew our affiliation agreements or fails to perform its obligations under those agreements, our ability to conduct business would be severely restricted and our share price would be negatively affected. TABLE OF CONTENTS PAGE If we materially breach our affiliation agreements with Sprint PCS, Sprint PCS may have the right to purchase our operating assets at a discount to market value. Our affiliation agreements with Sprint PCS require that we provide network coverage to a minimum network coverage area within specified time frames and that we meet and maintain Sprint PCS' technical and customer service requirements. A failure by us to meet Sprint PCS' technical or customer service requirements contained in the affiliation agreements, among other things, would constitute a material breach of the agreements, which could lead to their termination by Sprint PCS. We may amend our affiliation agreements with Sprint PCS in the future to expand our network coverage. Our affiliation agreements with Sprint PCS provide that upon the occurrence of an event of termination caused by our breach of such agreements, Sprint PCS has the right to, among other things, purchase our operating assets without stockholder approval and for a price equal to 72% of our "entire business value," which is our appraised value determined using certain principles set forth in our affiliation agreements with Sprint PCS and based on the price a willing buyer would pay a willing seller for our entire business as a going concern. See "Business Our Affiliation Agreements with Sprint PCS" for a description of how we calculate our entire business value. Sprint PCS may make decisions that could increase our expenses and/or our capital expenditure requirements, reduce our revenues or make our affiliate relationships with Sprint PCS less advantageous than expected. Under our affiliation agreements with Sprint PCS, Sprint PCS has a substantial amount of control over factors that significantly affect the conduct of our business. Accordingly, subject to newly established limits set forth in the amendments to our affiliation agreements with Sprint PCS, Sprint PCS may make decisions that adversely affect our business, such as the following: Sprint PCS prices its national calling plans based on its own objectives and could set price levels or change other characteristics of its plans in a way that may not be economically advantageous for our business; and Sprint PCS may alter its network and technical requirements or request that we build out additional areas within our territory, which could result in increased equipment and build-out costs or in Sprint PCS building out that area itself or assigning it to another PCS Affiliate of Sprint. Certain provisions of our affiliation agreements with Sprint PCS may diminish our value and restrict the sale of our business which may negatively affect our share price. Under specific circumstances and without stockholder approval, Sprint PCS may purchase our operating assets or capital stock at a discount. In addition, Sprint PCS has the right to withhold its consent to any transaction in which the "ultimate parent" of iPCS Wireless, Inc., our operating subsidiary that is the party to the affiliation agreements with Sprint PCS, changes. We must obtain the consent of Sprint PCS prior to any assignment by us of our affiliation agreements with it. Sprint PCS also has a right of first refusal if we decide to sell our operating assets to a third party. We are also subject to a number of restrictions on the transfer of our business, including a prohibition on the sale of our operating assets to competitors of Sprint. These restrictions and the other restrictions contained in our affiliation agreements with Sprint PCS restrict our ability to sell our business, may reduce the value a buyer would be willing to pay for our business, and may reduce our "entire business value," which is our appraised value determined using principles set forth in our affiliation agreements with Sprint PCS and based on the price a willing buyer would pay a willing seller for our entire business as a going concern. Problems with Sprint PCS' internal support systems could lead to customer dissatisfaction or increase our costs. We rely on Sprint PCS' internal support systems, including customer care, billing and back office support. Sprint PCS has entered into business process outsourcing agreements with third parties to provide these services. Sprint PCS may not be able to successfully add system capacity, its internal support systems may not be adequate and the third parties that Sprint PCS has contracted with may not perform their obligations. Problems with Sprint PCS' internal support systems could cause: delays or problems in our operations or services; delays or difficulty in gaining access to subscriber and financial information; a loss of subscribers; and an increase in the costs of customer care, billing and back-office services. Should Sprint PCS fail to deliver timely and accurate information, this may lead to adverse short-term decisions and inaccurate assumptions in our business plan. It could also adversely affect our cash flows, because Sprint PCS collects our receivables and remits to us a net amount that is based on the financial information it produces for us. Our costs for internal support systems may increase if Sprint PCS terminates all or part of our service agreements with it. The costs for the services provided by Sprint PCS under our affiliation agreements with Sprint PCS relative to billing, customer care and other back-office functions for the nine months ended June 30, 2004 were approximately $12.9 million and for the year ended September 30, 2003 were approximately $18.9 million. Because we incur the majority of these costs on a per-subscriber basis, which is fixed until the end of December 2006 and after which will be adjusted by Sprint PCS based on a formula related to Sprint PCS' costs to provide the services, we expect the aggregate cost for such services to increase as the number of our subscribers increases after December 2006. Sprint PCS may terminate any service provided under such agreements upon nine months' prior written notice, but if we desire to continue receiving such service, Sprint PCS has agreed that it will assist us in developing that function internally or locating a third party vendor that will provide that service. Although Sprint PCS has agreed in such an event to reimburse us for expenses we incur in transitioning to any service internally or to a third party, if Sprint PCS terminates a service for which we have not developed or are unable to develop a cost-effective alternative, our operating costs may increase beyond our expectations and our operations may be interrupted or restricted. We do not currently have a contingency plan if Sprint PCS terminates a service we currently receive from it. If Sprint PCS does not maintain control over its licensed spectrum, our affiliation agreements with Sprint PCS may be terminated which will negatively affect our operating results. Sprint PCS, not us, owns the licenses necessary to provide wireless services in our territory. The FCC requires that licensees like Sprint PCS maintain control of their licensed systems and not delegate control to third party operators or managers without the FCC's consent. Our affiliation agreements with Sprint PCS reflect an arrangement that the parties believe meets the FCC requirements for licensee control of licensed spectrum. However, if the FCC were to determine that any of our affiliation agreements with Sprint PCS need to be modified to increase the level of licensee control, we have agreed with Sprint PCS to use our best efforts to modify the agreements to comply with applicable law. If we cannot agree with Sprint PCS to modify the agreements, those agreements may be terminated. If the agreements are terminated, we would no longer be a part of the PCS network of Sprint PCS and we would not be able to conduct our business. The FCC may fail to renew the Sprint PCS wireless licenses under certain circumstances, which would prevent us from providing wireless services. Sprint PCS' wireless licenses are subject to renewal and revocation by the FCC. The Sprint PCS wireless licenses in our territory will expire in 2005 and 2007, but may be renewed for additional ten-year terms. The FCC has adopted specific standards that apply to wireless personal communications services license renewals. Any failure by Sprint PCS or us to comply with these standards could result in the non-renewal of the Sprint PCS licenses for our territory. Additionally, if Sprint PCS does not demonstrate to the FCC that Sprint PCS has met the construction requirements for each of its wireless personal communications services licenses, it can lose those licenses. If Sprint PCS loses its licenses in our territory for any of these reasons, we and our subsidiaries would not be able to provide wireless services without obtaining rights to other licenses. If Sprint PCS loses its licenses in another territory, Sprint PCS or the applicable PCS Affiliate of Sprint would not be able to provide wireless services without obtaining rights to other licenses and our ability to offer nationwide calling plans would be diminished and potentially more costly. We rely on Sprint PCS for a substantial amount of our financial information. If that information is not accurate, our ability to accurately report our financial data could be adversely affected, and the investment community could lose confidence in us. Under our affiliation agreements, Sprint performs our billing, customer care and collections, PCS network systems support, inventory logistics, long distance transport and national third party sales support. The data provided by Sprint related to these functions they perform for us is the primary source for our service revenue and for a significant portion of our cost of service and roaming, and selling and marketing expenses included in our statement of operations. We use this data to record our financial results and prepare our financial statements. If Sprint fails to deliver timely and accurate information, this may lead us to make adverse decisions and inaccurate assumptions for future business plans and could also negatively affect our cash flows as Sprint collects our receivables and remits a net amount to us that is based on the financial information it provides. In addition, delays and inaccuracies which are material could adversely affect the effectiveness of our disclosure controls and procedures and if we later identify material errors in that data provided to us, we may be required to restate our financial statements. If that occurs as to us or any other PCS Affiliate of Sprint, investors and securities analysts may lose confidence in us. If Sprint PCS does not succeed, our business may not succeed. In the event of a business combination involving Sprint, we could be adversely affected as a PCS Affiliate of Sprint in various ways that would be beyond our control. In particular, if a business combination is completed involving Sprint, we may incur significant costs associated with minimizing any customer confusion in the event the Sprint and Sprint PCS brand names are not retained by the successor entity. Any diminution in brand recognition or loyalty could cause a decrease in our revenues. If Sprint has a significant disruption to its business plan or network, fails to operate its business in an efficient manner or suffers a weakening of its brand name, our operations and profitability would likely be negatively impacted. If Sprint should have significant financial problems, including bankruptcy, our business would suffer material adverse consequences, which could include termination or revision of our affiliation agreements with Sprint PCS. If other PCS Affiliates of Sprint have financial difficulties, the PCS network of Sprint PCS could be disrupted which may negatively affect our operating results. The PCS network of Sprint PCS is a combination of networks. The large metropolitan areas are operated by Sprint, and the areas in between them are operated by PCS Affiliates of Sprint, all of which are independent companies like us. We believe that most, if not all, of these companies have incurred substantial debt to pay the large cost of building out their networks. If other PCS Affiliates of Sprint experience financial difficulties, the PCS network of Sprint could be disrupted in the territories of those PCS Affiliates of Sprint. Material disruptions in the PCS network of Sprint PCS could have a material adverse effect on our ability to attract and retain subscribers. If the affiliation agreements of those PCS Affiliates of Sprint are like ours, Sprint PCS would have the right to step in and operate the affected territory. However, this right could be delayed or hindered by legal proceedings, including any bankruptcy proceeding related to the affected PCS Affiliate of Sprint. In addition to us, another PCS Affiliate of Sprint has declared bankruptcy, alleging that Sprint violated its agreements with the PCS Affiliate, and others have experienced financial difficulties which have led to the reorganization of their debt obligations. We may have difficulty in obtaining an adequate supply of certain handsets from Sprint PCS, which could adversely affect our results of operations. We depend on our relationship with Sprint PCS to obtain handsets and other wireless devices. Sprint PCS orders handsets and other wireless devices from various manufacturers. We could have difficulty obtaining specific types of handsets in a timely manner if: Sprint PCS does not adequately project the need for handsets for itself, its PCS Affiliates and its other third-party distribution channels, particularly in transition to new technologies, such as 3G technology; Sprint PCS gives preference to other distribution channels, which has occurred in the past, most recently in 2000; we do not adequately project our need for handsets or other wireless devices; Sprint PCS modifies its handset logistics and delivery plan in a manner that restricts or delays our access to handsets; or there is an adverse development in the relationship between Sprint PCS and its suppliers or vendors. The occurrence of any of the foregoing could disrupt our customer service and/or result in a decrease in our subscribers. If we lose subscribers, our ability to maintain and increase revenues will be impaired and our operating margin will deteriorate. Risks Related to the Wireless Telecommunications Industry We may experience a high rate of subscriber turnover, which would adversely affect our financial performance. Significant competition in our industry and general economic conditions may cause our future churn rate to be higher than our historical rate. Factors that may contribute to higher churn include: inability or unwillingness of subscribers to pay, resulting in involuntary deactivations, which accounted for over 36% of our subscriber deactivations in the nine months ended June 30, 2004; subscriber mix and credit class, particularly sub-prime credit subscribers, which accounted for over 37% of our gross subscriber additions for the nine months ended June 30, 2004 and for approximately 24% of our subscriber base as of June 30, 2004; attractiveness of our competitors' products, services and pricing; network performance and coverage relative to our competitors; customer service; any increased prices for services in the future; and kilobytes of use for limited time periods. We offer these promotional campaigns to potential subscribers in our territory. Sales force with local presence. We have established local sales forces to execute our marketing strategy through our company-owned retail stores, local distributors, direct business-to-business contacts and other channels. Sales and Distribution Our sales and distribution plan is designed to mirror Sprint's multiple channel sales and distribution plan and to enhance it through the development of local distribution channels. Key elements of our sales and distribution plan consist of the following: Sprint PCS retail stores. As of June 30, 2004, we operated twelve Sprint PCS stores at various locations within our territory. These stores provide us with a local presence and visibility in certain markets within our territory. Following the Sprint PCS model, these stores are designed to facilitate retail sales, subscriber activation, bill collection and customer service. In addition to retail stores that we operate, we began in 2003 to enter into agreements with exclusive agents which operate Sprint PCS stores in our territory to further expand our distribution channels. These "branded stores" function similarly to our company-owned stores but are operated by a third party. This third party purchases equipment from us, resells it to the consumer and receives compensation from us in the form of commission. As of June 30, 2004, we had six of these branded stores and kiosks operating in our territory. In calendar year 2004, we plan to add four company-owned Sprint PCS retail stores and to re-emphasize obtaining new subscribers from our retail stores and local third party distributors in our territory. National third party retail stores. Sprint PCS has national distribution agreements with various national retailers such as RadioShack and Best Buy for such retailers to sell Sprint PCS products. These national agreements cover retailers' stores in our territory, and as of June 30, 2004, these retailers had approximately 208 locations in our territory. Local third party distributors. We contract directly with local third party distributors in our territory. These retailers are typically local businesses that have a presence in our markets. Local third party distributors purchase handsets and other PCS retail equipment from us and market Sprint PCS services on our behalf. We are responsible for managing this distribution channel and as of June 30, 2004, these local third party distributors had approximately 125 locations within our licensed territory. We compensate local third party distributors through commissions for subscriber activations. Electronic commerce. Sprint PCS maintains an Internet site, www.sprintpcs.com, which contains information on Sprint PCS products and services. A visitor to the Sprint PCS Internet site can order and pay for a handset and select a rate plan. Sprint PCS wireless subscribers visiting the site can review the status of their account, including the number of minutes used in the current billing cycle. We recognize the revenues generated by wireless subscribers in our territory who purchase Sprint PCS products and services over the Sprint PCS Internet site. Distribution mix. During the nine months ended June 30, 2004, the approximate percentage of our new subscribers that originated from each of our distribution channels is as follows: Sprint retail stores 30 % National third party retail stores 32 Local third party distributors 20 Other any future changes by us in the products and services we offer or in the terms under which we offer our products or services, especially to sub-prime credit subscribers. An additional factor that may contribute to a higher churn rate is the FCC's wireless local number portability ("WLNP") requirement. The FCC regulations relating to WLNP enable wireless subscribers to keep their telephone numbers when switching to another carrier. As of May 24, 2004, all covered Commercial Mobile Radio Service ("CMRS") providers, including broadband PCS, cellular and certain specialized mobile radio ("SMR") licensees, must allow customers to retain, subject to certain geographic limitations, their existing telephone number when switching from one telecommunications carrier to another. We anticipate that the WLNP mandate will impose increased operating costs on all CMRS providers, including us, and may result in higher churn rates and subscriber acquisition and retention costs. To date, WLNP has had a slight negative impact on our operations but the ultimate impact is uncertain. A high rate of subscriber turnover could adversely affect our competitive position, liquidity, financial position, results of operations and our costs of, or losses incurred in, obtaining new subscribers, especially because we subsidize most of the costs of initial purchases of handsets by subscribers. Regulation by government agencies and taxing authorities may increase our costs of providing service or require us to change our services. Our operations and those of Sprint PCS are subject to varying degrees of regulation by the FCC, the Federal Trade Commission, the Federal Aviation Administration, the Environmental Protection Agency, the Occupational Safety and Health Administration, and state and local regulatory agencies and legislative bodies. Adverse decisions or regulations of these regulatory bodies could negatively impact our operations and those of Sprint PCS thereby increasing our costs of doing business. For example, changes in tax laws or the interpretation of existing tax laws by state and local authorities could subject us to increased income, sales, gross receipts or other tax costs or require us to alter the structure of our current relationship with Sprint PCS. Concerns over health risks and safety posed by the use of wireless handsets may reduce consumer demand for our services. Media reports have suggested that radio frequency emissions from wireless handsets may: be linked to various health problems resulting from continued or excessive use, including cancer; interfere with various electronic medical devices, including hearing aids and pacemakers; and cause explosions if used while fueling an automobile. Widespread concerns over radio frequency emissions may expose us to potential litigation, discourage the use of wireless handsets or result in additional regulation imposing restrictions or increasing requirements on the location and operation of cell sites or the use or design of wireless handsets. Any resulting decrease in demand for these services or increase in the cost of complying with additional regulations could impair our ability to profitably operate our business. Such concerns may result in the loss of subscribers, which may impair our ability to maintain and increase revenues and lower our operating margin. In addition, we may need to dedicate a larger portion of any cash flow from our operating activities to comply with such additional regulations. Due to safety concerns, some state and local legislatures have passed or are considering legislation restricting the use of wireless telephones while driving automobiles. Concerns over safety risks and the effect of future legislation, if adopted in the areas we serve, could limit our ability to market and sell our wireless services. In addition, it may discourage use of our wireless devices and decrease our revenues from subscribers who now use their wireless telephones while driving. Further, litigation relating to accidents, deaths or serious bodily injuries allegedly incurred as a result of wireless telephone use while driving could result in damage awards, adverse publicity and further governmental regulation. Significant competition in the wireless telecommunications industry may result in our competitors offering new services or lower prices, which could prevent us from operating profitably and may cause prices for our services to continue to decline in the future. Competition in the wireless telecommunications industry is intense. Competition has caused, and we anticipate that competition will continue to cause, the market prices for two-way wireless products and services to decline. Our ability to compete will depend, in part, on our ability to anticipate and respond to various competitive factors affecting the wireless telecommunications industry. While we try to maintain and increase our ARPU, we cannot assure you that we will be able to do so. If prices for our services continue to decline, it could adversely affect our ability to increase revenue, which would have a material adverse effect on our financial condition, our results of operations and our ability to repay the senior notes. In addition, the viability of our business depends upon, among other things, our ability to compete with other wireless providers on reliability, quality of service, availability of voice and data features and customer care. In addition, the pricing of our services may be affected by competition, including the entry of new service providers into our markets. Furthermore, there has been a recent trend in the wireless telecommunications industry toward consolidation of wireless service providers, which we expect to lead to larger competitors over time. Our dependence on Sprint PCS to develop competitive products and services and the requirement that we obtain Sprint PCS' consent to sell non-Sprint approved equipment may limit our ability to keep pace with our competitors on the introduction of new products, services and equipment. Some of our competitors are larger than us, possess greater resources and more extensive coverage areas, and may market other services, such as landline telephone service, cable television and Internet access, along with their wireless communications services. In addition, we may be at a competitive disadvantage because we may be more highly leveraged than some of our competitors. We also face competition from paging, dispatch and conventional mobile radio operations, enhanced specialized mobile radio ("ESMR") and mobile satellite services. In addition, future FCC regulation or Congressional legislation may create additional spectrum allocations that would have the effect of adding new entrants (and thus additional competitors) into the mobile telecommunications market. Market saturation could limit or decrease our rate of new subscriber additions and increase costs to keep our current subscribers. Intense competition in the wireless telecommunications industry could cause prices for wireless products and services to continue to decline. If prices drop, our rate of net subscriber additions will take on greater significance in improving our financial condition and results of operations. However, as our and our competitors' penetration rates in our markets increase over time, our rate of adding net subscribers could decrease further. In addition, we may incur additional costs through equipment upgrades and other retention costs to keep our current subscribers from switching to our competitors. If this decrease were to happen, it could materially adversely affect our liquidity, financial condition and results of operations. Alternative technologies and current uncertainties in the wireless market may reduce demand for PCS products and services. The wireless telecommunications industry is experiencing significant and rapid technological change, as evidenced by the increasing pace of digital upgrades in existing analog wireless systems, evolving industry standards, ongoing improvements in the capacity and quality of digital technology, shorter development cycles for new products and enhancements and changes in end-user requirements and preferences. Technological advances and industry changes could cause the technology used in our network to become obsolete. We rely on Sprint PCS for research and development efforts with respect to Sprint PCS products and services and with respect to the technology used on our network. Sprint PCS may not be able to respond to such changes and implement new technology on a timely basis, or at an acceptable cost. If Sprint PCS is unable to keep pace with these technological changes or other changes in the wireless communications market, the technology used on our network or our business strategy may become obsolete. In addition, other carriers are in the process of completing, or have completed, upgrades to 1xRTT or other 3G technologies. 1xRTT is the name for the first phase in CDMA's evolution to 3G technology. 3G technology provides high-speed, always-on Internet connectivity and high-quality video and audio. We have upgraded our network to CDMA 1xRTT, and as of June 30, 2004, are offering PCS Vision services, in markets representing approximately 97% of the covered population in our territory. We are a consumer business and an economic downturn in the United States involving significantly lowered consumer spending could negatively affect our results of operations. Our primary subscriber base is composed of individual consumers, and in the event that the economic downturn that the United States and other countries have recently experienced becomes more pronounced or lasts longer than currently expected and spending by individual consumers drops significantly, our business may be negatively affected. Risks Related to Our Common Stock Your ability to influence corporate matters will be limited because a small number of stockholders beneficially own a substantial amount of our common stock. Entities that are investment advised by AIG Global Investment Corp. (a subsidiary of American International Group) own approximately 2,623,500 shares or 30.1% of our common stock and funds managed by affiliates of Silver Point Capital, L.P. ("Silver Point") own approximately 2,208,700 shares or 25.3% of our common stock. As a result, AIG Global Investment Corp. and Silver Point can exert significant influence over our management and policies until such time as they sell a substantial portion of their shares and may have interests that are different from yours. Sales of our common stock in connection with this offering could adversely affect our stock price. Sales of a substantial number of shares of our common stock into the public market through this offering or subject to limitations under Rule 144 could adversely effect our stock price. On July 20, 2004, we issued 8,724,998 shares of common stock in connection with our emergence from bankruptcy. Subject to our compliance with our obligations to maintain the effectiveness of the registration statement of which this prospectus is part, all of our outstanding shares of common stock are or will be freely tradable without restriction or further registration under the federal securities laws. There is not, and there may never be, an established active trading market for our common stock. There is no established active trading market for our common stock and such a trading market may never develop. Our common stock is currently quoted on the National Quotation Bureau's Pink Sheets. If an established active trading market does develop, it may not be sustained and a high degree of price volatility may continue to exist in any such market. We intend to apply for listing of our common stock on The Nasdaq National Market, but we may not be able to satisfy the listing requirements to do so, in particular, the requirements for a minimum number of round lot holders. If for any reason our common stock is not eligible for initial or continued listing on The Nasdaq Stock Market, or if a public trading market does not develop, purchasers of our common stock may have difficulty selling their shares. The price of our common stock may be more volatile than the equity securities of established companies and such volatility may disproportionately reduce the market value of our common stock at certain times. The market price of our common stock could be subject to significant fluctuations in response to various factors, including: variations in our, or Sprint PCS', quarterly operating results; our or Sprint PCS' failure to achieve operating results consistent with securities analysts' projections; the operating and stock price performance of other companies that investors may deem comparable to us or Sprint PCS; announcements of technological innovations or new products and services by us, Sprint PCS or our competitors; announcements by us or Sprint PCS of joint development efforts or corporate partnerships in the wireless telecommunications market; market conditions in the technology, telecommunications and other growth sectors; and rumors relating to us, Sprint PCS or our competitors. The stock market has experienced extreme price volatility. Under these market conditions, stock prices of many growth stage companies have often fluctuated in a manner unrelated or disproportionate to the operating performance of such companies. As we are a growth stage company, our common stock may be subject to greater price volatility than the stock market as a whole. You may not receive a return on investment through dividend payments nor upon the sale of your shares. We do not anticipate paying any cash dividends on our common stock in the foreseeable future. Instead, we intend to retain future earnings to fund our growth. Therefore, you will not receive a return on your investment in our common stock through the payment of dividends. You also may not realize a return on your investment upon selling your shares.
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+RISK FACTORS This offering involves a high degree of risk. You should consider carefully the risks and uncertainties described below and the other information in this prospectus, including the consolidated financial statements and the related notes appearing at the end of this prospectus, before deciding to invest in shares of our common stock. If any of the following risks or uncertainties actually occurs, our business, prospects, financial condition and operating results would likely suffer, possibly materially. In that event, the market price of our common stock could decline and you could lose all or part of your investment. Risks Relating to Our Business We depend heavily on the success of our lead product candidate, Macugen, which is still under development and with respect to which pivotal clinical trial data became available only recently. If we are unable to commercialize Macugen, or experience significant delays in doing so, our business will be materially harmed. We have invested a significant portion of our time and financial resources since our inception in the development of Macugen. We anticipate that in the near term our ability to generate revenues will depend solely on the successful development and commercialization of Macugen. The commercial success of Macugen will depend on several factors, including the following: successful completion of clinical trials; producing batches of the active pharmaceutical ingredient used in Macugen as well as finished drug product in sufficient commercial quantities through a validated process; receipt of marketing approvals from the FDA and similar foreign regulatory authorities; launching commercial sales of the product in collaboration with Pfizer; successfully building and sustaining manufacturing capacity to meet anticipated future market demand; and acceptance of the product in the medical community and with third party payors. Based on the results from the first year of our ongoing Phase 2/3 pivotal clinical trials for the use of Macugen in the treatment of wet AMD, we and Pfizer are filing a new drug application with the FDA as a rolling submission to seek marketing approval for the 0.3 mg dose of Macugen for the treatment of all subtypes of wet AMD. The FDA has accepted for review the preclinical and clinical study report sections of our NDA. However, new information may arise from our continuing analysis of the data that may be less favorable than currently anticipated. Clinical data often is susceptible to varying interpretations and many companies that have believed that their products performed satisfactorily in clinical trials have nonetheless failed to obtain FDA approval for their products. We may not complete the filing of our NDA for the use of Macugen in the treatment of wet AMD in the third quarter of 2004, our anticipated time frame. Furthermore, even after we complete the filing, the FDA may not accept our submission as complete, may request additional information from us, including data from additional clinical trials, and, ultimately, may not grant marketing approval for Macugen. If we are not successful in commercializing Macugen, or are significantly delayed in doing so, our business will be materially harmed and we may need to curtail or cease operations. The success of Macugen depends heavily on our collaboration with Pfizer, which was established in December 2002 and involves a complex sharing of control over decisions, responsibilities and costs and benefits. Any loss of Pfizer as a collaborator, or adverse development in the collaboration, would materially harm our business. In December 2002, we entered into our collaboration with Pfizer to develop and commercialize Macugen for the prevention and treatment of diseases of the eye. The collaboration involves a complex sharing of control over decisions, responsibilities and costs and benefits. For example, with respect to the Approximate date of commencement of proposed sale to the public: As soon as practicable after this Registration Statement is declared effective. If any of the securities being registered on this Form are offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, as amended (the Securities Act ) please check the following box. If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, please check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, please check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, please check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. If delivery of the prospectus is expected to be made pursuant to Rule 434, please check the following box. Table of Contents sharing of costs and benefits, Pfizer will co-promote Macugen with us in the United States and will share with us in profits and losses. Outside the United States, Pfizer will commercialize Macugen pursuant to an exclusive license and pay us a royalty on net sales. In addition, Pfizer generally is required to fund a majority of ongoing development costs incurred pursuant to an agreed upon development plan. With respect to control over decisions and responsibilities, the collaboration is governed by a joint operating committee, consisting of an equal number of representatives of Pfizer and us. There are also subcommittees with equal representation from both parties that have responsibility over development, regulatory, manufacturing and commercialization matters. Ultimate decision-making authority is vested in us as to some matters and in Pfizer as to other matters. A third category of decisions requires the approval of both Pfizer and us. Outside the United States, ultimate decision-making authority as to most matters is vested in Pfizer. Pfizer may terminate the collaboration relationship without cause upon six to twelve months prior notice, depending on when such notice is given. Any loss of Pfizer as a collaborator in the development or commercialization of Macugen, dispute over the terms of, or decisions regarding, the collaboration or other adverse development in our relationship with Pfizer would materially harm our business and might accelerate our need for additional capital. If our clinical trials are unsuccessful, or if we experience significant delays in these trials, our ability to commercialize Macugen and our future product candidates will be impaired. We must provide the FDA and similar foreign regulatory authorities with preclinical and clinical data that demonstrate that our product candidates are safe and effective for each target indication before they can be approved for commercial distribution. The preclinical testing and clinical trials of any product candidates that we develop must comply with regulations by numerous federal, state and local government authorities in the United States, principally the FDA, and by similar agencies in other countries. Clinical development is a long, expensive and uncertain process and is subject to delays. We may encounter delays or rejections based on our inability to enroll enough patients to complete our clinical trials. Patient enrollment depends on many factors, including the size of the patient population, the nature of the trial protocol, the proximity of patients to clinical sites and the eligibility criteria for the study. Our ongoing Phase 2/3 pivotal clinical trial for the use of Macugen in the treatment of wet AMD and Phase 2 clinical trial for use of Macugen in the treatment of DME are currently fully enrolled. We expect to commence a Phase 2 clinical trial for the use of Macugen in the treatment of retinal vein occlusion in the second quarter of 2004. We also may commence additional clinical trials in the future. Although we have not to date experienced any significant delays in enrolling clinical trial patients for our ongoing clinical trials, delays in patient enrollment for future trials may result in increased costs and delays, which could have a harmful effect on our ability to develop products. It may take several years to complete the testing of a product, and failure can occur at any stage of testing. For example: interim results of preclinical or clinical studies do not necessarily predict their final results, and acceptable results in early studies might not be seen in later studies, in large part because earlier phases of studies are often conducted on smaller groups of patients than later studies, and without the same trial design features, such as randomized controls and long-term patient follow-up and analysis; potential products that appear promising at early stages of development may ultimately fail for a number of reasons, including the possibility that the products may be ineffective, less effective than products of our competitors or cause harmful side effects; any preclinical or clinical test may fail to produce results satisfactory to the FDA or foreign regulatory authorities; preclinical and clinical data can be interpreted in different ways, which could delay, limit or prevent regulatory approval; CALCULATION OF REGISTRATION FEE Table of Contents negative or inconclusive results from a preclinical study or clinical trial or adverse medical events during a clinical trial could cause a preclinical study or clinical trial to be repeated or a program to be terminated, even if other studies or trials relating to the program are successful; the FDA can place a hold on a clinical trial if, among other reasons, it finds that patients enrolled in the trial are or would be exposed to an unreasonable and significant risk of illness or injury; we may encounter delays or rejections based on changes in regulatory agency policies during the period in which we develop a drug or the period required for review of any application for regulatory agency approval; and our clinical trials may not demonstrate the safety and efficacy needed for our products to receive regulatory approval. We have completed the first year of our Phase 2/3 pivotal clinical trials for the use of Macugen in the treatment of wet AMD. Based on results from the first year of these trials, we and Pfizer are filing sections of our NDA with the FDA for the use of Macugen in the treatment of all subtypes of wet AMD as a rolling submission. The FDA has accepted for review the preclinical and clinical study report sections of our NDA filing. We plan to complete our NDA filing in the third quarter of 2004. We are currently conducting a second year of these trials. We have also fully enrolled a Phase 2 clinical trial for the use of Macugen in the treatment of DME. To obtain marketing approval, we may decide to, or the FDA or other regulatory authorities may require us to, pursue additional clinical trials or other studies of Macugen. For example, in addition to our Phase 2 clinical trial for the use of Macugen in the treatment of DME, we anticipate that we need to conduct Phase 3 clinical trials for DME before filing a new drug application or supplemental new drug application, as the case may be, for this second indication. In addition, as part of the drug approval process, we must conduct a comprehensive assessment of the carcinogenic, or cancer causing, potential of our product candidates. Our testing of Macugen to date indicates that the product s carcinogenic potential is low. In one test for carcinogenicity risk, two potential Macugen metabolites showed, in one out of five bacterial strains tested, a small increase in the number of altered bacteria, a potential indicator of carcinogenicity risk. However, because this elevated proportion of altered bacteria did not increase further as we increased the dose of the metabolites, we do not believe the results from these tests indicate carcinogenicity potential. Furthermore, no other test, including animal studies, of Macugen and its metabolites showed carcinogenic potential. We have requested that the FDA grant us a waiver from the requirement to perform full animal carcinogenicity studies for the treatment of wet AMD based primarily on the unmet medical need presented by wet AMD, low overall systemic exposure to Macugen and the fact that this disease generally affects older populations. However, the FDA may require us to conduct additional carcinogenicity testing of Macugen. Based on our discussions with the FDA to date, if we are required to conduct further carcinogenicity testing of Macugen in connection with its use in the treatment of wet AMD, we believe that the FDA will allow us to conduct any such testing as a post-NDA approval study. However, we will not be certain of this until the NDA review process of Macugen for this indication is completed. We expect that the FDA may require us to complete satisfactory carcinogenicity testing of Macugen prior to any approval of the use of Macugen in the treatment of DME. If we are required to conduct additional clinical trials or other studies of Macugen beyond those that we currently contemplate, if we are unable to successfully complete our clinical trials or other studies or if the results of these trials or studies are not positive or are only modestly positive, we may be delayed in obtaining marketing approval for Macugen, we may not be able to obtain marketing approval or we may obtain approval for indications that are not as broad as intended. Our product development costs will also increase if we experience delays in testing or approvals. Significant clinical trial delays could allow our competitors to bring products to market before we do and impair our ability to commercialize our products or potential products. If any of this occurs, our business will be materially harmed. Table of Contents We face substantial competition, which may result in others discovering, developing or commercializing products before or more successfully than we do. The development and commercialization of new drugs is highly competitive. We will face competition with respect to Macugen and any products we may develop or commercialize in the future from major pharmaceutical companies, specialty pharmaceutical companies and biotechnology companies worldwide. Our competitors may develop products or other novel technologies that are more effective, safer or less costly than any that we are developing. Our competitors may also obtain FDA or other regulatory approval for their products more rapidly than we may obtain approval for ours. The two therapies currently available for the treatment of wet AMD are photodynamic therapy, which was developed by QLT, Inc. and is marketed by Novartis AG, and thermal laser treatment. In the United States, photodynamic therapy is FDA-approved only for the predominantly classic subtype of wet AMD. In the European Union, there is an approved therapy only for the predominantly classic and occult subtypes. In the United States, however, the Centers for Medicare Medicaid Services implemented a decision in April 2004 to provide coverage for photodynamic therapy to patients with wet AMD who have occult and minimally classic lesions that are four disc areas or less in size and show evidence of recent disease progression even though the FDA has not approved photodynamic therapy for such treatment. The current therapies for the treatment of DME are thermal laser treatment and steroid treatment administered by physicians on an off-label basis. Unless additional therapies are approved, these existing therapies will represent the principal competition for Macugen if Macugen is approved for marketing. Additional treatments for AMD and DME are in various stages of preclinical or clinical testing. If approved, these treatments would also compete with Macugen. Potential treatments in late stage clinical trials include drugs sponsored by a collaboration of Genentech, Inc. and Novartis, Alcon, Inc., Allergan, Inc. through its recent acquisition of Oculex Pharmaceuticals, Inc., Eli Lilly and Co., Bausch Lomb Incorporated, a collaboration of Regeneron Pharmaceuticals, Inc. and Aventis S.A., Miravant Medical Technologies, and Genaera Corporation. Some of the sponsors of these potential products have recently announced favorable results from Phase 1 or Phase 2 clinical trials. The Genentech/Novartis collaboration is developing an anti-VEGF humanized antibody fragment for intravitreal injection. This product candidate may be viewed as particularly competitive with Macugen because of the similarity of its mechanism of action. In addition, Alcon expects to announce results of its Phase 3 clinical trial of anecortave acetate, an angiostatic steroid, for the treatment of wet AMD patients, that features a less invasive injectable delivery that requires less frequent administration (every six months), in the fourth quarter of 2004 and to file an NDA thereafter for the predominantly classic subtype of wet AMD. Further, Alcon is enrolling patients in two Phase 3 clinical trials, one in South America and one in Europe, comparing the safety and efficacy of Alcon s steroid against placebo in patients with all subtypes of wet AMD. Other laser, surgical or pharmaceutical treatments for AMD and DME may also compete against Macugen. These competitive therapies may result in pricing pressure if we receive marketing approval for Macugen even if Macugen is otherwise viewed as a preferable therapy. Many of our competitors have substantially greater financial, technical and human resources than we have. Additional mergers and acquisitions in the pharmaceutical and biotechnology industries may result in even more resources being concentrated by our competitors. Competition may increase further as a result of advances made in the commercial applicability of technologies and greater availability of capital for investment in these fields. We may not be successful in our efforts to expand our portfolio of products. A key element of our strategy is to commercialize a portfolio of new ophthalmic drugs in addition to Macugen. We are seeking to do so through our internal research programs and through licensing or otherwise acquiring the rights to potential new drugs and drug targets for the treatment of ophthalmic disease. 1 .1 Form of Underwriting Agreement 3 .1(6) Amended and Restated Certificate of Incorporation of the Registrant 3 .3(6) Amended and Restated Bylaws of the Registrant 4 .1(1) Specimen Certificate evidencing shares of common stock 4 .2(2) Warrant Agreement, dated as of March 31, 2000, by and between the Registrant and Gilead Sciences, Inc. 4 .3(2) Warrant Agreement Amendment, dated as of September 4, 2003, by and among the Registrant, Gilead Sciences, Inc. and University License Equity Holdings, Inc. 4 .4 (3) Series D Preferred Stock Purchase Agreement, dated as of December 17, 2002, by and between the Registrant, Pfizer Ireland Pharmaceuticals and Pfizer Inc. 4 .5(2) Amended and Restated Investors Rights Agreement, dated as of February 7, 2003, by and among the Registrant and the parties listed therein 5 .1 Opinion of Morrison Foerster LLP 10 .1(2) 2001 Stock Plan, as amended 10 .2(6) 2003 Stock Incentive Plan 10 .3(6) 2003 Employee Stock Purchase Plan 10 .4 (3) License Agreement, dated as of December 17, 2002, by and between Pfizer Inc. and the Registrant 10 .5 (3) Collaboration Agreement, dated as of December 17, 2002, by and between Pfizer Inc. and the Registrant 10 .6 (3) License, Manufacturing and Supply Agreement, dated February 5, 2002, by and between Shearwater Corporation and the Registrant 1 .1 Form of Underwriting Agreement 3 .1(6) Amended and Restated Certificate of Incorporation of the Registrant 3 .3(6) Amended and Restated Bylaws of the Registrant 4 .1(1) Specimen Certificate evidencing shares of common stock 4 .2(2) Warrant Agreement, dated as of March 31, 2000, by and between the Registrant and Gilead Sciences, Inc. 4 .3(2) Warrant Agreement Amendment, dated as of September 4, 2003, by and among the Registrant, Gilead Sciences, Inc. and University License Equity Holdings, Inc. 4 .4 (3) Series D Preferred Stock Purchase Agreement, dated as of December 17, 2002, by and between the Registrant, Pfizer Ireland Pharmaceuticals and Pfizer Inc. 4 .5(2) Amended and Restated Investors Rights Agreement, dated as of February 7, 2003, by and among the Registrant and the parties listed therein 5 .1 Opinion of Morrison Foerster LLP 10 .1(2) 2001 Stock Plan, as amended 10 .2(6) 2003 Stock Incentive Plan 10 .3(6) 2003 Employee Stock Purchase Plan 10 .4 (3) License Agreement, dated as of December 17, 2002, by and between Pfizer Inc. and the Registrant 10 .5 (3) Collaboration Agreement, dated as of December 17, 2002, by and between Pfizer Inc. and the Registrant 10 .6 (3) License, Manufacturing and Supply Agreement, dated February 5, 2002, by and between Shearwater Corporation and the Registrant 10 .7 (3) Licensing Agreement, dated as of March 30, 2000 and amended on May 9, 2000, December 4, 2001 and April 12, 2002, by and between Gilead Sciences, Inc. and the Registrant 10 .8 (3) License Agreement, dated as of December 31, 2001, by and between Isis Pharmaceuticals, Inc. and the Registrant 10 .9(2) Consulting Agreement, dated as of November 1, 2001, by and between the Registrant and Samir Patel 10 .10(2) Executive Employment Agreement, dated as of April 12, 2000, by and between the Registrant and David R. Guyer 10 .11(2) Amendment to Executive Employment Agreement, dated as of August 25, 2003, by and between the Registrant and David R. Guyer 10 .12(2) Employment Agreement, dated as of August 25, 2003, by and between Paul Chaney and the Registrant 10 .13(2) Employment Agreement, dated as of February 1, 2002, by and between the Registrant and Glenn Sblendorio 10 .14(1) Amendment to Employment Agreement, dated as of October 17, 2003, by and between the Registrant and Glenn Sblendorio 10 .15(2) Employment Agreement, dated as of April 12, 2002, by and between the Registrant and Anthony P. Adamis 10 .16(1) Amendment to Employment Agreement, dated as of October 20, 2003, by and between the Registrant and Anthony P. Adamis 10 .17(2) Employment Agreement, dated as of August 25, 2003, by and between Douglas H. Altschuler and the Registrant Proposed Maximum Proposed Maximum Amount of Title of Each Class of Amount to Offering Price Aggregate Offering Registration Securities to be Registered be Registered Per Share(2) Price(2) Fee Table of Contents A significant portion of the research that we are conducting involves new and unproven technologies. Research programs to identify new disease targets and product candidates require substantial technical, financial and human resources whether or not we ultimately identify any candidates. Our research programs may initially show promise in identifying potential product candidates, yet fail to yield product candidates for clinical development for a number of reasons, including: the research methodology used may not be successful in identifying potential product candidates; or potential product candidates may on further study be shown to have harmful side effects or other characteristics that indicate they are unlikely to be effective drugs. We may be unable to license or acquire suitable product candidates or products from third parties for a number of reasons. In particular, the licensing and acquisition of pharmaceutical products is a competitive area. A number of more established companies are also pursuing strategies to license or acquire products in the ophthalmic field. These established companies may have a competitive advantage over us due to their size, cash resources and greater clinical development and commercialization capabilities. Other factors that may prevent us from licensing or otherwise acquiring suitable product candidates include the following: we may be unable to license or acquire the relevant technology on terms that would allow us to make an appropriate return from the product; companies that perceive us to be their competitors may be unwilling to assign or license their product rights to us; or we may be unable to identify suitable products or product candidates within our areas of expertise. If we are unable to develop suitable potential product candidates through internal research programs or by obtaining rights to novel therapeutics from third parties, our business will suffer. Market acceptance of Macugen and other products we develop in the future that are based on new technologies may be limited. The commercial success of the products for which we may obtain marketing approval from the FDA or other regulatory authorities will depend upon the acceptance of these products by the medical community and third party payors as clinically useful, cost-effective and safe. Even if a potential product displays a favorable efficacy and safety profile in clinical trials, market acceptance of the product will not be known until after it is commercially launched. We expect that many of the products that we develop will be based upon new technologies. For example, Macugen is an aptamer, which is a type of nucleic acid. To date, no aptamer has been approved as a pharmaceutical by the FDA. As a result, it may be more difficult for us to achieve market acceptance of our products, particularly the first products that we introduce to the market based on new technologies. Our efforts to educate the medical community about these potentially unique approaches may require greater resources than would be typically required for products based on conventional technologies. The safety, efficacy, convenience and cost-effectiveness of our products as compared to competitive products will also affect market acceptance. We are in the process of establishing our sales and marketing capabilities. We will need to successfully recruit sales personnel and build a sales infrastructure to successfully commercialize Macugen and other products that we develop, acquire or license. We have limited experience in selling products and are in the process of establishing our sales capabilities. While we have personnel with significant marketing experience and have been collaborating with our partner, Pfizer, we have limited experience as a company marketing products. To achieve commercial success for any approved product, we must develop an effective sales and marketing organization. We are beginning to recruit a specialty sales force to participate in detailing Xalatan and, assuming regulatory approval, to market and sell Macugen in the United States in collaboration with Pfizer. If we are not successful in recruiting sales personnel or in building a sales and marketing Common Stock, $0.01 par value per share(1) 4,600,000 $36.01 $165,646,000 $20,987.35(3) Table of Contents infrastructure, our business will materially suffer. Moreover, if the commercial launch of Macugen is delayed as a result of FDA requirements or other reasons, we may establish sales and marketing capabilities too early relative to the launch of Macugen. This may be expensive, and our investment would be lost if we cannot retain our sales and marketing personnel. We expect to depend on collaborations with third parties to develop and commercialize our products. Our business strategy includes entering into collaborations with corporate and academic collaborators for the research, development and commercialization of additional product candidates, such as our collaboration with Pfizer. These arrangements may not be scientifically or commercially successful. The termination of any of these arrangements might adversely affect our ability to develop, commercialize and market our products. The success of our collaboration arrangements will depend heavily on the efforts and activities of our collaborators. Our collaborators will have significant discretion in determining the efforts and resources that they will apply to these collaborations. The risks that we face in connection with these collaborations, including our collaboration with Pfizer, include the following: our collaboration agreements are, or are expected to be, for fixed terms and subject to termination under various circumstances, including, in many cases, on short notice without cause; we expect to be required in our collaboration agreements not to conduct specified types of research and development in the field that is the subject of the collaboration. These agreements may have the effect of limiting the areas of research and development that we may pursue, either alone or in cooperation with third parties; our collaborators may develop and commercialize, either alone or with others, products and services that are similar to or competitive with our products that are the subject of the collaboration with us; and our collaborators may change the focus of their development and commercialization efforts. Pharmaceutical and biotechnology companies historically have re-evaluated their priorities following mergers and consolidations, which have been common in recent years in these industries. The ability of our products to reach their potential could be limited if our collaborators decrease or fail to increase spending relating to such products. Collaborations with pharmaceutical companies and other third parties often are terminated or allowed to expire by the other party. Such terminations or expirations can adversely affect us financially as well as harm our business reputation. We may not be successful in establishing additional collaborations, which could adversely affect our ability to develop and commercialize products and services. An important element of our business strategy is entering into collaborations for the development and commercialization of products when we believe that doing so will maximize product value. If we are unable to reach agreements with suitable collaborators, we may fail to meet our business objectives for the affected product or program. We face significant competition in seeking appropriate collaborators. Moreover, these collaboration arrangements are complex to negotiate and time consuming to document. We may not be successful in our efforts to establish additional collaborations or other alternative arrangements. The terms of any additional collaborations or other arrangements that we establish may not be favorable to us. Moreover, these collaborations or other arrangements may not be successful. Table of Contents We have no manufacturing facilities and limited manufacturing personnel. We will depend on third parties to manufacture Macugen and future products. If these manufacturers fail to meet our requirements, our product development and commercialization efforts may be materially harmed. We have limited personnel with experience in, and we do not own facilities for, manufacturing any products. We will depend on third parties to manufacture Macugen and any future products that we may develop. For our clinical trials of Macugen, we engaged a third party manufacturer to produce the active pharmaceutical ingredient used in Macugen. We have entered into an agreement with an affiliate of this third party for commercial supply of the active pharmaceutical ingredient. For our clinical trials of Macugen, we also engaged a separate fill and finish manufacturer for the finished drug product to formulate the active pharmaceutical ingredient from a solid into a solution and to fill the solution into syringes. We have entered into an agreement with this manufacturer to provide these finished product services for commercial supply. These manufacturers of Macugen will be single source suppliers to us for a significant period of time. We also expect to continue to rely on a single source of supply for the PEGylation reagent used in the manufacture of Macugen. We believe we currently have sufficient capacity to supply the active pharmaceutical ingredient of Macugen to meet anticipated demand for Macugen if the product is approved based on a 0.3 mg dose for approximately 24 months after approval. However, in order to sustain Macugen supply at the quantities we believe will be necessary to meet anticipated future market demand, we and our contract manufacturer will need to increase the manufacturing capacity for the active pharmaceutical ingredient. We initially intend to increase manufacturing capacity for the active pharmaceutical ingredient by duplicating a portion of our manufacturing lines at the contract manufacturer s facility. We are also exploring other alternatives for increasing manufacturing capacity. If we are unable to increase our manufacturing capacity, or if the cost of this increased capacity is uneconomic to us, we may not be able to produce Macugen in a sufficient quantity to meet future requirements to sustain supply of the product to meet anticipated future demand. In addition, our revenues and gross margins could be adversely affected. Reliance on third party manufacturers entails risks to which we would not be subject if we manufactured products ourselves, including: reliance on the third party for regulatory compliance and quality assurance; the possible breach of the manufacturing agreement by the third party because of factors beyond our control; and the possibility of termination or non-renewal of the agreement by the third party, based on its own business priorities, at a time that is costly or inconvenient for us. We may in the future elect to establish our own manufacturing facilities to manufacture some of our products. We would need to invest substantial additional funds and recruit qualified personnel in order to build or lease and operate any manufacturing facilities. The manufacture and packaging of pharmaceutical products such as Macugen are subject to the requirements of the FDA and similar foreign regulatory bodies. If we or our third party manufacturers fail to satisfy these requirements, our product development and commercialization efforts may be materially harmed. The manufacture and packaging of pharmaceutical products, such as Macugen and our future product candidates, are regulated by the FDA and similar foreign regulatory bodies and must be conducted in accordance with the FDA s current good manufacturing practices and comparable requirements of foreign regulatory bodies. There are a limited number of manufacturers that operate under these current good manufacturing practices regulations who are both capable of manufacturing Macugen and willing to do so. Failure by us or our third party manufacturers to comply with applicable regulations, requirements, or guidelines could result in sanctions being imposed on us, including fines, injunctions, civil penalties, failure David R. Guyer, M.D. Paul G. Chaney 275,000 18 % $ 3.50 8/11/2013 $ 8,444,366 $ 14,016,363 Glenn P. Sblendorio Anthony P. Adamis, M.D Douglas H. Altschuler 200,000 (1) All the shares of common stock will be sold by selling stockholders. (2) Estimated solely for the purpose of computing the registration fee, based on the average of the high and low sales prices of the common stock as reported by the Nasdaq National Market on May 11, 2004 in accordance with Rule 457 under the Securities Act of 1933. (3) Previously paid. Table of Contents of regulatory authorities to grant marketing approval of our products, delays, suspension or withdrawal of approvals, license revocation, seizures or recalls of product, operating restrictions and criminal prosecutions, any of which could significantly and adversely affect our business. Changes in the manufacturing process or procedure, including a change in the location where the product is manufactured or a change of a third party manufacturer, may require prior FDA review and/or approval of the manufacturing process and procedures in accordance with the FDA s current good manufacturing practices. There are comparable foreign requirements. This review may be costly and time consuming and could delay or prevent the launch of a product. For example, our third party contract manufacturer changed the site used to manufacture the active pharmaceutical ingredient of Macugen. We have completed the transfer of the relevant manufacturing technology to the new site, have used the new site to supply the active pharmaceutical ingredient of Macugen for use in our clinical trials and plan to continue to use this site to produce commercial quantities of the active pharmaceutical ingredient of Macugen. We are performing analytical tests to demonstrate comparability of our active pharmaceutical ingredient following the site change. If we cannot establish that the products manufactured at the new site are comparable to the satisfaction of the FDA, we may not obtain or may be delayed in obtaining approval to launch Macugen. In addition, if we elect to manufacture products in our own facility or at the facility of another third party, we would need to ensure that the new facility and the manufacturing process are in substantial compliance with current good manufacturing practices. Any such new facility would be subject to a pre-approval inspection by FDA. Furthermore, in order to obtain approval of our products, including Macugen, by the FDA and foreign regulatory agencies, we need to complete testing on both the active pharmaceutical ingredient and on the finished product in the packaging we propose for commercial sales. This includes testing of stability, identification of impurities and testing of other product specifications by validated test methods. In addition, we will be required to consistently produce the active pharmaceutical ingredient in commercial quantities and of specified quality on a repeated basis and document our ability to do so. This requirement is referred to as process validation. With respect to Macugen, although we have manufactured Macugen at commercial scale, we have started, but not yet completed, this process validation requirement. If the required testing or process validation is delayed or produces unfavorable results, we may not obtain approval to launch the product or approval may be delayed. The FDA and similar foreign regulatory bodies may also implement new standards, or change their interpretation and enforcement of existing standards and requirements, for manufacture, packaging, or testing of products at any time. If we are unable to comply, we may be subject to regulatory, civil actions or penalties which could significantly and adversely affect our business. Macugen and our other potential products may not be commercially viable if we fail to obtain an adequate level of reimbursement for these products by Medicare and other third party payors. The markets for our products may also be limited by the indications for which their use may be reimbursed or the frequency in which they may be administered. The availability and levels of reimbursement by governmental and other third party payors affect the market for products such as Macugen and others that we may develop. These third party payors continually attempt to contain or reduce the costs of healthcare by challenging the prices charged for medical products and services. In some foreign countries, particularly Canada and the countries of the European Union, the pricing of prescription pharmaceuticals is subject to governmental control. In these countries, pricing negotiations with governmental authorities can take six to twelve months or longer after the receipt of regulatory marketing approval for a product. To obtain reimbursement or pricing approval in some countries, we may be required to conduct a clinical trial that compares the cost-effectiveness of our products, including Macugen, to other available therapies. If reimbursement for our products is unavailable or limited in scope or amount or if pricing is set at unsatisfactory levels, our business could be materially harmed. The Registrant hereby amends this Registration Statement on such date or dates as may be necessary to delay its effective date until Registrant shall file a further amendment which specifically states that this Registration Statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act or until the Registration Statement shall become effective on such date as the Commission, acting pursuant to Section 8(a), may determine. Table of Contents Because most persons suffering from wet AMD are elderly, we expect that coverage for Macugen in the United States will be primarily through the Medicare program. Although drugs that are not usually self-administered are ordinarily covered by Medicare, the Medicare program has taken the position that it can decide not to cover particular drugs if it determines that they are not reasonable and necessary for Medicare beneficiaries. Limitations on coverage could also be imposed at the local Medicare carrier level or by fiscal intermediaries. Our business could be materially adversely affected if the Medicare program, local Medicare carriers or fiscal intermediaries were to make such a determination and deny or limit the reimbursement of Macugen. Our business also could be adversely affected if physicians are not reimbursed by Medicare for the cost of the procedure in which they administer Macugen on a basis satisfactory to the administering physicians. If the local contractors that administer the Medicare program are slow to reimburse physicians for Macugen, the physicians may pay us more slowly, which would adversely affect our working capital requirements. We also will need to obtain approvals for payment for Macugen from private insurers, including managed care organizations. We expect that private insurers will consider the efficacy, cost-effectiveness and safety of Macugen in determining whether to approve reimbursement for Macugen therapy and at what level. Obtaining these approvals can be a time consuming and expensive process. Our business would be materially adversely affected if we do not receive approval for reimbursement of Macugen from private insurers on a satisfactory basis. Our business could also be adversely affected if the Medicare program or other reimbursing bodies or payors limit the indications for which Macugen will be reimbursed to a smaller set than we believe it is effective in treating or establish a limitation on the frequency with which Macugen may be administered that is less often than we believe would be effective. We expect to experience pricing pressures in connection with the sale of Macugen and our future products due to the trend toward programs aimed at reducing healthcare costs, the increasing influence of health maintenance organizations and additional legislative proposals. The recent Medicare prescription drug coverage legislation and future legislative or regulatory reform of the healthcare system may affect our ability to sell our products profitably. In both the United States and some non-U.S. jurisdictions, there have been a number of legislative and regulatory proposals to change the healthcare system in ways that could affect our ability to sell our products profitably. In the United States, new legislation has been proposed at the federal and state levels that would result in significant changes to the healthcare system, either nationally or at the state level. In particular, in December 2003, President Bush signed into law new Medicare prescription drug coverage legislation. Effective January 2004, the legislation changed the methodology used to calculate reimbursement for drugs such as Macugen that are administered in physicians offices in a manner intended to reduce the amount that is subject to reimbursement. In addition, beginning in January 2006, the legislation directs the Secretary of Health and Human Services to contract with procurement organizations to purchase physician-administered drugs from the manufacturers and provides physicians with the option to obtain drugs through these organizations as an alternative to purchasing from the manufacturers, which some physicians may find advantageous. These changes may also cause private insurers to reduce the amounts that they will pay for physician-administered drugs. In addition, the Centers for Medicare Medicaid Services, or CMS, the agency within the Department of Health and Human Services that administers Medicare and will be responsible for reimbursement of the cost of Macugen, has asserted the authority of Medicare not to cover particular drugs if it determines that they are not reasonable and necessary for Medicare beneficiaries or to cover them at a lesser rate, comparable to that for drugs already reimbursed that CMS considers to be therapeutically comparable. Further federal and state proposals and healthcare reforms are likely. Our results of operations could be materially adversely affected by the Medicare prescription drug coverage legislation, by the possible effect of this legislation on amounts that private insurers will pay and by other healthcare reforms that may be enacted or adopted in the future. Table of Contents We face the risk of product liability claims and may not be able to obtain insurance. Our business exposes us to the risk of product liability claims that is inherent in the manufacturing, testing and marketing of drugs and related products. If the use of one or more of our products harms people, we may be subject to costly and damaging product liability claims. We have product liability insurance that covers our clinical trials up to a $10 million annual aggregate limit. We intend to expand our insurance coverage to include the sale of commercial products if we obtain marketing approval for any of the products that we may develop. Insurance coverage is increasingly expensive. We may not be able to obtain or maintain adequate protection against potential liabilities. If we are unable to obtain insurance at acceptable cost or otherwise protect against potential product liability claims, we will be exposed to significant liabilities, which may materially and adversely affect our business and financial position. These liabilities could prevent or interfere with our product development and commercialization efforts. We depend on our key personnel. If we are not able to retain them or recruit additional technical personnel, our business will suffer. We are highly dependent on the principal members of our management and scientific staff, particularly Dr. David R. Guyer, our co-founder and Chief Executive Officer, and Dr. Anthony P. Adamis, our scientific pioneer, Chief Scientific Officer and Senior Vice President, Research. Our employment agreements with these and our other executive officers are terminable on short or no notice. We do not carry key man life insurance on any of our key personnel. The loss of service of any of our key employees could harm our business. In addition, our growth will require us to hire a significant number of qualified technical, commercial and administrative personnel. There is intense competition from other companies and research and academic institutions for qualified personnel in the areas of our activities. If we cannot continue to attract and retain, on acceptable terms, the qualified personnel necessary for the continued development of our business, we may not be able to sustain our operations or grow. We depend on third parties in the conduct of our clinical trials for Macugen and any failure of those parties to fulfill their obligations could adversely affect our development and commercialization plans. We depend on independent clinical investigators, contract research organizations and other third party service providers in the conduct of our clinical trials for Macugen and expect to do so with respect to other product candidates. We rely heavily on these parties for successful execution of our clinical trials, but do not control many aspects of their activities. For example, the investigators are not our employees. However, we are responsible for ensuring that each of our clinical trials is conducted in accordance with the general investigational plan and protocols for the trial. Third parties may not complete activities on schedule, or may not conduct our clinical trials in accordance with regulatory requirements or our stated protocols. The failure of these third parties to carry out their obligations could delay or prevent the development, approval and commercialization of Macugen and future product candidates. Regulatory Risks We may not be able to obtain marketing approval for any of the products resulting from our development efforts, including Macugen. Failure to obtain these approvals could materially harm our business. Although we may not require additional research and development for the approval of Macugen for the treatment of wet AMD, the use of Macugen for the treatment of other indications and other products that we are developing or may develop in the future will require additional research and development. The research and development work that we must perform will include extensive preclinical studies and clinical trials. We will be required to obtain an investigational new drug application, or IND, prior to initiating human clinical trials in the United States and must obtain regulatory approval prior to any commercial distribution. This process is expensive, uncertain and lengthy, often taking a number of years until a product is approved for commercial distribution. We have only one product, Macugen, that has advanced Table of Contents to clinical trials. We have not received regulatory approval to market Macugen in any jurisdiction. Failure to obtain required regulatory approvals could materially harm our business. We may need to successfully address a number of technological challenges in order to complete the development of Macugen or any of our future products. For example, to obtain marketing approval for Macugen, we will be required to consistently produce the active pharmaceutical ingredient in commercial quantities and of specified quality on a repeated basis and document our ability to do so. We have not yet completed this process validation requirement and, if we are unable to do so, our business will be materially adversely affected. In addition, administration of a drug via intravitreal injection is a new method for the potentially long-term treatment of chronic eye disease. As a result, the FDA and other regulatory agencies may apply new standards for safety, manufacturing, packaging and distribution of drugs using this mode of administration, including Macugen. We are working with the FDA in connection with its development of appropriate standards for drugs using this mode of administration. As part of this process, we also support efforts by the United States Pharmacopoeia, which works with the FDA to establish standards, to devise a particulate limit and a standard to measure particulate matter appropriate for ophthalmologic treatments administered as ultra low-volume injectables. It may be time consuming or expensive for us to comply with these standards. This could result in delays in our obtaining marketing approval for Macugen, or possibly preclude us from obtaining such approval. This could also increase our commercialization costs, possibly materially. Furthermore, Macugen and any of our future products may not be effective, may be only moderately effective or may prove to have undesirable or unintended side effects, toxicities or other characteristics that may preclude our obtaining regulatory approval or prevent or limit commercial use, which could have a material adverse effect on our business. The FDA and other regulatory authorities may not approve any product that we develop. The fast track designation for development of Macugen may not actually lead to a faster development or regulatory review or approval process. If a drug is intended for the treatment of a serious or life-threatening condition and the drug demonstrates the potential to address unmet medical needs for this condition, the drug sponsor may apply for FDA fast track designation. The fast track classification does not apply to the product alone, but applies to the combination of the product and the specific indication or indications for which it is being studied. The FDA s fast track programs are designed to facilitate the clinical development and evaluation of the drug s safety and efficacy for the fast track indication or indications. Marketing applications filed by sponsors of products in fast track development may qualify for expedited review under policies or procedures offered by the FDA, but the fast track designation does not assure such qualification. Although we have obtained a fast track designation from the FDA for Macugen for the treatment of both wet AMD and DME, we may not experience a faster development process, review or approval compared to conventional FDA procedures. Our fast track designation may be withdrawn by the FDA if it believes that the designation is no longer supported by data from our clinical development program. Our fast track designation does not guarantee that we will qualify for or be able to take advantage of the expedited review procedures. Our products could be subject to restrictions or withdrawal from the market and we may be subject to penalties if we fail to comply with regulatory requirements, or if we experience unanticipated problems with our products, when and if any of them are approved. Any product for which we obtain marketing approval, along with the manufacturing processes, post-approval clinical data, advertising and promotional activities for such product, will be subject to continual requirements, review and periodic inspections by the FDA and other regulatory bodies. Even if regulatory approval of a product is granted, the approval may be subject to limitations on the indicated uses for which the product may be marketed or to the conditions of approval, or contain requirements for costly Table of Contents post-marketing testing and surveillance to monitor the safety or efficacy of the product. Later discovery of previously unknown problems with our products, manufacturer or manufacturing processes, or failure to comply with regulatory requirements, may result in: restrictions on such products or manufacturing processes; withdrawal of the products from the market; voluntary or mandatory recall; fines; suspension of regulatory approvals; product seizure; and injunctions or the imposition of civil or criminal penalties. We may be slow to adapt, or we may never adapt, to changes in existing regulatory requirements or adoption of new regulatory requirements or policies. Failure to obtain regulatory approval in foreign jurisdictions would prevent us from marketing our products abroad. We intend to have our products marketed outside the United States. In order to market our products in the European Union and many other non-U.S. jurisdictions, we must obtain separate regulatory approvals and comply with numerous and varying regulatory requirements. In the case of Macugen, Pfizer has responsibility to obtain regulatory approvals outside the United States, and we will depend on Pfizer to obtain these approvals. The approval procedure varies among countries and can involve additional testing. The time required to obtain approval may differ from that required to obtain FDA approval. The foreign regulatory approval process may include all of the risks associated with obtaining FDA approval. We may not obtain foreign regulatory approvals on a timely basis, if at all. Approval by the FDA does not ensure approval by regulatory authorities in other countries, and approval by one foreign regulatory authority does not ensure approval by regulatory authorities in other foreign countries or by the FDA. We and our collaborators may not be able to file for regulatory approvals and may not receive necessary approvals to commercialize our products in any market. The failure to obtain these approvals could materially adversely affect our business, financial condition and results of operations. We have only limited experience in regulatory affairs, and some of our products may be based on new technologies. These factors may affect our ability or the time we require to obtain necessary regulatory approvals. We have only limited experience as a company in filing and prosecuting the applications necessary to gain regulatory approvals. Moreover, some of the products that are likely to result from our product development, licensing and acquisition programs may be based on new technologies that have not been extensively tested in humans. The regulatory requirements governing these types of products may be less well defined or more rigorous than for conventional products. As a result, we may experience a longer regulatory review in connection with obtaining regulatory approvals of any products that we develop, license or acquire. Risks Relating to Intellectual Property If we are unable to obtain and maintain protection for the intellectual property incorporated into our products, the value of our technology and products will be adversely affected. Our success will depend in large part on our ability or the ability of our licensors to obtain and maintain protection in the United States and other countries for the intellectual property incorporated into our products. The patent situation in the field of biotechnology and pharmaceuticals generally is highly uncertain and involves complex legal and scientific questions. Neither we nor our licensors may be able to The selling stockholders named in this prospectus are offering 3,860,000 shares of Eyetech Pharmaceuticals, Inc. common stock. We will not receive any of the proceeds from the sale of common stock in this offering. Shares of our common stock are quoted on the Nasdaq National Market under the symbol EYET. On May 25, 2004, the last sale price of the common stock as reported on the Nasdaq National Market was $32.89 per share. Investing in the common stock involves risks. See Risk Factors beginning on page 7. Table of Contents obtain additional issued patents relating to our technology. Even if issued, patents may be challenged, narrowed, invalidated, or circumvented, which could limit our ability to stop competitors from marketing similar products or limit the length of term of patent protection we may have for our products. In addition, our patents and our licensors patents also may not afford us protection against competitors with similar technology. Because patent applications in the United States and many foreign jurisdictions are typically not published until 18 months after filing, or in some cases not at all, and because publications of discoveries in the scientific literature often lag behind actual discoveries, neither we nor our licensors can be certain that we or they were the first to make the inventions claimed in issued patents or pending patent applications, or that we or they were the first to file for protection of the inventions set forth in these patent applications. If we fail to comply with our obligations in the agreements under which we license development or commercialization rights to products or technology from third parties, we could lose license rights that are important to our business. We are a party to a number of technology licenses that are important to our business and expect to enter into additional licenses in the future. For example, we hold licenses from Gilead, Nektar Therapeutics and Isis Pharmaceuticals under patents relating to Macugen. These licenses impose various commercialization, milestone payment, royalty, insurance, and other obligations on us. If we fail to comply with these obligations, the licensor may have the right to terminate the license, in which event we would not be able to market products, such as Macugen, that may be covered by the license. If we are unable to protect the confidentiality of our proprietary information and know-how, the value of our technology and products could be adversely affected. In addition to patented technology, we rely upon unpatented proprietary technology, processes, and know-how. We seek to protect this information in part by confidentiality agreements with our employees, consultants and third parties. These agreements may be breached, and we may not have adequate remedies for any such breach. In addition, our trade secrets may otherwise become known or be independently developed by competitors. Third parties may own or control patents or patent applications that would be infringed by our technologies, drug targets or potential products. This could cause us to become involved in expensive patent litigation or other proceedings, which could result in our incurring substantial costs and expenses and liability for damages. This could also require us to seek licenses, which could increase our development and commercialization costs. In either case, this could require us to stop some of our development and commercialization efforts. We may not have rights under some patents or patent applications that would be infringed by technologies that we use in our research, drug targets that we select or product candidates that we seek to develop and commercialize. Third parties may own or control these patents and patent applications in the United States and abroad. These third parties could bring claims against us or our collaborators that would cause us to incur substantial expenses and, if successful against us, could cause us to pay substantial damages. Further, if a patent infringement suit were brought against us or our collaborators, we or they could be forced to stop or delay research, development, manufacturing or sales of the product or product candidate that is the subject of the suit. As a result of patent infringement claims, or in order to avoid potential claims, we or our collaborators may choose to seek, or be required to seek, a license from the third party and would most likely be required to pay license fees or royalties or both. These licenses may not be available on acceptable terms, or at all. Even if we or our collaborators were able to obtain a license, the rights may be nonexclusive, which would give our competitors access to the same intellectual property. Ultimately, we could be prevented from commercializing a product, or be forced to cease some aspect of our business operations if, as a result of actual or threatened patent infringement claims, we or our collaborators are unable to enter into licenses on acceptable terms. This could harm our business significantly. PRICE $ A SHARE Table of Contents There has been substantial litigation and other proceedings regarding the patent and other intellectual property rights in the pharmaceutical and biotechnology industries. In addition to infringement claims against us, we may become a party to other patent litigation and other proceedings, including interference proceedings declared by the United States Patent and Trademark Office and opposition proceedings in the European Patent Office, regarding intellectual property rights with respect to our products and technology. The cost to us of any patent litigation or other proceeding, even if resolved in our favor, could be substantial. Some of our competitors may be able to sustain the costs of such litigation or proceedings more effectively than we can because of their substantially greater financial resources. Uncertainties resulting from the initiation and continuation of patent litigation or other proceedings could have a material adverse effect on our ability to compete in the marketplace. Patent litigation and other proceedings may also absorb significant management time. Risks Relating to Our Financial Results and Need for Financing We have a limited operating history and have incurred losses since inception. If we do not generate significant revenues, we will not be able to achieve profitability. We have no current source of product revenue. We have a limited operating history and have not yet commercialized any products. To date, we have focused primarily on the development of Macugen. We began operations in 2000, and we have not been profitable in any quarter since inception. As of March 31, 2004, we had an accumulated deficit of approximately $153.3 million. We expect to increase our spending significantly as we continue to expand our infrastructure, development programs and commercialization activities. As a result, we will need to generate significant revenues to pay these costs and achieve profitability. We do not know whether or when we will become profitable because of the significant uncertainties with respect to our ability to generate revenues from the sale of our products and from our existing and potential future collaborations. We may need additional financing, which may be difficult to obtain. Our failure to obtain necessary financing or doing so on unattractive terms could adversely affect our development programs and other operations. We will require substantial funds to conduct development, including preclinical testing and clinical trials, of our potential products. We will also require substantial funds to meet our obligations to our licensors and maximize the prospective benefits to us from our licensors, and manufacture and market products that are approved for commercial sale in the future, including Macugen. We currently believe that our available cash, cash equivalents and marketable securities, expected milestone payments and reimbursements from Pfizer under our collaboration and interest income will be sufficient to fund our anticipated levels of operations through at least the end of 2005. However, our future capital requirements will depend on many factors, including: the success of our collaboration with Pfizer to develop and commercialize Macugen; the scope and results of our clinical trials; advancement of other product candidates into development; potential acquisition or in-licensing of other products or technologies; the timing of, and the costs involved in, obtaining regulatory approvals; the cost of manufacturing activities; the cost of commercialization activities, including product marketing, sales and distribution; the costs involved in preparing, filing, prosecuting, maintaining and enforcing patent claims and other patent-related costs, including litigation costs and the results of such litigation; Underwriting Proceeds Discounts and to Selling Price to Public Commissions Stockholders Table of Contents our ability to establish and maintain additional collaborative arrangements; and the success of our detailing agreement with Pfizer relating to Xalatan. Additional financing may not be available to us when we need it or it may not be available on favorable terms. If we are unable to obtain adequate financing on a timely basis, we may be required to significantly curtail one or more of our development, licensing or acquisition programs. We could be required to seek funds through arrangements with collaborators or others that may require us to relinquish rights to some of our technologies, product candidates or products that we would otherwise pursue on our own. If we raise additional funds by issuing equity securities, our then-existing stockholders will experience dilution and the terms of any new equity securities may have preferences over our common stock. After this offering, our executive officers, directors and major stockholders will maintain the ability to control all matters submitted to stockholders for approval. When this offering is completed, our executive officers, directors and stockholders who own more than 5% of our outstanding common stock, will, in the aggregate, beneficially own shares representing approximately 59% of our capital stock (assuming no exercise of the underwriters overallotment option). As a result, if these stockholders were to choose to act together, they would be able to control all matters submitted to our stockholders for approval, as well as our management and affairs. For example, these persons, if they choose to act together, will control the election of directors and approval of any merger, consolidation or sale of all or substantially all of our assets. This concentration of voting power could delay or prevent an acquisition of our company on terms that other stockholders may desire. Provisions in our charter documents and under Delaware law may prevent or frustrate attempts by our stockholders to change our management and hinder efforts to acquire a controlling interest in us. Provisions of our corporate charter and bylaws may discourage, delay or prevent a merger, acquisition or other change in control that stockholders may consider favorable, including transactions in which you might otherwise receive a premium for your shares. These provisions may also prevent or frustrate attempts by our stockholders to replace or remove our management. These provisions include: a classified board of directors; limitations on the removal of directors; advance notice requirements for stockholder proposals and nominations; the inability of stockholders to act by written consent or to call special meetings; and the ability of our board of directors to designate the terms of and issue new series of preferred stock without stockholder approval. The affirmative vote of the holders of at least 75% of our shares of capital stock entitled to vote is necessary to amend or repeal the above provisions of our certificate of incorporation. In addition, absent approval of our board of directors, our bylaws may only be amended or repealed by the affirmative vote of the holders of at least 75% of our shares of capital stock entitled to vote. In addition, Section 203 of the Delaware General Corporation Law prohibits a publicly held Delaware corporation from engaging in a business combination with an interested stockholder, generally a person which together with its affiliates owns or within the last three years has owned 15% of our voting stock, for a period of three years after the date of the transaction in which the person became an interested stockholder, unless the business combination is approved in a prescribed manner. Accordingly, Section 203 may discourage, delay or prevent a change in control of our company. If our stock price is volatile, purchasers of our common stock could incur substantial losses. Our stock price has been, and is likely to continue to be, volatile. The stock market in general and the market for biotechnology companies in particular have experienced extreme volatility that has often been Table of Contents unrelated to the operating performance of particular companies. As a result of this volatility, investors may not be able to sell their common stock at or above the public offering price. The market price for our common stock may be influenced by many factors, including: results of our clinical trials or those of our competitors; the regulatory status of Macugen and our other potential products; failure of any of our product candidates, if approved, to achieve commercial success; developments concerning our collaborators, including Pfizer; regulatory developments in, and outside of, the United States; developments or disputes concerning patents or other proprietary rights; our ability to manufacture products to commercial standards; public concern over our drugs; litigation; the departure of key personnel; future sales of our common stock; variations in our financial results or those of companies that are perceived to be similar to us; changes in the structure of healthcare payment systems; investors perceptions of us; and general economic, industry and market conditions. If there are substantial sales of our common stock, our stock price could decline. If our existing stockholders sell a large number of shares of our common stock or the public market perceives that existing stockholders might sell shares of common stock, the market price of our common stock could decline significantly. All of the shares sold in our initial public offering were, and the shares sold in this offering will be, freely tradable without restriction or further registration under the federal securities laws, unless purchased by our affiliates as that term is defined in Rule 144 under the Securities Act. Approximately 15.6 million shares will be eligible for sale upon the expiration of 180-day lock-up agreements on July 28, 2004, including the shares of some of our significant stockholders. Approximately 13.3 million additional shares will be eligible for sale upon the expiration of lock-up agreements expiring 90 days after the date of this prospectus. These amounts assume no exercise of the underwriters overallotment option. See the description of these agreements under Underwriters below. Upon completion of this offering, holders of an aggregate of approximately 24.9 million shares (or approximately 24.3 million shares, if the underwriters exercise their overallotment option in full) of common stock will have rights with respect to the registration of their shares of common stock with the Securities and Exchange Commission. If we register their shares of common stock following the expiration of the applicable lock-up agreements, they can sell those shares in the public market. We have registered approximately 9,543,000 shares of common stock that are authorized for issuance under our stock plans. As of March 31, 2004, 5,729,664 shares were subject to outstanding options, 4,701,004 of which were immediately exercisable, but with respect to which we had the right to repurchase at the initial exercise price all but 2,014,929 of the shares issuable upon exercise of these options. Because they are registered, the shares authorized for issuance under our stock plans can be freely sold in the public market upon issuance, subject to our repurchase rights, the lock-up agreements referred to above and the restrictions imposed on our affiliates under Rule 144. Table of Contents
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+Risk Factors," "Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Business." These statements involve known and unknown risks, uncertainties and other factors which may cause our actual results, performance or achievements to be materially different from any future results, performances or achievements expressed or implied by the forward looking statements. Forward looking statements include, but are not limited to, statements about: marketing and commercialization of our products and services; our estimates for future revenues, expenses and profitability; our ability to attract customers and enter into customer contracts; our estimates regarding our capital requirements and our needs for additional financing; plans for future products and services and for enhancements of existing products and services; our patent applications and licensed technology; our plans to pursue strategic alliances and acquisitions; and sources of revenues and anticipated revenues and the continued viability and duration of those agreements. In some cases, you can identify forward looking statements by terms such as "may," "might," "will," "should," "could," "would," "expect," "believe," "intend," "estimate," "predict," "potential," or the negative of these terms, and similar expressions intended to identify forward looking statements. These statements reflect our current views with respect to future events and are based on assumptions and subject to risks and uncertainties. Given these uncertainties, you should not place undue reliance on these forward looking statements. We discuss many of these risks in this prospectus in greater detail under the heading "Risk Factors." Also, these forward looking statements represent our estimates and assumptions only as of the date of this prospectus. This prospectus contains statistical data that we obtained from industry publications and other industry sources, including reports generated by Giving USA and other third parties. These industry publications generally indicate that they have obtained their information from sources believed to be reliable, but do not guarantee the accuracy and completeness of their information. Although we believe that the publications are reliable, we have not independently verified their data. You should read this prospectus and the documents that we reference in this prospectus and have filed as exhibits to the registration statement, of which this prospectus is a part, completely and with the understanding that our actual future results may be materially different from what we expect. We qualify all of our forward looking statements by these cautionary statements. Information contained herein is subject to completion or amendment. A registration statement relating to these securities has been filed with the Securities and Exchange Commission. These securities may not be sold nor may offers to buy be accepted prior to the time the registration statement becomes effective. This prospectus shall not constitute an offer to sell or the solicitation of an offer to buy nor shall there be any sale of these securities in any state in which such offer, solicitation or sale would be unlawful prior to registration or qualification under the securities laws of any such state. (Subject to Completion, dated November 3, 2004) PRELIMINARY PROSPECTUS 2,694,998 Shares Common Stock Year ended December 31, 2004 First quarter $ 18.00 $ 9.70 Second quarter $ 17.73 $ 7.00 Third quarter $ 10.85 $ 5.25 Fourth quarter (through October 6, 2004) $ 10.13 $ 9.37 Year ended December 31, 2003 Fourth quarter (since December 19, 2003) $ 12.90 $ 7.91 DIVIDEND POLICY We have never declared or paid any cash dividends on our common stock and do not anticipate paying such cash dividends in the foreseeable future. We currently anticipate that we will retain all of our future earnings for use in the development and expansion of our business and for general corporate purposes. Any determination to pay dividends in the future will be at the discretion of our board of directors and will depend upon our results of operation, financial condition and other factors as the board of directors, in its discretion, deems relevant. This prospectus relates to the resale of 2,694,998 shares of our common stock held by certain of our stockholders. We are registering our common stock for resale by these selling stockholders who may offer such shares for sale from time to time at market prices prevailing at the time of sale or at privately negotiated prices. The selling stockholders may sell the shares directly to purchasers or through underwriters, broker-dealers or agents, that may receive compensation in the form of discounts, concessions or commissions. We will not receive any proceeds from this offering. See "Plan of Distribution." We will bear costs relating to the registration of these shares. Our common stock is traded on the Nasdaq National Market under the symbol "KNTA." On October 1, 2004, the last reported sales price for our common stock as quoted on the Nasdaq National Market was $9.80 per share.
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+Approximate date of commencement of proposed sale to the public: As soon as practicable after this Registration Statement becomes effective. If any of the securities being registered on this Form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933 check the following box: If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, please check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering: If this Form is to be a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement of the earlier effective registration statement for the same offering: If this Form is a post-effective amendment pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering: If the delivery of the prospectus is expected to be made pursuant to Rule 434, please check the following box: Profit on ordinary activities before taxation 3,867,747 4,645,095 4,009,478 Taxation on profit on ordinary activities The Registrant hereby amends this Registration Statement on such date or dates as may be necessary to delay its effective date until the Registrant shall file a further amendment which specifically states that this Registration Statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933 or until the Registration Statement shall become effective on such date as the Commission, acting pursuant to said Section 8(a), may determine. Profit for the financial year(1) 2,679,246 3,215,445 2,471,364 Dividends The information in this prospectus is not complete and may be changed. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell these securities, and it is not soliciting an offer to buy these securities, in any jurisdiction where the offer or sale is not permitted. PRELIMINARY PROSPECTUS Subject to Completion December 7, 2004 Fixed assets Intangible assets 9 1,574,328 Tangible assets 10 3,078,729 3,750,072 Investments 4,800,000 Shares Common Stock 3,308,729 5,397,400 Current assets Debtors The selling stockholders named in this prospectus are offering 4,800,000 shares of our common stock. We will not receive any proceeds from the sale of any shares of our common stock sold by the selling stockholders. Our common stock is listed on the Nasdaq National Market under the symbol "KBAY." On December 6, 2004, the last sale price of our common stock as reported on the Nasdaq National Market was $27.59 per share. Investing in our common stock involves a high degree of risk. Before buying any shares, you should carefully read the discussion of material risks of investing in our common stock under "Risk factors" beginning on page 7 of this prospectus. Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense. Per Share Total 5,586,617 7,858,462 Creditors: amounts falling due within one year Public offering price $ $ Underwriting discounts and commissions $ $ Total assets less current liabilities 5,538,373 7,728,721 Creditors: amounts falling due after more than one year 14 587,206 Provisions for liabilities and charges Deferred taxation Proceeds, before expenses, to the selling stockholders $ $ The underwriters may also purchase up to an additional 720,000 shares of our common stock from the selling stockholders to cover over-allotments, if any. The underwriters are offering the common stock as set forth under "Underwriting." Delivery of the shares of common stock will be made on or about , 2004. UBS Investment Bank Robert W. Baird & Co. Janney Montgomery Scott LLC The date of this prospectus is , 2004. Capital and reserves Called up share capital 16 914 918 Share premium account 17 29,480 57,701 Capital reserve 17 9,962 9,962 Profit and loss account You should rely only on the information contained in this prospectus. We have not, and the selling stockholders and the underwriters have not, authorized anyone to provide you with additional information or information different from that contained in this prospectus. The selling stockholders are offering to sell, and seeking offers to buy, shares of our common stock only in jurisdictions where those offers and sales are permitted. The information contained in this prospectus is accurate only as of the date of this prospectus, regardless of the time of delivery of this prospectus or of any sale of our common stock. TABLE OF CONTENTS Retained profit for the year Equity shareholders' funds(1) i Prospectus summary This summary highlights selected information contained elsewhere in this prospectus. This summary may not contain all the information that you should consider before investing in our common stock. You should carefully read the entire prospectus, including "Risk factors" and the financial statements, before making an investment decision. OUR BUSINESS We are a global provider of information technology, or IT, services and solutions focused on the financial services industry. We combine technical expertise with deep industry knowledge to offer a broad suite of services, including business process and technology advice, software package selection and integration, application development, maintenance and support, network and system security and specialized services, through our global delivery model. Our three-tier global delivery model combines onsite client relationship teams, senior technical and industry experts at our offsite regional service centers and cost-effective global delivery centers in India. The three tiers of our global delivery model help us to provide our clients with value-enhancing solutions using a seamless, consistent and cost-effective client service approach. We focus on the financial services industry and provide our services primarily to credit services companies, banking institutions, capital markets firms and insurance companies. In providing our services, we utilize a wide array of technologies to develop customized solutions that address our clients' specific needs. As of September 30, 2004, Household International (and its affiliates within the HSBC Group), Morgan Stanley, CitiFinancial (an affiliate of Citigroup), Development Bank of Singapore and ABN-AMRO were among our top clients. Our engagements with our top clients typically involve numerous projects and multiple business units within each client and vary in complexity, scope and duration. We seek to expand our client relationships and migrate each client over time from discrete initial engagements to longer-term, recurring projects. For example, over the past several years we have successfully deepened our relationship with our largest client, Household International. For the year ended December 31, 2003 and for the nine months ended September 30, 2004, Household International, which is also our largest stockholder with approximately 14.2% of our common stock after completion of this offering, and its affiliates within the HSBC Group, accounted for 53.2% and 56.0% of our total revenues. Similarly, we have successfully developed our relationship with our second largest client, Morgan Stanley, which will own approximately 4.7% of our common stock after completion of this offering, and accounted for 13.0% and 10.3% of our total revenues in the year ended December 31, 2003 and in the nine months ended September 30, 2004. Our five largest clients together accounted for 80.7% of our total revenues in the year ended December 31, 2003 and in the nine months ended September 30, 2004. We have operated our business since 1989 and are headquartered in suburban Chicago. We have operations and clients around the world, with regional offices located in eight countries and delivery centers in Pune and Hyderabad, India. We also own a 49.0% interest in SSS Holdings Corporation Limited (SSS), which is based in Liverpool, England and focuses on providing IT services to the securities industry. From 1999 through 2003, our revenues grew from $44.2 million to $107.2 million, representing a compound annual growth rate of 24.8%. Our net income was $11.4 million for the year ended December 31, 2003 and $19.3 million for the nine months ended September 30, 2004. Our share of the earnings of SSS provided us with $2.0 million of equity in earnings of affiliate for the year ended December 31, 2003 and for the nine months ended September 30, 2004. Net cash (used in) provided by financing activities 1,367 (1,412 ) (2,273 ) Effect of exchange rates on cash 50 (32 ) 1 OUR INDUSTRY The role of IT has evolved from simply supporting business enterprises to enabling their expansion and transformation. As a result of the recent global economic downturn, companies are placing a greater emphasis on improving their return on IT investments and closely managing IT spending. To attain high-quality IT services at a lower cost, companies are turning to providers with offshore delivery capabilities. India has become the preferred destination for the provision of offshore IT services, offering high-quality and accelerated delivery, significant cost benefits and an abundance of skilled professionals. The global financial services industry is currently faced with a number of challenges, including increased regulatory scrutiny, growing competition and ongoing domestic and international consolidation. As a result, providing rapid access to, and delivery of, real-time information and implementing solutions and processes that minimize system downtime are vital to the success of financial institutions. However, providing these solutions and processes internally is often more costly and time-consuming than outsourcing these services. Consequently, financial institutions are looking externally for solutions that allow them to reduce costs and improve performance. Total global IT services spending within the financial services industry is expected to increase from $123.1 billion in 2003 to $154.3 billion in 2007, representing a compound annual growth rate of 5.8%. The financial services industry is expected to account for 21.2% of total global IT services spending from 2003 to 2007, the highest percentage of any single industry sector. OUR COMPETITIVE STRENGTHS We believe our competitive strengths include: >Deep industry expertise. We have developed expertise in the financial services industry, with a specific focus on credit services companies, banking institutions, capital markets firms and insurance companies. Our industry focus has enabled us to acquire a thorough understanding of our clients' business issues and applicable technologies, which allows us to deliver services and solutions tailored to each client's needs. Because of our specific industry focus, a significant economic downturn in the financial services industry could negatively affect our business. >Three-tier global delivery model. Our global delivery model allows us to provide each of our clients with a responsive and accessible relationship management team at the client's location, a readily available offsite team of technology and industry experts at one of our regional delivery centers and a cost-effective application development, maintenance and support team at one of our global delivery centers in India. Although our global delivery model allows us to provide these benefits to our clients, demand for our services could decline as a result of negative public perception regarding or new legislation restricting the use of offshore IT service providers. >Commitment to attracting, developing and retaining the highest quality employees. We believe we have established a business culture throughout Kanbay that enables us to attract and retain the best available industry talent. From 2001 to 2003, we retained an average of 90% of our employees even though the number of our employees grew significantly. We believe that our high employee retention rate provides tangible benefits to our clients, such as low turnover on long-term engagements, retention of knowledge which can be applied to new projects, consistent quality and competent and responsive personnel. We expect that we will continue to grow and our anticipated growth could place a significant strain on our ability to maintain our culture and provide these tangible benefits to our clients. >Long-term client relationships. We have long-standing relationships with many large, international companies within the financial services industry. Our ability to successfully deliver consistent, seamless solutions on a global basis combined with our deep knowledge of the financial services industry helps us expand the breadth and scope of our engagements with existing clients. We Income (loss) from operations (3,691 ) 3,136 8,288 Other income (expense): Interest expense (335 ) (424 ) (287 ) Interest income 62 17 39 Foreign exchange gain (loss) (31 ) 69 (120 ) Equity in earnings of affiliate 861 2,241 2,046 Loss on investment (644 ) Other, net 8 6 Balance at December 31, 2003 3,333,333 $ 3 20,725,776 $ 2 manage client relationships with our relationship development methodology, which helps us to migrate our clients over time from discrete initial engagements to longer-term, recurring projects. Because of our long-standing relationships, we have historically earned, and believe that in the future we will continue to earn, a significant portion of our revenues from a limited number of clients. >Scalable global business model. We believe that our three-tier global delivery model allows us to quickly engage new projects in order to rapidly meet client needs. Because of our financial services industry focus, we can rapidly deploy our project teams on new engagements located anywhere in the world. Our ability to rapidly deploy our project teams on new engagements and to provide our services to our clients is dependent on many factors, including continued compliance with various immigration restrictions and the maintenance of our global communications infrastructure. OUR STRATEGY In order to enhance our position as a global IT services provider focused on the financial services industry, we intend to: >Diversify and develop our client base; >Expand our service offerings and solutions; >Deepen our financial services expertise; >Continue to attract and retain highly skilled IT professionals; and >Enhance our brand visibility. Our principal executive office is located at 6400 Shafer Court, Suite 100, Rosemont, Illinois 60018, and our telephone number at that office is (847) 384-6100. Our website is located at www.kanbay.com. Information contained on our website is not part of this prospectus. You should carefully consider the information contained in the "Risk factors" section of this prospectus before you decide to purchase our common stock. Strategic Investments Solutions Limited England 50 % Pension investment adviser The Monocle Holdings Corporation Limited England 23 % Computer software development The Monocle Corporation Limited England 3 The offering Common stock offered by the selling stockholders 4,800,000 shares Common stock to be outstanding after this offering 32,913,097 shares Use of proceeds after expenses We will not receive any proceeds from this offering. Nasdaq National Market symbol KBAY Unless otherwise indicated, the number of shares of common stock to be outstanding after this offering includes 512,264 shares of common stock offered hereby and to be issued upon the exercise of options by some of the selling stockholders and excludes: >8,287,680 shares of common stock issuable after the completion of this offering upon the exercise of outstanding stock options under our stock option plan and stock incentive plan at a weighted average exercise price of $7.58 per share; >596,064 shares of common stock issuable after the completion of this offering upon the exercise of outstanding warrants at a weighted average exercise price of $6.03 per share; and >1,640,520 shares of common stock available for future grants under our stock incentive plan. Unless otherwise indicated, all share amounts assume the underwriters' over-allotment option is not exercised. Certain of the selling stockholders have agreed to pay for a portion of the expenses we incur in connection with this offering. See "Underwriting Commissions and discounts." 4 Summary historical consolidated financial data The following table presents summary historical consolidated financial data as of, and for the years ended, December 31, 1999, 2000, 2001, 2002 and 2003, which has been derived from our audited consolidated financial statements, and as of, and for the nine months ended, September 30, 2003 and 2004, which has been derived from our unaudited consolidated financial statements and which, in our opinion, have been prepared on the same basis as the audited consolidated financial statements and reflect all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of our results of operations and financial position. These historical results are not necessarily indicative of results to be expected for any future period. You should read this information together with "Selected historical consolidated financial data," "Management's discussion and analysis of financial condition and results of operations," and our consolidated financial statements and related notes for the years ended December 31, 2001, 2002 and 2003 and the nine months ended September 30, 2003 and 2004, which are included elsewhere in this prospectus. Nine months ended September 30, Years ended December 31, Income (loss) from operations (4,363 ) (10,986 ) (3,691 ) 3,136 8,288 5,512 22,034 Interest expense (379 ) (1,478 ) (335 ) (424 ) (287 ) (206 ) (17 ) Interest income 103 129 62 17 39 16 261 Foreign exchange gain (loss) 209 (17 ) (31 ) 69 (120 ) (48 ) (168 ) Equity in earnings of affiliate(2) 29 861 2,241 2,046 1,569 2,009 Loss on investment (644 ) Other, net 2 8 6 21 12 Income from operations 5,512 22,034 Other income (expense): Interest expense (206 ) (17 ) Interest income 16 261 Foreign exchange gain (loss) (48 ) (168 ) Equity in earnings of affiliate 1,569 2,009 Other, net 12 (in thousands, except per share amounts) Net revenues related parties $ 11,292 $ 14,377 $ 38,001 $ 50,253 $ 70,942 $ 48,909 $ 87,308 Net revenues third parties 32,914 43,144 31,653 32,336 36,211 26,515 44,420 Total selling, general and administrative expenses 21,985 31,819 31,065 29,756 36,846 26,159 36,474 Depreciation and amortization 1,362 2,171 2,437 2,682 3,308 2,305 3,860 (Gain) loss on sale of fixed assets 2 (9 ) 57 38 36 31 Total selling, general and administrative expenses 21,985 31,819 31,065 29,756 36,846 26,159 36,474 Depreciation and amortization 1,362 2,171 2,437 2,682 3,308 2,305 3,860 (Gain) loss on sale of fixed assets 2 (9 ) 57 38 36 31 Total selling, general and administrative expenses 26,159 36,474 Depreciation and amortization 2,305 3,860 Loss on sale of fixed assets 31 Total revenues 44,206 57,521 69,654 82,589 107,153 75,424 131,728 Cost of revenues 25,220 34,526 39,786 46,977 58,675 41,417 69,326 Total selling, general and administrative expenses 31,065 29,756 36,846 Depreciation and amortization 2,437 2,682 3,308 Loss on sale of fixed assets 57 38 8,557 11,315 Investment in affiliate 18,858 22,185 Deferred income taxes 1,350 Other assets 161 Raymond J. Spencer(1) 54 Chairman and Chief Executive Officer William F. Weissman 46 Vice President and Chief Financial Officer Jean A. Cholka 46 Vice President Global Client Management Cyprian D'Souza 49 Chief People Officer and Director Shrihari Gokhale 41 Vice President Global Services Delivery Mark L. Gordon(1)(2) 53 Director Donald R. Caldwell(1)(3)(4) 58 Director Kenneth M. Harvey(2)(4) 44 Director B. Douglas Morriss(2)(3) 41 Director Michael E. Mikolajczyk(3)(4) Income (loss) from operations (4,363 ) (10,986 ) (3,691 ) 3,136 8,288 5,512 22,034 Other income (expense): Interest expense and other, net (67 ) (1,364 ) (296 ) (332 ) (347 ) (226 ) 103 Equity in earnings of affiliate(2) 29 861 2,241 2,046 1,569 2,009 Loss on investment (644 ) Income (loss) before cumulative effect of accounting change (4,368 ) (12,310 ) (3,788 ) 4,819 11,439 Cumulative effect of accounting change(3) (2,043 ) Payments to acquire subsidiary undertakings and goodwill (note 21) (75 ) (587,130 ) Net cash and bank balances acquired Net income (loss) (4,368 ) (12,310 ) (3,788 ) 2,776 11,439 6,755 19,317 Dividends on preferred stock (608 ) (610 ) (608 ) (608 ) (608 ) (455 ) (277 ) (Increase) decrease in carrying value of stock subject to repurchase (6,558 ) (864 ) (676 ) 4,077 3,063 (2,362 ) Foreign debt $ 1,680 $ Capital leases Income (loss) available to common stockholders $ (11,534 ) $ (13,784 ) $ (5,072 ) $ 6,245 $ 13,894 $ 3,938 $ 19,040 Carrying value in SSS at beginning of year $ 15,961 $ 18,858 Equity in earnings of SSS 2,241 2,046 Cash dividend received from SSS (1,215 ) (763 ) Foreign currency translation adjustments 1,779 2,134 Change in ownership percentage and other Note payable to stockholder, interest at 7.4%, due in monthly payments of $3 $ 25 $ Note payable to stockholder, interest at 6%, due on demand 200 Notes payable to stockholder, non interest bearing, due on demand 331 Other related party loans Income (loss) before income taxes (4,430 ) (12,321 ) (3,770 ) 5,045 9,987 6,855 24,146 Income tax expense (benefit) (62 ) (11 ) 18 226 (1,452 ) Income (loss) before income taxes (4,430 ) (12,321 ) (3,770 ) 5,045 9,987 6,855 24,146 Income tax expense (benefit) (62 ) (11 ) 18 226 (1,452 ) Income before income taxes 6,855 24,146 Income tax expense Strategic System Solutions Ltd England 100 % Computer software development Strategic System Solutions Inc. USA 100 % Computer software development Strategic Training Solutions Ltd England 100 % Computer training provider Strategic Back-Office Solutions Ltd England 75 % Back office services SSS Hangzhou Co. Limited(*) China 5 The following table presents a summary of our balance sheet as of September 30, 2004: >on an actual basis; and >on an as adjusted basis to give effect to the issuance of 512,264 shares of common stock in connection with the exercise of options by some of the selling stockholders in conjunction with this offering, resulting in proceeds of $401,000, after deducting the estimated offering expenses that we will pay. As of September 30, 2004 Consolidated balance sheet data: Actual As adjusted (in thousands) Cash and cash equivalents $ 16,650 $ 17,051 Working capital 76,268 76,669 Total assets 164,809 165,210 Long-term debt Total stockholders' equity 128,508 128,909 (1) Reflects the results of Kanbay Australia Pty Ltd. from the date of its acquisition on October 29, 1999 for approximately $3 million in cash and stock. (2) On November 30, 2000, we acquired a 49.4% interest in SSS Holdings Corporation Limited (SSS) in exchange for 2,086,697 shares of our common stock valued at approximately $15.9 million. As of September 30, 2004, we owned approximately 49.0% of SSS. We account for SSS under the equity method of accounting. (3) Effective January 1, 2002, we adopted Statement of Financial Accounting Standards (SFAS) No. 142, "Goodwill and Other Intangible Assets." SFAS No. 142 does not permit goodwill and indefinite-lived intangible assets to be amortized. Upon adoption of SFAS No. 142, we recorded a non-cash charge of $2.0 million to reduce the carrying value of goodwill. This non-cash charge was recorded as a cumulative effect of an accounting change. If we had applied SFAS No. 142 retroactively as of January 1, 1999, our net income (loss) would have been $(4.3 million) in 1999, $(12.0 million) in 2000 and $(2.4 million) in 2001. (4) For the period from January 1, 1999 through August 23, 2000, we operated as a Delaware limited liability company (LLC). On August 24, 2000, we converted from a LLC into a Delaware C corporation when all members exchanged their common and preferred units in the LLC for an equivalent number of shares of our common and preferred stock. Income (loss) per share of common stock and average shares outstanding is presented for the years during which we operated as a C corporation. Provision at U.S. federal statutory rate $ (1,282 ) $ 1,715 $ 3,396 State taxes, net of federal effect (94 ) 135 242 Foreign tax holiday (302 ) (655 ) (1,637 ) Undistributed earnings of SSS (402 ) (510 ) Foreign tax credit (259 ) Non-deductible items 501 326 470 Change in valuation allowance 1,204 (1,002 ) (2,772 ) Other (9 ) Risk factors You should carefully consider the following risks and other information in this prospectus before you decide to buy our common stock. An investment in our common stock involves a high degree of risk. Our business, financial condition or operating results may suffer if any of the following risks is realized. Additional risks and uncertainties not currently known to us may also adversely affect our business, financial condition or operating results. If any of these risks or uncertainties occurs, the trading price of our common stock could decline. RISKS RELATED TO OUR BUSINESS Our revenues are highly dependent on a small number of clients, including a single client from whom we receive more than 50% of our revenues and which is also our largest stockholder, and the loss of any one of our major clients could significantly impact our business. We have historically earned, and believe that in the future we will continue to earn, a significant portion of our revenues from a limited number of clients. Household International, which is our largest client, will own approximately 14.2% of our common stock after the completion of this offering and will continue to be our largest stockholder, accounted for 45.0%, 47.4%, 53.2% and 56.0% of our total revenues in the years ended December 31, 2001, 2002 and 2003 and in the nine months ended September 30, 2004, which, in 2003 and 2004, included revenues from its affiliates within the HSBC Group. Morgan Stanley, which is our second largest client and will own approximately 4.7% of our common stock after the completion of this offering, accounted for 9.6%, 13.5%, 13.0% and 10.3% of our total revenues in the years ended December 31, 2001, 2002 and 2003 and in the nine months ended September 30, 2004. Our five largest clients together accounted for 70.7%, 74.7%, 80.7% and 80.7% of our total revenues in the years ended December 31, 2001, 2002 and 2003 and in the nine months ended September 30, 2004. If we were to lose Household International, Morgan Stanley or one of our other major clients or have a major client cancel substantial projects or otherwise significantly reduce its volume of business with us, our revenues and profitability would be materially reduced. A significant or prolonged economic downturn in, increased regulation of and restrictions imposed on the financial services industry may result in our clients reducing or postponing spending on the services we offer. A significant portion of our revenues is derived from U.S. clients in the financial services industry, which is cyclical and recently experienced a significant downturn. In the nine months ended September 30, 2004, approximately 78% of our revenues were derived from the United States. If economic conditions weaken, particularly in the U.S. financial services industry, our clients may reduce or postpone their IT spending significantly, which may in turn lower the demand for our services and negatively affect our revenues and profitability. In addition to this economic downturn, there has been recent increased regulation of, and restrictions imposed on, financial services companies, which may negatively affect our clients and cause them to reduce their spending on the IT services we offer. Our failure to anticipate rapid changes in technology may negatively impact demand for our services in the marketplace. Our success will depend, in part, on our ability to develop and implement business and technology solutions that anticipate rapid and continuing changes in technology, industry standards and client preferences. We may not be successful in anticipating or responding to these developments on a timely basis, which may negatively impact demand for our solutions in the marketplace. Also, products and 7 technologies developed by our competitors may make our solutions noncompetitive or obsolete. Any one or a combination of these circumstances could have a material adverse effect on our ability to obtain and successfully complete client engagements. The IT services market is highly competitive, and our competitors have advantages that may allow them to better use economic incentives to secure contracts with our existing and prospective clients and attract skilled IT professionals. The IT services market in which we operate includes a large number of participants and is highly competitive. Our primary competitors include: >large consulting and other professional service firms, including Accenture, BearingPoint, Cap Gemini and Deloitte & Touche; >offshore IT service providers, including Cognizant Technology Solutions, Infosys Technologies and Wipro; and >in-house IT departments. The market in which we compete is experiencing rapid changes in its competitive landscape. Some of our competitors are large consulting firms or offshore IT service providers which have significant resources and financial capabilities combined with much larger numbers of IT professionals. Some of these competitors have gained access to public and private capital or have merged or consolidated with better capitalized partners, which has created and may in the future create larger and better capitalized competitors with superior abilities to compete for market share generally and for our existing and prospective clients. Our competitors may be better positioned to use significant economic incentives to secure contracts with our existing and prospective clients. These competitors may also be better able to compete for skilled professionals by offering them more attractive compensation or other incentives. In addition, one or more of our competitors may develop and implement methodologies that yield price reductions, superior productivity or enhanced quality that we are not able to match. Any of these circumstances would have an adverse effect on our revenues and profit margin. We also expect additional competition from offshore IT service providers with current operations in other countries, such as China and the Philippines, where we do not have operations other than our regional service center in Hong Kong. These competitors may be able to offer services using business models that are more effective than ours. Our executive officers and directors and their respective affiliates, including Household International, which will continue to own a large percentage of our common stock after the completion of this offering, have substantial voting control over Kanbay and their interests may differ from other stockholders. Upon completion of this offering, our executive officers and directors and their affiliates will beneficially own, in the aggregate, approximately 39.6% of our outstanding common stock. In particular, Household International will beneficially own approximately 14.2% of our common stock after the completion of this offering. As a result, these stockholders will be able to exercise significant control over all matters requiring stockholder approval, including the election of directors, any amendments to our certificate of incorporation and approval of significant corporate transactions. These stockholders may exercise this control even if they are opposed by our other stockholders. Without the consent of these stockholders, we could be delayed or prevented from entering into transactions (including the acquisition of our company by third parties) that may be viewed as beneficial to us or our other stockholders. In addition, this significant concentration of share ownership may adversely affect the trading price of our common stock if investors perceive disadvantages in owning stock in a company with controlling stockholders. 8 Negative public perception in the United States regarding offshore IT service providers and recently proposed federal legislation may adversely affect demand for our services. Recently, many organizations and public figures have publicly expressed concerns about a perceived association between offshore IT service providers and the loss of jobs in the United States. Our clients may stop using our services to avoid any negative perception that may be associated with utilizing an offshore IT service provider. In addition, federal legislation has been proposed that, if enacted, may restrict U.S. companies from outsourcing their IT work to companies outside the United States. Certain U.S. states have enacted legislation that restricts governmental agencies from outsourcing their IT work to companies outside the United States. Although we currently do not have significant contracts with governmental entities in the United States, it is possible that U.S. private sector companies may in the future be restricted from outsourcing their IT work related to government contracts to offshore service providers. Any expansion of existing laws or the enactment of new legislation restricting offshore IT outsourcing may adversely impact our ability to do business in the United States, particularly if these changes are widespread. If we do not effectively manage our anticipated rapid growth, we may not be able to develop or implement new systems, procedures and controls that are required to support our operations, market our services and manage our relationships with our clients. Between January 1, 2001 and September 30, 2004, the number of our employees has grown from 912 to 3,638. We expect that we will continue to grow and our anticipated growth could place a significant strain on our ability to: >recruit, train, motivate and retain highly skilled IT, marketing and management personnel; >adhere to our high quality process execution standards; >preserve our culture, values and entrepreneurial environment; >develop and improve our internal administrative infrastructure and our financial, operational, communications and other internal systems; and >maintain high levels of client satisfaction. To manage this anticipated growth, we must implement and maintain proper operational and financial controls and systems in order to expand our services and employee base. Further, we will need to manage our relationships with various clients, vendors and other third parties. We cannot give any assurance that we will be able to develop and implement, on a timely basis, the systems, procedures and controls required to support our operations. Our future operating results will also depend on our ability to develop and maintain a successful marketing and sales organization despite our rapid growth. If we are unable to manage our growth, our business, operating results and financial condition would be adversely affected. Our services may infringe on the intellectual property rights of others, which may subject us to legal liability, harm our reputation, prevent us from offering some services to our clients or distract management. We cannot be sure that our services or the products of others that we offer to our clients do not infringe on the intellectual property rights of third parties, and we may have infringement claims asserted against us or our clients. These claims may harm our reputation, distract management, cost us money and/or prevent us from offering some services to our clients. Historically, we have generally agreed to indemnify our clients for all expenses and liabilities resulting from claimed infringements of the intellectual property rights of third parties based on the services that we have performed. In some 9 instances, the amount of these indemnities may be greater than the revenues we receive from the client. In addition, as a result of intellectual property litigation, we may be required to stop selling, incorporating or using products that use the infringed intellectual property. We may be required to obtain a license or pay a royalty to make, sell or use the relevant technology from the owner of the infringed intellectual property, such licenses or royalties may not be available on commercially reasonable terms, or at all. We may also be required to redesign our products or change our methodologies so as not to use the infringed intellectual property, which may not be technically or commercially feasible and may cause us to expend significant resources. Any claims or litigation in this area, whether we ultimately win or lose, could be time-consuming and costly and/or injure our reputation. As the number of patents, copyrights and other intellectual property rights in our industry increases, we believe that companies in our industry will face more frequent infringement claims. Defending against these claims, even if the claims have no merit, could be expensive and divert management's attention and resources from operating our company. We have a limited ability to protect our intellectual property rights, and unauthorized use of our intellectual property could result in the loss of clients. Our success depends, in part, upon our ability to protect our proprietary methodologies and other intellectual property. We rely upon a combination of trade secrets, confidentiality policies, nondisclosure and other contractual arrangements and copyright and trademark laws to protect our intellectual property rights. However, existing laws of some countries in which we provide services, such as India, provide protection of intellectual property rights which may be more limited than those provided in the United States. The steps we take to protect our intellectual property may not be adequate to prevent or deter infringement or other unauthorized use of our intellectual property, and we may not be able to detect unauthorized use or take appropriate and timely steps to enforce our intellectual property rights. Our competitors may be able to imitate or duplicate our services or methodologies. The unauthorized use or duplication of our intellectual property could disrupt our ongoing business, distract our management and employees, reduce our revenues and increase our expenses. We may need to litigate to enforce our intellectual property rights or to determine the validity and scope of the proprietary rights of others. Any such litigation could be time-consuming and costly. Our engagements with clients may not be profitable. Unexpected costs or delays could make our contracts unprofitable. When making proposals for engagements, we estimate the costs and timing for completing the projects. These estimates reflect our best judgment regarding the efficiencies of our methodologies and costs. The profitability of our engagements, and in particular our fixed-price contracts, is affected by increased or unexpected costs or unanticipated delays in connection with the performance of these engagements, including delays caused by factors outside our control, which could make these contracts less profitable or unprofitable. The occurrence of any of these costs or delays could result in an unprofitable engagement or litigation. Our clients may terminate our contracts on short notice. Our clients typically retain us on a non-exclusive, engagement-by-engagement basis, rather than under exclusive long-term contracts. Many of our consulting engagements are less than 12 months in duration, and our clients may terminate most of our engagements on short notice. Large client projects typically involve multiple engagements or stages, and there is always a risk that a client may choose not to retain us for additional stages of a project or that a client will cancel or delay additional planned engagements. When contracts are terminated, we lose the associated revenues, and we may not be able to eliminate associated costs in a timely manner or transition employees to new engagements in an efficient manner. 10 Our profitability is dependent on our billing and utilization rates, and our ability to control these factors is only partially within our control. Our profit margin is largely a function of the rates we are able to charge for our services and the utilization rate, or chargeability, of our professionals. Accordingly, if we are not able to maintain the rates we charge for our services or maintain an appropriate utilization rate for our professionals, we will not be able to sustain our profit margin, and our profitability will suffer. The rates we are able to charge for our services are affected by a number of factors, including: >our clients' perception of our ability to add value through our services; >our ability to control our costs and improve our efficiency; >introduction of new services or products by us or our competitors; >pricing policies of our competitors; and >general economic conditions. Our utilization rates are affected by a number of factors, including: >seasonal trends, primarily our hiring cycle and holiday and summer vacations; >our ability to transition employees from completed and/or terminated projects to new engagements; >the amount of time spent by our employees on non-billable training activities; >our ability to forecast demand for our services and thereby maintain an appropriate headcount; and >our ability to manage employee attrition. If we are unsuccessful in developing our new outsourcing business, we may not recoup our start-up costs and other expenses incurred in connection with this business. In February 2003, we formed Kanbay Managed Solutions, Inc. to pursue application management outsourcing opportunities. We must fund certain start-up costs and other expenses in connection with this business. We anticipate that outsourcing engagements may have a different engagement length and may require different skills than the services we have traditionally offered. The success of these service offerings is dependent, in part, upon continued demand for these services by our existing and new clients and our ability to meet this demand in a cost-competitive and timely manner. In addition, our ability to effectively offer a wide breadth of outsourcing services depends on our ability to attract existing or new clients to these service offerings. To obtain engagements to provide outsourcing services, we are also more likely to compete with large, well established firms, resulting in increased competition and marketing costs. Accordingly, we cannot be certain that our new service offerings will effectively meet client needs or that we will be able to attract existing or new clients to these service offerings. Failure to maintain full utilization of employees at our U.S.-based development center could adversely affect our financial results. From time to time, we undertake new initiatives to enhance our ability to deliver services to our clients around the world. In early 2004, we established a regional off-site development center in the United States, using approximately 90 former employees of one of our clients as the initial staff. In connection with this initiative, we entered into a service agreement with the client. The agreement expires in February 2005. If we are unable to promptly redeploy the staff of the development center on new or existing projects after the agreement expires, our financial results could suffer from either the employee 11 termination costs resulting from a reduction in our workforce or the costs of carrying the staff at the development center until full utilization is achieved again, or both. It would be difficult to replace our chairman and chief executive officer. We are highly dependent upon our chairman and chief executive officer, Raymond J. Spencer, who is one of our founders and our first employee. Mr. Spencer's efforts, talent and leadership have been, and will continue to be, critical to our success. The diminution or loss of the services of Mr. Spencer could have a material adverse effect on our business, operating results and financial condition. Our management has limited experience managing a public company and regulatory compliance may divert its attention from the day-to-day management of our business. Prior to our initial public offering in July 2004, our management team operated our business as a private company. The individuals who now constitute our management team have limited experience managing a publicly-traded company and limited experience complying with the increasingly complex laws pertaining to public companies. Our management team may not successfully or efficiently manage our transition into a public company that will be subject to significant regulatory oversight and reporting obligations under the federal securities laws. In particular, these new obligations will require substantial attention from our senior management and divert its attention away from the day-to-day management of our business, which could materially and adversely impact our business operations. We are investing substantial cash assets in new facilities, and our profitability could be reduced if our business does not grow proportionately. We currently plan to spend approximately $45 million for the construction of a new delivery center in Hyderabad, India and the expansion of our delivery center in Pune, India. We may face cost overruns or project delays in connection with these facilities or other facilities we may construct in the future. Such expansion may significantly increase our fixed costs. If we are unable to grow our business and revenues proportionately, our profitability will be reduced. Our ability to raise capital in the future may be limited and our failure to raise capital when needed could prevent us from growing. We expect that our cash flow from operations, together with our net proceeds from the initial public offering of shares of our common stock and the amounts we are able to borrow under our credit facility, will be adequate to meet our anticipated needs for at least the next two years. However, we may in the future be required to raise additional funds through public or private financing, strategic relationships or other arrangements. Such financing may not be available on acceptable terms, or at all, and our failure to raise capital when needed could seriously harm our business. Additional equity financing may be dilutive to the holders of our common stock, and debt financing, if available, may involve restrictive covenants and could reduce our profitability. Moreover, strategic relationships, if necessary to raise additional funds, may require us to relinquish some important rights or modify our allocation of resources. We do not control the business, operations or dividend policy of SSS, which contributes a significant portion of our net income. We own a 49.0% interest in SSS Holdings Corporation Limited (SSS), which is a Liverpool, England based IT services firm that focuses primarily on the securities industry with revenues earned predominantly in the United Kingdom. We do not have control of the board of directors of SSS or voting control of SSS. Consequently, we do not control the business, operations or dividend policy of SSS. For the years ended December 31, 2002 and 2003 and for the nine months ended September 30, 2004, our share of the earnings of SSS provided us with $2.2 million, $2.0 million and $2.0 million of equity in earnings of affiliate. 12 RISKS RELATED TO OUR INDIAN AND INTERNATIONAL OPERATIONS Wage pressures in India may reduce our profit margins. Wage costs in India have historically been significantly lower than wage costs in the United States and Europe for comparably skilled professionals. However, wages in India are increasing at a faster rate than in the United States, which will result in increased costs for IT professionals, particularly project managers and other mid-level professionals. We may need to increase the levels of our employee compensation more rapidly than in the past to remain competitive. Compensation increases may reduce our profit margins and otherwise harm our business, operating results and financial condition. Changes in the policies of the Government of India or political instability could delay the further liberalization of the Indian economy and adversely affect economic conditions in India, which could adversely impact our business. The role of the Indian central and state governments in the Indian economy is significant. Although the current Government of India supported the economic liberalization of the Indian economy, this economic liberalization may not continue in the future and specific laws and policies affecting technology companies, foreign investment, currency exchange and other matters affecting our business could change as well. Changes in the policies of the Government of India or political instability could delay the further liberalization of the Indian economy and could adversely affect business and economic conditions in India in general and our business in particular. Terrorist attacks or a war or regional conflicts could adversely affect the Indian economy, disrupt our operations and cause our business to suffer. Terrorist attacks, such as the attacks of September 11, 2001 in the United States, and other acts of violence or war, such as a conflict between India and Pakistan, have the potential to directly impact our clients and the Indian economy by making travel more difficult, interrupting lines of communication and effectively curtailing our ability to deliver our services to our clients. These obstacles may increase our expenses and negatively affect our operating results. In addition, military activity, terrorist attacks and political tensions between India and Pakistan could create a greater perception that the acquisition of services from companies with significant Indian operations involves a higher degree of risk, which could adversely affect our business. Disruptions in telecommunications could harm our global delivery model, which could result in client dissatisfaction and a reduction of our revenues. A significant element of our business strategy is to continue to leverage and expand our delivery centers in Hyderabad and Pune, India. In particular, our delivery centers in Pune and Hyderabad, India accounted for approximately 49.2% and 52.0% of our revenues for the year ended December 31, 2003 and for the nine months ended September 30, 2004. We depend upon third party service providers and various satellite and optical links to link our global delivery centers to our clients. We may not be able to maintain active voice and data communications between our global delivery centers and our clients' sites at all times. Any significant loss in our ability to communicate could result in a disruption in business, which could hinder our performance or our ability to complete client projects on time. This, in turn, could lead to client dissatisfaction and a material adverse effect on our business, our operating results and financial condition. Our net income would decrease if the Government of India reduces or withdraws tax benefits and other incentives it provides to us or adjusts the amount of our income taxable in India or if we repatriate our earnings from India. Currently, we benefit from the tax holidays the Government of India gives to the export of IT services from specially designated software technology parks in India. When our tax holidays and taxable income deduction expire or terminate beginning in 2005, our tax expense will materially increase, 13 reducing our profitability. Recently, the Government of India has disallowed these tax exemptions for certain software companies and required the companies to pay additional taxes. As a result, we cannot be certain that the Government of India will not attempt to disallow our tax holidays or taxable income deduction or require us to pay additional taxes. If we were required to pay additional taxes, our net income and profitability would decrease. For more information regarding our Indian tax exemptions, see "Management's discussion and analysis of financial condition and results of operations Critical accounting policies, estimates and risks Income taxes." The Government of India recently enacted new transfer pricing rules and began audits of companies, including us, that may be subject to these new rules. We believe that our transfer pricing policies reflect best practices in our industry, but we cannot be certain that the audits will not result in adjustments to our Indian taxable income given the lack of precedent in applying the new requirements. To the extent our income is taxable in India, any such adjustments would be expected to increase our Indian tax liability and to thereby decrease our net income. Although we intend to use substantially all of our Indian earnings to expand our international operations instead of repatriating these funds to the United States, under Indian law if we repatriated our Indian earnings in the future or such earnings were no longer deemed to be indefinitely reinvested, we would accrue the applicable amount of taxes associated with such earnings. We cannot currently determine the applicable amount of taxes, however, such amount could be material. Restrictions on immigration may affect our ability to compete for and provide services to clients in the United States, which could adversely affect our ability to meet growth and revenue projections. The majority of our IT professionals are Indian nationals. The ability of our IT professionals to work in the United States, Europe and in other countries depends on our ability to obtain the necessary work visas and work permits. Existing and proposed limitations on and eligibility restrictions for these visas could have a significant impact on our ability to transfer IT professionals to the United States, Europe and other countries. Further, in response to recent global political events, the level of scrutiny in granting visas has increased. New security procedures may delay the issuance of visas and affect our ability to staff projects in a timely way. Our reliance on work visas for a significant number of our IT professionals makes us particularly vulnerable to legislative changes and strict enforcement of new security procedures, as it affects our ability to staff projects with IT professionals who are not citizens of the country where the on-site work is to be performed. If we are not able to obtain a sufficient number of visas for our IT professionals or encounter delays or additional costs in obtaining or maintaining such visas, our ability to meet our growth and revenue projections could be adversely affected. Currency exchange rate fluctuations will affect our operating results. As indicated in the translation table below, the exchange rate between the Indian rupee and the U.S. dollar has changed substantially in recent years and may fluctuate substantially in the future. We expect that a majority of our revenues will continue to be generated in U.S. dollars for the foreseeable future and that a significant portion of our expenses, including personnel costs, as well as capital and operating expenditures, will continue to be denominated in Indian rupees. Accordingly, an appreciation of the Indian rupee against the U.S. dollar may have a material adverse effect on our cost of revenues, gross profit margin and net income, which may in turn have a negative impact on our business, operating results and financial condition. Specifically, based on our current cost structure, a 1% appreciation of the Indian rupee against the U.S. dollar would cause our gross profit margin to decrease by 12 basis points and our operating profit margin to decline by 18 basis points. We expect to adopt by December 31, 2004 a foreign currency exchange management policy to hedge our Exchange rate at January 1 43.505 46.690 48.344 48.120 Exchange rate at December 31 46.690 48.343 48.044 45.600 Change 3.185 1.653 (0.300 ) (2.520 ) % Change 7.3 % 3.5 % (0.6 )% (5.2 )% Our international operations subject us to risks inherent in doing business in international markets. Currently, we have facilities in eight countries around the world, and we earned 22% of our revenues for the nine months ended September 30, 2004 from clients outside the United States. Accordingly, we must comply with a wide variety of national and local laws, and we are subject to restrictions on the import and export of certain technologies and multiple and overlapping tax structures. In addition, we face competition in other countries from companies that may have more experience with operations in those countries or with international operations generally. Consequently, we may not be able to compete effectively in other countries. RISKS RELATED TO THIS OFFERING AND OUR STOCK Our quarterly revenues, operating results and profitability may vary from quarter to quarter, which may result in increased volatility of our share price. Our gross profit margin has fluctuated by as much as 4.3% from quarter to quarter during the past two years. In addition, our quarterly revenues, operating results and profitability have varied in the past and are likely to vary significantly from quarter to quarter in the future, making them difficult to predict. This may lead to volatility in our share price. The factors that are likely to cause these variations include: >seasonal trends, primarily our hiring cycle and holiday and summer vacations; >the business decisions of our clients regarding the use of our services; >the timing and profitability of projects, unanticipated contract terminations or project postponements; >the amount and timing of income or loss from SSS; >our ability to manage utilization and transition employees quickly from completed projects to new engagements; >the introduction of new services by us or our competitors; >changes in our pricing policies or those of our competitors; >our ability to manage costs, including personnel costs and support services costs; >costs related to possible acquisitions of other businesses; 15 >exchange rate fluctuations; and >global economic conditions. Due to the foregoing factors, it is possible that in some future periods our revenues and operating results may be significantly below the expectations of public market analysts and investors. In such an event, the price of our common stock would likely be materially and adversely affected. The future sale of our common stock could negatively affect our stock price after this offering. After this offering, we will have 32,913,097 shares of common stock outstanding. Sales of a substantial number of our shares of common stock in the public market following this offering or the expectation of such sales could cause the market price of our common stock to decline. All the shares sold in this offering will be freely tradeable except that any shares purchased by our affiliates will remain subject to certain restrictions. After this offering, the holders of approximately 6,269,105 of our shares of common stock and 596,064 shares issuable upon exercise of outstanding warrants will be entitled to registration rights with respect to these shares. Such holders may require us to register the resale of substantially all of these shares upon demand. These holders include Household International, which will own approximately 14.2% of our common stock after this offering and will be selling shares of our common stock in this offering. Any sales of our common stock by Household International could be negatively perceived in the trading markets and negatively affect the price of our common stock. We have registered all shares of common stock that we may issue to our employees under our stock option plan and stock incentive plan. Certain of these shares are eligible for resale in the public market without restriction. For more information, see "Shares eligible for future sale." We are subject to anti-takeover provisions which could affect the price of our common stock. Certain provisions of Delaware law and of our certificate of incorporation and by-laws could have the effect of making it more difficult for a third party to acquire, or of discouraging a third party from attempting to acquire, control of us. For example, our certificate of incorporation and by-laws provide for a classified board of directors, limit the persons who may call special meetings of stockholders and allow us to issue preferred stock with rights senior to those of the common stock without any further vote or action by our stockholders. In addition, we will be subject to the anti-takeover provisions of Section 203 of the Delaware General Corporation Law, which could have the effect of delaying, deterring or preventing another party from acquiring control of Kanbay. These provisions could deprive our stockholders of an opportunity to receive a premium for their common stock as part of a sale of our company or may otherwise discourage a potential acquirer from attempting to obtain control of our company, which in turn could have a material adverse effect on the market price of our common stock. We do not intend to pay dividends, which may limit the return on your investment in us. We have never declared or paid cash dividends on our common stock. We currently intend to retain all available funds and any future earnings for use in the operation and expansion of our business and do not anticipate paying any cash dividends in the foreseeable future.
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+risks associated with operating a business or in a market in which we have little or no prior experience; potential write offs of acquired assets; loss of key employees of acquired businesses; and our inability to recover the costs of acquisitions or investments. If we are required to expense options, it could significantly reduce our net income in future periods. The Financial Accounting Standards Board, or FASB, issued an Exposure Draft, Share-Based Payment: an amendment of Statement of Financial Accounting Standards No. 123 and No. 95 in March 2004 that would require a company to recognize compensation cost for all share based payments, including employee stock options, at fair value beginning in 2005 and subsequent reporting periods. Recently the FASB concluded that the amendment referred to in the Exposure Draft would be effective for public companies for interim or annual periods beginning after June 15, 2005. If the amendment is enacted as described in the Exposure Draft, we will be required to record an expense for our stock-based compensation plans using the fair value method beginning on July 1, 2005. This expense could exceed the expense we currently record for our stock-based compensation plans and correspondingly reduce our net income in future periods. RISKS RELATED TO THIS OFFERING Our common stock could trade at prices below the initial public offering price. Before this offering, there has not been a public trading market for shares of our common stock. An active trading market may not develop or be sustained after this offering. The initial public offering price for the shares of common stock sold in this offering will be determined by negotiations between us and representatives of the underwriters. This price may bear no relationship to the price at which our common stock will trade after this offering. Our stock price may be volatile, and you may not be able to resell your shares at or above the initial public offering price. The trading price of our common stock after this offering may fluctuate widely, depending upon many factors, some of which are beyond our control. These factors include, among others, the risks identified above and the following: variations in our quarterly results of operations; announcements by us or our competitors or lead source providers; changes in estimates of our performance or recommendations, or termination of coverage by securities analysts; inability to meet quarterly or yearly estimates or targets of our performance; the hiring or departure of key personnel, including agents or groups of agents or key executives; changes in our reputation; acquisitions or strategic alliances involving us or our competitors; changes in the legal and regulatory environment affecting our business; and market conditions in our industry and the economy as a whole. If any of the securities being registered on this Form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, check the following box. If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, please check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. If delivery of the prospectus is expected to be made pursuant to Rule 434, check the following box. CALCULATION OF REGISTRATION FEE Title of Each Class of Proposed Maximum Aggregate Amount of Securities to be Registered Offering Price(1) Registration Fee(2) Common Stock $0.001 par value $69,000,000 $8,743 (1) Estimated solely for the purpose of computing the amount of the registration fee pursuant to Rule 457(o) under the Securities Act of 1933, as amended. (2) Previously paid. The Registrant hereby amends this Registration Statement on such date or dates as may be necessary to delay its effective date until the Registrant shall file a further amendment which specifically states that this Registration Statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933 or until the Registration Statement shall become effective on such date as the Commission acting pursuant to said Section 8(a) may determine. Income (loss) before income taxes (2,977 ) (2,225 ) 446 173 (115 ) 1,187 1,271 Provision for income taxes 30 Table of Contents The information in this preliminary prospectus is not complete and may be changed. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This preliminary prospectus is not an offer to sell these securities and we are not soliciting offers to buy these securities in any jurisdiction where the offer or sale is not permitted. PRELIMINARY PROSPECTUS Subject to completion November 8, 2004 4,550,000 Shares Common Stock This is our initial public offering of shares of our common stock. No public market currently exists for our common stock. The initial public offering price of our common stock is expected to be between $10.00 and $12.00 per share. The Nasdaq National Market has approved our common stock for quotation under the symbol ZIPR subject to notice of issuance. Before buying any shares, you should read the discussion of material risks of investing in our common stock in Risk factors beginning on page 9. Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense. Per share Total Other income (expense): Interest expense (226 ) (2,118 ) (2,273 ) (2,271 ) Interest income 193 126 60 44 95 Other income (expense), net 3 (14 ) Other income (expense): Interest expense (226 ) (2,118 ) (2,273 ) (2,271 ) Interest income 9 304 193 126 60 44 95 Other income (expense), net 3 (14 ) Other income (expense): Interest expense (226 ) (2,118 ) (2,273 ) (2,271 ) Interest income 193 126 60 44 95 Other income (expense), net 3 (14 ) Initial public offering price $ $ Underwriting discounts and commissions $ $ Proceeds, before expenses, to us $ $ The underwriters may also purchase up to 682,500 shares of common stock from us at the initial public offering price, less underwriting discounts and commissions, within 30 days from the date of this prospectus. The underwriters may exercise this option only to cover over-allotments, if any. The underwriters are offering the common stock as set forth under Underwriting. Delivery of the shares of common stock will be made on or about , 2004. UBS Investment Bank Deutsche Bank Securities Table of Contents Ziprealty is a full-service residential brokerage that uses the internet to empower consumers and deliver outstanding service and value to clients. Zip Realty Your home is where our heart is. ________________________________________________________________________________ You should only rely on the information contained in this prospectus. We have not authorized anyone to provide you with information different from that contained in this prospectus. We are offering to sell, and seeking offers to buy, shares of common stock only in jurisdictions where offers and sales are permitted. The information contained in this prospectus is accurate only as of the date of this prospectus, regardless of the time of delivery of this prospectus or of any sale of common stock. ZipRealty is our registered trademark in the United States. Our pending trademarks appearing in this prospectus include: Your home is where our heart is, ZipAgent, ZipNotify and ZipAgent Platform. REALTOR and REALTORS are registered trademarks of the National Association of REALTORS . All other trademarks, trade names and service marks appearing in this prospectus are the property of their respective owners. TABLE OF CONTENTS Table of Contents Summary financial data The following table summarizes financial data regarding our business and should be read together with Management s discussion and analysis of financial condition and results of operations and our financial statements and related notes included elsewhere in this prospectus. Nine months ended Year ended December 31, September 30, Net revenues 5,593 8,633 10,301 9,280 10,899 16,270 17,572 Operating expenses: Cost of revenues 3,653 5,163 5,894 5,219 6,093 8,710 9,587 Product development 518 461 384 354 447 549 643 Marketing and business development 1,045 1,362 1,375 1,221 1,660 2,203 2,462 General and administrative 2,457 2,496 2,188 2,323 2,788 3,594 (1) 3,632 (1) Stock-based compensation 19 19 19 28 38 47 Net revenues 3,963 17,163 33,807 24,527 44,741 Income (loss) before income taxes (13,792 ) (14,765 ) (4,583 ) (4,756 ) 2,343 Provision for income taxes Income (loss) before income taxes (2,209 ) (19,965 ) (13,792 ) (14,765 ) (4,583 ) (4,756 ) 2,343 Provision for income taxes Total other income (expense), net (30 ) (2,006 ) (2,192 ) (2,230 ) 95 Income (loss) before income taxes (13,792 ) (14,765 ) (4,583 ) (4,756 ) 2,343 Provision for income taxes (in thousands) Provision for income taxes $ $ 47 $ Eric A. Danziger 50 President, Chief Executive Officer and Director Gary M. Beasley 39 Executive Vice President and Chief Financial Officer William Scott Kucirek 38 Executive Vice President of New Market Development and Director William C. Sinclair 55 Senior Vice President of Sales and Operations Alain J. An 47 Vice President of Human Resources Joseph Patrick Lashinsky 37 Vice President of Marketing and Business Development David A. Rector 58 Vice President, Controller and Chief Accounting Officer Karen B. Seto 39 Vice President, General Counsel and Secretary Joseph P. Trifoglio 51 Vice President of Technology Ronald C. Brown(1)(3) 50 Director Marc L. Cellier(2) 41 Director Matthew E. Crisp(2) 33 Director Robert C. Kagle(2)(3) 48 Director Stanley M. Koonce, Jr.(1) 56 Director Juan F. Mini 36 Director Donald F. Wood(1)(3) Total operating expenses 17,725 29,922 36,198 27,053 42,493 Income (loss) from operations (13,762 ) (12,759 ) (2,391 ) (2,526 ) 2,248 Total other income (expense), net (878 ) (1,357 ) 5 38 12 (20 ) (in thousands) Stock-based compensation $ 57 $ 126 $ Stock-based compensation can be allocated to the following: Cost of revenues $ 5 $ 1 $ 8 $ 1 $ 37 Product development 44 25 23 17 10 Marketing and business development 68 19 18 14 5 General and administrative 68 39 36 25 Net income (loss) $ (13,792 ) $ (14,765 ) $ (4,583 ) $ (4,756 ) $ 2,296 Other operating data Number of ZipAgents at period end 162 279 440 425 782 Total value of real estate transactions closed during period (in billions) $ 0.2 $ 0.9 $ 1.6 $ 1.2 $ 2.1 Number of transactions closed during period(1) 844 3,379 5,394 3,992 6,163 Average net revenue per transaction during period(2) $ 4,629 $ 4,970 $ 6,058 $ 5,915 $ 7,086 Table of Contents The following table presents a summary of our balance sheet data at September 30, 2004: on an actual basis; and on a pro forma as adjusted basis to give effect to the conversion of all outstanding shares of preferred stock into shares of common stock immediately prior to the completion of this offering, the sale of 4,550,000 shares of common stock offered by us at an assumed initial public offering price of $11.00 per share, the mid-point of the range on the cover of this prospectus, and the application of the net proceeds from this offering, after deducting the estimated underwriting discounts and commissions and estimated offering expenses payable by us. September 30, 2004 Pro forma Balance sheet data Actual as adjusted Table of Contents Risk factors You should carefully consider the risk factors described below, together with all of the other information included in this prospectus, before you decide whether to invest in shares of our common stock. The occurrence of any of the following risks could harm our business, financial condition or results of operations. In that case, the market price of our common stock could decline, and you may lose all or part of your investment. RISKS RELATED TO OUR BUSINESS AND INDUSTRY Our business model is new and unproven, and we cannot guarantee our future success. Our Internet-enabled residential real estate brokerage service is a relatively new and unproven business model. Our business model differs significantly from that of a traditional real estate brokerage firm in several ways, including our heavy reliance on the Internet and technology and our employee agent model. The success of our business model depends on our ability to achieve higher transaction volumes at an overall lower cost per transaction in order to offset the costs associated with our technology, employee benefits, marketing and advertising expenses and discounts and rebates. If we are unable to efficiently acquire clients and maintain agent productivity, our ZipAgents may close fewer transactions and our net revenues could suffer as a result. In addition, our agents generally earn a lower per transaction commission than a traditional independent contractor agent. If we are unsuccessful in providing our agents with more opportunities to close transactions than under the traditional model, our ability to hire and retain qualified real estate agents would be harmed, which would in turn significantly harm our business. We have been profitable in only four quarters and may incur losses in the future, and our limited operating history makes our future financial performance difficult to assess. We were formed in January 1999 and therefore have a limited operating history upon which to evaluate our operations and future prospects. We have had a history of losses from inception through the first half of 2003 and at September 30, 2004 had an accumulated deficit of $53.0 million. While we were profitable in the third and fourth quarters of 2003 and the second and third quarters of 2004, we sustained a loss for the first quarter of 2004 and we may not be profitable in future quarters or on an annual basis. Our business model has evolved, and we have only recently achieved significant revenues. We may incur additional expenses with the expectation that our revenues will grow in the future, which may not occur. As a result, we could experience budgeting and cash flow management problems, unexpected fluctuations in our results of operations and other difficulties, any of which could harm our ability to achieve or maintain profitability, increase the volatility of the market price of our common stock or harm our ability to raise additional capital. We expect that we will continue to increase our expenses, including marketing and business development expenses and expenses incurred as a result of increasing the number of agents we employ. As we grow our business in existing markets and expand to new markets, we cannot guarantee our business strategies will be successful or that our revenues will ever increase sufficiently to achieve and maintain profitability on a quarterly or annual basis. Table of Contents Risk factors Our business model requires access to real estate listing services provided by third parties that we do not control, and the demand for our services may be reduced if our ability to display listings on our web site is restricted. A key component of our business model is that through our web site we offer clients access to, and the ability to search, real estate listings posted on the MLSs in the markets we serve. Most large metropolitan areas in the United States have at least one MLS, though there is no national MLS. The homes in each MLS are listed voluntarily by its members, who are licensed real estate brokers. The information distributed in an MLS allows brokers to cooperate in the identification of buyers for listed properties. If our access to one or more MLS databases were restricted or terminated, our service could be adversely affected and our business may be harmed. Because participation in an MLS is voluntary, a broker or group of brokers may decline to post their listings to the existing MLS and instead create a new proprietary real estate listing service. If a broker or group of brokers created a separate real estate listing database, we may be unable to obtain access to that private listing service on commercially reasonable terms, if at all. As a result, the percentage of available real estate listings that our clients would be able to search using our web site would be reduced, perhaps significantly, thereby making our services less attractive to potential clients. Additionally, the National Association of Realtors, or NAR, the dominant trade organization in the residential real estate industry, has recently adopted a mandatory policy for NAR-affiliated MLSs regarding the use and display of MLS listings data on virtual office web sites, or VOWs. We operate a VOW, which is a password protected website which allows us to show comprehensive MLS data directly to consumers without their having to visit an agent. Individual MLSs affiliated with NAR, which includes the vast majority of MLSs in the United States, will be required to implement their own individual VOW policies consistent with the NAR policy by July 1, 2005. NAR has extended the deadline for the implementation of its rules at least three times during an investigation by the antitrust division of the U.S. Department of Justice into NAR s policy that dictates how brokers can display other brokers property listings on their web sites. We presently do not know whether or when the NAR rules will be implemented in their current form or in a revised form, if at all. Once these individual MLS VOW policies are implemented, the NAR policy currently provides that member brokerages will have up to six months to comply with the policy. The NAR policy is designed to provide structure to the individual MLS VOW policies, subject to a number of areas in which the individual MLSs may tailor the policy to meet their local needs. One NAR policy provision with which the individual MLSs must adhere, once required to be implemented, is known as an opt-out. This provision creates a mechanism for individual brokers to prevent their listings data from being displayed on certain competitors VOWs. MLS members and participants, including individual brokers, could exercise a blanket opt-out, which would not allow their listings to be displayed on any competing VOW, or a selective opt-out, in which they could selectively prevent certain competing VOWs from displaying their listings, while allowing other VOWs to do so. A few of the MLSs of which we are a member, as well as at least one of the state Association of REALTORS of which we are a member, have adopted VOW policies with opt-out provisions, apparently in anticipation of their required implementation of the NAR policy. To our knowledge, to date no members or participants of any of those MLSs have exercised such an opt-out right. Should any such right be exercised, it could restrict our ability to display comprehensive MLS home listings data to our consumers, which is a key part of our business model. Should our ability to display MLS listings information on our web site be significantly restricted, it may reduce demand for our services and lead to a decrease in the number of residential real estate transactions completed by our ZipAgents, as well as increase our costs of ensuring compliance with such restrictions. Table of Contents Risk factors Total other income (expense), net (30 ) (2,006 ) (2,192 ) (2,230 ) If we fail to recruit, hire and retain qualified agents, we may be unable to service our clients and our growth could be impaired. Our business requires us to hire employees who are licensed real estate agents, and our strategy is based on consistently and rapidly growing our team of ZipAgents. Competition for qualified agents is intense, particularly in the markets in which we compete. While there are many licensed real estate agents in our markets and throughout the country, historically we have had difficulties in recruiting and retaining properly qualified licensed agents due particularly to agent discomfort with using technology and being actively managed by an employer. In addition, our lower per transaction agent commission model may be unattractive to certain higher performing agents. If we are unable to recruit, train and retain a sufficient number of qualified licensed real estate agents, we may be unable to service our clients properly and grow our business. Historically we have experienced a high degree of agent turnover, most of which occurs in the first few months after commencing employment. This turnover has required us to expend a substantial amount of time and money to replace agents who have left as we have been growing our business. If this situation worsens, our rate of expansion into new markets could be slowed and we will continue to employ a significantly higher number of new agents with less experience operating in our business model, which could cause us to be less effective at expanding our market share in our existing markets and entering new markets. Furthermore, we rely on federal and state exemptions from minimum wage and fair labor standards laws for our ZipAgents, who are compensated solely through commissions. Such exemptions may not continue to be available, or we may not qualify for such exemptions, which could subject us to penalties and damages for non-compliance. If similar exemptions are not available in states where we desire to expand our operations or if they cease to be available in the states where we currently operate, we may need to modify our agent compensation structure in such states. Our failure to effectively manage the growth of our ZipAgents and our information and control systems could adversely affect our ability to service our clients. As our operations have expanded, we have experienced rapid growth in our headcount from 233 total employees, including 162 ZipAgents, at December 31, 2001 to 919 total employees, including 782 ZipAgents, at September 30, 2004. We expect to continue to increase headcount in the future, particularly the number of ZipAgents. Our rapid growth has demanded, and will continue to demand, substantial resources and attention from our management. We will need to continue to hire additional qualified agents and improve and maintain our technology to properly manage our growth. If we do not effectively manage our growth, our client service and responsiveness could suffer and our costs could increase, which could negatively affect our brand and operating results. As we grow, our success will depend on our ability to continue to implement and improve our operational, financial and management information and control systems on a timely basis, together with maintaining effective cost controls. This ability will be particularly critical as we implement new systems and controls to help us comply with the more stringent requirements of being a public company, including the requirements of the Sarbanes-Oxley Act of 2002, which require management to evaluate and assess the effectiveness of our internal controls and our disclosure controls and procedures. Effective internal controls are required by law and are necessary for us to provide reliable financial reports and effectively prevent fraud. Effective disclosure controls and procedures will be required by law and are necessary for us to file complete, accurate and timely reports under the Securities Exchange Act of 1934. Any inability to provide reliable financial reports or prevent fraud or to file complete, accurate and timely reports under the Securities Exchange Act could harm our business, harm our reputation or result in a decline in or stock price. We are continuing to evaluate Total other income (expense), net 9 304 (30 ) (2,006 ) (2,192 ) (2,230 ) Table of Contents Risk factors and, where appropriate, enhance our systems, procedures and internal controls. We are in the process of establishing our disclosure controls and procedures. If our systems, procedures or controls are not adequate to support our operations and reliable, accurate and timely financial and other reporting, we may not be able to successfully satisfy regulatory and investor scrutiny, offer our services and implement our business plan. Our operating results are subject to seasonality and vary significantly among quarters during each calendar year, making meaningful comparisons of successive quarters difficult. The residential real estate market traditionally has experienced seasonality, with a peak in the spring and summer seasons and a decrease in activity during the fall and winter seasons. Revenues in each quarter are significantly affected by activity during the prior quarter, given the typical 30- to 45-day time lag between contract execution and closing. Historically, this seasonality has caused our revenues, operating income, net income and cash flow from operating activities to be lower in the first and fourth quarters and higher in the second and third quarters of each year. Factors affecting the timing of real estate transactions that can cause our quarterly results to fluctuate include: timing of widely observed holidays and vacation periods and availability of real estate agents and related service providers during these periods; a desire to relocate prior to the start of the school year; timing of employment compensation changes, such as raises and bonuses; and the time between entry into a purchase contract for real estate and closing of the transaction. We expect our revenues to continue to be subject to these seasonal fluctuations, which, combined with our recent growth, make it difficult to compare successive quarters. Interest rates have been at historic lows for the past several years, and increases in interest rates have the potential to negatively impact the housing market. When interest rates rise, all other things being equal, housing becomes less affordable, since at a given income level people cannot qualify to borrow as much principal, or given a fixed principal amount they will be faced with higher monthly payments. This result may mean that fewer people will be able to afford homes at prevailing prices, potentially leading to fewer transactions or reductions in home prices in certain regions, depending also on the relevant supply-demand dynamics of those markets. Since we operate in only 12 markets around the country, it is possible that we could experience a more pronounced impact than we would experience if our operations were more diversified. Should we experience softening in our markets and not be able to offset the potential negative market influences on price and volume by increasing our transaction volume through market share growth, our financial results could be negatively impacted. If consumers do not continue to use the Internet as a tool in their residential real estate buying or selling process, we may be unable to attract new clients and our growth and financial results may suffer. We rely substantially on our web site and web-based marketing for our client lead generation. As the residential real estate business has traditionally been characterized by personal, face-to-face relationships between buyers and sellers and their agents, our success will depend to a certain extent on the willingness of consumers to increase their use of online services in the real estate sales and purchasing process. In addition, our success will depend on consumers visiting our web site early in Table of Contents Risk factors their selling or buying process so that we can interface with potential clients before they have engaged a real estate agent to represent them in their transactions. If we are unable to convince visitors to our web site to transact business with us, our ZipAgents will have fewer opportunities to represent clients in residential real estate transactions and our net revenues could suffer. Our success depends in part on our ability to successfully expand into additional real estate markets. We currently operate in 12 markets, including 11 of the 25 most populous U.S. metropolitan statistical areas. A part of our business strategy is to grow our business by entering into additional real estate markets. Key elements of this expansion include our ability to identify strategically attractive real estate markets and to successfully establish our brand in those markets. We consider many factors when selecting a new market to enter, including: the economic conditions and demographics of a market; the general prices of real estate in a market; Internet use in a market; competition within a market from local and national brokerage firms; rules and regulations governing a market; the ability and capacity of our organization to manage expansion into additional geographic areas, additional headcount and increased organizational complexity; the existence of local MLSs; and state laws governing cash rebates and other regulatory restrictions. We have not entered a new geographic market since July 2000 and have limited experience expanding into and operating in multiple markets, managing multiple sales regions or addressing the factors described above. In addition, this expansion could involve significant initial start-up costs. We expect that significant revenues from new markets will be achieved, if ever, only after we have been operating in that market for some time and begun to build market awareness of our services. As a result, geographic expansion is likely to significantly increase our expenses and cause fluctuations in our operating results. In addition, if we are unable to successfully penetrate these new markets, we may continue to incur costs without achieving the expected revenues, which would harm our financial condition and results of operations. Unless we develop, maintain and protect a strong brand identity, our business may not grow and our financial results may suffer. We believe a strong brand is a competitive advantage in the residential real estate industry because of the fragmentation of the market and the large number of agents and brokers available to the consumer. Because our brand is relatively new, we currently do not have strong brand identity. In addition, we recently redesigned our logo and marketing slogan, which could result in loss of the brand recognition we currently have and confusion among consumers. We believe that establishing and maintaining brand identity and brand loyalty is critical to attracting new clients. In order to attract and retain clients, and respond to competitive pressures, we expect to increase our marketing and business development expenditures to maintain and enhance our brand in the future. We plan to expand our current online, radio, outdoor and newspaper advertising and conduct future television advertising campaigns. We plan to increase our advertising expenditures substantially in the future. While we intend to enhance our marketing and advertising activities in order to promote our Table of Contents Risk factors brand, these activities may not have a material positive impact on our brand identity. In addition, maintaining our brand will depend on our ability to provide a high-quality consumer experience and high quality service, which we may not do successfully. If we are unable to maintain and enhance our brand, our ability to attract new clients or successfully expand our operations will be harmed. We have numerous competitors, many of which have valuable industry relationships and access to greater resources than we do. The residential real estate market is highly fragmented, and we have numerous competitors, many of which have greater name recognition, longer operating histories, larger client bases, and significantly greater financial, technical and marketing resources than we do. Some of those competitors are large national brokerage firms or franchisors, such as Prudential Financial, Inc., RE/ MAX International Inc. and Cendant Corporation, which owns the Century 21, Coldwell Banker and ERA franchise brands, a large corporate relocation business and NRT Incorporated, the largest brokerage in the United States. NRT owns and operates brokerages that are typically affiliated with one of the franchise brands owned by Cendant. We are also subject to competition from local or regional firms, as well as individual real estate agents. We also compete or may in the future compete with various online services, such as InterActiveCorp and its LendingTree unit, HouseValues, Inc., HomeGain, Inc., Homestore, Inc. and its Realtor.com affiliate and Yahoo! Inc. that also look to attract and monetize home buyers and sellers using the Internet. Homestore is affiliated with NAR, the National Association of Home Builders, or NAHB, a number of major MLSs and Cendant, which may provide Homestore with preferred access to listing information and other competitive advantages. In addition, our technology-focused business model is a relatively new approach to the residential real estate market and many consumers may be hesitant to choose us over more established brokerage firms employing traditional techniques. Some of our competitors are able to undertake more extensive marketing campaigns, make more attractive offers to potential agents and clients and respond more quickly to new or emerging technologies. Over the past several years there has been a slow but steady decline in average commissions charged in the real estate brokerage industry, with the average commission percentage decreasing from 5.44% in 2000 to 5.14% in 2003 according to REAL Trends. Some of our competitors with greater resources may be able to better withstand the short- or long-term financial effects of this trend. In addition, the barriers to entry to providing an Internet-enabled real estate service are low, making it possible for current or new competitors to adopt certain aspects of our business model, including offering comprehensive MLS data to clients via the Internet, thereby reducing our competitive advantage. We may not be able to compete successfully for clients and agents, and increased competition could result in price reductions, reduced margins or loss of market share, any of which would harm our business, operating results and financial condition. Changes in federal and state real estate laws and regulations, and rules of industry organizations such as the National Association of REALTORS , could adversely affect our business. The real estate industry is heavily regulated in the United States, including regulation under the Fair Housing Act, the Real Estate Settlement Procedures Act, state and local licensing laws and regulations and federal and state advertising laws. In addition to existing laws and regulations, states and industry participants and regulatory organizations could enact legislation, regulatory or other policies in the future, which could restrict our activities or significantly increase our compliance costs. Moreover, the provision of real estate services over the Internet is a new and evolving business, and legislators, regulators and industry participants may advocate additional legislative or regulatory initiatives governing the conduct of our business. If existing laws or regulations are amended or new laws or Table of Contents Risk factors regulations are adopted, we may need to comply with additional legal requirements and incur significant compliance costs, or we could be precluded from certain activities. Because we operate through our web site, state and local governments other than where the subject property is located may attempt to regulate our activities, which could significantly increase our compliance costs and limit certain of our activities. In addition, industry organizations, such as NAR and other state and local organizations, can impose standards or other rules affecting the manner in which we conduct our business. As mentioned above, NAR has adopted rules that, if implemented, could result in a reduction in the number of home listings that could be viewed on our web site. NAR has extended the deadline for the implementation of its rules at least twice during an investigation by the antitrust division of the U.S. Department of Justice into NAR s policy that dictates how brokers can display other brokers property listings on their web sites. We presently do not know whether or when the NAR rules will be implemented in their current form or in a revised form, if at all. The implementation of the rules will not limit our access to listing information, but could limit the display of listing information to our clients through our web site in the manner we currently utilize, as well as increase our costs of ensuring compliance with such rules. Any significant lobbying or related activities, either of governmental bodies or industry organizations, required to respond to current or new initiatives in connection with our business could substantially increase our operating costs and harm our business. We derive a significant portion of our leads through third parties, and if any of our significant lead generation relationships are terminated or become more expensive, our ability to attract new clients and grow our business may be adversely affected. We generate leads for our ZipAgents through many sources, including leads from third parties with which we have only non-exclusive, short-term agreements that are generally terminable on little or no notice and with no penalties. Our largest third-party lead source in the first nine months of 2004, HomeGain, Inc., which competes with us for online customer acquisition, generated approximately 22% of our leads during that period. In addition, during the second quarter of 2004 our exclusive co-branded relationship which we had in four markets with one third-party lead source, Yahoo! Inc., was terminated, effective July 31, 2004. Leads from this source accounted for approximately 14% of our leads and 8% of our net revenues during the first nine months of 2004. These leads were inexpensive relative to those generated from competing sources, although they also were characterized by a lower conversion rate than is typical from our other sources. As a result, our lead replacement strategy includes delivering fewer leads to the agents in the areas impacted by the termination of the Yahoo! co-branded relationship with those leads characterized by what we believe to be higher conversion potential based upon historical experience. Should this replacement strategy not be successful, or any of our other lead generation relationships become materially more expensive such that we could not obtain substitute sources on acceptable terms, our ability to attract new clients and grow our business may be impaired. Our business could be harmed by economic events that are out of our control and may be difficult to predict. The success of our business depends in part on the health of the residential real estate market, which traditionally has been subject to cyclical economic swings. The purchase of residential real estate is a significant transaction for most consumers, and one which can be delayed or terminated based on the availability of discretionary income. Economic slowdown or recession, rising interest rates, adverse tax policies, lower availability of credit, increased unemployment, lower consumer confidence, lower wage and salary levels, war or terrorist attacks, or the public perception that any of these events may occur, could adversely affect the demand for residential real estate and would harm our business. Also, if interest rates increase significantly, homeowners ability to purchase a new home or a higher priced home may be reduced as higher monthly payments would make housing less affordable. In addition, Table of Contents Risk factors these conditions could lead to a decline in new listings, transaction volume and sales prices, any of which would harm our operating results. Our ability to expand our business may be limited by state laws governing cash rebates to home buyers. A significant component of our value proposition to our home buyer clients is a cash rebate provided to the buyer at closing. Currently, our clients who are home buyers represent a substantial majority of our business and revenues. Certain states, such as Alaska, Kansas, Kentucky, Louisiana, Mississippi, New Jersey, Oklahoma, Oregon and Tennessee, may presently prohibit sharing any commissions with, or providing rebates to, clients who are not licensed real estate agents. In addition, other states may limit or restrict our cash rebate program as currently structured, including Missouri and New York. Should we decide to expand into any of these states, we may have to adjust our pricing structure or refrain from offering rebates to buyers in these states. Moreover, we cannot predict whether alternative approaches will be cost effective or easily marketable to prospective clients. The failure to enter into these markets, or others that adopt similar restrictions, or to successfully attract clients in these markets, could harm our business. We may be unable to integrate our technology with each MLS on a cost-effective basis, which may harm our operating results and adversely affect our ability to service clients. Each MLS is operated independently and is run on its own technology platform. As a result, we must constantly modify our technology to successfully interact with each independent MLS in order to maintain access to that MLS s home listings information. In addition, when a new MLS is created, we must customize our technology to work with that new system. These activities require constant attention and significant resources. We may be unable to successfully interoperate with the MLSs without significantly increasing our engineering costs, which would increase our operating expenses without a related increase in net revenues and cause our operating results to suffer. We may also be unable to interoperate with the MLSs at all, which may adversely affect the demand for our services. If we fail to comply with real estate brokerage laws and regulations, we may incur significant financial penalties or lose our license to operate. Due to the geographic scope of our operations and the nature of the real estate services we perform, we are subject to numerous federal, state and local laws and regulations. For example, we are required to maintain real estate brokerage licenses in each state in which we operate and to designate individual licensed brokers of record. If we fail to maintain our licenses, lose the services of our designated broker of record or conduct brokerage activities without a license, we may be required to pay fines or return commissions received, our licenses may be suspended or we may be subject to other civil and/or criminal penalties. As we expand into new markets, we will need to obtain and maintain the required brokerage licenses and comply with the applicable laws and regulations of these markets, which may be different from those to which we are accustomed, may be difficult to obtain and will increase our compliance costs. In addition, because the size and scope of real estate sales transactions have increased significantly during the past several years, both the difficulty and cost of compliance with the numerous state licensing regimes and possible losses resulting from non-compliance have increased. Our failure to comply with applicable laws and regulations, the possible loss of real estate brokerage licenses or litigation by government agencies or affected clients may have a material adverse effect on our business, financial condition and operating results, and may limit our ability to expand into new markets. Table of Contents Risk factors We may have liabilities in connection with real estate brokerage activities. As a licensed real estate broker, we and our licensed employees are subject to statutory due diligence, disclosure and standard-of-care obligations. In the ordinary course of business we and our employees are subject to litigation from parties involved in transactions for alleged violations of these obligations. In addition, we may be required to indemnify our employees who become subject to litigation arising out of our business activities, including for claims related to the negligence of those employees. An adverse outcome in any such litigation could negatively impact our reputation and harm our business. We may be subject to liability for the Internet content that we publish. As a publisher of online content, we face potential liability for negligence, copyright, patent or trademark infringement, or other claims based on the nature and content of the material that we publish or distribute. Such claims may include the posting of confidential data, erroneous listings or listing information and the erroneous removal of listings. These types of claims have been brought successfully against the providers of online services in the past and could be brought against us or others in our industry. In addition, we may face liability if a MLS member or participant utilizes an opt-out provision, as previously discussed, and we fail to comply with that requirement. These claims, whether or not successful, could harm our reputation, business and financial condition. Although we carry general liability insurance, our insurance may not cover claims of these types or may be inadequate to protect us for all liability that we may incur. We monitor and evaluate the use of our web site by our registered users, which could raise privacy concerns. Visitors to our web site that register with us receive access to home listing and related information that we do not make available to unregistered users. As part of the registration process, our registered users consent to our use of information we gather from their use of our web site, such as the geographic areas in which they search for homes, the price range of homes they view, their activities while on our web site and other similar information. They also provide us with personal information such as telephone numbers and email addresses. While our registered users consent to our internal use of this information, if we were to use this information outside the scope of their consent or otherwise fail to keep this information confidential from third parties, including our former agents, we may be subject to legal claims or government action and our reputation and business could be harmed. While we do not share web site use and other personal information with any third parties, except with our clients consent to third parties involved in the transaction process, concern among consumers regarding our use of personal information gathered from visitors to our web site could cause them not to register with us. This would reduce the number of leads we derive from our web site. Because our web site is our primary client acquisition tool, any resistance by consumers to register on our web site would harm our business and results of operations, and could cause us to alter our business practices or incur significant expenses to educate consumers regarding the use we make of information. We may need to change the manner in which we conduct our business if government regulation of the Internet increases. The adoption or modification of laws or regulations relating to the Internet could adversely affect the manner in which we currently conduct our business. In addition, the growth and development of the market for online commerce may lead to more stringent consumer protection laws that may impose additional burdens on us. Laws and regulations directly applicable to communications or commerce over the Internet are becoming more prevalent. For example, both the U.S. government as well as the State of California have enacted Internet laws regarding privacy and sharing of customer information with third parties. Laws applicable to the Internet remain largely unsettled, even in areas where there Table of Contents Risk factors has been some legislative action. It may take years to determine whether and how existing laws such as those governing intellectual property, privacy, libel and taxation apply to the Internet. In addition, because each state in which we do business requires us to be a licensed real estate broker, and residents of states in which we do not do business could potentially access our web site, changes in Internet regulation could lead to situations in which we are considered to operate or do business in such states. This could result in potential claims or regulatory action. If we are required to comply with new regulations or new interpretations of existing regulations, we may not be able to differentiate our services from traditional competitors and may not attract a sufficient number of clients for our business to be successful. Our reputation and client and agent service offerings may be harmed by system failures and computer viruses. The performance and reliability of our technology infrastructure is critical to our reputation and ability to attract and retain clients and agents. Our network infrastructure is currently co-located at a single facility in Sunnyvale, California and we do not currently operate a back-up facility. As a result, any system failure or service outage at this primary facility would result in a loss of service for the duration of the failure or outage. Any system error or failure, or a sudden and significant increase in traffic, may significantly delay response times or even cause our system to fail resulting in the unavailability of our Internet platform. For example, earlier this year we experienced an unscheduled outage that lasted approximately 12 hours. During this period our clients and prospective clients were unable to access our web site or receive notifications of new listings. While we have taken measures to prevent unscheduled outages, outages may occur in the future. In addition, our systems and operations are vulnerable to interruption or malfunction due to certain events beyond our control, including natural disasters, such as earthquakes, fire and flood, power loss, telecommunication failures, break-ins, sabotage, computer viruses, intentional acts of vandalism and similar events. Our network infrastructure is located in the San Francisco Bay area, which is susceptible to earthquakes and has, in the past, experienced power shortages and outages, any of which could result in system failures and service outages. We may not be able to expand our network infrastructure, either on our own or through use of third party hosting systems or service providers, on a timely basis sufficient to meet demand. Any interruption, delay or system failure could result in client and financial losses, litigation or other consumer claims and damage to our reputation. Our intellectual property rights are valuable and our failure to protect those rights could adversely affect our business. Our intellectual property rights, including existing and future patents, trademarks, trade secrets, and copyrights, are and will continue to be valuable and important assets of our business. We believe that our proprietary ZAP technology and ZipNotify, as well as our ability to interoperate with multiple MLSs and our other technologies and business practices, are competitive advantages and that any duplication by competitors would harm our business. We have taken measures to protect our intellectual property, but these measures may not be sufficient or effective. For example, we seek to avoid disclosure of our intellectual property by requiring employees and consultants with access to our proprietary information to execute confidentiality agreements. We also seek to maintain certain intellectual property as trade secrets. Intellectual property laws and contractual restrictions may not prevent misappropriation of our intellectual property or deter others from developing similar technologies. In addition, others may develop technologies that are similar or superior to our technology, including our patented technology. Any significant impairment of our intellectual property rights could harm our business. Table of Contents Risk factors We may in the future be subject to intellectual property rights disputes, which could divert management attention, be costly to defend and require us to limit our service offerings. Our business depends on the protection and utilization of our intellectual property. Other companies may develop or acquire intellectual property rights that could prevent, limit or interfere with our ability to provide our products and services. One or more of these companies, which could include our competitors, could make claims alleging infringement of their intellectual property rights. Any intellectual property claims, with or without merit, could be time-consuming and expensive to litigate or settle and could significantly divert management resources and attention. Our technologies may not be able to withstand any third-party claims or rights against their use. If we were unable to successfully defend against such claims, we may have to: pay damages; stop using the technology found to be in violation of a third party s rights; seek a license for the infringing technology; or develop alternative non-infringing technology. If we have to obtain a license for the infringing technology, it may not be available on reasonable terms, if at all. Developing alternative non-infringing technology could require significant effort and expense. If we cannot license or develop alternative technology for the infringing aspects of our business, we may be forced to limit our product and service offerings. Any of these results could reduce our ability to compete effectively, and harm our business and results of operations. If we fail to attract and retain our key personnel, our ability to meet our business goals will be impaired and our financial condition and results of operations will suffer. The loss of the services of one or more of our key personnel could seriously harm our business. In particular, our success depends on the continued contributions of Eric A. Danziger, our President and Chief Executive Officer, and other senior level sales, operations, marketing, technology and financial officers. Our business plan was developed in large part by our senior level officers and its implementation requires their skills and knowledge. None of our officers or key employees has an employment agreement, and their employment is at will. We do not have key person life insurance policies covering any of our executives. We intend to evaluate acquisitions or investments in complementary technologies and businesses and we may not realize the anticipated benefits from, and may have to pay substantial costs related to, any acquisitions or investments that we undertake. As part of our business strategy, we plan to evaluate acquisitions of, or investments in, complementary technologies and businesses. We may be unable to identify suitable acquisition candidates in the future or be able to make these acquisitions on a commercially reasonable basis, or at all. If we complete an acquisition or investment, we may not realize the benefits we expect to derive from the transaction. Any future acquisitions and investments would have several risks, including: our inability to successfully integrate acquired technologies or operations; diversion of management s attention; problems maintaining uniform standards, procedures, controls and policies; potentially dilutive issuances of equity securities or the incurrence of debt or contingent liabilities; expenses related to amortization of intangible assets; Table of Contents Risk factors risks associated with operating a business or in a market in which we have little or no prior experience; potential write offs of acquired assets; loss of key employees of acquired businesses; and our inability to recover the costs of acquisitions or investments. If we are required to expense options, it could significantly reduce our net income in future periods. The Financial Accounting Standards Board, or FASB, issued an Exposure Draft, Share-Based Payment: an amendment of Statement of Financial Accounting Standards No. 123 and No. 95 in March 2004 that would require a company to recognize compensation cost for all share based payments, including employee stock options, at fair value beginning in 2005 and subsequent reporting periods. Recently the FASB concluded that the amendment referred to in the Exposure Draft would be effective for public companies for interim or annual periods beginning after June 15, 2005. If the amendment is enacted as described in the Exposure Draft, we will be required to record an expense for our stock-based compensation plans using the fair value method beginning on July 1, 2005. This expense could exceed the expense we currently record for our stock-based compensation plans and correspondingly reduce our net income in future periods. RISKS RELATED TO THIS OFFERING Our common stock could trade at prices below the initial public offering price. Before this offering, there has not been a public trading market for shares of our common stock. An active trading market may not develop or be sustained after this offering. The initial public offering price for the shares of common stock sold in this offering will be determined by negotiations between us and representatives of the underwriters. This price may bear no relationship to the price at which our common stock will trade after this offering. Our stock price may be volatile, and you may not be able to resell your shares at or above the initial public offering price. The trading price of our common stock after this offering may fluctuate widely, depending upon many factors, some of which are beyond our control. These factors include, among others, the risks identified above and the following: variations in our quarterly results of operations; announcements by us or our competitors or lead source providers; changes in estimates of our performance or recommendations, or termination of coverage by securities analysts; inability to meet quarterly or yearly estimates or targets of our performance; the hiring or departure of key personnel, including agents or groups of agents or key executives; changes in our reputation; acquisitions or strategic alliances involving us or our competitors; changes in the legal and regulatory environment affecting our business; and market conditions in our industry and the economy as a whole. Table of Contents Risk factors In addition, the stock market in general, and the market for technology companies in particular, have experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of those companies. These broad market and industry factors may seriously harm the market price of our common stock, regardless of our actual operating performance. Also, in the past, following periods of volatility in the overall market and the market price of a company s securities, securities class action litigation has often been instituted against these companies. This litigation, if instituted against us, could result in substantial costs and a diversion of our management s attention and resources and could harm the price of our common stock. Although we carry general liability and errors and omissions insurance, our insurance may not cover claims of these types or may be inadequate to protect us from all liability that we may incur. Our share price could decline due to the large number of outstanding shares of our common stock eligible for future sale. The market price of our common stock could decline as a result of sales of substantial amounts of our common stock in the public market after this offering, or from the perception that these sales could occur. These sales could also make it more difficult for us to sell our equity or equity-related securities in the future at a time and price that we deem appropriate. Immediately after this offering is completed, we will have 19,054,856 shares of common stock outstanding, or 19,737,356 shares if the representatives of the underwriters exercise their over-allotment option in full. The 4,550,000 shares sold pursuant to this offering will be immediately tradable without restriction. Of the remaining shares: no shares will be eligible for sale immediately upon completion of this offering; 12,399,323 shares will be eligible for sale upon the expiration of lock-up agreements, subject in some cases to the volume and other restrictions of Rule 144 and Rule 701 under the Securities Act of 1933, as amended; and 1,860,504 shares will be eligible for sale upon the exercise of vested options after the expiration of the lock-up agreements. The lock-up agreements expire 180 days after the date of this prospectus, provided that the 180-day lock-up period may be extended in most cases for up to 37 additional days under certain circumstances where we announce or pre-announce earnings or a material event within approximately 18 days prior to, or approximately 16 days after, the termination of the 180-day period. The representatives of the underwriters may, in their sole discretion and at any time without notice, release all or any portion of the securities subject to lock-up agreements. After the closing of this offering, we intend to register approximately 4,149,920 shares of common stock that have been issued or reserved for future issuance under our stock incentive plans. Our principal stockholders, executive officers and directors own a significant percentage of our stock, and as a result, the trading price for our shares may be depressed and these stockholders can take actions that may be adverse to your interests. Our executive officers and directors and entities affiliated with them will, in the aggregate, beneficially own more than two-thirds of our common stock following this offering. This significant concentration of share ownership may adversely affect the trading price for our common stock because investors often perceive disadvantages in owning stock in companies with controlling stockholders. These stockholders, acting together, will have the ability to exert control over all matters requiring approval by our stockholders, including the election and removal of directors and any proposed merger, consolidation or sale of all or substantially all of our assets. In addition, these stockholders who are Operating expenses: Cost of revenues 6,969 13,450 19,929 14,710 24,389 Product development 1,899 1,559 1,717 1,363 1,639 Marketing and business development 3,225 4,451 5,003 3,782 6,325 General and administrative 5,447 10,378 9,464 7,141 10,014 Stock-based compensation 185 84 85 57 Operating expenses: Cost of revenues 250 3,798 6,969 13,450 19,929 14,710 24,389 Product development 700 2,623 1,899 1,559 1,717 1,363 1,639 Marketing and business development 638 10,497 3,225 4,451 5,003 3,782 6,325 General and administrative 673 4,613 5,447 10,378 9,464 7,141 10,014 Stock-based compensation 124 185 84 85 57 Operating expenses: Cost of revenues 6,969 13,450 19,929 14,710 24,389 Product development 1,899 1,559 1,717 1,363 1,639 Marketing and business development 3,225 4,451 5,003 3,782 6,325 General and administrative 5,447 10,378 9,464 7,141 10,014 Stock-based compensation 185 84 85 57 Total stock-based compensation $ 185 $ 84 $ 85 $ 57 $ Table of Contents Risk factors executive officers or directors, or who have representatives on our board of directors, could dictate the management of our business and affairs. This concentration of ownership could have the effect of delaying, deferring or preventing a change in control, or impeding a merger or consolidation, takeover or other business combination that could be favorable to you. You will experience immediate and substantial dilution in the book value of your common stock. Investors purchasing shares of our common stock in this offering will pay more for their shares than the amount paid by existing stockholders who acquired shares prior to this offering. If you purchase common stock in this offering, you will incur immediate and substantial dilution in net tangible book value of approximately $7.63 per share. If the holders of outstanding options or warrants exercise those securities, you will most likely incur further dilution. See Dilution for additional information. Our charter documents and Delaware law could prevent a takeover that stockholders consider favorable and could also reduce the market price of our stock. Our amended and restated certificate of incorporation and our bylaws contain provisions that could delay or prevent a change in control of our company. These provisions could also make it more difficult for stockholders to elect directors and take other corporate actions. These provisions include: providing for a classified board of directors with staggered, three-year terms; not providing for cumulative voting in the election of directors; authorizing the board to issue, without stockholder approval, preferred stock with rights senior to those of common stock; prohibiting stockholder action by written consent; limiting the persons who may call special meetings of stockholders; and requiring advance notification of stockholder nominations and proposals. In addition, the provisions of Section 203 of Delaware General Corporate Law govern us. These provisions may prohibit large stockholders, in particular those owning 15% or more of our outstanding voting stock, from merging or combining with us for a certain period of time. These and other provisions in our amended and restated certificate of incorporation, our bylaws and under Delaware law could discourage potential takeover attempts, reduce the price that investors might be willing to pay for shares of our common stock in the future and result in the market price being lower than it would be without these provisions. See Description of capital stock Preferred Stock and Description of capital stock Anti-takeover Effects of Provisions of Our Amended and Restated Certificate of Incorporation, Our Bylaws and Delaware Law. Table of Contents
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+Risk Factors An investment in our IDSs and our notes involves a number of risks. In addition to the other information contained in this prospectus, prospective investors should give careful consideration to the following factors. Risks Relating to the IDSs, our Notes, the New Credit Facilities and the Shares of our Class A and Class B Common Stock You may not receive any dividends. We are not obligated to pay dividends. Dividend payments are not guaranteed and are within the absolute discretion of our board of directors. Future dividends with respect to shares of our capital stock, if any, will depend on, among other things, our results of operations, working capital requirements, financial condition, contractual restrictions, business opportunities, anticipated cash needs, provisions of applicable law and other factors that our board of directors may deem relevant. Our board of directors may decide not to pay dividends at any time and for any reason. Our general policy to distribute rather than retain excess cash is based upon our current assessment of our business and the environment in which it operates, and that assessment could change based on competitive or technological developments (which could, for example, increase our need for capital expenditures), new growth opportunities or other factors. Our board is free to depart from or change our dividend policy at any time and could do so, for example, if it were to determine that we had insufficient cash to take advantage of growth opportunities. The indenture governing the notes and our new credit facilities will contain limitations on our ability to pay dividends. See Dividend Policy and Restrictions. The reduction or elimination of dividends may negatively affect the market price of the IDSs. Our dividend policy may negatively impact our ability to finance capital expenditures or operations. Upon completion of this offering, our board of directors will adopt a dividend policy under which substantially all of the cash generated by our business in excess of operating needs and reserves will be distributed to our stockholders. As a result, we may not retain a sufficient amount of cash to finance growth opportunities or unanticipated capital expenditure needs or to fund our operations in the event of a significant business downturn. We may have to forego growth opportunities or capital expenditures that would otherwise be necessary or desirable in the event we do not find alternative sources of financing. In the event we do not have sufficient cash for these purposes, our financial condition and our business will suffer. Our substantial indebtedness could restrict our ability to pay interest and principal on the notes, pay dividends with respect to shares of our Class A common stock and Class B common stock, and impact our financing options and liquidity position. We have a significant amount of debt. For the last twelve months ended March 31, 2004, on a pro forma basis after giving the effect to this offering and related transactions as if they had occurred on April 1, 2003, our interest coverage ratio would have been 2.49 times and our ratio of total debt to Adjusted EBITDA would have been 4.21 times. The degree to which we are leveraged on a consolidated basis could have important consequences to the holders of the IDSs, including: it may be more difficult for us to satisfy our obligations under the notes and to the lenders under the new credit facilities, and to pay dividends on our Class A common stock and Class B common stock; our ability in the future to obtain additional financing for working capital, capital expenditures or acquisitions may be limited; we may not be able to refinance our indebtedness on terms acceptable to us or at all; a significant portion of our cash flow from operations is likely to be dedicated to the payment of the principal of and interest on our indebtedness, thereby reducing funds available for future operations, capital expenditures and/or dividends on our Class A common stock and Class B common stock; Primary Standard Industrial Classification Code Number Table of Contents we may be more vulnerable to economic downturns and be limited in our ability to withstand competitive pressures; and it may limit our flexibility to plan for and react to changes in our business or strategy. We may be able to incur substantially more debt, which would increase the risks described above associated with our substantial leverage. We may be able to incur substantial additional indebtedness in the future, including issuances of additional notes under the indenture. Any additional debt incurred by us could increase the risks associated with our substantial leverage. We are subject to restrictive debt covenants that limit our business flexibility by imposing operating and financial restrictions on our operations. Although credit facilities of similarly situated borrowers customarily prohibit payments of dividends on the shares of Class A common stock and Class B common stock, our new credit facilities will permit us to pay dividends on the shares of Class A common stock represented by IDSs and Class B common stock, so long as Holdings interest coverage ratio remains above certain established levels and no default or event of default exists under the new credit facilities. Because the payment of dividends will decrease the amount of cash available to service our senior debt, the new credit facilities will impose restrictions on our operations that are more restrictive than customary for credit facilities of similarly situated borrowers that prohibit or substantially limit payments of dividends. These restrictions prohibit or limit, among other things: the incurrence of additional indebtedness and the issuance of preferred stock and certain redeemable capital stock; the payment of dividends or distributions (including distributions by ASG to us to permit us to pay interest on the notes) on, and purchase or redemption of, capital stock; a number of other restricted payments, including investments and acquisitions; specified sales of assets; specified transactions with affiliates; the creation of liens on our assets; consolidations, mergers and transfers of all or substantially all of our assets; our ability to change the nature of our business; and our ability to make capital expenditures (other than maintenance capital expenditures). These restrictions could limit our ability to obtain future financing, make acquisitions or needed capital expenditures, withstand downturns in our business or take advantage of business opportunities. Furthermore, the new credit facilities will also require us to maintain specified financial ratios and satisfy financial condition tests, including a minimum fixed charge coverage ratio, a maximum leverage ratio and a maximum senior leverage ratio. Our ability to comply with the ratios or tests may be affected by events beyond our control, including prevailing economic, financial and industry conditions. A breach of any of these covenants, ratios or tests could result in a default under the new credit facilities and/or the indenture. Upon the occurrence of an event of default under the new credit facilities, the lenders could elect to declare all amounts outstanding under the new credit facilities to be immediately due and payable. If the lenders accelerate the payment of the indebtedness under the new credit facilities, our assets may not be sufficient to repay in full this indebtedness and our other indebtedness, including the notes. I.R.S. Employer Identification No. Table of Contents We may not be able to refinance our new credit facilities at maturity on favorable terms or at all. The new credit facilities will mature in full in 2008. We may not be able to renew or refinance the new credit facilities, or if renewed or refinanced, the renewal or refinancing may occur on less favorable terms. In particular, some of the terms of the notes that may be viewed as favorable to the senior lenders, such as our ability to defer interest and acceleration forbearance periods, become less favorable in 2009, which may materially adversely affect our ability to refinance or renew our new credit facilities beyond such dates. If we are unable to refinance or renew our new credit facilities, our failure to repay all amounts due on the maturity date would cause a default under the new credit facilities. In addition, our interest expense may increase significantly if we refinance our new credit facilities on terms that are less favorable to us than the terms of our new credit facilities. We will require a significant amount of cash, which may not be available to us, to service our debt, including the notes, and to fund our liquidity needs. Our ability to make payments on, or to refinance or repay, our debt, including the notes, to fund planned capital expenditures and expand our business, will depend largely upon our future operating performance. Our future operating performance is subject to general economic, financial, competitive, legislative and regulatory factors, as well as other factors that are beyond our control. If we are unable to generate sufficient cash to service our debt requirements, we will be required to refinance our new credit facilities. If we are unable to refinance our debt or obtain new financing, we would have to consider other options, including: sales of assets to meet our debt service requirements; sales of equity; and negotiations with our lenders to restructure the applicable debt. If we are forced to pursue any of the above options under distressed conditions, our business or the value of your investment in our IDSs and notes could be adversely affected. Compliance with rules regulating non-U.S. citizen ownership and control of fishing vessels may adversely affect the marketability or the price of our IDSs, shares of our Class A common stock or notes. The governance provisions we have adopted and the related steps we will take to comply with the foreign ownership restrictions imposed by federal law on companies that participate in U.S. fisheries are complex and burdensome. They may require beneficial owners of our Class A common stock to execute complex affidavits and provide detailed ownership information and they could require trades of IDSs or shares of our Class A common stock to be reversed or persons who hold IDSs or shares to dispose of them on unfavorable terms. These administrative burdens and requirements and the potential that trades could be unwound or sales required could have an adverse effect on the market for and trading price of IDSs, shares of our Class A common stock or notes. See Business Government Regulation. Our governance arrangements provide our present owners with the ability to exercise substantial control over us, which may create conflicts of interest. As the holders of our Series A, Series B and Series C preferred stock, Coastal Villages Pollock LLC, Bernt O. Bodal (who is our chairman and chief executive officer), and Centre Partners Management LLC will be entitled directly to designate a total of four members of our nine member board. In addition, through their ownership of Class B common stock, IDSs and preferred shares (which will vote together with the Class A common stock and Class B common stock based on the holders interests in ASLP and Holdings), Coastal, Mr. Bodal and Centre would, if they acted collectively, effectively have the ability to elect two additional independent members of our board through the operation of cumulative voting, which applies to the election of our directors and has the effect Code, and Telephone Number, Including Area Code, of Principal Executive Office Table of Contents of concentrating the voting power of significant holders. Accordingly, although they will hold only approximately 31.8% of the equity interests in Holdings, these three holders and their affiliates will have approximately 33.5% of the aggregate voting power in the Issuer and, effectively, the right to designate six of our nine directors. Our organizational documents require that all directors other than the four designated by the holders of preferred stock must satisfy all applicable independence requirements including those of the American Stock Exchange. In addition, for so long as Coastal does not sell equity that would reduce its holdings to below 5.0% of our business or is not otherwise diluted below 2.5% of our business, without the consent of Coastal and either of Mr. Bodal or Centre, or their permitted transferees, we may not create or modify any equity compensation plan, create or make certain modifications to any bonus or performance based compensation plan for executive officers or pay bonuses to executive officers other than pursuant to and in conformity with an existing bonus or performance based compensation plan. Coastal, Mr. Bodal and Centre will have the power to substantially dilute your voting power. Further, they may have views or interests that differ from those of the majority of IDS holders. Coastal Villages Pollock LLC will have board representation, voting and veto rights substantially in excess of its economic ownership, which may create conflicts of interest. Coastal Villages Pollock LLC, as the holder of the Series A preferred share, will have the right to elect two members of our board so long as Coastal does not sell equity that would reduce its holdings to below 5.0% of our business or is not otherwise diluted below 2.5% of our business (in which case it would be reduced to one director). In addition, for so long as it is entitled to two directors, Coastal has veto rights over changes to our governance arrangements and over certain compensation decisions made by the compensation committee of our board. Finally, by virtue of its ownership of IDSs, Class B common stock and the Series A preferred share, Coastal will have a total of 14.5% of our combined voting power. In addition, our nomination process will allow two or more directors who oppose any nominee for director proposed by our nominating and governance committee to propose an alternate nominee. So long as the alternative satisfies applicable independence and other requirements, we will be required to include disclosure about the alternate nominee in our annual proxy statement and processes. This mechanism, coupled with cumulative voting, would make it possible for Coastal to propose a candidate and use its cumulative voting rights to cast a significant number of votes in favor of such candidate. In our annual election of five directors, holders of approximately 16.7% of our voting power will have the ability to ensure the election of one director. After completion of this offering, Coastal will own approximately 14.5% of the voting power of our company or approximately 11.0% if the over-allotment option to purchase additional IDSs is exercised in full. Coastal will also have the right (for so long as it is entitled to elect two directors) to designate one member of our audit committee, provided the member satisfies applicable independence and other requirements. As a result of these various provisions, Coastal will have the ability to exert significant influence over our activities and decisions. Coastal is our largest supplier of community development quota and our current agreement with Coastal terminates on December 31, 2005. In addition, Coastal may, as an Alaska native organization, have goals or views that may differ from those of our other shareholders or our management and, accordingly, Coastal s substantial influence over our affairs may create conflicts of interest. Retained ownership by our existing owners and the special rights of our preferred stockholders may prevent you from receiving a premium in the event of a change of control. Upon the completion of the transactions contemplated by this offering, the existing owners, through their ownership of ASLP, IDSs and Class B common stock, will own approximately 39.2% of the equity interests of Table of Contents our business, or approximately 30.1% of the equity interests of our business, if the over-allotment option to purchase additional IDSs is exercised in full. If such existing owners, or their permitted transferees, exercise their rights to exchange all of their ownership in ASLP for IDSs, they will own approximately 39.2% of the voting power of our company. This concentration of ownership could have the effect of delaying, deferring or preventing a change in control, merger or tender offer, which would deprive you of an opportunity to receive a premium for your IDSs and may negatively affect the market price of the IDSs. Moreover, our existing owners could effectively receive a premium for transferring ownership to third parties that would not inure to your benefit. In addition, the special rights of preferred stockholders do not automatically cease upon a change of control and, therefore, the existence of these special rights may effectively deter a potential acquirer from acquiring us. We are a holding company and rely on dividends, interest and other payments, advances and transfers of funds from our subsidiaries to meet our debt service and other obligations. We are a holding company and conduct all of our operations through our subsidiaries and currently have no significant assets other than our equity interest in Holdings and our interest in the notes issued by Holdings. As a result, we will rely on interest and principal on the Holdings notes and on dividends, loans and other payments or distributions from our subsidiaries to meet our debt service obligations and enable us to pay interest and dividends. The ability of our subsidiaries to pay interest and dividends or make other payments or distributions to us will depend substantially on their respective operating results and will be subject to restrictions under, among other things, the laws of their jurisdiction of organization (which may limit the amount of funds available for the payment of dividends), agreements of those subsidiaries, the terms of the new credit facilities and the covenants of any future outstanding indebtedness we or our subsidiaries incur. Our new credit facilities will contain significant limitations on distributions and other payments. The new credit facilities will prohibit distributions from ASG and its subsidiaries to Holdings if, among other things, the interest coverage ratio of Holdings is less than the dividend suspension thresholds described under Description of Certain Indebtedness New Credit Facilities (or if we fail to timely deliver financial statements calculating such ratio), or if Holdings has any deferred and unpaid interest outstanding on the Holdings notes, other than distributions to pay interest on the Holdings notes and other permitted payments, such as to pay taxes. In addition, if the interest coverage ratio of Holdings is less than the interest deferral thresholds described under Description of Certain Indebtedness New Credit Facilities (or if we fail to timely deliver financial statements calculating such ratio), or if a default or event of default under the new credit facilities exists, the new credit facilities will prohibit distributions by ASG and its subsidiaries to Holdings to enable it to pay interest on the Holdings notes, as well as all other distributions from ASG to Holdings (other than distributions to pay taxes and certain administrative expenses). During any dividend suspension period or interest deferral period, ASG will be required to prepay the loans under the new credit facilities with a portion of its cash available after payments of taxes, scheduled principal and interest payments on its indebtedness, maintenance capital expenditures and other expenses, and such prepayments would reduce the amount of cash available for payments in respect of the notes. If the interest coverage ratio of Holdings is less than the interest deferral thresholds described under Description of Certain Indebtedness New Credit Facilities, the Issuer will be permitted to defer interest on the notes pursuant to the indenture governing the notes. However, the indenture provides that interest on the notes may not be deferred for more than eight quarters in the aggregate prior to 2009. If the Issuer may no longer defer interest on the notes but the interest coverage ratio of Holdings remains below the specified threshold and the new credit facilities prohibit ASG and its subsidiaries from making distributions to the Issuer, we will not have sufficient funds to pay interest on the notes, which would cause a default under the indenture governing the notes, entitling the holders of the notes to demand payment in full of all amounts outstanding under the notes, subject to an acceleration forbearance period of up to 90 days. The default and the acceleration of the notes under such circumstances would cause a default under our new credit facilities, and ASG and its subsidiaries might not have Table of Contents The information in this prospectus is not complete and may be changed. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is declared effective. This prospectus is not an offer to sell these securities and is not soliciting an offer to buy these securities in any state where the offer or sale is not permitted. Subject to Completion, Dated August 11, 2004 30,740,741 Income Deposit Securities (IDSs) Representing 30,740,741 Shares of Class A Common Stock and $158.3 million % Notes due 2019 and $27.9 million % Notes due 2019 Table of Contents sufficient funds to repay all amounts outstanding under the new credit facilities and make distributions to us to repay all amounts outstanding under the notes. Interest on the notes may not be deductible by us for U.S. federal income tax purposes, which could significantly reduce our future cash flow and impact our ability to make interest and dividend payments. While we believe that the notes should be treated as debt for U.S. federal income tax purposes, this position may not be sustained if challenged by the IRS. If the notes were treated as equity rather than debt for U.S. federal income tax purposes, then the stated interest on the notes would be treated as a dividend (to the extent paid out of our tax earnings and profits ), and interest on the notes would not be deductible by us for U.S. federal income tax purposes. Our inability to deduct interest on the notes could materially increase our taxable income and, thus, our U.S. federal and applicable state income tax liability. This would reduce our after-tax cash flow, which may result in a default under the new credit facilities, and would materially and adversely impact our ability to make interest and dividend payments and may also affect our ability to continue as a going concern. In the case of foreign holders, treatment of the notes as equity for U.S. federal income tax purposes would subject payments to such holders in respect of the notes to withholding or estate taxes in the same manner as payments made with regard to Class A common stock and could subject us to liability for withholding taxes that were not collected on payments of interest. You will be immediately diluted by $14.50 per share of Class A common stock if you purchase IDSs in this offering. Because there will be a net tangible book deficit for each share of Class A common stock outstanding immediately after this offering, if you purchase IDSs in this offering, based on the book value of our assets and liabilities, you will experience an immediate dilution of $14.50 per share of Class A common stock represented by the IDSs ($12.87 assuming all ASLP units have been exchanged for IDSs), which exceeds the price allocated to each share of Class A common stock represented by the IDSs in this offering. Our net tangible book deficit as of March 31, 2004, after giving effect to this offering, was approximately $228.7 million, or $6.15 per share of Class A and Class B common stock ($4.52 assuming all ASLP units have been exchanged for IDSs). As a result of this deficit, the face amount of notes will exceed the net book value of tangible assets by approximately $869 per $1,000 face amount of notes. The allocation of the purchase price of the IDSs may not be respected. The purchase price of each IDS must be allocated for tax purposes between the share of Class A common stock and the note comprising the IDS in proportion to their respective fair market values at the time of purchase. If our allocation is not respected, the notes may be treated as having been issued with original issue discount, or OID (if the allocation to the notes were determined to be too high), or amortizable bond premium (if the allocation to the notes were determined to be too low). You generally would be required to include OID in income in advance of the receipt of cash attributable to that income and would be able to elect to amortize bond premium over the term of the notes. Deferral of interest payments would have adverse tax consequences for you and may adversely affect the trading price of the IDSs or the notes. If interest payments on the notes are deferred, you will be required to recognize interest income for U.S. federal income tax purposes on an economic accrual basis in respect of the notes held by you before you receive any cash payment of this interest. See Material U.S. Federal Income Tax Considerations Consequences to U.S. Holders Notes Stated Interest; Deferral of Interest. In addition, you will not receive any cash payment with respect to accrued interest if you sell the IDSs or the notes before the end of any deferral period or before the record date relating to interest payments that are to be paid. We are selling 30,740,741 IDSs in respect of 30,740,741 shares of our Class A common stock and $158.3 million aggregate principal amount of our % notes due September 15, 2019. Each IDS represents: one share of our Class A common stock; and a % note with $5.15 principal amount. We are also selling separately (not represented by IDSs) $27.9 million aggregate principal amount of our % notes due September 15, 2019. The completion of the offering of separate notes is a condition to our sale of IDSs. This is the initial public offering of our IDSs and notes. We anticipate that the public offering price of the IDSs will be between $13.50 and $14.00 per IDS and the public offering price of the notes sold separately (not represented by IDSs) will be % of their stated principal amount. Holders of IDSs will have the right to separate IDSs into the shares of Class A common stock and notes represented thereby at any time after the earlier of 45 days from the closing of this offering or the occurrence of a change of control. Similarly, holders of our Class A common stock and notes may, at any time, unless the IDSs have automatically separated, combine the applicable number of shares of Class A common stock and notes to form IDSs. Separation of IDSs will occur automatically upon the continuance of a payment default on the notes for 90 days, or a repurchase, redemption or maturity of the notes. Upon a subsequent issuance by us of notes of the same series, a portion of your notes may be automatically exchanged for an identical principal amount of the notes issued in such subsequent issuance and, in such event, your IDSs or notes will be replaced with new IDSs or a unit consisting of your notes and new notes, as the case may be. In addition to the notes offered hereby, the registration statement of which this prospectus is a part also registers the notes and new IDSs to be issued to you upon any such subsequent issuance. For more information regarding these automatic exchanges and the effect they may have on your investment, see Risk Factors Subsequent issuances of notes may cause you to recognize original issue discount or cause a taxable exchange and Description of Notes Additional Notes and Material U.S. Federal Income Tax Considerations Consequences to U.S. Holders Notes Exchange Rights and Additional Issuances. We have applied to list our IDSs on the American Stock Exchange under the trading symbol SEA . We are subject to foreign ownership provisions of the American Fisheries Act as a result of which each owner of 5% or more of our capital stock (including purchasers in this offering) must certify to us that such person is a U.S. citizen, and at least 95% of all of our beneficial owners will be required to have U.S. addresses. These requirements, and the remedies we may need to invoke to satisfy them, may have an adverse effect on the market for and trading price of IDSs or shares of our Class A common stock. Investing in our IDSs and our notes involves risks. See Risk Factors beginning on page 25. Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense. Per IDS(1) Table of Contents If interest is deferred, the IDSs may trade at a price that does not fully reflect the value of accrued but unpaid interest on the notes. In addition, the existence of the right to defer payments of interest on the notes under certain circumstances may mean that the market price for the IDSs or the notes may be more volatile than other securities that do not have this feature. Your right to receive payments on the notes and the note guarantees is junior to all senior debt of Holdings and its subsidiaries. The Issuer and Holdings are holding companies and conduct all of their operations through ASG and its subsidiaries. The note guarantees issued by Holdings, ASG and the other subsidiary guarantors will be unsecured senior subordinated obligations, junior in right of payment to the senior debt of each subsidiary guarantor, respectively. As a result of the subordinated nature of these guarantees, upon any distribution to creditors of Holdings, ASG or the other subsidiary guarantors in bankruptcy, liquidation or reorganization or similar proceedings relating to Holdings, ASG or the other subsidiary guarantors or their property or assets, the holders of such entities senior indebtedness will be entitled to be paid in full in cash before any payment may be made with respect to the notes or the Holdings notes under the guarantees (and before any distribution may be made by ASG to Holdings or by Holdings to the Issuer). In the event of a bankruptcy, liquidation or reorganization or similar proceeding relating to ASG or the subsidiary guarantors, the Issuer, ASLP and the noteholders would participate under the guarantees with other holders of unsecured unsubordinated indebtedness after the payment in full of all senior indebtedness. In addition, as a result of contractual subordination of the guarantees to the guarantors obligations under the new credit facilities and other senior indebtedness, the Holders of the notes may receive less, ratably, than other creditors of the Guarantors that are not subject to contractual subordination. In any of these cases, there may not be sufficient funds to pay all of our creditors and the holders of the notes may receive less, ratably, than the holders of senior indebtedness. In such event the Issuer and the guarantors would not be able to make all principal payments on the notes. The subordination provisions of the indenture will also provide that payments to you under the subordinated note guarantees of Holdings, ASG and its domestic subsidiaries will be prohibited while a payment default exists under the senior indebtedness of these entities or if such senior indebtedness has been accelerated. In addition, these payments to you may be blocked for up to 179 days by holders of designated senior indebtedness if a default other than a payment default exists under such senior indebtedness. During any period in which payments to you are prohibited or blocked in this manner, any amounts received by you with respect to the subordinated note guarantees, including as a result of any legal action to enforce such guarantees, would be required to be turned over to the holders of senior indebtedness. In addition, so long as the notes are guaranteed by at least one guarantor, upon the occurrence of an event of default under the indenture governing the notes, the principal of and premium, if any, on the notes may not be accelerated for a period of up to 90 days until , 2009. See Description of Notes Acceleration Forbearance Periods, and Description of Notes Subordination of the Guarantees. On a pro forma basis, as of March 31, 2004, the subordinated guarantees would have ranked junior to $240.0 million of our outstanding senior indebtedness of subsidiary guarantors on a consolidated basis, all of which would have been secured. In addition, as of March 31, 2004, on a pro forma basis, ASG would have had the ability to borrow up to an additional amount of $60.0 million under the new revolver, which would have been senior in right of payment to the subordinated guarantees. In the event of bankruptcy or insolvency, the notes and guarantees could be adversely affected by principles of equitable subordination or recharacterization. In the event of bankruptcy or insolvency, a party in interest may seek to subordinate our debt, including the notes or the guarantees, under principles of equitable subordination or to recharacterize the notes as equity. In the event a court exercised its equitable powers to subordinate the notes or the guarantees, or recharacterizes the notes as equity, you may not recover any amounts owed on the notes or the guarantees and you may be required to return Total Table of Contents any payments made to you within six years before the bankruptcy on account of the notes or the guarantees. In addition, should the court treat the notes or the guarantees as equity either under principles of equitable subordination or recharacterization, you may not be able to enforce your rights under the notes or the guarantees. The notes and the guarantees may not be enforceable because of fraudulent conveyance laws. Under federal bankruptcy law and comparable provisions of state fraudulent transfer laws, a court could void the obligations under the notes or the guarantees, further subordinate the notes or the guarantees or take other action detrimental to you, if, among other things, at the time the indebtedness under the notes or the guarantees, as applicable, was incurred, the Issuer or a guarantor: issued the notes or the guarantee to delay, hinder or defraud present or future creditors; or received less than reasonably equivalent value or fair consideration for issuing the notes or the guarantee and, at the time it issued the notes or the guarantee: was insolvent or rendered insolvent by reason of issuing the notes or the guarantee and the application of the proceeds of the notes or the guarantee; was engaged or about to engage in a business or a transaction for which the guarantor s remaining unencumbered assets constituted unreasonably small capital to carry on its business; intended to incur, or believed that it would incur, debts beyond its ability to pay the debts as they mature; or was a defendant in an action for money damages, or had a judgment for money damages docketed against it if, in either case, after final judgment, the judgment is unsatisfied. The measures of insolvency for the purposes of fraudulent transfer laws vary depending upon the law applied in any proceeding to determine whether a fraudulent transfer has occurred. Generally, however, a person would be considered insolvent if, at the time it incurred the debt: the present fair saleable value of its assets was less than the amount that would be required to pay its probable liability on its existing debts, including contingent liabilities, as they become absolute and mature; or it could not pay its debts as they become due. Regardless of the standard that a court uses to determine whether we or a guarantor were solvent at the relevant time, the issuance of the notes or the guarantees may be voided or further subordinated to the claims of creditors if it concludes the Issuer or a guarantor was insolvent. The guarantee of the notes by Holdings, ASG or any other subsidiary guarantor could be subject to the claim that, since the guarantee was incurred for the benefit of the Issuer, and only indirectly for the benefit of the guarantor, the guarantee was incurred for less than fair consideration. A court could therefore void the obligations of Holdings, ASG or the subsidiary guarantor under the guarantees or subordinate these obligations to Holdings , ASG s or the subsidiary guarantor s other debt or take action detrimental to holders of the notes. If the guarantee of Holdings, ASG or any subsidiary guarantor were voided, the holders of the notes would not have a debt claim against Holdings, ASG or that subsidiary guarantor. In addition, in the event that we meet any of the financial condition fraudulent transfer tests described above at the time of or as a result of this offering, a court could view the issuance of the notes, the guarantees and the other transactions occurring on the issue date, such as repayment of our existing debt and various distributions described under Detailed Transaction Steps as a single transaction and, as a result, conclude that the Issuer did not get fair value for the offering. In such a case, a court could hold the debt (including the guarantees) owed to the noteholders void or unenforceable or may further subordinate it to the claims of other creditors. Per Separate Note Table of Contents Seasonality and variability of our businesses may cause volatility in the market value of your investment and may hinder our ability to make timely distributions on the IDSs and the notes. Our business is seasonal in nature, and our net sales and operating results vary significantly from quarter to quarter. For example, our revenue per pound of fish harvested tends to be higher in the January-to-April season due to the harvesting of roe. Consequently, results of operations for any particular quarter may not be indicative of results of operations for future quarterly periods, which makes it difficult to forecast our results for an entire year. This variability may cause volatility in the market price of the IDSs and the notes. In addition, the seasonality and variability of our business means that at certain times of the year our cash receipts are significantly higher than at other times. Our fishing seasons, including the important January-to-April season, straddle more than one quarter. As a result, the timing of the recognition of sometimes significant amounts of revenue from one quarter to another can be a function of unpredictable factors, such as the timing of roe auctions, weather, the timing of shipments to pollock roe customers, fishing pace and product delivery schedules, all of which are likely to vary from year to year. Given that we are required to make equal quarterly interest payments to note holders and intend to pay equal quarterly dividends as well, there is a risk that we will experience cash shortages, which could hinder our ability to make timely distributions or interest payments. Subsequent issuances of notes may cause you to recognize original issue discount or cause a taxable exchange. The indenture governing the notes and the agreements with DTC will provide that, in the event there is a subsequent issuance of notes by the Issuer having identical terms as the notes but with OID, each holder of notes or IDSs (as the case may be) agrees that upon the issuance of any such notes issued with OID, and upon any issuance of notes thereafter, a portion of such holder s notes will be automatically exchanged for a portion of the notes acquired by the holders of such subsequently issued notes, and the records of any record holders of notes will be revised to reflect such exchanges. Consequently, following each such subsequent issuance and exchange, without any further action by such holder, each holder of notes or IDSs (as the case may be) will own an inseparable unit composed of notes of each separate issuance in the same proportion as each other holder. However, the aggregate stated principal amount of notes owned by each holder will not change as a result of such subsequent issuance and exchange. It is unclear whether the exchange of notes for subsequently issued notes results in a taxable exchange for U.S. federal income tax purposes, and it is possible that the IRS might successfully assert that such an exchange should be treated as a taxable exchange. In such case, a holder would recognize any gain realized on such exchange, but a loss recognized might be disallowed. Regardless of whether the exchange is treated as a taxable event, such exchange would result in holders having to include OID in taxable income prior to the receipt of cash as described below, and may result in other potentially adverse tax consequences to holders. See Material U.S. Federal Income Tax Considerations Consequences to U.S. Holders Notes Exchange Rights and Additional Issuances. In addition, the potential amount of OID that would be required to be included in taxable income by holders as a result of an automatic exchange (as described below) is indefinite and may be a significant amount, in part due to our ability to engage in numerous subsequent issuances. Following the subsequent issuance and exchange, we (and our agents) will report any OID on the subsequently issued notes ratably among all holders of notes and IDSs, and each holder of notes or IDSs will, by purchasing notes or IDSs, agree to report OID in a manner consistent with this approach. However, the IRS may assert that any OID should be reported only to the persons that initially acquired such subsequently issued notes (and their transferees) and thus may challenge the holders reporting of OID on their tax returns. In addition, the IRS might further assert that, unless a holder can establish that it is not such a person, all of the notes held by such holder have OID. Any of these assertions by the IRS could create significant uncertainties in the pricing of IDSs and notes and could adversely affect the market for IDSs and notes. For these and additional tax-related risks, see Material U.S. Federal Income Tax Considerations. Total(2) Table of Contents We may have to establish a reserve for contingent tax liabilities in the future, which could adversely affect our ability to make dividend payments on the IDSs. Even if the IRS does not challenge the tax treatment of the notes, it is possible that as a result of an alteration of facts relied upon at the time of issuance of the notes, we will in the future need to change our anticipated accounting treatment and establish a reserve for contingent tax liabilities associated with a disallowance of all or part of the interest deductions on the notes. If we were required to maintain such a reserve, our ability to make dividend payments could be materially impaired and the market for the IDSs, Class A common stock and notes could be adversely affected. In addition, any resulting impact to our financial statements could lead to defaults under our new credit facilities. Holders of subsequently issued notes may not be able to collect their full stated principal amount prior to maturity. Holders of subsequently issued notes having OID (including the recipients of such notes in the involuntary exchanges pursuant to the indenture) may not be able under New York and federal bankruptcy law to collect the portion of their principal amount that represents unaccrued OID in the event of an acceleration of the notes or a bankruptcy of the Issuer prior to the notes maturity date. As a result, an automatic exchange that results in a holder receiving an OID note could have the effect of ultimately reducing the amount such holder can recover from us in the event of an acceleration or bankruptcy. Prior to the consummation of this offering, there was no public market for our IDSs, shares of our Class A common stock or notes, which may cause the price of the IDSs, shares of our Class A common stock or the notes to fluctuate substantially and negatively affect the value of your investment. Our IDSs, the shares of our Class A common stock and the notes have no public market history. In addition, there has not been an active market for securities similar to the IDSs. An active trading market for the IDSs, shares of our Class A common stock or the notes might not develop in the future, which may cause the price of the IDSs, shares of our Class A common stock or the notes to fluctuate substantially, and we currently do not expect that an active trading market for the shares of our Class A common stock will develop until the notes mature. If the notes represented by your IDSs mature or are redeemed or repurchased, the IDSs will be automatically separated and you will then hold the shares of our Class A common stock. We will not apply to list our shares of Class A common stock for separate trading on the American Stock Exchange or any other exchange until the number of shares held separately and not represented by IDSs is sufficient to satisfy applicable requirements for separate trading on such exchange. The Class A common stock may not be approved for listing at such time. We do not intend to list our notes on any securities exchange. The limited liquidity of the trading market for the notes sold separately (not represented by IDSs) may adversely affect the trading price of the separate notes. We are separately selling (not represented by IDSs) $27.9 million aggregate principal amount of notes, representing approximately 11% of the total outstanding notes assuming the exchange of all ASLP interests for IDSs. While the notes sold separately (not represented by IDSs) are part of the same series of notes as, and identical to, the notes represented by the IDSs at the time of the issuance of the separate notes, the notes represented by the IDSs will not be separable for at least 45 days and will not be separately tradeable until separated. As a result, the initial trading market for the notes sold separately (not represented by IDSs) will be very limited. Even after holders of the IDSs are permitted to separate their IDSs, a sufficient number of holders of IDSs may not separate their IDSs into shares of our Class A common stock and notes to create a sizable and more liquid trading market for the notes not represented by IDSs. Therefore, a liquid market for the notes may not develop, which may adversely affect the ability of the holders of the separate notes to sell any of their separate notes and the price at which these holders would be able to sell any of the notes sold separately. Public offering price $ $ % $ Underwriting discount $ $ % $ Proceeds to American Seafoods Corporation (before expenses)(3) $ $ % $ Table of Contents Future sales or the possibility of future sales of a substantial amount of IDSs, shares of our Class A common stock or our notes may depress the price of the IDSs, the shares of our Class A common stock and our notes. Future sales or the availability for sale of substantial amounts of IDSs or shares of our Class A common stock or a significant principal amount of our notes in the public market could adversely affect the prevailing market price of the IDSs, the shares of our Class A common stock and our notes and could impair our ability to raise capital through future sales of our securities. We may issue shares of our Class A common stock and notes, which may be in the form of IDSs, or other securities from time to time as consideration for future acquisitions and investments. In the event any such acquisition or investment is significant, the number of shares of our Class A common stock and the aggregate principal amount of notes, which may be in the form of IDSs, or the number or aggregate principal amount, as the case may be, of other securities that we may issue may in turn be significant. In addition, we may also grant registration rights covering those IDSs, shares of our Class A common stock, notes or other securities in connection with any such acquisitions and investments. In addition, the holders of 1,551,866 IDSs which will be issued in a private placement in connection with this offering will have certain registration rights. In addition, following the second anniversary of the closing of this offering, holders of Class B common stock may demand registration of their Class B common stock two times a year, during two window periods, which will match the window periods in the exchange warrant issued to all ASLP partners permitting such holders after one year to exchange their ASLP limited partnership units for IDSs. Our organizational documents could limit another party s ability to acquire us and deprive our investors of the opportunity to obtain a takeover premium for their securities. A number of provisions in our amended and restated certificate of incorporation and amended and restated by-laws will make it difficult for another company to acquire us and for you to receive any related takeover premium for your securities. For example, our organizational documents provide that stockholders generally may not act by written consent and only stockholders representing at least 50% in voting power may request that our board of directors call a special meeting. Our organizational documents also authorize the issuance of preferred stock without stockholder approval and upon such terms as the board of directors may determine. The rights of the holders of shares of our Class A common stock will be subject to, and may be adversely affected by, the rights of holders of preferred stock and any other class or series of preferred stock that may be issued in the future. Risks Relating to Our Industry and Its Regulation The repeal of, or adverse amendments to, the American Fisheries Act and other industry regulations would likely impair our profitability. The American Fisheries Act restricts the number of vessels operating in the catcher-processor sector of the U.S. Bering Sea pollock fishery to 19 named catcher-processor vessels, of which we own and operate seven, and by allocating 40% of the directed pollock catch to this sector (with 36.6% being allocated to these 19 catcher-processor vessels and 3.4% being allocated to catcher-vessels). In the event that the American Fisheries Act and other related industry regulations were repealed or modified to permit additional large vessels to operate in the catcher-processor sector of the U.S. Bering Sea pollock fishery, we could be subject to new competition that could adversely affect our profitability. In addition, our pollock harvesting rights and profitability would be adversely affected if the American Fisheries Act and other industry regulations were repealed or modified in a manner that decreases the percentage of the total pollock harvest allocated to the 19 catcher-processor vessels named in the Act. A repeal or modification of the American Fisheries Act or other industry regulations could result from changes in the political environment, a significant increase or decrease in the pollock biomass or other factors, all of which are difficult to predict and are beyond our control. The relatively stable and predictable nature of our harvesting operations and our efficiencies would deteriorate if the Pollock Conservation Cooperative agreement were terminated or adversely changed. The members of the Pollock Conservation Cooperative, which is comprised of all participants in the catcher-processor sector of the U.S. Bering Sea pollock fishery, have agreed that each member will catch only an agreed- CASH FLOWS USED IN FINANCING ACTIVITIES: Principal payments on long-term debt (37,265 ) (11,568 ) Net borrowings (payments) on revolving debt 44,000 (7,500 ) Payments on obligations to related party (5,312 ) Financing fees and costs (82 ) (380 ) Costs related to recapitalization transaction (1,296 ) Contributions from members (1) Comprised of $5.15 allocated to each note which represents 100% of its stated principal amount and $ allocated to each share of Class A common stock. (2) Represents the $27.9 million aggregate principal amount of notes sold separately (not represented by IDSs). (3) Approximately $ million of those proceeds will be paid to the current owners of our business before this offering and approximately $35.6 million will be paid to a related party to repay indebtedness and redeem preferred stock. Table of Contents upon share of the total allowable catch allocated to the catcher-processor sector in that fishery. By establishing allocations among all catcher-processors, the Pollock Conservation Cooperative, which we refer to as the Cooperative, ensures that members will have the opportunity to harvest a fixed percentage of the total pollock harvest and removes the incentives to harvest and process pollock as fast as possible, thereby giving each member a greater opportunity to optimize operational efficiencies. The Cooperative could be terminated as a result of an adverse change in the American Fisheries Act allocations, the bankruptcy of a Cooperative member or the decision of two or more Cooperative members. The termination of the Cooperative or any adverse change to the allocation system currently in place under the agreement could increase the volatility of our operations, cause us to lose operational efficiencies and have an adverse effect on our existing harvesting rights. Growth in our core pollock harvesting operations and our profitability are limited by the American Fisheries Act. The American Fisheries Act imposes a statutory limit on the maximum amount of pollock that we may independently harvest equal to 17.5% of the directed pollock catch. We are allocated 16.8% of the directed pollock catch under our Cooperative agreements, and we lease the right to harvest another 0.7% of the directed pollock catch from other vessels in our fishery, bringing us to the 17.5% limit. Our business could be materially affected if the community development quota we purchase is significantly reduced or eliminated or offered to us at prices we consider unreasonable. We supplement our pollock harvest through the purchase of community development quota, which plays an important part in our strategy of maximizing access to pollock. The primary agreements governing our current arrangements for purchasing community development quota expire at the end of 2005. The Alaska Community Development Groups from which we purchase community development quota could decline to continue to sell their quota to us or could offer their quota at prices we consider unreasonable, which could materially adversely affect our business. In addition, every three years the state of Alaska may re-allocate the community development quota allocation among the six Alaska Community Development Groups. The next reallocation is for the period beginning 2006. The Alaska Community Development Groups from which we purchase community development quota could have their quota allocation reduced below current levels. If any significant reduction were to occur, we could experience a significant decline in our revenues, earnings and profitability. Our ocean harvested whitefish operations are subject to regulatory control and political pressure from interest groups that may seek to materially limit our ability to harvest fish. Under the American Fisheries Act, the Magnuson-Stevens Fishery Conservation and Management Act and other relevant statutes and regulations, various regulatory agencies, including the National Marine Fisheries Service and the North Pacific Fishery Management Council, are endowed with the power to control our harvest of pollock and other groundfish in the fisheries of the North Pacific. These regulatory agencies have the authority to materially reduce the Alaska pollock total allowable catch allocated to the catcher-processor sector as well as our allocation of pollock and other groundfish without any compensation to us. These regulators may decrease or eliminate our allocation of the fish supply from a broad spectrum of lobbying interests including: native Alaskan groups seeking a greater allocation of the pollock harvest to be devoted to community development quotas; other sectors of the pollock fishery, such as inshore processors who periodically seek an increased allocation of the pollock harvest devoted to the on-shore sector; and environmental protection groups. Table of Contents The laws and rules that govern the highly-regulated fishing industry could change in a manner that would have a negative impact on our operations. In addition, protests and other similar acts of politically-motivated third party groups could cause substantial disruptions to the ability of our vessels to engage in harvesting activities. These factors may affect a substantial portion of our harvesting and processing operations in any year, which could have a material adverse effect on our business, results of operations or financial condition. Regulations related to our by-catch could impose substantial costs on our operations and reduce our operational flexibility. The National Marine Fisheries Service imposes various operational requirements aimed at limiting our ability to discard unwanted species, or by-catch, in the North Pacific. Regulation regarding by-catch is from time to time debated in various forums, including the United Nations, and is the subject of public campaigns by environmental groups. Any significant change in the by-catch rules resulting from these debates or campaigns could materially increase our costs or decrease the flexibility of our fishing operations. Efforts to protect endangered species, such as Steller sea lions, may significantly restrict our ability to access our primary fisheries and revenues. There is a risk that access to certain areas of the primary fisheries in which we operate could be restricted due to constraints imposed by governmental authorities in response to the listing of endangered species, such as Steller sea lions, for purposes of the Endangered Species Act. Since 1990, the National Marine Fisheries Service has issued various biological opinions as to the impact on Steller sea lions of the pollock and other groundfish fisheries of the U.S. Bering Sea. These opinions have analyzed the effects of the various groundfish fisheries in the waters off Alaska and have recommended actions to avoid jeopardy for the western population of Steller sea lions and the adverse modification of its habitat. Based upon these opinions, the National Marine Fisheries Service has adopted several regulations relating to the protection of Steller sea lions which have caused us to harvest our allocation of pollock and other groundfish from less than the full territory of the fisheries in which we have historically operated. The regulations to protect endangered species, such as Steller sea lions, may significantly restrict our fishing operations and revenues. Further, whatever measures that are adopted may be found to be inadequate or not in compliance with the Endangered Species Act. Therefore, as has occurred in the past, a court may in the future force us to modify our fishing operations by restricting our access to certain areas of the primary fisheries in which we operate in order to ensure the protection of the Steller sea lions in compliance with the Endangered Species Act. These restrictions could have an impact on our fishing operations, profitability and revenues which may be material to our business. In addition, the U.S. Fish and Wildlife Service is currently preparing a biological opinion on the effects of the Bering Sea/Aleutian Islands/Gulf of Alaska groundfish fisheries on bird species listed under the Endangered Species Act, in particular the short-tailed albatross. The National Marine Fisheries Service is also conducting an assessment of the potential interactions between short-tailed albatross and equipment used by trawl vessels in these fisheries. The measures that could be imposed as a result of these investigations could have an impact on our fishing operations, profitability and revenues which may be material to our business. The National Marine Fisheries Service has determined that under certain circumstances, the short-tailed albatross do interact with longliners gear. There is a risk that additional measures to prevent short-tailed albatross mortality may be required. Such measures may include temporary time and area closures within the U.S. Bering Sea Pacific cod fishery. If we and members of our crew fail to comply with applicable regulations, our vessels may become subject to liens, foreclosure risks and various penalties and our fishing rights could be revoked. Our industry is subject to highly complex statutes, rules and regulations. For example, we are subject to statutory and contractual limitations on the type and amount of fish we may harvest, as well as restrictions as to where we Table of Contents Table of Contents may fish within our fisheries. If we or members of our crew violate maritime law or otherwise become subject to civil and criminal fines, penalties and sanctions, our vessels could be subject to forfeiture and our fishing rights could be revoked. The violations that could give rise to these consequences include operating a vessel with expired or invalid vessel documentation or in violation of trading restrictions, violating international fishing treaties or fisheries laws or regulations, submitting false reports to a governmental agency, interfering with a fisheries observer or improperly handling or discarding pollock roe. Because our vessels harvesting and processing activities take place at sea, outside the day-to-day supervision of senior management, members of the crews of our vessels may have been guilty of infractions or violations that could subject them or us to significant penalties, which could have a material and adverse effect on our results of operations and financial condition. In 2001, we became aware of allegations that certain crew members may have tampered or attempted to tamper with measurement equipment on board one or more of our vessels, principally related to the 2001 fishing season. In 2002, we received additional tampering allegations relating to one of our vessels. The National Marine Fisheries Service conducted an investigation regarding these allegations, and in consultation with the National Marine Fisheries Service, we also conducted an internal investigation regarding these allegations. In 2004, we received additional tampering allegations relating to one of our vessels. We and the National Marine Fisheries Service are currently conducting an investigation regarding these allegations. It is possible that violations may have occurred or may occur in the future. In addition, our vessels may become subject to liens imposed by operation of maritime law in the ordinary course of business. These include liens for unpaid crew wages, liens for damages arising from maritime torts, liens for various services provided to the vessel and liens arising out of the operation, maintenance and repair of the vessel. The holders of these liens may have the right to foreclose on the vessel if the circumstances giving rise to the liens are not adequately addressed. If we do not comply with rules regulating non-U.S. citizen ownership and control of fishing vessels, we could lose our eligibility to participate in U.S. fisheries. The American Fisheries Act requires that vessels engaged in U.S. fisheries be owned by entities that are at least 75% U.S. citizen owned and controlled. This requirement applies at each tier of ownership and must also be examined in the aggregate. If the provisions and procedures we adopt prove to be inadequate, we could lose our eligibility to harvest pollock, which would have a material adverse effect on our business, financial condition or results of operations. See Business Government Regulation. In addition, the Maritime Administration has the right to review the terms of our loan covenants and financing arrangements to determine if they constitute an impermissible shifting of control to a non-U.S. citizen lender. Based on discussions with counsel and with pertinent government officials, we believe the intention of the Maritime Administration is to prevent provisions couched as loan covenants from serving as a device to shift control to non-U.S. citizens, and not to impede conventional market based loans and credit facilities. The American Fisheries Act is relatively new legislation. As a result, no reported judicial cases clearly interpret its meaning. For this reason, the full future impact of the American Fisheries Act on our ownership and debt capital structure remains uncertain. Risks Relating to Our Business Our products are subject to pricing volatility, and the prices of our pollock roe and pollock surimi products, which declined significantly in 2003, may remain at their current low levels or decline even further, which would significantly reduce our profitability. The sale of pollock roe is our highest margin business. Pollock roe prices have experienced significant volatility in recent years and may continue to do so in the future. The average price of pollock roe that we sell is heavily Table of Contents Table Of Contents Page Table of Contents influenced by the size and condition of roe skeins, its color and freshness, the maturity of the fish caught, the grade mix of the pollock roe and market perceptions of supply. In addition, pollock roe prices are influenced by anticipated Russian and U.S. production and Japanese inventory carry-over, as pollock roe is consumed almost exclusively in Japan. In addition, a decline in the quality of the pollock roe that we harvest or fluctuations in supply could cause a significant decline in the market price of pollock roe, which would reduce our margins and revenues. In addition, during the second half of 2003, our financial results and liquidity were adversely affected by lower pollock surimi prices and lower sales volume. The quantity of pollock surimi inventories we held at December 31, 2003 was approximately 1.5 times higher than the average pollock surimi inventories we held over the last three years. Over the last five years, our seasonal average pollock surimi prices have fluctuated within a range of approximately 200 to 300 yen per kilogram. In the second half of 2003, our average pollock surimi price was at the low end of that range. Our overall average surimi price for the six-month period ended June 30, 2004 has been below the low end of our historical average surimi price range and will reflect a decline of approximately 25% as compared to the same period in 2003, which reflects both the overall decline in surimi market prices as well as our sales of a greater percentage of lower quality surimi. Partly as a result of these pricing factors, together with high inventories, our overall performance in 2003 was at a level that would have caused us to be in violation of certain of our financial bank covenants. To prevent this potential violation, during the third quarter of 2003, we cancelled 2003 management bonuses and reversed accruals of those bonuses through June 30, 2003, in accordance with the terms of some of our employment agreements and our general bonus policy, which does not require the payment of bonuses based on financial performance for any year in which there is or would be a violation of a covenant under our credit agreement. Despite the cancellation and reversal of these bonuses, we would have been in violation of those financial covenants under our existing credit agreement at the end of 2003 if we had not obtained a covenant modification from our bank lenders. See Management s Discussion and Analysis of Financial Condition and Results of Operations Debt Covenants. Prices and sales volume may remain at these low levels or decline even further, which would materially and adversely affect our results of operations and could impair our ability to meet our anticipated distributions to you. High catfish prices charged by farmers would adversely impact our operations if market prices for our catfish products do not increase proportionally. If prices at which we purchase catfish remain at high levels or increase, in either case without a proportionate increase in the prices at which we sell our catfish products, our ability to maintain profitability in our catfish processing operations will be adversely affected. In the second half of 2003, many of the farmers from whom we purchase catfish increased their prices to levels that jeopardized our ability to maintain satisfactory profit margins in the catfish processing operations. Partially as a result of these farm price increases, in September 2003, we temporarily closed our catfish processing plant in Demopolis, Alabama. Our Demopolis plant resumed full operations in October 2003. However, the prices charged by catfish farmers have remained at relatively high levels, which have adversely affected our catfish processing results. Prices at which farmers are willing or able to sell their catfish to us could remain at levels that do not enable us to maintain satisfactory margins and do not allow us to continue these operations without further shutdowns or interruptions. Southern Pride s recent operating results have not met our expectations, primarily as a result of increased fish costs paid to catfish farmers combined with lower processing yields. Should these conditions continue, and should operating results continue to fall below management s current expectations or decline further from present levels, we may conclude that it is more likely than not that the carrying value of the Southern Pride assets exceeds their fair value. Under such circumstances, we would be obligated to undertake an interim impairment test of the $7.2 million of goodwill recorded in connection with the acquisition of the assets of Southern Pride in 2002. To the extent a goodwill impairment test indicates that the carrying value exceeds the fair value, we would be required to record an impairment charge to our operations for the write-down of all or a portion of the recorded goodwill. Table of Contents A material decline in the population and biomass of pollock, other groundfish and catfish stocks in the fisheries in which we operate would materially and adversely affect our business. The population and biomass of pollock and other groundfish stocks are subject to natural fluctuations which are beyond our control and which may be exacerbated by disease, reproductive problems or other biological issues. Pollock stocks are also largely dependent on proper resource management and enforcement. The overall health of a fish stock is difficult to measure and fisheries management is still a relatively inexact science. Since we are unable to predict the timing and extent of fluctuations in the population and biomass of the pollock stocks, we are unable to engage in any measures that might alleviate the adverse effects of these fluctuations. Any such fluctuation which results in a material decline in the population and biomass of the pollock stocks in the fisheries in which we operate would materially and adversely affect our business. Conversely, a significant increase in Russian pollock stocks could dramatically reduce the market price of our products. Our catfish operations are also subject to the risk of variations in supply. For example, disease in catfish ponds could reduce catfish stocks and adversely affect our business. Our business is subject to Japanese currency fluctuations that could materially adversely affect our financial condition and liquidity. Our profitability depends in part on revenues received in Japanese yen as a result of sales in Japan. During 2003, our Japanese sales represented 24.9% of our total revenues. A decline in the value of the yen against the U.S. dollar would adversely affect our earnings from sales in Japan. Fluctuations in currency are beyond our control and are unpredictable. During the year ended December 31, 2002, the value of the dollar declined by 9.6% against the yen, from 131.3 per $1.00 to 118.6 per $1.00. During the year ended December 31, 2003, the value of the dollar declined by 9.9% against the yen, from 118.6 per $1.00 as of December 31, 2002 to 106.9 per $1.00, as of December 31, 2003. In addition, during the three months ended March 31, 2004 the value of the dollar declined by 2.7% against the yen, from 106.9 per $1.00 as of December 31, 2003 to 104.0 per $1.00, as of March 31, 2004. To hedge our exposure to Japanese currency fluctuations, we purchase derivative instruments primarily in the form of foreign exchange contracts. In addition to our revenues being exposed to Japanese currency fluctuations, our liquidity can also be impacted by unrealized losses sustained to our portfolio of foreign exchange contracts. A majority of these contracts have been entered into with a financial institution that requires collateralization of unrealized losses sustained by the portfolio above a certain threshold. To mitigate our short-term liquidity risk with respect to these collateralization requirements, we have executed contracts to forward purchase yen and have placed additional standing orders to forward purchase yen should the yen strengthen to certain spot rates. With the yen strengthening, several of these standing orders have been executed and currently one remains outstanding. The orders are significant and of a shorter duration than the portfolio of our foreign contracts and, as a result, could have a significant adverse impact on our short-term liquidity should the yen strengthen in relation to the U.S. dollar. In addition, we expect to manage our exposure to interest rates related to our new credit facilities through a cross-currency swap to yen. We believe this cross-currency swap arrangement will provide additional risk management against Japanese currency fluctuations related to our sales to Japan. The mark to market value of this cross-currency swap may also adversely impact our ability to comply with certain covenants under our new credit facilities, specifically, our senior leverage covenant and our total leverage debt incurrence test. These instruments may not be sufficient to provide adequate protection against losses related to currency fluctuations and, accordingly, any such fluctuations could adversely affect our revenues. There also exists the risk, should our forecasted yen denominated sales decline, that we could become overhedged through these instruments and thereby exposed to further foreign currency fluctuations. Table of Contents The segments of the seafood industry in which we operate are competitive, and our inability to compete successfully could adversely affect our business, results of operations and financial condition. We compete with major integrated seafood companies such as Trident Seafoods, Nippon Suisan and Maruha, as well as with inshore processors that operate inshore on fixed location processing facilities, relying on catcher-vessels to harvest and deliver fish for processing. We also compete with motherships that are solely at-sea processors, relying on catcher-vessels to harvest and deliver fish for processing. Additionally, we compete with other pollock fisheries, particularly the Russian pollock fishery in the Sea of Okhotsk. Some of our competitors have the benefit of marketing their products under brand names that have better market recognition than ours, or have stronger marketing and distribution channels than we do. In addition, other competitors may produce better quality products or have more advantageous pricing margins than we do. We may not be able to compete successfully with any of these companies. In addition, production and distribution of substitute products for pollock could have a significant adverse impact on our profitability. Increased competition as to any of our products could result in price reduction, reduced margins and loss of market share, which could negatively affect our profitability. An increase in imported products in the U.S. at low prices could also negatively affect our profitability. All of our business activities are subject to a variety of natural risks, which could have a material adverse effect on our business, financial condition or results of operations. The U.S. Bering Sea pollock fishery, which is the primary fishery in which we operate, is characterized by extreme sea conditions. Unusual weather conditions could materially and adversely affect the quality and quantity of the fish products we produce and distribute. Our vessels are expensive assets that are subject to substantial risks of serious damage or destruction. The sinking or destruction of, or substantial damage to, any of our vessels would entail significant costs to us, including the loss of production while the vessel was being replaced or repaired. Our insurance coverage may prove to be inadequate or may not continue to be available to us. In the event that such coverage proves to be inadequate, the sinking or destruction of, or substantial damage to, any of our vessels could have a material adverse effect on our business, financial condition or results of operations. Should any of our vessels be destroyed or otherwise become inoperable, the American Fisheries Act would limit our ability to replace that vessel. The statute permits the replacement of lost vessels only if the loss is due to an Act of God, an act of war, the result of a collision, or otherwise not an intentional act of the vessel s owner. These rules would restrict our ability to replace our vessels on account of obsolescence and, accordingly, could cause us to incur increased costs of maintaining our vessels, including the substantial loss of capacity during times of such maintenance and rebuilding. We may be required to pay significant damages in connection with litigation that is pending against us. A pending lawsuit against us could require us to pay significant damages, which could have a material adverse effect on our business, results of operations or financial condition. See Business Litigation. We may be adversely affected by an IRS audit. The IRS has opened an audit of ASG with respect to tax year 2001. We do not know what issues will be raised in the course of this audit and such audit could result in adjustments that could have a material adverse effect on our financial condition. We may incur material costs associated with compliance with environmental regulations. We are subject to foreign, federal, state, and local environmental regulations, including those governing discharges to water, the management, treatment, storage and disposal of hazardous substances, and the Table of Contents remediation of contamination. If we do not fully comply with environmental regulations, or if a release of hazardous substances occurs at or from one of our facilities or vessels, we may be subject to penalties and could be held liable for the cost of remediation. For example, an accident involving one of our vessels could result in significant environmental liability, including fines and penalties and remediation costs. If we are subject to these penalties or costs, we may not be covered by insurance, or any insurance coverage that we do have may not cover the entire cost. Compliance with environmental regulations could require us to make material capital expenditures and could have a material adverse effect on our results of operations and financial condition. We produce and distribute food products that are susceptible to contamination and, as a result, we face the risk of exposure to product liability claims and damage to our reputation. As part of the fish processing, small pieces of metal or other similar foreign objects may enter into some of our products. Additionally, our fish products are vulnerable to contamination by disease-producing organisms or pathogens. Shipments of products that contained foreign objects or were so contaminated could lead to an increased risk of exposure to product liability claims, product recalls, adverse public relations and increased scrutiny by federal and state regulatory agencies. If a product liability claim were successful, our insurance might not be adequate to cover all the liabilities we would incur, and we might not be able to continue to maintain such insurance, or obtain comparable insurance at a reasonable cost, if at all. If we did not have adequate insurance or contractual indemnification available, product liability claims relating to defective products could significantly increase our operating costs. In addition, even if a product liability claim was not successful or was not fully pursued, the negative publicity surrounding any such assertion could harm our reputation with our customers. Our operations are labor intensive, and our failure to attract and retain qualified employees may adversely affect us. The segments of the harvesting and processing industry in which we compete are labor intensive and require an adequate supply of qualified production workers willing to work in rough weather and potentially dangerous operating conditions at sea. Some of our operations have from time to time experienced a high rate of employee turnover and could continue to experience high turnover in the future. Labor shortages, the inability to hire or retain qualified employees or increased labor costs could have a material adverse effect on our ability to control expenses and efficiently conduct our operations. We may not be able to continue to hire and retain the sufficiently skilled labor force necessary to operate efficiently and to support our operating strategies, or we may not continue to experience favorable labor relations. In addition, our labor expenses could increase as a result of a continuing shortage in the supply of personnel. Changes in applicable state and federal laws and regulations could increase labor costs, which could have a material adverse effect on our business, results of operations and financial condition. Table of Contents
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+Risk Factors An investment in our IDSs and our notes involves a number of risks. In addition to the other information contained in this prospectus, prospective investors should give careful consideration to the following factors. Risks Relating to the IDSs, our Notes, the New Credit Facilities and the Shares of our Class A and Class B Common Stock You may not receive any dividends. We are not obligated to pay dividends. Dividend payments are not guaranteed and are within the absolute discretion of our board of directors. Future dividends with respect to shares of our capital stock, if any, will depend on, among other things, our results of operations, working capital requirements, financial condition, contractual restrictions, business opportunities, anticipated cash needs, provisions of applicable law and other factors that our board of directors may deem relevant. Our board of directors may decide not to pay dividends at any time and for any reason. Our general policy to distribute rather than retain excess cash is based upon our current assessment of our business and the environment in which it operates, and that assessment could change based on competitive or technological developments (which could, for example, increase our need for capital expenditures), new growth opportunities or other factors. Our board is free to depart from or change our dividend policy at any time and could do so, for example, if it were to determine that we had insufficient cash to take advantage of growth opportunities. The indenture governing the notes and our new credit facilities will contain limitations on our ability to pay dividends. See Dividend Policy and Restrictions. The reduction or elimination of dividends may negatively affect the market price of the IDSs. Our dividend policy may negatively impact our ability to finance capital expenditures or operations. Upon completion of this offering, our board of directors will adopt a dividend policy under which substantially all of the cash generated by our business in excess of operating needs and reserves will be distributed to our stockholders. As a result, we may not retain a sufficient amount of cash to finance growth opportunities or unanticipated capital expenditure needs or to fund our operations in the event of a significant business downturn. We may have to forego growth opportunities or capital expenditures that would otherwise be necessary or desirable in the event we do not find alternative sources of financing. In the event we do not have sufficient cash for these purposes, our financial condition and our business will suffer. Our substantial indebtedness could restrict our ability to pay interest and principal on the notes, pay dividends with respect to shares of our Class A common stock and Class B common stock, and impact our financing options and liquidity position. We have a significant amount of debt. For the last twelve months ended March 31, 2004, on a pro forma basis after giving the effect to this offering and related transactions as if they had occurred on April 1, 2003, our interest coverage ratio would have been 2.49 times and our ratio of total debt to Adjusted EBITDA would have been 4.21 times. The degree to which we are leveraged on a consolidated basis could have important consequences to the holders of the IDSs, including: it may be more difficult for us to satisfy our obligations under the notes and to the lenders under the new credit facilities, and to pay dividends on our Class A common stock and Class B common stock; our ability in the future to obtain additional financing for working capital, capital expenditures or acquisitions may be limited; we may not be able to refinance our indebtedness on terms acceptable to us or at all; a significant portion of our cash flow from operations is likely to be dedicated to the payment of the principal of and interest on our indebtedness, thereby reducing funds available for future operations, capital expenditures and/or dividends on our Class A common stock and Class B common stock; Primary Standard Industrial Classification Code Number Table of Contents we may be more vulnerable to economic downturns and be limited in our ability to withstand competitive pressures; and it may limit our flexibility to plan for and react to changes in our business or strategy. We may be able to incur substantially more debt, which would increase the risks described above associated with our substantial leverage. We may be able to incur substantial additional indebtedness in the future, including issuances of additional notes under the indenture. Any additional debt incurred by us could increase the risks associated with our substantial leverage. We are subject to restrictive debt covenants that limit our business flexibility by imposing operating and financial restrictions on our operations. Although credit facilities of similarly situated borrowers customarily prohibit payments of dividends on the shares of Class A common stock and Class B common stock, our new credit facilities will permit us to pay dividends on the shares of Class A common stock represented by IDSs and Class B common stock, so long as Holdings interest coverage ratio remains above certain established levels and no default or event of default exists under the new credit facilities. Because the payment of dividends will decrease the amount of cash available to service our senior debt, the new credit facilities will impose restrictions on our operations that are more restrictive than customary for credit facilities of similarly situated borrowers that prohibit or substantially limit payments of dividends. These restrictions prohibit or limit, among other things: the incurrence of additional indebtedness and the issuance of preferred stock and certain redeemable capital stock; the payment of dividends or distributions (including distributions by ASG to us to permit us to pay interest on the notes) on, and purchase or redemption of, capital stock; a number of other restricted payments, including investments and acquisitions; specified sales of assets; specified transactions with affiliates; the creation of liens on our assets; consolidations, mergers and transfers of all or substantially all of our assets; our ability to change the nature of our business; and our ability to make capital expenditures (other than maintenance capital expenditures). These restrictions could limit our ability to obtain future financing, make acquisitions or needed capital expenditures, withstand downturns in our business or take advantage of business opportunities. Furthermore, the new credit facilities will also require us to maintain specified financial ratios and satisfy financial condition tests, including a minimum fixed charge coverage ratio, a maximum leverage ratio and a maximum senior leverage ratio. Our ability to comply with the ratios or tests may be affected by events beyond our control, including prevailing economic, financial and industry conditions. A breach of any of these covenants, ratios or tests could result in a default under the new credit facilities and/or the indenture. Upon the occurrence of an event of default under the new credit facilities, the lenders could elect to declare all amounts outstanding under the new credit facilities to be immediately due and payable. If the lenders accelerate the payment of the indebtedness under the new credit facilities, our assets may not be sufficient to repay in full this indebtedness and our other indebtedness, including the notes. I.R.S. Employer Identification No. Table of Contents We may not be able to refinance our new credit facilities at maturity on favorable terms or at all. The new credit facilities will mature in full in 2008. We may not be able to renew or refinance the new credit facilities, or if renewed or refinanced, the renewal or refinancing may occur on less favorable terms. In particular, some of the terms of the notes that may be viewed as favorable to the senior lenders, such as our ability to defer interest and acceleration forbearance periods, become less favorable in 2009, which may materially adversely affect our ability to refinance or renew our new credit facilities beyond such dates. If we are unable to refinance or renew our new credit facilities, our failure to repay all amounts due on the maturity date would cause a default under the new credit facilities. In addition, our interest expense may increase significantly if we refinance our new credit facilities on terms that are less favorable to us than the terms of our new credit facilities. We will require a significant amount of cash, which may not be available to us, to service our debt, including the notes, and to fund our liquidity needs. Our ability to make payments on, or to refinance or repay, our debt, including the notes, to fund planned capital expenditures and expand our business, will depend largely upon our future operating performance. Our future operating performance is subject to general economic, financial, competitive, legislative and regulatory factors, as well as other factors that are beyond our control. If we are unable to generate sufficient cash to service our debt requirements, we will be required to refinance our new credit facilities. If we are unable to refinance our debt or obtain new financing, we would have to consider other options, including: sales of assets to meet our debt service requirements; sales of equity; and negotiations with our lenders to restructure the applicable debt. If we are forced to pursue any of the above options under distressed conditions, our business or the value of your investment in our IDSs and notes could be adversely affected. Compliance with rules regulating non-U.S. citizen ownership and control of fishing vessels may adversely affect the marketability or the price of our IDSs, shares of our Class A common stock or notes. The governance provisions we have adopted and the related steps we will take to comply with the foreign ownership restrictions imposed by federal law on companies that participate in U.S. fisheries are complex and burdensome. They may require beneficial owners of our Class A common stock to execute complex affidavits and provide detailed ownership information and they could require trades of IDSs or shares of our Class A common stock to be reversed or persons who hold IDSs or shares to dispose of them on unfavorable terms. These administrative burdens and requirements and the potential that trades could be unwound or sales required could have an adverse effect on the market for and trading price of IDSs, shares of our Class A common stock or notes. See Business Government Regulation. Our governance arrangements provide our present owners with the ability to exercise substantial control over us, which may create conflicts of interest. As the holders of our Series A, Series B and Series C preferred stock, Coastal Villages Pollock LLC, Bernt O. Bodal (who is our chairman and chief executive officer), and Centre Partners Management LLC will be entitled directly to designate a total of four members of our nine member board. In addition, through their ownership of Class B common stock, IDSs and preferred shares (which will vote together with the Class A common stock and Class B common stock based on the holders interests in ASLP and Holdings), Coastal, Mr. Bodal and Centre would, if they acted collectively, effectively have the ability to elect two additional independent members of our board through the operation of cumulative voting, which applies to the election of our directors and has the effect Code, and Telephone Number, Including Area Code, of Principal Executive Office Table of Contents of concentrating the voting power of significant holders. Accordingly, although they will hold only approximately 31.8% of the equity interests in Holdings, these three holders and their affiliates will have approximately 33.5% of the aggregate voting power in the Issuer and, effectively, the right to designate six of our nine directors. Our organizational documents require that all directors other than the four designated by the holders of preferred stock must satisfy all applicable independence requirements including those of the American Stock Exchange. In addition, for so long as Coastal does not sell equity that would reduce its holdings to below 5.0% of our business or is not otherwise diluted below 2.5% of our business, without the consent of Coastal and either of Mr. Bodal or Centre, or their permitted transferees, we may not create or modify any equity compensation plan, create or make certain modifications to any bonus or performance based compensation plan for executive officers or pay bonuses to executive officers other than pursuant to and in conformity with an existing bonus or performance based compensation plan. Coastal, Mr. Bodal and Centre will have the power to substantially dilute your voting power. Further, they may have views or interests that differ from those of the majority of IDS holders. Coastal Villages Pollock LLC will have board representation, voting and veto rights substantially in excess of its economic ownership, which may create conflicts of interest. Coastal Villages Pollock LLC, as the holder of the Series A preferred share, will have the right to elect two members of our board so long as Coastal does not sell equity that would reduce its holdings to below 5.0% of our business or is not otherwise diluted below 2.5% of our business (in which case it would be reduced to one director). In addition, for so long as it is entitled to two directors, Coastal has veto rights over changes to our governance arrangements and over certain compensation decisions made by the compensation committee of our board. Finally, by virtue of its ownership of IDSs, Class B common stock and the Series A preferred share, Coastal will have a total of 14.5% of our combined voting power. In addition, our nomination process will allow two or more directors who oppose any nominee for director proposed by our nominating and governance committee to propose an alternate nominee. So long as the alternative satisfies applicable independence and other requirements, we will be required to include disclosure about the alternate nominee in our annual proxy statement and processes. This mechanism, coupled with cumulative voting, would make it possible for Coastal to propose a candidate and use its cumulative voting rights to cast a significant number of votes in favor of such candidate. In our annual election of five directors, holders of approximately 16.7% of our voting power will have the ability to ensure the election of one director. After completion of this offering, Coastal will own approximately 14.5% of the voting power of our company or approximately 11.0% if the over-allotment option to purchase additional IDSs is exercised in full. Coastal will also have the right (for so long as it is entitled to elect two directors) to designate one member of our audit committee, provided the member satisfies applicable independence and other requirements. As a result of these various provisions, Coastal will have the ability to exert significant influence over our activities and decisions. Coastal is our largest supplier of community development quota and our current agreement with Coastal terminates on December 31, 2005. In addition, Coastal may, as an Alaska native organization, have goals or views that may differ from those of our other shareholders or our management and, accordingly, Coastal s substantial influence over our affairs may create conflicts of interest. Retained ownership by our existing owners and the special rights of our preferred stockholders may prevent you from receiving a premium in the event of a change of control. Upon the completion of the transactions contemplated by this offering, the existing owners, through their ownership of ASLP, IDSs and Class B common stock, will own approximately 39.2% of the equity interests of Table of Contents our business, or approximately 30.1% of the equity interests of our business, if the over-allotment option to purchase additional IDSs is exercised in full. If such existing owners, or their permitted transferees, exercise their rights to exchange all of their ownership in ASLP for IDSs, they will own approximately 39.2% of the voting power of our company. This concentration of ownership could have the effect of delaying, deferring or preventing a change in control, merger or tender offer, which would deprive you of an opportunity to receive a premium for your IDSs and may negatively affect the market price of the IDSs. Moreover, our existing owners could effectively receive a premium for transferring ownership to third parties that would not inure to your benefit. In addition, the special rights of preferred stockholders do not automatically cease upon a change of control and, therefore, the existence of these special rights may effectively deter a potential acquirer from acquiring us. We are a holding company and rely on dividends, interest and other payments, advances and transfers of funds from our subsidiaries to meet our debt service and other obligations. We are a holding company and conduct all of our operations through our subsidiaries and currently have no significant assets other than our equity interest in Holdings and our interest in the notes issued by Holdings. As a result, we will rely on interest and principal on the Holdings notes and on dividends, loans and other payments or distributions from our subsidiaries to meet our debt service obligations and enable us to pay interest and dividends. The ability of our subsidiaries to pay interest and dividends or make other payments or distributions to us will depend substantially on their respective operating results and will be subject to restrictions under, among other things, the laws of their jurisdiction of organization (which may limit the amount of funds available for the payment of dividends), agreements of those subsidiaries, the terms of the new credit facilities and the covenants of any future outstanding indebtedness we or our subsidiaries incur. Our new credit facilities will contain significant limitations on distributions and other payments. The new credit facilities will prohibit distributions from ASG and its subsidiaries to Holdings if, among other things, the interest coverage ratio of Holdings is less than the dividend suspension thresholds described under Description of Certain Indebtedness New Credit Facilities (or if we fail to timely deliver financial statements calculating such ratio), or if Holdings has any deferred and unpaid interest outstanding on the Holdings notes, other than distributions to pay interest on the Holdings notes and other permitted payments, such as to pay taxes. In addition, if the interest coverage ratio of Holdings is less than the interest deferral thresholds described under Description of Certain Indebtedness New Credit Facilities (or if we fail to timely deliver financial statements calculating such ratio), or if a default or event of default under the new credit facilities exists, the new credit facilities will prohibit distributions by ASG and its subsidiaries to Holdings to enable it to pay interest on the Holdings notes, as well as all other distributions from ASG to Holdings (other than distributions to pay taxes and certain administrative expenses). During any dividend suspension period or interest deferral period, ASG will be required to prepay the loans under the new credit facilities with a portion of its cash available after payments of taxes, scheduled principal and interest payments on its indebtedness, maintenance capital expenditures and other expenses, and such prepayments would reduce the amount of cash available for payments in respect of the notes. If the interest coverage ratio of Holdings is less than the interest deferral thresholds described under Description of Certain Indebtedness New Credit Facilities, the Issuer will be permitted to defer interest on the notes pursuant to the indenture governing the notes. However, the indenture provides that interest on the notes may not be deferred for more than eight quarters in the aggregate prior to 2009. If the Issuer may no longer defer interest on the notes but the interest coverage ratio of Holdings remains below the specified threshold and the new credit facilities prohibit ASG and its subsidiaries from making distributions to the Issuer, we will not have sufficient funds to pay interest on the notes, which would cause a default under the indenture governing the notes, entitling the holders of the notes to demand payment in full of all amounts outstanding under the notes, subject to an acceleration forbearance period of up to 90 days. The default and the acceleration of the notes under such circumstances would cause a default under our new credit facilities, and ASG and its subsidiaries might not have Table of Contents The information in this prospectus is not complete and may be changed. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is declared effective. This prospectus is not an offer to sell these securities and is not soliciting an offer to buy these securities in any state where the offer or sale is not permitted. Subject to Completion, Dated August 11, 2004 30,740,741 Income Deposit Securities (IDSs) Representing 30,740,741 Shares of Class A Common Stock and $158.3 million % Notes due 2019 and $27.9 million % Notes due 2019 Table of Contents sufficient funds to repay all amounts outstanding under the new credit facilities and make distributions to us to repay all amounts outstanding under the notes. Interest on the notes may not be deductible by us for U.S. federal income tax purposes, which could significantly reduce our future cash flow and impact our ability to make interest and dividend payments. While we believe that the notes should be treated as debt for U.S. federal income tax purposes, this position may not be sustained if challenged by the IRS. If the notes were treated as equity rather than debt for U.S. federal income tax purposes, then the stated interest on the notes would be treated as a dividend (to the extent paid out of our tax earnings and profits ), and interest on the notes would not be deductible by us for U.S. federal income tax purposes. Our inability to deduct interest on the notes could materially increase our taxable income and, thus, our U.S. federal and applicable state income tax liability. This would reduce our after-tax cash flow, which may result in a default under the new credit facilities, and would materially and adversely impact our ability to make interest and dividend payments and may also affect our ability to continue as a going concern. In the case of foreign holders, treatment of the notes as equity for U.S. federal income tax purposes would subject payments to such holders in respect of the notes to withholding or estate taxes in the same manner as payments made with regard to Class A common stock and could subject us to liability for withholding taxes that were not collected on payments of interest. You will be immediately diluted by $14.50 per share of Class A common stock if you purchase IDSs in this offering. Because there will be a net tangible book deficit for each share of Class A common stock outstanding immediately after this offering, if you purchase IDSs in this offering, based on the book value of our assets and liabilities, you will experience an immediate dilution of $14.50 per share of Class A common stock represented by the IDSs ($12.87 assuming all ASLP units have been exchanged for IDSs), which exceeds the price allocated to each share of Class A common stock represented by the IDSs in this offering. Our net tangible book deficit as of March 31, 2004, after giving effect to this offering, was approximately $228.7 million, or $6.15 per share of Class A and Class B common stock ($4.52 assuming all ASLP units have been exchanged for IDSs). As a result of this deficit, the face amount of notes will exceed the net book value of tangible assets by approximately $869 per $1,000 face amount of notes. The allocation of the purchase price of the IDSs may not be respected. The purchase price of each IDS must be allocated for tax purposes between the share of Class A common stock and the note comprising the IDS in proportion to their respective fair market values at the time of purchase. If our allocation is not respected, the notes may be treated as having been issued with original issue discount, or OID (if the allocation to the notes were determined to be too high), or amortizable bond premium (if the allocation to the notes were determined to be too low). You generally would be required to include OID in income in advance of the receipt of cash attributable to that income and would be able to elect to amortize bond premium over the term of the notes. Deferral of interest payments would have adverse tax consequences for you and may adversely affect the trading price of the IDSs or the notes. If interest payments on the notes are deferred, you will be required to recognize interest income for U.S. federal income tax purposes on an economic accrual basis in respect of the notes held by you before you receive any cash payment of this interest. See Material U.S. Federal Income Tax Considerations Consequences to U.S. Holders Notes Stated Interest; Deferral of Interest. In addition, you will not receive any cash payment with respect to accrued interest if you sell the IDSs or the notes before the end of any deferral period or before the record date relating to interest payments that are to be paid. We are selling 30,740,741 IDSs in respect of 30,740,741 shares of our Class A common stock and $158.3 million aggregate principal amount of our % notes due September 15, 2019. Each IDS represents: one share of our Class A common stock; and a % note with $5.15 principal amount. We are also selling separately (not represented by IDSs) $27.9 million aggregate principal amount of our % notes due September 15, 2019. The completion of the offering of separate notes is a condition to our sale of IDSs. This is the initial public offering of our IDSs and notes. We anticipate that the public offering price of the IDSs will be between $13.50 and $14.00 per IDS and the public offering price of the notes sold separately (not represented by IDSs) will be % of their stated principal amount. Holders of IDSs will have the right to separate IDSs into the shares of Class A common stock and notes represented thereby at any time after the earlier of 45 days from the closing of this offering or the occurrence of a change of control. Similarly, holders of our Class A common stock and notes may, at any time, unless the IDSs have automatically separated, combine the applicable number of shares of Class A common stock and notes to form IDSs. Separation of IDSs will occur automatically upon the continuance of a payment default on the notes for 90 days, or a repurchase, redemption or maturity of the notes. Upon a subsequent issuance by us of notes of the same series, a portion of your notes may be automatically exchanged for an identical principal amount of the notes issued in such subsequent issuance and, in such event, your IDSs or notes will be replaced with new IDSs or a unit consisting of your notes and new notes, as the case may be. In addition to the notes offered hereby, the registration statement of which this prospectus is a part also registers the notes and new IDSs to be issued to you upon any such subsequent issuance. For more information regarding these automatic exchanges and the effect they may have on your investment, see Risk Factors Subsequent issuances of notes may cause you to recognize original issue discount or cause a taxable exchange and Description of Notes Additional Notes and Material U.S. Federal Income Tax Considerations Consequences to U.S. Holders Notes Exchange Rights and Additional Issuances. We have applied to list our IDSs on the American Stock Exchange under the trading symbol SEA . We are subject to foreign ownership provisions of the American Fisheries Act as a result of which each owner of 5% or more of our capital stock (including purchasers in this offering) must certify to us that such person is a U.S. citizen, and at least 95% of all of our beneficial owners will be required to have U.S. addresses. These requirements, and the remedies we may need to invoke to satisfy them, may have an adverse effect on the market for and trading price of IDSs or shares of our Class A common stock. Investing in our IDSs and our notes involves risks. See Risk Factors beginning on page 25. Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense. Per IDS(1) Table of Contents If interest is deferred, the IDSs may trade at a price that does not fully reflect the value of accrued but unpaid interest on the notes. In addition, the existence of the right to defer payments of interest on the notes under certain circumstances may mean that the market price for the IDSs or the notes may be more volatile than other securities that do not have this feature. Your right to receive payments on the notes and the note guarantees is junior to all senior debt of Holdings and its subsidiaries. The Issuer and Holdings are holding companies and conduct all of their operations through ASG and its subsidiaries. The note guarantees issued by Holdings, ASG and the other subsidiary guarantors will be unsecured senior subordinated obligations, junior in right of payment to the senior debt of each subsidiary guarantor, respectively. As a result of the subordinated nature of these guarantees, upon any distribution to creditors of Holdings, ASG or the other subsidiary guarantors in bankruptcy, liquidation or reorganization or similar proceedings relating to Holdings, ASG or the other subsidiary guarantors or their property or assets, the holders of such entities senior indebtedness will be entitled to be paid in full in cash before any payment may be made with respect to the notes or the Holdings notes under the guarantees (and before any distribution may be made by ASG to Holdings or by Holdings to the Issuer). In the event of a bankruptcy, liquidation or reorganization or similar proceeding relating to ASG or the subsidiary guarantors, the Issuer, ASLP and the noteholders would participate under the guarantees with other holders of unsecured unsubordinated indebtedness after the payment in full of all senior indebtedness. In addition, as a result of contractual subordination of the guarantees to the guarantors obligations under the new credit facilities and other senior indebtedness, the Holders of the notes may receive less, ratably, than other creditors of the Guarantors that are not subject to contractual subordination. In any of these cases, there may not be sufficient funds to pay all of our creditors and the holders of the notes may receive less, ratably, than the holders of senior indebtedness. In such event the Issuer and the guarantors would not be able to make all principal payments on the notes. The subordination provisions of the indenture will also provide that payments to you under the subordinated note guarantees of Holdings, ASG and its domestic subsidiaries will be prohibited while a payment default exists under the senior indebtedness of these entities or if such senior indebtedness has been accelerated. In addition, these payments to you may be blocked for up to 179 days by holders of designated senior indebtedness if a default other than a payment default exists under such senior indebtedness. During any period in which payments to you are prohibited or blocked in this manner, any amounts received by you with respect to the subordinated note guarantees, including as a result of any legal action to enforce such guarantees, would be required to be turned over to the holders of senior indebtedness. In addition, so long as the notes are guaranteed by at least one guarantor, upon the occurrence of an event of default under the indenture governing the notes, the principal of and premium, if any, on the notes may not be accelerated for a period of up to 90 days until , 2009. See Description of Notes Acceleration Forbearance Periods, and Description of Notes Subordination of the Guarantees. On a pro forma basis, as of March 31, 2004, the subordinated guarantees would have ranked junior to $240.0 million of our outstanding senior indebtedness of subsidiary guarantors on a consolidated basis, all of which would have been secured. In addition, as of March 31, 2004, on a pro forma basis, ASG would have had the ability to borrow up to an additional amount of $60.0 million under the new revolver, which would have been senior in right of payment to the subordinated guarantees. In the event of bankruptcy or insolvency, the notes and guarantees could be adversely affected by principles of equitable subordination or recharacterization. In the event of bankruptcy or insolvency, a party in interest may seek to subordinate our debt, including the notes or the guarantees, under principles of equitable subordination or to recharacterize the notes as equity. In the event a court exercised its equitable powers to subordinate the notes or the guarantees, or recharacterizes the notes as equity, you may not recover any amounts owed on the notes or the guarantees and you may be required to return Total Table of Contents any payments made to you within six years before the bankruptcy on account of the notes or the guarantees. In addition, should the court treat the notes or the guarantees as equity either under principles of equitable subordination or recharacterization, you may not be able to enforce your rights under the notes or the guarantees. The notes and the guarantees may not be enforceable because of fraudulent conveyance laws. Under federal bankruptcy law and comparable provisions of state fraudulent transfer laws, a court could void the obligations under the notes or the guarantees, further subordinate the notes or the guarantees or take other action detrimental to you, if, among other things, at the time the indebtedness under the notes or the guarantees, as applicable, was incurred, the Issuer or a guarantor: issued the notes or the guarantee to delay, hinder or defraud present or future creditors; or received less than reasonably equivalent value or fair consideration for issuing the notes or the guarantee and, at the time it issued the notes or the guarantee: was insolvent or rendered insolvent by reason of issuing the notes or the guarantee and the application of the proceeds of the notes or the guarantee; was engaged or about to engage in a business or a transaction for which the guarantor s remaining unencumbered assets constituted unreasonably small capital to carry on its business; intended to incur, or believed that it would incur, debts beyond its ability to pay the debts as they mature; or was a defendant in an action for money damages, or had a judgment for money damages docketed against it if, in either case, after final judgment, the judgment is unsatisfied. The measures of insolvency for the purposes of fraudulent transfer laws vary depending upon the law applied in any proceeding to determine whether a fraudulent transfer has occurred. Generally, however, a person would be considered insolvent if, at the time it incurred the debt: the present fair saleable value of its assets was less than the amount that would be required to pay its probable liability on its existing debts, including contingent liabilities, as they become absolute and mature; or it could not pay its debts as they become due. Regardless of the standard that a court uses to determine whether we or a guarantor were solvent at the relevant time, the issuance of the notes or the guarantees may be voided or further subordinated to the claims of creditors if it concludes the Issuer or a guarantor was insolvent. The guarantee of the notes by Holdings, ASG or any other subsidiary guarantor could be subject to the claim that, since the guarantee was incurred for the benefit of the Issuer, and only indirectly for the benefit of the guarantor, the guarantee was incurred for less than fair consideration. A court could therefore void the obligations of Holdings, ASG or the subsidiary guarantor under the guarantees or subordinate these obligations to Holdings , ASG s or the subsidiary guarantor s other debt or take action detrimental to holders of the notes. If the guarantee of Holdings, ASG or any subsidiary guarantor were voided, the holders of the notes would not have a debt claim against Holdings, ASG or that subsidiary guarantor. In addition, in the event that we meet any of the financial condition fraudulent transfer tests described above at the time of or as a result of this offering, a court could view the issuance of the notes, the guarantees and the other transactions occurring on the issue date, such as repayment of our existing debt and various distributions described under Detailed Transaction Steps as a single transaction and, as a result, conclude that the Issuer did not get fair value for the offering. In such a case, a court could hold the debt (including the guarantees) owed to the noteholders void or unenforceable or may further subordinate it to the claims of other creditors. Per Separate Note Table of Contents Seasonality and variability of our businesses may cause volatility in the market value of your investment and may hinder our ability to make timely distributions on the IDSs and the notes. Our business is seasonal in nature, and our net sales and operating results vary significantly from quarter to quarter. For example, our revenue per pound of fish harvested tends to be higher in the January-to-April season due to the harvesting of roe. Consequently, results of operations for any particular quarter may not be indicative of results of operations for future quarterly periods, which makes it difficult to forecast our results for an entire year. This variability may cause volatility in the market price of the IDSs and the notes. In addition, the seasonality and variability of our business means that at certain times of the year our cash receipts are significantly higher than at other times. Our fishing seasons, including the important January-to-April season, straddle more than one quarter. As a result, the timing of the recognition of sometimes significant amounts of revenue from one quarter to another can be a function of unpredictable factors, such as the timing of roe auctions, weather, the timing of shipments to pollock roe customers, fishing pace and product delivery schedules, all of which are likely to vary from year to year. Given that we are required to make equal quarterly interest payments to note holders and intend to pay equal quarterly dividends as well, there is a risk that we will experience cash shortages, which could hinder our ability to make timely distributions or interest payments. Subsequent issuances of notes may cause you to recognize original issue discount or cause a taxable exchange. The indenture governing the notes and the agreements with DTC will provide that, in the event there is a subsequent issuance of notes by the Issuer having identical terms as the notes but with OID, each holder of notes or IDSs (as the case may be) agrees that upon the issuance of any such notes issued with OID, and upon any issuance of notes thereafter, a portion of such holder s notes will be automatically exchanged for a portion of the notes acquired by the holders of such subsequently issued notes, and the records of any record holders of notes will be revised to reflect such exchanges. Consequently, following each such subsequent issuance and exchange, without any further action by such holder, each holder of notes or IDSs (as the case may be) will own an inseparable unit composed of notes of each separate issuance in the same proportion as each other holder. However, the aggregate stated principal amount of notes owned by each holder will not change as a result of such subsequent issuance and exchange. It is unclear whether the exchange of notes for subsequently issued notes results in a taxable exchange for U.S. federal income tax purposes, and it is possible that the IRS might successfully assert that such an exchange should be treated as a taxable exchange. In such case, a holder would recognize any gain realized on such exchange, but a loss recognized might be disallowed. Regardless of whether the exchange is treated as a taxable event, such exchange would result in holders having to include OID in taxable income prior to the receipt of cash as described below, and may result in other potentially adverse tax consequences to holders. See Material U.S. Federal Income Tax Considerations Consequences to U.S. Holders Notes Exchange Rights and Additional Issuances. In addition, the potential amount of OID that would be required to be included in taxable income by holders as a result of an automatic exchange (as described below) is indefinite and may be a significant amount, in part due to our ability to engage in numerous subsequent issuances. Following the subsequent issuance and exchange, we (and our agents) will report any OID on the subsequently issued notes ratably among all holders of notes and IDSs, and each holder of notes or IDSs will, by purchasing notes or IDSs, agree to report OID in a manner consistent with this approach. However, the IRS may assert that any OID should be reported only to the persons that initially acquired such subsequently issued notes (and their transferees) and thus may challenge the holders reporting of OID on their tax returns. In addition, the IRS might further assert that, unless a holder can establish that it is not such a person, all of the notes held by such holder have OID. Any of these assertions by the IRS could create significant uncertainties in the pricing of IDSs and notes and could adversely affect the market for IDSs and notes. For these and additional tax-related risks, see Material U.S. Federal Income Tax Considerations. Total(2) Table of Contents We may have to establish a reserve for contingent tax liabilities in the future, which could adversely affect our ability to make dividend payments on the IDSs. Even if the IRS does not challenge the tax treatment of the notes, it is possible that as a result of an alteration of facts relied upon at the time of issuance of the notes, we will in the future need to change our anticipated accounting treatment and establish a reserve for contingent tax liabilities associated with a disallowance of all or part of the interest deductions on the notes. If we were required to maintain such a reserve, our ability to make dividend payments could be materially impaired and the market for the IDSs, Class A common stock and notes could be adversely affected. In addition, any resulting impact to our financial statements could lead to defaults under our new credit facilities. Holders of subsequently issued notes may not be able to collect their full stated principal amount prior to maturity. Holders of subsequently issued notes having OID (including the recipients of such notes in the involuntary exchanges pursuant to the indenture) may not be able under New York and federal bankruptcy law to collect the portion of their principal amount that represents unaccrued OID in the event of an acceleration of the notes or a bankruptcy of the Issuer prior to the notes maturity date. As a result, an automatic exchange that results in a holder receiving an OID note could have the effect of ultimately reducing the amount such holder can recover from us in the event of an acceleration or bankruptcy. Prior to the consummation of this offering, there was no public market for our IDSs, shares of our Class A common stock or notes, which may cause the price of the IDSs, shares of our Class A common stock or the notes to fluctuate substantially and negatively affect the value of your investment. Our IDSs, the shares of our Class A common stock and the notes have no public market history. In addition, there has not been an active market for securities similar to the IDSs. An active trading market for the IDSs, shares of our Class A common stock or the notes might not develop in the future, which may cause the price of the IDSs, shares of our Class A common stock or the notes to fluctuate substantially, and we currently do not expect that an active trading market for the shares of our Class A common stock will develop until the notes mature. If the notes represented by your IDSs mature or are redeemed or repurchased, the IDSs will be automatically separated and you will then hold the shares of our Class A common stock. We will not apply to list our shares of Class A common stock for separate trading on the American Stock Exchange or any other exchange until the number of shares held separately and not represented by IDSs is sufficient to satisfy applicable requirements for separate trading on such exchange. The Class A common stock may not be approved for listing at such time. We do not intend to list our notes on any securities exchange. The limited liquidity of the trading market for the notes sold separately (not represented by IDSs) may adversely affect the trading price of the separate notes. We are separately selling (not represented by IDSs) $27.9 million aggregate principal amount of notes, representing approximately 11% of the total outstanding notes assuming the exchange of all ASLP interests for IDSs. While the notes sold separately (not represented by IDSs) are part of the same series of notes as, and identical to, the notes represented by the IDSs at the time of the issuance of the separate notes, the notes represented by the IDSs will not be separable for at least 45 days and will not be separately tradeable until separated. As a result, the initial trading market for the notes sold separately (not represented by IDSs) will be very limited. Even after holders of the IDSs are permitted to separate their IDSs, a sufficient number of holders of IDSs may not separate their IDSs into shares of our Class A common stock and notes to create a sizable and more liquid trading market for the notes not represented by IDSs. Therefore, a liquid market for the notes may not develop, which may adversely affect the ability of the holders of the separate notes to sell any of their separate notes and the price at which these holders would be able to sell any of the notes sold separately. Public offering price $ $ % $ Underwriting discount $ $ % $ Proceeds to American Seafoods Corporation (before expenses)(3) $ $ % $ Table of Contents Future sales or the possibility of future sales of a substantial amount of IDSs, shares of our Class A common stock or our notes may depress the price of the IDSs, the shares of our Class A common stock and our notes. Future sales or the availability for sale of substantial amounts of IDSs or shares of our Class A common stock or a significant principal amount of our notes in the public market could adversely affect the prevailing market price of the IDSs, the shares of our Class A common stock and our notes and could impair our ability to raise capital through future sales of our securities. We may issue shares of our Class A common stock and notes, which may be in the form of IDSs, or other securities from time to time as consideration for future acquisitions and investments. In the event any such acquisition or investment is significant, the number of shares of our Class A common stock and the aggregate principal amount of notes, which may be in the form of IDSs, or the number or aggregate principal amount, as the case may be, of other securities that we may issue may in turn be significant. In addition, we may also grant registration rights covering those IDSs, shares of our Class A common stock, notes or other securities in connection with any such acquisitions and investments. In addition, the holders of 1,551,866 IDSs which will be issued in a private placement in connection with this offering will have certain registration rights. In addition, following the second anniversary of the closing of this offering, holders of Class B common stock may demand registration of their Class B common stock two times a year, during two window periods, which will match the window periods in the exchange warrant issued to all ASLP partners permitting such holders after one year to exchange their ASLP limited partnership units for IDSs. Our organizational documents could limit another party s ability to acquire us and deprive our investors of the opportunity to obtain a takeover premium for their securities. A number of provisions in our amended and restated certificate of incorporation and amended and restated by-laws will make it difficult for another company to acquire us and for you to receive any related takeover premium for your securities. For example, our organizational documents provide that stockholders generally may not act by written consent and only stockholders representing at least 50% in voting power may request that our board of directors call a special meeting. Our organizational documents also authorize the issuance of preferred stock without stockholder approval and upon such terms as the board of directors may determine. The rights of the holders of shares of our Class A common stock will be subject to, and may be adversely affected by, the rights of holders of preferred stock and any other class or series of preferred stock that may be issued in the future. Risks Relating to Our Industry and Its Regulation The repeal of, or adverse amendments to, the American Fisheries Act and other industry regulations would likely impair our profitability. The American Fisheries Act restricts the number of vessels operating in the catcher-processor sector of the U.S. Bering Sea pollock fishery to 19 named catcher-processor vessels, of which we own and operate seven, and by allocating 40% of the directed pollock catch to this sector (with 36.6% being allocated to these 19 catcher-processor vessels and 3.4% being allocated to catcher-vessels). In the event that the American Fisheries Act and other related industry regulations were repealed or modified to permit additional large vessels to operate in the catcher-processor sector of the U.S. Bering Sea pollock fishery, we could be subject to new competition that could adversely affect our profitability. In addition, our pollock harvesting rights and profitability would be adversely affected if the American Fisheries Act and other industry regulations were repealed or modified in a manner that decreases the percentage of the total pollock harvest allocated to the 19 catcher-processor vessels named in the Act. A repeal or modification of the American Fisheries Act or other industry regulations could result from changes in the political environment, a significant increase or decrease in the pollock biomass or other factors, all of which are difficult to predict and are beyond our control. The relatively stable and predictable nature of our harvesting operations and our efficiencies would deteriorate if the Pollock Conservation Cooperative agreement were terminated or adversely changed. The members of the Pollock Conservation Cooperative, which is comprised of all participants in the catcher-processor sector of the U.S. Bering Sea pollock fishery, have agreed that each member will catch only an agreed- CASH FLOWS USED IN FINANCING ACTIVITIES: Principal payments on long-term debt (37,265 ) (11,568 ) Net borrowings (payments) on revolving debt 44,000 (7,500 ) Payments on obligations to related party (5,312 ) Financing fees and costs (82 ) (380 ) Costs related to recapitalization transaction (1,296 ) Contributions from members (1) Comprised of $5.15 allocated to each note which represents 100% of its stated principal amount and $ allocated to each share of Class A common stock. (2) Represents the $27.9 million aggregate principal amount of notes sold separately (not represented by IDSs). (3) Approximately $ million of those proceeds will be paid to the current owners of our business before this offering and approximately $35.6 million will be paid to a related party to repay indebtedness and redeem preferred stock. Table of Contents upon share of the total allowable catch allocated to the catcher-processor sector in that fishery. By establishing allocations among all catcher-processors, the Pollock Conservation Cooperative, which we refer to as the Cooperative, ensures that members will have the opportunity to harvest a fixed percentage of the total pollock harvest and removes the incentives to harvest and process pollock as fast as possible, thereby giving each member a greater opportunity to optimize operational efficiencies. The Cooperative could be terminated as a result of an adverse change in the American Fisheries Act allocations, the bankruptcy of a Cooperative member or the decision of two or more Cooperative members. The termination of the Cooperative or any adverse change to the allocation system currently in place under the agreement could increase the volatility of our operations, cause us to lose operational efficiencies and have an adverse effect on our existing harvesting rights. Growth in our core pollock harvesting operations and our profitability are limited by the American Fisheries Act. The American Fisheries Act imposes a statutory limit on the maximum amount of pollock that we may independently harvest equal to 17.5% of the directed pollock catch. We are allocated 16.8% of the directed pollock catch under our Cooperative agreements, and we lease the right to harvest another 0.7% of the directed pollock catch from other vessels in our fishery, bringing us to the 17.5% limit. Our business could be materially affected if the community development quota we purchase is significantly reduced or eliminated or offered to us at prices we consider unreasonable. We supplement our pollock harvest through the purchase of community development quota, which plays an important part in our strategy of maximizing access to pollock. The primary agreements governing our current arrangements for purchasing community development quota expire at the end of 2005. The Alaska Community Development Groups from which we purchase community development quota could decline to continue to sell their quota to us or could offer their quota at prices we consider unreasonable, which could materially adversely affect our business. In addition, every three years the state of Alaska may re-allocate the community development quota allocation among the six Alaska Community Development Groups. The next reallocation is for the period beginning 2006. The Alaska Community Development Groups from which we purchase community development quota could have their quota allocation reduced below current levels. If any significant reduction were to occur, we could experience a significant decline in our revenues, earnings and profitability. Our ocean harvested whitefish operations are subject to regulatory control and political pressure from interest groups that may seek to materially limit our ability to harvest fish. Under the American Fisheries Act, the Magnuson-Stevens Fishery Conservation and Management Act and other relevant statutes and regulations, various regulatory agencies, including the National Marine Fisheries Service and the North Pacific Fishery Management Council, are endowed with the power to control our harvest of pollock and other groundfish in the fisheries of the North Pacific. These regulatory agencies have the authority to materially reduce the Alaska pollock total allowable catch allocated to the catcher-processor sector as well as our allocation of pollock and other groundfish without any compensation to us. These regulators may decrease or eliminate our allocation of the fish supply from a broad spectrum of lobbying interests including: native Alaskan groups seeking a greater allocation of the pollock harvest to be devoted to community development quotas; other sectors of the pollock fishery, such as inshore processors who periodically seek an increased allocation of the pollock harvest devoted to the on-shore sector; and environmental protection groups. Table of Contents The laws and rules that govern the highly-regulated fishing industry could change in a manner that would have a negative impact on our operations. In addition, protests and other similar acts of politically-motivated third party groups could cause substantial disruptions to the ability of our vessels to engage in harvesting activities. These factors may affect a substantial portion of our harvesting and processing operations in any year, which could have a material adverse effect on our business, results of operations or financial condition. Regulations related to our by-catch could impose substantial costs on our operations and reduce our operational flexibility. The National Marine Fisheries Service imposes various operational requirements aimed at limiting our ability to discard unwanted species, or by-catch, in the North Pacific. Regulation regarding by-catch is from time to time debated in various forums, including the United Nations, and is the subject of public campaigns by environmental groups. Any significant change in the by-catch rules resulting from these debates or campaigns could materially increase our costs or decrease the flexibility of our fishing operations. Efforts to protect endangered species, such as Steller sea lions, may significantly restrict our ability to access our primary fisheries and revenues. There is a risk that access to certain areas of the primary fisheries in which we operate could be restricted due to constraints imposed by governmental authorities in response to the listing of endangered species, such as Steller sea lions, for purposes of the Endangered Species Act. Since 1990, the National Marine Fisheries Service has issued various biological opinions as to the impact on Steller sea lions of the pollock and other groundfish fisheries of the U.S. Bering Sea. These opinions have analyzed the effects of the various groundfish fisheries in the waters off Alaska and have recommended actions to avoid jeopardy for the western population of Steller sea lions and the adverse modification of its habitat. Based upon these opinions, the National Marine Fisheries Service has adopted several regulations relating to the protection of Steller sea lions which have caused us to harvest our allocation of pollock and other groundfish from less than the full territory of the fisheries in which we have historically operated. The regulations to protect endangered species, such as Steller sea lions, may significantly restrict our fishing operations and revenues. Further, whatever measures that are adopted may be found to be inadequate or not in compliance with the Endangered Species Act. Therefore, as has occurred in the past, a court may in the future force us to modify our fishing operations by restricting our access to certain areas of the primary fisheries in which we operate in order to ensure the protection of the Steller sea lions in compliance with the Endangered Species Act. These restrictions could have an impact on our fishing operations, profitability and revenues which may be material to our business. In addition, the U.S. Fish and Wildlife Service is currently preparing a biological opinion on the effects of the Bering Sea/Aleutian Islands/Gulf of Alaska groundfish fisheries on bird species listed under the Endangered Species Act, in particular the short-tailed albatross. The National Marine Fisheries Service is also conducting an assessment of the potential interactions between short-tailed albatross and equipment used by trawl vessels in these fisheries. The measures that could be imposed as a result of these investigations could have an impact on our fishing operations, profitability and revenues which may be material to our business. The National Marine Fisheries Service has determined that under certain circumstances, the short-tailed albatross do interact with longliners gear. There is a risk that additional measures to prevent short-tailed albatross mortality may be required. Such measures may include temporary time and area closures within the U.S. Bering Sea Pacific cod fishery. If we and members of our crew fail to comply with applicable regulations, our vessels may become subject to liens, foreclosure risks and various penalties and our fishing rights could be revoked. Our industry is subject to highly complex statutes, rules and regulations. For example, we are subject to statutory and contractual limitations on the type and amount of fish we may harvest, as well as restrictions as to where we Table of Contents Table of Contents may fish within our fisheries. If we or members of our crew violate maritime law or otherwise become subject to civil and criminal fines, penalties and sanctions, our vessels could be subject to forfeiture and our fishing rights could be revoked. The violations that could give rise to these consequences include operating a vessel with expired or invalid vessel documentation or in violation of trading restrictions, violating international fishing treaties or fisheries laws or regulations, submitting false reports to a governmental agency, interfering with a fisheries observer or improperly handling or discarding pollock roe. Because our vessels harvesting and processing activities take place at sea, outside the day-to-day supervision of senior management, members of the crews of our vessels may have been guilty of infractions or violations that could subject them or us to significant penalties, which could have a material and adverse effect on our results of operations and financial condition. In 2001, we became aware of allegations that certain crew members may have tampered or attempted to tamper with measurement equipment on board one or more of our vessels, principally related to the 2001 fishing season. In 2002, we received additional tampering allegations relating to one of our vessels. The National Marine Fisheries Service conducted an investigation regarding these allegations, and in consultation with the National Marine Fisheries Service, we also conducted an internal investigation regarding these allegations. In 2004, we received additional tampering allegations relating to one of our vessels. We and the National Marine Fisheries Service are currently conducting an investigation regarding these allegations. It is possible that violations may have occurred or may occur in the future. In addition, our vessels may become subject to liens imposed by operation of maritime law in the ordinary course of business. These include liens for unpaid crew wages, liens for damages arising from maritime torts, liens for various services provided to the vessel and liens arising out of the operation, maintenance and repair of the vessel. The holders of these liens may have the right to foreclose on the vessel if the circumstances giving rise to the liens are not adequately addressed. If we do not comply with rules regulating non-U.S. citizen ownership and control of fishing vessels, we could lose our eligibility to participate in U.S. fisheries. The American Fisheries Act requires that vessels engaged in U.S. fisheries be owned by entities that are at least 75% U.S. citizen owned and controlled. This requirement applies at each tier of ownership and must also be examined in the aggregate. If the provisions and procedures we adopt prove to be inadequate, we could lose our eligibility to harvest pollock, which would have a material adverse effect on our business, financial condition or results of operations. See Business Government Regulation. In addition, the Maritime Administration has the right to review the terms of our loan covenants and financing arrangements to determine if they constitute an impermissible shifting of control to a non-U.S. citizen lender. Based on discussions with counsel and with pertinent government officials, we believe the intention of the Maritime Administration is to prevent provisions couched as loan covenants from serving as a device to shift control to non-U.S. citizens, and not to impede conventional market based loans and credit facilities. The American Fisheries Act is relatively new legislation. As a result, no reported judicial cases clearly interpret its meaning. For this reason, the full future impact of the American Fisheries Act on our ownership and debt capital structure remains uncertain. Risks Relating to Our Business Our products are subject to pricing volatility, and the prices of our pollock roe and pollock surimi products, which declined significantly in 2003, may remain at their current low levels or decline even further, which would significantly reduce our profitability. The sale of pollock roe is our highest margin business. Pollock roe prices have experienced significant volatility in recent years and may continue to do so in the future. The average price of pollock roe that we sell is heavily Table of Contents Table Of Contents Page Table of Contents influenced by the size and condition of roe skeins, its color and freshness, the maturity of the fish caught, the grade mix of the pollock roe and market perceptions of supply. In addition, pollock roe prices are influenced by anticipated Russian and U.S. production and Japanese inventory carry-over, as pollock roe is consumed almost exclusively in Japan. In addition, a decline in the quality of the pollock roe that we harvest or fluctuations in supply could cause a significant decline in the market price of pollock roe, which would reduce our margins and revenues. In addition, during the second half of 2003, our financial results and liquidity were adversely affected by lower pollock surimi prices and lower sales volume. The quantity of pollock surimi inventories we held at December 31, 2003 was approximately 1.5 times higher than the average pollock surimi inventories we held over the last three years. Over the last five years, our seasonal average pollock surimi prices have fluctuated within a range of approximately 200 to 300 yen per kilogram. In the second half of 2003, our average pollock surimi price was at the low end of that range. Our overall average surimi price for the six-month period ended June 30, 2004 has been below the low end of our historical average surimi price range and will reflect a decline of approximately 25% as compared to the same period in 2003, which reflects both the overall decline in surimi market prices as well as our sales of a greater percentage of lower quality surimi. Partly as a result of these pricing factors, together with high inventories, our overall performance in 2003 was at a level that would have caused us to be in violation of certain of our financial bank covenants. To prevent this potential violation, during the third quarter of 2003, we cancelled 2003 management bonuses and reversed accruals of those bonuses through June 30, 2003, in accordance with the terms of some of our employment agreements and our general bonus policy, which does not require the payment of bonuses based on financial performance for any year in which there is or would be a violation of a covenant under our credit agreement. Despite the cancellation and reversal of these bonuses, we would have been in violation of those financial covenants under our existing credit agreement at the end of 2003 if we had not obtained a covenant modification from our bank lenders. See Management s Discussion and Analysis of Financial Condition and Results of Operations Debt Covenants. Prices and sales volume may remain at these low levels or decline even further, which would materially and adversely affect our results of operations and could impair our ability to meet our anticipated distributions to you. High catfish prices charged by farmers would adversely impact our operations if market prices for our catfish products do not increase proportionally. If prices at which we purchase catfish remain at high levels or increase, in either case without a proportionate increase in the prices at which we sell our catfish products, our ability to maintain profitability in our catfish processing operations will be adversely affected. In the second half of 2003, many of the farmers from whom we purchase catfish increased their prices to levels that jeopardized our ability to maintain satisfactory profit margins in the catfish processing operations. Partially as a result of these farm price increases, in September 2003, we temporarily closed our catfish processing plant in Demopolis, Alabama. Our Demopolis plant resumed full operations in October 2003. However, the prices charged by catfish farmers have remained at relatively high levels, which have adversely affected our catfish processing results. Prices at which farmers are willing or able to sell their catfish to us could remain at levels that do not enable us to maintain satisfactory margins and do not allow us to continue these operations without further shutdowns or interruptions. Southern Pride s recent operating results have not met our expectations, primarily as a result of increased fish costs paid to catfish farmers combined with lower processing yields. Should these conditions continue, and should operating results continue to fall below management s current expectations or decline further from present levels, we may conclude that it is more likely than not that the carrying value of the Southern Pride assets exceeds their fair value. Under such circumstances, we would be obligated to undertake an interim impairment test of the $7.2 million of goodwill recorded in connection with the acquisition of the assets of Southern Pride in 2002. To the extent a goodwill impairment test indicates that the carrying value exceeds the fair value, we would be required to record an impairment charge to our operations for the write-down of all or a portion of the recorded goodwill. Table of Contents A material decline in the population and biomass of pollock, other groundfish and catfish stocks in the fisheries in which we operate would materially and adversely affect our business. The population and biomass of pollock and other groundfish stocks are subject to natural fluctuations which are beyond our control and which may be exacerbated by disease, reproductive problems or other biological issues. Pollock stocks are also largely dependent on proper resource management and enforcement. The overall health of a fish stock is difficult to measure and fisheries management is still a relatively inexact science. Since we are unable to predict the timing and extent of fluctuations in the population and biomass of the pollock stocks, we are unable to engage in any measures that might alleviate the adverse effects of these fluctuations. Any such fluctuation which results in a material decline in the population and biomass of the pollock stocks in the fisheries in which we operate would materially and adversely affect our business. Conversely, a significant increase in Russian pollock stocks could dramatically reduce the market price of our products. Our catfish operations are also subject to the risk of variations in supply. For example, disease in catfish ponds could reduce catfish stocks and adversely affect our business. Our business is subject to Japanese currency fluctuations that could materially adversely affect our financial condition and liquidity. Our profitability depends in part on revenues received in Japanese yen as a result of sales in Japan. During 2003, our Japanese sales represented 24.9% of our total revenues. A decline in the value of the yen against the U.S. dollar would adversely affect our earnings from sales in Japan. Fluctuations in currency are beyond our control and are unpredictable. During the year ended December 31, 2002, the value of the dollar declined by 9.6% against the yen, from 131.3 per $1.00 to 118.6 per $1.00. During the year ended December 31, 2003, the value of the dollar declined by 9.9% against the yen, from 118.6 per $1.00 as of December 31, 2002 to 106.9 per $1.00, as of December 31, 2003. In addition, during the three months ended March 31, 2004 the value of the dollar declined by 2.7% against the yen, from 106.9 per $1.00 as of December 31, 2003 to 104.0 per $1.00, as of March 31, 2004. To hedge our exposure to Japanese currency fluctuations, we purchase derivative instruments primarily in the form of foreign exchange contracts. In addition to our revenues being exposed to Japanese currency fluctuations, our liquidity can also be impacted by unrealized losses sustained to our portfolio of foreign exchange contracts. A majority of these contracts have been entered into with a financial institution that requires collateralization of unrealized losses sustained by the portfolio above a certain threshold. To mitigate our short-term liquidity risk with respect to these collateralization requirements, we have executed contracts to forward purchase yen and have placed additional standing orders to forward purchase yen should the yen strengthen to certain spot rates. With the yen strengthening, several of these standing orders have been executed and currently one remains outstanding. The orders are significant and of a shorter duration than the portfolio of our foreign contracts and, as a result, could have a significant adverse impact on our short-term liquidity should the yen strengthen in relation to the U.S. dollar. In addition, we expect to manage our exposure to interest rates related to our new credit facilities through a cross-currency swap to yen. We believe this cross-currency swap arrangement will provide additional risk management against Japanese currency fluctuations related to our sales to Japan. The mark to market value of this cross-currency swap may also adversely impact our ability to comply with certain covenants under our new credit facilities, specifically, our senior leverage covenant and our total leverage debt incurrence test. These instruments may not be sufficient to provide adequate protection against losses related to currency fluctuations and, accordingly, any such fluctuations could adversely affect our revenues. There also exists the risk, should our forecasted yen denominated sales decline, that we could become overhedged through these instruments and thereby exposed to further foreign currency fluctuations. Table of Contents The segments of the seafood industry in which we operate are competitive, and our inability to compete successfully could adversely affect our business, results of operations and financial condition. We compete with major integrated seafood companies such as Trident Seafoods, Nippon Suisan and Maruha, as well as with inshore processors that operate inshore on fixed location processing facilities, relying on catcher-vessels to harvest and deliver fish for processing. We also compete with motherships that are solely at-sea processors, relying on catcher-vessels to harvest and deliver fish for processing. Additionally, we compete with other pollock fisheries, particularly the Russian pollock fishery in the Sea of Okhotsk. Some of our competitors have the benefit of marketing their products under brand names that have better market recognition than ours, or have stronger marketing and distribution channels than we do. In addition, other competitors may produce better quality products or have more advantageous pricing margins than we do. We may not be able to compete successfully with any of these companies. In addition, production and distribution of substitute products for pollock could have a significant adverse impact on our profitability. Increased competition as to any of our products could result in price reduction, reduced margins and loss of market share, which could negatively affect our profitability. An increase in imported products in the U.S. at low prices could also negatively affect our profitability. All of our business activities are subject to a variety of natural risks, which could have a material adverse effect on our business, financial condition or results of operations. The U.S. Bering Sea pollock fishery, which is the primary fishery in which we operate, is characterized by extreme sea conditions. Unusual weather conditions could materially and adversely affect the quality and quantity of the fish products we produce and distribute. Our vessels are expensive assets that are subject to substantial risks of serious damage or destruction. The sinking or destruction of, or substantial damage to, any of our vessels would entail significant costs to us, including the loss of production while the vessel was being replaced or repaired. Our insurance coverage may prove to be inadequate or may not continue to be available to us. In the event that such coverage proves to be inadequate, the sinking or destruction of, or substantial damage to, any of our vessels could have a material adverse effect on our business, financial condition or results of operations. Should any of our vessels be destroyed or otherwise become inoperable, the American Fisheries Act would limit our ability to replace that vessel. The statute permits the replacement of lost vessels only if the loss is due to an Act of God, an act of war, the result of a collision, or otherwise not an intentional act of the vessel s owner. These rules would restrict our ability to replace our vessels on account of obsolescence and, accordingly, could cause us to incur increased costs of maintaining our vessels, including the substantial loss of capacity during times of such maintenance and rebuilding. We may be required to pay significant damages in connection with litigation that is pending against us. A pending lawsuit against us could require us to pay significant damages, which could have a material adverse effect on our business, results of operations or financial condition. See Business Litigation. We may be adversely affected by an IRS audit. The IRS has opened an audit of ASG with respect to tax year 2001. We do not know what issues will be raised in the course of this audit and such audit could result in adjustments that could have a material adverse effect on our financial condition. We may incur material costs associated with compliance with environmental regulations. We are subject to foreign, federal, state, and local environmental regulations, including those governing discharges to water, the management, treatment, storage and disposal of hazardous substances, and the Table of Contents remediation of contamination. If we do not fully comply with environmental regulations, or if a release of hazardous substances occurs at or from one of our facilities or vessels, we may be subject to penalties and could be held liable for the cost of remediation. For example, an accident involving one of our vessels could result in significant environmental liability, including fines and penalties and remediation costs. If we are subject to these penalties or costs, we may not be covered by insurance, or any insurance coverage that we do have may not cover the entire cost. Compliance with environmental regulations could require us to make material capital expenditures and could have a material adverse effect on our results of operations and financial condition. We produce and distribute food products that are susceptible to contamination and, as a result, we face the risk of exposure to product liability claims and damage to our reputation. As part of the fish processing, small pieces of metal or other similar foreign objects may enter into some of our products. Additionally, our fish products are vulnerable to contamination by disease-producing organisms or pathogens. Shipments of products that contained foreign objects or were so contaminated could lead to an increased risk of exposure to product liability claims, product recalls, adverse public relations and increased scrutiny by federal and state regulatory agencies. If a product liability claim were successful, our insurance might not be adequate to cover all the liabilities we would incur, and we might not be able to continue to maintain such insurance, or obtain comparable insurance at a reasonable cost, if at all. If we did not have adequate insurance or contractual indemnification available, product liability claims relating to defective products could significantly increase our operating costs. In addition, even if a product liability claim was not successful or was not fully pursued, the negative publicity surrounding any such assertion could harm our reputation with our customers. Our operations are labor intensive, and our failure to attract and retain qualified employees may adversely affect us. The segments of the harvesting and processing industry in which we compete are labor intensive and require an adequate supply of qualified production workers willing to work in rough weather and potentially dangerous operating conditions at sea. Some of our operations have from time to time experienced a high rate of employee turnover and could continue to experience high turnover in the future. Labor shortages, the inability to hire or retain qualified employees or increased labor costs could have a material adverse effect on our ability to control expenses and efficiently conduct our operations. We may not be able to continue to hire and retain the sufficiently skilled labor force necessary to operate efficiently and to support our operating strategies, or we may not continue to experience favorable labor relations. In addition, our labor expenses could increase as a result of a continuing shortage in the supply of personnel. Changes in applicable state and federal laws and regulations could increase labor costs, which could have a material adverse effect on our business, results of operations and financial condition. Table of Contents
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+RISK FACTORS You should carefully consider the risk factors set forth below as well as the other information contained in this prospectus before deciding whether to participate in the exchange offer. The risks described below are not the only risks facing us. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial may also materially and adversely affect our business operations. Any of the following risks could materially and adversely affect our business, financial condition or results of operations. In such case, you may lose all or part of your original investment. Risks Relating to the Exchange Offer If you fail to exchange your old securities, they may continue to be restricted securities and may become less liquid. Old securities that you do not tender or we do not accept may, following the exchange offer, continue to be restricted securities. You may not offer or sell untendered old securities except pursuant to in exemption from, or in a transaction not subject to, the Securities Act and applicable state securities laws. We will issue new securities in exchange for the old securities pursuant to the exchange offer only following the satisfaction of the procedures and conditions described elsewhere in this prospectus. These procedures and conditions include timely receipt by the exchange agent of the old securities and of a properly completed and duly executed letter of transmittal for your securities. Because we anticipate that most holders of old securities will elect to exchange their old securities, we expect that the liquidity of the market for any old securities remaining after the completion of the exchange offer may be substantially limited. Any old security tendered and exchanged in an exchange offer will reduce the aggregate principal amount of the old securities of that class outstanding. Risks Relating to the Securities Your ability to transfer the registered securities may be limited by the absence of a trading market. There is no established trading market for the securities, and the securities will not be listed on any securities exchange or quoted on any automated dealer quotation system. CSFB intends to make a market in the securities, but it is not obligated to do so. Accordingly, we cannot ensure that a liquid market will develop for any of the securities, that you will be able to sell your securities at a particular time or that the prices that you receive when you sell will be favorable. In addition, CSFB is not obligated to make a market and any such market-making may be interrupted or discontinued at any time without notice. In addition, such market-making activity will be subject to the limits imposed by the Securities Act and the Exchange Act. Future trading prices of the securities or the registered securities will depend upon many factors, including, our operating performance and financial condition, prevailing interest rates and the market for similar securities. Historically, the market for noninvestment grade debt has been subject to disruptions that have caused substantial volatility in the prices of securities similar to the securities. Any such disruptions may adversely affect the ability of holders of securities to dispose of them for a profit or at all. Our substantial indebtedness could adversely affect our financial health and prevent us from fulfilling our obligations under the securities. We have a significant amount of indebtedness. As of November 30, 2003, we had total indebtedness of $433.2 million and had $62.8 million of additional borrowings available under our senior credit facility, based on our borrowing base availability and after excluding $2.3 million of letters of credit outstanding under that facility. In addition, subject to the restrictions in our senior credit facility and the indentures governing the securities and our senior subordinated notes, we may incur significant additional indebtedness from time to time. ADDITIONAL REGISTRANTS Exact name of registrant as specified in its charter Our substantial indebtedness could have important consequences to you. For example, it could: make it more difficult for us to satisfy our obligations with respect to the securities; increase our vulnerability to general adverse economic and industry conditions; require us to dedicate a substantial portion of our cash flow from operations to payments on our indebtedness, thereby reducing the availability of our cash flow to fund working capital, capital expenditures and other general corporate needs; limit our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate; result in higher interest expense in the event of increases in interest rates as some of our debt is, and will continue to be, at variable rates of interest; place us at a competitive disadvantage compared to our competitors that have less debt; and limit our ability to borrow additional funds. In addition, the indentures governing the securities and our senior subordinated notes and our senior credit facility contain restrictive covenants that limit our ability to engage in activities that may be in our long-term best interests. These covenants limit or restrict our ability to: incur additional indebtedness; create liens; pay dividends or make other equity distributions; purchase or redeem capital stock; make investments; sell assets; incur restrictions on the ability of subsidiaries to make dividends or distributions; engage in transactions with affiliates; and effect a consolidation or merger. These limitations and restrictions may adversely affect our ability to finance our future operations or capital needs or engage in other business activities that may be in our best interests. In addition, our senior credit facility requires us to comply with certain financial ratios and our ability to borrow under it is subject to borrowing base requirements. Our ability to comply with these ratios may be affected by events beyond our control. If we breach any of the covenants in our senior credit facility or our indentures, or if we are unable to comply with the required financial ratios, we may be in default under our senior credit facility or our indentures. If we default, the holders of the securities or lenders under our senior credit facility could declare all borrowings owed to them, including accrued interest and other fees, to be due and payable. If we were unable to repay the borrowings under our senior credit facility when due, the lenders under the senior credit facility could also proceed against the collateral granted to them, which could result in the holders of the securities receiving less, ratably, than those lenders. See "Risk Factors Your right to receive payments on the securities is effectively subordinated to the rights of our existing and future secured creditors," "Description of Certain Indebtedness" and "Description of Registered Securities." State or other jurisdiction of incorporation or organization We may not be able to service our debt without the need for additional financing, which we may not be able to obtain on satisfactory terms, if at all. Our ability to pay or to refinance our indebtedness, including the securities, will depend upon our future operating performance, which will be affected by general economic, financial, competitive, legislative, regulatory, business and other factors beyond our control. We cannot assure you that our business will generate sufficient cash flow from operations, that currently anticipated revenue growth and operating improvements will be realized or that future borrowings will be available to us in amounts sufficient to enable us to pay our indebtedness, including the securities, or to fund our other liquidity needs. If we are unable to meet our debt service obligations or fund our other liquidity needs, we could attempt to restructure or refinance our indebtedness or seek additional equity capital. We cannot assure you that we will be able to accomplish those actions on satisfactory terms, if at all. We will require a significant amount of cash to service our indebtedness. Our ability to generate cash depends on factors beyond our control. Our ability to make payments on our indebtedness, including our senior credit facility and the securities, and to fund our business initiatives will depend on our ability to generate cash in the future. This, to a certain extent, is subject to general economic, financial, competitive, legislative, regulatory and other factors that are beyond our control. We cannot assure you that our business will generate sufficient cash flow from operations or that future borrowings will be available to us under our senior credit facility in an amount sufficient to enable us to service our indebtedness, including our senior credit facility and the securities, or to fund our other liquidity needs. We may need to refinance all or a portion of our indebtedness, including our senior credit facility and the securities, on or before maturity. We cannot assure you that we will be able to refinance any of our indebtedness, including our senior credit facility or the securities, on commercially reasonable terms or at all. Your right to receive payments on the notes is effectively subordinated to the rights of our existing and future secured creditors. Furthermore, the guarantees of the notes are effectively subordinated to all our guarantors' existing and future secured indebtedness. Holders of our secured indebtedness and the guarantor's secured indebtedness will have claims that are prior to your claims as holders of the securities to the extent of the value of the assets securing that other indebtedness. Holdings, our company and the guarantors of the securities are parties to our senior credit facility, which is secured by liens on our outstanding capital stock and substantially all of our and our subsidiaries' property and assets. The securities will be effectively subordinated to all that indebtedness to the extent of the related security. In the event of any distribution or payment of our assets in any foreclosure, dissolution, winding-up, liquidation, reorganization or other bankruptcy proceeding, holders of secured indebtedness will have a prior claim to those of our assets that constitute their collateral. Holders of the securities will participate ratably with all holders of our unsecured indebtedness that is deemed to be of the same class as the securities or which is not expressly subordinated to the securities, and potentially with all of our other general creditors, based upon the respective amounts owed to each holder or creditor, in our remaining assets. In any of the foregoing events, we cannot assure you that there will be sufficient assets to pay amounts due on the securities. As a result, holders of the securities may receive less, ratably, than holders of secured indebtedness. As of November 30, 2003, the aggregate amount of our secured indebtedness and the secured indebtedness of our subsidiaries was approximately $17.5 million, and approximately $62.8 million would have been available for additional borrowing under our senior credit facility, after excluding Primary Standard Industrial Classification Code Number $2.3 million of letters of credit outstanding under that facility. See "Description of Certain Indebtedness Senior Credit Facility." We may not have the ability to raise the funds necessary to finance the change of control offer required by the indenture. Upon the occurrence of certain specific kinds of change of control events, the indenture governing the securities requires us to offer to repurchase all outstanding securities at 101% of the principal amount thereof plus accrued and unpaid interest and liquidated damages, if any, to the date of repurchase. However, it is possible that we will not have sufficient funds at the time of the change of control to make the required repurchase of the securities. Moreover, our senior credit facility prohibits our repurchase of the securities upon a change of control and our senior notes limit our ability to repurchase the securities upon a change of control. Additionally, the occurrence of a change of control may require us to repay our senior credit facility and the senior subordinated notes. See "Description of Registered Securities Repurchase at the Option of Holders." Your right to require us to redeem the securities is limited. The holders of securities have limited rights to require us to purchase or redeem the securities in the event of a takeover, recapitalization or similar restructuring, including an issuer recapitalization or similar transaction with management. Consequently, the change of control provisions of the indenture for the securities will not afford any protection in a highly leveraged transaction, including such a transaction initiated by us, if such transaction does not result in a change of control or otherwise result in an event of default under the securities indenture. Accordingly, the change of control provision is likely to be of limited usefulness in such situations. Federal and state statutes allow courts, under specific circumstances, to void guarantees and require note holders to return payments received from guarantors. Under the federal bankruptcy law and comparable provisions of state fraudulent transfer laws, a guarantee could be voided, or claims in respect of a guarantee could be subordinated to all other debts of the guarantor if, among other things, the guarantor, at the time it incurred the indebtedness evidenced by its guarantee: received less than reasonably equivalent value or fair consideration for the incurrence of such guarantee; and was insolvent or rendered insolvent by reason of such incurrence; or was engaged in a business or transaction for which the guarantor's remaining assets constituted unreasonably small capital; or intended to incur, or believed that it would incur, debts beyond its ability to pay such debts as they mature. In addition, any payment by that guarantor pursuant to its guarantee could be voided and required to be returned to the guarantor, or to a fund for the benefit of the creditors of the guarantor. The measures of insolvency for purposes of these fraudulent transfer laws will vary depending upon the law applied in any proceeding to determine whether a fraudulent transfer has occurred. Generally, however, a guarantor would be considered insolvent if: the sum of its debts, including contingent liabilities, was greater than the fair saleable value of all of its assets; I.R.S. Employer Identification Number the present fair saleable value of its assets was less than the amount that would be required to pay its probable liability on its existing debts, including contingent liabilities, as they become absolute and mature; or it could not pay its debts as they become due. On the basis of historical financial information, recent operating history and other factors, we believe that each guarantor, after giving effect to its guarantee of the securities, will not be insolvent, will not have unreasonably small capital for the business in which it is engaged and will not have incurred debts beyond its ability to pay such debts as they mature. We cannot assure you, however, as to what standard a court would apply in making these determinations or that a court would agree with our conclusions in this regard. Risks Relating to Our Business We have a narrow product range and our business would suffer if our products become obsolete or consumption of them decreased. We derive a significant portion of our net sales from customers in the business of publishing textbooks intended for the ELHI and college markets. Therefore, we are dependent upon the sale of books to these markets. Our business would suffer if consumption of these products decreased or if these products became obsolete. Our business could be adversely affected by factors such as changes in the funding of large institutional users of books such as elementary and high schools and colleges and universities. Our results of operations are dependent on our principal production facility for four-color educational textbooks. Approximately 50% of our net sales and 53% of our earnings before interest, taxes, depreciation and amortization for 2002 were generated from our Jefferson City, Missouri production facility where we manufacture, among other products, our four-color educational textbooks. Any disruption of our production capabilities at this facility for a significant term could adversely effect our operating results. While we maintain levels of insurance we believe to be adequate to protect against significant interruption in operations at our Jefferson City facility, there is no assurance that any proceeds from insurance would be sufficient to return such facility to operational status or that we could relocate our operations from such facility without incurring significant costs, including the possible loss of customers during any period during which production is interrupted. Our business is subject to seasonal and cyclical fluctuations in sales. We experience seasonal fluctuations in our sales. The seasonality of the ELHI market is significantly influenced by state and local school book purchasing schedules, which commence in the spring and peak in the summer months preceding the start of the school year. The college textbook market is also seasonal with the majority of textbook sales occurring during June through August and November through January. Significant amounts of inventory are acquired by publishers prior to those periods in order to meet customer delivery requirements. This places significant pressure on publishers and textbook manufacturers to monitor production and distribution accurately to satisfy these delivery requirements. We also experience cyclical fluctuations in our sales. The cyclicality of the ELHI market is primarily attributable to the textbook adoption cycle. Industry sales volume gains or losses in any year are principally due to shifts in adoption schedules and the availability of state and local government funding. Numerous states and localities are under budgetary constraints and are currently addressing deficit positions, which could result in short term funding reductions for these materials and may delay Address, including zip code, and telephone number, including area code, of registrant's principal executive office* future adoptions. To a lesser extent, the cyclicality of our business is also attributable to fluctuations in paper prices. Actual or perceived changes in paper prices will result in fluctuations in purchases by our customers and, accordingly, impact our sales in a given year. Lower than expected sales by us during the adoption period or a general economic downturn in our market or industry could have a material adverse effect on the timing of our cash flows and, therefore, on our ability to service our obligations with respect to the securities and our other indebtedness. See "Business The Instructional Materials Industry." Any problem or interruption in our supply of paper or other raw materials could delay production and adversely affect our sales. We rely on independent suppliers for key raw materials, principally paper, ink, bindery materials and adhesives, which may be available only from limited sources. Although supplies of our raw materials currently are adequate, shortages could occur in the future due to interruption of supply or increased industry demand. In addition, we do not have long-term contracts with any of our suppliers. We cannot assure you that these suppliers will continue to provide raw materials to us at attractive prices, or at all, or that we will be able to obtain such raw materials in the future from these or other providers on the scale and within the time frames we require. Although we believe we can obtain paper and other raw materials from alternate suppliers, any failure to obtain such raw materials on a timely basis at an affordable cost, or any significant delays or interruptions of supply could have a material adverse effect on our business, financial condition and results of operations. A significant amount of our business comes from a limited number of customers and our revenue and profits could decrease significantly if we lose one or more of them as customers. Our business depends on a limited number of customers. Our customers include, among others, approximately 50 autonomous divisions of the four major educational textbook publishers. Each of these divisions maintains its own manufacturing relationships and generally makes textbook manufacturing decisions independently of other divisions. Combining division sales, these four publishers accounted for approximately 42% of our net sales during 2002. We do not have long-term contracts with any of these customers. Accordingly, our ability to retain or increase our business often depends upon our relationships with each customer's divisional managers and senior executives. One or more of these customers may stop buying textbook manufacturing from us or may substantially reduce the amount of textbooks we manufacture for it. Any cancellation, deferral or significant reduction in manufacturing sold to these principal customers or a significant number of smaller customers could seriously harm our business, financial condition and results of operations. We operate in a very competitive business environment. Competition in our industry is intense. In particular, the educational textbook manufacturing market is concentrated and is served by large national printers and smaller regional printers. Because of greater resources, some of our competitors may be able to adapt more quickly to new or emerging technologies and changes in customer requirements or to devote greater resources to the promotion and sale of their products than we can. Since the textbook manufacturing process represents a small percentage of the total cost to publish a textbook, providers of textbook manufacturing have traditionally competed on the bases of quality of product, customer service, availability of printing time on appropriate equipment, timeliness of delivery and, to a lesser extent, price. We believe that maintaining a competitive advantage will require continued investment by us in product development, manufacturing capabilities and sales and marketing. We cannot assure you that we will have sufficient resources to make the necessary investments to do so, and we cannot assure you that we will be able to Registration No. compete successfully in our market or against our competitors. Accordingly, new competitors may emerge and rapidly acquire market share. See "Business Competition." If we do not retain our key personnel and attract and retain other highly skilled employees, our business could suffer. If we fail to retain and recruit the necessary personnel, our business and our ability to obtain new customers, maintain the quality of our products and provide acceptable levels of customer service could suffer. The success of our business depends heavily on the leadership of our senior management personnel and certain other key employees. If any of these persons were to leave our company, it could be difficult to replace them and our business could be harmed. See "Management." Our success also depends on our ability to recruit, retain and motivate highly skilled personnel. We believe that our success is attributable largely to the experience and stability of our labor force and our experienced and relatively stable workforce is one of our most significant assets, As our workforce ages and retirements occur, we may need to replace a significant portion of our skilled labor. Competition for these persons is intense, and we may not be successful in recruiting, training or retaining qualified personnel. Our productivity and growth depends on our ability to attract and retain additional qualified employees, and our failure to replace or expand our existing employee base could have a material adverse effect on our ability to grow. Our ultimate principal shareholder's interests may conflict with yours. DLJ Merchant Banking beneficially owns approximately 98.8% of Holdings' outstanding common stock. Holdings owns 100% of Von Hoffmann's common stock. As a result, DLJ Merchant Banking is in a position to control all matters affecting us, and may authorize actions or have interests that could conflict with your interests. DLJ Merchant Banking is an affiliate of CSFB. We could face considerable business and financial risk in implementing our acquisition strategy. As part of our growth strategy, we intend to consider acquiring complementary businesses. We cannot assure you that future acquisition opportunities will exist or, if they do, that we will be able to finance those opportunities. The indenture governing the securities and the senior subordinated notes and our senior credit facility contain covenants that limit our ability to incur additional indebtedness which could limit our ability to finance such acquisitions. Future acquisitions could result in us incurring debt and contingent liabilities or incurring impairment charges with respect to goodwill. Risks we could face with respect to acquisitions also include: difficulties in the integration of the operations, technologies, products and personnel of the acquired company; risks of entering markets in which we have no or limited prior experience; risks relating to potential unknown liabilities associated with acquired business; potential loss of employees; diversion of management's attention away from other business concerns; and expenses of any undisclosed or potential legal liabilities of the acquired company. The risks associated with acquisitions could have a material adverse effect upon our business, financial condition and results of operations. We cannot assure you that we will be successful in consummating future acquisitions on favorable terms or at all. H & S Graphics, Inc Delaware 27962 36-4228578 3640 Edison Place Rolling Meadows, IL 60008 (847) 506-9800 333-112031-03 The Lehigh Press, Inc. Pennsylvania 2752 23-1417330 701 North Park Drive Pennsauken, New Jersey 08109 (856) 665-5200 333-112031-01 Precision Offset Printing Company Delaware 27323 23-1354890 133 Main Street Leesport, PA 19533 (610) 926-3900 333-112031-02 If we are unable to successfully integrate the Lehigh Press business into our business, or if upon integration we fail to realize the expected cost savings of the combination, our operations could be disrupted and may suffer. Our acquisition of the Lehigh Press business has significantly increased the size and geographic scope of our operations. Our management's attention will be focused, in part, on the integration process for the foreseeable future. Our ability to integrate the Lehigh Press business with our existing business will be critical to the future success of our business. Our integration strategies are subject to numerous conditions beyond our control, including the possibility of negative reactions by existing customers or employees or adverse general and regional economic conditions, general negative industry trends and competition. We also may be unable to achieve the anticipated synergies and benefits from the Lehigh Press acquisition. If we are unable to realize these anticipated benefits due to our inability to address the challenges of integrating the Lehigh Press business or for any other reason, it could have a material adverse effect on our business and financial and operating results. We may be required to make significant capital expenditures in order to remain technologically and economically competitive. Production technology in the printing industry has evolved and continues to evolve. Although we have invested approximately $90.0 million in equipment and plant expansions (excluding equipment obtained in acquisitions) over the past five years and do not currently forecast any further major expenditure, the emergence of any significant technological advances utilized by competitors could require us to invest significant capital in additional production technology in order to remain competitive. We cannot assure you that we would be able to fund any such investments. Our failure to invest in new technologies could have a material adverse effect on our business, financial condition or results of operations. We are subject to significant environmental regulation and environmental compliance expenditures and liabilities. Our businesses are subject to many environmental and health and safety laws and regulations, particularly with respect to the generation, storage, transportation, disposal, release and emission into the environment of various substances. We believe we are in substantial compliance with these laws. Compliance with these laws and regulations is a significant factor in our business. Some or all of the environmental laws and regulations to which we are subject could become more stringent or more stringently enforced in the future and more stringent laws or regulations could be enacted. Our failure to comply with applicable environmental laws and regulations and permit requirements could result in civil or criminal fines or penalties or enforcement actions, including regulatory or judicial orders enjoining or curtailing operations or requiring corrective measures, installation of pollution control equipment or remedial actions. Some environmental laws and regulations impose liability and responsibility on present and former owners, operators or users of facilities and sites for contamination at such facilities and sites without regard to causation or knowledge of contamination. In addition, we occasionally evaluate various alternatives with respect to our facilities, including possible dispositions or closures. Investigations undertaken in connection with these activities may lead to discoveries of contamination that must be remediated, and closures of facilities may trigger compliance requirements that are not applicable to operating facilities. Consequently, we cannot assure you that existing or future circumstances or developments with respect to contamination will not require significant expenditures by us. Balances, December 31, 2002 $ *Name, address, including zip code, and telephone number, including area code, for agent of service of process for each of the Additional Registrants is Gary C. Wetzel at 1000 Camera Avenue, St. Louis, MO 63126, (314) 966-0909. EXPLANATORY NOTE This Registration Statement covers the registration of an aggregate principal amount of $60,000,000 of new 101/4% Senior Notes due 2009 of Von Hoffmann Corporation and related guarantees (collectively, the "New Securities") that may be exchanged for an equal principal amount of outstanding 101/4% Senior Notes due 2009 of Von Hoffmann Corporation and related guarantees. The registered notes will be, and the outstanding notes are, guaranteed by Von Hoffmann Holding Inc. and each of the additional registrants listed above under "Additional Registrants." This Registration Statement also covers the registration of the New Securities for resale by Credit Suisse First Boston Corporation and its affiliates that are affiliates of the registrants in market-making transactions. In addition, this Registration Statement is being filed as a post-effective amendment to Registration No. 333-90992. That Registration Statement (the "Earlier Registration Statement") covers the registration of $275,000,000 of 101/4% Senior Notes due 2009 and $100,000,000 of 103/8% Senior Subordinated Notes due 2007 of Von Hoffmann Corporation and $41,901,020 131/2% Subordinated Exchange Debentures due 2009 of Von Hoffmann Holdings Inc. for resale by Credit Suisse First Boston Corporation and its affiliates that are affiliates of the registrants in market-making transactions. The post effective amendment is being filed in accordance with Rule 429 of the Securities Act of 1933 to reflect the filing of a combined prospectus in this Registration Statement covering the resale of the New Securities and the resale of the securities registered under the Earlier Registration Statement. This Registration Statement accordingly contains two prospectuses, one relating to the exchange offer for the New Securities and the other relating to market-making transactions by Credit Suisse First Boston and its affiliates that are affiliates of the registrants covering both the resale of the New Securities and the securities registered under the Earlier Registration Statement. The complete prospectus to be used in the exchange offer follows immediately after this Explanatory Note. Following that are certain pages of the prospectus relating solely to market-making transactions, including alternate front and back cover pages, an alternate "Summary of the Terms of the Registered Securities" section, a section entitled "Risk Factors Risks Relating to the Senior Notes, the Senior Subordinated Notes and the Subordinated Exchange Debentures" to be used in lieu of the section entitled "Risk Factors Risks Relating to the Securities," and alternate "Plan of Distribution" and "Material United States Federal Income Tax Consequences" sections. In addition, the market making prospectus will include the following captions "Description of Registered Securities 103/8% Senior Subordinated Notes due 2007 and 131/2% Subordinated Exchange Debentures due 2009." In addition, the market-making prospectus will not include the following captions (or the information set forth under the captions) in the exchange offer prospectus: "Summary of the Terms of the Exchange Offer," "The Exchange Offer" "Description of Certain Indebtedness Senior Subordinated Notes and Subordinated Exchange Debentures." All other sections of the exchange offer prospectus will be included in the market-making prospectus.
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+RISK FACTORS In addition to the other information contained in this prospectus, the following factors should be considered carefully before investing in the IDSs (including the Class A common stock and senior subordinated notes represented thereby) or our senior subordinated notes. If any of the following risks actually occur, our business, results of operations or financial condition would likely suffer. Risks Relating to the IDSs, the Shares of Class A Common Stock and the Senior Subordinated Notes Represented by the IDSs, and the Senior Subordinated Notes Offered Separately Buffets Holdings is a holding company and relies on dividends, interest and other payments, advances and transfer of funds from its subsidiaries to meet its debt service and other obligations. Buffets Holdings has no direct operations and no significant assets other than ownership of 100% of the stock of Buffets, all of which will be pledged to the creditors under the Amended Credit Facility which Buffets Holdings guarantees. Because Buffets Holdings conducts its operations through its direct and indirect subsidiaries, Buffets Holdings depends on those entities for dividends and other payments to generate the funds necessary to meet its financial obligations, including payments of principal and interest on the senior subordinated notes, and to pay dividends with respect to the common stock. Legal and contractual restrictions in the Amended Credit Facility, the indenture governing Buffets Senior Notes and other agreements governing current and future indebtedness of Buffets Holdings subsidiaries, as well as the financial condition and operating requirements of Buffets Holdings subsidiaries, may limit Buffets Holdings ability to obtain cash from its subsidiaries. The earnings from, or other available assets of, Buffets Holdings subsidiaries may not be sufficient to pay dividends or make distributions or loans to enable Buffets Holdings to make payments in respect of the senior subordinated notes when such payments are due and to pay dividends on the common stock. Your rights as holders of the senior subordinated notes and guarantees thereof to receive payments will be contractually subordinated to those of holders of our senior indebtedness and may be otherwise adversely affected in the event of our bankruptcy. As a result of the subordinated nature of the senior subordinated notes and related guarantees, upon any distribution to our creditors or the creditors of the subsidiary guarantors in bankruptcy, liquidation or reorganization or similar proceeding relating to Buffets Holdings or the subsidiary guarantors or Buffets Holdings or their property, the holders of Buffets Holdings senior indebtedness and senior indebtedness of the subsidiary guarantors will be entitled to be paid in full in cash before any payment may be made with respect to the senior subordinated notes or the subsidiary guarantees. Holders of the senior subordinated notes would then participate with all other holders of unsecured senior subordinated indebtedness of Buffets Holdings or the subsidiary guarantors similarly subordinated in the assets remaining after Buffets Holdings and the subsidiary guarantors have paid all senior indebtedness. Buffets Holdings and the subsidiary guarantors may not have sufficient funds to pay all of our creditors, and holders of our senior subordinated notes may receive less, ratably, than the holders of senior indebtedness, and because of the obligation to turn over distributions to holders of senior indebtedness, the holders of the notes may receive less, ratably, than trade payables and other general unsecured indebtedness. Further, in the event of such bankruptcy proceedings, a party in interest may seek to subordinate the senior subordinated notes to all creditors under principles of equitable subordination or to recharacterize the senior subordinated notes as equity. If such a subordination or recharacterization did occur, you may not recover any amounts owing on the senior subordinated notes or the guarantees and you might be required to return any payments made to you on account of the senior subordinated notes up to six years prior to our bankruptcy. As of June 30, 2004, on a pro forma basis, the senior subordinated notes and the subsidiary guarantees would have ranked junior, on a consolidated basis, to approximately $ million of indebtedness, including borrowings under the Amended Credit Facility and Buffets Senior Notes. In addition, as of June 30, 2004, on a pro forma basis, we would have had the ability to borrow up to an 23 .3* Consent of Faegre Benson LLP (included in Exhibit 5.2 to this Registration Statement). 10 .13** Severance Protection Agreement, dated September 29, 2000, between Buffets, Inc. and Jean C. Rostollan (incorporated by reference to Exhibit 10.9.1 to Buffets, Inc. s Annual Report on Form 10-K filed with the Commission on September 30, 2003 (SEC file No. 033-00171)). 12 .1 Statement of Computation of Ratios of Earnings to Fixed Charges. 21 List of Subsidiaries of Buffets Holdings, Inc. 23 .1 Consent of Deloitte Touche LLP. 23 .2* Consent of Paul, Weiss, Rifkind, Wharton Garrison LLP (included in Exhibits 5.1 and 8.1 to this Registration Statement). 23 .3* Consent of Faegre Benson LLP (included in Exhibit 5.2 to this Registration Statement). Table of Contents BUFFETS HOLDINGS, INC. TABLE OF ADDITIONAL REGISTRANTS Primary Standard IRS Jurisdiction of Industrial Employer Incorporation or Classification Identification Name Organization Number Number Table of Contents additional amount of $ million under the Amended Credit Facility (less amounts reserved for letters of credit), which would have ranked senior in right of payment to the senior subordinated notes. Payments on the senior subordinated notes may be blocked if we default under senior indebtedness, including the Amended Credit Facility. If we default in the payment of any of our senior indebtedness, including the Amended Credit Facility and Buffets Senior Notes, we will not make any payments on the senior subordinated notes until the payment default has been cured or waived. In addition, even if we are making payments on our senior indebtedness on a timely basis, payments on the senior subordinated notes may be blocked for up to 180 days if we default on our senior indebtedness in some other manner. During any period in which payments on the senior subordinated notes are prohibited or blocked in this manner, we and the guarantors will be prohibited from making any payments in respect of the senior subordinated notes and the guarantees. Claims of noteholders will be structurally subordinated to claims of creditors of all of our existing and future unrestricted subsidiaries, all of which will not guarantee the senior subordinated notes. The senior subordinated notes will not be guaranteed by any of our current or future unrestricted subsidiaries. Our unrestricted subsidiaries are separate and distinct legal entities and have no obligation, contingent or otherwise, to pay any amounts due pursuant to the senior subordinated notes, or to make any funds available therefor, whether by dividends, loans, distributions or other payments. Any right that we or the guarantors have to receive any assets of any of the unrestricted subsidiaries upon the liquidation or reorganization of those subsidiaries, and the consequent rights of holders of senior subordinated notes to realize proceeds from the sale of any of those subsidiaries assets, will be structurally subordinated to the claims of that subsidiaries creditors, including trade creditors and holders of debt of those subsidiaries. Our substantial level of indebtedness could adversely affect our financial condition and prevent us from fulfilling our obligations under the senior subordinated notes. We have substantial indebtedness. As of June 30, 2004, on a pro forma basis, we would have had $ million of total indebtedness. Our ability to make distributions, pay dividends or make other payments will be subject to applicable law and contractual restrictions contained in the instruments governing any indebtedness of ours and our subsidiaries, including the Amended Credit Facility and Buffets Senior Notes. Our level of debt could have negative consequences to you and to us. For example, it could: make it more difficult for us to satisfy our obligations with respect to the senior subordinated notes; increase our vulnerability to general adverse economic and industry conditions, as well as increases in interest rates; limit our ability to fund future working capital, capital expenditures, debt service and general corporate requirements; require us to dedicate a substantial portion of our cash flow from operations to the payments on our indebtedness, thereby reducing the availability of our cash flow to fund working capital, capital expenditures and other general corporate purposes; place us at a competitive disadvantage compared to our competitors that have less debt; limit our ability to borrow additional funds; limit our ability to refinance our debt on terms acceptable to us or at all; make it more difficult to comply with the covenants in the indentures relating to our senior subordinated notes and Buffets Senior Notes and the amended credit agreement relating to the Table of Contents Amended Credit Facility, which could in turn result in an event of default under our indebtedness, which, if not cured or waived, could have a material adverse effect on us; and limit our flexibility in planning for, or reacting to, changes in our business and future business opportunities. Servicing our debt will require a significant amount of cash. Our subsidiaries ability to generate sufficient cash depends on numerous factors which are beyond our control and we may be unable to generate sufficient cash flow to service our debt obligations, including making payments on the senior subordinated notes, and to pay dividends on the common stock. Our ability to pay our expenses, principal and interest on the senior subordinated notes and other debt, and dividends on the common stock depends on our ability to generate positive cash flow in the future, which is subject to general economic, financial, competitive, legislative and regulatory factors and other factors that are beyond our control. Our subsidiaries operations may not generate sufficient cash flow from operations and future borrowings may not be available under the Amended Credit Facility in amounts sufficient to enable us or our subsidiaries to make payments in respect of the senior subordinated notes, to pay our other debt, to pay dividends on the common stock or to fund other liquidity needs. If our subsidiaries do not have sufficient cash flow from operations, Buffets Holdings or our subsidiaries may be required to incur additional indebtedness, refinance all or part of our existing debt or sell assets. If Buffets Holdings or our subsidiaries are required to refinance existing debt, or if Buffets Holdings or our subsidiaries are required to sell some of our assets, we may not be able to do so on terms that are acceptable to us or at all. In addition, the terms of existing or future debt agreements, including the indenture governing Buffets Senior Notes and the Amended Credit Facility, may restrict Buffets Holdings or our subsidiaries from effecting any of these alternatives or we may fail for other reasons. If we are required to pursue other alternatives, the value of the senior subordinated notes and the common stock, and our financial condition, could be significantly adversely affected. Despite our current leverage, we may still be able to incur substantially more debt. This could further exacerbate the risks that we and our subsidiaries face. We, including our subsidiaries, may be able to incur substantial additional indebtedness in the future. For example, the Amended Credit Facility will provide commitments of up to $ million, $ million of which would have been available for future borrowings as of June 30, 2004, on a pro forma basis, subject to the aggregate borrowing base availability and net of $ million in outstanding letters of credit. All of such indebtedness would have been secured and effectively senior to the senior subordinated notes. If we incur any additional indebtedness that ranks equally with the senior subordinated notes, the holders of that debt will be entitled to share ratably with the holders of the senior subordinated notes in any proceeds distributed in connection with any insolvency, liquidation, reorganization, dissolution or other winding-up of us. This may have the effect of reducing the amount of proceeds paid to you. If additional indebtedness is added to our or our subsidiaries current levels of indebtedness, the substantial risks described above would intensify. If we or our subsidiaries default on our or their obligations to pay our or their indebtedness, or fail to comply with other covenants thereunder, we may not be able to make payments on the senior subordinated notes and the common stock. If we or our subsidiaries are unable to generate sufficient cash flow and are otherwise unable to obtain funds necessary to meet required payments on our or their indebtedness, or if we or our subsidiaries otherwise fail to comply with the various covenants, including financial and operating covenants, in the instruments governing our or their indebtedness (including the Amended Credit Facility and our guarantee Table of Contents thereof and the indenture governing Buffets Senior Notes), we or they could be in default under the terms of the agreements governing such indebtedness. In the event of such default: the holders of such indebtedness could elect to declare all the funds borrowed thereunder to be due and payable, together with accrued and unpaid interest and liquidated damages, if any. The lenders under the Amended Credit Facility could elect to terminate their commitments, cease making further loans and institute foreclosure proceedings against our or our subsidiaries assets. We could directly or indirectly be prohibited from paying principal, premium, if any, and interest on the senior subordinated notes, and dividends with respect to the common stock, and we or our subsidiaries could be forced into bankruptcy or liquidation. We will be subject to restrictive covenants in our debt agreements that may limit our ability to pursue strategies that may otherwise improve our business. The indenture governing the senior subordinated notes, the indenture governing Buffets Senior Notes and the Amended Credit Facility will impose significant operating and financial restrictions on us. These restrictions will limit our ability, among other things, to: incur additional indebtedness; acquire the assets of, or merge or consolidate with, other companies; pay dividends or make other distributions on our capital stock or repurchase, repay or redeem the senior subordinated notes, subordinated debt and our capital stock; make certain investments; incur liens; make capital expenditures; enter into certain types of transactions with our stockholders and affiliates; limit dividends or other payments by our restricted subsidiaries to us; and transfer or sell certain or all or substantially all of our assets. These covenants in the indenture governing the senior subordinated notes, the indenture governing Buffets Senior Notes and the Amended Credit Facility may impair our ability to finance future operations or capital needs or to enter into acquisitions or joint ventures or engage in other favorable business activities. If we default under the indenture governing the senior subordinated notes, the indenture governing Buffets Senior Notes or the Amended Credit Facility or we fail to satisfy the financial covenants under the Amended Credit Facility, we could directly or indirectly be prohibited from making any payments with respect to the IDSs or our senior subordinated notes. In addition, the lenders under the Amended Credit Facility and the holders of Buffets Senior Notes could require immediate repayment of the entire principal that is outstanding under those facilities or those notes. If those lenders or holders require immediate repayment, our assets may not be sufficient to repay them and also repay the senior subordinated notes in full. Our dividend policy may negatively impact our ability to finance capital expenditure or operation. Upon completion of this offering, our board of directors will adopt a dividend policy under which cash generated by our business in excess of operating needs, interest and principal payments on indebtedness, and capital expenditures sufficient to maintain our properties would in general be distributed as regular quarterly dividends to the holders of our Class A common stock and Class B common stock rather than retained by us and used to finance growth opportunities. As a result, we may not retain a sufficient amount of cash to finance growth opportunities or unanticipated capital expenditure needs or to fund our Table of Contents operations in the event of a significant business downturn. We may have to forgo growth opportunities or capital expenditures that would otherwise be necessary or desirable if we do not find alternative sources or financing. If we do not have sufficient cash for these purposes or if the $ million in cash on hand available for capital expenditures is insufficient, our financial condition and our business will suffer. Federal and state laws permit a court to void the senior subordinated notes or the subsidiary guarantees under certain circumstances. The issuance of the senior subordinated notes and the guarantees may be subject to review under United States federal bankruptcy law and comparable provisions of state fraudulent conveyance laws if a bankruptcy or reorganization case or lawsuit is commenced by or on behalf of our or the guarantor s unpaid creditors. A court could void the obligations under the senior subordinated notes or the guarantees, further subordinate the senior subordinated notes or the guarantees or take other action detrimental to holders of the senior subordinated notes, if, among other things, at the time the indebtedness was incurred, Buffets Holdings or the guarantors: issued the senior subordinated notes or the guarantees to delay, hinder or defraud present or future creditors; or received less than reasonably equivalent value or fair consideration for issuing the senior subordinated notes or the guarantees at the time of issuance of the senior subordinated notes or the guarantees and: were insolvent or rendered insolvent by reason of issuing the senior subordinated notes or the guarantees; were engaged, or about to engage, in a business or transaction for which the remaining unencumbered assets constituted unreasonably small capital to carry on our or the guarantor s business; or intended to incur, or believed that we or the guarantor would incur, debts beyond our or the guarantor s ability to pay as they mature. The measures of insolvency for purposes of fraudulent transfer laws vary depending upon the law of the jurisdiction that is being applied in any proceeding to determine whether a fraudulent transfer had occurred. It is not clear what standard a court would use to determine whether or not we or a guarantor were solvent at the relevant time. Generally, however, a person would be considered insolvent if, at the time it incurred the debt: the sum of its debts, including contingent liabilities, was greater than the fair saleable value of all of its assets; the present fair saleable value of its assets was less than the amount that would be required to pay its probable liability on its existing debts, including contingent liabilities, as they become absolute and mature; or it could not pay its debts as they become due. The proceeds of the offering will be used to repurchase a portion of Buffets Holdings common stock from our existing stockholders and to repurchase all of our outstanding 13 7/8% Notes and Buffets 11 1/4% Notes, which may subject the holders of our senior subordinated notes in this offering to the claim that we did not receive fair consideration for the senior subordinated notes issued in this offering. In the event that we meet any of the financial condition fraudulent transfer tests described above at the time of or as a result of this offering, a court could integrate the issuance of our senior subordinated notes with the distribution to our shareholders and the repurchase of Buffets 11 1/4% Notes, and, therefore, conclude that we did not get fair value for the offering viewed as an integrated transaction. In such a case, a court could hold the debt owed to the holders of our senior subordinated notes void or unenforceable or may subordinate it to the claims of other creditors. BALANCE, July 2, 2003 69 (44 ) 34 (21 ) 317 (25 ) 420 (90 ) FY 2004 Activity: Amortization (12 ) (8 ) (20 ) Additions 28 Table of Contents The guarantee of our senior subordinated notes by any subsidiary guarantor could be subject to the claim that, since the guarantee was incurred for the benefit of Buffets Holdings, and only indirectly for the benefit of the subsidiary guarantor, the obligations of the subsidiary guarantor were incurred for less than fair consideration. If such a claim were successful and it was proven that the subsidiary guarantor was insolvent at the time the guarantee was issued, a court could void the obligations of the subsidiary guarantor under the guarantee or subordinate these obligations to the subsidiary guarantor s other debt or take action detrimental to the holders of the senior subordinated notes. If the guarantee of any subsidiary guarantor were voided, our notes would be effectively subordinated to the indebtedness of that subsidiary guarantor. If we defease the senior subordinated notes, such defeasance may be subject to preferential transfer laws. The indenture relating to the senior subordinated notes will provide that we may, after complying with certain conditions, defease the senior subordinated notes and be released from our obligations under many of the covenants contained in the indenture, or discharge all our obligations under the indenture within a year of the maturity date or a redemption date. One of the conditions to such defeasance or discharge is that we deposit sufficient funds with the trustee to pay the principal, interest and premium on the outstanding senior subordinated notes through maturity or an applicable redemption date. If a bankruptcy or reorganization proceeding is initiated within the applicable preference period, which generally varies from 90 days to one year, the deposit would likely be subject to review under federal bankruptcy law and comparable provisions of state law. In such an event, a court may void the deposit of funds with the trustee as a preferential transfer and recover such funds for the benefit of the bankruptcy estate and/or otherwise order that the funds be made available to satisfy claims of other creditors. In addition, under the fraudulent conveyance laws described above, a court could also void the deposit of funds or take other actions detrimental to you. The indenture will permit us to finance the defeasance deposit by issuing secured debt that we would not otherwise be permitted to incur under the indenture. In the event that the payments used to defease the senior subordinated notes are found to be a preferential transfer or a fraudulent conveyance, any claims arising out of or relating to the senior subordinated notes would be effectively subordinated in right of payment to any of our secured debt, including the secured debt incurred to finance the defeasance, to the extent of the value of the assets securing that debt. Your ability to recover on the senior subordinated notes after a defeasance or discharge may be reduced or eliminated as a result of these risks. You may not receive the level of dividends provided for in our dividend policy, which our board of directors is expected to adopt upon the closing of this offering, or any dividends at all. Our board of directors may, in its discretion, amend or repeal the dividend policy it is expected to adopt upon the closing of this offering. Our board of directors may decrease the level of dividends provided for in this dividend policy or entirely discontinue the payment of dividends. Future dividends with respect to shares of our capital stock, if any, will depend on, among other things, our results of operations, cash requirements, financial condition, contractual restrictions, business opportunities, provisions of applicable law and other factors that our board of directors may deem relevant. The Amended Credit Facility, the indenture governing Buffets Senior Notes and the indenture governing the senior subordinated notes will contain significant restrictions on our ability to make dividend payments. In addition, certain provisions of the Delaware General Corporation Law may limit our ability to pay dividends. The indenture governing the senior subordinated notes will permit us to pay a significant portion of our free cash flow to stockholders in the form of dividends. The indenture governing the senior subordinated notes, the indenture governing Buffets Senior Notes and the Amended Credit Facility will permit us to pay a significant portion of our free cash flow to holders of our common stock, including Class A common stock held as part of IDSs, and Class B common stock in the form of dividends. Holders of senior subordinated notes held separately from the IDSs may be Table of Contents The information in this prospectus is not complete and may be changed without notice. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell these securities and we are not soliciting offers to buy these securities in any jurisdiction where the offer or sale is not permitted. SUBJECT TO COMPLETION, DATED AUGUST 27, 2004 Prospectus Income Deposit Securities (IDSs) $ million % Senior Subordinated Notes due 2019 Buffets Holdings, Inc. Table of Contents adversely affected by such provisions because any amounts paid by us in the form of dividends will not be available in the future to satisfy our obligations under the senior subordinated notes. The realizable value of our assets upon liquidation may be insufficient to satisfy claims. As of June 30, 2004, on a pro forma basis, our total assets included intangible assets in the amount of $ million, representing approximately % of our total consolidated assets. The value of these intangible assets will continue to depend significantly upon the continued profitability of the respective brands. As a result, in the event of a default on our senior subordinated notes or any bankruptcy or dissolution of our company, the realizable value of these assets may be substantially lower and may be insufficient to satisfy the claims of our creditors. Subject to restrictions set forth in the indenture, we may defer the payment of interest to you for a significant period of time. Prior to , 2009, we may, subject to restrictions set forth in the indenture, defer interest payments on our senior subordinated notes on one or more occasions for up to an aggregate period of eight quarters. In addition, after , 2009, we may, subject to certain restrictions, defer interest payments on our senior subordinated notes on four occasions for up to two consecutive quarters per each occasion. At the end of any interest deferral period following , 2009, we may not further defer interest unless and until all deferred interest, including interest accrued on deferred interest, is paid in full. Deferred interest will bear interest at the same rate as the senior subordinated notes. For any interest deferred during the first five years, we are not obligated to pay any deferred interest until , 2009; so you may be owed a substantial amount of deferred interest that will not be due and payable until such time. For any interest deferred after , 2009, we are not obligated to pay all of the deferred interest until , 2019, so you may be owed a substantial amount of deferred interest that will not be due and payable until such time. During any interest deferral period and so long as any deferred interest or interest on deferred interest remains outstanding, we will not be permitted to make any payment of dividends on our capital stock. Deferral of interest payments would have adverse tax consequences for you and may adversely affect the trading price of the IDSs or the separately held senior subordinated notes. If interest payments on the senior subordinated notes are deferred, you will be required to recognize interest income for U.S. federal income tax purposes on an economic accrual basis in respect of interest payments on the senior subordinated notes represented by the IDSs or the separately held senior subordinated notes, as the case may be, held by you before you receive any cash payment of this interest. In addition, you will not receive the cash with respect to accrued interest if you sell the IDSs or the separately held senior subordinated notes, as the case may be, before the end of any deferral period or before the record date relating to interest payments that are to be paid. If interest is deferred, the IDSs or the separately held senior subordinated notes may trade at a price that does not fully reflect the value of accrued but unpaid interest on the senior subordinated notes. In addition, the fact that we may defer payments of interest on the senior subordinated notes under certain circumstances may mean that the market price for the IDSs or the separately held senior subordinated notes may be more volatile than other securities that do not have this term. See Material U.S. Federal Income Tax Consequences Consequences to U.S. Holders Senior Subordinated Notes Deferral of Interest. Interest on the notes may not be deductible by us for U.S. federal income tax purposes, which could significantly reduce our future cash flow and impact our ability to make interest and dividend payments. While we believe that the senior subordinated notes should be treated as debt for U.S. federal income tax purposes, this position may not be sustained if challenged by the Internal Revenue Service. If the senior subordinated notes were treated as equity rather than debt for U.S. federal income tax purposes, then the stated interest on the senior subordinated notes would be treated as a dividend (to the extent of our tax earnings and profits ), and interest on the senior subordinated notes would not be deductible by We are selling IDSs representing shares of our Class A common stock and $ million aggregate principal amount of our % senior subordinated notes due 2019. Each IDS initially represents: one share of our Class A common stock; and a % senior subordinated note with a $ principal amount. We are also selling $ million aggregate principal amount of our % senior subordinated notes separately (not represented by IDSs). The offering of IDSs and the offering of the separate senior subordinated notes are conditioned upon each other. This is the initial public offering of our IDSs, and the shares of our Class A common stock and senior subordinated notes represented thereby, and our separate senior subordinated notes. We anticipate that the public offering price of the IDSs will be between $ and $ per IDS and the public offering price of the senior subordinated notes sold separately will be % of their stated principal amount. We will apply to list our IDSs on the under the trading symbol . Holders of IDSs will have the right to separate the IDSs into the shares of our Class A common stock and senior subordinated notes represented thereby at any time after the earlier of 45 days from the closing of this offering or the occurrence of a change of control. Similarly, any holder of shares of our Class A common stock and senior subordinated notes may, at any time, unless the IDSs have automatically separated, combine the applicable number of shares of Class A common stock and principal amount of senior subordinated notes to form IDSs. Separation of all of the IDSs will occur automatically upon the continuance of a payment default on the senior subordinated notes for 90 days or upon the redemption, maturity or acceleration of the senior subordinated notes. Our senior subordinated notes mature on , 2019. We will be permitted to defer interest payments on our senior subordinated notes under certain circumstances and subject to the limitations described in Description of Senior Subordinated Notes Terms of the Notes Interest Deferral. Deferred interest on our senior subordinated notes will bear interest quarterly at a rate equal to the stated annual rate of interest on the senior subordinated notes divided by four. Upon a subsequent issuance by us of IDSs or senior subordinated notes of the same series, a portion of your senior subordinated notes may be automatically exchanged for an identical principal amount of the senior subordinated notes issued in such subsequent issuance, and in that event your IDSs will be replaced with new IDSs. In addition to the senior subordinated notes offered hereby, the registration statement of which this prospectus is a part also registers the senior subordinated notes and new IDSs to be issued upon any such subsequent issuance. We have granted the underwriters an option to purchase up to additional IDSs to cover over-allotments, if any. We will use all the proceeds from the sale of additional IDSs upon exercise of the underwriters over-allotment option to repurchase shares of our Class B common stock or other securities from certain of our existing stockholders. Investing in our IDSs, shares of our Class A common stock and senior subordinated notes involves risks. See Risk Factors beginning on page 24. Per IDS(1) Total Per Note(2) Total Table of Contents us for U.S. federal income tax purposes. Our inability to deduct interest on the senior subordinated notes could materially increase our taxable income and, thus, our U.S. federal and applicable state income tax liability. This would reduce our after-tax cash flow, which may result in a default under the Amended Credit Facility, and would materially and adversely impact our ability to make interest and dividend payments and may also affect our ability to continue as a going concern. In the case of foreign holders, treatment of the notes as equity for U.S. federal income tax purposes would subject payments to such holders in respect of the notes to withholding or estate taxes in the same manner as payments made with regard to Class A common stock and could subject us to liability for withholding taxes that were not collected on payments of interest. The allocation of the purchase price of the IDSs may not be respected. The purchase price of each IDS must be allocated for tax purposes between the share of Class A common stock and senior subordinated note represented thereby in proportion to their respective fair market values at the time of purchase. We expect to report the initial fair market value of each share of Class A common stock as $ and the initial fair market value of each of our senior subordinated notes represented by an IDS as $ and, by purchasing IDSs, you will agree to and be bound by such allocation, assuming an initial public offering price of $ per IDS, which represents the mid-point of the range set forth on the cover page of this prospectus. If this allocation is not respected, it is possible that the senior subordinated notes will be treated as having been issued with OID (if the allocation to the senior subordinated notes were determined to be too high) or amortizable bond premium (if the allocation to the senior subordinated notes were determined to be too low). You generally would have to include OID in income in advance of the receipt of cash attributable to that income and would be able to elect to amortize bond premium over the term of the senior subordinated notes. Subsequent issuances of senior subordinated notes may cause you to recognize OID and may be treated as a taxable exchange by you. The indenture governing the senior subordinated notes will provide that, in the event there is a subsequent issuance of senior subordinated notes but having terms that are otherwise identical (other than issuance date) to the senior subordinated notes, including any issuance of IDSs in exchange for shares of Class B common stock, but that are issued with OID, each holder of IDSs or separately held senior subordinated notes, as the case may be, agrees that, upon such issuance and any issuance of senior subordinated notes thereafter, a portion of such holder s senior subordinated notes will be automatically exchanged for a portion of the senior subordinated notes acquired by the holders of such subsequently issued senior subordinated notes. Consequently, immediately following such subsequent issuance and exchange, without any action by such holder, each holder of senior subordinated notes, held either as part of IDSs or separately, will own senior subordinated notes of each separate issuance in the same proportion as each other holder. Regardless of whether the exchange is treated as a taxable event, such exchange would result in holders having to include OID in taxable income prior to the receipt of cash as described below, and may result in other potentially adverse tax consequences to holders. See Material U.S. Federal Income Tax Consequences Consequences to U.S. Holders Senior Subordinated Notes Additional Issuances. In addition, the potential amount of OID that would be required to be included in taxable income by holders as a result of an automatic exchange (as described below) is indefinite and may be a significant amount, in part due to our ability to engage in numerous subsequent issuances. Following any subsequent issuance and exchange of senior subordinated notes with OID, we (and our agents) will report any OID on the subsequently issued senior subordinated notes ratably among all holders of IDSs and separately held senior subordinated notes, and each holder of IDSs and separately held senior subordinated notes will, by purchasing IDSs or separately held senior subordinated notes, agree to report OID in a manner consistent with this approach. However, the Internal Revenue Service may assert that any OID should be reported only to the persons that initially acquired such subsequently issued senior subordinated notes (and their transferees) and thus may challenge the holders reporting of OID on Table of Contents their tax returns. In such case, the Internal Revenue Service might further assert that, unless a holder can establish that it is not a person that initially acquired such subsequently issued senior subordinated notes (or a transferee thereof), all of the senior subordinated notes held by such holder would have OID. Any of these assertions by the Internal Revenue Service could create significant uncertainties in the pricing of IDSs and senior subordinated notes and could adversely affect the market for IDSs and senior subordinated notes. For a discussion of these tax related risks, see Material U.S. Federal Income Tax Consequences. The aggregate stated principal amount of the senior subordinated notes owned by each holder will not change as a result of such subsequent issuance and automatic exchange. However, under New York and federal bankruptcy law, holders of subsequently issued senior subordinated notes having OID may not be able to collect the portion of their principal face amount that represents unamortized OID at the acceleration or filing date in the event of an acceleration of the senior subordinated notes or our bankruptcy prior to the maturity date of the senior subordinated notes. As a result, an automatic exchange that results in a holder receiving a senior subordinated note with OID could have the effect of ultimately reducing the amount such holder can recover from us in the event of an acceleration or bankruptcy. We may have to establish a reserve for contingent tax liabilities in the future, which could adversely affect our ability to make dividend payments on the IDSs. Even if the IRS does not challenge the tax treatment of the senior subordinated notes, it is possible that as a result of an alteration of facts relied upon at the time of issuance of the notes, we will in the future need to change our anticipated accounting treatment and establish a reserve for contingent tax liabilities associated with the disallowance of all or part of the interest deductions on the notes. If we were required to maintain such a reserve, our ability to make dividend payments could be materially impaired and the market for the IDSs, Class A common stock and senior subordinated notes could be adversely affected. In addition, any resulting impact to our financial statements could lead to a default under the Amended Credit Facility. Before this offering, there has not been a public market for our IDSs, shares of our common stock or the senior subordinated notes, which may cause the price of the IDSs, shares of our common stock and separate senior subordinated notes to fluctuate substantially and negatively affect the value of your investment. None of the IDSs, the shares of our common stock or senior subordinated notes has a public market history. In addition, there has not been an active market in the United States for securities similar to the IDSs. An active trading market for the IDSs, shares of our common stock or the senior subordinated notes sold separately in this offering might not develop in the future, which may cause the price of the IDSs, shares of our common stock or the senior subordinated notes sold separately in this offering to fluctuate substantially, and we currently do not expect that an active trading market for the shares of our common stock will develop until the senior subordinated notes mature, if at all. If the senior subordinated notes represented by your IDSs are redeemed or mature, the IDSs will automatically separate and you will then hold the shares of our common stock. We do not intend to list our senior subordinated notes on any securities exchange. The initial public offering price of the IDSs and the senior subordinated notes sold separately in this offering will be determined by negotiations among us, our principal equity sponsor and the representatives of the underwriters and may not be indicative of the market price of the IDSs and the senior subordinated notes sold separately in this offering after the offering. Factors such as quarterly variations in our financial results and dividend payments, announcements by us or others, developments affecting us, our clients and our suppliers, general interest rate levels and general market volatility could cause the market price of the IDSs and the senior subordinated notes sold separately in this offering to fluctuate significantly. In addition, to the extent a market develops for our common stock or senior subordinated notes, or both, separate from the IDSs, the price of your IDSs may be affected. BALANCE, June 30, 2004 $ 3,185,672 $ Table of Contents The limited liquidity of the trading market for the senior subordinated notes sold separately may adversely affect the trading price of the separate senior subordinated notes. We are separately selling $ million aggregate principal amount of senior subordinated notes, representing approximately 10% of the total outstanding senior subordinated notes (including those senior subordinated notes represented by IDSs). While the senior subordinated notes sold separately are part of the same series of notes as, and are identical to, the senior subordinated notes represented by the IDSs, at the time of the issuance of the separate senior subordinated notes, the senior subordinated notes represented by the IDSs will not be separable for at least 45 days and will not be separately tradeable until separated. As a result, the initial trading market for the senior subordinated notes sold separately will be very limited. After the holders of the IDSs are permitted to separate their IDSs, a sufficient number of holders of IDSs may not separate their IDSs into shares of our common stock and senior subordinated notes so that a sizable and more liquid trading market for the senior subordinated notes not represented by IDSs may not develop or may not develop in a timely manner. Trading markets for debt securities have generally treated debt securities issued in larger aggregate principal amounts more favorably than similar securities issued in smaller aggregate principal amounts because of the increased liquidity created by potentially higher trading volumes associated with larger debt issuances. Because approximately 10% of the senior subordinated notes will initially be represented by the IDSs, it is likely that the senior subordinated notes sold separately will not trade at prices reflecting the aggregate principal amount of the combined issuance of senior subordinated notes included in the IDS offering and the separate senior subordinated notes offering. Therefore, a liquid market for the senior subordinated notes sold separately may not develop or may not develop in a timely manner, which may adversely affect the ability of the holders of the separate senior subordinated notes to sell any of their separate senior subordinated notes and the price at which these holders would be able to sell any of the senior subordinated notes sold separately. If interest rates rise, the trading value of our IDSs and the senior subordinated notes sold separately in this offering may decline. If interest rates rise or should the threat of rising interest rates develop, debt markets may be adversely affected. As a result, the trading value of our IDSs and senior subordinated notes may decline. Future sales or the possibility of future sales of a substantial amount of IDSs, shares of our common stock or the senior subordinated notes, together with the future conversion of our Class B common stock into IDSs, may depress the price of the IDSs, shares of our common stock and the senior subordinated notes. Future sales or the availability for sale of substantial amounts of IDSs or shares of our common stock or a significant principal amount of the senior subordinated notes in the public market could adversely affect the prevailing market price of the IDSs, shares of our common stock and the senior subordinated notes and could impair our ability to raise capital through future sales of our securities. After consummation of the Transactions, we anticipate that our existing stockholders will own IDSs and shares of our Class B common stock (or IDSs, if the underwriters over-allotment option is exercised in full). Subject to satisfaction of the Conversion Conditions, such shares of our Class B common stock will initially be convertible into IDSs. We may issue shares of our common stock and senior subordinated notes, which will be in the form of IDSs, or other securities from time to time as consideration for future acquisitions and investments. In the event any such acquisition or investment is significant, the number of shares of our common stock and the aggregate principal amount of senior subordinated notes, which may be in the form of IDSs, or the number or aggregate principal amount, as the case may be, of other securities that we may issue may in turn be significant. In addition, we may also grant registration rights covering those IDSs, shares of our common stock, senior subordinated notes or other securities in connection with any such acquisitions and investments. Table of Contents Our amended certificate of incorporation and by-laws and several other factors could limit another party s ability to acquire us and deprive our investors of the opportunity to obtain a takeover premium for their securities. Provisions contained in our amended and restated certificate of incorporation and by-laws could make it more difficult for a third party to acquire us, even if doing so might be beneficial to our stockholders. Provisions of our amended and restated certificate of incorporation and by-laws impose various procedural and other requirements that make it more difficult for stockholders to effect some corporate actions. For example, our amended and restated certificate of incorporation authorizes our board to determine the rights, preferences, privileges and restrictions of unissued series of preferred stock, without any vote or action by our stockholders. Thus, our board can authorize and issue shares of preferred stock with voting or conversion rights that could adversely affect the voting or other rights of holders of our common stock. These rights may have the effect of delaying or deterring a change of control of our company, and could limit the price that investors might be willing to pay in the future for shares of our common stock. In addition, a change of control of our company may be delayed or deferred as a result of our having three classes of directors. We are also subject to Section 203 of the Delaware General Corporation Law, which prohibits us from engaging in a business combination with an interested stockholder for a three-year period following the time that this stockholder becomes an interested stockholder, unless the business combination is approved in a prescribed manner. In addition, our amended and restated certificate of incorporation provides that for such time as Caxton-Iseman Capital together with its affiliates and related parties beneficially own at least 10% or 5% of our equity, it will be entitled to nominate two of our directors or one director, respectively. These provisions might make an unsolicited takeover more difficult or less likely to occur or might prevent such a takeover, even though such a takeover might offer our stockholders the opportunity to sell their stock at a price above the prevailing market price and might be favored by a majority of our stockholders. You will be immediately diluted by $ per share of common stock if you purchase IDSs in this offering. If you purchase IDSs in this offering, based on the book value of the assets and liabilities reflected on our balance sheet, you will experience an immediate dilution of $ per share of common stock represented by the IDSs, which exceeds the entire price allocated to each share of common stock represented by the IDSs in this offering, because there will be a net tangible book deficit for each share of common stock outstanding immediately after this offering. Our pro forma net tangible book deficiency as of June 30, 2004, after giving effect to this offering, was approximately $ million, or $ per share of Class A common stock. We may not be able to repurchase the senior subordinated notes upon a change of control. Upon the occurrence of specific kinds of change of control events, we will be required to offer to repurchase the outstanding senior subordinated notes at 101% of their principal amount at the date of repurchase unless such senior subordinated notes have been previously called for redemption. We may not have sufficient financial resources to purchase all of the senior subordinated notes that are tendered upon a change of control offer. Furthermore, the Amended Credit Facility, with certain limited exceptions, will prohibit the repurchase or redemption of the senior subordinated notes before their stated maturity. Consequently, lenders thereunder may have the right to prohibit any such purchase or redemption, in which event we will seek to obtain waivers from the required lenders. We may not be able to obtain such waivers or refinance our indebtedness on terms acceptable to us, or at all. Buffets Senior Notes will have similar terms restricting the repurchase of the senior subordinated notes while Buffets Senior Notes remain outstanding. Finally, the occurrence of a change of control could also constitute an event of default under the Amended Credit Facility, which could result in the acceleration of all amounts due thereunder. See Description of Senior Subordinated Notes Change of Control. Public offering price $ $ % $ Underwriting discount $ $ % $ Proceeds to Buffets Holdings, Inc. (before expenses)(3)(4) $ $ % $ (1) The price per IDS comprises $ allocated to each share of Class A common stock and $ allocated to each senior subordinated note. (2) Relates to the $ million aggregate principal amount of senior subordinated notes sold separately (not represented by IDSs). (3) Approximately $ million of these proceeds will be paid to our existing stockholders. (4) Assumes no exercise of the underwriters over-allotment option. The underwriters expect to deliver the IDSs and the senior subordinated notes in book-entry form only through the facilities of The Depository Trust Company to purchasers on or about , 2004. Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense. Table of Contents We may not be able to refinance the Amended Credit Facility or Buffets Senior Notes at maturity on favorable terms or at all. The amended and restated revolving credit facility and the senior secured term loan facility included in the Amended Credit Facility will mature in full in 2009 and 2011, respectively and Buffets Senior Notes will mature in 2014. We may not be able to renew or refinance the Amended Credit Facility or Buffets Senior Notes, or if renewed or refinanced, the renewal or refinancing may occur on less favorable terms. In particular, some of the terms of the senior subordinated notes that may be viewed as favorable to the senior lenders, such as our ability to defer interest and acceleration forbearance periods, become less favorable in 2009, which may materially adversely affect our ability to refinance or renew the Amended Credit Facility or Buffets Senior Notes beyond such date. If we are unable to refinance or renew the Amended Credit Facility or Buffets Senior Notes, our failure to repay all amounts due on the maturity date would cause a default under the Amended Credit Facility and Buffets Senior Notes. In addition, our interest expense may increase significantly if we refinance the Amended Credit Facility or Buffets Senior Notes on terms that are less favorable to us than the terms of the Amended Credit Facility or Buffets Senior Notes, respectively. Risks Relating to Our Business Our core buffet restaurants are a maturing restaurant concept and face intense competition. Our restaurants operate in a highly competitive industry comprising a large number of restaurants, including national and regional restaurant chains and franchised restaurant operations, as well as locally-owned, independent restaurants. Price, restaurant location, food quality, service and attractiveness of facilities are important aspects of competition, and the competitive environment is often affected by factors beyond a particular restaurant management s control, including changes in the public s taste and eating habits, population and traffic patterns and economic conditions. Many of our competitors have greater financial resources than we have and there are few non-economic barriers to entry. Therefore, new competitors may emerge at any time. We cannot assure you that we will be able to compete successfully against our competitors in the future or that competition will not have a material adverse effect on our operations or earnings. We have been operating our core buffet restaurant concept for 20 years, and our restaurant locations have a median age of approximately 10 years. As a result, we are exposed to vulnerabilities associated with being a mature concept. These include vulnerability to innovations by competitors and out-positioning in markets where the demographics or customer preferences have changed. Mature units require greater expenditures for repair, maintenance, refurbishments and re-concepting, and we will be required to continue making such expenditures in the future in order to preserve traffic at many of our restaurants. We cannot assure you, however, that these expenditures, particularly for remodeling and refurbishing, will be successful in preserving or building guest counts, as proved to be the case with a number of units recently upgraded as part of a two year re-imaging program. We are required to respond to changing consumer preferences and dining frequency. Our profits are dependent upon discretionary spending by consumers, which is markedly influenced by variations in the economy. Our average weekly sales declined 2.0% during fiscal 2003 due in large part to weak economic conditions. Furthermore, if our competitors in the casual dining, mid-scale and quick-service segments respond to economic changes through menu engineering or by adopting discount pricing strategies, it could have the effect of drawing customers away from companies such as ours that do not routinely engage in discount pricing, thereby reducing sales and pressuring margins. Because certain elements of our cost structure are fixed in nature, particularly over shorter time horizons, changes in marginal sales volume can have a more significant impact on our profitability than for a business possessing a more variable cost structure. We are dependent on attracting and retaining qualified employees while controlling labor costs. We operate in the service sector and are therefore extremely dependent upon the availability of qualified restaurant personnel. Availability of staff varies widely from location to location. If restaurant Joint Book-Running Managers Credit Suisse First Boston Banc of America Securities LLC CIBC World Markets Table of Contents management and staff turnover trends increase, we would suffer higher direct costs associated with recruiting and retaining replacement personnel. Moreover, we could suffer from significant indirect costs, including restaurant disruptions due to management changeover, increased above-store management staffing and potential delays in new store openings due to staff shortages. Competition for qualified employees exerts pressure on wages paid to attract qualified personnel, resulting in higher labor costs, together with greater expense to recruit and train them. Many of our employees are hourly workers whose wages may be impacted by an increase in the federal or state minimum wage. Proposals have been made at federal and state levels to increase minimum wage levels. An increase in the minimum wage may create pressure to increase the pay scale for our employees. A shortage in the labor pool or other general inflationary pressures or changes could also increase our labor costs. Furthermore, the operation of buffet-style restaurants is materially different from other restaurant concepts. Consequently, the retention of executive management familiar with our core buffet business is important to our continuing success. The departure of one or more key operations executives or the departure of multiple executives in a short time period could have an adverse impact on our business. Our former Executive Vice President of Purchasing separated from the company in 2004. We are currently considering the addition of one additional position to our executive management group. Our workers compensation and employee benefit expenses are disproportionately concentrated in states with adverse legislative climates. Our highest per-employee workers compensation insurance costs are in the State of California, where we retain a large employment presence. California also enacted legislation in October 2003 that would require large employers to provide health insurance or equivalent funding for workers who have traditionally not been covered by employer health plans. While this law is currently being challenged, other states have proposed similar legislation. Other state and federal mandates, such as compulsory paid absences, increases in overtime wages and unemployment tax rates, stricter citizenship requirements and revisions in the tax treatment of employee gratuities, could also adversely affect our business. Any increases in labor costs could have a material adverse effect on our results of operations and could decrease our profitability and cash available to service our debt obligations, if we were unable to compensate for such increased labor costs by raising the prices we charge our customers or realizing additional operational efficiencies. We are dependent on timely delivery of fresh ingredients by our suppliers. Our restaurant operations are dependent on timely deliveries of fresh ingredients, including fresh produce, dairy products and meat. The cost, availability and quality of the ingredients we use to prepare our food are subject to a range of factors, many of which are beyond our control. Fluctuations in weather, supply and demand and economic and political conditions could adversely affect the cost, availability and quality of our ingredients. Historically, when operating expenses increased due to inflation or increases in food costs, we recovered increased costs by increasing our menu prices. However, we may not be able to recover increased costs in the future because competition may limit or prohibit such future increases. If our food quality declines due to the lack of, or lower quality of, our ingredients or due to interruptions in the flow of fresh ingredients and similar factors, customer traffic may decline and negatively affect our restaurants results. We rely exclusively on third-party distributors and suppliers for such deliveries. The number of companies capable of servicing our distribution needs on a national basis has declined over time, reducing our bargaining leverage and increasing vulnerability to distributor interruptions. Our restaurant sales are subject to seasonality and major world events. Our restaurant sales volume fluctuates seasonally. Overall, restaurant sales are generally higher in the summer months and lower in the winter months. Positive or negative trends in weather conditions can have a strong influence on our business. This effect is heightened because many of our restaurants are in geographic areas that experience extremes in weather, including severe winter conditions and tropical storm patterns. Additionally, major world events may adversely affect our business. UBS Investment Bank Table of Contents We face risks associated with government regulations. In addition to wage and benefit regulatory risks, we are subject to other extensive government regulation at a federal, state and local level. These include, but are not limited to, regulations relating to the sale of food in all of our restaurants and of alcoholic beverages in our Tahoe Joe s Famous Steakhouse restaurants. We are required to obtain and maintain governmental licenses, permits and approvals. Difficulty or failure in obtaining or maintaining them in the future could result in delaying or canceling the opening of new restaurants or the closing of current ones. Local authorities may suspend or deny renewal of our governmental licenses if they determine that our operations do not meet the standards for initial grant or renewal. This risk would be even higher if there were a major change in the licensing requirements affecting our types of restaurants. The Federal Americans with Disabilities Act prohibits discrimination on the basis of disability in public accommodations and employment. Mandated modifications to our facilities in the future to make different accommodations for disabled persons could result in material, unanticipated expense. Application of state Dram Shop statutes, which generally provide a person injured by an intoxicated patron the right to recover damages from an establishment that wrongfully served alcoholic beverages to the intoxicated person, to our operations, or liabilities otherwise associated with liquor service in our Tahoe Joe s Famous Steakhouse restaurants, could negatively affect our financial condition if not otherwise insured under our general liability insurance policy. Negative publicity relating to one of our restaurants, including our franchised restaurants, could reduce sales at some or all of our other restaurants. We are, from time to time, faced with negative publicity relating to food quality, restaurant facilities, health inspection scores, employee relationships or other matters at one of our restaurants or those of our franchisees. Adverse publicity may negatively affect us, regardless of whether the allegations are valid or whether we are liable. In addition, the negative impact of adverse publicity relating to one restaurant may extend beyond the restaurant involved to affect some or all of our other restaurants. If a franchised restaurant fails to meet our franchise operating standards, our own restaurants could be adversely affected due to customer confusion or negative publicity. A similar risk exists with respect to totally unrelated food service businesses, if customers mistakenly associate such unrelated businesses with our own operations. Food-borne illness incidents could result in liability to us and could reduce our restaurant sales. We cannot guarantee that our internal controls and training will be fully effective in preventing all food-borne illnesses. Furthermore, our reliance on third-party food processors makes it difficult to monitor food safety compliance and increases the risk that food-borne illness would affect multiple locations rather than single restaurants. Some food-borne illness incidents could be caused by third-party food suppliers and transporters outside of our control. New illnesses resistant to our current precautions may develop in the future, or diseases with long incubation periods could arise, such as bovine spongiform encephalopathy ( BSE ), sometimes referred to as mad cow disease, that could give rise to claims or allegations on a retroactive basis. In addition, the levels of chemicals or other contaminants that are currently considered safe in certain foods may be regulated more restrictively in the future or become the subject of public concern. The reach of food-related public health concerns can be considerable given the attention given these matters by the media. Local public health developments could have a national adverse impact on our sales, whether or not specifically attributable to our restaurants or those of our franchisees or competitors. Any negative development relating to our self-service food service approach would have a material adverse impact on our primary business. Our buffet restaurants utilize a service format that is heavily dependent upon self-service by our customers. Food tampering by customers or other events affecting the self-service format could cause Co-Managers JPMorgan Piper Jaffray The date of this prospectus is , 2004. Table of Contents regulatory changes or changes in our business pattern or customer perception. Any development that would materially impede or prohibit our continued use of a self-service food service approach, or reduce the appeal of self-service to our guests, would have a material adverse impact on our primary business. We face risks associated with environmental laws. We are subject to federal, state and local laws, regulations and ordinances that govern activities or operations that may have adverse environmental effects, such as discharges to air and water, as well as handling and disposal practices for solid and hazardous wastes. These may impose liability for the costs of cleaning up, and damage resulting from, sites of past spills, disposals or other releases of hazardous materials, both from governmental and private claimants. We could incur such liabilities regardless of whether we lease or own the restaurants or land in question and regardless of whether such environmental conditions were created by us or by a prior owner or tenant. We cannot assure you that environmental conditions relating to our prior, existing or future restaurants or restaurant sites will not have a material adverse affect on us. We face risks because of the number of restaurants that we lease. Our success depends in part on our ability to secure leases in desired locations at rental rates we believe to be reasonable. We currently lease all of our restaurants located in shopping centers and malls, and we lease the land for all but one of our freestanding restaurants. By December 2007, approximately 85 of our current leases will have expiring base lease terms and be subject to renewal consideration. Each lease agreement provides that the lessor may terminate the lease for a number of reasons, including our default in any payment of rent or taxes or our breach of any covenant or agreement in the lease. Termination of any of our leases could harm our results of operations and, as with a default under any of our indebtedness, could have a material adverse impact on our liquidity. Although we believe that we will be able to renew the existing leases that we wish to extend, we cannot assure you that we will succeed in obtaining extensions in the future at rental rates that we believe to be reasonable or at all. Moreover, if some locations should prove to be unprofitable, we could remain obligated for lease payments even if we decided to withdraw from those locations. See Business Property. We will incur special charges relating to the closing of such restaurants, including lease termination costs. Impairment charges and other special charges will reduce our profits. We may not be able to protect our trademarks and other proprietary rights. We believe that our trademarks and other proprietary rights are important to our success and our competitive position. Accordingly, we devote substantial resources to the establishment and protection of our trademarks and proprietary rights. However, the actions taken by us may be inadequate to prevent imitation of our brands, proprietary rights and concepts by others, which may thereby dilute our brands in the marketplace or diminish the value of such proprietary rights, or to prevent others from claiming violations of their trademarks and proprietary rights by us. In addition, others may assert rights in our trademarks and other proprietary rights. Our exclusive rights to our trademarks are subject to the common law rights of any other person who began using the trademark (or a confusingly similar mark) prior to both the date of our registration and our first use of such trademarks in the relevant territory. For example, because of the common law rights of such a preexisting restaurant in portions of Colorado and Wyoming, our restaurants in those states use the name Country Buffet. We cannot assure you that third parties will not assert claims against our intellectual property or that we will be able to successfully resolve such claims. Future actions by third parties may diminish the strength of our restaurant concepts trademarks or other proprietary rights and decrease our competitive strength and performance. We could also incur substantial costs to defend or pursue legal actions relating to the use of our intellectual property, which could have a material adverse affect on our business, results of operation or financial condition. TABLE OF CONTENTS Page Table of Contents
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+RISK FACTORS In addition to the other information contained in this prospectus, the following factors should be considered carefully before investing in the IDSs (including the Class A common stock and senior subordinated notes represented thereby) or our senior subordinated notes. If any of the following risks actually occur, our business, results of operations or financial condition would likely suffer. Risks Relating to the IDSs, the Shares of Class A Common Stock and the Senior Subordinated Notes Represented by the IDSs, and the Senior Subordinated Notes Offered Separately Buffets Holdings is a holding company and relies on dividends, interest and other payments, advances and transfer of funds from its subsidiaries to meet its debt service and other obligations. Buffets Holdings has no direct operations and no significant assets other than ownership of 100% of the stock of Buffets, all of which will be pledged to the creditors under the Amended Credit Facility which Buffets Holdings guarantees. Because Buffets Holdings conducts its operations through its direct and indirect subsidiaries, Buffets Holdings depends on those entities for dividends and other payments to generate the funds necessary to meet its financial obligations, including payments of principal and interest on the senior subordinated notes, and to pay dividends with respect to the common stock. Legal and contractual restrictions in the Amended Credit Facility, the indenture governing Buffets Senior Notes and other agreements governing current and future indebtedness of Buffets Holdings subsidiaries, as well as the financial condition and operating requirements of Buffets Holdings subsidiaries, may limit Buffets Holdings ability to obtain cash from its subsidiaries. The earnings from, or other available assets of, Buffets Holdings subsidiaries may not be sufficient to pay dividends or make distributions or loans to enable Buffets Holdings to make payments in respect of the senior subordinated notes when such payments are due and to pay dividends on the common stock. Your rights as holders of the senior subordinated notes and guarantees thereof to receive payments will be contractually subordinated to those of holders of our senior indebtedness and may be otherwise adversely affected in the event of our bankruptcy. As a result of the subordinated nature of the senior subordinated notes and related guarantees, upon any distribution to our creditors or the creditors of the subsidiary guarantors in bankruptcy, liquidation or reorganization or similar proceeding relating to Buffets Holdings or the subsidiary guarantors or Buffets Holdings or their property, the holders of Buffets Holdings senior indebtedness and senior indebtedness of the subsidiary guarantors will be entitled to be paid in full in cash before any payment may be made with respect to the senior subordinated notes or the subsidiary guarantees. Holders of the senior subordinated notes would then participate with all other holders of unsecured senior subordinated indebtedness of Buffets Holdings or the subsidiary guarantors similarly subordinated in the assets remaining after Buffets Holdings and the subsidiary guarantors have paid all senior indebtedness. Buffets Holdings and the subsidiary guarantors may not have sufficient funds to pay all of our creditors, and holders of our senior subordinated notes may receive less, ratably, than the holders of senior indebtedness, and because of the obligation to turn over distributions to holders of senior indebtedness, the holders of the notes may receive less, ratably, than trade payables and other general unsecured indebtedness. Further, in the event of such bankruptcy proceedings, a party in interest may seek to subordinate the senior subordinated notes to all creditors under principles of equitable subordination or to recharacterize the senior subordinated notes as equity. If such a subordination or recharacterization did occur, you may not recover any amounts owing on the senior subordinated notes or the guarantees and you might be required to return any payments made to you on account of the senior subordinated notes up to six years prior to our bankruptcy. As of June 30, 2004, on a pro forma basis, the senior subordinated notes and the subsidiary guarantees would have ranked junior, on a consolidated basis, to approximately $ million of indebtedness, including borrowings under the Amended Credit Facility and Buffets Senior Notes. In addition, as of June 30, 2004, on a pro forma basis, we would have had the ability to borrow up to an 23 .3* Consent of Faegre Benson LLP (included in Exhibit 5.2 to this Registration Statement). 10 .13** Severance Protection Agreement, dated September 29, 2000, between Buffets, Inc. and Jean C. Rostollan (incorporated by reference to Exhibit 10.9.1 to Buffets, Inc. s Annual Report on Form 10-K filed with the Commission on September 30, 2003 (SEC file No. 033-00171)). 12 .1 Statement of Computation of Ratios of Earnings to Fixed Charges. 21 List of Subsidiaries of Buffets Holdings, Inc. 23 .1 Consent of Deloitte Touche LLP. 23 .2* Consent of Paul, Weiss, Rifkind, Wharton Garrison LLP (included in Exhibits 5.1 and 8.1 to this Registration Statement). 23 .3* Consent of Faegre Benson LLP (included in Exhibit 5.2 to this Registration Statement). Table of Contents BUFFETS HOLDINGS, INC. TABLE OF ADDITIONAL REGISTRANTS Primary Standard IRS Jurisdiction of Industrial Employer Incorporation or Classification Identification Name Organization Number Number Table of Contents additional amount of $ million under the Amended Credit Facility (less amounts reserved for letters of credit), which would have ranked senior in right of payment to the senior subordinated notes. Payments on the senior subordinated notes may be blocked if we default under senior indebtedness, including the Amended Credit Facility. If we default in the payment of any of our senior indebtedness, including the Amended Credit Facility and Buffets Senior Notes, we will not make any payments on the senior subordinated notes until the payment default has been cured or waived. In addition, even if we are making payments on our senior indebtedness on a timely basis, payments on the senior subordinated notes may be blocked for up to 180 days if we default on our senior indebtedness in some other manner. During any period in which payments on the senior subordinated notes are prohibited or blocked in this manner, we and the guarantors will be prohibited from making any payments in respect of the senior subordinated notes and the guarantees. Claims of noteholders will be structurally subordinated to claims of creditors of all of our existing and future unrestricted subsidiaries, all of which will not guarantee the senior subordinated notes. The senior subordinated notes will not be guaranteed by any of our current or future unrestricted subsidiaries. Our unrestricted subsidiaries are separate and distinct legal entities and have no obligation, contingent or otherwise, to pay any amounts due pursuant to the senior subordinated notes, or to make any funds available therefor, whether by dividends, loans, distributions or other payments. Any right that we or the guarantors have to receive any assets of any of the unrestricted subsidiaries upon the liquidation or reorganization of those subsidiaries, and the consequent rights of holders of senior subordinated notes to realize proceeds from the sale of any of those subsidiaries assets, will be structurally subordinated to the claims of that subsidiaries creditors, including trade creditors and holders of debt of those subsidiaries. Our substantial level of indebtedness could adversely affect our financial condition and prevent us from fulfilling our obligations under the senior subordinated notes. We have substantial indebtedness. As of June 30, 2004, on a pro forma basis, we would have had $ million of total indebtedness. Our ability to make distributions, pay dividends or make other payments will be subject to applicable law and contractual restrictions contained in the instruments governing any indebtedness of ours and our subsidiaries, including the Amended Credit Facility and Buffets Senior Notes. Our level of debt could have negative consequences to you and to us. For example, it could: make it more difficult for us to satisfy our obligations with respect to the senior subordinated notes; increase our vulnerability to general adverse economic and industry conditions, as well as increases in interest rates; limit our ability to fund future working capital, capital expenditures, debt service and general corporate requirements; require us to dedicate a substantial portion of our cash flow from operations to the payments on our indebtedness, thereby reducing the availability of our cash flow to fund working capital, capital expenditures and other general corporate purposes; place us at a competitive disadvantage compared to our competitors that have less debt; limit our ability to borrow additional funds; limit our ability to refinance our debt on terms acceptable to us or at all; make it more difficult to comply with the covenants in the indentures relating to our senior subordinated notes and Buffets Senior Notes and the amended credit agreement relating to the Table of Contents Amended Credit Facility, which could in turn result in an event of default under our indebtedness, which, if not cured or waived, could have a material adverse effect on us; and limit our flexibility in planning for, or reacting to, changes in our business and future business opportunities. Servicing our debt will require a significant amount of cash. Our subsidiaries ability to generate sufficient cash depends on numerous factors which are beyond our control and we may be unable to generate sufficient cash flow to service our debt obligations, including making payments on the senior subordinated notes, and to pay dividends on the common stock. Our ability to pay our expenses, principal and interest on the senior subordinated notes and other debt, and dividends on the common stock depends on our ability to generate positive cash flow in the future, which is subject to general economic, financial, competitive, legislative and regulatory factors and other factors that are beyond our control. Our subsidiaries operations may not generate sufficient cash flow from operations and future borrowings may not be available under the Amended Credit Facility in amounts sufficient to enable us or our subsidiaries to make payments in respect of the senior subordinated notes, to pay our other debt, to pay dividends on the common stock or to fund other liquidity needs. If our subsidiaries do not have sufficient cash flow from operations, Buffets Holdings or our subsidiaries may be required to incur additional indebtedness, refinance all or part of our existing debt or sell assets. If Buffets Holdings or our subsidiaries are required to refinance existing debt, or if Buffets Holdings or our subsidiaries are required to sell some of our assets, we may not be able to do so on terms that are acceptable to us or at all. In addition, the terms of existing or future debt agreements, including the indenture governing Buffets Senior Notes and the Amended Credit Facility, may restrict Buffets Holdings or our subsidiaries from effecting any of these alternatives or we may fail for other reasons. If we are required to pursue other alternatives, the value of the senior subordinated notes and the common stock, and our financial condition, could be significantly adversely affected. Despite our current leverage, we may still be able to incur substantially more debt. This could further exacerbate the risks that we and our subsidiaries face. We, including our subsidiaries, may be able to incur substantial additional indebtedness in the future. For example, the Amended Credit Facility will provide commitments of up to $ million, $ million of which would have been available for future borrowings as of June 30, 2004, on a pro forma basis, subject to the aggregate borrowing base availability and net of $ million in outstanding letters of credit. All of such indebtedness would have been secured and effectively senior to the senior subordinated notes. If we incur any additional indebtedness that ranks equally with the senior subordinated notes, the holders of that debt will be entitled to share ratably with the holders of the senior subordinated notes in any proceeds distributed in connection with any insolvency, liquidation, reorganization, dissolution or other winding-up of us. This may have the effect of reducing the amount of proceeds paid to you. If additional indebtedness is added to our or our subsidiaries current levels of indebtedness, the substantial risks described above would intensify. If we or our subsidiaries default on our or their obligations to pay our or their indebtedness, or fail to comply with other covenants thereunder, we may not be able to make payments on the senior subordinated notes and the common stock. If we or our subsidiaries are unable to generate sufficient cash flow and are otherwise unable to obtain funds necessary to meet required payments on our or their indebtedness, or if we or our subsidiaries otherwise fail to comply with the various covenants, including financial and operating covenants, in the instruments governing our or their indebtedness (including the Amended Credit Facility and our guarantee Table of Contents thereof and the indenture governing Buffets Senior Notes), we or they could be in default under the terms of the agreements governing such indebtedness. In the event of such default: the holders of such indebtedness could elect to declare all the funds borrowed thereunder to be due and payable, together with accrued and unpaid interest and liquidated damages, if any. The lenders under the Amended Credit Facility could elect to terminate their commitments, cease making further loans and institute foreclosure proceedings against our or our subsidiaries assets. We could directly or indirectly be prohibited from paying principal, premium, if any, and interest on the senior subordinated notes, and dividends with respect to the common stock, and we or our subsidiaries could be forced into bankruptcy or liquidation. We will be subject to restrictive covenants in our debt agreements that may limit our ability to pursue strategies that may otherwise improve our business. The indenture governing the senior subordinated notes, the indenture governing Buffets Senior Notes and the Amended Credit Facility will impose significant operating and financial restrictions on us. These restrictions will limit our ability, among other things, to: incur additional indebtedness; acquire the assets of, or merge or consolidate with, other companies; pay dividends or make other distributions on our capital stock or repurchase, repay or redeem the senior subordinated notes, subordinated debt and our capital stock; make certain investments; incur liens; make capital expenditures; enter into certain types of transactions with our stockholders and affiliates; limit dividends or other payments by our restricted subsidiaries to us; and transfer or sell certain or all or substantially all of our assets. These covenants in the indenture governing the senior subordinated notes, the indenture governing Buffets Senior Notes and the Amended Credit Facility may impair our ability to finance future operations or capital needs or to enter into acquisitions or joint ventures or engage in other favorable business activities. If we default under the indenture governing the senior subordinated notes, the indenture governing Buffets Senior Notes or the Amended Credit Facility or we fail to satisfy the financial covenants under the Amended Credit Facility, we could directly or indirectly be prohibited from making any payments with respect to the IDSs or our senior subordinated notes. In addition, the lenders under the Amended Credit Facility and the holders of Buffets Senior Notes could require immediate repayment of the entire principal that is outstanding under those facilities or those notes. If those lenders or holders require immediate repayment, our assets may not be sufficient to repay them and also repay the senior subordinated notes in full. Our dividend policy may negatively impact our ability to finance capital expenditure or operation. Upon completion of this offering, our board of directors will adopt a dividend policy under which cash generated by our business in excess of operating needs, interest and principal payments on indebtedness, and capital expenditures sufficient to maintain our properties would in general be distributed as regular quarterly dividends to the holders of our Class A common stock and Class B common stock rather than retained by us and used to finance growth opportunities. As a result, we may not retain a sufficient amount of cash to finance growth opportunities or unanticipated capital expenditure needs or to fund our Table of Contents operations in the event of a significant business downturn. We may have to forgo growth opportunities or capital expenditures that would otherwise be necessary or desirable if we do not find alternative sources or financing. If we do not have sufficient cash for these purposes or if the $ million in cash on hand available for capital expenditures is insufficient, our financial condition and our business will suffer. Federal and state laws permit a court to void the senior subordinated notes or the subsidiary guarantees under certain circumstances. The issuance of the senior subordinated notes and the guarantees may be subject to review under United States federal bankruptcy law and comparable provisions of state fraudulent conveyance laws if a bankruptcy or reorganization case or lawsuit is commenced by or on behalf of our or the guarantor s unpaid creditors. A court could void the obligations under the senior subordinated notes or the guarantees, further subordinate the senior subordinated notes or the guarantees or take other action detrimental to holders of the senior subordinated notes, if, among other things, at the time the indebtedness was incurred, Buffets Holdings or the guarantors: issued the senior subordinated notes or the guarantees to delay, hinder or defraud present or future creditors; or received less than reasonably equivalent value or fair consideration for issuing the senior subordinated notes or the guarantees at the time of issuance of the senior subordinated notes or the guarantees and: were insolvent or rendered insolvent by reason of issuing the senior subordinated notes or the guarantees; were engaged, or about to engage, in a business or transaction for which the remaining unencumbered assets constituted unreasonably small capital to carry on our or the guarantor s business; or intended to incur, or believed that we or the guarantor would incur, debts beyond our or the guarantor s ability to pay as they mature. The measures of insolvency for purposes of fraudulent transfer laws vary depending upon the law of the jurisdiction that is being applied in any proceeding to determine whether a fraudulent transfer had occurred. It is not clear what standard a court would use to determine whether or not we or a guarantor were solvent at the relevant time. Generally, however, a person would be considered insolvent if, at the time it incurred the debt: the sum of its debts, including contingent liabilities, was greater than the fair saleable value of all of its assets; the present fair saleable value of its assets was less than the amount that would be required to pay its probable liability on its existing debts, including contingent liabilities, as they become absolute and mature; or it could not pay its debts as they become due. The proceeds of the offering will be used to repurchase a portion of Buffets Holdings common stock from our existing stockholders and to repurchase all of our outstanding 13 7/8% Notes and Buffets 11 1/4% Notes, which may subject the holders of our senior subordinated notes in this offering to the claim that we did not receive fair consideration for the senior subordinated notes issued in this offering. In the event that we meet any of the financial condition fraudulent transfer tests described above at the time of or as a result of this offering, a court could integrate the issuance of our senior subordinated notes with the distribution to our shareholders and the repurchase of Buffets 11 1/4% Notes, and, therefore, conclude that we did not get fair value for the offering viewed as an integrated transaction. In such a case, a court could hold the debt owed to the holders of our senior subordinated notes void or unenforceable or may subordinate it to the claims of other creditors. BALANCE, July 2, 2003 69 (44 ) 34 (21 ) 317 (25 ) 420 (90 ) FY 2004 Activity: Amortization (12 ) (8 ) (20 ) Additions 28 Table of Contents The guarantee of our senior subordinated notes by any subsidiary guarantor could be subject to the claim that, since the guarantee was incurred for the benefit of Buffets Holdings, and only indirectly for the benefit of the subsidiary guarantor, the obligations of the subsidiary guarantor were incurred for less than fair consideration. If such a claim were successful and it was proven that the subsidiary guarantor was insolvent at the time the guarantee was issued, a court could void the obligations of the subsidiary guarantor under the guarantee or subordinate these obligations to the subsidiary guarantor s other debt or take action detrimental to the holders of the senior subordinated notes. If the guarantee of any subsidiary guarantor were voided, our notes would be effectively subordinated to the indebtedness of that subsidiary guarantor. If we defease the senior subordinated notes, such defeasance may be subject to preferential transfer laws. The indenture relating to the senior subordinated notes will provide that we may, after complying with certain conditions, defease the senior subordinated notes and be released from our obligations under many of the covenants contained in the indenture, or discharge all our obligations under the indenture within a year of the maturity date or a redemption date. One of the conditions to such defeasance or discharge is that we deposit sufficient funds with the trustee to pay the principal, interest and premium on the outstanding senior subordinated notes through maturity or an applicable redemption date. If a bankruptcy or reorganization proceeding is initiated within the applicable preference period, which generally varies from 90 days to one year, the deposit would likely be subject to review under federal bankruptcy law and comparable provisions of state law. In such an event, a court may void the deposit of funds with the trustee as a preferential transfer and recover such funds for the benefit of the bankruptcy estate and/or otherwise order that the funds be made available to satisfy claims of other creditors. In addition, under the fraudulent conveyance laws described above, a court could also void the deposit of funds or take other actions detrimental to you. The indenture will permit us to finance the defeasance deposit by issuing secured debt that we would not otherwise be permitted to incur under the indenture. In the event that the payments used to defease the senior subordinated notes are found to be a preferential transfer or a fraudulent conveyance, any claims arising out of or relating to the senior subordinated notes would be effectively subordinated in right of payment to any of our secured debt, including the secured debt incurred to finance the defeasance, to the extent of the value of the assets securing that debt. Your ability to recover on the senior subordinated notes after a defeasance or discharge may be reduced or eliminated as a result of these risks. You may not receive the level of dividends provided for in our dividend policy, which our board of directors is expected to adopt upon the closing of this offering, or any dividends at all. Our board of directors may, in its discretion, amend or repeal the dividend policy it is expected to adopt upon the closing of this offering. Our board of directors may decrease the level of dividends provided for in this dividend policy or entirely discontinue the payment of dividends. Future dividends with respect to shares of our capital stock, if any, will depend on, among other things, our results of operations, cash requirements, financial condition, contractual restrictions, business opportunities, provisions of applicable law and other factors that our board of directors may deem relevant. The Amended Credit Facility, the indenture governing Buffets Senior Notes and the indenture governing the senior subordinated notes will contain significant restrictions on our ability to make dividend payments. In addition, certain provisions of the Delaware General Corporation Law may limit our ability to pay dividends. The indenture governing the senior subordinated notes will permit us to pay a significant portion of our free cash flow to stockholders in the form of dividends. The indenture governing the senior subordinated notes, the indenture governing Buffets Senior Notes and the Amended Credit Facility will permit us to pay a significant portion of our free cash flow to holders of our common stock, including Class A common stock held as part of IDSs, and Class B common stock in the form of dividends. Holders of senior subordinated notes held separately from the IDSs may be Table of Contents The information in this prospectus is not complete and may be changed without notice. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell these securities and we are not soliciting offers to buy these securities in any jurisdiction where the offer or sale is not permitted. SUBJECT TO COMPLETION, DATED AUGUST 27, 2004 Prospectus Income Deposit Securities (IDSs) $ million % Senior Subordinated Notes due 2019 Buffets Holdings, Inc. Table of Contents adversely affected by such provisions because any amounts paid by us in the form of dividends will not be available in the future to satisfy our obligations under the senior subordinated notes. The realizable value of our assets upon liquidation may be insufficient to satisfy claims. As of June 30, 2004, on a pro forma basis, our total assets included intangible assets in the amount of $ million, representing approximately % of our total consolidated assets. The value of these intangible assets will continue to depend significantly upon the continued profitability of the respective brands. As a result, in the event of a default on our senior subordinated notes or any bankruptcy or dissolution of our company, the realizable value of these assets may be substantially lower and may be insufficient to satisfy the claims of our creditors. Subject to restrictions set forth in the indenture, we may defer the payment of interest to you for a significant period of time. Prior to , 2009, we may, subject to restrictions set forth in the indenture, defer interest payments on our senior subordinated notes on one or more occasions for up to an aggregate period of eight quarters. In addition, after , 2009, we may, subject to certain restrictions, defer interest payments on our senior subordinated notes on four occasions for up to two consecutive quarters per each occasion. At the end of any interest deferral period following , 2009, we may not further defer interest unless and until all deferred interest, including interest accrued on deferred interest, is paid in full. Deferred interest will bear interest at the same rate as the senior subordinated notes. For any interest deferred during the first five years, we are not obligated to pay any deferred interest until , 2009; so you may be owed a substantial amount of deferred interest that will not be due and payable until such time. For any interest deferred after , 2009, we are not obligated to pay all of the deferred interest until , 2019, so you may be owed a substantial amount of deferred interest that will not be due and payable until such time. During any interest deferral period and so long as any deferred interest or interest on deferred interest remains outstanding, we will not be permitted to make any payment of dividends on our capital stock. Deferral of interest payments would have adverse tax consequences for you and may adversely affect the trading price of the IDSs or the separately held senior subordinated notes. If interest payments on the senior subordinated notes are deferred, you will be required to recognize interest income for U.S. federal income tax purposes on an economic accrual basis in respect of interest payments on the senior subordinated notes represented by the IDSs or the separately held senior subordinated notes, as the case may be, held by you before you receive any cash payment of this interest. In addition, you will not receive the cash with respect to accrued interest if you sell the IDSs or the separately held senior subordinated notes, as the case may be, before the end of any deferral period or before the record date relating to interest payments that are to be paid. If interest is deferred, the IDSs or the separately held senior subordinated notes may trade at a price that does not fully reflect the value of accrued but unpaid interest on the senior subordinated notes. In addition, the fact that we may defer payments of interest on the senior subordinated notes under certain circumstances may mean that the market price for the IDSs or the separately held senior subordinated notes may be more volatile than other securities that do not have this term. See Material U.S. Federal Income Tax Consequences Consequences to U.S. Holders Senior Subordinated Notes Deferral of Interest. Interest on the notes may not be deductible by us for U.S. federal income tax purposes, which could significantly reduce our future cash flow and impact our ability to make interest and dividend payments. While we believe that the senior subordinated notes should be treated as debt for U.S. federal income tax purposes, this position may not be sustained if challenged by the Internal Revenue Service. If the senior subordinated notes were treated as equity rather than debt for U.S. federal income tax purposes, then the stated interest on the senior subordinated notes would be treated as a dividend (to the extent of our tax earnings and profits ), and interest on the senior subordinated notes would not be deductible by We are selling IDSs representing shares of our Class A common stock and $ million aggregate principal amount of our % senior subordinated notes due 2019. Each IDS initially represents: one share of our Class A common stock; and a % senior subordinated note with a $ principal amount. We are also selling $ million aggregate principal amount of our % senior subordinated notes separately (not represented by IDSs). The offering of IDSs and the offering of the separate senior subordinated notes are conditioned upon each other. This is the initial public offering of our IDSs, and the shares of our Class A common stock and senior subordinated notes represented thereby, and our separate senior subordinated notes. We anticipate that the public offering price of the IDSs will be between $ and $ per IDS and the public offering price of the senior subordinated notes sold separately will be % of their stated principal amount. We will apply to list our IDSs on the under the trading symbol . Holders of IDSs will have the right to separate the IDSs into the shares of our Class A common stock and senior subordinated notes represented thereby at any time after the earlier of 45 days from the closing of this offering or the occurrence of a change of control. Similarly, any holder of shares of our Class A common stock and senior subordinated notes may, at any time, unless the IDSs have automatically separated, combine the applicable number of shares of Class A common stock and principal amount of senior subordinated notes to form IDSs. Separation of all of the IDSs will occur automatically upon the continuance of a payment default on the senior subordinated notes for 90 days or upon the redemption, maturity or acceleration of the senior subordinated notes. Our senior subordinated notes mature on , 2019. We will be permitted to defer interest payments on our senior subordinated notes under certain circumstances and subject to the limitations described in Description of Senior Subordinated Notes Terms of the Notes Interest Deferral. Deferred interest on our senior subordinated notes will bear interest quarterly at a rate equal to the stated annual rate of interest on the senior subordinated notes divided by four. Upon a subsequent issuance by us of IDSs or senior subordinated notes of the same series, a portion of your senior subordinated notes may be automatically exchanged for an identical principal amount of the senior subordinated notes issued in such subsequent issuance, and in that event your IDSs will be replaced with new IDSs. In addition to the senior subordinated notes offered hereby, the registration statement of which this prospectus is a part also registers the senior subordinated notes and new IDSs to be issued upon any such subsequent issuance. We have granted the underwriters an option to purchase up to additional IDSs to cover over-allotments, if any. We will use all the proceeds from the sale of additional IDSs upon exercise of the underwriters over-allotment option to repurchase shares of our Class B common stock or other securities from certain of our existing stockholders. Investing in our IDSs, shares of our Class A common stock and senior subordinated notes involves risks. See Risk Factors beginning on page 24. Per IDS(1) Total Per Note(2) Total Table of Contents us for U.S. federal income tax purposes. Our inability to deduct interest on the senior subordinated notes could materially increase our taxable income and, thus, our U.S. federal and applicable state income tax liability. This would reduce our after-tax cash flow, which may result in a default under the Amended Credit Facility, and would materially and adversely impact our ability to make interest and dividend payments and may also affect our ability to continue as a going concern. In the case of foreign holders, treatment of the notes as equity for U.S. federal income tax purposes would subject payments to such holders in respect of the notes to withholding or estate taxes in the same manner as payments made with regard to Class A common stock and could subject us to liability for withholding taxes that were not collected on payments of interest. The allocation of the purchase price of the IDSs may not be respected. The purchase price of each IDS must be allocated for tax purposes between the share of Class A common stock and senior subordinated note represented thereby in proportion to their respective fair market values at the time of purchase. We expect to report the initial fair market value of each share of Class A common stock as $ and the initial fair market value of each of our senior subordinated notes represented by an IDS as $ and, by purchasing IDSs, you will agree to and be bound by such allocation, assuming an initial public offering price of $ per IDS, which represents the mid-point of the range set forth on the cover page of this prospectus. If this allocation is not respected, it is possible that the senior subordinated notes will be treated as having been issued with OID (if the allocation to the senior subordinated notes were determined to be too high) or amortizable bond premium (if the allocation to the senior subordinated notes were determined to be too low). You generally would have to include OID in income in advance of the receipt of cash attributable to that income and would be able to elect to amortize bond premium over the term of the senior subordinated notes. Subsequent issuances of senior subordinated notes may cause you to recognize OID and may be treated as a taxable exchange by you. The indenture governing the senior subordinated notes will provide that, in the event there is a subsequent issuance of senior subordinated notes but having terms that are otherwise identical (other than issuance date) to the senior subordinated notes, including any issuance of IDSs in exchange for shares of Class B common stock, but that are issued with OID, each holder of IDSs or separately held senior subordinated notes, as the case may be, agrees that, upon such issuance and any issuance of senior subordinated notes thereafter, a portion of such holder s senior subordinated notes will be automatically exchanged for a portion of the senior subordinated notes acquired by the holders of such subsequently issued senior subordinated notes. Consequently, immediately following such subsequent issuance and exchange, without any action by such holder, each holder of senior subordinated notes, held either as part of IDSs or separately, will own senior subordinated notes of each separate issuance in the same proportion as each other holder. Regardless of whether the exchange is treated as a taxable event, such exchange would result in holders having to include OID in taxable income prior to the receipt of cash as described below, and may result in other potentially adverse tax consequences to holders. See Material U.S. Federal Income Tax Consequences Consequences to U.S. Holders Senior Subordinated Notes Additional Issuances. In addition, the potential amount of OID that would be required to be included in taxable income by holders as a result of an automatic exchange (as described below) is indefinite and may be a significant amount, in part due to our ability to engage in numerous subsequent issuances. Following any subsequent issuance and exchange of senior subordinated notes with OID, we (and our agents) will report any OID on the subsequently issued senior subordinated notes ratably among all holders of IDSs and separately held senior subordinated notes, and each holder of IDSs and separately held senior subordinated notes will, by purchasing IDSs or separately held senior subordinated notes, agree to report OID in a manner consistent with this approach. However, the Internal Revenue Service may assert that any OID should be reported only to the persons that initially acquired such subsequently issued senior subordinated notes (and their transferees) and thus may challenge the holders reporting of OID on Table of Contents their tax returns. In such case, the Internal Revenue Service might further assert that, unless a holder can establish that it is not a person that initially acquired such subsequently issued senior subordinated notes (or a transferee thereof), all of the senior subordinated notes held by such holder would have OID. Any of these assertions by the Internal Revenue Service could create significant uncertainties in the pricing of IDSs and senior subordinated notes and could adversely affect the market for IDSs and senior subordinated notes. For a discussion of these tax related risks, see Material U.S. Federal Income Tax Consequences. The aggregate stated principal amount of the senior subordinated notes owned by each holder will not change as a result of such subsequent issuance and automatic exchange. However, under New York and federal bankruptcy law, holders of subsequently issued senior subordinated notes having OID may not be able to collect the portion of their principal face amount that represents unamortized OID at the acceleration or filing date in the event of an acceleration of the senior subordinated notes or our bankruptcy prior to the maturity date of the senior subordinated notes. As a result, an automatic exchange that results in a holder receiving a senior subordinated note with OID could have the effect of ultimately reducing the amount such holder can recover from us in the event of an acceleration or bankruptcy. We may have to establish a reserve for contingent tax liabilities in the future, which could adversely affect our ability to make dividend payments on the IDSs. Even if the IRS does not challenge the tax treatment of the senior subordinated notes, it is possible that as a result of an alteration of facts relied upon at the time of issuance of the notes, we will in the future need to change our anticipated accounting treatment and establish a reserve for contingent tax liabilities associated with the disallowance of all or part of the interest deductions on the notes. If we were required to maintain such a reserve, our ability to make dividend payments could be materially impaired and the market for the IDSs, Class A common stock and senior subordinated notes could be adversely affected. In addition, any resulting impact to our financial statements could lead to a default under the Amended Credit Facility. Before this offering, there has not been a public market for our IDSs, shares of our common stock or the senior subordinated notes, which may cause the price of the IDSs, shares of our common stock and separate senior subordinated notes to fluctuate substantially and negatively affect the value of your investment. None of the IDSs, the shares of our common stock or senior subordinated notes has a public market history. In addition, there has not been an active market in the United States for securities similar to the IDSs. An active trading market for the IDSs, shares of our common stock or the senior subordinated notes sold separately in this offering might not develop in the future, which may cause the price of the IDSs, shares of our common stock or the senior subordinated notes sold separately in this offering to fluctuate substantially, and we currently do not expect that an active trading market for the shares of our common stock will develop until the senior subordinated notes mature, if at all. If the senior subordinated notes represented by your IDSs are redeemed or mature, the IDSs will automatically separate and you will then hold the shares of our common stock. We do not intend to list our senior subordinated notes on any securities exchange. The initial public offering price of the IDSs and the senior subordinated notes sold separately in this offering will be determined by negotiations among us, our principal equity sponsor and the representatives of the underwriters and may not be indicative of the market price of the IDSs and the senior subordinated notes sold separately in this offering after the offering. Factors such as quarterly variations in our financial results and dividend payments, announcements by us or others, developments affecting us, our clients and our suppliers, general interest rate levels and general market volatility could cause the market price of the IDSs and the senior subordinated notes sold separately in this offering to fluctuate significantly. In addition, to the extent a market develops for our common stock or senior subordinated notes, or both, separate from the IDSs, the price of your IDSs may be affected. BALANCE, June 30, 2004 $ 3,185,672 $ Table of Contents The limited liquidity of the trading market for the senior subordinated notes sold separately may adversely affect the trading price of the separate senior subordinated notes. We are separately selling $ million aggregate principal amount of senior subordinated notes, representing approximately 10% of the total outstanding senior subordinated notes (including those senior subordinated notes represented by IDSs). While the senior subordinated notes sold separately are part of the same series of notes as, and are identical to, the senior subordinated notes represented by the IDSs, at the time of the issuance of the separate senior subordinated notes, the senior subordinated notes represented by the IDSs will not be separable for at least 45 days and will not be separately tradeable until separated. As a result, the initial trading market for the senior subordinated notes sold separately will be very limited. After the holders of the IDSs are permitted to separate their IDSs, a sufficient number of holders of IDSs may not separate their IDSs into shares of our common stock and senior subordinated notes so that a sizable and more liquid trading market for the senior subordinated notes not represented by IDSs may not develop or may not develop in a timely manner. Trading markets for debt securities have generally treated debt securities issued in larger aggregate principal amounts more favorably than similar securities issued in smaller aggregate principal amounts because of the increased liquidity created by potentially higher trading volumes associated with larger debt issuances. Because approximately 10% of the senior subordinated notes will initially be represented by the IDSs, it is likely that the senior subordinated notes sold separately will not trade at prices reflecting the aggregate principal amount of the combined issuance of senior subordinated notes included in the IDS offering and the separate senior subordinated notes offering. Therefore, a liquid market for the senior subordinated notes sold separately may not develop or may not develop in a timely manner, which may adversely affect the ability of the holders of the separate senior subordinated notes to sell any of their separate senior subordinated notes and the price at which these holders would be able to sell any of the senior subordinated notes sold separately. If interest rates rise, the trading value of our IDSs and the senior subordinated notes sold separately in this offering may decline. If interest rates rise or should the threat of rising interest rates develop, debt markets may be adversely affected. As a result, the trading value of our IDSs and senior subordinated notes may decline. Future sales or the possibility of future sales of a substantial amount of IDSs, shares of our common stock or the senior subordinated notes, together with the future conversion of our Class B common stock into IDSs, may depress the price of the IDSs, shares of our common stock and the senior subordinated notes. Future sales or the availability for sale of substantial amounts of IDSs or shares of our common stock or a significant principal amount of the senior subordinated notes in the public market could adversely affect the prevailing market price of the IDSs, shares of our common stock and the senior subordinated notes and could impair our ability to raise capital through future sales of our securities. After consummation of the Transactions, we anticipate that our existing stockholders will own IDSs and shares of our Class B common stock (or IDSs, if the underwriters over-allotment option is exercised in full). Subject to satisfaction of the Conversion Conditions, such shares of our Class B common stock will initially be convertible into IDSs. We may issue shares of our common stock and senior subordinated notes, which will be in the form of IDSs, or other securities from time to time as consideration for future acquisitions and investments. In the event any such acquisition or investment is significant, the number of shares of our common stock and the aggregate principal amount of senior subordinated notes, which may be in the form of IDSs, or the number or aggregate principal amount, as the case may be, of other securities that we may issue may in turn be significant. In addition, we may also grant registration rights covering those IDSs, shares of our common stock, senior subordinated notes or other securities in connection with any such acquisitions and investments. Table of Contents Our amended certificate of incorporation and by-laws and several other factors could limit another party s ability to acquire us and deprive our investors of the opportunity to obtain a takeover premium for their securities. Provisions contained in our amended and restated certificate of incorporation and by-laws could make it more difficult for a third party to acquire us, even if doing so might be beneficial to our stockholders. Provisions of our amended and restated certificate of incorporation and by-laws impose various procedural and other requirements that make it more difficult for stockholders to effect some corporate actions. For example, our amended and restated certificate of incorporation authorizes our board to determine the rights, preferences, privileges and restrictions of unissued series of preferred stock, without any vote or action by our stockholders. Thus, our board can authorize and issue shares of preferred stock with voting or conversion rights that could adversely affect the voting or other rights of holders of our common stock. These rights may have the effect of delaying or deterring a change of control of our company, and could limit the price that investors might be willing to pay in the future for shares of our common stock. In addition, a change of control of our company may be delayed or deferred as a result of our having three classes of directors. We are also subject to Section 203 of the Delaware General Corporation Law, which prohibits us from engaging in a business combination with an interested stockholder for a three-year period following the time that this stockholder becomes an interested stockholder, unless the business combination is approved in a prescribed manner. In addition, our amended and restated certificate of incorporation provides that for such time as Caxton-Iseman Capital together with its affiliates and related parties beneficially own at least 10% or 5% of our equity, it will be entitled to nominate two of our directors or one director, respectively. These provisions might make an unsolicited takeover more difficult or less likely to occur or might prevent such a takeover, even though such a takeover might offer our stockholders the opportunity to sell their stock at a price above the prevailing market price and might be favored by a majority of our stockholders. You will be immediately diluted by $ per share of common stock if you purchase IDSs in this offering. If you purchase IDSs in this offering, based on the book value of the assets and liabilities reflected on our balance sheet, you will experience an immediate dilution of $ per share of common stock represented by the IDSs, which exceeds the entire price allocated to each share of common stock represented by the IDSs in this offering, because there will be a net tangible book deficit for each share of common stock outstanding immediately after this offering. Our pro forma net tangible book deficiency as of June 30, 2004, after giving effect to this offering, was approximately $ million, or $ per share of Class A common stock. We may not be able to repurchase the senior subordinated notes upon a change of control. Upon the occurrence of specific kinds of change of control events, we will be required to offer to repurchase the outstanding senior subordinated notes at 101% of their principal amount at the date of repurchase unless such senior subordinated notes have been previously called for redemption. We may not have sufficient financial resources to purchase all of the senior subordinated notes that are tendered upon a change of control offer. Furthermore, the Amended Credit Facility, with certain limited exceptions, will prohibit the repurchase or redemption of the senior subordinated notes before their stated maturity. Consequently, lenders thereunder may have the right to prohibit any such purchase or redemption, in which event we will seek to obtain waivers from the required lenders. We may not be able to obtain such waivers or refinance our indebtedness on terms acceptable to us, or at all. Buffets Senior Notes will have similar terms restricting the repurchase of the senior subordinated notes while Buffets Senior Notes remain outstanding. Finally, the occurrence of a change of control could also constitute an event of default under the Amended Credit Facility, which could result in the acceleration of all amounts due thereunder. See Description of Senior Subordinated Notes Change of Control. Public offering price $ $ % $ Underwriting discount $ $ % $ Proceeds to Buffets Holdings, Inc. (before expenses)(3)(4) $ $ % $ (1) The price per IDS comprises $ allocated to each share of Class A common stock and $ allocated to each senior subordinated note. (2) Relates to the $ million aggregate principal amount of senior subordinated notes sold separately (not represented by IDSs). (3) Approximately $ million of these proceeds will be paid to our existing stockholders. (4) Assumes no exercise of the underwriters over-allotment option. The underwriters expect to deliver the IDSs and the senior subordinated notes in book-entry form only through the facilities of The Depository Trust Company to purchasers on or about , 2004. Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense. Table of Contents We may not be able to refinance the Amended Credit Facility or Buffets Senior Notes at maturity on favorable terms or at all. The amended and restated revolving credit facility and the senior secured term loan facility included in the Amended Credit Facility will mature in full in 2009 and 2011, respectively and Buffets Senior Notes will mature in 2014. We may not be able to renew or refinance the Amended Credit Facility or Buffets Senior Notes, or if renewed or refinanced, the renewal or refinancing may occur on less favorable terms. In particular, some of the terms of the senior subordinated notes that may be viewed as favorable to the senior lenders, such as our ability to defer interest and acceleration forbearance periods, become less favorable in 2009, which may materially adversely affect our ability to refinance or renew the Amended Credit Facility or Buffets Senior Notes beyond such date. If we are unable to refinance or renew the Amended Credit Facility or Buffets Senior Notes, our failure to repay all amounts due on the maturity date would cause a default under the Amended Credit Facility and Buffets Senior Notes. In addition, our interest expense may increase significantly if we refinance the Amended Credit Facility or Buffets Senior Notes on terms that are less favorable to us than the terms of the Amended Credit Facility or Buffets Senior Notes, respectively. Risks Relating to Our Business Our core buffet restaurants are a maturing restaurant concept and face intense competition. Our restaurants operate in a highly competitive industry comprising a large number of restaurants, including national and regional restaurant chains and franchised restaurant operations, as well as locally-owned, independent restaurants. Price, restaurant location, food quality, service and attractiveness of facilities are important aspects of competition, and the competitive environment is often affected by factors beyond a particular restaurant management s control, including changes in the public s taste and eating habits, population and traffic patterns and economic conditions. Many of our competitors have greater financial resources than we have and there are few non-economic barriers to entry. Therefore, new competitors may emerge at any time. We cannot assure you that we will be able to compete successfully against our competitors in the future or that competition will not have a material adverse effect on our operations or earnings. We have been operating our core buffet restaurant concept for 20 years, and our restaurant locations have a median age of approximately 10 years. As a result, we are exposed to vulnerabilities associated with being a mature concept. These include vulnerability to innovations by competitors and out-positioning in markets where the demographics or customer preferences have changed. Mature units require greater expenditures for repair, maintenance, refurbishments and re-concepting, and we will be required to continue making such expenditures in the future in order to preserve traffic at many of our restaurants. We cannot assure you, however, that these expenditures, particularly for remodeling and refurbishing, will be successful in preserving or building guest counts, as proved to be the case with a number of units recently upgraded as part of a two year re-imaging program. We are required to respond to changing consumer preferences and dining frequency. Our profits are dependent upon discretionary spending by consumers, which is markedly influenced by variations in the economy. Our average weekly sales declined 2.0% during fiscal 2003 due in large part to weak economic conditions. Furthermore, if our competitors in the casual dining, mid-scale and quick-service segments respond to economic changes through menu engineering or by adopting discount pricing strategies, it could have the effect of drawing customers away from companies such as ours that do not routinely engage in discount pricing, thereby reducing sales and pressuring margins. Because certain elements of our cost structure are fixed in nature, particularly over shorter time horizons, changes in marginal sales volume can have a more significant impact on our profitability than for a business possessing a more variable cost structure. We are dependent on attracting and retaining qualified employees while controlling labor costs. We operate in the service sector and are therefore extremely dependent upon the availability of qualified restaurant personnel. Availability of staff varies widely from location to location. If restaurant Joint Book-Running Managers Credit Suisse First Boston Banc of America Securities LLC CIBC World Markets Table of Contents management and staff turnover trends increase, we would suffer higher direct costs associated with recruiting and retaining replacement personnel. Moreover, we could suffer from significant indirect costs, including restaurant disruptions due to management changeover, increased above-store management staffing and potential delays in new store openings due to staff shortages. Competition for qualified employees exerts pressure on wages paid to attract qualified personnel, resulting in higher labor costs, together with greater expense to recruit and train them. Many of our employees are hourly workers whose wages may be impacted by an increase in the federal or state minimum wage. Proposals have been made at federal and state levels to increase minimum wage levels. An increase in the minimum wage may create pressure to increase the pay scale for our employees. A shortage in the labor pool or other general inflationary pressures or changes could also increase our labor costs. Furthermore, the operation of buffet-style restaurants is materially different from other restaurant concepts. Consequently, the retention of executive management familiar with our core buffet business is important to our continuing success. The departure of one or more key operations executives or the departure of multiple executives in a short time period could have an adverse impact on our business. Our former Executive Vice President of Purchasing separated from the company in 2004. We are currently considering the addition of one additional position to our executive management group. Our workers compensation and employee benefit expenses are disproportionately concentrated in states with adverse legislative climates. Our highest per-employee workers compensation insurance costs are in the State of California, where we retain a large employment presence. California also enacted legislation in October 2003 that would require large employers to provide health insurance or equivalent funding for workers who have traditionally not been covered by employer health plans. While this law is currently being challenged, other states have proposed similar legislation. Other state and federal mandates, such as compulsory paid absences, increases in overtime wages and unemployment tax rates, stricter citizenship requirements and revisions in the tax treatment of employee gratuities, could also adversely affect our business. Any increases in labor costs could have a material adverse effect on our results of operations and could decrease our profitability and cash available to service our debt obligations, if we were unable to compensate for such increased labor costs by raising the prices we charge our customers or realizing additional operational efficiencies. We are dependent on timely delivery of fresh ingredients by our suppliers. Our restaurant operations are dependent on timely deliveries of fresh ingredients, including fresh produce, dairy products and meat. The cost, availability and quality of the ingredients we use to prepare our food are subject to a range of factors, many of which are beyond our control. Fluctuations in weather, supply and demand and economic and political conditions could adversely affect the cost, availability and quality of our ingredients. Historically, when operating expenses increased due to inflation or increases in food costs, we recovered increased costs by increasing our menu prices. However, we may not be able to recover increased costs in the future because competition may limit or prohibit such future increases. If our food quality declines due to the lack of, or lower quality of, our ingredients or due to interruptions in the flow of fresh ingredients and similar factors, customer traffic may decline and negatively affect our restaurants results. We rely exclusively on third-party distributors and suppliers for such deliveries. The number of companies capable of servicing our distribution needs on a national basis has declined over time, reducing our bargaining leverage and increasing vulnerability to distributor interruptions. Our restaurant sales are subject to seasonality and major world events. Our restaurant sales volume fluctuates seasonally. Overall, restaurant sales are generally higher in the summer months and lower in the winter months. Positive or negative trends in weather conditions can have a strong influence on our business. This effect is heightened because many of our restaurants are in geographic areas that experience extremes in weather, including severe winter conditions and tropical storm patterns. Additionally, major world events may adversely affect our business. UBS Investment Bank Table of Contents We face risks associated with government regulations. In addition to wage and benefit regulatory risks, we are subject to other extensive government regulation at a federal, state and local level. These include, but are not limited to, regulations relating to the sale of food in all of our restaurants and of alcoholic beverages in our Tahoe Joe s Famous Steakhouse restaurants. We are required to obtain and maintain governmental licenses, permits and approvals. Difficulty or failure in obtaining or maintaining them in the future could result in delaying or canceling the opening of new restaurants or the closing of current ones. Local authorities may suspend or deny renewal of our governmental licenses if they determine that our operations do not meet the standards for initial grant or renewal. This risk would be even higher if there were a major change in the licensing requirements affecting our types of restaurants. The Federal Americans with Disabilities Act prohibits discrimination on the basis of disability in public accommodations and employment. Mandated modifications to our facilities in the future to make different accommodations for disabled persons could result in material, unanticipated expense. Application of state Dram Shop statutes, which generally provide a person injured by an intoxicated patron the right to recover damages from an establishment that wrongfully served alcoholic beverages to the intoxicated person, to our operations, or liabilities otherwise associated with liquor service in our Tahoe Joe s Famous Steakhouse restaurants, could negatively affect our financial condition if not otherwise insured under our general liability insurance policy. Negative publicity relating to one of our restaurants, including our franchised restaurants, could reduce sales at some or all of our other restaurants. We are, from time to time, faced with negative publicity relating to food quality, restaurant facilities, health inspection scores, employee relationships or other matters at one of our restaurants or those of our franchisees. Adverse publicity may negatively affect us, regardless of whether the allegations are valid or whether we are liable. In addition, the negative impact of adverse publicity relating to one restaurant may extend beyond the restaurant involved to affect some or all of our other restaurants. If a franchised restaurant fails to meet our franchise operating standards, our own restaurants could be adversely affected due to customer confusion or negative publicity. A similar risk exists with respect to totally unrelated food service businesses, if customers mistakenly associate such unrelated businesses with our own operations. Food-borne illness incidents could result in liability to us and could reduce our restaurant sales. We cannot guarantee that our internal controls and training will be fully effective in preventing all food-borne illnesses. Furthermore, our reliance on third-party food processors makes it difficult to monitor food safety compliance and increases the risk that food-borne illness would affect multiple locations rather than single restaurants. Some food-borne illness incidents could be caused by third-party food suppliers and transporters outside of our control. New illnesses resistant to our current precautions may develop in the future, or diseases with long incubation periods could arise, such as bovine spongiform encephalopathy ( BSE ), sometimes referred to as mad cow disease, that could give rise to claims or allegations on a retroactive basis. In addition, the levels of chemicals or other contaminants that are currently considered safe in certain foods may be regulated more restrictively in the future or become the subject of public concern. The reach of food-related public health concerns can be considerable given the attention given these matters by the media. Local public health developments could have a national adverse impact on our sales, whether or not specifically attributable to our restaurants or those of our franchisees or competitors. Any negative development relating to our self-service food service approach would have a material adverse impact on our primary business. Our buffet restaurants utilize a service format that is heavily dependent upon self-service by our customers. Food tampering by customers or other events affecting the self-service format could cause Co-Managers JPMorgan Piper Jaffray The date of this prospectus is , 2004. Table of Contents regulatory changes or changes in our business pattern or customer perception. Any development that would materially impede or prohibit our continued use of a self-service food service approach, or reduce the appeal of self-service to our guests, would have a material adverse impact on our primary business. We face risks associated with environmental laws. We are subject to federal, state and local laws, regulations and ordinances that govern activities or operations that may have adverse environmental effects, such as discharges to air and water, as well as handling and disposal practices for solid and hazardous wastes. These may impose liability for the costs of cleaning up, and damage resulting from, sites of past spills, disposals or other releases of hazardous materials, both from governmental and private claimants. We could incur such liabilities regardless of whether we lease or own the restaurants or land in question and regardless of whether such environmental conditions were created by us or by a prior owner or tenant. We cannot assure you that environmental conditions relating to our prior, existing or future restaurants or restaurant sites will not have a material adverse affect on us. We face risks because of the number of restaurants that we lease. Our success depends in part on our ability to secure leases in desired locations at rental rates we believe to be reasonable. We currently lease all of our restaurants located in shopping centers and malls, and we lease the land for all but one of our freestanding restaurants. By December 2007, approximately 85 of our current leases will have expiring base lease terms and be subject to renewal consideration. Each lease agreement provides that the lessor may terminate the lease for a number of reasons, including our default in any payment of rent or taxes or our breach of any covenant or agreement in the lease. Termination of any of our leases could harm our results of operations and, as with a default under any of our indebtedness, could have a material adverse impact on our liquidity. Although we believe that we will be able to renew the existing leases that we wish to extend, we cannot assure you that we will succeed in obtaining extensions in the future at rental rates that we believe to be reasonable or at all. Moreover, if some locations should prove to be unprofitable, we could remain obligated for lease payments even if we decided to withdraw from those locations. See Business Property. We will incur special charges relating to the closing of such restaurants, including lease termination costs. Impairment charges and other special charges will reduce our profits. We may not be able to protect our trademarks and other proprietary rights. We believe that our trademarks and other proprietary rights are important to our success and our competitive position. Accordingly, we devote substantial resources to the establishment and protection of our trademarks and proprietary rights. However, the actions taken by us may be inadequate to prevent imitation of our brands, proprietary rights and concepts by others, which may thereby dilute our brands in the marketplace or diminish the value of such proprietary rights, or to prevent others from claiming violations of their trademarks and proprietary rights by us. In addition, others may assert rights in our trademarks and other proprietary rights. Our exclusive rights to our trademarks are subject to the common law rights of any other person who began using the trademark (or a confusingly similar mark) prior to both the date of our registration and our first use of such trademarks in the relevant territory. For example, because of the common law rights of such a preexisting restaurant in portions of Colorado and Wyoming, our restaurants in those states use the name Country Buffet. We cannot assure you that third parties will not assert claims against our intellectual property or that we will be able to successfully resolve such claims. Future actions by third parties may diminish the strength of our restaurant concepts trademarks or other proprietary rights and decrease our competitive strength and performance. We could also incur substantial costs to defend or pursue legal actions relating to the use of our intellectual property, which could have a material adverse affect on our business, results of operation or financial condition. TABLE OF CONTENTS Page Table of Contents
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+RISK FACTORS Before investing in our ordinary shares you should carefully consider the following risk factors and all other information set forth in this prospectus. These risks could materially affect our business, results of operations or financial condition and cause the trading price of our ordinary shares to decline. You could lose all or part of your investment. Risks Relating to Our Business Since we have a limited operating history, it is difficult to predict our future performance. Our Bermuda insurance subsidiary, Endurance Bermuda, was formed on November 30, 2001 and began operations on December 17, 2001. Endurance Holdings was formed on June 27, 2002. Endurance U.S. was formed on September 5, 2002 and received a license to write certain lines of reinsurance business in the State of New York from the New York State Department of Insurance (the New York Department ) on December 18, 2002. Endurance U.K. was formed on April 10, 2002 and on December 4, 2002 was authorized by the United Kingdom s Financial Services Authority ( FSA ) to begin writing certain lines of insurance and reinsurance in the United Kingdom and European Union. As a result, there is limited historical financial and operating information available to help you evaluate our past performance or to make a decision about an investment in our ordinary shares. Companies in their initial stages of development present substantial business and financial risks and may suffer significant losses. These new companies must successfully develop business relationships, establish operating procedures, hire staff, install management information and other systems, establish facilities and obtain licenses, as well as take other steps necessary to conduct their intended business activities. As a result of these risks, it is possible that we may not be successful in implementing our business strategy or in completing the development of the infrastructure necessary to run our business. In addition, because of our limited operating history, our historical financial results may not accurately predict our future performance. As a result of industry factors or factors specific to us, we may have to alter our anticipated methods of conducting our business, such as the nature, amount and types of risks we assume. If actual claims exceed our reserve for losses and loss expenses, our financial condition and results of operations could be adversely affected. Our success depends upon our ability to accurately assess the risks associated with the businesses that we insure or reinsure. We establish loss reserves to cover our estimated liability for the payment of all losses and loss expenses incurred with respect to premiums earned on the policies that we write. Loss reserves do not represent an exact calculation of liability. Rather, loss reserves are estimates of what we expect the ultimate settlement and administration of claims will cost. These estimates are based upon actuarial and statistical projections and on our assessment of currently available data, as well as estimates of future trends in claims severity and frequency, judicial theories of liability and other factors. Loss reserve estimates are refined continually in an ongoing process as experience develops and claims are reported and settled. Establishing an appropriate level of loss reserves is an inherently uncertain process. Moreover, these uncertainties are greater for insurers like us than for insurers with a longer operating history because we do not yet have an established loss history. Because of this uncertainty, it is possible that our reserves at any given time will prove inadequate. To the extent we determine that actual losses and loss expenses exceed our expectations and reserves recorded in our financial statements, we will be required to immediately increase reserves. This could cause a material reduction in our profitability and capital. The number and size of reported claims that we have received to date have been moderate, resulting in $162.5 million in case reserves on our balance sheet at December 31, 2003. In the future, the number of claims could increase, and their cumulative size could exceed our loss reserves. The selling shareholders identified in this prospectus are offering up to 8,000,000 ordinary shares of Endurance Specialty Holdings Ltd. We will not receive any proceeds from the sale of ordinary shares by the selling shareholders. Our ordinary shares are listed on the New York Stock Exchange ( NYSE ) under the trading symbol ENH. The last reported sale price of our ordinary shares on the NYSE on March 1, 2004 was $33.86 per share. Investing in our ordinary shares involves risk. See Risk Factors beginning on page 8 to read about factors you should consider before buying ordinary shares. Back to Contents As a property and property catastrophe insurer and reinsurer, we are particularly vulnerable to losses from catastrophes. Our property and property catastrophe insurance and reinsurance operations expose us to claims arising out of catastrophes. Catastrophes can be caused by various unpredictable events, including earthquakes, hurricanes, hailstorms, severe winter weather, floods, fires, tornadoes, explosions and other natural or man-made disasters. We also face substantial exposure to losses resulting from acts of war, acts of terrorism and political instability. The global geographic distribution of our business subjects us to catastrophe exposure for natural events occurring in a number of areas throughout the world, including, but not limited to, windstorms in Europe, hurricanes in Florida, the Gulf Coast and the Atlantic coast regions of the United States, typhoons and earthquakes in Japan and earthquakes in California and the New Madrid region of the United States. The loss experience of property catastrophe insurers and reinsurers has generally been characterized as low frequency but high severity in nature. We expect that increases in the values and concentrations of insured property will increase the severity of such occurrences in the future. In the event that we experience catastrophe losses, there is a possibility that our unearned premium and loss reserves will be inadequate to cover these risks. In addition, because accounting regulations do not permit insurers and reinsurers to reserve for such catastrophic events until they occur, claims from catastrophic events could cause substantial volatility in our financial results for any fiscal quarter or year and could have a material adverse effect on our financial condition and results of operations. Our ability to write new business also could be adversely impacted. See Business Underwriting and Risk Management. As a property and casualty insurer and reinsurer, we could face losses from war, terrorism and political unrest. We may have substantial exposure to losses resulting from acts of war, acts of terrorism and political instability. These risks are inherently unpredictable, although recent events may lead to increased frequency and severity. It is difficult to predict their occurrence with statistical certainty or to estimate the amount of loss an occurrence will generate. Accordingly, it is possible that our loss reserves will be inadequate to cover these risks. Although we generally exclude acts of terrorism from insurance policies and reinsurance treaties where practicable, we also provide coverage in circumstances where we believe we are adequately compensated for assuming such risk. Even in cases where we have deliberately sought to exclude coverage, we may not be able to eliminate completely our exposure to terrorist acts and thus it is possible that these acts will have a material adverse effect on us. The risks associated with property and casualty reinsurance underwriting could adversely affect us. Because we participate in property and casualty reinsurance markets, the success of our underwriting efforts depends, in part, upon the policies, procedures and expertise of the ceding companies making the original underwriting decisions. We face the risk that these ceding companies may fail to accurately assess the risks that they assume initially, which, in turn, may lead us to inaccurately assess the risks we assume. If we fail to establish and receive appropriate premium rates, we could face significant losses on these contracts. If actual renewals of our existing contracts do not meet expectations, our premiums written in future years and our future results of operations could be materially adversely affected. Our contracts are generally for a one-year term. In our financial forecasting process, we make assumptions about the renewal of our prior year s contracts. If actual renewals do not meet expectations, our premiums written in future years and our future results of operations could be materially adversely affected. This risk is especially prevalent in the first quarter of each year when a large number of reinsurance contracts are subject to renewal. The failure of any of the loss limitation methods we employ could have a material adverse effect on our financial condition or on our results of operations. We seek to limit our loss exposure by writing many of our insurance and reinsurance contracts on an excess of loss basis, adhering to maximum limitations on policies written in defined geographical zones, Per Share Total limiting program size for each client, establishing per risk and per occurrence limitations for each event and prudent underwriting guidelines for each program written. In the case of proportional treaties, we seek per occurrence limitations or loss ratio caps to limit the impact of losses from any one event. Most of our direct liability insurance policies include maximum aggregate limitations. We also seek to limit our loss exposure through geographic diversification. Geographic zone limitations involve significant underwriting judgments, including the determination of the area of the zones and whether a policy falls within particular zone limits. Disputes relating to coverage and choice of legal forum may also arise. As a result, various provisions of our policies, such as limitations or exclusions from coverage or choice of forum, may not be enforceable in the manner we intend and some or all of our other loss limitation methods may prove to be ineffective. Underwriting is a matter of judgment, involving important assumptions about matters that are inherently unpredictable and beyond our control, and for which historical experience and probability analysis may not provide sufficient guidance. One or more catastrophic or other events could result in claims that substantially exceed our expectations, which could have a material adverse effect on our financial condition and our results of operations, possibly to the extent of eliminating our shareholders equity. Since we are dependent on key executives, the loss of any of these executives or our inability to retain other key personnel could adversely affect our business. Our success substantially depends upon our ability to attract and retain qualified employees and upon the ability of our senior management and other key employees to implement our business strategy. We believe there are only a limited number of available qualified executives in the business lines in which we compete. Although we are not aware of any planned departures, we rely substantially upon the services of Kenneth J. LeStrange, our Chief Executive Officer, President and Chairman of the board of directors, Steven W. Carlsen, Chairman of Endurance U.S. and President of Endurance Services, and James R. Kroner, our Chief Financial Officer. Each of Messrs. LeStrange, Carlsen and Kroner have employment agreements with the Company. We believe we have been successful in attracting and retaining key personnel since our inception. The loss of any of their services or the services of other members of our management team or the inability to attract and retain other talented personnel could impede the further implementation of our business strategy, which could have a material adverse effect on our business. We do not currently maintain key man life insurance policies with respect to any of our employees. Our business could be adversely affected by Bermuda employment restrictions. We will need to continue to hire employees to work in Bermuda. Under Bermuda law, non-Bermudians (other than spouses of Bermudians) may not engage in any gainful occupation in Bermuda without an appropriate governmental work permit. Work permits may be granted or extended by the Bermuda government upon showing that, after proper public advertisement in most cases, no Bermudian (or spouse of a Bermudian) is available who meets the minimum standard requirements for the advertised position. The Bermuda government recently announced a new policy limiting the duration of work permits to six years, with certain exemptions for key employees. All of our 48 Bermuda-based professional employees who require work permits, including Messrs. LeStrange and Kroner, have been granted permits by the Bermuda government. The terms of these permits range from three to five years depending on the individual. None of our current Bermuda employees for whom we have applied for a work permit have been denied. It is possible that we could lose the services of one or more of our key employees if we are unable to obtain or renew their work permits, which could have a material adverse effect on our business. A decline in the financial strength ratings of Endurance Bermuda, Endurance U.K. or Endurance U.S. could affect our standing among brokers and customers and cause our premiums and earnings to decrease. Ratings have become an increasingly important factor in establishing the competitive position of insurance and reinsurance companies. A.M. Best assigned to Endurance Bermuda, Endurance U.K. and Endurance U.S. a financial strength rating of A (Excellent) and Standard & Poor s assigned a financial strength rating to Endurance Bermuda, Endurance U.K. and Endurance U.S. of A- (Strong). The objective of A.M. Best s and Standard & Poor s rating systems is to provide an opinion of an insurer s or reinsurer s financial strength and ability to meet ongoing obligations to its policyholders. These ratings reflect A.M. Back to Contents Best s and Standard & Poor s opinions of Endurance Bermuda s, Endurance U.K. s and Endurance U.S. s initial capitalization, performance, management and sponsorship, and are not applicable to the ordinary shares offered by this prospectus and are not a recommendation to buy, sell or hold such shares. A.M. Best maintains a letter scale rating system ranging from A++ (Superior) to F (In Liquidation), and includes 16 separate ratings categories. Within these categories, A++ (Superior) and A+ (Superior) are the highest, followed by A (Excellent) and A- (Excellent). Publications of A.M. Best indicate that the A and A- ratings are assigned to those companies that, in A.M. Best s opinion, have demonstrated an excellent ability to meet their ongoing obligations to policyholders. These ratings are subject to periodic review by, and may be revised downward or revoked at the sole discretion of, A.M. Best. The rating A (Excellent) by A.M. Best is the third highest of 15 rating levels (the rating of S (Suspended) is considered a rating category but not a rating level). Standard & Poor s maintains a letter rating system ranging from AAA (Extremely Strong) to R (Under Regulatory Supervision). Within these categories, AAA (Extremely Strong) is the highest, followed by AA+, AA and AA- (Very Strong) and A+, A and A- (Strong). Publications of Standard & Poor s indicate that the A+, A and A- ratings are assigned to those companies that, in Standard & Poor s opinion, have demonstrated strong financial security characteristics, but are somewhat more likely to be affected by adverse business conditions than are insurers with higher ratings. These ratings may be changed, suspended, or withdrawn at the discretion of Standard & Poor s. The rating A- (Strong) by Standard & Poor s is the seventh highest of twenty-one rating levels. If Endurance Bermuda s, Endurance U.K. s or Endurance U.S. s rating is reduced from its current level by A.M. Best or Standard & Poor s, our competitive position in the insurance and reinsurance industry would suffer, and it would be more difficult for us to market our products. A downgrade could result in a significant reduction in the number of insurance and reinsurance contracts we write and in a substantial loss of business as client companies, and brokers that place such business, move to other competitors with higher ratings. Our holding company structure and certain regulatory and other constraints affect our ability to pay dividends and make other payments. Endurance Holdings is a holding company and, as such, has no substantial operations of its own. Dividends and other permitted distributions from insurance subsidiaries are expected to be Endurance Holdings primary source of funds to meet ongoing cash requirements, including debt service payments and other expenses, and to pay dividends, if any, to shareholders. Bermuda law and regulations, including, but not limited to, Bermuda insurance regulations, restrict the declaration and payment of dividends and the making of distributions by Endurance Bermuda unless certain regulatory requirements are met. The inability of Endurance Bermuda to pay dividends in an amount sufficient to enable Endurance Holdings to meet its cash requirements at the holding company level could have a material adverse effect on its operations. In addition, Endurance U.K. and Endurance U.S. are subject to significant regulatory restrictions limiting their ability to declare and pay dividends. We therefore do not expect to receive dividends from either of those subsidiaries for the foreseeable future. Endurance Holdings is subject to Bermuda regulatory constraints that will affect its ability to pay dividends on its ordinary shares and make other payments. Under the Bermuda Companies Act 1981, as amended (the Companies Act ), Endurance Holdings may declare or pay a dividend or make a distribution out of retained earnings or contributed surplus only if it has reasonable grounds for believing that it is, or would after the payment be, able to pay its liabilities as they become due and if the realizable value of its assets would thereby not be less than the aggregate of its liabilities and issued share capital and share premium accounts. In addition, our credit facilities prohibit Endurance Holdings from declaring or paying any dividends if a default or event of default has occurred and is continuing at the time of such declaration or payment or would result from such declaration or payment. For a discussion of the legal limitations on our subsidiaries ability to pay dividends to Endurance Holdings and of Endurance Holdings to pay dividends to its shareholders, see Dividend Policy, Management s Discussion and Analysis of Financial Condition and Results of Operations Liquidity and Capital Resources, Certain Indebtedness and Regulatory Matters. Back to Contents The cost of reinsurance security arrangements may materially impact our margins. As a Bermuda reinsurer, Endurance Bermuda is required to post collateral security with respect to reinsurance liabilities it assumes from ceding insurers domiciled in the U.S. The posting of collateral security is generally required in order for U.S. ceding companies to obtain credit on their U.S. statutory financial statements with respect to reinsurance liabilities ceded to unlicensed or unaccredited reinsurers. Under applicable statutory provisions, the security arrangements may be in the form of letters of credit, reinsurance trusts maintained by third-party trustees or funds-withheld arrangements whereby the trusted assets are held by the ceding company. Endurance Bermuda has the ability to issue up to $470 million in letters of credit under the Company s letter of credit and revolving credit facility that expires on August 6, 2004. If this facility is not sufficient or if the Company is unable to renew this facility or is unable to arrange for other types of security on commercially acceptable terms, the ability of Endurance Bermuda to provide reinsurance to U.S.-based clients may be severely limited. Security arrangements may subject our assets to security interests and/or require that a portion of our assets be pledged to, or otherwise held by, third parties. Although the investment income derived from our assets while held in trust typically accrues to our benefit, the investment of these assets is governed by the investment regulations of the state of domicile of the ceding insurer, which may be more restrictive than the investment regulations applicable to us under Bermuda law. The restrictions may result in lower investment yields on these assets, which could have a material adverse effect on our profitability. The right of certain significant investors to designate a majority of our directors may prevent or frustrate attempts by shareholders to replace or remove the current management of the Company. As of the date of this prospectus, our founding shareholders beneficially own ordinary shares aggregating approximately 82% of the equity interest in our ordinary shares on a fully diluted basis assuming the full exercise of all vested share options, restricted share units and warrants exercisable for ordinary shares or class A shares. Certain of our significant investors have contractual rights to nominate designees as candidates for election to our board of directors and select from our directors members of committees of our board of directors, and have so designated seven of our existing eleven directors. See Description of Share Capital Amended and Restated Shareholders Agreement Composition of Board and Board Committees. As a result of their ownership position and contractual rights, our significant investors and their board representatives, independently and voting together with our other existing shareholders, will have the ability to significantly influence matters requiring shareholder approval, including, without limitation, the election of directors and amalgamations, consolidations and sales of all or substantially all of our assets. The commercial and investment activities of our significant investors may lead to conflicts of interest. Certain of our significant investors engage in commercial activities and enter into transactions or agreements with us or in competition with us, which may give rise to conflicts of interest. We derive a significant portion of our business through reinsurance relationships and other arrangements in which Aon, one of the selling shareholders, has acted as a broker or insurance or reinsurance intermediary. Due to Aon s investment in us and their involvement in our formation, it is possible that certain brokers and intermediaries that compete with Aon will perceive a conflict of interest in our relationships with Aon and may, therefore, be hesitant to present insurance and reinsurance proposals and opportunities to us. As of the date of this prospectus, Aon held approximately 21.9% of our outstanding ordinary shares on a fully diluted basis. After giving effect to this offering, assuming no exercise of the over-allotment option, Aon would have held approximately 19.4% of our outstanding ordinary shares on a fully diluted basis as of that date. See Principal and Selling Shareholders. Some of our significant investors or their affiliates have sponsored, and may in the future sponsor, other entities engaged in or intending to engage in insurance and reinsurance underwriting, some of which, together with our significant investors, may compete with us. Certain of our significant investors and their affiliates have also entered into agreements with and made investments in numerous companies that may compete with us. Back to Contents Profitability may be adversely impacted by inflation. The effects of inflation could cause the cost of claims from catastrophes or other events to rise in the future. Our reserve for losses and loss expenses includes assumptions about future payments for settlement of claims and claims handling expenses, such as medical treatments and litigation costs. To the extent inflation causes these costs to increase above reserves established for these claims, we will be required to increase our loss reserves with a corresponding reduction in our net income in the period in which the deficiency is identified. Our investment performance may affect our financial assets and ability to conduct business. We derive a significant portion of our income from our invested assets. As a result, our operating results depend in part on the performance of our investment portfolio, which currently consists of fixed maturity securities. Our income derived from our invested assets was $76.7 million or 29.1% of our net income for the year ended December 31, 2003. Our operating results are subject to a variety of investment risks, including risks relating to general economic conditions, market volatility, interest rate fluctuations, liquidity risk and credit and default risk. Additionally, with respect to certain investments, we are subject to pre-payment or reinvestment risk. With respect to our longer-term liabilities, we strive to structure our investments in a manner that recognizes our liquidity needs for our future liabilities. In that regard, we attempt to correlate the maturity and duration of our investment portfolio to our general and specific liability profile. However, if our liquidity needs or general and specific liability profile unexpectedly change, we may not be successful in continuing to structure our investment portfolio in that manner. The market value of our fixed maturity investments will be subject to fluctuation depending on changes in various factors, including prevailing interest rates. To the extent that we are unsuccessful in correlating our investment portfolio with our liabilities, we may be forced to liquidate our investments at times and prices that are not optimal, which could have a material adverse effect on the performance of our investment portfolio. Interest rates are highly sensitive to many factors, including governmental monetary policies, domestic and international economic and political conditions and other factors beyond our control. Although we attempt to take measures to manage the risks of investing in a changing interest rate environment, we may not be able to mitigate interest rate sensitivity effectively. Our mitigation efforts include maintaining a high quality portfolio with a relatively short duration to reduce the effect of interest rate changes on book value. A significant portion of the investment portfolio matures each year, allowing for reinvestment at current market rates. The portfolio is actively managed and trades are made to balance our exposure to interest rates. However, a significant increase in interest rates could have a material adverse effect on our book value. We may be adversely affected by foreign currency fluctuations. We have made a significant investment in the capitalization of Endurance U.K., which is denominated in British Sterling. In addition, we enter into reinsurance and insurance contracts where we are obligated to pay losses in currencies other than U.S. dollars. For the year ended December 31, 2003, approximately 9% of our gross premiums were written in currencies other than the U.S. dollar. A portion of our cash and cash equivalents, investments and loss reserves are also denominated in non-U.S. currencies. The majority of our operating foreign currency assets and liabilities are denominated in Euros, British Sterling, Canadian Dollars, Japanese Yen and Australian Dollars ( Major Currencies ). We may, from time to time, experience losses from fluctuations in the values of these and other non-U.S. currencies, which could have a material adverse affect on our results of operations. We periodically buy and sell Major Currencies or investment securities denominated in Major Currencies in an attempt to match our non-U.S. dollar assets to our related non-U.S. dollar liabilities. We have no currency hedges in place; however, as part of our matching strategy, we consider the use of hedges when we become aware of probable significant losses that will be paid in non-U.S. currencies. However, it is possible that we will not successfully match our exposures or structure the hedges so as to effectively manage these risks. Public offering price $ $ Underwriting discount $ $ Proceeds, before expenses, to selling shareholders $ $ To the extent that the underwriters sell more than 8,000,000 ordinary shares, the underwriters have the option to purchase up to an additional 1,200,000 ordinary shares from the selling shareholders at the initial offering price less the underwriting discount. Neither the Securities and Exchange Commission, any state securities commission, the Registrar of Companies in Bermuda, the Bermuda Monetary Authority nor any other regulatory body has approved or disapproved of these securities or passed upon the adequacy of this prospectus. Any representation to the contrary is a criminal offense. The shares will be ready for delivery on or about , 2004. Back to Contents We may require additional capital in the future which may not be available or only available on unfavorable terms. Our future capital requirements depend on many factors, including our ability to write new business successfully and to establish premium rates and reserves at levels sufficient to cover losses. We may need to raise additional funds through financings or curtail our growth and reduce our assets. Any equity or debt financing, if available at all, may be on terms that are not favorable to us. In the case of equity financings, dilution to our shareholders could result, and in any case such securities may have rights, preferences and privileges that are senior to those of the ordinary shares offered hereby. If we cannot obtain adequate capital, our business, results of operations and financial condition could be adversely affected. Since we depend on a few brokers for a large portion of our revenues, loss of business provided by any one of them could adversely affect us. We market our insurance and reinsurance worldwide primarily through insurance and reinsurance brokers. In the year ended December 31, 2003, our top five brokers represented approximately 86% of our gross premiums written, excluding gross premiums acquired in the HartRe transaction. See Business Distribution. One of those brokers, Aon, is currently one of our investors and is a selling shareholder in the offering being made pursuant to this prospectus. Affiliates of two of these brokers, Marsh and Benfield, have also co- sponsored the formation of other Bermuda reinsurers that may compete with us, and these brokers may decide to favor the reinsurers they sponsored over other companies. Loss of all or a substantial portion of the business provided by one or more of these brokers could have a material adverse effect on our business. Our reliance on brokers subjects us to their credit risk. In accordance with industry practice, we frequently pay amounts owed on claims under our insurance or reinsurance contracts to brokers, and these brokers, in turn, pay these amounts over to the clients that have purchased insurance or reinsurance from us. If a broker fails to make such a payment, in a significant majority of business that the Company writes, it is highly likely that the Company will be liable to the client for the deficiency because of local laws or contractual obligations. Likewise, when the client pays premiums for these policies to brokers for payment over to us, these premiums are considered to have been paid and, in most cases, the client will no longer be liable to us for those amounts, whether or not we have actually received the premiums. Consequently, we assume a degree of credit risk associated with brokers around the world with respect to most of our insurance and reinsurance business. To date we have not experienced any losses related to such credit risks. The effects of emerging claim and coverage issues on our business are uncertain. As industry practices and legal, judicial, social and other environmental conditions change, unexpected and unintended issues related to claims and coverage may emerge. These issues may adversely affect our business by either extending coverage beyond our underwriting intent or by increasing the number or size of claims. In some instances, these changes may not become apparent until some time after we have issued insurance or reinsurance contracts that are affected by the changes. As a result, the full extent of liability under our insurance or reinsurance contracts may not be known for many years after a contract is issued. Recent examples of emerging claims and coverage issues include: larger settlements and jury awards for professionals and corporate directors and officers covered by professional liability and directors and officers liability insurance; and a growing trend of plaintiffs targeting property and casualty insurers in purported class action litigations relating to claims-handling, insurance sales practices and other practices related to the conduct of our business. The effects of these and other unforeseen emerging claim and coverage issues are extremely hard to predict and could harm our business. Goldman, Sachs & Co. Merrill Lynch & Co. Credit Suisse First Boston Deutsche Bank Securities JPMorgan Wachovia Securities Back to Contents We operate in a highly competitive environment which could adversely impact our operating margins. The insurance and reinsurance industries are highly competitive. We compete with major U.S. and non-U.S. insurers and reinsurers, including other Bermuda-based insurers and reinsurers. For information regarding competition in each of our business segments, see Business Business Segments. Many of our competitors have greater financial, marketing and management resources. A number of newly-organized, Bermuda-based insurance and reinsurance entities compete in the same market segments in which we operate. In addition, we may not be aware of other companies that may be planning to enter the segments of the insurance and reinsurance market in which we operate or of existing companies that may be planning to raise additional capital. Increasing competition could result in fewer submissions, lower premium rates and less favorable policy terms and conditions, which could have a material adverse impact on our growth and profitability. Further, insurance/risk-linked securities and derivative and other non-traditional risk transfer mechanisms and vehicles are being developed and offered by other parties, including non-insurance company entities, which could impact the demand for traditional insurance or reinsurance. A number of new, proposed or potential industry or legislative developments could further increase competition in our industry. These developments include: several new insurance and reinsurance companies have been formed and capitalized in excess of $500 million since September 2001 and a number of these companies compete with us in the same markets; legislative mandates for insurers to provide certain types of coverage in areas where we or our ceding clients do business, such as the mandated terrorism coverage in the Terrorism Risk Insurance Act of 2002, could eliminate the opportunities for us to write those coverages; and programs in which state-sponsored entities provide property insurance in catastrophe prone areas or other alternative markets types of coverage could eliminate the opportunities for us to write those coverages. In addition, insurance companies that merge may be able to enhance their negotiating position when buying reinsurance and may be able to spread their risks across a consolidated, larger capital base so that they require less reinsurance. New competition from these developments could cause the demand for insurance or reinsurance to fall or the expense of customer acquisition and retention to increase, either of which could have a material adverse affect on our growth and profitability. Efforts to comply with the Sarbanes-Oxley Act will entail significant expenditure; non-compliance with the Sarbanes-Oxley Act may adversely affect us. The Sarbanes-Oxley Act of 2002 that became law in July 2002, as well as new rules subsequently implemented by the Securities and Exchange Commission ( Commission ) and the NYSE, have required, and will require, changes to some of our accounting and corporate governance practices, including the requirement that we issue a report on our internal controls as required by Section 404 of the Sarbanes-Oxley Act. We expect these new rules and regulations to continue to increase our accounting, legal and other costs, and to make some activities more difficult, time consuming and/or costly. Compliance with Section 404 of the Sarbanes-Oxley Act is required by December 31, 2004. In the event that we are unable to achieve compliance with the Sarbanes-Oxley Act and related rules, it may have a material adverse effect on us. The historical cyclicality of the property and casualty reinsurance industry may cause fluctuations in our results. Historically, property and casualty reinsurers have experienced significant fluctuations in operating results due to competition, frequency of occurrence or severity of catastrophic events, levels of capacity, general economic conditions and other factors. Demand for reinsurance is influenced significantly by underwriting results of primary property and casualty insurers and prevailing general economic conditions. The date of this prospectus is , 2004. The information in this prospectus is not complete and may be changed. The selling shareholders may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell these securities and it is not soliciting an offer to buy these securities in any jurisdiction where the offer or sale is not permitted. The supply of reinsurance is related to prevailing prices, the levels of insured losses and the levels of industry surplus which, in turn, may fluctuate in response to changes in rates of return on investments being earned in the reinsurance industry. As a result, the reinsurance business historically has been a cyclical industry characterized by periods of intense price competition due to excessive underwriting capacity as well as periods when shortages of capacity permitted favorable premium levels. Although rates for many products have generally increased since our formation, and remain above our benchmark rates, the supply of reinsurance may increase, either by capital provided by new entrants or by the commitment of additional capital by existing reinsurers, which may cause prices to decrease. We are beginning to see more competition across many of the lines of business in which we participate. Any of these factors could lead to a significant reduction in premium rates, less favorable policy terms and conditions and fewer submissions for our underwriting services. In addition to these considerations, changes in the frequency and severity of losses suffered by insurers may affect the cycles of the reinsurance business significantly, and we expect to experience the effects of such cyclicality. For a description of recent trends in the property and casualty insurance and reinsurance industries, see Industry Background. Acquisitions or strategic investments that we made or may make could turn out to be unsuccessful. As part of our strategy, we have pursued and may continue to pursue growth through acquisitions and/or strategic investments in new businesses. The negotiation of potential acquisitions or strategic investments as well as the integration of an acquired business or new personnel could result in a substantial diversion of management resources. Acquisitions could involve numerous additional risks such as potential losses from unanticipated litigation or levels of claims and inability to generate sufficient revenue to offset acquisition costs. Our ability to manage our growth through acquisitions or strategic investments will depend, in part, on our success in addressing these risks. Any failure by us to effectively implement our acquisitions or strategic investment strategies could have a material adverse effect on our business, financial condition or results of operations. The regulatory system under which we operate, and potential changes thereto, could have a material adverse effect on our business. General. Our insurance subsidiaries may not be able to obtain or maintain necessary licenses, permits, authorizations or accreditations, or may be able to do so only at great cost. In addition, we may not be able to comply fully with, or obtain appropriate exemptions from, the wide variety of laws and regulations applicable to insurance or reinsurance companies or holding companies. Failure to comply with or to obtain appropriate exemptions under any applicable laws could result in restrictions on our ability to do business in one or more of the jurisdictions in which we operate and fines and other sanctions, which could have a material adverse effect on our business. See Regulatory Matters. Endurance Bermuda. Endurance Bermuda is a registered Class 4 Bermuda insurance and reinsurance company. Among other matters, Bermuda statutes, regulations and policies of the BMA require Endurance Bermuda to maintain minimum levels of statutory capital, statutory capital and surplus, and liquidity, to meet solvency standards, to obtain prior approval of ownership and transfer of shares and to submit to certain periodic examinations of its financial condition. These statutes and regulations may, in effect, restrict Endurance Bermuda s ability to write insurance and reinsurance policies, to make certain investments and to distribute funds. Endurance Bermuda does not maintain a principal office, and its personnel do not solicit, advertise, settle claims or conduct other activities that may constitute the transaction of the business of insurance or reinsurance, in any jurisdiction in which it is not licensed or otherwise not authorized to engage in such activities. Although Endurance Bermuda does not believe it is or will be in violation of insurance laws or regulations of any jurisdiction outside Bermuda, inquiries or challenges to Endurance Bermuda s insurance or reinsurance activities may still be raised in the future. The offshore insurance and reinsurance regulatory environment has become subject to increased scrutiny in many jurisdictions, including the United States and various states within the United States. Back to Contents Compliance with any new laws regulating offshore insurers or reinsurers could have a material adverse effect on our business. Endurance U.K. On December 4, 2002, Endurance U.K. received authorization from the FSA to begin writing certain lines of insurance and reinsurance in the United Kingdom. As an authorized insurer in the United Kingdom, Endurance U.K. is able to operate throughout the European Union, subject to compliance with certain notification requirements of the FSA and in some cases, certain local regulatory requirements. As an FSA authorized insurer, the insurance and reinsurance businesses of Endurance U.K. are subject to close supervision by the FSA. During 2004, the FSA will strengthen its requirements for senior management arrangements, systems and controls of insurance and reinsurance companies under its jurisdiction and will place an increased emphasis on risk identification and management in relation to the prudential regulation of insurance and reinsurance business in the United Kingdom. Though, in many respects, the 2004 changes in the FSA s requirements amplify existing FSA principles and rules and codify good business practice, certain of these changes, and any new guidance given by the FSA, may have an adverse impact on the business of Endurance U.K. In addition, given that the framework for supervision of insurance and reinsurance companies in the United Kingdom is largely formed by E.U. directives (which are implemented by member states through national legislation), changes at the E.U. level may affect the regulatory scheme under which Endurance U.K. operates. A general review of E.U. insurance solvency directives is currently in progress and may lead to changes, such as increased minimum capital requirements. Before this, however, the FSA has proposed to introduce new enhanced capital requirements ( ECR ) for insurers and reinsurers which will include capital charges based on assets, claims and premiums. The level of ECR seems likely to be at least twice the existing required minimum solvency margin for most companies, although the FSA has already adopted an informal approach of encouraging companies to hold at least twice the current EU minimum. In addition, the FSA is proposing to give guidance regularly to insurers under individual capital assessments, which may result in guidance that a company should hold in excess of the ECR. These changes may increase the required regulatory capital of Endurance U.K. Endurance U.S. Endurance U.S. is organized in and licensed to write certain lines of reinsurance business in the State of New York and, as a result, is subject to New York law and regulation under the supervision of the Superintendent of Insurance of the State of New York. The New York Superintendent also has regulatory authority over a number of affiliate transactions between Endurance U.S. and other members of our holding company system. The purpose of the state insurance regulatory statutes is to protect U.S. insureds and U.S. ceding insurance companies, not our shareholders. Among other matters, state insurance regulations require Endurance U.S. to maintain minimum levels of capital, surplus and liquidity, require Endurance U.S. to comply with applicable risk-based capital requirements and impose restrictions on the payment of dividends and distributions. These statutes and regulations may, in effect, restrict the ability of Endurance U.S. to write new business or distribute assets to Endurance Holdings. In recent years, the U.S. insurance regulatory framework has come under increased federal scrutiny, and some state legislators have considered or enacted laws that may alter or increase state regulation of insurance and reinsurance companies and holding companies. Moreover, the National Association of Insurance Commissioners ( NAIC ), which is an association of the insurance commissioners of all 50 states and the District of Columbia, and state insurance regulators regularly reexamine existing laws and regulations. Changes in these laws and regulations or the interpretation of these laws and regulations could have a material adverse effect on our business. For example, in response to the tightening of supply in certain insurance and reinsurance markets resulting from, among other things, the World Trade Center tragedy, the Terrorism Risk Insurance Act of 2002 was enacted to ensure the availability of insurance coverage for terrorist acts in the United States. This law establishes a federal assistance program through the end of 2005 to help the commercial property and casualty insurance industry cover claims related to future terrorism related losses and regulates the terms of insurance relating to terrorism coverage. This has increased underwriting capacity for certain of our competitors as a result of the Act s requirement that coverage for terrorist acts be offered by insurers. To date, this law has resulted in an increase of certain terrorism coverages which we are required to offer. We Back to Contents have taken steps to provide that our insurance operations are able to receive the benefit of this law. We are currently unable to predict the extent to which the foregoing new initiative may affect the demand for our products or the risks which may be available for us to consider underwriting. Risks Related to Ownership of Our Ordinary Shares Future sales of ordinary shares may affect their market price. We cannot predict what effect, if any, future sales of our ordinary shares, or the availability of ordinary shares for future sale, will have on the market price of our ordinary shares. Sales of substantial amounts of our ordinary shares in the public market following this offering, or the perception that such sales could occur, could adversely affect the market price of our ordinary shares and may make it more difficult for you to sell your ordinary shares at a time and price which you deem appropriate. See Description of Share Capital Registration Rights Agreement and Shares Eligible for Future Sale for further information regarding circumstances under which additional ordinary shares may be sold. As of March 1, 2004, 63,915,000 ordinary shares were outstanding and an additional 9,418,077 common shares were issuable upon the full exercise or conversion of outstanding vested options, warrants and restricted share units. We, our directors and officers, all of our warrant holders and the selling shareholders have agreed, with limited exceptions, for a period of 90 days after the date of this prospectus, that we and they will not, without the prior written consent of Goldman, Sachs & Co. and Merrill Lynch, Pierce, Fenner & Smith Incorporated on behalf of the underwriters, directly or indirectly, offer to sell, sell or otherwise dispose of or hedge any of our ordinary shares. One of our founding shareholders has agreed to the foregoing for a period of 30 days. In connection with an exchange offer in July of 2002 with all of our existing shareholders at the time, we granted rights to such shareholders to require us to register their ordinary shares under the Securities Act of 1933, as amended ( Securities Act ) for sale into the public markets pursuant to a registration rights agreement, dated as of July 22, 2002. A copy of the registration rights agreement has been filed as an exhibit to the registration statement of which this prospectus forms a part. We have filed this registration statement pursuant to the exercise of demand registration rights under such agreement by Aon, Capital Z Financial Services, Perry Corp., Texas Pacific Group and various Thomas H. Lee related entities. See Principal and Selling Shareholders. Pursuant to the registration rights agreement, we gave notice to our other founding shareholders that we have received notice of the exercise of demand registration rights under the registration rights agreement and gave such other shareholders the opportunity to include their shares in the registration statement and this prospectus. The other founding shareholders had up to 21 days after receipt of the notice, or February 23, 2004, to elect to include their shares in the offering to be made pursuant to this prospectus. It is possible that shareholders may decide to withdraw their shares from registration, as they have no obligation to sell any shares even though they may have exercised demand or other registration rights under our registration rights agreement. The actual number of shares to be sold by the selling shareholders pursuant to this offering (including pursuant to the over-allotment option) will be reflected in the final prospectus. Upon effectiveness of the registration statement, all shares included in such registration statement will be freely transferable. Upon consummation of this offering, the shareholders under the registration rights agreement and their transferees will continue to have the right to require us to register their ordinary shares for sale under the Securities Act, subject to the 90-day lock-up agreements described above and certain other exceptions. See Description of Share Capital Registration Rights Agreement. There are provisions in our charter documents that may reduce or increase the voting rights of our ordinary shares. As used in this prospectus, all references to bye-laws refer to the amended and restated bye-laws of Endurance Holdings. The bye-laws generally provide that any shareholder owning, directly, indirectly or, in the case of any U.S. Person, by attribution, more than 9.5% of our ordinary shares will have the voting rights attached to such ordinary shares reduced so that it may not exercise more than 9.5% of the total voting rights. The reduction in votes is generally to be applied proportionately among all shareholders who are members of the first shareholder s control group. A control group means, with respect to any person, all shares directly owned by such person and all shares directly owned by each other shareholder any of whose shares are included in the controlled shares of such person. Controlled shares means all ordinary shares that a person is deemed to own directly, indirectly (within the meaning of Section 958(a) of the Internal Revenue Code of 1986, as amended (the Code )) or, in the case of a U.S. Person, constructively (within the meaning of Section 958(b) of the Code). A similar limitation is to be applied to shares held directly by members of a related group. A related group means a group of shareholders that are investment vehicles and are under common control and management. Any reduction in votes will generally be allocated proportionately among members of the shareholder s control group or related group, as the case may be. The amount of any reduction of votes that occurs by operation of the above limitations will generally be reallocated proportionately among all other shareholders of Endurance Holdings who were not members of these groups so long as such reallocation does not cause any person to become a 9.5% shareholder. Under these provisions, certain shareholders may have their voting rights limited to less than one vote per share, while other shareholders may have voting rights in excess of one vote per share. Moreover, these provisions could have the effect of reducing the votes of certain shareholders who would not otherwise be subject to the 9.5% limitation by virtue of their direct share ownership. The bye-laws of Endurance Holdings provide that shareholders will be notified of their voting interests prior to any vote to be taken by the shareholders. See Description of Share Capital Voting Adjustments. As a result of any reallocation of votes, your voting rights might increase above 5% of the aggregate voting power of the outstanding ordinary shares, thereby possibly resulting in your becoming a reporting person subject to Schedule 13D or 13G filing requirements under the Securities Exchange Act of 1934, as amended (the Exchange Act ). In addition, the reallocation of your votes could result in your becoming subject to filing requirements under Section 16 of the Exchange Act. The Company also has the authority to request information from any shareholder for the purpose of determining whether a shareholder s voting rights are to be reallocated pursuant to the bye-laws. If a shareholder fails to respond to a request for information from the Company or submits incomplete or inaccurate information (after a reasonable cure period) in response to a request, the Company, in its reasonable discretion, may reduce or eliminate the shareholder s voting rights. Provisions of Endurance Holdings bye-laws may restrict the ability to transfer shares of Endurance Holdings. Pursuant to its bye-laws, Endurance Holdings board of directors may decline to register a transfer of any ordinary shares if the relevant instrument of transfer (if any) is in favor of five persons or more jointly or is not properly executed, the transferred shares are not fully paid shares or if the transferor fails to comply with all applicable laws and regulations governing the transfer. A shareholder may be required to sell its shares of Endurance Holdings. Endurance Holdings bye-laws provide that we have the option, but not the obligation, to require a shareholder to sell its ordinary shares for their fair market value to us, to other shareholders or to third parties if we determine, based on the written advice of legal counsel, that failure to exercise our option would result in adverse tax consequences to us or certain U.S. Persons as to which the shares held by such shareholder constitute controlled shares. In the latter case, our right to require a shareholder to sell its ordinary shares to us will be limited to the purchase of a number of ordinary shares that will permit avoidance of those adverse tax consequences. See Description of Share Capital Bye-laws Acquisition of Ordinary Shares by Endurance Holdings. Back to Contents A shareholder may be required to indemnify us for any tax liability that results from the acts of that shareholder. Our bye-laws provide certain protections against adverse tax consequences to us resulting from laws that apply to our shareholders. If a shareholder s death or non-payment of any tax or duty payable by the shareholder, or any other act or thing involving the shareholder, causes any adverse tax consequences to us, (i) the shareholder (or his executor or administrator) is required to indemnify us against any tax liability that we incur as a result, (ii) we will have a lien on any dividends or any other distributions payable to the shareholder by us to the extent of the tax liability, and (iii) if any amounts not covered by our lien on dividends and distributions are owed to us by the shareholder as a result of our tax liability, we have the right to refuse to register any transfer of the shareholder s shares. There are regulatory limitations on the ownership and transfer of our ordinary shares. Ordinary shares may be offered or sold in Bermuda only in compliance with the provisions of the Investment Business Act of 2003 of Bermuda which regulates the sale of securities in Bermuda. In addition, the BMA must approve all issuances and transfers of shares of a Bermuda exempted company. We have received from the BMA their permission for the issue and free transferability of the ordinary shares in the Company being offered pursuant to this prospectus, as long as the shares are listed on the NYSE, to and among persons who are non-residents of Bermuda for exchange control purposes. In addition, we will deliver to and file a copy of this prospectus with the Registrar of Companies in Bermuda in accordance with Bermuda law. The BMA and the Registrar of Companies accept no responsibility for the financial soundness of any proposal or for the correctness of any of the statements made or opinions expressed in this prospectus. The Financial Services and Markets Act 2000 ( FSMA ) regulates the acquisition of control of any U.K. insurance company authorized under FSMA. Any company or individual that (together with its or his associates) directly or indirectly acquires 10% or more of the shares of a U.K. authorized insurance company or its parent company, or is entitled to exercise or control the exercise of 10% or more of the voting power in such authorized insurance company or its parent company, would be considered to have acquired control for the purposes of FSMA, as would a person who had significant influence over the management of such authorized insurance company or its parent company by virtue of his shareholding or voting power in either. A purchaser of more than 10% of our ordinary shares would therefore be considered to have acquired control of Endurance U.K. Under the FSMA, any person proposing to acquire control over a U.K. authorized insurance company must notify the FSA of his intention to do so and obtain the FSA s prior approval. The FSA would then have three months to consider that person s application to acquire control. In considering whether to approve such application, the FSA must be satisfied both that the acquirer is a fit and proper person to have such control and that the interests of consumers would not be threatened by such acquisition of control. Failure to make the relevant prior application would constitute a criminal offense. State laws in the United States also require prior notices or regulatory agency approval of changes in control of an insurer or its holding company. The insurance laws of the State of New York, where Endurance U.S. is domiciled, provide that no corporation or other person except an authorized insurer may acquire control of a domestic insurance or reinsurance company unless it has given notice to such company and obtained prior written approval of the New York Superintendent. Any purchaser of 10% or more of our ordinary shares could become subject to such regulations and could be required to file certain notices and reports with the New York Superintendent prior to such acquisition. Back to Contents U.S. persons who own our ordinary shares may have more difficulty in protecting their interests than U.S. persons who are shareholders of a U.S. corporation. The Companies Act, which applies to Endurance Holdings and Endurance Bermuda, differs in certain material respects from laws generally applicable to U.S. corporations and their shareholders. In order to highlight those differences, set forth below is a summary of certain significant provisions of the Companies Act, including, where relevant, information on Endurance Holdings bye-laws, which differ in certain respects from provisions of Delaware corporate law. Because the following statements are summaries, they do not discuss all aspects of Bermuda law that may be relevant to Endurance Holdings and our shareholders. Interested Directors. Under Bermuda law and Endurance Holdings bye-laws, we cannot void any transaction we enter into in which a director has an interest, nor can such director be accountable to us for any benefit realized pursuant to such transaction, provided the nature of the interest is disclosed at the first opportunity at a meeting of directors, or in writing, to the directors. In addition, Endurance Holdings bye-laws allow a director to be taken into account in determining whether a quorum is present and to vote on a transaction in which he has an interest, but the resolution with respect to such transactions will fail unless it is approved by a majority of the disinterested directors voting on such a transaction. Under Delaware law such transaction would not be voidable if: the material facts as to such interested director s relationship or interests were disclosed or were known to the board of directors and the board had in good faith authorized the transaction by the affirmative vote of a majority of the disinterested directors; such material facts were disclosed or were known to the shareholders entitled to vote on such transaction and the transaction were specifically approved in good faith by vote of the majority of shares entitled to vote thereon; or the transaction was fair as to the corporation as of the time it was authorized, approved or ratified. Under Delaware law, the interested director could be held liable for a transaction in which the director derived an improper personal benefit. Business Combinations with Large Shareholders or Affiliates. As a Bermuda company, Endurance Holdings may enter into business combinations with its large shareholders or one or more wholly-owned subsidiaries, including asset sales and other transactions in which a large shareholder or a wholly-owned subsidiary receives, or could receive, a financial benefit that is greater than that received, or to be received, by other shareholders or other wholly-owned subsidiaries, without obtaining prior approval from our shareholders and without special approval from our board of directors. Under Bermuda law, amalgamations require the approval of the board of directors, and in some instances, shareholder approval. However, when the affairs of a Bermuda company are being conducted in a manner which is oppressive or prejudicial to the interests of some shareholders, one or more shareholders may apply to a Bermuda court, which may make such order as it sees fit, including an order regulating the conduct of the company s affairs in the future or ordering the purchase of the shares of any shareholders by other shareholders or the company. If we were a Delaware company, we would need prior approval from our board of directors or a supermajority of our shareholders to enter into a business combination with an interested shareholder for a period of three years from the time the person became an interested shareholder, unless we opted out of the relevant Delaware statute. Bermuda law or Endurance Holdings bye-laws would require board approval and in some instances, shareholder approval, of such transactions. Shareholders Suits. The rights of shareholders under Bermuda law are not as extensive as the rights of shareholders in many United States jurisdictions. Class actions and derivative actions are generally not available to shareholders under Bermuda law. However, the Bermuda courts ordinarily would be expected to follow English case law precedent, which would permit a shareholder to commence a derivative action in the name of a company where the act complained of is alleged to be beyond the corporate power of the company, is illegal or would result in the violation of Endurance Holdings memorandum of association or bye-laws. Furthermore, consideration would be given by the court to acts that are alleged to constitute a fraud against the minority shareholders or where an act requires the approval of a greater percentage of our Back to Contents Risks Relating to Our Company As part of your evaluation of the Company, you should take into account the risks we face in our business. These risks include: Limited Operating History. We have a limited operating and financial history. As a result, there is limited historical financial and operating information to help you evaluate our past performance or to make a decision about an investment in our ordinary shares. Uncertainty of Establishing Loss Reserves. Establishing and maintaining an appropriate level of loss reserves is an inherently uncertain process, especially for recently formed insurers like us without an established loss history. Because of this uncertainty, it is possible that our loss reserves at any given time will prove inadequate. This could cause a material reduction in our profitability and capital. Vulnerability to Losses from Catastrophes. Our property and property catastrophe insurance and reinsurance operations expose us to claims arising from catastrophes. In the event that we experience catastrophe losses, there is a possibility that our unearned premium and loss reserves will be inadequate to cover these risks, which could have a material adverse effect on our financial condition and our results of operations. Failure of Our Loss Limitation Methods. Limitations or exclusions from coverage or choice of forum, or other loss limitation methods we employ may not be effective or may not be enforceable in the manner we intend, which could have a material adverse effect on our financial condition and our results of operations, possibly to the extent of eliminating our shareholders equity. Non-renewal of Existing Contracts. Our contracts are generally for a one-year term. In our financial forecasting process, we make assumptions about the renewal of our prior year s contracts. If actual renewals do not meet expectations, our premiums written in future years and our future results of operations could be materially adversely affected. This risk is especially prevalent in the first quarter of each year when a large number of reinsurance contracts are subject to renewal. Constraints Related to Our Holding Company Structure. As a holding company, Endurance Holdings has no substantial operations of its own. Dividends and other permitted distributions from insurance subsidiaries are expected to be Endurance Holdings sole source of funds to meet ongoing cash requirements. These payments are limited by the regulations in the jurisdictions in which our subsidiaries operate. The inability of these subsidiaries to pay dividends in sufficient amounts for Endurance Holdings to meet its cash requirements could have a material adverse effect on its operations. Cyclical Nature of the Insurance and Reinsurance Business. Historically, the property and casualty reinsurance business has been a cyclical industry characterized by periods of intense price competition. Although premium levels for many products have generally increased during the past two years, the supply of insurance and reinsurance capacity may increase, either by capital provided by new entrants or by the commitment of additional capital by existing insurers and reinsurers, which may cause prices to decrease. For more information about these and other risks, see Risk Factors beginning on page 8. You should carefully consider these risk factors together with all the other information included in this prospectus before making an investment decision. Back to Contents shareholders than actually approved it. The successful party in such an action generally would be able to recover a portion of attorneys fees incurred in connection with such action. Endurance Holdings bye-laws provide that shareholders waive all claims or rights of action that they might have, individually or in the right of Endurance Holdings, against any director or officer for any action or failure to act in the performance of such director s or officer s duties, except such waiver shall not extend to any claims or rights of action that would render the waiver void pursuant to the Companies Act, that arise out of fraud or dishonesty on the part of such director or officer or with respect to the recovery of any gain, personal profit or advantage to which the officer or director is not legally entitled. Class actions and derivative actions generally are available to shareholders under Delaware law for, among other things, breach of fiduciary duty, corporate waste and actions not taken in accordance with applicable law. In such actions, the court has discretion to permit the winning party to recover attorneys fees incurred in connection with such action. Indemnification of Directors and Officers. Under Bermuda law and Endurance Holdings bye-laws, Endurance Holdings will indemnify its directors or officers or any person appointed to any committee by the board of directors and any resident representative (and their respective heirs, executors or administrators) against all actions, costs, charges, liabilities, loss, damage or expense, to the full extent permitted by law, incurred or suffered by such officer, director or other person by reason of any act done, conceived in or omitted in the conduct of the company s business or in the discharge of his/her duties; provided that such indemnification shall not extend to any matter involving any fraud or dishonesty on the part of such director, officer or other person. Under Delaware law, a corporation may indemnify a director or officer of the corporation against expenses (including attorneys fees), judgments, fines and amounts paid in settlement actually and reasonably incurred in defense of an action, suit or proceeding by reason of such position if such director or officer acted in good faith and in a manner he or she reasonably believed to be in or not be opposed to the best interests of the corporation and, with respect to any criminal action or proceeding, such director or officer had no reasonable cause to believe his or her conduct was unlawful. For more information on the differences between Bermuda and Delaware corporate laws, see Description of Share Capital Differences in Corporate Law. Anti-takeover provisions in our bye-laws could impede an attempt to replace or remove our directors, which could diminish the value of our ordinary shares. Endurance Holdings bye-laws contain provisions that may entrench directors and make it more difficult for shareholders to replace directors even if the shareholders consider it beneficial to do so. In addition, these provisions could delay or prevent a change of control that a shareholder might consider favorable. For example, these provisions may prevent a shareholder from receiving the benefit from any premium over the market price of our ordinary shares offered by a bidder in a potential takeover. Even in the absence of an attempt to effect a change in management or a takeover attempt, these provisions may adversely affect the prevailing market price of our ordinary shares if they are viewed as discouraging changes in management and takeover attempts in the future. Examples of provisions in our bye-laws that could have such an effect include: election of our directors is staggered, meaning that the members of only one of three classes of our directors are elected each year; the total voting power of any shareholder owning more than 9.5% of our ordinary shares will be reduced to 9.5% of the total voting power of our ordinary shares; our directors may, in their discretion, decline to record the transfer of any ordinary shares on our share register, unless the instrument of transfer is in favor of less than five persons jointly or if they are not satisfied that all required regulatory approvals for such transfer have been obtained; and we have the option, but not the obligation, to require a shareholder to sell its ordinary shares to us, to our other shareholders or to third parties at fair market value if we determine, based on Back to Contents the advice of legal counsel, that failure to exercise our option would result in adverse tax consequences to us or certain U.S. Persons as to which the shares held by such shareholder constitute controlled shares. It may be difficult to enforce service of process and enforcement of judgments against us and our officers and directors. Endurance Holdings is a Bermuda company and certain of its officers and directors are residents of various jurisdictions outside the United States. A substantial portion of its assets and its officers and directors, at any one time, are or may be located in jurisdictions outside the United States. Although Endurance Holdings has irrevocably appointed CT Corporation System as an agent in New York, New York to receive service of process with respect to actions against Endurance Holdings arising out of violations of the U.S. federal securities laws in any federal or state court in the United States relating to the transactions covered by this prospectus, it may be difficult for investors to effect service of process within the United States on our directors and officers who reside outside the United States or to enforce against us or our directors and officers judgments of U.S. courts predicated upon civil liability provisions of the U.S. federal securities laws. We have been advised by Appleby Spurling & Kempe, our Bermuda counsel, that there is no treaty in force between the United States and Bermuda providing for the reciprocal recognition and enforcement of judgments in civil and commercial matters. As a result, whether a United States judgment would be enforceable in Bermuda against us or our directors and officers depends on whether the U.S. court that entered the judgment is recognized by the Bermuda court as having jurisdiction over us or our directors and officers, as determined by reference to Bermuda conflict of law rules. A judgment debt from a U.S. court that is final and for a sum certain based on U.S. federal securities laws will not be enforceable in Bermuda unless the judgment debtor had submitted to the jurisdiction of the U.S. court, and the issue of submission and jurisdiction is a matter of Bermuda (not United States) law. In addition to and irrespective of jurisdictional issues, the Bermuda courts will not enforce a United States federal securities law that is either penal or contrary to public policy. It is the advice of Appleby Spurling & Kempe that an action brought pursuant to a public or penal law, the purpose of which is the enforcement of a sanction, power or right at the instance of the state in its sovereign capacity, will not be entertained by a Bermuda Court. Certain remedies available under the laws of U.S. jurisdictions, including certain remedies under U.S. federal securities laws, would not be available under Bermuda law or enforceable in a Bermuda court, as they would be contrary to Bermuda public policy. Further, no claim may be brought in Bermuda against us or our directors and officers in the first instance for violation of U.S. federal securities laws because these laws have no extraterritorial jurisdiction under Bermuda law and do not have force of law in Bermuda. A Bermuda court may, however, impose civil liability on us or our directors and officers if the facts alleged in a complaint constitute or give rise to a cause of action under Bermuda law. Risks Related to Taxation We may become subject to taxes in Bermuda after March 28, 2016, which may have a material adverse effect on our financial condition. The Bermuda Minister of Finance, under the Exempted Undertakings Tax Protection Act 1966, as amended, of Bermuda, has given Endurance Holdings and Endurance Bermuda an assurance that if any legislation is enacted in Bermuda that would impose tax computed on profits or income or computed on any capital asset, gain or appreciation, or any tax in the nature of estate duty or inheritance tax, then the imposition of any such tax will not be applicable to Endurance Holdings, Endurance Bermuda or any of their respective operations, shares, debentures or other obligations until March 28, 2016. See Material Tax Considerations Certain Bermuda Tax Considerations. Given the limited duration of the Minister of Finance s assurance, however, it is possible that after March 28, 2016 we may be subject to Bermuda taxes. Back to Contents We and our subsidiaries may be subject to U.S. tax which may have a material adverse effect on our financial condition and results of operations. Endurance Holdings and Endurance Bermuda are Bermuda companies and Endurance U.K. is an English company. Endurance Holdings, Endurance Bermuda and Endurance U.K. each intends to operate in such a manner that none of these companies will be deemed to be engaged in the conduct of a trade or business within the United States. Nevertheless, because definitive identification of activities which constitute being engaged in a trade or business in the United States is not provided by the Code, or regulations or court decisions, the Internal Revenue Service ( IRS ), might contend that any of Endurance Holdings, Endurance Bermuda and/or Endurance U.K. are/is engaged in a trade or business in the United States. If Endurance Holdings, Endurance Bermuda and/or Endurance U.K. were engaged in a trade or business in the United States, and if Endurance U.K. or Endurance Bermuda were to qualify for benefits under the applicable income tax treaty with the United States, but such trade or business were attributable to a permanent establishment in the United States (or in the case of Endurance Bermuda, with respect to investment income, arguably even if such income were not attributable to a permanent establishment ), Endurance Holdings, Endurance U.K. and/or Endurance Bermuda would be subject to U.S. federal income tax at regular corporate rates on the income that is effectively connected with the U.S. trade or business, plus an additional 30% branch profits tax in certain circumstances, in which case our financial condition and results of operations and your investment could be materially adversely affected. See Material Tax Considerations Certain United States Federal Income Tax Considerations United States Taxation of Endurance Holdings, Endurance Bermuda, Endurance U.K. and Endurance U.S. Endurance Holdings and/or any of its subsidiaries could be subject to U.S. tax on a portion of its income that is earned from U.S. sources (and certain types of foreign source income which are effectively connected with the conduct of a U.S. trade or business) if any of them are considered to be a personal holding company, or a PHC, for U.S. federal income tax purposes. This status will depend on whether more than 50% of our shares could be deemed to be owned by five or fewer individuals and the percentage of our income, or that of our subsidiaries, that consists of personal holding company income, as determined for U.S. federal income tax purposes. We believe, based upon information made available to us regarding our existing shareholder base, that neither we nor any of our subsidiaries will be considered a PHC, but due to the lack of complete information regarding our ultimate share ownership, we cannot be certain that this will be the case, or that the amount of U.S. tax that would be imposed if it were not the case would be immaterial. See Material Tax Considerations Certain United States Federal Income Tax Considerations United States Taxation of Endurance Holdings, Endurance Bermuda, Endurance U.K. and Endurance U.S. Personal Holding Companies. We and our subsidiaries may be subject to U.K. tax which may have a material adverse effect on our financial condition and results of operations. Endurance Holdings and Endurance Bermuda are organized in Bermuda and Endurance U.S. is a company incorporated in the United States. Accordingly, because they are not incorporated in the United Kingdom, none of Endurance Holdings, Endurance Bermuda or Endurance U.S. will be treated as being resident in the United Kingdom unless their central management and control is exercised in the United Kingdom. The concept of central management and control is indicative of the highest level of control of a company, which is wholly a question of fact. The directors of Endurance Holdings, Endurance Bermuda and Endurance U.S. intend to manage their affairs so that none of them are resident in the United Kingdom for tax purposes. A company not resident in the United Kingdom for corporation tax purposes can nevertheless be subject to U.K. corporation tax if it carries on a trade through a branch or agency in the United Kingdom but the charge to U.K. corporation tax is limited to profits (including revenue profits and capital gains) connected with such branch or agency. The directors of Endurance Holdings, Endurance Bermuda and Endurance U.S. intend that each will operate in such a manner that none of these companies carry on a trade through a branch or agency in the United Kingdom. Nevertheless, because neither case law nor U.K. statute definitively defines the activities that constitute trading in the United Kingdom through a branch or agency, the U.K. Inland Revenue might contend that any of Endurance Holdings, Endurance Bermuda and/or Endurance U.S. Back to Contents Summary Consolidated Financial Information The following table sets forth our summary consolidated financial information for the periods ended and as of the dates indicated. As described in Note 1 to our consolidated financial statements included elsewhere in this prospectus, our consolidated financial statements include the accounts of Endurance Holdings, Endurance Bermuda, Endurance U.K. and Endurance U.S. Endurance Bermuda was incorporated on November 30, 2001 and commenced operations on December 17, 2001. Endurance Holdings was incorporated on June 27, 2002 and effected an exchange offer in July 2002 with the shareholders of Endurance Bermuda. The exchange offer was accounted for as a business combination of companies under common control. On December 17, 2002, we effected a share premium issuance to our existing shareholders. Except as otherwise indicated, all share data in this prospectus assumes the share premium issuance to our existing shareholders of four additional shares for each common share outstanding had occurred as of the date such data is presented. The summary consolidated financial information presented below is derived from our consolidated financial statements included elsewhere in this prospectus. These historical results are not necessarily indicative of results to be expected from any future period. You should read this summary consolidated financial information together with our consolidated financial statements and related notes and the section of this prospectus entitled Management s Discussion and Analysis of Financial Condition and Results of Operations. Year Ended December 31, 2003 Year Ended December 31, 2002 Period Ended December 31, 2001 Back to Contents are/is trading in the United Kingdom through a branch or agency in the United Kingdom. If Endurance U.S. were trading in the U.K. through a branch or agency and Endurance U.S. were to qualify for benefits under the applicable income tax treaty between the United Kingdom and the United States, only those profits which were attributable to a permanent establishment in the United Kingdom would be subject to U.K. corporation tax. The United Kingdom has no income tax treaty with Bermuda. If Endurance Holdings, Endurance Bermuda or Endurance U.S. were treated as being resident in the United Kingdom for U.K. corporation tax purposes, or as carrying on a trade in the United Kingdom through a branch or agency, our financial condition and results of operations and your investment could be materially adversely affected. If you acquire 10% or more of Endurance Holdings ordinary shares, you may be subject to taxation under the controlled foreign corporation ( CFC ) rules. Each 10% U.S. Shareholder of a foreign corporation that is a CFC for an uninterrupted period of 30 days or more during a taxable year, and who owns shares in the CFC directly or indirectly through foreign entities on the last day of the CFC s taxable year, must include in its gross income for U.S. federal income tax purposes its pro rata share of the CFC s subpart F income, even if the subpart F income is not distributed. A foreign corporation is considered a CFC if 10% U.S. Shareholders own more than 50% of the total combined voting power of all classes of voting stock of such foreign corporation, or the total value of all stock of such corporation. A 10% U.S. Shareholder is a U.S. Person who owns at least 10% of the total combined voting power of all classes of stock entitled to vote of the foreign corporation. For purposes of taking into account insurance income, a CFC also includes a foreign corporation in which more than 25% of the total combined voting power of all classes of stock (or more than 25% of the total value of the stock) is owned by 10% U.S. Shareholders, on any day during the taxable year of such corporation, if the gross amount of premiums or other consideration for the reinsurance or the issuing of insurance or annuity contracts exceeds 75% of the gross amount of all premiums or other consideration in respect of all risks. For purposes of determining whether a corporation is a CFC, and therefore whether the 50% (or 25%, in the case of insurance income) and 10% ownership tests have been satisfied, own means owned directly, indirectly through foreign entities or is considered as owned by application of certain constructive ownership rules. Due to the anticipated dispersion of Endurance Holdings share ownership among holders, its bye-law provisions that impose limitations on the concentration of voting power of its ordinary shares and authorize the board of directors to purchase such shares under certain circumstances, and other factors, no U.S. Person that owns shares in Endurance Holdings directly or indirectly through foreign entities should be subject to treatment as a 10% U.S. Shareholder of a CFC. It is possible, however, that the IRS could challenge the effectiveness of these provisions and that a court could sustain such a challenge. See Material Tax Considerations Certain United States Federal Income Tax Considerations United States Taxation of Holders of Ordinary Shares Shareholders Who Are U.S. Persons. U.S. Persons who hold ordinary shares may be subject to U.S. income taxation on their pro rata share of our related party insurance income ( RPII ). If Endurance U.K. s or Endurance Bermuda s RPII were to equal or exceed 20% of Endurance U.K. s or Endurance Bermuda s gross insurance income in any taxable year and direct or indirect insureds (and persons related to such insureds) own (or are treated as owning directly or indirectly) 20% or more of the voting power or value of the shares of Endurance U.K. or Endurance Bermuda, a U.S. Person who owns ordinary shares of Endurance Holdings directly or indirectly through foreign entities on the last day of the taxable year would be required to include in its income for U.S. federal income tax purposes the shareholder s pro rata share of Endurance U.K. s or Endurance Bermuda s RPII for the entire taxable year, determined as if such RPII were distributed proportionately to such U.S. shareholders at that date regardless of whether such income is distributed. In addition, any RPII that is includible in the income of a U.S. tax-exempt organization would be treated as unrelated business taxable income. The amount of RPII earned by Endurance U.K. or Endurance Bermuda (generally, premium and related investment income from the direct or indirect insurance or reinsurance of any direct or indirect U.S. shareholder of Endurance U.K. or Endurance Bermuda or any person related to such shareholder) depends on a number of factors, including the Back to Contents geographic distribution of Endurance U.K. s or Endurance Bermuda s business and the identity of persons directly or indirectly insured or reinsured by Endurance U.K. or Endurance Bermuda. Although we believe that our RPII has not in the recent past equaled or exceeded 20% of our gross insurance income, and do not expect it to do so in the foreseeable future, some of the factors, which determine the extent of RPII in any period, may be beyond Endurance U.K. s or Endurance Bermuda s control. Consequently, Endurance U.K. s or Endurance Bermuda s RPII could equal or exceed 20% of its gross insurance income in any taxable year and ownership of its shares by direct or indirect insureds and related persons could equal or exceed the 20% threshold described above. The RPII rules provide that if a shareholder who is a U.S. Person disposes of shares in a foreign insurance corporation that has RPII (even if the amount of RPII is less than 20% of the corporation s gross insurance income or the ownership of its shares by direct or indirect insureds and related persons is less than the 20% threshold) and in which U.S. Persons own 25% or more of the shares, any gain from the disposition will generally be treated as ordinary income to the extent of the shareholder s share of the corporation s undistributed earnings and profits that were accumulated during the period that the shareholder owned the shares (whether or not such earnings and profits are attributable to RPII). In addition, such a shareholder will be required to comply with certain reporting requirements, regardless of the amount of shares owned by the shareholder. These rules should not apply to dispositions of ordinary shares because Endurance Holdings will not itself be directly engaged in the insurance business. The RPII provisions, however, have not been interpreted by the courts or the U.S. Treasury Department, and regulations interpreting the RPII provisions of the Code exist only in proposed form. Accordingly, the IRS might interpret the proposed regulations in a different manner and the applicable proposed regulations may be promulgated in final form in a manner that would cause these rules to apply to dispositions of our ordinary shares. See Material Tax Considerations Certain United States Federal Income Tax Considerations United States Taxation of Holders of Ordinary Shares Shareholders Who Are U.S. Persons. U.S. Persons who hold ordinary shares will be subject to adverse tax consequences if we are considered a passive foreign investment company (a PFIC ) for U.S. federal income tax purposes. We believe that we should not be considered a PFIC for U.S. federal income purposes for the year ended December 31, 2003. Moreover, we do not expect to conduct our activities in a manner that would cause us to become a PFIC in the future. However, it is possible that we could be deemed a PFIC by the IRS for 2003 or any future year. If we were considered a PFIC it could have material adverse tax consequences for an investor that is subject to U.S. federal income taxation, including subjecting the investor to a greater tax liability than might otherwise apply or subjecting the investor to tax on amounts in advance of when tax would otherwise be imposed. There are currently no regulations regarding the application of the PFIC provisions to an insurance company. New regulations or pronouncements interpreting or clarifying these rules may be forthcoming. We cannot predict what impact, if any, such guidance would have on a shareholder that is subject to U.S. federal income taxation. See Material Tax Considerations Certain United States Federal Income Tax Considerations United States Taxation of Holders of Ordinary Shares Shareholders Who Are U.S. Persons Passive Foreign Investment Companies. U.S. Persons who hold ordinary shares will be subject to adverse tax consequences if we or any of our subsidiaries are considered a foreign personal holding company ( FPHC ) for U.S. federal income tax purposes. Endurance Holdings and/or any of its non-U.S. subsidiaries could be considered to be a FPHC for U.S. federal income tax purposes. This status will depend on whether more than 50% of our shares could be deemed to be owned by five or fewer individuals who are citizens or residents of the United States, and the percentage of our income, or that of our subsidiaries, that consists of foreign personal holding company income, as determined for U.S. federal income tax purposes. We believe, based upon information made available to us regarding our existing shareholder base, that neither we nor any of our subsidiaries are, and we currently do not expect any of them or us to become, a FPHC for U.S. federal income tax purposes. Due to the lack of complete information regarding our ultimate share ownership, however, we cannot be certain that we will not be considered a FPHC. If we were considered a FPHC it could have material adverse tax Back to Contents consequences for an investor that is subject to U.S. federal income taxation including subjecting the investor to a greater tax liability than might otherwise apply and subjecting the investor to tax on amounts in advance of when tax would otherwise be imposed. See Material Tax Considerations Certain United States Federal Income Tax Considerations United States Taxation of Holders of Ordinary Shares Shareholders Who Are U.S. Persons Foreign Personal Holding Companies. Changes in U.S. federal income tax law could materially adversely affect shareholders investment. Legislation has been introduced in the U.S. Congress intended to eliminate certain perceived tax advantages of companies (including insurance companies) that have legal domiciles outside the United States but have certain U.S. connections. While there is no currently pending legislative proposal which, if enacted, would have a material adverse effect on us, our subsidiaries or our shareholders, it is possible that broader-based legislative proposals could emerge in the future that could have an adverse impact on us, our subsidiaries or our shareholders. Back to Contents
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+RISK FACTORS Before you invest in our common stock, you should be aware that there are risks, including those set forth below. You should carefully consider these risk factors, together with all the other information included in this prospectus, before you decide to purchase shares of our common stock. Risks Related to Our Business We have never achieved profitability on a quarterly or annual basis. We have never achieved profitability on a quarterly or annual basis. We incurred net losses of $18.7 million in 2003, $23.2 million in 2002, and $22.3 million in 2001. We cannot assure you that we will ever achieve or maintain profitability. We have secured only one retailer to sell our HDTVs, and we do not have long-term purchase commitments from OEM customers for our home theater or near-to-eye microdisplay products. We have secured only one retailer to sell our HDTVs. The inability to secure additional retailers to sell our HDTVs would substantially impede our revenue growth and could require us to write off substantial investments that we have made in this aspect of our business. We anticipate that our initial HDTV sales will be to a limited number of customers. As a result, we will face the risks inherent in relying on a concentration of customers. Additionally, the agreement with our first retailer customer provides that customer with certain termination rights. Any material delay, cancellation, or reduction of orders by one of these customers would adversely affect our operating results. Our OEM customers generally do not provide us with firm, long-term volume purchase commitments. In addition, the worldwide adverse economic slowdown commencing in 2001 has led to radically shortened lead times on purchase orders. Although we sometimes enter into manufacturing contracts with our OEM customers, these contracts typically clarify order lead times, inventory risk allocation, and similar matters rather than provide firm, long-term volume purchase commitments. As a result, OEM customers generally can cancel purchase commitments or reduce or delay orders at any time. The cancellation, delay, or reduction of OEM customer commitments could result in reduced revenue and in our holding excess and obsolete inventory and having unabsorbed manufacturing capacity. The large percentage of our OEM sales to customers in the electronics industry, which is subject to severe competitive pressures, rapid technological change, and product obsolescence, increases our inventory and overhead risks. In addition, we make significant decisions, including production schedules, component procurement commitments, facility requirements, personnel needs, and other resource requirements, based on our estimates of OEM customer requirements. The short-term nature of our OEM customers commitments and the possibility of rapid changes in demand for their products reduce our ability to estimate accurately the future requirements of those customers. Our operating results may be materially and adversely affected as a result of the failure to obtain anticipated orders and deferrals or cancellations of purchase commitments because of changes in OEM customer requirements. Because many of our costs and operating expenses are relatively fixed, a reduction in OEM customer demand can harm our gross margins and operating results. On occasion, OEM customers may require rapid increases in production, which can stress our resources and reduce operating margins. Although we have had a net increase in our manufacturing capacity over the past few years, we may not have sufficient capacity at any given time to meet all of our customers demands or to meet the requirements of a specific project. We face intense competition. Our HDTVs will encounter competition from a number of the world s most recognized consumer electronics companies, such as JVC, Panasonic, Philips, Samsung, Sharp, Sony, Thompson, and Toshiba. All of these companies have greater market recognition, larger customer bases, and substantially greater Table of Contents financial, technical, marketing, distribution, and other resources than we possess, which afford them competitive advantages over us. Intel has also announced its intention to begin manufacturing liquid crystal on silicon microdisplays. Other companies, such as Dell, Hewlett-Packard, Gateway, and ViewSonic, could directly or indirectly compete with our HDTVs. In addition to the high-definition television market, we serve intensely competitive industries that are characterized by price erosion, rapid technological change, and competition from major domestic and international companies. Our competitive position in these markets could suffer if one or more of our OEM customers decide to design and manufacture their own microdisplays, to use microdisplay products that we do not offer, to utilize competitive products, or to use alternative technologies that we may not offer. In addition, our OEM customers sometimes develop a second source, even for microdisplays we supply to them. These second source suppliers may win an increasing share of a program, particularly as it grows and matures, by competing primarily on price rather than on performance. Our ability to compete successfully depends on a number of factors, both within and outside our control. These factors include the following: our success in developing and producing new products; our ability to address the needs of our retailer and OEM customers; the pricing, quality, performance, reliability, features, ease of use, and diversity of our products; the quality of our customer service; our efficiency of production; the rate at which customers incorporate our products into their own products; product or technology introductions by our competitors; and foreign currency devaluations, especially in Asian currencies, such as the Japanese yen, the Korean won, and the Taiwanese dollar, which may cause a foreign competitor s products to be priced significantly lower than our products. Competing technologies could reduce the demand for our products. We are also subject to competition from competing technologies, such as CRT, high-temperature polysilicon, plasma, thin film transistor liquid crystal displays, or TFT LCDs, and digital micromirror technologies, as well as other emerging technologies or technologies that may be introduced in the future. For example, Motorola recently announced carbon nanotube technology that is intended to enable manufacturers to design large flat panel displays that exceed the image quality characteristics of plasma and LCD screens at a lower cost. The success of competing technologies could substantially reduce the demand for our products. We rely on contract manufacturers and assemblers for a portion of our HDTV production requirements, and any interruptions of these arrangements could disrupt our ability to fill customer orders. We outsource to various contract manufacturers and assemblers the production requirements for our HDTVs. The loss of our relationships with our contract manufacturers or assemblers or their inability to conduct their manufacturing and assembly services for us as anticipated in terms of cost, quality, and timeliness could adversely affect our ability to fill retailer customer orders in accordance with required delivery, quality, and performance requirements. If this were to occur, the resulting decline in revenue and revenue potential would harm our business. Securing new contract manufacturers and assemblers is time-consuming and might result in unforeseen manufacturing and operations problems. (State or Other Jurisdiction of Incorporation or Organization) (Primary Standard Industrial Classification Code Number) (I.R.S. Employer Identification Number) 1600 North Desert Drive Tempe, Arizona 85281-1230 (602) 389-8888 Table of Contents Our contract manufacturers and assemblers must maintain satisfactory delivery schedules and their inability to do so could increase our costs, disrupt our supply chain, and result in our inability to deliver our HDTV products, which would adversely affect our results of operations. Our contract manufacturers and assemblers must maintain high levels of productivity and satisfactory delivery schedules. We do not have long-term arrangements with any of our contract manufacturers or assemblers that guarantee production capacity, prices, lead times, or delivery schedules. Our contract manufacturers and assemblers serve many other customers, a number of which have greater production requirements than we do. As a result, our contract manufacturers and assemblers could determine to prioritize production capacity for other customers or reduce or eliminate services for us on short notice. Longer delivery schedules may be encountered in commencing volume production of our HDTVs. Any such problems could result in our inability to deliver our HDTV products in a timely manner and adversely affect our operating results. Shortages of components and materials may delay or reduce our sales and increase our costs. Our inability or the inability of our contract manufacturers and assemblers to obtain sufficient quantities of components and other materials necessary for the production of our products could result in delayed sales or lost orders, increased inventory, and underutilized manufacturing capacity. Many of the materials used in the production of our HDTV and microdisplay products are available only from a limited number of foreign suppliers, including our light engines from OCLI (a subsidiary of JDS Uniphase), our video processing integrated circuits from Pixelworks, and our screens from Toppan. As a result, we are subject to increased costs, supply interruptions, and difficulties in obtaining materials. Our OEM customers also may encounter difficulties or increased costs in obtaining from others the materials necessary to produce their products into which our products are incorporated. We depend on Shanghai-based Semiconductor Manufacturing International Corporation, or SMIC, for the fabrication of silicon wafers and ASICs for our HDTV microdisplay products. We depend on Taiwan-based United Microelectronics Corporation, or UMC, for the fabrication of silicon wafers and ASICs for our near-to-eye microdisplay products. We do not have a long-term contract with SMIC or UMC. As a result, neither is obligated to supply us with silicon wafers or ASICs for any specific period, in any specific quantity, or at any specific price, except as provided in purchase orders from time to time. The termination of our arrangements with SMIC or UMC or their inability or unwillingness to provide us with the necessary amount or quality of silicon wafers or ASICs on a timely basis would adversely affect our ability to manufacture and ship our microdisplay products until alternative sources of supply could be arranged. We cannot assure you that we would be able to secure alternative arrangements. We also depend on TFS for printed circuit board assembly and on Suntron Corporation for assembly, production, and project management services. The failure or unwillingness of TFS or Suntron to continue to provide such services to us would adversely affect our operations. Materials and components for some of our major programs may not be available in sufficient quantities to satisfy our needs because of shortages of these materials and components. Any supply interruption or shortages may result in lost sales opportunities. We do not sell any products to end users and depend on the market acceptance of the products of our customers. We do not sell any products to end users. Instead, we design and develop HDTVs for sale by retailers under their own brand names, and we sell microdisplay products that our OEM customers incorporate into their products. As a result, our success depends on the ability of our retailer customers to sell our HDTVs and the widespread market acceptance of our OEM customers products. Any significant slowdown in the demand for our customers products would adversely affect our business. Because our success depends on the widespread market acceptance of our customers products, we must secure successful retailers for our HDTV products and establish relationships for our microdisplay (Address, Including Zip Code, and Telephone Number, Including Area Code, of Registrant s Principal Executive Offices) VINCENT F. SOLLITTO, JR. PRESIDENT AND CHIEF EXECUTIVE OFFICER BRILLIAN CORPORATION 1600 North Desert Drive Tempe, Arizona 85281-1230 (602) 389-8888 Table of Contents products with OEMs in industries that have significant growth potential. Our failure to secure retailers to sell our HDTVs or to establish relationships with OEMs in those high-growth markets would reduce our revenue potential. Our dependence on the success of the products of our retailer and OEM customers exposes us to a variety of risks, including the following: our ability to supply products for customers on a timely and cost-effective basis; our success in maintaining customer satisfaction with our products; our ability to match our manufacturing capacity with customer demand and to maintain satisfactory delivery schedules; customer order patterns, changes in order mix, and the level and timing of orders placed by customers that we can complete in a quarter; and the cyclical nature of the industries and markets we serve. Our failure to address these risks may adversely affect our results of operations. We are subject to lengthy development periods and product acceptance cycles. We sell our microdisplay products to OEMs, which then incorporate them into the products they sell. OEMs make the determination during their product development programs whether to incorporate our microdisplay products or pursue other alternatives. This may require us to make significant investments of time and capital well before our OEM customers introduce their products incorporating our products and before we can be sure that we will generate any significant sales to our OEM customers or even recover our investment. During an OEM customer s entire product development process, we face the risk that our products will fail to meet our OEM customer s technical, performance, or cost requirements or will be replaced by a competing product or alternative technology. Even if we offer products that are satisfactory to an OEM customer, the customer may delay or terminate its product development efforts. The occurrence of any of these events would adversely affect our revenue. The lengthy development period also means that it is difficult to immediately replace an unexpected loss of existing business. Our Arizona facility and its high-volume LCoS microdisplay manufacturing line are critical to our success. Our Arizona facility and its high-volume LCoS microdisplay manufacturing line are critical to our success. We currently produce all of our LCoS microdisplays on this dedicated line. This facility also houses our principal research, development, engineering, design, and managerial operations. Any event that causes a disruption of the operation of this facility for even a relatively short period of time would adversely affect our ability to produce our LCoS microdisplays and to provide technical and manufacturing support for our customers. We experienced lower than expected manufacturing yields in commencing volume production of LCoS microdisplays, and we must achieve satisfactory manufacturing yields. The design and manufacture of microdisplays are new and highly complex processes that are sensitive to a wide variety of factors, including the level of contaminants in the manufacturing environment, impurities in the materials used, and the performance of personnel and equipment. As a result of these factors, we have experienced lower than expected manufacturing yields in producing LCoS microdisplays. These issues could continue, and we may continue to encounter lower than desired manufacturing yields as we manufacture LCoS microdisplays in higher volumes, which could result in the delay of the ramp-up to high-volume LCoS manufacturing production. Continued lower than expected manufacturing yields could significantly and adversely affect our operating margins. (Name, Address Including Zip Code, and Telephone Number, Including Area Code, of Agent for Service) Copies to: ROBERT S. KANT, ESQ. BRIAN H. BLANEY, ESQ. GREENBERG TRAURIG, LLP 2375 East Camelback Road Phoenix, Arizona 85016 (602) 445-8000 JOHN T. SHERIDAN, ESQ. ADAM R. DOLINKO, ESQ. JOILENE W. GROVE, ESQ. WILSON SONSINI GOODRICH ROSATI, P.C. 650 Page Mill Road Palo Alto, California 94304 (650) 493-9300 Table of Contents Although we added additional equipment to our Arizona manufacturing facility in the last two years for manufacturing LCoS microdisplays, the high-volume manufacture of LCoS microdisplays will require us to overcome numerous challenges, including the following: the availability of a sufficient quantity of quality materials, the implementation of new manufacturing techniques, the incorporation of new handling procedures, the maintenance of clean manufacturing environments, and the ability to master precise tolerances in the manufacturing process. In addition, the complexity of manufacturing processes will increase along with increases in the sophistication of microdisplays. Any problems with our manufacturing operations could result in the lengthening of our delivery schedules, reductions in the quality or performance of our design and manufacturing services, and reduced customer satisfaction. Various target markets for our LCoS microdisplays are uncertain, may be slow to develop, or could use competing technologies. Various target markets for our LCoS microdisplays, including HDTVs, home theaters, and near-to-eye microdisplays, are uncertain, may be slow to develop, or could utilize competing technologies, especially high-temperature polysilicon and digital micromirror devices. Many manufacturers have well-established positions in these markets. HDTV has only recently become available to consumers, and widespread market acceptance is uncertain. Penetrating this market will require us to offer an improved value, higher performance proposition to existing technology. In addition, the commercial success of the near-to-eye microdisplay market is uncertain. Gaining acceptance in these markets may prove difficult because of the radically different approach of microdisplays to the presentation of information. We must provide customers with lower cost, higher performance microdisplays for their products in these markets. The failure of any of our target markets to develop, or our failure to penetrate these markets, would impede our sales growth. Even if our products successfully meet our price and performance goals, our retailer customers may not achieve success in selling our HDTVs and our OEM customers may not achieve commercial success in selling their products that incorporate our microdisplay products. Our business depends on new products and technologies. We operate in rapidly changing industries. Technological advances, the introduction of new products, and new design and manufacturing techniques could adversely affect our business unless we are able to adapt to the changing conditions. As a result, we will be required to expend substantial funds for and commit significant resources to the following: continuing research and development activities on existing and potential products; engaging additional engineering and other technical personnel; purchasing advanced design, production, and test equipment; maintaining and enhancing our technological capabilities; and expanding our manufacturing capacity. We may be unable to recover any expenditures we make relating to one or more new technologies that ultimately prove to be unsuccessful for any reason. In addition, any investments or acquisitions made to enhance our technologies may prove to be unsuccessful. Our future operating results will depend to a significant extent on our ability to provide new products that compare favorably on the basis of time to introduction, cost, and performance with the products of Approximate date of commencement of proposed sale to the public: As soon as practicable after the effective date of this Registration Statement. If any of the securities being registered in this form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, check the following box. If this form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. If this form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. If this form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. If delivery of the prospectus is expected to be made pursuant to Rule 434, check the following box. CALCULATION OF REGISTRATION FEE Table of Contents competitive third-party suppliers and technologies. Our success in attracting new customers and developing new business depends on various factors, including the following: the acceptance of our technology; utilization of advances in technology; innovative development of new microdisplay products for customer products; and efficient, timely, and cost-effective manufacture of microdisplay products. Our products may not achieve commercial success or widespread market acceptance. A key element of our current business involves the ongoing commercialization of our LCoS microdisplay technology. Our products may not achieve customer or widespread market acceptance. Some or all of our products may not achieve commercial success as a result of technological problems, competitive cost issues, yield problems, and other factors. Even when we successfully introduce a new product designed for OEM customers, our OEM customers may determine not to introduce or may terminate products utilizing our products for a variety of reasons, including the following: difficulties with other suppliers of components for the products, superior technologies developed by our competitors, price considerations, lack of anticipated or actual market demand for the products, and unfavorable comparisons with products introduced by others. Our products are complex and may require modifications to resolve undetected errors or unforeseen failures, which could lead to an increase in our costs, a loss of customers, or a delay in market acceptance of our products. Our products are complex and may contain undetected errors or experience unforeseen failures when first introduced or as new versions are released. These errors could cause us to incur significant re-engineering costs, divert the attention of our engineering personnel from product development efforts, and cause significant customer relations and business reputation problems. If we deliver products with defects, our credibility and the market acceptance and sales of our products could be harmed. Defects could also lead to liability for defective products as a result of lawsuits against us or against our customers. We also may agree to indemnify our customers in some circumstances against liability from defects in our products. A successful product liability claim could require us to make significant damage payments. We must protect our intellectual property and could be subject to infringement claims by others. We believe that our success depends in part on protecting our proprietary technology. We rely on a combination of patent, trade secret, and trademark laws, confidentiality procedures, and contractual provisions to protect our intellectual property. We seek to protect certain aspects of our technology under trade secret laws, which afford only limited protection. We face risks associated with our intellectual property, including the following: intellectual property laws may not protect our intellectual property rights; third parties may challenge, invalidate, or circumvent any patents issued to us; rights granted under patents issued to us may not provide competitive advantages to us; pending patent applications may not be issued; unauthorized parties may attempt to obtain and use information that we regard as proprietary despite our efforts to protect our proprietary rights; Table of Contents others may independently develop similar technology or design around any patents issued to us; and effective protection of intellectual property rights may be limited or unavailable in some foreign countries in which we operate. We may not be able to obtain effective patent, trademark, service mark, copyright, and trade secret protection in every country in which we sell our products. We may find it necessary to take legal action in the future to enforce or protect our intellectual property rights or to defend against claims of infringement and such action may be unsuccessful. Third parties could claim that we are infringing their patents or other intellectual property rights. In the event that a third party alleges that we are infringing its rights, we may not be able to obtain licenses on commercially reasonable terms from the third party, if at all, or the third party may commence litigation against us. Litigation can be very expensive and can distract our management s time and attention, which could adversely affect our business. In addition, we may not be able to obtain a favorable outcome in any intellectual property litigation. The nature of our business requires us to make significant capital expenditures and investments. The nature of our business requires us to make significant capital expenditures and investments. For example, the capital acquisition cost of our assets, including intangibles such as tooling, licenses, and patents, was $27.1 million through December 31, 2003. To facilitate the development of our LCoS microdisplay products, we also made an equity investment of $3.8 million in Inviso, Inc., which we had to write off in 2001 as a result of the closing of those operations. In 2002, we purchased all of the technology of Inviso for $780,000 after Inviso ceased operations. In addition, we purchased assets and technology of the former Light Valve business unit of National Semiconductor Corporation for approximately $3.6 million during 1999. In early 2002, we purchased certain fixed assets of Zight Corporation at a liquidator s auction for approximately $600,000. Following that auction, we then negotiated with the representatives of the defunct Zight Corporation to purchase its intellectual property for approximately $2.0 million. We also invested $1.3 million in an advanced packaging company, Silicon Bandwidth, Inc., during 2001 and $5.1 million in ColorLink, Inc., a private company providing color management systems for LCoS microdisplay light engines, during 2002. We may be required to make similar investments and capital expenditures in the future to maintain or enhance our ability to offer technologically advanced products. We must finance the growth of our business and the development of new products. To remain competitive, we must continue to make significant investments in research and development, equipment, and facilities. As a result of the increase in fixed costs and operating expenses related to these capital expenditures, our failure to increase sufficiently our net sales to offset these increased costs would adversely affect our operating results. Rapid sales increases would also require substantial increases in working capital. From time to time, in addition to this offering, we may seek additional equity or debt financing to provide for the capital expenditures required to maintain or expand our design and production facilities and equipment or to finance working capital requirements. We cannot predict the timing or amount of any such capital requirements at this time. If such financing is not available on satisfactory terms, we may be unable to expand our business or to develop new business at the rate desired and our operating results may suffer. Debt financing increases expenses and must be repaid regardless of operating results. Equity financing could result in additional dilution to existing stockholders. We have agreed with TFS not to issue common stock if such issuance could result in the imposition of a tax under Section 355(e) of the Internal Revenue Code unless we receive an opinion of counsel that Section 355(e) would not apply to such issuance because it was not part of a plan at the time of the spin-off. Amount Proposed Maximum Proposed Maximum Title of Each Class of Securities to be to be Aggregate Offering Aggregate Amount of Registered Registered(1) Price Per Share(2) Offering Price(2) Registration Fee(3) Table of Contents If we choose to manufacture or sell in the European and Asian markets, we may encounter challenges. Any efforts to manufacture or sell in the European and Asian markets may create a number of challenges. We and our contract manufacturers and assemblers purchase certain materials from international sources, and in the future we may decide to move certain manufacturing functions to, or establish additional manufacturing functions in, international locations. Purchasing, manufacturing, and selling products internationally exposes us to various economic, political, and other risks, including the following: management of a multinational organization; the burdens and costs of compliance with local laws and regulatory requirements as well as changes in those laws and requirements; imposition of restrictions on currency conversion or the transfer of funds; transportation delays or interruptions and other effects of less developed infrastructures; foreign exchange rate fluctuations; employment and severance issues, including possible employee turnover or labor unrest; overlap of tax issues; tariffs and duties; lack of developed infrastructure; and political or economic instability in certain parts of the world. Political and economic conditions abroad may adversely affect our foreign relationships. Protectionist trade legislation in either the United States or foreign countries, such as a change in the current tariff structures, export or import compliance laws, or other trade policies, could adversely affect our ability to manufacture or sell microdisplays in foreign markets and to purchase materials or equipment from foreign suppliers. Changes in policies by the United States or foreign governments resulting in, among other things, increased duties, higher taxation, currency conversion limitations, restrictions on the transfer or repatriation of funds, limitations on imports or exports, or the expropriation of private enterprises also could have a material adverse effect on us. In addition, U.S. trade policies, such as most favored nation status and trade preferences for certain Asian nations, could affect the attractiveness of our products to our U.S. customers. While we transact business predominantly in U.S. dollars and bill and collect most of our sales in U.S. dollars, we occasionally collect a portion of our revenue in non-U.S. currencies. In the future, customers may make payments in non-U.S. currencies. Fluctuations in foreign currency exchange rates could affect our cost of goods and operating margins and could result in exchange losses. In addition, currency devaluation can result in a loss to us if we hold deposits of that currency. Hedging foreign currencies can be difficult, especially if the currency is not freely traded. We cannot predict the impact of future exchange rate fluctuations on our operating results. The cyclical nature of the consumer electronics industry may cause substantial period-to-period fluctuations in our operating results. The consumer electronics industry has experienced significant economic downturns at various times, characterized by diminished product demand, accelerated erosion of average selling prices, intense competition, and production over-capacity. In addition, the consumer electronics industry is cyclical in nature. We may experience substantial period-to-period fluctuations in operating results, at least in part because of general industry conditions or events occurring in the general economy. Common Stock, $.001 par value per share 1,725,000 $8.48 $14,628,000.00 $1,853.37 Table of Contents Our operating results may have significant periodic and seasonal fluctuations. In addition to the variability resulting from the short-term nature of our customers commitments, other factors may contribute to significant periodic and seasonal quarterly fluctuations in our results of operations. These factors include the following: the timing and volume of orders relative to our capacity; product introductions or enhancements and market acceptance of product introductions and enhancements by us, our OEM customers, and competitors; evolution in the life cycles of customers products; timing of expenditures in anticipation of future orders; effectiveness in managing manufacturing processes; changes in cost and availability of labor and components; product mix; pricing and availability of competitive products; and changes or anticipated changes in economic conditions. Accordingly, you should not rely on the results of any past periods as an indication of our future performance. It is likely that in some future period, our operating results may be below expectations of public market analysts or investors. If this occurs, our stock price may decline. We must effectively manage our growth. The failure to manage our growth effectively could adversely affect our operations. Our ability to manage our planned growth effectively will require us to enhance our operational, financial, and management systems; expand our facilities and equipment; and successfully hire, train, and motivate additional employees, including the technical personnel necessary to operate our production facility in Tempe, Arizona. We incur increased costs as a result of being a public company. As a public company, we incur significant legal, accounting, and other expenses that we did not incur as a division of TFS. In addition, the Sarbanes-Oxley Act of 2002, as well as new rules subsequently implemented by the Securities and Exchange Commission and Nasdaq, have required changes in corporate governance practices of public companies. We expect these new rules and regulations to increase our legal and financial compliance costs and to make some activities more time-consuming and costly. In addition, we incur additional costs associated with our public company reporting requirements. We also expect these new rules and regulations to make it more difficult and more expensive for us to obtain director and officer liability insurance, and we may be required to accept reduced policy limits and coverage or incur substantially higher costs to obtain the same or similar coverage. As a result, it may be more difficult for us to attract and retain qualified persons to serve on our board of directors or as executive officers. We are currently evaluating and monitoring developments with respect to these new rules, and we cannot predict or estimate the amount of additional costs we may incur or the timing of such costs. We depend on key personnel. Our development and operations depend substantially on the efforts and abilities of our senior management and technical personnel. The competition for qualified management and technical personnel is intense. Although we have not experienced problems of recruiting and maintaining qualified personnel to Table of Contents date, we have limited experience in personnel recruitment or retention as an independent company. The loss of services of one or more of our key employees or the inability to add key personnel could have a material adverse effect on us. Although we maintain non-competition and nondisclosure covenants with certain key personnel, we do not have any fixed-term agreements with, or key person life insurance covering, any officer or employee. Potential strategic alliances may not achieve their objectives. We have entered into various strategic alliances, and we plan to enter into other similar types of alliances in the future. Among other matters, we will explore strategic alliances designed to do the following: enhance or complement our technology or work in conjunction with our technology; increase our manufacturing capacity; provide necessary know-how, components, or supplies; and develop, introduce, or distribute products utilizing our technology. Any strategic alliances may not achieve their strategic objectives, and parties to our strategic alliances may not perform as contemplated. Any acquisitions that we undertake could be difficult to integrate, disrupt our business, dilute stockholder value, and harm our operating results. We plan to review opportunities to buy other businesses or technologies that would complement our current products, expand the breadth of our markets, enhance our technical capabilities, or otherwise offer growth opportunities. While we have no current agreements or active negotiations underway, we may buy businesses, products, or technologies in the future. If we make any future acquisitions, we could issue stock that would dilute existing stockholders percentage ownership, incur substantial debt, or assume contingent liabilities. We have agreed with TFS not to issue common stock in an acquisition transaction if such issuance could result in the imposition of a tax under Section 355(e) of the Internal Revenue Code unless we receive an opinion of counsel that Section 355(e) would not apply to such issuance because it was not part of a plan at the time of the spin-off. Our experience in acquiring other businesses and technologies is limited. Potential acquisitions also involve numerous risks, including the following: problems integrating the purchased operations, technologies, products, or services with our own; unanticipated costs associated with the acquisition; diversion of management s attention from our core businesses; adverse effects on existing business relationships with suppliers and customers; risks associated with entering markets in which we have no or limited prior experience; and potential loss of key employees and customers of purchased organizations. Our acquisition strategy entails reviewing and potentially reorganizing acquired business operations, corporate infrastructure and systems, and financial controls. Unforeseen expenses, difficulties, and delays frequently encountered in connection with rapid expansion through acquisitions could inhibit our growth and negatively impact our profitability. We may be unable to identify suitable acquisition candidates or to complete the acquisitions of candidates that we identify. Increased competition for acquisition candidates may increase purchase prices for acquisitions to levels beyond our financial capability or to levels that would not result in the returns required by our acquisition criteria. In addition, we may encounter difficulties in integrating the operations of acquired businesses with our own operations or managing acquired businesses profitably without substantial costs, delays, or other operational or financial problems. (1) Includes 225,000 shares of common stock that the underwriters have the option to purchase to cover over-allotments, if any. (2) Estimated solely for the purpose of calculating the registration fee pursuant to Rule 457(c) under the Securities Act of 1933. (3) A filing fee in the amount of $5,068.00 was previously paid in connection with the filing of the Registration Statement. Table of Contents We are subject to governmental regulations. Like all businesses, our operations are subject to certain federal, state, and local regulatory requirements relating to environmental, waste management, health, and safety matters. We could become subject to liabilities as a result of a failure to comply with applicable laws and incur substantial costs from complying with existing, new, modified, or more stringent requirements. In addition, our past, current, or future operations may give rise to claims of exposure by employees or the public or to other claims or liabilities relating to environmental, waste management, or health and safety concerns. Risks Related to Our Recent Spin-Off We have a limited operating history as a public company, and our business has relied on TFS for various financial, managerial, and administrative services. We have a limited operating history as an independent company. Our business historically relied on TFS for various financial, managerial, and administrative services and was able to benefit from the earnings, assets, and cash flows of TFS other businesses. TFS is no longer obligated to provide assistance or services to us, except as described in the Master Separation and Distribution Agreement, the Transition Services Agreement, and the other agreements entered into between the companies, which are described under Relationship With TFS. Our historical financial information may not be representative of our results as a separate company, as we previously operated as a division of TFS. The historical financial information included in this prospectus may not be representative of our results of operations, financial position, and cash flows had we operated as a separate, stand-alone entity rather than as a division of TFS during the periods prior to September 15, 2003 or of our results of operations, financial position, and cash flows in the future. This results from the following: in preparing this information, we have made adjustments and allocations because TFS did not account for us as, and we were not operated as, a stand-alone business for all periods prior to the spin-off; and the information prior to the spin-off does not reflect many changes in our funding and operations as a result of our spin-off from TFS. We cannot assure you that the adjustments and allocations we have made in preparing our historical financial statements appropriately reflect our operations during those periods as if we had in fact operated as a stand-alone entity. We could incur significant tax liability if the contribution or the spin-off from TFS does not qualify for tax-free treatment. TFS received a private letter ruling from the IRS to the effect that, among other things, the spin-off was tax free to TFS and the TFS stockholders under Section 355 of the Internal Revenue Code, except to the extent that cash was received in lieu of fractional shares. The private letter ruling, while generally binding upon the IRS, was based upon factual representations and assumptions and commitments on our behalf with respect to future operations made in the ruling request. The IRS could modify or revoke the private letter ruling retroactively if the factual representations and assumptions in the request were materially incomplete or untrue, the facts upon which the private letter ruling was based were materially different from the facts at the time of the spin-off, or if we do not meet certain commitments made. If the spin-off failed to qualify under Section 355 of the Internal Revenue Code, corporate tax would be payable by the consolidated group of which TFS is the common parent based upon the difference between the aggregate fair market value of the assets of our business and the adjusted tax bases of such business to TFS prior to the spin-off. The corporate level tax would be payable by TFS. We have agreed, The Registrant hereby amends this Registration Statement on such date or dates as may be necessary to delay its effective date until the Registrant shall file a further amendment which specifically states that this Registration Statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933 or until the Registration Statement shall become effective on such date as the Commission, acting pursuant to Section 8(a), may determine. Table of Contents however, to indemnify TFS for this and certain other tax liabilities if they result from actions taken by us or from the spin-off. In addition, under the Internal Revenue Code s consolidated return regulations, each member of the TFS consolidated group, including our company, will be severally liable for these tax liabilities. If we are required to indemnify TFS for these liabilities or otherwise are found liable to the IRS for these liabilities, the resulting obligation could materially and adversely affect our financial condition. The agreements governing our relationship with TFS following the spin-off were negotiated while we were a subsidiary of TFS and, as a result, we cannot assure you that the agreements are on terms favorable to us. The agreements governing our relationship with TFS following the spin-off were negotiated in a parent-subsidiary context and were negotiated in the overall context of our separation from TFS. At the time of these negotiations, certain of our officers were employees of TFS. We cannot assure you that these agreements were the result of arm s-length negotiations. Especially as it relates to the Transition Services Agreement and the Real Property Sublease Agreement, we cannot assure you that these agreements are on terms comparable to those which might have been obtained from unaffiliated third parties. Additionally, upon the expiration of these agreements, we may not be able to replace the services and support that TFS provides under these agreements in a timely manner or on terms and conditions, including costs, as favorable as those we receive from TFS. While TFS is contractually obligated to provide us with certain transitional services, we cannot assure you that these services will be sustained at the same level as when we were part of TFS or that we will obtain the same benefits. In addition, as we build our own infrastructure during the term of those agreements, we will incur additional costs for duplicated administrative services. We will not be able to rely on TFS to fund future capital requirements and, therefore, we may not be able to provide for our capital needs. In the past, our capital needs were satisfied by TFS. However, TFS no longer provides any funds to finance our working capital or other cash requirements and does not guarantee our financial or other obligations. The $20.9 million cash funding that TFS provided us in connection with the spin-off may not be adequate for us to fund our planned operations and expenditures beyond 2004. It will be necessary for us to reduce substantially our operating losses (through either increased sales, reduced expenses, or both) or to raise additional funds, such as those to be provided by this offering. We cannot assure you that we will be able to increase our sales or raise necessary funds on terms satisfactory to us. We believe that our capital requirements will vary greatly from quarter to quarter, depending on, among other things, capital expenditures, fluctuations in our operating results, and financing activities. To increase our financial resources, we may be required to raise additional capital through a public offering or private placement of equity with strategic or other investors or through debt financing in the future. Future equity financings would dilute the relative percentage ownership of the then existing holders of our common stock and may be limited by our agreements with TFS, particularly the Tax Sharing Agreement. Future debt financings could involve restrictive covenants that limit our ability to take certain actions, such as pay dividends, incur additional indebtedness, or create liens. We may not be able to obtain financing on terms as favorable as those historically enjoyed by TFS. For a more complete discussion of our capital resources, see Management s Discussion and Analysis of Financial Condition and Results of Operations Liquidity and Capital Resources. Table of Contents Risks Related to this Offering The market price for our common stock may be volatile, and you may not be able to sell our stock at a favorable price or at all. Many factors could cause the market price of our common stock to rise and fall, including the following: variations in our quarterly results; announcements of technological innovations by us or by our competitors; introductions of new products or new pricing policies by us or by our competitors; acquisitions or strategic alliances by us or by our competitors; recruitment or departure of key personnel; the gain or loss of significant orders; the gain or loss of significant customers; changes in the estimates of our operating performance or changes in recommendations by any securities analysts that follow our stock; and market conditions in our industry, the industries of our customers, and the economy as a whole. In addition, stocks of technology companies have experienced extreme price and volume fluctuations that often have been unrelated or disproportionate to these companies operating performance. Public announcements by technology companies concerning, among other things, their performance, accounting practices, or legal problems could cause the market price of our common stock to decline regardless of our actual operating performance. Management will have discretion over the use of proceeds from this offering and could spend or invest those proceeds in ways with which you might not agree. Our management will have broad discretion with respect to the use of the net proceeds of this offering, and you will be relying on the judgment of our management regarding the application of these proceeds. We currently expect to use these proceeds to expand our HDTV business, to expand our sales and marketing efforts, to finance working capital needs associated with anticipated revenue increases, and for general corporate purposes. In addition, we may use a portion of the net proceeds to acquire or invest in complementary businesses, products, or technologies. These investments may not yield a favorable return. Substantial sales of our common stock, or the perception that such sales might occur, could depress the market price of our common stock. Substantially all of the shares of our common stock are eligible for immediate resale in the public market. Any sales of substantial amounts of our common stock in the public market, or the perception that such sales might occur, could depress the market price of our common stock. We have agreed to restrictions and adopted policies in connection with the spin-off that could have possible anti-takeover effects. We have agreed to certain restrictions on our future actions to assure that the spin-off is tax-free, including restrictions with respect to an acquisition of shares of our common stock by an unrelated party. If we fail to abide by these restrictions, and, as a result, the spin-off fails to qualify as a tax-free reorganization, we will be obligated to indemnify TFS for any resulting tax liability. These restrictions and the potential tax liability that could arise from an acquisition of shares of our common stock, together with Cash Flows from Financing Activities: Net transfers from Three-Five Systems, Inc. 10,226 33,898 24,411 Cash received in spin-off 20,853 Stock options exercised Table of Contents our related indemnification obligations, could have the effect of delaying, deferring, or preventing a change in control of our company. See Relationship With TFS Tax Sharing Agreement. Provisions in our certificate of incorporation, our bylaws, and Delaware law could make it more difficult for a third party to acquire us, discourage a takeover, and adversely affect existing stockholders. Our certificate of incorporation and the Delaware General Corporation Law contain provisions that may have the effect of making more difficult or delaying attempts by others to obtain control of our company, even when these attempts may be in the best interests of stockholders. These include provisions limiting the stockholders powers to remove directors or take action by written consent instead of at a stockholders meeting. Our certificate of incorporation also authorizes our board of directors, without stockholder approval, to issue one or more series of preferred stock, which could have voting and conversion rights that adversely affect or dilute the voting power of the holders of common stock. Delaware law also imposes conditions on certain business combination transactions with interested stockholders. We have also adopted a stockholder rights plan intended to encourage anyone seeking to acquire our company to negotiate with our board of directors prior to attempting a takeover. While the plan was designed to guard against coercive or unfair tactics to gain control of our company, the plan may have the effect of making more difficult or delaying any attempts by others to obtain control of our company. These provisions and others that could be adopted in the future could deter unsolicited takeovers or delay or prevent changes in our control or management, including transactions in which stockholders might otherwise receive a premium for their shares over then current market prices. These provisions may also limit the ability of stockholders to approve transactions that they may deem to be in their best interests. We do not pay cash dividends. We have never paid any cash dividends on our common stock and do not anticipate that we will pay cash dividends in the foreseeable future. Instead, we intend to apply any earnings to the expansion and development of our business.
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+RISK FACTORS If you are interested in us you should consider carefully the risks described below, together with the other information contained in this Prospectus. GENERAL RISK FACTORS 1. THE POSSIBLE NEED FOR ADDITIONAL FINANCING MAY IMPAIR OUR ABILITY TO LOCATE ANY AVAILABLE BUSINESS OPPORTUNITY. We have extremely limited funds, and such funds may not be adequate to take advantage of any available business opportunities that would require a cash investment. Even if our funds prove to be sufficient to acquire an interest in, or complete a transaction with, a business opportunity, we may not have enough capital to exploit the opportunity. Our ultimate success may depend upon our ability to raise additional capital. We have not investigated the availability, source, or terms that might govern the acquisition of additional capital and will not do so until it determines a need for additional financing. If additional capital is needed, there is no assurance that funds will be available from any source or, if available, that they can be obtained on terms acceptable to us. If additional capital is not available, once a business opportunity is concluded, our operations will be limited to those that can be financed with our extremely limited capital and the capital, if any, of the acquired business or entity. 2. OUR LACK OF ANY OPERATING HISTORY MAY SEVERELY IMPACT OUR ABILITY TO LOCATE A VIABLE BUSINESS OPPORTUNITY. We were formed in April of 2003 for the purpose of registering our shares of common stock under the Securities Act of 1933 for the purpose of acquiring a business opportunity. We have no operating history, revenues from operations, or any significant assets. This lack of an operating history and our insignificant assets may impair our ability to attract a viable business opportunity. In fact, we may only be able to attract newly formed or development stage companies with a limited operating history. 3. REPORTING REQUIREMENTS MAY DELAY OR PRECLUDE OUR BUSINESS COMBINATION OBJECTIVES. Section 13 of the 1934 Act requires companies subject thereto to provide certain information about significant acquisitions, including certified financial statements for the company acquired, covering one or two years, depending on the relative size of the acquisition. The time and additional costs that may be incurred by some target entities to prepare such statements may significantly delay or essentially preclude consummation of an otherwise desirable acquisition by us. Acquisition prospects that do not have or are unable to obtain the required audited statements may not be appropriate for acquisition so long as the reporting requirements of the 1934 Act are applicable. 4. OUR POTENTIAL BUSINESS OPPORTUNITY HAS NOT BEEN IDENTIFIED AND WILL BE HIGHLY RISKY. We have not identified and have no commitments to enter into or acquire a specific business opportunity and therefore can only disclose the risks and hazards of a business or opportunity that we may enter into in a general manner, and cannot disclose the risks and hazards of any specific business or opportunity that we may enter into. A Shareholder should expect a potential business opportunity to be quite risky. Our acquisition of, or participation in, a business opportunity will likely be highly illiquid and could result in a total loss to us and our shareholders if the business or opportunity proves to be unsuccessful. 5. OUR FINANCIAL STATEMENTS CONTAIN A STATEMENT INDICATING THAT OUR ABILITY TO CONTINUE AS A GOING CONCERN IS DEPENDENT ON OUR ABILITY TO RAISE CAPITAL. We may not be able to operate as a going concern. Our independent auditor's report accompanying our financial statements contains an explanation that our financial statements have been prepared assuming that we will continue as a going concern. Since our inception on April 25, 2003,we have had no business operations and have incurred a net loss of $3,154 through March 31, 2004. On March 31, 2004, we had cash on hand totaling $105. We intend to use our shares of common stock to provide the consideration for any business combination in which we may participate. We do not expect that there will be any cash requirement for us to participate in any such business combination. However, it is possible that we will be required to issue more than the 8,250,000 shares of common stock being registered hereunder in connection with any business combination. In such event, it is possible that our existing shareholders may sell a portion of their shares or that we will issue additional, unregistered shares of common stock as part of any required consideration. 6. WE WILL HAVE SUBSTANTIAL COMPETITION FOR BUSINESS OPPORTUNITIES WHICH MAY AFFECT OUR ABILITY TO MERGE WITH OR ACQUIRE A BUSINESS. We are and will continue to be an insignificant participant in the business of seeking business opportunities. A substantial number of established and well financed entities, including investment banking and venture capital firms, have substantially greater financial resources, technical expertise and managerial capabilities than we have and, consequently, we will be at a competitive disadvantage in identifying suitable merger or acquisition candidates and successfully concluding a proposed merger or acquisition. 7. WE MAY NOT BE ABLE TO CONDUCT AN EXHAUSTIVE INVESTIGATION AND ANALYSIS OF POTENTIAL BUSINESS OPPORTUNITIES AND CONSEQUENTLY MAY NEVER FIND A BUSINESS OPPORTUNITY. Our limited funds and the lack of full-time management will likely make it impracticable to conduct a complete and exhaustive investigation and analysis of potential business opportunities. Management decisions, therefore, will likely be made without detailed feasibility studies, independent analysis, market surveys and the like which, if we had more funds available to us, would be desirable. We will be particularly dependent in making decisions upon information provided by the promoter, owner, sponsor, or others associated with the business opportunity seeking our participation. 8. THERE WILL BE A LIMITED PARTICIPATION BY MANAGEMENT IN OUR DAILY OPERATIONS, WHICH COULD DELAY OUR SEARCH FOR A BUSINESS OPPORTUNITY. We currently have five (5) individuals who are serving as our sole officers and directors. We will be heavily dependent upon their skills, talents, and abilities to implement our business plan, and may, from time to time, find that the inability of the officers and directors to devote their full time attention to our business results in a delay in progress toward implementing our business plan. Furthermore, since only five individuals are serving as our officers and directors, it will be entirely dependent upon their experience in seeking, investigating, and acquiring a business and in making decisions regarding our operations. At present our officers and directors have indicated that they will only be available on a limited basis for our affairs. They have indicated that they expect to commit not more than 3 - 4 hours per week to our business. 9. THERE IS A LACK OF CONTINUITY IN OUR MANAGEMENT AND WE WILL HAVE LIMITED ABILITY TO EVALUATE THE MANAGEMENT OF AN ACQUISITION CANDIDATE. We do not have an employment agreement with our officers and directors, and as a result, there is no assurance that they will continue to manage us in the future. In connection with acquisition of a business opportunity, it is highly likely that our current officers and directors will resign and that the management of the acquired business will then become our management. A decision to resign will be based upon the identity of the business opportunity and the nature of the transaction, and is likely to occur without the vote or consent of our shareholders. 10. THE CONTROL OF MADISON GROUP BY PRINCIPAL SHAREHOLDERS, OFFICERS AND DIRECTORS COULD IMPEDE OUR SHAREHOLDERS FROM HAVING ANY ABILITY TO DIRECT AFFAIRS AND BUSINESS. If all 8,250,000 shares are issued in a future business combination, our existing shareholders, officers and directors will beneficially own approximately 17.5% of our shares of common stock, assuming no additional shares are issued. As a result, the shareholders of the business entity acquired will have the ability to control us and direct our affairs and business. 11. OUR INDEMNIFICATION OF OFFICERS AND DIRECTORS MAY RESULT IN SUBSTANTIAL EXPENDITURES. Our Articles of Incorporation provide for the indemnification of directors, officers, employees, and agents, under certain circumstances, against attorney's fees and other expenses incurred by them in any litigation to which they become a party arising from their association with or activities on our behalf. We will also bear the expenses of such litigation for any directors, officers, employees, or agents, upon such person's promise to repay us therefore if it is ultimately determined that any such person shall not have been entitled to indemnification. This indemnification policy could result in substantial expenditures by us that it will be unable to recoup. 12. LACK OF MARKET FOR OUR SHARES WHICH WILL LIMIT LIQUIDITY AND PRICE OF OUR SHARES. Since there is no market for our shares we cannot predict the extent, if any, to which such a market may develop following completion of a business combination. In significant part, any market that may develop will be based upon the operating history, revenues and profitability, or lack thereof, of any company we may acquire. 13. A MARKET FOR OUR SHARES MAY NOT DEVELOP. An active trading market for our shares may never develop or, if developed, it may not be maintained. Shareholders may be unable to sell their shares in any market involving our shares unless that market can be established or maintained, and therefore your investment would be a complete loss. 14. REQUIRED REGULATORY DISCLOSURE RELATING TO LOW-PRICED STOCKS MAY NEGATIVELY IMPACT LIQUIDITY IN OUR COMMON STOCK. If our common stock does become publicly traded following completion of a business combination, it is likely that it will be considered a "penny stock," which generally is a stock trading under $5.00 and not registered on national securities exchanges or quoted on the national NASDAQ market. The SEC has adopted rules that impose special sales practice requirements upon broker- dealers who sell such securities to persons other than established customers or accredited investors. For purposes of the rule, the phrase "accredited investors" means, in general terms, institutions with assets in excess of $5,000,000, or individuals having a net worth in excess of $1,000,000 or having an annual income that exceeds $200,000 (or that, when combined with a spouse's income, exceeds $300,000). For transactions covered by the rule, the broker- dealer must make a special suitability determination for the purchaser and receive the purchaser's written agreement to the transaction prior to the sale. Consequently, the rule may affect the ability of broker-dealers to sell our shares and also may affect the ability of shareholders in this offering to sell their shares in any market that might develop therefore. In addition, the SEC has adopted a number of rules to regulate "penny stocks." Such rules include Rules 3a51-1, 15g-1, 15g-2, 15g-3, 15g-4, 15g-5, 15g-6, and 15g-7 under the 1934 Act, as amended. The rules may further affect the ability of shareholders to sell their shares in any market that might develop therefore. Shareholders should be aware that, according to SEC Release No. 34-29093, the market for penny stocks has suffered in recent years from patterns of fraud and abuse. Such patterns include (i) control of the market for the security by one or a few broker-dealers that are often related to the promoter or issuer; (ii) manipulation of prices through prearranged matching of purchases and sales and false and misleading press releases; (iii) "boiler room" practices involving high-pressure sales tactics and unrealistic price projections by inexperienced sales persons; (iv) excessive and undisclosed bid-ask differentials and markups by selling broker-dealers; and (v) the wholesale dumping of the same securities by promoters and broker-dealers after prices have been manipulated to a desired level, along with the resulting inevitable collapse of those prices and with consequent investor losses. The additional burdens imposed upon broker-dealers by such requirements may discourage broker-dealers from effecting transactions in our shares, which could severely limit the market liquidity and the ability of shareholders to sell the shares in the secondary market. RISKS FOR OWNERS OF POTENTIAL TARGET COMPANIES 1. INCREASED SCRUTINY FROM THE REGULATORY COMMUNITY AND SKEPTICISM FROM THE FINANCIAL COMMUNITY. Congress has found that blank check companies have been common vehicles for fraud and manipulation in the penny stock market in the past. Moreover, the financial community views shell transactions with a high degree of skepticism until the combined companies have been active for a sufficient period of time to demonstrate credible operating performance. Increased regulatory scrutiny and heightened market skepticism may increase your future costs of regulatory compliance and make it more difficult for the combined companies to establish an active trading market. 2. INEFFECTIVE MEANS FOR RAISING ADDITIONAL CAPITAL. A business combination with us will not provide an effective means of accessing the capital markets. Therefore, you should not consider a business combination with us if you currently need additional capital, or will require additional capital within twelve (12) to eighteen (18) months. Until the combined companies have been active for a sufficient period of time to demonstrate credible operating performance, it will be very difficult, if not impossible, for you to raise additional capital to finance the combined companies' operations. You cannot assume that the combined companies will ever be able to raise additional capital.
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+RISK FACTORS You should carefully consider the risk factors set forth below as well as the other information contained in this prospectus before deciding whether to invest in our notes. If any of the following risks actually occur, our business, financial condition or results of operations could suffer. In such case, you may lose all or part of your original investment. Risks Relating to the Notes Substantial Leverage Our substantial indebtedness could adversely affect our financial health and prevent us from fulfilling our obligations under the notes. We have a significant amount of indebtedness. On March 31, 2004, we had total indebtedness of $453.2 million (of which $280.0 million consisted of the notes and the balance consisted of senior debt under our senior credit facility and obligations under capital leases and long-term software arrangements). Our ratio of earnings to fixed charges was 0.4x and 2.4x for the six months ended December 31, 2003 and the three months ended March 31, 2004, respectively. Our substantial indebtedness could have important consequences to you. For example, it could: make it more difficult for us to satisfy our obligations with respect to the notes; increase our vulnerability to general adverse economic and industry conditions; require us to dedicate a substantial portion of our cash flow from operations to payments on our indebtedness, thereby reducing the availability of our cash flow to fund working capital, capital expenditures, research and development efforts and other general corporate purposes; limit our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate; place us at a competitive disadvantage compared to our competitors that have less debt; and limit our ability to borrow additional funds. In addition, the indenture and our senior credit facility contain financial and other restrictive covenants that limit our ability to engage in activities that may be in our long-term best interests. Our failure to comply with those covenants could result in an event of default which, if not cured or waived, could result in the acceleration of all of our debts. Additional Borrowings Available Despite current indebtedness levels, we and our subsidiaries may still be able to incur substantially more debt. This could further exacerbate the risks associated with our substantial leverage. We and our subsidiaries may be able to incur substantial additional indebtedness in the future. The terms of the indenture do not fully prohibit us or our subsidiaries from doing so. Our senior credit facility permits additional borrowings of up to $50.0 million. If new debt is added to our and our subsidiaries' current debt levels, the related risks that we and they now face could intensify. See "Description of Other Indebtedness Senior Credit Facility." Restrictions on Existing Indebtedness Restrictions on our outstanding debt instruments may limit our ability to make payments on the notes or operate our business. Our senior credit facility and the indenture governing the notes contain covenants that limit the discretion of our management with respect to certain business matters. These covenants will significantly restrict our ability to (among other things): incur additional indebtedness; State of Incorporation or Organization create liens or other encumbrances; pay dividends or make certain other payments, investments, loans and guarantees; and sell or otherwise dispose of assets and merge or consolidate with another entity. In addition, our senior credit facility requires us to meet certain financial ratios and financial condition tests. You should read the discussions under the headings "Description of Other Indebtedness Senior Credit Facility" and "Description of the Notes Certain Covenants" for further information about these covenants. Events beyond our control can affect our ability to meet these financial ratios and financial condition tests. Our failure to comply with these obligations could cause an event of default under our senior credit facility. If an event of default occurs, our lenders could elect to declare all amounts outstanding and accrued and unpaid interest in our senior credit facility to be immediately due, and the lenders thereafter could foreclose upon the assets securing the senior credit facility. In that event, we cannot assure you that we would have sufficient assets to repay all of our obligations, including the notes and the related guarantees. We may incur other indebtedness in the future that may contain financial or other covenants more restrictive than those applicable to our senior credit facility or the indenture governing the notes. Ability to Service Debt To service our indebtedness, we will require a significant amount of cash. Our ability to generate cash depends on many factors beyond our control. Our ability to make payments on and to refinance our indebtedness, including the notes, and to fund planned capital expenditures and research and development efforts will depend on our ability to generate cash in the future. This, to a certain extent, is subject to general economic, financial, competitive, legislative, regulatory and other factors that are beyond our control. Based on our current level of operations and anticipated cost savings and operating improvements, we believe our cash flow from operations, available cash and available borrowings under our senior credit facility, will be adequate to meet our future liquidity needs for the foreseeable future. We cannot assure you, however, that our business will generate sufficient cash flow from operations, that currently anticipated cost savings and operating improvements will be realized on schedule or that future borrowings will be available to us under our senior credit facility in an amount sufficient to enable us to pay our indebtedness, including the notes, or to fund our other liquidity needs. We may need to refinance all or a portion of our indebtedness, including the notes on or before maturity. We cannot assure you that we will be able to refinance any of our indebtedness, including our senior credit facility and the notes, on commercially reasonable terms or at all. Subordination to Secured Creditors Your right to receive payments on the notes is effectively subordinated to the rights of our existing and future secured creditors. Further, the guarantees of the notes are effectively subordinated to all our guarantors' existing and future secured indebtedness. Holders of our secured indebtedness and the secured indebtedness of the guarantors will have claims that are prior to your claims as holders of the notes to the extent of the value of the assets securing that other indebtedness. Notably, we and certain of our subsidiaries, including the guarantors, are parties to a senior credit facility, which is secured by liens on substantially all of our assets and the assets of the guarantors. In addition, our capital leases and long-term software arrangements are secured by the assets under such leases and arrangements. The notes are effectively subordinated to all that secured indebtedness. In the event of any distribution or payment of our assets in any foreclosure, dissolution, winding-up, liquidation, reorganization, or other bankruptcy proceeding, holders of secured indebtedness will have prior claim to those of our assets that constitute their collateral. Holders of the notes will participate ratably with all holders of our unsecured indebtedness that is deemed to be of the same class as the notes, and potentially with all of our other general creditors, based upon the respective amounts owed to each holder or creditor, in our remaining assets. In any of the foregoing Primary Standard Industrial Classification Code Number events, we cannot assure you that there will be sufficient assets to pay amounts due on the notes. As a result, holders of notes may receive less, ratably, than holders of secured indebtedness. As of March 31, 2004, the aggregate amount of our secured indebtedness and the secured indebtedness of our subsidiaries was approximately $86.0 million, and approximately $50.0 million was available for additional borrowing under the revolving credit facility portion of our senior credit facility. We are permitted to borrow substantial additional indebtedness, including senior debt, in the future under the terms of the indenture. See "Description of Other Indebtedness Senior Credit Facility." Not all Subsidiaries are Guarantors Your right to receive payments on the notes could be adversely affected if any of our non-guarantor subsidiaries declare bankruptcy, liquidate or reorganize. None of our foreign subsidiaries will guarantee the notes. In the event of a bankruptcy, liquidation or reorganization of any of our non-guarantor subsidiaries, holders of their indebtedness and their trade creditors will generally be entitled to payment of their claims from the assets of those subsidiaries before any assets are made available for distribution to us. As of March 31, 2004, our non-guarantor subsidiaries had approximately $28.3 million of trade accounts payable and other accrued expenses. Our non-guarantor subsidiaries generated approximately 14.2% of our consolidated revenues in the three month period ended March 31, 2004 and held approximately 3.5% of our consolidated assets as of March 31, 2004. See footnote 16 to our consolidated financial statements included at the back of this prospectus. Financing Change of Control Offer We may not have the ability to raise the funds necessary to finance the change of control offer required by the indenture. Upon the occurrence of certain specific kinds of change of control events, we will be required to offer to repurchase all outstanding notes at 101% of the principal amount thereof plus accrued and unpaid interest and liquidated damages, if any, to the date of repurchase. However, it is possible that we will not have sufficient funds at the time of the change of control to make the required repurchase of the notes or that restrictions in our senior credit facility will not allow such repurchases. In addition, certain important corporate events, such as leveraged recapitalizations that would increase the level of our indebtedness, would not constitute a "Change of Control" under the indenture. See "Description of the Notes Repurchase at the Option of Holders." Fraudulent Conveyance Matters Federal and state statutes allow courts, under specific circumstances, to void debts, including guarantees, and require note holders to return payments received from us or the guarantors. Under the federal bankruptcy law and comparable provisions of state fraudulent transfer laws, obligations under a note or a guarantee could be voided, or claims in respect of a note or a guarantee could be subordinated to all other debts of the debtor or guarantor if, among other things, the debtor or the guarantor, at the time it incurred the indebtedness evidenced by its note or guarantee: received less than reasonably equivalent value or fair consideration for the incurrence of such debt or guarantee; and one of the following applies: it was insolvent or rendered insolvent by reason of such incurrence; it was engaged in a business or transaction for which the guarantor's remaining assets constituted unreasonably small capital; or it intended to incur, or believed that it would incur, debts beyond its ability to pay such debts as they mature. IRS Employer Identification No. In addition, any payment by that debtor or guarantor pursuant to its note or guarantee could be voided and required to be returned to the debtor or guarantor, as the case may be, or to a fund for the benefit of the creditors of the debtor or guarantor. The measures of insolvency for purposes of these fraudulent transfer laws will vary depending upon the law applied in any proceeding to determine whether a fraudulent transfer has occurred. Generally, however, a debtor or guarantor would be considered insolvent if: the sum of its debts, including contingent liabilities, was greater than the fair saleable value of all of its assets; if the present fair saleable value of its assets was less than the amount that would be required to pay its probable liability on its existing debts, including contingent liabilities, as they become absolute and mature; or it could not pay its debts as they become due. On the basis of historical financial information, recent operating history and other factors, we believe that the debtor and each guarantor, after giving effect to its note or guarantee of the notes, as the case may be, will not be insolvent, will not have unreasonably small capital for the business in which it is engaged and will not have incurred debts beyond its ability to pay such debts as they mature. We cannot assure you, however, as to what standard a court would apply in making these determinations or that a court would agree with our conclusions in this regard. Trading Market for Resale Notes If an active trading market is not sustained for these notes, you may not be able to sell them. We cannot assure you that an active trading market will exist for your notes. We do not intend to apply for listing of the notes on any securities exchange or for quotation through the National Association of Securities Dealers Automated Quotation system. The liquidity of any market for the notes will depend on various factors, including: the number of holders of the notes; the interest of securities dealers in making a market for the notes; the overall market for high yield securities; our financial performance or prospects; and the prospects for companies in our industry generally. Risks Relating To Our Business Dependence on Travel Industry in General and Airline Industry in Particular Our revenues are highly dependent on the travel industry, and particularly on the airlines, and a substantial decrease in travel bookings could adversely affect our business and operating results. Substantially all of our revenues are derived from airlines, hotel operators, car rental companies and other suppliers in the travel industry. Our revenues increase and decrease with the level of travel activity and are therefore highly subject to declines in or disruptions to travel. In particular, because a significant portion of our revenues are derived from transaction fees generated by airline bookings and airline outsourcing services, our revenues and earnings are especially sensitive to events that affect airline travel, the airlines that participate in our GDS and the airlines that obtain travel information technology services from us. Our business could also be adversely affected by a reduction in bookings on the airlines that participate in our GDS as a result of those airlines losing business for other reasons, including losing market share to other airlines, such as low-cost carriers, that do not participate in our GDS. In addition, travel expenditures are seasonal and are sensitive to business and personal discretionary spending levels and tend to decline during general economic downturns, which could also reduce our revenues and profits. The downturn in the commercial airline market, together with the terrorist attacks of September 11, 2001, the global economic downturn, SARS and the war and continuing conflict in Iraq, have adversely affected the financial condition of many commercial airlines and other travel suppliers. Several major airlines are experiencing liquidity problems, some have sought bankruptcy protection and still others may consider bankruptcy relief. A substantial portion of our revenues are derived from transaction fees received directly from airlines and from the sale of products and services directly to airlines. If an airline declared bankruptcy, we may be unable to collect our outstanding accounts receivable from the airline. In addition, the bankruptcy of the airline might result in reduced transaction fees and other revenues from the airline or a rejection by the airline of some or all of our agreements with it, all of which could have a material adverse effect on our business, financial condition and results of operations. Susceptibility to Terrorism and War Acts of terrorism and war could have an adverse effect on the travel industry, which in turn could adversely affect our business and operating results. Travel is sensitive to safety and security concerns, and thus declines after occurrences of, and fears of future incidents of, terrorism and hostilities that affect the safety, security and confidence of travelers. For example, the start of the war in Iraq in March 2003 and the continuing conflict and the terrorist attacks of September 11, 2001, which included attacks on the World Trade Center and the Pentagon using hijacked commercial aircraft, resulted in the cancellation of a significant number of flights and travel bookings and a decrease in new travel bookings. Future revenues may be reduced by similar and/or other acts of terrorism or war. The effects of these events could include, among other things, a protracted decrease in demand for air travel due to fears regarding additional acts of terrorism, military and governmental responses to acts of terrorism and a perceived inconvenience in traveling by air and increased costs and reduced operations by airlines due, in part, to new safety and security directives adopted by the Federal Aviation Administration or other governmental agencies. As an example, escalation of the U.S. Government's terrorist security alert level to code orange or higher may adversely impact demand for air travel. These effects, depending on their scope and duration, which we cannot predict, could significantly impact our business, financial condition and results of operations. Competition We operate in highly competitive markets, and we may not be able to compete effectively. In our electronic travel distribution segment, we compete primarily against other large and well-established GDSs, including those operated by Amadeus, Galileo and Sabre, each of which may have greater financial, technical and other resources than we have. These greater resources may allow our competitors to better finance more strategic transactions and more research and development than us and it could allow them to offer more or better products and services for less than we can. Competition among GDSs to attract and retain travel agencies is intense. In competitive markets, we and other GDSs offer discounts, incentive payments and other inducements to travel agencies if productivity or transaction volume growth targets are achieved. In order to compete effectively, we may need to increase inducements, increase spending on marketing or product development, make significant investments to purchase strategic assets or take other costly actions. Although expansion of the use of these inducements could adversely affect our profitability, our failure to continue to provide inducements could result in the loss of some travel agency customers. If we were to lose a significant portion of our current base of travel agencies to a competing GDS or if we were forced to increase the amounts of these inducements significantly, our business, financial condition and results of operations could be materially adversely affected. In addition, we face competition in the travel agency market from travel suppliers and new types of travel distribution companies that seek to bypass GDSs and distribute directly to travel agencies or consumers. In our information technology services segment, there are several organizations offering internal reservation system and related technology services to the airlines, with our main competitors being The information in this prospectus is not complete and may be changed. These securities may not be sold until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell these securities and it is not soliciting an offer to buy these securities in any state where the offer or sale is not permitted. SUBJECT TO COMPLETION, DATED MAY 21, 2004 PROSPECTUS $30,000,000 Worldspan, L.P. WS Financing Corp. 95/8% Senior Notes Due 2011 Amadeus, EDS, Navitaire, Sabre and Unisys/SITA. This segment is highly competitive and the competitors are highly aggressive. If we cannot compete effectively to keep and grow this segment of business, we risk losing customers and economies of scale which could have a negative impact on our operating results. Factors affecting the competitive success of GDSs include the timeliness, reliability and scope of the information offered, the reliability and ease of use of the GDS, the fees charged and inducements paid to travel agencies, the transaction fees charged to travel suppliers and the range of products and services available to travel suppliers and travel agencies. We believe that we compete effectively with respect to each of these factors. In addition, deregulation of the GDS industry in the U.S. will likely increase competition between the GDSs. Increased competition could require us to increase spending on marketing or product development, decrease our transaction fees and other revenues, increase inducement payments or take other actions that could have a material adverse effect on our business, financial condition and results of operations. Travel Supplier Cost Savings Travel supplier cost savings efforts may shift business away from us or cause us to reduce the fees we charge to suppliers or increase the inducements we offer to travel agencies, thereby adversely affecting our results of operations. Travel suppliers, particularly airlines, are aggressively seeking ways to reduce distribution costs and, through the use of the Internet and otherwise, are seeking to decrease their reliance on global distribution systems including us. Travel suppliers have increasingly been providing direct access to their inventory through their own websites through travel agencies and through travel supplier joint ventures, which potentially bypass GDSs. See "Business Competition." Some of these travel suppliers offer lower prices when their products and services are purchased directly from these supplier-related distribution channels. These lower prices are not always available to us. Some of these travel suppliers are also not providing their lowest fares to GDSs unless the GDS provides them with lower transaction fees. These practices may have the effect of diverting customers away from us to other distribution channels, including websites, or of forcing us to reduce our transaction fees, which could have a material adverse effect on our business, financial condition and results of operations. Moreover, consolidation among travel suppliers, including airline mergers and alliances, may increase competition from these supplier-related distribution channels. In addition, some travel suppliers have reduced or eliminated commissions paid to both traditional and online travel agencies. The reduction or loss of commissions may cause travel agencies to become more dependent on other sources of revenues, such as traveler-paid service fees and GDS-paid inducements. We may have to increase inducement payments or incur other expenses in order to compete for travel agency business. Fare Content Agreements Our efforts to obtain more comprehensive content through airline fare content agreements may cause downward pressure on pricing and adversely affect our revenues and operating results. In recent months, some airlines have differentiated the fare content that they provide to us and to our GDS competitors. Some fare content has been provided to GDSs at no additional charge under standard participation agreements, and other content, such as web fares, has been withheld unless the GDS agrees to provide discounts, payments or other benefits to the airline. We have recently entered into fare content agreements with Continental Airlines, Delta, Northwest and United Air Lines. Generally, in these agreements, the airlines commit (subject to the exceptions contained in the agreements) to provide travel agencies covered by the agreements in the territories covered by the agreements with substantially the same fare content (including web fares) it provides to the travel agencies of other GDSs in exchange for payments from us to each airline and subject to us keeping steady the average transaction fees paid by each airline for travel agency bookings in the territories covered by the agreements. Further, in February 2004, we executed a three-year fare content agreement with British Airways to provide access to virtually all of their published fares (including web fares) to This prospectus relates to the offer and sale from time to time by the selling noteholder identified in this prospectus of up to $30,000,000 aggregate principal amount of 95/8% Senior Notes due 2011 issued by Worldspan, L.P. and WS Financing Corp. The notes being offered by the selling noteholder were initially issued on June 30, 2003 in a transaction exempt from the registration requirements of the Securities Act of 1933, as amended. We will not receive any of the proceeds from the sale of our senior subordinated notes being sold by the selling noteholders. The notes being offered by the selling noteholder are sometimes referred to in this prospectus as the "resale notes." Our senior notes are being registered to permit the selling noteholder to sell the securities from time to time to the public. The selling noteholder may sell the senior notes through ordinary brokerage transactions or through any other means described in the section entitled "Plan of Distribution." We do no know when or in what amounts a selling noteholder may offer securities for sale. The selling noteholders may sell any, all or none of the senior notes offered by this prospectus. We currently have outstanding an aggregate principal amount of $280,000,000 of 95/8% Senior Notes due 2011, of which the resale notes are a part. The remaining $250,000,000 of the outstanding notes are Series B 95/8% Senior Notes which have been registered with the Securities and Exchange Commission and were exchanged for a like amount of 95/8% Senior Notes due 2011 on January 30, 2004. The selling noteholder was not permitted to participate in the exchange offer because it is our affiliate. As a result, the resale notes are currently restricted securities and will remain so until transferred pursuant to this prospectus or pursuant to an available exemption from registration in which the restrictions on transfer lapse. Interest is payable on June 15 and December 15 of each year. The notes will mature on June 15, 2011. We may redeem all or part of the notes on or after June 15, 2007. Before June 15, 2006, we may redeem up to 35% of the notes from the proceeds of certain equity offerings. Redemption prices are set forth under "Description of the Notes Optional Redemption." The notes are guaranteed on a senior basis by all of our existing and future domestic subsidiaries. The notes and the guarantees will be our and the guarantors' general, unsecured obligations, are equal in right of payment to all of our and the guarantors' senior debt and are senior in right of payment to our and the guarantors' future subordinated indebtedness. Our foreign subsidiaries do not guarantee the notes. As a result, the notes are effectively junior to the creditors, including trade creditors, of those foreign subsidiaries. We do not intend to list the senior notes on any exchange. We cannot assure you that an active trading market for the senior notes will develop. some of our U.K. travel agencies. We believe that obtaining similar fare content from other major airline travel suppliers is important to our ability to compete, since other GDSs have also entered into fare content agreements with various airlines. Consequently, we plan to pursue agreements similar to these fare content agreements with some other major airlines. We expect that our fare content agreements will require us to make, in the aggregate, significant payments or other concessions to the participating airlines which could have a material adverse effect on our business, financial condition and results of operations in the future, including during the next three-year period. In addition, our fare content agreements are subject to several conditions, exceptions, term limitations and termination rights. There is no guarantee that the participating airlines will continue to provide their fare content to us to the same extent as they do at the current time. The loss or substantial reduction in the amount of fare content received from the participating airlines could negatively affect our business, financial condition and results of operations. Dependence on Small Number of Airlines We depend on a relatively small number of airlines for a significant portion of our revenues and the loss of any of our major airline relationships would harm our revenues and operating results. We depend on a relatively small number of airlines for a significant portion of our revenues. Our five largest airline relationships represented an aggregate of approximately 54% of our total 2003 revenues, down from 56% in 2002, while our ten largest airline relationships represented an aggregate of approximately 66% of our total 2003 revenues, down from 68% in 2002. Our five largest airline relationships by total revenue in 2003 were with Delta, Northwest, United Air Lines, American and US Airways, representing 19%, 12%, 9%, 8% and 5% of our total 2003 revenues, respectively. In 2002, these carriers accounted for 20%, 14%, 7%, 9% and 6%, respectively. We expect to continue to depend upon a relatively small number of airlines for a significant portion of our revenues. In addition, although we expect to continue our relationships with these airlines, our airline contracts can be terminated on short notice. Because our major airline relationships represent such a large part of our business, the loss of any of our major airline relationships, including due to the bankruptcy of an airline, could have a material negative impact on our business, financial condition and results of operations. Dependence on Small Number of Online Travel Agencies We are highly dependent on a small number of large online travel agencies, and the success of our business depends on continuing these relationships and the continued growth of online travel commerce. In 2003, Expedia, Hotwire, Orbitz and Priceline represented approximately 43% of our total transactions, with Expedia representing over 20% of our total transactions. If we were to lose and not replace the transactions generated by any of these online travel agencies, our business, financial condition and results of operations would be materially adversely impacted. In addition, if other online travel agencies become more successful or new online travel agencies emerge and we lose online transaction volumes as a result, our business, financial condition (including the carrying value of certain intangibles) and results of operations could be materially adversely impacted. While we have long-term contracts with Expedia, Orbitz and Priceline, these agencies have a variety of termination rights and other rights to reduce their business with Worldspan. Hotwire has the right to terminate its contract with us for any reason on 90 days advance notice. Expedia has the right to renegotiate the inducements payable to it by us every three years (with the next renegotiation right scheduled for July 2004), and it can terminate its contract with us if we cannot reach an agreement on inducements. In addition, Expedia informed us in May 2004 that it intends to exercise its right to move a portion of its transactions to another GDS provider. Although we currently continue to operate under these agreements, we cannot assure you that any travel agency will not attempt to terminate its agreement with us or otherwise move business to another GDS in the future. Any such termination or See "Risk Factors" beginning on page 12 for a discussion of risks that you should consider before buying the notes. a significant reduction in transaction volumes would have a material adverse effect on our business, financial condition (including the carrying value of certain intangibles) and results of operations. In addition, our growth strategy relies on the continuing growth in the travel industry of the Internet as a distribution channel. If consumers do not book significantly more travel online than they currently do today and if the use of the Internet as a medium of commerce for travel bookings does not continue to grow or grows more slowly than expected, our revenues and profit may be adversely affected. Consumers have historically relied on traditional travel agencies and travel suppliers and are accustomed to a high degree of human interaction in purchasing travel products and services. The success of our business is dependent on the number of consumers who use the Internet to make travel bookings increasing significantly. Relationships with Our Founding Airlines A significant portion of our current revenues are attributable to our founding airlines, and there is no guarantee that these airlines will continue to use our services to the same extent that they did when they owned us or that they will not indirectly compete with us. Each of American, Delta and Northwest has important commercial relations with us, and, in 2003, revenues received from our founding airlines represented, in the aggregate, approximately 39% of our revenues. Approximately 79% of this revenue was from transaction fees and the balance was derived from information technology services provided to Delta and Northwest. Delta is the largest single travel supplier utilizing our GDS, as measured by transaction fee revenues, generating transaction fees that accounted for approximately 14% of our 2003 revenue, while Northwest and American represent approximately 9% and 8%, respectively. In addition, approximately 86% of our information technology services revenues, which represented approximately 10% of our total revenues in 2003, are derived from providing processing, software development and other services to Delta and Northwest. Although we believe that each founding airline will continue to distribute its travel services through our GDS and that Delta and Northwest will continue to use our information technology services, there is no guarantee that our founding airlines will continue to use these services to the same extent as they did prior to the Acquisition or at all. In addition, although we have entered into noncompetition agreements with our founding airlines and each has agreed not to operate a GDS for three years after the Acquisition, there is no guarantee that our founding airlines will not indirectly compete with us in some or all of our markets, such as through supplier direct connections which could bypass our GDS. The loss or substantial reduction of fees from any of our founding airlines, or direct or indirect competition from any of our founding airlines, could negatively affect our business, financial condition and results of operations. For instance, the information technology services that we perform for Delta include computer functionality known as "PNR Sync." In 2003, Delta notified us that it intended to terminate PNR Sync. Following discussions with Delta relating to the mutual benefits of PNR Sync to Delta and us, we reached an agreement with Delta in December 2003 to continue to provide PNR Sync to Delta for a minimum three-year period at a fixed price and subject to several conditions, term limitations and termination rights. A termination of the PNR Sync functionality by Delta would represent a material adverse effect on our business, financial condition and results of operations. Additionally, in March 2004, Delta notified us that our GDS transaction fee pricing did not satisfy the conditions of our marketing support agreement with Delta. Delta indicated that, until we modify our GDS transaction fee pricing, it would suspend marketing support of us and the discount that Delta has provided to us for business travel. Pursuant to the agreement, we are working with Delta to review the relevant data and to resolve these issues. Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or passed upon the adequacy or accuracy of this prospectus. Any representation to the contrary is a criminal offense. FASA Credits The FASA credits and FASA credit payments owed under the FASAs may continue despite a significant reduction in or termination of FASA revenues. Pursuant to our founder airline services agreements, or FASAs, with each of Delta and Northwest, we are obligated to provide monthly FASA credits to Delta and Northwest to be applied against FASA service fee payments due from those airlines to us. The FASA credits are structured and will be applied through June 2012 in an amount up to an aggregate of approximately $116.7 million to each of Delta and Northwest as of December 31, 2003. Our obligations to provide these FASA credits to Delta and Northwest may continue despite a significant reduction in service fee payments from Delta or Northwest under the FASAs, as applicable. For instance, if Delta or Northwest reduces or ceases operations in a way that reduces or eliminates the amount of airline services the airline obtains from us under its FASA, our FASA credit obligations will remain, although its failure to comply with its software development minimum and exclusivity obligations will constitute a breach of its agreement. In the event that the monthly FASA credits deliverable by us to Delta or Northwest are more than the FASA service fee payments due from the applicable airline, then we will be obligated to pay such excess to such airline in cash. In addition, if we terminate the FASA other than as expressly permitted by the agreement, then we will be obligated to provide the scheduled FASA credits to the applicable airline by way of a monthly cash payment rather than applying the FASA credits against FASA service fee payments due from the airline. As a result, there could be a significant reduction in the revenues we receive from Delta and/or Northwest under the FASAs while our obligations to provide FASA credits and make FASA credit payments to Delta and/or Northwest, as applicable, would continue without interruption. In addition, Delta or Northwest may terminate its FASA due to our failure to satisfy the mainframe processing time, system availability or critical production data performance standards under that agreement. Furthermore, such a termination by Delta or Northwest of its FASA will constitute an event of default under our senior credit facility and may constitute a default under any other of our future senior credit facilities. If an event of default occurs, our lenders could elect to declare all amounts outstanding under our senior credit facility and any of our future credit facilities to be immediately due, and the lenders thereafter could foreclose upon the assets securing our senior credit facilities. In that event, we cannot assure you that we would have sufficient assets to repay all of our obligations, including our senior notes and the related guarantees. If the event of default is waived by the applicable lenders under our senior credit facilities or our senior credit facilities are no longer outstanding, the remaining portion of the FASA credits deliverable by us to the terminating airline will not be provided according to the nine year schedule and will instead be payable in cash to the terminating airline as and when, and only to the extent that, we are permitted to make such payments as "Restricted Payments" under the restricted payment covenant test contained in the indenture governing our senior notes. In such a circumstance, we will be required to make FASA credit payments to a terminating airline at a time when such airline is no longer paying FASA service fees to us. Although we have historically satisfied the relevant FASA performance standards under our predecessor services agreements with Delta and Northwest, we cannot assure you that we will continue to satisfy those standards and that the FASAs will not be terminated by Delta or Northwest. A termination of one or both of the FASAs under any of these circumstances could have a material adverse effect on our business, financial condition and results of operations. For further discussion of the terms of the FASAs, see "Management's Discussion and Analysis of Financial Condition and Results of Operations Liquidity." Critical Systems Our systems may suffer failures, capacity constraints and business interruptions, which could increase our operating costs, decrease our revenues and cause us to lose customers. The reliability of our GDS is critical to the success of our business. Much of our computer and communications hardware is located in a single data center located near Atlanta, Georgia. Our systems might be damaged or interrupted by fire, flood, power loss, telecommunications failure, break-ins, Net cash provided by (used in) operating activities $ 25,256 $ (1,582 ) $ $ 23,674 Cash flows from investing activities: Purchase of property and equipment (2,228 ) (634 ) (2,862 ) Proceeds from sale of property and equipment 20 The date of this prospectus is , 2004. earthquakes, terrorist attacks, war or similar events. Computer malfunctions, computer viruses, physical or electronic break-ins and similar disruptions might cause system interruptions and delays and loss of critical data and could significantly diminish our reputation and brand name and prevent us from providing services. Although we believe we have taken adequate steps to address these risks, we could be harmed by outages in, or unreliability of, the data center or computer systems. In addition, we rely on several communications services companies in the United States and internationally to provide network connections between our data center and our travel agencies' access terminals and also our travel suppliers. In particular, we rely upon AT&T and SITA, which is owned by a consortium of airlines and other travel-related businesses, to maintain our data communications and to provide network services in the United States and in many countries served by us. We occasionally experience network interruptions and malfunctions that make our global distribution system or other data processing services unavailable or less usable. Any significant failure or inability of AT&T, SITA or other communications companies to provide and maintain network access could have a material adverse effect on our business, financial condition and results of operations. Protection of Technology We may not protect our technology effectively, which would allow competitors to duplicate our products and services. This could make it more difficult for us to compete with them. Our success and ability to compete depend, in part, upon our technology. Among our significant assets are our software and other proprietary information and intellectual property rights. We rely on a combination of copyright, trademark and patent laws, trade secrets, confidentiality procedures and contractual provisions to protect these assets. Our software and related documentation, however, are protected principally under trade secret and copyright laws, which afford only limited protection, and the laws of some foreign jurisdictions provide less protection for our proprietary rights than the laws of the United States. Unauthorized use and misuse of our intellectual property could have a material adverse effect on our business, financial condition and results of operations, and there can be no assurance that our legal remedies would adequately compensate us for the damages caused by unauthorized use. In addition, licenses for a number of software products have been granted to us. Some of these licenses, individually and in the aggregate, are material to our business. Although we believe that the risk that we will lose any material license is remote, any loss could have a material adverse effect on our business, financial condition and results of operations. Intellectual Property Our products and services may infringe on claims of intellectual property rights of third parties, which could adversely affect our business and operating results. We do not believe that any of our products, services or activities infringe upon the intellectual property rights of third parties in any material respect. There can be no assurance, however, that third parties will not claim infringement by us with respect to current or future products, services or activities. Any infringement claim, with or without merit, could result in substantial costs and diversion of management and financial resources, and a successful claim could effectively block our ability to use or license products and services in the United States or abroad or cost us money. Any infringement claim, therefore, could have a material adverse effect on our business, financial condition and results of operations. Technological Change Rapid technological changes may render our technology obsolete or decrease the attractiveness of our products and services to customers. Our industry is subject to rapid technological change as travel suppliers, travel agencies and competitors create new and innovative products and services. Our ability to compete in our business and our future results will depend, in part, upon our ability to make timely, innovative and cost- TABLE OF CONTENTS Page effective enhancements and additions to our technology and to introduce new products and services that meet the demands of travel suppliers, travel agencies and other customers. The success of new products and services depends on several factors, including: identifying the needs of travel suppliers, travel agencies and other customers; developing and introducing effective new products and services in a timely and efficient manner; managing the cost of new product development and operations; differentiating new products and services from those of our competitors; and achieving market acceptance of new products and services. In addition, maintaining the flexibility to respond to technological and market changes may require substantial expenditures and lead time. There can be no assurance that we will successfully identify and develop new products or services in a timely manner, that products, technologies or services developed by others will not render our offerings obsolete or noncompetitive or that the technologies in which we focus our research and development investments will achieve acceptance in the marketplace. Our technology infrastructure is largely fixed. As a result, in the event of a significant reduction in transaction volumes or revenues, technology costs would remain relatively constant. If a reduction continued for a prolonged period, our business, financial condition and results of operations could be materially adversely affected. Regulatory Risks Regulatory developments could limit our ability to compete by restricting our flexibility to respond to competitive conditions. Changes and developments in the regulatory environment could have an adverse affect on our financial condition or results of operations, including by negatively impacting our transaction volume, transaction fees and by otherwise impacting the way we operate our business. GDSs are regulated by the U.S., the European Union ("E.U.") and other countries in which we operate. The U.S. Department of Transportation ("DOT") and the European Commission ("EC") are the relevant regulatory authorities in the U.S. and the E.U., respectively. Most of the regulating bodies have reexamined or are examining their GDS regulations and appear to be moving toward deregulation. Regulatory changes in the U.S., E.U. or other countries could have a material adverse effect on our business, financial condition and results of operations. On January 31, 2004, most DOT rules governing GDSs were lifted. The remaining DOT rules will be phased out at the end of July 2004. The DOT rules no longer contain any rules that apply uniquely to GDSs that are owned or marketed by airlines. In addition, deregulation in the U.S. could create uncertainty as to established GDS business models. Discontinuance of the rules could facilitate efforts by the airlines to divert travel bookings to distribution channels that they own and control and could also facilitate movement of travel agencies from one GDS to another. In addition, elimination of the rule prohibiting discrimination in airline fees could affect transaction fee revenues. E.U. regulations continue to address the participation of airline GDS owners in other GDSs. See "Business GDS Industry Regulation." The EC is engaged in a comprehensive review of its rules governing GDSs. It is unclear at this time when the EC will complete its review and what changes, if any, will be made to the E.U. rules. We could be unfairly and adversely affected if the E.U. rules are retained as to traditional global distribution systems used by travel agencies but are not applied to businesses providing comparable services, such as travel distribution websites owned by more than one airline. In addition, we could be adversely affected if changes to the rules, changes in interpretations of the rules, or new rules increase our cost of doing business, limit our ability to establish relationships with travel agencies, airlines, or others, impair the enforceability of existing agreements with travel agencies and other users of our system, prohibit or limit us from offering services or products, or limit our ability to establish or changes fees. Continued GDS regulation in the E.U. and elsewhere, while GDS regulations are being abolished in the U.S., could also create the operational challenge of supporting different products, services and business practices to conform to the different regulatory regimes. There are also GDS regulations in Canada, under the regulatory authority of the Canadian Department of Transport. On April 27, 2004, a significant number of these regulations were lifted. Amendments to the rules include eliminating the "obligated carrier" rule, which required larger airlines in Canada to participate equally in the GDSs, and elimination of the requirement that transaction fees charged by GDSs to airlines be non-discriminatory. Due to the elimination of the obligated carrier rule in Canada, Air Canada, the dominant Canadian airline, could choose distribution channels that it owns and controls or distribution through another GDS rather than through the Worldspan GDS. Privacy and Data Protection Our processing, storage, use and disclosure of personal data could give rise to liabilities as a result of governmental regulation, conflicting legal requirements or differing views of personal privacy rights. In our processing of travel transactions, we receive and store a large volume of personally identifiable data. This data is increasingly subject to legislation in numerous jurisdictions around the world, including the E.U. through its Data Protection Directive (and variations of this Directive in the E.U. Member States). This legislation is typically intended to protect the privacy of personal data that is collected, processed and transmitted in or from the governing jurisdiction. We could be adversely affected if the legislation is expanded to require changes in our business practices or if governing jurisdictions interpret or implement their legislation in ways that negatively affect our business, financial condition and results of operations. In addition, in the aftermath of the terrorist attacks of September 11, 2001, government agencies have been contemplating or developing initiatives to enhance national and aviation security, including the Transportation Security Administration's Computer-Assisted Passenger Prescreening System, known as CAPPS II. These initiatives may result in conflicting legal requirements with respect to data handling. As privacy and data protection has become a more sensitive issue, we may also incur legal defense costs and become exposed to potential liabilities as a result of differing views on the privacy of travel data. Travel businesses have also been subjected to investigations, lawsuits and adverse publicity due to allegedly improper disclosure of passenger information. For example, we were initially named as one of the defendants in a class action lawsuit arising from disclosures by Northwest of passenger data to a U.S. government agency. An amended and consolidated class action lawsuit was recently refiled in this case and we are no longer a named defendant in the matter. We are evaluating whether we have any future liability arising from this matter. While we do not believe that this matter is material, other privacy developments that are difficult to anticipate could impact our business, financial condition and results of operations. Key Employees Our ability to attract, train and retain executives and other qualified employees is crucial to results of operations and future growth. We depend substantially on the continued services and performance of our key executives, senior management and skilled personnel, particularly our professionals with experience in our business and operations and the GDS industry, including: Rakesh Gangwal, our Chairman and Chief Executive Officer; Gregory O'Hara, our Executive Vice President Corporate Planning and Development; Ninan Chacko, our Senior Vice President e-Commerce and Product Planning; David A. Lauderdale, our Chief Technology Officer and Senior Vice President Technical Operations; Michael B. Parks, our Senior Vice President and General Manager; Susan J. Powers, our Chief Information Officer and Senior Vice President Worldwide Product Solutions; Jeffrey C. Smith, our General Counsel, Secretary and Senior Vice President Human Resources; and Michael Wood, our Senior Vice President and Chief Financial Officer. We have entered into employment agreements with Messrs. Gangwal, O'Hara, Chacko and Wood to provide them with incentives to remain employed by us, all as more fully described in the section of this prospectus entitled "Management Employment Agreements." However, we cannot assure you that any of these individuals will continue to be employed by us. The specialized skills needed by our business are time-consuming and difficult to acquire and in short supply, and this shortage is likely to continue. A lengthy period of time is required to hire and train replacement personnel when skilled personnel depart the company. An inability to hire, train and retain a sufficient number of qualified employees could materially hinder our business by, for example, delaying our ability to bring new products and services to market or impairing the success of our operations. Even if we are able to maintain our employee base, the resources needed to attract and retain such employees may adversely affect our profits, growth and operating margins. Business Combinations and Strategic Investments We may not successfully make and integrate business combinations and strategic investments. We plan to continue to enter into business combinations, investments, joint ventures and other strategic alliances with other companies in order to maintain and grow revenue and market presence as well as to provide us with access to technology, products and services. Those transactions with other companies create risks such as difficulty in assimilating the technology, products and operations with our technology, products and operations; disruption of our ongoing business, including loss of management focus on existing businesses; impairment of relationships with existing executives, employees, customers and business partners; and losses that may arise from equity investments. In the past, in an effort to secure new technologies or obtain unique content for our GDS, we have invested in a number of early-stage technology companies. Each of these investments has required senior management attention. Many of these companies have failed, and most of our investments have been written down. If we enter into such transactions in the future, we may expend cash, incur debt, assume contingent liabilities or create additional expenses related to amortizing other intangible assets with estimable useful lives, any of which might harm our business, financial condition or results of operations. In addition, we may not be able to identify suitable candidates for these transactions or obtain financing or otherwise make these transactions on acceptable terms. Seasonality Because our business is seasonal, our quarterly results will fluctuate. The travel industry is seasonal in nature. Bookings, and thus transaction fee revenues charged for the use of our GDS, typically decrease each year in the fourth quarter, due to the early bookings by customers for travel during the holiday season and a decline in bookings for business travel during the holiday season. During 2002 and 2003, our transactions in the fourth quarter have averaged approximately 22% of total transactions for those years. Seasonality could cause our revenues to fluctuate significantly from quarter to quarter. Substantial fluctuations in our results of operations could have a material adverse effect on us. Trade Barriers We face trade barriers outside of the United States that limit our ability to compete. Trade barriers erected by non-U.S. travel suppliers, which are sometimes government-owned, have on occasion interfered with our ability to offer our products and services in their markets or have denied us content or features that they give to our competitors. Those trade barriers make our products and services less attractive to travel agencies in those countries than products and services offered by other GDSs that have these capabilities and have restricted our ability to gain market share outside of the U.S. Competition and trade barriers in those countries could require us to increase inducements, reduce prices, increase spending on marketing or product development, withdraw from or not enter certain markets or otherwise take actions adverse to us. 10.80 Amendment, dated as of May 12, 2004, to Employment Agreement among Worldspan Technologies Inc., M. Gregory O'Hara and Worldspan, L.P. 12.1 Computation of Ratio of Earnings to Fixed Charges 21.1 Subsidiaries of Worldspan, L.P.(4) 23.1 Consent of Dechert LLP* 23.2 Consent of PricewaterhouseCoopers LLP PROSPECTUS SUMMARY This following summary highlights certain significant aspects of our business and this offering, but you should read this entire prospectus, including the financial data and related notes, before making an investment decision. Unless the context otherwise requires, references to the "issuers" refer to Worldspan, L.P., exclusive of its subsidiaries, and WS Financing Corp. References to "WTI" refer to Worldspan Technologies Inc. References in this prospectus to "Worldspan," "we," "us," "our" and "our company" refer to the consolidated businesses of Worldspan, L.P. and all of its subsidiaries unless otherwise specified. References in this prospectus to the "Acquisition" refer to the acquisition by WTI, formerly named Travel Transaction Processing Corporation, through its wholly-owned subsidiaries, of the general partnership interests and limited partnership interest of Worldspan, L.P. You should carefully consider the information set forth under the heading "Risk Factors." Worldspan, L.P. We are a leading provider of mission-critical transaction processing and information technology services to the global travel industry. We are the second largest transaction processor for travel agencies in the United States (the world's largest travel market) and the largest processor globally for online travel agencies as measured by transactions. In 2003, we processed over 65% of online airline transactions made in the United States and processed by a global distribution system, or GDS. We provide subscribers (including traditional travel agencies, online travel agencies and corporate travel departments) with real-time access to schedule, price, availability and other travel information and the ability to process reservations and issue tickets for the products and services of approximately 800 travel suppliers (such as airlines, hotels, car rental companies, tour companies and cruise lines) throughout the world. During the year ended December 31, 2003, we processed approximately 193 million transactions. We also provide information technology services to the travel industry, primarily airline internal reservation systems, flight operations technology and software development. In recent years, the travel industry has been marked by the emergence and growth of the Internet as a travel distribution channel. The growth in use of the Internet has led to the establishment of online travel agencies that provide a link between the consumer and the travel supplier, typically through a GDS. In 2003, airline transactions generated through online travel agencies accounted for approximately 28% of all airline transactions in the United States processed by a GDS, up from approximately 23% in 2002 and approximately 17% in 2001. Between 1999 and 2003, the number of airline transactions in the United States generated through online travel agencies and processed by a GDS increased at a compound annual growth rate of 40.5% and an annual growth rate of 14.1% for the most recent year. The chart below illustrates airline transactions generated through online and traditional travel agencies in the United States and processed by a GDS.(1) International Operations Our international operations are subject to other risks which may impede our ability to grow internationally. Approximately 14% of our revenues during the twelve months ended December 31, 2003 were generated through our foreign subsidiaries. We face risks inherent in international operations, such as risks of: currency exchange rate fluctuations; local economic and political conditions, including conditions resulting from the continuing conflict in Iraq; restrictive governmental actions (such as trade protection measures, privacy rules, consumer protection laws and restrictions on pricing or discounts); changes in legal or regulatory requirements; limitations on the repatriation of funds; difficulty in obtaining distribution and support; nationalization; different accounting practices and potentially longer payment cycles; seasonal reductions in business activity; higher costs of doing business; lack of, or the failure to implement, the appropriate infrastructure to support our technology; lesser protection in some jurisdictions for our intellectual property; disruptions of capital and trading markets; laws and policies of the U.S. affecting trade, foreign investment and loans; and foreign tax and other laws. These risks may adversely affect our ability to conduct and grow business internationally, which could cause us to increase expenditures and costs, decrease our revenue growth or both. Exchange Rate Fluctuations Fluctuations in the exchange rate of the U.S. dollar and other foreign currencies could have a material adverse effect on our financial performance and results of operations. While we and our subsidiaries transact business primarily in U.S. dollars and most of our revenues are denominated in U.S. dollars, a portion of our costs and revenues are denominated in other currencies, such as the euro and the British pound sterling. As a result, changes in the exchange rates of these currencies or any other applicable currencies to the U.S. dollar will affect our operating expenses and operating margins and could result in exchange losses. The impact of future exchange rate fluctuations on our results of operations cannot be accurately predicted. In the past, we have incurred such losses, including a $1.0 million loss during 2001. Environmental, Health and Safety Requirements We could be adversely affected by environmental, health and safety requirements. We are subject to requirements of foreign, federal, state and local environmental and occupational health and safety laws and regulations. These requirements are complex, constantly changing and have tended to become more stringent over time. It is possible that these requirements may change or liabilities may arise in the future in a manner that could have a material adverse effect on our business, financial condition and results of operations. We cannot assure you that we have been or will be at all times in complete compliance with all those requirements or that we will not incur material costs or liabilities in connection with those requirements in the future. Additional Capital We may need additional capital in the future and it may not be available on acceptable terms. We may require more capital in the future to: fund our operations; finance investments in equipment and infrastructure needed to maintain and expand our network; fund the FASA credit payments; enhance and expand the range of services we offer; and respond to competitive pressures and potential strategic opportunities, such as investments, acquisitions and international expansion. We cannot assure you that additional financing will be available on terms favorable to us, or at all. The terms of available financing may place limits on our financial and operating flexibility. If adequate funds are not available on acceptable terms, we may be forced to reduce our operations or abandon expansion opportunities. Moreover, even if we are able to continue our operations, the failure to obtain additional financing could reduce our competitiveness as our competitors may provide better maintained networks or offer an expanded range of services. Securities Laws Compliance Recently enacted and proposed changes in securities laws and regulations are likely to increase our costs. The Sarbanes-Oxley Act of 2002, as well as new rules subsequently implemented by the Securities and Exchange Commission, have required changes in some of our corporate governance and accounting practices. In addition, the New York Stock Exchange has promulgated a number of regulations. We expect these laws, rules and regulations to increase our legal and financial compliance costs and to make some activities more difficult, time consuming and costly. We also expect these new rules and regulations to make it more difficult and more expensive for us to obtain director and officer liability insurance, and we may be required to accept reduced coverage or incur significantly higher costs to obtain coverage. These new laws, rules and regulations could also make it more difficult for us to attract and retain qualified members of our board of directors, particularly to serve on our audit committee, and qualified executive officers. Principal Stockholders Our principal stockholders could exercise their influence over us to your detriment. As a result of their stock ownership of WTI, our ultimate parent, CVC, certain of its affiliates and OTPP together own beneficially about 91% of WTI's outstanding capital stock. By virtue of their stock ownership, these entities have significant influence over our management and will be able to determine the outcome of all matters required to be submitted to the stockholders for approval, including the election of our directors and the approval of mergers, consolidations and the sale of all or substantially all of our assets. The interests of CVC and OTPP as equity owners of WTI may differ from your interests, and, as such, they may take actions which may not be in your interest. For example, if we encounter financial difficulties or are unable to pay our debts as they mature, the interests of our equity owners might conflict with your interests as a noteholder. In addition, our equity owners may have an interest in pursuing acquisitions, divestitures, financings or other transactions that, in their judgment, could enhance their equity investments, even though such transactions might involve risks to you as a holder of the notes.
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+RISK FACTORS You should carefully consider the risk factors set forth below as well as the other information contained in this prospectus before deciding whether to invest in our notes. If any of the following risks actually occur, our business, financial condition or results of operations could suffer. In such case, you may lose all or part of your original investment. Risks Relating to the Notes Substantial Leverage Our substantial indebtedness could adversely affect our financial health and prevent us from fulfilling our obligations under the notes. We have a significant amount of indebtedness. On March 31, 2004, we had total indebtedness of $453.2 million (of which $280.0 million consisted of the notes and the balance consisted of senior debt under our senior credit facility and obligations under capital leases and long-term software arrangements). Our ratio of earnings to fixed charges was 0.4x and 2.4x for the six months ended December 31, 2003 and the three months ended March 31, 2004, respectively. Our substantial indebtedness could have important consequences to you. For example, it could: make it more difficult for us to satisfy our obligations with respect to the notes; increase our vulnerability to general adverse economic and industry conditions; require us to dedicate a substantial portion of our cash flow from operations to payments on our indebtedness, thereby reducing the availability of our cash flow to fund working capital, capital expenditures, research and development efforts and other general corporate purposes; limit our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate; place us at a competitive disadvantage compared to our competitors that have less debt; and limit our ability to borrow additional funds. In addition, the indenture and our senior credit facility contain financial and other restrictive covenants that limit our ability to engage in activities that may be in our long-term best interests. Our failure to comply with those covenants could result in an event of default which, if not cured or waived, could result in the acceleration of all of our debts. Additional Borrowings Available Despite current indebtedness levels, we and our subsidiaries may still be able to incur substantially more debt. This could further exacerbate the risks associated with our substantial leverage. We and our subsidiaries may be able to incur substantial additional indebtedness in the future. The terms of the indenture do not fully prohibit us or our subsidiaries from doing so. Our senior credit facility permits additional borrowings of up to $50.0 million. If new debt is added to our and our subsidiaries' current debt levels, the related risks that we and they now face could intensify. See "Description of Other Indebtedness Senior Credit Facility." Restrictions on Existing Indebtedness Restrictions on our outstanding debt instruments may limit our ability to make payments on the notes or operate our business. Our senior credit facility and the indenture governing the notes contain covenants that limit the discretion of our management with respect to certain business matters. These covenants will significantly restrict our ability to (among other things): incur additional indebtedness; State of Incorporation or Organization create liens or other encumbrances; pay dividends or make certain other payments, investments, loans and guarantees; and sell or otherwise dispose of assets and merge or consolidate with another entity. In addition, our senior credit facility requires us to meet certain financial ratios and financial condition tests. You should read the discussions under the headings "Description of Other Indebtedness Senior Credit Facility" and "Description of the Notes Certain Covenants" for further information about these covenants. Events beyond our control can affect our ability to meet these financial ratios and financial condition tests. Our failure to comply with these obligations could cause an event of default under our senior credit facility. If an event of default occurs, our lenders could elect to declare all amounts outstanding and accrued and unpaid interest in our senior credit facility to be immediately due, and the lenders thereafter could foreclose upon the assets securing the senior credit facility. In that event, we cannot assure you that we would have sufficient assets to repay all of our obligations, including the notes and the related guarantees. We may incur other indebtedness in the future that may contain financial or other covenants more restrictive than those applicable to our senior credit facility or the indenture governing the notes. Ability to Service Debt To service our indebtedness, we will require a significant amount of cash. Our ability to generate cash depends on many factors beyond our control. Our ability to make payments on and to refinance our indebtedness, including the notes, and to fund planned capital expenditures and research and development efforts will depend on our ability to generate cash in the future. This, to a certain extent, is subject to general economic, financial, competitive, legislative, regulatory and other factors that are beyond our control. Based on our current level of operations and anticipated cost savings and operating improvements, we believe our cash flow from operations, available cash and available borrowings under our senior credit facility, will be adequate to meet our future liquidity needs for the foreseeable future. We cannot assure you, however, that our business will generate sufficient cash flow from operations, that currently anticipated cost savings and operating improvements will be realized on schedule or that future borrowings will be available to us under our senior credit facility in an amount sufficient to enable us to pay our indebtedness, including the notes, or to fund our other liquidity needs. We may need to refinance all or a portion of our indebtedness, including the notes on or before maturity. We cannot assure you that we will be able to refinance any of our indebtedness, including our senior credit facility and the notes, on commercially reasonable terms or at all. Subordination to Secured Creditors Your right to receive payments on the notes is effectively subordinated to the rights of our existing and future secured creditors. Further, the guarantees of the notes are effectively subordinated to all our guarantors' existing and future secured indebtedness. Holders of our secured indebtedness and the secured indebtedness of the guarantors will have claims that are prior to your claims as holders of the notes to the extent of the value of the assets securing that other indebtedness. Notably, we and certain of our subsidiaries, including the guarantors, are parties to a senior credit facility, which is secured by liens on substantially all of our assets and the assets of the guarantors. In addition, our capital leases and long-term software arrangements are secured by the assets under such leases and arrangements. The notes are effectively subordinated to all that secured indebtedness. In the event of any distribution or payment of our assets in any foreclosure, dissolution, winding-up, liquidation, reorganization, or other bankruptcy proceeding, holders of secured indebtedness will have prior claim to those of our assets that constitute their collateral. Holders of the notes will participate ratably with all holders of our unsecured indebtedness that is deemed to be of the same class as the notes, and potentially with all of our other general creditors, based upon the respective amounts owed to each holder or creditor, in our remaining assets. In any of the foregoing Primary Standard Industrial Classification Code Number events, we cannot assure you that there will be sufficient assets to pay amounts due on the notes. As a result, holders of notes may receive less, ratably, than holders of secured indebtedness. As of March 31, 2004, the aggregate amount of our secured indebtedness and the secured indebtedness of our subsidiaries was approximately $86.0 million, and approximately $50.0 million was available for additional borrowing under the revolving credit facility portion of our senior credit facility. We are permitted to borrow substantial additional indebtedness, including senior debt, in the future under the terms of the indenture. See "Description of Other Indebtedness Senior Credit Facility." Not all Subsidiaries are Guarantors Your right to receive payments on the notes could be adversely affected if any of our non-guarantor subsidiaries declare bankruptcy, liquidate or reorganize. None of our foreign subsidiaries will guarantee the notes. In the event of a bankruptcy, liquidation or reorganization of any of our non-guarantor subsidiaries, holders of their indebtedness and their trade creditors will generally be entitled to payment of their claims from the assets of those subsidiaries before any assets are made available for distribution to us. As of March 31, 2004, our non-guarantor subsidiaries had approximately $28.3 million of trade accounts payable and other accrued expenses. Our non-guarantor subsidiaries generated approximately 14.2% of our consolidated revenues in the three month period ended March 31, 2004 and held approximately 3.5% of our consolidated assets as of March 31, 2004. See footnote 16 to our consolidated financial statements included at the back of this prospectus. Financing Change of Control Offer We may not have the ability to raise the funds necessary to finance the change of control offer required by the indenture. Upon the occurrence of certain specific kinds of change of control events, we will be required to offer to repurchase all outstanding notes at 101% of the principal amount thereof plus accrued and unpaid interest and liquidated damages, if any, to the date of repurchase. However, it is possible that we will not have sufficient funds at the time of the change of control to make the required repurchase of the notes or that restrictions in our senior credit facility will not allow such repurchases. In addition, certain important corporate events, such as leveraged recapitalizations that would increase the level of our indebtedness, would not constitute a "Change of Control" under the indenture. See "Description of the Notes Repurchase at the Option of Holders." Fraudulent Conveyance Matters Federal and state statutes allow courts, under specific circumstances, to void debts, including guarantees, and require note holders to return payments received from us or the guarantors. Under the federal bankruptcy law and comparable provisions of state fraudulent transfer laws, obligations under a note or a guarantee could be voided, or claims in respect of a note or a guarantee could be subordinated to all other debts of the debtor or guarantor if, among other things, the debtor or the guarantor, at the time it incurred the indebtedness evidenced by its note or guarantee: received less than reasonably equivalent value or fair consideration for the incurrence of such debt or guarantee; and one of the following applies: it was insolvent or rendered insolvent by reason of such incurrence; it was engaged in a business or transaction for which the guarantor's remaining assets constituted unreasonably small capital; or it intended to incur, or believed that it would incur, debts beyond its ability to pay such debts as they mature. IRS Employer Identification No. In addition, any payment by that debtor or guarantor pursuant to its note or guarantee could be voided and required to be returned to the debtor or guarantor, as the case may be, or to a fund for the benefit of the creditors of the debtor or guarantor. The measures of insolvency for purposes of these fraudulent transfer laws will vary depending upon the law applied in any proceeding to determine whether a fraudulent transfer has occurred. Generally, however, a debtor or guarantor would be considered insolvent if: the sum of its debts, including contingent liabilities, was greater than the fair saleable value of all of its assets; if the present fair saleable value of its assets was less than the amount that would be required to pay its probable liability on its existing debts, including contingent liabilities, as they become absolute and mature; or it could not pay its debts as they become due. On the basis of historical financial information, recent operating history and other factors, we believe that the debtor and each guarantor, after giving effect to its note or guarantee of the notes, as the case may be, will not be insolvent, will not have unreasonably small capital for the business in which it is engaged and will not have incurred debts beyond its ability to pay such debts as they mature. We cannot assure you, however, as to what standard a court would apply in making these determinations or that a court would agree with our conclusions in this regard. Trading Market for Resale Notes If an active trading market is not sustained for these notes, you may not be able to sell them. We cannot assure you that an active trading market will exist for your notes. We do not intend to apply for listing of the notes on any securities exchange or for quotation through the National Association of Securities Dealers Automated Quotation system. The liquidity of any market for the notes will depend on various factors, including: the number of holders of the notes; the interest of securities dealers in making a market for the notes; the overall market for high yield securities; our financial performance or prospects; and the prospects for companies in our industry generally. Risks Relating To Our Business Dependence on Travel Industry in General and Airline Industry in Particular Our revenues are highly dependent on the travel industry, and particularly on the airlines, and a substantial decrease in travel bookings could adversely affect our business and operating results. Substantially all of our revenues are derived from airlines, hotel operators, car rental companies and other suppliers in the travel industry. Our revenues increase and decrease with the level of travel activity and are therefore highly subject to declines in or disruptions to travel. In particular, because a significant portion of our revenues are derived from transaction fees generated by airline bookings and airline outsourcing services, our revenues and earnings are especially sensitive to events that affect airline travel, the airlines that participate in our GDS and the airlines that obtain travel information technology services from us. Our business could also be adversely affected by a reduction in bookings on the airlines that participate in our GDS as a result of those airlines losing business for other reasons, including losing market share to other airlines, such as low-cost carriers, that do not participate in our GDS. In addition, travel expenditures are seasonal and are sensitive to business and personal discretionary spending levels and tend to decline during general economic downturns, which could also reduce our revenues and profits. The downturn in the commercial airline market, together with the terrorist attacks of September 11, 2001, the global economic downturn, SARS and the war and continuing conflict in Iraq, have adversely affected the financial condition of many commercial airlines and other travel suppliers. Several major airlines are experiencing liquidity problems, some have sought bankruptcy protection and still others may consider bankruptcy relief. A substantial portion of our revenues are derived from transaction fees received directly from airlines and from the sale of products and services directly to airlines. If an airline declared bankruptcy, we may be unable to collect our outstanding accounts receivable from the airline. In addition, the bankruptcy of the airline might result in reduced transaction fees and other revenues from the airline or a rejection by the airline of some or all of our agreements with it, all of which could have a material adverse effect on our business, financial condition and results of operations. Susceptibility to Terrorism and War Acts of terrorism and war could have an adverse effect on the travel industry, which in turn could adversely affect our business and operating results. Travel is sensitive to safety and security concerns, and thus declines after occurrences of, and fears of future incidents of, terrorism and hostilities that affect the safety, security and confidence of travelers. For example, the start of the war in Iraq in March 2003 and the continuing conflict and the terrorist attacks of September 11, 2001, which included attacks on the World Trade Center and the Pentagon using hijacked commercial aircraft, resulted in the cancellation of a significant number of flights and travel bookings and a decrease in new travel bookings. Future revenues may be reduced by similar and/or other acts of terrorism or war. The effects of these events could include, among other things, a protracted decrease in demand for air travel due to fears regarding additional acts of terrorism, military and governmental responses to acts of terrorism and a perceived inconvenience in traveling by air and increased costs and reduced operations by airlines due, in part, to new safety and security directives adopted by the Federal Aviation Administration or other governmental agencies. As an example, escalation of the U.S. Government's terrorist security alert level to code orange or higher may adversely impact demand for air travel. These effects, depending on their scope and duration, which we cannot predict, could significantly impact our business, financial condition and results of operations. Competition We operate in highly competitive markets, and we may not be able to compete effectively. In our electronic travel distribution segment, we compete primarily against other large and well-established GDSs, including those operated by Amadeus, Galileo and Sabre, each of which may have greater financial, technical and other resources than we have. These greater resources may allow our competitors to better finance more strategic transactions and more research and development than us and it could allow them to offer more or better products and services for less than we can. Competition among GDSs to attract and retain travel agencies is intense. In competitive markets, we and other GDSs offer discounts, incentive payments and other inducements to travel agencies if productivity or transaction volume growth targets are achieved. In order to compete effectively, we may need to increase inducements, increase spending on marketing or product development, make significant investments to purchase strategic assets or take other costly actions. Although expansion of the use of these inducements could adversely affect our profitability, our failure to continue to provide inducements could result in the loss of some travel agency customers. If we were to lose a significant portion of our current base of travel agencies to a competing GDS or if we were forced to increase the amounts of these inducements significantly, our business, financial condition and results of operations could be materially adversely affected. In addition, we face competition in the travel agency market from travel suppliers and new types of travel distribution companies that seek to bypass GDSs and distribute directly to travel agencies or consumers. In our information technology services segment, there are several organizations offering internal reservation system and related technology services to the airlines, with our main competitors being The information in this prospectus is not complete and may be changed. These securities may not be sold until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell these securities and it is not soliciting an offer to buy these securities in any state where the offer or sale is not permitted. SUBJECT TO COMPLETION, DATED MAY 21, 2004 PROSPECTUS $30,000,000 Worldspan, L.P. WS Financing Corp. 95/8% Senior Notes Due 2011 Amadeus, EDS, Navitaire, Sabre and Unisys/SITA. This segment is highly competitive and the competitors are highly aggressive. If we cannot compete effectively to keep and grow this segment of business, we risk losing customers and economies of scale which could have a negative impact on our operating results. Factors affecting the competitive success of GDSs include the timeliness, reliability and scope of the information offered, the reliability and ease of use of the GDS, the fees charged and inducements paid to travel agencies, the transaction fees charged to travel suppliers and the range of products and services available to travel suppliers and travel agencies. We believe that we compete effectively with respect to each of these factors. In addition, deregulation of the GDS industry in the U.S. will likely increase competition between the GDSs. Increased competition could require us to increase spending on marketing or product development, decrease our transaction fees and other revenues, increase inducement payments or take other actions that could have a material adverse effect on our business, financial condition and results of operations. Travel Supplier Cost Savings Travel supplier cost savings efforts may shift business away from us or cause us to reduce the fees we charge to suppliers or increase the inducements we offer to travel agencies, thereby adversely affecting our results of operations. Travel suppliers, particularly airlines, are aggressively seeking ways to reduce distribution costs and, through the use of the Internet and otherwise, are seeking to decrease their reliance on global distribution systems including us. Travel suppliers have increasingly been providing direct access to their inventory through their own websites through travel agencies and through travel supplier joint ventures, which potentially bypass GDSs. See "Business Competition." Some of these travel suppliers offer lower prices when their products and services are purchased directly from these supplier-related distribution channels. These lower prices are not always available to us. Some of these travel suppliers are also not providing their lowest fares to GDSs unless the GDS provides them with lower transaction fees. These practices may have the effect of diverting customers away from us to other distribution channels, including websites, or of forcing us to reduce our transaction fees, which could have a material adverse effect on our business, financial condition and results of operations. Moreover, consolidation among travel suppliers, including airline mergers and alliances, may increase competition from these supplier-related distribution channels. In addition, some travel suppliers have reduced or eliminated commissions paid to both traditional and online travel agencies. The reduction or loss of commissions may cause travel agencies to become more dependent on other sources of revenues, such as traveler-paid service fees and GDS-paid inducements. We may have to increase inducement payments or incur other expenses in order to compete for travel agency business. Fare Content Agreements Our efforts to obtain more comprehensive content through airline fare content agreements may cause downward pressure on pricing and adversely affect our revenues and operating results. In recent months, some airlines have differentiated the fare content that they provide to us and to our GDS competitors. Some fare content has been provided to GDSs at no additional charge under standard participation agreements, and other content, such as web fares, has been withheld unless the GDS agrees to provide discounts, payments or other benefits to the airline. We have recently entered into fare content agreements with Continental Airlines, Delta, Northwest and United Air Lines. Generally, in these agreements, the airlines commit (subject to the exceptions contained in the agreements) to provide travel agencies covered by the agreements in the territories covered by the agreements with substantially the same fare content (including web fares) it provides to the travel agencies of other GDSs in exchange for payments from us to each airline and subject to us keeping steady the average transaction fees paid by each airline for travel agency bookings in the territories covered by the agreements. Further, in February 2004, we executed a three-year fare content agreement with British Airways to provide access to virtually all of their published fares (including web fares) to This prospectus relates to the offer and sale from time to time by the selling noteholder identified in this prospectus of up to $30,000,000 aggregate principal amount of 95/8% Senior Notes due 2011 issued by Worldspan, L.P. and WS Financing Corp. The notes being offered by the selling noteholder were initially issued on June 30, 2003 in a transaction exempt from the registration requirements of the Securities Act of 1933, as amended. We will not receive any of the proceeds from the sale of our senior subordinated notes being sold by the selling noteholders. The notes being offered by the selling noteholder are sometimes referred to in this prospectus as the "resale notes." Our senior notes are being registered to permit the selling noteholder to sell the securities from time to time to the public. The selling noteholder may sell the senior notes through ordinary brokerage transactions or through any other means described in the section entitled "Plan of Distribution." We do no know when or in what amounts a selling noteholder may offer securities for sale. The selling noteholders may sell any, all or none of the senior notes offered by this prospectus. We currently have outstanding an aggregate principal amount of $280,000,000 of 95/8% Senior Notes due 2011, of which the resale notes are a part. The remaining $250,000,000 of the outstanding notes are Series B 95/8% Senior Notes which have been registered with the Securities and Exchange Commission and were exchanged for a like amount of 95/8% Senior Notes due 2011 on January 30, 2004. The selling noteholder was not permitted to participate in the exchange offer because it is our affiliate. As a result, the resale notes are currently restricted securities and will remain so until transferred pursuant to this prospectus or pursuant to an available exemption from registration in which the restrictions on transfer lapse. Interest is payable on June 15 and December 15 of each year. The notes will mature on June 15, 2011. We may redeem all or part of the notes on or after June 15, 2007. Before June 15, 2006, we may redeem up to 35% of the notes from the proceeds of certain equity offerings. Redemption prices are set forth under "Description of the Notes Optional Redemption." The notes are guaranteed on a senior basis by all of our existing and future domestic subsidiaries. The notes and the guarantees will be our and the guarantors' general, unsecured obligations, are equal in right of payment to all of our and the guarantors' senior debt and are senior in right of payment to our and the guarantors' future subordinated indebtedness. Our foreign subsidiaries do not guarantee the notes. As a result, the notes are effectively junior to the creditors, including trade creditors, of those foreign subsidiaries. We do not intend to list the senior notes on any exchange. We cannot assure you that an active trading market for the senior notes will develop. some of our U.K. travel agencies. We believe that obtaining similar fare content from other major airline travel suppliers is important to our ability to compete, since other GDSs have also entered into fare content agreements with various airlines. Consequently, we plan to pursue agreements similar to these fare content agreements with some other major airlines. We expect that our fare content agreements will require us to make, in the aggregate, significant payments or other concessions to the participating airlines which could have a material adverse effect on our business, financial condition and results of operations in the future, including during the next three-year period. In addition, our fare content agreements are subject to several conditions, exceptions, term limitations and termination rights. There is no guarantee that the participating airlines will continue to provide their fare content to us to the same extent as they do at the current time. The loss or substantial reduction in the amount of fare content received from the participating airlines could negatively affect our business, financial condition and results of operations. Dependence on Small Number of Airlines We depend on a relatively small number of airlines for a significant portion of our revenues and the loss of any of our major airline relationships would harm our revenues and operating results. We depend on a relatively small number of airlines for a significant portion of our revenues. Our five largest airline relationships represented an aggregate of approximately 54% of our total 2003 revenues, down from 56% in 2002, while our ten largest airline relationships represented an aggregate of approximately 66% of our total 2003 revenues, down from 68% in 2002. Our five largest airline relationships by total revenue in 2003 were with Delta, Northwest, United Air Lines, American and US Airways, representing 19%, 12%, 9%, 8% and 5% of our total 2003 revenues, respectively. In 2002, these carriers accounted for 20%, 14%, 7%, 9% and 6%, respectively. We expect to continue to depend upon a relatively small number of airlines for a significant portion of our revenues. In addition, although we expect to continue our relationships with these airlines, our airline contracts can be terminated on short notice. Because our major airline relationships represent such a large part of our business, the loss of any of our major airline relationships, including due to the bankruptcy of an airline, could have a material negative impact on our business, financial condition and results of operations. Dependence on Small Number of Online Travel Agencies We are highly dependent on a small number of large online travel agencies, and the success of our business depends on continuing these relationships and the continued growth of online travel commerce. In 2003, Expedia, Hotwire, Orbitz and Priceline represented approximately 43% of our total transactions, with Expedia representing over 20% of our total transactions. If we were to lose and not replace the transactions generated by any of these online travel agencies, our business, financial condition and results of operations would be materially adversely impacted. In addition, if other online travel agencies become more successful or new online travel agencies emerge and we lose online transaction volumes as a result, our business, financial condition (including the carrying value of certain intangibles) and results of operations could be materially adversely impacted. While we have long-term contracts with Expedia, Orbitz and Priceline, these agencies have a variety of termination rights and other rights to reduce their business with Worldspan. Hotwire has the right to terminate its contract with us for any reason on 90 days advance notice. Expedia has the right to renegotiate the inducements payable to it by us every three years (with the next renegotiation right scheduled for July 2004), and it can terminate its contract with us if we cannot reach an agreement on inducements. In addition, Expedia informed us in May 2004 that it intends to exercise its right to move a portion of its transactions to another GDS provider. Although we currently continue to operate under these agreements, we cannot assure you that any travel agency will not attempt to terminate its agreement with us or otherwise move business to another GDS in the future. Any such termination or See "Risk Factors" beginning on page 12 for a discussion of risks that you should consider before buying the notes. a significant reduction in transaction volumes would have a material adverse effect on our business, financial condition (including the carrying value of certain intangibles) and results of operations. In addition, our growth strategy relies on the continuing growth in the travel industry of the Internet as a distribution channel. If consumers do not book significantly more travel online than they currently do today and if the use of the Internet as a medium of commerce for travel bookings does not continue to grow or grows more slowly than expected, our revenues and profit may be adversely affected. Consumers have historically relied on traditional travel agencies and travel suppliers and are accustomed to a high degree of human interaction in purchasing travel products and services. The success of our business is dependent on the number of consumers who use the Internet to make travel bookings increasing significantly. Relationships with Our Founding Airlines A significant portion of our current revenues are attributable to our founding airlines, and there is no guarantee that these airlines will continue to use our services to the same extent that they did when they owned us or that they will not indirectly compete with us. Each of American, Delta and Northwest has important commercial relations with us, and, in 2003, revenues received from our founding airlines represented, in the aggregate, approximately 39% of our revenues. Approximately 79% of this revenue was from transaction fees and the balance was derived from information technology services provided to Delta and Northwest. Delta is the largest single travel supplier utilizing our GDS, as measured by transaction fee revenues, generating transaction fees that accounted for approximately 14% of our 2003 revenue, while Northwest and American represent approximately 9% and 8%, respectively. In addition, approximately 86% of our information technology services revenues, which represented approximately 10% of our total revenues in 2003, are derived from providing processing, software development and other services to Delta and Northwest. Although we believe that each founding airline will continue to distribute its travel services through our GDS and that Delta and Northwest will continue to use our information technology services, there is no guarantee that our founding airlines will continue to use these services to the same extent as they did prior to the Acquisition or at all. In addition, although we have entered into noncompetition agreements with our founding airlines and each has agreed not to operate a GDS for three years after the Acquisition, there is no guarantee that our founding airlines will not indirectly compete with us in some or all of our markets, such as through supplier direct connections which could bypass our GDS. The loss or substantial reduction of fees from any of our founding airlines, or direct or indirect competition from any of our founding airlines, could negatively affect our business, financial condition and results of operations. For instance, the information technology services that we perform for Delta include computer functionality known as "PNR Sync." In 2003, Delta notified us that it intended to terminate PNR Sync. Following discussions with Delta relating to the mutual benefits of PNR Sync to Delta and us, we reached an agreement with Delta in December 2003 to continue to provide PNR Sync to Delta for a minimum three-year period at a fixed price and subject to several conditions, term limitations and termination rights. A termination of the PNR Sync functionality by Delta would represent a material adverse effect on our business, financial condition and results of operations. Additionally, in March 2004, Delta notified us that our GDS transaction fee pricing did not satisfy the conditions of our marketing support agreement with Delta. Delta indicated that, until we modify our GDS transaction fee pricing, it would suspend marketing support of us and the discount that Delta has provided to us for business travel. Pursuant to the agreement, we are working with Delta to review the relevant data and to resolve these issues. Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or passed upon the adequacy or accuracy of this prospectus. Any representation to the contrary is a criminal offense. FASA Credits The FASA credits and FASA credit payments owed under the FASAs may continue despite a significant reduction in or termination of FASA revenues. Pursuant to our founder airline services agreements, or FASAs, with each of Delta and Northwest, we are obligated to provide monthly FASA credits to Delta and Northwest to be applied against FASA service fee payments due from those airlines to us. The FASA credits are structured and will be applied through June 2012 in an amount up to an aggregate of approximately $116.7 million to each of Delta and Northwest as of December 31, 2003. Our obligations to provide these FASA credits to Delta and Northwest may continue despite a significant reduction in service fee payments from Delta or Northwest under the FASAs, as applicable. For instance, if Delta or Northwest reduces or ceases operations in a way that reduces or eliminates the amount of airline services the airline obtains from us under its FASA, our FASA credit obligations will remain, although its failure to comply with its software development minimum and exclusivity obligations will constitute a breach of its agreement. In the event that the monthly FASA credits deliverable by us to Delta or Northwest are more than the FASA service fee payments due from the applicable airline, then we will be obligated to pay such excess to such airline in cash. In addition, if we terminate the FASA other than as expressly permitted by the agreement, then we will be obligated to provide the scheduled FASA credits to the applicable airline by way of a monthly cash payment rather than applying the FASA credits against FASA service fee payments due from the airline. As a result, there could be a significant reduction in the revenues we receive from Delta and/or Northwest under the FASAs while our obligations to provide FASA credits and make FASA credit payments to Delta and/or Northwest, as applicable, would continue without interruption. In addition, Delta or Northwest may terminate its FASA due to our failure to satisfy the mainframe processing time, system availability or critical production data performance standards under that agreement. Furthermore, such a termination by Delta or Northwest of its FASA will constitute an event of default under our senior credit facility and may constitute a default under any other of our future senior credit facilities. If an event of default occurs, our lenders could elect to declare all amounts outstanding under our senior credit facility and any of our future credit facilities to be immediately due, and the lenders thereafter could foreclose upon the assets securing our senior credit facilities. In that event, we cannot assure you that we would have sufficient assets to repay all of our obligations, including our senior notes and the related guarantees. If the event of default is waived by the applicable lenders under our senior credit facilities or our senior credit facilities are no longer outstanding, the remaining portion of the FASA credits deliverable by us to the terminating airline will not be provided according to the nine year schedule and will instead be payable in cash to the terminating airline as and when, and only to the extent that, we are permitted to make such payments as "Restricted Payments" under the restricted payment covenant test contained in the indenture governing our senior notes. In such a circumstance, we will be required to make FASA credit payments to a terminating airline at a time when such airline is no longer paying FASA service fees to us. Although we have historically satisfied the relevant FASA performance standards under our predecessor services agreements with Delta and Northwest, we cannot assure you that we will continue to satisfy those standards and that the FASAs will not be terminated by Delta or Northwest. A termination of one or both of the FASAs under any of these circumstances could have a material adverse effect on our business, financial condition and results of operations. For further discussion of the terms of the FASAs, see "Management's Discussion and Analysis of Financial Condition and Results of Operations Liquidity." Critical Systems Our systems may suffer failures, capacity constraints and business interruptions, which could increase our operating costs, decrease our revenues and cause us to lose customers. The reliability of our GDS is critical to the success of our business. Much of our computer and communications hardware is located in a single data center located near Atlanta, Georgia. Our systems might be damaged or interrupted by fire, flood, power loss, telecommunications failure, break-ins, Net cash provided by (used in) operating activities $ 25,256 $ (1,582 ) $ $ 23,674 Cash flows from investing activities: Purchase of property and equipment (2,228 ) (634 ) (2,862 ) Proceeds from sale of property and equipment 20 The date of this prospectus is , 2004. earthquakes, terrorist attacks, war or similar events. Computer malfunctions, computer viruses, physical or electronic break-ins and similar disruptions might cause system interruptions and delays and loss of critical data and could significantly diminish our reputation and brand name and prevent us from providing services. Although we believe we have taken adequate steps to address these risks, we could be harmed by outages in, or unreliability of, the data center or computer systems. In addition, we rely on several communications services companies in the United States and internationally to provide network connections between our data center and our travel agencies' access terminals and also our travel suppliers. In particular, we rely upon AT&T and SITA, which is owned by a consortium of airlines and other travel-related businesses, to maintain our data communications and to provide network services in the United States and in many countries served by us. We occasionally experience network interruptions and malfunctions that make our global distribution system or other data processing services unavailable or less usable. Any significant failure or inability of AT&T, SITA or other communications companies to provide and maintain network access could have a material adverse effect on our business, financial condition and results of operations. Protection of Technology We may not protect our technology effectively, which would allow competitors to duplicate our products and services. This could make it more difficult for us to compete with them. Our success and ability to compete depend, in part, upon our technology. Among our significant assets are our software and other proprietary information and intellectual property rights. We rely on a combination of copyright, trademark and patent laws, trade secrets, confidentiality procedures and contractual provisions to protect these assets. Our software and related documentation, however, are protected principally under trade secret and copyright laws, which afford only limited protection, and the laws of some foreign jurisdictions provide less protection for our proprietary rights than the laws of the United States. Unauthorized use and misuse of our intellectual property could have a material adverse effect on our business, financial condition and results of operations, and there can be no assurance that our legal remedies would adequately compensate us for the damages caused by unauthorized use. In addition, licenses for a number of software products have been granted to us. Some of these licenses, individually and in the aggregate, are material to our business. Although we believe that the risk that we will lose any material license is remote, any loss could have a material adverse effect on our business, financial condition and results of operations. Intellectual Property Our products and services may infringe on claims of intellectual property rights of third parties, which could adversely affect our business and operating results. We do not believe that any of our products, services or activities infringe upon the intellectual property rights of third parties in any material respect. There can be no assurance, however, that third parties will not claim infringement by us with respect to current or future products, services or activities. Any infringement claim, with or without merit, could result in substantial costs and diversion of management and financial resources, and a successful claim could effectively block our ability to use or license products and services in the United States or abroad or cost us money. Any infringement claim, therefore, could have a material adverse effect on our business, financial condition and results of operations. Technological Change Rapid technological changes may render our technology obsolete or decrease the attractiveness of our products and services to customers. Our industry is subject to rapid technological change as travel suppliers, travel agencies and competitors create new and innovative products and services. Our ability to compete in our business and our future results will depend, in part, upon our ability to make timely, innovative and cost- TABLE OF CONTENTS Page effective enhancements and additions to our technology and to introduce new products and services that meet the demands of travel suppliers, travel agencies and other customers. The success of new products and services depends on several factors, including: identifying the needs of travel suppliers, travel agencies and other customers; developing and introducing effective new products and services in a timely and efficient manner; managing the cost of new product development and operations; differentiating new products and services from those of our competitors; and achieving market acceptance of new products and services. In addition, maintaining the flexibility to respond to technological and market changes may require substantial expenditures and lead time. There can be no assurance that we will successfully identify and develop new products or services in a timely manner, that products, technologies or services developed by others will not render our offerings obsolete or noncompetitive or that the technologies in which we focus our research and development investments will achieve acceptance in the marketplace. Our technology infrastructure is largely fixed. As a result, in the event of a significant reduction in transaction volumes or revenues, technology costs would remain relatively constant. If a reduction continued for a prolonged period, our business, financial condition and results of operations could be materially adversely affected. Regulatory Risks Regulatory developments could limit our ability to compete by restricting our flexibility to respond to competitive conditions. Changes and developments in the regulatory environment could have an adverse affect on our financial condition or results of operations, including by negatively impacting our transaction volume, transaction fees and by otherwise impacting the way we operate our business. GDSs are regulated by the U.S., the European Union ("E.U.") and other countries in which we operate. The U.S. Department of Transportation ("DOT") and the European Commission ("EC") are the relevant regulatory authorities in the U.S. and the E.U., respectively. Most of the regulating bodies have reexamined or are examining their GDS regulations and appear to be moving toward deregulation. Regulatory changes in the U.S., E.U. or other countries could have a material adverse effect on our business, financial condition and results of operations. On January 31, 2004, most DOT rules governing GDSs were lifted. The remaining DOT rules will be phased out at the end of July 2004. The DOT rules no longer contain any rules that apply uniquely to GDSs that are owned or marketed by airlines. In addition, deregulation in the U.S. could create uncertainty as to established GDS business models. Discontinuance of the rules could facilitate efforts by the airlines to divert travel bookings to distribution channels that they own and control and could also facilitate movement of travel agencies from one GDS to another. In addition, elimination of the rule prohibiting discrimination in airline fees could affect transaction fee revenues. E.U. regulations continue to address the participation of airline GDS owners in other GDSs. See "Business GDS Industry Regulation." The EC is engaged in a comprehensive review of its rules governing GDSs. It is unclear at this time when the EC will complete its review and what changes, if any, will be made to the E.U. rules. We could be unfairly and adversely affected if the E.U. rules are retained as to traditional global distribution systems used by travel agencies but are not applied to businesses providing comparable services, such as travel distribution websites owned by more than one airline. In addition, we could be adversely affected if changes to the rules, changes in interpretations of the rules, or new rules increase our cost of doing business, limit our ability to establish relationships with travel agencies, airlines, or others, impair the enforceability of existing agreements with travel agencies and other users of our system, prohibit or limit us from offering services or products, or limit our ability to establish or changes fees. Continued GDS regulation in the E.U. and elsewhere, while GDS regulations are being abolished in the U.S., could also create the operational challenge of supporting different products, services and business practices to conform to the different regulatory regimes. There are also GDS regulations in Canada, under the regulatory authority of the Canadian Department of Transport. On April 27, 2004, a significant number of these regulations were lifted. Amendments to the rules include eliminating the "obligated carrier" rule, which required larger airlines in Canada to participate equally in the GDSs, and elimination of the requirement that transaction fees charged by GDSs to airlines be non-discriminatory. Due to the elimination of the obligated carrier rule in Canada, Air Canada, the dominant Canadian airline, could choose distribution channels that it owns and controls or distribution through another GDS rather than through the Worldspan GDS. Privacy and Data Protection Our processing, storage, use and disclosure of personal data could give rise to liabilities as a result of governmental regulation, conflicting legal requirements or differing views of personal privacy rights. In our processing of travel transactions, we receive and store a large volume of personally identifiable data. This data is increasingly subject to legislation in numerous jurisdictions around the world, including the E.U. through its Data Protection Directive (and variations of this Directive in the E.U. Member States). This legislation is typically intended to protect the privacy of personal data that is collected, processed and transmitted in or from the governing jurisdiction. We could be adversely affected if the legislation is expanded to require changes in our business practices or if governing jurisdictions interpret or implement their legislation in ways that negatively affect our business, financial condition and results of operations. In addition, in the aftermath of the terrorist attacks of September 11, 2001, government agencies have been contemplating or developing initiatives to enhance national and aviation security, including the Transportation Security Administration's Computer-Assisted Passenger Prescreening System, known as CAPPS II. These initiatives may result in conflicting legal requirements with respect to data handling. As privacy and data protection has become a more sensitive issue, we may also incur legal defense costs and become exposed to potential liabilities as a result of differing views on the privacy of travel data. Travel businesses have also been subjected to investigations, lawsuits and adverse publicity due to allegedly improper disclosure of passenger information. For example, we were initially named as one of the defendants in a class action lawsuit arising from disclosures by Northwest of passenger data to a U.S. government agency. An amended and consolidated class action lawsuit was recently refiled in this case and we are no longer a named defendant in the matter. We are evaluating whether we have any future liability arising from this matter. While we do not believe that this matter is material, other privacy developments that are difficult to anticipate could impact our business, financial condition and results of operations. Key Employees Our ability to attract, train and retain executives and other qualified employees is crucial to results of operations and future growth. We depend substantially on the continued services and performance of our key executives, senior management and skilled personnel, particularly our professionals with experience in our business and operations and the GDS industry, including: Rakesh Gangwal, our Chairman and Chief Executive Officer; Gregory O'Hara, our Executive Vice President Corporate Planning and Development; Ninan Chacko, our Senior Vice President e-Commerce and Product Planning; David A. Lauderdale, our Chief Technology Officer and Senior Vice President Technical Operations; Michael B. Parks, our Senior Vice President and General Manager; Susan J. Powers, our Chief Information Officer and Senior Vice President Worldwide Product Solutions; Jeffrey C. Smith, our General Counsel, Secretary and Senior Vice President Human Resources; and Michael Wood, our Senior Vice President and Chief Financial Officer. We have entered into employment agreements with Messrs. Gangwal, O'Hara, Chacko and Wood to provide them with incentives to remain employed by us, all as more fully described in the section of this prospectus entitled "Management Employment Agreements." However, we cannot assure you that any of these individuals will continue to be employed by us. The specialized skills needed by our business are time-consuming and difficult to acquire and in short supply, and this shortage is likely to continue. A lengthy period of time is required to hire and train replacement personnel when skilled personnel depart the company. An inability to hire, train and retain a sufficient number of qualified employees could materially hinder our business by, for example, delaying our ability to bring new products and services to market or impairing the success of our operations. Even if we are able to maintain our employee base, the resources needed to attract and retain such employees may adversely affect our profits, growth and operating margins. Business Combinations and Strategic Investments We may not successfully make and integrate business combinations and strategic investments. We plan to continue to enter into business combinations, investments, joint ventures and other strategic alliances with other companies in order to maintain and grow revenue and market presence as well as to provide us with access to technology, products and services. Those transactions with other companies create risks such as difficulty in assimilating the technology, products and operations with our technology, products and operations; disruption of our ongoing business, including loss of management focus on existing businesses; impairment of relationships with existing executives, employees, customers and business partners; and losses that may arise from equity investments. In the past, in an effort to secure new technologies or obtain unique content for our GDS, we have invested in a number of early-stage technology companies. Each of these investments has required senior management attention. Many of these companies have failed, and most of our investments have been written down. If we enter into such transactions in the future, we may expend cash, incur debt, assume contingent liabilities or create additional expenses related to amortizing other intangible assets with estimable useful lives, any of which might harm our business, financial condition or results of operations. In addition, we may not be able to identify suitable candidates for these transactions or obtain financing or otherwise make these transactions on acceptable terms. Seasonality Because our business is seasonal, our quarterly results will fluctuate. The travel industry is seasonal in nature. Bookings, and thus transaction fee revenues charged for the use of our GDS, typically decrease each year in the fourth quarter, due to the early bookings by customers for travel during the holiday season and a decline in bookings for business travel during the holiday season. During 2002 and 2003, our transactions in the fourth quarter have averaged approximately 22% of total transactions for those years. Seasonality could cause our revenues to fluctuate significantly from quarter to quarter. Substantial fluctuations in our results of operations could have a material adverse effect on us. Trade Barriers We face trade barriers outside of the United States that limit our ability to compete. Trade barriers erected by non-U.S. travel suppliers, which are sometimes government-owned, have on occasion interfered with our ability to offer our products and services in their markets or have denied us content or features that they give to our competitors. Those trade barriers make our products and services less attractive to travel agencies in those countries than products and services offered by other GDSs that have these capabilities and have restricted our ability to gain market share outside of the U.S. Competition and trade barriers in those countries could require us to increase inducements, reduce prices, increase spending on marketing or product development, withdraw from or not enter certain markets or otherwise take actions adverse to us. 10.80 Amendment, dated as of May 12, 2004, to Employment Agreement among Worldspan Technologies Inc., M. Gregory O'Hara and Worldspan, L.P. 12.1 Computation of Ratio of Earnings to Fixed Charges 21.1 Subsidiaries of Worldspan, L.P.(4) 23.1 Consent of Dechert LLP* 23.2 Consent of PricewaterhouseCoopers LLP PROSPECTUS SUMMARY This following summary highlights certain significant aspects of our business and this offering, but you should read this entire prospectus, including the financial data and related notes, before making an investment decision. Unless the context otherwise requires, references to the "issuers" refer to Worldspan, L.P., exclusive of its subsidiaries, and WS Financing Corp. References to "WTI" refer to Worldspan Technologies Inc. References in this prospectus to "Worldspan," "we," "us," "our" and "our company" refer to the consolidated businesses of Worldspan, L.P. and all of its subsidiaries unless otherwise specified. References in this prospectus to the "Acquisition" refer to the acquisition by WTI, formerly named Travel Transaction Processing Corporation, through its wholly-owned subsidiaries, of the general partnership interests and limited partnership interest of Worldspan, L.P. You should carefully consider the information set forth under the heading "Risk Factors." Worldspan, L.P. We are a leading provider of mission-critical transaction processing and information technology services to the global travel industry. We are the second largest transaction processor for travel agencies in the United States (the world's largest travel market) and the largest processor globally for online travel agencies as measured by transactions. In 2003, we processed over 65% of online airline transactions made in the United States and processed by a global distribution system, or GDS. We provide subscribers (including traditional travel agencies, online travel agencies and corporate travel departments) with real-time access to schedule, price, availability and other travel information and the ability to process reservations and issue tickets for the products and services of approximately 800 travel suppliers (such as airlines, hotels, car rental companies, tour companies and cruise lines) throughout the world. During the year ended December 31, 2003, we processed approximately 193 million transactions. We also provide information technology services to the travel industry, primarily airline internal reservation systems, flight operations technology and software development. In recent years, the travel industry has been marked by the emergence and growth of the Internet as a travel distribution channel. The growth in use of the Internet has led to the establishment of online travel agencies that provide a link between the consumer and the travel supplier, typically through a GDS. In 2003, airline transactions generated through online travel agencies accounted for approximately 28% of all airline transactions in the United States processed by a GDS, up from approximately 23% in 2002 and approximately 17% in 2001. Between 1999 and 2003, the number of airline transactions in the United States generated through online travel agencies and processed by a GDS increased at a compound annual growth rate of 40.5% and an annual growth rate of 14.1% for the most recent year. The chart below illustrates airline transactions generated through online and traditional travel agencies in the United States and processed by a GDS.(1) International Operations Our international operations are subject to other risks which may impede our ability to grow internationally. Approximately 14% of our revenues during the twelve months ended December 31, 2003 were generated through our foreign subsidiaries. We face risks inherent in international operations, such as risks of: currency exchange rate fluctuations; local economic and political conditions, including conditions resulting from the continuing conflict in Iraq; restrictive governmental actions (such as trade protection measures, privacy rules, consumer protection laws and restrictions on pricing or discounts); changes in legal or regulatory requirements; limitations on the repatriation of funds; difficulty in obtaining distribution and support; nationalization; different accounting practices and potentially longer payment cycles; seasonal reductions in business activity; higher costs of doing business; lack of, or the failure to implement, the appropriate infrastructure to support our technology; lesser protection in some jurisdictions for our intellectual property; disruptions of capital and trading markets; laws and policies of the U.S. affecting trade, foreign investment and loans; and foreign tax and other laws. These risks may adversely affect our ability to conduct and grow business internationally, which could cause us to increase expenditures and costs, decrease our revenue growth or both. Exchange Rate Fluctuations Fluctuations in the exchange rate of the U.S. dollar and other foreign currencies could have a material adverse effect on our financial performance and results of operations. While we and our subsidiaries transact business primarily in U.S. dollars and most of our revenues are denominated in U.S. dollars, a portion of our costs and revenues are denominated in other currencies, such as the euro and the British pound sterling. As a result, changes in the exchange rates of these currencies or any other applicable currencies to the U.S. dollar will affect our operating expenses and operating margins and could result in exchange losses. The impact of future exchange rate fluctuations on our results of operations cannot be accurately predicted. In the past, we have incurred such losses, including a $1.0 million loss during 2001. Environmental, Health and Safety Requirements We could be adversely affected by environmental, health and safety requirements. We are subject to requirements of foreign, federal, state and local environmental and occupational health and safety laws and regulations. These requirements are complex, constantly changing and have tended to become more stringent over time. It is possible that these requirements may change or liabilities may arise in the future in a manner that could have a material adverse effect on our business, financial condition and results of operations. We cannot assure you that we have been or will be at all times in complete compliance with all those requirements or that we will not incur material costs or liabilities in connection with those requirements in the future. Additional Capital We may need additional capital in the future and it may not be available on acceptable terms. We may require more capital in the future to: fund our operations; finance investments in equipment and infrastructure needed to maintain and expand our network; fund the FASA credit payments; enhance and expand the range of services we offer; and respond to competitive pressures and potential strategic opportunities, such as investments, acquisitions and international expansion. We cannot assure you that additional financing will be available on terms favorable to us, or at all. The terms of available financing may place limits on our financial and operating flexibility. If adequate funds are not available on acceptable terms, we may be forced to reduce our operations or abandon expansion opportunities. Moreover, even if we are able to continue our operations, the failure to obtain additional financing could reduce our competitiveness as our competitors may provide better maintained networks or offer an expanded range of services. Securities Laws Compliance Recently enacted and proposed changes in securities laws and regulations are likely to increase our costs. The Sarbanes-Oxley Act of 2002, as well as new rules subsequently implemented by the Securities and Exchange Commission, have required changes in some of our corporate governance and accounting practices. In addition, the New York Stock Exchange has promulgated a number of regulations. We expect these laws, rules and regulations to increase our legal and financial compliance costs and to make some activities more difficult, time consuming and costly. We also expect these new rules and regulations to make it more difficult and more expensive for us to obtain director and officer liability insurance, and we may be required to accept reduced coverage or incur significantly higher costs to obtain coverage. These new laws, rules and regulations could also make it more difficult for us to attract and retain qualified members of our board of directors, particularly to serve on our audit committee, and qualified executive officers. Principal Stockholders Our principal stockholders could exercise their influence over us to your detriment. As a result of their stock ownership of WTI, our ultimate parent, CVC, certain of its affiliates and OTPP together own beneficially about 91% of WTI's outstanding capital stock. By virtue of their stock ownership, these entities have significant influence over our management and will be able to determine the outcome of all matters required to be submitted to the stockholders for approval, including the election of our directors and the approval of mergers, consolidations and the sale of all or substantially all of our assets. The interests of CVC and OTPP as equity owners of WTI may differ from your interests, and, as such, they may take actions which may not be in your interest. For example, if we encounter financial difficulties or are unable to pay our debts as they mature, the interests of our equity owners might conflict with your interests as a noteholder. In addition, our equity owners may have an interest in pursuing acquisitions, divestitures, financings or other transactions that, in their judgment, could enhance their equity investments, even though such transactions might involve risks to you as a holder of the notes.
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+RISK FACTORS You should carefully consider the risk factors set forth below as well as the other information contained in this prospectus before making a decision to participate in the exchange offer. Any of the following risks could materially adversely affect our business, financial condition or results of operations. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial may also materially and adversely affect our business operations. Risks Relating to the Notes Because there is no public market for the notes, you may not be able to resell your notes. There is no existing trading market for the exchange notes, and there can be no assurance regarding the development of an active or liquid trading market in the exchange notes or the ability of the holders of the exchange notes to sell their exchange notes or the price at which the holders may be able to sell their exchange notes. If a liquid market were to develop, the exchange notes could trade at prices that may be higher or lower than their initial offering price depending on many factors, including prevailing interest rates, our operating performance and financial condition, the interest of securities dealers in making a market in the exchange notes and the market for similar securities. Although it is not obligated to do so, CIBC World Markets Corp. intends to make a market in the exchange notes. Any such market-making activity may be discontinued at any time, for any reason, without notice at the sole discretion of CIBC World Markets Corp. No assurance can be given as to the liquidity of, or the trading market for, the exchange notes. Our substantial indebtedness could adversely affect our financial health and prevent us from fulfilling our obligations under the notes. We have a significant amount of indebtedness. As of December 31, 2003, our total debt was $257.2 million and our total senior debt was $101.4 million. Our substantial indebtedness could have important consequences to you. For example, it could: make it more difficult for us to satisfy our obligations with respect to the notes; increase our vulnerability to general adverse economic and industry conditions; require us to dedicate a substantial portion of our cash flow from operations to payments on our indebtedness, thereby reducing the availability of our cash flow to fund working capital, capital expenditures, expansion through acquisitions and other general corporate purposes; limit our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate; place us at a competitive disadvantage compared to our competitors that have less debt; and limit our ability, among other things, to borrow additional funds. Our substantial indebtedness may make it difficult for us to satisfy our obligations under the senior credit facility. If we cannot satisfy our obligations under the senior credit facility, our senior lenders could declare a default. A default, if not waived or cured, could result in an acceleration of our indebtedness and a foreclosure on our assets. A foreclosure would make it extremely difficult for us to operate as a going concern. In addition, a default, if not cured or waived, may permit the acceleration of our other indebtedness. (26,130 ) 192,138 26,544 192,552 Member's equity: Contributed capital 116,060 64,417 40,879 (105,296 ) 116,060 Accumulated deficit (71,708 ) (43,671 ) (12,002 ) 55,673 (71,708 ) Accumulated other comprehensive loss (14,831 ) (26,130 ) 192,138 26,544 192,552 Member's equity: Contributed capital 116,060 64,417 40,879 (105,296 ) 116,060 Accumulated deficit (71,708 ) (43,671 ) (12,002 ) 55,673 (71,708 ) Accumulated other comprehensive loss (14,831 ) David F. Myers, Jr. Executive Vice President, Secretary, and Chief Financial Officer 2211 York Road, Suite 215 Oak Brook, Illinois 60523 Telephone: (630) 572-5715 (Name, address, including zip code, and telephone number, including area code, of agent for service) Despite current indebtedness levels, we may still be able to incur substantially more debt. This could further exacerbate the risks described above. We and our subsidiaries may be able to incur substantial additional indebtedness in the future. The terms of the indenture governing the notes do not fully prohibit us or our subsidiaries from doing so. As of December 31, 2003 our senior credit facility permited borrowings of up to $30 million and C$10 million and revolving credit facilities at our European subsidiaries permitted borrowings of up to 3.1 million and borrowings under these revolving credit facilities would rank senior to the notes and the subsidiary guarantees. If new debt is added to our current debt levels, the related risks that we now face could intensify. To service our indebtedness, we require a significant amount of cash, the availability of which depends on many factors beyond our control. If we cannot service our indebtedness, we may not be able to satisfy our obligations under the notes. Our ability to make payments on and to refinance our indebtedness, including the notes, and to fund planned capital expenditures will depend on our ability to generate cash in the future from our operations. Our ability to generate cash is, to a certain extent, subject to general economic, financial, competitive, legislative, regulatory and other factors that are beyond our control. Our business may not generate sufficient cash flow from operations and future borrowings may not be available to us under our senior credit facility in an amount sufficient to enable us to pay our indebtedness, including the notes, or to fund our other liquidity needs. As of December 31, 2003, the current portion (due within one year) of our debt service payments, which includes principal and interest, was approximately $23.5 million. We intend to service these obligations through our future cash flows from operations. If our future cash flow from operations and other capital resources are insufficient to pay our obligations as they mature or to fund our liquidity needs, we may be forced to reduce or delay our business activities and capital expenditures, sell assets, obtain additional equity capital or restructure or refinance all or a portion of our debt, including the notes, on or before maturity. We may not be able to refinance any of our indebtedness, including our senior credit facility and the notes, on satisfactory terms or at all. NSP conducts a substantial portion of its operations through subsidiaries, and NSP's subsidiaries are not obligated to make distributions to NSP to service the notes. NSP's subsidiaries conduct a substantial portion of its operations and own a substantial portion of its assets. NSP's cash flow and its ability to meet its debt service obligations depend upon the cash flow of its subsidiaries and the payment of funds by its subsidiaries in the form of loans and dividends. NSP's subsidiaries are not obligated to make distributions to NSP to service the notes. In addition, the ability of its subsidiaries to make payments to it will depend on their earnings, the terms of their debt, business and tax considerations and legal restrictions. NSP's foreign subsidiaries are not subsidiary guarantors, and as a result, any right of NSP to participate in any distribution of assets of its foreign subsidiaries upon liquidation or otherwise will be subject to the prior claims of its foreign subsidiaries' creditors. The subsidiary guarantors include only NSP's domestic direct and indirect subsidiaries. However, our historical consolidated financial information and the pro forma consolidated financial information included in this prospectus are presented on a consolidated basis, including both our domestic and foreign subsidiaries. The aggregate net sales and operating income of our subsidiaries that are not subsidiary guarantors were $82.1 million and $6.0 million, respectively, for the year ended December 31, 2002 and $78.0 million and $7.3 million, respectively, for the nine months ended September 27, 2003 and their consolidated tangible assets at September 27, 2003 were $76.6 million. In 9. Lease Commitments The Company leases certain facilities and equipment under various noncancelable operating lease agreements. Future minimum lease payments under noncancelable operating leases as of December 31, 2002, are as follows: 2003 23 2004 Copies to: Dennis M. Myers, P.C. Kirkland & Ellis LLP 200 E. Randolph Drive Chicago, Illinois 60601 Telephone: (312) 861-2000 * The Co-Registrants listed on the next page are also included in this Form S-4 Registration Statement as additional Registrants. The Co-Registrants are the direct and indirect domestic subsidiaries of the Registrant and the guarantors of the notes to be registered hereby. Approximate date of commencement of proposed sale of the securities to the public: The exchange will occur as soon as practicable after the effective date of this Registration Statement. If the securities being registered on this Form are being offered in connection with the formation of a holding company and there is compliance with General Instruction G, check the following box. If this form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. If this form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. CALCULATION OF REGISTRATION FEE addition, the notes are effectively subordinated to all existing and future liabilities (including trade payables) of our non-guarantor subsidiaries. As of December 31, 2003, our non-guarantor subsidiaries had $19.8 million of indebtedness and other liabilities (including trade payables). As a result, any right of NSP to participate in any distribution of assets of its non-guarantor subsidiaries upon the liquidation, reorganization or insolvency of any such subsidiary (and the consequential right of the holders of the notes to participate in the distribution of those assets) will be subject to the prior claims of such subsidiaries' creditors. The indenture for the notes restricts our ability and the ability of most of our subsidiaries to engage in some business and financial transactions. Our failure to comply may result in an event of default under the indenture. The indenture for the notes, among other things, restricts our ability and the ability of our restricted subsidiaries to, among other things: incur additional debt or issue preferred stock; pay dividends and make distributions on, or redeem or repurchase, capital stock; issue stock of subsidiaries; make investments; create liens; enter into transactions with affiliates; enter into sale-leaseback transactions; merge or consolidate; and transfer and sell assets. Our failure to comply with obligations under the indenture for the notes may result in an event of default under the indenture. A default, if not cured or waived, may permit acceleration of our other indebtedness. We may not have funds available to remedy these defaults. If our indebtedness is accelerated, we may not have sufficient funds available to pay the accelerated indebtedness or the ability to refinance the accelerated indebtedness on terms favorable to us or at all. Your right to receive payments on the notes is junior to our senior indebtedness and possibly all of our future borrowings. Further, the guarantees of the notes are junior to all of our guarantors' senior indebtedness and all their future borrowings. The notes and the subsidiary guarantees rank behind all of our and our subsidiary guarantors' senior indebtedness (other than trade payables) and all of our and their future borrowings (other than trade payables), except any future indebtedness that expressly provides that it ranks equal with, or subordinated in right of payment to, the notes and the guarantees. In addition, the notes are structurally subordinated to indebtedness and other liabilities of our subsidiaries which are not guaranteeing the notes. As a result, upon any distribution to our creditors or the creditors of the guarantors in a bankruptcy, liquidation or reorganization or similar proceeding relating to us or the guarantors or our or their property, the holders of our senior debt and the guarantors' senior debt will be entitled to be paid in full in cash before any payment may be made with respect to the notes or the subsidiary guarantees. In the event of a bankruptcy, liquidation or reorganization or similar proceeding relating to us or the guarantors, holders of the notes will participate with trade creditors and all other holders of our and the guarantors' subordinated indebtedness in the assets remaining after we and the subsidiary Title of Each Class of Securities to be Registered Proposed Maximum Aggregate Offering Price Amount of Registration Fee guarantors have paid all of our senior debt. However, because the indenture requires that amounts otherwise payable to holders of the notes in a bankruptcy or similar proceeding be paid to holders of senior debt instead, holders of the notes may receive less, ratably, than holders of trade payables in any such proceeding. In any of these cases, we and the subsidiary guarantors may not have sufficient funds to pay all of our creditors and holders of notes may receive less, ratably, than the holders of our senior debt. As of December 31, 2003, the notes and the subsidiary guarantees were subordinated to $101.4 million of senior debt, and we had approximately $41.6 million of additional borrowing capacity under our senior revolving credit facilities. We will be permitted to borrow substantial additional indebtedness, including senior debt, in the future under the terms of the indenture. The notes are not secured by any assets, while our obligations under the senior credit facility are secured by liens on substantially all of our assets. Under certain circumstances, note holders may receive less, ratably, than holders of our senior debt. The notes are not secured by any collateral. However, our obligations under the senior credit facility are secured by liens on substantially all of our assets. Therefore, in a bankruptcy, liquidation or reorganization or similar proceeding relating to us or the guarantors, or our or their property, holders of the notes and all other holders of our and the guarantors' senior subordinated indebtedness will participate in the assets remaining after we and the subsidiary guarantors have paid all of our senior debt. In any of these cases, we and the subsidiary guarantors may not have sufficient funds to pay all of our creditors and the holders of notes may receive less, ratably, than the holders of our senior debt. We may not have the ability to raise the funds necessary to finance the change of control offer required by the indenture. Upon the occurrence of certain specific kinds of change of control events, we will be required to offer to repurchase all outstanding notes at 101% of their principal amount plus accrued and unpaid interest and liquidated damages, if any, to the date of repurchase. However, it is possible that we will not have sufficient funds at the time of the change of control to make any required repurchases or that restrictions in our senior credit facility will not allow such repurchases. A change in control of the Company can be the basis for the declaration of an event of default under our senior credit agreement, which, if not waived, accelerates our obligations under the credit agreement and, under the terms of the indenture, we would be prohibited from making, and the trustee from accepting, any payment with respect to the notes until the senior indebtedness was paid in full. If we do not repay all borrowings under our senior credit facility or obtain a consent of our lenders under our senior credit facility to repurchase the notes, we will be prohibited from purchasing the notes. Our failure to purchase tendered notes would constitute a default under the indenture governing the notes, which, in turn, would constitute a default under our senior credit facility. In addition to the outstanding notes as of December 31, 2003 we had $105.7 million of indebtedness outstanding that is payable in full at the option of the payees upon a change of control. Also, we could in the future enter into transactions, including acquisitions, refinancings or other recapitalizations or highly leveraged transactions, that would not constitute a change of control under the indenture, but that could increase the amount of indebtedness outstanding at such time or adversely affect our capital structure or credit ratings. See "Description of the Notes Change of Control Offer." Balance at January 1, 2001 4,602 2,666 7,268 Foreign currency translation adjustments 9 Net cash used in financing activities (219 ) (801 ) Effect of exchange rate changes on cash 97/8 Senior Subordinated Notes due 2011 $152,500,000 (1) The senior credit facility contains certain restrictive covenants, including leverage and interest coverage ratios. If we fail to comply with these financial covenants, a default could be declared, and the senior lenders could accelerate our repayment obligations. The senior credit facility contains certain restrictive covenants, including covenants that require us to maintain certain financial ratios. Those ratios include: a fixed charge coverage ratio of EBITDA less capital expenditures over fixed charges for the period, an interest coverage ratio of EBITDA over interest expense for the period, a senior leverage ratio of senior debt over EBITDA for the period, and a total leverage ratio of total debt over EBITDA for the period. The specific ratios we are required to maintain change over time. If we fail to maintain these ratios and the failure is not cured, the senior lenders could declare a default under the credit agreement, accelerate our payment obligations and foreclose on our assets. A foreclosure would make it extremely difficult for us to operate as a going concern. In addition, a default, if not cured or waived, may permit the acceleration of our other indebtedness. We may not have funds available to remedy these defaults. If our indebtedness is accelerated, we may not have sufficient funds available to pay the accelerated indebtedness or the ability to refinance the accelerated indebtedness on terms favorable to us or at all. Federal and state statutes allow courts, under specific circumstances, to void guarantees and require note holders to return payments received from guarantors. Under the federal bankruptcy law and comparable provisions of state fraudulent transfer laws, a guarantee could be voided, or claims in respect of a guarantee could be subordinated to all other debts of that guarantor if, among other things, the guarantor, at the time it incurred the indebtedness evidenced by its guarantee received less than reasonably equivalent value or fair consideration for the incurrence of such guarantee; and was insolvent or rendered insolvent by reason of such incurrence; or was engaged in a business or transaction for which the guarantor's remaining assets constituted unreasonably small capital; or intended to incur, or believed that it would incur, debts beyond its ability to pay such debts as they matured. In addition, any payment by that guarantor pursuant to its guarantee could be voided and required to be returned to the guarantor, or to a fund for the benefit of the creditors of the guarantor. The measures of insolvency for purposes of these fraudulent transfer laws will vary depending upon the law applied in any proceeding to determine whether a fraudulent transfer has occurred. Generally, however, a guarantor would be considered insolvent if: the sum of its debts, including contingent liabilities, were greater than the fair saleable value of all of its assets; or the present fair saleable value of its assets was less than the amount that would be required to pay its probable liability on its existing debts, including contingent liabilities, as they became absolute and mature; or it could not pay its debts as they became due. On the basis of historical financial information, recent operating history and other factors, we believe that each guarantor, after giving effect to its guarantee of the notes, will not be insolvent, will not have unreasonably small capital for the business in which it is engaged and will not have incurred debts beyond its ability to pay such debts as they mature. We cannot predict with certainty, however, 2,580 2,449 Members' equity: Contributed capital 4,602 4,602 Retained earnings 3,525 4,563 Accumulated other comprehensive income 9 Balance at December 31, 2002 4,602 4,563 Guarantees on Senior Subordinated Notes (2) (3) what standard a court would apply in making these determinations or whether a court would agree with our conclusions in this regard. You should not rely on Norcross Capital in evaluating an investment in the notes. Norcross Capital was formed in connection with the offering of the outstanding notes and has no assets and no operations and is prohibited from engaging in any business activities, except in connection with the issuance of the notes. You should therefore not rely upon Norcross Capital in evaluating whether to invest in the notes. Risks Relating to our Business If we are unable to retain senior executives and other qualified professionals our growth may be hindered, which could negatively impact our results of operations and our ability to make payments on the notes. Our success depends in part on our ability to attract, hire, train and retain qualified managerial, sales and marketing personnel. Competition for these types of personnel is intense. We may be unsuccessful in attracting and retaining the personnel we require to conduct and expand our operations successfully. Our results of operations could be materially and adversely affected if we are unable to attract, hire, train and retain qualified personnel. Our success also depends to a significant extent on the continued service of our management team. The loss of any member of the management team could have a material adverse effect on our business, results of operations and financial condition. The markets in which we compete are highly competitive, and some of our competitors have greater financial and other resources than we do. The competitive pressures faced by us could materially and adversely affect our business, results of operations and financial condition. The personal protection equipment market is highly competitive, with participants ranging in size from small companies focusing on single types of safety products, to large multinational corporations which manufacture and supply many types of safety products. Our main competitors vary by region and product. We believe that participants in this industry compete primarily on the basis of product characteristics (such as functional performance, design and style), price, brand name recognition and service. Some of our competitors have greater financial and other resources than we do and our cash flows from operations could be adversely affected by competitors' new product innovations and pricing changes made by us in response to competition from existing or new competitors. Individual competitors have advantages and strengths in different sectors of the industry, in different products and in different areas, including manufacturing and distribution systems, geographic market presence, customer service and support, breadth of product, delivery time and price. We may not be able to compete successfully against current and future competitors and the competitive pressures faced by us could materially and adversely affect our business, results of operations and financial condition. See "Business Competition." Many of our products are subject to existing regulations and standards, changes in which could materially and adversely affect our results of operations. Our net sales may be materially and adversely affected by changes in safety regulations and standards covering industrial workers, firefighters and utility workers in the United States and Canada, including safety regulations of OSHA and standards of the NFPA, ANSI and ASTM. Our net sales could also be adversely affected by a reduction in the level of enforcement of such regulations. Changes in regulations could reduce the demand for our products or require us to reengineer our products, thereby creating opportunities for our competitors. (1)Pursuant to Rule 457(q) under the Securities Act of 1933, as amended, no filing fee is required for the registration of an indeterminate amount of securities to be offered solely for market-making purposes by an affiliate of the registrant. (2)All subsidiary guarantors are wholly owned direct or indirect subsidiaries of the Registrant and have guaranteed the Notes being registered. (3)Pursuant to Rule 457(n), no separate fee is payable with respect to the guarantees being registered hereby. A reduction in the spending patterns of government agencies could materially and adversely affect our net sales. We sell a significant portion of our products in the United States and Canada to various governmental agencies. In addition, a portion of our products are sold to government agencies through fixed price contracts awarded by competitive bids submitted to state and local agencies. Many of these governmental agency contracts are awarded on an annual basis. Accordingly, notwithstanding our long-standing relationship with various governmental agencies, we may lose our contracts with such agencies to lower bidders in the competitive bid process. Moreover, the terms and conditions of such sales and the government contract process are subject to extensive regulation by various federal, state and local authorities in the United States and Canada. In most markets in which we compete, there are frequent introductions of new products and product line extensions. If we fail to introduce successful new products, we may lose market position and our financial performance may be negatively impacted. If we are unable to identify emerging consumer and technological trends, maintain and improve the competitiveness of our products and introduce these products on a global basis, we may lose market position, which could have a material adverse effect on our business, financial condition and results of operations. Continued product development and marketing efforts have all the risks inherent in the development of new products and line extensions, including development delays, the failure of new products and line extensions to achieve anticipated levels of market acceptance and the cost of failed product introductions. Our international operations are subject to various uncertainties and a significant reduction in international sales of our products could have a material adverse effect on our results of operations. Our international operations are subject to various political, economic and other uncertainties which could adversely effect our business. A significant reduction of our international business due to any of these risks would adversely affect our revenues. In 2002, approximately 25% of our net sales were outside the United States. These risks include: unexpected changes in regulatory requirements; currency exchange rate fluctuations; changes in trade policy or tariff regulations; customs matters; longer payment cycles; higher tax rates and potentially adverse tax consequences, including restrictions on repatriating earnings and the threat of "double taxation"; additional tax withholding requirements; intellectual property protection difficulties; difficulty in collecting accounts receivable; complications in complying with a variety of foreign laws and regulations, many of which conflict with United States laws; costs and difficulties in integrating, staffing and managing international operations; and strains on financial and other systems to properly administer VAT and other taxes. Income before income taxes and minority interest 1,788 1,969 134 3,891 Income tax expense (benefit) 1,972 769 (162 )(7) 2,579 Minority interest (1 ) 13 586 Income before income taxes and minority interest 1,242 1,779 Income tax expense 508 694 Minority interest 5 The Registrant and the Co-Registrants hereby amend this Registration Statement on such date or dates as may be necessary to delay its effective date until the Registrant and the Co-Registrants shall file a further amendment which specifically states that this Registration Statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933 or until this Registration Statement shall become effective on such date as the Commission, acting pursuant to said Section 8(a), may determine. In addition, foreign operations involve uncertainties arising from local business practices, cultural considerations and international political and trade tensions. For example, in 2002, we recorded a non-cash impairment charge with regard to, our Zimbabwe subsidiary due to adverse economic and political conditions. In addition, a portion of our manufacturing and outsourcing relationships involve China. If we are unable to successfully manage the risks associated with expanding our global business or to adequately manage operational fluctuations internationally, it could have a material adverse effect on our business, financial condition or results of operations. We may incur restructuring or impairment charges that would reduce our earnings. We have in the past and may in the future restructure some of our operations, including our recently acquired subsidiaries. In such circumstances, we may take actions that would result in a charge related to discontinued operations, thereby reducing our earnings. These restructurings have or may be undertaken to realign our subsidiaries, eliminate duplicative functions, rationalize our operating facilities and products, and reduce our staff. For the year ended December 31, 2002, we recorded restructuring charges of approximately $9.3 million related to a restructuring plan to exit certain manufacturing facilities and move certain hand operations to China. Additionally, on January 1, 2002 we adopted Statement of Financial Accounting Standards (SFAS) No. 142, "Goodwill and Other Intangible Assets," which requires that goodwill and intangible assets that have an indefinite useful life be tested at least annually for impairment. We carry a very significant amount of goodwill and intangible assets and SFAS No. 142 requires us to perform an annual assessment for possible impairment. As of September 27, 2003, we had goodwill of approximately $134.5 million. We do not anticipate that our goodwill will be impaired for the year ended December 31, 2003. If we determine our goodwill to be impaired, the resulting non-cash charge could be substantial. We may be unable to successfully execute or effectively integrate acquisitions, including our acquisition of KCL, which may adversely affect our results of operations. One of our key operating strategies is to selectively pursue acquisitions. Acquisitions, including our acquisition of KCL, involve a number of risks including: failure of the acquired businesses to achieve the results we expect; diversion of our management's attention from operational matters; our inability to retain key personnel of the acquired businesses; risks associated with unanticipated events or liabilities; the potential disruption of our existing business; and customer dissatisfaction or performance problems at the acquired businesses. If we are unable to integrate or successfully manage KCL or any other business that we may acquire in the future, we may not realize anticipated cost savings, improved manufacturing efficiencies and revenue growth, which may result in reduced profitability or operating losses. In addition, we expect to face competition for acquisition candidates, which may limit the number of our acquisition opportunities and may lead to higher acquisition prices. Moreover, acquisitions of businesses may require additional debt financing, resulting in additional leverage. The covenants in our senior credit facility and the indenture may further limit our ability to complete acquisitions. The realization of all or any of the risks described above could materially and adversely affect our reputation and our results of operations. Net cash provided by (used in) financing activities 11,986 (8,669 ) 21,316 24,633 Effect of exchange rate changes on cash 3,179 Our continued success depends on our ability to protect our intellectual property. If we are unable to protect our intellectual property, our sales could be materially and adversely affected. Our success depends, in part, on our ability to obtain and enforce patents, maintain trade secret protection and operate without infringing on the proprietary rights of third parties. We have been issued patents and have registered trademarks with respect to many of our products, but our competitors could independently develop similar or superior products or technologies, duplicate any of our designs, trademarks, processes or other intellectual property or design around any processes or designs on which we have or may obtain patents or trademark protection. In addition, it is possible that third parties may have or acquire licenses for other technology or designs that we may use or desire to use, so that we may need to acquire licenses to, or to contest the validity of, such patents or trademarks of third parties. Such licenses may not be made available to us on acceptable terms, if at all, and we may not prevail in contesting the validity of third party rights. In addition to patent and trademark protection, we also protect trade secrets, know-how and other confidential information against unauthorized use by others or disclosure by persons who have access to them, such as our employees, through contractual arrangements. These agreements may not provide meaningful protection for our trade secrets, know-how or other proprietary information in the event of any unauthorized use, misappropriation or disclosure of such trade secrets, know-how or other proprietary information. If we are unable to maintain the proprietary nature of our technologies, our sales could be materially adversely affected. See "Business Intellectual Property." We do not have long-term contracts with many of our customers and they may terminate their relationship with us at any time, which could have a material adverse effect on our operating results. A significant portion of our contracts are not long-term contacts and are terminable at will by either party. If a significant number of our customers choose to terminate their contracts or to not renew their contracts with us upon expiration, it would have a material adverse effect on our business, financial condition and results of operations. We face an inherent business risk of exposure to product liability claims which could have a material adverse effect on our operating results. We face an inherent business risk of exposure to product liability claims arising from the claimed failure of our products to prevent the types of personal injury or death against which they are designed to protect. We have not experienced any material uninsured losses due to product liability claims, but it is possible that we could experience material losses in the future. In particular, our North Safety Products subsidiary, its predecessors and/or the former owners of such business are presently named as a defendant in approximately 670 lawsuits involving respirators manufactured and sold by it or its predecessors. We are also monitoring an additional 10 lawsuits in which we feel that North Safety Products, its predecessors and/or the former owners of such businesses may be named as defendants. Collectively, these 680 lawsuits represent a total of approximately 32,000 plaintiffs. Approximately 88% of these lawsuits involve plaintiffs alleging they suffer from silicosis, with the remainder alleging they suffer from other or combined injuries, including asbestosis. These lawsuits typically allege that these conditions resulted in part from respirators that were negligently designed or manufactured. Invensys plc ("Invensys"), formerly Siebe plc, is contractually obligated to indemnify us for any losses, including costs of defending claims, resulting from respiratory products manufactured prior to our acquisition of North Safety Products in October 1998. In addition, our North Safety Products subsidiary is contractually entitled to indemnification from Norton Company, an affiliate of Saint-Gobain, which owned the North Safety Products business prior to Invensys. Pursuant to a December 14, 1982 asset purchase agreement, Siebe Norton, Inc., a newly formed wholly-owned subsidiary of Norton Company, acquired the assets of Norton's Safety Products (1)Through December 2, 2003. Plaintiffs have asserted specific dollar claims in less than a quarter of the approximately 670 cases pending as of December 2, 2003 in which North Safety Products, its predecessors and/or the former owners of such businesses have been named as defendants. A majority of cases prohibit specifying damages in tort cases such as these, and most of the remaining jurisdictions do not require such specification. In those cases in which plaintiffs choose to assert specific dollar amounts in their complaints, brought in states that permit such pleading, the amounts claimed are typically not meaningful as an indicator of a company's potential liability. This is because (1) the amounts claimed typically bear no relation to the level of the plaintiff's injury, (2) the complaints typically assert claims against numerous defendants, and (3) many cases are brought on behalf of plaintiffs who have not suffered any medical injury, and, ultimately, are resolved without any payment or payment of a small fraction of the damages initially claimed. Of the 668 complaints maintained in our records, 506 do not Exact Name of Additional Registrants* specify the amount of damages sought, 1 generally alleges damages less than $50,000, 31 generally allege damages in excess of $50,000, 3 allege compensatory damages in excess of $50,000 and an unspecified amount of punitive damages, 26 allege compensatory damages and punitive damages, each in excess of $25,000, 8 generally allege damages in excess of $100,000, 51 allege compensatory damages and punitive damages, each in excess of $50,000, 37 generally allege damages of $15.0 million, 4 allege compensatory damages and punitive damages, each in the amount of $15.0 million and one alleges damages not to exceed $290.0 million. We currently do not have access to the complaints with respect to the additional approximately 2 cases that were pending as of December 2, 2003 in which North Safety Products, its predecessors and/or the former owners of such businesses have been named as defendants, or the previously mentioned 10 additional cases we are monitoring, and therefore do not know whether these cases allege specific damages, and, if so, the amount of such damages, but are in the process of seeking to obtain such information. Due to the reasons noted above and to the indemnification arrangements benefiting the Company, we do not believe that the damage amounts specified in these complaints are a meaningful factor in any assessment of the Company's potential liability. Bankruptcy filings of companies with asbestos and silica-related litigation could increase our cost over time. If we were found liable in these cases and either Invensys or Norton Company failed to meet their indemnification obligations to us or the suit involved products manufactured by us after our October 1998 acquisition of North Safety Products, it would have a material adverse effect on our business. For more information, see "Business Legal Proceedings." Also, in the event any of our products prove to be defective, we could be required to recall or redesign such products. We maintain insurance against product liability claims (with the exception of asbestosis and silicosis cases, for which coverage is not commercially available), but it is possible that our insurance coverage will not continue to be available on terms acceptable to us or that such coverage will not be adequate for liabilities actually incurred. A successful claim brought against us in excess of available insurance coverage, or any claim or product recall that results in significant expense or adverse publicity against us, could have a material adverse effect on our business, operating results and financial condition. We are subject to various environmental laws and any violation of these laws could adversely effect our results of operations. We are subject to federal, state and local laws, regulations and ordinances relating to the protection of the environment, including those governing discharges to air and water, handling and disposal practices for solid and hazardous wastes, and the maintenance of a safe workplace. These laws impose penalties for noncompliance and liability for response costs and certain damages resulting from past and current spills, disposals or other releases of hazardous materials. We could incur substantial costs as a result of noncompliance with or liability for cleanup pursuant to these environmental laws. We have identified three potential environmental liabilities, though we do not believe they are material. See "Business Environmental Matters." Environmental laws have changed rapidly in recent years, and we may be subject to more stringent environmental laws in the future. If more stringent environmental laws are enacted, these future laws could have a material adverse effect on our results of operations. The interests of our controlling equityholders could conflict with those of the holders of the notes. We are a wholly owned subsidiary of NSP Holdings. Equityholders of NSP Holdings that individually hold greater than 5% of a class of its voting securities, taken as a group, hold a total of 79.9% of its outstanding voting equity. See "Principal Equityholders." Pursuant to NSP Holdings' Amended and Restated Limited Liability Company Agreement, as amended, Argosy-Safety Products L.P. has the right to appoint three of the possible six members of Holdings' board of managers. These appointees have the authority to make decisions affecting our capital structure, including the issuance Jurisdiction of Formation of additional indebtedness and the making of distributions. Argosy-Safety Products L.P.'s limited partners include individuals who are employees of CIBC. NSP Holdings' Amended and Restated Limited Liability Company Agreement may be amended by the vote of the holders of the majority of its voting equity, so long as the amendment is also approved by John Hancock Life Insurance Company and Hancock Mezzanine Partners L.P., on the one hand, and Argosy, CIBC and CIBC's affiliates, on the other hand. Therefore, these entities, acting together, have sufficient voting power to amend NSP Holdings' Amended and Restated Limited Liability Company Agreement. Entities associated with some of our principal equityholders are lenders under our senior credit facilities. These entities may lend to us on a senior basis in the future. NSP Holdings' principal equityholders may pursue transactions that could enhance their investments while involving risks to your interests. The interests of these entities could conflict with the interests of the holders of the notes. I.R.S. Employer Identification No.
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+RISK FACTORS You should carefully consider the risk factors set forth below as well as the other information contained in this prospectus before making a decision to participate in the exchange offer. Any of the following risks could materially adversely affect our business, financial condition or results of operations. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial may also materially and adversely affect our business operations. Risks Relating to the Notes Because there is no public market for the notes, you may not be able to resell your notes. There is no existing trading market for the exchange notes, and there can be no assurance regarding the development of an active or liquid trading market in the exchange notes or the ability of the holders of the exchange notes to sell their exchange notes or the price at which the holders may be able to sell their exchange notes. If a liquid market were to develop, the exchange notes could trade at prices that may be higher or lower than their initial offering price depending on many factors, including prevailing interest rates, our operating performance and financial condition, the interest of securities dealers in making a market in the exchange notes and the market for similar securities. Although it is not obligated to do so, CIBC World Markets Corp. intends to make a market in the exchange notes. Any such market-making activity may be discontinued at any time, for any reason, without notice at the sole discretion of CIBC World Markets Corp. No assurance can be given as to the liquidity of, or the trading market for, the exchange notes. Our substantial indebtedness could adversely affect our financial health and prevent us from fulfilling our obligations under the notes. We have a significant amount of indebtedness. As of December 31, 2003, our total debt was $257.2 million and our total senior debt was $101.4 million. Our substantial indebtedness could have important consequences to you. For example, it could: make it more difficult for us to satisfy our obligations with respect to the notes; increase our vulnerability to general adverse economic and industry conditions; require us to dedicate a substantial portion of our cash flow from operations to payments on our indebtedness, thereby reducing the availability of our cash flow to fund working capital, capital expenditures, expansion through acquisitions and other general corporate purposes; limit our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate; place us at a competitive disadvantage compared to our competitors that have less debt; and limit our ability, among other things, to borrow additional funds. Our substantial indebtedness may make it difficult for us to satisfy our obligations under the senior credit facility. If we cannot satisfy our obligations under the senior credit facility, our senior lenders could declare a default. A default, if not waived or cured, could result in an acceleration of our indebtedness and a foreclosure on our assets. A foreclosure would make it extremely difficult for us to operate as a going concern. In addition, a default, if not cured or waived, may permit the acceleration of our other indebtedness. (26,130 ) 192,138 26,544 192,552 Member's equity: Contributed capital 116,060 64,417 40,879 (105,296 ) 116,060 Accumulated deficit (71,708 ) (43,671 ) (12,002 ) 55,673 (71,708 ) Accumulated other comprehensive loss (14,831 ) (26,130 ) 192,138 26,544 192,552 Member's equity: Contributed capital 116,060 64,417 40,879 (105,296 ) 116,060 Accumulated deficit (71,708 ) (43,671 ) (12,002 ) 55,673 (71,708 ) Accumulated other comprehensive loss (14,831 ) David F. Myers, Jr. Executive Vice President, Secretary, and Chief Financial Officer 2211 York Road, Suite 215 Oak Brook, Illinois 60523 Telephone: (630) 572-5715 (Name, address, including zip code, and telephone number, including area code, of agent for service) Despite current indebtedness levels, we may still be able to incur substantially more debt. This could further exacerbate the risks described above. We and our subsidiaries may be able to incur substantial additional indebtedness in the future. The terms of the indenture governing the notes do not fully prohibit us or our subsidiaries from doing so. As of December 31, 2003 our senior credit facility permited borrowings of up to $30 million and C$10 million and revolving credit facilities at our European subsidiaries permitted borrowings of up to 3.1 million and borrowings under these revolving credit facilities would rank senior to the notes and the subsidiary guarantees. If new debt is added to our current debt levels, the related risks that we now face could intensify. To service our indebtedness, we require a significant amount of cash, the availability of which depends on many factors beyond our control. If we cannot service our indebtedness, we may not be able to satisfy our obligations under the notes. Our ability to make payments on and to refinance our indebtedness, including the notes, and to fund planned capital expenditures will depend on our ability to generate cash in the future from our operations. Our ability to generate cash is, to a certain extent, subject to general economic, financial, competitive, legislative, regulatory and other factors that are beyond our control. Our business may not generate sufficient cash flow from operations and future borrowings may not be available to us under our senior credit facility in an amount sufficient to enable us to pay our indebtedness, including the notes, or to fund our other liquidity needs. As of December 31, 2003, the current portion (due within one year) of our debt service payments, which includes principal and interest, was approximately $23.5 million. We intend to service these obligations through our future cash flows from operations. If our future cash flow from operations and other capital resources are insufficient to pay our obligations as they mature or to fund our liquidity needs, we may be forced to reduce or delay our business activities and capital expenditures, sell assets, obtain additional equity capital or restructure or refinance all or a portion of our debt, including the notes, on or before maturity. We may not be able to refinance any of our indebtedness, including our senior credit facility and the notes, on satisfactory terms or at all. NSP conducts a substantial portion of its operations through subsidiaries, and NSP's subsidiaries are not obligated to make distributions to NSP to service the notes. NSP's subsidiaries conduct a substantial portion of its operations and own a substantial portion of its assets. NSP's cash flow and its ability to meet its debt service obligations depend upon the cash flow of its subsidiaries and the payment of funds by its subsidiaries in the form of loans and dividends. NSP's subsidiaries are not obligated to make distributions to NSP to service the notes. In addition, the ability of its subsidiaries to make payments to it will depend on their earnings, the terms of their debt, business and tax considerations and legal restrictions. NSP's foreign subsidiaries are not subsidiary guarantors, and as a result, any right of NSP to participate in any distribution of assets of its foreign subsidiaries upon liquidation or otherwise will be subject to the prior claims of its foreign subsidiaries' creditors. The subsidiary guarantors include only NSP's domestic direct and indirect subsidiaries. However, our historical consolidated financial information and the pro forma consolidated financial information included in this prospectus are presented on a consolidated basis, including both our domestic and foreign subsidiaries. The aggregate net sales and operating income of our subsidiaries that are not subsidiary guarantors were $82.1 million and $6.0 million, respectively, for the year ended December 31, 2002 and $78.0 million and $7.3 million, respectively, for the nine months ended September 27, 2003 and their consolidated tangible assets at September 27, 2003 were $76.6 million. In 9. Lease Commitments The Company leases certain facilities and equipment under various noncancelable operating lease agreements. Future minimum lease payments under noncancelable operating leases as of December 31, 2002, are as follows: 2003 23 2004 Copies to: Dennis M. Myers, P.C. Kirkland & Ellis LLP 200 E. Randolph Drive Chicago, Illinois 60601 Telephone: (312) 861-2000 * The Co-Registrants listed on the next page are also included in this Form S-4 Registration Statement as additional Registrants. The Co-Registrants are the direct and indirect domestic subsidiaries of the Registrant and the guarantors of the notes to be registered hereby. Approximate date of commencement of proposed sale of the securities to the public: The exchange will occur as soon as practicable after the effective date of this Registration Statement. If the securities being registered on this Form are being offered in connection with the formation of a holding company and there is compliance with General Instruction G, check the following box. If this form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. If this form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. CALCULATION OF REGISTRATION FEE addition, the notes are effectively subordinated to all existing and future liabilities (including trade payables) of our non-guarantor subsidiaries. As of December 31, 2003, our non-guarantor subsidiaries had $19.8 million of indebtedness and other liabilities (including trade payables). As a result, any right of NSP to participate in any distribution of assets of its non-guarantor subsidiaries upon the liquidation, reorganization or insolvency of any such subsidiary (and the consequential right of the holders of the notes to participate in the distribution of those assets) will be subject to the prior claims of such subsidiaries' creditors. The indenture for the notes restricts our ability and the ability of most of our subsidiaries to engage in some business and financial transactions. Our failure to comply may result in an event of default under the indenture. The indenture for the notes, among other things, restricts our ability and the ability of our restricted subsidiaries to, among other things: incur additional debt or issue preferred stock; pay dividends and make distributions on, or redeem or repurchase, capital stock; issue stock of subsidiaries; make investments; create liens; enter into transactions with affiliates; enter into sale-leaseback transactions; merge or consolidate; and transfer and sell assets. Our failure to comply with obligations under the indenture for the notes may result in an event of default under the indenture. A default, if not cured or waived, may permit acceleration of our other indebtedness. We may not have funds available to remedy these defaults. If our indebtedness is accelerated, we may not have sufficient funds available to pay the accelerated indebtedness or the ability to refinance the accelerated indebtedness on terms favorable to us or at all. Your right to receive payments on the notes is junior to our senior indebtedness and possibly all of our future borrowings. Further, the guarantees of the notes are junior to all of our guarantors' senior indebtedness and all their future borrowings. The notes and the subsidiary guarantees rank behind all of our and our subsidiary guarantors' senior indebtedness (other than trade payables) and all of our and their future borrowings (other than trade payables), except any future indebtedness that expressly provides that it ranks equal with, or subordinated in right of payment to, the notes and the guarantees. In addition, the notes are structurally subordinated to indebtedness and other liabilities of our subsidiaries which are not guaranteeing the notes. As a result, upon any distribution to our creditors or the creditors of the guarantors in a bankruptcy, liquidation or reorganization or similar proceeding relating to us or the guarantors or our or their property, the holders of our senior debt and the guarantors' senior debt will be entitled to be paid in full in cash before any payment may be made with respect to the notes or the subsidiary guarantees. In the event of a bankruptcy, liquidation or reorganization or similar proceeding relating to us or the guarantors, holders of the notes will participate with trade creditors and all other holders of our and the guarantors' subordinated indebtedness in the assets remaining after we and the subsidiary Title of Each Class of Securities to be Registered Proposed Maximum Aggregate Offering Price Amount of Registration Fee guarantors have paid all of our senior debt. However, because the indenture requires that amounts otherwise payable to holders of the notes in a bankruptcy or similar proceeding be paid to holders of senior debt instead, holders of the notes may receive less, ratably, than holders of trade payables in any such proceeding. In any of these cases, we and the subsidiary guarantors may not have sufficient funds to pay all of our creditors and holders of notes may receive less, ratably, than the holders of our senior debt. As of December 31, 2003, the notes and the subsidiary guarantees were subordinated to $101.4 million of senior debt, and we had approximately $41.6 million of additional borrowing capacity under our senior revolving credit facilities. We will be permitted to borrow substantial additional indebtedness, including senior debt, in the future under the terms of the indenture. The notes are not secured by any assets, while our obligations under the senior credit facility are secured by liens on substantially all of our assets. Under certain circumstances, note holders may receive less, ratably, than holders of our senior debt. The notes are not secured by any collateral. However, our obligations under the senior credit facility are secured by liens on substantially all of our assets. Therefore, in a bankruptcy, liquidation or reorganization or similar proceeding relating to us or the guarantors, or our or their property, holders of the notes and all other holders of our and the guarantors' senior subordinated indebtedness will participate in the assets remaining after we and the subsidiary guarantors have paid all of our senior debt. In any of these cases, we and the subsidiary guarantors may not have sufficient funds to pay all of our creditors and the holders of notes may receive less, ratably, than the holders of our senior debt. We may not have the ability to raise the funds necessary to finance the change of control offer required by the indenture. Upon the occurrence of certain specific kinds of change of control events, we will be required to offer to repurchase all outstanding notes at 101% of their principal amount plus accrued and unpaid interest and liquidated damages, if any, to the date of repurchase. However, it is possible that we will not have sufficient funds at the time of the change of control to make any required repurchases or that restrictions in our senior credit facility will not allow such repurchases. A change in control of the Company can be the basis for the declaration of an event of default under our senior credit agreement, which, if not waived, accelerates our obligations under the credit agreement and, under the terms of the indenture, we would be prohibited from making, and the trustee from accepting, any payment with respect to the notes until the senior indebtedness was paid in full. If we do not repay all borrowings under our senior credit facility or obtain a consent of our lenders under our senior credit facility to repurchase the notes, we will be prohibited from purchasing the notes. Our failure to purchase tendered notes would constitute a default under the indenture governing the notes, which, in turn, would constitute a default under our senior credit facility. In addition to the outstanding notes as of December 31, 2003 we had $105.7 million of indebtedness outstanding that is payable in full at the option of the payees upon a change of control. Also, we could in the future enter into transactions, including acquisitions, refinancings or other recapitalizations or highly leveraged transactions, that would not constitute a change of control under the indenture, but that could increase the amount of indebtedness outstanding at such time or adversely affect our capital structure or credit ratings. See "Description of the Notes Change of Control Offer." Balance at January 1, 2001 4,602 2,666 7,268 Foreign currency translation adjustments 9 Net cash used in financing activities (219 ) (801 ) Effect of exchange rate changes on cash 97/8 Senior Subordinated Notes due 2011 $152,500,000 (1) The senior credit facility contains certain restrictive covenants, including leverage and interest coverage ratios. If we fail to comply with these financial covenants, a default could be declared, and the senior lenders could accelerate our repayment obligations. The senior credit facility contains certain restrictive covenants, including covenants that require us to maintain certain financial ratios. Those ratios include: a fixed charge coverage ratio of EBITDA less capital expenditures over fixed charges for the period, an interest coverage ratio of EBITDA over interest expense for the period, a senior leverage ratio of senior debt over EBITDA for the period, and a total leverage ratio of total debt over EBITDA for the period. The specific ratios we are required to maintain change over time. If we fail to maintain these ratios and the failure is not cured, the senior lenders could declare a default under the credit agreement, accelerate our payment obligations and foreclose on our assets. A foreclosure would make it extremely difficult for us to operate as a going concern. In addition, a default, if not cured or waived, may permit the acceleration of our other indebtedness. We may not have funds available to remedy these defaults. If our indebtedness is accelerated, we may not have sufficient funds available to pay the accelerated indebtedness or the ability to refinance the accelerated indebtedness on terms favorable to us or at all. Federal and state statutes allow courts, under specific circumstances, to void guarantees and require note holders to return payments received from guarantors. Under the federal bankruptcy law and comparable provisions of state fraudulent transfer laws, a guarantee could be voided, or claims in respect of a guarantee could be subordinated to all other debts of that guarantor if, among other things, the guarantor, at the time it incurred the indebtedness evidenced by its guarantee received less than reasonably equivalent value or fair consideration for the incurrence of such guarantee; and was insolvent or rendered insolvent by reason of such incurrence; or was engaged in a business or transaction for which the guarantor's remaining assets constituted unreasonably small capital; or intended to incur, or believed that it would incur, debts beyond its ability to pay such debts as they matured. In addition, any payment by that guarantor pursuant to its guarantee could be voided and required to be returned to the guarantor, or to a fund for the benefit of the creditors of the guarantor. The measures of insolvency for purposes of these fraudulent transfer laws will vary depending upon the law applied in any proceeding to determine whether a fraudulent transfer has occurred. Generally, however, a guarantor would be considered insolvent if: the sum of its debts, including contingent liabilities, were greater than the fair saleable value of all of its assets; or the present fair saleable value of its assets was less than the amount that would be required to pay its probable liability on its existing debts, including contingent liabilities, as they became absolute and mature; or it could not pay its debts as they became due. On the basis of historical financial information, recent operating history and other factors, we believe that each guarantor, after giving effect to its guarantee of the notes, will not be insolvent, will not have unreasonably small capital for the business in which it is engaged and will not have incurred debts beyond its ability to pay such debts as they mature. We cannot predict with certainty, however, 2,580 2,449 Members' equity: Contributed capital 4,602 4,602 Retained earnings 3,525 4,563 Accumulated other comprehensive income 9 Balance at December 31, 2002 4,602 4,563 Guarantees on Senior Subordinated Notes (2) (3) what standard a court would apply in making these determinations or whether a court would agree with our conclusions in this regard. You should not rely on Norcross Capital in evaluating an investment in the notes. Norcross Capital was formed in connection with the offering of the outstanding notes and has no assets and no operations and is prohibited from engaging in any business activities, except in connection with the issuance of the notes. You should therefore not rely upon Norcross Capital in evaluating whether to invest in the notes. Risks Relating to our Business If we are unable to retain senior executives and other qualified professionals our growth may be hindered, which could negatively impact our results of operations and our ability to make payments on the notes. Our success depends in part on our ability to attract, hire, train and retain qualified managerial, sales and marketing personnel. Competition for these types of personnel is intense. We may be unsuccessful in attracting and retaining the personnel we require to conduct and expand our operations successfully. Our results of operations could be materially and adversely affected if we are unable to attract, hire, train and retain qualified personnel. Our success also depends to a significant extent on the continued service of our management team. The loss of any member of the management team could have a material adverse effect on our business, results of operations and financial condition. The markets in which we compete are highly competitive, and some of our competitors have greater financial and other resources than we do. The competitive pressures faced by us could materially and adversely affect our business, results of operations and financial condition. The personal protection equipment market is highly competitive, with participants ranging in size from small companies focusing on single types of safety products, to large multinational corporations which manufacture and supply many types of safety products. Our main competitors vary by region and product. We believe that participants in this industry compete primarily on the basis of product characteristics (such as functional performance, design and style), price, brand name recognition and service. Some of our competitors have greater financial and other resources than we do and our cash flows from operations could be adversely affected by competitors' new product innovations and pricing changes made by us in response to competition from existing or new competitors. Individual competitors have advantages and strengths in different sectors of the industry, in different products and in different areas, including manufacturing and distribution systems, geographic market presence, customer service and support, breadth of product, delivery time and price. We may not be able to compete successfully against current and future competitors and the competitive pressures faced by us could materially and adversely affect our business, results of operations and financial condition. See "Business Competition." Many of our products are subject to existing regulations and standards, changes in which could materially and adversely affect our results of operations. Our net sales may be materially and adversely affected by changes in safety regulations and standards covering industrial workers, firefighters and utility workers in the United States and Canada, including safety regulations of OSHA and standards of the NFPA, ANSI and ASTM. Our net sales could also be adversely affected by a reduction in the level of enforcement of such regulations. Changes in regulations could reduce the demand for our products or require us to reengineer our products, thereby creating opportunities for our competitors. (1)Pursuant to Rule 457(q) under the Securities Act of 1933, as amended, no filing fee is required for the registration of an indeterminate amount of securities to be offered solely for market-making purposes by an affiliate of the registrant. (2)All subsidiary guarantors are wholly owned direct or indirect subsidiaries of the Registrant and have guaranteed the Notes being registered. (3)Pursuant to Rule 457(n), no separate fee is payable with respect to the guarantees being registered hereby. A reduction in the spending patterns of government agencies could materially and adversely affect our net sales. We sell a significant portion of our products in the United States and Canada to various governmental agencies. In addition, a portion of our products are sold to government agencies through fixed price contracts awarded by competitive bids submitted to state and local agencies. Many of these governmental agency contracts are awarded on an annual basis. Accordingly, notwithstanding our long-standing relationship with various governmental agencies, we may lose our contracts with such agencies to lower bidders in the competitive bid process. Moreover, the terms and conditions of such sales and the government contract process are subject to extensive regulation by various federal, state and local authorities in the United States and Canada. In most markets in which we compete, there are frequent introductions of new products and product line extensions. If we fail to introduce successful new products, we may lose market position and our financial performance may be negatively impacted. If we are unable to identify emerging consumer and technological trends, maintain and improve the competitiveness of our products and introduce these products on a global basis, we may lose market position, which could have a material adverse effect on our business, financial condition and results of operations. Continued product development and marketing efforts have all the risks inherent in the development of new products and line extensions, including development delays, the failure of new products and line extensions to achieve anticipated levels of market acceptance and the cost of failed product introductions. Our international operations are subject to various uncertainties and a significant reduction in international sales of our products could have a material adverse effect on our results of operations. Our international operations are subject to various political, economic and other uncertainties which could adversely effect our business. A significant reduction of our international business due to any of these risks would adversely affect our revenues. In 2002, approximately 25% of our net sales were outside the United States. These risks include: unexpected changes in regulatory requirements; currency exchange rate fluctuations; changes in trade policy or tariff regulations; customs matters; longer payment cycles; higher tax rates and potentially adverse tax consequences, including restrictions on repatriating earnings and the threat of "double taxation"; additional tax withholding requirements; intellectual property protection difficulties; difficulty in collecting accounts receivable; complications in complying with a variety of foreign laws and regulations, many of which conflict with United States laws; costs and difficulties in integrating, staffing and managing international operations; and strains on financial and other systems to properly administer VAT and other taxes. Income before income taxes and minority interest 1,788 1,969 134 3,891 Income tax expense (benefit) 1,972 769 (162 )(7) 2,579 Minority interest (1 ) 13 586 Income before income taxes and minority interest 1,242 1,779 Income tax expense 508 694 Minority interest 5 The Registrant and the Co-Registrants hereby amend this Registration Statement on such date or dates as may be necessary to delay its effective date until the Registrant and the Co-Registrants shall file a further amendment which specifically states that this Registration Statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933 or until this Registration Statement shall become effective on such date as the Commission, acting pursuant to said Section 8(a), may determine. In addition, foreign operations involve uncertainties arising from local business practices, cultural considerations and international political and trade tensions. For example, in 2002, we recorded a non-cash impairment charge with regard to, our Zimbabwe subsidiary due to adverse economic and political conditions. In addition, a portion of our manufacturing and outsourcing relationships involve China. If we are unable to successfully manage the risks associated with expanding our global business or to adequately manage operational fluctuations internationally, it could have a material adverse effect on our business, financial condition or results of operations. We may incur restructuring or impairment charges that would reduce our earnings. We have in the past and may in the future restructure some of our operations, including our recently acquired subsidiaries. In such circumstances, we may take actions that would result in a charge related to discontinued operations, thereby reducing our earnings. These restructurings have or may be undertaken to realign our subsidiaries, eliminate duplicative functions, rationalize our operating facilities and products, and reduce our staff. For the year ended December 31, 2002, we recorded restructuring charges of approximately $9.3 million related to a restructuring plan to exit certain manufacturing facilities and move certain hand operations to China. Additionally, on January 1, 2002 we adopted Statement of Financial Accounting Standards (SFAS) No. 142, "Goodwill and Other Intangible Assets," which requires that goodwill and intangible assets that have an indefinite useful life be tested at least annually for impairment. We carry a very significant amount of goodwill and intangible assets and SFAS No. 142 requires us to perform an annual assessment for possible impairment. As of September 27, 2003, we had goodwill of approximately $134.5 million. We do not anticipate that our goodwill will be impaired for the year ended December 31, 2003. If we determine our goodwill to be impaired, the resulting non-cash charge could be substantial. We may be unable to successfully execute or effectively integrate acquisitions, including our acquisition of KCL, which may adversely affect our results of operations. One of our key operating strategies is to selectively pursue acquisitions. Acquisitions, including our acquisition of KCL, involve a number of risks including: failure of the acquired businesses to achieve the results we expect; diversion of our management's attention from operational matters; our inability to retain key personnel of the acquired businesses; risks associated with unanticipated events or liabilities; the potential disruption of our existing business; and customer dissatisfaction or performance problems at the acquired businesses. If we are unable to integrate or successfully manage KCL or any other business that we may acquire in the future, we may not realize anticipated cost savings, improved manufacturing efficiencies and revenue growth, which may result in reduced profitability or operating losses. In addition, we expect to face competition for acquisition candidates, which may limit the number of our acquisition opportunities and may lead to higher acquisition prices. Moreover, acquisitions of businesses may require additional debt financing, resulting in additional leverage. The covenants in our senior credit facility and the indenture may further limit our ability to complete acquisitions. The realization of all or any of the risks described above could materially and adversely affect our reputation and our results of operations. Net cash provided by (used in) financing activities 11,986 (8,669 ) 21,316 24,633 Effect of exchange rate changes on cash 3,179 Our continued success depends on our ability to protect our intellectual property. If we are unable to protect our intellectual property, our sales could be materially and adversely affected. Our success depends, in part, on our ability to obtain and enforce patents, maintain trade secret protection and operate without infringing on the proprietary rights of third parties. We have been issued patents and have registered trademarks with respect to many of our products, but our competitors could independently develop similar or superior products or technologies, duplicate any of our designs, trademarks, processes or other intellectual property or design around any processes or designs on which we have or may obtain patents or trademark protection. In addition, it is possible that third parties may have or acquire licenses for other technology or designs that we may use or desire to use, so that we may need to acquire licenses to, or to contest the validity of, such patents or trademarks of third parties. Such licenses may not be made available to us on acceptable terms, if at all, and we may not prevail in contesting the validity of third party rights. In addition to patent and trademark protection, we also protect trade secrets, know-how and other confidential information against unauthorized use by others or disclosure by persons who have access to them, such as our employees, through contractual arrangements. These agreements may not provide meaningful protection for our trade secrets, know-how or other proprietary information in the event of any unauthorized use, misappropriation or disclosure of such trade secrets, know-how or other proprietary information. If we are unable to maintain the proprietary nature of our technologies, our sales could be materially adversely affected. See "Business Intellectual Property." We do not have long-term contracts with many of our customers and they may terminate their relationship with us at any time, which could have a material adverse effect on our operating results. A significant portion of our contracts are not long-term contacts and are terminable at will by either party. If a significant number of our customers choose to terminate their contracts or to not renew their contracts with us upon expiration, it would have a material adverse effect on our business, financial condition and results of operations. We face an inherent business risk of exposure to product liability claims which could have a material adverse effect on our operating results. We face an inherent business risk of exposure to product liability claims arising from the claimed failure of our products to prevent the types of personal injury or death against which they are designed to protect. We have not experienced any material uninsured losses due to product liability claims, but it is possible that we could experience material losses in the future. In particular, our North Safety Products subsidiary, its predecessors and/or the former owners of such business are presently named as a defendant in approximately 670 lawsuits involving respirators manufactured and sold by it or its predecessors. We are also monitoring an additional 10 lawsuits in which we feel that North Safety Products, its predecessors and/or the former owners of such businesses may be named as defendants. Collectively, these 680 lawsuits represent a total of approximately 32,000 plaintiffs. Approximately 88% of these lawsuits involve plaintiffs alleging they suffer from silicosis, with the remainder alleging they suffer from other or combined injuries, including asbestosis. These lawsuits typically allege that these conditions resulted in part from respirators that were negligently designed or manufactured. Invensys plc ("Invensys"), formerly Siebe plc, is contractually obligated to indemnify us for any losses, including costs of defending claims, resulting from respiratory products manufactured prior to our acquisition of North Safety Products in October 1998. In addition, our North Safety Products subsidiary is contractually entitled to indemnification from Norton Company, an affiliate of Saint-Gobain, which owned the North Safety Products business prior to Invensys. Pursuant to a December 14, 1982 asset purchase agreement, Siebe Norton, Inc., a newly formed wholly-owned subsidiary of Norton Company, acquired the assets of Norton's Safety Products (1)Through December 2, 2003. Plaintiffs have asserted specific dollar claims in less than a quarter of the approximately 670 cases pending as of December 2, 2003 in which North Safety Products, its predecessors and/or the former owners of such businesses have been named as defendants. A majority of cases prohibit specifying damages in tort cases such as these, and most of the remaining jurisdictions do not require such specification. In those cases in which plaintiffs choose to assert specific dollar amounts in their complaints, brought in states that permit such pleading, the amounts claimed are typically not meaningful as an indicator of a company's potential liability. This is because (1) the amounts claimed typically bear no relation to the level of the plaintiff's injury, (2) the complaints typically assert claims against numerous defendants, and (3) many cases are brought on behalf of plaintiffs who have not suffered any medical injury, and, ultimately, are resolved without any payment or payment of a small fraction of the damages initially claimed. Of the 668 complaints maintained in our records, 506 do not Exact Name of Additional Registrants* specify the amount of damages sought, 1 generally alleges damages less than $50,000, 31 generally allege damages in excess of $50,000, 3 allege compensatory damages in excess of $50,000 and an unspecified amount of punitive damages, 26 allege compensatory damages and punitive damages, each in excess of $25,000, 8 generally allege damages in excess of $100,000, 51 allege compensatory damages and punitive damages, each in excess of $50,000, 37 generally allege damages of $15.0 million, 4 allege compensatory damages and punitive damages, each in the amount of $15.0 million and one alleges damages not to exceed $290.0 million. We currently do not have access to the complaints with respect to the additional approximately 2 cases that were pending as of December 2, 2003 in which North Safety Products, its predecessors and/or the former owners of such businesses have been named as defendants, or the previously mentioned 10 additional cases we are monitoring, and therefore do not know whether these cases allege specific damages, and, if so, the amount of such damages, but are in the process of seeking to obtain such information. Due to the reasons noted above and to the indemnification arrangements benefiting the Company, we do not believe that the damage amounts specified in these complaints are a meaningful factor in any assessment of the Company's potential liability. Bankruptcy filings of companies with asbestos and silica-related litigation could increase our cost over time. If we were found liable in these cases and either Invensys or Norton Company failed to meet their indemnification obligations to us or the suit involved products manufactured by us after our October 1998 acquisition of North Safety Products, it would have a material adverse effect on our business. For more information, see "Business Legal Proceedings." Also, in the event any of our products prove to be defective, we could be required to recall or redesign such products. We maintain insurance against product liability claims (with the exception of asbestosis and silicosis cases, for which coverage is not commercially available), but it is possible that our insurance coverage will not continue to be available on terms acceptable to us or that such coverage will not be adequate for liabilities actually incurred. A successful claim brought against us in excess of available insurance coverage, or any claim or product recall that results in significant expense or adverse publicity against us, could have a material adverse effect on our business, operating results and financial condition. We are subject to various environmental laws and any violation of these laws could adversely effect our results of operations. We are subject to federal, state and local laws, regulations and ordinances relating to the protection of the environment, including those governing discharges to air and water, handling and disposal practices for solid and hazardous wastes, and the maintenance of a safe workplace. These laws impose penalties for noncompliance and liability for response costs and certain damages resulting from past and current spills, disposals or other releases of hazardous materials. We could incur substantial costs as a result of noncompliance with or liability for cleanup pursuant to these environmental laws. We have identified three potential environmental liabilities, though we do not believe they are material. See "Business Environmental Matters." Environmental laws have changed rapidly in recent years, and we may be subject to more stringent environmental laws in the future. If more stringent environmental laws are enacted, these future laws could have a material adverse effect on our results of operations. The interests of our controlling equityholders could conflict with those of the holders of the notes. We are a wholly owned subsidiary of NSP Holdings. Equityholders of NSP Holdings that individually hold greater than 5% of a class of its voting securities, taken as a group, hold a total of 79.9% of its outstanding voting equity. See "Principal Equityholders." Pursuant to NSP Holdings' Amended and Restated Limited Liability Company Agreement, as amended, Argosy-Safety Products L.P. has the right to appoint three of the possible six members of Holdings' board of managers. These appointees have the authority to make decisions affecting our capital structure, including the issuance Jurisdiction of Formation of additional indebtedness and the making of distributions. Argosy-Safety Products L.P.'s limited partners include individuals who are employees of CIBC. NSP Holdings' Amended and Restated Limited Liability Company Agreement may be amended by the vote of the holders of the majority of its voting equity, so long as the amendment is also approved by John Hancock Life Insurance Company and Hancock Mezzanine Partners L.P., on the one hand, and Argosy, CIBC and CIBC's affiliates, on the other hand. Therefore, these entities, acting together, have sufficient voting power to amend NSP Holdings' Amended and Restated Limited Liability Company Agreement. Entities associated with some of our principal equityholders are lenders under our senior credit facilities. These entities may lend to us on a senior basis in the future. NSP Holdings' principal equityholders may pursue transactions that could enhance their investments while involving risks to your interests. The interests of these entities could conflict with the interests of the holders of the notes. I.R.S. Employer Identification No.
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+RISK FACTORS An investment in our shares involves a high degree of risk. Before making an investment decision, you should carefully consider all of the risks described in this prospectus. If any of the risks discussed in this prospectus actually occur, our business, financial condition and results of operations could be materially and adversely affected. If this were to happen, the price of our shares could decline significantly and you may lose all or a part of your investment. Risks Related to our Business We have a limited operating history. If we are unable to implement our business strategy or operate our business as we currently expect, our results may be adversely affected. We were organized on May 23, 2003 and began our business operations after the closing of the Private Offering on September 3, 2003. Because we only recently commenced operations, we are just beginning to develop name recognition and a reputation in the insurance and reinsurance industry. Businesses, such as ours, that are starting up or in their initial stages of development, present substantial business and financial risks and may suffer significant losses. We must hire and retain additional key employees and other staff, develop and maintain business relations, continue to establish operating procedures, obtain additional facilities, implement new systems, obtain approvals from insurance regulatory agencies or organizations and complete other tasks necessary for the conduct of our intended business activities. If we are unable to implement these actions in a timely manner, our results may be adversely affected. As a result of industry factors or factors specific to us, we have altered and may continue to alter our methods of conducting our business, such as the nature, amount and types of risks we assume and the terms and limits of the products we write or intend to write. A future downgrade in our rating from A.M. Best would materially and adversely affect our competitive position. Competition in the types of insurance and reinsurance business that we intend to underwrite and reinsure are based on many factors, including the perceived financial strength of the insurer and ratings assigned by independent rating agencies. A.M. Best Company, Inc., or A.M. Best, is generally considered to be a significant rating agency with respect to the evaluation of insurance and reinsurance companies. Its ratings are based on a quantitative evaluation of a company's performance with respect to profitability, leverage and liquidity and a qualitative evaluation of spread of risk, investments, reinsurance programs, reserves and management. In addition, its rating of us took into consideration the fact that we have recently commenced our operations. Insurance ratings are used by customers, brokers, reinsurers and reinsurance intermediaries as an important means of assessing the financial strength and quality of insurers. In addition, the rating of a company seeking reinsurance, also known as a ceding company, may be adversely affected by the lack of a rating of its reinsurer. Therefore, the lack of a rating or a poor rating will dissuade a ceding company from reinsuring with us and will influence a ceding company to reinsure with a competitor of ours. Numerous insurers and reinsurers have been downgraded since September 11, 2001, and numerous ratings agencies have kept the reinsurance industry on negative outlook after many reinsurers posted disappointing 2002 and semi-annual 2003 results. We have received a rating of "A–" (excellent) from A.M. Best, which is the fourth highest of fifteen rating levels and indicates A.M. Best's opinion of our financial strength and ability to meet ongoing obligations to our future policyholders. We cannot assure you that we will be able to maintain this rating. A significant ratings downgrade would result in a substantial loss of business and business opportunities as insureds and ceding companies purchase insurance or reinsurance from companies with higher claims-paying and financial strength ratings instead of from us. For further discussion, see "Industry Background — Recent Industry Developments — Ratings Decline." We are dependent on our key executives and may not be able to hire and retain key employees or successfully integrate our management team. Our success will depend largely on our senior management, which includes, among others, Tobey J. Russ, our chairman and chief executive officer, and Michael J. Murphy, our deputy chairman and chief operating officer. We have employment agreements with Messrs. Russ and Murphy for employment through September 2008, which include non-competition obligations. Further, we have an arrangement with David R. Whiting, who manages our Bermuda-based reinsurance operations, for employment through September 2005. While we also have employment arrangements with John S. Brittain, Jr., our chief financial officer, and Gary G. Wang, our chief risk officer, and other key employees, many of them presently do not have non-competition or non-solicitation agreements with us. Therefore, these other executive officers and key employees may voluntarily terminate their employment with us at any time and are not restricted from seeking employment with our competitors or others who may seek their expertise. We do not currently maintain key man life insurance policies with respect to any of our employees other than a $10 million policy on the life of Mr. Murphy that we acquired in the ESC acquisition. While we have assembled a core group of underwriting officers, underwriters and other professionals to write insurance and reinsurance policies, we must attract and retain additional experienced underwriters, claims personnel, actuarial staff and risk analysis and modeling personnel in order to successfully operate and grow our businesses. We will continue to pursue hiring additional executives or other personnel, individually or in groups, from other companies in the insurance and reinsurance industry. For example, we are presently conducting a search for a permanent President of U.S. Insurance to replace Kevin J. McHugh, who served as Interim President of U.S. Insurance from September 2003 until his resignation on March 31, 2004. The number of available, qualified personnel in the insurance and reinsurance industry to fill these positions may be limited. Companies with qualified candidates may have agreements that restrict those persons and our existing employees from soliciting or hiring their employees and working for competitors and may seek to retain, or prevent us from hiring, their executives and other personnel. We cannot assure you that we will be successful in hiring executives or other personnel. In particular, we cannot assure you that we will be able to successfully employ any qualified candidate who is subject to these restrictions or whose employer seeks to prevent us from hiring them or that we will not incur any liability in connection with our hiring, or attempting to hire, such executives or other personnel. For an example, see the description of our settlement of claims made by CNA against some of our employees and against Thomas F. Taylor, one of our former executive officers, in "Business — Legal Proceedings." Our ability to implement our business strategy will depend on the retention and successful integration of our management team and other personnel. Our inability to attract, integrate and retain members of our management team, key employees and other personnel could delay or prevent us from fully implementing our business strategy and could significantly and negatively affect our business. Further, although we are not aware of any planned departures or retirements, if we were to lose the services of our senior executives or key employees, our business could be materially and adversely affected. We cannot assure you that we will successfully attract, retain and integrate our executives, key employees and other personnel. We will require additional capital in the future, which may not be available on favorable terms or at all. We will need to raise additional funds through financings in order to fully implement our business plan. We will require additional capital because some of the markets in which we intend to sell specialty insurance require higher capital levels than the capital we have currently available. We may also require additional funds to acquire other businesses or groups of underwriters or other personnel. The amount and timing of these capital requirements will depend on many factors, including our ability to write new business successfully in accordance with our expectations and to establish premium rates and reserves at levels sufficient to cover our losses. At this time, we are not able to quantify the amount of additional capital we will require in the future or predict the timing of our future capital needs. We intend for us or one or more of our subsidiaries to enter into a secured bank letter of credit and revolving credit facility with a syndicate of lenders. However, we currently have no commitment from any lender with respect to a credit facility. Any equity or debt financing, if available at all, may be on terms that are not favorable to us. If we are able to raise capital through equity financings, your interest in our company would be diluted, and the securities we issue may have rights, preferences and privileges that are senior to the shares offered under this prospectus. If we cannot obtain adequate capital, our business, financial condition and results of operations will be adversely affected. Our future performance cannot be predicted based on the financial information included in this prospectus. As a newly formed company, we have a limited operating history to base an estimate of our future earnings prospects. We are presenting in this prospectus our unaudited pro forma financial statements after giving effect to the acquisition of ESC and the NFU Standard acquisition as if they had occurred as of January 1, 2003. Additionally, this prospectus includes the consolidated historical financial statements of Quanta Holdings, ESC and NFU Standard. The present operating results of ESC, our predecessor, are intended to be only a small portion of our consolidated business in the future, and the business of ESC is not representative of or comparable with our primary business strategy. Additionally, the historical activity of NFU Standard is not indicative of future results since NFU is retaining NFU Standard's historical business other than statutory deposits. Further, because we have only recently commenced our operations, the historical financial results of Quanta Holdings will not provide a meaningful indication of our future performance. As a result, the historical financial information and unaudited pro forma financial information of ESC and NFU Standard presented in this prospectus are not comparable with or representative of the results that we expect to achieve in future periods and will not be helpful in deciding whether to invest in our shares. When purchasing our shares you cannot rely on the pro forma and historical financial information of Quanta Holdings, ESC and NFU Standard in this prospectus to form a meaningful basis on which to assess the value of an investment in Quanta Holdings. We compete with a large number of companies in the insurance and reinsurance industry for underwriting revenues. We compete with a large number of other companies in our selected lines of business. We compete with major insurers and reinsurers, such as ACE Limited ("ACE"), American International Group, Inc. ("AIG"), CNA Financial Corporation ("CNA"), The Chubb Corporation ("Chubb"), XL Capital Ltd., Arch Capital Group Ltd., Swiss Reinsurance Company, Berkshire Hathaway Inc., Munich Re Group, Travelers Property Casualty Corp. ("Travelers") and The St. Paul Companies ("St. Paul") and other new Bermuda insurers and reinsurers, such as Endurance Specialty Holdings Ltd., Axis Capital Holdings Limited, Allied World Assurance Company, Ltd., Platinum Underwriters Holdings, Ltd. and Montpelier Re Holdings Ltd. These insurers and reinsurers have more capital than we have, offer the lines of insurance and reinsurance that we offer or will offer, target the same markets as we do and utilize similar business strategies. We face competition both from specialty insurance companies, underwriting agencies and intermediaries, as well as diversified financial services companies. In addition, newly formed and existing insurance industry companies have recently raised capital to meet perceived demand in the current environment and address underwriting capacity issues. Other newly formed and existing insurance companies may also be preparing to enter the same market segments in which we compete or raise new capital. Since we have a limited operating history, many of our competitors have greater name and brand recognition than we have. Many of them also have more (in some cases substantially more) capital and greater marketing and management resources than we have and may offer a broader range of products and more competitive pricing than we expect to, or will be able to, offer. While we believe our unencumbered capital base, our experienced management team, our technical expertise and other elements of our business strategy will allow us to be competitive, we cannot assure you that we will be able to timely or effectively implement these strategies in a manner that will generate returns on capital superior to those of our competitors. Our competitive position is based on many factors, including our perceived financial strength, ratings assigned by independent rating agencies, geographic scope of business, client relationships, premiums charged, contract terms and conditions, products and services offered (including the ability to design customized programs), speed of claims payment, reputation, experience and qualifications of employees and local presence. Since we have recently commenced operations, we may not be able to compete successfully on many of these bases. If competition limits our ability to write new business at adequate rates, our return on capital may be adversely affected. A number of new, proposed or potential industry developments could further increase competition in our industry. These developments include: an increase in capital-raising activities by companies in our lines of business, which could result in additional new entrants to our markets and an excess of capital in the industry; programs in which state-sponsored entities provide property insurance in catastrophe-prone areas or other "alternative markets" types of coverage; and changing practices caused by the Internet, which may lead to greater competition in the insurance business. New competition from these developments could cause the supply and/or demand for insurance or reinsurance to change, which could affect our ability to price our products at attractive rates and adversely affect our underwriting results. We may misevaluate the risks we seek to insure in the underwriting and pricing of our products. If we misevaluate these risks, our actual insured losses may be greater than our loss reserves, which would negatively impact our business, reputation, financial condition and results of operations. We are a Bermuda company formed to provide specialty lines insurance and reinsurance products on a global basis through our operating subsidiaries. The market for specialty lines insurance and reinsurance products differs significantly from the standard market. In the standard market, insurance rates and forms are highly regulated, products and coverages are largely uniform and have relatively predictable exposures and companies tend to compete for customers on the basis of price and service. In contrast, the specialty market, especially the structured products market, provides coverage for risks that do not fit the underwriting criteria of the standard carriers. We have formed teams of experienced underwriting officers and underwriters with specialized knowledge of their respective market segments to manage each of our product lines where we currently write business. Our success will depend on the ability of these underwriters to accurately assess the risks associated with the businesses that we insure. Underwriting for specialty lines and structured products requires us to make assumptions about matters that are inherently unpredictable and beyond our control and for which historical experience and probability analysis may not provide sufficient guidance. Further, underwriting for specialty lines presents particular difficulties because there is usually limited information available on the client's loss history for the perils being insured and structured insurance products frequently involve coverages for multiple years and multiple business segments. If we fail to adequately evaluate the risks to be insured, our business, financial condition and results of operations could be materially and adversely affected. Significant periods of time often elapse between the occurrence of an insured loss, the reporting of the loss to an insurer and payment by the insurer of that loss. As we recognize liabilities for unpaid losses, we will continue to establish reserves. These reserves represent estimates of amounts needed to pay reported losses and unreported losses and the related loss adjustment expense. Loss reserves are only an estimate of what an insurer anticipates the ultimate costs of claims to be and do not represent an exact calculation of liability. Estimating loss reserves is a difficult and complex process involving many variables and subjective judgments, particularly for new companies, such as ours, that have no loss development experience. As part of our reserving process, we review historical data as well as actuarial and statistical projections and consider the impact of various factors such as: trends in claim frequency and severity; changes in operations; emerging economic and social trends; inflation; and changes in the regulatory and litigation environments. This process assumes that past experience, adjusted for the effects of current developments and anticipated trends, is an appropriate basis for predicting future events. There is no precise method, however, for evaluating the impact of any specific factor on the adequacy of reserves, and actual results are likely to differ from original estimates. In addition, unforeseen losses, the type or magnitude of which we cannot predict, may emerge in the future. To the extent our loss reserves are insufficient to cover actual losses or loss adjustment expenses, we will have to add to these loss reserves and incur a charge to our earnings, which could have a material adverse effect on our financial condition, results of underwriting and cash flows. In addition, because we, like other insurers and reinsurers, do not separately evaluate each of the individual risks assumed under reinsurance treaties, we are largely dependent on the original underwriting decisions made by ceding companies. We are subject to the risk that our ceding companies may not have adequately evaluated the risks to be reinsured and that the premiums ceded to us may not adequately compensate us for the risks we assume. We may not be able to manage our growth effectively. We only began our business operations after the closing of the Private Offering on September 3, 2003, and we need to continue to rapidly and significantly expand our operations to realize our growth strategy. Our anticipated growth will place significant demands on our management and other resources. As we grow our business in the future, we will need to raise additional capital, continue to obtain, develop and implement systems and acquire human resources. These processes are time consuming and expensive, will increase management responsibilities and will absorb management attention. We cannot assure you that we will be able to meet our capital needs, expand our systems effectively, allocate our human resources optimally, identify and hire qualified employees or incorporate effectively the components of any businesses we may acquire in our effort to achieve growth. The failure to manage our growth effectively could have a material adverse effect on our business, financial condition and results of operations. We may pursue additional opportunities to acquire complementary businesses or groups of underwriters or other individuals, which could adversely affect our financial situation if we fail to successfully integrate the acquired business or group. Since our organization on May 23, 2003, we have acquired ESC, a provider of risk assessment and consulting services, Quanta Specialty Lines, an excess and surplus lines insurer, and Quanta Indemnity, a U.S. licensed insurer with licenses in approximately 41 states. We intend to continue to pursue selective acquisitions of complementary businesses or groups of underwriters or other individuals in the future. Inherent in any future acquisition are certain risks, such as the difficulty of assimilating operations, services, cultures, products and facilities of the acquired business or group, which could have a material adverse effect on our operating results, particularly during the period immediately following such acquisition. Additional debt or equity capital may be required to complete, integrate and fund future acquisitions of these businesses or groups, and there can be no assurance that we will be able to raise the required capital. Furthermore, acquisitions involve a number of risks and challenges, including: diversion of management's attention; the need to integrate acquired businesses, groups of underwriters or other individuals; potential loss of key employees and customers of the acquired business or group; lack of experience in operating in the geographical market of the acquired business or group; an increase in our expenses and working capital requirements; misjudgment of the value of the acquired businesses or groups of underwriters in determining the price paid for the acquisition; and inaccurate assessment of the amount or nature of the liabilities or obligations of the businesses being acquired or assuming liabilities unknown to us at the time of the acquisition. Any of these and other factors could adversely affect our ability to achieve anticipated cash flows at acquired operations or realize other anticipated benefits of acquisitions. Our business is dependent upon insurance and reinsurance brokers, and the failure to develop or maintain important broker relationships could materially adversely affect our ability to market our products and services. We market our insurance and reinsurance products primarily through brokers, and we derive a significant portion of our business from a limited number of brokers. Many of our competitors have had longer term relationships with the brokers that we use or intend to use than we have. Affiliates of at least two of the brokers through whom we market our products, Marsh & McLennan Companies, or Marsh, and Aon Corporation, have also co-sponsored the formation of Bermuda reinsurers that compete with us, and those brokers may decide to favor the companies they sponsored over other companies. While our senior management team and underwriting officers have industry relationships with major industry brokers that we believe are allowing us to establish our presence in the insurance and reinsurance markets, we cannot assure you that we will successfully cultivate and maintain these relationships. The failure to develop or maintain relationships with brokers from whom we expect to receive our business could have a material adverse effect on us. Our reliance on brokers subjects us to their credit risk. In accordance with industry practice, we anticipate that we will frequently pay amounts owed on claims under our insurance or reinsurance contracts to brokers, and these brokers, in turn, will pay these amounts over to the clients that have purchased insurance or reinsurance from us. If a broker fails to make such a payment, in a significant majority of business that we will write, it is highly likely that we will be liable to the client for the deficiency under local laws or contractual obligations. Likewise, when the client pays premiums for these policies to brokers for payment over to us, these premiums are considered to have been paid and, in most cases, the client will no longer be liable to us for those amounts, whether or not we actually receive the premiums from the brokers. Consequently, we will assume a degree of credit risk associated with brokers around the world with respect to most of our insurance and reinsurance business. The occurrence of severe catastrophic events may have a material adverse effect on us. We intend to underwrite property and casualty insurance and reinsurance and will have large aggregate exposures to natural and man-made disasters such as hurricane, typhoon, windstorm, flood, earthquake, acts of war, acts of terrorism and political instability. We expect that our loss experience generally will include infrequent events of great severity. The risks associated with natural and man-made disasters are inherently unpredictable, and it is difficult to predict the timing of such events with statistical certainty or estimate the amount of loss any given occurrence will generate. The extent of losses from a catastrophe is a function of both the total amount of insured exposure in the area affected by the event and the severity of the event. The occurrence of losses from catastrophic events may have a material adverse effect on our ability to write new business, results of operations and financial condition. These losses could eliminate our shareholders' equity and statutory surplus (which is the amount remaining after all liabilities, including loss reserves, are subtracted from all admitted assets, as determined under statutory accounting principles, or SAP). Increases in the values and geographic concentrations of insured property and the effects of inflation have resulted in increased severity of industry losses in recent years and we expect that those factors will increase the severity of catastrophe losses in the future. The availability of reinsurance and retrocessional coverage that we intend to use to limit our exposure to risks may be limited, and counterparty credit and other risks associated with our reinsurance arrangements may result in losses which could adversely affect our financial condition and results of operations. To limit our risk of loss, we use reinsurance and also may use retrocessional coverage, which is reinsurance of a reinsurer's business. The availability and cost of reinsurance and retrocessional protection is subject to market conditions, which are beyond our control. Currently, there is a high level of demand for these arrangements. Because we only recently commenced operations, we may experience difficulties in obtaining or renewing reinsurance and retrocessional protection. We cannot assure you that we will be able to obtain or renew adequate levels of reinsurance or retrocessional protection at cost-effective rates in the future. As a result of market conditions and other factors, we may not be able to successfully alleviate risk through reinsurance and retrocessional arrangements. Further, we will be subject to credit risk with respect to our reinsurance and retrocessional arrangements because the ceding of risk to reinsurers and retrocessionaires will not relieve us of our liability to the clients or companies we insure or reinsure. Our failure to establish adequate reinsurance or retrocessional arrangements or the failure of our reinsurance or retrocessional arrangements to protect us from overly concentrated risk exposure could adversely affect our business, financial condition and results of operations. We must develop, implement and integrate new software and systems. While we have acquired new software and systems responsible for accounting, claims management, modeling and other tasks relating to our insurance and reinsurance operations, we still must implement and integrate these software and systems with each other and with those that we are developing ourselves. In addition, we must acquire or obtain the right to use additional software and systems and continue to develop those systems that we are creating internally. Our failure to acquire, implement or integrate these systems in a timely and effective manner could impede our ability to achieve our business strategy and could significantly and adversely affect our business, financial condition and results of operations. Our business could be adversely affected by Bermuda employment restrictions. We intend to hire primarily non-Bermudians to work for us in Bermuda. Under Bermuda law, non-Bermudians (other than spouses of Bermudians) may not engage in any gainful occupation in Bermuda without an appropriate governmental work permit. Work permits may be granted or extended by the Bermuda government upon showing that, after proper public advertisement in most cases, no Bermudian (or spouse of a Bermudian) is available who meets the minimum standard requirements for the advertised position. The Bermuda government recently announced a new policy limiting the duration of work permits to six years, with certain exemptions for key employees. While we have been able to obtain work permits that we have needed for our employees to date, we can not assure you that we will not encounter difficulties in the future. We may not be able to use the services of one or more of our key employees if we are not able to obtain work permits for them, which could have a material adverse effect on our business. A significant amount of our invested assets will be subject to market volatility. We invest the premiums we receive from customers. Our investment portfolio currently contains highly rated and liquid fixed income securities. Because we classify substantially all of our invested assets as available for sale, we expect changes in the market value of our securities will be reflected in our consolidated balance sheet. Our funds are invested by several professional investment advisory management firms under the direction of our management team in accordance with our investment guidelines and are subject to market-wide risks and fluctuations, as well as to risks inherent in particular securities. The volatility of our claims may force us to liquidate securities, which may cause us to incur capital losses. Our investment results and, therefore, our financial condition may also be impacted by changes in the business, financial condition or results of operations of the entities in which we invest, as well as changes in interest rates, government monetary policies, general economic conditions and overall market conditions. For example, between 2000 and 2002 insurers and reinsurers experienced adverse investment returns as a result of, among other things, high profile bankruptcies and a low interest rate environment. For a further discussion, see "Industry — Recent Industry Developments — Adverse Investment Returns." Further, if we do not structure our investment portfolio so that it is appropriately matched with our insurance and reinsurance liabilities, we may be forced to liquidate investments prior to maturity at a significant loss to cover such liabilities. Investment losses could significantly decrease our asset base, which will affect our ability to conduct business. We may be adversely affected by interest rate changes. Our investment portfolio contains interest rate-sensitive instruments, such as bonds, which may be adversely affected by changes in interest rates. Because of the unpredictable nature of losses that may arise under insurance and reinsurance policies, we expect our liquidity needs will be substantial and may arise at any time. Increases in interest rates during periods when we sell investments to satisfy liquidity needs may result in losses. Changes in interest rates could also have an adverse effect on our investment income and results of operations. For example, if interest rates decline, reinvested funds will earn less than expected. In addition, we expect that our investment portfolio will include highly-rated mortgage-backed securities. As with other fixed income investments, the fair market value of these securities fluctuates depending on market and other general economic conditions and the interest rate environment. Changes in interest rates can expose us to prepayment risks on these investments. In periods of declining interest rates, mortgage prepayments generally increase and mortgage-backed securities are prepaid more quickly, requiring us to reinvest the proceeds at the then current market rates. Interest rates are highly sensitive to many factors, including governmental monetary policies, domestic and international economic and political conditions and other factors beyond our control. Although we attempt to take measures to manage the risks of investing in a changing interest rate environment, we may not be able to mitigate interest rate sensitivity effectively. Our mitigation efforts include maintaining a high quality portfolio with a relatively short duration to reduce the effect of interest rate changes on book value. Despite our mitigation efforts, a significant increase in interest rates could have a material adverse effect on our book value. Fluctuations in currency exchange rates may cause us to experience losses. Our functional currency is the U.S. dollar. Our operating currency generally will also be the U.S. dollar. However, we expect the premiums receivable and losses payable in respect of a portion of our business will be denominated in currencies of other countries. We will attempt to manage our foreign currency risk by seeking to match our liabilities under insurance and reinsurance policies that are payable in foreign currencies either with forward purchase contracts or with investments that are denominated in these currencies. To the extent we believe that it may be practical, we may hedge our foreign currency exposure with respect to potential losses by maintaining assets denominated in the same currency or entering into forward purchase contracts for specific currencies. We intend to consider using forward purchase contracts when we are advised of known or probable significant losses that will be paid in non-U.S. currencies in order to manage currency fluctuation exposure. We may also consider using forward purchase contracts to hedge our non-U.S. dollar currency exposure with respect to premiums receivable, which will be generally collected over the relevant contract term to the extent practical and to the extent we do not expect we will need these receipts to fund potential losses in such currencies. We may make foreign currency-denominated investments, generally for the purpose of improving overall portfolio yield. However, we may not be successful in reducing foreign currency exchange risks. As a result, we may from time to time experience losses resulting from fluctuations in values of foreign currencies, which could have a material adverse effect on our results of operations. Our profitability may be adversely impacted by inflation. The effects of inflation could cause the severity of claims to rise in the future. Our reserve for losses and loss expenses will include assumptions about future payments for settlement of claims and claims handling expenses, such as medical treatments and litigation costs. To the extent inflation causes these costs to increase above reserves established for these costs, we would be required to increase our loss reserves with a corresponding reduction in our net income in the period in which the deficiency is identified. We have made certain decisions concerning the allocation of our capital base among our subsidiaries. Those decisions could have a major impact on our ability to meet our growth and return objectives. We have established operating subsidiaries in Bermuda, Ireland and the United States and we intend to establish a branch in the United Kingdom. We have attempted to allocate capital among our subsidiaries in such a way as to maximize the composite return to shareholders stemming from our overall capital base. These capital allocation decisions require us to make various operating, regulatory and tax assumptions. If our assumptions were not correct, we may not have allocated our capital in the most optimal manner. This could adversely affect our ability to meet our growth and return objectives. We may incur liability in connection with NFU Standard's past operations if NFU or the reinsurer with which NFU reinsures NFU Standard's liabilities fails to pay the liabilities assumed or reinsured. On December 19, 2003, we purchased all of the outstanding capital stock of NFU Standard, a U.S. licensed insurer with licenses in approximately 41 states, from NFU. NFU assumed from NFU Standard all of its underwriting contracts and associated liabilities except those for which regulatory approvals have not yet been received. NFU has reinsured NFU Standard for 100% of the underwriting contracts and their associated liabilities that are still subject to regulatory approval and will assume these contracts when it obtains regulatory approval. NFU's obligations are guaranteed by OneBeacon Insurance Company, the parent of NFU and a wholly-owned subsidiary of White Mountains Insurance Group, Ltd. In the event that NFU, OneBeacon Insurance Company or any reinsurer fails to pay or is unable to pay the liabilities assumed or reinsured in connection with the acquisition, we would be liable for such claims, which could have a material adverse effect on us. ESC's and Quanta Technical Services' work may expose us to liability. The assessment, analysis and assumption of environmental liabilities, and the management, remediation, and engineering of environmental conditions constitute a significant portion of our consulting business. From time to time, we may also offer a liability assumption program under which a special-purpose entity assumes specified liabilities (at times including taking title to property) associated with environmental conditions for which we provide consulting services, which may be insured or guaranteed by us. These businesses involve significant risks, including the possibility that we may be liable to clients, third parties and governmental authorities for property damage, personal injuries, breach of contract or breach of warranty claims, fines and penalties and regulatory action. As a result, we could be subject to substantial liabilities or fines in the future that could adversely affect our business. In addition, although ESC's former shareholders have indemnified us for certain losses we incur due to breaches of their representations and warranties in the purchase agreement for the acquisition of ESC, this protection is limited and we will be exposed to ESC's liabilities for actions taken prior to our acquisition of ESC to the extent they exceed the indemnification coverage or to the extent that we are not indemnified against these liabilities. ESC's and Quanta Technical Services' services may expose us to professional liability in excess of their current insurance coverage. ESC and Quanta Technical Services may have liability to clients for errors or omissions in the services they perform. These liabilities could exceed ESC's and Quanta Technical Services' insurance coverage and the fees they derive from those services. Prior to our acquisition of ESC, ESC maintained general liability insurance and professional liability insurance. The cost of obtaining these insurance policies is rising. We cannot assure you that this insurance will be sufficient to cover any liabilities ESC incurs or that we will be able to maintain ESC's insurance at reasonable rates or at all. If we terminate ESC's policies and do not obtain retroactive coverage, we will be uninsured for claims against ESC made after termination even if these claims are based on events or acts that occurred during the term of the policy. In addition, we cannot assure you that we will be able to obtain insurance coverage for the new services or areas into which we expand ESC's and Quanta Technical Services' services on favorable terms or at all. We do not yet have in place a bank letter of credit facility, and failure to arrange for such a facility could adversely affect our ability to compete for certain business. While we intend for us or one or more of our operating subsidiaries to enter into a secured bank facility with a syndicate of lenders providing for the issuance of letters of credit and loans on a revolving basis, we do not yet have such a facility or any commitment from a lender to provide that facility. Many U.S. jurisdictions do not permit insurance companies to take credit for reinsurance obtained from unlicensed or non-admitted insurers on their U.S. statutory financial statements without appropriate security, which can include a letter of credit. Quanta Bermuda, Quanta U.S. Re and Quanta Ireland are not, and will not be, licensed in any U.S. jurisdiction. We cannot assure you that we will be able to obtain a credit facility on terms that would be acceptable to us. If we fail to obtain an adequate letter of credit facility, and are unable to otherwise provide the necessary security, insurance companies may be unwilling to purchase our reinsurance products. If this is the case, there may be a material adverse effect on our results of operations. Our holding company structure and certain regulatory and other constraints affect our ability to pay dividends and make other payments. Quanta Holdings is a holding company. As a result, we do not, and will not, have any significant operations or assets other than our ownership of the shares of our subsidiaries. We expect that dividends and other permitted distributions from our operating subsidiaries will be our sole source of funds to pay dividends, if any, to shareholders and to meet ongoing cash requirements, including debt service payments and other expenses. Bermuda law and regulations, including, but not limited to Bermuda insurance regulation, will restrict the declaration and payment of dividends and the making of distributions by Quanta Bermuda and Quanta U.S. Re unless specific regulatory requirements are met. In addition, each of Quanta Ireland, Quanta Specialty Lines and Quanta Indemnity will be subject to significant regulatory restrictions limiting its ability to declare and pay dividends. In addition, any dividends paid by Quanta U.S. Holdings will be subject to a 30% withholding tax. Therefore, we do not expect to receive dividends from any of those subsidiaries, or any other subsidiaries we may form, for the foreseeable future. The inability of our operating subsidiaries to pay dividends in an amount sufficient to enable us to meet our cash requirements at the holding company level could have a material adverse effect on our operations. For a discussion of the legal limitations on our existing and future U.S. subsidiaries' ability to pay dividends and the taxation of these dividends, see "Regulation — U.S. Regulation — Regulation of Dividends and other Payments from Insurance Subsidiaries" and "Material Tax Considerations — Certain U.S. Federal Income Tax Considerations — U.S. Taxation of Quanta Holdings, Quanta Bermuda, Quanta Ireland, Quanta U.S. Holdings, Quanta Specialty Lines, Quanta U.S. Re and Quanta Indemnity." We are subject to Bermuda regulatory constraints that affect our ability to pay dividends on our shares and make other payments. Under the Bermuda Companies Act 1981, as amended (the "Companies Act"), we may declare or pay a dividend out of distributable reserves only if we have reasonable grounds for believing that we are, or would after the payment be, able to pay our liabilities as they become due and if the realizable value of our assets would thereby not be less than the aggregate of our liabilities and issued share capital and share premium accounts. For a discussion of the legal limitations on our existing and future Bermuda subsidiaries' ability to pay dividends to Quanta Holdings and of Quanta Holdings to pay dividends to its shareholders, see "Regulation — Bermuda Regulation — Minimum Solvency Margin and Restrictions on Dividends and Distributions." We are subject to extensive regulation in Bermuda and the United States, and, once authorized, will be subject to extensive regulation in Ireland and the United Kingdom, which may adversely affect our ability to achieve our business objectives. If we do not comply with these regulations, we may be subject to penalties, including fines, suspensions and withdrawals of licenses, which may adversely affect our financial condition and results of operations. We are subject to extensive governmental regulation and supervision. Most insurance regulations are designed to protect the interests of policyholders rather than shareholders and other investors. These regulations, generally administered by a department of insurance in each jurisdiction in which we will do business, relate to, among other things: approval of policy forms and premium rates; standards of solvency, including risk-based capital measurements; licensing of insurers and their agents; limits on the size and nature of risks assumed; restrictions on the nature, quality and concentration of investments; restrictions on the ability of our insurance company subsidiaries to pay dividends to us; restrictions on transactions between insurance company subsidiaries and their affiliates; restrictions on the size of risks insurable under a single policy; requiring deposits for the benefit of policyholders; requiring certain methods of accounting; periodic examinations of our operations and finances; prescribing the form and content of records of financial condition required to be filed; and requiring reserves for unearned premium, losses and other purposes. Insurance departments also conduct periodic examinations of the affairs of insurance companies and require the filing of annual and other reports relating to financial condition, holding company issues and other matters. These regulatory requirements may adversely affect or inhibit our ability to achieve some or all of our business objectives. In addition, regulatory authorities have relatively broad discretion to deny or revoke licenses for various reasons, including the violation of regulations. We intend to base some of our practices on our interpretations of regulations or practices that we believe are generally followed by the industry. These practices may turn out to be different from the interpretations of regulatory authorities. If we do not have the requisite licenses and approvals or do not comply with applicable regulatory requirements, insurance regulatory authorities could preclude or temporarily suspend us from carrying on some or all of our activities or otherwise penalize us. This could adversely affect our ability to operate our business. Further, changes in the level of regulation of the insurance or reinsurance industry or changes in the laws or regulations themselves or interpretations by regulatory authorities could adversely affect our ability to operate our business. Regulation in the United States. In recent years, the state insurance regulatory framework in the United States has come under increased federal scrutiny, and some state legislators have considered or enacted laws that may alter or increase state authority to regulate insurance companies and insurance holding companies. Moreover, the National Association of Insurance Commissioners ("NAIC"), which is an association of the senior insurance regulatory officials of all 50 states and the District of Columbia, and state insurance regulators regularly reexamine existing laws and regulations, interpretations of existing laws and the development of new laws, which may be more restrictive or may result in higher costs to us than current statutory requirements. Federal legislation is also being discussed that would require all states to adopt uniform standards relating to the regulation of products, licensing, rates and market conduct. We are unable to predict whether any of these or other proposed laws and regulations will be adopted, the form in which any such laws and regulations would be adopted, or the effect, if any, these developments would have on our operations and financial condition. The offshore insurance and reinsurance regulatory framework recently has also become subject to increased scrutiny in many jurisdictions, including in the United States and in various states within the United States. In the past, there have been congressional and other proposals in the United States regarding increased supervision and regulation of the insurance industry, including proposals to supervise and regulate reinsurers domiciled outside the United States. If Quanta Bermuda or Quanta U.S. Re were to become subject to any insurance laws and regulations of the United States or any U.S. state, which are generally more restrictive than those applicable to it in Bermuda, at any time in the future, they might be required to post deposits or maintain minimum surplus levels and might be prohibited from engaging in lines of business or from writing specified types of policies or contracts. Complying with those laws could have a material adverse effect on our ability to conduct business or on our results of operations Regulation in Bermuda. Quanta Bermuda and Quanta U.S. Re are registered Bermuda insurance companies and subject to regulation and supervision in Bermuda. The applicable Bermuda statutes and regulations generally are designed to protect insureds and ceding insurance companies, not our shareholders. Quanta Bermuda and Quanta U.S. Re are not registered or licensed as insurance companies in any jurisdiction outside Bermuda, conduct business through offices in Bermuda and do not maintain an office, and their personnel do not conduct any insurance activities in the United States or elsewhere. Inquiries or challenges to the insurance activities of Quanta Bermuda or Quanta U.S. Re. may be raised in the future. Regulation in Ireland. We expect that, once authorized, Quanta Ireland will be a non-life insurance company incorporated under the laws of Ireland and will be subject to the regulation and supervision of the Irish Financial Services Regulatory Authority, or IFSRA, under the Irish Insurance Acts, 1909 to 2000 and the regulations relating to insurance business and directions made under those regulations (together, the "Insurance Acts and Regulations"). In addition, Quanta Ireland, once authorized, will be subject to certain additional supervisory requirements of IFSRA for authorized non-life insurers that fall outside the strict legislative framework, such as guidelines issued by IFSRA in 2001 requiring actuarial certification of certain reserves. Among other things, without consent of IFSRA, Quanta Ireland may not be permitted to reduce the level of its initial capital, or make any dividend payments or loans. Quanta Ireland will be required to maintain a minimum solvency margin and reserves against underwriting liabilities. Assets constituting these reserves must comply with asset diversification, localization and currency matching rules. If Quanta Ireland writes credit insurance, it will be required to maintain a further equalization reserve. Additionally, Quanta Ireland, once authorized, will be required to agree, in connection with receiving its authorization to engage in the insurance business, to adhere to IFSRA's policy restricting the reinsurance business written by a direct insurer. Under this policy, a direct insurer is prohibited from engaging in reinsurance except to an extent that is not significant (to maximum 10% to 20% of overall business) and subject to certain conditions. In practice IFSRA generally expects a direct insurer to write reinsurance in very limited circumstances. An insurance company supervised by IFSRA may have its authorization revoked or suspended by IFSRA under various circumstances, including, among others, if IFSRA determines that it has not used its authorization for the last 12 months, it has expressly renounced its authorization, has ceased to carry on business covered by the authorization for more than six months; no longer fulfills the conditions required for granting authorization or fails seriously in its obligations under the Insurance Acts and Regulations. The appointment of the directors and senior managers of Quanta Ireland, once authorized, will be subject to prior approval from IFSRA. Changes to any of the Insurance Acts and Regulations, or to the interpretation of these or to the additional supervisory requirements of IFSRA referred to above could have a material adverse effect on our business, financial condition and results of operations. We may be subject to U.S. tax that may have a material adverse effect on our results of operations and your investment. Quanta Holdings and Quanta Bermuda are Bermuda companies and Quanta Ireland is an Irish company. We intend to manage our business so that each of these companies will not be treated as engaged in a trade or business within the United States and, as a result, will not be subject to U.S. tax (other than U.S. excise tax on insurance and reinsurance premium income attributable to insuring or reinsuring U.S. risks and U.S. withholding tax on certain U.S. source investment income). However, because there is considerable uncertainty as to what activities constitute being engaged in a trade or business within the United States, we cannot be certain that the U.S. Internal Revenue Service ("IRS") will not be able to successfully contend that any of Quanta Holdings or its foreign subsidiaries are engaged in a trade or business in the United States. If Quanta Holdings or any of its foreign subsidiaries were considered to be engaged in a business in the United States, we could be subject to U.S. corporate income and branch profits taxes on the portion of our earnings effectively connected to such U.S. business, in which case our results of operations and your investment could be materially adversely affected. See "Material Tax Considerations — Certain U.S. Federal Income Tax Considerations — U.S. Taxation of Quanta Holdings, Quanta Bermuda, Quanta Ireland, Quanta U.S. Holdings, Quanta Specialty Lines, Quanta U.S. Re and Quanta Indemnity." Quanta Holdings or one of its subsidiaries might be subject to U.S. tax on a portion of its income (which in the case of a foreign subsidiary would only include income from U.S. sources) if Quanta Holdings or a subsidiary is considered a personal holding company ("PHC") for U.S. federal income tax purposes. This status will depend on whether more than 50% of our shares by value could be deemed to be owned (under some constructive ownership rules) by five or fewer individuals and whether 60% or more of Quanta Holdings' adjusted ordinary income, or the income of any of its subsidiaries, as determined for U.S. federal income tax purposes, consists of "personal holding company income," which is, in general, certain forms of passive and investment income. We believe based upon information made available to us regarding our shareholder base that neither Quanta Holdings nor any of its subsidiaries should be considered a PHC. Additionally, we intend to manage our business to minimize the possibility that we will meet the 60% income threshold. However, because of the lack of complete information regarding our ultimate share ownership (i.e., as determined by the constructive ownership rules for PHCs), we cannot assure you that Quanta Holdings and/or any of its subsidiaries will not be considered PHC or that the amount of U.S. tax that would be imposed if it were not the case would be immaterial. See "Material Tax Considerations — Certain U.S. Federal Income Tax Considerations — U.S. Taxation of Quanta Holdings, Quanta Bermuda, Quanta Ireland, Quanta U.S. Holdings, Quanta Specialty Lines, Quanta U.S. Re and Quanta Indemnity — Personal Holding Companies." We may be subject to additional Irish tax or to U.K. tax. If any of our non-Irish companies were considered to be resident in Ireland, or to be doing business in Ireland, or, in the case of our U.S. subsidiaries which qualify for the benefits of an existing tax treaty with Ireland, to be doing business through a permanent establishment in Ireland, those companies would be subject to Irish tax. If we or any of our subsidiaries were considered to be resident in the United Kingdom, or to be carrying on a trade in the United Kingdom through a permanent establishment in the United Kingdom, those companies would be subject to United Kingdom tax. If any of our U.S. subsidiaries were subject to Irish tax or U.K. tax, that tax would generally be creditable against their U.S. tax liability, subject to limitations. If we or any of our Bermuda subsidiaries were subject to Irish tax or U.K. tax, that could have a material adverse impact on our results of operation and on the value of our shares. The impact of Bermuda's letter of commitment to the Organization for Economic Cooperation and Development to eliminate harmful tax practices is uncertain and could adversely affect our tax status in Bermuda. The Organization for Economic Cooperation and Development, which is commonly referred to as the OECD, has published reports and launched a global dialogue among member and non-member countries on measures to limit harmful tax competition. These measures are largely directed at counteracting the effects of tax havens and preferential tax regimes in countries around the world. In the OECD's report dated June 26, 2000, Bermuda was not listed as a tax haven jurisdiction because it had previously signed a letter committing itself to eliminate harmful tax practices by the end of 2005 and to embrace international tax standards for transparency, exchange of information and the elimination of any aspects of the regimes for financial and other services that attract business with no substantial domestic activity. We are not able to predict what changes will arise from the commitment or whether these changes will subject us to additional taxes. We may become subject to taxes in Bermuda after March 28, 2016, which may have a material adverse effect on our results of operations and your investment. The Bermuda Minister of Finance, under the Exempted Undertakings Tax Protection Act 1966, as amended, of Bermuda, has given each of Quanta Holdings, Quanta Bermuda and Quanta U.S. Re, an assurance that if any legislation is enacted in Bermuda that would impose tax computed on profits or income, or computed on any capital asset, gain or appreciation, or any tax in the nature of estate duty or inheritance tax, then the imposition of any such tax will not be applicable to Quanta Holdings, Quanta Bermuda and Quanta U.S. Re any of their operations, shares, debentures or other obligations until March 28, 2016. See "Material Tax Considerations — Certain Bermuda Tax Considerations." Given the limited duration of the Minister of Finance's assurance, we cannot be certain that we will not be subject to any Bermuda tax after March 28, 2016. Risks Related to the Industry The insurance and reinsurance business is historically cyclical, and we expect to experience periods with excess underwriting capacity and unfavorable premium rates. Historically, insurers and reinsurers have experienced significant fluctuations in operating results due to competition, frequency of occurrence or severity of catastrophic and other loss events, levels of capacity, general economic and social conditions and other factors. The supply of insurance and reinsurance is related to prevailing prices, the level of insured losses and the level of industry surplus which, in turn, may fluctuate in response to changes in rates of return on investments being earned in the insurance and reinsurance industry. As a result, the insurance and reinsurance business historically has been a cyclical industry characterized by periods of intense price competition due to excessive underwriting capacity as well as periods when shortages of capacity permitted favorable premium levels. Although premium levels for many products, including specialty line products, have increased in recent years, the supply of insurance and reinsurance may increase, either due to capital provided by new entrants or by the commitment of additional capital by existing insurers or reinsurers, which may cause prices to decrease. Any of these factors could lead to a significant reduction in premium rates, less favorable policy terms and fewer submissions for our underwriting services. In addition to these considerations, changes in the frequency and severity of losses suffered by insureds and insurers may affect the cycles of the insurance and reinsurance business significantly. While we believe that our specialty insurance and reinsurance lines may experience less volatility through different business cycles than more standard lines, we expect that our returns will be impacted by the cyclical nature of the insurance and reinsurance industry. A return to negative market conditions may affect our ability to write insurance and reinsurance at rates that we consider appropriate relative to the risk assumed. If we cannot write our specialty lines of insurance and reinsurance at appropriate rates, our ability to transact our business would be significantly and adversely affected. Consolidation in the insurance and reinsurance industry could lead to lower margins for us and less demand for our products and services. The insurance and reinsurance industry is undergoing a process of consolidation as industry participants seek to enhance their product and geographic reach, client base, operating efficiency and general market power through merger and acquisition activities. For example, two of our competitors, Travelers and St. Paul announced on November 17, 2003 that they have signed a definitive merger agreement that will create the nation's second largest commercial insurer. The merger is expected to be completed in the second quarter of 2004. We believe that the larger entities resulting from these merger and acquisition activities may seek to use the benefits of consolidation, including improved efficiencies and economies of scale, to, among other things, implement price reductions for their products and services to increase their market share. If competitive pressures compel us to reduce our prices, our operating margins will decrease. As the insurance industry consolidates, competition for customers may become more intense and the importance of acquiring and properly servicing each customer will become greater. We could incur greater expenses relating to customer acquisition and retention, which could reduce our operating margins. The effects of emerging claim and coverage issues on our business are uncertain. As industry practices and legal, judicial, social and other environmental conditions change, unexpected issues related to claims and coverage may emerge. These issues may adversely affect our business by either extending coverage beyond our underwriting intent or by increasing the number or size of claims. In some instances, these changes may not become apparent until some time after we have issued insurance or reinsurance contracts that are affected by the changes. As a result, the full extent of liability under our insurance or reinsurance contracts may not be known for many years after a contract is issued. Recent examples of emerging claims and coverage issues include: larger settlements and jury awards against professionals and corporate directors and officers covered by professional liability and directors' and officers' liability insurance; and a growing trend of plaintiffs targeting property and casualty insurers in purported class action litigation relating to claims-handling, insurance sales practices and other practices related to the conduct of business in our industry. The effects of these and other unforeseen emerging claim and coverage issues are extremely hard to predict and could harm our business, financial condition and results of operations. Recent federal legislation may negatively affect the business opportunities we perceive are available to us in the market. The Terrorism Risk Insurance Act of 2002 ("TRIA") was enacted by the U.S. Congress and became effective in November 2002 in response to the tightening of supply in some insurance markets resulting from, among other things, the terrorist attacks of September 11, 2001. TRIA applies to the commercial property and casualty insurance written by our U.S. operating subsidiaries. The U.S. Treasury has the power to extend the application of TRIA to our non-U.S. insurance operating subsidiaries as well. TRIA generally requires U.S. insurers, including Quanta Indemnity and Quanta Specialty Lines, to make insurance coverage for certified acts of terrorism available to their policyholders at the same limits and terms as are available for other coverages. Exclusions or sub-limited coverage for certified acts of terrorism may be established, but solely at the discretion of an insured. We are currently unable to predict the extent which TRIA may affect the demand for the products of our U.S. insurance operating subsidiaries, or the risks that may be available for them to consider underwriting. The extent to which coverage for acts of terrorism will be offered by the insurance and reinsurance markets in the future is uncertain. Risks Related to our Shares An active trading market for our shares may not develop. Our shares have no established trading market and are not currently listed on any securities exchange. Although the shares that were sold to qualified institutional buyers in the Private Offering are currently eligible for trading among qualified institutional buyers in The Portal Market of the National Association of Securities Dealers, Inc., shares sold pursuant to this prospectus will not continue to trade on The Portal Market. Our common shares have been approved for listing on the Nasdaq National Market System under the symbol "QNTA." However, an active trading market for the shares may not develop. If an active trading market does not develop or is not maintained, holders of the shares may experience difficulty in reselling, or an inability to sell, the shares. Future trading prices for the shares may be adversely affected by many factors, including changes in our financial performance, changes in the overall market for similar shares and performance or prospects for companies in our industry. We do not currently intend to pay dividends and any determination to pay dividends in the future will be at the discretion of our board of directors and will depend on a number of factors such as whether we have the resources to pay dividends. We currently intend to retain any profits to provide capacity to write insurance and reinsurance and to accumulate reserves and surplus for the payment of claims. As a result, our board of directors currently does not intend to declare dividends or make any other distributions. Our board of directors plans to periodically reevaluate our dividend policy. Any determination to pay dividends in the future will be at the discretion of our board of directors and will depend upon our results of operations, financial condition and other factors deemed relevant by our board of directors. Consequently, it is uncertain when, if ever, we will declare dividends to our shareholders. If you require dividend income, you should carefully consider these risks before investing in our company. Our results of operations and revenues may fluctuate as a result of many factors, including cyclical changes in the insurance and reinsurance industry, which may cause the price of our shares to decline. The results of operations of companies in the insurance and reinsurance industry historically have been subject to significant fluctuations and uncertainties. Our profitability can be affected significantly by: the differences between actual and expected losses that we cannot reasonably anticipate using historical loss data and other identifiable factors at the time we price our products; volatile and unpredictable developments, including man-made, weather-related and other natural catastrophes or terrorist attacks, or court grants of large awards for particular damages; cyclicality relating to the demand and supply of insurance and reinsurance products; changes in the level of reinsurance capacity; changes in the amount of loss reserves resulting from new types of claims and new or changing judicial interpretations relating to the scope of insurers' liabilities; and fluctuations in equity markets, interest rates, credit risk and foreign currency exposure, inflationary pressures and other changes in the investment environment, which affect returns on invested assets and may impact the ultimate payout of losses. In addition, the demand for the types of insurance we will offer can vary significantly, rising as the overall level of economic activity increases and falling as that activity decreases, causing our revenues to fluctuate. These fluctuations in results of operations and revenues may cause the price of our securities to be volatile. Future sales of shares may adversely affect their price. Future sales of common shares by our shareholders or us, or the perception that such sales may occur, could adversely affect the market price of our common shares. Currently, 56,798,218 common shares are outstanding. We have also issued options and Founder Warrants to purchase up to 5,426,213 of our common shares. All of our outstanding common shares, other than the 291,262 common shares sold to Nigel W. Morris as described below, are being registered for resale pursuant to the registration statement of which this prospectus is part. Additionally, all of the 2,542,813 common shares underlying the Founder Warrants are being registered pursuant to the registration statement of which this prospectus is a part, and when and if they are issued, will be freely tradable without restriction under the Securities Act, assuming they are not held by our affiliates. See "Shares Eligible for Future Sales." On December 22, 2003, we sold 291,262 common shares in a private placement to Nigel W. Morris, one of our directors. These shares are not being registered pursuant to the registration statement of which this prospectus is part, but we have entered into a registration rights agreement with Mr. Morris covering these shares. See "Certain Relationships and Related Transactions — Private Placement to Nigel Morris" and "Description of Share Capital — Registration Rights." Provisions in our charter documents may reduce or increase the voting power associated with our shares. Our bye-laws generally provide that shareholders have one vote for each share held by them and are entitled to vote, on a non-cumulative basis, at all meetings of shareholders. However, pursuant to a mechanism specified in our bye-laws, the voting rights exercisable by a shareholder may be limited so that certain persons or groups are not deemed to hold more than 9.5% of the voting power conferred by our shares. In addition, our board of directors retains certain discretion to make adjustments to the aggregate number of votes attaching to the shares of any shareholder that they consider fair and reasonable in all the circumstances to ensure that no person will hold more than 9.5% of the voting power represented by our then outstanding shares. Under these provisions, some shareholders may have the right to exercise their voting rights limited to less than one vote per share. Moreover, these provisions could have the effect of reducing the voting power of certain shareholders who would not otherwise be subject to the limitation by virtue of their direct share ownership. See "Description of Share Capital — Limitation on Voting Rights." As a result of any reduction in the votes of other shareholders, your voting power might increase above 5% of the aggregate voting power of the outstanding shares, which may result in your becoming a reporting person subject to Schedule 13D or 13G filing requirements under the Exchange Act of 1934, as amended (the "Exchange Act"). We also have the authority under our bye-laws to request information from any shareholder for the purpose of determining whether a shareholder's voting rights are to be reduced pursuant to the bye-laws. If a shareholder fails to respond to our request for information or submits incomplete or inaccurate information in response to our request, we may, in our sole discretion, determine that the votes of that shareholder shall be disregarded until the shareholder provides the requested information. It may be difficult for a third party to acquire us. Provisions of our organizational documents may discourage, delay or prevent a merger, tender offer or other change of control that holders of our shares may consider favorable. These provisions impose various procedural and other requirements that could make it more difficult for shareholders to effect various corporate actions. These provisions could: have the effect of delaying, deferring or preventing a change in control of us; discourage bids for our securities at a premium over the price; adversely affect the price of, and the voting and other rights of the holders of, our securities; or impede the ability of the holders of our securities to change our management. See "Description of Share Capital" for a summary of these provisions. U.S. persons who own our shares may have more difficulty in protecting their interests than U.S. persons who are shareholders of a U.S. corporation. The Companies Act, which applies to us, differs in certain material respects from laws generally applicable to U.S. corporations and their shareholders. As a result of these differences, U.S. persons who own our shares may have more difficulty protecting their interests than U.S. persons who own shares of a U.S. corporation. To further understand the risks associated with U.S. persons who own our shares, see "Description of Share Capital — Differences in Corporate Law" for more information on the differences between Bermuda and Delaware corporate laws. We are a Bermuda company and it may be difficult for you to enforce judgments against us or our directors and executive officers. We are incorporated under the laws of Bermuda and our business is based in Bermuda. In addition, some of our directors and officers and some of the experts named in this prospectus reside outside the United States, and all or a substantial portion of our assets and the assets of these persons are, and will continue to be, located in jurisdictions outside the United States. As such, it may be difficult or impossible to effect service of process within the United States upon us or those persons or to recover against us or them on judgments of U.S. courts, including judgments predicated upon civil liability provisions of the U.S. federal securities laws. Further, no claim may be brought in Bermuda against us or our directors and officers in the first instance for violation of U.S. federal securities laws because these laws have no extraterritorial jurisdiction under Bermuda law and do not have force of law in Bermuda. A Bermuda court may, however, impose civil liability, including the possibility of monetary damages, on us or our directors and officers if the facts alleged in a complaint constitute or give rise to a cause of action under Bermuda law. We have been advised by Conyers Dill & Pearman, our Bermuda counsel, that there is doubt as to whether the courts of Bermuda would enforce judgments of U.S. courts obtained in actions against us or our directors and officers, as well as the experts named in this prospectus, predicated upon the civil liability provisions of the U.S. federal securities laws or original actions brought in Bermuda against us or these persons predicated solely upon U.S. federal securities laws. Further, we have been advised by Conyers Dill & Pearman that there is no treaty in effect between the United States and Bermuda providing for the enforcement of judgments of U.S. courts, and there are grounds upon which Bermuda courts may not enforce judgments of U.S. courts. Some remedies available under the laws of U.S. jurisdictions, including some remedies available under the U.S. federal securities laws, may not be allowed in Bermuda courts as contrary to that jurisdiction's public policy. Because judgments of U.S. courts are not automatically enforceable in Bermuda, it may be difficult for you to recover against us based upon such judgments. If you acquire 10% or more of Quanta Holdings' shares, you may be subject to taxation under the "controlled foreign corporation" ("CFC") rules. Each "10% U.S. Shareholder" of a foreign corporation that is a CFC for an uninterrupted period of 30 days or more during a taxable year, and that owns shares in the CFC directly or indirectly through foreign entities on the last day of the CFC's taxable year, must include in its gross income for U.S. federal income tax purposes its pro rata share of the CFC's "subpart F income," even if the subpart income is not distributed. A foreign corporation is considered a CFC if "10% U.S. Shareholders" own more than 50% of the total combined voting power of all classes of voting stock of the foreign corporation, or the total value of all stock of the corporation. A 10% U.S. Shareholder is a U.S. person, as defined in the Internal Revenue Code, that owns at least 10% of the total combined voting power of all classes of stock entitled to vote of the foreign corporation. A CFC also includes a foreign corporation in which more than 25% of the total combined voting power of all classes of stock (or more than 25% of the total value of the stock) is owned by 10% U.S. Shareholders, on any day during the taxable year of such corporation, if the gross amount of premiums or other consideration for the reinsurance or the issuing of insurance or annuity contracts generating subpart F income exceeds specified limits. For purposes of determining whether a corporation is a CFC, and therefore whether the more-than-50% (or more-than-25%, in the case of insurance income) and 10% ownership tests have been satisfied, shares owned includes shares owned directly or indirectly through foreign entities or shares considered owned under constructive ownership rules. The attribution rules are complicated and depend on the particular facts relating to each investor. See "Material Tax Considerations — Certain U.S. Federal Income Tax Considerations — U.S. Taxation of Holders of Shares — Shareholders Who Are U.S. Persons." Quanta Holdings' bye-laws contain provisions that impose limitations on the concentration of voting power of its shares and that authorize the board to purchase its shares under specified circumstances. Accordingly, based upon these provisions and information we have about our shareholder base, we do not believe that we have any 10% U.S. shareholders. It is possible, however that the IRS could challenge the effectiveness of these provisions and that a court could sustain such a challenge. We may require you to sell your shares of Quanta Holdings to us. Our bye-laws provide that we have the option, but not the obligation, to require a shareholder to sell its shares at a purchase price equal to their fair market value to us, to other shareholders or to third parties if our board of directors in its absolute discretion determines that the share ownership of that shareholder may result in adverse tax consequences to us, any of our subsidiaries or any other shareholder. To the extent possible under the circumstances, the board of directors will use its best efforts to exercise this option equally among similarly situated shareholders. Our right to require a shareholder to sell its shares to us will be limited to the purchase of a number of shares that we determine is necessary to avoid or cure those adverse tax consequences. See "Description of Share Capital — Bye-laws." U.S. persons who hold shares could be subject to adverse tax consequences if we are considered a "passive foreign investment company" (a "PFIC") for U. S. federal income tax purposes. We do not intend to conduct our activities in a manner that would cause us to become a PFIC. However, it is possible that we could be deemed a PFIC by the IRS for 2003 or any future year. If we were considered a PFIC it could have material adverse tax consequences for an investor that is subject to U.S. federal income taxation, including subjecting the investor to a greater tax liability than might otherwise apply or subjecting the investor to tax on amounts in advance of when tax would otherwise be imposed. There are currently no regulations regarding the application of the PFIC provisions to an insurance company. New regulations or pronouncements interpreting or clarifying these rules may be issued in the future. We cannot predict what impact, if any, this guidance would have on a shareholder that is subject to U.S. federal income taxation. We have not sought and do not intend to seek an opinion of legal counsel as to whether or not we were a PFIC for the year ended December 31, 2003. See "Material Tax Considerations — Certain U.S. Federal Income Tax Considerations — U.S. Taxation of Holders of Shares — Shareholders Who Are U.S. Persons." U.S. persons who hold shares will be subject to adverse tax consequences if we or any of our subsidiaries are considered a "foreign personal holding company" ("FPHC") for U.S. federal income tax purposes. Quanta Holdings and/or any of its future non-U.S. subsidiaries could be considered to be a FPHC for U.S. federal income tax purposes. This status will depend on whether more than 50% of our shares by vote or value could be deemed to be owned by five or fewer individuals who are citizens or residents of the United States, and the percentage of our income, or that of our subsidiaries, that consists of "foreign personal holding company income," as determined for U.S. federal income tax purposes. We believe, based upon information made available to us regarding our shareholder base, that neither we nor any of our subsidiaries are, and we currently do not expect any of them or us to become, a FPHC for U.S. federal income tax purposes. Due to the lack of complete information regarding our ultimate share ownership, however, we cannot be certain that we will not be considered a FPHC. If we were considered a FPHC it could have material adverse tax consequences for an investor that is subject to U.S. federal income taxation including subjecting the investor to a greater tax liability than might otherwise apply and subjecting the investor to tax on amounts in advance of when tax would otherwise be imposed. See "Material Tax Considerations — Certain U.S. Federal Income Tax Considerations — U.S. Taxation of Holders of Shares — Shareholders Who Are U.S. Persons." U.S. persons who hold shares may be subject to U.S. income taxation on their pro rata share of our "related party insurance income" ("RPII"). If: Quanta Ireland's or Quanta Bermuda's RPII equals or exceeds 20% of that company's gross insurance income in any taxable year, direct or indirect insureds (and persons related to such insureds) own (or are treated as owning directly or indirectly) 20% or more of the voting power or value of the shares of Quanta Ireland or Quanta Bermuda, and U.S. persons are considered to own in the aggregate 25% or more of the stock of either corporation by vote or value, then a U.S. person who owns shares of Quanta Holdings directly or indirectly through foreign entities on the last day of the taxable year would be required to include in its income for U.S. federal income tax purposes the shareholder's pro rata share of Quanta Ireland's or Quanta Bermuda's RPII for the U.S. person's taxable year that includes the end of the corporation's taxable year determined as if such RPII were distributed proportionately to such U.S. shareholders at that date regardless of whether such income is distributed. In addition any RPII that is includible in the income of a U.S. tax-exempt organization will be treated as unrelated business taxable income. The amount of RPII earned by Quanta Ireland or Quanta Bermuda (generally, premium and related investment income from the direct or indirect insurance or reinsurance of any direct or indirect U.S. shareholder of Quanta Ireland or Quanta Bermuda or any person related to such shareholder) will depend on a number of factors, including the geographic distribution of Quanta Ireland's or Quanta Bermuda's business and the identity of persons directly or indirectly insured or reinsured by Quanta Ireland or Quanta Bermuda. Although we do not expect our RPII to exceed 20% of our gross insurance income in the foreseeable future, some of the factors which determine the extent of RPII in any period may be beyond Quanta Ireland's or Quanta Bermuda's control. Consequently, Quanta Ireland's or Quanta Bermuda's RPII could equal or exceed 20% of its gross insurance income in any taxable year and ownership of its shares by direct or indirect insureds and related persons could equal or exceed the 20% threshold described above. The RPII rules provide that if a shareholder that is a U.S. person disposes of shares in a foreign insurance corporation that has RPII (even if the amount of RPII is less than 20% of the corporation's gross insurance income or the ownership of its shares by direct or indirect insureds and related persons is less than the 20% threshold) and in which U.S. persons own 25% or more of the shares, any gain from the disposition will generally be treated as ordinary income to the extent of the shareholder's share of the corporation's undistributed earnings and profits that were accumulated during the period that the shareholder owned the shares (whether or not such earnings and profits are attributable to RPII). In addition, such a shareholder will be required to comply with reporting requirements, regardless of the amount of shares owned by the shareholder. These rules should not apply to dispositions of our shares because Quanta Holdings will not itself be directly engaged in the insurance business and because proposed U.S. Treasury regulations appear to apply only in the case of shares of corporations that are directly engaged in the insurance business. However, the IRS might interpret the proposed regulations in a different manner and the applicable proposed regulations may be promulgated in final form in a manner that would cause these rules to apply to dispositions of our shares. See "Material Tax Considerations — Certain U.S. Federal Income Tax Considerations — U.S. Taxation of Holders of Shares — Shareholders Who Are U.S. Persons." Changes in U.S. federal income tax law could materially adversely affect an investment in our shares. Legislation has been introduced in the U.S. Congress that is intended to eliminate some perceived tax advantages of companies (including insurance companies) that have legal domiciles outside the United States but have some U.S. connections, including legislation that would permit the IRS to reallocate or recharacterize items of income, deduction or some other items related to a reinsurance agreement between related parties to reflect the proper source, character and amount for each item (in contrast to current law, which only refers to source and character). While we do not believe that this proposal, or any other currently pending legislative proposal, if enacted, would have a material adverse effect on us, our subsidiaries or our shareholders, it is possible that broader based legislative proposals could emerge in the future that, if enacted, could have an adverse impact on us, our subsidiaries or our shareholders. Additionally, the U.S. federal income tax laws and interpretations regarding whether a company is engaged in a trade or business within the United States, or is a PFIC or whether U.S. persons would be required to include in their gross income the subpart F income or the RPII of a CFC are subject to change, possibly on a retroactive basis. There are currently no regulations regarding the application of the PFIC rules to insurance companies and the regulations regarding RPII are still in proposed form. New regulations or pronouncements interpreting or clarifying such rules may be issued in the future. We cannot be certain if, when or in what form such regulations or pronouncements may be provided and whether such regulations or guidance will have a retroactive effect.
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+RISK FACTORS You should consider carefully the following factors, as well as the information contained in the rest of this prospectus before deciding whether to participate in the exchange offer. Risk Factors Relating to the Exchange Offer You must carefully follow the required procedures in order to exchange your original notes. The exchange notes will be issued in exchange for original notes only after timely receipt by the exchange agent of a duly executed letter of transmittal and all other required documents. Therefore, if you wish to tender your original notes, you must allow sufficient time to ensure timely delivery. Neither we nor the exchange agent has any duty to notify you of defects or irregularities with respect to tenders of original notes for exchange. Any holder of original notes who tenders in the exchange offer for the purpose of participating in a distribution of the exchange notes will be required to comply with the registration and prospectus delivery requirements of the Securities Act in connection with any resale transaction. Each broker or dealer that receives exchange notes for its own account in exchange for original notes that were acquired in market-making or other trading activities must acknowledge that it will deliver a prospectus in connection with any resale of the exchange notes. If you do not exchange original notes for exchange notes, transfer restrictions will continue and trading of the original notes may be adversely affected. The original notes have not been registered under the Securities Act and are subject to substantial restrictions on transfer. Original notes that are not tendered for exchange for exchange notes or are tendered but are not accepted will, following completion of the exchange offer, continue to be subject to existing restrictions upon transfers. We do not currently expect to register the original notes under the Securities Act. To the extent that original notes are tendered and accepted in the exchange offer, the trading market for original notes, if any, could be adversely affected. Risks Relating to the Exchange Notes Our substantial indebtedness could adversely affect our cash flow and prevent us from fulfilling our obligations, including making payments on the exchange notes. We have a significant amount of debt. As of September 30, 2003, we had $261.7 million of total debt and members equity of $222.5 million. Our substantial amount of debt could have important consequences to you. For example, it could: make it more difficult for us to satisfy our obligations under the exchange notes and under the new senior secured credit facility; require us to dedicate a substantial portion of our cash flow from operations to make interest and principal payments on our debt, thereby limiting the availability of our cash flow to fund future capital expenditures, working capital and other general corporate requirements; limit our flexibility in planning for, or reacting to, changes in our business, which may place us at a competitive disadvantage compared with competitors that have less debt; increase our vulnerability to adverse economic and industry conditions; and limit our ability to borrow additional funds, even when necessary to maintain adequate liquidity. The terms of the agreement governing our new senior secured credit facility and the indenture governing the exchange notes allow us to incur substantial amounts of additional debt. Any such additional debt could increase the risks associated with our substantial leverage. (In thousands) Current $ 248 $ 460 $ 519 Deferred Table of Contents Your right to receive payments on the exchange notes will be junior to our existing and future senior debt, including borrowings under our new senior secured credit facility. Further, the guarantees of the exchange notes are junior to all of the guarantors existing and future senior debt. The exchange notes will rank behind all of our existing and future senior debt. The guarantees will rank behind all of the guarantors existing and future senior debt. As of September 30, 2003, we had $4.8 million of senior debt, none of which represented borrowings under our new senior secured credit facility, and all of which was incurred by the guarantors. Our new senior secured credit facility provides for borrowings of up to $125.0 million, subject to a borrowing base (which is the maximum amount we may borrow at any one time based upon the sum of a percentage of the book value of certain accounts receivable and a percentage of the net book value of certain fixed assets), and a $200.0 million incremental term loan facility in certain events. Any borrowings under our new senior secured credit facility would be senior debt when borrowed. As of September 30, 2003, we could have borrowed the maximum $125.0 million under the credit facility according to the borrowing base. We are permitted to borrow substantial additional senior indebtedness in the future under the terms of the indenture that will govern the exchange notes. As a result of such subordination, upon any distribution to our creditors in a bankruptcy, liquidation, reorganization or similar proceeding, the holders of our senior debt will be entitled to be paid in full before any payment will be made on the exchange notes. In addition, upon any distribution to the creditors of the guarantors in a bankruptcy, liquidation, reorganization or similar proceeding, the holders of the guarantors senior debt will be entitled to be paid in full before any payment will be made on the guarantees. In addition, we will be prohibited from making any payments on the exchange notes and the guarantees if we default on our payment obligations on our senior debt and we may be prohibited from making any such payments for up to 179 consecutive days if certain non-payment defaults on senior debt occur. In the event of a bankruptcy, liquidation or reorganization or similar proceeding relating to us or the guarantors, you, as a holder of the exchange notes, will participate with all other holders of subordinated indebtedness in the assets remaining after we and the guarantors have paid all of our and their senior debt. However, because the indenture requires that amounts otherwise payable to you in a bankruptcy or similar proceeding be paid to holders of senior debt instead, you may receive less, ratably, than holders of other subordinated debt in any such proceeding. In any of these cases, we may not have sufficient funds to pay all of our creditors and you may receive less, ratably, than the holders of senior debt. Not all of our subsidiaries will guarantee the exchange notes, and the assets of our non-guarantor subsidiaries may not be available to make payments on the exchange notes. The guarantors of the exchange notes will not include all of our subsidiaries. One of our subsidiaries, Lovelace Health Systems, Inc., is a regulated health maintenance organization, or HMO, and is therefore prohibited from providing a full and unconditional guarantee of the exchange notes. On October 1, 2003, our New Mexico operations (other than the operations of AHS S.E.D. Medical Laboratories, Inc.) were merged and consolidated into Lovelace Health Systems, Inc. and the note guarantees of certain New Mexico entities were released. The newly-created entity, Lovelace Sandia Health System, Inc., continues to be a regulated HMO and is therefore prohibited from providing a full and unconditional guarantee of the exchange notes. For the nine months ended September 30, 2003, the entities constituting Lovelace Sandia Health System, Inc. after this merger and consolidation had aggregate revenues of $693.2 million, which constituted 70.8% of our consolidated revenues for that period. As of September 30, 2003, these entities had aggregate total assets of $451.2 million, which represented 57.6% of our total assets, and $241.5 million of aggregate indebtedness and other liabilities, which represented 53.6% of our total indebtedness and other liabilities. In addition, the indenture governing the notes allows us to create additional non-guarantor subsidiaries and to release the guarantees of subsidiary guarantors upon the sale of a subsidiary guarantor or upon our designation of a subsidiary guarantor as a non-restricted subsidiary under the indenture, provided in each case that we meet certain tests under the indenture. In order to sell any subsidiary guarantor, the indenture requires that we receive consideration at least equal to the fair market value of the guarantor, of which at Table of Contents Primary State or Other Standard I.R.S. Address, including zip code, and Jurisdiction of Industrial Employer telephone number, including Exact Name of Registrant Incorporation Classification Identification area code, of Registrant s as Specified in its Charter or Organization Code Number principal executive offices Table of Contents least 75% must be in the form of cash, cash equivalents or replacement assets (which are non-current tangible assets to be used in our business), and that the proceeds of the sale must be applied to the repayment of senior debt, to purchase replacement assets or make a capital expenditure that is useful in our business. To the extent we have any amount of proceeds remaining, we are required to make an offer to purchase that amount of outstanding notes and any other indebtedness which ranks equally with the notes. The indenture also sets forth certain requirements we must meet in order to designate a subsidiary guarantor as a non-restricted subsidiary, including that the subsidiary s indebtedness must be permissible under the indenture, the aggregate fair market value of all investments owned by us and the other subsidiary guarantors in that subsidiary must be permissible under the indenture, and that the subsidiary cannot own any equity interests of, or hold any liens on any property of, us or the other subsidiary guarantor. Additionally, that subsidiary cannot be party to any agreement with us or any subsidiary guarantor the terms of which are less favorable than those that might be obtained from unrelated third parties, and that subsidiary cannot have guaranteed or provided credit support for any indebtedness of us or any other guarantor. That subsidiary is also required to have one director and one officer who do not serve as directors or officers of us or any other subsidiary guarantor and no event of default may be in existence at the time of our designation under the indenture. In the event that any non-guarantor subsidiary becomes insolvent, liquidates, reorganizes, dissolves or otherwise winds up, holders of its indebtedness and its trade creditors generally will be entitled to payment on their claims from the assets of that subsidiary before any of those assets are made available to us. Consequently, your claims in respect of the exchange notes will be effectively subordinated to all of the liabilities of our non-guarantor subsidiaries, including trade payables. We are a holding company and, as such, we do not have, and will not have in the future, any income from operations. We are a holding company and conduct substantially all of our operations through our subsidiaries. Consequently we do not have any income from operations and do not expect to generate income from operations in the future. As a result, our ability to meet our debt service obligations, including our obligations under the exchange notes, substantially depends upon our subsidiaries cash flow and payment of funds to us by our subsidiaries as dividends, loans, advances or other payments. The payment of dividends or the making of loans, advances or other payments to us by our subsidiaries may be subject to regulatory or contractual restrictions. As a regulated insurance company, Lovelace Sandia Health System, Inc. may be restricted from paying dividends to us, which may reduce the amount of cash available to us. The ability of Lovelace Sandia Health System, Inc. to pay dividends or make other distributions to us is restricted by state insurance company laws and regulations. These laws and regulations require Lovelace Sandia Health System, Inc. to give notice to the New Mexico Department of Insurance prior to paying dividends or making distributions to us. In addition, Lovelace Sandia Health System, Inc. is subject to state-imposed risk-based or other net worth-based capital requirements that effectively limit the amount of funds the subsidiary has available to distribute or pay to us. As a result of these capital requirements or other agreements we may enter into with state regulators, we may not be able to receive any funds from Lovelace Sandia Health System, Inc. and, moreover, we may be required to make contributions to Lovelace Sandia Health System, Inc. to enable the subsidiary to meet its capital requirements, thereby further limiting the funds we may have to make payments with respect to the exchange notes. At September 30, 2003, Lovelace Sandia Health System, Inc. was required to maintain a net worth of $34.1 million. Actual net worth as of that date exceeded the requirement by $16.9 million. As a result of the merger and consolidation of our New Mexico operations (other than the operations of AHS S.E.D. Medical Laboratories, Inc.) into Lovelace Sandia Health System, Inc., the entities constituting Lovelace Sandia Health System, Inc. (which, for the nine months ended September 30, 2003, accounted for approximately 71% of our total net revenues) are subject to the above restrictions and regulations. As of September 30, 2003, these entities had cash and cash equivalents of approximately $33.2 million. Table of Contents To service our debt, we will require a significant amount of cash, which may not be available to us. Our ability to make payments on, or repay or refinance, our debt, including the exchange notes, and to fund planned capital expenditures, will depend largely upon our future operating performance. Our debt service obligation, including principal and interest payments, for calendar year 2004 is anticipated to be approximately $29.5 million. Our future performance, to a certain extent, is subject to general economic, financial, competitive, legislative, regulatory and other factors that are beyond our control. We cannot assure you that our business will generate sufficient cash flow from operations or that future borrowings will be available to us under our new senior secured credit facility or from other sources in an amount sufficient to enable us to pay our debt, including the exchange notes, or to fund our other liquidity needs. In addition, prior to the repayment of the exchange notes, we will be required to refinance our new senior secured credit facility. We cannot assure you that we will be able to refinance any of our debt, including our new senior secured credit facility, on commercially reasonable terms or at all. If we were unable to make payments or refinance our debt or obtain new financing under these circumstances, we would have to consider other options, such as: sales of assets; sales of equity; and/or negotiations with our lenders to restructure the applicable debt. Our credit agreements and the indenture governing the exchange notes restrict, and market or business conditions may limit, our ability to sell assets or equity or restructure any debt. The agreements governing our debt, including the exchange notes and our new senior secured credit facility, contain various covenants that limit our discretion in the operation of our business and could lead to the acceleration of our debt. Our new senior secured credit facility imposes, and future financing agreements are likely to impose, operating and financial restrictions on our activities. These restrictions require us to comply with or maintain certain financial tests and ratios, including minimum net worth and interest coverage ratios and maximum total and senior leverage ratios and limit or prohibit our ability to, among other things: incur additional debt and issue preferred stock; create liens; redeem and/or prepay certain debt; pay dividends on our stock or repurchase stock; make certain investments; enter new lines of business; engage in consolidations, mergers and acquisitions; make certain capital expenditures; and pay dividends and make other distributions. These restrictions on our ability to operate our business could seriously harm our business by, among other things, limiting our ability to take advantage of financings, mergers, acquisitions and other corporate opportunities. Various risks, uncertainties and events beyond our control could affect our ability to comply with these covenants and maintain these financial tests and ratios. Failure to comply with any of the covenants in our existing or future financing agreements could result in a default under those agreements and under other agreements containing cross-default provisions. A default would permit lenders to accelerate the maturity for the debt under these agreements and to foreclose upon any collateral securing the debt. Under Pretax income (loss): United States $ 7,033 $ 4,258 $ (771 ) $ 1,803 $ (11,151 ) Foreign Table of Contents these circumstances, we might not have sufficient funds or other resources to satisfy all of our obligations, including our obligations under the exchange notes. In addition, the limitations imposed by financing agreements on our ability to incur additional debt and to take other actions might significantly impair our ability to obtain other financing. The exchange notes generally are not secured by our assets or those of the guarantors, whereas the lenders under our new senior secured credit facility are entitled to remedies available to a secured lender, which gives them priority over you to collect amounts due to them. In addition to being subordinated to all our existing and future senior debt, the exchange notes and the guarantees will not be secured by any of our assets other than the intercompany note pledged in connection with the consolidation of the majority of our New Mexico operations. Our obligations under our new senior secured credit facility are secured by, among other things, a first priority pledge of all of the common stock of our subsidiaries and substantially all our assets. If we become insolvent or are liquidated, or if payment under our new senior secured credit facility or in respect of any other secured indebtedness is accelerated, the lenders under our new senior secured credit facility or holders of other secured indebtedness are entitled to exercise the remedies available to a secured lender under applicable law (in addition to any remedies that may be available under documents pertaining to our new senior secured credit facility or other senior debt). These lenders will have a claim on all assets securing their debt before the holders of unsecured debt, including the exchange notes. The interests of the principal members of our parent may not be aligned with your interests as a holder of the exchange notes. Welsh, Carson, Anderson Stowe IX, L.P. and its related investors control a majority of the voting power of the outstanding common units of our parent, which in turn holds all of the voting power of our common stock. Consequently, these equity holders will control all of our affairs and policies. Circumstances may occur in which the interests of these equity holders could be in conflict with the interest of the holders of the exchange notes. Generally, holders of debt securities such as the exchange notes have limited opportunities for capital appreciation and therefore are primarily focused on an issuer s creditworthiness and ability to make interest and principal payments. Because we do not currently pay a dividend to our equity holders, they are focused primarily on capital appreciation. As a result, our equity holders may have an interest in causing us to pursue acquisitions, divestitures or other transactions that, in the judgment of such equity holders, have the potential to enhance the value of their equity investment, even though such transactions might also involve risks to holders of the exchange notes, including risks to our creditworthiness. Our senior secured credit facility prohibits our ability to make a change of control offer required by the indenture governing the exchange notes, which could lead to a default under the indenture. The terms of the exchange notes will require us to make an offer to repurchase the exchange notes upon the occurrence of a change of control at a purchase price equal to 101% of the principal amount of the exchange notes, plus accrued interest to the date of the purchase. We are prohibited under the new senior secured credit facility, and may be prohibited under future debt agreements, from purchasing any exchange notes prior to their stated maturity. In such circumstances, we will be required to repay or obtain the requisite consent from the affected lenders to permit the repurchase of the exchange notes. Absent a consent, we can only make a change in control offer if there are sufficient funds remaining after repaying all amounts outstanding under the senior secured credit facility. If we are unable to repay all of such debt or are unable to obtain the necessary consents, we will be unable to offer to repurchase the exchange notes, which would constitute an event of default under the indenture governing the exchange notes, which itself would also constitute a default under our new senior secured credit facility and our other existing financing arrangements. Table of Contents The guarantees may not be enforceable because of fraudulent conveyance laws. The guarantors guarantees of the exchange notes may be subject to review under U.S. federal bankruptcy law or relevant state fraudulent conveyance laws if a bankruptcy lawsuit is commenced by or on behalf of our or the guarantors unpaid creditors. Under these laws, if in such a lawsuit a court were to find that, at the time a guarantor incurred debt (including debt represented by the guarantee), such guarantor: incurred this debt with the intent of hindering, delaying or defrauding current or future creditors; or received less than reasonably equivalent value or fair consideration for incurring this debt and the guarantor: was insolvent or was rendered insolvent by reason of the related financing transactions; was engaged, or about to engage, in a business or transaction for which its remaining assets constituted unreasonably small capital to carry on its business; or intended to incur, or believed that it would incur, debts beyond its ability to pay these debts as they mature, as all of the foregoing terms are defined in or interpreted under the relevant fraudulent transfer or conveyance statutes; then the court could void the guarantee or subordinate the amounts owing under the guarantee to the guarantor s presently existing or future debt or take other actions detrimental to you. In addition, the subsidiary guarantors may be subject to the allegation that since they incurred their guarantees for our benefit, they incurred the obligations under the guarantees for less than reasonably equivalent value or fair consideration. The measure of insolvency for purposes of the foregoing considerations will vary depending upon the law of the jurisdiction that is being applied in any such proceeding. Generally, a company would be considered insolvent if, at the time it incurred the debt or issued the guarantee: it could not pay its debts or contingent liabilities as they become due; the sum of its debts, including contingent liabilities, is greater than its assets, at fair valuation; or the present fair saleable value of its assets is less than the amount required to pay the probable liability on its total existing debts and liabilities, including contingent liabilities, as they become absolute and mature. If a guarantee is voided as a fraudulent conveyance or found to be unenforceable for any other reason, you will not have a claim against that obligor and will only be our creditor or that of any guarantor whose obligation was not set aside or found to be unenforceable. In addition, the loss of a guarantee will constitute a default under the indenture, which default would cause all outstanding notes to become immediately due and payable. An active public market may not develop for the exchange notes, which may hinder your ability to liquidate your investment. The exchange notes are a new issue of securities with no established trading market, and we do not intend to list them on any securities exchange. The liquidity of the trading market in the exchange notes, and the market price quoted for the exchange notes, may be adversely affected by changes in the overall market for fixed income securities and by changes in our financial performance or prospects or in the prospects for companies in our industry in general. As a result, we cannot assure you that an active trading market will develop for the exchange notes. If no active trading market develops, you may not be able to resell your exchange notes at their fair market value or at all. Table of Contents Risks Relating to Our Business We may not successfully integrate our recent and future acquisitions and may be unable to achieve anticipated cost savings and other benefits from these acquisitions. Since August 2001, we have acquired seven acute care hospitals, including a significant health plan, two behavioral hospitals and various other ancillary services. These acquisitions have significantly increased the size and geographic scope of our operations. In addition, one of our primary growth strategies for the future is completing additional acquisitions. The integration of past and future acquisitions involves a number of risks and presents financial, managerial and operational challenges. For example, at one of our acquired hospitals, we experienced delays in billings related to information systems transitions, and as a result, our results of operations were negatively affected. In addition to risk associated with information systems integration, we face the following risks: we may have difficulty integrating personnel and physicians from acquired hospitals; we may have difficulty, and may incur unanticipated expenses related to, upgrading the financial systems and controls at our new facilities; we may uncover liabilities at our newly-acquired operations of which we are not aware or that are greater than expected and for which the previous owner may be unable or unwilling to indemnify us; and we may be unable to improve existing managed care agreements and the mix of specialties offered at our hospitals. Failure to integrate past and future acquisitions successfully and in a timely fashion may have an adverse effect on our business, results of operations and financial condition. In addition, we may be unable to achieve the anticipated cost savings from these acquisitions for many reasons, including: contractual constraints on our ability to reduce excess staffing, inability to achieve expected tax savings from a more streamlined legal structure or inability to extract lower prices from our suppliers. Our strategy depends in part on our ability to acquire hospitals that meet our target criteria. If we are unable to do so, our future growth could be limited and our operating results could be adversely affected. The competition to acquire acute care and behavioral hospitals in the selected markets that we will target is significant, including competition from healthcare companies with greater financial resources than us and larger development staffs focused on identifying and completing acquisitions. We may be unable to identify acquisitions opportunities and to negotiate and complete acquisitions on favorable terms. Our inability to complete such acquisitions may negatively impact our future growth and results of operations. We may have difficulty acquiring hospitals from not-for-profit entities due to increased regulatory scrutiny. Many states have enacted or are considering enacting laws affecting sales, leases or other transactions in which control of not-for-profit hospitals is acquired by for-profit entities. These laws, in general, include provisions relating to state attorney general approval, advance notification and community involvement, determination of appropriate valuation of assets divested and the use of proceeds of the sale by the not-for-profit entity. In addition, state attorneys general in states without specific conversion legislation governing such transactions may exercise authority based upon charitable trust and other existing laws. The increased legal and regulatory review of these transactions involving the change of control of not-for-profit hospitals may increase the costs and time required for such acquisitions, and therefore, limit our ability to acquire not-for-profit hospitals. In addition, as a condition to approving an acquisition, certain state attorneys general may require us to maintain certain services, such as emergency departments, or to continue to provide certain levels of charity care, which may affect our decision to acquire or the terms of an acquisition of these hospitals as well as the future profitability of any such hospitals we acquire. Net income (loss) from continuing operations $ 4,343 $ Table of Contents Our acquisition strategy may be limited by restrictions and covenants in our new senior secured credit facility and by the lack of adequate alternative sources of financing. Our senior secured credit facility contains limitations on acquisitions of regulated and non-regulated entities. If we are unable to obtain any required consents from our lenders for future acquisitions, our strategy of growing by selective acquisitions may be limited. In addition, our acquisition strategy may require that we obtain additional capital to finance future transactions. Sufficient capital or financing may not be available to us on satisfactory terms, if at all. Either of these factors would negatively affect our future operating performance. Our revenues may decline if federal or state programs reduce our Medicare or Medicaid payments or managed care companies reduce our reimbursements. A substantial portion of our total net revenues is derived from the Medicare and Medicaid programs. The Medicare program accounted for 42.2% of our acute care patient days and 9.4% of our behavioral patient days for the nine months ended September 30, 2003. The Medicaid program accounted for 7.4% of our acute care patient days and 33.8% of our behavioral patient days during the nine months ended September 30, 2003. In recent years, federal and state governments have made significant changes in the Medicare and Medicaid programs. In addition, due to budget deficits in many states, significant decreases in state funding for the Medicaid programs have occurred or are being proposed. These changes in the Medicare and Medicaid programs have decreased the amounts of money we receive for our services to patients who participate in these programs. In recent years, Congress and some state legislatures have introduced a number of other proposals to make major changes in the healthcare system. Medicare-reimbursed, hospital-outpatient services converted to a prospective payment system on August 1, 2000. This system creates limitations on levels of payment for a substantial portion of hospital outpatient procedures. Future federal and state legislation may further reduce the payments we receive for our services. A number of states have adopted legislation designed to reduce their Medicaid expenditures. Some states have enrolled Medicaid recipients in managed care programs (which generally tend to reduce the level of hospital utilization) and have imposed additional taxes on hospitals to help finance or expand the states Medicaid systems. Some states have also reduced the scope of Medicaid eligibility and coverage, making an increasing number of residents unable to pay for their care. Other states propose to take similar steps. In addition, insurance and managed care companies and other third parties from whom we receive payment for our services increasingly attempt to control healthcare costs by requiring that hospitals discount their fees in exchange for exclusive or preferred participation in their benefit plans. We believe that this trend may continue and may reduce the payments we receive for our services. We face intense competition from other hospitals and other healthcare providers which may result in a decline in revenues, profitability and market share. The healthcare business is highly competitive and competition among hospitals and other healthcare providers for patients has intensified in recent years. Most of our facilities operate in geographic areas where we compete with at least one other hospital that provides services comparable to those offered by our facilities. In addition, the number of freestanding specialty hospitals and outpatient surgery and diagnostic centers in the areas in which our hospitals operate has also increased significantly. Some of the hospitals that compete with us are owned or operated by tax-supported governmental bodies or by private not-for-profit entities supported by endowments and charitable contributions which can finance capital expenditures on a tax-exempt basis and are exempt from sales, property and income taxes. Some of our competitors are more established, offer highly specialized facilities, equipment and services, which may not be available at our hospitals, offer a wider range of services or have more capital or other resources. The intense competition we face from other healthcare providers may have an adverse effect on our market share, revenues and results of operations. (A) (A) (A) (B) (Dollars in thousands) Statement of Operations Data: Revenues: Net patient service revenue $ 369,539 $ 7,994 $ 113,902 $ 138,396 $ $ 629,831 Premium revenue 13,232 27,268 509,580 550,080 Other revenue 25,213 Table of Contents Primary State or Other Standard I.R.S. Address, including zip code, and Jurisdiction of Industrial Employer telephone number, including Exact Name of Registrant Incorporation Classification Identification area code, of Registrant s as Specified in its Charter or Organization Code Number principal executive offices Table of Contents Regional concentration of our business may subject us to economic downturns in the State of New Mexico and, in particular, the Albuquerque metropolitan area. With our recent acquisitions of five acute care hospitals (including one inpatient rehabilitation hospital), two health maintenance organizations (which we subsequently merged), and certain ancillary services in New Mexico, the majority of our revenue is generated in New Mexico. For the nine months ended September 30, 2003, our New Mexico operations accounted for approximately 72% of our total net revenues. This concentration of business in New Mexico exposes us to potential losses resulting from a downturn in the economy of the State of New Mexico and, in particular, Albuquerque. If economic conditions deteriorate, we may experience a reduction in existing and new business, which may have an adverse effect on our business, financial condition and results of operations. Our success depends on our ability to attract new physicians and maintain good relationships with physicians and other healthcare professionals at our hospitals. Because physicians working with acute care hospitals generally direct the majority of hospital admissions, our success in operating our acute care hospitals will be, in part, dependent upon the number and quality of physicians on these hospitals medical staffs, the admissions practices of the physicians at these hospitals and our ability to maintain good relations with our physicians. With the exception of approximately 320 employed physicians in Albuquerque, our physicians are generally not employees of the hospitals at which they practice and most physicians have admitting privileges at other hospitals in addition to our hospitals. Physicians may terminate their affiliation with our hospitals at any time. If we are unable to successfully maintain good relationships with physicians, our hospitals admissions may decrease and our results of operations may be adversely affected. For example, patient volume at Sandia Health System was negatively affected during the nine-month period ended September 30, 2003 by the departure of certain physicians. In addition, physicians are increasingly seeking to supplement their declining income by building facilities or offering services that compete with acute care hospitals, such as ambulatory surgery centers, diagnostic imaging centers, or specialty hospitals. These facilities and services may attract patients from the more profitable service lines of an acute care hospital, leaving the hospital with less profitable or unprofitable service lines, such as emergency departments, that the hospital may be unable to close for community relations and other reasons. We compete with other healthcare providers in recruiting and retaining qualified management and staff personnel responsible for the day-to-day operations of each of our hospitals, including nurses and other non-physician healthcare professionals. In the healthcare industry generally, including our markets, the scarcity of nurses and other medical support personnel has become a significant operating issue. This shortage may require us to increase wages and benefits to recruit and retain nurses and other medical support personnel, or to hire more expensive contract or temporary personnel. If our labor costs increase, we may not be able to raise rates to offset these increased costs. Because a significant percentage of our revenues are derived from fixed, prospective payments, our ability to pass along increased labor costs is constrained. Our failure to recruit and retain qualified management, nurses and other medical support personnel, or to control our labor costs, could have an adverse effect on our business and results of operations. We depend heavily on our senior and local management personnel, and the loss of the services of one or more of our key senior management personnel or our key local management personnel could weaken our management team and our ability to deliver healthcare services efficiently. We have been, and will continue to be, dependent upon the services and management experience of David T. Vandewater, our Chief Executive Officer, Jamie E. Hopping, our Chief Operating Officer, R. Dirk Allison, our Chief Financial Officer, and our other senior executive officers. We have entered into employment agreements with each of these senior executive officers, but we do not maintain key person life insurance for these executive officers. If Mr. Vandewater, Ms. Hopping, Mr. Allison or any of our other senior executive officers were to resign their positions or otherwise be unable to serve, our management could be weakened and operating results could be adversely affected. In addition, our success Substantially all of the Company s long-term investments are held in the CHI Investment Program. The Program is structured under a Limited Partnership Agreement between CHI, as managing general partner, and each participant. All investments in the Program are professionally managed by the Company under the administration of CHI. Investments held in the Program are represented by pool units valued monthly under a custodian accounting system. Investment income from the Program, including interest income, dividends, and realized gains or losses from the sale of securities, is distributed to participants based on the earnings per pool unit. Gains or losses also are realized by participants when pool units are sold, representing the difference between the cost basis and the market value of the pool units sold. The fair value of the assets held is an allocation of the underlying market value of the assets in the Program, based upon pool units held by the participants. The underlying fair value of investments in the Program, which are traded on national exchanges, is based on the last reported sales price on the last business day of the fiscal year. The market value of investments traded in over-the-counter markets is based on the average of the last recorded bid and asked prices. Net unrealized gains (losses) on investments was $(0.59 million) at August 31, 2002. Investment losses and gains for assets limited as to use, cash equivalents, and other investments for the two-month period ended August 31, 2002 is as follows: Income (loss): Interest income $ 112 Realized gains (losses) on sales of securities (467 ) Dividend income Table of Contents depends on our ability to attract and retain local managers at our hospitals and related facilities, on the ability of our officers and key employees to manage growth successfully and on our ability to attract and retain skilled employees. If we are unable to attract and retain local management, our operating performance could be adversely affected. We conduct business in a heavily regulated industry; changes in regulations or violations of regulations may result in increased costs or sanctions that could reduce revenue and profitability. Healthcare providers are required to comply with many laws and regulations at the federal, state and local government levels. These laws and regulations relate to: licensing; the conduct of operations; the relationships among hospitals and their affiliated providers; the ownership of facilities; the addition of facilities and services; confidentiality, maintenance and security issues associated with medical records; billing for services; and prices for services. If we fail to comply with applicable laws and regulations, we could suffer civil and criminal penalties, including the loss of our licenses to operate and our ability to participate in Medicare, Medicaid, and other federal and state healthcare programs. In addition, there are heightened coordinated civil and criminal enforcement efforts by both federal and state government agencies relating to the healthcare industry, including the hospital segment. The ongoing investigations in this industry relate generally to various referral, cost reporting and billing practices, laboratory and home healthcare services, and physician ownership and joint ventures involving hospitals. In the future, different interpretations or enforcement of these laws and regulations could subject our current practices to allegations of impropriety or illegality or could require us to make changes in our operations. We may be subjected to actions brought by individuals on the government s behalf under the False Claims Act s qui tam or whistleblower provisions. Whistleblower provisions allow private individuals to bring actions on behalf of the government alleging that the defendant has defrauded the federal government. Because qui tam lawsuits are filed under seal, we could be named in one or more such lawsuits of which we are not aware. Several of our subsidiaries have been named as defendants in two qui tam lawsuits. Defendants determined to be liable under the False Claims Act may be required to pay three times the actual damages sustained by the government, plus mandatory civil penalties of between $5,500 and $11,000 for each separate false claim. Typically, each fraudulent bill submitted by a provider is considered a separate false claim, and thus the penalties under a false claim case may be substantial. Liability arises when an entity knowingly submits a false claim for reimbursement to the federal government. In some cases, whistleblowers or the federal government have taken the position that providers who allegedly have violated other statutes, such as the anti-kickback statute or the Stark Law and have submitted claims to a governmental payor during the time period they allegedly violated these other statutes, have thereby submitted false claims under the False Claims Act. In addition, a number of states have adopted their own false claims provisions as well as their own whistleblower provisions allowing a private party to file a civil lawsuit in state court. The cost of our malpractice insurance and the malpractice insurance of physicians who practice at our facilities or who participate in our networks continues to rise. Successful malpractice or tort claims asserted against us, our providers or our employees could adversely affect our financial condition and profitability. In recent years, physicians, hospitals and other healthcare providers have become subject to an increasing number of legal actions alleging malpractice or related legal theories. Many of these actions involve large claims and significant defense costs. To protect ourselves from the cost of these claims, we generally maintain professional malpractice liability insurance and general liability insurance coverage in amounts and with deductibles that we believe to be appropriate for our operations. Effective October 31, 2003, we established a wholly owned captive insurance subsidiary to insure our professional and general liability risk for claims up to $2.0 million. In addition, effective October 31, 2003, we purchased excess insurance coverage with independent third-party carriers for claims up to $75.0 million per occurrence and Net income (loss) 3,904 5,007 5,053 2,716 17,869 3,336 (7,829 ) Accrued preferred dividends 5,892 3,944 5,993 1,210 8 12 (Unaudited) Property, plant, and equipment $ $ 203 $ 19 $ 279 $ $ 2,550 Other assets, net 350 Table of Contents in the aggregate. However, our insurance coverage may not cover all claims against us or continue to be available at a reasonable cost for us to maintain adequate levels of insurance. In addition, physicians malpractice insurance costs have dramatically increased to the point where some physicians are either choosing to retire early or leave certain markets. If physician malpractice costs continue to escalate in markets in which we operate, some physicians may choose not to practice at our facilities, which could reduce our patient volume and thus our revenue. Our managed care providers involved in medical care decisions may be exposed to the risk of medical malpractice claims. Many of our network providers are our employees for whose acts we may be liable as an employer. In addition, managed care organizations may be sued directly for various types of alleged negligence, such as in connection with the credentialing of network providers or improper denials or delay of care. Finally, Congress is considering legislation that would permit managed care organizations to be held liable for negligent treatment decisions or benefits coverage determinations. If this or similar legislation were enacted, claims of this nature could result in substantial damage awards against us and our providers that could exceed the limits of any applicable medical malpractice insurance coverage and could have a material adverse effect on our financial condition. Our business depends on our information systems, and our inability to effectively integrate and manage our information systems could disrupt our operations. Our business is dependent on effective information systems that assist us in, among other things, monitoring utilization and other cost factors, supporting our healthcare management techniques, processing provider claims and providing data to our regulators. Our managed care providers also depend upon our information systems for membership verifications, claims status and other information. If we experience a reduction in the performance, reliability or availability of our information systems, our operations and ability to produce timely and accurate reports could be adversely impacted. Our information systems and applications require continual maintenance, upgrading and enhancement to meet our operational needs. Moreover, our acquisition activity requires transitions to or from, and the integration of, various information systems. We regularly upgrade and expand our information systems capabilities and are currently in the process of rolling out new clinical and financial reporting systems throughout our operations. If we experience difficulties with the transition to or from information systems or are unable to properly implement, maintain or expand our systems, we could suffer, among other things, from operational disruptions, loss of membership in our networks, regulatory problems and increases in administrative expenses. Failure to maintain the privacy and security of patients medical records could expose us to liability. The Health Insurance Portability and Accountability Act of 1996 required the Department of Health and Human Services to issue regulations requiring hospitals and other providers to implement measures to ensure the privacy and security of patients medical records and the use of uniform data standards for the exchange of information between the hospitals and health plans, including claims and payment transactions. The privacy standard became effective October 15, 2002. Full compliance with the privacy standard was required by April 14, 2003. Although we believe we have met the April 14, 2003 privacy standard compliance deadline, compliance will be an ongoing process. The transaction standard and the security standard became effective on October 16, 2000 and February 20, 2003, respectively. Full compliance with the transaction standard was required by October 16, 2003 and full compliance with the security standard is required by April 20, 2005. We are in the process of complying with the transaction standard and security standard. We may incur additional expenses in order to comply with these standards. We cannot predict the full extent of our costs of implementing all of the requirements at this stage. If we violate these standards, we may be subject to civil monetary fines and sanctions and criminal penalties. Further, a substantial portion of our revenue is derived from payments by governmental health plans, such as Medicare, and private health plans. Our failure, or the failure of the health plans with which we transact, to comply with the transaction standard may result in significant disruptions in the payments we Table of Contents receive from such health plans. Finally, because of the confidential nature of the health information we store and transmit, privacy or security breaches could expose us to a risk of regulatory action, litigation, possible liability and loss. Our privacy or security measures may be inadequate to prevent breaches, and our business operations would be adversely impacted by cancellation of contracts and loss of members if they are not prevented. A reduction in enrollment in our health plan or the failure to maintain satisfactory relationships with providers could affect our business and profitability. Premium revenue from our health plan accounted for approximately 46.1% of our total net revenues for the nine months ended September 30, 2003. A reduction in the number of members in our health plan could reduce our revenues and profitability. Factors that could contribute to a reduction in membership include premium increases, benefit changes and reductions in workforce by existing customers. In recent years, the managed care industry has received considerable negative publicity. This publicity has led to increased review of industry practices, legislation, regulation and litigation. These factors may adversely affect our ability to market our health plan services, require us to change our health plan procedures or services, and increase the regulatory burdens under which our health plan operates, further increasing the costs of doing business and adversely affecting our operating results. The profitability of our health plan depends, in large part, upon its ability to contract favorably with hospitals, physicians and other healthcare providers in appropriate numbers and at locations appropriate for the health plan s members in New Mexico. Providers could refuse to contract, demand higher payments or take other actions that could result in higher healthcare costs. If any of the key providers to our health plan refuses or is otherwise unavailable to contract with our health plan, uses its market position to negotiate more favorable contracts or otherwise places our health plan at a competitive disadvantage, our operating results could be adversely affected. Provider arrangements for our health plan with contracted primary care physicians, specialists and hospitals in its network usually have one-year terms and automatically renew for successive one-year periods. Generally, these contracts may also be cancelled by either party without cause upon 30 to 90 days prior written notice. Our health plan may be unable to continue to renew such contracts or enter into new contracts enabling our health plan to service its members profitably. If our health plan is unable to retain its current provider contracts or enter into new provider contracts on a timely basis or on favorable terms, our results of operations could be adversely affected. If we are unable to effectively price our health plan premiums or manage medical costs, our profitability will be reduced. A large amount of revenues of our health plan consists of fixed monthly payments per member. These payments are fixed by contract, and the health plan is obligated during the contract period to provide or arrange for the provision of all healthcare services required by such member. Historically, medical care costs of our health plan as a percentage of premium and other operating revenue has fluctuated. If premiums are not increased and medical care costs rise, the earnings of our health plan on insured business could decrease. In addition, actual medical care costs of our health plan may exceed its estimated costs on insured business. The premiums our health plan receives under its current insurance contracts may therefore be inadequate to cover all claims, which may cause our profits to decline. Our health plan profitability depends, to a significant degree, on our ability to predict and effectively manage medical costs. Historically, there have been fluctuations in the medical care cost ratio of our health plan. Relatively small changes in these medical care cost ratios can create significant changes in our financial results. Changes in healthcare laws, regulations and practices, utilization of services, hospital costs, pharmaceutical costs, major epidemics, terrorism or bioterrorism, new medical technologies and other external factors, including general economic conditions such as inflation levels, could reduce our ability to predict and effectively control the costs of providing healthcare services. If our medical care costs increase, our profits could be reduced or we may not remain profitable. Beginning temporarily restricted net assets $ 2,148 $ 2,184 $ 4,733 Temporarily restricted contributions 1,097 669 834 Net assets released from restrictions (503 ) (775 ) (3,055 ) Investment income (14 ) 44 278 Other changes 5 Table of Contents Our medical care costs also include estimates of claims incurred but not reported, or IBNR. We, together with our independent actuaries, estimate our medical claims liabilities using actuarial methods based on historical data for payment patterns, cost trends, product mix, seasonality, utilization of healthcare services and other relevant factors. The estimation methods and the resulting accrued liabilities are continually reviewed and updated, and adjustments, if necessary, are reflected in the period when they become known. While our IBNR estimates generally have been adequate in the past, they may be inadequate in the future, which would negatively affect our results of operations. Further, our inability to accurately estimate IBNR may also affect our ability to take timely corrective actions, further exacerbating the extent of the negative impact on our results. We maintain accrued liabilities on our financial statements in amounts we believe are adequate to provide for actuarial estimates of medical claims. We also maintain reinsurance to protect us against certain catastrophic medical claims by Medicaid beneficiaries who participate in our health plan. While we believe our reinsurance coverage with respect to these Medicaid claims is adequate, in the future such reinsurance coverage may be inadequate or unavailable to us or the cost of such reinsurance coverage may limit our ability to obtain other insurance. We do not maintain reinsurance to protect us against other catastrophic medical claims under our health plan. Recently enacted or proposed legislation, regulations and initiatives could adversely affect our business by increasing our operating costs, reducing our health plan membership or subjecting us to additional litigation. In recent years, an increasing number of legislative initiatives have been introduced or proposed in Congress and in state legislatures that would effect major changes in the healthcare system, either nationally or at the state level. Among the proposals that have been introduced are price controls on hospitals, insurance market reforms to increase the availability of group health insurance to small businesses, requirements that all businesses offer health insurance coverage to their employees and the creation of a government health insurance plan or plans that would cover all citizens, and increased payments by beneficiaries. Increased regulations, mandated benefits and more oversight, audits and investigations and changes in laws allowing access to federal and state courts to challenge healthcare decisions may increase our administrative, litigation and healthcare costs. We cannot predict whether any of the above proposals or any other proposals will be adopted, and if adopted, no assurance can be given that the implementation of such reforms will not have a material adverse effect on our business and results of operations. Net cash (used in) provided by discontinued operations (67 ) 20 (1 ) (112 ) 34 You should rely only on the information contained in this prospectus. We have not authorized any person to provide you with any information or represent anything about us or this offering that is not contained in this prospectus. If given or made, any such other information or representation should not be relied upon as having been authorized by us. We are not making an offer of the exchange notes in any jurisdiction where an offer is not permitted. Table of Contents Primary State or Other Standard I.R.S. Address, including zip code, and Jurisdiction of Industrial Employer telephone number, including Exact Name of Registrant Incorporation Classification Identification area code, of Registrant s as Specified in its Charter or Organization Code Number principal executive offices Table of Contents THE EXCHANGE OFFER Purposes and Effect of the Exchange Offer We sold the original notes on August 19, 2003 to Banc of America Securities LLC, UBS Securities LLC, Banc One Capital Markets, Inc. and Merrill Lynch, Pierce, Fenner Smith Incorporated (the initial purchasers ), who resold the original notes to qualified institutional buyers in reliance on Rule 144A under the Securities Act and outside the United States to non-U.S. persons in compliance with Regulation S under the Securities Act. In connection with the issuance of the original notes, we, our parent and our subsidiaries that guarantee the original notes (the subsidiary guarantors ) entered into a registration rights agreement with the initial purchasers of the original notes. The following description of the registration rights agreement is a summary only. It is not complete and does not describe all of the provisions of the registration rights agreement. For more information, you should review the provisions of the registration rights agreement that we filed with the SEC as an exhibit to the registration statement of which this prospectus is a part. Under the registration rights agreement, we agreed that, promptly after the effectiveness of the registration statement of which this prospectus is a part, we would offer to the holders of original notes who are not prohibited by any law or policy of the SEC from participating in the exchange offer, the opportunity to exchange their original notes for a new series of notes, which we refer to as the exchange notes, that are identical in all material respects to the original notes, except that the exchange notes do not contain transfer restrictions, have been registered under the Securities Act and are not subject to further registration rights. We, our parent and our subsidiary guarantors have agreed to use our reasonable best efforts to keep the exchange offer open for not less than 20 business days, or longer if required by applicable law, after the date on which notice of the exchange offer is mailed to the holders of the original notes. We, our parent and our subsidiary guarantors also have agreed to use our reasonable best efforts to cause the exchange offer to be consummated on the earliest practicable date after the registration statement of which this prospectus is a part has become effective, but in no event later than 30 business days after such date of effectiveness. If: (1) we, our parent and our subsidiary guarantors are not permitted to file an exchange offer registration statement or consummate the exchange offer because the exchange offer is not permitted by applicable law or SEC policy; (2) for any reason the exchange offer is not consummated within 30 business days after the registration statement of which this prospectus is a part is declared effective; or (3) any holder of transfer restricted securities notifies us that: (a) it is prohibited by law or SEC policy from participating in the exchange offer; or (b) it may not resell the exchange notes acquired by it in the exchange offer to the public without delivering a prospectus and the prospectus contained in the registration statement of which this prospectus is a part is not appropriate or available for such resales; or (c) it is a broker-dealer and owns original notes acquired directly from us or one of our affiliates, then we, our parent and the subsidiary guarantors will: (1) as soon as practicable but in any event on or prior to 45 days after the filing obligation arises, file a shelf registration statement with the SEC covering resales of the transfer restricted securities by the holders thereof who satisfy certain conditions relating to the provision of information in connection with the shelf registration statement; Table of Contents (2) use reasonable best efforts to cause the shelf registration statement to become effective on or before 135 days after the filing obligation arises; and (3) use reasonable best efforts to keep the shelf registration statement effective until the earliest to occur of (a) two years from the date on which the shelf registration statement is declared effective and (b) the time when all notes covered by the shelf registration statement have been sold pursuant to the shelf registration statement or are no longer transfer restricted securities. For purposes of the foregoing, a transfer restricted security is each original note until the earliest to occur of: (1) the date on which the original note has been exchanged in the exchange offer and may be resold to the public by the holder without complying with the prospectus delivery requirements of the Securities Act; (2) the date on which the original note has been effectively registered under the Securities Act and disposed of in accordance with the shelf registration statement; and (3) the date on which the original note is distributed to the public pursuant to Rule 144 under the Securities Act or by a broker-dealer pursuant to the procedures described in Plan of Distribution. A registration default will be deemed to occur under the registration rights agreement if: (1) any registration statement required by the registration rights agreement is not filed with the SEC on or prior to the date specified for such filing in the registration rights agreement; (2) any registration statement required by the registration rights agreement has not been declared effective by the SEC on or prior to the date specified for such effectiveness in the registration rights agreement; (3) the exchange offer has not been consummated within 30 business days of the effective date of the registration statement of which this prospectus is a part; or (4) any registration statement required by the registration rights agreement is filed and declared effective by the SEC but thereafter shall cease to be effective or fail to be usable for its intended purpose during the periods specified in the registration statement. Upon the occurrence of a registration default, we will pay liquidated damages to each holder of transfer restricted securities, with respect to the first 90-day period immediately following the occurrence of the first registration default in an amount equal to a per annum rate of 0.50% on the principal amount of transfer restricted securities held by such holder. The amount of the liquidated damages will increase by an additional per annum rate of 0.50% with respect to each subsequent 90-day period until all registration defaults have been cured, up to a maximum amount of liquidated damages for all registration defaults of 1.50% per annum on the principal amount of transfer restricted securities. Following the cure of all registration defaults, the accrual of liquidated damages will cease. By acquiring transfer restricted securities, a holder will be deemed to have agreed to indemnify us, our parent and our subsidiary guarantors against certain losses arising out of information furnished by the holder in writing for inclusion in any registration statement. Holders of transfer restricted securities will also be required to suspend their use of the prospectus included in the registration statement under certain circumstances upon receipt of notice to that effect from us. Resale of the Exchange Notes Based on an interpretation by the staff of the SEC set forth in no-action letters issued to third parties, we believe that, unless you are a broker-dealer or an affiliate of us, you may offer for resale, resell or otherwise transfer the exchange notes issued to you pursuant to the exchange offer without compliance with the registration and prospectus delivery provisions of the Securities Act, provided that you acquire the Balance at September 30, 2003 5,000 $ 131,252 30,005 $ Table of Contents exchange notes in the ordinary course of business and you do not intend to participate and have no arrangement or understanding with any person to participate in the distribution of the exchange notes. If you are an affiliate of us or if you tender in the exchange offer with the intention to participate, or for the purpose of participating, in a distribution of the exchange notes, you may not rely on the position of the staff of the SEC enunciated in Exxon Capital Holdings Corporation (available May 13, 1988) and Morgan Stanley Co., Incorporated (available June 5, 1991), or similar no-action letters, but rather must comply with the registration and prospectus delivery requirements of the Securities Act in connection with any resale transaction. In addition, any such resale transaction should be covered by an effective registration statement containing the selling security holder information required by Item 507 or 508, as applicable, of Regulation S-K of the Securities Act. Each broker-dealer that receives exchange notes for its own account in exchange for original notes, where the original notes were acquired by such broker-dealer as a result of market-making activities or other trading activities, must acknowledge that it will deliver a prospectus in connection with any resale of the exchange notes. See Plan of Distribution. By tendering in the exchange offer, you represent to us that, among other things: (1) you are not an affiliate of us; (2) you are not engaged in, and do not intend to engage in, and have no arrangement or understanding with any person to participate in, a distribution of the exchange notes to be issued in the exchange offer; (3) you are acquiring the exchange notes in the ordinary course of business; and (4) you acknowledge and agree that if you are a broker-dealer or are using the exchange offer to participate in a distribution of the exchange notes acquired in the exchange offer: (a) you cannot rely on the no-action letters described above; and (b) you must, in the absence of an exemption, comply with the registration and prospectus delivery requirements of the Securities Act in connection with any resale of the exchange notes. Terms of the Exchange Offer Upon satisfaction or waiver of all the conditions of the exchange offer, we will accept any and all original notes properly tendered and not validly withdrawn prior to the expiration date and will promptly issue the exchange notes. See Conditions to the Exchange Offer and Procedures for Tendering. We will issue $1,000 principal amount of exchange notes in exchange for each $1,000 principal amount of original notes accepted in the exchange offer. As of the date of this prospectus, there is $225,000,000 in principal amount of original notes. Holders may tender some or all of their original notes pursuant to the exchange offer. However, original notes may be tendered only in integral multiples of $1,000. The exchange offer is not conditioned upon any number or aggregate principal amount of original notes being tendered. The form and terms of the exchange notes will be the same in all material respects as the form and terms of the original notes, except that the exchange notes will be registered under the Securities Act and therefore will not bear legends restricting their transfer. The exchange notes will evidence the same debt as the original notes and will be issued pursuant to, and entitled to the benefits of, the indenture pursuant to which the original notes were issued. Original notes that are accepted for exchange will be cancelled and retired. Interest on the exchange notes will accrue from the most recent date to which interest has been paid on the original notes or, if no interest has been paid on the original notes, the issue date. Accordingly, registered holders of exchange notes on the relevant record date for the first interest payment date following the completion of the exchange offer will receive interest accruing from the most recent date to which interest has been paid or, if no interest has been paid on the original notes, the issue date. Original notes accepted for exchange will cease to accrue interest from and after the date the exchange offer closes. Table of Contents If your original notes are accepted for exchange, you will not receive any payment in respect of interest on the original notes for which the record date occurs on or after completion of the exchange offer. You do not have any appraisal or dissenters rights under the indenture in connection with the exchange offer. We intend to conduct the exchange offer in accordance with the provisions of the registration rights agreement. If you do not tender for exchange or if your tender is not accepted, the original notes will remain outstanding and you will be entitled to the benefits of the indenture, but will not be entitled to any registration rights under the registration rights agreement. For purposes of the exchange offer, we will be deemed to have accepted validly tendered original notes when, and if, we have given oral or written notice thereof to the exchange agent. The exchange agent will act as our agent for the purpose of distributing the appropriate exchange notes from us to the tendering holders. If we do not accept any tendered original notes because of an invalid tender, the occurrence of certain other events set forth in this prospectus or otherwise, we will return the unaccepted original notes, without expense, to the tendering holder thereof promptly after the expiration date. If you tender your original notes in the exchange offer, you will not be required to pay brokerage commissions or fees or, subject to the instructions in the letter of transmittal, transfer taxes with respect to the exchange of original notes pursuant to the exchange offer. We will pay all charges and expenses, other than certain applicable taxes described below, in connection with the exchange offer. See Fees and Expenses below. Expiration Date; Extension; Termination; Amendments The exchange offer will expire at 5:00 p.m., New York City time, on , 2004, unless extended (the expiration date ). We reserve the right to extend the exchange offer at our discretion, in which event the term expiration date shall mean the time and date on which the exchange offer as so extended shall expire. We will notify the exchange agent of any extension by oral or written notice and will make a public announcement of any extension and specify the principal amount of original notes tendered to date, each prior to 9:00 a.m., New York City time, on the next business day after the previously scheduled expiration date. We reserve the right, in our sole discretion, to: (1) delay accepting for exchange any original notes for exchange notes or to extend or terminate the exchange offer and not accept for exchange any original notes for exchange notes if any of the events set forth under the caption Conditions of the Exchange Offer occur and we do not waive the condition by giving oral or written notice of the delay or termination to the exchange agent; or (2) amend the terms of the exchange offer in any manner. We will not delay payment of accepted original notes after the expiration date other than in anticipation of our receipt of any necessary government approvals. If we amend the exchange offer in any manner material to investors or if we extend or terminate the exchange offer, we will promptly file a post-effective amendment to the registration statement of which this prospectus is a part. We will also announce any such change in media outlets, including PR Newswire. Any delay in acceptance for exchange, extension or amendment will be followed as promptly as practicable by a public announcement of the delay. If we amend the exchange offer in a manner we determine constitutes a material change, we will promptly disclose the amendment in a manner reasonably calculated to inform the holders of original notes of the amendment, and we will extend the exchange offer for a period of five to ten business days, depending upon the significance of the amendment and the manner of disclosure to the holders of the original notes, if the exchange offer would otherwise expire during that five to ten business day period. The rights we have reserved in this paragraph are in addition to our rights set forth under the caption Conditions of the Exchange Offer. Table of Contents Conditions of the Exchange Offer Our obligation to consummate the exchange offer is not subject to any conditions, other than that the exchange offer does not violate any applicable law or SEC staff interpretation. Accordingly, we will not be required to accept for exchange any original notes tendered and may terminate or amend the exchange offer as provided herein before the acceptance of any original notes if: (1) any action or proceeding is instituted or threatened in any court or by or before any governmental agency or regulatory authority with respect to the exchange offer which, in our judgment, could reasonably be expected to materially impair our ability to proceed with the exchange offer; or (2) there shall have been proposed, adopted or enacted any law, statute, rule, regulation, order or SEC staff interpretation which, in our judgment, could reasonably be expected to materially impair our ability to proceed with the exchange offer. The foregoing conditions are for our sole benefit and may be asserted regardless of the circumstances giving rise to the conditions or may be waived by us in whole or in part at any time and from time to time in our sole discretion prior to the expiration date. If we waive or amend the foregoing conditions, we will, if required by applicable law, extend the exchange offer for a minimum of five business days from the date that we first give notice, by public announcement or otherwise, of such waiver or amendment, if the exchange offer would otherwise expire within that five business-day period. Our determination concerning the events described above will be final and binding upon all parties. Procedures For Tendering Only a holder of original notes may tender them in the exchange offer. To validly tender in the exchange offer by book-entry transfer, you must deliver an agent s message or a completed and signed letter of transmittal (or facsimile thereof), together with any required signature guarantees and any other required documents, to the exchange agent prior to 5:00 p.m., New York City time, on the expiration date, and the original notes must be tendered pursuant to the procedures for book-entry transfer set forth below. To validly tender by means other than book-entry transfer, you must deliver a completed and signed letter of transmittal (or facsimile thereof), together with any required signature guarantees and any other required documents and the original notes, to the exchange agent prior to 5:00 p.m., New York City time, on the expiration date. Any financial institution that is a participant in DTC s Book-Entry Transfer Facility system may make book-entry delivery of the original notes by causing DTC to transfer the original notes into the exchange agent s account in accordance with DTC s ATOP procedures for transfer. However, although delivery of original notes may be effected through book-entry transfer into the exchange agent s account at DTC, an agent s message or a completed and signed letter of transmittal (or facsimile thereof), with any required signature guarantees and any other required documents, must, in any case, be transmitted to and received or confirmed by the exchange agent at its addresses set forth under the caption Exchange Agent prior to 5:00 p.m., New York City time, on the expiration date, or the guaranteed delivery procedure set forth below must be complied with. DELIVERY OF DOCUMENTS TO DTC IN ACCORDANCE WITH DTC S PROCEDURES DOES NOT CONSTITUTE DELIVERY TO THE EXCHANGE AGENT. The term agent s message means, with respect to any tendered original notes, a message transmitted by DTC to and received by the exchange agent and forming part of a book-entry confirmation, stating that DTC has received an express acknowledgment from each tendering participant to the effect that, with respect to those original notes, the participant has received and agrees to be bound by the letter of transmittal and that we may enforce the letter of transmittal against the participant. The term book-entry confirmation means a timely confirmation of a book-entry transfer of original notes into the exchange agent s account at DTC. Table of Contents If you tender an original note, and do not validly withdraw your tender, your actions will constitute an agreement with us in accordance with the terms and subject to the conditions set forth in this prospectus and in the letter of transmittal. The method of delivery of your original notes and the letter of transmittal and all other required documents to the exchange agent is at your election and risk. Instead of delivery by mail, we recommend that you use an overnight or hand delivery service. In all cases, you should allow sufficient time to assure delivery to the exchange agent before the expiration date. No letter of transmittal or original note should be sent to us; instead, they should be sent to the exchange agent. You may request that your broker, dealer, commercial bank, trust company or nominee effect the tender for you. Signatures on a letter of transmittal or a notice of withdrawal, as the case may be, must be guaranteed by an eligible institution (as defined below) unless the original notes are being tendered: (1) by a registered holder who has not completed the box entitled Special Issuance Instructions or Special Delivery Instructions on the letter of transmittal; or (2) for the account of an eligible institution. If signatures on a letter of transmittal or a notice of withdrawal, as the case may be, are required to be guaranteed, the guarantee must be by a member of a signature guarantee program within the meaning of Rule 17Ad-15 under the Exchange Act (an eligible institution ). If the letter of transmittal or any original notes or bond powers are signed by trustees, executors, administrators, guardians, attorneys-in-fact, officers of corporations or others acting in a fiduciary or representative capacity, those persons should so indicate when signing, and unless we waive it, evidence satisfactory to us of their authority to act must be submitted with the letter of transmittal. We will determine, in our sole discretion, all questions as to the validity, form, eligibility (including time of receipt) and acceptance and withdrawal of tendered original notes. Our determination will be final and binding. We reserve the absolute right to reject any and all original notes not properly tendered or any original notes our acceptance of which would, in the opinion of our counsel, be unlawful. We also reserve the right to waive any defects, irregularities or conditions of tender as to particular original notes. Our interpretation of the terms and conditions of the exchange offer (including the instructions in the letter of transmittal) will be final and binding on all parties. Unless waived, you must cure any defects or irregularities in connection with tenders of your original notes within a time period we will determine. Although we intend to request that the exchange agent notify you of defects or irregularities with respect to your tender of original notes, we will not, nor will the exchange agent or any other person, incur any liability for failure to give you any notification. Tenders of original notes will not be deemed to have been made until any defects or irregularities have been cured or waived. Any original notes received by the exchange agent that are not properly tendered and as to which the defects or irregularities have not been cured or waived will be returned by the exchange agent to the tendering holders, unless otherwise provided in the letter of transmittal, promptly after the expiration date. In addition, we reserve the right in our sole discretion (subject to the limitations contained in the indenture for the exchange notes): (1) to purchase or make offers for any original notes that remain outstanding after the expiration date; and (2) to the extent permitted by applicable law, to purchase original notes in the open market, in privately negotiated transactions or otherwise. The terms of any purchases or offers could differ from the terms of the exchange offer. 16,092 Other assets Table of Contents The information in this prospectus is not complete and may be changed. We may not exchange these securities until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to exchange these securities and it is not soliciting an offer to exchange these securities in any state where the offer or exchange is not permitted. SUBJECT TO COMPLETION, DATED JANUARY 26, 2004 PROSPECTUS Ardent Health Services, Inc. Offer to Exchange up to $225,000,000 of 10% Senior Subordinated Notes due 2013 for up to $225,000,000 of 10% Senior Subordinated Notes due 2013 that have been registered under the Securities Act of 1933 We are offering to exchange our 10% senior subordinated notes due 2013, or the exchange notes, for our currently outstanding 10% senior subordinated notes due 2013, or the original notes. We sometimes refer to the exchange notes and the original notes collectively as the notes. Terms of the exchange notes: The exchange notes are substantially identical to the original notes, except that the exchange notes have been registered under the Securities Act of 1933, or the Securities Act, and will not contain restrictions on transfer or have registration rights. The exchange notes will represent the same debt as the original notes, and we will issue the exchange notes under the same indenture. The exchange notes will be subordinated to any existing and future senior indebtedness, including borrowings under our senior secured credit facility, and will rank equally with any future senior subordinated indebtedness. Assuming the exchange offer had been completed on September 30, 2003, the exchange notes would have been subordinated to approximately $4.8 million of our outstanding indebtedness. Terms of the exchange offer: The exchange offer expires at 5:00 p.m., New York City time, on , 2004, unless extended. We will exchange all original notes that are validly tendered and not validly withdrawn prior to the expiration of the exchange offer. You may withdraw tendered original notes at any time prior to the expiration of the exchange offer. We do not intend to apply for listing of the exchange notes on any securities exchange or to arrange for them to be quoted on any quotation system. The exchange offer is subject to customary conditions, including the condition that the exchange offer not violate applicable law or any applicable interpretation of the staff of the Securities and Exchange Commission, or the SEC. The exchange of original notes for exchange notes pursuant to the exchange offer will not constitute a taxable event for U.S. federal income tax purposes. We will not receive any proceeds from the exchange offer. Broker-dealers who acquired original notes from us in the initial offering are not eligible to participate in the exchange offer with respect to such original notes. Each broker-dealer that receives exchange notes for its own account pursuant to the exchange offer must acknowledge that it will deliver a prospectus in connection with any resale of the exchange notes. The letter of transmittal states that by so acknowledging and by delivering a prospectus, a broker-dealer will not be deemed to admit that it is an underwriter within the meaning of the Securities Act of 1933. This prospectus, as it may be amended or supplemented from time to time, may be used by a broker-dealer in connection with any resales of exchange notes received in exchange for original notes where the original notes were acquired by the broker-dealer as a result of market-making activities or other trading activities. We have agreed that, for up to 180 days after the expiration date, as defined in this prospectus, we will make this prospectus available to any broker-dealer for use in connection with any such resale. See Plan of Distribution. Investing in the exchange notes involves risks. See Risk Factors beginning on page 15. Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of the securities to be distributed in the exchange offer or determined that this prospectus is truthful or complete. Any representation to the contrary is a criminal offense. The date of this prospectus is , 2004. Table of Contents By tendering, you represent to us, among other things, that: (1) you are not affiliate of us (as defined in Rule 405 under the Securities Act); (2) you are not engaged in, and do not intend to engage in, and have no arrangement or understanding with any person to participate in, a distribution of the exchange notes; and (3) you are acquiring the exchange notes in the ordinary course of business. If you are a broker-dealer that will receive exchange notes for your own account in exchange for original notes that were acquired as a result of market-making activities or other trading activities, you must acknowledge that you will deliver a prospectus in connection with any resale of the exchange notes. Guaranteed Delivery Procedures If you wish to tender your original notes and either your original notes are not immediately available, or you cannot deliver your original notes and other required documents to the exchange agent, or cannot complete the procedure for book-entry transfer prior to the expiration date, you may effect a tender if: (1) you make a tender through an eligible institution; (2) prior to the expiration date, the exchange agent receives from the eligible institution a properly completed and duly executed notice of guaranteed delivery (by facsimile transmission, mail or hand delivery) setting forth your name and address, the certificate number(s) of the original notes (if available) and the principal amount of original notes tendered together with a duly executed letter of transmittal (or a facsimile thereof), stating that the tender is being made thereby and guaranteeing that, within three business days after the expiration date, the certificate(s) representing the original notes to be tendered, in proper form for transfer (or a confirmation of a book-entry transfer into the exchange agent s account at DTC of original notes delivered electronically) and any other documents required by the letter of transmittal, will be deposited by the eligible institution with the exchange agent; and (3) the certificate(s) representing all tendered original notes in proper form for transfer (or confirmation of a book-entry transfer into the exchange agent s account at DTC of original notes delivered electronically) and all other documents required by the letter of transmittal are received by the exchange agent within three business days after the expiration date. Upon request to the exchange agent, you will be sent a notice of guaranteed delivery if you wish to tender your original notes according to the guaranteed delivery procedures set forth above. Withdrawal of Tenders Except as otherwise provided in this prospectus, you may withdraw any tenders of original notes at any time prior to 5:00 p.m., New York City time, on the expiration date, unless previously accepted for exchange. For your withdrawal to be effective, the exchange agent must receive a written or facsimile transmission notice of withdrawal at its address set forth herein prior to 5:00 p.m., New York City time, on the expiration date, and prior to our acceptance for exchange. Any notice of withdrawal must: (1) specify the name of the person having tendered the original notes to be withdrawn; (2) identify the original notes to be withdrawn (including the certificate number or numbers, if applicable, and principal amount of the original notes); (3) be signed in the same manner as the original signature on the letter of transmittal by which the original notes were tendered (including any required signature guarantees) or be accompanied by documents of transfer sufficient to have the trustee with respect to the original notes register the transfer of the original notes into the name of the person withdrawing the tender; and TABLE OF CONTENTS SUMMARY RISK FACTORS
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+RISK FACTORS You should consider carefully the following factors, as well as the information contained in the rest of this prospectus before deciding whether to participate in the exchange offer. Risk Factors Relating to the Exchange Offer You must carefully follow the required procedures in order to exchange your original notes. The exchange notes will be issued in exchange for original notes only after timely receipt by the exchange agent of a duly executed letter of transmittal and all other required documents. Therefore, if you wish to tender your original notes, you must allow sufficient time to ensure timely delivery. Neither we nor the exchange agent has any duty to notify you of defects or irregularities with respect to tenders of original notes for exchange. Any holder of original notes who tenders in the exchange offer for the purpose of participating in a distribution of the exchange notes will be required to comply with the registration and prospectus delivery requirements of the Securities Act in connection with any resale transaction. Each broker or dealer that receives exchange notes for its own account in exchange for original notes that were acquired in market-making or other trading activities must acknowledge that it will deliver a prospectus in connection with any resale of the exchange notes. If you do not exchange original notes for exchange notes, transfer restrictions will continue and trading of the original notes may be adversely affected. The original notes have not been registered under the Securities Act and are subject to substantial restrictions on transfer. Original notes that are not tendered for exchange for exchange notes or are tendered but are not accepted will, following completion of the exchange offer, continue to be subject to existing restrictions upon transfers. We do not currently expect to register the original notes under the Securities Act. To the extent that original notes are tendered and accepted in the exchange offer, the trading market for original notes, if any, could be adversely affected. Risks Relating to the Exchange Notes Our substantial indebtedness could adversely affect our cash flow and prevent us from fulfilling our obligations, including making payments on the exchange notes. We have a significant amount of debt. As of September 30, 2003, we had $261.7 million of total debt and members equity of $222.5 million. Our substantial amount of debt could have important consequences to you. For example, it could: make it more difficult for us to satisfy our obligations under the exchange notes and under the new senior secured credit facility; require us to dedicate a substantial portion of our cash flow from operations to make interest and principal payments on our debt, thereby limiting the availability of our cash flow to fund future capital expenditures, working capital and other general corporate requirements; limit our flexibility in planning for, or reacting to, changes in our business, which may place us at a competitive disadvantage compared with competitors that have less debt; increase our vulnerability to adverse economic and industry conditions; and limit our ability to borrow additional funds, even when necessary to maintain adequate liquidity. The terms of the agreement governing our new senior secured credit facility and the indenture governing the exchange notes allow us to incur substantial amounts of additional debt. Any such additional debt could increase the risks associated with our substantial leverage. (In thousands) Current $ 248 $ 460 $ 519 Deferred Table of Contents Your right to receive payments on the exchange notes will be junior to our existing and future senior debt, including borrowings under our new senior secured credit facility. Further, the guarantees of the exchange notes are junior to all of the guarantors existing and future senior debt. The exchange notes will rank behind all of our existing and future senior debt. The guarantees will rank behind all of the guarantors existing and future senior debt. As of September 30, 2003, we had $4.8 million of senior debt, none of which represented borrowings under our new senior secured credit facility, and all of which was incurred by the guarantors. Our new senior secured credit facility provides for borrowings of up to $125.0 million, subject to a borrowing base (which is the maximum amount we may borrow at any one time based upon the sum of a percentage of the book value of certain accounts receivable and a percentage of the net book value of certain fixed assets), and a $200.0 million incremental term loan facility in certain events. Any borrowings under our new senior secured credit facility would be senior debt when borrowed. As of September 30, 2003, we could have borrowed the maximum $125.0 million under the credit facility according to the borrowing base. We are permitted to borrow substantial additional senior indebtedness in the future under the terms of the indenture that will govern the exchange notes. As a result of such subordination, upon any distribution to our creditors in a bankruptcy, liquidation, reorganization or similar proceeding, the holders of our senior debt will be entitled to be paid in full before any payment will be made on the exchange notes. In addition, upon any distribution to the creditors of the guarantors in a bankruptcy, liquidation, reorganization or similar proceeding, the holders of the guarantors senior debt will be entitled to be paid in full before any payment will be made on the guarantees. In addition, we will be prohibited from making any payments on the exchange notes and the guarantees if we default on our payment obligations on our senior debt and we may be prohibited from making any such payments for up to 179 consecutive days if certain non-payment defaults on senior debt occur. In the event of a bankruptcy, liquidation or reorganization or similar proceeding relating to us or the guarantors, you, as a holder of the exchange notes, will participate with all other holders of subordinated indebtedness in the assets remaining after we and the guarantors have paid all of our and their senior debt. However, because the indenture requires that amounts otherwise payable to you in a bankruptcy or similar proceeding be paid to holders of senior debt instead, you may receive less, ratably, than holders of other subordinated debt in any such proceeding. In any of these cases, we may not have sufficient funds to pay all of our creditors and you may receive less, ratably, than the holders of senior debt. Not all of our subsidiaries will guarantee the exchange notes, and the assets of our non-guarantor subsidiaries may not be available to make payments on the exchange notes. The guarantors of the exchange notes will not include all of our subsidiaries. One of our subsidiaries, Lovelace Health Systems, Inc., is a regulated health maintenance organization, or HMO, and is therefore prohibited from providing a full and unconditional guarantee of the exchange notes. On October 1, 2003, our New Mexico operations (other than the operations of AHS S.E.D. Medical Laboratories, Inc.) were merged and consolidated into Lovelace Health Systems, Inc. and the note guarantees of certain New Mexico entities were released. The newly-created entity, Lovelace Sandia Health System, Inc., continues to be a regulated HMO and is therefore prohibited from providing a full and unconditional guarantee of the exchange notes. For the nine months ended September 30, 2003, the entities constituting Lovelace Sandia Health System, Inc. after this merger and consolidation had aggregate revenues of $693.2 million, which constituted 70.8% of our consolidated revenues for that period. As of September 30, 2003, these entities had aggregate total assets of $451.2 million, which represented 57.6% of our total assets, and $241.5 million of aggregate indebtedness and other liabilities, which represented 53.6% of our total indebtedness and other liabilities. In addition, the indenture governing the notes allows us to create additional non-guarantor subsidiaries and to release the guarantees of subsidiary guarantors upon the sale of a subsidiary guarantor or upon our designation of a subsidiary guarantor as a non-restricted subsidiary under the indenture, provided in each case that we meet certain tests under the indenture. In order to sell any subsidiary guarantor, the indenture requires that we receive consideration at least equal to the fair market value of the guarantor, of which at Table of Contents Primary State or Other Standard I.R.S. Address, including zip code, and Jurisdiction of Industrial Employer telephone number, including Exact Name of Registrant Incorporation Classification Identification area code, of Registrant s as Specified in its Charter or Organization Code Number principal executive offices Table of Contents least 75% must be in the form of cash, cash equivalents or replacement assets (which are non-current tangible assets to be used in our business), and that the proceeds of the sale must be applied to the repayment of senior debt, to purchase replacement assets or make a capital expenditure that is useful in our business. To the extent we have any amount of proceeds remaining, we are required to make an offer to purchase that amount of outstanding notes and any other indebtedness which ranks equally with the notes. The indenture also sets forth certain requirements we must meet in order to designate a subsidiary guarantor as a non-restricted subsidiary, including that the subsidiary s indebtedness must be permissible under the indenture, the aggregate fair market value of all investments owned by us and the other subsidiary guarantors in that subsidiary must be permissible under the indenture, and that the subsidiary cannot own any equity interests of, or hold any liens on any property of, us or the other subsidiary guarantor. Additionally, that subsidiary cannot be party to any agreement with us or any subsidiary guarantor the terms of which are less favorable than those that might be obtained from unrelated third parties, and that subsidiary cannot have guaranteed or provided credit support for any indebtedness of us or any other guarantor. That subsidiary is also required to have one director and one officer who do not serve as directors or officers of us or any other subsidiary guarantor and no event of default may be in existence at the time of our designation under the indenture. In the event that any non-guarantor subsidiary becomes insolvent, liquidates, reorganizes, dissolves or otherwise winds up, holders of its indebtedness and its trade creditors generally will be entitled to payment on their claims from the assets of that subsidiary before any of those assets are made available to us. Consequently, your claims in respect of the exchange notes will be effectively subordinated to all of the liabilities of our non-guarantor subsidiaries, including trade payables. We are a holding company and, as such, we do not have, and will not have in the future, any income from operations. We are a holding company and conduct substantially all of our operations through our subsidiaries. Consequently we do not have any income from operations and do not expect to generate income from operations in the future. As a result, our ability to meet our debt service obligations, including our obligations under the exchange notes, substantially depends upon our subsidiaries cash flow and payment of funds to us by our subsidiaries as dividends, loans, advances or other payments. The payment of dividends or the making of loans, advances or other payments to us by our subsidiaries may be subject to regulatory or contractual restrictions. As a regulated insurance company, Lovelace Sandia Health System, Inc. may be restricted from paying dividends to us, which may reduce the amount of cash available to us. The ability of Lovelace Sandia Health System, Inc. to pay dividends or make other distributions to us is restricted by state insurance company laws and regulations. These laws and regulations require Lovelace Sandia Health System, Inc. to give notice to the New Mexico Department of Insurance prior to paying dividends or making distributions to us. In addition, Lovelace Sandia Health System, Inc. is subject to state-imposed risk-based or other net worth-based capital requirements that effectively limit the amount of funds the subsidiary has available to distribute or pay to us. As a result of these capital requirements or other agreements we may enter into with state regulators, we may not be able to receive any funds from Lovelace Sandia Health System, Inc. and, moreover, we may be required to make contributions to Lovelace Sandia Health System, Inc. to enable the subsidiary to meet its capital requirements, thereby further limiting the funds we may have to make payments with respect to the exchange notes. At September 30, 2003, Lovelace Sandia Health System, Inc. was required to maintain a net worth of $34.1 million. Actual net worth as of that date exceeded the requirement by $16.9 million. As a result of the merger and consolidation of our New Mexico operations (other than the operations of AHS S.E.D. Medical Laboratories, Inc.) into Lovelace Sandia Health System, Inc., the entities constituting Lovelace Sandia Health System, Inc. (which, for the nine months ended September 30, 2003, accounted for approximately 71% of our total net revenues) are subject to the above restrictions and regulations. As of September 30, 2003, these entities had cash and cash equivalents of approximately $33.2 million. Table of Contents To service our debt, we will require a significant amount of cash, which may not be available to us. Our ability to make payments on, or repay or refinance, our debt, including the exchange notes, and to fund planned capital expenditures, will depend largely upon our future operating performance. Our debt service obligation, including principal and interest payments, for calendar year 2004 is anticipated to be approximately $29.5 million. Our future performance, to a certain extent, is subject to general economic, financial, competitive, legislative, regulatory and other factors that are beyond our control. We cannot assure you that our business will generate sufficient cash flow from operations or that future borrowings will be available to us under our new senior secured credit facility or from other sources in an amount sufficient to enable us to pay our debt, including the exchange notes, or to fund our other liquidity needs. In addition, prior to the repayment of the exchange notes, we will be required to refinance our new senior secured credit facility. We cannot assure you that we will be able to refinance any of our debt, including our new senior secured credit facility, on commercially reasonable terms or at all. If we were unable to make payments or refinance our debt or obtain new financing under these circumstances, we would have to consider other options, such as: sales of assets; sales of equity; and/or negotiations with our lenders to restructure the applicable debt. Our credit agreements and the indenture governing the exchange notes restrict, and market or business conditions may limit, our ability to sell assets or equity or restructure any debt. The agreements governing our debt, including the exchange notes and our new senior secured credit facility, contain various covenants that limit our discretion in the operation of our business and could lead to the acceleration of our debt. Our new senior secured credit facility imposes, and future financing agreements are likely to impose, operating and financial restrictions on our activities. These restrictions require us to comply with or maintain certain financial tests and ratios, including minimum net worth and interest coverage ratios and maximum total and senior leverage ratios and limit or prohibit our ability to, among other things: incur additional debt and issue preferred stock; create liens; redeem and/or prepay certain debt; pay dividends on our stock or repurchase stock; make certain investments; enter new lines of business; engage in consolidations, mergers and acquisitions; make certain capital expenditures; and pay dividends and make other distributions. These restrictions on our ability to operate our business could seriously harm our business by, among other things, limiting our ability to take advantage of financings, mergers, acquisitions and other corporate opportunities. Various risks, uncertainties and events beyond our control could affect our ability to comply with these covenants and maintain these financial tests and ratios. Failure to comply with any of the covenants in our existing or future financing agreements could result in a default under those agreements and under other agreements containing cross-default provisions. A default would permit lenders to accelerate the maturity for the debt under these agreements and to foreclose upon any collateral securing the debt. Under Pretax income (loss): United States $ 7,033 $ 4,258 $ (771 ) $ 1,803 $ (11,151 ) Foreign Table of Contents these circumstances, we might not have sufficient funds or other resources to satisfy all of our obligations, including our obligations under the exchange notes. In addition, the limitations imposed by financing agreements on our ability to incur additional debt and to take other actions might significantly impair our ability to obtain other financing. The exchange notes generally are not secured by our assets or those of the guarantors, whereas the lenders under our new senior secured credit facility are entitled to remedies available to a secured lender, which gives them priority over you to collect amounts due to them. In addition to being subordinated to all our existing and future senior debt, the exchange notes and the guarantees will not be secured by any of our assets other than the intercompany note pledged in connection with the consolidation of the majority of our New Mexico operations. Our obligations under our new senior secured credit facility are secured by, among other things, a first priority pledge of all of the common stock of our subsidiaries and substantially all our assets. If we become insolvent or are liquidated, or if payment under our new senior secured credit facility or in respect of any other secured indebtedness is accelerated, the lenders under our new senior secured credit facility or holders of other secured indebtedness are entitled to exercise the remedies available to a secured lender under applicable law (in addition to any remedies that may be available under documents pertaining to our new senior secured credit facility or other senior debt). These lenders will have a claim on all assets securing their debt before the holders of unsecured debt, including the exchange notes. The interests of the principal members of our parent may not be aligned with your interests as a holder of the exchange notes. Welsh, Carson, Anderson Stowe IX, L.P. and its related investors control a majority of the voting power of the outstanding common units of our parent, which in turn holds all of the voting power of our common stock. Consequently, these equity holders will control all of our affairs and policies. Circumstances may occur in which the interests of these equity holders could be in conflict with the interest of the holders of the exchange notes. Generally, holders of debt securities such as the exchange notes have limited opportunities for capital appreciation and therefore are primarily focused on an issuer s creditworthiness and ability to make interest and principal payments. Because we do not currently pay a dividend to our equity holders, they are focused primarily on capital appreciation. As a result, our equity holders may have an interest in causing us to pursue acquisitions, divestitures or other transactions that, in the judgment of such equity holders, have the potential to enhance the value of their equity investment, even though such transactions might also involve risks to holders of the exchange notes, including risks to our creditworthiness. Our senior secured credit facility prohibits our ability to make a change of control offer required by the indenture governing the exchange notes, which could lead to a default under the indenture. The terms of the exchange notes will require us to make an offer to repurchase the exchange notes upon the occurrence of a change of control at a purchase price equal to 101% of the principal amount of the exchange notes, plus accrued interest to the date of the purchase. We are prohibited under the new senior secured credit facility, and may be prohibited under future debt agreements, from purchasing any exchange notes prior to their stated maturity. In such circumstances, we will be required to repay or obtain the requisite consent from the affected lenders to permit the repurchase of the exchange notes. Absent a consent, we can only make a change in control offer if there are sufficient funds remaining after repaying all amounts outstanding under the senior secured credit facility. If we are unable to repay all of such debt or are unable to obtain the necessary consents, we will be unable to offer to repurchase the exchange notes, which would constitute an event of default under the indenture governing the exchange notes, which itself would also constitute a default under our new senior secured credit facility and our other existing financing arrangements. Table of Contents The guarantees may not be enforceable because of fraudulent conveyance laws. The guarantors guarantees of the exchange notes may be subject to review under U.S. federal bankruptcy law or relevant state fraudulent conveyance laws if a bankruptcy lawsuit is commenced by or on behalf of our or the guarantors unpaid creditors. Under these laws, if in such a lawsuit a court were to find that, at the time a guarantor incurred debt (including debt represented by the guarantee), such guarantor: incurred this debt with the intent of hindering, delaying or defrauding current or future creditors; or received less than reasonably equivalent value or fair consideration for incurring this debt and the guarantor: was insolvent or was rendered insolvent by reason of the related financing transactions; was engaged, or about to engage, in a business or transaction for which its remaining assets constituted unreasonably small capital to carry on its business; or intended to incur, or believed that it would incur, debts beyond its ability to pay these debts as they mature, as all of the foregoing terms are defined in or interpreted under the relevant fraudulent transfer or conveyance statutes; then the court could void the guarantee or subordinate the amounts owing under the guarantee to the guarantor s presently existing or future debt or take other actions detrimental to you. In addition, the subsidiary guarantors may be subject to the allegation that since they incurred their guarantees for our benefit, they incurred the obligations under the guarantees for less than reasonably equivalent value or fair consideration. The measure of insolvency for purposes of the foregoing considerations will vary depending upon the law of the jurisdiction that is being applied in any such proceeding. Generally, a company would be considered insolvent if, at the time it incurred the debt or issued the guarantee: it could not pay its debts or contingent liabilities as they become due; the sum of its debts, including contingent liabilities, is greater than its assets, at fair valuation; or the present fair saleable value of its assets is less than the amount required to pay the probable liability on its total existing debts and liabilities, including contingent liabilities, as they become absolute and mature. If a guarantee is voided as a fraudulent conveyance or found to be unenforceable for any other reason, you will not have a claim against that obligor and will only be our creditor or that of any guarantor whose obligation was not set aside or found to be unenforceable. In addition, the loss of a guarantee will constitute a default under the indenture, which default would cause all outstanding notes to become immediately due and payable. An active public market may not develop for the exchange notes, which may hinder your ability to liquidate your investment. The exchange notes are a new issue of securities with no established trading market, and we do not intend to list them on any securities exchange. The liquidity of the trading market in the exchange notes, and the market price quoted for the exchange notes, may be adversely affected by changes in the overall market for fixed income securities and by changes in our financial performance or prospects or in the prospects for companies in our industry in general. As a result, we cannot assure you that an active trading market will develop for the exchange notes. If no active trading market develops, you may not be able to resell your exchange notes at their fair market value or at all. Table of Contents Risks Relating to Our Business We may not successfully integrate our recent and future acquisitions and may be unable to achieve anticipated cost savings and other benefits from these acquisitions. Since August 2001, we have acquired seven acute care hospitals, including a significant health plan, two behavioral hospitals and various other ancillary services. These acquisitions have significantly increased the size and geographic scope of our operations. In addition, one of our primary growth strategies for the future is completing additional acquisitions. The integration of past and future acquisitions involves a number of risks and presents financial, managerial and operational challenges. For example, at one of our acquired hospitals, we experienced delays in billings related to information systems transitions, and as a result, our results of operations were negatively affected. In addition to risk associated with information systems integration, we face the following risks: we may have difficulty integrating personnel and physicians from acquired hospitals; we may have difficulty, and may incur unanticipated expenses related to, upgrading the financial systems and controls at our new facilities; we may uncover liabilities at our newly-acquired operations of which we are not aware or that are greater than expected and for which the previous owner may be unable or unwilling to indemnify us; and we may be unable to improve existing managed care agreements and the mix of specialties offered at our hospitals. Failure to integrate past and future acquisitions successfully and in a timely fashion may have an adverse effect on our business, results of operations and financial condition. In addition, we may be unable to achieve the anticipated cost savings from these acquisitions for many reasons, including: contractual constraints on our ability to reduce excess staffing, inability to achieve expected tax savings from a more streamlined legal structure or inability to extract lower prices from our suppliers. Our strategy depends in part on our ability to acquire hospitals that meet our target criteria. If we are unable to do so, our future growth could be limited and our operating results could be adversely affected. The competition to acquire acute care and behavioral hospitals in the selected markets that we will target is significant, including competition from healthcare companies with greater financial resources than us and larger development staffs focused on identifying and completing acquisitions. We may be unable to identify acquisitions opportunities and to negotiate and complete acquisitions on favorable terms. Our inability to complete such acquisitions may negatively impact our future growth and results of operations. We may have difficulty acquiring hospitals from not-for-profit entities due to increased regulatory scrutiny. Many states have enacted or are considering enacting laws affecting sales, leases or other transactions in which control of not-for-profit hospitals is acquired by for-profit entities. These laws, in general, include provisions relating to state attorney general approval, advance notification and community involvement, determination of appropriate valuation of assets divested and the use of proceeds of the sale by the not-for-profit entity. In addition, state attorneys general in states without specific conversion legislation governing such transactions may exercise authority based upon charitable trust and other existing laws. The increased legal and regulatory review of these transactions involving the change of control of not-for-profit hospitals may increase the costs and time required for such acquisitions, and therefore, limit our ability to acquire not-for-profit hospitals. In addition, as a condition to approving an acquisition, certain state attorneys general may require us to maintain certain services, such as emergency departments, or to continue to provide certain levels of charity care, which may affect our decision to acquire or the terms of an acquisition of these hospitals as well as the future profitability of any such hospitals we acquire. Net income (loss) from continuing operations $ 4,343 $ Table of Contents Our acquisition strategy may be limited by restrictions and covenants in our new senior secured credit facility and by the lack of adequate alternative sources of financing. Our senior secured credit facility contains limitations on acquisitions of regulated and non-regulated entities. If we are unable to obtain any required consents from our lenders for future acquisitions, our strategy of growing by selective acquisitions may be limited. In addition, our acquisition strategy may require that we obtain additional capital to finance future transactions. Sufficient capital or financing may not be available to us on satisfactory terms, if at all. Either of these factors would negatively affect our future operating performance. Our revenues may decline if federal or state programs reduce our Medicare or Medicaid payments or managed care companies reduce our reimbursements. A substantial portion of our total net revenues is derived from the Medicare and Medicaid programs. The Medicare program accounted for 42.2% of our acute care patient days and 9.4% of our behavioral patient days for the nine months ended September 30, 2003. The Medicaid program accounted for 7.4% of our acute care patient days and 33.8% of our behavioral patient days during the nine months ended September 30, 2003. In recent years, federal and state governments have made significant changes in the Medicare and Medicaid programs. In addition, due to budget deficits in many states, significant decreases in state funding for the Medicaid programs have occurred or are being proposed. These changes in the Medicare and Medicaid programs have decreased the amounts of money we receive for our services to patients who participate in these programs. In recent years, Congress and some state legislatures have introduced a number of other proposals to make major changes in the healthcare system. Medicare-reimbursed, hospital-outpatient services converted to a prospective payment system on August 1, 2000. This system creates limitations on levels of payment for a substantial portion of hospital outpatient procedures. Future federal and state legislation may further reduce the payments we receive for our services. A number of states have adopted legislation designed to reduce their Medicaid expenditures. Some states have enrolled Medicaid recipients in managed care programs (which generally tend to reduce the level of hospital utilization) and have imposed additional taxes on hospitals to help finance or expand the states Medicaid systems. Some states have also reduced the scope of Medicaid eligibility and coverage, making an increasing number of residents unable to pay for their care. Other states propose to take similar steps. In addition, insurance and managed care companies and other third parties from whom we receive payment for our services increasingly attempt to control healthcare costs by requiring that hospitals discount their fees in exchange for exclusive or preferred participation in their benefit plans. We believe that this trend may continue and may reduce the payments we receive for our services. We face intense competition from other hospitals and other healthcare providers which may result in a decline in revenues, profitability and market share. The healthcare business is highly competitive and competition among hospitals and other healthcare providers for patients has intensified in recent years. Most of our facilities operate in geographic areas where we compete with at least one other hospital that provides services comparable to those offered by our facilities. In addition, the number of freestanding specialty hospitals and outpatient surgery and diagnostic centers in the areas in which our hospitals operate has also increased significantly. Some of the hospitals that compete with us are owned or operated by tax-supported governmental bodies or by private not-for-profit entities supported by endowments and charitable contributions which can finance capital expenditures on a tax-exempt basis and are exempt from sales, property and income taxes. Some of our competitors are more established, offer highly specialized facilities, equipment and services, which may not be available at our hospitals, offer a wider range of services or have more capital or other resources. The intense competition we face from other healthcare providers may have an adverse effect on our market share, revenues and results of operations. (A) (A) (A) (B) (Dollars in thousands) Statement of Operations Data: Revenues: Net patient service revenue $ 369,539 $ 7,994 $ 113,902 $ 138,396 $ $ 629,831 Premium revenue 13,232 27,268 509,580 550,080 Other revenue 25,213 Table of Contents Primary State or Other Standard I.R.S. Address, including zip code, and Jurisdiction of Industrial Employer telephone number, including Exact Name of Registrant Incorporation Classification Identification area code, of Registrant s as Specified in its Charter or Organization Code Number principal executive offices Table of Contents Regional concentration of our business may subject us to economic downturns in the State of New Mexico and, in particular, the Albuquerque metropolitan area. With our recent acquisitions of five acute care hospitals (including one inpatient rehabilitation hospital), two health maintenance organizations (which we subsequently merged), and certain ancillary services in New Mexico, the majority of our revenue is generated in New Mexico. For the nine months ended September 30, 2003, our New Mexico operations accounted for approximately 72% of our total net revenues. This concentration of business in New Mexico exposes us to potential losses resulting from a downturn in the economy of the State of New Mexico and, in particular, Albuquerque. If economic conditions deteriorate, we may experience a reduction in existing and new business, which may have an adverse effect on our business, financial condition and results of operations. Our success depends on our ability to attract new physicians and maintain good relationships with physicians and other healthcare professionals at our hospitals. Because physicians working with acute care hospitals generally direct the majority of hospital admissions, our success in operating our acute care hospitals will be, in part, dependent upon the number and quality of physicians on these hospitals medical staffs, the admissions practices of the physicians at these hospitals and our ability to maintain good relations with our physicians. With the exception of approximately 320 employed physicians in Albuquerque, our physicians are generally not employees of the hospitals at which they practice and most physicians have admitting privileges at other hospitals in addition to our hospitals. Physicians may terminate their affiliation with our hospitals at any time. If we are unable to successfully maintain good relationships with physicians, our hospitals admissions may decrease and our results of operations may be adversely affected. For example, patient volume at Sandia Health System was negatively affected during the nine-month period ended September 30, 2003 by the departure of certain physicians. In addition, physicians are increasingly seeking to supplement their declining income by building facilities or offering services that compete with acute care hospitals, such as ambulatory surgery centers, diagnostic imaging centers, or specialty hospitals. These facilities and services may attract patients from the more profitable service lines of an acute care hospital, leaving the hospital with less profitable or unprofitable service lines, such as emergency departments, that the hospital may be unable to close for community relations and other reasons. We compete with other healthcare providers in recruiting and retaining qualified management and staff personnel responsible for the day-to-day operations of each of our hospitals, including nurses and other non-physician healthcare professionals. In the healthcare industry generally, including our markets, the scarcity of nurses and other medical support personnel has become a significant operating issue. This shortage may require us to increase wages and benefits to recruit and retain nurses and other medical support personnel, or to hire more expensive contract or temporary personnel. If our labor costs increase, we may not be able to raise rates to offset these increased costs. Because a significant percentage of our revenues are derived from fixed, prospective payments, our ability to pass along increased labor costs is constrained. Our failure to recruit and retain qualified management, nurses and other medical support personnel, or to control our labor costs, could have an adverse effect on our business and results of operations. We depend heavily on our senior and local management personnel, and the loss of the services of one or more of our key senior management personnel or our key local management personnel could weaken our management team and our ability to deliver healthcare services efficiently. We have been, and will continue to be, dependent upon the services and management experience of David T. Vandewater, our Chief Executive Officer, Jamie E. Hopping, our Chief Operating Officer, R. Dirk Allison, our Chief Financial Officer, and our other senior executive officers. We have entered into employment agreements with each of these senior executive officers, but we do not maintain key person life insurance for these executive officers. If Mr. Vandewater, Ms. Hopping, Mr. Allison or any of our other senior executive officers were to resign their positions or otherwise be unable to serve, our management could be weakened and operating results could be adversely affected. In addition, our success Substantially all of the Company s long-term investments are held in the CHI Investment Program. The Program is structured under a Limited Partnership Agreement between CHI, as managing general partner, and each participant. All investments in the Program are professionally managed by the Company under the administration of CHI. Investments held in the Program are represented by pool units valued monthly under a custodian accounting system. Investment income from the Program, including interest income, dividends, and realized gains or losses from the sale of securities, is distributed to participants based on the earnings per pool unit. Gains or losses also are realized by participants when pool units are sold, representing the difference between the cost basis and the market value of the pool units sold. The fair value of the assets held is an allocation of the underlying market value of the assets in the Program, based upon pool units held by the participants. The underlying fair value of investments in the Program, which are traded on national exchanges, is based on the last reported sales price on the last business day of the fiscal year. The market value of investments traded in over-the-counter markets is based on the average of the last recorded bid and asked prices. Net unrealized gains (losses) on investments was $(0.59 million) at August 31, 2002. Investment losses and gains for assets limited as to use, cash equivalents, and other investments for the two-month period ended August 31, 2002 is as follows: Income (loss): Interest income $ 112 Realized gains (losses) on sales of securities (467 ) Dividend income Table of Contents depends on our ability to attract and retain local managers at our hospitals and related facilities, on the ability of our officers and key employees to manage growth successfully and on our ability to attract and retain skilled employees. If we are unable to attract and retain local management, our operating performance could be adversely affected. We conduct business in a heavily regulated industry; changes in regulations or violations of regulations may result in increased costs or sanctions that could reduce revenue and profitability. Healthcare providers are required to comply with many laws and regulations at the federal, state and local government levels. These laws and regulations relate to: licensing; the conduct of operations; the relationships among hospitals and their affiliated providers; the ownership of facilities; the addition of facilities and services; confidentiality, maintenance and security issues associated with medical records; billing for services; and prices for services. If we fail to comply with applicable laws and regulations, we could suffer civil and criminal penalties, including the loss of our licenses to operate and our ability to participate in Medicare, Medicaid, and other federal and state healthcare programs. In addition, there are heightened coordinated civil and criminal enforcement efforts by both federal and state government agencies relating to the healthcare industry, including the hospital segment. The ongoing investigations in this industry relate generally to various referral, cost reporting and billing practices, laboratory and home healthcare services, and physician ownership and joint ventures involving hospitals. In the future, different interpretations or enforcement of these laws and regulations could subject our current practices to allegations of impropriety or illegality or could require us to make changes in our operations. We may be subjected to actions brought by individuals on the government s behalf under the False Claims Act s qui tam or whistleblower provisions. Whistleblower provisions allow private individuals to bring actions on behalf of the government alleging that the defendant has defrauded the federal government. Because qui tam lawsuits are filed under seal, we could be named in one or more such lawsuits of which we are not aware. Several of our subsidiaries have been named as defendants in two qui tam lawsuits. Defendants determined to be liable under the False Claims Act may be required to pay three times the actual damages sustained by the government, plus mandatory civil penalties of between $5,500 and $11,000 for each separate false claim. Typically, each fraudulent bill submitted by a provider is considered a separate false claim, and thus the penalties under a false claim case may be substantial. Liability arises when an entity knowingly submits a false claim for reimbursement to the federal government. In some cases, whistleblowers or the federal government have taken the position that providers who allegedly have violated other statutes, such as the anti-kickback statute or the Stark Law and have submitted claims to a governmental payor during the time period they allegedly violated these other statutes, have thereby submitted false claims under the False Claims Act. In addition, a number of states have adopted their own false claims provisions as well as their own whistleblower provisions allowing a private party to file a civil lawsuit in state court. The cost of our malpractice insurance and the malpractice insurance of physicians who practice at our facilities or who participate in our networks continues to rise. Successful malpractice or tort claims asserted against us, our providers or our employees could adversely affect our financial condition and profitability. In recent years, physicians, hospitals and other healthcare providers have become subject to an increasing number of legal actions alleging malpractice or related legal theories. Many of these actions involve large claims and significant defense costs. To protect ourselves from the cost of these claims, we generally maintain professional malpractice liability insurance and general liability insurance coverage in amounts and with deductibles that we believe to be appropriate for our operations. Effective October 31, 2003, we established a wholly owned captive insurance subsidiary to insure our professional and general liability risk for claims up to $2.0 million. In addition, effective October 31, 2003, we purchased excess insurance coverage with independent third-party carriers for claims up to $75.0 million per occurrence and Net income (loss) 3,904 5,007 5,053 2,716 17,869 3,336 (7,829 ) Accrued preferred dividends 5,892 3,944 5,993 1,210 8 12 (Unaudited) Property, plant, and equipment $ $ 203 $ 19 $ 279 $ $ 2,550 Other assets, net 350 Table of Contents in the aggregate. However, our insurance coverage may not cover all claims against us or continue to be available at a reasonable cost for us to maintain adequate levels of insurance. In addition, physicians malpractice insurance costs have dramatically increased to the point where some physicians are either choosing to retire early or leave certain markets. If physician malpractice costs continue to escalate in markets in which we operate, some physicians may choose not to practice at our facilities, which could reduce our patient volume and thus our revenue. Our managed care providers involved in medical care decisions may be exposed to the risk of medical malpractice claims. Many of our network providers are our employees for whose acts we may be liable as an employer. In addition, managed care organizations may be sued directly for various types of alleged negligence, such as in connection with the credentialing of network providers or improper denials or delay of care. Finally, Congress is considering legislation that would permit managed care organizations to be held liable for negligent treatment decisions or benefits coverage determinations. If this or similar legislation were enacted, claims of this nature could result in substantial damage awards against us and our providers that could exceed the limits of any applicable medical malpractice insurance coverage and could have a material adverse effect on our financial condition. Our business depends on our information systems, and our inability to effectively integrate and manage our information systems could disrupt our operations. Our business is dependent on effective information systems that assist us in, among other things, monitoring utilization and other cost factors, supporting our healthcare management techniques, processing provider claims and providing data to our regulators. Our managed care providers also depend upon our information systems for membership verifications, claims status and other information. If we experience a reduction in the performance, reliability or availability of our information systems, our operations and ability to produce timely and accurate reports could be adversely impacted. Our information systems and applications require continual maintenance, upgrading and enhancement to meet our operational needs. Moreover, our acquisition activity requires transitions to or from, and the integration of, various information systems. We regularly upgrade and expand our information systems capabilities and are currently in the process of rolling out new clinical and financial reporting systems throughout our operations. If we experience difficulties with the transition to or from information systems or are unable to properly implement, maintain or expand our systems, we could suffer, among other things, from operational disruptions, loss of membership in our networks, regulatory problems and increases in administrative expenses. Failure to maintain the privacy and security of patients medical records could expose us to liability. The Health Insurance Portability and Accountability Act of 1996 required the Department of Health and Human Services to issue regulations requiring hospitals and other providers to implement measures to ensure the privacy and security of patients medical records and the use of uniform data standards for the exchange of information between the hospitals and health plans, including claims and payment transactions. The privacy standard became effective October 15, 2002. Full compliance with the privacy standard was required by April 14, 2003. Although we believe we have met the April 14, 2003 privacy standard compliance deadline, compliance will be an ongoing process. The transaction standard and the security standard became effective on October 16, 2000 and February 20, 2003, respectively. Full compliance with the transaction standard was required by October 16, 2003 and full compliance with the security standard is required by April 20, 2005. We are in the process of complying with the transaction standard and security standard. We may incur additional expenses in order to comply with these standards. We cannot predict the full extent of our costs of implementing all of the requirements at this stage. If we violate these standards, we may be subject to civil monetary fines and sanctions and criminal penalties. Further, a substantial portion of our revenue is derived from payments by governmental health plans, such as Medicare, and private health plans. Our failure, or the failure of the health plans with which we transact, to comply with the transaction standard may result in significant disruptions in the payments we Table of Contents receive from such health plans. Finally, because of the confidential nature of the health information we store and transmit, privacy or security breaches could expose us to a risk of regulatory action, litigation, possible liability and loss. Our privacy or security measures may be inadequate to prevent breaches, and our business operations would be adversely impacted by cancellation of contracts and loss of members if they are not prevented. A reduction in enrollment in our health plan or the failure to maintain satisfactory relationships with providers could affect our business and profitability. Premium revenue from our health plan accounted for approximately 46.1% of our total net revenues for the nine months ended September 30, 2003. A reduction in the number of members in our health plan could reduce our revenues and profitability. Factors that could contribute to a reduction in membership include premium increases, benefit changes and reductions in workforce by existing customers. In recent years, the managed care industry has received considerable negative publicity. This publicity has led to increased review of industry practices, legislation, regulation and litigation. These factors may adversely affect our ability to market our health plan services, require us to change our health plan procedures or services, and increase the regulatory burdens under which our health plan operates, further increasing the costs of doing business and adversely affecting our operating results. The profitability of our health plan depends, in large part, upon its ability to contract favorably with hospitals, physicians and other healthcare providers in appropriate numbers and at locations appropriate for the health plan s members in New Mexico. Providers could refuse to contract, demand higher payments or take other actions that could result in higher healthcare costs. If any of the key providers to our health plan refuses or is otherwise unavailable to contract with our health plan, uses its market position to negotiate more favorable contracts or otherwise places our health plan at a competitive disadvantage, our operating results could be adversely affected. Provider arrangements for our health plan with contracted primary care physicians, specialists and hospitals in its network usually have one-year terms and automatically renew for successive one-year periods. Generally, these contracts may also be cancelled by either party without cause upon 30 to 90 days prior written notice. Our health plan may be unable to continue to renew such contracts or enter into new contracts enabling our health plan to service its members profitably. If our health plan is unable to retain its current provider contracts or enter into new provider contracts on a timely basis or on favorable terms, our results of operations could be adversely affected. If we are unable to effectively price our health plan premiums or manage medical costs, our profitability will be reduced. A large amount of revenues of our health plan consists of fixed monthly payments per member. These payments are fixed by contract, and the health plan is obligated during the contract period to provide or arrange for the provision of all healthcare services required by such member. Historically, medical care costs of our health plan as a percentage of premium and other operating revenue has fluctuated. If premiums are not increased and medical care costs rise, the earnings of our health plan on insured business could decrease. In addition, actual medical care costs of our health plan may exceed its estimated costs on insured business. The premiums our health plan receives under its current insurance contracts may therefore be inadequate to cover all claims, which may cause our profits to decline. Our health plan profitability depends, to a significant degree, on our ability to predict and effectively manage medical costs. Historically, there have been fluctuations in the medical care cost ratio of our health plan. Relatively small changes in these medical care cost ratios can create significant changes in our financial results. Changes in healthcare laws, regulations and practices, utilization of services, hospital costs, pharmaceutical costs, major epidemics, terrorism or bioterrorism, new medical technologies and other external factors, including general economic conditions such as inflation levels, could reduce our ability to predict and effectively control the costs of providing healthcare services. If our medical care costs increase, our profits could be reduced or we may not remain profitable. Beginning temporarily restricted net assets $ 2,148 $ 2,184 $ 4,733 Temporarily restricted contributions 1,097 669 834 Net assets released from restrictions (503 ) (775 ) (3,055 ) Investment income (14 ) 44 278 Other changes 5 Table of Contents Our medical care costs also include estimates of claims incurred but not reported, or IBNR. We, together with our independent actuaries, estimate our medical claims liabilities using actuarial methods based on historical data for payment patterns, cost trends, product mix, seasonality, utilization of healthcare services and other relevant factors. The estimation methods and the resulting accrued liabilities are continually reviewed and updated, and adjustments, if necessary, are reflected in the period when they become known. While our IBNR estimates generally have been adequate in the past, they may be inadequate in the future, which would negatively affect our results of operations. Further, our inability to accurately estimate IBNR may also affect our ability to take timely corrective actions, further exacerbating the extent of the negative impact on our results. We maintain accrued liabilities on our financial statements in amounts we believe are adequate to provide for actuarial estimates of medical claims. We also maintain reinsurance to protect us against certain catastrophic medical claims by Medicaid beneficiaries who participate in our health plan. While we believe our reinsurance coverage with respect to these Medicaid claims is adequate, in the future such reinsurance coverage may be inadequate or unavailable to us or the cost of such reinsurance coverage may limit our ability to obtain other insurance. We do not maintain reinsurance to protect us against other catastrophic medical claims under our health plan. Recently enacted or proposed legislation, regulations and initiatives could adversely affect our business by increasing our operating costs, reducing our health plan membership or subjecting us to additional litigation. In recent years, an increasing number of legislative initiatives have been introduced or proposed in Congress and in state legislatures that would effect major changes in the healthcare system, either nationally or at the state level. Among the proposals that have been introduced are price controls on hospitals, insurance market reforms to increase the availability of group health insurance to small businesses, requirements that all businesses offer health insurance coverage to their employees and the creation of a government health insurance plan or plans that would cover all citizens, and increased payments by beneficiaries. Increased regulations, mandated benefits and more oversight, audits and investigations and changes in laws allowing access to federal and state courts to challenge healthcare decisions may increase our administrative, litigation and healthcare costs. We cannot predict whether any of the above proposals or any other proposals will be adopted, and if adopted, no assurance can be given that the implementation of such reforms will not have a material adverse effect on our business and results of operations. Net cash (used in) provided by discontinued operations (67 ) 20 (1 ) (112 ) 34 You should rely only on the information contained in this prospectus. We have not authorized any person to provide you with any information or represent anything about us or this offering that is not contained in this prospectus. If given or made, any such other information or representation should not be relied upon as having been authorized by us. We are not making an offer of the exchange notes in any jurisdiction where an offer is not permitted. Table of Contents Primary State or Other Standard I.R.S. Address, including zip code, and Jurisdiction of Industrial Employer telephone number, including Exact Name of Registrant Incorporation Classification Identification area code, of Registrant s as Specified in its Charter or Organization Code Number principal executive offices Table of Contents THE EXCHANGE OFFER Purposes and Effect of the Exchange Offer We sold the original notes on August 19, 2003 to Banc of America Securities LLC, UBS Securities LLC, Banc One Capital Markets, Inc. and Merrill Lynch, Pierce, Fenner Smith Incorporated (the initial purchasers ), who resold the original notes to qualified institutional buyers in reliance on Rule 144A under the Securities Act and outside the United States to non-U.S. persons in compliance with Regulation S under the Securities Act. In connection with the issuance of the original notes, we, our parent and our subsidiaries that guarantee the original notes (the subsidiary guarantors ) entered into a registration rights agreement with the initial purchasers of the original notes. The following description of the registration rights agreement is a summary only. It is not complete and does not describe all of the provisions of the registration rights agreement. For more information, you should review the provisions of the registration rights agreement that we filed with the SEC as an exhibit to the registration statement of which this prospectus is a part. Under the registration rights agreement, we agreed that, promptly after the effectiveness of the registration statement of which this prospectus is a part, we would offer to the holders of original notes who are not prohibited by any law or policy of the SEC from participating in the exchange offer, the opportunity to exchange their original notes for a new series of notes, which we refer to as the exchange notes, that are identical in all material respects to the original notes, except that the exchange notes do not contain transfer restrictions, have been registered under the Securities Act and are not subject to further registration rights. We, our parent and our subsidiary guarantors have agreed to use our reasonable best efforts to keep the exchange offer open for not less than 20 business days, or longer if required by applicable law, after the date on which notice of the exchange offer is mailed to the holders of the original notes. We, our parent and our subsidiary guarantors also have agreed to use our reasonable best efforts to cause the exchange offer to be consummated on the earliest practicable date after the registration statement of which this prospectus is a part has become effective, but in no event later than 30 business days after such date of effectiveness. If: (1) we, our parent and our subsidiary guarantors are not permitted to file an exchange offer registration statement or consummate the exchange offer because the exchange offer is not permitted by applicable law or SEC policy; (2) for any reason the exchange offer is not consummated within 30 business days after the registration statement of which this prospectus is a part is declared effective; or (3) any holder of transfer restricted securities notifies us that: (a) it is prohibited by law or SEC policy from participating in the exchange offer; or (b) it may not resell the exchange notes acquired by it in the exchange offer to the public without delivering a prospectus and the prospectus contained in the registration statement of which this prospectus is a part is not appropriate or available for such resales; or (c) it is a broker-dealer and owns original notes acquired directly from us or one of our affiliates, then we, our parent and the subsidiary guarantors will: (1) as soon as practicable but in any event on or prior to 45 days after the filing obligation arises, file a shelf registration statement with the SEC covering resales of the transfer restricted securities by the holders thereof who satisfy certain conditions relating to the provision of information in connection with the shelf registration statement; Table of Contents (2) use reasonable best efforts to cause the shelf registration statement to become effective on or before 135 days after the filing obligation arises; and (3) use reasonable best efforts to keep the shelf registration statement effective until the earliest to occur of (a) two years from the date on which the shelf registration statement is declared effective and (b) the time when all notes covered by the shelf registration statement have been sold pursuant to the shelf registration statement or are no longer transfer restricted securities. For purposes of the foregoing, a transfer restricted security is each original note until the earliest to occur of: (1) the date on which the original note has been exchanged in the exchange offer and may be resold to the public by the holder without complying with the prospectus delivery requirements of the Securities Act; (2) the date on which the original note has been effectively registered under the Securities Act and disposed of in accordance with the shelf registration statement; and (3) the date on which the original note is distributed to the public pursuant to Rule 144 under the Securities Act or by a broker-dealer pursuant to the procedures described in Plan of Distribution. A registration default will be deemed to occur under the registration rights agreement if: (1) any registration statement required by the registration rights agreement is not filed with the SEC on or prior to the date specified for such filing in the registration rights agreement; (2) any registration statement required by the registration rights agreement has not been declared effective by the SEC on or prior to the date specified for such effectiveness in the registration rights agreement; (3) the exchange offer has not been consummated within 30 business days of the effective date of the registration statement of which this prospectus is a part; or (4) any registration statement required by the registration rights agreement is filed and declared effective by the SEC but thereafter shall cease to be effective or fail to be usable for its intended purpose during the periods specified in the registration statement. Upon the occurrence of a registration default, we will pay liquidated damages to each holder of transfer restricted securities, with respect to the first 90-day period immediately following the occurrence of the first registration default in an amount equal to a per annum rate of 0.50% on the principal amount of transfer restricted securities held by such holder. The amount of the liquidated damages will increase by an additional per annum rate of 0.50% with respect to each subsequent 90-day period until all registration defaults have been cured, up to a maximum amount of liquidated damages for all registration defaults of 1.50% per annum on the principal amount of transfer restricted securities. Following the cure of all registration defaults, the accrual of liquidated damages will cease. By acquiring transfer restricted securities, a holder will be deemed to have agreed to indemnify us, our parent and our subsidiary guarantors against certain losses arising out of information furnished by the holder in writing for inclusion in any registration statement. Holders of transfer restricted securities will also be required to suspend their use of the prospectus included in the registration statement under certain circumstances upon receipt of notice to that effect from us. Resale of the Exchange Notes Based on an interpretation by the staff of the SEC set forth in no-action letters issued to third parties, we believe that, unless you are a broker-dealer or an affiliate of us, you may offer for resale, resell or otherwise transfer the exchange notes issued to you pursuant to the exchange offer without compliance with the registration and prospectus delivery provisions of the Securities Act, provided that you acquire the Balance at September 30, 2003 5,000 $ 131,252 30,005 $ Table of Contents exchange notes in the ordinary course of business and you do not intend to participate and have no arrangement or understanding with any person to participate in the distribution of the exchange notes. If you are an affiliate of us or if you tender in the exchange offer with the intention to participate, or for the purpose of participating, in a distribution of the exchange notes, you may not rely on the position of the staff of the SEC enunciated in Exxon Capital Holdings Corporation (available May 13, 1988) and Morgan Stanley Co., Incorporated (available June 5, 1991), or similar no-action letters, but rather must comply with the registration and prospectus delivery requirements of the Securities Act in connection with any resale transaction. In addition, any such resale transaction should be covered by an effective registration statement containing the selling security holder information required by Item 507 or 508, as applicable, of Regulation S-K of the Securities Act. Each broker-dealer that receives exchange notes for its own account in exchange for original notes, where the original notes were acquired by such broker-dealer as a result of market-making activities or other trading activities, must acknowledge that it will deliver a prospectus in connection with any resale of the exchange notes. See Plan of Distribution. By tendering in the exchange offer, you represent to us that, among other things: (1) you are not an affiliate of us; (2) you are not engaged in, and do not intend to engage in, and have no arrangement or understanding with any person to participate in, a distribution of the exchange notes to be issued in the exchange offer; (3) you are acquiring the exchange notes in the ordinary course of business; and (4) you acknowledge and agree that if you are a broker-dealer or are using the exchange offer to participate in a distribution of the exchange notes acquired in the exchange offer: (a) you cannot rely on the no-action letters described above; and (b) you must, in the absence of an exemption, comply with the registration and prospectus delivery requirements of the Securities Act in connection with any resale of the exchange notes. Terms of the Exchange Offer Upon satisfaction or waiver of all the conditions of the exchange offer, we will accept any and all original notes properly tendered and not validly withdrawn prior to the expiration date and will promptly issue the exchange notes. See Conditions to the Exchange Offer and Procedures for Tendering. We will issue $1,000 principal amount of exchange notes in exchange for each $1,000 principal amount of original notes accepted in the exchange offer. As of the date of this prospectus, there is $225,000,000 in principal amount of original notes. Holders may tender some or all of their original notes pursuant to the exchange offer. However, original notes may be tendered only in integral multiples of $1,000. The exchange offer is not conditioned upon any number or aggregate principal amount of original notes being tendered. The form and terms of the exchange notes will be the same in all material respects as the form and terms of the original notes, except that the exchange notes will be registered under the Securities Act and therefore will not bear legends restricting their transfer. The exchange notes will evidence the same debt as the original notes and will be issued pursuant to, and entitled to the benefits of, the indenture pursuant to which the original notes were issued. Original notes that are accepted for exchange will be cancelled and retired. Interest on the exchange notes will accrue from the most recent date to which interest has been paid on the original notes or, if no interest has been paid on the original notes, the issue date. Accordingly, registered holders of exchange notes on the relevant record date for the first interest payment date following the completion of the exchange offer will receive interest accruing from the most recent date to which interest has been paid or, if no interest has been paid on the original notes, the issue date. Original notes accepted for exchange will cease to accrue interest from and after the date the exchange offer closes. Table of Contents If your original notes are accepted for exchange, you will not receive any payment in respect of interest on the original notes for which the record date occurs on or after completion of the exchange offer. You do not have any appraisal or dissenters rights under the indenture in connection with the exchange offer. We intend to conduct the exchange offer in accordance with the provisions of the registration rights agreement. If you do not tender for exchange or if your tender is not accepted, the original notes will remain outstanding and you will be entitled to the benefits of the indenture, but will not be entitled to any registration rights under the registration rights agreement. For purposes of the exchange offer, we will be deemed to have accepted validly tendered original notes when, and if, we have given oral or written notice thereof to the exchange agent. The exchange agent will act as our agent for the purpose of distributing the appropriate exchange notes from us to the tendering holders. If we do not accept any tendered original notes because of an invalid tender, the occurrence of certain other events set forth in this prospectus or otherwise, we will return the unaccepted original notes, without expense, to the tendering holder thereof promptly after the expiration date. If you tender your original notes in the exchange offer, you will not be required to pay brokerage commissions or fees or, subject to the instructions in the letter of transmittal, transfer taxes with respect to the exchange of original notes pursuant to the exchange offer. We will pay all charges and expenses, other than certain applicable taxes described below, in connection with the exchange offer. See Fees and Expenses below. Expiration Date; Extension; Termination; Amendments The exchange offer will expire at 5:00 p.m., New York City time, on , 2004, unless extended (the expiration date ). We reserve the right to extend the exchange offer at our discretion, in which event the term expiration date shall mean the time and date on which the exchange offer as so extended shall expire. We will notify the exchange agent of any extension by oral or written notice and will make a public announcement of any extension and specify the principal amount of original notes tendered to date, each prior to 9:00 a.m., New York City time, on the next business day after the previously scheduled expiration date. We reserve the right, in our sole discretion, to: (1) delay accepting for exchange any original notes for exchange notes or to extend or terminate the exchange offer and not accept for exchange any original notes for exchange notes if any of the events set forth under the caption Conditions of the Exchange Offer occur and we do not waive the condition by giving oral or written notice of the delay or termination to the exchange agent; or (2) amend the terms of the exchange offer in any manner. We will not delay payment of accepted original notes after the expiration date other than in anticipation of our receipt of any necessary government approvals. If we amend the exchange offer in any manner material to investors or if we extend or terminate the exchange offer, we will promptly file a post-effective amendment to the registration statement of which this prospectus is a part. We will also announce any such change in media outlets, including PR Newswire. Any delay in acceptance for exchange, extension or amendment will be followed as promptly as practicable by a public announcement of the delay. If we amend the exchange offer in a manner we determine constitutes a material change, we will promptly disclose the amendment in a manner reasonably calculated to inform the holders of original notes of the amendment, and we will extend the exchange offer for a period of five to ten business days, depending upon the significance of the amendment and the manner of disclosure to the holders of the original notes, if the exchange offer would otherwise expire during that five to ten business day period. The rights we have reserved in this paragraph are in addition to our rights set forth under the caption Conditions of the Exchange Offer. Table of Contents Conditions of the Exchange Offer Our obligation to consummate the exchange offer is not subject to any conditions, other than that the exchange offer does not violate any applicable law or SEC staff interpretation. Accordingly, we will not be required to accept for exchange any original notes tendered and may terminate or amend the exchange offer as provided herein before the acceptance of any original notes if: (1) any action or proceeding is instituted or threatened in any court or by or before any governmental agency or regulatory authority with respect to the exchange offer which, in our judgment, could reasonably be expected to materially impair our ability to proceed with the exchange offer; or (2) there shall have been proposed, adopted or enacted any law, statute, rule, regulation, order or SEC staff interpretation which, in our judgment, could reasonably be expected to materially impair our ability to proceed with the exchange offer. The foregoing conditions are for our sole benefit and may be asserted regardless of the circumstances giving rise to the conditions or may be waived by us in whole or in part at any time and from time to time in our sole discretion prior to the expiration date. If we waive or amend the foregoing conditions, we will, if required by applicable law, extend the exchange offer for a minimum of five business days from the date that we first give notice, by public announcement or otherwise, of such waiver or amendment, if the exchange offer would otherwise expire within that five business-day period. Our determination concerning the events described above will be final and binding upon all parties. Procedures For Tendering Only a holder of original notes may tender them in the exchange offer. To validly tender in the exchange offer by book-entry transfer, you must deliver an agent s message or a completed and signed letter of transmittal (or facsimile thereof), together with any required signature guarantees and any other required documents, to the exchange agent prior to 5:00 p.m., New York City time, on the expiration date, and the original notes must be tendered pursuant to the procedures for book-entry transfer set forth below. To validly tender by means other than book-entry transfer, you must deliver a completed and signed letter of transmittal (or facsimile thereof), together with any required signature guarantees and any other required documents and the original notes, to the exchange agent prior to 5:00 p.m., New York City time, on the expiration date. Any financial institution that is a participant in DTC s Book-Entry Transfer Facility system may make book-entry delivery of the original notes by causing DTC to transfer the original notes into the exchange agent s account in accordance with DTC s ATOP procedures for transfer. However, although delivery of original notes may be effected through book-entry transfer into the exchange agent s account at DTC, an agent s message or a completed and signed letter of transmittal (or facsimile thereof), with any required signature guarantees and any other required documents, must, in any case, be transmitted to and received or confirmed by the exchange agent at its addresses set forth under the caption Exchange Agent prior to 5:00 p.m., New York City time, on the expiration date, or the guaranteed delivery procedure set forth below must be complied with. DELIVERY OF DOCUMENTS TO DTC IN ACCORDANCE WITH DTC S PROCEDURES DOES NOT CONSTITUTE DELIVERY TO THE EXCHANGE AGENT. The term agent s message means, with respect to any tendered original notes, a message transmitted by DTC to and received by the exchange agent and forming part of a book-entry confirmation, stating that DTC has received an express acknowledgment from each tendering participant to the effect that, with respect to those original notes, the participant has received and agrees to be bound by the letter of transmittal and that we may enforce the letter of transmittal against the participant. The term book-entry confirmation means a timely confirmation of a book-entry transfer of original notes into the exchange agent s account at DTC. Table of Contents If you tender an original note, and do not validly withdraw your tender, your actions will constitute an agreement with us in accordance with the terms and subject to the conditions set forth in this prospectus and in the letter of transmittal. The method of delivery of your original notes and the letter of transmittal and all other required documents to the exchange agent is at your election and risk. Instead of delivery by mail, we recommend that you use an overnight or hand delivery service. In all cases, you should allow sufficient time to assure delivery to the exchange agent before the expiration date. No letter of transmittal or original note should be sent to us; instead, they should be sent to the exchange agent. You may request that your broker, dealer, commercial bank, trust company or nominee effect the tender for you. Signatures on a letter of transmittal or a notice of withdrawal, as the case may be, must be guaranteed by an eligible institution (as defined below) unless the original notes are being tendered: (1) by a registered holder who has not completed the box entitled Special Issuance Instructions or Special Delivery Instructions on the letter of transmittal; or (2) for the account of an eligible institution. If signatures on a letter of transmittal or a notice of withdrawal, as the case may be, are required to be guaranteed, the guarantee must be by a member of a signature guarantee program within the meaning of Rule 17Ad-15 under the Exchange Act (an eligible institution ). If the letter of transmittal or any original notes or bond powers are signed by trustees, executors, administrators, guardians, attorneys-in-fact, officers of corporations or others acting in a fiduciary or representative capacity, those persons should so indicate when signing, and unless we waive it, evidence satisfactory to us of their authority to act must be submitted with the letter of transmittal. We will determine, in our sole discretion, all questions as to the validity, form, eligibility (including time of receipt) and acceptance and withdrawal of tendered original notes. Our determination will be final and binding. We reserve the absolute right to reject any and all original notes not properly tendered or any original notes our acceptance of which would, in the opinion of our counsel, be unlawful. We also reserve the right to waive any defects, irregularities or conditions of tender as to particular original notes. Our interpretation of the terms and conditions of the exchange offer (including the instructions in the letter of transmittal) will be final and binding on all parties. Unless waived, you must cure any defects or irregularities in connection with tenders of your original notes within a time period we will determine. Although we intend to request that the exchange agent notify you of defects or irregularities with respect to your tender of original notes, we will not, nor will the exchange agent or any other person, incur any liability for failure to give you any notification. Tenders of original notes will not be deemed to have been made until any defects or irregularities have been cured or waived. Any original notes received by the exchange agent that are not properly tendered and as to which the defects or irregularities have not been cured or waived will be returned by the exchange agent to the tendering holders, unless otherwise provided in the letter of transmittal, promptly after the expiration date. In addition, we reserve the right in our sole discretion (subject to the limitations contained in the indenture for the exchange notes): (1) to purchase or make offers for any original notes that remain outstanding after the expiration date; and (2) to the extent permitted by applicable law, to purchase original notes in the open market, in privately negotiated transactions or otherwise. The terms of any purchases or offers could differ from the terms of the exchange offer. 16,092 Other assets Table of Contents The information in this prospectus is not complete and may be changed. We may not exchange these securities until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to exchange these securities and it is not soliciting an offer to exchange these securities in any state where the offer or exchange is not permitted. SUBJECT TO COMPLETION, DATED JANUARY 26, 2004 PROSPECTUS Ardent Health Services, Inc. Offer to Exchange up to $225,000,000 of 10% Senior Subordinated Notes due 2013 for up to $225,000,000 of 10% Senior Subordinated Notes due 2013 that have been registered under the Securities Act of 1933 We are offering to exchange our 10% senior subordinated notes due 2013, or the exchange notes, for our currently outstanding 10% senior subordinated notes due 2013, or the original notes. We sometimes refer to the exchange notes and the original notes collectively as the notes. Terms of the exchange notes: The exchange notes are substantially identical to the original notes, except that the exchange notes have been registered under the Securities Act of 1933, or the Securities Act, and will not contain restrictions on transfer or have registration rights. The exchange notes will represent the same debt as the original notes, and we will issue the exchange notes under the same indenture. The exchange notes will be subordinated to any existing and future senior indebtedness, including borrowings under our senior secured credit facility, and will rank equally with any future senior subordinated indebtedness. Assuming the exchange offer had been completed on September 30, 2003, the exchange notes would have been subordinated to approximately $4.8 million of our outstanding indebtedness. Terms of the exchange offer: The exchange offer expires at 5:00 p.m., New York City time, on , 2004, unless extended. We will exchange all original notes that are validly tendered and not validly withdrawn prior to the expiration of the exchange offer. You may withdraw tendered original notes at any time prior to the expiration of the exchange offer. We do not intend to apply for listing of the exchange notes on any securities exchange or to arrange for them to be quoted on any quotation system. The exchange offer is subject to customary conditions, including the condition that the exchange offer not violate applicable law or any applicable interpretation of the staff of the Securities and Exchange Commission, or the SEC. The exchange of original notes for exchange notes pursuant to the exchange offer will not constitute a taxable event for U.S. federal income tax purposes. We will not receive any proceeds from the exchange offer. Broker-dealers who acquired original notes from us in the initial offering are not eligible to participate in the exchange offer with respect to such original notes. Each broker-dealer that receives exchange notes for its own account pursuant to the exchange offer must acknowledge that it will deliver a prospectus in connection with any resale of the exchange notes. The letter of transmittal states that by so acknowledging and by delivering a prospectus, a broker-dealer will not be deemed to admit that it is an underwriter within the meaning of the Securities Act of 1933. This prospectus, as it may be amended or supplemented from time to time, may be used by a broker-dealer in connection with any resales of exchange notes received in exchange for original notes where the original notes were acquired by the broker-dealer as a result of market-making activities or other trading activities. We have agreed that, for up to 180 days after the expiration date, as defined in this prospectus, we will make this prospectus available to any broker-dealer for use in connection with any such resale. See Plan of Distribution. Investing in the exchange notes involves risks. See Risk Factors beginning on page 15. Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of the securities to be distributed in the exchange offer or determined that this prospectus is truthful or complete. Any representation to the contrary is a criminal offense. The date of this prospectus is , 2004. Table of Contents By tendering, you represent to us, among other things, that: (1) you are not affiliate of us (as defined in Rule 405 under the Securities Act); (2) you are not engaged in, and do not intend to engage in, and have no arrangement or understanding with any person to participate in, a distribution of the exchange notes; and (3) you are acquiring the exchange notes in the ordinary course of business. If you are a broker-dealer that will receive exchange notes for your own account in exchange for original notes that were acquired as a result of market-making activities or other trading activities, you must acknowledge that you will deliver a prospectus in connection with any resale of the exchange notes. Guaranteed Delivery Procedures If you wish to tender your original notes and either your original notes are not immediately available, or you cannot deliver your original notes and other required documents to the exchange agent, or cannot complete the procedure for book-entry transfer prior to the expiration date, you may effect a tender if: (1) you make a tender through an eligible institution; (2) prior to the expiration date, the exchange agent receives from the eligible institution a properly completed and duly executed notice of guaranteed delivery (by facsimile transmission, mail or hand delivery) setting forth your name and address, the certificate number(s) of the original notes (if available) and the principal amount of original notes tendered together with a duly executed letter of transmittal (or a facsimile thereof), stating that the tender is being made thereby and guaranteeing that, within three business days after the expiration date, the certificate(s) representing the original notes to be tendered, in proper form for transfer (or a confirmation of a book-entry transfer into the exchange agent s account at DTC of original notes delivered electronically) and any other documents required by the letter of transmittal, will be deposited by the eligible institution with the exchange agent; and (3) the certificate(s) representing all tendered original notes in proper form for transfer (or confirmation of a book-entry transfer into the exchange agent s account at DTC of original notes delivered electronically) and all other documents required by the letter of transmittal are received by the exchange agent within three business days after the expiration date. Upon request to the exchange agent, you will be sent a notice of guaranteed delivery if you wish to tender your original notes according to the guaranteed delivery procedures set forth above. Withdrawal of Tenders Except as otherwise provided in this prospectus, you may withdraw any tenders of original notes at any time prior to 5:00 p.m., New York City time, on the expiration date, unless previously accepted for exchange. For your withdrawal to be effective, the exchange agent must receive a written or facsimile transmission notice of withdrawal at its address set forth herein prior to 5:00 p.m., New York City time, on the expiration date, and prior to our acceptance for exchange. Any notice of withdrawal must: (1) specify the name of the person having tendered the original notes to be withdrawn; (2) identify the original notes to be withdrawn (including the certificate number or numbers, if applicable, and principal amount of the original notes); (3) be signed in the same manner as the original signature on the letter of transmittal by which the original notes were tendered (including any required signature guarantees) or be accompanied by documents of transfer sufficient to have the trustee with respect to the original notes register the transfer of the original notes into the name of the person withdrawing the tender; and TABLE OF CONTENTS SUMMARY RISK FACTORS
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+RISK FACTORS You should consider carefully the following factors, as well as the information contained in the rest of this prospectus before deciding whether to participate in the exchange offer. Risk Factors Relating to the Exchange Offer You must carefully follow the required procedures in order to exchange your original notes. The exchange notes will be issued in exchange for original notes only after timely receipt by the exchange agent of a duly executed letter of transmittal and all other required documents. Therefore, if you wish to tender your original notes, you must allow sufficient time to ensure timely delivery. Neither we nor the exchange agent has any duty to notify you of defects or irregularities with respect to tenders of original notes for exchange. Any holder of original notes who tenders in the exchange offer for the purpose of participating in a distribution of the exchange notes will be required to comply with the registration and prospectus delivery requirements of the Securities Act in connection with any resale transaction. Each broker or dealer that receives exchange notes for its own account in exchange for original notes that were acquired in market-making or other trading activities must acknowledge that it will deliver a prospectus in connection with any resale of the exchange notes. If you do not exchange original notes for exchange notes, transfer restrictions will continue and trading of the original notes may be adversely affected. The original notes have not been registered under the Securities Act and are subject to substantial restrictions on transfer. Original notes that are not tendered for exchange for exchange notes or are tendered but are not accepted will, following completion of the exchange offer, continue to be subject to existing restrictions upon transfers. We do not currently expect to register the original notes under the Securities Act. To the extent that original notes are tendered and accepted in the exchange offer, the trading market for original notes, if any, could be adversely affected. Risks Relating to the Exchange Notes Our substantial indebtedness could adversely affect our cash flow and prevent us from fulfilling our obligations, including making payments on the exchange notes. We have a significant amount of debt. As of September 30, 2003, we had $261.7 million of total debt and members equity of $222.5 million. Our substantial amount of debt could have important consequences to you. For example, it could: make it more difficult for us to satisfy our obligations under the exchange notes and under the new senior secured credit facility; require us to dedicate a substantial portion of our cash flow from operations to make interest and principal payments on our debt, thereby limiting the availability of our cash flow to fund future capital expenditures, working capital and other general corporate requirements; limit our flexibility in planning for, or reacting to, changes in our business, which may place us at a competitive disadvantage compared with competitors that have less debt; increase our vulnerability to adverse economic and industry conditions; and limit our ability to borrow additional funds, even when necessary to maintain adequate liquidity. The terms of the agreement governing our new senior secured credit facility and the indenture governing the exchange notes allow us to incur substantial amounts of additional debt. Any such additional debt could increase the risks associated with our substantial leverage. (In thousands) Current $ 248 $ 460 $ 519 Deferred Table of Contents Your right to receive payments on the exchange notes will be junior to our existing and future senior debt, including borrowings under our new senior secured credit facility. Further, the guarantees of the exchange notes are junior to all of the guarantors existing and future senior debt. The exchange notes will rank behind all of our existing and future senior debt. The guarantees will rank behind all of the guarantors existing and future senior debt. As of September 30, 2003, we had $4.8 million of senior debt, none of which represented borrowings under our new senior secured credit facility, and all of which was incurred by the guarantors. Our new senior secured credit facility provides for borrowings of up to $125.0 million, subject to a borrowing base (which is the maximum amount we may borrow at any one time based upon the sum of a percentage of the book value of certain accounts receivable and a percentage of the net book value of certain fixed assets), and a $200.0 million incremental term loan facility in certain events. Any borrowings under our new senior secured credit facility would be senior debt when borrowed. As of September 30, 2003, we could have borrowed the maximum $125.0 million under the credit facility according to the borrowing base. We are permitted to borrow substantial additional senior indebtedness in the future under the terms of the indenture that will govern the exchange notes. As a result of such subordination, upon any distribution to our creditors in a bankruptcy, liquidation, reorganization or similar proceeding, the holders of our senior debt will be entitled to be paid in full before any payment will be made on the exchange notes. In addition, upon any distribution to the creditors of the guarantors in a bankruptcy, liquidation, reorganization or similar proceeding, the holders of the guarantors senior debt will be entitled to be paid in full before any payment will be made on the guarantees. In addition, we will be prohibited from making any payments on the exchange notes and the guarantees if we default on our payment obligations on our senior debt and we may be prohibited from making any such payments for up to 179 consecutive days if certain non-payment defaults on senior debt occur. In the event of a bankruptcy, liquidation or reorganization or similar proceeding relating to us or the guarantors, you, as a holder of the exchange notes, will participate with all other holders of subordinated indebtedness in the assets remaining after we and the guarantors have paid all of our and their senior debt. However, because the indenture requires that amounts otherwise payable to you in a bankruptcy or similar proceeding be paid to holders of senior debt instead, you may receive less, ratably, than holders of other subordinated debt in any such proceeding. In any of these cases, we may not have sufficient funds to pay all of our creditors and you may receive less, ratably, than the holders of senior debt. Not all of our subsidiaries will guarantee the exchange notes, and the assets of our non-guarantor subsidiaries may not be available to make payments on the exchange notes. The guarantors of the exchange notes will not include all of our subsidiaries. One of our subsidiaries, Lovelace Health Systems, Inc., is a regulated health maintenance organization, or HMO, and is therefore prohibited from providing a full and unconditional guarantee of the exchange notes. On October 1, 2003, our New Mexico operations (other than the operations of AHS S.E.D. Medical Laboratories, Inc.) were merged and consolidated into Lovelace Health Systems, Inc. and the note guarantees of certain New Mexico entities were released. The newly-created entity, Lovelace Sandia Health System, Inc., continues to be a regulated HMO and is therefore prohibited from providing a full and unconditional guarantee of the exchange notes. For the nine months ended September 30, 2003, the entities constituting Lovelace Sandia Health System, Inc. after this merger and consolidation had aggregate revenues of $693.2 million, which constituted 70.8% of our consolidated revenues for that period. As of September 30, 2003, these entities had aggregate total assets of $451.2 million, which represented 57.6% of our total assets, and $241.5 million of aggregate indebtedness and other liabilities, which represented 53.6% of our total indebtedness and other liabilities. In addition, the indenture governing the notes allows us to create additional non-guarantor subsidiaries and to release the guarantees of subsidiary guarantors upon the sale of a subsidiary guarantor or upon our designation of a subsidiary guarantor as a non-restricted subsidiary under the indenture, provided in each case that we meet certain tests under the indenture. In order to sell any subsidiary guarantor, the indenture requires that we receive consideration at least equal to the fair market value of the guarantor, of which at Table of Contents Primary State or Other Standard I.R.S. Address, including zip code, and Jurisdiction of Industrial Employer telephone number, including Exact Name of Registrant Incorporation Classification Identification area code, of Registrant s as Specified in its Charter or Organization Code Number principal executive offices Table of Contents least 75% must be in the form of cash, cash equivalents or replacement assets (which are non-current tangible assets to be used in our business), and that the proceeds of the sale must be applied to the repayment of senior debt, to purchase replacement assets or make a capital expenditure that is useful in our business. To the extent we have any amount of proceeds remaining, we are required to make an offer to purchase that amount of outstanding notes and any other indebtedness which ranks equally with the notes. The indenture also sets forth certain requirements we must meet in order to designate a subsidiary guarantor as a non-restricted subsidiary, including that the subsidiary s indebtedness must be permissible under the indenture, the aggregate fair market value of all investments owned by us and the other subsidiary guarantors in that subsidiary must be permissible under the indenture, and that the subsidiary cannot own any equity interests of, or hold any liens on any property of, us or the other subsidiary guarantor. Additionally, that subsidiary cannot be party to any agreement with us or any subsidiary guarantor the terms of which are less favorable than those that might be obtained from unrelated third parties, and that subsidiary cannot have guaranteed or provided credit support for any indebtedness of us or any other guarantor. That subsidiary is also required to have one director and one officer who do not serve as directors or officers of us or any other subsidiary guarantor and no event of default may be in existence at the time of our designation under the indenture. In the event that any non-guarantor subsidiary becomes insolvent, liquidates, reorganizes, dissolves or otherwise winds up, holders of its indebtedness and its trade creditors generally will be entitled to payment on their claims from the assets of that subsidiary before any of those assets are made available to us. Consequently, your claims in respect of the exchange notes will be effectively subordinated to all of the liabilities of our non-guarantor subsidiaries, including trade payables. We are a holding company and, as such, we do not have, and will not have in the future, any income from operations. We are a holding company and conduct substantially all of our operations through our subsidiaries. Consequently we do not have any income from operations and do not expect to generate income from operations in the future. As a result, our ability to meet our debt service obligations, including our obligations under the exchange notes, substantially depends upon our subsidiaries cash flow and payment of funds to us by our subsidiaries as dividends, loans, advances or other payments. The payment of dividends or the making of loans, advances or other payments to us by our subsidiaries may be subject to regulatory or contractual restrictions. As a regulated insurance company, Lovelace Sandia Health System, Inc. may be restricted from paying dividends to us, which may reduce the amount of cash available to us. The ability of Lovelace Sandia Health System, Inc. to pay dividends or make other distributions to us is restricted by state insurance company laws and regulations. These laws and regulations require Lovelace Sandia Health System, Inc. to give notice to the New Mexico Department of Insurance prior to paying dividends or making distributions to us. In addition, Lovelace Sandia Health System, Inc. is subject to state-imposed risk-based or other net worth-based capital requirements that effectively limit the amount of funds the subsidiary has available to distribute or pay to us. As a result of these capital requirements or other agreements we may enter into with state regulators, we may not be able to receive any funds from Lovelace Sandia Health System, Inc. and, moreover, we may be required to make contributions to Lovelace Sandia Health System, Inc. to enable the subsidiary to meet its capital requirements, thereby further limiting the funds we may have to make payments with respect to the exchange notes. At September 30, 2003, Lovelace Sandia Health System, Inc. was required to maintain a net worth of $34.1 million. Actual net worth as of that date exceeded the requirement by $16.9 million. As a result of the merger and consolidation of our New Mexico operations (other than the operations of AHS S.E.D. Medical Laboratories, Inc.) into Lovelace Sandia Health System, Inc., the entities constituting Lovelace Sandia Health System, Inc. (which, for the nine months ended September 30, 2003, accounted for approximately 71% of our total net revenues) are subject to the above restrictions and regulations. As of September 30, 2003, these entities had cash and cash equivalents of approximately $33.2 million. Table of Contents To service our debt, we will require a significant amount of cash, which may not be available to us. Our ability to make payments on, or repay or refinance, our debt, including the exchange notes, and to fund planned capital expenditures, will depend largely upon our future operating performance. Our debt service obligation, including principal and interest payments, for calendar year 2004 is anticipated to be approximately $29.5 million. Our future performance, to a certain extent, is subject to general economic, financial, competitive, legislative, regulatory and other factors that are beyond our control. We cannot assure you that our business will generate sufficient cash flow from operations or that future borrowings will be available to us under our new senior secured credit facility or from other sources in an amount sufficient to enable us to pay our debt, including the exchange notes, or to fund our other liquidity needs. In addition, prior to the repayment of the exchange notes, we will be required to refinance our new senior secured credit facility. We cannot assure you that we will be able to refinance any of our debt, including our new senior secured credit facility, on commercially reasonable terms or at all. If we were unable to make payments or refinance our debt or obtain new financing under these circumstances, we would have to consider other options, such as: sales of assets; sales of equity; and/or negotiations with our lenders to restructure the applicable debt. Our credit agreements and the indenture governing the exchange notes restrict, and market or business conditions may limit, our ability to sell assets or equity or restructure any debt. The agreements governing our debt, including the exchange notes and our new senior secured credit facility, contain various covenants that limit our discretion in the operation of our business and could lead to the acceleration of our debt. Our new senior secured credit facility imposes, and future financing agreements are likely to impose, operating and financial restrictions on our activities. These restrictions require us to comply with or maintain certain financial tests and ratios, including minimum net worth and interest coverage ratios and maximum total and senior leverage ratios and limit or prohibit our ability to, among other things: incur additional debt and issue preferred stock; create liens; redeem and/or prepay certain debt; pay dividends on our stock or repurchase stock; make certain investments; enter new lines of business; engage in consolidations, mergers and acquisitions; make certain capital expenditures; and pay dividends and make other distributions. These restrictions on our ability to operate our business could seriously harm our business by, among other things, limiting our ability to take advantage of financings, mergers, acquisitions and other corporate opportunities. Various risks, uncertainties and events beyond our control could affect our ability to comply with these covenants and maintain these financial tests and ratios. Failure to comply with any of the covenants in our existing or future financing agreements could result in a default under those agreements and under other agreements containing cross-default provisions. A default would permit lenders to accelerate the maturity for the debt under these agreements and to foreclose upon any collateral securing the debt. Under Pretax income (loss): United States $ 7,033 $ 4,258 $ (771 ) $ 1,803 $ (11,151 ) Foreign Table of Contents these circumstances, we might not have sufficient funds or other resources to satisfy all of our obligations, including our obligations under the exchange notes. In addition, the limitations imposed by financing agreements on our ability to incur additional debt and to take other actions might significantly impair our ability to obtain other financing. The exchange notes generally are not secured by our assets or those of the guarantors, whereas the lenders under our new senior secured credit facility are entitled to remedies available to a secured lender, which gives them priority over you to collect amounts due to them. In addition to being subordinated to all our existing and future senior debt, the exchange notes and the guarantees will not be secured by any of our assets other than the intercompany note pledged in connection with the consolidation of the majority of our New Mexico operations. Our obligations under our new senior secured credit facility are secured by, among other things, a first priority pledge of all of the common stock of our subsidiaries and substantially all our assets. If we become insolvent or are liquidated, or if payment under our new senior secured credit facility or in respect of any other secured indebtedness is accelerated, the lenders under our new senior secured credit facility or holders of other secured indebtedness are entitled to exercise the remedies available to a secured lender under applicable law (in addition to any remedies that may be available under documents pertaining to our new senior secured credit facility or other senior debt). These lenders will have a claim on all assets securing their debt before the holders of unsecured debt, including the exchange notes. The interests of the principal members of our parent may not be aligned with your interests as a holder of the exchange notes. Welsh, Carson, Anderson Stowe IX, L.P. and its related investors control a majority of the voting power of the outstanding common units of our parent, which in turn holds all of the voting power of our common stock. Consequently, these equity holders will control all of our affairs and policies. Circumstances may occur in which the interests of these equity holders could be in conflict with the interest of the holders of the exchange notes. Generally, holders of debt securities such as the exchange notes have limited opportunities for capital appreciation and therefore are primarily focused on an issuer s creditworthiness and ability to make interest and principal payments. Because we do not currently pay a dividend to our equity holders, they are focused primarily on capital appreciation. As a result, our equity holders may have an interest in causing us to pursue acquisitions, divestitures or other transactions that, in the judgment of such equity holders, have the potential to enhance the value of their equity investment, even though such transactions might also involve risks to holders of the exchange notes, including risks to our creditworthiness. Our senior secured credit facility prohibits our ability to make a change of control offer required by the indenture governing the exchange notes, which could lead to a default under the indenture. The terms of the exchange notes will require us to make an offer to repurchase the exchange notes upon the occurrence of a change of control at a purchase price equal to 101% of the principal amount of the exchange notes, plus accrued interest to the date of the purchase. We are prohibited under the new senior secured credit facility, and may be prohibited under future debt agreements, from purchasing any exchange notes prior to their stated maturity. In such circumstances, we will be required to repay or obtain the requisite consent from the affected lenders to permit the repurchase of the exchange notes. Absent a consent, we can only make a change in control offer if there are sufficient funds remaining after repaying all amounts outstanding under the senior secured credit facility. If we are unable to repay all of such debt or are unable to obtain the necessary consents, we will be unable to offer to repurchase the exchange notes, which would constitute an event of default under the indenture governing the exchange notes, which itself would also constitute a default under our new senior secured credit facility and our other existing financing arrangements. Table of Contents The guarantees may not be enforceable because of fraudulent conveyance laws. The guarantors guarantees of the exchange notes may be subject to review under U.S. federal bankruptcy law or relevant state fraudulent conveyance laws if a bankruptcy lawsuit is commenced by or on behalf of our or the guarantors unpaid creditors. Under these laws, if in such a lawsuit a court were to find that, at the time a guarantor incurred debt (including debt represented by the guarantee), such guarantor: incurred this debt with the intent of hindering, delaying or defrauding current or future creditors; or received less than reasonably equivalent value or fair consideration for incurring this debt and the guarantor: was insolvent or was rendered insolvent by reason of the related financing transactions; was engaged, or about to engage, in a business or transaction for which its remaining assets constituted unreasonably small capital to carry on its business; or intended to incur, or believed that it would incur, debts beyond its ability to pay these debts as they mature, as all of the foregoing terms are defined in or interpreted under the relevant fraudulent transfer or conveyance statutes; then the court could void the guarantee or subordinate the amounts owing under the guarantee to the guarantor s presently existing or future debt or take other actions detrimental to you. In addition, the subsidiary guarantors may be subject to the allegation that since they incurred their guarantees for our benefit, they incurred the obligations under the guarantees for less than reasonably equivalent value or fair consideration. The measure of insolvency for purposes of the foregoing considerations will vary depending upon the law of the jurisdiction that is being applied in any such proceeding. Generally, a company would be considered insolvent if, at the time it incurred the debt or issued the guarantee: it could not pay its debts or contingent liabilities as they become due; the sum of its debts, including contingent liabilities, is greater than its assets, at fair valuation; or the present fair saleable value of its assets is less than the amount required to pay the probable liability on its total existing debts and liabilities, including contingent liabilities, as they become absolute and mature. If a guarantee is voided as a fraudulent conveyance or found to be unenforceable for any other reason, you will not have a claim against that obligor and will only be our creditor or that of any guarantor whose obligation was not set aside or found to be unenforceable. In addition, the loss of a guarantee will constitute a default under the indenture, which default would cause all outstanding notes to become immediately due and payable. An active public market may not develop for the exchange notes, which may hinder your ability to liquidate your investment. The exchange notes are a new issue of securities with no established trading market, and we do not intend to list them on any securities exchange. The liquidity of the trading market in the exchange notes, and the market price quoted for the exchange notes, may be adversely affected by changes in the overall market for fixed income securities and by changes in our financial performance or prospects or in the prospects for companies in our industry in general. As a result, we cannot assure you that an active trading market will develop for the exchange notes. If no active trading market develops, you may not be able to resell your exchange notes at their fair market value or at all. Table of Contents Risks Relating to Our Business We may not successfully integrate our recent and future acquisitions and may be unable to achieve anticipated cost savings and other benefits from these acquisitions. Since August 2001, we have acquired seven acute care hospitals, including a significant health plan, two behavioral hospitals and various other ancillary services. These acquisitions have significantly increased the size and geographic scope of our operations. In addition, one of our primary growth strategies for the future is completing additional acquisitions. The integration of past and future acquisitions involves a number of risks and presents financial, managerial and operational challenges. For example, at one of our acquired hospitals, we experienced delays in billings related to information systems transitions, and as a result, our results of operations were negatively affected. In addition to risk associated with information systems integration, we face the following risks: we may have difficulty integrating personnel and physicians from acquired hospitals; we may have difficulty, and may incur unanticipated expenses related to, upgrading the financial systems and controls at our new facilities; we may uncover liabilities at our newly-acquired operations of which we are not aware or that are greater than expected and for which the previous owner may be unable or unwilling to indemnify us; and we may be unable to improve existing managed care agreements and the mix of specialties offered at our hospitals. Failure to integrate past and future acquisitions successfully and in a timely fashion may have an adverse effect on our business, results of operations and financial condition. In addition, we may be unable to achieve the anticipated cost savings from these acquisitions for many reasons, including: contractual constraints on our ability to reduce excess staffing, inability to achieve expected tax savings from a more streamlined legal structure or inability to extract lower prices from our suppliers. Our strategy depends in part on our ability to acquire hospitals that meet our target criteria. If we are unable to do so, our future growth could be limited and our operating results could be adversely affected. The competition to acquire acute care and behavioral hospitals in the selected markets that we will target is significant, including competition from healthcare companies with greater financial resources than us and larger development staffs focused on identifying and completing acquisitions. We may be unable to identify acquisitions opportunities and to negotiate and complete acquisitions on favorable terms. Our inability to complete such acquisitions may negatively impact our future growth and results of operations. We may have difficulty acquiring hospitals from not-for-profit entities due to increased regulatory scrutiny. Many states have enacted or are considering enacting laws affecting sales, leases or other transactions in which control of not-for-profit hospitals is acquired by for-profit entities. These laws, in general, include provisions relating to state attorney general approval, advance notification and community involvement, determination of appropriate valuation of assets divested and the use of proceeds of the sale by the not-for-profit entity. In addition, state attorneys general in states without specific conversion legislation governing such transactions may exercise authority based upon charitable trust and other existing laws. The increased legal and regulatory review of these transactions involving the change of control of not-for-profit hospitals may increase the costs and time required for such acquisitions, and therefore, limit our ability to acquire not-for-profit hospitals. In addition, as a condition to approving an acquisition, certain state attorneys general may require us to maintain certain services, such as emergency departments, or to continue to provide certain levels of charity care, which may affect our decision to acquire or the terms of an acquisition of these hospitals as well as the future profitability of any such hospitals we acquire. Net income (loss) from continuing operations $ 4,343 $ Table of Contents Our acquisition strategy may be limited by restrictions and covenants in our new senior secured credit facility and by the lack of adequate alternative sources of financing. Our senior secured credit facility contains limitations on acquisitions of regulated and non-regulated entities. If we are unable to obtain any required consents from our lenders for future acquisitions, our strategy of growing by selective acquisitions may be limited. In addition, our acquisition strategy may require that we obtain additional capital to finance future transactions. Sufficient capital or financing may not be available to us on satisfactory terms, if at all. Either of these factors would negatively affect our future operating performance. Our revenues may decline if federal or state programs reduce our Medicare or Medicaid payments or managed care companies reduce our reimbursements. A substantial portion of our total net revenues is derived from the Medicare and Medicaid programs. The Medicare program accounted for 42.2% of our acute care patient days and 9.4% of our behavioral patient days for the nine months ended September 30, 2003. The Medicaid program accounted for 7.4% of our acute care patient days and 33.8% of our behavioral patient days during the nine months ended September 30, 2003. In recent years, federal and state governments have made significant changes in the Medicare and Medicaid programs. In addition, due to budget deficits in many states, significant decreases in state funding for the Medicaid programs have occurred or are being proposed. These changes in the Medicare and Medicaid programs have decreased the amounts of money we receive for our services to patients who participate in these programs. In recent years, Congress and some state legislatures have introduced a number of other proposals to make major changes in the healthcare system. Medicare-reimbursed, hospital-outpatient services converted to a prospective payment system on August 1, 2000. This system creates limitations on levels of payment for a substantial portion of hospital outpatient procedures. Future federal and state legislation may further reduce the payments we receive for our services. A number of states have adopted legislation designed to reduce their Medicaid expenditures. Some states have enrolled Medicaid recipients in managed care programs (which generally tend to reduce the level of hospital utilization) and have imposed additional taxes on hospitals to help finance or expand the states Medicaid systems. Some states have also reduced the scope of Medicaid eligibility and coverage, making an increasing number of residents unable to pay for their care. Other states propose to take similar steps. In addition, insurance and managed care companies and other third parties from whom we receive payment for our services increasingly attempt to control healthcare costs by requiring that hospitals discount their fees in exchange for exclusive or preferred participation in their benefit plans. We believe that this trend may continue and may reduce the payments we receive for our services. We face intense competition from other hospitals and other healthcare providers which may result in a decline in revenues, profitability and market share. The healthcare business is highly competitive and competition among hospitals and other healthcare providers for patients has intensified in recent years. Most of our facilities operate in geographic areas where we compete with at least one other hospital that provides services comparable to those offered by our facilities. In addition, the number of freestanding specialty hospitals and outpatient surgery and diagnostic centers in the areas in which our hospitals operate has also increased significantly. Some of the hospitals that compete with us are owned or operated by tax-supported governmental bodies or by private not-for-profit entities supported by endowments and charitable contributions which can finance capital expenditures on a tax-exempt basis and are exempt from sales, property and income taxes. Some of our competitors are more established, offer highly specialized facilities, equipment and services, which may not be available at our hospitals, offer a wider range of services or have more capital or other resources. The intense competition we face from other healthcare providers may have an adverse effect on our market share, revenues and results of operations. (A) (A) (A) (B) (Dollars in thousands) Statement of Operations Data: Revenues: Net patient service revenue $ 369,539 $ 7,994 $ 113,902 $ 138,396 $ $ 629,831 Premium revenue 13,232 27,268 509,580 550,080 Other revenue 25,213 Table of Contents Primary State or Other Standard I.R.S. Address, including zip code, and Jurisdiction of Industrial Employer telephone number, including Exact Name of Registrant Incorporation Classification Identification area code, of Registrant s as Specified in its Charter or Organization Code Number principal executive offices Table of Contents Regional concentration of our business may subject us to economic downturns in the State of New Mexico and, in particular, the Albuquerque metropolitan area. With our recent acquisitions of five acute care hospitals (including one inpatient rehabilitation hospital), two health maintenance organizations (which we subsequently merged), and certain ancillary services in New Mexico, the majority of our revenue is generated in New Mexico. For the nine months ended September 30, 2003, our New Mexico operations accounted for approximately 72% of our total net revenues. This concentration of business in New Mexico exposes us to potential losses resulting from a downturn in the economy of the State of New Mexico and, in particular, Albuquerque. If economic conditions deteriorate, we may experience a reduction in existing and new business, which may have an adverse effect on our business, financial condition and results of operations. Our success depends on our ability to attract new physicians and maintain good relationships with physicians and other healthcare professionals at our hospitals. Because physicians working with acute care hospitals generally direct the majority of hospital admissions, our success in operating our acute care hospitals will be, in part, dependent upon the number and quality of physicians on these hospitals medical staffs, the admissions practices of the physicians at these hospitals and our ability to maintain good relations with our physicians. With the exception of approximately 320 employed physicians in Albuquerque, our physicians are generally not employees of the hospitals at which they practice and most physicians have admitting privileges at other hospitals in addition to our hospitals. Physicians may terminate their affiliation with our hospitals at any time. If we are unable to successfully maintain good relationships with physicians, our hospitals admissions may decrease and our results of operations may be adversely affected. For example, patient volume at Sandia Health System was negatively affected during the nine-month period ended September 30, 2003 by the departure of certain physicians. In addition, physicians are increasingly seeking to supplement their declining income by building facilities or offering services that compete with acute care hospitals, such as ambulatory surgery centers, diagnostic imaging centers, or specialty hospitals. These facilities and services may attract patients from the more profitable service lines of an acute care hospital, leaving the hospital with less profitable or unprofitable service lines, such as emergency departments, that the hospital may be unable to close for community relations and other reasons. We compete with other healthcare providers in recruiting and retaining qualified management and staff personnel responsible for the day-to-day operations of each of our hospitals, including nurses and other non-physician healthcare professionals. In the healthcare industry generally, including our markets, the scarcity of nurses and other medical support personnel has become a significant operating issue. This shortage may require us to increase wages and benefits to recruit and retain nurses and other medical support personnel, or to hire more expensive contract or temporary personnel. If our labor costs increase, we may not be able to raise rates to offset these increased costs. Because a significant percentage of our revenues are derived from fixed, prospective payments, our ability to pass along increased labor costs is constrained. Our failure to recruit and retain qualified management, nurses and other medical support personnel, or to control our labor costs, could have an adverse effect on our business and results of operations. We depend heavily on our senior and local management personnel, and the loss of the services of one or more of our key senior management personnel or our key local management personnel could weaken our management team and our ability to deliver healthcare services efficiently. We have been, and will continue to be, dependent upon the services and management experience of David T. Vandewater, our Chief Executive Officer, Jamie E. Hopping, our Chief Operating Officer, R. Dirk Allison, our Chief Financial Officer, and our other senior executive officers. We have entered into employment agreements with each of these senior executive officers, but we do not maintain key person life insurance for these executive officers. If Mr. Vandewater, Ms. Hopping, Mr. Allison or any of our other senior executive officers were to resign their positions or otherwise be unable to serve, our management could be weakened and operating results could be adversely affected. In addition, our success Substantially all of the Company s long-term investments are held in the CHI Investment Program. The Program is structured under a Limited Partnership Agreement between CHI, as managing general partner, and each participant. All investments in the Program are professionally managed by the Company under the administration of CHI. Investments held in the Program are represented by pool units valued monthly under a custodian accounting system. Investment income from the Program, including interest income, dividends, and realized gains or losses from the sale of securities, is distributed to participants based on the earnings per pool unit. Gains or losses also are realized by participants when pool units are sold, representing the difference between the cost basis and the market value of the pool units sold. The fair value of the assets held is an allocation of the underlying market value of the assets in the Program, based upon pool units held by the participants. The underlying fair value of investments in the Program, which are traded on national exchanges, is based on the last reported sales price on the last business day of the fiscal year. The market value of investments traded in over-the-counter markets is based on the average of the last recorded bid and asked prices. Net unrealized gains (losses) on investments was $(0.59 million) at August 31, 2002. Investment losses and gains for assets limited as to use, cash equivalents, and other investments for the two-month period ended August 31, 2002 is as follows: Income (loss): Interest income $ 112 Realized gains (losses) on sales of securities (467 ) Dividend income Table of Contents depends on our ability to attract and retain local managers at our hospitals and related facilities, on the ability of our officers and key employees to manage growth successfully and on our ability to attract and retain skilled employees. If we are unable to attract and retain local management, our operating performance could be adversely affected. We conduct business in a heavily regulated industry; changes in regulations or violations of regulations may result in increased costs or sanctions that could reduce revenue and profitability. Healthcare providers are required to comply with many laws and regulations at the federal, state and local government levels. These laws and regulations relate to: licensing; the conduct of operations; the relationships among hospitals and their affiliated providers; the ownership of facilities; the addition of facilities and services; confidentiality, maintenance and security issues associated with medical records; billing for services; and prices for services. If we fail to comply with applicable laws and regulations, we could suffer civil and criminal penalties, including the loss of our licenses to operate and our ability to participate in Medicare, Medicaid, and other federal and state healthcare programs. In addition, there are heightened coordinated civil and criminal enforcement efforts by both federal and state government agencies relating to the healthcare industry, including the hospital segment. The ongoing investigations in this industry relate generally to various referral, cost reporting and billing practices, laboratory and home healthcare services, and physician ownership and joint ventures involving hospitals. In the future, different interpretations or enforcement of these laws and regulations could subject our current practices to allegations of impropriety or illegality or could require us to make changes in our operations. We may be subjected to actions brought by individuals on the government s behalf under the False Claims Act s qui tam or whistleblower provisions. Whistleblower provisions allow private individuals to bring actions on behalf of the government alleging that the defendant has defrauded the federal government. Because qui tam lawsuits are filed under seal, we could be named in one or more such lawsuits of which we are not aware. Several of our subsidiaries have been named as defendants in two qui tam lawsuits. Defendants determined to be liable under the False Claims Act may be required to pay three times the actual damages sustained by the government, plus mandatory civil penalties of between $5,500 and $11,000 for each separate false claim. Typically, each fraudulent bill submitted by a provider is considered a separate false claim, and thus the penalties under a false claim case may be substantial. Liability arises when an entity knowingly submits a false claim for reimbursement to the federal government. In some cases, whistleblowers or the federal government have taken the position that providers who allegedly have violated other statutes, such as the anti-kickback statute or the Stark Law and have submitted claims to a governmental payor during the time period they allegedly violated these other statutes, have thereby submitted false claims under the False Claims Act. In addition, a number of states have adopted their own false claims provisions as well as their own whistleblower provisions allowing a private party to file a civil lawsuit in state court. The cost of our malpractice insurance and the malpractice insurance of physicians who practice at our facilities or who participate in our networks continues to rise. Successful malpractice or tort claims asserted against us, our providers or our employees could adversely affect our financial condition and profitability. In recent years, physicians, hospitals and other healthcare providers have become subject to an increasing number of legal actions alleging malpractice or related legal theories. Many of these actions involve large claims and significant defense costs. To protect ourselves from the cost of these claims, we generally maintain professional malpractice liability insurance and general liability insurance coverage in amounts and with deductibles that we believe to be appropriate for our operations. Effective October 31, 2003, we established a wholly owned captive insurance subsidiary to insure our professional and general liability risk for claims up to $2.0 million. In addition, effective October 31, 2003, we purchased excess insurance coverage with independent third-party carriers for claims up to $75.0 million per occurrence and Net income (loss) 3,904 5,007 5,053 2,716 17,869 3,336 (7,829 ) Accrued preferred dividends 5,892 3,944 5,993 1,210 8 12 (Unaudited) Property, plant, and equipment $ $ 203 $ 19 $ 279 $ $ 2,550 Other assets, net 350 Table of Contents in the aggregate. However, our insurance coverage may not cover all claims against us or continue to be available at a reasonable cost for us to maintain adequate levels of insurance. In addition, physicians malpractice insurance costs have dramatically increased to the point where some physicians are either choosing to retire early or leave certain markets. If physician malpractice costs continue to escalate in markets in which we operate, some physicians may choose not to practice at our facilities, which could reduce our patient volume and thus our revenue. Our managed care providers involved in medical care decisions may be exposed to the risk of medical malpractice claims. Many of our network providers are our employees for whose acts we may be liable as an employer. In addition, managed care organizations may be sued directly for various types of alleged negligence, such as in connection with the credentialing of network providers or improper denials or delay of care. Finally, Congress is considering legislation that would permit managed care organizations to be held liable for negligent treatment decisions or benefits coverage determinations. If this or similar legislation were enacted, claims of this nature could result in substantial damage awards against us and our providers that could exceed the limits of any applicable medical malpractice insurance coverage and could have a material adverse effect on our financial condition. Our business depends on our information systems, and our inability to effectively integrate and manage our information systems could disrupt our operations. Our business is dependent on effective information systems that assist us in, among other things, monitoring utilization and other cost factors, supporting our healthcare management techniques, processing provider claims and providing data to our regulators. Our managed care providers also depend upon our information systems for membership verifications, claims status and other information. If we experience a reduction in the performance, reliability or availability of our information systems, our operations and ability to produce timely and accurate reports could be adversely impacted. Our information systems and applications require continual maintenance, upgrading and enhancement to meet our operational needs. Moreover, our acquisition activity requires transitions to or from, and the integration of, various information systems. We regularly upgrade and expand our information systems capabilities and are currently in the process of rolling out new clinical and financial reporting systems throughout our operations. If we experience difficulties with the transition to or from information systems or are unable to properly implement, maintain or expand our systems, we could suffer, among other things, from operational disruptions, loss of membership in our networks, regulatory problems and increases in administrative expenses. Failure to maintain the privacy and security of patients medical records could expose us to liability. The Health Insurance Portability and Accountability Act of 1996 required the Department of Health and Human Services to issue regulations requiring hospitals and other providers to implement measures to ensure the privacy and security of patients medical records and the use of uniform data standards for the exchange of information between the hospitals and health plans, including claims and payment transactions. The privacy standard became effective October 15, 2002. Full compliance with the privacy standard was required by April 14, 2003. Although we believe we have met the April 14, 2003 privacy standard compliance deadline, compliance will be an ongoing process. The transaction standard and the security standard became effective on October 16, 2000 and February 20, 2003, respectively. Full compliance with the transaction standard was required by October 16, 2003 and full compliance with the security standard is required by April 20, 2005. We are in the process of complying with the transaction standard and security standard. We may incur additional expenses in order to comply with these standards. We cannot predict the full extent of our costs of implementing all of the requirements at this stage. If we violate these standards, we may be subject to civil monetary fines and sanctions and criminal penalties. Further, a substantial portion of our revenue is derived from payments by governmental health plans, such as Medicare, and private health plans. Our failure, or the failure of the health plans with which we transact, to comply with the transaction standard may result in significant disruptions in the payments we Table of Contents receive from such health plans. Finally, because of the confidential nature of the health information we store and transmit, privacy or security breaches could expose us to a risk of regulatory action, litigation, possible liability and loss. Our privacy or security measures may be inadequate to prevent breaches, and our business operations would be adversely impacted by cancellation of contracts and loss of members if they are not prevented. A reduction in enrollment in our health plan or the failure to maintain satisfactory relationships with providers could affect our business and profitability. Premium revenue from our health plan accounted for approximately 46.1% of our total net revenues for the nine months ended September 30, 2003. A reduction in the number of members in our health plan could reduce our revenues and profitability. Factors that could contribute to a reduction in membership include premium increases, benefit changes and reductions in workforce by existing customers. In recent years, the managed care industry has received considerable negative publicity. This publicity has led to increased review of industry practices, legislation, regulation and litigation. These factors may adversely affect our ability to market our health plan services, require us to change our health plan procedures or services, and increase the regulatory burdens under which our health plan operates, further increasing the costs of doing business and adversely affecting our operating results. The profitability of our health plan depends, in large part, upon its ability to contract favorably with hospitals, physicians and other healthcare providers in appropriate numbers and at locations appropriate for the health plan s members in New Mexico. Providers could refuse to contract, demand higher payments or take other actions that could result in higher healthcare costs. If any of the key providers to our health plan refuses or is otherwise unavailable to contract with our health plan, uses its market position to negotiate more favorable contracts or otherwise places our health plan at a competitive disadvantage, our operating results could be adversely affected. Provider arrangements for our health plan with contracted primary care physicians, specialists and hospitals in its network usually have one-year terms and automatically renew for successive one-year periods. Generally, these contracts may also be cancelled by either party without cause upon 30 to 90 days prior written notice. Our health plan may be unable to continue to renew such contracts or enter into new contracts enabling our health plan to service its members profitably. If our health plan is unable to retain its current provider contracts or enter into new provider contracts on a timely basis or on favorable terms, our results of operations could be adversely affected. If we are unable to effectively price our health plan premiums or manage medical costs, our profitability will be reduced. A large amount of revenues of our health plan consists of fixed monthly payments per member. These payments are fixed by contract, and the health plan is obligated during the contract period to provide or arrange for the provision of all healthcare services required by such member. Historically, medical care costs of our health plan as a percentage of premium and other operating revenue has fluctuated. If premiums are not increased and medical care costs rise, the earnings of our health plan on insured business could decrease. In addition, actual medical care costs of our health plan may exceed its estimated costs on insured business. The premiums our health plan receives under its current insurance contracts may therefore be inadequate to cover all claims, which may cause our profits to decline. Our health plan profitability depends, to a significant degree, on our ability to predict and effectively manage medical costs. Historically, there have been fluctuations in the medical care cost ratio of our health plan. Relatively small changes in these medical care cost ratios can create significant changes in our financial results. Changes in healthcare laws, regulations and practices, utilization of services, hospital costs, pharmaceutical costs, major epidemics, terrorism or bioterrorism, new medical technologies and other external factors, including general economic conditions such as inflation levels, could reduce our ability to predict and effectively control the costs of providing healthcare services. If our medical care costs increase, our profits could be reduced or we may not remain profitable. Beginning temporarily restricted net assets $ 2,148 $ 2,184 $ 4,733 Temporarily restricted contributions 1,097 669 834 Net assets released from restrictions (503 ) (775 ) (3,055 ) Investment income (14 ) 44 278 Other changes 5 Table of Contents Our medical care costs also include estimates of claims incurred but not reported, or IBNR. We, together with our independent actuaries, estimate our medical claims liabilities using actuarial methods based on historical data for payment patterns, cost trends, product mix, seasonality, utilization of healthcare services and other relevant factors. The estimation methods and the resulting accrued liabilities are continually reviewed and updated, and adjustments, if necessary, are reflected in the period when they become known. While our IBNR estimates generally have been adequate in the past, they may be inadequate in the future, which would negatively affect our results of operations. Further, our inability to accurately estimate IBNR may also affect our ability to take timely corrective actions, further exacerbating the extent of the negative impact on our results. We maintain accrued liabilities on our financial statements in amounts we believe are adequate to provide for actuarial estimates of medical claims. We also maintain reinsurance to protect us against certain catastrophic medical claims by Medicaid beneficiaries who participate in our health plan. While we believe our reinsurance coverage with respect to these Medicaid claims is adequate, in the future such reinsurance coverage may be inadequate or unavailable to us or the cost of such reinsurance coverage may limit our ability to obtain other insurance. We do not maintain reinsurance to protect us against other catastrophic medical claims under our health plan. Recently enacted or proposed legislation, regulations and initiatives could adversely affect our business by increasing our operating costs, reducing our health plan membership or subjecting us to additional litigation. In recent years, an increasing number of legislative initiatives have been introduced or proposed in Congress and in state legislatures that would effect major changes in the healthcare system, either nationally or at the state level. Among the proposals that have been introduced are price controls on hospitals, insurance market reforms to increase the availability of group health insurance to small businesses, requirements that all businesses offer health insurance coverage to their employees and the creation of a government health insurance plan or plans that would cover all citizens, and increased payments by beneficiaries. Increased regulations, mandated benefits and more oversight, audits and investigations and changes in laws allowing access to federal and state courts to challenge healthcare decisions may increase our administrative, litigation and healthcare costs. We cannot predict whether any of the above proposals or any other proposals will be adopted, and if adopted, no assurance can be given that the implementation of such reforms will not have a material adverse effect on our business and results of operations. Net cash (used in) provided by discontinued operations (67 ) 20 (1 ) (112 ) 34 You should rely only on the information contained in this prospectus. We have not authorized any person to provide you with any information or represent anything about us or this offering that is not contained in this prospectus. If given or made, any such other information or representation should not be relied upon as having been authorized by us. We are not making an offer of the exchange notes in any jurisdiction where an offer is not permitted. Table of Contents Primary State or Other Standard I.R.S. Address, including zip code, and Jurisdiction of Industrial Employer telephone number, including Exact Name of Registrant Incorporation Classification Identification area code, of Registrant s as Specified in its Charter or Organization Code Number principal executive offices Table of Contents THE EXCHANGE OFFER Purposes and Effect of the Exchange Offer We sold the original notes on August 19, 2003 to Banc of America Securities LLC, UBS Securities LLC, Banc One Capital Markets, Inc. and Merrill Lynch, Pierce, Fenner Smith Incorporated (the initial purchasers ), who resold the original notes to qualified institutional buyers in reliance on Rule 144A under the Securities Act and outside the United States to non-U.S. persons in compliance with Regulation S under the Securities Act. In connection with the issuance of the original notes, we, our parent and our subsidiaries that guarantee the original notes (the subsidiary guarantors ) entered into a registration rights agreement with the initial purchasers of the original notes. The following description of the registration rights agreement is a summary only. It is not complete and does not describe all of the provisions of the registration rights agreement. For more information, you should review the provisions of the registration rights agreement that we filed with the SEC as an exhibit to the registration statement of which this prospectus is a part. Under the registration rights agreement, we agreed that, promptly after the effectiveness of the registration statement of which this prospectus is a part, we would offer to the holders of original notes who are not prohibited by any law or policy of the SEC from participating in the exchange offer, the opportunity to exchange their original notes for a new series of notes, which we refer to as the exchange notes, that are identical in all material respects to the original notes, except that the exchange notes do not contain transfer restrictions, have been registered under the Securities Act and are not subject to further registration rights. We, our parent and our subsidiary guarantors have agreed to use our reasonable best efforts to keep the exchange offer open for not less than 20 business days, or longer if required by applicable law, after the date on which notice of the exchange offer is mailed to the holders of the original notes. We, our parent and our subsidiary guarantors also have agreed to use our reasonable best efforts to cause the exchange offer to be consummated on the earliest practicable date after the registration statement of which this prospectus is a part has become effective, but in no event later than 30 business days after such date of effectiveness. If: (1) we, our parent and our subsidiary guarantors are not permitted to file an exchange offer registration statement or consummate the exchange offer because the exchange offer is not permitted by applicable law or SEC policy; (2) for any reason the exchange offer is not consummated within 30 business days after the registration statement of which this prospectus is a part is declared effective; or (3) any holder of transfer restricted securities notifies us that: (a) it is prohibited by law or SEC policy from participating in the exchange offer; or (b) it may not resell the exchange notes acquired by it in the exchange offer to the public without delivering a prospectus and the prospectus contained in the registration statement of which this prospectus is a part is not appropriate or available for such resales; or (c) it is a broker-dealer and owns original notes acquired directly from us or one of our affiliates, then we, our parent and the subsidiary guarantors will: (1) as soon as practicable but in any event on or prior to 45 days after the filing obligation arises, file a shelf registration statement with the SEC covering resales of the transfer restricted securities by the holders thereof who satisfy certain conditions relating to the provision of information in connection with the shelf registration statement; Table of Contents (2) use reasonable best efforts to cause the shelf registration statement to become effective on or before 135 days after the filing obligation arises; and (3) use reasonable best efforts to keep the shelf registration statement effective until the earliest to occur of (a) two years from the date on which the shelf registration statement is declared effective and (b) the time when all notes covered by the shelf registration statement have been sold pursuant to the shelf registration statement or are no longer transfer restricted securities. For purposes of the foregoing, a transfer restricted security is each original note until the earliest to occur of: (1) the date on which the original note has been exchanged in the exchange offer and may be resold to the public by the holder without complying with the prospectus delivery requirements of the Securities Act; (2) the date on which the original note has been effectively registered under the Securities Act and disposed of in accordance with the shelf registration statement; and (3) the date on which the original note is distributed to the public pursuant to Rule 144 under the Securities Act or by a broker-dealer pursuant to the procedures described in Plan of Distribution. A registration default will be deemed to occur under the registration rights agreement if: (1) any registration statement required by the registration rights agreement is not filed with the SEC on or prior to the date specified for such filing in the registration rights agreement; (2) any registration statement required by the registration rights agreement has not been declared effective by the SEC on or prior to the date specified for such effectiveness in the registration rights agreement; (3) the exchange offer has not been consummated within 30 business days of the effective date of the registration statement of which this prospectus is a part; or (4) any registration statement required by the registration rights agreement is filed and declared effective by the SEC but thereafter shall cease to be effective or fail to be usable for its intended purpose during the periods specified in the registration statement. Upon the occurrence of a registration default, we will pay liquidated damages to each holder of transfer restricted securities, with respect to the first 90-day period immediately following the occurrence of the first registration default in an amount equal to a per annum rate of 0.50% on the principal amount of transfer restricted securities held by such holder. The amount of the liquidated damages will increase by an additional per annum rate of 0.50% with respect to each subsequent 90-day period until all registration defaults have been cured, up to a maximum amount of liquidated damages for all registration defaults of 1.50% per annum on the principal amount of transfer restricted securities. Following the cure of all registration defaults, the accrual of liquidated damages will cease. By acquiring transfer restricted securities, a holder will be deemed to have agreed to indemnify us, our parent and our subsidiary guarantors against certain losses arising out of information furnished by the holder in writing for inclusion in any registration statement. Holders of transfer restricted securities will also be required to suspend their use of the prospectus included in the registration statement under certain circumstances upon receipt of notice to that effect from us. Resale of the Exchange Notes Based on an interpretation by the staff of the SEC set forth in no-action letters issued to third parties, we believe that, unless you are a broker-dealer or an affiliate of us, you may offer for resale, resell or otherwise transfer the exchange notes issued to you pursuant to the exchange offer without compliance with the registration and prospectus delivery provisions of the Securities Act, provided that you acquire the Balance at September 30, 2003 5,000 $ 131,252 30,005 $ Table of Contents exchange notes in the ordinary course of business and you do not intend to participate and have no arrangement or understanding with any person to participate in the distribution of the exchange notes. If you are an affiliate of us or if you tender in the exchange offer with the intention to participate, or for the purpose of participating, in a distribution of the exchange notes, you may not rely on the position of the staff of the SEC enunciated in Exxon Capital Holdings Corporation (available May 13, 1988) and Morgan Stanley Co., Incorporated (available June 5, 1991), or similar no-action letters, but rather must comply with the registration and prospectus delivery requirements of the Securities Act in connection with any resale transaction. In addition, any such resale transaction should be covered by an effective registration statement containing the selling security holder information required by Item 507 or 508, as applicable, of Regulation S-K of the Securities Act. Each broker-dealer that receives exchange notes for its own account in exchange for original notes, where the original notes were acquired by such broker-dealer as a result of market-making activities or other trading activities, must acknowledge that it will deliver a prospectus in connection with any resale of the exchange notes. See Plan of Distribution. By tendering in the exchange offer, you represent to us that, among other things: (1) you are not an affiliate of us; (2) you are not engaged in, and do not intend to engage in, and have no arrangement or understanding with any person to participate in, a distribution of the exchange notes to be issued in the exchange offer; (3) you are acquiring the exchange notes in the ordinary course of business; and (4) you acknowledge and agree that if you are a broker-dealer or are using the exchange offer to participate in a distribution of the exchange notes acquired in the exchange offer: (a) you cannot rely on the no-action letters described above; and (b) you must, in the absence of an exemption, comply with the registration and prospectus delivery requirements of the Securities Act in connection with any resale of the exchange notes. Terms of the Exchange Offer Upon satisfaction or waiver of all the conditions of the exchange offer, we will accept any and all original notes properly tendered and not validly withdrawn prior to the expiration date and will promptly issue the exchange notes. See Conditions to the Exchange Offer and Procedures for Tendering. We will issue $1,000 principal amount of exchange notes in exchange for each $1,000 principal amount of original notes accepted in the exchange offer. As of the date of this prospectus, there is $225,000,000 in principal amount of original notes. Holders may tender some or all of their original notes pursuant to the exchange offer. However, original notes may be tendered only in integral multiples of $1,000. The exchange offer is not conditioned upon any number or aggregate principal amount of original notes being tendered. The form and terms of the exchange notes will be the same in all material respects as the form and terms of the original notes, except that the exchange notes will be registered under the Securities Act and therefore will not bear legends restricting their transfer. The exchange notes will evidence the same debt as the original notes and will be issued pursuant to, and entitled to the benefits of, the indenture pursuant to which the original notes were issued. Original notes that are accepted for exchange will be cancelled and retired. Interest on the exchange notes will accrue from the most recent date to which interest has been paid on the original notes or, if no interest has been paid on the original notes, the issue date. Accordingly, registered holders of exchange notes on the relevant record date for the first interest payment date following the completion of the exchange offer will receive interest accruing from the most recent date to which interest has been paid or, if no interest has been paid on the original notes, the issue date. Original notes accepted for exchange will cease to accrue interest from and after the date the exchange offer closes. Table of Contents If your original notes are accepted for exchange, you will not receive any payment in respect of interest on the original notes for which the record date occurs on or after completion of the exchange offer. You do not have any appraisal or dissenters rights under the indenture in connection with the exchange offer. We intend to conduct the exchange offer in accordance with the provisions of the registration rights agreement. If you do not tender for exchange or if your tender is not accepted, the original notes will remain outstanding and you will be entitled to the benefits of the indenture, but will not be entitled to any registration rights under the registration rights agreement. For purposes of the exchange offer, we will be deemed to have accepted validly tendered original notes when, and if, we have given oral or written notice thereof to the exchange agent. The exchange agent will act as our agent for the purpose of distributing the appropriate exchange notes from us to the tendering holders. If we do not accept any tendered original notes because of an invalid tender, the occurrence of certain other events set forth in this prospectus or otherwise, we will return the unaccepted original notes, without expense, to the tendering holder thereof promptly after the expiration date. If you tender your original notes in the exchange offer, you will not be required to pay brokerage commissions or fees or, subject to the instructions in the letter of transmittal, transfer taxes with respect to the exchange of original notes pursuant to the exchange offer. We will pay all charges and expenses, other than certain applicable taxes described below, in connection with the exchange offer. See Fees and Expenses below. Expiration Date; Extension; Termination; Amendments The exchange offer will expire at 5:00 p.m., New York City time, on , 2004, unless extended (the expiration date ). We reserve the right to extend the exchange offer at our discretion, in which event the term expiration date shall mean the time and date on which the exchange offer as so extended shall expire. We will notify the exchange agent of any extension by oral or written notice and will make a public announcement of any extension and specify the principal amount of original notes tendered to date, each prior to 9:00 a.m., New York City time, on the next business day after the previously scheduled expiration date. We reserve the right, in our sole discretion, to: (1) delay accepting for exchange any original notes for exchange notes or to extend or terminate the exchange offer and not accept for exchange any original notes for exchange notes if any of the events set forth under the caption Conditions of the Exchange Offer occur and we do not waive the condition by giving oral or written notice of the delay or termination to the exchange agent; or (2) amend the terms of the exchange offer in any manner. We will not delay payment of accepted original notes after the expiration date other than in anticipation of our receipt of any necessary government approvals. If we amend the exchange offer in any manner material to investors or if we extend or terminate the exchange offer, we will promptly file a post-effective amendment to the registration statement of which this prospectus is a part. We will also announce any such change in media outlets, including PR Newswire. Any delay in acceptance for exchange, extension or amendment will be followed as promptly as practicable by a public announcement of the delay. If we amend the exchange offer in a manner we determine constitutes a material change, we will promptly disclose the amendment in a manner reasonably calculated to inform the holders of original notes of the amendment, and we will extend the exchange offer for a period of five to ten business days, depending upon the significance of the amendment and the manner of disclosure to the holders of the original notes, if the exchange offer would otherwise expire during that five to ten business day period. The rights we have reserved in this paragraph are in addition to our rights set forth under the caption Conditions of the Exchange Offer. Table of Contents Conditions of the Exchange Offer Our obligation to consummate the exchange offer is not subject to any conditions, other than that the exchange offer does not violate any applicable law or SEC staff interpretation. Accordingly, we will not be required to accept for exchange any original notes tendered and may terminate or amend the exchange offer as provided herein before the acceptance of any original notes if: (1) any action or proceeding is instituted or threatened in any court or by or before any governmental agency or regulatory authority with respect to the exchange offer which, in our judgment, could reasonably be expected to materially impair our ability to proceed with the exchange offer; or (2) there shall have been proposed, adopted or enacted any law, statute, rule, regulation, order or SEC staff interpretation which, in our judgment, could reasonably be expected to materially impair our ability to proceed with the exchange offer. The foregoing conditions are for our sole benefit and may be asserted regardless of the circumstances giving rise to the conditions or may be waived by us in whole or in part at any time and from time to time in our sole discretion prior to the expiration date. If we waive or amend the foregoing conditions, we will, if required by applicable law, extend the exchange offer for a minimum of five business days from the date that we first give notice, by public announcement or otherwise, of such waiver or amendment, if the exchange offer would otherwise expire within that five business-day period. Our determination concerning the events described above will be final and binding upon all parties. Procedures For Tendering Only a holder of original notes may tender them in the exchange offer. To validly tender in the exchange offer by book-entry transfer, you must deliver an agent s message or a completed and signed letter of transmittal (or facsimile thereof), together with any required signature guarantees and any other required documents, to the exchange agent prior to 5:00 p.m., New York City time, on the expiration date, and the original notes must be tendered pursuant to the procedures for book-entry transfer set forth below. To validly tender by means other than book-entry transfer, you must deliver a completed and signed letter of transmittal (or facsimile thereof), together with any required signature guarantees and any other required documents and the original notes, to the exchange agent prior to 5:00 p.m., New York City time, on the expiration date. Any financial institution that is a participant in DTC s Book-Entry Transfer Facility system may make book-entry delivery of the original notes by causing DTC to transfer the original notes into the exchange agent s account in accordance with DTC s ATOP procedures for transfer. However, although delivery of original notes may be effected through book-entry transfer into the exchange agent s account at DTC, an agent s message or a completed and signed letter of transmittal (or facsimile thereof), with any required signature guarantees and any other required documents, must, in any case, be transmitted to and received or confirmed by the exchange agent at its addresses set forth under the caption Exchange Agent prior to 5:00 p.m., New York City time, on the expiration date, or the guaranteed delivery procedure set forth below must be complied with. DELIVERY OF DOCUMENTS TO DTC IN ACCORDANCE WITH DTC S PROCEDURES DOES NOT CONSTITUTE DELIVERY TO THE EXCHANGE AGENT. The term agent s message means, with respect to any tendered original notes, a message transmitted by DTC to and received by the exchange agent and forming part of a book-entry confirmation, stating that DTC has received an express acknowledgment from each tendering participant to the effect that, with respect to those original notes, the participant has received and agrees to be bound by the letter of transmittal and that we may enforce the letter of transmittal against the participant. The term book-entry confirmation means a timely confirmation of a book-entry transfer of original notes into the exchange agent s account at DTC. Table of Contents If you tender an original note, and do not validly withdraw your tender, your actions will constitute an agreement with us in accordance with the terms and subject to the conditions set forth in this prospectus and in the letter of transmittal. The method of delivery of your original notes and the letter of transmittal and all other required documents to the exchange agent is at your election and risk. Instead of delivery by mail, we recommend that you use an overnight or hand delivery service. In all cases, you should allow sufficient time to assure delivery to the exchange agent before the expiration date. No letter of transmittal or original note should be sent to us; instead, they should be sent to the exchange agent. You may request that your broker, dealer, commercial bank, trust company or nominee effect the tender for you. Signatures on a letter of transmittal or a notice of withdrawal, as the case may be, must be guaranteed by an eligible institution (as defined below) unless the original notes are being tendered: (1) by a registered holder who has not completed the box entitled Special Issuance Instructions or Special Delivery Instructions on the letter of transmittal; or (2) for the account of an eligible institution. If signatures on a letter of transmittal or a notice of withdrawal, as the case may be, are required to be guaranteed, the guarantee must be by a member of a signature guarantee program within the meaning of Rule 17Ad-15 under the Exchange Act (an eligible institution ). If the letter of transmittal or any original notes or bond powers are signed by trustees, executors, administrators, guardians, attorneys-in-fact, officers of corporations or others acting in a fiduciary or representative capacity, those persons should so indicate when signing, and unless we waive it, evidence satisfactory to us of their authority to act must be submitted with the letter of transmittal. We will determine, in our sole discretion, all questions as to the validity, form, eligibility (including time of receipt) and acceptance and withdrawal of tendered original notes. Our determination will be final and binding. We reserve the absolute right to reject any and all original notes not properly tendered or any original notes our acceptance of which would, in the opinion of our counsel, be unlawful. We also reserve the right to waive any defects, irregularities or conditions of tender as to particular original notes. Our interpretation of the terms and conditions of the exchange offer (including the instructions in the letter of transmittal) will be final and binding on all parties. Unless waived, you must cure any defects or irregularities in connection with tenders of your original notes within a time period we will determine. Although we intend to request that the exchange agent notify you of defects or irregularities with respect to your tender of original notes, we will not, nor will the exchange agent or any other person, incur any liability for failure to give you any notification. Tenders of original notes will not be deemed to have been made until any defects or irregularities have been cured or waived. Any original notes received by the exchange agent that are not properly tendered and as to which the defects or irregularities have not been cured or waived will be returned by the exchange agent to the tendering holders, unless otherwise provided in the letter of transmittal, promptly after the expiration date. In addition, we reserve the right in our sole discretion (subject to the limitations contained in the indenture for the exchange notes): (1) to purchase or make offers for any original notes that remain outstanding after the expiration date; and (2) to the extent permitted by applicable law, to purchase original notes in the open market, in privately negotiated transactions or otherwise. The terms of any purchases or offers could differ from the terms of the exchange offer. 16,092 Other assets Table of Contents The information in this prospectus is not complete and may be changed. We may not exchange these securities until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to exchange these securities and it is not soliciting an offer to exchange these securities in any state where the offer or exchange is not permitted. SUBJECT TO COMPLETION, DATED JANUARY 26, 2004 PROSPECTUS Ardent Health Services, Inc. Offer to Exchange up to $225,000,000 of 10% Senior Subordinated Notes due 2013 for up to $225,000,000 of 10% Senior Subordinated Notes due 2013 that have been registered under the Securities Act of 1933 We are offering to exchange our 10% senior subordinated notes due 2013, or the exchange notes, for our currently outstanding 10% senior subordinated notes due 2013, or the original notes. We sometimes refer to the exchange notes and the original notes collectively as the notes. Terms of the exchange notes: The exchange notes are substantially identical to the original notes, except that the exchange notes have been registered under the Securities Act of 1933, or the Securities Act, and will not contain restrictions on transfer or have registration rights. The exchange notes will represent the same debt as the original notes, and we will issue the exchange notes under the same indenture. The exchange notes will be subordinated to any existing and future senior indebtedness, including borrowings under our senior secured credit facility, and will rank equally with any future senior subordinated indebtedness. Assuming the exchange offer had been completed on September 30, 2003, the exchange notes would have been subordinated to approximately $4.8 million of our outstanding indebtedness. Terms of the exchange offer: The exchange offer expires at 5:00 p.m., New York City time, on , 2004, unless extended. We will exchange all original notes that are validly tendered and not validly withdrawn prior to the expiration of the exchange offer. You may withdraw tendered original notes at any time prior to the expiration of the exchange offer. We do not intend to apply for listing of the exchange notes on any securities exchange or to arrange for them to be quoted on any quotation system. The exchange offer is subject to customary conditions, including the condition that the exchange offer not violate applicable law or any applicable interpretation of the staff of the Securities and Exchange Commission, or the SEC. The exchange of original notes for exchange notes pursuant to the exchange offer will not constitute a taxable event for U.S. federal income tax purposes. We will not receive any proceeds from the exchange offer. Broker-dealers who acquired original notes from us in the initial offering are not eligible to participate in the exchange offer with respect to such original notes. Each broker-dealer that receives exchange notes for its own account pursuant to the exchange offer must acknowledge that it will deliver a prospectus in connection with any resale of the exchange notes. The letter of transmittal states that by so acknowledging and by delivering a prospectus, a broker-dealer will not be deemed to admit that it is an underwriter within the meaning of the Securities Act of 1933. This prospectus, as it may be amended or supplemented from time to time, may be used by a broker-dealer in connection with any resales of exchange notes received in exchange for original notes where the original notes were acquired by the broker-dealer as a result of market-making activities or other trading activities. We have agreed that, for up to 180 days after the expiration date, as defined in this prospectus, we will make this prospectus available to any broker-dealer for use in connection with any such resale. See Plan of Distribution. Investing in the exchange notes involves risks. See Risk Factors beginning on page 15. Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of the securities to be distributed in the exchange offer or determined that this prospectus is truthful or complete. Any representation to the contrary is a criminal offense. The date of this prospectus is , 2004. Table of Contents By tendering, you represent to us, among other things, that: (1) you are not affiliate of us (as defined in Rule 405 under the Securities Act); (2) you are not engaged in, and do not intend to engage in, and have no arrangement or understanding with any person to participate in, a distribution of the exchange notes; and (3) you are acquiring the exchange notes in the ordinary course of business. If you are a broker-dealer that will receive exchange notes for your own account in exchange for original notes that were acquired as a result of market-making activities or other trading activities, you must acknowledge that you will deliver a prospectus in connection with any resale of the exchange notes. Guaranteed Delivery Procedures If you wish to tender your original notes and either your original notes are not immediately available, or you cannot deliver your original notes and other required documents to the exchange agent, or cannot complete the procedure for book-entry transfer prior to the expiration date, you may effect a tender if: (1) you make a tender through an eligible institution; (2) prior to the expiration date, the exchange agent receives from the eligible institution a properly completed and duly executed notice of guaranteed delivery (by facsimile transmission, mail or hand delivery) setting forth your name and address, the certificate number(s) of the original notes (if available) and the principal amount of original notes tendered together with a duly executed letter of transmittal (or a facsimile thereof), stating that the tender is being made thereby and guaranteeing that, within three business days after the expiration date, the certificate(s) representing the original notes to be tendered, in proper form for transfer (or a confirmation of a book-entry transfer into the exchange agent s account at DTC of original notes delivered electronically) and any other documents required by the letter of transmittal, will be deposited by the eligible institution with the exchange agent; and (3) the certificate(s) representing all tendered original notes in proper form for transfer (or confirmation of a book-entry transfer into the exchange agent s account at DTC of original notes delivered electronically) and all other documents required by the letter of transmittal are received by the exchange agent within three business days after the expiration date. Upon request to the exchange agent, you will be sent a notice of guaranteed delivery if you wish to tender your original notes according to the guaranteed delivery procedures set forth above. Withdrawal of Tenders Except as otherwise provided in this prospectus, you may withdraw any tenders of original notes at any time prior to 5:00 p.m., New York City time, on the expiration date, unless previously accepted for exchange. For your withdrawal to be effective, the exchange agent must receive a written or facsimile transmission notice of withdrawal at its address set forth herein prior to 5:00 p.m., New York City time, on the expiration date, and prior to our acceptance for exchange. Any notice of withdrawal must: (1) specify the name of the person having tendered the original notes to be withdrawn; (2) identify the original notes to be withdrawn (including the certificate number or numbers, if applicable, and principal amount of the original notes); (3) be signed in the same manner as the original signature on the letter of transmittal by which the original notes were tendered (including any required signature guarantees) or be accompanied by documents of transfer sufficient to have the trustee with respect to the original notes register the transfer of the original notes into the name of the person withdrawing the tender; and TABLE OF CONTENTS SUMMARY RISK FACTORS
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+RISK FACTORS You should consider carefully the following factors, as well as the information contained in the rest of this prospectus before deciding whether to participate in the exchange offer. Risk Factors Relating to the Exchange Offer You must carefully follow the required procedures in order to exchange your original notes. The exchange notes will be issued in exchange for original notes only after timely receipt by the exchange agent of a duly executed letter of transmittal and all other required documents. Therefore, if you wish to tender your original notes, you must allow sufficient time to ensure timely delivery. Neither we nor the exchange agent has any duty to notify you of defects or irregularities with respect to tenders of original notes for exchange. Any holder of original notes who tenders in the exchange offer for the purpose of participating in a distribution of the exchange notes will be required to comply with the registration and prospectus delivery requirements of the Securities Act in connection with any resale transaction. Each broker or dealer that receives exchange notes for its own account in exchange for original notes that were acquired in market-making or other trading activities must acknowledge that it will deliver a prospectus in connection with any resale of the exchange notes. If you do not exchange original notes for exchange notes, transfer restrictions will continue and trading of the original notes may be adversely affected. The original notes have not been registered under the Securities Act and are subject to substantial restrictions on transfer. Original notes that are not tendered for exchange for exchange notes or are tendered but are not accepted will, following completion of the exchange offer, continue to be subject to existing restrictions upon transfers. We do not currently expect to register the original notes under the Securities Act. To the extent that original notes are tendered and accepted in the exchange offer, the trading market for original notes, if any, could be adversely affected. Risks Relating to the Exchange Notes Our substantial indebtedness could adversely affect our cash flow and prevent us from fulfilling our obligations, including making payments on the exchange notes. We have a significant amount of debt. As of September 30, 2003, we had $261.7 million of total debt and members equity of $222.5 million. Our substantial amount of debt could have important consequences to you. For example, it could: make it more difficult for us to satisfy our obligations under the exchange notes and under the new senior secured credit facility; require us to dedicate a substantial portion of our cash flow from operations to make interest and principal payments on our debt, thereby limiting the availability of our cash flow to fund future capital expenditures, working capital and other general corporate requirements; limit our flexibility in planning for, or reacting to, changes in our business, which may place us at a competitive disadvantage compared with competitors that have less debt; increase our vulnerability to adverse economic and industry conditions; and limit our ability to borrow additional funds, even when necessary to maintain adequate liquidity. The terms of the agreement governing our new senior secured credit facility and the indenture governing the exchange notes allow us to incur substantial amounts of additional debt. Any such additional debt could increase the risks associated with our substantial leverage. (In thousands) Current $ 248 $ 460 $ 519 Deferred Table of Contents Your right to receive payments on the exchange notes will be junior to our existing and future senior debt, including borrowings under our new senior secured credit facility. Further, the guarantees of the exchange notes are junior to all of the guarantors existing and future senior debt. The exchange notes will rank behind all of our existing and future senior debt. The guarantees will rank behind all of the guarantors existing and future senior debt. As of September 30, 2003, we had $4.8 million of senior debt, none of which represented borrowings under our new senior secured credit facility, and all of which was incurred by the guarantors. Our new senior secured credit facility provides for borrowings of up to $125.0 million, subject to a borrowing base (which is the maximum amount we may borrow at any one time based upon the sum of a percentage of the book value of certain accounts receivable and a percentage of the net book value of certain fixed assets), and a $200.0 million incremental term loan facility in certain events. Any borrowings under our new senior secured credit facility would be senior debt when borrowed. As of September 30, 2003, we could have borrowed the maximum $125.0 million under the credit facility according to the borrowing base. We are permitted to borrow substantial additional senior indebtedness in the future under the terms of the indenture that will govern the exchange notes. As a result of such subordination, upon any distribution to our creditors in a bankruptcy, liquidation, reorganization or similar proceeding, the holders of our senior debt will be entitled to be paid in full before any payment will be made on the exchange notes. In addition, upon any distribution to the creditors of the guarantors in a bankruptcy, liquidation, reorganization or similar proceeding, the holders of the guarantors senior debt will be entitled to be paid in full before any payment will be made on the guarantees. In addition, we will be prohibited from making any payments on the exchange notes and the guarantees if we default on our payment obligations on our senior debt and we may be prohibited from making any such payments for up to 179 consecutive days if certain non-payment defaults on senior debt occur. In the event of a bankruptcy, liquidation or reorganization or similar proceeding relating to us or the guarantors, you, as a holder of the exchange notes, will participate with all other holders of subordinated indebtedness in the assets remaining after we and the guarantors have paid all of our and their senior debt. However, because the indenture requires that amounts otherwise payable to you in a bankruptcy or similar proceeding be paid to holders of senior debt instead, you may receive less, ratably, than holders of other subordinated debt in any such proceeding. In any of these cases, we may not have sufficient funds to pay all of our creditors and you may receive less, ratably, than the holders of senior debt. Not all of our subsidiaries will guarantee the exchange notes, and the assets of our non-guarantor subsidiaries may not be available to make payments on the exchange notes. The guarantors of the exchange notes will not include all of our subsidiaries. One of our subsidiaries, Lovelace Health Systems, Inc., is a regulated health maintenance organization, or HMO, and is therefore prohibited from providing a full and unconditional guarantee of the exchange notes. On October 1, 2003, our New Mexico operations (other than the operations of AHS S.E.D. Medical Laboratories, Inc.) were merged and consolidated into Lovelace Health Systems, Inc. and the note guarantees of certain New Mexico entities were released. The newly-created entity, Lovelace Sandia Health System, Inc., continues to be a regulated HMO and is therefore prohibited from providing a full and unconditional guarantee of the exchange notes. For the nine months ended September 30, 2003, the entities constituting Lovelace Sandia Health System, Inc. after this merger and consolidation had aggregate revenues of $693.2 million, which constituted 70.8% of our consolidated revenues for that period. As of September 30, 2003, these entities had aggregate total assets of $451.2 million, which represented 57.6% of our total assets, and $241.5 million of aggregate indebtedness and other liabilities, which represented 53.6% of our total indebtedness and other liabilities. In addition, the indenture governing the notes allows us to create additional non-guarantor subsidiaries and to release the guarantees of subsidiary guarantors upon the sale of a subsidiary guarantor or upon our designation of a subsidiary guarantor as a non-restricted subsidiary under the indenture, provided in each case that we meet certain tests under the indenture. In order to sell any subsidiary guarantor, the indenture requires that we receive consideration at least equal to the fair market value of the guarantor, of which at Table of Contents Primary State or Other Standard I.R.S. Address, including zip code, and Jurisdiction of Industrial Employer telephone number, including Exact Name of Registrant Incorporation Classification Identification area code, of Registrant s as Specified in its Charter or Organization Code Number principal executive offices Table of Contents least 75% must be in the form of cash, cash equivalents or replacement assets (which are non-current tangible assets to be used in our business), and that the proceeds of the sale must be applied to the repayment of senior debt, to purchase replacement assets or make a capital expenditure that is useful in our business. To the extent we have any amount of proceeds remaining, we are required to make an offer to purchase that amount of outstanding notes and any other indebtedness which ranks equally with the notes. The indenture also sets forth certain requirements we must meet in order to designate a subsidiary guarantor as a non-restricted subsidiary, including that the subsidiary s indebtedness must be permissible under the indenture, the aggregate fair market value of all investments owned by us and the other subsidiary guarantors in that subsidiary must be permissible under the indenture, and that the subsidiary cannot own any equity interests of, or hold any liens on any property of, us or the other subsidiary guarantor. Additionally, that subsidiary cannot be party to any agreement with us or any subsidiary guarantor the terms of which are less favorable than those that might be obtained from unrelated third parties, and that subsidiary cannot have guaranteed or provided credit support for any indebtedness of us or any other guarantor. That subsidiary is also required to have one director and one officer who do not serve as directors or officers of us or any other subsidiary guarantor and no event of default may be in existence at the time of our designation under the indenture. In the event that any non-guarantor subsidiary becomes insolvent, liquidates, reorganizes, dissolves or otherwise winds up, holders of its indebtedness and its trade creditors generally will be entitled to payment on their claims from the assets of that subsidiary before any of those assets are made available to us. Consequently, your claims in respect of the exchange notes will be effectively subordinated to all of the liabilities of our non-guarantor subsidiaries, including trade payables. We are a holding company and, as such, we do not have, and will not have in the future, any income from operations. We are a holding company and conduct substantially all of our operations through our subsidiaries. Consequently we do not have any income from operations and do not expect to generate income from operations in the future. As a result, our ability to meet our debt service obligations, including our obligations under the exchange notes, substantially depends upon our subsidiaries cash flow and payment of funds to us by our subsidiaries as dividends, loans, advances or other payments. The payment of dividends or the making of loans, advances or other payments to us by our subsidiaries may be subject to regulatory or contractual restrictions. As a regulated insurance company, Lovelace Sandia Health System, Inc. may be restricted from paying dividends to us, which may reduce the amount of cash available to us. The ability of Lovelace Sandia Health System, Inc. to pay dividends or make other distributions to us is restricted by state insurance company laws and regulations. These laws and regulations require Lovelace Sandia Health System, Inc. to give notice to the New Mexico Department of Insurance prior to paying dividends or making distributions to us. In addition, Lovelace Sandia Health System, Inc. is subject to state-imposed risk-based or other net worth-based capital requirements that effectively limit the amount of funds the subsidiary has available to distribute or pay to us. As a result of these capital requirements or other agreements we may enter into with state regulators, we may not be able to receive any funds from Lovelace Sandia Health System, Inc. and, moreover, we may be required to make contributions to Lovelace Sandia Health System, Inc. to enable the subsidiary to meet its capital requirements, thereby further limiting the funds we may have to make payments with respect to the exchange notes. At September 30, 2003, Lovelace Sandia Health System, Inc. was required to maintain a net worth of $34.1 million. Actual net worth as of that date exceeded the requirement by $16.9 million. As a result of the merger and consolidation of our New Mexico operations (other than the operations of AHS S.E.D. Medical Laboratories, Inc.) into Lovelace Sandia Health System, Inc., the entities constituting Lovelace Sandia Health System, Inc. (which, for the nine months ended September 30, 2003, accounted for approximately 71% of our total net revenues) are subject to the above restrictions and regulations. As of September 30, 2003, these entities had cash and cash equivalents of approximately $33.2 million. Table of Contents To service our debt, we will require a significant amount of cash, which may not be available to us. Our ability to make payments on, or repay or refinance, our debt, including the exchange notes, and to fund planned capital expenditures, will depend largely upon our future operating performance. Our debt service obligation, including principal and interest payments, for calendar year 2004 is anticipated to be approximately $29.5 million. Our future performance, to a certain extent, is subject to general economic, financial, competitive, legislative, regulatory and other factors that are beyond our control. We cannot assure you that our business will generate sufficient cash flow from operations or that future borrowings will be available to us under our new senior secured credit facility or from other sources in an amount sufficient to enable us to pay our debt, including the exchange notes, or to fund our other liquidity needs. In addition, prior to the repayment of the exchange notes, we will be required to refinance our new senior secured credit facility. We cannot assure you that we will be able to refinance any of our debt, including our new senior secured credit facility, on commercially reasonable terms or at all. If we were unable to make payments or refinance our debt or obtain new financing under these circumstances, we would have to consider other options, such as: sales of assets; sales of equity; and/or negotiations with our lenders to restructure the applicable debt. Our credit agreements and the indenture governing the exchange notes restrict, and market or business conditions may limit, our ability to sell assets or equity or restructure any debt. The agreements governing our debt, including the exchange notes and our new senior secured credit facility, contain various covenants that limit our discretion in the operation of our business and could lead to the acceleration of our debt. Our new senior secured credit facility imposes, and future financing agreements are likely to impose, operating and financial restrictions on our activities. These restrictions require us to comply with or maintain certain financial tests and ratios, including minimum net worth and interest coverage ratios and maximum total and senior leverage ratios and limit or prohibit our ability to, among other things: incur additional debt and issue preferred stock; create liens; redeem and/or prepay certain debt; pay dividends on our stock or repurchase stock; make certain investments; enter new lines of business; engage in consolidations, mergers and acquisitions; make certain capital expenditures; and pay dividends and make other distributions. These restrictions on our ability to operate our business could seriously harm our business by, among other things, limiting our ability to take advantage of financings, mergers, acquisitions and other corporate opportunities. Various risks, uncertainties and events beyond our control could affect our ability to comply with these covenants and maintain these financial tests and ratios. Failure to comply with any of the covenants in our existing or future financing agreements could result in a default under those agreements and under other agreements containing cross-default provisions. A default would permit lenders to accelerate the maturity for the debt under these agreements and to foreclose upon any collateral securing the debt. Under Pretax income (loss): United States $ 7,033 $ 4,258 $ (771 ) $ 1,803 $ (11,151 ) Foreign Table of Contents these circumstances, we might not have sufficient funds or other resources to satisfy all of our obligations, including our obligations under the exchange notes. In addition, the limitations imposed by financing agreements on our ability to incur additional debt and to take other actions might significantly impair our ability to obtain other financing. The exchange notes generally are not secured by our assets or those of the guarantors, whereas the lenders under our new senior secured credit facility are entitled to remedies available to a secured lender, which gives them priority over you to collect amounts due to them. In addition to being subordinated to all our existing and future senior debt, the exchange notes and the guarantees will not be secured by any of our assets other than the intercompany note pledged in connection with the consolidation of the majority of our New Mexico operations. Our obligations under our new senior secured credit facility are secured by, among other things, a first priority pledge of all of the common stock of our subsidiaries and substantially all our assets. If we become insolvent or are liquidated, or if payment under our new senior secured credit facility or in respect of any other secured indebtedness is accelerated, the lenders under our new senior secured credit facility or holders of other secured indebtedness are entitled to exercise the remedies available to a secured lender under applicable law (in addition to any remedies that may be available under documents pertaining to our new senior secured credit facility or other senior debt). These lenders will have a claim on all assets securing their debt before the holders of unsecured debt, including the exchange notes. The interests of the principal members of our parent may not be aligned with your interests as a holder of the exchange notes. Welsh, Carson, Anderson Stowe IX, L.P. and its related investors control a majority of the voting power of the outstanding common units of our parent, which in turn holds all of the voting power of our common stock. Consequently, these equity holders will control all of our affairs and policies. Circumstances may occur in which the interests of these equity holders could be in conflict with the interest of the holders of the exchange notes. Generally, holders of debt securities such as the exchange notes have limited opportunities for capital appreciation and therefore are primarily focused on an issuer s creditworthiness and ability to make interest and principal payments. Because we do not currently pay a dividend to our equity holders, they are focused primarily on capital appreciation. As a result, our equity holders may have an interest in causing us to pursue acquisitions, divestitures or other transactions that, in the judgment of such equity holders, have the potential to enhance the value of their equity investment, even though such transactions might also involve risks to holders of the exchange notes, including risks to our creditworthiness. Our senior secured credit facility prohibits our ability to make a change of control offer required by the indenture governing the exchange notes, which could lead to a default under the indenture. The terms of the exchange notes will require us to make an offer to repurchase the exchange notes upon the occurrence of a change of control at a purchase price equal to 101% of the principal amount of the exchange notes, plus accrued interest to the date of the purchase. We are prohibited under the new senior secured credit facility, and may be prohibited under future debt agreements, from purchasing any exchange notes prior to their stated maturity. In such circumstances, we will be required to repay or obtain the requisite consent from the affected lenders to permit the repurchase of the exchange notes. Absent a consent, we can only make a change in control offer if there are sufficient funds remaining after repaying all amounts outstanding under the senior secured credit facility. If we are unable to repay all of such debt or are unable to obtain the necessary consents, we will be unable to offer to repurchase the exchange notes, which would constitute an event of default under the indenture governing the exchange notes, which itself would also constitute a default under our new senior secured credit facility and our other existing financing arrangements. Table of Contents The guarantees may not be enforceable because of fraudulent conveyance laws. The guarantors guarantees of the exchange notes may be subject to review under U.S. federal bankruptcy law or relevant state fraudulent conveyance laws if a bankruptcy lawsuit is commenced by or on behalf of our or the guarantors unpaid creditors. Under these laws, if in such a lawsuit a court were to find that, at the time a guarantor incurred debt (including debt represented by the guarantee), such guarantor: incurred this debt with the intent of hindering, delaying or defrauding current or future creditors; or received less than reasonably equivalent value or fair consideration for incurring this debt and the guarantor: was insolvent or was rendered insolvent by reason of the related financing transactions; was engaged, or about to engage, in a business or transaction for which its remaining assets constituted unreasonably small capital to carry on its business; or intended to incur, or believed that it would incur, debts beyond its ability to pay these debts as they mature, as all of the foregoing terms are defined in or interpreted under the relevant fraudulent transfer or conveyance statutes; then the court could void the guarantee or subordinate the amounts owing under the guarantee to the guarantor s presently existing or future debt or take other actions detrimental to you. In addition, the subsidiary guarantors may be subject to the allegation that since they incurred their guarantees for our benefit, they incurred the obligations under the guarantees for less than reasonably equivalent value or fair consideration. The measure of insolvency for purposes of the foregoing considerations will vary depending upon the law of the jurisdiction that is being applied in any such proceeding. Generally, a company would be considered insolvent if, at the time it incurred the debt or issued the guarantee: it could not pay its debts or contingent liabilities as they become due; the sum of its debts, including contingent liabilities, is greater than its assets, at fair valuation; or the present fair saleable value of its assets is less than the amount required to pay the probable liability on its total existing debts and liabilities, including contingent liabilities, as they become absolute and mature. If a guarantee is voided as a fraudulent conveyance or found to be unenforceable for any other reason, you will not have a claim against that obligor and will only be our creditor or that of any guarantor whose obligation was not set aside or found to be unenforceable. In addition, the loss of a guarantee will constitute a default under the indenture, which default would cause all outstanding notes to become immediately due and payable. An active public market may not develop for the exchange notes, which may hinder your ability to liquidate your investment. The exchange notes are a new issue of securities with no established trading market, and we do not intend to list them on any securities exchange. The liquidity of the trading market in the exchange notes, and the market price quoted for the exchange notes, may be adversely affected by changes in the overall market for fixed income securities and by changes in our financial performance or prospects or in the prospects for companies in our industry in general. As a result, we cannot assure you that an active trading market will develop for the exchange notes. If no active trading market develops, you may not be able to resell your exchange notes at their fair market value or at all. Table of Contents Risks Relating to Our Business We may not successfully integrate our recent and future acquisitions and may be unable to achieve anticipated cost savings and other benefits from these acquisitions. Since August 2001, we have acquired seven acute care hospitals, including a significant health plan, two behavioral hospitals and various other ancillary services. These acquisitions have significantly increased the size and geographic scope of our operations. In addition, one of our primary growth strategies for the future is completing additional acquisitions. The integration of past and future acquisitions involves a number of risks and presents financial, managerial and operational challenges. For example, at one of our acquired hospitals, we experienced delays in billings related to information systems transitions, and as a result, our results of operations were negatively affected. In addition to risk associated with information systems integration, we face the following risks: we may have difficulty integrating personnel and physicians from acquired hospitals; we may have difficulty, and may incur unanticipated expenses related to, upgrading the financial systems and controls at our new facilities; we may uncover liabilities at our newly-acquired operations of which we are not aware or that are greater than expected and for which the previous owner may be unable or unwilling to indemnify us; and we may be unable to improve existing managed care agreements and the mix of specialties offered at our hospitals. Failure to integrate past and future acquisitions successfully and in a timely fashion may have an adverse effect on our business, results of operations and financial condition. In addition, we may be unable to achieve the anticipated cost savings from these acquisitions for many reasons, including: contractual constraints on our ability to reduce excess staffing, inability to achieve expected tax savings from a more streamlined legal structure or inability to extract lower prices from our suppliers. Our strategy depends in part on our ability to acquire hospitals that meet our target criteria. If we are unable to do so, our future growth could be limited and our operating results could be adversely affected. The competition to acquire acute care and behavioral hospitals in the selected markets that we will target is significant, including competition from healthcare companies with greater financial resources than us and larger development staffs focused on identifying and completing acquisitions. We may be unable to identify acquisitions opportunities and to negotiate and complete acquisitions on favorable terms. Our inability to complete such acquisitions may negatively impact our future growth and results of operations. We may have difficulty acquiring hospitals from not-for-profit entities due to increased regulatory scrutiny. Many states have enacted or are considering enacting laws affecting sales, leases or other transactions in which control of not-for-profit hospitals is acquired by for-profit entities. These laws, in general, include provisions relating to state attorney general approval, advance notification and community involvement, determination of appropriate valuation of assets divested and the use of proceeds of the sale by the not-for-profit entity. In addition, state attorneys general in states without specific conversion legislation governing such transactions may exercise authority based upon charitable trust and other existing laws. The increased legal and regulatory review of these transactions involving the change of control of not-for-profit hospitals may increase the costs and time required for such acquisitions, and therefore, limit our ability to acquire not-for-profit hospitals. In addition, as a condition to approving an acquisition, certain state attorneys general may require us to maintain certain services, such as emergency departments, or to continue to provide certain levels of charity care, which may affect our decision to acquire or the terms of an acquisition of these hospitals as well as the future profitability of any such hospitals we acquire. Net income (loss) from continuing operations $ 4,343 $ Table of Contents Our acquisition strategy may be limited by restrictions and covenants in our new senior secured credit facility and by the lack of adequate alternative sources of financing. Our senior secured credit facility contains limitations on acquisitions of regulated and non-regulated entities. If we are unable to obtain any required consents from our lenders for future acquisitions, our strategy of growing by selective acquisitions may be limited. In addition, our acquisition strategy may require that we obtain additional capital to finance future transactions. Sufficient capital or financing may not be available to us on satisfactory terms, if at all. Either of these factors would negatively affect our future operating performance. Our revenues may decline if federal or state programs reduce our Medicare or Medicaid payments or managed care companies reduce our reimbursements. A substantial portion of our total net revenues is derived from the Medicare and Medicaid programs. The Medicare program accounted for 42.2% of our acute care patient days and 9.4% of our behavioral patient days for the nine months ended September 30, 2003. The Medicaid program accounted for 7.4% of our acute care patient days and 33.8% of our behavioral patient days during the nine months ended September 30, 2003. In recent years, federal and state governments have made significant changes in the Medicare and Medicaid programs. In addition, due to budget deficits in many states, significant decreases in state funding for the Medicaid programs have occurred or are being proposed. These changes in the Medicare and Medicaid programs have decreased the amounts of money we receive for our services to patients who participate in these programs. In recent years, Congress and some state legislatures have introduced a number of other proposals to make major changes in the healthcare system. Medicare-reimbursed, hospital-outpatient services converted to a prospective payment system on August 1, 2000. This system creates limitations on levels of payment for a substantial portion of hospital outpatient procedures. Future federal and state legislation may further reduce the payments we receive for our services. A number of states have adopted legislation designed to reduce their Medicaid expenditures. Some states have enrolled Medicaid recipients in managed care programs (which generally tend to reduce the level of hospital utilization) and have imposed additional taxes on hospitals to help finance or expand the states Medicaid systems. Some states have also reduced the scope of Medicaid eligibility and coverage, making an increasing number of residents unable to pay for their care. Other states propose to take similar steps. In addition, insurance and managed care companies and other third parties from whom we receive payment for our services increasingly attempt to control healthcare costs by requiring that hospitals discount their fees in exchange for exclusive or preferred participation in their benefit plans. We believe that this trend may continue and may reduce the payments we receive for our services. We face intense competition from other hospitals and other healthcare providers which may result in a decline in revenues, profitability and market share. The healthcare business is highly competitive and competition among hospitals and other healthcare providers for patients has intensified in recent years. Most of our facilities operate in geographic areas where we compete with at least one other hospital that provides services comparable to those offered by our facilities. In addition, the number of freestanding specialty hospitals and outpatient surgery and diagnostic centers in the areas in which our hospitals operate has also increased significantly. Some of the hospitals that compete with us are owned or operated by tax-supported governmental bodies or by private not-for-profit entities supported by endowments and charitable contributions which can finance capital expenditures on a tax-exempt basis and are exempt from sales, property and income taxes. Some of our competitors are more established, offer highly specialized facilities, equipment and services, which may not be available at our hospitals, offer a wider range of services or have more capital or other resources. The intense competition we face from other healthcare providers may have an adverse effect on our market share, revenues and results of operations. (A) (A) (A) (B) (Dollars in thousands) Statement of Operations Data: Revenues: Net patient service revenue $ 369,539 $ 7,994 $ 113,902 $ 138,396 $ $ 629,831 Premium revenue 13,232 27,268 509,580 550,080 Other revenue 25,213 Table of Contents Primary State or Other Standard I.R.S. Address, including zip code, and Jurisdiction of Industrial Employer telephone number, including Exact Name of Registrant Incorporation Classification Identification area code, of Registrant s as Specified in its Charter or Organization Code Number principal executive offices Table of Contents Regional concentration of our business may subject us to economic downturns in the State of New Mexico and, in particular, the Albuquerque metropolitan area. With our recent acquisitions of five acute care hospitals (including one inpatient rehabilitation hospital), two health maintenance organizations (which we subsequently merged), and certain ancillary services in New Mexico, the majority of our revenue is generated in New Mexico. For the nine months ended September 30, 2003, our New Mexico operations accounted for approximately 72% of our total net revenues. This concentration of business in New Mexico exposes us to potential losses resulting from a downturn in the economy of the State of New Mexico and, in particular, Albuquerque. If economic conditions deteriorate, we may experience a reduction in existing and new business, which may have an adverse effect on our business, financial condition and results of operations. Our success depends on our ability to attract new physicians and maintain good relationships with physicians and other healthcare professionals at our hospitals. Because physicians working with acute care hospitals generally direct the majority of hospital admissions, our success in operating our acute care hospitals will be, in part, dependent upon the number and quality of physicians on these hospitals medical staffs, the admissions practices of the physicians at these hospitals and our ability to maintain good relations with our physicians. With the exception of approximately 320 employed physicians in Albuquerque, our physicians are generally not employees of the hospitals at which they practice and most physicians have admitting privileges at other hospitals in addition to our hospitals. Physicians may terminate their affiliation with our hospitals at any time. If we are unable to successfully maintain good relationships with physicians, our hospitals admissions may decrease and our results of operations may be adversely affected. For example, patient volume at Sandia Health System was negatively affected during the nine-month period ended September 30, 2003 by the departure of certain physicians. In addition, physicians are increasingly seeking to supplement their declining income by building facilities or offering services that compete with acute care hospitals, such as ambulatory surgery centers, diagnostic imaging centers, or specialty hospitals. These facilities and services may attract patients from the more profitable service lines of an acute care hospital, leaving the hospital with less profitable or unprofitable service lines, such as emergency departments, that the hospital may be unable to close for community relations and other reasons. We compete with other healthcare providers in recruiting and retaining qualified management and staff personnel responsible for the day-to-day operations of each of our hospitals, including nurses and other non-physician healthcare professionals. In the healthcare industry generally, including our markets, the scarcity of nurses and other medical support personnel has become a significant operating issue. This shortage may require us to increase wages and benefits to recruit and retain nurses and other medical support personnel, or to hire more expensive contract or temporary personnel. If our labor costs increase, we may not be able to raise rates to offset these increased costs. Because a significant percentage of our revenues are derived from fixed, prospective payments, our ability to pass along increased labor costs is constrained. Our failure to recruit and retain qualified management, nurses and other medical support personnel, or to control our labor costs, could have an adverse effect on our business and results of operations. We depend heavily on our senior and local management personnel, and the loss of the services of one or more of our key senior management personnel or our key local management personnel could weaken our management team and our ability to deliver healthcare services efficiently. We have been, and will continue to be, dependent upon the services and management experience of David T. Vandewater, our Chief Executive Officer, Jamie E. Hopping, our Chief Operating Officer, R. Dirk Allison, our Chief Financial Officer, and our other senior executive officers. We have entered into employment agreements with each of these senior executive officers, but we do not maintain key person life insurance for these executive officers. If Mr. Vandewater, Ms. Hopping, Mr. Allison or any of our other senior executive officers were to resign their positions or otherwise be unable to serve, our management could be weakened and operating results could be adversely affected. In addition, our success Substantially all of the Company s long-term investments are held in the CHI Investment Program. The Program is structured under a Limited Partnership Agreement between CHI, as managing general partner, and each participant. All investments in the Program are professionally managed by the Company under the administration of CHI. Investments held in the Program are represented by pool units valued monthly under a custodian accounting system. Investment income from the Program, including interest income, dividends, and realized gains or losses from the sale of securities, is distributed to participants based on the earnings per pool unit. Gains or losses also are realized by participants when pool units are sold, representing the difference between the cost basis and the market value of the pool units sold. The fair value of the assets held is an allocation of the underlying market value of the assets in the Program, based upon pool units held by the participants. The underlying fair value of investments in the Program, which are traded on national exchanges, is based on the last reported sales price on the last business day of the fiscal year. The market value of investments traded in over-the-counter markets is based on the average of the last recorded bid and asked prices. Net unrealized gains (losses) on investments was $(0.59 million) at August 31, 2002. Investment losses and gains for assets limited as to use, cash equivalents, and other investments for the two-month period ended August 31, 2002 is as follows: Income (loss): Interest income $ 112 Realized gains (losses) on sales of securities (467 ) Dividend income Table of Contents depends on our ability to attract and retain local managers at our hospitals and related facilities, on the ability of our officers and key employees to manage growth successfully and on our ability to attract and retain skilled employees. If we are unable to attract and retain local management, our operating performance could be adversely affected. We conduct business in a heavily regulated industry; changes in regulations or violations of regulations may result in increased costs or sanctions that could reduce revenue and profitability. Healthcare providers are required to comply with many laws and regulations at the federal, state and local government levels. These laws and regulations relate to: licensing; the conduct of operations; the relationships among hospitals and their affiliated providers; the ownership of facilities; the addition of facilities and services; confidentiality, maintenance and security issues associated with medical records; billing for services; and prices for services. If we fail to comply with applicable laws and regulations, we could suffer civil and criminal penalties, including the loss of our licenses to operate and our ability to participate in Medicare, Medicaid, and other federal and state healthcare programs. In addition, there are heightened coordinated civil and criminal enforcement efforts by both federal and state government agencies relating to the healthcare industry, including the hospital segment. The ongoing investigations in this industry relate generally to various referral, cost reporting and billing practices, laboratory and home healthcare services, and physician ownership and joint ventures involving hospitals. In the future, different interpretations or enforcement of these laws and regulations could subject our current practices to allegations of impropriety or illegality or could require us to make changes in our operations. We may be subjected to actions brought by individuals on the government s behalf under the False Claims Act s qui tam or whistleblower provisions. Whistleblower provisions allow private individuals to bring actions on behalf of the government alleging that the defendant has defrauded the federal government. Because qui tam lawsuits are filed under seal, we could be named in one or more such lawsuits of which we are not aware. Several of our subsidiaries have been named as defendants in two qui tam lawsuits. Defendants determined to be liable under the False Claims Act may be required to pay three times the actual damages sustained by the government, plus mandatory civil penalties of between $5,500 and $11,000 for each separate false claim. Typically, each fraudulent bill submitted by a provider is considered a separate false claim, and thus the penalties under a false claim case may be substantial. Liability arises when an entity knowingly submits a false claim for reimbursement to the federal government. In some cases, whistleblowers or the federal government have taken the position that providers who allegedly have violated other statutes, such as the anti-kickback statute or the Stark Law and have submitted claims to a governmental payor during the time period they allegedly violated these other statutes, have thereby submitted false claims under the False Claims Act. In addition, a number of states have adopted their own false claims provisions as well as their own whistleblower provisions allowing a private party to file a civil lawsuit in state court. The cost of our malpractice insurance and the malpractice insurance of physicians who practice at our facilities or who participate in our networks continues to rise. Successful malpractice or tort claims asserted against us, our providers or our employees could adversely affect our financial condition and profitability. In recent years, physicians, hospitals and other healthcare providers have become subject to an increasing number of legal actions alleging malpractice or related legal theories. Many of these actions involve large claims and significant defense costs. To protect ourselves from the cost of these claims, we generally maintain professional malpractice liability insurance and general liability insurance coverage in amounts and with deductibles that we believe to be appropriate for our operations. Effective October 31, 2003, we established a wholly owned captive insurance subsidiary to insure our professional and general liability risk for claims up to $2.0 million. In addition, effective October 31, 2003, we purchased excess insurance coverage with independent third-party carriers for claims up to $75.0 million per occurrence and Net income (loss) 3,904 5,007 5,053 2,716 17,869 3,336 (7,829 ) Accrued preferred dividends 5,892 3,944 5,993 1,210 8 12 (Unaudited) Property, plant, and equipment $ $ 203 $ 19 $ 279 $ $ 2,550 Other assets, net 350 Table of Contents in the aggregate. However, our insurance coverage may not cover all claims against us or continue to be available at a reasonable cost for us to maintain adequate levels of insurance. In addition, physicians malpractice insurance costs have dramatically increased to the point where some physicians are either choosing to retire early or leave certain markets. If physician malpractice costs continue to escalate in markets in which we operate, some physicians may choose not to practice at our facilities, which could reduce our patient volume and thus our revenue. Our managed care providers involved in medical care decisions may be exposed to the risk of medical malpractice claims. Many of our network providers are our employees for whose acts we may be liable as an employer. In addition, managed care organizations may be sued directly for various types of alleged negligence, such as in connection with the credentialing of network providers or improper denials or delay of care. Finally, Congress is considering legislation that would permit managed care organizations to be held liable for negligent treatment decisions or benefits coverage determinations. If this or similar legislation were enacted, claims of this nature could result in substantial damage awards against us and our providers that could exceed the limits of any applicable medical malpractice insurance coverage and could have a material adverse effect on our financial condition. Our business depends on our information systems, and our inability to effectively integrate and manage our information systems could disrupt our operations. Our business is dependent on effective information systems that assist us in, among other things, monitoring utilization and other cost factors, supporting our healthcare management techniques, processing provider claims and providing data to our regulators. Our managed care providers also depend upon our information systems for membership verifications, claims status and other information. If we experience a reduction in the performance, reliability or availability of our information systems, our operations and ability to produce timely and accurate reports could be adversely impacted. Our information systems and applications require continual maintenance, upgrading and enhancement to meet our operational needs. Moreover, our acquisition activity requires transitions to or from, and the integration of, various information systems. We regularly upgrade and expand our information systems capabilities and are currently in the process of rolling out new clinical and financial reporting systems throughout our operations. If we experience difficulties with the transition to or from information systems or are unable to properly implement, maintain or expand our systems, we could suffer, among other things, from operational disruptions, loss of membership in our networks, regulatory problems and increases in administrative expenses. Failure to maintain the privacy and security of patients medical records could expose us to liability. The Health Insurance Portability and Accountability Act of 1996 required the Department of Health and Human Services to issue regulations requiring hospitals and other providers to implement measures to ensure the privacy and security of patients medical records and the use of uniform data standards for the exchange of information between the hospitals and health plans, including claims and payment transactions. The privacy standard became effective October 15, 2002. Full compliance with the privacy standard was required by April 14, 2003. Although we believe we have met the April 14, 2003 privacy standard compliance deadline, compliance will be an ongoing process. The transaction standard and the security standard became effective on October 16, 2000 and February 20, 2003, respectively. Full compliance with the transaction standard was required by October 16, 2003 and full compliance with the security standard is required by April 20, 2005. We are in the process of complying with the transaction standard and security standard. We may incur additional expenses in order to comply with these standards. We cannot predict the full extent of our costs of implementing all of the requirements at this stage. If we violate these standards, we may be subject to civil monetary fines and sanctions and criminal penalties. Further, a substantial portion of our revenue is derived from payments by governmental health plans, such as Medicare, and private health plans. Our failure, or the failure of the health plans with which we transact, to comply with the transaction standard may result in significant disruptions in the payments we Table of Contents receive from such health plans. Finally, because of the confidential nature of the health information we store and transmit, privacy or security breaches could expose us to a risk of regulatory action, litigation, possible liability and loss. Our privacy or security measures may be inadequate to prevent breaches, and our business operations would be adversely impacted by cancellation of contracts and loss of members if they are not prevented. A reduction in enrollment in our health plan or the failure to maintain satisfactory relationships with providers could affect our business and profitability. Premium revenue from our health plan accounted for approximately 46.1% of our total net revenues for the nine months ended September 30, 2003. A reduction in the number of members in our health plan could reduce our revenues and profitability. Factors that could contribute to a reduction in membership include premium increases, benefit changes and reductions in workforce by existing customers. In recent years, the managed care industry has received considerable negative publicity. This publicity has led to increased review of industry practices, legislation, regulation and litigation. These factors may adversely affect our ability to market our health plan services, require us to change our health plan procedures or services, and increase the regulatory burdens under which our health plan operates, further increasing the costs of doing business and adversely affecting our operating results. The profitability of our health plan depends, in large part, upon its ability to contract favorably with hospitals, physicians and other healthcare providers in appropriate numbers and at locations appropriate for the health plan s members in New Mexico. Providers could refuse to contract, demand higher payments or take other actions that could result in higher healthcare costs. If any of the key providers to our health plan refuses or is otherwise unavailable to contract with our health plan, uses its market position to negotiate more favorable contracts or otherwise places our health plan at a competitive disadvantage, our operating results could be adversely affected. Provider arrangements for our health plan with contracted primary care physicians, specialists and hospitals in its network usually have one-year terms and automatically renew for successive one-year periods. Generally, these contracts may also be cancelled by either party without cause upon 30 to 90 days prior written notice. Our health plan may be unable to continue to renew such contracts or enter into new contracts enabling our health plan to service its members profitably. If our health plan is unable to retain its current provider contracts or enter into new provider contracts on a timely basis or on favorable terms, our results of operations could be adversely affected. If we are unable to effectively price our health plan premiums or manage medical costs, our profitability will be reduced. A large amount of revenues of our health plan consists of fixed monthly payments per member. These payments are fixed by contract, and the health plan is obligated during the contract period to provide or arrange for the provision of all healthcare services required by such member. Historically, medical care costs of our health plan as a percentage of premium and other operating revenue has fluctuated. If premiums are not increased and medical care costs rise, the earnings of our health plan on insured business could decrease. In addition, actual medical care costs of our health plan may exceed its estimated costs on insured business. The premiums our health plan receives under its current insurance contracts may therefore be inadequate to cover all claims, which may cause our profits to decline. Our health plan profitability depends, to a significant degree, on our ability to predict and effectively manage medical costs. Historically, there have been fluctuations in the medical care cost ratio of our health plan. Relatively small changes in these medical care cost ratios can create significant changes in our financial results. Changes in healthcare laws, regulations and practices, utilization of services, hospital costs, pharmaceutical costs, major epidemics, terrorism or bioterrorism, new medical technologies and other external factors, including general economic conditions such as inflation levels, could reduce our ability to predict and effectively control the costs of providing healthcare services. If our medical care costs increase, our profits could be reduced or we may not remain profitable. Beginning temporarily restricted net assets $ 2,148 $ 2,184 $ 4,733 Temporarily restricted contributions 1,097 669 834 Net assets released from restrictions (503 ) (775 ) (3,055 ) Investment income (14 ) 44 278 Other changes 5 Table of Contents Our medical care costs also include estimates of claims incurred but not reported, or IBNR. We, together with our independent actuaries, estimate our medical claims liabilities using actuarial methods based on historical data for payment patterns, cost trends, product mix, seasonality, utilization of healthcare services and other relevant factors. The estimation methods and the resulting accrued liabilities are continually reviewed and updated, and adjustments, if necessary, are reflected in the period when they become known. While our IBNR estimates generally have been adequate in the past, they may be inadequate in the future, which would negatively affect our results of operations. Further, our inability to accurately estimate IBNR may also affect our ability to take timely corrective actions, further exacerbating the extent of the negative impact on our results. We maintain accrued liabilities on our financial statements in amounts we believe are adequate to provide for actuarial estimates of medical claims. We also maintain reinsurance to protect us against certain catastrophic medical claims by Medicaid beneficiaries who participate in our health plan. While we believe our reinsurance coverage with respect to these Medicaid claims is adequate, in the future such reinsurance coverage may be inadequate or unavailable to us or the cost of such reinsurance coverage may limit our ability to obtain other insurance. We do not maintain reinsurance to protect us against other catastrophic medical claims under our health plan. Recently enacted or proposed legislation, regulations and initiatives could adversely affect our business by increasing our operating costs, reducing our health plan membership or subjecting us to additional litigation. In recent years, an increasing number of legislative initiatives have been introduced or proposed in Congress and in state legislatures that would effect major changes in the healthcare system, either nationally or at the state level. Among the proposals that have been introduced are price controls on hospitals, insurance market reforms to increase the availability of group health insurance to small businesses, requirements that all businesses offer health insurance coverage to their employees and the creation of a government health insurance plan or plans that would cover all citizens, and increased payments by beneficiaries. Increased regulations, mandated benefits and more oversight, audits and investigations and changes in laws allowing access to federal and state courts to challenge healthcare decisions may increase our administrative, litigation and healthcare costs. We cannot predict whether any of the above proposals or any other proposals will be adopted, and if adopted, no assurance can be given that the implementation of such reforms will not have a material adverse effect on our business and results of operations. Net cash (used in) provided by discontinued operations (67 ) 20 (1 ) (112 ) 34 You should rely only on the information contained in this prospectus. We have not authorized any person to provide you with any information or represent anything about us or this offering that is not contained in this prospectus. If given or made, any such other information or representation should not be relied upon as having been authorized by us. We are not making an offer of the exchange notes in any jurisdiction where an offer is not permitted. Table of Contents Primary State or Other Standard I.R.S. Address, including zip code, and Jurisdiction of Industrial Employer telephone number, including Exact Name of Registrant Incorporation Classification Identification area code, of Registrant s as Specified in its Charter or Organization Code Number principal executive offices Table of Contents THE EXCHANGE OFFER Purposes and Effect of the Exchange Offer We sold the original notes on August 19, 2003 to Banc of America Securities LLC, UBS Securities LLC, Banc One Capital Markets, Inc. and Merrill Lynch, Pierce, Fenner Smith Incorporated (the initial purchasers ), who resold the original notes to qualified institutional buyers in reliance on Rule 144A under the Securities Act and outside the United States to non-U.S. persons in compliance with Regulation S under the Securities Act. In connection with the issuance of the original notes, we, our parent and our subsidiaries that guarantee the original notes (the subsidiary guarantors ) entered into a registration rights agreement with the initial purchasers of the original notes. The following description of the registration rights agreement is a summary only. It is not complete and does not describe all of the provisions of the registration rights agreement. For more information, you should review the provisions of the registration rights agreement that we filed with the SEC as an exhibit to the registration statement of which this prospectus is a part. Under the registration rights agreement, we agreed that, promptly after the effectiveness of the registration statement of which this prospectus is a part, we would offer to the holders of original notes who are not prohibited by any law or policy of the SEC from participating in the exchange offer, the opportunity to exchange their original notes for a new series of notes, which we refer to as the exchange notes, that are identical in all material respects to the original notes, except that the exchange notes do not contain transfer restrictions, have been registered under the Securities Act and are not subject to further registration rights. We, our parent and our subsidiary guarantors have agreed to use our reasonable best efforts to keep the exchange offer open for not less than 20 business days, or longer if required by applicable law, after the date on which notice of the exchange offer is mailed to the holders of the original notes. We, our parent and our subsidiary guarantors also have agreed to use our reasonable best efforts to cause the exchange offer to be consummated on the earliest practicable date after the registration statement of which this prospectus is a part has become effective, but in no event later than 30 business days after such date of effectiveness. If: (1) we, our parent and our subsidiary guarantors are not permitted to file an exchange offer registration statement or consummate the exchange offer because the exchange offer is not permitted by applicable law or SEC policy; (2) for any reason the exchange offer is not consummated within 30 business days after the registration statement of which this prospectus is a part is declared effective; or (3) any holder of transfer restricted securities notifies us that: (a) it is prohibited by law or SEC policy from participating in the exchange offer; or (b) it may not resell the exchange notes acquired by it in the exchange offer to the public without delivering a prospectus and the prospectus contained in the registration statement of which this prospectus is a part is not appropriate or available for such resales; or (c) it is a broker-dealer and owns original notes acquired directly from us or one of our affiliates, then we, our parent and the subsidiary guarantors will: (1) as soon as practicable but in any event on or prior to 45 days after the filing obligation arises, file a shelf registration statement with the SEC covering resales of the transfer restricted securities by the holders thereof who satisfy certain conditions relating to the provision of information in connection with the shelf registration statement; Table of Contents (2) use reasonable best efforts to cause the shelf registration statement to become effective on or before 135 days after the filing obligation arises; and (3) use reasonable best efforts to keep the shelf registration statement effective until the earliest to occur of (a) two years from the date on which the shelf registration statement is declared effective and (b) the time when all notes covered by the shelf registration statement have been sold pursuant to the shelf registration statement or are no longer transfer restricted securities. For purposes of the foregoing, a transfer restricted security is each original note until the earliest to occur of: (1) the date on which the original note has been exchanged in the exchange offer and may be resold to the public by the holder without complying with the prospectus delivery requirements of the Securities Act; (2) the date on which the original note has been effectively registered under the Securities Act and disposed of in accordance with the shelf registration statement; and (3) the date on which the original note is distributed to the public pursuant to Rule 144 under the Securities Act or by a broker-dealer pursuant to the procedures described in Plan of Distribution. A registration default will be deemed to occur under the registration rights agreement if: (1) any registration statement required by the registration rights agreement is not filed with the SEC on or prior to the date specified for such filing in the registration rights agreement; (2) any registration statement required by the registration rights agreement has not been declared effective by the SEC on or prior to the date specified for such effectiveness in the registration rights agreement; (3) the exchange offer has not been consummated within 30 business days of the effective date of the registration statement of which this prospectus is a part; or (4) any registration statement required by the registration rights agreement is filed and declared effective by the SEC but thereafter shall cease to be effective or fail to be usable for its intended purpose during the periods specified in the registration statement. Upon the occurrence of a registration default, we will pay liquidated damages to each holder of transfer restricted securities, with respect to the first 90-day period immediately following the occurrence of the first registration default in an amount equal to a per annum rate of 0.50% on the principal amount of transfer restricted securities held by such holder. The amount of the liquidated damages will increase by an additional per annum rate of 0.50% with respect to each subsequent 90-day period until all registration defaults have been cured, up to a maximum amount of liquidated damages for all registration defaults of 1.50% per annum on the principal amount of transfer restricted securities. Following the cure of all registration defaults, the accrual of liquidated damages will cease. By acquiring transfer restricted securities, a holder will be deemed to have agreed to indemnify us, our parent and our subsidiary guarantors against certain losses arising out of information furnished by the holder in writing for inclusion in any registration statement. Holders of transfer restricted securities will also be required to suspend their use of the prospectus included in the registration statement under certain circumstances upon receipt of notice to that effect from us. Resale of the Exchange Notes Based on an interpretation by the staff of the SEC set forth in no-action letters issued to third parties, we believe that, unless you are a broker-dealer or an affiliate of us, you may offer for resale, resell or otherwise transfer the exchange notes issued to you pursuant to the exchange offer without compliance with the registration and prospectus delivery provisions of the Securities Act, provided that you acquire the Balance at September 30, 2003 5,000 $ 131,252 30,005 $ Table of Contents exchange notes in the ordinary course of business and you do not intend to participate and have no arrangement or understanding with any person to participate in the distribution of the exchange notes. If you are an affiliate of us or if you tender in the exchange offer with the intention to participate, or for the purpose of participating, in a distribution of the exchange notes, you may not rely on the position of the staff of the SEC enunciated in Exxon Capital Holdings Corporation (available May 13, 1988) and Morgan Stanley Co., Incorporated (available June 5, 1991), or similar no-action letters, but rather must comply with the registration and prospectus delivery requirements of the Securities Act in connection with any resale transaction. In addition, any such resale transaction should be covered by an effective registration statement containing the selling security holder information required by Item 507 or 508, as applicable, of Regulation S-K of the Securities Act. Each broker-dealer that receives exchange notes for its own account in exchange for original notes, where the original notes were acquired by such broker-dealer as a result of market-making activities or other trading activities, must acknowledge that it will deliver a prospectus in connection with any resale of the exchange notes. See Plan of Distribution. By tendering in the exchange offer, you represent to us that, among other things: (1) you are not an affiliate of us; (2) you are not engaged in, and do not intend to engage in, and have no arrangement or understanding with any person to participate in, a distribution of the exchange notes to be issued in the exchange offer; (3) you are acquiring the exchange notes in the ordinary course of business; and (4) you acknowledge and agree that if you are a broker-dealer or are using the exchange offer to participate in a distribution of the exchange notes acquired in the exchange offer: (a) you cannot rely on the no-action letters described above; and (b) you must, in the absence of an exemption, comply with the registration and prospectus delivery requirements of the Securities Act in connection with any resale of the exchange notes. Terms of the Exchange Offer Upon satisfaction or waiver of all the conditions of the exchange offer, we will accept any and all original notes properly tendered and not validly withdrawn prior to the expiration date and will promptly issue the exchange notes. See Conditions to the Exchange Offer and Procedures for Tendering. We will issue $1,000 principal amount of exchange notes in exchange for each $1,000 principal amount of original notes accepted in the exchange offer. As of the date of this prospectus, there is $225,000,000 in principal amount of original notes. Holders may tender some or all of their original notes pursuant to the exchange offer. However, original notes may be tendered only in integral multiples of $1,000. The exchange offer is not conditioned upon any number or aggregate principal amount of original notes being tendered. The form and terms of the exchange notes will be the same in all material respects as the form and terms of the original notes, except that the exchange notes will be registered under the Securities Act and therefore will not bear legends restricting their transfer. The exchange notes will evidence the same debt as the original notes and will be issued pursuant to, and entitled to the benefits of, the indenture pursuant to which the original notes were issued. Original notes that are accepted for exchange will be cancelled and retired. Interest on the exchange notes will accrue from the most recent date to which interest has been paid on the original notes or, if no interest has been paid on the original notes, the issue date. Accordingly, registered holders of exchange notes on the relevant record date for the first interest payment date following the completion of the exchange offer will receive interest accruing from the most recent date to which interest has been paid or, if no interest has been paid on the original notes, the issue date. Original notes accepted for exchange will cease to accrue interest from and after the date the exchange offer closes. Table of Contents If your original notes are accepted for exchange, you will not receive any payment in respect of interest on the original notes for which the record date occurs on or after completion of the exchange offer. You do not have any appraisal or dissenters rights under the indenture in connection with the exchange offer. We intend to conduct the exchange offer in accordance with the provisions of the registration rights agreement. If you do not tender for exchange or if your tender is not accepted, the original notes will remain outstanding and you will be entitled to the benefits of the indenture, but will not be entitled to any registration rights under the registration rights agreement. For purposes of the exchange offer, we will be deemed to have accepted validly tendered original notes when, and if, we have given oral or written notice thereof to the exchange agent. The exchange agent will act as our agent for the purpose of distributing the appropriate exchange notes from us to the tendering holders. If we do not accept any tendered original notes because of an invalid tender, the occurrence of certain other events set forth in this prospectus or otherwise, we will return the unaccepted original notes, without expense, to the tendering holder thereof promptly after the expiration date. If you tender your original notes in the exchange offer, you will not be required to pay brokerage commissions or fees or, subject to the instructions in the letter of transmittal, transfer taxes with respect to the exchange of original notes pursuant to the exchange offer. We will pay all charges and expenses, other than certain applicable taxes described below, in connection with the exchange offer. See Fees and Expenses below. Expiration Date; Extension; Termination; Amendments The exchange offer will expire at 5:00 p.m., New York City time, on , 2004, unless extended (the expiration date ). We reserve the right to extend the exchange offer at our discretion, in which event the term expiration date shall mean the time and date on which the exchange offer as so extended shall expire. We will notify the exchange agent of any extension by oral or written notice and will make a public announcement of any extension and specify the principal amount of original notes tendered to date, each prior to 9:00 a.m., New York City time, on the next business day after the previously scheduled expiration date. We reserve the right, in our sole discretion, to: (1) delay accepting for exchange any original notes for exchange notes or to extend or terminate the exchange offer and not accept for exchange any original notes for exchange notes if any of the events set forth under the caption Conditions of the Exchange Offer occur and we do not waive the condition by giving oral or written notice of the delay or termination to the exchange agent; or (2) amend the terms of the exchange offer in any manner. We will not delay payment of accepted original notes after the expiration date other than in anticipation of our receipt of any necessary government approvals. If we amend the exchange offer in any manner material to investors or if we extend or terminate the exchange offer, we will promptly file a post-effective amendment to the registration statement of which this prospectus is a part. We will also announce any such change in media outlets, including PR Newswire. Any delay in acceptance for exchange, extension or amendment will be followed as promptly as practicable by a public announcement of the delay. If we amend the exchange offer in a manner we determine constitutes a material change, we will promptly disclose the amendment in a manner reasonably calculated to inform the holders of original notes of the amendment, and we will extend the exchange offer for a period of five to ten business days, depending upon the significance of the amendment and the manner of disclosure to the holders of the original notes, if the exchange offer would otherwise expire during that five to ten business day period. The rights we have reserved in this paragraph are in addition to our rights set forth under the caption Conditions of the Exchange Offer. Table of Contents Conditions of the Exchange Offer Our obligation to consummate the exchange offer is not subject to any conditions, other than that the exchange offer does not violate any applicable law or SEC staff interpretation. Accordingly, we will not be required to accept for exchange any original notes tendered and may terminate or amend the exchange offer as provided herein before the acceptance of any original notes if: (1) any action or proceeding is instituted or threatened in any court or by or before any governmental agency or regulatory authority with respect to the exchange offer which, in our judgment, could reasonably be expected to materially impair our ability to proceed with the exchange offer; or (2) there shall have been proposed, adopted or enacted any law, statute, rule, regulation, order or SEC staff interpretation which, in our judgment, could reasonably be expected to materially impair our ability to proceed with the exchange offer. The foregoing conditions are for our sole benefit and may be asserted regardless of the circumstances giving rise to the conditions or may be waived by us in whole or in part at any time and from time to time in our sole discretion prior to the expiration date. If we waive or amend the foregoing conditions, we will, if required by applicable law, extend the exchange offer for a minimum of five business days from the date that we first give notice, by public announcement or otherwise, of such waiver or amendment, if the exchange offer would otherwise expire within that five business-day period. Our determination concerning the events described above will be final and binding upon all parties. Procedures For Tendering Only a holder of original notes may tender them in the exchange offer. To validly tender in the exchange offer by book-entry transfer, you must deliver an agent s message or a completed and signed letter of transmittal (or facsimile thereof), together with any required signature guarantees and any other required documents, to the exchange agent prior to 5:00 p.m., New York City time, on the expiration date, and the original notes must be tendered pursuant to the procedures for book-entry transfer set forth below. To validly tender by means other than book-entry transfer, you must deliver a completed and signed letter of transmittal (or facsimile thereof), together with any required signature guarantees and any other required documents and the original notes, to the exchange agent prior to 5:00 p.m., New York City time, on the expiration date. Any financial institution that is a participant in DTC s Book-Entry Transfer Facility system may make book-entry delivery of the original notes by causing DTC to transfer the original notes into the exchange agent s account in accordance with DTC s ATOP procedures for transfer. However, although delivery of original notes may be effected through book-entry transfer into the exchange agent s account at DTC, an agent s message or a completed and signed letter of transmittal (or facsimile thereof), with any required signature guarantees and any other required documents, must, in any case, be transmitted to and received or confirmed by the exchange agent at its addresses set forth under the caption Exchange Agent prior to 5:00 p.m., New York City time, on the expiration date, or the guaranteed delivery procedure set forth below must be complied with. DELIVERY OF DOCUMENTS TO DTC IN ACCORDANCE WITH DTC S PROCEDURES DOES NOT CONSTITUTE DELIVERY TO THE EXCHANGE AGENT. The term agent s message means, with respect to any tendered original notes, a message transmitted by DTC to and received by the exchange agent and forming part of a book-entry confirmation, stating that DTC has received an express acknowledgment from each tendering participant to the effect that, with respect to those original notes, the participant has received and agrees to be bound by the letter of transmittal and that we may enforce the letter of transmittal against the participant. The term book-entry confirmation means a timely confirmation of a book-entry transfer of original notes into the exchange agent s account at DTC. Table of Contents If you tender an original note, and do not validly withdraw your tender, your actions will constitute an agreement with us in accordance with the terms and subject to the conditions set forth in this prospectus and in the letter of transmittal. The method of delivery of your original notes and the letter of transmittal and all other required documents to the exchange agent is at your election and risk. Instead of delivery by mail, we recommend that you use an overnight or hand delivery service. In all cases, you should allow sufficient time to assure delivery to the exchange agent before the expiration date. No letter of transmittal or original note should be sent to us; instead, they should be sent to the exchange agent. You may request that your broker, dealer, commercial bank, trust company or nominee effect the tender for you. Signatures on a letter of transmittal or a notice of withdrawal, as the case may be, must be guaranteed by an eligible institution (as defined below) unless the original notes are being tendered: (1) by a registered holder who has not completed the box entitled Special Issuance Instructions or Special Delivery Instructions on the letter of transmittal; or (2) for the account of an eligible institution. If signatures on a letter of transmittal or a notice of withdrawal, as the case may be, are required to be guaranteed, the guarantee must be by a member of a signature guarantee program within the meaning of Rule 17Ad-15 under the Exchange Act (an eligible institution ). If the letter of transmittal or any original notes or bond powers are signed by trustees, executors, administrators, guardians, attorneys-in-fact, officers of corporations or others acting in a fiduciary or representative capacity, those persons should so indicate when signing, and unless we waive it, evidence satisfactory to us of their authority to act must be submitted with the letter of transmittal. We will determine, in our sole discretion, all questions as to the validity, form, eligibility (including time of receipt) and acceptance and withdrawal of tendered original notes. Our determination will be final and binding. We reserve the absolute right to reject any and all original notes not properly tendered or any original notes our acceptance of which would, in the opinion of our counsel, be unlawful. We also reserve the right to waive any defects, irregularities or conditions of tender as to particular original notes. Our interpretation of the terms and conditions of the exchange offer (including the instructions in the letter of transmittal) will be final and binding on all parties. Unless waived, you must cure any defects or irregularities in connection with tenders of your original notes within a time period we will determine. Although we intend to request that the exchange agent notify you of defects or irregularities with respect to your tender of original notes, we will not, nor will the exchange agent or any other person, incur any liability for failure to give you any notification. Tenders of original notes will not be deemed to have been made until any defects or irregularities have been cured or waived. Any original notes received by the exchange agent that are not properly tendered and as to which the defects or irregularities have not been cured or waived will be returned by the exchange agent to the tendering holders, unless otherwise provided in the letter of transmittal, promptly after the expiration date. In addition, we reserve the right in our sole discretion (subject to the limitations contained in the indenture for the exchange notes): (1) to purchase or make offers for any original notes that remain outstanding after the expiration date; and (2) to the extent permitted by applicable law, to purchase original notes in the open market, in privately negotiated transactions or otherwise. The terms of any purchases or offers could differ from the terms of the exchange offer. 16,092 Other assets Table of Contents The information in this prospectus is not complete and may be changed. We may not exchange these securities until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to exchange these securities and it is not soliciting an offer to exchange these securities in any state where the offer or exchange is not permitted. SUBJECT TO COMPLETION, DATED JANUARY 26, 2004 PROSPECTUS Ardent Health Services, Inc. Offer to Exchange up to $225,000,000 of 10% Senior Subordinated Notes due 2013 for up to $225,000,000 of 10% Senior Subordinated Notes due 2013 that have been registered under the Securities Act of 1933 We are offering to exchange our 10% senior subordinated notes due 2013, or the exchange notes, for our currently outstanding 10% senior subordinated notes due 2013, or the original notes. We sometimes refer to the exchange notes and the original notes collectively as the notes. Terms of the exchange notes: The exchange notes are substantially identical to the original notes, except that the exchange notes have been registered under the Securities Act of 1933, or the Securities Act, and will not contain restrictions on transfer or have registration rights. The exchange notes will represent the same debt as the original notes, and we will issue the exchange notes under the same indenture. The exchange notes will be subordinated to any existing and future senior indebtedness, including borrowings under our senior secured credit facility, and will rank equally with any future senior subordinated indebtedness. Assuming the exchange offer had been completed on September 30, 2003, the exchange notes would have been subordinated to approximately $4.8 million of our outstanding indebtedness. Terms of the exchange offer: The exchange offer expires at 5:00 p.m., New York City time, on , 2004, unless extended. We will exchange all original notes that are validly tendered and not validly withdrawn prior to the expiration of the exchange offer. You may withdraw tendered original notes at any time prior to the expiration of the exchange offer. We do not intend to apply for listing of the exchange notes on any securities exchange or to arrange for them to be quoted on any quotation system. The exchange offer is subject to customary conditions, including the condition that the exchange offer not violate applicable law or any applicable interpretation of the staff of the Securities and Exchange Commission, or the SEC. The exchange of original notes for exchange notes pursuant to the exchange offer will not constitute a taxable event for U.S. federal income tax purposes. We will not receive any proceeds from the exchange offer. Broker-dealers who acquired original notes from us in the initial offering are not eligible to participate in the exchange offer with respect to such original notes. Each broker-dealer that receives exchange notes for its own account pursuant to the exchange offer must acknowledge that it will deliver a prospectus in connection with any resale of the exchange notes. The letter of transmittal states that by so acknowledging and by delivering a prospectus, a broker-dealer will not be deemed to admit that it is an underwriter within the meaning of the Securities Act of 1933. This prospectus, as it may be amended or supplemented from time to time, may be used by a broker-dealer in connection with any resales of exchange notes received in exchange for original notes where the original notes were acquired by the broker-dealer as a result of market-making activities or other trading activities. We have agreed that, for up to 180 days after the expiration date, as defined in this prospectus, we will make this prospectus available to any broker-dealer for use in connection with any such resale. See Plan of Distribution. Investing in the exchange notes involves risks. See Risk Factors beginning on page 15. Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of the securities to be distributed in the exchange offer or determined that this prospectus is truthful or complete. Any representation to the contrary is a criminal offense. The date of this prospectus is , 2004. Table of Contents By tendering, you represent to us, among other things, that: (1) you are not affiliate of us (as defined in Rule 405 under the Securities Act); (2) you are not engaged in, and do not intend to engage in, and have no arrangement or understanding with any person to participate in, a distribution of the exchange notes; and (3) you are acquiring the exchange notes in the ordinary course of business. If you are a broker-dealer that will receive exchange notes for your own account in exchange for original notes that were acquired as a result of market-making activities or other trading activities, you must acknowledge that you will deliver a prospectus in connection with any resale of the exchange notes. Guaranteed Delivery Procedures If you wish to tender your original notes and either your original notes are not immediately available, or you cannot deliver your original notes and other required documents to the exchange agent, or cannot complete the procedure for book-entry transfer prior to the expiration date, you may effect a tender if: (1) you make a tender through an eligible institution; (2) prior to the expiration date, the exchange agent receives from the eligible institution a properly completed and duly executed notice of guaranteed delivery (by facsimile transmission, mail or hand delivery) setting forth your name and address, the certificate number(s) of the original notes (if available) and the principal amount of original notes tendered together with a duly executed letter of transmittal (or a facsimile thereof), stating that the tender is being made thereby and guaranteeing that, within three business days after the expiration date, the certificate(s) representing the original notes to be tendered, in proper form for transfer (or a confirmation of a book-entry transfer into the exchange agent s account at DTC of original notes delivered electronically) and any other documents required by the letter of transmittal, will be deposited by the eligible institution with the exchange agent; and (3) the certificate(s) representing all tendered original notes in proper form for transfer (or confirmation of a book-entry transfer into the exchange agent s account at DTC of original notes delivered electronically) and all other documents required by the letter of transmittal are received by the exchange agent within three business days after the expiration date. Upon request to the exchange agent, you will be sent a notice of guaranteed delivery if you wish to tender your original notes according to the guaranteed delivery procedures set forth above. Withdrawal of Tenders Except as otherwise provided in this prospectus, you may withdraw any tenders of original notes at any time prior to 5:00 p.m., New York City time, on the expiration date, unless previously accepted for exchange. For your withdrawal to be effective, the exchange agent must receive a written or facsimile transmission notice of withdrawal at its address set forth herein prior to 5:00 p.m., New York City time, on the expiration date, and prior to our acceptance for exchange. Any notice of withdrawal must: (1) specify the name of the person having tendered the original notes to be withdrawn; (2) identify the original notes to be withdrawn (including the certificate number or numbers, if applicable, and principal amount of the original notes); (3) be signed in the same manner as the original signature on the letter of transmittal by which the original notes were tendered (including any required signature guarantees) or be accompanied by documents of transfer sufficient to have the trustee with respect to the original notes register the transfer of the original notes into the name of the person withdrawing the tender; and TABLE OF CONTENTS SUMMARY RISK FACTORS
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+Risk factors The following risk factors should be considered carefully in addition to the other information contained in this prospectus. This prospectus contains forward looking statements that involve risks and uncertainties. Our actual results could differ materially from those contained in the forward looking statements. Factors that may cause these differences include those discussed below as well as those discussed elsewhere in this prospectus. Risks Relating to Our Business Our net sales, net income and growth depend largely on the economies in the geographic markets that we serve. Many of our customers use our products as components in their own products, systems or networks or in projects undertaken for their customers. Our ability to sell our products is largely dependent on general economic conditions, including how much our customers and end-users spend on information technology, new construction and building, maintaining or reconfiguring their communications network, industrial manufacturing assets and power transmission and distribution infrastructures. Over the past few years, many companies have significantly reduced their capital equipment and information technology budgets, and construction activity that necessitates the building or modification of communication networks and power transmission and distribution infrastructures has slowed considerably as a result of a weakening of the U.S. and foreign economies. As a result, our net sales and financial results have declined significantly. In the event that these markets do not improve, or if they were to become weaker, we could suffer further decreased sales and net income and we may not be able to service our debt. The increased use of fiber optic cable in the "local loop" may reduce the market for our products. Through our communications cable segment, we are the largest supplier, based on sales, of copper OSP cables used by the RBOCs and other telephone companies in the "local loop" portion of the telecommunications infrastructure. Copper OSP is the communications cable segment's largest product group. Over the past several years, fiber optic cable has been deployed in trunking line applications connecting central office to central office and in some feeder lines that connect central offices to the "local loop." Fiber optic cable provides increased bandwidth and transmission speeds as compared to copper cable. While the cost to install and operate fiber optic cable in the "local loop" currently exceeds that for copper cable, the cost of installing, operating and maintaining fiber optic cable and related systems in the "local loop" has continued to decline. Furthermore, the RBOCs have been forced through government regulation into wholesaling of their copper cabling infrastructure to competitors. Recent regulatory rulings by the Federal Communication Commission do not require such wholesaling of fiber optic networks. Although these rulings have been challenged in court, if allowed to stand they could provide increased economic incentives for our customers to deploy fiber optic cable in the "local loop." If the rate of introduction of fiber optic cable into the "local loop" accelerates, then the demand for our copper OSP cable would likely decrease. This decrease could result in a significant decline in sales of copper OSP cable, our revenues and liquidity. Advancing technologies, such as fiber optic and wireless technologies, may make some of our products less competitive. Technological developments could have a material adverse effect on our business. For example, a significant decrease in the cost and complexity of installation of fiber optic systems or increase in the cost of copper based systems could make fiber optic systems superior on a price performance basis to copper systems and may have a material adverse effect on our business. The superior technological characteristics of fiber optic cables has caused companies increasingly to deploy it in the local loop. If any of the securities being registered on this Form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, as amended, check the following box. If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. If delivery of the prospectus is expected to be made pursuant to Rule 434, check the following box. Also, competitive alternatives to traditional telephone service, such as wireless and cable telephony and "voice over Internet Protocol," or VOIP, services, have had a negative impact on the demand for copper OSP wire and cable, and these threats are not expected to diminish and may increase. While we sell some fiber optic cable and components and cable that is used in certain wireless applications, if fiber optic systems or wireless technology were to significantly erode the markets for copper based systems, our sales of fiber optic cable and products for wireless applications may not be sufficient to offset any decrease in sales or profitability of other products that may occur. Spending reductions by the telephone industry could adversely affect our business. Our largest customer segments for the communications cable segment are the RBOCs and independent telephone operating companies. Over 60% of sales of the communications cable segment are attributable to these customers. Beginning in the second half of 2001 and continuing through 2003, the RBOCs and the independent telephone companies have substantially reduced their capital expenditure levels, including substantial reductions in purchases of the communications cable products that we supply. The telephone companies are experiencing extreme competitive pressures from CATV companies and other alternative providers of local exchange service, resulting in negative access line growth and loss of subscribers. These market conditions could result in further reductions in the demand for our communications cable products. Further reductions in demand could lead to a substantial decrease in our revenues and liquidity. Substantial spending reductions by the RBOCs and independent telephone operating companies contributed to significant revenue declines in the past three years with the most pronounced reductions in revenues occurring in 2002. Declines in access lines, including a decline in the new start housing market, could adversely affect our business. A decrease in access lines to homes and businesses could have a negative impact on our business. Competitive alternatives, such as wireless and cable telephony, digital subscriber lines or "DSL", VOIP services, and cable modems have had a negative impact on the demand for additional access lines. Furthermore, the demand for access lines is impacted by new housing starts. Any negative access line growth resulting from these factors could result in further reductions in the demand for our communications cable products. Migration of magnet wire demand to China may adversely affect our business. Our business may suffer due to the migration of magnet wire demand to China. Our magnet wire and distribution segment's principal product is magnet wire, which is used primarily in motors for industrial, automotive, appliance and other applications. We currently service the North American market, with limited sales elsewhere. Several of our major magnet wire customers are shifting, or have plans to shift, certain levels of product manufacturing to China. We do not currently have production capabilities in China, but are evaluating entering the China market to service the growing demand there, including the requirements of existing customers who are located in, or are relocating production to, China. There can be no assurance that we will be able to establish production facilities or other arrangements in China, or that we will be able to successfully compete in China and/or offset any loss of business resulting from the decline in demand of our products in North America from this shift of customer requirements to China. Fluctuations in the supply or pricing of copper and other principal raw materials could harm our business. Copper is the primary raw material that we use to manufacture our products. There are a limited number of copper suppliers in the United States. If we are unable to maintain good relations with our The registrant hereby amends this Registration Statement on such date or dates as may be necessary to delay its effective date until the registrant files a further amendment that specifically states that this Registration Statement will thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933, as amended, or until the Registration Statement becomes effective on such date as the Securities and Exchange Commission, acting pursuant to Section 8(a), determines. copper suppliers or if there are any business interruptions at our copper suppliers, we may not have access to a sufficient supply of copper. If we were to suffer the loss of one or more important suppliers of copper, we may not be able to meet customer demand, which could result in the loss of customers and revenues. In addition, copper is a commodity and is therefore subject to price volatility. We may not be able to adjust product pricing to properly match the price of copper billed with the copper cost component of the inventory shipped. Any fluctuations in the cost of copper that we cannot effectively manage could cause us to increase prices for our products, which could hinder our ability to sell those products. Copper pricing under our major telephone companies contracts is generally based on the average copper price for the preceding quarter. To minimize the risk of fluctuations in the price of copper, we forward price copper purchases with our suppliers based on forecasted demand. To the extent forecasted demand differs significantly from actual demand, changes in the price of copper may have a negative impact on our operating profit. Beginning in the fourth quarter of 2003 and continuing through the first six months of 2004, copper prices have escalated rapidly, increasing from an average of $0.88 per pound for the month of October 2003 to an average of $1.23 per pound for the first six months of 2004. Additionally, the daily spot price for copper has fluctuated from a low of $1.06 per pound to a high of $1.39 per pound during the first six months of 2004. The rapid increase in copper prices can impact profitability in the short term based upon the timing of product price adjustments to match the increased copper costs. While we did not experience a material negative impact from this situation in 2003 or the first quarter of 2004, our results in the second quarter of 2004 were negatively impacted due to accelerated orders by some communications cable customers in the first quarter of 2004 in anticipation of future contractual price adjustments related to increased copper costs. There can be no assurance that continued volatility in copper prices will not impact our future profitability. In addition, significant increases in the price of copper and the resultant increase in accounts receivable and, to a lesser degree, inventory impacts our working capital requirements. As a result of the increase in copper prices, we have experienced an increase in our working capital financing requirements of $15 million to $25 million. See "Management's discussion and analysis of financial condition and results of operations Liquidity and Capital Resources" below. The other raw materials we use in the manufacture of our wire and cable products are aluminum, bronze, steel, optical fibers and plastics, such as polyethylene and polyvinyl chloride. Although Superior TeleCom had not experienced any shortages in the recent past, no assurance can be given that we will be able to procure adequate supplies of our essential raw materials to meet our future needs. Our indebtedness may limit cash flow available to invest in the ongoing needs of our business to generate future cash flow. Our outstanding debt, including Superior Essex Holding's series A preferred stock (which is classified as debt for accounting purposes), as of June 30, 2004 was $311.9 million. We may also incur additional debt from time to time to finance working capital, acquisitions, capital expenditures and other general corporate purposes. Our indebtedness could have important consequences to holders of our common stock. For example, it could: require us to dedicate a substantial portion of our cash flow from operations to payments on our indebtedness, reducing the availability of our cash flow to fund working capital, acquisitions, capital expenditures, research and development efforts and other general corporate purposes; increase the amount of interest expense that we have to pay, because some of our borrowings (approximately $49.7 million as of June 30, 2004) are at variable rates of interest, which, if interest rates increase, could result in higher interest expense; Cash flows from investing activities: Capital expenditures (1,739 ) (2,838 ) (10,123 ) (27,264 ) Net proceeds from the sale of assets 5,681 83,576 6,389 Superior Israel customer loan repayments (advances) 6,157 (13,018 ) Other 633 1,013 Cash flows provided by operating activities $ 357 $ 32,590 $ 7,268 $ 18,680 $ 58,895 Cash flows from investing activities: Capital expenditures (20,013 ) (3,226 ) (4,025 ) (27,264 ) Net proceeds from sale of assets 4,325 10 2,054 6,389 Superior Israel customer loan advances, net (13,018 ) (13,018 ) Other 11 (in thousands) Net income (loss) $ 3,396 $ (49,444 ) Foreign currency translation adjustment (53 ) 1,712 Change in unrealized gains on derivatives, net (7 ) 1,183 Additional minimum pension liability (291 ) Other 65 increase our vulnerability to adverse general economic or industry conditions; limit our flexibility in planning for, or reacting to, changes in our business or the industry in which we operate; or place us at a competitive disadvantage compared to some of our competitors that have less debt. We may be unable to meet our covenant obligations under our senior secured revolving credit facility which could adversely affect our business. Our operations are dependent on the availability and cost of working capital financing and may be adversely affected by any shortage or increased cost of such financing. We entered into a senior secured revolving credit facility upon emergence from bankruptcy. The senior secured revolving credit facility contains covenants that we may not be able to meet. If we cannot meet these covenants, events of default would arise, which could result in payment of the applicable indebtedness being accelerated and a cross default to our other indebtedness. In addition, if we require working capital greater than that provided by our senior secured revolving credit facility, we may be required either to (1) seek to increase the availability under the senior secured revolving credit facility, (2) obtain other sources of financing or (3) reduce our operations. There can be no assurance that any amendment of our senior secured revolving credit facility or replacement financing would be available on terms that are favorable or acceptable to us. Moreover, there can be no assurance that we will be able to obtain an acceptable new credit facility upon expiration of our senior secured revolving credit facility or that the terms of any such new credit facility would be acceptable. We may be unable to raise additional capital to meet capital expenditure needs if our operations do not generate sufficient funds to do so. Our business is expected to have continuing capital expenditure needs. While we anticipate that our operations will generate sufficient funds to meet our capital expenditure needs for the foreseeable future, our ability to gain access to additional capital, if needed, cannot be assured, particularly in view of competitive factors and industry conditions. If we are unable to obtain additional capital, or unable to obtain additional capital on favorable terms, our business and financial condition could be adversely affected. Declining returns in the investment portfolio of our defined benefit plans will require us to increase cash contributions to the plans. Funding for the defined benefit pension plans we sponsor is based upon the funded status of the plans and a number of actuarial assumptions, including an expected long-term rate of return on assets and discount rate. On December 1, 2003, we announced that benefit accruals under our defined benefit pension plans for salaried employees and for eligible employees who are not included in a unit of employees covered by a collective bargaining agreement would be frozen as of January 22, 2004. Due to declining returns in the investment portfolio of our defined benefit pension plans in recent years, the defined benefit plans were underfunded as of December 31, 2003 by approximately $35.8 million, based on the actuarial methods and assumptions utilized for purposes of FAS 87 and after giving effect to the planned curtailment of benefits. As a result, we expect to experience an increase in our future cash contributions to our defined benefit pension plans. Our required cash contributions are expected to increase to $11.9 million in 2004 from $3.8 million in 2003. In 2005, total cash contributions are expected to be approximately $2.1 million. In the event that actual results differ negatively from the actuarial assumptions, the funded status of our defined benefit plans may change and any such deficiency could result in additional charges to equity and against earnings and increase our required cash contributions. Our inability to compete with other manufacturers in the wire and cable industry could harm our business. The market for wire and cable products is highly competitive. Each of our businesses competes with at least one major competitor. Many of our products are made to industry specifications and, therefore, may be interchangeable with competitors' products. We are subject to competition in many markets on the basis of price, delivery time, customer service and our ability to meet specialty needs. Some of our competitors are significantly larger and have greater resources, financial and otherwise, than we do. There can be no assurance that we will be able to compete successfully with our existing competitors or with new competitors. Failure to compete successfully could result in a significant decrease in sales of our products and our revenues. If we are unable to retain senior management, our business operations could be adversely affected. Our success and future prospects depend on the continued contributions of our senior management. There can be no assurances that we would be able to find qualified replacements for these individuals if their services were no longer available. The loss of services of one or more members of our senior management team, and the process of integrating their replacements, could severely disrupt our operations. Failure to negotiate extensions of our labor agreements as they expire may result in a disruption of our operations. Approximately 21% of our employees are represented by various labor unions. Labor agreements covering approximately 10% of our employees expire during 2004. We cannot predict what issues may be raised by the collective bargaining units representing our employees and, if raised, whether negotiations concerning such issues will be successfully concluded. A protracted work stoppage could result in a disruption of our operations which could adversely affect our ability to deliver certain products and our financial results. We may not be able to realize the benefits of the Belden Asset Acquisition or to identify, finance or integrate other acquisitions. We cannot assure you that we will be able to realize the benefits of the Belden Asset Acquisition. Customers of Belden that have agreed to have their contracts assigned to us may not continue to purchase at past or anticipated future levels. In addition to the Belden Asset Acquisition, we evaluate possible acquisition opportunities from time to time. We cannot assure you that we will be able to consummate acquisitions in the future on terms acceptable to us, if at all. We cannot assure you that any future acquisitions will be successful or that the anticipated strategic benefits of any future acquisitions will be realized. We recently emerged from a Chapter 11 bankruptcy reorganization and have a history of losses. On March 3, 2003, Superior TeleCom and certain of its U.S. subsidiaries filed voluntary petitions for relief under Chapter 11 of the United States Bankruptcy Code in the United States Bankruptcy Court for the District of Delaware. In accordance with the plan of reorganization, on November 10, 2003, the effective date of the plan, we acquired the business formerly conducted by Superior TeleCom and its subsidiaries. Superior TeleCom incurred net losses of approximately $32.5 million in 2001 and $961.3 million in 2002. We adopted fresh-start reporting as of November 10, 2003, and our emergence from Chapter 11 resulted in a new reporting entity. The net effect of all fresh start reporting adjustments resulted in a charge of $12.1 million, which is reflected in Superior TeleCom's statement of operations for the period January 1, 2003 to November 10, 2003. We may continue to incur losses in the future. The information in this prospectus is not complete and may be changed. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell these securities and it is not soliciting an offer to buy these securities in any state where the offer or sale is not permitted. SUBJECT TO COMPLETION, DATED NOVEMBER 9, 2004 PROSPECTUS 5,392,405 Shares Superior Essex Inc. Common Stock Our historical financial information is not comparable to our current financial condition and results of operations. As a result of our emergence from bankruptcy, we are operating our business with a new capital structure. We are also subject to the fresh-start reporting prescribed by GAAP and our financial statements for periods subsequent to November 10, 2003 reflect the application of these rules. Accordingly, our financial condition and results of operations will not be comparable to the financial condition and results of operations reflected in the historical financial statements of Superior TeleCom contained in this prospectus, which may make it difficult for you to assess our future prospects based on historical performance. You are unlikely to be able to seek remedies against Arthur Andersen LLP, Superior TeleCom's former independent auditor. The audited consolidated financial statements and schedules of Superior TeleCom as of December 31, 2001 and for the year ended December 31, 2001 included in this prospectus have been audited by Arthur Andersen LLP, or Arthur Andersen, independent accountants, whose report thereon is also included in this prospectus. On August 31, 2002, Arthur Andersen ceased practicing before the Commission. Commission rules require us to present our audited financial statements in various Commission filings. We do not expect to receive Arthur Andersen's consent in any filing that we make with the Commission, including this registration statement. Without this consent, it may become more difficult for you to seek remedies against Arthur Andersen. Furthermore, relief in connection with claims, which may be available to investors under the federal securities laws against auditing firms, may not be available as a practical matter against Arthur Andersen. You are unlikely to be able to exercise effective remedies or judgments against Arthur Andersen. Risks Relating to our Common Stock An active trading market may not develop for our common stock, and we cannot assure you as to the market price for our common stock if a market does develop. Our common stock is currently listed on the Nasdaq National Market under the trading symbol SPSX, but no established market exists for our common stock. There can be no assurance that an active market for our common stock will develop or, if any such market does develop, that it will continue to exist or the degree of price volatility in any such market. In addition, our common stock was issued under the plan of reorganization to holders of pre-petition senior secured debt claims of Superior TeleCom, some of which may prefer to liquidate their investment rather than to hold it on a long-term basis. Accordingly, it is anticipated that the market for our common stock will be volatile, at least for an initial period after the effective date of the plan of reorganization. The market price of our common stock will be subject to significant fluctuation in response to numerous factors, including variations in our annual or quarterly financial results or those of our competitors, changes by financial analysts in their estimates of our future earnings, conditions in the economy in general or in the wire and cable industry in particular and other factors beyond our control. No assurance can be given as to the market price for our common stock. If our share price declines significantly, then our common stock may be deemed to be penny stock, which could adversely affect the liquidity of, and market for, our common stock. If our common stock is considered penny stock, it would be subject to rules that impose additional sales practices on broker-dealers who sell our securities. Penny stocks generally are equity securities with a price of less than $5.00, other than securities registered on some national securities exchanges or quoted on Nasdaq. In this event, some brokers may be unwilling to effect transactions in our common stock because of the additional obligations imposed. This could adversely affect the liquidity of our This prospectus is part of a registration statement that we filed with the Securities and Exchange Commission using the "shelf" registration process. It relates to the public offering, which is not being underwritten, of 5,392,405 shares of our common stock that are held by the selling stockholders identified in this prospectus. We issued such shares to these selling stockholders in connection with the plan of reorganization of Superior TeleCom Inc. The selling stockholders may sell these shares from time to time in the over-the-counter market in regular brokerage transactions, in transactions directly with market makers or in privately negotiated transactions. For additional information on the methods of sale that may be used by the selling stockholders, see the section entitled "Plan of distribution." We will not receive any of the proceeds from the sale of these shares. We will bear the costs relating to the registration of these shares. Our common stock is currently listed on the Nasdaq National Market under the trading symbol "SPSX." Our common stock was quoted on the OTC Bulletin Board under the trading symbol "SESX.OB" until November 8, 2004. On November 3, 2004, the last sale price of our common stock on the OTC Bulletin Board was $17.20 per share. common stock and the ability of investors to sell our common stock. For example, broker-dealers must make a special suitability determination for the purchaser and have received the purchaser's written consent to the transaction prior to sale. Also, a disclosure schedule must be prepared prior to any transaction involving a penny stock, and disclosure is required about sales commissions payable to both the broker-dealer and the registered representative and current quotations for the securities. Furthermore, monthly statements are required to be sent disclosing recent price information for the penny stock held in the account and information on the limited market in penny stock. Our dividend policies and other restrictions on the payment of dividends may prevent the payment of dividends for the foreseeable future. We do not anticipate paying any dividends on our common stock for the foreseeable future. In addition, covenants in our debt instruments restrict our ability to pay cash dividends and may prohibit the payment of dividends and certain other payments. Some institutional investors may only invest in dividend-paying equity securities or may operate under other restrictions that may prohibit or limit their ability to invest in our common stock. Provisions of our certificate of incorporation and bylaws could discourage potential acquisition proposals and could deter or prevent a change in control. Some provisions of our certificate of incorporation and bylaws, as well as Delaware statutes, may have the effect of delaying, deferring or preventing a change in control. These provisions, including those providing for the possible issuance of preferred stock and regulating the nomination of directors, may make it more difficult for other persons, without the approval of our board of directors, to make a tender offer or otherwise acquire substantial amounts of our common stock or to launch other takeover attempts that a stockholder might consider to be in such stockholder's best interest. These provisions could limit the price that some investors might be willing to pay in the future for shares of our common stock. An investment in our common stock involves risks. See "Risk factors" beginning on page 9.
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+RISK FACTORS An investment in our common stock involves a number of risks. You should carefully consider the following information about these risks, together with the other information contained in this prospectus, before investing in shares of our common stock. Any of the risks described below could result in a significant or material adverse effect on our results of operations or financial condition and a corresponding decline in the market price of our common stock. RISKS RELATED TO OUR COMPANY If our financial results continue to be inconsistent, our profitability and share price may suffer. For the first quarter ended March 31, 2004 we generated a net loss of $361,000. For the year ended December 31, 2003, we had net income of $226,000. We generated net losses of $574,000 and $1,393,000 in 2002 and 2001, respectively. In 2000 we had net income of $1,017,000. We cannot assure investors that we will be profitable in the future. The fluctuations in our earnings can be attributed to several factors such as large catastrophe losses, severe weather losses, rate inadequacy and other factors that may occur again in the future. Because we concentrate all of our business in Michigan, its weather will affect our results. All insurance policies we write are generated in Michigan, with a significant portion in four counties (Kent, Newaygo, Berrien and Van Buren). Companies that have a more diversified geographic portfolio would not be as exposed to Michigan weather as we are. Catastrophe and natural peril losses may hurt our financial condition. By their nature, catastrophe losses are unpredictable in their number and severity. They can be caused by various severe weather events, including snow storms, ice storms, freezing temperatures, tornadoes, wild fires, wind and hail. The extent of net losses from catastrophes depends upon three factors: the total amount of insured exposure in the area affected by the event, the severity of the event, and the amount and structure of our reinsurance coverage. We obtain reinsurance to aid in paying catastrophe loss claims, but we may experience operating losses in years when catastrophe claims are higher than expected. We experienced higher than expected catastrophe losses in 2001 and 1999 that significantly affected our underwriting results. In 2001 and 1999 we incurred catastrophe losses net of reinsurance recoveries of approximately $2,464,000 and $1,413,000, respectively. Natural perils such as freezing rain, snow storms, wind storms and tornadoes, which may occur frequently but not rise to the level of a catastrophe, may cause us to lose money because they are not classified as a catastrophe under our reinsurance program. If our reinsurance pays catastrophe loss claims, we may still incur substantial expense to reinstate the coverage used. If we underestimated the amount of our required loss reserves, our results may suffer. We maintain reserves to cover our estimated liability for losses and loss adjustment expenses ( LAE ) with respect to reported and unreported claims incurred. Our reserves for loss and loss adjustment expenses as of We are converting Fremont Mutual Insurance Company into a company owned by shareholders. As part of this conversion, we are offering you the opportunity to become shareholders of a new holding company, Fremont Michigan InsuraCorp, Inc., which will own all of the shares of the Insurance Company. This offering is made only to Michigan residents and this prospectus will be used for all three of the following components of the offering which will be conducted concurrently: first, a Surplus Note Exchange Offering to the holders of the Insurance Company s surplus notes due September 30, 2007, of up to approximately 363,000 shares; second, a Subscription Offering to eligible policyholders, directors and officers of the Insurance Company for any and all shares not exchanged for surplus notes; and third, a Community Offering to the general public for any and all shares not exchanged or subscribed for in the Surplus Note Exchange Offering and the Subscription Offering. The offering will occur after completion of the conversion of the Insurance Company from a mutual to a stock company. We will not sell any shares unless the Insurance Company s policyholders approve our conversion to a stock company and unless a minimum of 680,000 shares is subscribed for in the offering. The Holding Company will place all funds submitted to buy shares in an escrow account with The Huntington National Bank until the offering terminates and at least the minimum number of shares are sold or the funds are returned. Minimum Table of Contents March 31, 2004 and December 31, 2003, 2002 and 2001 were approximately $17,148,000, $13,878,000, $8,677,000 and $11,060,000, respectively. Reserves are estimates involving actuarial and statistical projections at a given point in time of what we expect to be the cost of the ultimate settlement and administration of claims based on facts and circumstances then known, actual and historical information, predictions of future events, estimates of future trends in claims severity and judicial theories of liability, legislative activity and other variable factors, such as inflation, investment returns, and price increases because of local shortages. The Insurance Company s overall reserving practice provides for ongoing claims evaluation and adjustment (if necessary) based on the development of related data and other relevant information pertaining to such claims. Loss and LAE reserves, including reserves for claims that have been incurred but not yet reported, are analyzed regularly and we adjust our reserves based on such reviews. We believe our reserves are adequate. However, establishing appropriate reserves is an uncertain process. There is no guarantee that our ultimate losses will not exceed our reserves. To the extent that reserves prove to be inadequate in the future, we would have to increase reserves, which would reduce our earnings and could have a material adverse effect on the Insurance Company s results of operations and financial condition. We face strong competition from large companies, which may reduce our earnings and profits. We principally insure against property and casualty losses. This segment of the market is highly competitive. We compete against other Michigan-based insurance carriers as well as major regional and national carriers. The national carriers we compete with on a regular basis are Citizens Insurance Company of America, State Farm Mutual Automobile Insurance Company and the Allstate Corporation. Regional companies that are important competitors include Auto Owners Insurance Group, Allied Insurance, Farm Bureau Mutual Insurance Company of Michigan, Frankenmuth Insurance and Hastings Mutual Insurance Company. Smaller state competitors would include Michigan Insurance Company, Pioneer State Mutual Insurance Company and Wolverine Mutual Insurance Company. Many of our competitors have substantially greater financial, technical and operating resources than we do. As a result, many of our lines of insurance are subject to strong price competition and heavy advertising by larger companies, which could result in loss of business and adversely affect our earnings. Our reliance on independent insurance agencies to sell our products as well as their ability to sell products of our competitors could adversely affect the sale of our products. We market our property and casualty insurance products exclusively in Michigan through approximately 170 independent agencies. Our independent insurance agencies represent other insurance companies, including our competitors, which also compete for the service and allegiance of these agencies. If a significant number of the independent agencies shift profitable accounts from us to our competitors, it could adversely affect our business. No single agency accounted for more than 10% of our direct written premiums for 2003, 2002 or 2001. The percentage of direct written premiums attributable to our 10 largest independent agency producers was 20%, 20% and 18% for 2003, 2002 and 2001, respectively. Our experience in commercial insurance and personal automobile insurance is limited, which could hurt our ability to respond to market changes. In the recent past, we have entered the commercial insurance and personal automobile insurance markets. Our skills, resources and operating experiences in these product lines are limited, creating the additional risk that we may not be able to respond to market changes or forces in ways that our more seasoned competitors do. Anti-takeover provisions in our articles of incorporation and bylaws may discourage takeover attempts and prevent or frustrate attempts to replace or remove our management, which could limit your opportunity to receive a high value for your stock if another company seeks to acquire us. Our articles of incorporation and bylaws contain provisions that have the effect of discouraging or preventing takeover attempts not supported by our board of directors. In addition, these provisions may also 25,044 247 162 Equity securities: Preferred stocks 518 19 Common stocks 2,242 455 2,760 474 Total $ 2,760 $ 13 $ Maximum Table of Contents prevent or frustrate attempts to replace or remove our management. Management entrenchment may also have the effect of discouraging potential purchasers from making takeover offers. Examples of these provisions include, among other things: Staggered three-year terms for the members of the board of directors; Super-majority provisions for amendment of our articles of incorporation or bylaws; Restrictions on voting of common stock by any individual, entity or group owning more than 10% of the common stock; and Provisions allowing the directors to issue preferred stock with voting rights. In addition, the Michigan Insurance Code provides that no person may acquire 10% or more of our voting stock, or more than 5% of our voting stock within 5 years of the conversion, without approval of the Commissioner of Michigan s Office of Financial and Insurance Services ( Insurance Commissioner ). Takeover attempts generally include offering shareholders a premium for their stock. Therefore, preventing a takeover attempt may cause you to lose an opportunity to sell your shares at a premium. A downgrade in our A.M. Best rating could hurt our premium volume. Ratings assigned by A.M. Best Company, Inc. influence the competitive position of insurance companies. Their ratings are based upon factors of concern to policyholders and are not directed toward the protection of investors. Our current rating is B+ (Very Good). Our business is sensitive to those ratings. If we were to experience a rating downgrade, our independent agents could be inclined to place their customers with higher-rated insurance carriers, which could result in a loss of premium volume and could have a material adverse effect on us. In addition, a downgrade in our A.M. Best rating could make it more difficult or costly to obtain reinsurance. If we are unable to obtain adequate reinsurance coverage at reasonable rates in the future, we may be unable to manage our underwriting risks and operate our business profitably. Reinsurance is the practice of transferring part of the liabilities and the premiums under an insurance policy to another insurance company. Like other insurance companies, we use reinsurance arrangements to limit and manage the amount of risk we retain and to stabilize our underwriting results. Reinsurance can be facultative reinsurance or treaty reinsurance. Under facultative reinsurance, each risk or portion of a risk is reinsured individually. Under treaty reinsurance, an agreed-upon portion of business written is automatically reinsured. Treaty reinsurance can also be classified as quota share reinsurance, pro-rata insurance or excess of loss reinsurance. Under quota share reinsurance and pro-rata insurance, the ceding company cedes a percentage of its insurance liability to the reinsurer in exchange for a like percentage of premiums, less a ceding commission, and, in turn, will recover from the reinsurer the reinsurer s share of losses and loss adjustment expenses incurred on those risks. Under excess of loss reinsurance, an insurer limits its liability to all or a particular portion of the amount in excess of a predetermined deductible or retention. Regardless of type, reinsurance does not legally discharge the ceding insurer from primary liability for the full amount due under the reinsured policies. However, the assuming reinsurer is obligated to reimburse the ceding company to the extent of the coverage ceded. The availability and cost of reinsurance are subject to prevailing market conditions and may vary significantly over time. Reinsurance rates have risen significantly in the past several years as a result of high insurance losses, including those experienced by us, and the recent terrorist events in the United States. Reinsurance rates are not regulated and reinsurers are able to quickly raise their rates in response to changing market conditions. On the other hand, the Insurance Company s rates are regulated, and it could take us years to obtain regulatory approval and collect rate increases based on the rising costs of reinsurance. There is no assurance that regulators would approve a rate increase based on these costs. Reinsurance may not be available to us in the future at commercially reasonable rates. If it is not available at reasonable rates, we may be unable to manage our underwriting risks and operate our business profitably. Offering price per share $ 10.00 $ 10.00 Number of shares 680,000 920,000 Underwriting commissions and other expenses $ 600,000 $ 800,000 Net proceeds to the Holding Company $ 6,200,000 $ 8,400,000 Net proceeds per share $ 9.11 $ 9.13 The minimum purchase requirement for all of the offerings is 250 shares and the maximum purchase amount for any person is 5% of the total shares sold, which will range from 34,000 to 46,000 shares depending on the total shares issued in the offerings. All three components of the offering will commence concurrently on , 2004. The Surplus Note Exchange and the Subscription Offerings will remain open for 30 days. No subscriptions will be accepted in the Community Offering until immediately after the Surplus Note Exchange and Subscription Offerings have concluded. The Community Offering will remain open for an additional 30 days or until the maximum number of shares have been sold, whichever occurs first. We have engaged Centennial Securities Company, Inc. to advise us with respect to this offering. Centennial has agreed to use its best efforts to assist us with our solicitation of subscriptions and purchase orders for shares of common stock in the offering. Centennial will not purchase any shares of common stock in the offering and is not obligated to sell any specific number of shares. Because this is our initial offering of common stock, there is currently no public market for the common stock. We expect that brokers will publish bid and ask quotations for our shares in the Pink Sheets centralized quotation service after the completion of the offering under the symbol FMIC. The common stock offered by this prospectus involves a significant amount of risk. Please refer to Risk Factors beginning on page 12 of this prospectus for a discussion of risks that you should consider before investing. Neither the Securities and Exchange Commission, nor any state securities agency, nor any state insurance bureau has approved or disapproved of these securities or passed upon the adequacy or accuracy of this prospectus. Any representation to the contrary is a criminal offense. Centennial Securities Company, Inc. THE DATE OF THIS PROSPECTUS IS , 2004 Table of Contents If our reinsurers do not fulfill their financial obligations to us it may jeopardize our earnings and financial condition. We are subject to loss and credit risk relating to the reinsurers we deal with because buying reinsurance does not relieve us of our liability to policyholders. The insolvency or inability of any reinsurer to meet its obligations may have a material adverse effect on the business, results of operations and financial condition of the Insurance Company. If we do not have adequate reinsurance coverage, our earnings and financial condition would be in jeopardy. It is possible that the losses we experience on risks we have reinsured will exceed the coverage limits on the reinsurance. If the amount of our reinsurance is not sufficient, our insurance losses would increase which could jeopardize our earnings and financial condition. In 2004, we have the following types of reinsurance: Multi-Lines Excess of Loss Coverage. The multi-lines excess of loss program is designed to help stabilize financial results, limit exposure on larger risks, and increase capacity. The largest exposure retained by us on any one risk in 2004 is $125,000. The 2004 property coverage for this program provides up to $2,375,000 of coverage over the $125,000 retention per risk. The 2004 casualty coverage for this program provides up to $4,875,000 over the $125,000 retention. Our 2004 workers compensation reinsurance provides up to $9,875,000 of coverage above the $125,000 retention. Catastrophe Excess of Loss Coverage. Catastrophe reinsurance protects us from significant aggregate loss exposure arising from a single event such as windstorm, hail, tornado, hurricane, earthquake, blizzard, freezing temperatures, and other extraordinary events. In 2004, we have three layers of catastrophe excess of loss reinsurance providing coverage for up to $20,000,000 above the $1,000,000 retention. Facultative. We utilize facultative reinsurance to provide additional underwriting capacity, to mitigate the effect of individual losses and to reduce net liability on individual risks. In 2004, we purchased this reinsurance where our liability is greater than $2,500,000 for all lines of business. Quota Share Coverage. In 2003 we also utilized quota share reinsurance under agreements that provide coverage on all lines of business. In 2003, we ceded 45% of our net written premium and losses to the quota share reinsurers. The Insurance Company placed the multi-line quota share agreement into runoff after December 31, 2003. Because we are not renewing our use of quota share reinsurance, we will retain more risk, which could result in losses. In recent years, the Insurance Company ceded 45% of its direct written premium to its quota share reinsurers. Quota share reinsurance refers to a form of pro rata reinsurance arrangement pursuant to which the reinsurer participates in a specified percentage of the premiums and losses on every risk that comes within the scope of the reinsurance agreement. For the year 2004, we have decided not to renew our use of quota share reinsurance for new and renewal policies, although we still maintain other treaty and facultative reinsurance coverages, including the excess of loss and catastrophe reinsurance coverages. Thus, we will retain and earn more of the premiums we write, but also retain more of the related losses. Terminating our use of quota share reinsurance has increased our risk and exposure to such losses, which could have a material adverse effect on our business, financial condition and results of operations. As a holding company, our primary source of income is dividends from the Insurance Company, which is limited by and dependent upon the ability of the Insurance Company to pay dividends to us. We have no present intention of adding to our holdings or paying dividends in the foreseeable future. Our immediate primary function is to serve as the holding company for the Insurance Company after its conversion. The Holding Company s sole source of income for operations will depend upon the ability of the Insurance Company to pay dividends to us. Table of Contents TABLE OF CONTENTS Page Table of Contents The payment of dividends by the Insurance Company is subject to limitations imposed by the Michigan Insurance Code. The Insurance Company may not pay an extraordinary dividend unless it notifies the Insurance Commissioner and the Insurance Commissioner does not disapprove the payment. An extraordinary dividend includes any dividend which, when taken together with other dividends paid within the preceding 12 months, exceeds the greater of 10% of an insurance company s statutory policyholders surplus as of December 31 of the immediately preceding year or its statutory net income, excluding realized capital gains, for the 12-month period ending December 31 of the immediately preceding year. Also, in the absence of approval of the Insurance Commissioner, dividends may only be paid from statutory earned surplus. The Michigan Insurance Code gives the Commissioner the authority to disallow any dividend that renders the surplus of the insurer inadequate, so, in order to pay any dividends, the Insurance Company must be in a position to satisfy the requirement that it continues to be safe, reliable and entitled to public confidence. Changes in prevailing interest rates may reduce our revenues, cash flows and shareholders equity. We have invested a significant portion of our investment portfolio in fixed income securities. In recent years, we have earned our investment income primarily from interest income on this portfolio. Lower interest rates could reduce the return on our portfolio and the amount of this income if we must reinvest at rates below those we have on securities currently in the portfolio. The reduced investment income could also reduce our cash flows. In addition, in a declining interest rate environment, we may lower our credit quality standards in order to maintain yield on the investment portfolio, which would negatively impact the quality of our investment portfolio. A decline in the quality of our portfolio could result in realized losses on securities, creating additional volatility in our statement of operations. Higher interest rates could reduce the market value of our fixed income investments. We could be forced to sell investments to meet our liquidity requirements. We believe that we maintain adequate amounts of cash and short-term investments to pay claims, and do not expect to sell securities prematurely for such purposes. We may, however, decide to sell securities as a result of changes in interest rates, credit quality, the rate of repayment or other similar factors. A significant increase in market interest rates could result in a situation in which we are required to sell securities at depressed prices to fund payments to our insureds. Since we carry debt securities at fair value, we expect that these securities would be sold with no material impact on our net equity. However, if these securities are sold, future net investment income may be reduced if we are unable to reinvest in securities with similar or better yields. Declining debt and equity markets could adversely affect our investment portfolio. A declining market could stress the values of investments of all firms and could cause the investment ratings of the issuers of debt or equity to decline. Therefore, a declining market could negatively impact the credit quality of our investment portfolio as adverse equity markets also affect issuers of securities held by us. Declines in the quality of the portfolio could cause additional realized losses on securities, thus causing volatility in our statement of operations. Summary 1 Risk Factors 12
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+RISK FACTORS Investing in our common shares involves a high degree of risk. Before you invest in our common shares, you should carefully consider the following risks and cautionary statements. If any of the events described in the following risks actually occur, our business, financial condition or results of operations may suffer. As a result, the trading price of our common shares could decline, and you could lose all or a substantial portion of your investment. Risks Related To Our Business Our actual incurred losses may be greater than our loss and loss expense reserves, which could cause our future earnings, liquidity and financial rating to decline. We are liable for loss and loss expenses under the terms of the insurance policies we underwrite. In many cases, several years may elapse between the occurrence of an insured loss, the reporting of the loss to us and our payment of the loss. We establish loss and loss expense reserves for the ultimate payment of all loss and loss expenses incurred. If any of our reserves should prove to be inadequate, we will be required to increase reserves resulting in a reduction in our net income in the period in which the inadequacy is identified. Future loss experience substantially in excess of established reserves could also cause our future earnings, liquidity and financial rating to decline. These reserves are based on historical data and estimates of future events and by their nature are imprecise. Our ultimate loss and loss expenses may vary from established reserves. Furthermore, factors that are subject to change, such as: claims inflation; claims development patterns; legislative activity; social and economic patterns; and litigation and regulatory trends may have a substantial impact on our future loss experience. Additionally, we have established loss and loss expense reserves for certain lines of business we have exited, but circumstances could develop that would make these reserves insufficient. As of December 31, 2003, unpaid loss and loss expense reserves (net of reserves ceded to our reinsurers) were $95.2 million, consisting of case loss and loss expense reserves of $41.4 million and incurred but not reported loss and loss expense reserves of $53.8 million. We have re-estimated our loss and loss expense reserves attributable to insured events in prior years, which includes re-estimations with respect to excess and surplus lines and products we no longer write. These re-estimations resulted in an increase in reserves of $3.1 million, $5.3 million, $17.5 million and $26.3 million for the years ended December 31, 2000, 2001, 2002 and 2003, respectively. A decline in our financial rating assigned by A.M. Best may result in a reduction of new or renewal business. Our insurance subsidiaries currently have a pooled A- (excellent) rating from A.M. Best, the fourth highest of 16 A.M. Best ratings. A.M. Best assigns ratings that generally are based on an insurance company s ability to pay policyholder obligations (not towards protection of investors) and focus on capital adequacy, loss and loss expense reserve adequacy and operating performance. A reduction in our performance in these criteria could result in a downgrade of our rating. In addition, as part of the Evergreen and Continental transactions, we will terminate the intercompany pooling agreement among Century, Evergreen and Continental effective January 1, 2004. As a result of the termination of the intercompany pooling agreement, we will no longer qualify for a pooled rating, and we will lose the ability to use the surplus from Evergreen and Continental. We believe the contribution of surplus from ProCentury to Century from the Initial public offering price $ $ Underwriting discount Proceeds (before expenses) to us Proceeds (before expenses) to selling shareholders We have granted the underwriters a 30-day option to purchase up to an additional 1,335,000 common shares at the public offering price, less the underwriting discount, to cover over-allotments, if any. Neither the Securities and Exchange Commission nor any state securities commission or regulatory authority has approved or disapproved of these securities or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense. The underwriters expect to deliver the common shares to purchasers on or about , 2004. Table of Contents proceeds of this offering will exceed the amount of surplus lost from the disposition of Evergreen and Continental. As a result, we do not believe that the Evergreen and Continental transactions will have an adverse effect on our rating with A.M. Best. A downgrade of our rating could cause our current and future general agents, retail brokers and insureds to choose other, more highly rated competitors. We are subject to extensive regulation, which may adversely affect our ability to achieve our business objectives. In addition, if we fail to comply with these regulations, we may be subject to penalties, including fines and suspensions, which may adversely affect our financial condition and results of operations. General. Century is subject to regulations, administered primarily by Ohio, our domiciliary state, and to a lesser degree, the five other states in which Century is licensed or admitted to sell insurance. Most insurance regulations are designed to protect the interests of insurance policyholders, as opposed to the interests of shareholders. These regulations, generally are administered by a department of insurance in each state and relate to, among other things, excess and surplus lines of business authorizations, capital and surplus requirements, rate and form approvals, investment parameter restrictions, underwriting limitations, affiliate transactions, dividend limitations, changes in control and a variety of other financial and non-financial components of our business. Significant changes in these laws and regulations could further limit our discretion or make it more expensive to conduct our business. State insurance departments also conduct periodic examinations of the affairs of insurance companies and require the filing of annual and other reports relating to financial condition, holding company issues and other matters. These regulatory requirements may adversely affect or inhibit our ability to achieve some or all of our business objectives. Required Licensing. In addition, regulatory authorities have broad discretion to deny or revoke licenses for various reasons, including the violation of regulations. In some instances, where there is uncertainty as to applicability, we follow practices based on our interpretations of regulations or practices that we believe generally to be followed by the industry. These practices may turn out to be different from the interpretations of regulatory authorities. If we do not have the requisite licenses and approvals or do not comply with applicable regulatory requirements, insurance regulatory authorities could preclude or temporarily suspend us from carrying on some or all of our activities or otherwise penalize us. This could adversely affect our ability to operate our business. Further, changes in the level of regulation of the insurance industry or changes in laws or regulations themselves or interpretations by regulatory authorities could adversely affect our ability to operate our business. Risk-Based Capital. The National Association of Insurance Commissioners (the NAIC ) has adopted a system to test the adequacy of statutory capital, known as risk-based capital. This system establishes the minimum amount of risk-based capital necessary for a company to support its overall business operations. It identifies property and casualty insurers that may be inadequately capitalized by looking at certain inherent risks of each insurer s assets and liabilities and its mix of net written premiums. Insurers falling below a calculated threshold may be subject to varying degrees of regulatory action, including supervision, rehabilitation or liquidation. Failure to maintain our risk-based capital at the required levels could cause our insurance subsidiary to lose its regulatory authority to conduct its business. See Management s Discussion and Analysis of Financial Condition and Results of Operations Liquidity and Capital Resources for a discussion of our risk-based capital as of December 31, 2003. IRIS Ratios. The NAIC Insurance Regulatory Information System ( IRIS ) is part of a collection of analytical tools designed to provide state insurance regulators with an integrated approach to screening and analyzing the financial condition of insurance companies. IRIS has two phases of screening: statistical and analytical. In the statistical phase, the NAIC database generates financial ratios based on financial information obtained from insurance companies annual statutory statements. The analytical phase is a review of the annual statements, financial ratios and other automated solvency tools. A ratio result falling outside the usual range of IRIS ratios is viewed as part of the regulatory early monitoring system. As of December 31, 2003, Century had five IRIS ratios outside the usual range, as described in Business Regulatory Environment IRIS Ratios, which could result in regulatory action. Friedman Billings Ramsey A.G. Edwards Sons, Inc. Raymond James The date of this prospectus is , 2004. Table of Contents Our general agents may exceed their authority and bind us to policies outside our underwriting guidelines, and until we affect a cancellation, we may incur loss and loss expenses related to that policy. As of December 31, 2003, we underwrote 59.4% of our property and casualty premiums on a binding authority basis. Binding authority business represents risks that may be quoted and bound by our general agents prior to our underwriting review. If a general agent exceeds this authority by binding us on a risk that does not comply with our underwriting guidelines, we are at risk for claims under that policy that occur during the period from its issue date until we receive the policy and cancel it. We have not suffered material adverse consequences due to our general agents exceeding their underwriting authority. Since current management assumed control in 2000, there have been two instances in which we have recovered paid loss amounts from a general agent due to a violation of underwriting authority. Such funds were covered by the required errors and omissions insurance carried by each of our agents. To cancel a policy for exceeding underwriting authority, we must receive and cancel the policy within statutorily prescribed time limits, typically 60 days. Our general agents are required by contract to have bound policies issued and a copy sent to our office within 30 days of the effective date of coverage. Our policy review generally takes two to four weeks, depending on the time of year. Upon review of a policy, we issue instructions to cure any material errors discovered. If cancellation of the policy is the only cure, we order the cancellation of the policy at that time pursuant to state law. As a result, we may be bound by a policy that does not comply with our underwriting guidelines, and until we can effect a cancellation, we may incur loss and loss expenses related to that policy. If we lose key personnel or are unable to recruit qualified personnel, our ability to implement our business strategies could be delayed or hindered. Our future success will depend, in large part, upon the efforts of our executive officers and other key personnel. We rely substantially upon the services of Edward F. Feighan, our Chairman of the Board, President and Chief Executive Officer, Charles D. Hamm, our Chief Financial Officer and Treasurer, Christopher J. Timm, our Executive Vice President and Director, and John A. Marazza, our Executive Vice President, Chief Operating Officer, Secretary and Director. Each of Messrs. Feighan, Hamm, Timm and Marazza has an employment agreement with us. The loss of any of these officers or other key personnel could cause our ability to implement our business strategies to be delayed or hindered. We do not have key person insurance on the lives of any of our key management personnel, except one officer. As we continue to grow, we will need to recruit and retain additional qualified personnel, but we may not be able to do so. As we have grown, we have generally been successful in filling key positions, but our ability to continue to recruit and retain such personnel will depend upon a number of factors, such as our results of operations, prospects and the level of competition then prevailing in the market for qualified personnel. Our investment results and, therefore, our financial condition may be impacted by changes in the business, financial condition or operating results of the entities in which we invest, as well as changes in government monetary policies, general economic conditions and overall capital market conditions, all of which impact interest rates. Our results of operations depend, in part, on the performance of our invested assets. Fluctuations in interest rates affect our returns on and the fair value of fixed-income securities. Unrealized gains and losses on fixed-income securities are recognized in accumulated other comprehensive income, net of taxes and minority interest, and increase or decrease our shareholders equity. Interest rates in the United States are currently low relative to historical levels. An increase in interest rates could reduce the fair value of our investments in fixed-income securities. In addition, defaults by third parties who fail to pay or perform obligations could reduce our investment income and realized investment gains and could result in investment losses in our portfolio. 3 .2 Form of Amended and Restated Code of Regulations of ProCentury Corporation 4 .1 Specimen Certificate for common shares, without par value, of ProCentury Corporation 4 .2 Indenture, dated as of December 4, 2002, by and between ProFinance Holdings Corporation and State Street Bank and Trust Company of Connecticut 4 .3 Amended and Restated Declaration of Trust, dated as of December 4, 2002, by and among State Street Bank and Trust Company of Connecticut, ProFinance Holdings Corporation and Steven R. Young and John Marazza, as Administrators 4 .4 Guarantee Agreement, dated as of December 4, 2002, by and between ProFinance Holdings Corporation and State Street Bank and Trust Company of Connecticut 4 .5 Indenture, dated as of May 15, 2003, by and between ProFinance Holdings Corporation and U.S. Bank National Association 4 .6 Amended and Restated Declaration of Trust, dated as of May 15, 2003, by and among U.S. Bank National Association, ProFinance Holdings Corporation and Steven R. Young and John Marazza, as Administrators 4 .7 Guarantee Agreement, dated as of May 15, 2003, by and between ProFinance Holdings Corporation and U.S. Bank National Association 4 .8 Universal Note and Security Agreement, dated as of October 5, 2001, by and between ProFinance Holding Corporation and Eaton National Bank Trust Co., as supplemented and amended 5 Opinion of Baker Hostetler LLP regarding legality 10 .1 Employment Agreement, dated as of December 15, 2003, by and between ProCentury Corporation and Edward F. Feighan 10 .2 Employment Agreement, dated as of December 15, 2003, by and between ProCentury Corporation and John A. Marazza 10 .3 Employment Agreement, dated as of December 15, 2003, by and between ProCentury Corporation and Christopher J. Timm 10 .4 Employment Agreement, dated as of December 15, 2003, by and between ProCentury Corporation and Charles D. Hamm 10 .6 Form of ProCentury Corporation Indemnification Agreement by and between ProCentury Corporation and director 10 .7 ProCentury Corporation 2004 Stock Option and Award Plan 10 .8 ProCentury Corporation Deferred Compensation Plan 10 .9 ProCentury Corporation Deferred Compensation Plan Rabbi Trust Agreement 10 .10 ProCentury Corporation Annual Incentive Plan 10 .11* Transitional Administrative Agreement, effective as of January 1, 2004, by and among ProCentury Corporation, Evergreen National Indemnity Corporation and Continental Heritage Insurance Company 10 .12* Loss Portfolio Transfer Reinsurance Contract, effective as of January 1, 2004, issued to Century Surety Company by Evergreen National Indemnity Company 10 .13* Loss Portfolio Transfer Reinsurance Contract, effective as of January 1, 2004, issued to Continental Heritage Insurance Company by Century Surety Company 10 .14* Loss Portfolio Transfer Reinsurance Contract, effective as of January 1, 2004, issued to Evergreen National Indemnity Company by Century Surety Company 10 .15* Quota Share Reinsurance Contract, effective as of January 1, 2004, issued to Evergreen National Indemnity Company by Century Surety Company 10 .16* Quota Share Reinsurance Contract, effective as of January 1, 2004, issued to Continental Heritage Insurance Company by Century Surety Company 1 Proposed form of Underwriting Agreement among ProCentury Corporation, the selling shareholders and the underwriters 3 .1 Form of Amended and Restated Articles of Incorporation of ProCentury Corporation 3 .2 Form of Amended and Restated Code of Regulations of ProCentury Corporation 4 .1 Specimen Certificate for common shares, without par value, of ProCentury Corporation 4 .2 Indenture, dated as of December 4, 2002, by and between ProFinance Holdings Corporation and State Street Bank and Trust Company of Connecticut 4 .3 Amended and Restated Declaration of Trust, dated as of December 4, 2002, by and among State Street Bank and Trust Company of Connecticut, ProFinance Holdings Corporation and Steven R. Young and John Marazza, as Administrators 4 .4 Guarantee Agreement, dated as of December 4, 2002, by and between ProFinance Holdings Corporation and State Street Bank and Trust Company of Connecticut 4 .5 Indenture, dated as of May 15, 2003, by and between ProFinance Holdings Corporation and U.S. Bank National Association 4 .6 Amended and Restated Declaration of Trust, dated as of May 15, 2003, by and among U.S. Bank National Association, ProFinance Holdings Corporation and Steven R. Young and John Marazza, as Administrators 4 .7 Guarantee Agreement, dated as of May 15, 2003, by and between ProFinance Holdings Corporation and U.S. Bank National Association 4 .8 Universal Note and Security Agreement, dated as of October 5, 2001, by and between ProFinance Holding Corporation and Eaton National Bank Trust Co., as supplemented and amended 5 Opinion of Baker Hostetler LLP regarding legality 10 .1 Employment Agreement, dated as of December 15, 2003, by and between ProCentury Corporation and Edward F. Feighan 10 .2 Employment Agreement, dated as of December 15, 2003, by and between ProCentury Corporation and John A. Marazza 10 .3 Employment Agreement, dated as of December 15, 2003, by and between ProCentury Corporation and Christopher J. Timm 10 .4 Employment Agreement, dated as of December 15, 2003, by and between ProCentury Corporation and Charles D. Hamm 10 .6 Form of ProCentury Corporation Indemnification Agreement by and between ProCentury Corporation and director 10 .7 ProCentury Corporation 2004 Stock Option and Award Plan 10 .8 ProCentury Corporation Deferred Compensation Plan 10 .9 ProCentury Corporation Deferred Compensation Plan Rabbi Trust Agreement 10 .10 ProCentury Corporation Annual Incentive Plan 10 .11* Transitional Administrative Agreement, effective as of January 1, 2004, by and among ProCentury Corporation, Evergreen National Indemnity Corporation and Continental Heritage Insurance Company 10 .12* Loss Portfolio Transfer Reinsurance Contract, effective as of January 1, 2004, issued to Century Surety Company by Evergreen National Indemnity Company 10 .13* Loss Portfolio Transfer Reinsurance Contract, effective as of January 1, 2004, issued to Continental Heritage Insurance Company by Century Surety Company 10 .14* Loss Portfolio Transfer Reinsurance Contract, effective as of January 1, 2004, issued to Evergreen National Indemnity Company by Century Surety Company TABLE OF CONTENTS PROSPECTUS SUMMARY RISK FACTORS
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+RISK FACTORS You should carefully consider the following factors in addition to the other information presented in this prospectus. Factors relating to the Senior Secured Notes There is no active trading market for the Senior Secured Notes The Senior Secured Notes are new securities and therefore do not currently have an active trading market. If the Senior Secured Notes are traded after their initial issuance, they may trade at a discount from their nominal price, depending upon prevailing interest rates, the market for similar securities, general economic conditions and our financial condition. The Senior Secured Notes are not listed on any exchange. As a result, we cannot assure you that an active trading market will develop for the Senior Secured Notes or that the market for the Notes will provide any liquidity for holders that wish to sell their Senior Secured Notes. We may not be able to finance a change of control offer Under the terms of the indenture governing the Senior Secured Notes, we are required to offer to repurchase all of the Senior Secured Notes if a change of control (as defined under "Description of the Senior Secured Notes Offer to Purchase Upon a Change of Control") occurs. However, it is possible that we will not have sufficient funds at the time of the change of control to make the required repurchase. Other financing arrangements to which we and our subsidiaries are or may become a party may also require that we repay, or offer to repurchase, other obligations upon a change of control. In addition, other agreements to which we and our subsidiaries are or may become subject, including other financing arrangements, may contain provisions that prohibit us from making such a repurchase. Therefore, there can be no assurance that we will be permitted to consummate a repurchase if a change of control occurs without causing a default under or breach of such other financing arrangements. We are primarily a holding company and we depend upon funds received from our operating subsidiaries to make payments on our indebtedness We are primarily a holding company and conduct the majority of our operations, and hold a substantial portion of our operating assets, through numerous direct and indirect subsidiaries. As a result, we rely on income from dividends and fees related to administrative services provided to our operating subsidiaries for our operating income, including the funds necessary to service our indebtedness. As a matter of Mexican law, profits of our subsidiaries may only be distributed upon approval by the subsidiaries' shareholders, and no profits may be distributed by our subsidiaries to us until all losses incurred in prior fiscal years have been offset against any sub-account of our capital or net worth account. In addition, at least 5% of the profits of our subsidiaries must be separated to create a reserve (fondo de reserva) until such reserve is equal to 20% of the aggregate value of such subsidiary's capital stock (as calculated based on the actual nominal subscription price received by such subsidiary for all issued shares that are outstanding at the time). There is no restriction under Mexican law upon our subsidiaries remitting funds to us in the form of loans or advances in the ordinary course of business, except to the extent that such loans or advances would result in the insolvency of our subsidiaries, or for our subsidiaries to pay to us fees or other amounts for services. In addition, the indentures governing TFM's notes and TFM's First Amended and Restated Credit Agreement restrict TFM's ability to pay dividends under certain circumstances and limit the dividends payable to an accrued maximum aggregate amount or "basket" based on Grupo TFM's accumulated consolidated net income after a specified date. Furthermore, we do not own 100% of all of our subsidiaries and, to the extent that we rely on dividends or other distributions from subsidiaries that we do not wholly own, we will only be entitled to a pro rata share of the dividends or other distributions. In May 2002, TFM completed a consent solicitation of holders of its notes as a result of which the indentures were amended to, among other things, further restrict TFM's ability to pay dividends. There is currently no availability under TFM's dividend basket to pay dividends. Consequently, it is unlikely that TFM will provide us with funds necessary to service our debt obligations. In addition to operations at our subsidiaries, we are a party to a number of arrangements with other parties where we and those parties have jointly invested in our subsidiaries and we may enter into other similar arrangements in the future. Our partners in these subsidiaries may at any time have economic, business or legal interests or goals that are inconsistent with our interests or those of the entity itself. Any of these partners may also be unable to meet their economic or other obligations to the subsidiaries, and we may be required to fulfill those obligations. Furthermore, any dividends that are distributed from subsidiaries that we do not wholly own would be shared pro rata with our partners according to our relative ownership interests. Disagreements for these or any other reasons with companies with which we have a strategic alliance or relationship could impair or adversely affect our ability to conduct our business and to receive distributions from, and return on our investments in, those subsidiaries. In December 2001, a dispute arose between us and KCS, resulting from a dividend declaration by Grupo TFM and a lease transaction between TFM and Mexrail, Inc. ("Mexrail"). Although we settled the dispute, both we and KCS preserved our respective interpretations of the operative agreements governing our investment in Grupo TFM. In addition, in connection with the dispute with KCS regarding the termination of the agreement for the sale of our interest in Grupo TFM to KCS for a combination of cash and stock of KCS and an additional earnout (the "TFM Sale"), KCS has commenced numerous legal proceedings against us and our officers in Mexico seeking, among other things, to nullify actions taken at board meetings of Grupo TFM and TFM. It is possible that similar or other disputes may arise with respect to other matters relating to Grupo TFM. See "Legal Proceedings" for a more detailed description of disputes. A portion of the security for the Senior Secured Notes is subject to rights of first refusal or other restrictions on transfer Some of the shares which are owned by the guarantors which are part of the security for the obligations under the Senior Secured Notes and the guarantees are subject to rights of first refusal or other rights in favor of third parties. Our ability to sell such shares upon foreclosure could be adversely affected if bidders prove to be unwilling to make an offer to purchase such shares due to the existence of such rights in favor of third parties. The shares of our direct and indirect subsidiaries may be difficult to sell in the event the Company cannot fulfill its obligations with respect to the Senior Secured Notes, or the guarantors are called upon to satisfy their guarantees of the Senior Secured Notes There is no public market for the shares of our and our guarantors' subsidiaries, including Grupo TFM, TMM Multimodal or TMM Holdings, and the shares of these entities cannot be easily liquidated. Accordingly, the number of potential purchasers of such shares is very limited, and may include competitors of the Company. In the event that the holders of Senior Secured Notes seek to foreclose on the shares that the Company or the guarantors have pledged under the security agreements, there can be no assurance that such foreclosure would be able to generate sufficient funds to pay the Senior Secured Notes in full, or that any sale would not be delayed, possibly for a long period of time. Furthermore, certain shareholder agreements and other contracts relating to the shares of our and our guarantors' subsidiaries contain significant restrictions on the sale of those shares, including, with respect to Grupo TFM, our agreement not to sell those shares to a competitor of the Company or KCS. In addition, existing foreign investment restrictions, as well as Mexican antitrust law Transportation revenues $ 40,949 $ 127,226 $ 889,825 $ (49,384 ) $ 1,008,616 Costs and expenses 56,875 $ and the governing concession, could also significantly limit the number of potential purchasers for the shares of our and our guarantors' subsidiaries, and could thus negatively impact our ability to sell such shares. See "Business Grupo TMM's Strategic Partners." Mexican law and regulations may impair your ability to enforce in Mexico certain rights in connection with the Senior Secured Notes Under Mexican law, as our creditors, your rights are limited in the following ways: service of process by mail does not constitute effective service under Mexican law, and if a final judgment based on service of process by mail was made outside of Mexico, it would not be enforceable in Mexico; and any judgments as a result of enforcement proceedings in Mexico would be payable in pesos. You may not be able to receive your payments on the Senior Secured Notes in U.S. dollars in certain circumstances We are required to make payments of amounts owed under the Senior Secured Notes and the guarantees in U.S. dollars. However, under the Mexican Monetary Law (Ley Monetaria de los Estados Unidos Mexicanos), obligations to make payments in Mexico in foreign currency may be discharged in pesos at the rate of exchange for pesos prevailing at the time and place of payment. Although we are contractually required, and intend, to make all payments of amounts owed under the Senior Secured Notes and the guarantees in U.S. dollars, we are legally entitled to pay in pesos if payment on the Senior Secured Notes or the guarantees is sought in Mexico (through the enforcement of a non-Mexican judgment or otherwise). In the event that we make payment in pesos, you may experience a U.S. dollar shortfall when converting the pesos to U.S. dollars. The indenture for the Senior Secured Notes restricts our ability to take certain actions The indenture for the Senior Secured Notes imposes significant operating and financial restrictions. These restrictions affect, and in many respects significantly limit or prohibit, our ability and the ability of our restricted subsidiaries to, among other things: incur indebtedness; create or suffer to exist liens; make prepayments of particular indebtedness; pay dividends; make investments; engage in transactions with shareholders or affiliates; use assets as security in other transactions; create any unrestricted subsidiary; sell assets; and engage in mergers and consolidations or in sale-leaseback transactions. If we do not comply with these restrictions, a default could occur even if we could at that time pay the amounts required under the Senior Secured Notes. If there were a default, the holders of Senior Secured Notes could demand immediate payment of the Senior Secured Notes. Should that occur, we might not be able to pay or refinance the Senior Secured Notes on acceptable terms. SCHEDULE A CO-REGISTRANTS SUBSIDIARY GUARANTORS The following direct and indirect wholly-owned subsidiaries of Grupo TMM are guarantors of the Senior Secured Notes and are Co-Registrants, each of which is incorporated in the jurisdiction opposite its name set forth below and none of which has an I.R.S. Employer Identification Number. Name of Co-Registrant Factors relating to Grupo TMM Our dispute with Kansas City Southern could result in a material adverse effect on our business We are currently involved in a dispute with KCS regarding the Acquisition Agreement (the "Acquisition Agreement") executed by us and KCS on April 20, 2003, relating to the TFM Sale. Under the terms of the Acquisition Agreement, KCS was to purchase our interest in Grupo TFM in exchange for cash, shares of KCS and an additional cash earnout payment which was contingent on the timing of certain events, such as receipt of the VAT Proceeds and repurchase of the shares of TFM owned by the Mexican government. Subsequent to the execution of the Acquisition Agreement, we believe that KCS representatives undertook certain activities that threatened to jeopardize the value of the earnout. Thereafter, on August 18, 2003, our shareholders voted to reject the Acquisition Agreement and we notified KCS that we were terminating the Acquisition Agreement on August 22, 2003. KCS disputed our right to terminate the Acquisition Agreement and alleged certain breaches by us of the Acquisition Agreement. Under the terms of the Acquisition Agreement, the parties submitted these disputes to binding arbitration. An arbitration panel (the "panel") was chosen in accordance with the terms of the Acquisition Agreement. KCS obtained a preliminary injunction from the Delaware Chancery Court enjoining us from violating the terms of the Acquisition Agreement pending a subsequent decision by a panel of arbitrators regarding whether the Acquisition Agreement was properly terminated. On December 8, 2003, we and KCS participated in a preliminary hearing with the arbitrators during which the arbitrators deliberated whether the issue of the Acquisition Agreement's continued effectiveness should be bifurcated from the other issues in the case. On December 22, 2003, the panel bifurcated the issue of whether Grupo TMM properly terminated the Acquisition Agreement from the other disputed issues between the parties and scheduled a hearing on that issue. On February 2, 3 and 4, 2004, a hearing was held in New York on the issue of whether Grupo TMM's termination was proper. We maintained that we properly terminated the Acquisition Agreement while KCS sought a declaration that the Acquisition Agreement was wrongfully terminated. On February 19, 2004, we and KCS filed post-hearing briefs with the panel. On March 19, 2004, the panel issued an Interim Award in which it concluded that the rejection of the Acquisition Agreement by Grupo TMM's shareholders in its vote on August 18, 2003, did not authorize Grupo TMM's purported termination of that Agreement, dated August 22, 2003. Accordingly, the Acquisition Agreement remains in force and binding on the parties until otherwise terminated according to its terms or by law. In reaching this conclusion, the panel found it unnecessary to determine whether approval by Grupo TMM's shareholders is a "condition" of the Agreement. On April 4, 2004, the panel issued an order, which was stipulated to by KCS and Grupo TMM (the "Order and Stipulation"), providing that the parties agreed "not to request a scheduling order for a further hearing in the arbitration at this time" and that "[e]ach party reserves the right to request a scheduling order for a further hearing at any time." Since the issuance in April 2004 of the Order and Stipulation, the Company and KCS and their respective representatives have engaged in discussions regarding the potential settlement of the dispute and the possible amendment of the existing Acquisition Agreement. There is no assurance that the parties will be able to agree on the terms of any settlement or amendment or, if an agreement is reached, as to the terms of that agreement. The transaction contemplated by the existing Acquisition Agreement would constitute a "Qualifying Disposition" under the indenture governing the Senior Secured Notes that would permit the Company to complete the transaction without any further consent or approval of the holders of the Senior Secured Notes, subject to compliance with certain conditions, such as receipt of required fairness opinions and a limitation on the ability of KCS to exercise a right to pay a portion of the cash purchase price in additional shares of KCS common stock if the cash consideration would be less than 35% of the principal amount of, and accrued unpaid interest on, the Senior Secured Notes outstanding at the time the transaction is completed. The Company expects that any transaction pursuant to any amended Acquisition Agreement would also constitute a Qualifying Disposition. As a result, if an agreement is reached on that basis, the Company would be permitted State or Other Jurisdiction of Incorporation or Organization under the indenture governing the Senior Secured Notes to complete any transaction provided for under an amended agreement without any further consent or approval from the holders of the Senior Secured Notes. See "Description of the Senior Secured Notes Certain Convenants Restrictions on Asset Dispositions; Use of Proceeds of Asset Dispositions, Grupo TFM Dispositions, VAT Proceeds." We cannot predict the ultimate outcome of any further arbitration on the remaining disputed issues. If KCS were to be awarded substantial damages in any such proceeding, it could have a material adverse effect on our business. For a more complete discussion of the legal dispute with KCS, see "Legal Proceedings Dispute with Kansas City Southern." We have a contingent obligation to purchase shares of TFM owned by the Mexican government The Mexican government retained a 20% interest in TFM in connection with the privatization of TFM in 1997, and pursuant to the original agreements relating to the concession, Grupo TFM has an obligation to purchase such interest at the original peso purchase price per share paid by Grupo TFM, indexed to account for Mexican inflation. If Grupo TFM does not purchase the Mexican government's interest, the Mexican government may require that we and KCS, either jointly or individually, purchase the Mexican government's interest at this price. The price of the Mexican government's interest, as indexed for Mexican inflation, was approximately 1,570.3 million UDIs (representing ps. 5,357 million pesos, or approximately $464.6 million, as of June 30, 2004). The estimated fair market value of the Mexican government's interest as of June 30, 2004, was $476.6 million. As a result of legal proceedings initiated by the Company in Mexico, the exercise of the put by the Mexican government has been enjoined by a court in Mexico; however, there is no assurance that the injunction will remain in place. Although our purchase of the Mexican government's interest would not result in a default under any of our obligations in connection with the Senior Secured Notes, we cannot assure you that we will have sufficient resources to acquire the Mexican government's interest if required to do so, or that we will not be prohibited by other agreements from completing the purchase. See "Business The Mexican Government Put." Our substantial indebtedness, and that of our subsidiary TFM, could adversely affect our business and, consequently, our ability to pay interest and repay our indebtedness We and TFM each have a significant amount of indebtedness, which requires significant debt service. After giving effect to our restructuring, at June 30, 2004, we had consolidated indebtedness of approximately $1,474.2 million, which includes $959.7 million of TFM's indebtedness. At such date, after giving effect to our restructuring, our shareholders' equity, including minority interest in consolidated subsidiaries, was $720.2 million, and TFM's shareholders' equity, including minority interest, was $977.6 million resulting in a debt to equity ratio of 204.7% and 98.2%, respectively. The level of our and TFM's consolidated indebtedness could have important consequences. For example, it could: limit cash flow available for capital expenditures, acquisitions, working capital and other general corporate purposes because a substantial portion of our cash flow from operations must be dedicated to servicing debt; increase our vulnerability to general adverse economic and industry conditions; expose us to risks inherent in interest rate fluctuations because some borrowings are at variable rates of interest, which could result in higher interest expenses in the event of increases in interest rates; limit our flexibility in planning for, or reacting to, competitive and other changes in our business and the industries in which we operate; place us at a competitive disadvantage compared to our competitors that have less debt and greater operating and financing flexibility than we do; and I.R.S. Employer Identification Number limit, through covenants in our indebtedness, our ability to borrow additional funds. Our and TFM's ability to pay interest and to repay or refinance indebtedness will depend upon future operating performance, including the ability to increase revenues significantly and control expenses. Future operating performance depends upon prevailing economic, financial, competitive, legislative, regulatory, business and other factors that are beyond our control. We cannot assure you that our business will generate sufficient cash flow from operations, that currently anticipated revenues and operating performance will be realized or that future borrowings will be available to us in amounts sufficient to enable us to pay our indebtedness or to fund our other liquidity needs. In addition, we may have difficulty accessing cash flows generated by our subsidiaries and joint ventures in which we participate. See "Business Our Liquidity Position" and "Risk Factors Factors relating to the Senior Secured Notes We are primarily a holding company and we depend upon funds received from our operating subsidiaries to make payments on our indebtedness." If we or TFM are unable to meet our debt service obligations or fund our other liquidity needs, we could attempt to restructure or refinance our indebtedness, seek additional equity capital or sell assets. We cannot assure you that we will be able to accomplish those actions on satisfactory terms, if at all. The indentures relating to our and TFM's debt securities contain a number of restrictive covenants and any additional financing arrangements we enter into may contain additional restrictive covenants. These covenants restrict or prohibit many actions, including our ability, or that of our subsidiaries, to: incur indebtedness; create or suffer to exist liens; make prepayments of particular indebtedness; pay dividends; make investments; engage in transactions with shareholders and affiliates; use assets as security in other transactions; create any unrestricted subsidiary; sell assets; and engage in mergers and consolidations or in sale-leaseback transactions. If we fail to comply with these restrictive covenants, our obligation to repay our debt may be accelerated. TFM has sought waivers under its credit agreements and may require additional waivers in the future TFM would not have met certain required maintenance covenants under its bank credit facilities during 2003. Accordingly, TFM sought and received waivers from the lenders under its bank credit facilities for such expected non-compliance. In October 2003 and March 2004, TFM received waivers from the banks which participate in its credit facilities of the term loan facility and U.S. commercial paper program. The waivers applied to the three months ended September 30, 2003, the three months ended December 31, 2003 and the three months ended March 31, 2004, respectively. It is possible that TFM may require additional waivers under its bank credit facilities. If TFM requires such waivers in the future, there can be no assurance that such waivers will be obtained. If such waivers are not obtained, TFM would be in default under its bank credit facilities and such default could result in acceleration of amounts due under the bank credit facilities and in cross-defaults under other obligations. TMM Holdings, S.A. de C.V. United Mexican States N/A Operadora de Apoyo Log stico, S.A. de C.V. United Mexican States N/A Compa a Arrendadora TMM, S.A. de C.V. United Mexican States N/A Transportes Mar timos M xico, S.A. United Mexican States N/A Divisi n de Negocios Especializados, S.A. de C.V. United Mexican States N/A Inmobiliaria TMM, S.A. de C.V. United Mexican States N/A Lacto Comercial Organizada, S.A. de C.V. United Mexican States N/A L nea Mexicana TMM, S.A. de C.V. United Mexican States N/A Naviera del Pacifico, S.A. de C.V. United Mexican States N/A Operadora Mar tima TMM, S.A. de C.V. United Mexican States N/A Operadora Portuaria de Tuxpan, S.A. de C.V. United Mexican States N/A Personal Mar timo, S.A. de C.V. United Mexican States N/A Servicios Administrativos de Transportaci n, S.A. de C.V. United Mexican States N/A Servicios de Log stica de M xico, S.A. de C.V. United Mexican States N/A Servicios en Operaciones Log sticas, S.A. de C.V. United Mexican States N/A Servicios en Puertos y Terminales, S.A. de C.V. United Mexican States N/A Terminal Mar tima de Tuxpan, S.A. de C.V. United Mexican States N/A TMG Overseas S.A. Republic of Panama N/A TMM Agencias, S.A. de C.V. United Mexican States N/A TMM Logistics, S.A. de C.V. United Mexican States N/A Transportaci n Portuaria Terrestre, S.A. de C.V. United Mexican States N/A The address, including zip code, of each of the principal executive offices of the Co-Registrants listed above is Avenida de la C spide, No. 4755, Colonia Parques del Pedregal, 14010 Mexico, D.F. The name and address, including zip code, area code and telephone number of the above listed Co-Registrants' agent for service of process is CT Corporation System, 111 Eighth Avenue, 13th Floor, New York, NY 10011, (212) 590-9200. The I.R.S. Employer Identification Number requirement is not applicable to the above listed Co-Registrants. Uncertainties relating to our financial condition and other factors currently raise substantial doubt about our ability to continue as a going concern The Company's audited consolidated financial statements as of December 31, 2003 and 2002 have been prepared assuming that it will continue as a going concern. The auditors' report on the Company's financial statements as of and for the three-year period ended December 31, 2003, includes an explanatory paragraph describing the existence of substantial doubt about the Company's ability to continue as a "going concern." The report indicates that (i) we had outstanding obligations amounting to $176.9 million which became due on May 15, 2003 and we did not make the payment of principal amount thereof nor the accrued interest on the due date; (ii) as a result we entered into default under the terms of the 2003 notes resulting in a cross-default under the 2006 notes with a principal amount of $200.0 million; (iii) payments of interest on the Old Senior Notes amounting to $45.7 million became due on May 15, 2003 and November 15, 2003; (iv) outstanding commercial paper and obligations for sale of receivables amounting to $85.0 million and $15.3 million will become effective September 2004, and on a monthly basis during 2004, respectively; (v) during the year ended December 31, 2003, we incurred a net loss of $86.7 million; and (vi) at December 31, 2003, we had an excess of current liabilities over current assets of $497.0 million and a deficit of $68.0 million. Following the consummation of the Exchange Offer, we are no longer in default under the Old Senior Notes, see "Management's Discussion and Analysis of Financial Condition and Results of Operations Our Current Liquidity Difficulties and Outlook" and " Contractual Obligations." We may be unable to successfully expand our business Future growth of our business will depend on a number of factors, including: identification and continued evaluation of niche markets; identification of joint venture opportunities or acquisition candidates; our ability to enter into acquisitions or joint ventures on favorable terms; our ability to hire and train qualified personnel; the successful integration of any acquired businesses with our existing operations; and our ability to effectively manage expansion and to obtain required financing. In order to maintain and improve operating results from new businesses, as well as our existing business, we will be required to manage our growth and expansion effectively. However, the management of new businesses involves numerous risks, including difficulties in assimilating the operations and services of the new businesses, the diversion of management's attention from other business concerns and the disadvantage of entering markets in which we may have no or limited direct or prior experience. Our failure to effectively manage our expansion could have a material adverse effect on our operational results. The Company is controlled by the Serrano Segovia family Members of the Serrano Segovia family control the Company through their direct and indirect ownership of our Series A Shares. Since the Series A Shares underlying our CPOs are required to be voted by the CPO Trustee in the same manner as the majority of the Series A Shares not so owned vote on any matter submitted to our stockholders, the Serrano Segovia family effectively controls all matters as to which a shareholder vote is required. As a result, the Serrano Segovia family will be able to direct and control the policies of the Company and its subsidiaries, including mergers, sales of assets and similar transactions. See "Major Shareholders and Related Party Transactions Major Shareholders." The indenture for the Senior Secured Notes contains covenants that prohibit transactions between the Company and its subsidiaries, affiliates and associates, such as the Serrano The information in this prospectus is not complete and may be changed. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell these securities and is not soliciting an offer to buy these securities in any state or jurisdiction where the offer or sale is not permitted. SUBJECT TO COMPLETION, DATED SEPTEMBER 10, 2004 PRELIMINARY PROSPECTUS $392,646,832 Grupo TMM, S.A. Senior Secured Notes Due 2007 This prospectus covers the resale by certain selling noteholders named in this prospectus of up to $392,646,832 of our Senior Secured Notes due 2007 plus such additional amounts of Senior Secured Notes that may be issued from time to time in connection with payments in kind of interest on the Senior Secured Notes. We refer to all of our Senior Secured Notes due 2007 from time to time outstanding as the "Senior Secured Notes" and we refer to the Senior Secured Notes that may be sold pursuant to this prospectus as the "Notes." All of the Senior Secured Notes being registered may be offered and sold from time to time by the selling noteholders. You should read this prospectus carefully before you invest. The Notes were initially issued (i) to certain holders of our 91/2% Notes due 2003, which we refer to as our 2003 notes, and our 101/4% Senior Notes due 2006, which we refer to as our 2006 notes (we refer to the 2003 notes and the 2006 notes collectively as the "Old Senior Notes"), in a private exchange offer that closed simultaneously with a public exchange offer (we refer to both exchange offers collectively as the "Exchange Offer") of Senior Secured Notes for Old Senior Notes and (ii) in a private placement to certain holders of the Old Senior Notes who agreed to purchase additional Notes to fund our debt restructuring and to certain other creditors of the Company as consideration for cancellation of outstanding obligations of the Company. The Notes are being registered pursuant to registration rights granted in connection with the initial issuance and sale of the Notes. The Senior Secured Notes are guaranteed by each of our wholly-owned subsidiaries that is listed on Schedule A hereto. We may redeem the Senior Secured Notes at any time, in whole or in part, at the applicable redemption price described herein. Investing in the Senior Secured Notes involves risks. See "Risk Factors" beginning on page 11 of this prospectus. The persons listed as the selling noteholders in this prospectus are offering up to $392,646,832 aggregate principal amount of the Notes plus such additional amounts of Senior Secured Notes that may be issued from time to time in connection with payments in kind of interest on the Senior Secured Notes. The selling noteholders may offer their Notes through public or private transactions, in the Private Offering Resales and Trading through Automated Linkages or "PORTAL" market and at prevailing market prices or at privately negotiated prices. The Notes may be sold directly or through agents or broker-dealers acting as principal or agent. The selling noteholders may engage underwriters, brokers, dealers or agents, who may receive commissions or discounts from the selling noteholders. We will not receive any proceeds from the sale of the Notes by the selling noteholders. We will pay all of the expenses incident to the registration of the Notes, except for the selling commissions, if any. See "Plan of Distribution." Neither the Securities and Exchange Commission nor any state or foreign securities commission has approved or disapproved of these securities or passed upon the adequacy or accuracy of this prospectus. Any representation to the contrary is a criminal offense. Segovia family. See "Description of the Senior Secured Notes Certain Covenants Limitation on Transactions with Affiliates." A substantial portion of the Series A Shares and ADSs of the Company held by the Serrano Segovia family is currently pledged to secure indebtedness of the Serrano Segovia family and entities controlled by them and may from time to time in the future be pledged to secure obligations of other of their affiliates. A foreclosure upon any such Series A Shares held by the Serrano Segovia family could constitute a change of control under the Indenture governing the Senior Secured Notes and certain other debt instruments of the Company and its subsidiaries. Such occurrence of a change of control would enable holders of the Senior Secured Notes to require the Company to repurchase their Senior Secured Notes. There can be no assurance that upon a change of control the assets of the Company would be sufficient to repurchase the Senior Secured Notes. See "Risk Factors Factors relating to the Senior Secured Notes We may not be able to finance a change of control offer." If we sell our interest in Grupo TFM, we may be classified as an investment company If we sell our interest in Grupo TFM, we may receive as consideration securities of another issuer. Consequently, since a significant portion of the Company's assets may then consist of the shares of an unrelated entity, we risk becoming an inadvertent "investment company" under the U.S. Investment Company Act of 1940 (the "Investment Company Act"). Generally, an issuer is deemed to be an investment company subject to registration if its holdings of "investment securities," which usually are securities other than securities issued by majority owned subsidiaries and government securities, exceed 40% of the value of its total assets, exclusive of government securities and cash items, on an unconsolidated basis. Registered investment companies are subject to extensive, restrictive and potentially adverse regulation relating to, among other things, operating methods, management, capital structure, dividends and transactions with affiliates. Registered investment companies are not permitted to operate their business in the manner in which we operate our business. Securities we could receive through the sale of our interest in Grupo TFM would be considered investment securities. However, a company that otherwise would be deemed to be an investment company may be excluded from such status for a one-year period provided that such company has a bona fide intent to be engaged as soon as reasonably possible, and in any event within that one-year period, primarily in a business other than that of investing, reinvesting, owning, holding or trading in securities. If we would otherwise be deemed to be an investment company under the Investment Company Act, we intend to rely on this exemption while we attempt to redeploy assets, effectuate a combination with another operating business or take other steps to avoid classification as an investment company. If we have not taken such steps within the one-year period referred to above, we may be required to (1) apply to the SEC for exemptive relief from the requirements of the Investment Company Act, or (2) invest certain of our assets in government securities and cash equivalents that are not considered "investment securities" under the Investment Company Act. There can be no assurance that we will be able to obtain exemptive relief from the SEC. Investing our assets in government securities and cash equivalents could yield a significantly lower rate of return than other investments we could make if we chose to register as an investment company (although there is no assurance we could successfully register as an investment company even if we chose to do so). If we are deemed an unregistered investment company, there would be a risk, among other material adverse consequences, that we could become subject to monetary penalties or injunctive relief, or both, in an action brought by the SEC, that we would be unable to enforce contracts with third parties or that third parties could seek to obtain rescission of transactions with us undertaken during the period in which it was established that we were an unregistered investment company. In addition, if we are unable to take steps to avoid becoming an investment company or to obtain exemptive relief from the SEC, we may be in default under the indenture governing the Senior Secured Notes. See "Description of the Senior Secured Notes Certain Covenants Restriction on Investment Activity." [ ], 2004. We may be, or may become, subject to Passive Foreign Investment Company rules If we are, or were in the future to become, a "passive foreign investment company" ("PFIC") for United States federal income tax purposes, United States holders of our ADSs or our shares generally will be subject to special United States tax rules that would differ in certain respects from the tax treatment described herein. We do not believe that we are currently a PFIC for United States federal income tax purposes. However, PFIC status is determined annually based on the composition of an entity's assets and income from time to time. As a result, our PFIC status may change. In general, if 50% or more of our assets are "passive assets," or 75% or more of our income is "passive income," we would be deemed a PFIC. Passive assets generally include any interest in another corporation in which we own less than a 25% interest (by value). Thus, a reduction in our ownership interest in Grupo TFM, either as a result of our sale of our shares or through dilution due to the sale of shares in Grupo TFM or any of our subsidiaries through which we own shares, could result in our interest in Grupo TFM being considered a passive asset. If this were to occur, we could become a PFIC. In general, if we are classified as a PFIC, United States holders of our ADSs or shares will be subject to a special tax at ordinary income tax rates on "excess distributions," including certain distributions by us with respect to ADSs or shares as well as gain that such holders recognize on the sale of ADSs or shares. The amount of income tax on any excess distributions will be increased by an interest charge to compensate for tax deferral, calculated as if the excess distributions were earned ratably over the period a holder held the ADSs or shares. With respect to ADSs and shares, a United States holder can avoid the unfavorable rules described in the preceding paragraph by electing to mark its ADSs and shares to market. If a United States holder makes this mark-to-market election, such holder will be required in any year in which we are a PFIC to include as ordinary income the excess of the fair market value of its ADSs and shares at year-end over its basis in those ADSs and shares. In addition, any gain a United States holder recognizes upon the sale of its ADSs and shares will be taxed as ordinary income in the year of sale. Alternatively, if we provide the necessary information, a United States holder may elect to treat its ADSs and shares as an interest in a "qualified electing fund" ("QEF Election"). Such a QEF Election is available only if we comply with applicable information reporting requirements, and we have not yet determined whether we can or will do so. If a United States holder makes a "QEF Election," such holder will be required to include in income its proportionate share of our income and net capital gain in years in which we were a PFIC, but any gain that such holder subsequently recognizes upon the sale of its ADSs and shares generally will be taxed as capital gain. TFM's business is very capital intensive TFM's business is capital intensive and requires substantial ongoing expenditures for, among other things, improvements to roadway, structures and technology, acquisitions, leases and repair of equipment, and maintenance of its rail system. TFM's failure to make necessary capital expenditures could impair its ability to accommodate increases in traffic volumes or service its existing customers. In addition, TFM's railroad concession from the Mexican government requires TFM to make investments and undertake capital projects, including capital projects described in a business plan filed every five years with the Mexican government. TFM may defer capital expenditures with respect to its five-year business plan with the permission of the Secretar a de Comunicaciones y Transportes (Ministry of Communications and Transports or "Ministry of Transportation"). However, the Ministry of Transportation may not grant this permission, and TFM's failure to comply with the commitments in its business plan could result in the Mexican government revoking the concession. TFM's concession is subject to revocation or termination in certain circumstances The Mexican government may terminate the concession granted to TFM as a result of TFM's surrender of its rights under the concession, or for reasons of public interest, by revocation or upon TFM's liquidation or bankruptcy. (The Mexican government would not, however, be entitled to revoke the concession upon the occurrence of a liquidation or bankruptcy of Grupo TMM or Grupo TFM.) The Mexican government may also temporarily seize TFM's assets and its rights under the concession. The Ley Reglamentaria del Servicio Ferroviario (Law Regulating Railroad Services or "Mexican railroad services law and regulations") provides that the Ministry of Transportation may revoke the concession upon the occurrence of specified events, some of which will trigger automatic revocation. Revocation or termination of the concession would prevent TFM from operating its railroad and would materially adversely affect TFM's operations and its ability to make payments on its debt. In the event that the concession is revoked by the Ministry of Transportation, TFM will receive no compensation, and its interest in its rail lines and all other fixtures covered by the concession, as well as all improvements made by it, will revert to the Mexican government. See "Business Railroad Operations The Concession." Our interest in TFM is held with our partner, KCS, and we may not be able to control significant operating decisions We and KCS are the principal shareholders of Grupo TFM. Although we hold a majority voting interest in Grupo TFM, decisions on certain matters that may be material to TFM's operations and business require the approval of both shareholders or of their representatives on Grupo TFM's board of directors. Differences of views between us and KCS have in the past resulted, and may in the future result, in delayed decisions or the failure to reach an agreement, which could adversely affect TFM's operations and business. See "Legal Proceedings Dispute with Kansas City Southern." TFM's results from operations are heavily dependent on fuel expenses Approximately 98% of the locomotives TFM operates are diesel-powered, and TFM's fuel expenses are significant. TFM currently meets, and expects to continue to meet, its fuel requirements almost exclusively through purchases at market prices from Petr leos Mexicanos, the national oil company of Mexico ("PEMEX"), a government-owned entity exclusively responsible for the distribution and sale of diesel fuel in Mexico. TFM is party to a fuel supply contract with PEMEX of indefinite duration. Either party may terminate the contract upon 30 days' written notice to the other at any time. If the fuel contract is terminated and TFM is unable to acquire diesel fuel from alternate sources on acceptable terms, TFM's operations could be materially adversely affected. Crude oil prices in August 2004 have been at or near record levels and continued instability in the Middle East and Venezuela may result in continued high fuel prices or further increases in fuel prices. Since TFM's fuel expense represents a significant portion of its operating expenses, high diesel fuel prices have a material adverse effect on TFM's results of operations. TFM may be unable to generate sufficient cash to service or refinance its debt TFM's ability to satisfy its obligations under its debt in the future will depend upon TFM's future performance, including its ability to increase revenues significantly and control expenses. TFM's future operating performance depends upon prevailing economic, financial, business and competitive conditions and other factors, many of which are beyond its control. If TFM's cash flow from operations is insufficient to satisfy its obligations, TFM may take specific actions, including delaying or reducing capital expenditures, attempting to refinance its debt at or prior to its maturity or, in the absence of such refinancing, attempting to sell assets quickly in order to make up for any shortfall in payments under circumstances that might not be favorable to getting the best price for the assets, or seeking additional equity capital. TFM's ability to refinance its debt and take other actions will depend on, among other things, its financial condition at the time, the restrictions in the instruments governing its debt and other factors, including market conditions, beyond TFM's control. TFM may be unable to take any of these actions on satisfactory terms or in a timely manner. TFM route $ 1,473,326 $ 1,473,326 Cruise ship terminal on Cozumel Island 7,148 20 API Acapulco 6,783 6,783 20 Tugboats in the port of Manzanillo 2,170 2,170 10 Manzanillo port 2,589 20 Progreso port 4,577 TFM Lines 1,473,326 1,473,326 International cruise ship terminal on Cozumel Island 7,148 20 Integral Acapulco Port Administration 6,783 6,783 20 Tugboats in the Port of Manzanillo 2,170 2,170 10 Manzanillo Port 2,589 20 Progreso Port 4,577 Further, any of these actions may not be sufficient to allow TFM to meet its debt obligations. TFM's indentures and commercial paper credit agreement limit its ability to take certain of these actions. TFM's failure to successfully undertake any of these actions or to earn enough revenues to pay its debts, or significant increases in the peso cost to service its dollar-denominated debt, could materially and adversely affect TFM's business or operations. Certain regulatory and market factors could adversely affect our ability to expand our rail transportation operations The trucking industry is TFM's primary competition. In February 2001, a North American Free Trade Agreement ("NAFTA") tribunal ruled in an arbitration between the United States and Mexico that the United States must allow Mexican trucks to cross the border and operate on U.S. highways. NAFTA called for Mexican trucks to have unrestricted access to highways in U.S. border states by 1995 and full access to all U.S. highways by January 2000. However, the United States has not followed the timetable because of concerns over Mexico's trucking safety standards. On March 14, 2002, as part of its agreement under NAFTA, the U.S. Department of Transportation issued safety rules that allow Mexican truckers to apply for operating authority to transport goods beyond the 20-mile commercial zones along the U.S.-Mexico border. These safety rules require Mexican carriers seeking to operate in the United States to pass, among other things, safety inspections, obtain valid insurance with a U.S. registered insurance company, conduct alcohol and drug testing for drivers and to obtain a U.S. Department of Transportation identification number. Mexican commercial vehicles with authority to operate beyond the commercial zones will be permitted to enter the United States only at commercial border crossings and only when a certified motor carrier safety inspector is on duty. Given these recent developments, we cannot assure you that truck transport between Mexico and the United States will not increase substantially in the future. Such an increase could affect TFM's ability to continue converting traffic to rail from truck transport because it may result in an expansion of the availability, or an improvement of the quality, of the trucking services offered in Mexico. In recent years, there has been significant consolidation among major North American rail carriers. The resulting merged railroads could attempt to use their size and pricing power to block other railroads' access to efficient gateways and routing options that are currently and have been historically available. We cannot assure you that further consolidation will not have an adverse effect on us. Approximately 50% of TFM's expected revenue growth during the next few years is expected to result from increased truck-to-rail conversion. If the railroad industry in general, and TFM in particular, are unable to preserve their competitive advantages vis- -vis the trucking industry, TFM's business plan may not be achieved and its projected revenue growth could be adversely affected. Additionally, TFM's revenue growth could be affected by, among other factors, its inability to grow its existing customer base, negative macroeconomic developments impacting the United States and Mexican economies, and failure to capture additional cargo transport market share from the shipping industry and other railroads. Significant competition could adversely affect our future financial performance Certain of our business segments face significant competition, which could have an adverse effect on our results of operations. TFM faces significant competition from trucks and other rail carriers as well as limited competition from the shipping industry in its freight operations. Our parcel tanker and supply ship services operating in the Gulf of Mexico have faced significant competition, mainly from U.S. shipping companies. Although we expect that a Mexican law, enacted in January 1994, and amended in May 2000, which restricts cabotage of ships (movement of ships within Mexico and Mexican waters) at Mexican ports to Mexican-owned vessels carrying the Mexican flag, will reduce competition from non-Mexican companies in this sector, there can be no assurance that such competition will be reduced. In our land operations division, our trucking transport and automotive EXCHANGE RATES We maintain our financial records in dollars. However, we keep our tax records in pesos. We record in our financial records the dollar equivalent of the actual peso charges for taxes at the time incurred using the prevailing exchange rate. In 2003, approximately 57% of our net consolidated revenues and 54% of our operating expenses from continuing operations were generated or incurred in dollars. Most of the remainder of our net consolidated revenues and operating expenses from continuing operations were denominated in pesos. The following tables set forth, for the periods and dates indicated, information regarding the noon buying rate for cable transfers payable in pesos as certified by the Federal Reserve Bank of New York for customs purposes, expressed in pesos per dollar. On December 31, 2003, the noon buying rate was 11.23 pesos per dollar. On August 13, 2004, the noon buying rate was 11.42 pesos per dollar. Noon Buying Rate(a) Year ended December 31, logistics services have faced intense competition, including price competition, from a large number of Mexican, U.S. and international trucking lines. We cannot assure you that we will not lose business in the future due to our inability to respond to competitive pressures by decreasing our prices without adversely affecting our gross margins and operational results. TFM faces significant competition from the trucking industry, as well as from some industry segments from other railroads, in particular Ferrocarril Mexicano, S.A. de C.V. ("Ferromex"), which operates the Pacific-North Rail Lines. In particular, TFM has experienced, and continues to experience, competition from Ferromex with respect to the transport of grain, minerals and steel products. The rail lines operated by Ferromex run from Guadalajara and Mexico City to four U.S. border crossings west of Laredo, Texas, providing a potential alternative to TFM's routes for the transport of freight from those cities to the U.S. border. Ferromex directly competes with TFM in some areas of its service territory, including Tampico, Saltillo, Monterrey and Mexico City. Ferrocarril del Sureste, S.A. de C.V. ("Ferrosur"), which operates the Southeast Rail Lines, also competes directly with TFM for traffic to and from southeastern Mexico. Ferrosur, like TFM, serves Mexico City, Puebla and Veracruz. Ferromex and Ferrosur are privately owned companies that may have greater financial resources than TFM. Among other things, this advantage may give them greater ability to reduce freight prices. Price reductions by competitors would make TFM's freight services less competitive and we cannot assure you that TFM would be able to match these rate reductions. Under TFM's concession, TFM must grant to Ferromex the right to operate over a north-south portion of its rail lines between Ramos Arizpe near Monterrey and the city of Quer taro that constitutes over 600 kilometers of TFM's main track. Using these trackage rights, Ferromex may be able to compete with TFM over its rail lines for traffic between Mexico City and the United States. TFM's concession also requires it to grant rights to use certain portions of its tracks to Ferrosur and the "belt railroad" operated in the greater Mexico City area by the Ferrocarril y Terminal del Valle de M xico, S.A. de C.V. (the Mexico City Railroad and Terminal), thereby providing Ferrosur with more efficient access to certain Mexico City industries. As a result of having to grant trackage rights to other railroads, TFM incurs additional maintenance costs and also loses the flexibility of using its tracks at all times. In February 2002, Ferromex and Ferrosur announced that they agreed to the acquisition of Ferrosur by Ferromex. TFM filed a notice with the Mexican Antitrust Commission objecting to the proposed acquisition on the grounds that it would limit competition. The acquisition was reviewed by the Mexican Antitrust Commission and on May 16, 2002, the Mexican Antitrust Commission announced that it had notified Ferromex that authorization to consummate the acquisition was denied on antitrust grounds. Ferromex subsequently filed an appeal for review of the order, and on September 18, 2002, the Mexican Antitrust Commission confirmed its prior ruling denying authorization to consummation of the acquisition. Ferromex requested that the Federal Courts in Mexico review the decision of the Mexican Antitrust Commission. TFM also requested a Federal Court in Mexico to review its complaint against the acquisition, requesting to be recognized as a party to the proceedings of the Mexican Antitrust Commission, and obtained a favorable ruling (amparo). Ferromex and Ferrosur subsequently withdrew their petition before the Mexican Antitrust Commission, which terminated the acquisition request in October 2003. The rates for trackage rights set by the Ministry of Transportation may not adequately compensate TFM Pursuant to TFM's concession, TFM is required to grant rights to use portions of its tracks to Ferromex, Ferrosur and the Mexico City Railroad and Terminal. Applicable law stipulates that Ferromex, Ferrosur and the Mexico City Railroad and Terminal are required to grant to TFM rights to use portions of their tracks. Applicable law provides that the Ministry of Transportation is entitled to set the rates in the event that TFM and the party to whom it is granting the rights cannot agree on a rate. TFM and Ferromex have not been able to agree upon the rates each of them is required to pay High the other for interline services and haulage and trackage rights. Therefore, in accordance with its rights under the Mexican railroad services law and regulations, TFM initiated an administrative proceeding in February 2001, requesting a determination of such rates by the Ministry of Transportation, which subsequently issued a ruling establishing rates using the criteria set forth in the Mexican railroad services law and regulations. TFM and Ferromex appealed the rulings before the Mexican Federal Courts due to, among other things, a disagreement with the methodology employed by the Ministry of Transportation in calculating the trackage rights and interline rates. TFM and Ferromex also requested and obtained a suspension of the effectiveness of the ruling pending resolution of this appeal. We cannot predict whether TFM will ultimately prevail in this proceeding and whether the rates TFM is ultimately allowed to charge will be adequate to compensate it. See "Business Railroad Operations" for more information. If our time charter arrangements are terminated or expire, our business could be adversely affected We currently time charter three product tankers to PEMEX. In the event that our time charter arrangements with PEMEX are terminated or expire, we will be required to seek new time charter arrangements for these vessels. We cannot be sure that time charters will be available for the vessels following termination or expiration or that time charter rates in effect at the time of such termination or expiration will be comparable to those in effect under the existing time charters or in the present market. In the event that time charters are not available on terms acceptable to us, we may employ those tankers in the spot market. Because charter rates in the spot market are subject to greater fluctuation than time charter rates, any failure to maintain existing, or enter into comparable, charter arrangements could adversely affect our operating results. Terrorist activities and geopolitical events and their consequences could adversely affect our operations As a result of the terrorist attacks in the United States on September 11, 2001 and the March 11, 2004, terrorist attacks in Spain, and the continuation of armed hostilities involving, among others, the United States and Iraq, there has been increased short-term market volatility, and there may be long-term effects on U.S. and world economies and markets. Terrorist attacks may negatively affect our operations. The continued threat of terrorism within the United States and abroad and the potential for military action and heightened security measures in response to such threats may cause significant disruption to commerce throughout the world, including restrictions on cross-border transport and trade. In addition, related political events may cause a lengthy period of uncertainty that may adversely affect our business. Political and economic instability in other regions of the world, including the United States and Canada, may also result and could negatively impact our operations. The consequences of terrorism and the responses thereto are unpredictable and could have an adverse effect on our operations. Downturns in the U.S. economy or in trade between the United States and Mexico and fluctuations in the peso dollar exchange rate would likely have adverse effects on our business and results of operations The level and timing of our business activity are heavily dependent upon the level of U.S.-Mexican trade and the effects of NAFTA on such trade. Downturns in the U.S. or Mexican economy or in trade between the United States and Mexico would likely have adverse effects on our business and results of operations. Our business of logistics and transportation of products traded between Mexico and the United States depends on the U.S. and Mexican markets for these products, the relative position of Mexico and the United States in these markets at any given time and tariffs or other barriers to trade. Our revenues as well as TFM's were affected by the downturn in the U.S. economy in 2003. However, we believe the U.S. economy started to reflect a recovery in the third quarter of 2003, and in general, continued improving in the first half of 2004. Any future downturn in the U.S. economy could have a Low material adverse effect on our results of operations and our ability to meet our debt service obligations as described above. Also, fluctuations in the peso dollar exchange rate could lead to shifts in the types and volumes of Mexican imports and exports. Although a decrease in the level of exports of some of the commodities that we transport to the United States may be offset by a subsequent increase in imports of other commodities we haul into Mexico and vice versa, any offsetting increase might not occur on a timely basis, if at all. Future developments in U.S.-Mexican trade beyond our control may result in a reduction of freight volumes or in an unfavorable shift in the mix of products and commodities we carry. Downturns in certain cyclical industries in which our customers operate could have adverse effects on our results of operations The shipping, transportation and logistics industries are highly cyclical, generally tracking the cycles of the world economy. Although transportation markets are affected by general economic conditions, there are numerous specific factors within each particular market segment that may influence operating results. Some of our customers do business in industries that are highly cyclical, including the oil and gas, automotive and agricultural sectors. Any downturn in these sectors could have a material adverse effect on our operating results. For example, during the first half of 2004, our results were negatively impacted by continued sluggish conditions in the automotive sector. Also, some of the products we transport have had a historical pattern of price cyclicality which has typically been influenced by the general economic environment and by industry capacity and demand. For example, global steel and petrochemical prices have decreased in the past. We cannot assure you that prices and demand for these products will not decline in the future, adversely affecting those industries and, in turn, our financial results. We are exposed to the risk of loss and liability Our business is affected by a number of risks, including mechanical failure of vessels and equipment, collisions, property loss of vessels and equipment, cargo loss or damage, as well as business interruption due to political circumstances in foreign countries, hostilities and labor strikes. In addition, the operation of any ocean-going vessel is subject to the inherent possibility of catastrophic marine disaster, including oil spills and other environmental accidents, and the liabilities arising from owning and operating vessels in international trade. We maintain insurance to cover the risk of partial or total loss of or damage to all of our assets, including, but not limited to, railtrack, rail cars, port facilities, port equipment, trucks, land facilities and offices. In particular, we maintain marine hull and machinery and war risk insurance on our vessels, which covers the risk of actual or constructive total loss. Additionally, we have protection and indemnity insurance for damage caused by our operations to third persons. We do not carry insurance covering the loss of revenue resulting from a downturn in our operations or resulting from off-hire time on certain vessels. We cannot assure you that our insurance would be sufficient to cover the cost of damages suffered by us or damages to others, that any particular claim will be paid or that such insurance will continue to be available at commercially reasonable rates in the future. We face potential environmental liability Our operations are subject to Mexican federal and state laws and regulations relating to the protection of the environment. The primary environmental law in Mexico is the General Law of Ecological Balance and Environmental Protection (the "Ecological Law"). The Mexican federal agency in charge of overseeing compliance with and enforcement of the federal environmental law is the Ministry of Environmental Protection and Natural Resources (Secretar a del Medio Ambiente y Recursos Naturales, or "Semarnat"). As part of its enforcement powers, Semarnat is empowered to bring Year-end Average(b) administrative and criminal proceedings and impose economic sanctions against companies that violate environmental laws, and temporarily or even permanently close non-complying facilities. Under the Ecological Law, the Mexican government has implemented a program to protect the environment by promulgating rules concerning water, land, air and noise pollution, and hazardous substances. We are also subject to the laws of various jurisdictions and international conferences with respect to the discharge of materials into the environment. While we maintain insurance against certain of these environmental risks in an amount which we believe is consistent with industry norms, we cannot assure you that our insurance would be sufficient to cover damages suffered by us. We cannot predict the effect, if any, that the adoption of additional or more stringent environmental laws and regulations would have on our results of operations, cash flows or financial condition. Under the United States Oil Pollution Act of 1990, or "OPA 90," owners and operators of ships could be exposed to substantial liability, and in some cases, unlimited liability for removal costs and damages resulting from the discharge of oil, petroleum or related substances into United States waters by their vessels. In some jurisdictions, including the United States, claims for removal costs and damages would enable claimants to immediately seize the ships of the owning and operating company and sell them in satisfaction of a final judgment. The existence of statutes enacted by individual states of the United States on the same subject, but requiring different measures of compliance and liability, creates the potential for similar claims being brought under state law. In addition, several international conventions that impose liability for the discharge of pollutants have been adopted by other countries. We time-charter product tankers to PEMEX, which PEMEX uses to transport refined petroleum products domestically. Pursuant to these time-charters, PEMEX has the right to transport crude oil and operate internationally. We also operate parcel tankers in the international market. See "Business Specialized Maritime Services." If a spill were to occur in the course of operation of one of our vessels carrying petroleum products, and such spill affected the United States or another country that had enacted legislation similar to OPA 90, we could be exposed to substantial or unlimited liability. Additionally, our vessels carry bunkers (ship fuel) and certain goods that could, if spilled, under certain conditions, cause pollution and result in substantial claims against us, including claims under OPA 90 and other United States federal, state and local laws. Our railroad operations are subject to the provisions of the Ecological Law. The regulations issued under the Ecological Law and technical environmental requirements issued by the Semarnat have promulgated standards for, among other things, water discharge, water supply, emissions, noise pollution, hazardous substances and transportation and handling of hazardous and solid waste. In addition, TFM's ownership of Mexrail may also create certain environmental liabilities with respect to U.S. environmental laws. The U.S. Comprehensive Environmental Response, Compensation and Liability Act ("CERCLA" or "Superfund") and similar state laws (known as Superfund laws) impose liability for the cost of remedial or removal actions, natural resources damages and related costs at certain sites identified as posing a threat to the environment or public health. CERCLA imposes strict liability on the owners and operators of facilities in which hazardous waste and other hazardous substances are deposited or from which they are released or are likely to be released into the environment. Liability may be imposed, without regard to fault or the legality of the activity, on certain classes of persons, including the current and certain prior owners or operators of a site and persons that arranged for the disposal or treatment of hazardous substances. Liability is imposed on a joint and several basis. In addition, other potentially responsible parties, adjacent landowners or other third parties may initiate cost recovery actions or toxic tort litigation against sites subject to CERCLA or similar state laws. Potential labor disruptions could adversely affect our financial condition and our ability to meet our obligations under our debt Approximately 67.7% of our employees are covered by a labor agreement. The compensation terms of the labor agreement are subject to renegotiation on an annual basis and all other terms are renegotiated every two years. We may not be able to negotiate these provisions favorably, and strikes, boycotts or other disruptions could occur. These potential disruptions could have a material adverse effect on our financial condition and results of operations and on our ability to meet our payment obligations under our debt agreements. Our customers may take actions that may reduce our revenues If our customers believe that we may not be able to continue as a going concern or if they believe that our weakened financial condition will result in a lower quality of service, they may discontinue use of our services. Additionally, some customers may demand lower prices. While we have contracts with some of our customers that prevent them from terminating the services we provide them or which impose penalties on customers who terminate their services with us, it may be impractical or uneconomical to enforce these agreements in Mexican courts. If any of these events occur, our revenues will be reduced. Factors Relating to Mexico Mexico is an emerging market economy, with attendant risks to our results of operations and financial condition The Mexican government has exercised, and continues to exercise, significant influence over the Mexican economy. Accordingly, Mexican governmental actions concerning the economy and state-owned enterprises could have a significant impact on Mexican private sector entities in general and on us in particular, as well as on market conditions, prices and returns on Mexican securities, including our securities. The national elections held on July 2, 2000, ended 71 years of rule by the Institutional Revolutionary Party ("PRI") with the election of President Vicente Fox Quesada, a member of the National Action Party ("PAN"), and resulted in the increased representation of opposition parties in the Mexican Congress and in mayoral and gubernatorial positions. Although there have not yet been any material adverse repercussions resulting from this political change, multiparty rule is still relatively new in Mexico and could result in economic or political conditions that could materially and adversely affect our operations. We cannot predict the impact that this new political landscape will have on the Mexican economy. Furthermore, our financial condition, results of operations and prospects and, consequently, the market price for our securities, may be affected by currency fluctuations, inflation, interest rates, regulation, taxation, social instability and other political, social and economic developments in or affecting Mexico. The Mexican economy in the past has suffered balance of payment deficits and shortages in foreign exchange reserves. There are currently no exchange controls in Mexico. However, Mexico has imposed foreign exchange controls in the past. Pursuant to the provisions of NAFTA, if Mexico experiences serious balance of payment difficulties or the threat thereof in the future, Mexico would have the right to impose foreign exchange controls on investments made in Mexico, including those made by U.S. and Canadian investors. Any restrictive exchange control policy could adversely affect our ability to obtain dollars or to convert pesos into dollars for purposes of making interest and principal payments to holders of Senior Secured Notes, to the extent that we may have to effect those conversions. This could have a material adverse effect on our business and financial condition. Securities of companies in emerging market countries tend to be influenced by economic and market conditions in other emerging market countries. Emerging market countries, including Argentina and Brazil, have recently been experiencing significant economic downturns and market volatility. These Land $ 132,878 $ 132,878 50 Buildings 33,113 33,113 27-30 Bridges 75,350 75,350 41 Tunnels 94,043 94,043 40 Rail 317,268 317,268 29 Concrete and wood ties 137,351 137,351 27 Yards 106,174 106,174 35 Ballast 107,189 107,189 27 Grading 391,808 391,808 50 Culverts 14,942 14,942 21 Signals 1,418 1,418 Land $ 132,878 $ 132,878 50 Buildings 33,113 33,113 27 30 Bridges 75,350 75,350 41 Tunnels 94,043 94,043 40 Rail 317,268 317,268 29 Concrete and wood ties 137,351 137,351 27 Yards 106,174 106,174 35 Ballast 107,189 107,189 27 Grading 391,808 391,808 50 Culverts 14,942 14,942 21 Signals 1,418 1,418 Land $ 132,878 $ 132,878 50 Buildings 33,113 33,113 27-30 Bridges 75,350 75,350 41 Tunnels 94,043 94,043 40 Rail 317,268 317,268 29 Concrete and wood ties 137,351 137,351 27 Yards 106,174 106,174 35 Ballast 107,189 107,189 27 Grading 391,808 391,808 50 Culverts 14,942 14,942 21 Signals 1,418 1,418 (a)Source: Federal Reserve Bank of New York. (b)Average of month-end rates. Noon Buying Rate(a) Month end events have had an adverse effect on the economic conditions and securities markets of emerging market countries, including Mexico. Any devaluation of the peso would cause the peso cost of our dollar-denominated debt to increase, adversely affecting our ability to make payments on our indebtedness After a five-year period of controlled devaluation of the peso, on December 19, 1994, the value of the peso dropped sharply as a result of pressure against the currency. Although the peso had been appreciating relative to the dollar over the past few years, the peso depreciated 13.8% in 2002, 7.5% in 2003 and 1.6% in the six months ended June 30, 2004, against the dollar. Any additional devaluation in the peso would cause the peso cost of our dollar-denominated debt to increase. In addition, currency instability may affect the balance of trade between the United States and Mexico. Mexico may experience high levels of inflation in the future which could adversely affect our results of operations Mexico has a history of high levels of inflation, and may experience inflation in the future. During most of the 1980s and during the mid- and late-1990s, Mexico experienced periods of high levels of inflation. The annual rates of inflation for the last five years, as measured by changes in the National Consumer Price Index, as provided by Banco de M xico, were: 1999 12.32 % 2000 8.96 % 2001 4.40 % 2002 5.70 % 2003 3.98 % 2004 (January through June) 1.63 % In 2003, the Mexican inflation rate hit its lowest levels in over 30 years. We cannot give any assurance that the Mexican inflation rate will continue to decrease or maintain its current level for any significant period of time. A substantial increase in the Mexican inflation rate would have the effect of increasing some of our costs, which could adversely affect our results of operations and financial condition, as well as the market value of our Senior Secured Notes. High levels of inflation may also affect the balance of trade between Mexico and the United States, and other countries, which could adversely affect our results of operations. High
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+RISK FACTORS You should carefully consider the following factors in addition to the other information presented in this prospectus. Factors relating to the Senior Secured Notes There is no active trading market for the Senior Secured Notes The Senior Secured Notes are new securities and therefore do not currently have an active trading market. If the Senior Secured Notes are traded after their initial issuance, they may trade at a discount from their nominal price, depending upon prevailing interest rates, the market for similar securities, general economic conditions and our financial condition. The Senior Secured Notes are not listed on any exchange. As a result, we cannot assure you that an active trading market will develop for the Senior Secured Notes or that the market for the Notes will provide any liquidity for holders that wish to sell their Senior Secured Notes. We may not be able to finance a change of control offer Under the terms of the indenture governing the Senior Secured Notes, we are required to offer to repurchase all of the Senior Secured Notes if a change of control (as defined under "Description of the Senior Secured Notes Offer to Purchase Upon a Change of Control") occurs. However, it is possible that we will not have sufficient funds at the time of the change of control to make the required repurchase. Other financing arrangements to which we and our subsidiaries are or may become a party may also require that we repay, or offer to repurchase, other obligations upon a change of control. In addition, other agreements to which we and our subsidiaries are or may become subject, including other financing arrangements, may contain provisions that prohibit us from making such a repurchase. Therefore, there can be no assurance that we will be permitted to consummate a repurchase if a change of control occurs without causing a default under or breach of such other financing arrangements. We are primarily a holding company and we depend upon funds received from our operating subsidiaries to make payments on our indebtedness We are primarily a holding company and conduct the majority of our operations, and hold a substantial portion of our operating assets, through numerous direct and indirect subsidiaries. As a result, we rely on income from dividends and fees related to administrative services provided to our operating subsidiaries for our operating income, including the funds necessary to service our indebtedness. As a matter of Mexican law, profits of our subsidiaries may only be distributed upon approval by the subsidiaries' shareholders, and no profits may be distributed by our subsidiaries to us until all losses incurred in prior fiscal years have been offset against any sub-account of our capital or net worth account. In addition, at least 5% of the profits of our subsidiaries must be separated to create a reserve (fondo de reserva) until such reserve is equal to 20% of the aggregate value of such subsidiary's capital stock (as calculated based on the actual nominal subscription price received by such subsidiary for all issued shares that are outstanding at the time). There is no restriction under Mexican law upon our subsidiaries remitting funds to us in the form of loans or advances in the ordinary course of business, except to the extent that such loans or advances would result in the insolvency of our subsidiaries, or for our subsidiaries to pay to us fees or other amounts for services. In addition, the indentures governing TFM's notes and TFM's First Amended and Restated Credit Agreement restrict TFM's ability to pay dividends under certain circumstances and limit the dividends payable to an accrued maximum aggregate amount or "basket" based on Grupo TFM's accumulated consolidated net income after a specified date. Furthermore, we do not own 100% of all of our subsidiaries and, to the extent that we rely on dividends or other distributions from subsidiaries that we do not wholly own, we will only be entitled to a pro rata share of the dividends or other distributions. In May 2002, TFM completed a consent solicitation of holders of its notes as a result of which the indentures were amended to, among other things, further restrict TFM's ability to pay dividends. There is currently no availability under TFM's dividend basket to pay dividends. Consequently, it is unlikely that TFM will provide us with funds necessary to service our debt obligations. In addition to operations at our subsidiaries, we are a party to a number of arrangements with other parties where we and those parties have jointly invested in our subsidiaries and we may enter into other similar arrangements in the future. Our partners in these subsidiaries may at any time have economic, business or legal interests or goals that are inconsistent with our interests or those of the entity itself. Any of these partners may also be unable to meet their economic or other obligations to the subsidiaries, and we may be required to fulfill those obligations. Furthermore, any dividends that are distributed from subsidiaries that we do not wholly own would be shared pro rata with our partners according to our relative ownership interests. Disagreements for these or any other reasons with companies with which we have a strategic alliance or relationship could impair or adversely affect our ability to conduct our business and to receive distributions from, and return on our investments in, those subsidiaries. In December 2001, a dispute arose between us and KCS, resulting from a dividend declaration by Grupo TFM and a lease transaction between TFM and Mexrail, Inc. ("Mexrail"). Although we settled the dispute, both we and KCS preserved our respective interpretations of the operative agreements governing our investment in Grupo TFM. In addition, in connection with the dispute with KCS regarding the termination of the agreement for the sale of our interest in Grupo TFM to KCS for a combination of cash and stock of KCS and an additional earnout (the "TFM Sale"), KCS has commenced numerous legal proceedings against us and our officers in Mexico seeking, among other things, to nullify actions taken at board meetings of Grupo TFM and TFM. It is possible that similar or other disputes may arise with respect to other matters relating to Grupo TFM. See "Legal Proceedings" for a more detailed description of disputes. A portion of the security for the Senior Secured Notes is subject to rights of first refusal or other restrictions on transfer Some of the shares which are owned by the guarantors which are part of the security for the obligations under the Senior Secured Notes and the guarantees are subject to rights of first refusal or other rights in favor of third parties. Our ability to sell such shares upon foreclosure could be adversely affected if bidders prove to be unwilling to make an offer to purchase such shares due to the existence of such rights in favor of third parties. The shares of our direct and indirect subsidiaries may be difficult to sell in the event the Company cannot fulfill its obligations with respect to the Senior Secured Notes, or the guarantors are called upon to satisfy their guarantees of the Senior Secured Notes There is no public market for the shares of our and our guarantors' subsidiaries, including Grupo TFM, TMM Multimodal or TMM Holdings, and the shares of these entities cannot be easily liquidated. Accordingly, the number of potential purchasers of such shares is very limited, and may include competitors of the Company. In the event that the holders of Senior Secured Notes seek to foreclose on the shares that the Company or the guarantors have pledged under the security agreements, there can be no assurance that such foreclosure would be able to generate sufficient funds to pay the Senior Secured Notes in full, or that any sale would not be delayed, possibly for a long period of time. Furthermore, certain shareholder agreements and other contracts relating to the shares of our and our guarantors' subsidiaries contain significant restrictions on the sale of those shares, including, with respect to Grupo TFM, our agreement not to sell those shares to a competitor of the Company or KCS. In addition, existing foreign investment restrictions, as well as Mexican antitrust law Transportation revenues $ 40,949 $ 127,226 $ 889,825 $ (49,384 ) $ 1,008,616 Costs and expenses 56,875 $ and the governing concession, could also significantly limit the number of potential purchasers for the shares of our and our guarantors' subsidiaries, and could thus negatively impact our ability to sell such shares. See "Business Grupo TMM's Strategic Partners." Mexican law and regulations may impair your ability to enforce in Mexico certain rights in connection with the Senior Secured Notes Under Mexican law, as our creditors, your rights are limited in the following ways: service of process by mail does not constitute effective service under Mexican law, and if a final judgment based on service of process by mail was made outside of Mexico, it would not be enforceable in Mexico; and any judgments as a result of enforcement proceedings in Mexico would be payable in pesos. You may not be able to receive your payments on the Senior Secured Notes in U.S. dollars in certain circumstances We are required to make payments of amounts owed under the Senior Secured Notes and the guarantees in U.S. dollars. However, under the Mexican Monetary Law (Ley Monetaria de los Estados Unidos Mexicanos), obligations to make payments in Mexico in foreign currency may be discharged in pesos at the rate of exchange for pesos prevailing at the time and place of payment. Although we are contractually required, and intend, to make all payments of amounts owed under the Senior Secured Notes and the guarantees in U.S. dollars, we are legally entitled to pay in pesos if payment on the Senior Secured Notes or the guarantees is sought in Mexico (through the enforcement of a non-Mexican judgment or otherwise). In the event that we make payment in pesos, you may experience a U.S. dollar shortfall when converting the pesos to U.S. dollars. The indenture for the Senior Secured Notes restricts our ability to take certain actions The indenture for the Senior Secured Notes imposes significant operating and financial restrictions. These restrictions affect, and in many respects significantly limit or prohibit, our ability and the ability of our restricted subsidiaries to, among other things: incur indebtedness; create or suffer to exist liens; make prepayments of particular indebtedness; pay dividends; make investments; engage in transactions with shareholders or affiliates; use assets as security in other transactions; create any unrestricted subsidiary; sell assets; and engage in mergers and consolidations or in sale-leaseback transactions. If we do not comply with these restrictions, a default could occur even if we could at that time pay the amounts required under the Senior Secured Notes. If there were a default, the holders of Senior Secured Notes could demand immediate payment of the Senior Secured Notes. Should that occur, we might not be able to pay or refinance the Senior Secured Notes on acceptable terms. SCHEDULE A CO-REGISTRANTS SUBSIDIARY GUARANTORS The following direct and indirect wholly-owned subsidiaries of Grupo TMM are guarantors of the Senior Secured Notes and are Co-Registrants, each of which is incorporated in the jurisdiction opposite its name set forth below and none of which has an I.R.S. Employer Identification Number. Name of Co-Registrant Factors relating to Grupo TMM Our dispute with Kansas City Southern could result in a material adverse effect on our business We are currently involved in a dispute with KCS regarding the Acquisition Agreement (the "Acquisition Agreement") executed by us and KCS on April 20, 2003, relating to the TFM Sale. Under the terms of the Acquisition Agreement, KCS was to purchase our interest in Grupo TFM in exchange for cash, shares of KCS and an additional cash earnout payment which was contingent on the timing of certain events, such as receipt of the VAT Proceeds and repurchase of the shares of TFM owned by the Mexican government. Subsequent to the execution of the Acquisition Agreement, we believe that KCS representatives undertook certain activities that threatened to jeopardize the value of the earnout. Thereafter, on August 18, 2003, our shareholders voted to reject the Acquisition Agreement and we notified KCS that we were terminating the Acquisition Agreement on August 22, 2003. KCS disputed our right to terminate the Acquisition Agreement and alleged certain breaches by us of the Acquisition Agreement. Under the terms of the Acquisition Agreement, the parties submitted these disputes to binding arbitration. An arbitration panel (the "panel") was chosen in accordance with the terms of the Acquisition Agreement. KCS obtained a preliminary injunction from the Delaware Chancery Court enjoining us from violating the terms of the Acquisition Agreement pending a subsequent decision by a panel of arbitrators regarding whether the Acquisition Agreement was properly terminated. On December 8, 2003, we and KCS participated in a preliminary hearing with the arbitrators during which the arbitrators deliberated whether the issue of the Acquisition Agreement's continued effectiveness should be bifurcated from the other issues in the case. On December 22, 2003, the panel bifurcated the issue of whether Grupo TMM properly terminated the Acquisition Agreement from the other disputed issues between the parties and scheduled a hearing on that issue. On February 2, 3 and 4, 2004, a hearing was held in New York on the issue of whether Grupo TMM's termination was proper. We maintained that we properly terminated the Acquisition Agreement while KCS sought a declaration that the Acquisition Agreement was wrongfully terminated. On February 19, 2004, we and KCS filed post-hearing briefs with the panel. On March 19, 2004, the panel issued an Interim Award in which it concluded that the rejection of the Acquisition Agreement by Grupo TMM's shareholders in its vote on August 18, 2003, did not authorize Grupo TMM's purported termination of that Agreement, dated August 22, 2003. Accordingly, the Acquisition Agreement remains in force and binding on the parties until otherwise terminated according to its terms or by law. In reaching this conclusion, the panel found it unnecessary to determine whether approval by Grupo TMM's shareholders is a "condition" of the Agreement. On April 4, 2004, the panel issued an order, which was stipulated to by KCS and Grupo TMM (the "Order and Stipulation"), providing that the parties agreed "not to request a scheduling order for a further hearing in the arbitration at this time" and that "[e]ach party reserves the right to request a scheduling order for a further hearing at any time." Since the issuance in April 2004 of the Order and Stipulation, the Company and KCS and their respective representatives have engaged in discussions regarding the potential settlement of the dispute and the possible amendment of the existing Acquisition Agreement. There is no assurance that the parties will be able to agree on the terms of any settlement or amendment or, if an agreement is reached, as to the terms of that agreement. The transaction contemplated by the existing Acquisition Agreement would constitute a "Qualifying Disposition" under the indenture governing the Senior Secured Notes that would permit the Company to complete the transaction without any further consent or approval of the holders of the Senior Secured Notes, subject to compliance with certain conditions, such as receipt of required fairness opinions and a limitation on the ability of KCS to exercise a right to pay a portion of the cash purchase price in additional shares of KCS common stock if the cash consideration would be less than 35% of the principal amount of, and accrued unpaid interest on, the Senior Secured Notes outstanding at the time the transaction is completed. The Company expects that any transaction pursuant to any amended Acquisition Agreement would also constitute a Qualifying Disposition. As a result, if an agreement is reached on that basis, the Company would be permitted State or Other Jurisdiction of Incorporation or Organization under the indenture governing the Senior Secured Notes to complete any transaction provided for under an amended agreement without any further consent or approval from the holders of the Senior Secured Notes. See "Description of the Senior Secured Notes Certain Convenants Restrictions on Asset Dispositions; Use of Proceeds of Asset Dispositions, Grupo TFM Dispositions, VAT Proceeds." We cannot predict the ultimate outcome of any further arbitration on the remaining disputed issues. If KCS were to be awarded substantial damages in any such proceeding, it could have a material adverse effect on our business. For a more complete discussion of the legal dispute with KCS, see "Legal Proceedings Dispute with Kansas City Southern." We have a contingent obligation to purchase shares of TFM owned by the Mexican government The Mexican government retained a 20% interest in TFM in connection with the privatization of TFM in 1997, and pursuant to the original agreements relating to the concession, Grupo TFM has an obligation to purchase such interest at the original peso purchase price per share paid by Grupo TFM, indexed to account for Mexican inflation. If Grupo TFM does not purchase the Mexican government's interest, the Mexican government may require that we and KCS, either jointly or individually, purchase the Mexican government's interest at this price. The price of the Mexican government's interest, as indexed for Mexican inflation, was approximately 1,570.3 million UDIs (representing ps. 5,357 million pesos, or approximately $464.6 million, as of June 30, 2004). The estimated fair market value of the Mexican government's interest as of June 30, 2004, was $476.6 million. As a result of legal proceedings initiated by the Company in Mexico, the exercise of the put by the Mexican government has been enjoined by a court in Mexico; however, there is no assurance that the injunction will remain in place. Although our purchase of the Mexican government's interest would not result in a default under any of our obligations in connection with the Senior Secured Notes, we cannot assure you that we will have sufficient resources to acquire the Mexican government's interest if required to do so, or that we will not be prohibited by other agreements from completing the purchase. See "Business The Mexican Government Put." Our substantial indebtedness, and that of our subsidiary TFM, could adversely affect our business and, consequently, our ability to pay interest and repay our indebtedness We and TFM each have a significant amount of indebtedness, which requires significant debt service. After giving effect to our restructuring, at June 30, 2004, we had consolidated indebtedness of approximately $1,474.2 million, which includes $959.7 million of TFM's indebtedness. At such date, after giving effect to our restructuring, our shareholders' equity, including minority interest in consolidated subsidiaries, was $720.2 million, and TFM's shareholders' equity, including minority interest, was $977.6 million resulting in a debt to equity ratio of 204.7% and 98.2%, respectively. The level of our and TFM's consolidated indebtedness could have important consequences. For example, it could: limit cash flow available for capital expenditures, acquisitions, working capital and other general corporate purposes because a substantial portion of our cash flow from operations must be dedicated to servicing debt; increase our vulnerability to general adverse economic and industry conditions; expose us to risks inherent in interest rate fluctuations because some borrowings are at variable rates of interest, which could result in higher interest expenses in the event of increases in interest rates; limit our flexibility in planning for, or reacting to, competitive and other changes in our business and the industries in which we operate; place us at a competitive disadvantage compared to our competitors that have less debt and greater operating and financing flexibility than we do; and I.R.S. Employer Identification Number limit, through covenants in our indebtedness, our ability to borrow additional funds. Our and TFM's ability to pay interest and to repay or refinance indebtedness will depend upon future operating performance, including the ability to increase revenues significantly and control expenses. Future operating performance depends upon prevailing economic, financial, competitive, legislative, regulatory, business and other factors that are beyond our control. We cannot assure you that our business will generate sufficient cash flow from operations, that currently anticipated revenues and operating performance will be realized or that future borrowings will be available to us in amounts sufficient to enable us to pay our indebtedness or to fund our other liquidity needs. In addition, we may have difficulty accessing cash flows generated by our subsidiaries and joint ventures in which we participate. See "Business Our Liquidity Position" and "Risk Factors Factors relating to the Senior Secured Notes We are primarily a holding company and we depend upon funds received from our operating subsidiaries to make payments on our indebtedness." If we or TFM are unable to meet our debt service obligations or fund our other liquidity needs, we could attempt to restructure or refinance our indebtedness, seek additional equity capital or sell assets. We cannot assure you that we will be able to accomplish those actions on satisfactory terms, if at all. The indentures relating to our and TFM's debt securities contain a number of restrictive covenants and any additional financing arrangements we enter into may contain additional restrictive covenants. These covenants restrict or prohibit many actions, including our ability, or that of our subsidiaries, to: incur indebtedness; create or suffer to exist liens; make prepayments of particular indebtedness; pay dividends; make investments; engage in transactions with shareholders and affiliates; use assets as security in other transactions; create any unrestricted subsidiary; sell assets; and engage in mergers and consolidations or in sale-leaseback transactions. If we fail to comply with these restrictive covenants, our obligation to repay our debt may be accelerated. TFM has sought waivers under its credit agreements and may require additional waivers in the future TFM would not have met certain required maintenance covenants under its bank credit facilities during 2003. Accordingly, TFM sought and received waivers from the lenders under its bank credit facilities for such expected non-compliance. In October 2003 and March 2004, TFM received waivers from the banks which participate in its credit facilities of the term loan facility and U.S. commercial paper program. The waivers applied to the three months ended September 30, 2003, the three months ended December 31, 2003 and the three months ended March 31, 2004, respectively. It is possible that TFM may require additional waivers under its bank credit facilities. If TFM requires such waivers in the future, there can be no assurance that such waivers will be obtained. If such waivers are not obtained, TFM would be in default under its bank credit facilities and such default could result in acceleration of amounts due under the bank credit facilities and in cross-defaults under other obligations. TMM Holdings, S.A. de C.V. United Mexican States N/A Operadora de Apoyo Log stico, S.A. de C.V. United Mexican States N/A Compa a Arrendadora TMM, S.A. de C.V. United Mexican States N/A Transportes Mar timos M xico, S.A. United Mexican States N/A Divisi n de Negocios Especializados, S.A. de C.V. United Mexican States N/A Inmobiliaria TMM, S.A. de C.V. United Mexican States N/A Lacto Comercial Organizada, S.A. de C.V. United Mexican States N/A L nea Mexicana TMM, S.A. de C.V. United Mexican States N/A Naviera del Pacifico, S.A. de C.V. United Mexican States N/A Operadora Mar tima TMM, S.A. de C.V. United Mexican States N/A Operadora Portuaria de Tuxpan, S.A. de C.V. United Mexican States N/A Personal Mar timo, S.A. de C.V. United Mexican States N/A Servicios Administrativos de Transportaci n, S.A. de C.V. United Mexican States N/A Servicios de Log stica de M xico, S.A. de C.V. United Mexican States N/A Servicios en Operaciones Log sticas, S.A. de C.V. United Mexican States N/A Servicios en Puertos y Terminales, S.A. de C.V. United Mexican States N/A Terminal Mar tima de Tuxpan, S.A. de C.V. United Mexican States N/A TMG Overseas S.A. Republic of Panama N/A TMM Agencias, S.A. de C.V. United Mexican States N/A TMM Logistics, S.A. de C.V. United Mexican States N/A Transportaci n Portuaria Terrestre, S.A. de C.V. United Mexican States N/A The address, including zip code, of each of the principal executive offices of the Co-Registrants listed above is Avenida de la C spide, No. 4755, Colonia Parques del Pedregal, 14010 Mexico, D.F. The name and address, including zip code, area code and telephone number of the above listed Co-Registrants' agent for service of process is CT Corporation System, 111 Eighth Avenue, 13th Floor, New York, NY 10011, (212) 590-9200. The I.R.S. Employer Identification Number requirement is not applicable to the above listed Co-Registrants. Uncertainties relating to our financial condition and other factors currently raise substantial doubt about our ability to continue as a going concern The Company's audited consolidated financial statements as of December 31, 2003 and 2002 have been prepared assuming that it will continue as a going concern. The auditors' report on the Company's financial statements as of and for the three-year period ended December 31, 2003, includes an explanatory paragraph describing the existence of substantial doubt about the Company's ability to continue as a "going concern." The report indicates that (i) we had outstanding obligations amounting to $176.9 million which became due on May 15, 2003 and we did not make the payment of principal amount thereof nor the accrued interest on the due date; (ii) as a result we entered into default under the terms of the 2003 notes resulting in a cross-default under the 2006 notes with a principal amount of $200.0 million; (iii) payments of interest on the Old Senior Notes amounting to $45.7 million became due on May 15, 2003 and November 15, 2003; (iv) outstanding commercial paper and obligations for sale of receivables amounting to $85.0 million and $15.3 million will become effective September 2004, and on a monthly basis during 2004, respectively; (v) during the year ended December 31, 2003, we incurred a net loss of $86.7 million; and (vi) at December 31, 2003, we had an excess of current liabilities over current assets of $497.0 million and a deficit of $68.0 million. Following the consummation of the Exchange Offer, we are no longer in default under the Old Senior Notes, see "Management's Discussion and Analysis of Financial Condition and Results of Operations Our Current Liquidity Difficulties and Outlook" and " Contractual Obligations." We may be unable to successfully expand our business Future growth of our business will depend on a number of factors, including: identification and continued evaluation of niche markets; identification of joint venture opportunities or acquisition candidates; our ability to enter into acquisitions or joint ventures on favorable terms; our ability to hire and train qualified personnel; the successful integration of any acquired businesses with our existing operations; and our ability to effectively manage expansion and to obtain required financing. In order to maintain and improve operating results from new businesses, as well as our existing business, we will be required to manage our growth and expansion effectively. However, the management of new businesses involves numerous risks, including difficulties in assimilating the operations and services of the new businesses, the diversion of management's attention from other business concerns and the disadvantage of entering markets in which we may have no or limited direct or prior experience. Our failure to effectively manage our expansion could have a material adverse effect on our operational results. The Company is controlled by the Serrano Segovia family Members of the Serrano Segovia family control the Company through their direct and indirect ownership of our Series A Shares. Since the Series A Shares underlying our CPOs are required to be voted by the CPO Trustee in the same manner as the majority of the Series A Shares not so owned vote on any matter submitted to our stockholders, the Serrano Segovia family effectively controls all matters as to which a shareholder vote is required. As a result, the Serrano Segovia family will be able to direct and control the policies of the Company and its subsidiaries, including mergers, sales of assets and similar transactions. See "Major Shareholders and Related Party Transactions Major Shareholders." The indenture for the Senior Secured Notes contains covenants that prohibit transactions between the Company and its subsidiaries, affiliates and associates, such as the Serrano The information in this prospectus is not complete and may be changed. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell these securities and is not soliciting an offer to buy these securities in any state or jurisdiction where the offer or sale is not permitted. SUBJECT TO COMPLETION, DATED SEPTEMBER 10, 2004 PRELIMINARY PROSPECTUS $392,646,832 Grupo TMM, S.A. Senior Secured Notes Due 2007 This prospectus covers the resale by certain selling noteholders named in this prospectus of up to $392,646,832 of our Senior Secured Notes due 2007 plus such additional amounts of Senior Secured Notes that may be issued from time to time in connection with payments in kind of interest on the Senior Secured Notes. We refer to all of our Senior Secured Notes due 2007 from time to time outstanding as the "Senior Secured Notes" and we refer to the Senior Secured Notes that may be sold pursuant to this prospectus as the "Notes." All of the Senior Secured Notes being registered may be offered and sold from time to time by the selling noteholders. You should read this prospectus carefully before you invest. The Notes were initially issued (i) to certain holders of our 91/2% Notes due 2003, which we refer to as our 2003 notes, and our 101/4% Senior Notes due 2006, which we refer to as our 2006 notes (we refer to the 2003 notes and the 2006 notes collectively as the "Old Senior Notes"), in a private exchange offer that closed simultaneously with a public exchange offer (we refer to both exchange offers collectively as the "Exchange Offer") of Senior Secured Notes for Old Senior Notes and (ii) in a private placement to certain holders of the Old Senior Notes who agreed to purchase additional Notes to fund our debt restructuring and to certain other creditors of the Company as consideration for cancellation of outstanding obligations of the Company. The Notes are being registered pursuant to registration rights granted in connection with the initial issuance and sale of the Notes. The Senior Secured Notes are guaranteed by each of our wholly-owned subsidiaries that is listed on Schedule A hereto. We may redeem the Senior Secured Notes at any time, in whole or in part, at the applicable redemption price described herein. Investing in the Senior Secured Notes involves risks. See "Risk Factors" beginning on page 11 of this prospectus. The persons listed as the selling noteholders in this prospectus are offering up to $392,646,832 aggregate principal amount of the Notes plus such additional amounts of Senior Secured Notes that may be issued from time to time in connection with payments in kind of interest on the Senior Secured Notes. The selling noteholders may offer their Notes through public or private transactions, in the Private Offering Resales and Trading through Automated Linkages or "PORTAL" market and at prevailing market prices or at privately negotiated prices. The Notes may be sold directly or through agents or broker-dealers acting as principal or agent. The selling noteholders may engage underwriters, brokers, dealers or agents, who may receive commissions or discounts from the selling noteholders. We will not receive any proceeds from the sale of the Notes by the selling noteholders. We will pay all of the expenses incident to the registration of the Notes, except for the selling commissions, if any. See "Plan of Distribution." Neither the Securities and Exchange Commission nor any state or foreign securities commission has approved or disapproved of these securities or passed upon the adequacy or accuracy of this prospectus. Any representation to the contrary is a criminal offense. Segovia family. See "Description of the Senior Secured Notes Certain Covenants Limitation on Transactions with Affiliates." A substantial portion of the Series A Shares and ADSs of the Company held by the Serrano Segovia family is currently pledged to secure indebtedness of the Serrano Segovia family and entities controlled by them and may from time to time in the future be pledged to secure obligations of other of their affiliates. A foreclosure upon any such Series A Shares held by the Serrano Segovia family could constitute a change of control under the Indenture governing the Senior Secured Notes and certain other debt instruments of the Company and its subsidiaries. Such occurrence of a change of control would enable holders of the Senior Secured Notes to require the Company to repurchase their Senior Secured Notes. There can be no assurance that upon a change of control the assets of the Company would be sufficient to repurchase the Senior Secured Notes. See "Risk Factors Factors relating to the Senior Secured Notes We may not be able to finance a change of control offer." If we sell our interest in Grupo TFM, we may be classified as an investment company If we sell our interest in Grupo TFM, we may receive as consideration securities of another issuer. Consequently, since a significant portion of the Company's assets may then consist of the shares of an unrelated entity, we risk becoming an inadvertent "investment company" under the U.S. Investment Company Act of 1940 (the "Investment Company Act"). Generally, an issuer is deemed to be an investment company subject to registration if its holdings of "investment securities," which usually are securities other than securities issued by majority owned subsidiaries and government securities, exceed 40% of the value of its total assets, exclusive of government securities and cash items, on an unconsolidated basis. Registered investment companies are subject to extensive, restrictive and potentially adverse regulation relating to, among other things, operating methods, management, capital structure, dividends and transactions with affiliates. Registered investment companies are not permitted to operate their business in the manner in which we operate our business. Securities we could receive through the sale of our interest in Grupo TFM would be considered investment securities. However, a company that otherwise would be deemed to be an investment company may be excluded from such status for a one-year period provided that such company has a bona fide intent to be engaged as soon as reasonably possible, and in any event within that one-year period, primarily in a business other than that of investing, reinvesting, owning, holding or trading in securities. If we would otherwise be deemed to be an investment company under the Investment Company Act, we intend to rely on this exemption while we attempt to redeploy assets, effectuate a combination with another operating business or take other steps to avoid classification as an investment company. If we have not taken such steps within the one-year period referred to above, we may be required to (1) apply to the SEC for exemptive relief from the requirements of the Investment Company Act, or (2) invest certain of our assets in government securities and cash equivalents that are not considered "investment securities" under the Investment Company Act. There can be no assurance that we will be able to obtain exemptive relief from the SEC. Investing our assets in government securities and cash equivalents could yield a significantly lower rate of return than other investments we could make if we chose to register as an investment company (although there is no assurance we could successfully register as an investment company even if we chose to do so). If we are deemed an unregistered investment company, there would be a risk, among other material adverse consequences, that we could become subject to monetary penalties or injunctive relief, or both, in an action brought by the SEC, that we would be unable to enforce contracts with third parties or that third parties could seek to obtain rescission of transactions with us undertaken during the period in which it was established that we were an unregistered investment company. In addition, if we are unable to take steps to avoid becoming an investment company or to obtain exemptive relief from the SEC, we may be in default under the indenture governing the Senior Secured Notes. See "Description of the Senior Secured Notes Certain Covenants Restriction on Investment Activity." [ ], 2004. We may be, or may become, subject to Passive Foreign Investment Company rules If we are, or were in the future to become, a "passive foreign investment company" ("PFIC") for United States federal income tax purposes, United States holders of our ADSs or our shares generally will be subject to special United States tax rules that would differ in certain respects from the tax treatment described herein. We do not believe that we are currently a PFIC for United States federal income tax purposes. However, PFIC status is determined annually based on the composition of an entity's assets and income from time to time. As a result, our PFIC status may change. In general, if 50% or more of our assets are "passive assets," or 75% or more of our income is "passive income," we would be deemed a PFIC. Passive assets generally include any interest in another corporation in which we own less than a 25% interest (by value). Thus, a reduction in our ownership interest in Grupo TFM, either as a result of our sale of our shares or through dilution due to the sale of shares in Grupo TFM or any of our subsidiaries through which we own shares, could result in our interest in Grupo TFM being considered a passive asset. If this were to occur, we could become a PFIC. In general, if we are classified as a PFIC, United States holders of our ADSs or shares will be subject to a special tax at ordinary income tax rates on "excess distributions," including certain distributions by us with respect to ADSs or shares as well as gain that such holders recognize on the sale of ADSs or shares. The amount of income tax on any excess distributions will be increased by an interest charge to compensate for tax deferral, calculated as if the excess distributions were earned ratably over the period a holder held the ADSs or shares. With respect to ADSs and shares, a United States holder can avoid the unfavorable rules described in the preceding paragraph by electing to mark its ADSs and shares to market. If a United States holder makes this mark-to-market election, such holder will be required in any year in which we are a PFIC to include as ordinary income the excess of the fair market value of its ADSs and shares at year-end over its basis in those ADSs and shares. In addition, any gain a United States holder recognizes upon the sale of its ADSs and shares will be taxed as ordinary income in the year of sale. Alternatively, if we provide the necessary information, a United States holder may elect to treat its ADSs and shares as an interest in a "qualified electing fund" ("QEF Election"). Such a QEF Election is available only if we comply with applicable information reporting requirements, and we have not yet determined whether we can or will do so. If a United States holder makes a "QEF Election," such holder will be required to include in income its proportionate share of our income and net capital gain in years in which we were a PFIC, but any gain that such holder subsequently recognizes upon the sale of its ADSs and shares generally will be taxed as capital gain. TFM's business is very capital intensive TFM's business is capital intensive and requires substantial ongoing expenditures for, among other things, improvements to roadway, structures and technology, acquisitions, leases and repair of equipment, and maintenance of its rail system. TFM's failure to make necessary capital expenditures could impair its ability to accommodate increases in traffic volumes or service its existing customers. In addition, TFM's railroad concession from the Mexican government requires TFM to make investments and undertake capital projects, including capital projects described in a business plan filed every five years with the Mexican government. TFM may defer capital expenditures with respect to its five-year business plan with the permission of the Secretar a de Comunicaciones y Transportes (Ministry of Communications and Transports or "Ministry of Transportation"). However, the Ministry of Transportation may not grant this permission, and TFM's failure to comply with the commitments in its business plan could result in the Mexican government revoking the concession. TFM's concession is subject to revocation or termination in certain circumstances The Mexican government may terminate the concession granted to TFM as a result of TFM's surrender of its rights under the concession, or for reasons of public interest, by revocation or upon TFM's liquidation or bankruptcy. (The Mexican government would not, however, be entitled to revoke the concession upon the occurrence of a liquidation or bankruptcy of Grupo TMM or Grupo TFM.) The Mexican government may also temporarily seize TFM's assets and its rights under the concession. The Ley Reglamentaria del Servicio Ferroviario (Law Regulating Railroad Services or "Mexican railroad services law and regulations") provides that the Ministry of Transportation may revoke the concession upon the occurrence of specified events, some of which will trigger automatic revocation. Revocation or termination of the concession would prevent TFM from operating its railroad and would materially adversely affect TFM's operations and its ability to make payments on its debt. In the event that the concession is revoked by the Ministry of Transportation, TFM will receive no compensation, and its interest in its rail lines and all other fixtures covered by the concession, as well as all improvements made by it, will revert to the Mexican government. See "Business Railroad Operations The Concession." Our interest in TFM is held with our partner, KCS, and we may not be able to control significant operating decisions We and KCS are the principal shareholders of Grupo TFM. Although we hold a majority voting interest in Grupo TFM, decisions on certain matters that may be material to TFM's operations and business require the approval of both shareholders or of their representatives on Grupo TFM's board of directors. Differences of views between us and KCS have in the past resulted, and may in the future result, in delayed decisions or the failure to reach an agreement, which could adversely affect TFM's operations and business. See "Legal Proceedings Dispute with Kansas City Southern." TFM's results from operations are heavily dependent on fuel expenses Approximately 98% of the locomotives TFM operates are diesel-powered, and TFM's fuel expenses are significant. TFM currently meets, and expects to continue to meet, its fuel requirements almost exclusively through purchases at market prices from Petr leos Mexicanos, the national oil company of Mexico ("PEMEX"), a government-owned entity exclusively responsible for the distribution and sale of diesel fuel in Mexico. TFM is party to a fuel supply contract with PEMEX of indefinite duration. Either party may terminate the contract upon 30 days' written notice to the other at any time. If the fuel contract is terminated and TFM is unable to acquire diesel fuel from alternate sources on acceptable terms, TFM's operations could be materially adversely affected. Crude oil prices in August 2004 have been at or near record levels and continued instability in the Middle East and Venezuela may result in continued high fuel prices or further increases in fuel prices. Since TFM's fuel expense represents a significant portion of its operating expenses, high diesel fuel prices have a material adverse effect on TFM's results of operations. TFM may be unable to generate sufficient cash to service or refinance its debt TFM's ability to satisfy its obligations under its debt in the future will depend upon TFM's future performance, including its ability to increase revenues significantly and control expenses. TFM's future operating performance depends upon prevailing economic, financial, business and competitive conditions and other factors, many of which are beyond its control. If TFM's cash flow from operations is insufficient to satisfy its obligations, TFM may take specific actions, including delaying or reducing capital expenditures, attempting to refinance its debt at or prior to its maturity or, in the absence of such refinancing, attempting to sell assets quickly in order to make up for any shortfall in payments under circumstances that might not be favorable to getting the best price for the assets, or seeking additional equity capital. TFM's ability to refinance its debt and take other actions will depend on, among other things, its financial condition at the time, the restrictions in the instruments governing its debt and other factors, including market conditions, beyond TFM's control. TFM may be unable to take any of these actions on satisfactory terms or in a timely manner. TFM route $ 1,473,326 $ 1,473,326 Cruise ship terminal on Cozumel Island 7,148 20 API Acapulco 6,783 6,783 20 Tugboats in the port of Manzanillo 2,170 2,170 10 Manzanillo port 2,589 20 Progreso port 4,577 TFM Lines 1,473,326 1,473,326 International cruise ship terminal on Cozumel Island 7,148 20 Integral Acapulco Port Administration 6,783 6,783 20 Tugboats in the Port of Manzanillo 2,170 2,170 10 Manzanillo Port 2,589 20 Progreso Port 4,577 Further, any of these actions may not be sufficient to allow TFM to meet its debt obligations. TFM's indentures and commercial paper credit agreement limit its ability to take certain of these actions. TFM's failure to successfully undertake any of these actions or to earn enough revenues to pay its debts, or significant increases in the peso cost to service its dollar-denominated debt, could materially and adversely affect TFM's business or operations. Certain regulatory and market factors could adversely affect our ability to expand our rail transportation operations The trucking industry is TFM's primary competition. In February 2001, a North American Free Trade Agreement ("NAFTA") tribunal ruled in an arbitration between the United States and Mexico that the United States must allow Mexican trucks to cross the border and operate on U.S. highways. NAFTA called for Mexican trucks to have unrestricted access to highways in U.S. border states by 1995 and full access to all U.S. highways by January 2000. However, the United States has not followed the timetable because of concerns over Mexico's trucking safety standards. On March 14, 2002, as part of its agreement under NAFTA, the U.S. Department of Transportation issued safety rules that allow Mexican truckers to apply for operating authority to transport goods beyond the 20-mile commercial zones along the U.S.-Mexico border. These safety rules require Mexican carriers seeking to operate in the United States to pass, among other things, safety inspections, obtain valid insurance with a U.S. registered insurance company, conduct alcohol and drug testing for drivers and to obtain a U.S. Department of Transportation identification number. Mexican commercial vehicles with authority to operate beyond the commercial zones will be permitted to enter the United States only at commercial border crossings and only when a certified motor carrier safety inspector is on duty. Given these recent developments, we cannot assure you that truck transport between Mexico and the United States will not increase substantially in the future. Such an increase could affect TFM's ability to continue converting traffic to rail from truck transport because it may result in an expansion of the availability, or an improvement of the quality, of the trucking services offered in Mexico. In recent years, there has been significant consolidation among major North American rail carriers. The resulting merged railroads could attempt to use their size and pricing power to block other railroads' access to efficient gateways and routing options that are currently and have been historically available. We cannot assure you that further consolidation will not have an adverse effect on us. Approximately 50% of TFM's expected revenue growth during the next few years is expected to result from increased truck-to-rail conversion. If the railroad industry in general, and TFM in particular, are unable to preserve their competitive advantages vis- -vis the trucking industry, TFM's business plan may not be achieved and its projected revenue growth could be adversely affected. Additionally, TFM's revenue growth could be affected by, among other factors, its inability to grow its existing customer base, negative macroeconomic developments impacting the United States and Mexican economies, and failure to capture additional cargo transport market share from the shipping industry and other railroads. Significant competition could adversely affect our future financial performance Certain of our business segments face significant competition, which could have an adverse effect on our results of operations. TFM faces significant competition from trucks and other rail carriers as well as limited competition from the shipping industry in its freight operations. Our parcel tanker and supply ship services operating in the Gulf of Mexico have faced significant competition, mainly from U.S. shipping companies. Although we expect that a Mexican law, enacted in January 1994, and amended in May 2000, which restricts cabotage of ships (movement of ships within Mexico and Mexican waters) at Mexican ports to Mexican-owned vessels carrying the Mexican flag, will reduce competition from non-Mexican companies in this sector, there can be no assurance that such competition will be reduced. In our land operations division, our trucking transport and automotive EXCHANGE RATES We maintain our financial records in dollars. However, we keep our tax records in pesos. We record in our financial records the dollar equivalent of the actual peso charges for taxes at the time incurred using the prevailing exchange rate. In 2003, approximately 57% of our net consolidated revenues and 54% of our operating expenses from continuing operations were generated or incurred in dollars. Most of the remainder of our net consolidated revenues and operating expenses from continuing operations were denominated in pesos. The following tables set forth, for the periods and dates indicated, information regarding the noon buying rate for cable transfers payable in pesos as certified by the Federal Reserve Bank of New York for customs purposes, expressed in pesos per dollar. On December 31, 2003, the noon buying rate was 11.23 pesos per dollar. On August 13, 2004, the noon buying rate was 11.42 pesos per dollar. Noon Buying Rate(a) Year ended December 31, logistics services have faced intense competition, including price competition, from a large number of Mexican, U.S. and international trucking lines. We cannot assure you that we will not lose business in the future due to our inability to respond to competitive pressures by decreasing our prices without adversely affecting our gross margins and operational results. TFM faces significant competition from the trucking industry, as well as from some industry segments from other railroads, in particular Ferrocarril Mexicano, S.A. de C.V. ("Ferromex"), which operates the Pacific-North Rail Lines. In particular, TFM has experienced, and continues to experience, competition from Ferromex with respect to the transport of grain, minerals and steel products. The rail lines operated by Ferromex run from Guadalajara and Mexico City to four U.S. border crossings west of Laredo, Texas, providing a potential alternative to TFM's routes for the transport of freight from those cities to the U.S. border. Ferromex directly competes with TFM in some areas of its service territory, including Tampico, Saltillo, Monterrey and Mexico City. Ferrocarril del Sureste, S.A. de C.V. ("Ferrosur"), which operates the Southeast Rail Lines, also competes directly with TFM for traffic to and from southeastern Mexico. Ferrosur, like TFM, serves Mexico City, Puebla and Veracruz. Ferromex and Ferrosur are privately owned companies that may have greater financial resources than TFM. Among other things, this advantage may give them greater ability to reduce freight prices. Price reductions by competitors would make TFM's freight services less competitive and we cannot assure you that TFM would be able to match these rate reductions. Under TFM's concession, TFM must grant to Ferromex the right to operate over a north-south portion of its rail lines between Ramos Arizpe near Monterrey and the city of Quer taro that constitutes over 600 kilometers of TFM's main track. Using these trackage rights, Ferromex may be able to compete with TFM over its rail lines for traffic between Mexico City and the United States. TFM's concession also requires it to grant rights to use certain portions of its tracks to Ferrosur and the "belt railroad" operated in the greater Mexico City area by the Ferrocarril y Terminal del Valle de M xico, S.A. de C.V. (the Mexico City Railroad and Terminal), thereby providing Ferrosur with more efficient access to certain Mexico City industries. As a result of having to grant trackage rights to other railroads, TFM incurs additional maintenance costs and also loses the flexibility of using its tracks at all times. In February 2002, Ferromex and Ferrosur announced that they agreed to the acquisition of Ferrosur by Ferromex. TFM filed a notice with the Mexican Antitrust Commission objecting to the proposed acquisition on the grounds that it would limit competition. The acquisition was reviewed by the Mexican Antitrust Commission and on May 16, 2002, the Mexican Antitrust Commission announced that it had notified Ferromex that authorization to consummate the acquisition was denied on antitrust grounds. Ferromex subsequently filed an appeal for review of the order, and on September 18, 2002, the Mexican Antitrust Commission confirmed its prior ruling denying authorization to consummation of the acquisition. Ferromex requested that the Federal Courts in Mexico review the decision of the Mexican Antitrust Commission. TFM also requested a Federal Court in Mexico to review its complaint against the acquisition, requesting to be recognized as a party to the proceedings of the Mexican Antitrust Commission, and obtained a favorable ruling (amparo). Ferromex and Ferrosur subsequently withdrew their petition before the Mexican Antitrust Commission, which terminated the acquisition request in October 2003. The rates for trackage rights set by the Ministry of Transportation may not adequately compensate TFM Pursuant to TFM's concession, TFM is required to grant rights to use portions of its tracks to Ferromex, Ferrosur and the Mexico City Railroad and Terminal. Applicable law stipulates that Ferromex, Ferrosur and the Mexico City Railroad and Terminal are required to grant to TFM rights to use portions of their tracks. Applicable law provides that the Ministry of Transportation is entitled to set the rates in the event that TFM and the party to whom it is granting the rights cannot agree on a rate. TFM and Ferromex have not been able to agree upon the rates each of them is required to pay High the other for interline services and haulage and trackage rights. Therefore, in accordance with its rights under the Mexican railroad services law and regulations, TFM initiated an administrative proceeding in February 2001, requesting a determination of such rates by the Ministry of Transportation, which subsequently issued a ruling establishing rates using the criteria set forth in the Mexican railroad services law and regulations. TFM and Ferromex appealed the rulings before the Mexican Federal Courts due to, among other things, a disagreement with the methodology employed by the Ministry of Transportation in calculating the trackage rights and interline rates. TFM and Ferromex also requested and obtained a suspension of the effectiveness of the ruling pending resolution of this appeal. We cannot predict whether TFM will ultimately prevail in this proceeding and whether the rates TFM is ultimately allowed to charge will be adequate to compensate it. See "Business Railroad Operations" for more information. If our time charter arrangements are terminated or expire, our business could be adversely affected We currently time charter three product tankers to PEMEX. In the event that our time charter arrangements with PEMEX are terminated or expire, we will be required to seek new time charter arrangements for these vessels. We cannot be sure that time charters will be available for the vessels following termination or expiration or that time charter rates in effect at the time of such termination or expiration will be comparable to those in effect under the existing time charters or in the present market. In the event that time charters are not available on terms acceptable to us, we may employ those tankers in the spot market. Because charter rates in the spot market are subject to greater fluctuation than time charter rates, any failure to maintain existing, or enter into comparable, charter arrangements could adversely affect our operating results. Terrorist activities and geopolitical events and their consequences could adversely affect our operations As a result of the terrorist attacks in the United States on September 11, 2001 and the March 11, 2004, terrorist attacks in Spain, and the continuation of armed hostilities involving, among others, the United States and Iraq, there has been increased short-term market volatility, and there may be long-term effects on U.S. and world economies and markets. Terrorist attacks may negatively affect our operations. The continued threat of terrorism within the United States and abroad and the potential for military action and heightened security measures in response to such threats may cause significant disruption to commerce throughout the world, including restrictions on cross-border transport and trade. In addition, related political events may cause a lengthy period of uncertainty that may adversely affect our business. Political and economic instability in other regions of the world, including the United States and Canada, may also result and could negatively impact our operations. The consequences of terrorism and the responses thereto are unpredictable and could have an adverse effect on our operations. Downturns in the U.S. economy or in trade between the United States and Mexico and fluctuations in the peso dollar exchange rate would likely have adverse effects on our business and results of operations The level and timing of our business activity are heavily dependent upon the level of U.S.-Mexican trade and the effects of NAFTA on such trade. Downturns in the U.S. or Mexican economy or in trade between the United States and Mexico would likely have adverse effects on our business and results of operations. Our business of logistics and transportation of products traded between Mexico and the United States depends on the U.S. and Mexican markets for these products, the relative position of Mexico and the United States in these markets at any given time and tariffs or other barriers to trade. Our revenues as well as TFM's were affected by the downturn in the U.S. economy in 2003. However, we believe the U.S. economy started to reflect a recovery in the third quarter of 2003, and in general, continued improving in the first half of 2004. Any future downturn in the U.S. economy could have a Low material adverse effect on our results of operations and our ability to meet our debt service obligations as described above. Also, fluctuations in the peso dollar exchange rate could lead to shifts in the types and volumes of Mexican imports and exports. Although a decrease in the level of exports of some of the commodities that we transport to the United States may be offset by a subsequent increase in imports of other commodities we haul into Mexico and vice versa, any offsetting increase might not occur on a timely basis, if at all. Future developments in U.S.-Mexican trade beyond our control may result in a reduction of freight volumes or in an unfavorable shift in the mix of products and commodities we carry. Downturns in certain cyclical industries in which our customers operate could have adverse effects on our results of operations The shipping, transportation and logistics industries are highly cyclical, generally tracking the cycles of the world economy. Although transportation markets are affected by general economic conditions, there are numerous specific factors within each particular market segment that may influence operating results. Some of our customers do business in industries that are highly cyclical, including the oil and gas, automotive and agricultural sectors. Any downturn in these sectors could have a material adverse effect on our operating results. For example, during the first half of 2004, our results were negatively impacted by continued sluggish conditions in the automotive sector. Also, some of the products we transport have had a historical pattern of price cyclicality which has typically been influenced by the general economic environment and by industry capacity and demand. For example, global steel and petrochemical prices have decreased in the past. We cannot assure you that prices and demand for these products will not decline in the future, adversely affecting those industries and, in turn, our financial results. We are exposed to the risk of loss and liability Our business is affected by a number of risks, including mechanical failure of vessels and equipment, collisions, property loss of vessels and equipment, cargo loss or damage, as well as business interruption due to political circumstances in foreign countries, hostilities and labor strikes. In addition, the operation of any ocean-going vessel is subject to the inherent possibility of catastrophic marine disaster, including oil spills and other environmental accidents, and the liabilities arising from owning and operating vessels in international trade. We maintain insurance to cover the risk of partial or total loss of or damage to all of our assets, including, but not limited to, railtrack, rail cars, port facilities, port equipment, trucks, land facilities and offices. In particular, we maintain marine hull and machinery and war risk insurance on our vessels, which covers the risk of actual or constructive total loss. Additionally, we have protection and indemnity insurance for damage caused by our operations to third persons. We do not carry insurance covering the loss of revenue resulting from a downturn in our operations or resulting from off-hire time on certain vessels. We cannot assure you that our insurance would be sufficient to cover the cost of damages suffered by us or damages to others, that any particular claim will be paid or that such insurance will continue to be available at commercially reasonable rates in the future. We face potential environmental liability Our operations are subject to Mexican federal and state laws and regulations relating to the protection of the environment. The primary environmental law in Mexico is the General Law of Ecological Balance and Environmental Protection (the "Ecological Law"). The Mexican federal agency in charge of overseeing compliance with and enforcement of the federal environmental law is the Ministry of Environmental Protection and Natural Resources (Secretar a del Medio Ambiente y Recursos Naturales, or "Semarnat"). As part of its enforcement powers, Semarnat is empowered to bring Year-end Average(b) administrative and criminal proceedings and impose economic sanctions against companies that violate environmental laws, and temporarily or even permanently close non-complying facilities. Under the Ecological Law, the Mexican government has implemented a program to protect the environment by promulgating rules concerning water, land, air and noise pollution, and hazardous substances. We are also subject to the laws of various jurisdictions and international conferences with respect to the discharge of materials into the environment. While we maintain insurance against certain of these environmental risks in an amount which we believe is consistent with industry norms, we cannot assure you that our insurance would be sufficient to cover damages suffered by us. We cannot predict the effect, if any, that the adoption of additional or more stringent environmental laws and regulations would have on our results of operations, cash flows or financial condition. Under the United States Oil Pollution Act of 1990, or "OPA 90," owners and operators of ships could be exposed to substantial liability, and in some cases, unlimited liability for removal costs and damages resulting from the discharge of oil, petroleum or related substances into United States waters by their vessels. In some jurisdictions, including the United States, claims for removal costs and damages would enable claimants to immediately seize the ships of the owning and operating company and sell them in satisfaction of a final judgment. The existence of statutes enacted by individual states of the United States on the same subject, but requiring different measures of compliance and liability, creates the potential for similar claims being brought under state law. In addition, several international conventions that impose liability for the discharge of pollutants have been adopted by other countries. We time-charter product tankers to PEMEX, which PEMEX uses to transport refined petroleum products domestically. Pursuant to these time-charters, PEMEX has the right to transport crude oil and operate internationally. We also operate parcel tankers in the international market. See "Business Specialized Maritime Services." If a spill were to occur in the course of operation of one of our vessels carrying petroleum products, and such spill affected the United States or another country that had enacted legislation similar to OPA 90, we could be exposed to substantial or unlimited liability. Additionally, our vessels carry bunkers (ship fuel) and certain goods that could, if spilled, under certain conditions, cause pollution and result in substantial claims against us, including claims under OPA 90 and other United States federal, state and local laws. Our railroad operations are subject to the provisions of the Ecological Law. The regulations issued under the Ecological Law and technical environmental requirements issued by the Semarnat have promulgated standards for, among other things, water discharge, water supply, emissions, noise pollution, hazardous substances and transportation and handling of hazardous and solid waste. In addition, TFM's ownership of Mexrail may also create certain environmental liabilities with respect to U.S. environmental laws. The U.S. Comprehensive Environmental Response, Compensation and Liability Act ("CERCLA" or "Superfund") and similar state laws (known as Superfund laws) impose liability for the cost of remedial or removal actions, natural resources damages and related costs at certain sites identified as posing a threat to the environment or public health. CERCLA imposes strict liability on the owners and operators of facilities in which hazardous waste and other hazardous substances are deposited or from which they are released or are likely to be released into the environment. Liability may be imposed, without regard to fault or the legality of the activity, on certain classes of persons, including the current and certain prior owners or operators of a site and persons that arranged for the disposal or treatment of hazardous substances. Liability is imposed on a joint and several basis. In addition, other potentially responsible parties, adjacent landowners or other third parties may initiate cost recovery actions or toxic tort litigation against sites subject to CERCLA or similar state laws. Potential labor disruptions could adversely affect our financial condition and our ability to meet our obligations under our debt Approximately 67.7% of our employees are covered by a labor agreement. The compensation terms of the labor agreement are subject to renegotiation on an annual basis and all other terms are renegotiated every two years. We may not be able to negotiate these provisions favorably, and strikes, boycotts or other disruptions could occur. These potential disruptions could have a material adverse effect on our financial condition and results of operations and on our ability to meet our payment obligations under our debt agreements. Our customers may take actions that may reduce our revenues If our customers believe that we may not be able to continue as a going concern or if they believe that our weakened financial condition will result in a lower quality of service, they may discontinue use of our services. Additionally, some customers may demand lower prices. While we have contracts with some of our customers that prevent them from terminating the services we provide them or which impose penalties on customers who terminate their services with us, it may be impractical or uneconomical to enforce these agreements in Mexican courts. If any of these events occur, our revenues will be reduced. Factors Relating to Mexico Mexico is an emerging market economy, with attendant risks to our results of operations and financial condition The Mexican government has exercised, and continues to exercise, significant influence over the Mexican economy. Accordingly, Mexican governmental actions concerning the economy and state-owned enterprises could have a significant impact on Mexican private sector entities in general and on us in particular, as well as on market conditions, prices and returns on Mexican securities, including our securities. The national elections held on July 2, 2000, ended 71 years of rule by the Institutional Revolutionary Party ("PRI") with the election of President Vicente Fox Quesada, a member of the National Action Party ("PAN"), and resulted in the increased representation of opposition parties in the Mexican Congress and in mayoral and gubernatorial positions. Although there have not yet been any material adverse repercussions resulting from this political change, multiparty rule is still relatively new in Mexico and could result in economic or political conditions that could materially and adversely affect our operations. We cannot predict the impact that this new political landscape will have on the Mexican economy. Furthermore, our financial condition, results of operations and prospects and, consequently, the market price for our securities, may be affected by currency fluctuations, inflation, interest rates, regulation, taxation, social instability and other political, social and economic developments in or affecting Mexico. The Mexican economy in the past has suffered balance of payment deficits and shortages in foreign exchange reserves. There are currently no exchange controls in Mexico. However, Mexico has imposed foreign exchange controls in the past. Pursuant to the provisions of NAFTA, if Mexico experiences serious balance of payment difficulties or the threat thereof in the future, Mexico would have the right to impose foreign exchange controls on investments made in Mexico, including those made by U.S. and Canadian investors. Any restrictive exchange control policy could adversely affect our ability to obtain dollars or to convert pesos into dollars for purposes of making interest and principal payments to holders of Senior Secured Notes, to the extent that we may have to effect those conversions. This could have a material adverse effect on our business and financial condition. Securities of companies in emerging market countries tend to be influenced by economic and market conditions in other emerging market countries. Emerging market countries, including Argentina and Brazil, have recently been experiencing significant economic downturns and market volatility. These Land $ 132,878 $ 132,878 50 Buildings 33,113 33,113 27-30 Bridges 75,350 75,350 41 Tunnels 94,043 94,043 40 Rail 317,268 317,268 29 Concrete and wood ties 137,351 137,351 27 Yards 106,174 106,174 35 Ballast 107,189 107,189 27 Grading 391,808 391,808 50 Culverts 14,942 14,942 21 Signals 1,418 1,418 Land $ 132,878 $ 132,878 50 Buildings 33,113 33,113 27 30 Bridges 75,350 75,350 41 Tunnels 94,043 94,043 40 Rail 317,268 317,268 29 Concrete and wood ties 137,351 137,351 27 Yards 106,174 106,174 35 Ballast 107,189 107,189 27 Grading 391,808 391,808 50 Culverts 14,942 14,942 21 Signals 1,418 1,418 Land $ 132,878 $ 132,878 50 Buildings 33,113 33,113 27-30 Bridges 75,350 75,350 41 Tunnels 94,043 94,043 40 Rail 317,268 317,268 29 Concrete and wood ties 137,351 137,351 27 Yards 106,174 106,174 35 Ballast 107,189 107,189 27 Grading 391,808 391,808 50 Culverts 14,942 14,942 21 Signals 1,418 1,418 (a)Source: Federal Reserve Bank of New York. (b)Average of month-end rates. Noon Buying Rate(a) Month end events have had an adverse effect on the economic conditions and securities markets of emerging market countries, including Mexico. Any devaluation of the peso would cause the peso cost of our dollar-denominated debt to increase, adversely affecting our ability to make payments on our indebtedness After a five-year period of controlled devaluation of the peso, on December 19, 1994, the value of the peso dropped sharply as a result of pressure against the currency. Although the peso had been appreciating relative to the dollar over the past few years, the peso depreciated 13.8% in 2002, 7.5% in 2003 and 1.6% in the six months ended June 30, 2004, against the dollar. Any additional devaluation in the peso would cause the peso cost of our dollar-denominated debt to increase. In addition, currency instability may affect the balance of trade between the United States and Mexico. Mexico may experience high levels of inflation in the future which could adversely affect our results of operations Mexico has a history of high levels of inflation, and may experience inflation in the future. During most of the 1980s and during the mid- and late-1990s, Mexico experienced periods of high levels of inflation. The annual rates of inflation for the last five years, as measured by changes in the National Consumer Price Index, as provided by Banco de M xico, were: 1999 12.32 % 2000 8.96 % 2001 4.40 % 2002 5.70 % 2003 3.98 % 2004 (January through June) 1.63 % In 2003, the Mexican inflation rate hit its lowest levels in over 30 years. We cannot give any assurance that the Mexican inflation rate will continue to decrease or maintain its current level for any significant period of time. A substantial increase in the Mexican inflation rate would have the effect of increasing some of our costs, which could adversely affect our results of operations and financial condition, as well as the market value of our Senior Secured Notes. High levels of inflation may also affect the balance of trade between Mexico and the United States, and other countries, which could adversely affect our results of operations. High
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+RISK FACTORS In addition to the other information contained in this prospectus, the following factors should be considered carefully before investing in the IDSs or our senior subordinated notes issued separately from the IDSs. If any of the following risks actually occur, our business, results of operations or financial condition would likely suffer. RISKS RELATING TO THE IDSs, THE SHARES OF COMMON STOCK AND SENIOR SUBORDINATED NOTES UAP Holdings is a holding company and relies on dividends, interest and other payments, advances and transfer of funds from its subsidiaries to meet its debt service and other obligations. UAP Holdings has no direct operations and no significant assets other than ownership of 100% of the stock of United Agri Products. Because UAP Holdings conducts its operations through its subsidiaries, UAP Holdings depends on those entities for dividends and other payments to generate the funds necessary to meet its financial obligations, including payments of principal and interest on the senior subordinated notes, and to pay dividends with respect to the common stock. Legal and contractual restrictions in the Amended Credit Facilities and other agreements governing current and future indebtedness of UAP Holdings subsidiaries, as well as the financial condition and operating requirements of UAP Holdings subsidiaries, may limit UAP Holdings ability to obtain cash from its subsidiaries. The earnings from, or other available assets of, UAP Holdings subsidiaries may not be sufficient to pay dividends or make distributions or loans to enable UAP Holdings to make payments in respect of the senior subordinated notes when such payments are due and to pay dividends on the common stock. You may not receive the level of dividends provided for in our anticipated dividend policy, which our board of directors will adopt upon the closing of this offering, or any dividends at all. Dividend payments are not mandatory or guaranteed. Our board of directors may, in its discretion, amend or repeal the dividend policy it will adopt upon the closing of this offering. Our board of directors may decrease the level of dividends provided for in this dividend policy or entirely discontinue the payment of dividends. Future dividends with respect to shares of our capital stock, if any, will depend on, among other things, our results of operations, cash requirements, financial condition, contractual restrictions, business opportunities, provisions of applicable law and other factors that our board of directors may deem relevant. The Amended Credit Facilities, the indenture governing the senior subordinated notes and the terms of our participating preferred stock will contain significant restrictions on our ability to make dividend payments. In addition, certain provisions of the Delaware General Corporation Law may limit our ability to pay dividends. There can be no assurance that we will have sufficient cash in the future to pay dividends on our common stock in the intended amounts or at all. In the past, cash flow provided by our operating activities has been highly variable, resulting in negative net cash flow during certain periods. Because of this variability, we may have to rely on cash provided by financing activities in order to fund dividend payments, and such financing may or may not be available. However, if we use working capital or borrowings under our Amended Credit Facilities to fund dividends, we would have less cash available for future dividends and other purposes, which could negatively impact our financial condition, our results of operations and our ability to expand our business. In addition, our after-tax cash flow available for dividend and interest payments would be reduced if the senior subordinated notes were treated as equity rather than debt for United States federal income tax purposes. In that event, the stated interest on the senior subordinated notes could be treated as a dividend, and interest on the senior subordinated notes would not be deductible by us for United States federal income tax purposes. Our inability to deduct interest on the senior subordinated notes could materially increase our taxable income and, thus, our United States federal and applicable state income tax liability. Holders of our participating preferred stock are entitled to receive dividend payments before the holders of our common stock. Preferred dividends on our participating preferred stock will rank ahead of dividends on our common stock. The holders of our participating preferred stock will be entitled to receive, when, as and if declared by the board Table of Contents of directors, out of funds legally available therefor, with respect to each share of participating preferred stock, quarterly preferred dividends in an amount equal to the product of the liquidation preference of such share multiplied by a per annum dividend rate equal to the per annum interest rate on our senior subordinated notes. To the extent such preferred dividends are not paid in cash on a dividend payment date, they will be added to the liquidation preference of such share. Such preferred dividends will accrue whether or not earned or declared (and regardless of whether sufficient funds are legally available therefor) and will be cumulative from the issue date. If we fail to pay all accrued preferred dividends on our participating preferred stock in full, we will be prohibited from paying dividends on our common stock. In addition, holders of our participating preferred stock will also participate in all dividends declared and paid to holders of our common stock on an as if converted basis. See Description of Capital Stock Preferred Stock Participating Preferred Stock beginning on page 140. Our dividend policy may negatively impact our ability to finance capital expenditures or operations. Upon completion of this offering, our board of directors will adopt a dividend policy under which cash generated by our business in excess of operating needs, interest and current or future principal payments on indebtedness, and capital expenditures sufficient to maintain our properties would in general be distributed as regular quarterly dividends to the holders of our common stock and participating preferred stock rather than retained by us and used to finance growth opportunities. As a result, we may not retain a sufficient amount of cash to finance growth opportunities or unanticipated capital expenditure needs or to fund our operations in the event of a significant business downturn. We may have to forego growth opportunities or capital expenditures that would otherwise be necessary or desirable if we do not find alternative sources of financing. If we do not have sufficient cash for these purposes, our financial condition and our business will suffer. Subject to certain limitations, we may defer interest on the senior subordinated notes at any time at our option. If we defer interest we will not be permitted to make any payment of dividends so long as any deferred interest or interest on deferred interest remains outstanding. Prior to , 2009, subject to certain limitations, interest payments on the senior subordinated notes may be deferred, at our option, on one or more occasions with respect to eight quarterly payments in the aggregate. After , 2009, subject to certain limitations, interest payments may be deferred, at our option, on no more than four occasions for up to two quarters per occasion; provided that after the end of the first interest deferral period, we may not defer interest on the senior subordinated notes unless and until all previously deferred interest and interest on deferred interest has been paid in full. After the end of any interest deferral period occurring before , 2009, deferred interest, together with any accrued interest thereon, will be required to be repaid on , 2009. Consequently, you may be owed a substantial amount of deferred interest that will not be due and payable until such date. All interest deferred after , 2009, together with any accrued interest thereon, must be repaid on , 2019. Consequently, you may be owed a substantial amount of deferred interest that will not be due and payable until such date. During any interest deferral period and so long as any deferred interest or interest on deferred interest remains outstanding, we will not be permitted to make any payment of dividends with respect to shares of our common stock and or participating preferred stock or any payment with respect to vested options to acquire participating preferred stock. Your rights as holders of the senior subordinated notes and guarantees thereof to receive payments will be contractually subordinated to those of holders of our senior indebtedness and may be otherwise adversely affected by our bankruptcy. As a result of the senior subordinated nature of the senior subordinated notes and related guarantees, upon any distribution to our creditors or the creditors of the subsidiary guarantors in bankruptcy, liquidation or reorganization or similar proceeding relating to us or the subsidiary guarantors or our or their property, the holders of our senior indebtedness and senior indebtedness of the subsidiary guarantors will be entitled to be paid in full in cash before any payment may be made with respect to the senior subordinated notes or the subsidiary Table of Contents guarantees. Holders of the senior subordinated notes would then participate with all other holders of unsecured senior subordinated indebtedness of ours or the subsidiary guarantors similarly subordinated in the assets remaining after we and the subsidiary guarantors have paid all senior indebtedness. We and the subsidiary guarantors may not have sufficient funds to pay all of our creditors, and holders of our senior subordinated notes may receive less, ratably, than the holders of senior indebtedness, and because of the obligation to turn over distributions to holders of senior indebtedness, the holders of the notes may receive less, ratably, than trade payables and other general unsecured indebtedness. Further, in the event of bankruptcy or insolvency, a party in interest may seek to subordinate the senior subordinated notes or the guarantees under principles of equitable subordination or to recharacterize the senior subordinated notes as equity. There can be no assurance as to the outcome of such proceedings. In the event a court subordinates the senior subordinated notes or the guarantees, or recharacterizes the senior subordinated notes as equity, we cannot assure you that you would recover any amounts owed on the senior subordinated notes or the guarantees and you may be required to return any payments made to you within six years before the bankruptcy on account of the senior subordinated notes or the guarantees. In addition, should the court equitably subordinate the senior subordinated notes or the guarantees, or recharacterize the senior subordinated notes as equity, you may not be able to enforce the guarantees. As of May 30, 2004, on a pro forma basis after giving effect to the Transactions, the senior subordinated notes and the subsidiary guarantees would have ranked junior, on a consolidated basis, to $294.3 million of borrowings under the Amended Credit Facilities. In addition, as of May 30, 2004, on a pro forma basis, we would have had the ability to borrow up to an additional amount of $370.7 million under the Amended Credit Facilities (less amounts reserved for letters of credit), which would have ranked senior in right of payment to the senior subordinated notes. Payments on the senior subordinated notes may be blocked if we default under our senior indebtedness, including the Amended Credit Facilities. If we default in the payment of any of our senior indebtedness, including the Amended Credit Facilities, we will not make any payments on the senior subordinated notes until the payment default has been cured or waived. In addition, even if we are making payments on our senior indebtedness on a timely basis, payments on the senior subordinated notes may be blocked for up to 180 days if we default on our senior indebtedness in some other manner. During any period in which payments on the senior subordinated notes are prohibited or blocked in this manner, we and the guarantors will be prohibited from making any payments in respect of the senior subordinated notes and the guarantees. In addition, until the earlier of , 2009 and the time when no designated senior indebtedness (including any guaranty of designated senior indebtedness) is outstanding, upon the occurrence of an event of default under the indenture governing the notes (other than certain bankruptcy defaults), the principal of the notes may not be accelerated for a period of up to 90 days (subject to earlier termination in certain circumstances). See Description of Senior Subordinated Notes Acceleration Forbearance Period beginning on page 150. Claims of noteholders will be structurally subordinated to claims of creditors of all of our existing and future non-U.S. subsidiaries all of which will not guarantee the senior subordinated notes. The senior subordinated notes will not be guaranteed by any of our non-U.S. subsidiaries. Our non-U.S. subsidiaries are separate and distinct legal entities and have no obligation, contingent or otherwise, to pay any amounts due pursuant to the senior subordinated notes, or to make any funds available therefor, whether by dividends, loans, distributions or other payments. Any right that we or the guarantors have to receive any assets of any of the foreign subsidiaries upon the liquidation or reorganization of those subsidiaries, and the consequent rights of holders of senior subordinated notes to realize proceeds from the sale of any of those subsidiaries assets, will be structurally subordinated to the claims of that subsidiaries creditors, including trade creditors and holders of debt of those subsidiaries. On May 30, 2004, on a pro forma basis after giving effect to the Transactions, our non-U.S. subsidiaries had approximately $32.4 million of liabilities, including trade payables. In addition, our non-U.S. subsidiaries can incur up to $20.0 million under the Amended Credit Facilities, subject to aggregate borrowing base availability. Table of Contents Our substantial indebtedness could restrict our ability to pay interest and principal on the senior subordinated notes, pay dividends with respect to shares of our common stock and impact our financing options and liquidity position. We have substantial indebtedness. As of May 30, 2004, on a pro forma basis after giving the effect to the Transactions, we would have had $626.9 million of total indebtedness (assuming the over-allotment option is not exercised). The degree to which we are leveraged on a consolidated basis could have important consequences to the holders of the IDSs and our senior subordinated notes, including: it may be more difficult for us to satisfy our obligations under the senior subordinated notes and to the lenders under the Amended Credit Facilities, and to pay dividends on our common stock participating preferred stock; our ability to obtain additional financing for working capital, capital expenditures, acquisitions or general corporate purposes may be impaired; we may not be able to refinance our indebtedness on terms acceptable to us or at all; we must use a substantial portion of our cash flow from operations to pay interest and principal on the senior subordinated notes and other indebtedness, which will reduce the funds available to us for other purposes, such as future operations, capital expenditures and/or dividends on our common stock and participating preferred stock; we may have a higher level of indebtedness than some of our competitors, which may put us at a competitive disadvantage and reduce our flexibility in planning for, or responding to, changing conditions in our industry, including increased competition; we may be more vulnerable to economic downturns and adverse development in our business; and it may limit our flexibility to plan for and react to changes in our business or strategy. Servicing our debt will require a significant amount of cash. Our subsidiaries ability to generate sufficient cash depends on numerous factors which are beyond our control and we may be unable to generate sufficient cash flow to service our debt obligations, including making payments on the senior subordinated notes, and to pay dividends on the common stock. Our ability to pay our expenses, principal and interest on the senior subordinated notes and other debt, and dividends on the common stock depends on our ability to generate positive cash flow in the future, which is subject to general economic, financial, competitive, legislative and regulatory factors and other factors that are beyond our control. A significant portion of our cash flow from operations will be dedicated to servicing our debt requirements. In addition, we currently expect to distribute a significant portion of our remaining cash flow to our stockholders in the form of quarterly dividends. Our subsidiaries operations may not generate sufficient cash flow from operations and future borrowings may not be available under the Amended Credit Facilities in amounts sufficient to enable us or our subsidiaries to make payments in respect of the senior subordinated notes, to pay our other debt, to pay dividends on the common stock or to fund other liquidity needs, including working capital. We have experienced net losses in the past. If our subsidiaries do not have sufficient cash flow from operations, we or our subsidiaries may be required to incur additional indebtedness, refinance all or part of our existing debt or sell assets. United Agri Products ability to borrow funds under its Amended Credit Facilities in the future will depend on its meeting the financial covenants in such credit facility, and sufficient borrowings may not be available to us or our subsidiaries. See Description of Other Indebtedness beginning on page 122. If we or our subsidiaries are required to refinance existing debt, or if we or our subsidiaries are required to sell some of our assets, we may not be able to do so on terms that are acceptable to us or at all. In addition, the terms of existing or future debt agreements, including the indenture governing the senior subordinated notes and the Amended Credit Facilities, may restrict us or our Table of Contents subsidiaries from effecting any of these alternatives or we may fail for other reasons. If we are required to pursue other alternatives, the value of the senior subordinated notes and the common stock, and our financial condition, could be significantly adversely affected. Despite our current leverage, we may still be able to incur substantially more debt. This could further exacerbate the risks that we and our subsidiaries face. We, including our subsidiaries, may be able to incur substantial additional indebtedness in the future. For example, the Amended Credit Facilities will provide commitments of up to $665.0 million, $342.9 million of which would have been available for future borrowings as of May 30, 2004, on a pro forma basis after giving effect to the Transactions, subject to the aggregate borrowing base availability and net of $27.8 million in outstanding letters of credit. All of such indebtedness would have been secured and effectively senior to the senior subordinated notes. If we incur any additional indebtedness that ranks equally with the senior subordinated notes, the holders of that debt will be entitled to share ratably with the holders of the senior subordinated notes in any proceeds distributed in connection with any insolvency, liquidation, reorganization, dissolution or other winding-up of us. This may have the effect of reducing the amount of proceeds paid to you. If additional indebtedness is added to our or our subsidiaries current levels of indebtedness, the substantial risks described above would intensify. We may not be able to refinance the Amended Credit Facilities at maturity on favorable terms or at all. The amended and restated revolving credit facility and the senior secured second lien term loan facility included in the Amended Credit Facilities will mature in full in 2008 and 2011, respectively. We may not be able to renew or refinance the Amended Credit Facilities, or if renewed or refinanced, the renewal or refinancing may occur on less favorable terms. In particular, some of the terms of the senior subordinated notes that may be viewed as favorable to the senior lenders, such as our ability to defer interest and acceleration forbearance periods, become less favorable in 2009, which may materially adversely affect our ability to refinance or renew the Amended Credit Facilities beyond such dates. If we are unable to refinance or renew the Amended Credit Facilities, our failure to repay all amounts due on the maturity date would cause a default under the Amended Credit Facilities. In addition, our interest expense may increase significantly if we refinance the Amended Credit Facilities on terms that are less favorable to us than the terms of the Amended Credit Facilities. The Amended Credit Facilities will contain significant limitations on distributions and other payments. The Amended Credit Facilities will restrict our ability to pay interest on the senior subordinated notes and dividends on our common stock based on the achievement of minimum EBITDA levels and minimum cash fixed charge coverage ratios. If the EBITDA levels and cash fixed charge coverage ratio requirements are not satisfied, we will be permitted to defer interest on the senior subordinated notes pursuant to the indenture governing those notes. However, the indenture provides that interest on the senior subordinated notes may not be deferred for more than eight quarters in the aggregate prior to 2009. If we may no longer defer interest on the senior subordinated notes but our EBITDA levels and cash fixed charge coverage ratio continue to fall short of the Amended Credit Facilities requirements, we will not be permitted to pay interest on the senior subordinated notes, which would cause a default under the indenture, entitling the holders of the senior subordinated notes to demand payment in full of all amounts outstanding under the senior subordinated notes, subject to an acceleration forbearance period of up to 90 days. The default and the acceleration of the senior subordinated notes under such circumstances would cause a default under the Amended Credit Facilities, and we might not have sufficient funds to repay all amounts outstanding under the Amended Credit Facilities and the senior subordinated notes. Your right to receive payments on the senior subordinated notes is effectively junior to those lenders who have a security interest in our assets. Our obligations under the senior subordinated notes are unsecured and are effectively subordinated to any of our existing or future secured indebtedness, including obligations under the Amended Credit Facilities, which Table of Contents will be secured by a security interest in substantially all our domestic tangible and intangible assets and a portion of the stock of certain of our non-U.S. subsidiaries. In the event of a foreclosure, dissolution, winding-up, liquidation, reorganization, bankruptcy or similar proceeding involving us, the assets which serve as collateral for any secured indebtedness will be used to satisfy the obligations under the secured indebtedness before any payments are made on the senior subordinated notes. If any assets remained after payment of secured indebtedness, they might be insufficient to satisfy your claims fully or at all. See Description of Other Indebtedness beginning on page 122. As of May 30, 2004, on a pro forma basis after giving effect to the Acquisition and the Transactions, we would have had $294.3 million of senior secured indebtedness (all of which would have been indebtedness under the Amended Credit Facilities, and which would not have included availability of $342.9 million under the Amended Credit Facilities, which availability is subject to the aggregate borrowing base availability and net of $27.8 million in outstanding letters of credit). The indenture permits the incurrence of substantial additional indebtedness by us and our restricted subsidiaries in the future, including secured indebtedness. If we or our subsidiaries default on our or their obligations to pay our or their indebtedness, or fail to comply with other covenants thereunder, we may not be able to make payments on the senior subordinated notes and the common stock. If we or our subsidiaries are unable to generate sufficient cash flow and are otherwise unable to obtain funds necessary to meet required payments on our or their indebtedness, or if we or our subsidiaries otherwise fail to comply with the various covenants, including financial and operating covenants, in the instruments governing our or their indebtedness (including the Amended Credit Facilities and our guarantee thereof), we or they could be in default under the terms of the agreements governing such indebtedness. In the event of such default: the holders of such indebtedness could elect to declare all the funds borrowed thereunder to be due and payable, together with accrued and unpaid interest and liquidated damages, if any. The lenders under the Amended Credit Facilities could elect to terminate their commitments, cease making further loans and institute foreclosure proceedings against our or our subsidiaries assets. We could directly or indirectly be prohibited from paying principal, premium, if any, and interest on the senior subordinated notes, and dividends with respect to the common stock, and we or our subsidiaries could be forced into bankruptcy or liquidation. The proceeds of the offering will be used to repurchase a portion of UAP Holdings common stock and Series A redeemable preferred stock from UAP Holdings existing shareholders and to repurchase all the outstanding notes of UAP Holdings and United Agri Products, which may subject the note holders in this offering to the claim that UAP Holdings did not receive fair consideration for the senior subordinated notes issued in this offering. In the event that we meet any of the financial condition fraudulent transfer tests described below under Federal and state laws permit a court to void the senior subordinated notes or the subsidiary guarantees under certain circumstances at the time of or as a result of this offering, a court could integrate the issuance of our senior subordinated notes with the distribution to our shareholders and the repurchase of the outstanding notes of United Agri Products, and, therefore, conclude that we did not get fair value for the offering viewed as an integrated transaction. In such a case, a court could hold the debt owed to the senior subordinated note holders void, unenforceable or may subordinate it to the claims of other creditors. The guarantee of our senior subordinated notes by any subsidiary guarantor could be subject to the claim that, since the guarantee was incurred for the benefit of UAP Holdings, and only indirectly for the benefit of the subsidiary guarantor, the obligations of the subsidiary guarantor were incurred for less than fair consideration. If such a claim were successful and it was proven that the subsidiary guarantor was insolvent at the time the guarantee was issued, a court could void the obligations of the subsidiary guarantor under the guarantee or Table of Contents subordinate these obligations to the subsidiary guarantor s other debt or take action detrimental to the holders of the senior subordinated notes. If the guarantee of any subsidiary guarantor were voided, our senior subordinated notes would be effectively subordinated to the indebtedness of that subsidiary guarantor. We will be subject to restrictive covenants in our debt agreements that may limit our ability to pursue strategies that may otherwise improve our business. The indenture governing the senior subordinated notes and the Amended Credit Facilities will impose significant operating and financial restrictions on us. These restrictions will limit our ability, among other things, to: incur additional indebtedness; acquire the assets of, or merge or consolidate with, other companies; pay dividends or make other distributions on our capital stock or repurchase, repay or redeem the senior subordinated notes, subordinated debt and our capital stock; make certain investments; incur liens; make capital expenditures; enter into certain types of transactions with our stockholders and affiliates; limit dividends or other payments by our restricted subsidiaries to us; and transfer or sell certain or all or substantially all of our assets. These covenants in the Amended Credit Facilities and the indenture governing the senior subordinated notes may impair our ability to finance future operations or capital needs or to enter into acquisitions or joint ventures or engage in other favorable business activities. If we default under the Amended Credit Facilities or we fail to satisfy the financial covenants under the Amended Credit Facilities, we could directly or indirectly be prohibited from making any payments with respect to the IDSs or our senior subordinated notes. In addition, the lenders under the Amended Credit Facilities could require immediate repayment of the entire principal that is outstanding under those facilities. If those lenders require immediate repayment, our assets may not be sufficient to repay them and also repay the senior subordinated notes in full. Federal and state laws permit a court to void the senior subordinated notes or the subsidiary guarantees under certain circumstances. The issuance of the senior subordinated notes and the guarantees may be subject to review under United States federal bankruptcy law and comparable provisions of state fraudulent conveyance laws if a bankruptcy or reorganization case or lawsuit is commenced by or on behalf of our or the guarantor s unpaid creditors. A court could void the obligations under the senior subordinated notes or the guarantees, further subordinate the senior subordinated notes or the guarantees or take other action detrimental to holders of the senior subordinated notes, if, among other things, at the time the indebtedness was incurred, we or the guarantors: issued the senior subordinated notes or the guarantees to delay, hinder or defraud present or future creditors; or received less than reasonably equivalent value or fair consideration for issuing the senior subordinated notes or the guarantees at the time of issuance of the senior subordinated notes or the guarantees and: were insolvent or rendered insolvent by reason of issuing the senior subordinated notes or the guarantees; Table of Contents The following table illustrates the estimated sources and uses of the funds for the Transactions, assuming the Transactions all occurred on May 30, 2004 and 100% of the 8 % Senior Notes and 10 % Senior Discount Notes are tendered and purchased in the Tender Offers. Actual amounts may differ. Total Sources and Uses of Funds (Dollars in millions) Sources Table of Contents were engaged, or about to engage, in a business or transaction for which the remaining unencumbered assets constituted unreasonably small capital to carry on our or the guarantor s business; or intended to incur, or believed that we or the guarantor would incur, debts beyond our or the guarantor s ability to pay as they mature. The measures of insolvency for purposes of fraudulent transfer laws vary depending upon the law of the jurisdiction that is being applied in any proceeding to determine whether a fraudulent transfer had occurred. It is not clear what standard a court would use to determine whether or not we or a guarantor were solvent at the relevant time. Generally, however, a person would be considered insolvent if, at the time it incurred the debt: the sum of its debts, including contingent liabilities, was greater than the fair saleable value of all of its assets; the present fair saleable value of its assets was less than the amount that would be required to pay its probable liability on its existing debts, including contingent liabilities, as they become absolute and mature; or it could not pay its debts as they become due. Since the senior subordinated notes or the guarantees were incurred for the benefit of the holders of our equity and only indirectly for the benefit of us or the guarantor, our obligations or the obligations of the applicable guarantor could be subject to the claim that they were incurred for less than fair consideration. If we defease the senior subordinated notes, such defeasance may be subject to preferential transfer laws. The indenture relating to the senior subordinated notes will provide that we may, after complying with certain conditions, defease the senior subordinated notes and be released from our obligations under many of the covenants contained in the indenture, or discharge all our obligations under the indenture within a year of the maturity date or a redemption date. One of the conditions to such defeasance or discharge is that we deposit sufficient funds with the trustee to pay the principal, interest and premium on the outstanding senior subordinated notes through maturity or an applicable redemption date. If a bankruptcy or reorganization proceeding is initiated within the applicable preference period, which generally varies from 90 days to one year, the deposit would likely be subject to review under federal bankruptcy law and comparable provisions of state law. In such an event, a court may void the deposit of funds with the trustee as a preferential transfer and recover such funds for the benefit of the bankruptcy estate and/or otherwise order that the funds be made available to satisfy claims of other creditors. In addition, under the fraudulent conveyance laws described above, a court could also void the deposit of funds or take other actions detrimental to you. The indenture will permit us to finance the defeasance deposit by issuing secured debt that we would not otherwise be permitted to incur under the indenture. In the event that the payments used to defease the senior subordinated notes are found to be a preferential transfer or a fraudulent conveyance, any claims arising out of or relating to the senior subordinated notes would be effectively subordinated in right of payment to any of our secured debt, including the secured debt incurred to finance the defeasance, to the extent of the value of the assets securing that debt. Your ability to recover on the senior subordinated notes after a defeasance or discharge may be reduced or eliminated as a result of these risks. The indenture governing the senior subordinated notes will permit us to pay a significant portion of our free cash flow to stockholders in the form of dividends. The indenture governing the senior subordinated notes and our Amended Credit Facilities will permit us to pay a significant portion of our free cash flow to holders of our common stock, including common stock held as part of IDSs, and participating preferred stock in the form of dividends. Holders of senior subordinated notes held separately from the IDSs may be adversely affected by such provisions because any amounts paid by us in the form of dividends will not be available in the future to satisfy our obligations under the senior subordinated notes. Amount Table of Contents The realizable value of our assets upon liquidation may be insufficient to satisfy claims. As of May 30, 2004, on a pro forma basis after giving effect to the Transactions, our total assets included intangible assets in the amount of $50.2 million, representing approximately 2.8% of our total consolidated assets. The value of these intangible assets will continue to depend significantly upon the continued profitability of the respective brands. As a result, in the event of a default on our senior subordinated notes or any bankruptcy or dissolution of our company, the realizable value of these assets may be substantially lower and may be insufficient to satisfy the claims of our creditors. Deferral of interest payments would have adverse tax consequences for you and may adversely affect the trading price of the IDSs or the separately held senior subordinated notes. If interest payments on the senior subordinated notes are deferred, you will be required to recognize interest income for U.S. federal income tax purposes in respect of interest payments on the senior subordinated notes represented by the IDSs or the separately held senior subordinated notes, as the case may be, held by you before you receive any cash payment of this interest. In addition, you will not receive this cash if you sell the IDSs or the separately held senior subordinated notes, as the case may be, before the end of any deferral period or before the record date relating to interest payments that are to be paid. If interest is deferred, the IDSs or the separately held senior subordinated notes may trade at a price that does not fully reflect the value of accrued but unpaid interest on the senior subordinated notes. In addition, the fact that we may defer payments of interest on the senior subordinated notes under certain circumstances may mean that the market price for the IDSs or the separately held senior subordinated notes may be more volatile than other securities that do not have this term. The U.S. federal income tax consequences of the issuance, purchase, ownership and disposition of IDSs are unclear. No statutory, judicial or administrative authority directly addresses the treatment of the IDSs or instruments similar to the IDSs for U.S. federal income tax purposes. As a result, the U.S. federal income tax consequences of the purchase, ownership and disposition of IDSs are unclear. We believe that an IDS should be treated as a unit representing a share of common stock and $8.00 principal amount of senior subordinated notes. However, the Internal Revenue Service or the courts may take the position that the senior subordinated notes included in the IDSs are equity, which could adversely affect the amount, timing and character of income, gain or loss in respect of your investment in IDSs, and materially increase our taxable income and, thus, our U.S. federal and applicable state income tax liability. This would reduce our after-tax cash flow and materially and adversely affect our ability to make interest and dividend payments on the senior subordinated notes, including the separate senior subordinated notes, and the common stock. In addition, non-U.S. holders could be subject to withholding with regard to the senior subordinated notes included in the IDSs in the same manner as they will be with regard to the common stock and it could subject us to liability for withholding taxes that were not collected on payments of interest. Payments to non-U.S. holders would not be grossed-up for any such taxes. Moreover, if, for U.S. federal income tax purposes, we are, in the opinion of a nationally recognized law firm experienced in such matters, not permitted to deduct from income more than 90% of the interest payable on the senior subordinated notes, we may, at our option, redeem all of the senior subordinated notes. See Material U.S. Federal Income Tax Consequences beginning on page 199. We may have to establish a reserve for contingent tax liabilities in the future, which could adversely affect our ability to make dividend payments on the IDSs. Even if the IRS does not challenge the tax treatment of the senior subordinated notes, it is possible that as a result of an alteration of facts relied upon at the time of issuance of the senior subordinated notes, we will in the future need to change our anticipated accounting treatment and establish a reserve for contingent tax liabilities associated with a disallowance of all or part of the interest deductions on the senior subordinated notes. If we were required to maintain such a reserve, our ability to make dividend payments could be materially impaired Cash on hand $ 7.8 Amended and restated revolving credit facility 87.2 New term loan facility 165.0 IDSs offered hereby(1) 730.0 Senior subordinated notes offered hereby separately from the IDSs 40.6 Table of Contents and the market for the IDSs, common stock and senior subordinated notes could be adversely affected. In addition, any resulting impact to our financial statements could lead to defaults under the Amended Credit Facilities. Future changes that increase cash taxes payable by us could significantly decrease our future cash flow available to make interest and dividend payments with respect to the IDSs and the separate senior subordinated notes. We have been permitted to take certain deductions from our taxable income in computing our cash taxes. In connection with this offering we have assumed that we will be able to take an aggregate of approximately $65.0 million in incremental deductions from taxable income relating to the redemption or repayment of our outstanding indebtedness. If there is a change in U.S. federal tax law that reduces any of these available deductions or results in an increase in our corporate tax rate, our cash taxes payable may increase, which could significantly reduce our future cash flow and impact our ability to make interest and dividend payments. The allocation of the purchase price of the IDSs may not be respected. The purchase price of each IDS must be allocated between the share of common stock and senior subordinated note represented thereby in proportion to their respective fair market values at the time of purchase. Assuming an initial public offering price of $20.00 per IDS, which represents the mid-point of the range set forth on the cover page of this prospectus, we expect to report the initial fair market value of each share of common stock as $12.00 and the initial fair market value of each of our senior subordinated notes represented by an IDS as $8.00, and by purchasing IDSs, you will agree to be bound by such allocation. If this allocation is not respected it is possible that the senior subordinated notes will be treated as having been issued with OID (if the allocation to the senior subordinated notes were determined to be too high) or amortizable bond premium (if the allocation to the senior subordinated notes were determined to be too low). You generally would have to include OID in income in advance of the receipt of cash attributable to that income and would be able to elect to amortize bond premium over the term of the senior subordinated notes. If we subsequently issue senior subordinated notes with significant OID, we may not be able to deduct all the interest on those senior subordinated notes. It is possible that senior subordinated notes we issue in a subsequent issuance will be issued at a discount to their face value and, accordingly, could have significant original issue discount and thus be classified as applicable high yield discount obligations, or AHYDOs. If any such senior subordinated notes were so treated, a portion of the OID on such senior subordinated notes could be nondeductible by us and the remainder would be deductible only when paid. This treatment would have the effect of increasing our taxable income and may adversely affect our cash flow available for interest payments and distributions to our equityholders. Subsequent issuances of senior subordinated notes may cause you to recognize OID and may be treated as a taxable exchange by you. The indenture governing the senior subordinated notes will provide that, if there is a subsequent issuance of senior subordinated notes having identical terms as the senior subordinated notes represented by the IDSs and the senior subordinated notes being offered separately in this offering but issued with OID, including an issuance upon a conversion of participating preferred stock, each holder of IDSs or separately held senior subordinated notes, as the case may be, agrees that upon such issuance and upon any issuance of senior subordinated notes thereafter, a portion of such holder s senior subordinated notes will be automatically exchanged for a portion of the senior subordinated notes acquired by the holders of such subsequently issued senior subordinated notes. Immediately following such subsequent issuance and exchange, each holder of senior subordinated notes, held either as part of IDSs or separately, will own an inseparable unit composed of a proportionate percentage of senior subordinated notes of each separate issuance. Therefore, subsequent issuances of senior subordinated notes Table of Contents with OID may adversely affect your tax treatment by increasing the OID, if any, that you were previously accruing with respect to the senior subordinated notes represented by your IDSs or separately held. Furthermore, it is unclear whether the exchange of senior subordinated notes for subsequently issued senior subordinated notes results in a taxable exchange for U.S. federal income tax purposes, and it is possible that the IRS might successfully assert that such an exchange should be treated as a taxable exchange. Following any subsequent issuance and exchange of senior subordinated notes with OID, we (and our agents) will report any OID on the subsequently issued senior subordinated notes ratably among all holders of IDSs and separately held senior subordinated notes, and each holder of IDSs and separately held senior subordinated notes will, by purchasing IDSs or separately held senior subordinated notes, agree to report OID in a manner consistent with this approach. However, the Internal Revenue Service may assert that any OID should be reported only to the persons that initially acquired such subsequently issued senior subordinated notes (and their transferees) and thus may challenge the holders reporting of OID on their tax returns. In such case, the Internal Revenue Service might further assert that, unless a holder can establish that it is not a person that initially acquired such subsequently issued senior subordinated notes (or a transferee thereof), all of the senior subordinated notes held by such holder have OID. Any of these assertions by the Internal Revenue Service could create significant uncertainties in the pricing of IDSs and senior subordinated notes and could adversely affect the market for IDSs and senior subordinated notes. For a discussion of these tax related risks, see Material U.S. Federal Income Tax Consequences beginning on page 199. The aggregate stated principal amount of the senior subordinated notes owned by each holder will not change as a result of such subsequent issuance and automatic exchange. However, under New York and federal bankruptcy law, holders of subsequently issued senior subordinated notes having OID may not be able to collect the portion of their principal face amount that represents unamortized OID at the acceleration or filing date in the event of an acceleration of the senior subordinated notes or our bankruptcy prior to the maturity date of the senior subordinated notes. As a result, an automatic exchange that results in a holder receiving a senior subordinated note with OID could have the effect of ultimately reducing the amount such holder can recover from us in the event of an acceleration or bankruptcy. Because of the deferral of interest provisions, our senior subordinated notes may be treated as issued with OID. Under applicable Treasury regulations, a remote contingency that stated interest will not be timely paid will be ignored in determining whether a debt instrument is issued with OID. Although there is no authority directly on point, based on our financial forecasts, we believe that the likelihood of deferral of interest payments on the senior subordinated notes is remote within the meaning of the Treasury regulations. Based on the foregoing, although the matter is not free from doubt because of the lack of direct authority, the senior subordinated notes would not be considered issued with OID at the time of their original issuance. If deferral of any payment of interest were determined not to be remote, then the senior subordinated notes would be treated as issued with OID at the time of issuance. In such case, all stated interest on the senior subordinated notes would be treated as OID, with the consequence that all holders would be required to include the yield on the senior subordinated notes in income as it is accrued on a constant yield basis, possibly in advance of their receipt of the associated cash and regardless of their method of tax accounting. Before this offering, there has not been a public market for our IDSs, shares of our common stock or the senior subordinated notes, which may cause the price of the IDSs, shares of our common stock and separate senior subordinated notes to fluctuate substantially and negatively affect the value of your investment. None of the IDSs, the shares of our common stock or senior subordinated notes has a public market history. In addition, there has not been an active market in the United States for securities similar to the IDSs. An active Total sources $ 1,030.6 Table of Contents trading market for the IDSs, shares of our common stock or the senior subordinated notes sold separately in this offering might not develop in the future, which may cause the price of the IDSs, shares of our common stock or the senior subordinated notes sold separately in this offering to fluctuate substantially, and we currently do not expect that an active trading market for the shares of our common stock will develop until the senior subordinated notes mature, if at all. If the senior subordinated notes represented by your IDSs are redeemed or mature, the IDSs will automatically separate and you will then hold the shares of our common stock. We do not intend to list our senior subordinated notes on any securities exchange. The initial public offering price of the IDSs and the senior subordinated notes sold separately in this offering will be determined by negotiations among us, our equity sponsor and the representatives of the underwriters and may not be indicative of the market price of the IDSs and the senior subordinated notes sold separately in this offering after the offering. Factors such as quarterly variations in our financial results and dividend payments, announcements by us or others, developments affecting us, our clients and our suppliers, general interest rate levels and general market volatility could cause the market price of the IDSs and the senior subordinated notes sold separately in this offering to fluctuate significantly. In addition, to the extent that a market develops for our common stock or senior subordinated notes, or both, separate from the IDSs, the price of your IDSs may be affected. The limited liquidity of the trading market for the senior subordinated notes sold separately may adversely affect the trading price of the separate senior subordinated notes. We are separately selling $40.6 million aggregate principal amount of senior subordinated notes, representing approximately 10.8% of the total outstanding senior subordinated notes (including those senior subordinated notes represented by IDSs and assuming the underwriters exercise their over-allotment option in full). While the senior subordinated notes sold separately are part of the same series of notes as, and are identical to, the senior subordinated notes represented by the IDSs, at the time of the issuance of the separate senior subordinated notes, the senior subordinated notes represented by the IDSs will not be separable for at least 45 days and will not be separately tradeable until separated. As a result, the initial trading market for the senior subordinated notes sold separately will be very limited. After the holders of the IDSs are permitted to separate their IDSs, a sufficient number of holders of IDSs may not separate their IDSs into shares of our common stock and senior subordinated notes so that a sizable and more liquid trading market for the senior subordinated notes not represented by IDSs may not develop or may not develop in a timely manner. Trading markets for debt securities have generally treated debt securities issued in larger aggregate principal amounts more favorably than similar securities issued in smaller aggregate principal amounts because of the increased liquidity created by potentially higher trading volumes associated with larger debt issuances. Because approximately 89.2% of the senior subordinated notes will initially be represented by the IDSs, it is likely that the senior subordinated notes sold separately will not trade at prices reflecting the aggregate principal amount of the combined issuance of senior subordinated notes included in the IDS offering and the separate senior subordinated notes offering. Therefore, a liquid market for the senior subordinated notes sold separately may not develop or may not develop in a timely manner, which may adversely affect the ability of the holders of the separate senior subordinated notes to sell any of their separate senior subordinated notes and the price at which these holders would be able to sell any of the senior subordinated notes sold separately. If interest rates rise, the trading value of our IDSs and the senior subordinated notes sold separately in this offering may decline. If interest rates rise or should the threat of rising interest rates develop, debt markets may be adversely affected. As a result, the trading value of our IDSs and senior subordinated notes may decline. Table of Contents Future sales or the possibility of future sales of a substantial amount of IDSs, shares of our common stock or the senior subordinated notes, together with the future conversion of our participating preferred stock into IDSs, may depress the price of the IDSs, shares of our common stock and the senior subordinated notes. Future sales or the availability for sale of substantial amounts of IDSs or shares of our common stock or a significant principal amount of the senior subordinated notes in the public market could adversely affect the prevailing market price of the IDSs, shares of our common stock and the senior subordinated notes and could impair our ability to raise capital through future sales of our securities. After consummation of the Transactions, we anticipate that our equity sponsor will own 6,403,289 shares of our participating preferred stock (or 928,289 shares of our participating preferred stock, if the underwriters over-allotment option is exercised in full). Subject to satisfaction of the Conversion Conditions, such shares will initially be convertible into 6,403,289 IDSs (or 928,289 IDSs, if the underwriters over-allotment option is exercised in full) after the first anniversary of the closing of the offering. In addition, we will be obligated to use our reasonable best efforts to effect one or more registered offerings of IDSs in order to fund certain repurchases of our participating preferred stock, under certain circumstances, upon the request of holders of our participating preferred stock. Such sales could cause a decline in the market price of the IDSs. We may issue shares of our common stock and senior subordinated notes, which will be in the form of IDSs, or other securities from time to time as consideration for future acquisitions and investments. In the event any such acquisition or investment is significant, the number of shares of our common stock and the aggregate principal amount of senior subordinated notes, which may be in the form of IDSs, or the number or aggregate principal amount, as the case may be, of other securities that we may issue may in turn be significant. In addition, we may also grant registration rights covering those IDSs, shares of our common stock, senior subordinated notes or other securities in connection with any such acquisitions and investments. Our amended certificate of incorporation and several other factors could limit another party s ability to acquire us and deprive our investors of the opportunity to obtain a takeover premium for their securities. Our amended certificate of incorporation contains certain provisions that may make it difficult for another company to acquire us and for you to receive any related takeover premium for your securities. For example, our amended certificate of incorporation authorizes the issuance of preferred stock without stockholder approval and upon such terms as the board of directors may determine. The rights of the holders of shares of our common stock will be subject to, and may be adversely affected by, the rights of holders of any class or series of preferred stock that may be issued in the future. In addition, our amended certificate of incorporation prohibits stockholders from taking action by written consent. You will be immediately diluted by $ per share of common stock if you purchase IDSs in this offering. If you purchase IDSs in this offering, based on the book value of the assets and liabilities reflected on our balance sheet, you will experience an immediate dilution of $ per share of common stock represented by the IDSs, which exceeds the entire price allocated to each share of common stock represented by the IDSs in this offering, because there will be a net tangible book deficit for each share of common stock outstanding immediately after this offering. Our pro forma net tangible book deficiency as of May 30, 2004, after giving effect to this offering, was approximately $ million, or $ per share of common stock. We may not be able to repurchase the senior subordinated notes upon a change of control. Upon the occurrence of specific kinds of change of control events, we will be required to offer to repurchase the outstanding senior subordinated notes at 101% of their principal amount at the date of repurchase unless such senior subordinated notes have been previously called for redemption. We may not have sufficient financial resources to purchase all of the senior subordinated notes that are tendered upon a change of control offer. Furthermore, the Amended Credit Facilities, with certain limited exceptions, will prohibit the repurchase or Uses Table of Contents redemption of the senior subordinated notes before their stated maturity. Consequently, lenders thereunder may have the right to prohibit any such purchase or redemption, in which event we will seek to obtain waivers from the required lenders. We may not be able to obtain such waivers or refinance our indebtedness on terms acceptable to us, or at all. Finally, the occurrence of a change of control could also constitute an event of default under the Amended Credit Facilities, which could result in the acceleration of all amounts due thereunder. See Description of Senior Subordinated Notes Repurchase at the Option of Holders Change of Control beginning on page 152. Retained ownership by our equity sponsor may prevent you from receiving a premium in the event of a change of control and may create conflicts of interest. Upon the completion of the Transactions, Apollo will beneficially own 14.3% of the voting power of UAP Holdings capital stock, or 2.1% if the underwriters over- allotment option is exercised in full. This concentration of ownership could have the effect of delaying, deferring or preventing a change in control, merger or tender offer, which would deprive you of an opportunity to receive a premium for your IDSs and may negatively affect the market price of the IDSs. RISKS RELATING TO OUR BUSINESS Our and our customers businesses are subject to seasonality and this may affect our revenues, carrying costs and collection of receivables. Our and our customers businesses are seasonal, based upon the planting, growing and harvesting cycles, and the inherent seasonality of the industry we serve could have a material adverse effect on our business. During fiscal 2002, 2003 and 2004, at least 75% of our net sales occurred during the first and second fiscal quarters of each year because of the condensed nature of the planting season. Since interim period operating results reflect the seasonal nature of our business, they are not indicative of results expected for the full fiscal year. In addition, quarterly results can vary significantly from one year to the next due primarily to weather-related shifts in planting schedules and purchase patterns. We incur substantial expenditures for fixed costs throughout the year and substantial expenditures for inventory in advance of the spring planting season. Seasonality also relates to the limited windows of opportunity that our customers have to complete required tasks at each stage of crop cultivation. Should events such as adverse weather or transportation interruptions occur during these seasonal windows, we would face the possibility of reduced revenue without the opportunity to recover until the following season. In addition, because of the seasonality of agriculture, we face the risk of significant inventory carrying costs should our customers activities be curtailed during their normal seasons. The seasonality of our industry can also affect the amount of bad debt that we are forced to carry on our books and can negatively impact our accounts receivable collections. See Management s Discussion and Analysis of Financial Condition and Results of Operations Seasonality beginning on page 70. Weather conditions may materially impact the demand for our products and services. Weather conditions have a significant impact on the farm economy and, consequently, on our operating results. Weather conditions affect the demand for, and in some cases the supply of, products, which, in turn, has an impact on our prices. For example, weather patterns such as flood, drought or frost can cause crop failures that in turn affect the supply of feed and seed and the marketing of grain products, as well as the demand for fertilizer, crop protectants, seeds and other agronomic supplies. In recent years, we have experienced unusually severe weather conditions, including ice storms, floods and wind damage, and a summer dearth of water and pasture in some states. Adverse weather conditions can also impact the financial position of agricultural producers who do business with us, including producers to whom we extend credit. This, in turn, may adversely affect the ability of those producers to repay their obligations to us in a timely manner, or at all. Accordingly, the weather can have a material effect on our business, financial condition, results of operations and liquidity. Amount Table of Contents Our industry is very competitive and increased competition could reduce our sales and profit margins. We operate in a highly competitive industry, particularly with respect to price and service. Our principal competitors in the distribution of crop production inputs include agricultural cooperatives, national fertilizer producers, major grain companies and independent distributors and brokers. Some of our competitors have greater financial, marketing and research and development resources, or better name recognition, than we do and can better withstand adverse economic or market conditions. In addition, as a result of increased pricing pressures caused by competition, we may experience reductions in the profit margins on sales, or may be unable to pass future material price increases on to our customers, which would also reduce profit margins. Our success depends on a limited number of key employees and we may not be able to adequately replace them if they leave. We believe that the success of our business strategy and our ability to operate profitably depend on the continued employment of our senior management team. The loss of the services of some of these key employees could have a material adverse effect on us. See Management beginning on page 98. Government regulation and agricultural policy may affect the demand for our products, and therefore our financial viability. Existing and future government regulations and laws may greatly influence how we operate our business, our business strategy and, ultimately, our financial viability. Existing and future laws may impact the amounts and locations of fertilizer and pesticide applications. The federal Clean Water Act and the equivalent state and local water pollution control laws are designed to protect water quality. The application of fertilizer and pesticides have been identified as a source of water pollution and are currently regulated and may be more closely regulated in the future. This regulation may lead to decreases in the quantity of fertilizer and pesticides applied to crops. The application of fertilizers can also result in the emissions of nitrogen compounds and particulate matter to the air. Compliance with future requirements to limit these emissions under the federal Clean Air Act and state equivalents may affect the quantity of fertilizer used by our customers. U.S. governmental policies and regulations may directly or indirectly influence the number of acres planted, the level of inventories, the mix of crops planted, crop prices and the amounts of and locations where fertilizers and pesticides may be applied. The market for our products could also be affected by challenges brought under the Endangered Species Act and by changes in regulatory policies affecting genetically modified seeds. We are subject to expenses, claims and liabilities under environmental, health and safety laws and regulations. We operate in a highly regulated environment. As a producer and distributor of crop production inputs, we must comply with federal, state and local environmental, health and safety laws and regulations. These regulations govern our operations and our storage, handling, discharge and disposal of a variety of substances. Our operations are regulated at the federal level under the Clean Air Act, the Clean Water Act, the Resource Conservation and Recovery Act, the Occupational Safety and Health Act, and at the state level under analogous state laws and regulations. As a formulator, seller and distributor of crop production inputs, we are also subject to registration requirements under the Federal Insecticide, Fungicide, and Rodenticide Act and related state statutes, which require us to provide information to regulatory authorities regarding the benefits and risks of the products we sell and distribute, and to update that information. Risk information supplied to governmental authorities by us or others could result in the cancellation of products or in limitations on their use. In addition, these laws govern information contained in product labels and in promotional materials, require that products are manufactured in adherence to manufacturing specifications, and impose reporting and recordkeeping requirements relating to production and sale of certain pesticides. Non-compliance with these environmental, health and safety laws can result in significant fines or penalties or restrictions on our ability to sell or transport products. Repurchase of 8 % Senior Notes(2) $ 225.0 Repurchase of 10 % Senior Discount Notes(3) 86.4 Repurchase of Series A Redeemable Preferred Stock(4) 35.4 Proceeds to our existing stockholders(5) 566.6 Transaction fees and expenses(6) 117.2 Table of Contents Under the Comprehensive Environmental Response, Compensation and Liability Act of 1980, we could be held jointly and severally responsible for the removal or remediation of any hazardous substance contamination at facilities that we currently own or operate, at facilities that we owned or operated in the past, at neighboring properties to which such contamination has migrated from our facilities, and at third party waste disposal sites to which we have sent wastes. We could also be held liable for natural resource damages. We may incur substantial costs to comply with these environmental, health and safety law requirements. We may also incur substantial costs for liabilities arising from past releases of, or exposure to, hazardous substances. From time to time claims have been made against us for consequences arising out of human exposure to these substances or other damage, including property damages. Currently, four such claims are pending in relation to our Greenville, Mississippi facility. In addition, we may discover currently unknown environmental problems or conditions. The continued compliance with environmental laws, the discovery of currently unknown environmental problems or conditions, changes in environmental, health and safety laws and regulations or other unanticipated events may subject us to material expenditures or liabilities in the future. Our variable rate indebtedness subjects us to interest rate risk, which could cause our debt service obligations to increase significantly. Certain of our borrowings, primarily borrowings under the Amended Credit Facilities, are at variable rates of interest and expose us to interest rate risk. If interest rates increase, our debt service obligations on our variable rate indebtedness would increase even though the amount borrowed remained the same, and our net income and cash available for servicing our other indebtedness, including the senior subordinated notes, would decrease. Our profitability depends significantly on rebates from our vendors. If we are unsuccessful in earning, negotiating or collecting rebates, it could have an adverse impact on our business. We receive rebates from crop protection chemicals and seed vendors based on programs offered by our suppliers to all of their customers. The programs vary based on product type and specific vendor practice. The majority of the rebate programs run on a crop year basis, typically from October 1st to September 30th, although other periods are sometimes utilized. The majority of these rebates are product-specific and are based on our sales of that product in a given crop year. We also negotiate individually with our vendors for additional rebates after the conclusion of the crop year and often several months after we have purchased and sold the products for which we are negotiating rebates. These individually negotiated rebates are based on various goals, such as our ability to grow sales of a particular vendor s products at a faster rate than that vendor s aggregate growth in sales for the same year, as well as increasing the percentage of our aggregate sales represented by a vendor s product line as compared with our sales of the vendor s competitors product lines and rebates in response to lower prices from a vendor s competitors. Our ability to earn, negotiate and collect rebates is critical to the success of our business. Generally, we sell the crop protection chemicals and seed we purchase from vendors at a reduced margin, with the profit from any sales of such products being made primarily from rebates from vendors. We price our products to our customers based on the amount of rebates we expect to receive at year-end. However, the amount of rebates we earn and the nature of our rebate programs are determined by our vendors and are directly related to the performance of our business. If our sales in any crop year are lower than expected, either because of poor weather conditions, increased competition or for any other reason, we will earn fewer rebates, and our gross margins may suffer. Additionally, our vendors may reduce the amount of rebates offered under their programs, or increase the sales goals or other conditions we must meet to earn rebates to levels that we cannot achieve. Finally, our ability to negotiate individually for additional rebates may cease or become limited, and our efforts to collect cash rebates periodically throughout the year may be unsuccessful. The occurrence of any of these events could have an adverse impact on our margins, net income or business. Table of Contents DISCLOSURE REGARDING FORWARD-LOOKING STATEMENTS This prospectus includes forward-looking statements that involve risks and uncertainties. Forward-looking statements include statements concerning our plans, objectives, goals, strategies, future events, future revenue or performance, capital expenditures, financing needs, plans or intentions relating to acquisitions, business trends and other information that is not historical information and, in particular, appear under the headings Prospectus Summary, Management s Discussion and Analysis of Financial Condition and Results of Operations and Business. When used in this prospectus, the words estimates, expects, anticipates, projects, plans, intends, believes, forecasts, foresees, likely, may, should, goal, target, and variations of such words or similar expressions are intended to identify forward-looking statements. All forward-looking statements are based upon information available to us on the date of this prospectus. These forward-looking statements are subject to risks, uncertainties and other factors, many of which are outside of our control, that could cause actual results to differ materially from the results discussed in the forward-looking statements, including, among other things, the matters discussed in this prospectus in the sections captioned: Prospectus Summary, beginning on page 1, Risk Factors beginning on page 26, and Management s Discussion and Analysis of Financial Condition and Results of Operations beginning on page 69. Such factors may include: general economic and business conditions; industry trends; restrictions contained in our debt agreements; our substantial leverage, including the inability to generate the necessary amount of cash to service our existing debt and the incurrence of substantial indebtedness in the future; the seasonality of our business and weather conditions; the risk that the senior subordinated notes will not be treated as debt for U.S. federal income tax purposes; the possibility of liability for pollution and other damage that is not covered by insurance or that exceeds our insurance coverage; increased competition in the markets in which we operate; our dependence on rebate programs to attain profitability; our dependence on a limited number of key executives who we may not be able to adequately replace if they leave our company; changes in government regulations, agricultural policy and environmental, health and safety laws and regulations; the cost of developing our own stand-alone systems and infrastructure; changes in business strategy, development plans or cost savings plans; the loss of any of our major suppliers or the bankruptcy or financial distress of our customers; the ability to attain and maintain any price increases for our products; availability, terms and deployment of capital; and other factors over which we have little or no control. There may be other factors that could cause our actual results to differ materially from the results referred to in the forward-looking statements. All forward-looking statements attributable to us or persons acting on our behalf apply only as of the date of this prospectus and are expressly qualified in their entirety by the cautionary statements included in this prospectus. We undertake no obligation to publicly update or revise forward-looking statements to reflect events or circumstances after the date made or to reflect the occurrence of unanticipated events. Total uses $ 1,030.6 (1) Includes $438.0 million of proceeds from the sale of common stock by our equity sponsor. We will not receive any of the proceeds from the sale by our equity sponsor of shares of common stock represented by the IDSs offered hereby. To the extent the underwriters over-allotment option is exercised, we will use all the proceeds from the sale of additional IDSs to repurchase shares of our participating preferred stock from our equity sponsor pursuant to the recapitalization agreement. (2) Reflects the repurchase in the 8 % Senior Note Tender Offer of 100% of United Agri Products existing 8 % Senior Notes. The proceeds of the 8 % Senior Notes, which mature on December 15, 2011, were used to repay United Agri Products senior bridge loan facility, which was incurred in connection with the Acquisition, to repay a portion of the existing revolving credit facility and to pay related fees and expenses. See Description of Other Indebtedness 8 % Senior Notes beginning on page 128. (3) Reflects the repurchase in the 10 % Senior Discount Note Tender Offer of 100% of UAP Holdings 10 % Senior Discount Notes. The proceeds of the 10 % Senior Discount Notes, which mature on July 15, 2012, were used to pay a dividend to the holders of our common stock, to redeem a portion of our outstanding Series A Redeemable Preferred Stock and to pay related fees and expenses. See Description of Other Indebtedness beginning on page 122. (4) Reflects the redemption of all our issued and outstanding Series A Redeemable Preferred Stock from ConAgra Foods. (5) Reflects the proceeds to our existing stockholders from (a) the sale of common stock represented by the IDSs offered hereby by our equity sponsor, (b) the repurchase of shares of our outstanding common stock from our equity sponsor pursuant to a recapitalization agreement and (c) cash payments of approximately $13.7 million to certain members of our management in exchange for the cancellation of 20% of their vested common equity, including options that will immediately vest in connection with this offering, pursuant to the management incentive agreement. To the extent the underwriters over-allotment option is exercised, we will use all the proceeds from the sale of additional IDSs to repurchase shares of our participating preferred stock from our equity sponsor pursuant to the recapitalization agreement. (6) Includes $55.0 million of prepayment penalties related to the repurchase of outstanding indebtedness, $8.4 million of accrued interest, and $53.8 million of fees and expenses related to this offering. Table of Contents DIVIDEND POLICY AND RESTRICTIONS General Upon completion of this offering, our board of directors will adopt a dividend policy which reflects a basic judgment that our stockholders would be better served if we distributed to them any cash available to pay dividends instead of retaining it in our business. Under this policy, cash generated by our business in excess of operating needs, interest and current or future principal payments on indebtedness, and capital expenditures sufficient to maintain our properties would in general be distributed as regular quarterly dividends to the holders of our common stock and participating preferred stock and vested options to acquire participating preferred stock rather than retained by us and used to finance growth opportunities. However, you may not receive any dividends as a result of the following factors: nothing requires us to pay dividends; while our current dividend policy contemplates the distribution of any cash available to pay dividends, this policy could be modified or revoked at any time; even if our dividend policy were not modified or revoked, the actual amount of dividends distributed under the policy and the decision to make any distribution is entirely at the discretion of our board of directors; the amount of dividends distributed is and will be subject to restrictions under: the indenture governing the senior subordinated notes, the terms of our Amended Credit Facilities, the terms of any other outstanding indebtedness incurred by us after the completion of this offering, and the terms of our amended and restated certificate of incorporation related to dividends on our participating preferred stock; the amount of dividends distributed is subject to state law restrictions; our stockholders have no contractual or other legal right to dividends; and we may not have enough cash to pay dividends due to changes to our operating earnings, working capital requirements and anticipated cash needs. We currently intend to pay an initial dividend under this policy on February 1, 2005 with respect to the partial quarterly period commencing on the completion of this offering and ending October 15, 2004 and a regular quarterly dividend payment for the period commencing on October 16, 2004 and ending on January 15, 2005 based on a quarterly dividend level of $0.235 per share of common stock and $0.475 per share of participating preferred stock. We currently intend to continue to pay quarterly dividends at this rate for the remainder of the first year following the closing of this offering. In respect of the first year following the closing of this offering, this would be $0.940 per share, or approximately $34.3 million in the aggregate, on the common stock and $1.90 per share, or approximately $17.4 million in the aggregate, on the participating preferred stock. In determining our expected initial dividend levels, we reviewed and analyzed, among other things, our operating and financial performance in recent years, the anticipated cash requirements associated with our new capital structure, our anticipated capital expenditure requirements, our expected other cash needs, the terms of our debt instruments, including our amended and restated revolving credit facility, other potential sources of liquidity and various other aspects of our business. We have not paid dividends on our capital stock in the past, except for an extraordinary dividend of approximately $52.9 million that we paid to the holders of our common stock with a portion of the proceeds from the 10 3/4% Senior Discount Notes. We have no history of paying dividends out of our cash flow. Table of Contents Minimum EBITDA, As Defined We do not, as a matter of course, make public projections as to future sales, earnings or other results. However, our management has prepared the estimated financial information set forth above to present the estimated cash available to pay dividends based on the estimated minimum EBITDA, as defined in the indenture governing the senior subordinated notes (which we refer to in this prospectus as EBITDA, as defined ), that we believe will be needed in order to fund dividends at the levels described above. The accompanying estimated financial information was not prepared with a view toward complying with the Public Company Accounting Oversight Board guidelines with respect to prospective financial information, but, in the view of our management, was prepared on a reasonable basis, reflects the best currently available estimates, judgments and beliefs, and presents, to the best of the management s knowledge and belief, our expected course of action and our expected future financial performance. Neither our independent registered public accounting firm, nor any other independent registered public accounting firm, has compiled, examined, or performed any procedures with respect to the estimated financial information contained herein, nor have they expressed any opinion or any other form of assurance on such information or its achievability, and assume no responsibility for, and disclaim any association with, the estimated financial information. The assumptions and estimates underlying the estimated financial information set forth above are inherently uncertain and, though considered reasonable by our management as of the date of its preparation, are subject to a wide variety of significant business, economic, and competitive risks and uncertainties, which may cause actual results to differ materially from the estimated financial information. See Risk Factors Risks Relating to Our Business beginning on page 39. Accordingly, there can be no assurance that our EBITDA, as defined, for the year following this offering will in fact equal or exceed the minimum level set forth below, and our belief that it will equal or exceed such level is subject to all the aforementioned risks and uncertainties. Without limiting those risks and uncertainties, this belief is subject to the assumption that there will be no material adverse development which impairs customer demand for or pricing of our products, rebate programs offered by our suppliers, government subsidies to our growers and the regulatory environment, other than those developments the occurrence of which during the year following the closing of this offering is reasonably foreseeable at the present time. We believe that, in order to fund dividends to holders of our common stock and participating preferred common stock at the levels described above from cash generated by our business, our minimum EBITDA, as defined for the year following this offering would need to be at least $112.8 million. As described under Assumptions and Considerations beginning on page 49 below, we believe that our minimum EBITDA, as defined, for the year following the closing of this offering will be at least $112.8 million. We have also determined that if our EBITDA, as defined, for such period were at or above this level, we would be permitted to pay dividends at these levels under the restricted payment covenants in the Amended Credit Facilities (so long as the other conditions contained therein and described below under Description of Other Indebtedness Senior Secured Second Lien Term Loan Facility Restrictions on Payment of Dividends and Interest on the Notes beginning on page 127 are met) and the indenture governing our senior subordinated notes. The following table sets forth our calculation that $112.8 million of EBITDA, as defined, would be sufficient to fund dividends at the above levels and would satisfy such restricted payment covenants (so long as the other conditions contained therein and described below are met). (1) EBITDA, as defined in the indenture governing the senior subordinated notes, which we refer to in this prospectus as EBITDA, as defined, is calculated by adjusting EBITDA for certain items. EBITDA represents net income (loss) before interest expense, finance charges, income taxes, depreciation and amortization. The adjustments to EBITDA used to calculate EBITDA, as defined, relate to (a) the add back of losses from discontinued operations, net of taxes, (b) the add back of inventory fair market value adjustments as a result of the Acquisition, (c) the add back of expenses relating to a transition services agreement and (d) the add back/deduction of loss/gain from the sale of certain businesses. (2) Our total capital expenditures were approximately $15.3 million for the year ended February 22, 2004 and approximately $10.7 million for the twelve months ended May 30, 2004. Total capital expenditures include growth capital expenditures and maintenance capital expenditures as described below. Growth capital expenditures include items with a cost in excess of $5,000 that management believes will increase our future cash flow from operations, as evidenced by an analysis showing the expected increase to our cash flow in relation to the expenditures. Growth capital expenditures are intended to support our strategic growth activities or bring about efficiencies in our formulation facilities and Table of Contents include items such as the addition of new warehouse space, seed equipment, bulk fertilizer and chemical storage, cost reduction projects at our formulation facilities, investments in information technology that generate better buying decisions or improvements in working capital, and the investment in registrations for our proprietary products. Growth capital expenditures are initiated at the discretion of management based on a cost and benefit analysis for each item as it may occur. Management estimates that growth capital expenditures would have been approximately $9.2 million for the year ended February 22, 2004, $1.5 million in fiscal 2003, $7.0 million in fiscal 2002, and approximately $5.6 million for the twelve months ended May 30, 2004. Growth capital expenditures during these periods were primarily due to the implementation of our new location operating system, a fertilizer capacity expansion, and an investment in a proprietary product line. Growth capital expenditures also include our investments in projects required to separate ourselves from ConAgra Foods. In fiscal 2005, we expect growth capital expenditures to total approximately $12.5 million, which includes approximately $3.7 million of capital expenditures for transition projects to enable our separation from our former parent, ConAgra Foods, approximately $5.3 million for an investment in information systems and approximately $3.5 million in other growth capital expenditures. We expect to fund these amounts with borrowings under our amended and restated revolving credit facility. Maintenance capital expenditures include all expenditures which meet capitalization requirements under generally accepted accounting principles but which do not meet the definition of growth capital expenditures above. Maintenance capital expenditures tend to support our current operations and the current level of profitability as it relates to our existing location base. Maintenance capital expenditures include items such as refurbishment or replacement of existing distribution or formulating equipment, compliance related projects, computer hardware, and quality improvement projects. Such costs tend to be recurring in nature and are generally incurred after our busy season. On an annual basis, we do not expect maintenance capital expenditures to vary significantly from our estimated amounts. Maintenance capital expenditures are subtracted from EBITDA, as defined, for purposes of determining estimated cash available to pay dividends. Management estimates that maintenance capital expenditures would have been approximately $6.1 million for the year ended February 22, 2004, $4.9 million in fiscal 2003, $6.6 million in fiscal 2002, and approximately $5.1 million for the twelve months ended May 30, 2004. Maintenance capital expenditures during these periods were primarily due to the types of projects described above. For a more detailed discussion of our capital expenditures, see Management s Discussion and Analysis of Financial Condition and Results of Operations Liquidity and Capital Resources Capital Expenditures beginning on page 75. (3) Reflects our anticipated cash interest expense under our new capital structure. Accordingly, it assumes 12.0% interest on $292.0 million of senior subordinated notes represented by IDSs and $40.6 million of senior subordinated notes not represented by IDSs. (4) Reflects our anticipated cash interest expense under our new capital structure. Accordingly, it assumes interest at current rates, estimated to be 5.50% average interest rate payable on $165.0 million outstanding borrowings under the new senior secured second lien term facility, 4.50% interest rate payable on an estimated annual average annual balance of $90.0 million under the amended and restated revolving credit facility, and 0.5% commitment fee payable on the average unused balance of $410.0 million under the amended and restated revolving credit facility. The estimated annual average balance of $90.0 million under our amended and restated revolving credit facility was determined by taking into consideration our historical seasonality and working capital requirements, including scheduled annual amortization payments of $1.65 million on the senior secured second lien term loan facility, total maintenance and growth capital expenditures and estimated dividends on our common stock and preferred stock, in each case, after giving effect to this offering and the new capital structure. As the interest rates on the new senior secured second lien term facility and the amended and restated revolving credit facility are floating and are tied to the level of LIBOR, the actual interest rates and the related interest expense for the year following this offering, with respect to outstanding borrowings under the new senior secured second lien term facility and the amended and restated revolving credit facility may be higher than those assumed in our calculations due to an increase in the LIBOR rate. To hedge against significant upward movements in LIBOR, we intend to enter into an interest rate cap agreement that provides for an upper cap of 2% for the level to which LIBOR might increase, which as a result would cap the maximum interest rate with respect to outstanding borrowings under the new senior secured second lien term loan facility at 5.75%. If LIBOR were to increase to 2% or higher for the entire year following the offering, then the interest expense payable with respect to outstanding borrowings under the new senior secured second lien term facility and the amended and restated revolving credit facility would have been $15.8 million, and the total interest expense would have been $20.5 million. (5) We do not expect any cash income taxes during the year following the closing of this offering because of the significant non-recurring expenses incurred in connection with the Transactions. In computing our cash income taxes, as adjusted for the Transactions for this period, we have assumed the following one-time non-recurring incremental deductions from taxable income resulting from the Transactions totaling $65.0 million: (i) $55.0 million in prepayment penalties and transaction fees associated with the Tender Offers and (ii) the write-off of $10.0 million of deferred financing fees associated with the retirement of existing indebtedness. Had we not incurred these non-cash expenses in connection with the Transactions, our income tax expense for the twelve months ended May 30, 2004 would have been approximately $12.6 million. After the first year following the closing of this offering, we expect that we will be required to pay cash income taxes, which will reduce cash available to pay dividends and our ability to pay dividends. As illustrated by the table above, for the twelve months ended May 30, 2004, on a pro forma basis after giving effect to the Transactions, we would have had sufficient cash available to pay dividends to the holders of our common stock and participating preferred stock at the level set forth above. However, for the fiscal year ended February 22, 2004, on a pro forma basis after giving effect to the Transactions, we would not have had sufficient cash available to pay dividends to the holders of our common stock and participating preferred stock at the maximum level contemplated by our dividend policy. Accordingly, for the fiscal year ended February 22, 2004 we would have had to reduce the aggregate amounts of dividends payable on our common stock and participating preferred stock for such period by approximately $429,600 and $107,400, respectively. Table of Contents Assumptions and Considerations Based on a review and analysis conducted by our management and our board, we believe that our minimum EBITDA, as defined, for the year following the closing will be at least $112.8 million, and we have determined that the assumptions as to capital expenditures, cash interest expense, working capital and revolver availability in the above tables are reasonable. We considered numerous factors in making such determination, including the following: Our EBITDA, as defined, for the twelve-month period ended May 30, 2004 was $137.9 million. For fiscal years 2004 and 2003, our EBITDA, as defined, was, respectively, $121.5 million and $102.8 million. The improvement in EBITDA, as defined, since fiscal 2003 has been a result of a series of initiatives taken since current management joined in the middle of fiscal year 2002. The initiatives taken to improve the overall profitability of the business included rationalizing headcount, locations, customers, and product lines. Accordingly, we believe that our EBITDA, as defined, for fiscal 2003 is not indicative of our EBITDA, as defined, for the year following the closing of the offering as the complete impact of those management initiatives was not realized by us until fiscal 2004. For more information, see Management s Discussion and Analysis of Financial Condition and Results of Operations beginning on page 69. As a result of seasonality of our sales, we experience significant fluctuations in working capital. Since 2002 we have taken steps to reduce working capital. These steps have included better inventory payable management, centralized purchasing and SKU reduction programs. We will continue to seek to reduce working capital. For fiscal years 2004, 2003 and 2002, and for the twelve months ended May 30, 2004, we incurred $6.1 million, $4.9 million, $6.6 million and $5.1 million, respectively, in capital expenditures that we believe constituted maintenance capital expenditures. While the timing of maintenance capital expenditures may vary from quarter to quarter, we do not expect that maintenance capital expenditures will vary significantly on an annual basis. For fiscal years 2004, 2003 and 2002 and for the twelve months ended May 30, 2004, we incurred $9.2 million, $1.5 million, $7.0 million and $5.6 million, respectively, in capital expenditures that we believe constituted growth capital expenditures. In fiscal 2005, we expect growth capital expenditures to total approximately $12.5 million, which includes approximately $3.7 million of capital expenditures for transition projects to enable our separation from our former parent, ConAgra Foods, approximately $5.3 million for an investment in information systems and $3.5 million in other growth capital expenditures. We expect to fund these amounts with borrowings under our amended and restated revolving credit facility. Growth capital expenditures are initiated at the discretion of management based on a cost and benefit analysis for each item as it may occur. Average annual draws on the amended and restated revolving credit facility under the new capital structure would have been approximately $150.0 million on a pro forma basis for fiscal 2005. However, we anticipate that the average annual balance for the twelve months following the offering would be approximately $90.0 million, as a result of steps taken to reduce working capital, such as better inventory payable management, centralized purchasing and SKU reduction programs, and the fact that we do not expect to pay any cash income taxes during the year following the closing of this offering due to significant non-recurring expenses incurred in connection with the Transactions. If our EBITDA, as defined, for the first year were to fall below the $112.8 million level (or if our assumptions as to capital expenditures or interest expense were too low or our assumptions as to the sufficiency of borrowings under our amended and restated revolving credit facility to finance our working capital needs were to prove incorrect), we would need to either reduce or eliminate dividends or, to the extent we were permitted to do so under the indenture governing the senior subordinated notes and the Amended Credit Facilities, fund a portion of our dividends with borrowings or from other sources. If we were to use working capital or permanent borrowings to fund dividends, we would have less cash available for future dividends and other purposes, which could negatively impact our financial condition, our results of operations and our ability to maintain or expand our business. Additionally, the $500.0 million amended and restated revolving credit facility will mature in 2008, the new $165.0 million senior secured second lien term facility will mature in 2011 and the senior subordinated Table of Contents notes will mature in 2019. If we are unable to refinance any such indebtedness prior to its stated maturity, we would be required to use cash to repay such indebtedness, and although our dividend policy takes into account retaining cash to fund payments on indebtedness, we may not have sufficient cash available to us at that time. See Risk Factors Risks Relating to the IDSs, the Shares of Common Stock and Senior Subordinated Notes Servicing our debt will require a significant amount of cash. Our subsidiaries ability to generate sufficient cash depends on numerous factors which are beyond our control and we may be unable to generate sufficient cash flow to service our debt obligations, including making payments on the senior subordinated notes, and to pay dividends on the common stock beginning on page 29. Even if we do have sufficient cash, such repayment would significantly decrease the amount of cash, if any, available to pay dividends. Under our amended certificate of incorporation the holders of outstanding shares of participating preferred stocks will be entitled to receive, when, as and if declared by the board of directors, out of funds legally available therefor, with respect to each share of participating preferred stock, quarterly preferred dividends in an amount equal to the product of: the liquidation preference of such share multiplied by a per annum dividend rate equal to the per annum interest rate on the senior subordinated notes. To the extent such preferred dividends are not paid in cash on a dividend payment date, they will be added to the liquidation preference of such share. Such preferred dividends will accrue whether or not earned or declared (and regardless of whether sufficient funds are legally available therefor), will be cumulative from the issue date and will rank prior to dividend rights with respect to our common stock and any other class of our capital stock. No preferred dividends may be declared by our board of directors or paid by us to the extent that such declaration or payment shall be restricted or prohibited by law or to the extent that at the time of such payment, we are restricted or prohibited, for any reason, from paying interest on the senior subordinated notes. The holders of participating preferred stock will also participate in all dividends declared and paid to holders of our common stock on an as if converted basis. Our and our customers businesses are seasonal, based upon the planting, growing and harvesting cycles. During fiscal 2003 and 2004, at least 75% of our net sales occurred during the first and second fiscal quarters of each year because of the condensed nature of the planting season. As a result of the seasonality of sales, we experience significant fluctuations in our revenues, income and net working capital levels. Because of this, we may have to borrow under our amended and restated revolving credit facility to finance seasonal and periodic variations. We anticipate that during some periods of the year when our working capital is at peak usage, we will use borrowings under the amended and restated revolving credit facility to pay quarterly dividends even if our annual EBITDA, as defined, were to equal or exceed $112.8 million. The estimated financial information set forth above reflects the additional interest expense that would be incurred as a result of such borrowings under the amended and restated revolving credit facility. As noted above, we have estimated our initial dividend level and our minimum EBITDA, as defined, only for the twelve-month period following the closing of this offering. Moreover, there can be no assurance that during or following such period we will pay dividends at the levels estimated above, or at all. Dividend payments are within the absolute discretion of our board of directors and will be dependent upon many factors and future developments that could differ materially from our current expectations. Indeed, over time our capital and other cash needs will invariably be subject to uncertainties which could impact the level of any dividends we pay in the future. Interest on our Amended Credit Facilities is variable and our interest expense could well be higher. We may not be able to renew or refinance the Amended Credit Facilities, or if renewed or refinanced, the renewal or refinancing may occur on less favorable terms, which may materially adversely affect our ability to pay dividends. In particular, some of the terms of the senior subordinated notes that may be viewed as favorable to the senior lenders, such as our ability to defer interest and acceleration forbearance periods, become less favorable in 2009, which may materially adversely affect our ability to refinance or renew our Amended Credit Facilities beyond such dates. If we are unable to refinance or renew our Amended Credit Facilities, our failure to repay all amounts due on the maturity date would cause a default under the Amended Credit Facilities. In (1) Represents the interest on the average outstanding balance of the amount drawn on the credit facility at LIBOR plus 275 basis points plus the 0.5% commitment fee on the unused portion of the amended and restated credit facility. (i) Represents adjustments to reflect the 8% dividend on the outstanding portion of the Series A redeemable preferred stock. (j) Represents the tax effect of the pro forma adjustments at an estimated 38% effective tax rate. The dividends on the Series A redeemable preferred stock have not been tax effected as they are not tax deductible. (k) Gives effect to the Transactions, assuming no exercise of the underwriters over-allotment option and 100% of the 8 1/4% Senior Notes and 10 3/4% Senior Discount Notes are tendered and repurchased in the Tender Offers. Subject to satisfaction of the Conversion Conditions, each share of participating preferred stock will be convertible at the option of the holder into either one IDS or, if the IDSs have automatically separated prior to such conversion, (x) one or more senior subordinated notes having an aggregate principal amount equal to the liquidation preference of such share and (y) one share of common stock. Accordingly, a portion of the participating preferred stock that is convertible into senior subordinated notes has been classified as mezzanine equity. See Description of Capital Stock Participating Preferred Stock beginning on page 140. Table of Contents addition, our interest expense may increase significantly if we refinance our Amended Credit Facilities on terms that are less favorable to us than the terms of our Amended Credit Facilities. The senior subordinated notes will mature in 2019, and we may not be able to refinance the senior subordinated notes when they become due. If we are unable to refinance the senior subordinated notes, our failure to repay all amounts due on the maturity date would cause a default under the indenture governing the senior subordinated notes. Even if we were able to refinance the senior subordinated notes, the refinancing may occur on terms that are less favorable to us, which would materially adversely affect our results of operations and our ability to pay dividends. In addition, to the extent we finance capital expenditures with indebtedness, we will begin to incur incremental debt service obligations. Our intended policy to distribute rather than retain cash available to pay dividends is based upon our assessment of our financial performance, our cash needs and our investment opportunities. If these factors were to change based on, for example, competitive or technological developments (which could increase our need for capital expenditures), or new investment opportunities, we would need to reassess that policy. Our board is free to depart from or change our dividend policy at any time and could do so, for example, if it were to determine that we had insufficient cash to take advantage of growth opportunities. Although management currently has no specific plans to increase capital spending to materially expand our business, management will evaluate growth opportunities as they arise and may pursue opportunities that it believes would result in net increases to our cash available for distribution. Restrictions on Payment of Dividends Under Delaware law, we can only pay dividends either out of surplus or out of current or the immediately preceding year s earnings. Surplus is defined as the excess, if any, at any given time, of the total assets of a corporation over its total liabilities and statutory capital. The value of a corporation s assets can be measured in a number of ways and may not necessarily equal their book value. While we will have a stockholders deficit following the consummation of the Transactions, we do not anticipate that we will have, and in prior years we would not have had, sufficient earnings to pay dividends at the levels described above and therefore expect that we will pay dividends out of surplus. Although we believe we will have sufficient surplus to pay dividends at the anticipated levels during the first year following this offering, our board will seek periodically to assure itself of this before actually declaring any dividends. The indenture governing our senior subordinated notes will restrict our ability to declare and pay dividends on our capital stock as follows: We may not pay dividends on our capital stock, including the common stock and the participating preferred stock, or make payments with respect to vested options to acquire participating preferred stock at any time that a default or event of default has occurred and is continuing under such indenture. The aggregate amount of dividends on our common stock and our participating preferred stock (to the extent such dividends on the participating preferred stock do not have a preference over dividends on the common stock) and payments with respect to vested options to acquire participating preferred stock (to the extent such payments corresponded to dividends on the participating preferred stock that do not have a preference over dividends on the common stock) in any fiscal quarter may not exceed 100% of our excess cash, as defined (which is EBITDA, as defined, minus the sum of cash interest expense, income tax expense and certain capital expenditures), for the 12-month period ending on the last day of our then most recently ended fiscal quarter for which internal financial statements are available at the time such dividend is declared and paid divided by four; provided that if our fixed charge coverage ratio is less than 1.6 to 1.0, we may not declare or pay dividends on our common stock or our participating preferred stock (to the extent such dividends on the participating preferred stock do not have a preference over dividends on the common stock) or make payments with respect to vested options to acquire participating preferred stock (to the extent such payments corresponded to dividends on the Table of Contents participating preferred stock that do not have a preference over dividends on the common stock) other than dividends and payments in an aggregate amount after the date of the indenture not to exceed $10.0 million. We may not pay any dividends on our common stock and the participating preferred stock or make payments with respect to vested options to acquire participating preferred stock while interest on the senior subordinated notes is being deferred or, after the end of any interest deferral, so long as any deferred interest or interest on deferred interest has not been paid in full. In addition, the indenture will contain a provision allowing us to make up to $25.0 million of restricted payments generally, which we could use to pay dividends. See Description of Senior Subordinated Notes beginning on page 145 for a more complete description of the dividend restrictions described above. The Amended Credit Facilities will also restrict our ability to pay interest on the senior subordinated notes and to declare and pay dividends on our capital stock as set forth below. The new second lien term loan facility will permit us to pay interest on the senior subordinated notes based on: there not being an event of default under such facility; there not being a payment blockage period under the indenture governing our senior subordinated notes; and the achievement of specified minimum EBITDA levels and minimum cash fixed charge coverage ratios (as set forth under Description of Other Indebtedness Senior Secured Second Lien Term Loan Facility beginning on page 125). The new second lien term loan facility will permit us to pay dividends on our capital stock based on: there not being an event of default under such facility; our ability to pay interest on the senior subordinated notes pursuant to the tests set forth above; there not being any outstanding, unpaid interest on the senior subordinated notes; and the achievement of specified minimum EBITDA levels and minimum pro forma cash fixed charge-dividends coverage ratios (as set forth under Description of Other Indebtedness Senior Secured Second Lien Term Loan Facility beginning on page 125). The amended and restated revolving credit facility will contain substantially similar restrictions on our ability to pay interest on the senior subordinated notes and dividends on our capital stock. In addition, the amended and restated revolving credit facility will not permit us to pay interest on the senior subordinated notes and dividends on our capital stock unless we are able to borrow at least $40.0 million under such facility and there is no event of default under such facility. Based on estimated minimum EBITDA, as defined, of $112.8 million, we should meet the financial ratio and other requirements under the Amended Credit Facilities to pay dividends on our capital stock for the 12 months following the date of this offering (so long as the other conditions described under Description of Other Indebtedness Senior Secured Second Lien Term Loan Facility Restrictions on Payment of Dividends and Interest on the Notes beginning on page 127 are met). Notwithstanding the foregoing, the Amended Credit Facilities permit us to make other restricted payments, including payments of interest on our senior subordinated notes and dividends on our capital stock, through the general basket in such facility. See Description of Other Indebtedness The Amended and Restated Revolving Credit Facility beginning on page 122 and Description of Other Indebtedness Senior Secured Second Lien Term Loan Facility beginning on page 125 for a more complete description of these interest and dividend restrictions. Under our amended and restated certificate of incorporation, we will not be permitted to pay dividends on our common stock unless and until all required dividends are paid to the holders of our outstanding participating preferred stock. See Description of Capital Stock beginning on page 138. (1) On June 10, 2004, we used $60.0 million of borrowings under the revolving credit facility to satisfy in full the amount due to ConAgra Foods as a result of the Acquisition. Such payment is not included in the pro forma financial information included in this prospectus. (2) Represents senior subordinated notes sold separately from IDSs. (3) Following the first anniversary of the closing of this offering and subject to satisfaction of the Conversion Conditions, each share of participating preferred stock will be convertible at the option of the holder into either one IDS or, if the IDSs have automatically separated prior to the time of such conversion, (x) one or more senior subordinated notes having an aggregate principal amount equal to the liquidation preference of such share and (y) one share of common stock. Accordingly, a portion of the participating preferred stock that is convertible into senior subordinated notes has been classified as mezzanine equity. See Description of Capital Stock Participating Preferred Stock beginning on page 140. (4) In connection with the Recapitalization and Transactions, we expect to incur charges to stockholders equity (deficit) related to (i) costs associated with the equity sponsor s sale of equity securities, (ii) the repurchase of common stock from our equity sponsor and certain members of management, (iii) stock compensation charges associated with modifications to stock and stock options held by certain members of management, (iv) prepayment penalties and write-off of debt issue costs associated with the Tender Offers, and (v) the incremental fair value pertaining to the issuance of the participating preferred stock and options to convert participating preferred stock into IDSs to existing shareholders. These charges have been reflected in the capitalization table above, and a reconciliation of these charges is included in note (f) to the pro forma financial statements in Unaudited Pro Forma Condensed Consolidated Financial Data beginning on page 55. Balance at November 23, 2003 $ 651,946 $ Existing stockholders % $ New investors Total % $ Table of Contents UNAUDITED PRO FORMA CONDENSED CONSOLIDATED FINANCIAL DATA We derived the unaudited pro forma condensed consolidated financial data set forth below by the application of the pro forma adjustments to the historical consolidated financial statements of UAP Holding Corp. appearing elsewhere in this prospectus. The unaudited pro forma condensed consolidated balance sheet as of May 30, 2004 gives effect to the Recapitalization and Transactions as if they had occurred on such date. The unaudited pro forma condensed consolidated statements of earnings for the fiscal year ended February 22, 2004, the fourteen weeks ended May 30, 2004 and the twelve months ended May 30, 2004 give effect to the Acquisition, the Recapitalization and the Transactions as if they occurred as of February 24, 2003. The unaudited pro forma condensed consolidated financial data do not purport to represent what our results of operations or financial position would have been if the Acquisition, the Recapitalization and the Transactions had occurred as of the dates indicated or what such results will be for any future periods. The unaudited pro forma condensed consolidated financial data have been prepared giving effect to the Acquisition, which is accounted for in accordance with Statement of Financial Accounting Standards ( SFAS ) No. 141, Business Combinations. The unaudited pro forma adjustments are based upon available information and certain assumptions that we believe are reasonable. The unaudited pro forma condensed consolidated statements of earnings exclude certain non-recurring charges that were incurred in connection with the Acquisition and the Transactions and certain financing transactions related thereto, consisting of: (i) prepayment penalties associated with the repayment of our 8 1/4% Senior Notes and 10 3/4% Senior Discount Notes of $55.0 million, (ii) write-off of deferred finance fees of $14.3 million associated with the 8 1/4% Senior Notes and 10 3/4% Senior Discount Notes to be repaid in connection with this offering, (iii) transaction fees and expenses associated with this offering and the tender offers of $53.8 million, (iv) costs associated with the equity sponsors sale of equity securities of $15.6 million on an after tax basis, and (v) non-cash compensation expense of approximately $42.6 million after-tax associated with causing our outstanding stock options to become exercisable for participating preferred stock. You should read our unaudited pro forma condensed consolidated financial statements and the accompanying notes in conjunction with the historical consolidated financial statements and the accompanying notes thereto of UAP Holding Corp. other financial information contained in Capitalization beginning on page 53 and Management s Discussion and Analysis of Financial Condition and Results of Operations beginning on page 69. Table of Contents SUMMARY UNAUDITED PRO FORMA CONDENSED CONSOLIDATED FINANCIAL AND OTHER DATA The summary unaudited pro forma condensed consolidated financial data of UAP Holding Corp. gives effect, in the manner described under Unaudited Pro Forma Condensed Consolidated Financial Data beginning on page 55 and the notes thereto, to the Acquisition and the Transactions, as if they occurred as of February 24, 2003 in the case of the unaudited pro forma statements of operations data and to the Transactions as if they occurred as of May 30, 2004 in the case of the unaudited pro forma balance sheet data. The unaudited pro forma financial data do not purport to represent what our results of operations or financial position would have been if the Acquisition and the Transactions had occurred as of the dates indicated or what such results will be for future periods. The results of operations for the interim periods are not necessarily indicative of the operating results for the entire year or any future period. You should read the information contained in this table in conjunction with The Transactions beginning on page 4, Unaudited Pro Forma Condensed Consolidated Financial Data beginning on page 55, Selected Historical Financial and Other Data beginning on page 66, Management s Discussion and Analysis of Financial Condition and Results of Operations beginning on page 69, and the historical combined financial statements and the accompanying notes thereto of UAP Holding Corp. included elsewhere in this prospectus. Pro Forma (dollars in thousands) Fourteen Weeks Ended May 30, 2004 (ii) Each share of participating preferred stock may be converted into one IDS following the first anniversary of this offering. Accordingly, a portion of the participating preferred stock will be classified as temporary equity in the amount equal to the present value of the senior subordinated note s par amount that the holder will be entitled to receive upon the earliest possible date of exchange using a discount rate equal to the interest rate on the senior subordinated notes, see Accounting for Participating Preferred Stock beginning on page 79. Participating Preferred Stock Debt Par Amount $ 66,540 Present value of the debt par amount of the participating preferred stock based on a discount rate of 12% and expected conversion dates of one year and two years based on provisions included as part of the offering $ 57,235 (iii) The participating preferred stock includes a right to exchange the participating preferred stock for a fixed number of IDSs. Such a right is an embedded derivative which requires bifurcation. The derivative will be recorded at fair value, as a liability, at issuance with the offsetting amount as a distribution to the holders of the participating preferred stock. The fair value of the embedded derivative was estimated at $6 per share, see Accounting for Participating Preferred Stock beginning on page 79. (g) Represents amortization of intangible assets resulting from the Acquisition. Twelve Months Ended May 30, 2004 Interest rates utilized to calculate pro forma interest expense are estimated based on rates disclosed in the registration statement. A 1% change in interest rates will affect annual interest expense by $1.5 million. Statement of Operations Data: Net sales $ 2,451,885 $ 1,258,489 $ 2,636,025 Costs and expenses: Cost of goods sold 2,108,740 1,122,755 2,299,731 Selling, general and administrative expenses 235,878 82,557 233,920 Corporate allocations Selling, general and administrative expenses 8,983 5,923 Table of Contents SELECTED HISTORICAL FINANCIAL AND OTHER DATA The following table sets forth our selected historical financial data at the dates and for the periods indicated. We derived the selected historical statement of operations data for the fiscal years ended February 24, 2002, February 23, 2003 and the thirty-nine week period ended November 23, 2003, and balance sheet data at February 23, 2003 of the ConAgra Agricultural Products Business (the Predecessor ) and the selected historical statement of operations data for the thirteen weeks ended February 22, 2004 and balance sheet data at February 22, 2004 of UAP Holding Corp. from the audited historical financial statements appearing elsewhere in this prospectus. We derived the selected historical statement of operations data for the fiscal year ended February 25, 2001 and balance sheet data at February 24, 2002 from audited historical financial statements of the Predecessor which are not included in this prospectus. We derived the selected historical statement of operations data for the fiscal year ended February 27, 2000, and balance sheet data at February 27, 2000 and February 25, 2001 from the unaudited historical financial statements of the Predecessor which are not included in this prospectus. We derived the summary historical statement of operations data for the fourteen weeks ended May 30, 2004 and balance sheet data at May 30, 2004 of UAP Holding Corp. from the unaudited financial statements of UAP Holding Corp. appearing elsewhere in this prospectus. We derived the summary historical statement of operations data for the thirteen weeks ended May 25, 2003 and balance sheet data at May 25, 2003 from the unaudited financial statements of the Predecessor appearing elsewhere in this prospectus. In the opinion of management, the unaudited financial statements include all adjustments (consisting of normal recurring accruals) necessary for a fair presentation of the financial position and results of operations for these periods. The results of operations for any quarter or a partial fiscal year period or for the periods presented for the Predecessor or Successor are not necessarily indicative of the results of operations to be expected for other periods or for the full fiscal year. Accounting principles generally accepted in the United States of America require our operating results prior to the Acquisition, the periods prior to November 23, 2003, to be reported as the results of the ConAgra Agricultural Products Business (the Predecessor ) in the historical financial statements. Our operating results subsequent to the Acquisition are presented as the Successor s results in the historical financial statements and include the thirteen-week period from November 24, 2003 through February 22, 2004 and the fourteen-week period from February 23, 2004 through May 30, 2004. The summary historical financial and other data does not give effect to the proposed 49.578-for-1 split of our common stock to be effected prior to the consummation of this offering. In order to effect the stock split, we will obtain the approval of our board of directors and will also obtain the approval of our stockholders to an amendment and restatement of our existing certificate of incorporation in order to increase the authorized number of shares of our common stock. The stock split will become effective upon the filing of the amendment to our certificate of incorporation with the Secretary of State of the State of Delaware. While completion of the necessary steps to effect the stock split has not yet taken place, we believe we will obtain all necessary approvals. You should read the information contained in this table in conjunction with The Transactions beginning on page 4, Unaudited Pro Forma Condensed Consolidated Financial Data beginning on page 55, Management s Discussion and Analysis of Financial Condition and Results of Operations beginning on page 69 and the historical consolidated and combined financial statements and the accompanying notes thereto of the Successor and Predecessor included elsewhere in this prospectus. (a) Represents expenses incurred by ConAgra Foods and allocated to the ConAgra Agricultural Products Business based on specific services provided or based on ConAgra Foods investment in the ConAgra Agricultural Products Business in proportion to ConAgra Foods total investment in its subsidiaries. (b) Represents amounts charged to the ConAgra Agricultural Products Business by ConAgra Foods on ConAgra Foods investment in and intercompany advances to the ConAgra Agricultural Products Business. (c) EBITDA represents net income (loss) before interest expense, finance charges, income taxes, depreciation and amortization. We present EBITDA because we believe it is a useful indicator of our historical debt capacity and ability to service debt, and consider it to be a measure of liquidity. EBITDA, as defined in the indenture, is calculated by adjusting EBITDA for certain items. The adjustments to EBITDA relate to: (1) the add back of losses from discontinued operations, net of taxes, (2) the add back of inventory fair market value adjustments, (2) the add back of (1) Consists of the added cost of goods sold expense due to the step up to fair market value of certain inventories on hand at November 23, 2003, as a result of the allocation of the purchase price of the Acquisition to inventory. (2) Consists of the expensing of the prepaid fee to ConAgra Foods for services performed under a transition services agreement entered into in connection with the Acquisition. (3) Consists of gain on the sale of two divisions, both of which occurred in November 2003. (d) For the purposes of calculating the ratio of earnings to fixed charges, earnings represent income (loss) before income taxes plus fixed charges. Fixed charges consist of interest expense which includes discounts and amortization of financing costs and financing costs and the portion of operating rental expense which management believes is representative of the interest component of rent expense. For fiscal 2002, the ConAgra Agricultural Products Businesses earnings were insufficient to cover fixed charges by $48.6 million. Table of Contents MANAGEMENT S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS On November 24, 2003, UAP Holding Corp. acquired the United States and Canadian agricultural inputs businesses of ConAgra Foods in a series of transactions referred to in this prospectus as the Acquisition and described in this prospectus in this section under the heading Certain Relationships and Related Transactions The Acquisition beginning on page 110. In this prospectus, the term ConAgra Agricultural Products Business means the entities that were historically operated by ConAgra Foods as an integrated business, which included a wholesale fertilizer and other international crop distribution businesses that we did not acquire in the Acquisition. The businesses not acquired are reflected as discontinued operations within the ConAgra Agricultural Products Business financial statements. The following discussion and analysis of our financial condition and results of operations covers periods prior to the Acquisition. Accordingly, the discussion and analysis of historical periods do not reflect the significant impact that the Acquisition had on us. In addition, the statements in the discussion and analysis regarding industry outlook, our expectations regarding the performance of our business, our liquidity and capital resources and the other non-historical statements in the discussion and analysis are forward-looking statements. These forward-looking statements are subject to numerous risks and uncertainties, including, but not limited to, the risks and uncertainties described in Risk Factors beginning on page 26. Our actual results may differ materially from those contained in or implied by any forward-looking statements. You should read the following discussion together with the sections entitled Risk Factors beginning on page 26, Unaudited Pro Forma Condensed Consolidated Financial Data beginning on page 55, Selected Historical Financial and Other Data beginning on page 66, and the historical consolidated and combined financial statements and the accompanying notes thereto of the Successor and Predecessor included elsewhere in this prospectus. BACKGROUND Founded in 1978, we are the largest private distributor of agricultural and non-crop inputs in the United States and Canada. We market a comprehensive line of products including crop protection chemicals, seeds and fertilizers to growers and regional dealers. As part of our product offering, we provide a broad array of value-added services including crop management, biotechnology advisory services, custom blending, inventory management and custom applications of crop inputs. The products and services we offer are critical to growers because they lower the overall cost of crop production and improve crop quality and yield. As a result of our broad scale and scope, we provide leading agricultural input companies with an efficient means to access a highly fragmented customer base of farmers and growers. At the end of fiscal 2002, our new management team began to implement several strategic initiatives to increase our operational efficiency. As part of that strategy, we enhanced our credit policies and information systems, improved inventory management, rationalized headcount and closed unprofitable distribution centers. Our implementation of new credit policies has reduced average trade accounts receivables and overall selling, general and administrative costs by lowering bad debt expense. Improved inventory management, including central purchasing, product mix enhancement, SKU rationalization, and enhanced sharing of existing stocks, have resulted in lower average inventory levels and higher margins. Headcount reductions and location closures have contributed to lower supply chain and selling, general and administrative costs. Our financial and operational success has been driven by providing customers with high quality products at competitive prices, supported by consistent and reliable service and expertise. We will continue to seek to improve margins and reduce working capital through the following principal strategies: Targeting continued margin enhancement and working capital management; Expanding our presence in seeds, branded and non-crop products; and Leveraging our scale. Table of Contents SEASONALITY Our and our customers businesses are seasonal, based upon the planting, growing and harvesting cycles. During fiscal 2003 and 2004, at least 75% of our net sales occurred during the first and second fiscal quarters of each year because of the condensed nature of the planting season. As a result of the seasonality of sales, we experience significant fluctuations in our revenues, income and net working capital levels. However, our integrated network of formulation and blending, distribution and warehousing facilities and technical expertise allows us to efficiently process, distribute and store product close to our end-users and to supply our customers on a timely basis during the compressed planting and growing season. FINANCIAL INFORMATION Accounting principles generally accepted in the United States of America require our operating results prior to the Acquisition, the periods prior to November 23, 2003, to be reported as the results of the Predecessor in our historical financial statements. Our operating results subsequent to the Acquisition are presented as the Successor s results in the historical financial statements and include the thirteen week period from November 24, 2003 through February 22, 2004 and the fourteen-week period from February 23, 2004 through May 30, 2004. The information presented below for the fiscal year ended February 22, 2004 (Pro Forma) has been derived by combining the historical statement of operations data of UAP Holding Corp. (the Successor ) for the thirteen weeks ended February 22, 2004 with the historical statement of operations data of the Predecessor for the thirty-nine weeks ended November 23, 2003 and applying the pro forma adjustments for the Acquisition. The pro forma statement of operations for the 52 weeks ended February 22, 2004 should be read in conjunction with the Unaudited Pro Forma Condensed Consolidated Financial Data beginning on page 55. The information for the fourteen weeks ended May 30, 2004 represent the results of operations of the Successor. The information for the fiscal year ended February 23, 2003 and February 24, 2002, and for the thirteen-week period ended May 23, 2003, represent the results of operations of the Predecessor. The results of operations for any fourteen- or thirteen-week period are not necessarily indicative of the results to be expected for the full fiscal year. FOURTEEN WEEKS ENDED MAY 30, 2004 COMPARED TO THIRTEEN WEEKS ENDED MAY 25, 2003 Net Sales. Sales increased to $1,258.5 million in the fourteen weeks ended May 30, 2004, compared to $1,074.3 million for the thirteen weeks ended May 25, 2003. Sales of all segments benefited from an earlier planting season and from an additional week in the current period versus the prior period. Sales of crop protection chemicals rose to $724.1 million in the fourteen weeks ended May 30, 2004 from $650.6 million in the thirteen weeks ended May 25, 2003. The increase was largely due to the earlier planting season and the extra week in the current fiscal quarter. Sales of fertilizer rose to $280.7 million in the fourteen weeks ended May 30, 2004, from $225.5 million for the thirteen weeks ended May 25, 2003, due to higher pricing specifically in nitrogen-based fertilizers, higher volumes, and the extra week in the current fiscal quarter. Sales of seed rose to $233.6 million in the fourteen weeks ended May 30, 2004, from $173.9 million for the thirteen weeks ended May 25, 2003 due to the earlier season, volume growth, and the extra week in the current fiscal quarter. Sales of other products decreased to $20.1 million in the fourteen weeks ended May 30, 2004, from $24.3 million for the thirteen weeks ended May 25, 2003, due to lower animal feed business sales resulting from the divestment of our Montana feed division. Cost of Goods Sold. Cost of goods sold was $1,122.8 million in the fourteen weeks ended May 30, 2004, compared with $931.8 million for the thirteen weeks ended May 25, 2003. Gross profit (net sales less cost of goods sold) was $135.7 million in the fourteen weeks ended May 30, 2004, compared with $142.6 million for the thirteen weeks ended May 25, 2003; while gross margin (gross profit as a percentage of net sales) was 10.8% in Table of Contents the fourteen weeks ended May 30, 2004, compared with 13.3% for the thirteen weeks ended May 25, 2003. Gross profits declined for the following reasons: a $17.3 million dollar fair market adjustment to the inventory on hand on the date of the Acquisition that was sold during the fourteen-week period ended May 30, 2004, higher delivery costs due to the price of fuel, and lower upfront pricing for our sales of glyphosate herbicides due to a product mix shift to lower-priced products. These items were slightly offset by an increase in chemical and seed rebates due to enhancements in our monthly rebate estimation process and changes in certain rebate programs. Selling, General and Administrative Expenses. Direct selling, general and administrative ( SG&A ) expenses increased to $83.0 million in the fourteen weeks ended May 30, 2004, from $82.4 million for the thirteen weeks ended May 25, 2003. SG&A expenses were 6.6% of sales during the fourteen weeks ended May 30, 2004, and 7.7% of sales during for the thirteen weeks ended May 25, 2003. The increase in SG&A expenses is due to expenses associated with a transition services agreement to ConAgra (including $2.3 million of expenses), an extra week of expenses in the current quarter, offset by lower labor and location expenses due to our location rationalization efforts. Interest Expense. Interest expense was $11.2 million in the fourteen weeks ended May 30, 2004, which related primarily to the notes issued in connection with the Acquisition. Third party interest expense was $0.3 million for the thirteen weeks ended May 25, 2003, which related to a vendor financing program. Corporate Allocations Selling, general and administrative. Corporate allocations include charges that have been allocated by ConAgra Foods and recorded as an expense for corporate services, including executive, finance and tax. Expenses incurred by ConAgra Foods and allocated to the ConAgra Agricultural Products Business are determined based on the specific services being provided or are allocated based on ConAgra Foods investment in the ConAgra Agricultural Products Business in proportion to ConAgra Foods total investment in its subsidiaries. Such expenses are included in allocated selling, general and administrative expenses and were $3.1 million in the thirteen weeks ended May 25, 2003. Corporate Allocations Finance Charges. Corporate allocations also include finance charges that have been allocated by ConAgra Foods based on ConAgra Foods investment in the ConAgra Agricultural Products Business in proportion to ConAgra Foods total investment in its subsidiaries. ConAgra Foods allocated finance costs of $4.1 million in the thirteen weeks ended May 25, 2003. Income Taxes. The effective income tax rate was 39.3% for the fourteen weeks ended May 30, 2004, compared with 38.9% for in the thirteen weeks ended May 25, 2003. FIFTY-TWO WEEKS ENDED FEBRUARY 22, 2004 (PRO FORMA) COMPARED TO FIFTY-TWO WEEKS ENDED FEBRUARY 23, 2003 Net Sales. Sales declined to $2,451.9 million in fiscal 2004 from $2,526.8 million in fiscal 2003. Sales of crop protection chemicals declined to $1,579.7 million in fiscal 2004 from $1,661.3 million in fiscal 2003. The decline was largely due to the reduced number of locations from our rationalization efforts throughout the year and a more restrictive customer credit policy. Sales of fertilizer rose to $526.2 million in fiscal 2004 from $510.6 million in fiscal 2003, due to slightly higher pricing throughout the year. Sales of seed declined to $258.9 million in fiscal 2004 from $270.8 million as store rationalizations offset volume growth. Sales of other products increased to $87.1 from $84.1 million. Cost of Goods Sold. Cost of goods sold was $2,108.7 million in fiscal 2004 compared with $2,166.6 million in fiscal 2003. Gross profit (net sales less cost of goods sold) was $343.2 million in fiscal 2004 compared with $360.2 million in fiscal 2003; while gross margin (gross profit as a percentage of net sales) was 14.0% in fiscal 2004 compared with 14.3% in fiscal 2003. Gross profits declined due to fewer sales due to location closures and a $3.7 million dollar charge to cost of goods sold from the purchase price allocation of the acquisition. Table of Contents Selling, General and Administrative Expenses. Selling, general and administrative ( SG&A ) expenses decreased to $245.7 million in fiscal 2004 from $275.2 million in the fiscal 2003 period. SG&A expenses were 10.0% of sales during fiscal 2004 and 10.9% of sales during fiscal 2003. The decline in SG&A expenses is the result of reduced location expenses associated with the closure of unprofitable locations, gains from the sale of two formulation facilities and the Montana feed business, and lower expenses in the formulation plants as a result of consolidation efforts. Interest Expense. Interest expense was $5.7 million during fiscal 2004, on a pro forma basis for the Acquisition. Third party interest expense was $1.9 million in fiscal 2003, which related to a vendor financing program. Corporate Allocations Selling, general and administrative. Corporate allocations include charges that have been allocated by ConAgra Foods and recorded as an expense for corporate services, including executive, finance and tax. Expenses incurred by ConAgra Foods and allocated to the ConAgra Agricultural Products Business are determined based on the specific services being provided or are allocated based on ConAgra Foods investment in the ConAgra Agricultural Products Business in proportion to ConAgra Foods total investment in its subsidiaries. Such expenses are included in allocated selling, general and administrative expenses and are $9.0 million and $10.8 million in fiscal 2004 and fiscal 2003, respectively. Corporate Allocations Finance Charges. Corporate allocations also include finance charges that have been allocated by ConAgra Foods based on ConAgra Foods investment in the ConAgra Agricultural Products Business in proportion to ConAgra Foods total investment in its subsidiaries. ConAgra Foods allocated finance costs of $12.2 million and $22.5 million in fiscal 2004 and fiscal 2003, respectively. Income Taxes. The effective income tax rate was 37.9% for fiscal 2004 compared with 38.9% for fiscal 2003. The decrease in the effective rate was due to the impact of permanent tax differences. FISCAL 2003 COMPARED TO FISCAL 2002 Net Sales. Net sales were $2,526.8 million in fiscal 2003 compared with $2,770.2 million in fiscal 2002. Net sales of crop protection chemicals declined to $1,661.3 million in fiscal 2003 from $1,826.4 million in fiscal 2002 due largely to the impact of our implementation of strategic initiatives to change customer mix, product mix, and the rationalization of unprofitable locations. Net sales of fertilizer declined to $510.6 million in fiscal 2003 from $581.0 million in fiscal 2002 on lower prices and volumes primarily due to lower fall applications of fertilizer. Net sales of seed declined to $270.8 million in fiscal 2003 from $282.8 million in fiscal 2002 due largely to the impact of our implementation of the previously described strategic initiatives to change customer mix and location rationalization, partially offset by continued volume growth in existing locations. Net sales of other products increased 5.1% to $84.1 million. Cost of Goods Sold. Cost of goods sold was $2,166.6 million in fiscal 2003, compared with $2,428.2 million in fiscal 2002. Gross profit was $360.2 million in fiscal 2003, compared with $342.0 million in fiscal 2002; while gross margin was 14.3% in fiscal 2003 compared with 12.3% in fiscal 2002. Gross margin improved principally due to a more profitable product mix and lower supply chain costs due to the rationalization of unprofitable locations. Gross margin was also favorably impacted by increased rebate income as a percentage of net sales and improved inventory management resulting in lower inventory write-offs and markdowns in fiscal 2003. These improvements helped offset the gross profit impact from the decline in net sales. Fiscal 2002 gross margin was unfavorably impacted by fertilizer inventory write-offs of approximately $29.6 million. Selling, General and Administrative Expenses. SG&A expenses decreased to $275.2 million in fiscal 2003 from $334.6 million in fiscal 2002. SG&A expenses were 10.9% of net sales during fiscal 2003, compared with 12.1% of net sales during fiscal 2002. The decline was due largely to lower bad debt expenses from selling to a more profitable customer mix, and reduced administrative and operating expenses associated with cost Pension benefit cost company plans 121 219 216 Total pension benefit cost $ 5,574 $ 7,267 $ 7,268 $ Operating income 98,284 53,177 96,451 Interest expense 67,386 18,038 68,371 Finance fee income (10,773 ) (971 ) (10,035 ) Table of Contents management initiatives including the closure of unprofitable locations. Fiscal 2002 selling, general and administrative expenses were unfavorably impacted by bad debt expense of approximately $29.2 million due to unfavorable industry conditions. Interest Expense. Interest expense decreased to $1.9 million in fiscal 2003 from $5.4 million in fiscal 2002, due to decreased purchasing activity under a vendor finance program. Corporate Allocations Selling, General and Administrative. Corporate allocations include charges that have been allocated by ConAgra Foods and recorded as an expense for corporate services, including executive, finance and tax. Expenses incurred by ConAgra Foods and allocated to the ConAgra Agricultural Products Business are determined based on the specific services being provided or are allocated based on ConAgra Foods investment in the ConAgra Agricultural Products Business in proportion to ConAgra Foods total investment in its subsidiaries. Such expenses are included in allocated selling, general and administrative expenses and were $10.8 million and $10.5 million in fiscal 2003 and fiscal 2002, respectively. Corporate Allocations Finance Charges. Corporate allocations also include finance charges that have been allocated by ConAgra Foods based on ConAgra Foods investment in the ConAgra Agricultural Products Business in proportion to ConAgra Foods total investment in its subsidiaries. ConAgra Foods allocated finance costs of $22.5 million and $39.5 million in fiscal 2003 and fiscal 2002, respectively. Income Taxes. The effective income tax rate was 38.9% for fiscal 2003, compared with 36.0% for fiscal 2002. The increase in the effect rate was due to the impact of permanent tax differences. LIQUIDITY AND CAPITAL RESOURCES Overview Our principal liquidity requirements following the completion of the offering will be for working capital, consisting primarily of receivables, inventories, pre-paid expenses, reduced by accounts payable and accrued expenses; capital expenditures; and debt service. In addition, our board of directors will adopt a dividend policy which reflects a basic judgment that our stockholders would be better served if we distributed to them any cash available to pay dividends instead of retaining it in our business. Under this policy, cash generated by our business in excess of operating needs, interest and principal payments on indebtedness, and certain capital expenditures would in general be distributed as regular quarterly dividends to the holders of our common stock and participating preferred stock and vested options to acquire participating preferred stock rather than retained by us and used to finance growth opportunities. We currently intend to pay an initial dividend on February 1, 2005 with respect to the partial quarterly period commencing on the closing of this offering and ending on October 15, 2004 and a regular quarterly dividend payment for the period commencing on October 16, 2004 and ending on January 15, 2005 based on a quarterly dividend level of $0.235 per share of common stock and $0.475 per share of participating preferred stock. We currently intend to continue to pay quarterly dividends at these rates for the remainder of the first full year following the closing of this offering. In respect of the first year following the closing of this offering, this would be $0.940 per share, or approximately $34.3 million in the aggregate, on the common stock and $1.90 per share, or approximately $17.4 million in the aggregate, on the participating preferred stock. In determining our expected initial dividend levels, we reviewed and analyzed, among other things, our operating and financial performance in recent years, the anticipated cash requirements associated with our new capital structure, our anticipated capital expenditure requirements, our expected other cash needs, the terms of our debt instruments, including our amended and restated revolving credit facility, other potential sources of liquidity and various other aspects of our business. See Dividend Policy and Restrictions beginning on page 44. We will fund our liquidity needs and our intended dividends with cash generated from operations and, to the extent necessary, through borrowings under the amended and restated revolving credit facility. In addition, as Table of Contents noted below, we expect to fund any growth capital expenditures with incremental borrowings. As of May 30, 2004 and February 22, 2004, we had $42.1 million and $0 million, respectively, outstanding under United Agri Products existing revolving credit facility. The revolver is included in our financial statements as part of our short-term debt. We believe that our cash flows from operating activities and borrowing capabilities under the amended and restated revolving credit facility will be sufficient to meet our liquidity requirements in the foreseeable future, including funding of capital expenditures, and payment obligations under our debt service, the senior subordinated notes and our intended dividend payments on our common stock and participating preferred stock and vested options to acquire participating preferred stock. Historical Cash Flow from Operating Activities Historically, the ConAgra Agricultural Products Business sources of cash were primarily cash flows from operations and advances received from ConAgra Foods. The information presented below for the fiscal year ended February 22, 2004 (Pro Forma) has been derived by combining the cash flow activity of UAP Holding Corp. (the Successor ) for the thirteen weeks ended February 22, 2004 with the cash flow activity of the Predecessor for the thirty-nine weeks ended November 23, 2003 and applying the pro forma adjustments for the Acquisition. The information for the fourteen weeks ended May 30, 2004 represent the cash flow activity of the successor. The information for the fiscal year ended February 23, 2003 and February 24, 2002 represent the cash flow activity of the Predecessor. Cash flows provided by (used in) operating activities totaled ($203.7) million in the fourteen weeks ended May 30, 2004 and ($154.8) million for the thirteen weeks ended May 25, 2003. The usage in the fourteen weeks ended May 30, 2004 was due to higher accounts receivable due to increased sales, offset by lower inventories and higher payables due to better inventory payable management. The decrease in the thirteen weeks ended May 25, 2003 was primarily due to higher accounts receivable and inventories, offset by higher payables. The increased usage in the current period versus the prior period was due to the purchasing of inventory closer to the seasonal use in the current period, as opposed to prepaying for inventory as in the prior period. Cash flows provided by (used in) operating activities totaled $341.8 million, ($266.8) million and $120.7 million in fiscal 2004, 2003 and 2002, respectively. The increase in fiscal 2004 was due to improvements in working capital, including better inventory payable management due to a lower participation by us in early purchasing programs from our suppliers. The decrease in fiscal 2003 was primarily due to prepayments to various suppliers for early payment discounts on crop protection chemicals and lower year-end accounts payable to suppliers. This was partially offset by lower inventories and increased earnings. Cash flows used in investing activities totaled $2.7 million in the fourteen weeks ended May 30, 2004 and ($8.5) million for the thirteen weeks ended May 25, 2003. Investing activities primarily represent expenditures for property, plant and equipment. Cash flows used in investing activities totaled $653.1 million, $4.0 million and $12.8 million in fiscal 2004, 2003 and 2002, respectively. The increase in cash used in investing activities in fiscal 2004 was due to the Acquisition. Cash flows used in investing activities include capital expenditures for property, plant and equipment, which totaled $15.3 million, $6.4 million and $13.6 million in fiscal 2004, 2003 and 2002, respectively. Cash flows provided by financing activities were $42.1 million in the fourteen weeks ended May 30, 2004 and $134.7 million in the thirteen weeks ended May 25, 2003. Cash flows provided by financing activities in the fourteen week period ended May 30, 2004 reflect borrowings under our existing revolving credit facility used to accommodate the seasonal working capital needs of our business. Financing activities in the prior period were primarily limited to net investments by ConAgra Foods and bank overdrafts. Table of Contents Cash flows provided by (used in) financing activities were $455.4 million, $226.7 million and ($181.5) million in fiscal 2004, 2003 and 2002, respectively. Cash flows provided by financing activities in fiscal 2004 included the contribution of equity by Apollo and issuance of long-term debt in connection with the Acquisition. Financing activities have historically been primarily limited to investments by and (distributions) to ConAgra Foods, which totaled $231.1 million and ($182.1) million in fiscal 2003 and 2002 respectively. Capital Expenditures Capital expenditures are expected to be approximately $18.1 million for fiscal 2005, which includes approximately $5.6 million for maintenance capital expenditures. This also includes approximately $3.7 million of capital expenditures for transition projects to enable our separation from our former parent, ConAgra Foods, and approximately $5.3 million for an investment in information systems. The remainder, or approximately $3.5 million, represents growth capital expenditures that are intended to support our strategic growth activities or bring about efficiencies in our formulation facilities. This expected figure represents management s estimate of spending, but may change due to a variety of conditions, including local business conditions, changes in the farm economy, competitive conditions, changes that impact the economics of a given project, and the seasonality of our business. We estimate that we will have capital expenditure requirements of approximately $10.0 million per year on average for the next two fiscal years, approximately $6.0 million of which in each fiscal year is expected to represent maintenance capital expenditures and approximately $4.0 million of which is expected to be allocated to growth projects. We expect we will finance maintenance capital expenditures from cash generated from operations, and we expect to finance growth capital expenditures through cash generated from operations, reductions in working capital, or incremental debt. Maintenance capital expenditures include all expenditures which meet capitalization requirements under generally accepted accounting principles but which do not meet the definition of growth capital expenditures set forth under Dividend Policy and Restrictions Minimum EBITDA, As defined beginning on page 45 above. Maintenance capital expenditures generally support our current operations and our current level of profitability as it relates to our existing location base. Maintenance capital expenditures include items such as refurbishment or replacement of existing distribution or formulating equipment, compliance related projects, computer hardware, and quality improvement projects. Credit Facilities and Other Long Term Debt In connection with the Acquisition, United Agri Products entered into the existing five-year $500.0 million asset-based revolving credit facility. The existing revolving credit facility also provides for a $20.0 million revolving credit sub-facility for United Agri Products Canada Inc. ( UAP Canada ), a $50.0 million letter of credit sub-facility, a $25.0 million swingline loan sub-facility and a $25.0 million in-season over-advance sub- facility. The interest rates with respect to revolving loans under the existing revolving credit facility are based, at our option, on either the agent s index rate plus an applicable index margin of 1.50% or upon LIBOR plus an applicable LIBOR margin of 2.75%. The interest rates with respect to in-season overadvances under the existing revolving credit facility are based, at our option, on either the agent s index rate plus an applicable index margin of 2.75% or upon LIBOR plus an applicable LIBOR margin of 4.00%. These applicable margins are in each case subject to prospective reduction on a quarterly basis (other than the margins on in-season overadvances) if we reduce our ratio of funded debt to EBITDA (on a consolidated basis). Overdue principal, interest and other amounts will bear interest at a rate per annum equal to the rate otherwise applicable thereto plus an additional 2.0%. The obligations under the existing revolving credit facility are (or, in the case of future subsidiaries, will be) guaranteed by UAP Holdings and each of its existing and future direct and indirect U.S. subsidiaries. The obligations under the existing revolving credit facility are secured by a first priority lien on, or security interest in, subject to certain exceptions, substantially all of UAP Holdings , United Agri Products and UAP Canada s properties and assets and the properties and assets of each of the guarantors. The existing revolving credit facility contains customary representations, warranties and covenants and events of default for the type and nature of the Acquisition and a business such as ours. We have excluded lease obligations of $52.8 million from the table above as these are cancelable within one year. Table of Contents The above table also does not include the effects of this offering. As of May 30, 2004, on a pro forma basis after giving effect to this offering, our total indebtedness would have been $497.6 million, of which $292.0 million would have consisted of the senior subordinated notes represented by IDSs, $40.6 million would have consisted of the separate senior subordinated notes and $165.0 million would have consisted of the new senior secured second lien term loan. The Amended Credit Facilities consist of the amended and restated revolving facility, which has a five-year term, and a new senior secured second lien term loan facility, which has a seven year term. The senior subordinated notes will mature in 2014, subject to extension of maturity as described herein. Additionally, the above table does not include our obligation to pay to ConAgra Foods 50% of rebate payments received by us related to the 2003 and prior crop years. As of the date hereof, we have paid ConAgra Foods $54.0 million pursuant to such obligation. See Certain Relationships and Related Transactions The Acquisition The Stock Purchase Agreement beginning on page 110. As of May 30, 2004, we had $27.8 million of outstanding commercial commitment arrangements (e.g., guarantees). As of May 30, 2004, on a pro forma basis after giving effect to the Transactions, our total other commercial commitments (consisting of outstanding letters of credit) would have been $27.8 million. The 8 % Senior Notes were issued on December 16, 2003 and the proceeds from such offering were used to repay the entire principal amount, plus accrued interest, incurred in connection with a $175.0 million unsecured senior bridge loan facility. United Agri Products entered into the senior bridge loan facility on November 24, 2003 and used borrowings thereunder to fund, in part, the Acquisition. As a holding company, our investments in our operating subsidiaries, including United Agri Products, constitute substantially all of our operating assets. Consequently, our subsidiaries conduct all of our consolidated operations and own substantially all of our operating assets. Our principal source of the cash required to pay our and our subsidiaries obligations and to repay the principal amount of our and our subsidiaries obligations, including the senior subordinated notes, is the cash that our subsidiaries generate from their operations and their borrowings under the existing revolving credit facility. Our subsidiaries are separate and distinct legal entities and have no obligations to make funds available to us. The terms of the Amended Credit Facilities will restrict our subsidiaries from paying dividends, making loans or other distributions and otherwise transferring assets to us. Furthermore, our subsidiaries will be permitted under the terms of the Amended Credit Facilities and the indenture governing the senior subordinated notes to incur additional indebtedness that may severely restrict or prohibit the making of distributions, the payment of dividends or the making of loans by such subsidiaries to us. We cannot assure you that the agreements governing our current and future indebtedness will permit our subsidiaries to provide us with sufficient dividends, distributions or loans to fund scheduled interest and principal payments on the senior subordinated notes when due. If we consummate an acquisition, our debt service requirements could increase. We may need to refinance all or a portion of our indebtedness, including the senior subordinated notes on or before maturity. We cannot assure you that we will be able to refinance any of our indebtedness, including the Amended Credit Facilities and the senior subordinated notes, on commercially reasonable terms or at all. TRADING ACTIVITIES As of May 30, 2004 and May 25, 2003, we had no outstanding derivative contracts. However, subject to limitations set forth in our debt agreements, including the indenture, we may, in the future, enter into derivative contracts to limit our exposure to changes in interest rates, foreign currency exchange rates and energy prices. CRITICAL ACCOUNTING POLICIES The process of preparing financial statements requires the use of estimates on the part of management. The estimates used by management are based on our historical experiences combined with management s Table of Contents understanding of current facts and circumstances. Certain of our accounting policies are considered critical as they are both important to the portrayal of our financial condition and results of operations and require significant or complex judgment on the part of management. The following is a summary of certain accounting policies considered critical by our management. Allowance for Doubtful Accounts. Our allowance for doubtful accounts reflects reserves for customer receivables to reduce receivables to amounts expected to be collected. Management uses significant judgment in estimating uncollectible amounts. In estimating uncollectible amounts, management considers factors such as current overall economic conditions, industry-specific economic conditions, historical customer performance and anticipated customer performance. While management believes our processes effectively address our exposure for doubtful accounts, changes in the economy, industry, or specific customer conditions may require adjustment to the allowance for doubtful accounts recorded by us. Inventory Valuation. Management reviews inventory balances to determine if inventories can be sold at amounts equal to or greater than their carrying amounts. The review includes identification of slow moving inventories, obsolete inventories and discontinued products or lines of products. The identification process includes historical performance of the inventory, current operational plans for the inventory, as well as industry and customer specific trends. If our actual results differ from management expectations with respect to the selling of our inventories at amounts equal to or greater than their carrying amounts, we would be required to adjust our inventory balances accordingly. Impairment of Long-Lived Assets (Including Property, Plant and Equipment), Goodwill and Identifiable Intangible Assets. We reduce the carrying amounts of long-lived assets, goodwill and identifiable intangible assets to their fair values when the fair value of such assets is determined to be less than their carrying amounts (i.e., assets are deemed to be impaired). Fair value is typically estimated using a discounted cash flow analysis, which requires us to estimate the future cash flows anticipated to be generated by the particular asset(s) being tested for impairment as well as select a discount rate to measure the present value of the anticipated cash flows. When determining future cash flow estimates, we consider historical results adjusted to reflect current and anticipated operating conditions. Estimating future cash flows requires significant judgment by us in such areas as future economic conditions, industry-specific conditions, product pricing and necessary capital expenditures. The use of different assumptions or estimates for future cash flows could produce different impairment amounts (or none at all) for long-lived assets, goodwill and identifiable intangible assets. Rebate Receivables. Rebates are received from crop protection and seed products, based on programs offered by our vendors. The programs vary based on the product type and specific vendor practice. Historically, more than 85% of the rebates earned were from our chemical suppliers. The majority of the rebate programs run on a crop year basis, typically from October 1st to September 30th, although other periods are sometimes used. We also negotiate individually with our vendors for additional rebates after the conclusion of the crop year and often several months after we have purchased and sold the products for which we are negotiating rebates. Historically, the majority of the rebates have been earned based on our sales of the suppliers products in a given crop year. The rebate receivable recorded monthly is based on actual sales and the historical rebate percentage received. The actual rebates earned for most programs are finalized in our fourth fiscal quarter and adjustments are made to the accrual as necessary. The majority of our rebate receivables are collected during our fourth quarter. Because of the nature of the programs and the amount of rebates available are determined by our vendors, there can be no assurance that historical rebate trends will continue. Accounting Treatment for IDSs. We will not receive any proceeds from the sale of common stock in this offering. Accordingly, we intend to record the senior subordinated notes offered hereby at the fair value or the amount of proceeds received. Our IDS units include common stock and senior subordinated notes, which include three embedded derivative features that may require bifurcation under FASB 133. The potential embedded derivative features include (i) optional redemption by UAP Holdings beginning in 2011; (ii) optional redemption by UAP Holdings Table of Contents upon certain disallowances of the tax deduction for interest on the senior subordinated notes; (iii) a provision under which the holders of senior subordinated notes could require UAP Holdings to redeem their senior subordinated notes upon a change of control. Upon determination of the pricing associated with this offering or subsequent offerings, a determination will be made based upon any discount or premium associated with the senior subordinated notes if an embedded derivative should be bifurcated. If it is determined that an investor in these debt securities may be contractually obliged to settle in such a way that the investor would not recover substantially all of its initial recorded investment or there is a possible future interest rate scenario (even though it may be remote) under which the embedded derivative would at least double the investor s initial rate of return on the debt instrument, the embedded derivative will be required to be bifurcated and separately accounted for. If it is determined that any of the embedded derivatives are required to be bifurcated and separately accounted for, the combination of derivatives that will be bifurcated will be classified as an asset or liability, not as mezzanine equity, and a portion of the proceeds from the original issuance will be allocated to those derivatives equal to the combined fair value of those derivatives. If a portion of the initial proceeds is allocated to any of the derivatives, the senior subordinated notes will initially be recorded at a premium or discount and accreted to their redemption value as a component of interest expense using the effective interest method. Any such allocation will not affect the tax treatment of the IDSs. The common stock portion of the IDS unit will be included in stockholders equity, and dividends paid on the common stock will be recorded as a reduction to retained earnings when declared by us. The transaction costs related to the common stock portion of the IDS unit will be charged to expense as we will not receive any proceeds from this part of the offering. The senior subordinated notes portion of the IDS unit will be included in long-term debt, and the related transaction costs will be capitalized as deferred financing costs and amortized to interest expense using the effective interest method. Interest on the senior subordinated notes will be charged to expense as accrued by us. The bifurcated derivatives if any will be recorded as an asset or liability and will be marked to market with changes in fair value being recorded in earnings. We intend to determine the fair value of the senior subordinated notes and embedded derivatives with reference to a number of factors, including the price obtained on the sale of the separate senior subordinated notes, which have the same terms as the senior subordinated notes included in the IDSs. Accounting Treatment for Participating Preferred Stock. In connection with the Recapitalization, we will issue approximately 8.4 million shares of participating preferred stock to certain current equity holders. Subject to certain conditions, shares of participating preferred stock may be converted into IDSs following the first anniversary of the consummation of this offering. One of the conditions to conversion is compliance with the requirement under the indenture governing the senior subordinated notes that approximately 2.8 million shares of participating preferred stock, which represents 10% of the fair value of our equity immediately after this offering, remain outstanding for the first two years following this offering. The participating preferred stock contains dividend features which are intended to replicate the yield on the IDS units. Any time a dividend is paid to the holders of common stock, holders of the participating preferred stock will be paid a dividend equal to the same amount per share as paid to the holders of the common stock on an as if converted basis. In addition to any such dividend, holders of the participating preferred stock will accrue dividends at a rate that will replicate the interest on the senior subordinated notes. At the option of the holder subject to specified conditions referred to above, each share of participating preferred stock may be converted into one IDS (as may be adjusted for stock splits or stock dividends) following the first anniversary of the closing of this offering. Accordingly, at the date of issuance, a portion of participating preferred stock will be classified as temporary equity in the amount equal to the present value of the senior subordinated note s par amount that the holder will be entitled to receive upon the earliest possible date of exchange using a discount rate equal to the interest rate on the senior subordinated note s par amount. The difference between the amount recorded as temporary equity and the amount the holder will receive upon exchange will be accreted as a dividend and will be recorded as a reduction to retained earnings. Any such allocation will not affect the tax treatment of the IDSs. The issuance of participating preferred stock is part of a common control transaction and the related shares will be issued in exchange for the remaining shares of common stock held by our equity sponsor and management. Table of Contents The participating preferred stockholders right to exchange their shares of participating preferred stock for a fixed number of IDSs is an embedded derivative financial instrument which will require bifurcation under SFAS No. 133. We will recognize this derivative financial instrument as a liability at fair value with the offsetting amount as a distribution to our equity holders on the transaction date which will be recorded as a reduction to retained earnings. The derivative will be recorded at fair value at each subsequent balance sheet date with the change in fair value recorded through earnings for so long as the exchange rights are outstanding. Upon conversion of the participating preferred stock to IDSs, we will record the debt component of the IDSs issued at fair value at the date of conversion. The equity component of the IDSs will be accounted for at par value. Upon conversion, the amounts recorded for the conversion option, temporary equity, and par value of the participating preferred stock will be eliminated with the excess (deficiency) being accounted for as a charge against paid in capital. We do not anticipate such a transaction to impact earnings or earnings per share. In connection with the Recapitalization, we will issue shares of participating preferred stock to a rabbi trust in exchange for shares of common stock currently held in such trust, and the deferred compensation accounts under our deferred compensation plans, which are currently deemed to be invested in such shares of common stock, will instead be deemed to be invested in such shares of participating preferred stock. The resulting compensation expense will be based upon the incremental fair value of the shares of participating preferred stock received by management at the date of exchange. We intend to present earnings per share in accordance with EITF 03-6. The issuance of the participating preferred stock will be treated as a new issuance of shares. Accordingly, in the period in which this transaction occurs, UAP Holdings will present earnings per share on a three class basis (founders shares pre-transaction, IDS common stock and participating preferred stock). On a prospective basis, earnings per share will be presented on a two class basis (participating preferred stock and IDS common stock). Income will be allocated to each class of shares based on the distribution preferences of each class of stock and actual dividends paid, including accretion on temporary equity. Diluted earnings per share will reflect the participating preferred stock on an as-converted basis. To the extent that holders exercise their conversion rights, the portion of common stock included in temporary equity will be reclassified to debt and the associated interest payments will be included in interest expense. Income Taxes. We intend to account for our issuance of the IDSs in this offering as representing shares of common stock and senior subordinated notes by allocating the proceeds for each IDS unit to the underlying common stock, senior subordinated note or bifurcated embedded derivatives based upon the relative fair values of each. Accordingly, we will account for the portion of the aggregate IDSs outstanding that represents senior subordinated notes as long-term debt bearing a stated interest rate of % maturing on , 2019. We have concluded that it is appropriate and we intend to annually deduct interest expense of approximately $ million on the senior subordinated notes from taxable income for U.S. federal and state income tax purposes. There can be no assurances that the Internal Revenue Service will not seek to challenge the treatment of these senior subordinated notes as debt or the amount of interest expense deducted, although to date we have not been notified that the senior subordinated notes should be treated as equity rather than debt for U.S. federal and state income tax purposes. If the senior subordinated notes were required to be treated as equity for income tax purposes, the cumulative interest expense associated with the senior subordinated notes would not be deductible from taxable income, and we would be required to recognize additional tax expense and establish a related income tax liability. In addition, to the extent any portion of the interest expense is determined not to be deductible, we would be required to recognize additional tax expense and establish a related income tax liability. The additional tax due to the federal and state authorities would be based on our taxable income or loss for each of the years that we take the interest expense deduction. We do not currently intend to record a liability for a potential disallowance of this interest expense deduction. In addition, non-U.S. holders could be subject to withholding taxes on the payment of interest, which would be taxed as dividends, and we could be subject to additional liability for the withholding taxes that we do not intend to collect on such payments. For a discussion of the U.S. federal income tax treatment of the senior subordinated notes, see Material U.S. Federal Income Tax Consequences beginning on page 199. Table of Contents RECENTLY ISSUED ACCOUNTING STANDARDS In May 2003, the Financial Accounting Standards Board ( FASB ) issued Statement of Financial Accounting Standards ( SFAS ) No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. SFAS No. 150 establishes standards for classification and measurement in the balance sheets for certain financial instruments which possess characteristics of both a liability and equity. Generally, it requires classification of such financial instruments as a liability. SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003. For financial instruments in existence prior to May 31, 2003, SFAS No. 150 is effective as of the beginning of fiscal 2005. We adopted SFAS No. 150 on May 30, 2004. The EITF Task Force issued EITF No. 03-6, Participating Securities and the Two-Class Method under FASB Statement No. 128, Earnings per Share (EITF 03-6). EITF 03-6 clarifies accounting for entities which have participating securities outstanding. Generally, unallocated earnings should be allocated between common stock and participating securities based upon contractual participation rights in the determination of earnings per share. EITF 03-6 will be effective upon the issuance of any shares of participating preferred stock by UAP Holdings and its determination of earnings per share. OFF BALANCE SHEET ARRANGEMENTS In January 2003, the FASB issued FIN No. 46, Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin No. 51 (ARB 51), which clarifies the consolidation accounting guidance in ARB 51, Consolidated Financial Statements, as it applies to certain entities in which equity investors who do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entities to finance their activities without additional subordinated financial support from other parties. Such entities are known as variable interest entities (VIEs). FIN No. 46 requires that the primary beneficiary of a VIE consolidates the VIE. FIN No. 46 also requires new disclosures for significant relationships with VIEs, whether or not consolidation accounting is used or anticipated. In December 2003, the FASB revised and re-released FIN No. 46 as FIN No. 46(R). The provisions of FIN No. 46(R) are effective for periods ending after March 15, 2004, and upon adoption by the company as of February 22, 2004, did not have a material impact on our financial position or results of operations. All future cash payments required under our noncancelable leasing arrangements having remaining noncancelable lease terms of more than one year are reflected in the contractual obligations table above under Obligations and Commitments beginning on page 76. RELATED PARTY TRANSACTIONS ConAgra Foods executive, finance, tax and other corporate departments have historically performed services for the ConAgra Agricultural Products Business, and, pursuant to the Transition Services Agreement described in Certain Relationships and Related Transactions Ancillary Agreements beginning on page 112, will continue to perform certain administrative and other services for us. Expenses incurred by ConAgra Foods and allocated to the ConAgra Agricultural Products Business were historically determined based on the specific services that were provided or were allocated based on ConAgra Foods investment in the ConAgra Agricultural Products Business in proportion to ConAgra Foods total investment in its subsidiaries. In addition, ConAgra Foods charged the ConAgra Agricultural Products Business finance charges on ConAgra Foods investment in and advances to the ConAgra Agricultural Products Business. We believe that such expense allocations were reasonable. It is not practical to estimate the expenses that would have been incurred by the ConAgra Agricultural Products Business if it had been operated on a stand-alone basis. Corporate allocations for the thirteen weeks ended May 25, 2003 totaled $7.2 million, of which $3.1 million represented selling, general and administrative charges and $4.1 million represented finance charges. Income from continuing operations before income taxes 41,671 36,110 38,115 Income tax expense 16,612 12,373 13,558 Table of Contents As part of the Acquisition, we entered into a transition services agreement with ConAgra Foods in which ConAgra Foods would provide certain information technology and other administrative services to us for a period of one year. As consideration for these services, we paid ConAgra Foods $7.5 million. For the fourteen-week period ended May 30, 2004, $1.9 million in expense was recognized by us for services performed pursuant to this agreement. Under the terms of our Management Agreement (as defined in Certain Relationships and Related Transactions Ancillary Agreements Apollo Management Consulting Agreement beginning on page 117), we retained Apollo to provide certain management consulting and financial advisory services, for which we pay Apollo an annual management fee of $1.0 million in quarterly payments of $250,000. In addition, as consideration for arranging the Acquisition and services pertaining to certain related financing transactions, we paid Apollo a fee of $5.0 million in January 2004, which was accounted for as part of the Acquisition. MARKET RISK The principal market risk affecting our business has been exposure to changes in energy prices and, to a lesser extent, foreign currency risks. We are currently exposed to market risks including exposure to changes in energy prices, with respect to which we currently pay market rates. As a result of the Acquisition and the Transactions, we are also and will continue to be subject to interest rate risk. Based upon the amounts outstanding under the existing revolving credit facility, on a pro forma basis after consummation of the Transactions as of May 30, 2004, a one percentage point change in the assumed weighted average interest rate on such credit facility would change our annual pro forma interest expense by $1.5 million. Table of Contents BUSINESS OVERVIEW We are the largest private distributor of agricultural and non-crop inputs in the United States and Canada. We market a comprehensive line of products including crop protection chemicals, seeds and fertilizers to growers and regional dealers. As part of our product offering, we provide a broad array of value-added services including crop management, biotechnology advisory services, custom blending, inventory management and custom applications of crop inputs. The products and services we offer are critical to growers because they lower the overall cost of crop production and improve crop quality and yield. As a result of our broad scale and scope, we provide leading agricultural input companies with an efficient means to access a highly fragmented customer base of farmers and growers. As of February 22, 2004, we maintained a comprehensive network of approximately 350 distribution and storage facilities and five formulation and blending plants, strategically located in the major crop-producing areas of the United States and Canada. As of February 22, 2004, our integrated sales network covered over 40,000 active stock keeping units, or SKUs, supported by approximately 1,000 sales people, the majority of whom have technical training in agronomy. This network of facilities, together with our technical expertise, enables us to efficiently process, distribute and store products close to our end-users and to supply our customers on a timely basis during the compressed planting and growing season. In addition, our widespread geographical presence provides a diversified base of sales that helps to insulate our overall business from difficult farming conditions in any one area as a result of poor weather or adverse market conditions for specific crops or regions. We distribute products manufactured by the world s leading agricultural input companies, including BASF, Bayer, Dow, DuPont, Monsanto and Syngenta, as well as ConAgra International Fertilizer Company. We believe we are amongst the largest customers of agricultural inputs of these suppliers and have long-standing relationships with these companies. We also distribute products from over 150 other suppliers as well as over 250 of our own proprietary private label products. Our extensive infrastructure is a critical element of our suppliers route-to-market, as it enables them to reach a highly fragmented customer base. As of February 22, 2004, we had approximately 78,000 customers, with our ten largest customers accounting for approximately 2% of our net sales in fiscal 2004, on a pro forma basis. Our customers include commercial growers and regional dealers, as well as consumers in non-crop industries. Our significant scale provides our customers with an efficient and cost-effective method of purchasing agricultural and non-crop inputs. At the end of fiscal 2002, our new management team began to implement several strategic initiatives to increase our operational efficiency. As part of that strategy, we rationalized headcount, enhanced our credit policies and information systems, improved inventory management and closed unprofitable distribution centers. Largely as a result of that strategy, we successfully increased our income before income taxes as a percentage of net sales from 0.1% in fiscal 2001 to 2.0% in fiscal 2004, on a pro forma basis after giving effect to the Transactions, while reducing average working capital as a percentage of net sales from approximately 25% in fiscal 2001 to approximately 20% in fiscal 2004, on a pro forma basis after giving effect to the Transactions, a reduction of $216.9 million. We believe we are well positioned to drive further efficiencies in working capital and further enhance our margins. UAP was initially formed by ConAgra Foods through a series of acquisitions, beginning in May 1978 with the acquisition of a 49% interest in a group of companies engaged in the domestic distribution of agricultural chemicals. ConAgra Foods purchased the remaining 51% from several remaining stockholders in 1980. In 1983, UAP acquired AgChem, Inc., and in 1985 acquired Cropmate Company Inc. UAP expanded its business into Canada through the 1988 purchase of Pfizer Canada, and in 1991 acquired Donnell Agriculture. After a series of additional acquisitions, on November 24, 2003, ConAgra Certain Relationships and Related Transactions Foods sold UAP and its related businesses to UAP Holdings. For more information on this transaction see Certain Relationships and Related Transactions the Acquisition beginning on page 110. Table of Contents INDUSTRY OVERVIEW AND TRENDS The agricultural inputs market in the United States was estimated at $27.7 billion in 2003 and has experienced relative stability since 1997, as measured by total revenues, according to the most recent available survey by the USDA National Agricultural Statistics Service. Key drivers of the market include: continued population growth; the use of more effective chemicals and fertilizers; stable planted acreage; the trend towards larger and more efficient farms; and the increased use of biotechnology in the production of seeds. The three primary product areas of the market are crop protection chemicals, seeds and fertilizer. Crop Protection Chemicals. Crop protection chemicals expenditures in the United States were approximately $8.4 billion in 2003, according to the most recent available survey by the USDA National Agricultural Statistics Service. Since 1997, the volume of crop protection chemicals sold in the United States has increased, but overall revenues have remained essentially flat as lower-priced generic products have replaced higher-priced patented products, according to the same survey. This product area includes: (i) herbicides, which keep weed infestations from depriving crops of plant nutrients and water; (ii) insecticides, which keep insects from damaging crops; and (iii) fungicides, which guard against plant diseases. Seeds. Seed expenditures in the United States were approximately $9.3 billion in 2003, according to the most recent available survey by the USDA National Agricultural Statistics Service. The seed market in the United States has experienced significant growth since 1997, according to the same survey, driven primarily by increased pricing as a result of improvements in seed technology. In particular, biological traits are becoming genetically engineered into seeds, thus reducing the need for chemical treatment of crops. These traits include providing a plant with the ability to resist pests without a chemical application and the ability of a plant to selectively resist herbicides. These technological improvements, together with the availability of more productive seed hybrids, have resulted in higher crop yields. Fertilizer. Fertilizer expenditures in the United States were approximately $10.0 billion in 2003, according to the most recent available survey by the USDA National Agricultural Statistics Service. Since 1997, the volume of fertilizer sold in the United States has increased, but overall revenues have remained essentially flat, due largely to falling prices as a result of overproduction, according to the same survey. Fertilizers are added to soil to replace or supplement one or more deficient nutrients necessary for plant growth. Nearly all commercial crops grown in the United States and Canada today are produced with the use of a commercial fertilizer, as modern crop varieties and higher yields cannot be sustained by other methods. Agricultural input manufacturers vary by product category and include major international chemical, fertilizer and seed companies such as Agrium, Bayer Crop Science, ConAgra International Fertilizer Company, Dow AgroScience, DuPont, IMC, Monsanto, PCS and Syngenta. Agricultural input distributors represent the main route-to-market for crop protection chemicals and fertilizer products, and fill a critical need in the U.S. and Canadian agricultural inputs market by allowing suppliers to economically access a highly fragmented customer base of approximately two million growers, dealers and non-crop customers. In addition, we believe that both suppliers and customers value the supplementary services that distributors provide, including inventory management, extension of credit, provision of equipment for the application of agricultural products, custom blending and crop management consulting. The primary channel for seed distribution has historically been through grower dealers who distribute seeds within an area around their farms. We believe the trend in seed sales is migrating towards agricultural distributors who have the technical knowledge and ability to bundle seed sales with complementary chemical products. Grower-owned co-operatives constitute a significant portion of the agricultural inputs distribution industry, including two of the six largest retailers. The market has consolidated significantly over the last ten years. We believe, based on independent consulting work which we sponsored, that in 2003 the largest six retailers Crop Protection Chemicals Fungicides, Insecticides and Pesticides #1 17% Seeds Seed and Seed Treatment #1 14% Fertilizers Plant Nutrition #1 9% We believe our leading market shares strengthen our position with our suppliers and enhance our ability to increase sales to existing customers and attract new customers. We believe our scale provides us with several benefits, including: (i) volume purchasing and increased shelf space resulting in additional incentives from our suppliers; (ii) operating efficiencies from leveraging our fixed costs; and (iii) the ability to invest in our infrastructure in a cost-effective manner, including information technology systems. In fiscal 2004, on a pro forma basis, we had net sales of $2.5 billion, including net sales of crop protection chemicals of $1.6 billion, net sales of seeds of $259.0 million and net sales of fertilizer of $526.1 million. In addition, our leading local presence in the markets we serve further benefits us because it allows us to attract and retain sales people and customers while controlling our risk through geographic diversity. Operating Model Focused on Free Cash Flow We believe that our operating model generates significant free cash flow as a result of our variable cost structure, low capital expenditure requirements and efficient working capital management. Our capital expenditures have averaged less than 1% of net sales over the past three fiscal years. Largely as a result of operational initiatives implemented during fiscal 2002 and fiscal 2003, our income before income taxes as a percentage of net sales increased from 0.1% in fiscal 2001 to 2.0% in fiscal 2004, on a pro forma basis. Our average working capital has been reduced from approximately 25% of net sales in fiscal 2001 to approximately 20% of net pro forma sales in fiscal 2004, a reduction of $216.9 million. We believe that our continued focus on cost reductions and working capital management will allow us to continue to generate strong free cash flow. Table of Contents Extensive Distribution Network As of February 22, 2004, we operated a broad network of approximately 350 retail and wholesale farm distribution and storage facilities and five formulation facilities, strategically located in major crop producing regions. As of February 22, 2004, we had a sales presence in all 50 states of the United States, and nine of the 13 Canadian provinces, and our geographic diversity helps us to mitigate poor weather patterns or economic volatility in any one region and our exposure to any one crop. We operate an integrated system of distribution warehouses and, as of February 22, 2004, employed approximately 1,000 sales people across the United States and Canada. Our network enables us to provide customers with a broad range of products and reliable service. Our sales people, the majority of whom have technical training in agronomy, possess an in-depth knowledge of the industry and have established long-term relationships with their customers. As residents of the areas in which we operate, our sales people are an integrated part of the community and understand the region-specific needs of their customers. We believe that our approach has helped us to form strong relationships with customers at the local level and has enabled us to generate revenues per retail outlet of $5.0 million versus $3.1 million on average among the largest 100 retailers in 2003 as measured by sales, based on independent consulting work which we sponsored. Strong Supplier Relationships We purchase products from over 150 suppliers, including some of the largest chemical, seed and fertilizer companies in the world. We have strong long-term relationships with our suppliers, and our relationships with our ten largest suppliers date back to the original acquisition of UAP by ConAgra Foods in 1978. We are a critical part of our suppliers route-to-market because we are able to help them access a highly fragmented customer base. We believe we are one of the largest customers of agricultural inputs of our seven largest suppliers, and our purchasing scale provides us with a competitive advantage relative to smaller businesses. We believe that our strategic relationships with our suppliers provide us with reliable access to inventory, volume purchasing benefits and the ability to deliver a diverse product offering on a cost-effective basis. Diversified Product Offering We provide our customers with a comprehensive offering of agricultural inputs, comprised of over 40,000 active SKUs as of February 22, 2004 consisting of a broad variety of crop protection chemicals, seeds, and fertilizers, with no single brand accounting for more than 5% of our pro forma net sales in fiscal 2004. We offer a full line of branded products such as CleanCrop, ACA, Savage, Shotgun, Signature and Dyna-Gro, in areas such as plant nutrition, seed treatment, crop protection, adjuvants and seed. The breadth and diversity of our products and services allows us to act as a one-stop-shop that is tailored to meet the region-specific needs of our customers. In addition, we are the largest independent distributor of agricultural seed products in the United States and Canada, and we believe we are well positioned to benefit from the expected future growth of this market. We believe the trend in seed distribution is migrating towards using agricultural distributors such as ourselves, as this allows formulators supplying bio-engineered seeds with complementary chemical products to reach the market. Proven and Incentivized Management Team Our current senior management team has an average of over 18 years of experience in the agricultural inputs industry. Kenny Cordell joined the company in 2001 and served as President and Chief Operating Officer from February 2002 until December 2003, when he was promoted to Chief Executive Officer of United Agri Products. Our current senior management team has been responsible for developing our recent business strategy, including store rationalization, enhanced credit policies and an increased focus on working capital management, which has resulted in operational improvements and margin expansion. Largely as a result of initiatives implemented by our Table of Contents management team during fiscal 2002 and fiscal 2003, we successfully increased our margins and reduced working capital. After giving effect to this offering, our management will own approximately 6.8% of our common equity on a fully diluted basis, a portion of which is subject to time and performance vesting criteria. See Principal and Selling Stockholders beginning on page 107. OUR STRATEGY Our financial and operational success has largely been driven by providing customers with high quality products at competitive prices, supported by consistent and reliable service and expertise. We will continue to seek to improve margins and reduce working capital through the principal strategies outlined below. Target Continued Margin Enhancement and Working Capital Management We believe we are well positioned to achieve further margin enhancements and reductions in working capital through the continued implementation of our cost saving initiatives. We intend to monitor performance regularly through detailed management reporting on productivity, profitability, inventory flow and return on assets. At a company-wide level, our senior management will continue to: focus on our credit policies in order to seek to maximize our profitability; optimize our product mix through increased centralized pricing controls; improve company-wide performance through the dissemination of best practices; optimize procurement through increased centralized purchasing controls; rationalize our infrastructure by closing or selling unprofitable facilities; reduce our investment in working capital through the use of enhanced management information systems; and reduce selling, general and administrative expenses through centralization efforts in our formulation operations and administration. In August 2002, management initiated a monthly scorecard of key performance indicators linked to the management incentive plan, to drive return-based financial performance within regions of our company. In addition, our management has centralized credit and procurement functions to better coordinate various working capital initiatives and has adopted a discounted cash flow approach to capital investments. Expanded Presence in Seeds, Branded and Non-Crop Products Seed. We increased net sales of our seed products from $196.2 million in fiscal 2001 to $259.0 million in fiscal 2004, on a pro forma basis after giving effect to the Transactions, and believe that there is the potential for significant further growth in this area. We believe that seed varieties that have been enhanced through biotechnology will serve as a platform for growth due to the increased value-added nature of their sale to the customer, coupled with an increased need for ancillary services when compared with sales of conventional products. In addition, advancements in seed varieties and technologies have increased our customers needs for real-time information and access to the genetic varieties in branded and non-branded lines, which we believe benefits larger suppliers such as UAP. We intend to leverage our growth in this business through: (i) advanced technical training for our sales personnel; (ii) hiring and strategically placing experienced sales people; (iii) incentivizing our sales organization with seed-specific performance goals and incorporating specific targets for individual sales people in their respective performance management plans; (iv) nurturing our relationships with seed suppliers; and (v) continuing to focus the resources of our management and sales force in our seed distribution infrastructure. As part of our strategy, we will focus on increasing our sales of our Dyna-Gro brand of proprietary seed products as part of our effort to increase overall seed sales. We believe that Dyna-Gro is recognized in the Table of Contents marketplace for its high quality and yield, and we currently market Dyna-Gro in corn, soybeans, sorghum and alfalfa, as well as other minor crops. The margin contribution to us for our Dyna-Gro brand is higher than that of a commodity brand because we use internal resources to source and market it. Proprietary Branded Products. We intend to focus on increasing sales of our proprietary branded products, which provide value-added features to benefit customers and higher margins to us as compared with other products we sell for third parties. Increased sales of our proprietary branded products have contributed to our margin improvement from fiscal 2001 through fiscal 2003, largely as a result of providing enhanced formulations and tailoring the products to fit growers needs in specific regions, including unique dry herbicide formulations and specialized Nortrace brand micronutrients and Dyna-Gro seed. We seek to further improve our product mix through internal development and close cooperation with our major suppliers, and plan to introduce five new proprietary products during the fourth quarter of fiscal 2004. Non-Crop. We also distribute agricultural chemicals, seed and fertilizers for many non-agricultural markets, and are the only distributor in our markets with a presence in the three major non-crop market product areas of turf and ornamental (golf courses, resorts, nurseries and greenhouses), pest control operators and right-of-way vegetation management. This non-crop business has a distinctly different customer base from the agricultural markets, and requires different service levels and locations closer to suburban or leisure centers. We believe that many non-crop markets are experiencing natural growth with general demographic trends. For example, as population growth expands in the Southern United States, we expect increased opportunities for sales to pest control operators. As leisure spending increases, we expect increased opportunities for sales to turf, golf course, resort and nursery businesses. The non-crop market is an important strategic growth area for UAP, and as such we are focused on expansion of our current non-crop business through small acquisitions, increased sales of branded products, introduction of new branded products and improving operational performance through consolidation. Leverage our Scale We believe that our scale and extensive network of distribution facilities provides us with competitive advantages over smaller regional competitors, including an enhanced competitive position with our suppliers, the ability to leverage our fixed costs and the ability to attract and retain a strong management team and sales force. We intend to capitalize on these advantages by continuing to: (i) strengthen our relationships with our suppliers in order to maintain a diversified product offering and capture higher levels of incentives; (ii) cost-effectively invest in information systems to ensure efficient inventory management; and (iii) provide high levels of value-added services to our customers by maintaining an experienced and well-trained sales force. We believe this provides us with a strong platform for continued growth and profitability. BUSINESS OPERATIONS We operate our business through two primary divisions: Distribution and Products. The Distribution Division, which accounted for approximately 80% of our pro forma net sales in fiscal 2004, purchases agricultural input products from third parties and resells these products, together with our own proprietary private label products, to growers and regional dealers. As of February 22, 2004, the Distribution Division maintained a network of approximately 350 facilities throughout the United States and Canada. The Products Division, which, together with our non-crop Distribution Business, accounted for approximately 20% of our pro forma net sales in fiscal 2004, formulates our proprietary products and provides blending and formulation services for the private label brands of our suppliers. As of February 22, 2004, the Products Division consisted of five blending and formulation facilities that produce crop protection chemicals, seeds and fertilizers. The proprietary products formulated by the Products Division are sold to our customers through the distribution network of our Distribution Division. Coastal AZ, CA, CT, DE, FL, HI, MA, MD, ME, NC, NH, NJ, NV, NY, OR, PA, RI, SC, VA, VT, WA, WV Tree fruits, nuts, vines, vegetables, rice, cotton, alfalfa, corn, peanuts, wheat and tobacco 644 $ 663.6 Southern AL, AR, IA, GA, KY, LA, MS, OK, TN, TX Cotton, soybeans, rice, peanuts and corn 664 $ 536.8 Northern CO, IA, ID, IL, IN, KS, MI, MN, MO, MT, ND, NE, OH, SD, UT, WI, WY Corn, soybeans, wheat, sorghum, sunflowers, corn, potatoes and sugarbeets 1,058 $ 1,011.8 Canada AB, BC, MN, NB, NS, ON, PEI, QU, SK Tree fruits, vegetables, soybeans, corn, wheat, canola and tobacco 104 $ 97.1 We sell a complete line of products and services to growers through our distribution facilities, with each site tailoring its product offering to the specific needs of the growers in its service area. Our product offering, coupled with the advice of our sales professionals, provides our customers with a one-stop shop for all their agricultural inputs needs. Table of Contents Crop Protection Chemicals. Crop protection chemicals represent a significant portion of our business, accounting for approximately 65% of fiscal 2004 pro forma net sales. We distribute a full range of crop protection chemicals through our distribution locations, including herbicides, insecticides and fungicides, adjuvants and surfactants. We also provide a variety of services related to the application of crop protection chemicals. Within crop protection chemicals, we have experienced a trend towards bundling chemicals products with complementary seed products, as a result of advances in seed technology. Seed. We have placed an emphasis on new seed technology and provide a complete range of seed and seed treatments to growers through our distribution centers. Increasingly, our seed products are prepared by leading seed companies, and sold both under their brand names and our private labels (for example, Dyna-Gro). For example, we were one of the first companies to distribute Roundup Ready soybean and cotton seeds and technology for Monsanto in the United States. Roundup is a popular crop protection product, and Roundup Ready enables soybeans and cotton plants to be Roundup tolerant. We believe that seed technology based on genetic engineering is an important growth area for agriculture. Fertilizer. We distribute a full range of fertilizer products through our distribution centers, including nitrogen, potassium and phosphorous, and various micronutrients such as iron, boron and calcium. We also provide fertilizer application services, as well as customized fertilizer blending for the specific needs of individual growers. Services. In addition to selling traditional crop production inputs, our distribution centers provide agronomic services to growers. These services range from the traditional custom blending and application of crop nutrients to meet the needs of individual growers, to more sophisticated and technologically advanced services on a fee basis such as soil sampling, pest level monitoring and yield monitoring using global position systems satellite grids and satellite-linked variable rate spreaders and applicators to take advantage of the data. Non-Crop. We also distribute agricultural chemicals, seed and fertilizers for many non-agricultural markets, such as turf and ornamental (golf courses, resorts, nurseries and greenhouses), pest control operators and right-of-way vegetation management. This non-crop business has a distinctly different customer base from the agricultural markets, and requires different service levels and locations closer to suburban or leisure centers. We believe that many non-crop markets are experiencing natural growth with general demographic trends. For example, as population growth expands in the Southern U.S., we expect increased opportunities for sales to pest control operators. As leisure spending increases in the U.S., we expect increased opportunities for sales to turf, golf course, resort and nursery businesses. We are the only distributor in our markets with a presence in the three major non-crop market product areas of turf and ornamental, pest control operators and right-of-way vegetation management, and as such it is an important strategic growth area for UAP. We are focused on expansion of our current structure through small acquisitions, increased sales of branded products, introduction of new branded products and improving operational performance through consolidation. Products Division The Products Division consists of our formulating, blending and packaging operations. Our marketing group works closely with the Products Division to drive its portfolio management, sales activities, advertising and technical service. We operate five formulation facilities throughout the U.S. that produce our proprietary branded products as well as private label products from third parties. Typically, these private label products were developed independently by us or in cooperation with our leading suppliers. We generally distribute the products formulated by our Products Division through our Distribution Division. Income from continuing operations $ 25,059 $ 23,737 $ 24,557 Crop Protection Chemicals/Adjuvants Savage, Shotgun, Salvo, Strategy, Amplify, LI 700, Choice, Weather Guard, Liberate Seed and Seed Treatments Dyna-Gro, DynaStart, So-Fast Fertilizers ACA, Awaken, Nortrace Non-Crop Signature, Bisect Our proprietary brands allow us to enhance our product offering and provide formulations designed to meet the needs of growers in each region that we serve. As a result, we are able to obtain a higher contribution margin from our proprietary branded products than from commodity brands we distribute from other suppliers. We believe our proprietary branded products represent a significant value for our customers and help increase the overall value of our suppliers products. Many of our proprietary branded products are patented in the U.S. or Canada. The Products Division also provides formulating, blending and packaging services for third parties, primarily our major suppliers such as BASF, Bayer, Dow, DuPont, Monsanto and Syngenta. This relationship with our suppliers allows us to leverage our fixed costs and increase plant efficiencies. In addition, by working in such an integrated manner with our suppliers, we are able to remain at the forefront of the newest product technology and market offerings. As a result of the management initiatives implemented at the end of fiscal 2002, we have streamlined our product offering, focused our resources on driving sales of the most profitable brands within each product segment, and reduced our cost structure. For example, we closed two formulation plants during the current fiscal year as part of these initiatives. With our major initiatives substantially complete and an efficient operating platform in place, we intend to focus on increasing sales and margins in our Products Division by continued enhancement of our product mix and increased offerings in each product segment. New product offerings will be generated through internal development and continued cooperation with our major suppliers. INTELLECTUAL PROPERTY We use a wide array of technological and proprietary processes to enhance our crop protection, seed and fertilizer inputs and product development programs. We believe these technologies and proprietary processes enable us to create novel product concepts and reduce time to market. In certain circumstances, we file for patents on technology that we believe is patentable. As of February 22, 2004 we held approximately 200 trademarks (pending or registered) in the United States either directly or through one of our subsidiaries. These trademarks pertain to products formulated and distributed by us, including pesticides, herbicides, fertilizers and feed. As of February 22, 2004 United Agri Products Canada Inc., one of our subsidiaries, held approximately 60 trademarks (pending or registered) either directly or through one of its subsidiaries. These trademarks pertain to products formulated and distributed by us, including pesticides, herbicides, fungicides and fertilizers. In addition, we and our subsidiaries possess contractual rights to certain trademarks held by third parties through arrangements with certain of our suppliers and distributors, including licenses to use trademarks owned by Dow AgroSciences, DuPont, FMC, Monsanto, Valent and Gowan. Intellectual property rights help protect our products and technologies from use by competitors and others. In addition to trademarks, intellectual property rights of importance to us include trade secrets, confidential statements of formulation and other proprietary manufacturing information. We use nondisclosure agreements to In fiscal 2004, our top ten products accounted for approximately 15% of net sales on a pro forma basis after giving effect to the Transactions. COMPETITION The market for the distribution of crop protection chemicals, seeds, fertilizers and agronomic services is highly competitive. In each of our local markets, we typically compete with two or three other distributors. These distributors include agricultural cooperatives, multinational corporation-owned distribution outlets and other independent distribution companies. Agricultural cooperatives are operated for the benefit of their member growers and include companies such as Agriliance, LLC and Growmark, Inc. Multinational corporation-owned distribution outlets include companies such as Helena Chemical Company (a subsidiary of Marubeni Corporation), and other independent distributors such as Royster-Clark, Inc. Our market has experienced significant consolidation over the past several years as the number of outlets has declined from approximately 12,500 in 1995 to 9,500 in 2001. Based on independent consulting work which we sponsored, we believe that independent national distributors increased their retail market share amongst the top 100 retailers in sales from 37% in 1998 to 41% in 2003, and that larger companies, such as UAP, will continue to increase their competitive advantage over businesses with fewer resources. We generally compete with other distributors on the basis of breadth of product offering, ability to provide one-stop shopping with customized local products and services, our salesforce s knowledge of and relationships with our customers, and price. We believe that we compete successfully in each of these areas. Table of Contents SALES ON CREDIT, EXTENSIONS OF CREDIT AND ACCOUNTS RECEIVABLE A significant portion of our sales to growers and independent retailers are made through the use of credit incentives and programs. Typically, we sell products on cash or credit terms, with credit terms ranging from 30 days to crop terms, which typically require payments in December. Many accounts accrue service or finance charges. The interest rate on such charges varies by state, subject to maximum allowable interest under the particular state s laws. As of February 22, 2004, our aggregate accounts receivable, most of which constituted extensions of credit to trade customers, totaled $170.8 million. We have a dedicated and focused credit department, responsible for all our credit and risk management, and our centralized credit and procurement functions are responsible for coordinating various working capital initiatives. Our credit department is also responsible for establishing credit terms and credit limits, compiling data and generating reports to monitor collections and reserves for bad debt, monitoring progress of credit related initiatives, assuring data integrity and distributing relevant reports to the field credit managers. Beginning in the latter half of fiscal 2002, our new management team, including a new Senior Vice President of Credit, implemented more disciplined and sophisticated credit and collections policies and procedures as part of an effort to increase our operational efficiency. These new credit policies and procedures included detailed computerized analysis of a particular customer s credit prior to the sale, routine monitoring of customer credit limits, systematic inactivation of non-conforming accounts and hiring a dedicated staff of collections specialists. MANAGEMENT INFORMATION SYSTEMS Our finance, credit and information technology departments are responsible for all of our financial reporting, information technology and systems, treasury and cash management, financial analysis and budgeting, state tax filings, and credit and risk management. In addition, our finance and credit departments perform financial modeling and analysis, due diligence and contract negotiations for acquisitions. Our credit department also establishes credit terms and credit limits, compiles data and generates reports to monitor collections, reserves for bad debt, and progress of credit related initiatives, and to assure data integrity and distribute relevant reports to the field credit managers. Our finance department is currently consolidating from its five current locations to two locations in Greeley, Colorado and Tampa, Florida. We have point-of-sale computer systems at our locations which provide daily reports, including sales and profitability data, credit information and working capital data. We use these systems to provide data for inventory control, credit controls, budgeting, forecasting and working capital management requirements. RAW MATERIALS AND SUPPLIES We purchase our crop protection products and seed primarily from the world s leading agrochemical companies. We have contracts with each of BASF, Bayer Crop Science, Dow AgroSciences, DuPont Nemours, Monsanto, Syngenta and other prominent suppliers in the industry. We act as a leading distributor of crop protection products for major agricultural chemical companies, purchasing crop protection products at the chemical companies distributor price and receiving a cash rebate based on volume and type of product. The cash rebate is typically paid near the end of the calendar year, but may be advanced monthly with the balance paid at year-end. Such rebate programs may be published programs, in which case rebates are calculated similarly among all buyers, or unpublished programs, in which case rebates are structured solely according to our business. Historically we have purchased, and will continue to purchase, our fertilizer primarily from ConAgra International Fertilizer Company, an affiliate of ConAgra Foods, and one of the largest U.S. marketers of fertilizer. In connection with the Acquisition, we entered into a five-year fertilizer supply agreement with ConAgra International Fertilizer Company. Our agreement with ConAgra International Fertilizer Company Greeley, Colorado Leased 47,753 N/A Headquarters Greeley, Colorado Owned 67,100 11,500 Formulating Fremont, Nebraska Owned 84,751 58,880 Formulating Greenville, Mississippi Owned 291,000 57,000 Formulating Caldwell, Idaho Owned 29,746 5,970 Formulating Billings, Montana Owned 61,071 20,320 Formulating Mortgages on 36 of our owned properties secure our obligations under the Amended Credit Facilities. See Description of Other Indebtedness beginning on page 122. ENVIRONMENTAL MATTERS Our facilities and operations must comply with a wide variety of federal, state and local environmental laws, regulations and ordinances, including those related to air emissions, water discharges and chemical and hazardous waste management and disposal. Our operations are regulated at the federal level under the Clean Air Act, the Clean Water Act, the Resource Conservation and Recovery Act, the Occupational Safety and Health Act, and at the state level under analogous state laws and regulations. Our operations also are governed by laws relating to workplace safety and worker health and safety, primarily the rules of the Occupational Safety and Health Administration and the United States Department of Transportation. Non-compliance with these environmental, health and safety laws can result in significant fines or penalties or restrictions on our ability to sell or transport products. We manage these regulatory risks by employing a staff of highly trained professionals, by performing periodic compliance audits, and by participating in industry stewardship initiatives. We believe that our operations are in compliance in all material respects with current requirements under environmental laws and employee safety laws, except for matters that are not expected to have a material adverse effect on our business, financial conditions, results of operations or liquidity. Environmental laws may hold current owners or operators of land or businesses liable for their own and for previous owners or operators releases of hazardous or toxic substances, materials or wastes, pollutants or contaminants, including petroleum and petroleum products. Because of our operations, the history of industrial or Table of Contents commercial uses at some of our facilities, the operations of predecessor owners or operators of some of the businesses, and the use, production and release of hazardous substances at these sites, we are affected by the liability provisions of environmental laws. Many of our facilities have experienced some level of regulatory scrutiny in the past and are or may be subject to further regulatory inspections, future requests for investigation or liability for hazardous substance management practices. From time to time, we incur expenses in connection with remediation of hazardous substances, including nitrates, phosphorous and pesticides in soils and/or groundwater at our current and former facilities. Much of this work is conducted on a voluntary basis under state law, which provides for reimbursement of expenses by state agricultural funds. In addition, we are engaged in corrective action under the Resource Conservation and Recovery Act at our facilities in Billings, Montana and Garden City, Kansas, and our former facility in Nichols, Iowa. We have also removed or closed underground storage tanks from some of our facilities and, in some instances, are responding to historic releases at these locations. In total, both voluntary and government ordered cleanups of releases of hazardous substances are planned or being performed at approximately 24 sites. Without consideration of third-party contributions, the cost of these on-going and potential response actions is not expected to have a material adverse effect on our business, financial condition, results of operations or liquidity. In some cases, third parties (including government reimbursement funds and insurers) may contribute to the costs of cleanup at these sites. ConAgra has agreed to provide us with a partial reimbursement of costs that we may incur in the future relating to any cleanup requirements arising out of pre-closing environmental conditions at our Greenville, Mississippi facility. On October 14, 2002, December 23, 2002 and December 31, 2002, three separate lawsuits were filed in the Circuit Court of Washington County, Mississippi against our subsidiary, Platte Chemical Company ( Platte ), and certain former employees of Platte, relating to alleged releases from Platte s Greenville, Mississippi facility. The plaintiffs in such suits are seeking compensation for alleged personal injury and property damage. In connection with the Acquisition, ConAgra agreed to partially reimburse us, subject to a cap, for fees and expenses we incur in connection with such lawsuits. Subsequent to November 23, 2003, another lawsuit not covered by the ConAgra cost sharing agreement was filed in the Circuit Court of Washington County, Mississippi against us and Apollo, which lawsuit relates to the same alleged releases from the Greenville, Mississippi facility. In January 2004, the plaintiffs requested permission from the court to amend their first three complaints to include United Agri Products, UAP Holdings, Apollo and various other Apollo entities as defendants. The plaintiffs request to amend the complaints was denied by the court. While the Greenville litigations are at an early stage, based on information available to us at this time we do not believe that such litigations, if adversely determined, would have a material adverse effect on our business, financial condition, results of operations or liquidity. The Comprehensive Environmental Response, Compensation and Liability Act, as amended ( CERCLA ), provides for responses to, and, in some instances, joint and several liability for releases of, hazardous substances into the environment. At the present time, there is one off-site disposal facility at which we have been identified as a potentially responsible party under CERCLA. We believe we are a de minimis party at that site. REGULATORY LICENSES AND APPROVALS As a seller and distributor of crop production inputs, we are subject to registration requirements under the Federal Insecticide, Fungicide, and Rodenticide Act and related state statutes, which require us to provide information to regulatory authorities regarding the benefits and risks of the products we sell and distribute, and to periodically update that information. Risk information supplied to governmental authorities by us or others could result in the cancellation of products or in limitations on their use. In addition, these laws regulate information contained in product labels and in promotional materials, require that products are manufactured in adherence to manufacturing specifications, and impose reporting and recordkeeping requirements relating to production and sale of certain pesticides. Non-compliance with these environmental, health and safety laws can result in significant fines or penalties or restrictions on our ability to sell our products. Based on our experience to date, these requirements are not expected to have a material adverse effect on our business, financial condition, results of operations or liquidity. Table of Contents LEGAL PROCEEDINGS In addition to the matters discussed above under Environmental Matters beginning on page 95, we are involved in periodic litigation in the ordinary course of our business, including lawsuits brought by employees and former employees alleging discriminatory practices, intellectual property infringement claims, product liability claims, property damage claims, personal injury claims, contract claims and worker s compensation claims. We do not believe that there are any pending or threatened legal proceedings, including ordinary litigation incidental to the conduct of our business and the ownership of our properties, that, if adversely determined, would have a material adverse effect on our business, financial condition, results of operations or liquidity. However, we cannot assure you that future litigation will not adversely affect our business, financial condition, results of operations or liquidity. L. Kenny Cordell 47 President, Chief Executive Officer and Director Bryan S. Wilson 44 President, Distribution David W. Bullock 40 Executive Vice President and Chief Financial Officer Todd A. Suko 37 Vice President, General Counsel and Secretary Joshua J. Harris 39 Director Robert Katz 36 Director Marc E. Becker 32 Director Stan Parker 28 Director Carl J. Rickertsen 44 Director Thomas R. Miklich 57 Director L. Kenny Cordell has been the President and a director of UAP Holdings and United Agri Products since the closing of the Acquisition on November 24, 2003 and became the Chief Executive Officer of United Agri Products in December 2003 and of UAP Holding Corp. in January 2004. He joined UAP in 2001 and was promoted to President and Chief Operating Officer in February 2002. Prior to joining UAP, Mr. Cordell worked for FMC Agricultural Products Group from 1992 to 2001, serving most recently as Director of the North American Agricultural Products Group. Mr. Cordell also held various positions in the agricultural units of BASF (1989 to 1992) and Rohm & Haas (1979 to 1989). Bryan S. Wilson has been the President, Distribution of UAP Holdings and United Agri Products since January 2004. He joined UAP in September 2002 as President and General Manager, Products and Non-Crop. Prior to joining UAP, Mr. Wilson worked for BASF from 1987 to 2002, holding various positions both domestically and internationally, serving most recently as President of Microflo, Inc., a subsidiary of BASF. David W. Bullock has been the Executive Vice President of UAP Holdings and United Agri Products since the closing of the Acquisition on November 24, 2003, and became the Chief Financial Officer of United Agri Products in December 2003 and of UAP Holdings in January 2004. He joined UAP in June 2002 as Senior Financial Officer. Prior to joining UAP, Mr. Bullock worked for FMC Agricultural Products Group from 1995 to 2002, serving most recently as Controller of the North American agriculture business. Mr. Bullock also held various financial positions with Air Products and Chemicals (1991 to 1995). Todd A. Suko has been the Vice President, General Counsel and Secretary of UAP Holdings since the Acquisition on November 24, 2003. He joined United Agri Products in February 2001 as Associate Counsel and was promoted to Vice President Legal and Regulatory Services and Corporate Counsel in October 2002. Prior to joining United Agri Products, he practiced law at McKenna & Cuneo, LLP in Washington, D.C. from 1996 to 2001. Joshua J. Harris has been a director of UAP Holdings and United Agri Products since the closing of the Acquisition on November 24, 2003. Mr. Harris has been a founding senior partner of Apollo Management, L.P. since 1990. Prior to that time, Mr. Harris was a member of the Mergers and Acquisitions department of Drexel Burnham Lambert Incorporated. Mr. Harris is also a director of Breuners Home Furnishings Corporation, Pacer International, Inc., Compass Minerals Group, Inc., Resolution Performance Products Inc., Quality Distribution, Inc., Nalco Investment Holdings LLC and General Nutrition Centers, Inc. Table of Contents Robert Katz has been a director of UAP Holdings and United Agri Products since the closing of the Acquisition on November 24, 2003. Mr. Katz has been associated with Apollo Management, L.P. since 1990. Mr. Katz is also a director of Vail Resorts, Inc., SpectraSite, Inc. and Horizon PCS, Inc. Marc E. Becker has been a director of UAP Holdings and United Agri Products since the closing of the Acquisition on November 24, 2003. Mr. Becker has also been employed with Apollo Management, L.P. since 1996 and has served as an officer of certain affiliates of Apollo since 1999. Prior to that time, Mr. Becker was employed by Smith Barney Inc. within its Investment Banking division. Mr. Becker serves on several boards of directors including National Financial Partners Corp., Pacer International, Inc. and Quality Distribution, Inc. Stan Parker has been a director of UAP Holdings since March 2004 and a director of United Agri Products since April 2004. Mr. Parker has also been employed with Apollo Management, L.P. since 2000. From 1998 to 2000, Mr. Parker was employed by Salomon Smith Barney, Inc. Carl J. Rickertsen has been a director of UAP Holdings since March 2004 and a director of United Agri Products since April 2004. Mr. Rickertsen has been the managing partner of Pine Creek Partners since January 2004. Prior to that time, Mr. Rickertsen was the Chief Operating Officer and a Partner of Thayer Capital Partners and a General Partner at Hancock Park Associates. Mr. Rickertsen is also a director of MicroStrategy Incorporated and Convera Corporation. Thomas R. Miklich has been a director of UAP Holdings since March 2004 and a director of United Agri Products since April 2004. Mr. Miklich was the Chief Financial Officer of OM Group, Inc. from May 2002 to April 2004. Prior to that time, Mr. Miklich was the Chief Financial Officer and General Counsel of Invacare Corporation. Within one year following the consummation of the offering, to comply with the listing standards of the American Stock Exchange, we expect that the composition of our board of directors will be changed to include a majority of directors who qualify as independent under such listing standards. DIRECTOR COMPENSATION Initial compensation for our directors who are not also employed by us will be $10,000 per director per quarter and $2,000 per director for attending meetings of the board of directors in person ($1,000 if by telephone) and $2,000 per director for attending committee meetings of the board of directors in person ($1,000 if by telephone). COMMITTEES OF THE BOARD OF DIRECTORS Our board of directors currently has an audit committee and a compensation committee. The members of the audit committee are Messrs. Rickertsen, Micklich and Becker. Within one year following the consummation of the offering, we expect that Mr. Becker will be replaced as a member of the audit committee with a new director who will qualify as an independent director under the applicable listing standards of the American Stock Exchange and the SEC s rules and regulations. The members of the compensation committee are Messrs. Harris, Katz and Rickertsen. Within ninety days following the completion of this offering, we expect that Mr. Katz will be replaced as a member of the compensation committee with a new director who will qualify as an independent director under the applicable listing standards of the American Stock Exchange. Within one year following the completion of this offering, we expect that Mr. Harris will be replaced as a member of the compensation committee with a new director who will qualify as an independent director under the applicable listing standards of the American Stock Exchange. Prior to the completion of the offering, we expect that our Board of Directors will designate a nominating committee, whose members will meet the applicable listing standards of the American Stock Exchange. Income Per Share Common stock: Basic $ $ $ L. Kenny Cordell . . . . . . . . . . . President and Chief Executive Officer 2004 $ 350,000 $ 449,731 $ 1,300,000 $ 726,791 (2) Bryan S. Wilson . . . . . . . . . . . . President, Distribution 2004 $ 250,000 $ 250,940 $ 800,000 $ 449,530 (3) David W. Bullock . . . . . . . . . . . Executive Vice President and Chief Financial Officer 2004 $ 200,000 $ 225,975 $ 800,000 $ 11,029 (4) Dave Tretter . . . . . . . . . . . . . . . Executive Vice President, Procurement 2004 $ 180,000 $ 191,981 $ 500,000 $ 446,183 (5) Robert A. Boyce, Jr. . . . . . . . . Executive Vice President, Verdicon 2004 $ 180,000 $ 230,378 $ 775,000 $ 186,582 (6) (1) As described in more detail below under Retention Agreements, we granted Messrs. Cordell, Wilson, Bullock, Tretter, and Boyce deferred share awards in connection with the Acquisition covering 644,514, 396,624, 396,624, 247,890 and 384,230 deferred shares of common stock, respectively. The value set forth above with respect to each such grant represents the number of deferred shares of common stock awarded multiplied by the approximate value of a share of our common stock as of the date of grant of the award. As described in more detail below under Amended and Restated 2004 Deferred Compensation Plan, each deferred share award is subject to a two-year vesting requirement measured from the date of the consummation of the offering, carries dividend equivalent rights, and if and when payable represents the right to receive one share of common stock from UAP Holdings. Also as described in more detail below under Amended and Restated 2004 Deferred Compensation Plan, the deferred shares of common stock will be converted into the right to receive shares of participating preferred stock, as opposed to common stock, in connection with this offering. Each named executive continued to hold the number of deferred shares of common stock set forth above as of February 22, 2004. The value of these deferred shares of common stock held by Messrs. Cordell, Wilson, Bullock, Tretter, and Boyce as of that date, measured by multiplying the number of deferred shares subject to the award by the approximate value of a share of our common stock on February 22, 2004, was substantially the same as the grant-date value reflected in the table above. (2) Consists of a company contribution to UAP Holdings retirement (401(k)) plan of $5,115, a relocation benefit of $8,787, and, as described in more detail below under Retention Agreements, a special bonus paid in connection with the Acquisition of $712,889. Of the special bonus paid to Mr. Cordell, ConAgra Foods paid Mr. Cordell $389,289 and UAP Holdings paid Mr. Cordell $323,600. UAP Holdings subsequently reimbursed ConAgra Foods for $81,400 of its payment to Mr. Cordell. (3) Consists of a company contribution to UAP Holdings retirement (401(k)) plan of $5,583, a relocation benefit of $63,947, and, as described in more detail below under Retention Agreements, a special bonus paid in connection with the Acquisition of $380,000. (4) Consists of a company contribution to UAP Holdings retirement (401(k)) plan of $6,029, and, as described in more detail below under Retention Agreements, a special bonus paid in connection with the Acquisition of $5,000. (5) Consists of a company contribution to UAP Holdings retirement (401(k)) plan of $4,892, a relocation benefit of $76,291, and, as described in more detail below under Retention Agreements, a special bonus paid in connection with the Acquisition of $365,000. (6) Consists of a company contribution to UAP Holdings retirement (401(k)) plan of $5,106, a relocation benefit of $11,476, and, as described in more detail below under Retention Agreements, a special bonus paid in connection with the Acquisition of $170,000. The table above does not reflect restricted stock awards and options exercisable for the common stock of ConAgra Foods which were awarded by ConAgra Foods prior to the closing of the Acquisition. RETENTION AGREEMENTS In connection with the Acquisition, UAP Holdings entered into retention agreements with ten of its top executives. The terms and conditions of the retention agreements are substantially identical. Under each agreement, the applicable executive received, upon the consummation of the Acquisition, a cash bonus and a bonus payable by crediting deferred shares of common stock to such executive s deferred compensation account under the 2003 deferred compensation plan. Concurrently with the closing of the Transactions, each of the retention agreements will be terminated, and all shares of common stock in which each executive s deferred compensation account is deemed to be invested (other than those being cancelled pursuant to the management incentive agreement) will be exchanged for shares of participating preferred stock pursuant to the amended and restated 2004 deferred compensation plan. The amended and restated 2004 deferred compensation plan will amend and restate the 2003 deferred compensation plan in its entirety. The bonuses received by our named executive officers and number of deferred shares of common stock granted to our officers in connection with the Acquisitions are set forth under Executive Compensation above. Table of Contents 2003 AND 2004 DEFERRED COMPENSATION PLANS IN EFFECT PRIOR TO THE OFFERING In connection with the Acquisition and subsequently thereafter, UAP Holdings adopted 2003 and 2004 deferred compensation plans for the benefit of certain of its executives and members of management. The 2003 plan provides for the creation of individual deferred compensation accounts for each executive that has entered into a retention agreement, and, as described above, such accounts were credited at the closing of the Acquisition with a specified number of deferred shares of common stock. The 2004 plan provides for the creation of individual deferred compensation accounts for each member of management that has waived the right to receive a cash bonus for the 2004 fiscal year and such accounts were credited with a specified number of deferred shares of common stock. The plans prohibit the assignment of the shares except upon an executive s death. The plans also prohibit the substitution of collateral for the deferred shares of common stock credited to such accounts (other than equity securities issued upon a subsequent redemption of common stock). UAP Holdings has agreed to indemnify and reimburse directors, officers and employees in connection with the administration of the plans. 2003 STOCK OPTION PLAN In connection with the Acquisition, UAP Holdings adopted a stock option plan for the benefit of certain of its employees, which we refer to in this prospectus as the 2003 option plan. The purpose of the 2003 option plan is to further the growth and success of UAP Holdings and its subsidiaries by enabling directors and employees of, and consultants to, UAP Holdings and its subsidiaries to acquire shares of UAP Holdings common stock, thereby increasing their personal interest in such growth and success, and to provide a means of rewarding outstanding performance by such persons. Options granted under the 2003 option plan may not be assigned or transferred, except for transfers upon the optionee s death. The 2003 option plan only allows for the issuance of non-qualified options. Each of the executives that is a party to a retention agreement received options under the 2003 option plan pursuant to individual option agreements, the terms and conditions of which are substantially identical. Each agreement provides for the issuance of three tranches of options to purchase common stock of UAP Holdings. The term of each option expires on the thirtieth day immediately following the eighth anniversary of the grant date of such option, unless otherwise terminated sooner. The Tranche A options vest 20% on each of the first five anniversaries of the grant date. All of the Tranche B options vest on the earlier to occur of the eighth anniversary of the grant date or a realization event whereby the equity sponsor receives an internal rate of return equal to or exceeding 25%. All of the Tranche C options vest on the earlier to occur of the eighth anniversary of the grant date or a realization event whereby the equity sponsor receives an internal rate of return equal to or exceeding 30%. Upon an executive s termination of his employment, all of such executive s issued and outstanding options automatically terminate upon the earlier to occur of (i) the thirtieth day following the eighth anniversary of the grant date or (ii) the ninetieth day following any termination of such employee s relationship with UAP Holdings. As of May 12, 2004, UAP Holdings board of directors had granted options to purchase 3,889,642 shares of UAP Holdings common stock under the 2003 option plan. Upon completion of this offering, all outstanding options under the 2003 option plan will be exchanged for shares of participating preferred stock. UAP Holdings does not intend to grant additional employee stock options but does intend to create a separate long term incentive plan after the offering. See Amended and Restated 2004 Deferred Compensation Plan beginning on page 102. AMENDED AND RESTATED 2004 DEFERRED COMPENSATION PLAN In connection with the Transactions, UAP Holdings intends to combine the 2003 deferred compensation plan, the 2004 deferred compensation plan and the 2003 option plan into one plan to be called the amended and restated 2004 deferred compensation plan. The amended and restated 2004 deferred compensation plan will have similar terms and conditions as the predecessor deferred compensation plans, including a prohibition on assignment and an indemnity identical to that discussed above. Table of Contents The deferred shares of common stock in each participant s deferred compensation account under the current deferred compensation plans (other than those being cancelled in exchange for a cash payment pursuant to the management incentive agreement) will be exchanged for deferred shares of participating preferred stock. In the management incentive agreement, each participant will also agree to the cancellation of his or her options under the 2003 option plan (other than those being cancelled in exchange for a cash payment pursuant to the management incentive agreement) in exchange for the issuance of additional deferred shares of participating preferred stock to his or her deferred compensation account. The deferred shares of participating preferred stock issued in exchange for the cancellation of Tranche A options will continue to vest on the same schedule as the cancelled Tranche A options would have vested had they not been cancelled, and the deferred shares of participating preferred stock issued in exchange for deferred shares of common stock or the cancellation of Tranche B and Tranche C options will be fully vested upon issuance. The deferred shares of participating preferred stock issued in exchange for the cancellation of options will be identical to the deferred shares of participating preferred stock issued in exchange for deferred shares of common stock. If UAP Holdings pays any non-cash dividend on its participating preferred stock, each participant s deferred compensation account will be credited with an additional number of deferred shares equal to the number obtained by dividing (i) the aggregate value of the dividend that is paid on the shares of participating preferred stock represented by the vested deferred shares that such participant s deferred compensation account is credited with as of the record date for such dividend payment by (ii) the fair market value of one share of participating preferred stock as of the date such dividend is paid (with such fair market value determined after giving effect to such dividend). If UAP Holdings pays any cash dividend on shares of its participating preferred stock, the cash distribution payable on the shares of participating preferred stock represented by the vested deferred shares that such participant s deferred compensation account is credited with as of the record date for such dividend payment shall be paid to each participant contemporaneously with the payment of such cash distribution to the holders of the participating preferred stock. Pursuant to the amended and restated 2004 deferred compensation plan, so long as no event of bankruptcy, liquidation, appointment of receiver or similar proceeding has occurred or is continuing, deferred shares of participating preferred stock may be forfeited in one of the following ways: upon a termination of employment (a) for Full Cause (as defined below) or (b) during the twenty-four month period immediately following the closing of the offering of the IDSs, a resignation for any reason other than Good Reason (as defined below), then a participant shall forfeit all of the deferred shares of participating preferred stock except for the number of deferred shares of participating preferred stock equal to the sum of: (i) the number of shares obtained by dividing the amount of compensation such participant originally deferred into either the 2003 deferred compensation plan or the 2004 deferred compensation plan by the fair market value of a deferred share of participating preferred stock on the date of forfeiture, and (ii) the number of vested shares at such time issued in exchange for the cancellation of Tranche A, Tranche B and Tranche C options; and upon a termination of employment (a) for Half Cause (as defined below) or (b) during the period commencing on the twenty-four month anniversary of the closing of the offering of the IDSs, a resignation for any reason other than Good Reason, then a participant shall forfeit all of the deferred shares of participating preferred stock except for the number of deferred shares of participating preferred stock equal to the sum of: (i) the number of shares obtained by dividing the amount of compensation such participant originally deferred into either the 2003 deferred compensation plan or the 2004 deferred compensation plan by the fair market value of a deferred share of participating preferred stock on the date of forfeiture, (ii) the number of vested shares at such time issued in exchange for the cancellation of Tranche A, Tranche B or Tranche C options and (iii) 50% of the difference between (x) the aggregate number of deferred shares of preferred stock allocated to a participant s account immediately prior to the forfeiture date and (y) the sum of (A) the number of deferred shares of participating preferred stock included in clauses (i) and (ii) above and (B) the number of unvested deferred shares of participating preferred stock. Table of Contents For purposes of the amended and restated 2004 deferred compensation plan, the terms Full Cause, Good Reason and Half Cause will have the meanings listed below: Full Cause shall mean, with respect to any participant, (a) such participant s indictment for a crime of moral turpitude or a felony that involves financial misconduct or moral turpitude that has resulted, or reasonably could be expected to result, in any adverse publicity regarding the participant or UAP Holdings or economic injury to UAP Holdings, (b) a knowing and intentional fraudulent act or failure to act by such participant that has resulted, or reasonably could be expected to result, in demonstrable and serious economic injury to UAP Holdings or (c) a material breach by such participant of the amended and restated 2004 deferred compensation plan or any agreement entered into between the participant and UAP Holdings or any of its subsidiaries or affiliates, in each case, after notice and a reasonable opportunity to cure (if such breach can be cured). For purposes hereof, no act or omission shall be considered willful unless committed in bad faith or without a reasonable belief that the act or omission was in the best interests of UAP Holdings. Good Reason shall mean (a) a reduction in the amount of any participant s annual base salary as in effect on or after the date of the consummation of this offering, or (b) without limiting the generality of the foregoing, any material breach by UAP Holdings or any of its subsidiaries or other affiliates of the amended and restated 2004 deferred compensation plan or any other agreement between the participant and UAP Holdings or any such subsidiary or other affiliate, which material breach is not remedied by UAP Holdings promptly after receipt of notice thereof given by the participant; provided, however, that the participant agrees not to terminate his or her employment for Good Reason if, after notice and a reasonable opportunity to cure, UAP Holdings has remedied such facts and circumstances constituting Good Reason. Half Cause shall mean, with respect to any participant, insubordination by such participant in connection with his or her employment, including, by way of example, a failure by such participant to follow a reasonable and legal direction given to such participant in the course of his or her employment by any person to whom such participant reports, but only to the extent such insubordination continues after written notice (detailing with reasonable specificity the acts or omissions constituting insubordination) and a reasonable opportunity to cure. All determinations of a Participant s insubordination under this definition of Half Cause shall be made by UAP Holdings chief executive officer or by its board of directors. To the extent that any deferred shares are forfeited as described above, all such forfeited deferred shares will be held on reserve for subsequent reallocation to existing participants and/or to new participants by the administrator of the amended and restated 2004 deferred compensation plan in its sole discretion, in a separate deferred compensation account. In the event that such forfeited deferred shares are not reallocated prior to (i) the record date for the payment of dividends on the participating preferred stock (or prior to such dividend payment date if there is no record date), (ii) the acquisition of more than 30% of the voting power of UAP Holding s common equity (on a fully-diluted basis) by persons other than the equity sponsors and its affiliates, (iii) a merger involving UAP Holdings in which the shareholders of UAP Holdings immediately prior to such merger own less than 50% of the voting power of the surviving corporation after such merger, (iv) the sale, transfer or lease of all or substantially all of the assets of UAP Holdings, (v) the occurrence of a change of control as defined in any indenture or agreement to which UAP Holdings or any of its subsidiaries is a party with respect to indebtedness for borrowed money in excess of the aggregate principal amount of $100,000,000 or (vi) an event of bankruptcy, liquidation, appointment of receiver or similar proceeding, such forfeited deferred shares will automatically be deemed to be reallocated to existing participants pro rata based on the number of deferred shares held by each such participant on the date of the event giving rise to the automatic reallocation. Immediately after the expiration of such event (other than an event of bankruptcy, liquidation, appointment of receiver or similar proceeding), such forfeited deferred shares will be reallocated to a separate deferred compensation account until such time as such forfeited deferred shares are further reallocated to existing participants and/or new participants. Table of Contents Unless otherwise forfeited as described above, each participant s deferred shares of participating preferred stock shall be distributed to such participant upon the earliest to occur of (i) the participant s termination of employment, (ii) the exercise by the participant of distribution rights to sell IDSs issued or issuable upon conversion of such participant s deferred shares of participating preferred stock, as set forth in the management incentive agreement, (iii) the acquisition of more than 30% of the voting power of UAP Holdings common equity (on a fully-diluted basis) by persons other than the equity sponsor and its affiliates, (iv) a merger involving UAP Holdings in which the shareholders of UAP Holdings immediately prior to such merger own less than 50% of the voting power of the surviving corporation after such merger, (v) the sale, transfer or lease of all or substantially all of the assets of UAP Holdings or (vi) the occurrence of a change of control as defined in any indenture or agreement to which UAP Holdings or any of its subsidiaries is a party with respect to indebtedness for borrowed money in excess of the aggregate principal amount of $100,000,000. However, in no event will distributions be permitted, unless the conversion of the shares of participating preferred stock being distributed is then permitted. Deferred shares of participating preferred stock may not be converted prior to the distribution of such shares. 2004 NON-EXECUTIVE DIRECTOR STOCK OPTION PLAN On March 8, 2004, UAP Holdings adopted a stock option plan for the benefit of its non-executive directors, which we refer to in this prospectus as the 2004 non-executive director option plan. The purposes of the 2004 non-executive director option plan is to further the growth and success of UAP Holdings and its subsidiaries by enabling directors of UAP Holdings or any of its subsidiaries to acquire shares of UAP Holdings common stock, thereby increasing their personal interest in such growth and success, and to provide a means of rewarding outstanding performance by such persons. All options granted under the plan will be non-qualified stock options. No option granted under the 2004 non-executive director option plan may be assigned or otherwise transferred by the optionee, except for transfers by will or by the laws of descent and distribution. The 2004 non-executive director option plan will terminate on the tenth anniversary of its adoption, and no options may be granted under the plan thereafter. As of May 30, 2004, UAP Holdings board of directors had granted options to purchase 446,202 shares of UAP Holdings common stock under the 2004 non-executive director option plan, all of which vested immediately, and another 297,468 shares of common stock remained available for future grants. In connection with the offering, UAP Holdings will amend and restate the 2004 non-executive director option plan. The amended and restated 2004 non-executive director stock option plan will be substantially similar to the existing 2004 non-executive director option plan, but will provide that all options, whether vested or unvested, will become exercisable for shares of participating preferred stock. Each option will become exercisable for a number of shares of participating preferred stock (or a fraction thereof) equal to the quotient obtained by dividing: the value of the share of common stock underlying such options (with the per share value equaling the price per shares paid to Apollo for shares of common stock sold to the underwriters, after giving effect to underwriting discounts and commissions), by the value of one share of participating preferred stock immediately after the completion of the offering (with the per share value of the participating preferred stock equaling the price per IDS paid to us for IDSs sold to the underwriters, after giving effect to underwriting discounts and commissions). The exercise price of each option will also be adjusted accordingly such that the aggregate exercise price payable with respect to the options for common stock is the same as the aggregate exercise price payable with respect to the options for participating preferred stock. Table of Contents In addition, the amended and restated 2004 non-executive director option plan will provide that any and all dividends paid on shares of participating preferred stock will be paid to the holders of vested options as if such holders had exercised such vested options on a cashless basis immediately prior to the record date or immediately prior to the date of payment if there is no record date. 2004 LONG TERM INCENTIVE PLAN Concurrently with the closing of the offering, UAP Holdings intends to adopt a long-term incentive plan for the benefit of certain employees and consultants that are hired following the Recapitalization. UAP Holdings currently anticipates that the number of IDSs to be held on reserve pursuant to this plan will not exceed % of the number of shares of IDSs outstanding, on a fully-diluted basis, immediately after the Recapitalization. PROSPECTUS SUMMARY 1 RISK FACTORS 26 DISCLOSURE REGARDING FORWARD-LOOKING STATEMENTS 42 USE OF PROCEEDS 43 DIVIDEND POLICY AND RESTRICTIONS 44 CAPITALIZATION 53 DILUTION 54 UNAUDITED PRO FORMA CONDENSED CONSOLIDATED FINANCIAL DATA 55 SELECTED HISTORICAL FINANCIAL AND OTHER DATA 66 MANAGEMENT S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 69 BUSINESS 83 MANAGEMENT 98 PRINCIPAL AND SELLING STOCKHOLDERS Table of Contents PRINCIPAL AND SELLING STOCKHOLDERS The following table sets forth information as of September 24, 2004 regarding the beneficial ownership of UAP Holdings common stock before the completion of this offering and UAP Holdings common stock and participating preferred stock after the completion of this offering (in each case, as adjusted to reflect the proposed 49.578-for-1 stock split of the common stock), and shows the number of shares and percentage owned by (i) each person known to beneficially own more than 5% of the common stock of UAP Holdings before completion of this offering and UAP Holdings common stock and participating preferred stock after the completion of this offering, (ii) each member of the Board of Directors of UAP Holdings, (iii) each of UAP Holdings named executive officers and, (iv) all of the executive officers and members of the Board of Directors of UAP Holdings as a group. The amounts and percentages of common stock and participating preferred stock beneficially owned are reported on the basis of regulations of the SEC governing the determination of beneficial ownership of securities. Under the rules of the SEC, a person is deemed to be a beneficial owner of a security if that person has or shares voting power, which includes the power to vote or to direct the voting of such security, or investment power, which includes the power to dispose of or to direct the disposition of such security. A person is also deemed to be a beneficial owner of any securities of which that person has a right to acquire beneficial ownership within 60 days. Under these rules, more than one person may be deemed a beneficial owner of the same securities and a person may be deemed a beneficial owner of securities as to which he has no economic interest. Our equity sponsor will sell a portion of its shares of common stock to the underwriters for inclusion in the IDS. The column below titled Shares to be Sold in this Offering represents the shares of common stock represented by IDSs being sold in this offering by Apollo Management V, L.P., our equity sponsor, to the underwriters for inclusion in the IDSs. Additional information with respect to our equity sponsor and its relationships with our company is provided under the caption Certain Relationships and Related Transactions beginning on page 110. Except as indicated by footnote, the persons named in the table below have sole voting and investment power with respect to all shares of common stock and participating preferred stock shown as beneficially owned by them. In addition, except as indicated by footnote, the shares of common stock and participating preferred stock beneficially owned by our executive officers, including Mr. Cordell, consist of deferred shares of common stock credited as of May 30, 2004 to the deferred compensation accounts of such persons under the 2003 deferred compensation plan and the 2004 deferred compensation plan and deferred shares of participating preferred stock to be credited to the deferred compensation accounts of such persons under the amended and restated 2004 deferred compensation plan. These deferred shares are distributable only upon a termination of employment, certain corporate transactions or in accordance with the terms of the management incentive agreement. The executive officers do not have voting or investment power over these deferred shares. * Less than one percent. (a) With respect to shares beneficially owned prior to this offering, includes (i) 56,741,753 shares of common stock owned of record by Apollo Investment Fund V, L.P. and its related co-investment partnerships (the Apollo Funds ) and (ii) 3,190,333 shares of common stock beneficially owned by the named executive officers and other members of our management through UAP Holdings 2003 deferred compensation plan. Under the terms of an investor rights agreement entered into in connection with the Acquisition among UAP Holdings and its securityholders, the trustee under the plan must vote the shares subject to the plan at the direction of Apollo Management V, L.P. ( Apollo Management ). Apollo Management serves as investment manager of each of the Apollo Funds and has voting and investment power over the shares owned of record by each of the Apollo Funds. The investor rights agreement also grants Apollo Management the right to require the named executive officers and other members of our management to join in certain sales or transfers of shares to a third party. Concurrently with the closing of this offering, the investor rights agreement will be amended and restated by a new management incentive agreement, which will terminate Apollo Management s right to direct the vote and sale of shares owned through UAP Holdings 2003 deferred compensation plan. See Management Amended and Restated 2004 Deferred Compensation Plan beginning on page 102 and Certain Relationships and Related Party Transactions Ancillary Agreements Investor Rights Agreement beginning on page 117. With respect to shares beneficially owned after this offering, includes 6,403,289 shares of participating preferred stock owned of record by the Apollo Funds (or 928,289 shares assuming the underwriters over-allotment option is exercised in full). The general or managing partner of each of the Apollo Funds is Apollo Advisors V, L.P. ( Apollo Advisors ), an affiliate of Apollo Management. The address of each of the Apollo Funds, Apollo Management and Apollo Advisors is c/o Apollo Management V, L.P., Two Manhattanville Road, Purchase, New York 10577. (b) The holders of participating preferred stock will be entitled to vote as a single class with the holders of common stock on all matters on which holders of participating preferred stock and common stock are entitled to vote on an as if converted basis. In addition, following the first anniversary of this offering and subject to satisfaction of the Conversion Conditions, the participating preferred stock will be convertible into IDSs or, if the IDSs have automatically separated, senior subordinated notes and shares of common stock. See Description of Capital Stock Preferred Stock Participating Preferred Stock beginning on page 140. (c) With respect to shares beneficially owned prior to this offering, (i) includes 644,511 deferred shares of common stock under the 2003 deferred compensation plan, (ii) includes 72,714 shares of common stock that are issuable upon exercise of Tranche A options, which will vest on November 24, 2004 and (iii) does not include 1,017,997 shares of common stock that are issuable upon exercise of Tranche A options, Tranche B options and Tranche C options under the 2003 option plan, all of which remain subject to vesting. Diluted $ $ $ Table of Contents With respect to shares beneficially owned after this offering, (i) includes 643,353 vested deferred shares of participating preferred stock under the amended and restated 2004 deferred compensation plan and (ii) does not include 174,514 unvested deferred shares of participating preferred stock under the amended and restated 2004 deferred compensation plan, all of which will remain subject to vesting. (d) With respect to shares beneficially owned prior to this offering, (i) includes 396,622 deferred shares of common stock under the 2003 deferred compensation plan, (ii) includes 39,662 shares of common stock that are issuable upon exercise of Tranche A options, which will vest on November 24, 2004 and (iii) does not include 555,271 shares of common stock that are issuable upon exercise of Tranche A options, Tranche B options and Tranche C options under the 2003 option plan, all of which remain subject to vesting. With respect to shares beneficially owned after this offering, (i) includes 372,994 vested deferred shares of participating preferred stock under the amended and restated 2004 deferred compensation plan and (ii) does not include 95,190 unvested deferred shares of participating preferred stock under the amended and restated 2004 deferred compensation plan, all of which will remain subject to vesting. (e) With respect to shares beneficially owned prior to this offering, (i) includes 396,622 deferred shares of common stock under the 2003 deferred compensation plan, (ii) includes 39,662 shares of common stock that are issuable upon exercise of Tranche A options, which will vest on November 24, 2004 and (iii) does not include 555,271 shares of common stock that are issuable upon exercise of Tranche A options, Tranche B options and Tranche C options under the 2003 option plan, all of which remain subject to vesting. With respect to shares beneficially owned after this offering, (i) includes 372,994 vested deferred shares of participating preferred stock under the amended and restated 2004 deferred compensation plan and (ii) does not include 95,190 unvested deferred shares of participating preferred stock under the amended and restated 2004 deferred compensation plan, all of which will remain subject to vesting. (f) With respect to shares beneficially owned prior to this offering, (i) includes 247,889 deferred shares of common stock under the 2003 deferred compensation plan, (ii) includes 21,484 shares of common stock that are issuable upon exercise of Tranche A options, which will vest on November 24, 2004 and (iii) does not include 300,771 shares of common stock that are issuable upon exercise of Tranche A options, Tranche B options and Tranche C options under the 2003 option plan, all of which remain subject to vesting. With respect to shares beneficially owned after this offering, (i) includes 217,665 vested deferred shares of participating preferred stock under the amended and restated 2004 deferred compensation plan and (ii) does not include 51,561 unvested deferred shares of participating preferred stock under the amended and restated 2004 deferred compensation plan, all of which will remain subject to vesting. (g) With respect to shares beneficially owned prior to this offering, (i) includes 384,228 deferred shares of common stock under the 2003 deferred compensation plan, (ii) includes 38,340 shares of common stock that are issuable upon exercise of Tranche A options, which will vest on November 24, 2004 and (iii) does not include 536,762 shares of common stock that are issuable upon exercise of Tranche A options, Tranche B options and Tranche C options under the 2003 option plan, all of which remain subject to vesting. With respect to shares beneficially owned after this offering, (i) includes 360,533 vested deferred shares of participating preferred stock under the amended and restated 2004 deferred compensation plan and (ii) does not include 92,016 unvested deferred shares of participating preferred stock under the amended and restated 2004 deferred compensation plan, all of which will remain subject to vesting. (h) Messrs. Harris and Becker are each principals and officers of certain affiliates of Apollo Management. Although each of Messrs. Harris and Becker may be deemed to be the beneficial owner of shares of common stock or participating preferred stock beneficially owned by Apollo Management, as the case may be, each of them disclaims beneficial ownership of any such shares. (i) Messrs. Katz and Parker are associated with Apollo Management but disclaim beneficial ownership of any of the shares of common stock or participating preferred stock beneficially owned by Apollo Management, as the case may be. (j) With respect to shares beneficially owned prior to this offering, includes shares of common stock that are issuable upon exercise of options under UAP Holdings 2004 non-executive director option plan that are immediately exercisable. See Management 2004 Non-Executive Director Stock Option Plan beginning on page 105. With respect to shares beneficially owned after this offering, includes shares of participating preferred stock issuable exercise of options under UAP Holdings amended and restated 2004 non-executive director option plan that are immediately exercisable. See Management 2004 Non-Executive Director Stock Option Plan beginning on page 105. (k) With respect to shares beneficially owned prior to this offering, (i) includes 1,474,938 deferred shares of common stock under the 2003 deferred compensation plan, (ii) includes 446,202 shares of common stock issuable upon exercise of options under the 2004 non-executive director option plan (iii) includes 214,837 shares of common stock that are issuable upon exercise of Tranche A options, which will vest on November 24, 2004 and (iv) does not include 2,110,360 shares of common stock that are issuable upon exercise of Tranche A options, Tranche B options and Tranche C options under the 2003 option plan, all of which remain subject to vesting. With respect to shares beneficially owned after this offering, (i) includes 1,449,917 deferred shares of participating preferred stock under the amended and restated 2004 deferred compensation plan, (ii) includes 222,720 shares of participating preferred stock issuable upon exercise of options under the 2004 non-executive director option plan, and (iii) does not include 336,137 unvested deferred shares of participating preferred stock under the amended and restated 2004 deferred compensation plan, all of which will remain subject to vesting. As of September 24, 2004, there were approximately six holders of record of our common stock. Table of Contents CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The following contains a summary of the Acquisition and related financings, as well as summaries of certain agreements relating to the Acquisition. The descriptions of such agreements do not purport to be complete and are qualified in their entirety by reference to such agreements. Copies of the stock purchase agreement and other material contracts described below are filed or incorporated by reference as exhibits to the registration statement of which this prospectus forms a part. THE ACQUISITION Overview On November 24, 2003, pursuant to the stock purchase agreement, dated as of October 29, 2003, as amended on November 24, 2003, among United Agri Products, ConAgra Foods and UAP Holdings, UAP Holdings acquired United Agri Products and its subsidiaries from ConAgra Foods in a merger and related transactions (the Acquisition ). As part of the Acquisition, UAP Holdings acquired United Agri Products Canadian affiliates and caused its newly formed subsidiary, UAP Acquisition Corp., to merge into United Agri Products. In connection with the merger, UAP Holdings contributed all the outstanding capital stock of United Agri Products Canadian affiliates to United Agri Products. The purchase price was $575.0 million and is subject to post-closing adjustments as described below. On November 24, 2003, the aggregate consideration paid to ConAgra Foods was $560.0 million, of which $500.0 million was paid in cash and $60.0 million was paid in the form of shares of Series A Redeemable Preferred Stock of UAP Holdings. The aggregate consideration paid to ConAgra Foods at the closing of the Acquisition equaled United Agri Products estimated net book value, including the value of United Agri Products Canadian subsidiaries, as of the closing of the Acquisition, less the sum of certain rebate payments, management retention bonuses United Agri Products agreed to assume and a $7.5 million expense paid to ConAgra Foods at the closing of the Acquisition pursuant to a transition services agreement. Pursuant to the stock purchase agreement, we agreed to pay ConAgra Foods, prior to April 30, 2004, and subject to certain post-closing adjustments, the amount equal to the difference between the estimated net book value of the businesses acquired in the Acquisition at the effective time of the closing of the Acquisition, and the amount of consideration actually paid to ConAgra Foods at such closing. This estimated net book value and the rebate payments to be made to ConAgra Foods after the closing of the Acquisition were based on the assumption that we would collect 100% of the estimated rebates for the 2003 and prior crop years (the Estimated Rebates ). Pursuant to the stock purchase agreement, we agreed to hold for the benefit of ConAgra up to 50% of all rebate payments received by us related to the 2003 and prior crop years from the closing of the Acquisition until April 30, 2004, subject to certain post-closing adjustments. Shortly after April 30, 2004, we adjusted the Estimated Rebates by an amount equal to the rebate payments actually received by us prior to April 30, 2004 related to the 2003 and prior crop years. In addition to the rebate adjustment, we adjusted the aggregate consideration to be paid after the closing based on the closing net book value. Ultimately, we agreed to pay ConAgra Foods an aggregate amount of $60.1 million, which includes interest charges of $1.9 million, as satisfaction in full of all amounts owed in connection with the Acquisition. This payment was funded through a draw on United Agri Products line of credit in June 2004. The Acquisition was financed with approximately $242.0 million of borrowings under United Agri Products secured $500.0 million asset-based revolving credit facility, $175.0 million of borrowings under United Agri Products senior bridge loan facility, the sale of $120.0 million of UAP Holdings common stock and the issuance of $60.0 million of UAP Holdings Series A Redeemable Preferred Stock. See Description of Other Indebtedness beginning on page 122 for a summary of the terms of the Amended Credit Facilities, and Description of Capital Stock beginning on page 138 for a summary of the terms of UAP Holdings common stock and Series A Redeemable Preferred Stock. The Stock Purchase Agreement Representations and Warranties. The stock purchase agreement dated October 29, 2003, as amended on November 24, 2003, contains customary representations, warranties and covenants. The representations and warranties survive the closing for eighteen months. Certain fundamental representations and warranties survive Table of Contents the closing indefinitely. The environmental representations and warranties survive the closing for four years. Some of the representations and warranties relating to tax matters survive the closing until thirty days after the expiration of the applicable statute of limitations. Indemnity. ConAgra Foods has agreed to indemnify us from certain liabilities, including: losses or damages arising from the inaccuracy or breach of any representation or warranty of ConAgra Foods contained in the stock purchase agreement, subject to the limitations described below; losses or damages arising from breaches of the covenants and agreements made or to be performed by ConAgra Foods pursuant to the stock purchase agreement; losses or damages related to the assets and businesses retained by ConAgra Foods; and losses or damages related to the restatement of earnings announced by ConAgra Foods on May 23, 2001 and any shareholder litigation or investigations by the SEC related thereto. The stock purchase agreement does not allow us to make a claim for indemnification for any loss or damage relating to a breach of a representation or warranty, unless the damages for any claim or series of related claims exceed $10.0 million (other than for losses relating to certain fundamental representations and warranties). Our indemnification for breaches of representations and warranties (other than for losses arising from breaches of specified representations and warranties to which this cap does not apply) is limited to $150.0 million. In addition, ConAgra Foods agreed to indemnify us for pre-closing income taxes and to reflect liability accruals for pre-closing non-income taxes in the final net book value calculation. We have agreed to indemnify ConAgra Foods for breaches of the applicable agreements and certain pre-closing matters, including the assumed litigation and pre-closing employee benefits. Insurance. We were historically self-insured by ConAgra Foods, subject to our deductible, which ranged from $500,000 in 1986 to $2.5 million in 2003. For pre-closing insured occurrences, events or conditions, liabilities in excess of our deductible, but below ConAgra Foods self-insured amount, will be paid by ConAgra Foods. For pre-closing insured occurrences, events or conditions, ConAgra Foods self-insured amount has ranged from $2 million in 1991 to $7.5 million in 2003 except that, for a portion of 2002, ConAgra Foods self-insured amount was $10 million. Any amounts above our deductible and above ConAgra Foods self-insured amount will be covered by insurance. Subject to our deductible, ConAgra Foods will continue to be responsible for insured claims resulting from any occurrence, event or condition existing or occurring prior to the closing up to ConAgra Foods self-insurance amount for the applicable year. We were also insured by third party insurers, both through policies issued to ConAgra Foods and through policies in which we were listed as named insured. We are entitled to the benefit of any payments required to be made by third party insurers pursuant to insurance policies with respect to such claims. To the extent permitted under applicable law we shall have direct rights as named insured parties under ConAgra Foods insurance policies. If we do not have direct rights under the applicable insurance policy ConAgra Foods will, to the extent permitted by the applicable insurance policy or otherwise consented by the third party insurer, assign to us the right to any claims as provided in the stock purchase agreement. If such assignment is prohibited, ConAgra Foods shall hold the obligations, rights or benefits relating to any claims not assignable to us in trust for our account. Covenant Not to Compete. ConAgra Foods has agreed, subject to certain exceptions, not to compete with us in the United States and Canada for a five-year period in the businesses of manufacturing, formulating, selling or distributing agricultural or non-crop protection chemicals, selling agricultural seeds for grain crops or selling fertilizer products for retail or developing. We agreed, subject to certain exceptions, not to compete with ConAgra Foods in the same businesses outside the United States and Canada for a three-year period. Non-Solicitation. ConAgra Foods has agreed, subject to certain exceptions, not to solicit our management or sales employees for a period of two years after the closing of the Acquisition. We agreed, subject to certain exceptions, not to solicit ConAgra Foods management or sales employees for the same two-year period. Table of Contents Unassigned or Unassignable Contracts. ConAgra Foods has agreed that if any third party s consent or approval to the assignment or other transfer to us, or any of our subsidiaries, of any contract or agreement referred to in the stock purchase agreement was not obtained prior to the closing of the Acquisition, then ConAgra Foods would hold such obligations, rights or benefits under such agreements or contracts in trust for us or our subsidiaries and take all reasonable actions to preserve the value of such agreements or contracts and we and ConAgra Foods will continue to use our commercially reasonable efforts to obtain such consents or approvals. Additionally, we, or our subsidiaries, will perform the obligations under such agreements or contracts. Guarantees. We have agreed to release ConAgra Foods from all guarantees, indemnities, bonding arrangements, letters of credit and letters of comfort given by ConAgra Foods or its affiliates for our benefit of which UAP Holdings is aware. If any release cannot be obtained, UAP Holdings has agreed to indemnify and hold ConAgra Foods and its affiliates harmless from any liability relating to any such guarantees, indemnities, bonding arrangements, letters of credit or letters of comfort not released and not to renew or otherwise extend the original term of any contract, agreement, lease or other document or instrument to which such guarantee, indemnity, bonding arrangement, letter of credit or letter of comfort relates. Additionally, ConAgra Foods has agreed to maintain each such indemnity, bonding arrangement, letter of credit or letter of comfort for the remainder of its term. Equipment Lease. Pursuant to the stock purchase agreement, ConAgra Foods has agreed to provide to us subleases of all the equipment we are presently using, which ConAgra Foods has leased on our behalf. We have agreed to provide ConAgra Foods with an irrevocable letter of credit for $10.0 million, which will decrease if our liabilities under the applicable subleases are less than $10.0 million. Expenses. Each party paid its own expenses in connection with the Acquisition and the Financings, except that ConAgra reimbursed us for $5.0 million of the fees and expenses that we incurred in connection with the senior bridge loan facility. THE RELATED FINANCINGS The Acquisition was financed with approximately $242.0 million of borrowings under United Agri Products existing secured $500.0 million asset-based revolving credit facility, $175.0 million of borrowings under United Agri Products senior bridge loan facility, the sale of $120.0 million of UAP Holdings common stock to Apollo and members of our management, and the issuance of $60.0 million of UAP Holdings Series A Redeemable Preferred Stock to ConAgra Foods. On December 16, 2003, United Agri Products consummated a private offering of $225.0 million aggregate principal amount of its 8 % Senior Notes, the proceeds of which were used to repay United Agri Products $175.0 million senior bridge loan facility, plus accrued interest, to repay a portion of the existing revolving credit facility and to pay fees and expenses associated with such offering. See Description of Other Indebtedness beginning on page 122. THE OFFERING OF SENIOR DISCOUNT NOTES On January 26, 2004, UAP Holdings completed the private offering of its 10 % Senior Discount Notes. The proceeds from the offering of the 10 % Senior Discount Notes were used to pay a dividend of $52.9 million to our existing stockholders, to redeem $26.4 million of our outstanding Series A Redeemable Preferred Stock and to pay fees and expenses associated with the offering of the 10 % Senior Discount Notes. See Description of Other Indebtedness 10 % Senior Discount Notes beginning on page 131 for a more detailed description of the 10 % Senior Discount Notes. ANCILLARY AGREEMENTS In addition to the stock purchase agreement described above, UAP Holdings and certain of its subsidiaries entered into the following agreements with ConAgra Foods as of the closing of the Acquisition. Table of Contents Transition Services Agreements On November 24, 2003, UAP Holdings and certain of its subsidiaries entered into a transition services agreement with ConAgra Foods (the Buyer Transition Services Agreement ) pursuant to which, among other things, ConAgra Foods will provide us with certain transition services, including information technology, accounting and human resources services. The initial term of the Buyer Transition Services Agreement is one year. As consideration for the services, we paid ConAgra Foods an initial fee of $7.5 million on November 24, 2003 and will be required to pay additional fees to ConAgra Foods based on actual usage of transition services. In addition, the Buyer Transition Services Agreement provides that, until December 31, 2004, employees of our subsidiaries that are a party to the agreement will continue their participation in welfare plans and programs maintained by ConAgra Foods and specified by us that provide health, disability, life and other welfare benefits. Our subsidiaries will reimburse ConAgra Foods for all actual costs associated with their employees continued participation in the plans. Also on November 24, 2003, UAP Holdings, together with United Agri Products and certain of its other subsidiaries, entered into another transition services agreement with ConAgra Foods (the Seller Transition Services Agreement ) pursuant to which, among other things, we will provide ConAgra Foods and certain of its international subsidiaries with certain transition services, including information technology, accounting and office support services. The term of the Seller Transition Services Agreement is one year. In addition, we granted to ConAgra Foods and its international subsidiaries an exclusive two-year license to use certain of our trademarks and trade names outside the United States and Canada. ConAgra Foods will pay us an aggregate fee of $1.3 million for the license and for the services provided under the Seller Transition Services Agreement. The Seller Transition Services Agreement was terminated in accordance with its terms on August 30, 2004. Indemnification Agreement On November 24, 2003, United Agri Products, together with certain of its subsidiaries, entered into an indemnification agreement with ConAgra Foods, pursuant to which United Agri Products and such subsidiaries agreed to be bound by UAP Holdings indemnification and non-competition obligations and certain other covenants under the stock purchase agreement. Fertilizer Supply Agreement On November 24, 2003, United Agri Products entered into a fertilizer supply agreement with ConAgra International Fertilizer Company (the Fertilizer Supply Agreement ) under which United Agri Products agreed to buy fertilizer products from ConAgra International Fertilizer Company. The initial term of the Fertilizer Supply Agreement is five years and automatically renews from year to year after the initial term unless terminated by either party on not less than 180 days notice prior to the end of the initial or any renewal term. Subject to the parties agreeing on prices and producer availability, United Agri Products is obligated to buy an amount of fertilizer products equal to its historical purchases from ConAgra International Fertilizer Company (approximately 70% of our requirements for such products). In addition, United Agri Products granted ConAgra International Fertilizer Company a right of first negotiation with respect to the sale of assets relating to or comprising certain of its fertilizer locations. The Fertilizer Supply Agreement contains customary mutual indemnification provisions, and each party may terminate the agreement upon mutual agreement with the other party, upon the breach of any material terms of the agreement by the other party, or upon the bankruptcy or insolvency of the other party. International Supply Agreement On November 24, 2003, United Agri Products entered into an international supply agreement with ConAgra Foods (the International Supply Agreement ) pursuant to which United Agri Products agreed to sell certain agricultural chemical products to ConAgra Foods non-U.S. distribution companies and certain customers located outside of the United States and Canada who purchased such products during the two year period prior to November 24, 2003. The initial term of the International Supply Agreement is one year and renews automatically Table of Contents for an additional year unless terminated by either party upon 60 days notice. In addition, each party may terminate the International Supply Agreement upon mutual agreement with the other party, upon the breach of any material term of the agreement by the other party (or, in our case, one of ConAgra Foods non-U.S. distribution companies), or upon the other party s insolvency. Under the terms of the International Supply Agreement, United Agri Products is required to sell agricultural chemical products ordered by ConAgra Foods distribution companies at the prices applicable to sales of such products to such distribution companies immediately prior to the date of the agreement. In addition, United Agri Products agreed to sell agricultural chemical products ordered by customers located outside of the United States and Canada at prices established by it after consultation with ConAgra Foods distribution companies. United Agri Products is required to pay to ConAgra Foods, on each sale to customers other than affiliates of ConAgra Foods, the difference (if a positive number) between the amount paid to United Agri Products by such customers and the cost of such products if purchased by a ConAgra Foods distribution company. The International Supply Agreement also limits each party s ability to sell agricultural chemical products in certain geographic areas during the term of the agreement. Con Agra Foods distribution companies can purchase products under the agreement only for resale outside the United States and Canada. Conversely, United Agri Products cannot sell agricultural chemical products within any territory outside the United States and Canada if such territory was served by one of Con Agra Foods distribution companies prior to the date of the agreement. United Agri Products also cannot sell products to any third party that it knows or has reason to know will resell such products within any such territory. Finally, pursuant to the International Supply Agreement United Agri Products granted each Con Agra Foods distribution company that purchases products under the agreement a non-exclusive, non-transferable right to use any trademarks and trade names associated with the products in connection with the marketing, manufacture, distribution and sale of such products. Releases On November 24, 2003, United Agri Products, together with certain of its subsidiaries, entered into a release with ConAgra Foods under which United Agri Products and its subsidiaries party to such release irrevocably released ConAgra Foods, its affiliates and their directors, officers and employees from any liabilities and causes of action, whether known or unknown, relating to, arising out of, or in any way connected with events or happenings that occurred or failed to occur on or prior to the date of the release (other than (i) claims arising under the stock purchase agreement, the ancillary agreements entered into in connection with the stock purchase agreement or any agreement entered into in connection with the Acquisition, (ii) product liability claims for products sold by ConAgra Foods to United Agri Products or any of its subsidiaries prior to the date of the release and (iii) claims arising from any act or omission constituting fraud, gross negligence or willful misconduct). Similarly, ConAgra Foods entered into a release with UAP Holdings under which ConAgra Foods and its subsidiaries irrevocably released United Agri Products, its subsidiaries and their directors, officers and employees from any liabilities and causes of action, whether known or unknown, relating to, arising out of, or in any way connected with the events or happenings that occurred or failed to occur on or prior to the date of the release (other than (i) claims arising under the stock purchase agreement, the ancillary agreements entered into in connection with the stock purchase agreement or any agreement entered into in connection with the Acquisition and (ii) claims arising from any act or omission constituting fraud, gross negligence or willful misconduct). Canadian Operations Assignment and Assumption Agreement On November 18, 2003, UAP Canada, which is one of our subsidiaries purchased in the Acquisition but on November 18, 2003 was a subsidiary of ConAgra Limited, entered into an asset purchase agreement (the UAP Canada Asset Purchase Agreement ) with ConAgra Limited pursuant to which UAP Canada purchased certain assets (including, among other things, owned and leased properties, contracts, inventories, intellectual property Table of Contents and accounts receivable) owned by ConAgra Limited. Such assets related to the UAP Canada business carried on by ConAgra Limited, and excluded ConAgra Limited s bulk wholesale fertilizer business, commodity grain business and imagery technology business. The purchase price equaled Cdn$54,000,000 and was paid by the assumption of certain liabilities of ConAgra Limited and the delivery to ConAgra Limited of 99 common shares of the issued and outstanding shares of UAP Canada. In connection with the UAP Canada Asset Purchase Agreement, ConAgra Limited also assigned, and UAP Canada assumed, all assets, liabilities and obligations of the Pension Plan for Employees of United Agri-Products (UAP Canada), a division of ConAgra International (Canada) Limited, and the UAP Canada Savings Plan. Imperial Plant Agreement On November 24, 2003, United Agri Products entered into an imperial plant agreement with ConAgra International Fertilizer Company (the Imperial Plant Agreement ), pursuant to which ConAgra International Fertilizer Company agreed to deliver various agricultural fertilizer materials to United Agri Products plant located in Imperial, Nebraska for United Agri Products to blend, process and store. ConAgra International Fertilizer Company then sells the materials to United Agri Products at the plant at prices determined in accordance with the Fertilizer Supply Agreement. The Imperial Plant Agreement has a term of one year. The Imperial Plant Agreement provides that, at the end of each fiscal quarter of ConAgra International Fertilizer Company during the term of the agreement, the parties will equally share Net Profits or Losses (as defined below) resulting from ConAgra International Fertilizer Company s sales of agricultural fertilizer materials from the Imperial Plant. If there is a Net Profit, then ConAgra International Fertilizer Company must pay United Agri Products 50% of such Net Profit. Conversely, if the plant incurs a Net Loss, then United Agri Products must pay ConAgra International Fertilizer Company 50% of such Net Loss. The Imperial Plant Agreement defines Net Profits or Losses as gross revenues derived from ConAgra International Fertilizer Company s sale of materials from the plant, less ConAgra International Fertilizer Company s depreciation expenses on certain ConAgra International Fertilizer Company assets located at the plant and less any cost or expense ConAgra International Fertilizer Company incurs in replacing, maintaining or repairing such assets, and before any federal or state income taxes. The value of materials lost or damaged while in United Agri Products control at the plant is deducted from United Agri Products share of Net Profits and added to United Agri Products share of Net Losses, provided that United Agri Products is given a shrink allowance of up to one-half of one percent. Mix Plants Agreement On November 24, 2003, United Agri Products also entered into a mix plants agreement with ConAgra International Fertilizer Company (the Mix Plants Agreement ), pursuant to which ConAgra International Fertilizer Company agreed to blend and process various agricultural fertilizer materials for United Agri Products at certain of its plants located in Iowa, Minnesota, Illinois and Indiana. ConAgra International Fertilizer Company then sells the blended and processed materials to United Agri Products at prices determined in accordance with the Fertilizer Supply Agreement. The Mix Plants Agreement has a term of one year, except that United Agri Products may terminate it with respect to any plant if there is a pending or threatened environmental claim or investigation at such plant. As with the Imperial Plant Agreement, the Mix Plants Agreement provides that the parties will share Net Profits or Losses (as defined below) at each plant, based on United Agri Products applicable Margin Contribution (as defined below) at each such plant. If there is a Net Profit, then ConAgra International Fertilizer Company must pay United Agri Products an amount equal to the product of (i) United Agri Products Margin Contribution at the applicable plant multiplied by (ii) the Net Profit at such plant. Conversely, if a plant incurs a Net Loss, then United Agri Products must pay ConAgra International Fertilizer Company the product of (i) United Agri Products Margin Contribution multiplied by (ii) the Net Loss. The Mix Plants Agreement defines Net Profits or Losses as gross revenues derived from the sale of all materials produced at a plant, less all costs Total current liabilities 873,698 45,786 406,671 1,326,155 LONG-TERM DEBT DEFERRED INCOME TAXES OTHER LIABILITIES 115 Table of Contents associated with operating the plant, and before federal and state income taxes. The agreement defines Margin Contribution as the difference between ConAgra International Fertilizer Company s cost of materials at the plant and the sales price to United Agri Products at the time of such sale. For purposes of computing Net Profits or Losses, all raw materials provided by ConAgra International Fertilizer Company to the plants are deemed to be provided at ConAgra International Fertilizer Company s cost including applicable rebates. Grain Merchandising Agreements On November 24, 2003, one of our indirect, wholly owned subsidiaries entered into six grain merchandising agreements with ConAgra Foods. Each agreement has a one year term beginning on November 24, 2003. The grain merchandising agreements relate to grain elevators that UAP owns and has historically used to perform various storage and delivery services for ConAgra Foods. UAP agreed to purchase grain at these elevators as agent for ConAgra Foods, with ConAgra Foods providing the actual payment amount, while UAP provides the administrative services necessary for such purchases. UAP agreed to then store, ship or deliver such grain as directed by ConAgra Foods. UAP also agreed to provide all labor, equipment and supplies reasonably necessary to handle and transfer the grain and grain products at these elevators. During the term of the grain merchandising agreements, UAP has agreed not to handle or store grain at the grain elevators other than as directed by ConAgra Foods. At the end of every month during the term of these agreements, ConAgra Foods will determine the profit or loss at each elevator for the previous month. If there has been a profit for the previous month, ConAgra Foods will pay United Agri Products three-quarters of such profit. If there has been a loss for the previous month, United Agri Products will pay ConAgra Foods one-quarter of such loss. Leases In connection with the Acquisition, United Agri Products or one of its direct, wholly owned subsidiaries entered into 15-year ground leases with ConAgra Foods and its affiliates for six facilities in the United States and four facilities in Canada. Rent is approximately Cdn$4,667 per month for each Canadian ground lease and between $250 and $1,350 per month for the U.S. ground leases. After the fifth and tenth years of the term of each of the ground leases, rent will be adjusted to the then current market rents. In addition to rent for certain facilities, United Agri Products will pay additional fees based on tonnage unloaded or rail cars spotted. In connection with the Acquisition, United Agri Products or one of its direct, wholly owned subsidiaries also entered into subleases with ConAgra Foods and its affiliates for facilities located in Carrington, North Dakota and Browns, Illinois. Rent is $500 per month under the Browns sublease and $1,000 per month under the Carrington sublease. The subleases expire when the applicable master leases expire or terminate. Scale License Agreements Certain of our wholly owned subsidiaries are party to two scale license agreements with ConAgra Foods. Each agreement allows us to use a scale owned or operated by ConAgra Foods for a monthly fee of $200. In addition, we are responsible for 50% of the maintenance costs of the scales at these locations. Storage Agreement On November 24, 2003, one of our indirect wholly owned subsidiaries entered into a storage agreement with ConAgra Foods providing for the storage by ConAgra Foods of certain fertilizer products owned by UAP or one of its subsidiaries at a ConAgra Foods facility in Dubuque, Iowa. The term of the agreement ends on June 30, 2005. UAP has agreed to pay a minimum of $180,000 to ConAgra Foods for services performed under this storage agreement. If UAP s aggregate payments to ConAgra Foods do not total at least $180,000 by June 30, 2005, UAP has agreed pay to ConAgra Foods the difference between the aggregate amount UAP has paid for services under the agreement and $180,000. Table of Contents Investor Rights Agreement All employees that have deferred compensation accounts under our deferred compensation plans and own stock options are subject to an investor rights agreement with Apollo and UAP Holdings (the Investor Rights Agreement ), which governs certain aspects of UAP Holdings relationship with its security holders. The Investor Rights Agreement, among other things: allows security holders to join, and allows Apollo and its affiliates to require security holders to join, in any sale or transfer of shares of common stock or preferred stock to any third party prior to a qualified public offering of common stock or preferred stock, following which (when aggregated with all prior such sales or transfers) Apollo and its affiliates shall have disposed of at least 10% of the number of shares of common stock or preferred stock, as applicable, that Apollo and its affiliates owned as of November 24, 2003; restricts the ability of security holders to transfer, assign, sell, gift, pledge, hypothecate or encumber, or otherwise dispose of, common stock or preferred stock or of all or part of the voting power associated with common stock or preferred stock; allows security holders to include certain securities in a registration statement filed by the Company with respect to an offering of common stock or preferred stock (i) in connection with the exercise of any demand rights by Apollo and its affiliates or any other security holders possessing such rights, or (ii) in connection with which Apollo and its affiliates exercise piggyback registration rights; allows UAP Holdings and Apollo to repurchase all or any portion of the common stock and preferred stock held by directors, employees and consultants of UAP Holdings upon the termination of their employment with UAP Holdings, their death or their bankruptcy or insolvency; and contains a provision that at any meeting of UAP Holdings stockholders and in any action by written consent of UAP Holdings stockholders, the trustee under UAP Holdings 2003 Deferred Compensation Plan will vote the shares of common stock in which each security holder s deferred compensation account is deemed to be invested at the direction of Apollo. In connection with this offering, the Investor Rights Agreement will be amended and restated in its entirety by the management incentive agreement. See Related Party Transactions in Connection with this Offering Management Incentive Agreement beginning on page 118. Apollo Management Consulting Agreement United Agri Products is a party to a management consulting agreement dated as of November 21, 2003 with Apollo (the Management Agreement ). Under the terms of the Management Agreement, United Agri Products retained Apollo to provide certain management consulting and financial advisory services, for which United Agri Products pays Apollo an annual management fee of $1.0 million in quarterly payments of $250,000. In particular, the Management Agreement requires Apollo to advise United Agri Products concerning such management matters that relate to proposed financial transactions, acquisitions and other senior management matters related to the business, administration and policies of United Agri Products and its affiliates, in each case as United Agri Products shall reasonably and specifically request in writing. In addition, as consideration for arranging the Acquisition, certain related financing transactions and the preparation of a registration statement with respect to an exchange offer for the 8 % Senior Notes, United Agri Products paid Apollo a fee of $5.0 million in January 2004. Upon the consummation of this offering, United Agri Products also expects to pay Apollo a transaction fee of 1% of the aggregate value of the shares of common stock included in the IDSs sold to the public (not including any IDSs that may be issued upon exercise of the underwriters over-allotment option). We estimate such transaction fee will equal approximately $4.4 million, assuming an initial public offering price of $20 per IDS, which represents the mid-point of the range set forth on the cover page of this prospectus. The Management Agreement has an initial term of seven years, which commenced on November 21, 2003. Upon the fourth anniversary of the date of the Management Agreement and the end of each year thereafter (each of such fourth anniversary and the end of each year thereafter, a Year End ), the term is automatically extended for an additional year unless terminated by either party at least 30, but no more than 60, days prior to such year end. Concurrently with the closing of the Transactions and upon payment of the aforementioned transaction fee, the Management Agreement will be terminated in its entirety. Participating preferred stock: Basic $ $ $ Table of Contents RELATED PARTY TRANSACTIONS PRIOR TO THE ACQUISITION ConAgra Foods executive, finance, tax and other corporate departments have historically performed services for the ConAgra Agricultural Products Business, and, pursuant to the Buyer Transition Services Agreement described in Ancillary Agreements beginning on page 112, will continue to perform certain administrative and other services for us. Expenses incurred by ConAgra Foods and allocated to the ConAgra Agricultural Products Business were historically determined based on the specific services that were provided or were allocated based on ConAgra Foods investment in the ConAgra Agricultural Products Business in proportion to ConAgra Foods total investment in its subsidiaries. In addition, ConAgra Foods charged the ConAgra Agricultural Products Business finance charges on ConAgra Foods investment in and advances to the ConAgra Agricultural Products Business. We believe that such expense allocations were reasonable. It is not practical to estimate the expenses that would have been incurred by the ConAgra Agricultural Products Business if it had been operated on a stand-alone basis. Corporate allocations included allocation of selling, administrative and general expenses of approximately $9.0 million for the thirty-nine weeks ended November 23, 2003, and $10.8 million, $10.5 million and $10.9 million for fiscal 2003, 2002 and 2001, respectively, and allocated finance charges of approximately $12.2 million for the thirty-nine weeks ended November 23, 2003, and $22.5 million, $39.5 million and $57.5 million in fiscal 2003, 2002 and 2001, respectively. Allocated finance charges are presented net of third party finance fee income of $7.3 million for the thirty-nine weeks ended November 23, 2003 and $10.8 million, $13.4 million and $13.5 million in fiscal 2003, 2002 and 2001, respectively. UAP also has historically entered into transactions in the normal course of business with parties under common ownership of ConAgra Foods. Net sales to related parties were $5.8 million during the thirty-nine weeks ended November 23, 2003, and $25.5 million, $33.8 million and $13.4 million in fiscal years 2003, 2002 and 2001, respectively. Gross margins associated with related party net sales were $2.0 million during the thirty-nine weeks ended November 23, 2003, and $2.5 million, $2.6 million and $1.5 million in fiscal years 2003, 2002 and 2001, respectively. RELATED PARTY TRANSACTIONS IN CONNECTION WITH THIS OFFERING Management Incentive Agreement In connection with this offering, UAP Holdings, its equity sponsor and certain management security holders will enter into a management incentive agreement. That agreement will prohibit the management security holders from offering to sell, contracting to sell, or otherwise selling, disposing of, loaning, pledging or granting any rights with respect to any shares of participating preferred stock acquired pursuant to the amended and restated 2004 deferred compensation plan, any IDSs into which such shares of participating preferred stock are converted, any shares of common stock or senior subordinated notes represented by such IDSs and any securities issued in respect of the foregoing, subject to the following exceptions: Upon the closing of this offering, UAP Holdings will use a portion of the proceeds from the senior subordinated notes represented by the IDSs and the senior subordinated notes sold separately from the IDSs to make a cash payment to each management security holder equal to 20% of the sum of: the excess of the value of the common stock underlying his or her vested options (with the per share value equaling the price per share paid to UAP Holdings equity sponsor for shares of common stock sold to the underwriters, after giving effect to underwriting discounts and commissions) over the exercise price of such options; and the value of the common stock in which his or her deferred compensation account under our deferred compensation plans is deemed to be invested (with the per share value equaling the price per share paid to UAP Holdings equity sponsor for shares of common stock sold to the underwriters, after giving effect to underwriting discounts and commissions). Table of Contents In consideration for such payment, UAP Holdings shall first cancel the management security holder s Tranche C options and then, to the extent the value of such security holder s Tranche C options is less than his payment, Tranche B options and then, to the extent the combined value of such security holder s Tranche C options and Tranche B options is less than his payment, shares of common stock in which such security holder s deferred compensation account is deemed to be invested. Upon the closing of this offering, UAP Holdings will cancel each management security holder s remaining vested and unvested options and, in consideration thereof, credit such holder s deferred compensation account under the amended and restated 2004 deferred compensation plan with additional deferred shares of participating preferred stock. The number of additional deferred shares of participating preferred stock to be credited to a holder s deferred compensation account will equal the quotient obtained by dividing: the excess of the value of the common stock underlying his or her remaining options (with the per share value equaling the price per share paid to UAP Holdings equity sponsor for shares of common stock sold to the underwriters, after giving effect to underwriting discounts and commissions) over the exercise price of such options, by the value of one share of participating preferred stock immediately after the completion of the offering (with the per share value of the participating preferred stock equaling the price per IDS paid to us for IDSs sold to the underwriters, after giving effect to the underwriting discounts and commissions). On March 1, June 1, September 1 and December 1 of each year, commencing on December 1, 2006 in the case of management security holders other than Kenneth Cordell and David Bullock and on June 1, 2007 in the case of Kenneth Cordell and David Bullock (each such date, a release date ), and until shares no longer remain credited in the deferred compensation accounts, each management security holder will be permitted to sell IDSs received upon conversion of up to 5% of the participating preferred stock that is represented by vested deferred shares immediately after the consummation of the offering, but before giving effect to the cancellation described in the foregoing paragraph. On each release date, each management security holder will be permitted to sell IDSs received upon conversion of up to an additional 5% of the participating preferred stock that is represented by deferred shares that become vested deferred shares after the consummation of the offering and on or before such release date and were credited to such management security holder s deferred compensation account immediately after consummation of the offering, plus all dividends paid in respect of such vested deferred shares in the form of additional shares of participating preferred stock. At any time after a release date, in addition to the foregoing, each security holder will be permitted to sell a number of IDSs received upon the conversion of participating preferred stock equal to the number of IDSs that such management security holder was entitled to, but did not, sell as of such release date. At any time, each management security holder will be permitted to sell such number of IDSs as is necessary for him to generate sufficient proceeds, net of any underwriter s commissions and discounts, to satisfy any withholdings tax obligations and federal income tax liabilities (together with interest, penalties and additions to tax) resulting from: certain successful challenges of the tax deferral benefits of the amended and restated 2004 deferred compensation plan by the Internal Revenue Service or the distribution of securities from the amended and restated 2004 deferred compensation plan in connection with such management security holder s termination of employment by UAP Holdings without cause or by such management security holder for good reason. The management incentive agreement will also provide that, within two years of the consummation of this offering, UAP Holdings must file or cause to be filed, and use commercially reasonable efforts to cause to become and remain effective for so long as any management security holder beneficially owns securities covered Table of Contents by the management incentive agreement, a registration statement on Form S-1 or S-3 or other appropriate form with respect to the issuance of IDSs upon the conversion of shares of participating preferred stock received upon distributions from such management security holder s deferred compensation account. Pursuant to the management incentive agreement, each of the retention agreements entered into in connection with the Acquisition will be terminated. Each management security holder that is party to the management incentive agreement will agree not to: disclose or use at any time, either during the term of his employment or thereafter, any confidential information about the business of UAP Holdings and its subsidiaries of which he is or becomes aware, except to the extent that such disclosure or use is directly related to and required by his performance in good faith of duties assigned to him by UAP Holdings and its affiliates or required pursuant to an order of a court of competent jurisdiction; induce or attempt to induce any employee of UAP Holdings and its subsidiaries to leave the employ of UAP Holdings and its subsidiaries or in any way interfere with the relationship between UAP Holdings and its subsidiaries, on the one hand, and any employee thereof, on the other hand; hire any person who was an employee of UAP Holdings and its subsidiaries until six months after such individual s employment relationship with UAP Holdings and its subsidiaries has been terminated; induce or attempt to induce any customer, supplier, licensee or other business relation of UAP Holdings and its subsidiaries to cease doing business with UAP Holdings and its subsidiaries, or in any way interfere with the relationship between any such customer, supplier, licensee or business relation, on the one hand, and UAP Holdings and its subsidiaries, on the other hand; or during the period commencing on the date of the management incentive agreement and ending on the first anniversary of the date of termination of employment, directly or indirectly own, manage, control, participate in, consult with, render services for, or in any manner engage in or represent any business competing with the businesses or the products of UAP Holdings and its subsidiaries as such businesses and/or products exist or are in the process of being formed or acquired as of the date of the termination of employment, within the United States, Canada and any other country in which any product, process, good or service has been manufactured, provided, sold or offered or promoted for sale by UAP Holdings and its subsidiaries on or prior to the date that he ceases to be employed by UAP Holdings and its subsidiaries. Finally, each management security holder will consent in the management incentive agreement to the amendment and restatement of the 2004 Non-Executive Director Stock Option Plan, to the cancellation of options issued under the 2003 Stock Option Plan in consideration of deferred shares of participating preferred stock issued pursuant to the amended and restated deferred compensation plan and to the adoption by UAP Holdings board of directors of a long-term incentive plan to be titled the 2004 Performance Incentive Plan. Recapitalization Agreement Prior to the closing of this offering, UAP Holdings and its equity sponsor will enter into a recapitalization agreement, pursuant to which each will agree to effect the following transactions: Our equity sponsor will sell a portion of its shares of common stock to the underwriters for inclusion in the IDSs. We refer to these shares as the IDS shares. We will sell to the underwriters senior subordinated notes to be combined with the IDS shares to form IDSs and senior subordinated notes to be sold separately from the IDSs. We refer to these notes as the Company securities. We will use a portion of the proceeds from the Company securities to repurchase a portion of our equity sponsor s shares of common stock other than the IDS shares. We refer to these shares as the sponsor repurchased shares. Table of Contents We will issue shares of our new participating preferred stock in exchange for all shares of common stock held by our equity sponsor other than the IDS shares and the sponsor repurchased shares. To the extent the underwriters over-allotment option is exercised, we will sell additional IDSs to the underwriters. We will use the proceeds from the additional IDSs to repurchase shares of participating preferred stock from our equity sponsor. Amended and Restated Registration Rights Agreement On November 24, 2003, UAP Holdings entered into a registration rights agreement with Apollo, pursuant to which Apollo and its affiliates have certain demand and incidental registration rights with respect to UAP Holdings common stock. Concurrently with, and subject to the closing of this offering, the registration rights agreement will be amended and restated. Under the amended and restated registration rights agreement, UAP Holdings will grant Apollo and its affiliates five demand registration rights with respect to the issuance and subsequent resale of the IDSs (including the common stock and senior subordinated notes comprising the IDSs) they may receive upon conversion of shares of participating preferred stock held by them. With respect to one of such demand registration rights, Apollo and its affiliates may require us to use our reasonable best efforts to keep the registration statement filed upon the exercise of such right continuously effective, supplemented and amended, as required by the Securities Act, until all securities covered by such registration have been sold. Apollo and its affiliates will also have the right to participate, or piggy-back, in certain registrations initiated by UAP Holdings. Table of Contents DESCRIPTION OF OTHER INDEBTEDNESS THE AMENDED AND RESTATED REVOLVING CREDIT FACILITY We anticipate, in connection with this offering, amending and restating our existing revolving credit facility with General Electric Capital Corporation as Agent and Lender, GE Canada Finance Holding Company, as Canadian Agent and Lender, GECC Capital Markets Group, Inc. as Co-Lead Arranger, UBS Securities LLC, as Co-Lead Arranger and Co-Syndication Agent, Co peratieve Centrale Raiffeisen-Boerenleenbank B.A., Rabobank International, New York Branch, as Co-Documentation Agent and Lender and Merrill Lynch Capital, a division of Merrill Lynch Business Financial Services Inc., as Co-Documentation Agent and Lender to permit the Transactions. The currently anticipated terms of the amended and restated revolving credit facility are as set forth below. The description of the amended and restated revolving credit facility does not purport to be complete and is qualified in its entirety by reference to the complete text of the related credit agreement. As amended and restated, the revolving credit facility will provide for the following, to be used for, among other things, United Agri Products and its respective subsidiaries working capital, the repurchase of a portion of the 8 1/4% Senior Notes and the 10 3/4% Senior Discount Notes, and general corporate purposes, including, without limitation, effecting certain permitted acquisitions and investments: a five-year $500.0 million asset-based revolving credit facility; a $20.0 million revolving credit sub-facility for UAP Canada; a $50.0 million letter of credit sub-facility; a $25.0 million swingline loan sub-facility; and a $25.0 million in-season overadvance sub-facility. Borrowing Bases Borrowings by United Agri Products and UAP Canada will be subject to borrowing availability under the amended and restated revolving credit facility. United Agri Products borrowing availability will be an amount equal to the lesser of: the maximum amount of the revolving loan commitment, less the outstanding amount of loans to UAP Canada under the Canadian revolving loan sub-facility; or the U.S. borrowing base, plus (if applicable) the maximum in-season overadvance amount; in each case less the sum of the outstanding U.S. revolving loans (including the outstanding amount of letter of credit obligations, swingline loans and in-season overadvances). The U.S. borrowing base will be, at any date of determination, an amount equal to the sum of: 85% of the book value (net of reserves) of United Agri Products and its wholly-owned domestic subsidiaries eligible accounts receivable (other than extended accounts receivable and other than those of certain inactive subsidiaries); 75% of the book value (net of reserves) of United Agri Products and its wholly-owned domestic subsidiaries eligible extended accounts receivable (other than those of certain inactive subsidiaries); and the lesser of (1) 55% (or 65% between April 1st and July 31st of each year) of the book value (net of reserves) of United Agri Products and its wholly-owned domestic subsidiaries eligible inventory (other than that of certain inactive subsidiaries) valued at the lower of cost or market or (2) 85% multiplied by a net orderly liquidation value factor multiplied by the book value (net of reserves) of United Agri Products and its wholly-owned domestic subsidiaries eligible inventory (other than that of certain inactive subsidiaries). Table of Contents Borrowings by UAP Canada will also be subject to borrowing availability under the amended and restated revolving credit facility. Its borrowing availability will be an amount equal to the lesser of: the maximum amount of the Canadian revolving loan sub-facility; or the U.S. dollar-equivalent of the Canadian borrowing base; in each case less the sum of (1) the U.S. dollar-equivalent of outstanding Canadian revolving loans and (2) the amount of the U.S. revolving loans (including letter of credit obligations, swingline loans and in-season overadvances) outstanding in excess of $480.0 million. The Canadian borrowing base will be calculated using a formula identical to the one used to calculate the U.S. borrowing base (except that it will be applied only to eligible Canadian accounts receivable and inventory). Interest and Applicable Margins The interest rates under the amended and restated revolving credit facility will be based, at United Agri Products option, on either the agent s index rate plus an applicable index margin of 1.50% or upon LIBOR plus an applicable LIBOR margin of 2.75%. The interest rates with respect to in-season overadvances under the amended and restated revolving credit facility will be based, at United Agri Products option, on either the agent s index rate plus an applicable index margin of 2.75% or upon LIBOR plus an applicable LIBOR margin of 4.00%. These applicable margins (other than the margin on in-season overadvances) will, in each case, be subject to prospective reduction on a quarterly basis if United Agri Products reduces its ratio of funded debt to EBITDA (on a consolidated basis). Following an event of default, all amounts owing under the amended and restated revolving credit facility will bear interest at a rate per annum equal to the rate otherwise applicable thereto plus an additional 2.0%. With respect to LIBOR loans, United Agri Products will be able to elect interest periods of one, two, three or six months and interest will be payable in arrears at the end of each applicable interest period, but in any event at least every three months. With respect to index rate loans, interest will be payable on the first business day of each month. In each case, calculations of interest will be based on a 360-day year and actual days elapsed. Fees The amended and restated revolving credit facility will require the payment of the following fees: certain fees specified in a fee letter entered into with GE Capital; an unused line of credit fee in an amount equal to an applicable unused line fee margin of 0.50% (which margin may be reduced prospectively on a quarterly basis if we reduce our ratio of funded debt to EBITDA on a consolidated basis) multiplied by the difference between (x) the maximum amount of United Agri Products amended and restated revolving credit facility (as it may be reduced from time to time) and (y) the average daily balance of revolving loans (including swingline loans) for the preceding month; a letter of credit fee equal to the average daily undrawn face amount of all outstanding letters of credit during such month multiplied by the applicable margin then in effect with respect to LIBOR loans (other than in-season overadvances); and customary administrative charges. Guaranties and Collateral The obligations under the amended and restated revolving credit facility will be guaranteed by UAP Holdings and each of its existing and future direct and indirect subsidiaries. However, none of the non-U.S. subsidiaries of UAP Holdings will guarantee any of United Agri Products obligations or those of its U.S. subsidiaries. The obligations of UAP Canada under the amended and restated revolving credit facility will be guaranteed by UAP Holdings and each of its existing and future direct and indirect Canadian and U.S. subsidiaries (including United Agri Products). Table of Contents United Agri Products obligations and the obligations of the U.S. guarantors under the amended and restated revolving credit facility and the related documents will be secured by a first priority lien on or security interest in, subject to certain exceptions, substantially all of UAP Holdings and United Agri Products properties and assets and the properties and assets of each of the U.S. guarantors, in each case whether now owned or hereafter acquired. The obligations of UAP Canada under the amended and restated revolving credit facility and the related documents will be secured by a first priority lien on or security interest in, subject to certain exceptions, substantially all of the properties and assets of UAP Holdings and each of its existing and future direct or indirect Canadian and U.S. subsidiaries (including United Agri Products), in each case whether now owned or hereafter acquired. The obligations of each of the Canadian guarantors under the amended and restated revolving credit facility and the related documents will be secured by a first priority lien on or security interest in, subject to certain exceptions, substantially all of the properties and assets of such Canadian guarantors and of UAP Holdings, United Agri Products, and each of the U.S. guarantors, in each case whether now owned or hereafter acquired. Such security will include a pledge of all capital stock and certain debt instruments owned by such parties, except that, in general, not more than 66% of the total outstanding voting stock of any non-U.S., non-Canadian subsidiary of UAP Holdings will be required to be pledged in support of the obligations of UAP Holdings, United Agri Products or its subsidiaries. Our bank accounts, and those of our U.S. and Canadian subsidiaries, will be subjected to a cash management system that provides for daily sweeps of certain account balances to repay the obligations under the amended and restated revolving credit facility. Representations, Warranties and Covenants The amended and restated revolving credit facility will contain certain customary representations, warranties and affirmative covenants. In addition, the amended and restated revolving credit facility will contain customary negative covenants restricting UAP Holdings ability and the ability of its subsidiaries to, among other things: incur additional indebtedness (other than certain permitted indebtedness); incur liens (other than certain permitted encumbrances), enter into agreements that limit the ability to incur liens, or permit any encumbrance or restriction on certain inter-company payments and transfers; make investments (other than certain permitted investments); become liable for certain contingent obligations; make certain restricted payments in respect of capital stock or subordinated debt, provided, that, if minimum borrowing availability of $40 million exists, no default or event of default exists, and the additional tests described below in the first two paragraphs under Senior Secured Second Lien Term Loan Facility Restrictions on Payment of Dividends and Interest on the Notes beginning on page 127 are satisfied, the interest on our senior subordinated notes and dividends on our capital stock may be paid, provided further, that, if the tests described below in the last paragraph under Senior Secured Second Lien Term Loan Facility Restrictions on Payment of Dividends and Interest on the Notes beginning on page 127 are satisfied, the amended and restated revolving credit facility will permit us to make the restricted payments described therein; amend certain organizational, corporate and other documents; engage in mergers or make acquisitions (except for certain permitted acquisitions); sell or dispose of assets or the stock of subsidiaries; enter into transactions with affiliates; engage in any new business; change in fiscal year without notice to the agent; create or establish new subsidiaries without delivering guaranties and security as described above; create new bank accounts (subject to certain exceptions) unless the agent is granted a security interest therein; permit certain releases of certain hazardous materials; Table of Contents take any actions that could cause an ERISA event that could reasonably be expected to have a material adverse effect (as defined); enter into certain sale-leaseback, lease in-lease out and similar transactions; or voluntarily purchase, redeem, defease or prepay any subordinated debt. We anticipate that the amended and restated revolving credit facility will also contain the following financial covenants: If and for so long as aggregate borrowing availability is less than $40.0 million, UAP Holdings and its subsidiaries will be required to have EBITDA of at least $80.0 million, measured as of the last day of each month for the trailing twelve-month period then ended. If and for so long as aggregate borrowing availability is less than $40.0 million, UAP Holdings and its subsidiaries will be required to maintain a cash fixed charge coverage ratio of not less than 1.1 to 1.0, measured as of the last day of each month for the trailing twelve-month period then ended. Events of Default Events of default under the amended and restated revolving credit facility will include: failure to pay principal when due or pay a reimbursement obligation in respect of a letter of credit; failure to pay interest within three days after its due date; default with respect to certain other indebtedness, including the second lien term loan facility; failure to maintain UAP s corporate existence or that of UAP Canada; failure to cause any new subsidiary to guarantee UAP s obligations and/or those of UAP Canada and to collateralize the same with security interests, liens and pledges on the terms and conditions set forth in United Agri Products amended and restated revolving credit facility and related documents; failure to comply with the negative, financial, borrowing base and certain other reporting covenants in the amended and restated revolving credit facility; a material breach of any representation or warranty; other defaults under the amended and restated revolving credit facility documents which are not cured or waived within 30 days; voluntary and involuntary events of bankruptcy; the entrance or filing of a material money judgment or similar process which is not adequately covered by insurance and remains undischarged, unvacated, unbonded or unstayed for a period of 30 days; the entrance of an order, decree or judgment decreeing the dissolutions of UAP Holdings or any subsidiary which is a party to the amended and restated revolving credit facility, which order, decree or judgment remains undischarged or unstayed for a period in excess of 30 days; any of the amended and restated revolving credit facility documents become invalid; and certain changes of control with respect to UAP Holdings, United Agri Products or UAP Canada. SENIOR SECURED SECOND LIEN TERM LOAN FACILITY Concurrent with, and subject to completion of, this offering, United Agri Products will enter into a new senior secured second lien term loan facility. The key terms of the second lien term loan are described below. Such description is not complete and is qualified in its entirety by reference to the complete text of the related term loan agreement. The new second lien term loan will provide for a seven-year, $165.0 million senior secured second lien term loan facility with General Electric Capital Corporation, as Agent and Lender, and other financial institutions as Lenders. The proceeds of the second lien term loan will be applied to repurchase a portion of the 8 1/4% Senior Notes and a portion of the 10 3/4% Senior Discount Notes. Table of Contents Interest and Applicable Margins The interest rates with respect to the second lien term loan facility will be based, at United Agri Products option, on either the agent s index rate plus 2.00% or upon LIBOR plus 3.25%. Following an event of default, all amounts owing under the second lien term loan facility will bear interest at a rate per annum equal to the rate otherwise applicable thereto plus an additional 2.0%. The second lien term loan will have amortization of 1.00% per annum, payable in equal quarterly installments, with the remainder due at maturity. Fees The second lien term loan facility will require the payment of the following fees: certain fees specified in a fee letter entered into with GE Capital; and customary administrative charges. Guaranties and Collateral The obligations under the second lien term loan facility will be guaranteed by UAP Holdings and each of its existing and future direct and indirect domestic subsidiaries. United Agri Products obligations and the obligations of the guarantors under the second lien term loan facility will be secured by a second priority lien on or security interest in, subject to certain exceptions, all of the collateral securing the existing revolving facility, which includes substantially all of UAP Holdings and United Agri Products properties and assets and the properties and assets of each of the guarantors, in each case whether now owned or hereinafter acquired. Such security will include a pledge of all capital stock and certain debt instruments owned by such parties, except that, in general, not more than 65% of the total outstanding voting stock of any non-U.S. subsidiary of UAP Holdings will be required to be pledged in support of the obligations of UAP Holdings, United Agri Products or its subsidiaries. Representations, Warranties and Covenants The second lien term loan facility will contain certain customary representations, warranties and affirmative covenants. In addition, the second lien term loan facility will contain customary negative covenants restricting UAP Holdings ability and the ability of its subsidiaries to, among other things: incur additional indebtedness (other than certain permitted indebtedness); incur liens (other than certain permitted encumbrances), enter into agreements that limit the ability to incur liens, or permit any encumbrance or restriction on certain inter-company payments and transfers; make investments (other than certain permitted investments); become liable for certain contingent obligations; make certain restricted payments in respect of capital stock or subordinated debt; provided, that, if the financial and other tests described below under Senior Secured Second Lien Term Loan Facility Restrictions on Payment of Dividends and Interest on the Notes beginning on page 127 are satisfied, the interest on our senior subordinated notes and dividends on our capital stock may be paid; amend certain organizational, corporate and other documents; engage in mergers or make acquisitions (except for certain permitted acquisitions); sell or dispose of assets or the stock of subsidiaries; enter into transactions with affiliates; engage in any new business; change in fiscal year without notice to the agent; create or establish new subsidiaries without delivering guaranties and security as described above; Diluted $ $ $ Table of Contents create new bank accounts (subject to certain exceptions) unless the agent is granted a security interest therein; permit certain releases of certain hazardous materials; take any actions that could cause an ERISA event that could reasonably be expected to have a material adverse effect (as defined); or enter into certain sale-leaseback, lease in-lease out and similar transactions. voluntarily purchase, redeem, defease or prepay any subordinated debt. The second lien term loan facility will contain the following financial covenants: UAP Holdings and its subsidiaries will be required to have minimum EBITDA of at least $80.0 million, measured as of the last day of each month for the trailing twelve month period then ended; and UAP Holdings and its subsidiaries will be required to maintain a cash fixed charge coverage ratio of not less than 1.1 to 1.0, measured as of the last day of each month for the trailing twelve-month period then ended. Events of Default Events of default under the second lien term loan facility will include: failure to pay interest within three days after its due date; failure to make any installment of principal when due; default with respect to certain other indebtedness, including the amended and restated revolving credit facility; failure to maintain UAP s corporate existence; failure to cause any new domestic subsidiary to guarantee UAP s obligations and to collateralize the same with security interests, liens and pledges on the terms and conditions set forth in United Agri Products second lien term loan facility and related documents; failure to comply with the negative and certain reporting covenants in the second lien term loan facility; a material breach of any representation or warranty; other defaults under the second lien term loan facility documents which are not cured or waived within 30 days; voluntary and involuntary events of bankruptcy, insolvency or dissolution; the entrance or filing of a material money judgment or similar process which is not adequately covered by insurance and remains undischarged, unvacated, unbonded or unstayed for a period of 30 days; the entrance of an order, decree or judgment decreeing the dissolutions of UAP Holdings or any subsidiary which is a party to the second lien term loan facility, which order, decree or judgment remains undischarged or unstayed for a period in excess of 30 days; any of the second lien term loan facility documents become invalid; and certain changes of control with respect to UAP Holdings and United Agri Products. Restrictions on Payment of Dividends and Interest on the Notes The second lien term loan will restrict our ability to pay interest on the senior subordinated notes based on: (i) there not being an event of default, (ii) there not being any payment blockage period under the indenture and (dollars in millions) 2005 $105 1.00 2006 $110 1.00 2007 $115 1.00 2008 $117.5 1.00 2009 and thereafter $120 1.05 Notwithstanding the foregoing restrictions, the second lien term loan facility will permit us to make restricted payments (which would include dividends on our capital stock) in the amount of $25,000,000, plus 50% of our excess cash flow (determined generally as our EBITDA minus certain capital expenditures, principal payments on debt and cash dividends, tax and cash interest payments) since the closing of the Transactions, minus payments used to make certain investments and certain prepayments on other indebtedness, so long as: (i) no event of default has occurred and is continuing or would result from such payment, (ii) we are permitted, and would still be permitted, to make interest payments (as set forth above) after such payment and (iii) if the excess cash flow formula is zero or negative, United Agri Products and its Canadian operations are projected to be able to borrow at least $75,000,000 under the amended and restated revolver for a period of at least 12 months after giving effect to such payment. 8 % SENIOR NOTES On December 16, 2003, United Agri Products completed a private offering of $225.0 million aggregate principal amount of its 8 1/4% Senior Notes due 2011 (the 8 1/4% Senior Notes ). The net proceeds from the offering of the 8 1/4% Senior Notes were used to repay United Agri Products $175.0 million senior bridge loan Table of Contents facility, plus accrued interest, to repay a portion of the existing revolving credit facility, and to pay related fees and expenses. The 8 1/4% Senior Notes were issued under an indenture among United Agri Products, certain of its subsidiaries and JPMorgan Chase Bank, as trustee. UAP Holdings has not guaranteed United Agri Products obligations under the 8 1/4% Senior Notes. Interest on the 8 1/4% Senior Notes accrues at the rate of 8 1/4% per annum and is payable semi-annually in arrears on June 15 and December 15 of each year, beginning on June 15, 2004. The 8 1/4% Senior Notes mature on December 15, 2011. United Agri Products is not required to make mandatory redemption or sinking fund payments with respect to the 8 1/4% Senior Notes. Optional Redemption United Agri Products may redeem some or all of the 8 1/4% Senior Notes at any time on or after December 15, 2007 at a redemption price equal to 100% of the principal amount plus a premium declining ratably to par, plus accrued and unpaid interest and liquidated damages, if any, to the redemption date. At any time prior to December 15, 2006, United Agri Products may use the proceeds of certain equity offerings to redeem up to 35% of the aggregate principal amount of the 8 1/4% Senior Notes originally issued under the indenture governing the 8 1/4% Senior Notes and all or a portion of any additional notes issued under such indenture after the date of such indenture, in each case at a redemption price equal to 108.250% of the principal amount, plus accrued and unpaid interest and liquidated damages, if any, to the redemption date. Depending on whether we consummate the Tender Offers, we also intend to cause United Agri Products to exercise its right to redeem up to 35% of the aggregate principal amount of the 8 1/4% Senior Notes under this provision with a portion of the proceeds from this offering. In addition, at any time prior to December 15, 2007, United Agri Products may redeem some or all of the 8 % Senior Notes at a redemption price equal to 100% of the principal amount plus a make-whole premium, plus accrued and unpaid interest and liquidated damages, if any, to the redemption date. Guarantees; Ranking The 8 1/4% Senior Notes are United Agri Products general unsecured obligations and rank equally in right of payment with all of United Agri Products existing and future unsecured senior debt. The 8 1/4% Senior Notes are effectively subordinated in right of payment to all of United Agri Products existing and future secured debt, including debt under the Amended Credit Facilities, to the extent of the value of the assets securing that debt. In addition, the 8 1/4% Senior Notes are structurally subordinate to all obligations, including trade payables, of United Agri Products subsidiaries that do not guarantee the 8 1/4% Senior Notes. The 8 1/4% Senior Notes are guaranteed on a senior unsecured basis by United Agri Products current and future domestic restricted subsidiaries. The guarantees are general unsecured obligations of the guarantors and rank equally in right of payment with their existing and future unsecured senior debt. The guarantees are effectively subordinated in right of payment to all of the guarantors existing and future secured debt, including guarantees under the Amended Credit Facilities, to the extent of the value of the assets securing that debt. Covenants The indenture governing the 8 1/4% Senior Notes contains certain limitations and restrictions on United Agri Products and certain of its subsidiaries ability to, among other things: incur additional indebtedness; Table of Contents pay dividends or make other distributions on United Agri Products capital stock or repurchase, repay or redeem our capital stock or subordinated debt; make certain investments; incur liens; enter into certain types of transactions with affiliates; and limit dividends or other payments by United Agri Products restricted subsidiaries to United Agri Products; and sell all or substantially all of United Agri Products assets or merge with or into other companies. These covenants are subject to important exceptions and qualifications. Events of Default The indenture governing the 8 1/4% Senior Notes contains certain events of default, including (subject, in some cases, to customary cure periods and materiality thresholds) defaults based on (i) the failure to make payments under the indenture when due, (ii) breach of covenants, (iii) cross-defaults to other material indebtedness, (iv) bankruptcy events and (v) material judgments. The events of default in the indenture governing the 8 1/4% Senior Notes are substantially similar to the events of default contained in the indenture governing the senior subordinated notes. Tender Offer and Consent Solicitation As of the date of this prospectus, United Agri Products had $225.0 million aggregate principal amount of 8 1/4% Senior Notes outstanding. On April 26, 2004, United Agri Products commenced a tender offer and consent solicitation with respect to all of its outstanding $225.0 million aggregate principal amount of 8 1/4% Senior Notes. The total consideration to be paid for tendered and accepted 8 % Senior Notes will be a blended price based on: $1,082.50 per $1,000 principal amount, the price at which United Agri Products could redeem a portion of the 8 % Senior Notes with the proceeds of an equity offering; and the present value of future cash flows up to and including December 15, 2007 (the first date on which the 8 % Senior Notes may be redeemed) on the 8 % Senior Notes, based on the assumption that the 8 % Senior Notes will be redeemed in full at $1,041.25 per $1,000 principal amount on such date, discounted at a rate equal to 137.5 basis points over the yield to maturity on the 8 % Senior Note Reference Security. The total consideration to be paid for tendered 8 % Senior Notes will also include accrued but unpaid interest on the 8 % Senior Notes to, but not including, the payment date. Of this total consideration, $20.00 will be a consent payment payable to holders who validly tendered the 8 % Senior Notes and delivered consent by the Consent Payment Deadline. UBS Investment Bank, the dealer manager for the Tender Offers, has calculated that the yield to maturity on the 8 % Senior Note Reference Security as of 2:00 p.m., New York City time, on May 7, 2004 was 3.438%. Based on an assumed payment date of May 28, 2004, the total consideration to be paid for each $1,000 principal amount of tendered and accepted 8 % Senior Notes would be $1,123.56 (which includes the consent payment and any accrued, but unpaid interest). As of May 10, 2004, United Agri Products had received the requisite consents with respect to the 8 1/4% Senior Notes. As of the date of this prospectus, all $225,000,000 aggregate principal amount of the 8 1/4% Senior Notes have been validly tendered and have not been withdrawn in the 8 1/4% Senior Note Tender Offer, and United Agri Products has executed a supplemental indenture with respect to the 8 1/4% Senior Notes and an amendment to the registration rights agreement relating to the 8 1/4% Senior Notes, in each case with effectiveness subject to consummation of the Tender Offers. We expect that upon completion of this offering all of the 8 1/4% Senior Notes will be repurchased in the 8 1/4% Senior Note Tender Offer and the indenture governing the 8 1/4% Senior Notes will be discharged. Table of Contents The supplemental indenture will delete all of the material restrictive covenants and certain events of default contained in the indenture governing the 8 1/4% Senior Notes. The only operative material covenant in the indenture will be the covenant to make payment on the 8 1/4% Senior Notes. The amendment to the registration rights agreement relating to the 8 1/4% securities will eliminate the registration rights and liquidated damages provisions. 10 % SENIOR DISCOUNT NOTES On January 26, 2004, UAP Holdings completed a private offering of $125.0 million aggregate principal amount at maturity of its 10 3/4% Senior Discount Notes due 2012 (the 10 3/4% Senior Discount Notes ). The net proceeds from the offering of the 10 3/4% Senior Discount Notes were used to redeem approximately $26.4 million of the outstanding Series A Redeemable Preferred Stock, to pay a dividend of approximately $52.9 million to the holders of common stock, and to pay related fees and expenses. The 10 3/4% Senior Discount Notes were issued under an indenture between UAP Holdings and JPMorgan Chase Bank, as trustee. No interest will accrue on the 10 3/4% Senior Discount Notes prior to January 15, 2008. Instead, the accreted value of each 10 3/4% Senior Discount Note will increase (representing amortization of original issue discount) from the date of original issuance to but not including January 15, 2008 at a rate of 10 3/4% per annum, such that the accreted value on January 15, 2008 will be equal to the full principal amount at maturity. Beginning on January 15, 2008, interest on the 10 3/4% Senior Discount Notes will accrue at a rate of 10 3/4% per annum and will be payable in cash semi-annually in arrears on January 15 and July 15, commencing on July 15, 2008. Optional Redemption UAP Holdings may redeem some or all of the 10 3/4% Senior Discount Notes at any time on or after January 15, 2008 at a redemption price equal to 100% of the principal amount at maturity thereof plus a premium declining ratably to par, plus accrued and unpaid interest and liquidated damages, if any, to the redemption date. At any time prior to January 15, 2007, we may use the proceeds of certain equity offerings to redeem up to 40% of the aggregate principal amount at maturity of 10 3/4% Senior Discount Notes originally issued under the indenture governing the 10 3/4% Senior Discount Notes and all or a portion of any additional notes issued under such indenture after the date of the indenture, in each case at a redemption price equal to 110.750% of the accreted value thereof, plus liquidated damages, if any, to the redemption date. Depending on whether we consummate the Tender Offers, we may exercise our right to redeem up to 40% of the aggregate principal amount at maturity of the 10 3/4% Senior Discount Notes under this provision with a portion of the proceeds from this offering. In addition, if we experience a change of control prior to January 15, 2008, we may redeem the 10 3/4% Senior Discount Notes, in whole but not in part, at a redemption price equal to 100% of the accreted value thereof, plus a premium declining ratably to 8.063%, plus liquidated damages, if any, to the redemption date. If we experience a change of control, we may be required to offer to repurchase some or all the 10 3/4% Senior Discount Notes at a purchase price equal to 101% of the accreted value thereof, plus liquidated damages, if any, to the repurchase date (if prior to January 15, 2008) or 101% of the principal amount at maturity, plus accrued and unpaid interest and liquidated damages, if any, to the repurchase date (if on or after January 15, 2008). Ranking The 10 3/4% Senior Discount Notes are our general unsecured obligations and rank equally in right of payment with all of our existing and future unsecured senior debt. The 10 3/4% Senior Discount Notes are effectively subordinated in right of payment to all of our existing and future secured debt, including our guarantees of debt under the Amended Credit Facilities, to the extent of the value of the assets securing that debt. The 10 3/4% Senior Discount Notes are structurally subordinated to all obligations of our existing and future subsidiaries, including United Agri Products. Table of Contents Covenants The indenture governing the 10 3/4% Senior Discount Notes contains certain limitations and restrictions on our and certain of our subsidiaries ability to, among other things: incur additional indebtedness; pay dividends or make other distributions on our capital stock or repurchase, repay or redeem our capital stock or subordinated debt; make certain investments; incur liens; enter into certain types of transactions with affiliates; limit dividends or other payments by our restricted subsidiaries to us; and sell all or substantially all of our assets or merge with or into other companies. These covenants are subject to important exceptions and qualifications. Events of Default The indenture governing the 10 3/4% Senior Discount Notes contains certain events of default, including (subject, in some cases, to customary cure periods and materiality thresholds) defaults based on (i) the failure to make payments under the indenture when due, (ii) breach of covenants, (iii) cross-defaults to other material indebtedness, (iv) bankruptcy events and (v) material judgments. The events of default in the indenture governing the 10 3/4% Senior Discount Notes are substantially similar to the events of default contained in the indenture governing the senior subordinated notes. Tender Offer and Consent Solicitation As of the date of this prospectus, UAP Holdings had $125.0 million aggregate principal amount at maturity of 10 3/4% Senior Discount Notes outstanding. On April 26, 2004, UAP Holdings commenced a tender offer and consent solicitation with respect to all of its outstanding $125.0 million aggregate principal amount at maturity of 10 3/4% Senior Discount Notes. The total consideration to be paid for tendered and accepted 10 % Senior Discount Notes will equal the product of: the Accreted Value of the 10 % Senior Discount Notes on the date that is 30 days immediately following the payment date for the 10 % Senior Discount Notes, and 116.125%. Of this total consideration, $20.00 will be a consent payment payable only to holders who validly tendered the 10 % Discount Notes and delivered consents by the Consent Payment Deadline. As of May 10, 2004, UAP Holdings had received the requisite consents with respect to the 10 3/4% Senior Discount Notes. As of the date of this prospectus, all $125,000,000 aggregate principal amount at maturity of the 10 3/4% Senior Discount Notes have been validly tendered and have not been withdrawn in the 10 3/4% Senior Discount Note Tender Offer, and UAP Holdings has executed a supplemental indenture with respect to the 10 3/4% Senior Discount Notes and an amendment to the registration rights agreement relating to the 10 3/4% Senior Discount Notes, in each case with effectiveness subject to consummation of the Tender Offers. We expect that upon completion of this offering, all of the 10 3/4% Senior Discount Notes will be repurchased in the 10 3/4% Senior Discount Note Tender Offer and the indenture governing the 10 3/4% Senior Discount Notes will be discharged. The supplemental indenture will delete all of the material restrictive covenants and certain events of default contained in the indenture governing the 10 3/4% Senior Discount Notes. The only operative material covenant in the indenture will be the covenant to make payment on the 10 3/4% Senior Discount Notes. The amendment to the registration rights agreement relating to the 10 3/4% Senior Discount Notes will eliminate the registration rights and liquidated damages provisions. Table of Contents DESCRIPTION OF INCOME DEPOSIT SECURITIES (IDSs) GENERAL We are selling 36,500,000 IDSs in this offering. Each IDS initially represents: one share of our common stock; and a % senior subordinated note with a $8.00 principal amount. The ratio of common stock to principal amount of senior subordinated notes represented by an IDS is subject to change in the event of a stock split, recombination or reclassification of our common stock. For example, if we elect to effect a two for one stock split, from and after the effective date of the stock split, each IDS will represent two shares of common stock and the same principal amount of senior subordinated notes as it previously represented. Likewise, if we effect a recombination or reclassification of our common stock, each IDS will thereafter represent the appropriate number of shares of common stock on a recombined or reclassified basis, as applicable, and the same principal amount of senior subordinated notes as it previously represented. Immediately following the occurrence of any such event, we will file with the SEC a Current Report on Form 8-K or any other applicable form, disclosing the changes in the ratio of common stock to principal amount of senior subordinated notes as a result of such event. Holders of IDSs are at all times the beneficial owners of the common stock and senior subordinated notes represented by such IDSs and, through their broker or other financial institution and the Depository Trust Company ( DTC ), will have exactly the same rights, privileges and preferences, including voting rights, rights to receive distributions, rights and preferences in the event of a default under the indenture governing the senior subordinated notes, ranking upon bankruptcy and rights to receive communications and notices as a direct holder of common stock and senior subordinated notes, as applicable. The IDSs will be issued in book entry form only. As discussed below under Clearance and Settlement beginning on page 134, Cede & Co., a nominee of DTC will be the sole registered holder of the IDSs. That means you will not be a registered holder of IDSs, and you will not receive a certificate for your IDSs. However, a holder of common stock, including a holder of an IDS that requests that IDSs be separated, has a legal right under Delaware law to request that we issue a certificate for such common stock. Until such request is made, you must rely on your broker or other financial institution that will maintain your book-entry position to receive the benefits and exercise the rights of a holder of IDSs that are described below. You should consult with your broker or financial institution to find out what those procedures are. All IDS issuances will be registered under the Securities Act. VOLUNTARY SEPARATION AND RECOMBINATION Holders of IDSs, whether purchased in this offering or in a subsequent offering of IDSs of the same series may, at any time after the earlier of 45 days from the date of the closing of this offering or the occurrence of a change of control, through their broker or other financial institution, separate the IDSs into the shares of our common stock and senior subordinated notes represented thereby. Unless the IDSs have previously automatically separated as a result of redemption or maturity or otherwise, any holder of shares of our common stock and senior subordinated notes may, at any time after the senior subordinated notes become separable by the holders, through his or her broker or other financial institution, combine the applicable number of shares of common stock and senior subordinated notes to form IDSs. We currently do not anticipate that our common stock or our senior subordinated notes will trade on any exchange. We will use reasonable efforts to list our common stock for separate trading on the American Stock Exchange, if a sufficient number of shares of our common stock are held separately to meet the minimum Table of Contents distribution requirements for separate trading on the respective stock exchange for at least 30 consecutive trading days (assuming that we otherwise continue to satisfy all other applicable listing requirements of such stock exchange at that time). AUTOMATIC SEPARATION Upon the occurrence of any of the following, the IDSs will be automatically separated into the shares of common stock and senior subordinated notes represented thereby: exercise by us of our right to redeem all or a portion of the senior subordinated notes, which may be represented by IDSs at the time of such redemption; the date on which principal on the senior subordinated notes becomes due and payable, whether at the stated maturity date or upon acceleration thereof; or if the Depository Trust Company, known as DTC, no longer makes IDS securities eligible for deposit or ceases to be a registered clearing agency under the Securities Exchange Act of 1934 and we are unable to find a successor depository. Following the automatic separation of the IDSs as a result of the redemption or maturity of any senior subordinated notes, shares of common stock and senior subordinated notes may no longer be combined to form IDSs. CLEARANCE AND SETTLEMENT DTC, will act as securities depository for the IDSs, the senior subordinated notes and the common stock represented by the IDSs. The transfer agent for the IDSs will act as custodian for the IDSs on behalf of the holders of the IDSs. The transfer agent for the IDSs will also act as custodian for the common stock and the senior subordinated notes represented by the IDSs (together, the components ) on behalf of the holders of the IDSs. The components and the IDSs will be issued in fully-registered form and will be represented by one or more global notes and global certificates. The IDSs will be registered in the name of DTC s nominee, Cede & Co., and the components will be registered in the name of the custodian for the holders of the IDSs. Book Entry Procedures. If you intend to purchase IDSs in the manner provided by this prospectus you must do so through the DTC system or through direct and indirect participants. The participant that you purchase through will receive a credit for the applicable security on DTC s records. The ownership interest of each actual purchaser of the applicable security, who we refer to as a beneficial owner, is to be recorded on the participant s records. All interests in the securities held through book entry will be subject to the operations and procedures of DTC, to the extent that DTC acts as the depository for the securities. The operations and procedures of DTC may be changed at any time. We are not responsible for DTC s rules, procedures and operations or for the performance by DTC or its participants or indirect participants of their respective obligations under the rules and procedures governing their operations. However, we will take responsibility for actions taken by DTC in accordance with instructions provided by us. DTC has advised us as follows: DTC is a limited purpose trust company organized under the laws of the State of New York, a banking organization within the meaning of the New York State Banking Law, a member of the Federal Reserve System, a clearing corporation within the meaning of the Uniform Commercial Code and a clearing agency registered under Section 17A of the Securities Exchange Act of 1934. DTC was created to hold securities for its participants and to facilitate the clearance and settlement of securities transactions between its participants through electronic book entry changes to the accounts of its participants. DTC s participants include securities brokers and dealers, including the underwriters, banks and trust companies, clearing corporations and other organizations. Indirect access to DTC s system is also available to others such as Table of Contents banks, brokers, dealers and trust companies. These indirect participants clear through or maintain a custodial relationship with a DTC participant, either directly or indirectly. The rules that apply to DTC and its participants are on file with the SEC. To facilitate subsequent transfers, all IDSs deposited by direct participants with DTC are registered in the name of DTC s nominee, Cede & Co. The components will be registered in the name of the custodian for the holders of the IDSs. The deposit of IDSs with DTC and their registration in the name of Cede & Co. or the custodians effect no change in beneficial ownership. DTC has no knowledge of the actual beneficial owners of the securities. DTC s records reflect only the identity of the direct participants to whose accounts such securities are credited, which may or may not be the beneficial owners. The participants and custodians will remain responsible for keeping account of their holdings on behalf of their customers. Transfers of ownership interests in the securities are to be accomplished by entries made on the books of participants acting on behalf of beneficial owners. Beneficial owners will not receive certificates representing their ownership interests in the applicable security except in the event that use of the book entry system at DTC for the securities is discontinued. The information in this section concerning DTC and DTC s book entry system has been obtained from sources that we believe to be reliable, including DTC. Separation and Combination. Holders of IDSs may, at any time after 45 days from the date of original issuance, through their broker or other financial institution, separate their IDSs into the shares of common stock and senior subordinated notes represented thereby. Similarly, any holder of shares of our common stock and senior subordinated notes may, at any time, through their broker or other financial institution, combine the applicable number of shares of common stock and senior subordinated notes to form IDSs. Any such separation or recombination will be effective as of the close of business on the trading day that DTC receives such instructions from a participant or custodians, provided that such instructions are received by 3:00 p.m., Eastern Time, on that trading day. Any instructions received after 3:00 p.m., Eastern Time, will be effective the next business day, if permitted by the custodian or participant delivering the instructions. All outstanding IDSs will be automatically separated into the shares of common stock and senior subordinated notes represented thereby upon the occurrence of the following: exercise by us of our right to redeem all or a portion of the senior subordinated notes, which may be represented by IDSs at the time of such redemption, the date on which principal on the senior subordinated notes becomes due and payable, whether at the stated maturity date or upon acceleration thereof, or if DTC no longer makes IDSs eligible for deposit or ceases to be a registered clearing agency under the Securities Exchange Act of 1934 and we are unable to find a successor depository. Following the automatic separation of the IDSs as a result of the redemption or maturity of any senior subordinated notes, shares of common stock and senior subordinated notes may no longer be combined to form IDSs. Any voluntary separation of IDSs and any subsequent voluntary recombination of IDSs from components will be accomplished by entries made by DTC based upon instructions given by DTC participants acting on behalf of beneficial owners. Voluntary separation or recombination of IDSs will be accomplished via the use of DTC s Deposit/Withdrawal at Custodian, or DWAC, transaction. Participants or custodians seeking to separate or recombine IDSs will be required to enter a DWAC transaction in each of the IDS and its underlying components. Separation will require submission of a Withdrawal-DWAC in the IDS in conjunction with a Deposit-DWAC in each of the underlying components. Upon receipt of DWAC instructions in good order, the transfer Weighted average shares outstanding Common stock: Basic Table of Contents agents for the IDSs and their components will cause the IDSs to be debited from Cede & Co. s account in the IDSs and credited to a separation/recombination reserve account in the IDS, and will cause an appropriate number of the components to be debited from the custodian s account in the components and credited to Cede & Co. s position in the components. Recombination of IDSs from underlying components will require submission of a Deposit-DWAC in the IDS in conjunction with a Withdrawal-DWAC in each of the underlying components. Upon receipt of DWAC instructions in good order, the transfer agent for the IDS and their components will cause an appropriate number of components to be debited from Cede & Co. s position in the components and credited to the account of the custodian, and will cause an appropriate number of IDSs to be debited from the separation/recombination reserve account and credited to Cede & Co. s account in the IDS. There may be certain transactional fees imposed upon you by brokers and other financial intermediaries in connection with separation or recombination of IDSs and you are urged to consult your broker regarding any such transactional fees. Any transactional fees charged by the transfer agent in connection with separation and or recombination of IDSs will be borne by us. We have been informed by DTC that the current fee per transaction per participant account for any separation or recombination is $4.50. However, DTC s fee is subject to periodic changes. Notices and Communications. Conveyance of notices and other communications by DTC to direct participants, by direct participants to indirect participants, and by participants to beneficial owners will be governed by arrangements among them, subject to any statutory or regulatory requirements as may be in effect from time to time. Neither DTC nor Cede & Co. will consent or vote with respect to the IDSs or the underlying components and the custodians will not consent or vote with respect to the common stock and senior subordinated notes. Under its usual procedures, DTC would mail an omnibus proxy to participants as soon as possible after the record date. The omnibus proxy assigns Cede & Co. s consenting or voting rights to those direct participants to whose accounts the securities are credited on the record date (identified in a listing attached to the omnibus proxy). Payments. We, indirectly through the trustee, will make any payments on the senior subordinated notes to DTC and we will make all payments on the common stock to the transfer agent for the benefit of the record holders. The transfer agent will deliver these payments to DTC. DTC s practice is to credit direct participants accounts on the payment date in accordance with their respective holdings shown on DTC s records unless DTC has reason to believe that it will not receive payment on the payment date. Payments by participants to beneficial owners will be governed by standing instructions and customary practices, as is the case with securities held for the accounts of customers in bearer form or registered in street name, and will be the responsibility of such participant and not of DTC, us or the transfer agent and registrar, subject to any statutory or regulatory requirements as may be in effect from time to time. We will be responsible for the payment, indirectly through the trustee, of all amounts to DTC and the transfer agent. The transfer agent will be responsible for the disbursement of those payments to DTC. DTC will be responsible for the disbursement of those payments to its participants, and the participants will be responsible for disbursements of those payments to beneficial owners. We will remain responsible for any actions DTC and participants take in accordance with instruction we provide. Successor Depository; Physical Certificates. DTC may discontinue providing its service as securities depository with respect to the IDSs, the shares of our common stock or our senior subordinated notes at any time by giving reasonable notice to us or the trustee. If DTC discontinues providing its service as securities depository with respect to the IDSs and we are unable to obtain a successor securities depository, you will automatically take a position in the component securities. If the custodian discontinues providing its service as securities depository with respect to the shares of our common stock and/or our senior subordinated notes and we are unable to obtain a successor custodian, we will print and deliver to you certificates for the securities that have been discontinued and you will automatically take a position in the other component securities. Table of Contents Also, in case we decide to discontinue use of the system of book entry transfers through DTC (or a successor securities depository) we will print and deliver to you certificates for the various certificates of common stock and senior subordinated notes you may own. Disclaimer. Except for actions taken by DTC in accordance with our instructions, neither we nor the trustee nor the underwriters will have any responsibility or obligation to participants, or the persons for whom they act as nominees, with respect to: the accuracy of the records of DTC, its nominee or any participant with respect to any ownership interest in the securities on DTC s books, or any payments, or the providing of notice, to participants or beneficial owners. Procedures Relating to Subsequent Issuances. The indenture governing the senior subordinated notes and the agreements with DTC will provide that, if there is a subsequent issuance of senior subordinated notes having identical terms as the senior subordinated notes represented by the IDSs and the senior subordinated being offered separately in this offering but issued with OID, including an issuance upon a conversion of participating preferred stock, each holder of IDSs or separately held senior subordinated notes (as the case may be) agrees that upon such issuance of notes and upon each issuance of notes thereafter a portion of such holder s senior subordinated notes (whether held directly in book entry form or held as part of IDSs) will be exchanged, without any further action of such holder, for a portion of the senior subordinated notes acquired by the holders of such subsequently issued senior subordinated notes. Immediately following each such subsequent issuance and exchange, each holder of senior subordinated notes or IDSs (as the case may be) will own senior subordinated notes of each separate issuance in the same proportion as each other holder. Immediately following any exchange resulting from a subsequent offering, a new CUSIP number will be assigned to represent an inseparable unit consisting of the senior subordinated notes outstanding prior to the subsequent issuance and the senior subordinated notes issued in the subsequent issuance. Consequently, the senior subordinated notes issued in the original offering cannot be separated from the senior subordinated notes issued in any subsequent offering. In addition, immediately following any exchange resulting from a subsequent offering, new IDSs will be issued in exchange for the existing IDSs which will consist of the inseparable unit described above representing the proportionate principal amounts of each issuance of senior subordinated notes (but with the same aggregate principal amount as the senior subordinated notes (or inseparable unit) represented by the IDSs immediately prior to such subsequent issuance and exchange) and the common stock. All accounts of DTC participants or custodians with a position in the securities will be automatically revised to reflect the new CUSIP numbers. In the event of any voluntary or automatic separation of IDSs following any such automatic exchange, holders will receive the then existing components which are the Class A common stock and the inseparable notes unit. An automatic exchange of the senior subordinated notes described above should not impair the rights any holder would otherwise have to assert a claim under applicable securities laws against us or the underwriters with respect to the full amount of the senior subordinated notes purchased by such holder, including senior subordinated notes purchased in this offering and senior subordinated notes received by such holder in an automatic exchange. However, if such notes are issued with OID, holders of such notes may not be able to recover the portion of their principal amount treated as unaccrued OID in the event of an acceleration of the notes or a bankruptcy of the issuer prior to the maturity of the notes. See Risk Factors Subsequent issuances of senior subordinated notes may cause you to recognize OID and may be treated as a taxable exchange by you beginning on page 35. Immediately following any subsequent issuance we will file with the SEC a Current Report on Form 8-K or any other applicable form disclosing the changes, if any, to the OID attributable to your senior subordinated notes as a result of such subsequent issuance. IDS TRANSFER AGENT AND CUSTODIAN FOR IDSS AND COMPONENTS Mellon Investor Services LLC is the IDS transfer agent. As the transfer agent for the IDSs, Mellon Investor Services LLC will also act as custodian for the IDSs and the components, in each case, on behalf of the holders of the IDSs. Table of Contents DESCRIPTION OF CAPITAL STOCK GENERAL Under our amended and restated certificate of incorporation, our capital stock consists of total authorized shares (after giving effect to a 49.578-for-1 stock split of the common stock), of which shares, $0.001 par value per share, will be designated as common stock, shares, $0.001 par value per share, will be designated as Class A common stock and shares, $0.001 par value per share, will be designated as Preferred Stock. There will be no shares of Class A common stock outstanding immediately following this offering. We have set forth a summary description of the material terms and provisions of our amended and restated certificate of incorporation. The following description of our capital stock is intended as a summary only and is qualified in its entirety by reference to our amended and restated certificate of incorporation. COMMON STOCK AND CLASS A COMMON STOCK The holders of shares of our common stock and Class A common stock will be entitled to: one vote for each share of common stock or Class A common stock, as the case may be, held of record voting as a single class with the participating preferred stock on all matters submitted to a vote of our stockholders; receive ratably such dividends as may be declared by our board of directors out of funds legally available therefor, after all required dividends are paid to the holders of our outstanding shares of Preferred Stock; and in the event of our liquidation, dissolution or winding up, share ratably in all assets which remain after our payment of all of our corporate debts and the required payment of all amounts due to the holders of our outstanding shares of Preferred Stock. Voting is noncumulative, and all shares of our common stock outstanding on May 30, 2004 were fully paid and non-assessable. The holders of shares of our common stock and Class A common stock do not have preemptive, subscription or redemption rights and are not subject to further calls or assessments. Class Rights and Restrictions. Shares of our common stock and Class A common stock will be identical in all respects and will be entitled to the same rights, preferences and privileges, and vote together as a single class with the participating preferred stock on all matters upon which the common stock is entitled to vote, except that our certificate of incorporation will provide that we may not issue any shares of common stock, unless such shares of common stock are issued as part of IDSs. PREFERRED STOCK Shares of Preferred Stock may be issued from time to time, in one or more series, with the designations, assigned values, voting rights, powers, preferences and relative, participating, optional or other special rights, qualifications, limitations or restrictions thereof as our board of directors from time to time may adopt by resolution, subject to certain limitations. Each series shall consist of that number of shares as shall be stated and expressed in the certificate of designations providing for the issuance of the stock of the series. All shares of any one series of Preferred Stock shall be identical. Series A Redeemable Preferred Stock In connection with the Acquisition, we issued $60.0 million of Series A Redeemable Preferred Stock to ConAgra Foods. We redeemed approximately $26.4 million of Series A Redeemable Preferred Stock on January 26, 2004 with a portion of the proceeds from the offering of the 10 % Senior Discount Notes. The key terms of the Series A Redeemable Preferred Stock are described below. Such description is not complete and is qualified in its entirety by reference to the complete text of the applicable certificate of designation, a copy of which is filed as an exhibit to the registration statement of which this prospectus forms a part. Table of Contents The authorized number of shares of Series A Redeemable Preferred Stock is 175,000, of which 33,937 are outstanding as of the date of this prospectus. The outstanding Series A Redeemable Preferred Stock was issued by us for $1,000 per share (the Face Amount ) and ranks prior to our common stock, Class A common stock and any other class of our capital stock ranking junior to the Series A Redeemable Preferred Stock with respect to dividends, liquidation, dissolution and winding up of UAP Holdings. All shares of Series A Redeemable Preferred Stock will be redeemed with the proceeds of the offering and will no longer be outstanding. Dividends. The holders of outstanding shares of Series A Redeemable Preferred Stock are entitled to receive, when, as and if declared by the board of directors, out of funds legally available therefor, with respect to each share of Series A Redeemable Preferred Stock, semiannual preferred dividends in an amount equal to the product of (i) the Face Amount thereof multiplied by (ii) 50% of the per annum dividend rate. The per annum dividend rate is 8.0% until November 24, 2008, 9.0% from November 24, 2008 to, but not including, November 24, 2009, and 10% from November 24, 2009 and thereafter. Dividends may be paid, at our option, either in cash or by delivering to the record holders of Series A Redeemable Preferred Stock additional shares of Series A Redeemable Preferred Stock (and fractional shares to the extent applicable) having an aggregate Face Amount equal to the amount of the dividend to be paid on the applicable dividend payment date. Liquidation. Upon a liquidation or winding up of UAP Holdings in a single transaction or series of transactions, the holders of Series A Redeemable Preferred Stock will be entitled to be paid, out of the assets of UAP Holdings available for distribution to its shareholders, whether from capital, surplus or earnings ( Available Assets ), an amount equal to the Face Amount plus all accrued and unpaid dividends on each share, if any (in the aggregate, the Liquidation Preference Amount ), before any distribution is made on any other class of our stock ranking junior to the Series A Redeemable Preferred Stock with respect to a liquidation or winding up, including our common stock and Class A common stock. If the Available Assets are insufficient to pay the holders of the Series A Redeemable Preferred Stock the full Liquidation Preference Amount, the holders of the Series A Redeemable Preferred Stock shall share ratably in any distribution of assets according to the respective amounts which would be payable in respect of the shares held by them upon such distribution if all amounts payable on or with respect to said shares were paid in full. The Liquidation Preference Amount must be paid to the holders of Series A Redeemable Preferred Stock in cash. Redemption. On December 15, 2012 (the Maturity Date ), we are required to redeem all of the Series A Redeemable Preferred Stock then outstanding for an amount equal to the Liquidation Preference Amount. At any time prior to December 15, 2012, we have the option of redeeming, in whole or in part, the outstanding shares of Series A Redeemable Preferred Stock at a price equal to the then current Liquidation Preference Amount. In the case of a redemption of less than all of the shares of Series A Redeemable Preferred Stock at the time outstanding, the shares to be redeemed shall be selected pro rata or by lot as reasonably determined by us to be equitable. Upon a change of control, each holder of Series A Redeemable Preferred Stock has the right, at such holder s election, to receive on the date the change of control occurs in respect of each share owned by such holder a sum equal to (a) the then applicable Face Amount multiplied by 1.01 plus (b) all accrued and unpaid dividends on each such share (the Change of Control Redemption Amount ). Also upon a change of control, we may elect to redeem all (but not less than all) of the outstanding shares of Series A Redeemable Preferred Stock for an amount equal to the Change of Control Redemption Amount. A change of control means: prior to our initial public offering, any person other than Apollo owns more than 50% of the voting power of our common stock on a fully diluted basis; after our initial public offering, any person other than Apollo owns more than 30% of the voting power of our common stock; a merger or consolidation in which our stockholders own less than 50% of the voting securities of the surviving corporation; Table of Contents sale of all or substantially all of our assets; or a change of control under and as defined in any indenture or agreement to which UAP Holdings or any of its subsidiaries is a party with respect to indebtedness for borrowed money in excess of the aggregate principal amount of $100 million. In addition, in the event that Apollo sells its common stock to an entity not affiliated with Apollo and such sale does not result in a change of control, we are required to redeem the Series A Redeemable Preferred Stock in a number and for a price to be determined, in part, by the aggregate consideration received by Apollo in any such sale. Notwithstanding the foregoing, we will not be required to redeem the Series A Redeemable Preferred Stock at any time such redemption is either prohibited by law or is prohibited by, or would be a default under, the terms of the Amended Credit Facilities. No Voting Rights. Except as specifically set forth in the Delaware General Corporation Law, the holders of Series A Redeemable Preferred Stock are not entitled to any voting rights with respect to any matters voted upon by stockholders, provided, however, the consent of the holders of at least two-thirds of the outstanding shares of Series A Redeemable Preferred Stock is required for any action which: (i) alters or changes the rights, preferences or privileges of the Series A Redeemable Preferred Stock in a manner adverse to the holders thereof; (ii) increases or decreases the authorized number of shares of Series A Redeemable Preferred Stock; (iii) creates, by reclassification or otherwise, any new class or series of shares having rights, preferences or privileges on parity or senior to the Series A Redeemable Preferred Stock; or (iv) amends or waives any provisions of our amended certificate of incorporation in a manner adverse to the holders of the outstanding shares of Series A preferred stock. No Preemptive Rights. No holder of shares of Series A Redeemable Preferred Stock has by virtue of such ownership any preemptive or subscription rights in respect of any of our securities that may be issued. Participating Preferred Stock As part of the Recapitalization, we will issue 6,403,289 shares of participating preferred stock to our equity sponsor and 1,914,198 shares of participating preferred stock to a rabbi trust under our amended and restated 2004 deferred compensation plan. The key terms of the participating preferred stock are described below. Such description is not complete and is qualified in its entirety by reference to the complete text of the applicable certificate of designation, a form of is filed as an exhibit to the registration statement of which this prospectus forms a part. Upon completion of the Transactions, the authorized number of shares of participating preferred stock will be , of which 8,317,487 will be outstanding upon consummation of this offering. Dividends. The holders of outstanding shares of participating preferred stock will be entitled to receive, when, as and if declared by the board of directors, out of funds legally available therefor, with respect to each share of participating preferred stock, quarterly preferred dividends in an amount equal to the product of (i) the liquidation preference of such share multiplied by (ii) a per annum dividend rate equal to the per annum interest rate on the senior subordinated notes. To the extent such preferred dividends are not paid in cash on a dividend payment date, they will be added to the liquidation preference of such share. Such preferred dividends will accrue whether or not earned or declared (and regardless of whether sufficient funds are legally available therefor), will be cumulative from the issue date and will rank prior to dividend rights with respect to our common stock, Class A common stock and any other class of our capital stock. No preferred dividends may be declared by the board of directors or paid by UAP Holdings to the extent that such declaration or payment shall be restricted or prohibited by law or to the extent that at the time of such payment, UAP Holdings is restricted or prohibited, for any reason, from paying interest on the senior subordinated votes. Table of Contents The holders of participating preferred stock will also participate in all dividends declared and paid to holders of our common stock on an as if converted basis. Liquidation. Upon a liquidation, dissolution or winding up of UAP Holdings in a single transaction or series of transactions, the holders of participating preferred stock will be entitled to be paid, out of the assets of UAP Holdings available for distribution to its shareholders, whether from capital, surplus or earnings, an amount in cash equal to the liquidation preference of each share plus accrued and unpaid dividends thereon to the extent such accrued and unpaid dividends have not been added to the liquidation preference, before any distribution is made on any other class of our capital stock, including our common stock and Class A common stock. The initial liquidation preference of each share of participating preferred stock will equal the principal amount of a senior subordinated note represented by one IDS. Following such distribution, each holder of participating preferred stock will be entitled to be paid an amount equal to its pro rata share of the remaining assets available for distribution to holders of our common stock on an as if converted basis, together with the holders of our common stock. Conversion. Each holder of participating preferred stock shall have the right to convert each share of participating preferred stock into one IDS at any time after the first anniversary of the offering date, provided that: UAP Holdings has funds legally available to permit such conversion; such conversion is not prohibited by the indenture governing the senior subordinated notes (including the Conversion Conditions described under Description of Senior Subordinated Notes Certain Definitions beginning on page 176) or the Amended Credit Facilities or, in each case, any refinancing thereof; and the issuance of the IDS and the senior subordinated notes and common stock represented by the IDSs issued in such conversion are covered by an effective registration statement under the Securities Act. Shares of participating preferred stock will be convertible only on: March 1, June 1, September 1 and December 1 of each year, or any other date so long as the aggregate number of IDSs issuable upon conversion of all shares of participating preferred stock being converted on such date, whether by our equity sponsor or other persons, has an aggregate fair market value of at least $20.0 million. We may, at our option, elect to satisfy this conversion right delivering IDSs or by paying to such holder of participating preferred stock an amount in cash equal to the market price of IDSs issuable to such holder upon conversion, or any combination thereof. If we elect to satisfy the conversion right, in whole or in part, by payment of cash, the amount of cash will equal the number of IDS to be deliverable upon such conversion multiplied by the market price of an IDS on the settlement date. The market price of an IDS on any settlement date means the last closing sale price of our IDSs on the trading day immediately prior to such settlement date. To the extent the IDSs have been automatically separated into shares of common stock and senior subordinated notes at the time of any conversion, each holder of participating preferred stock shall receive a number of shares of common stock and senior subordinated notes that constituted one IDS on the date this offering is consummated, subject to certain adjustments as noted below. In the event of a redemption, optional repurchase or other event (including maturity) following which there will no longer be any senior subordinated notes (whether or not comprising IDSs) outstanding, then notwithstanding the applicable conversion provisions, in connection with such redemption, repurchase or other event, all shares of participating preferred stock will be automatically exchanged for IDSs on the applicable redemption, repurchase or such other event date and the senior subordinated notes acquired by the holders of the participating preferred stock as part of the IDSs in the exchange will be redeemed or repurchased by the Company together with all of the other senior subordinated notes. Table of Contents No fractional portion of an IDS (or fractional portion of the components of an IDS) will be issued upon a conversion of shares of participating preferred stock. Instead, we will pay the holder of the shares converted an amount in cash in respect of the fractional interest based upon the fair market value of the IDSs on the trading day immediately preceding the date of conversion. Upon any conversion, UAP Holdings shall pay in cash all accrued and unpaid dividends owing to the converting holder to the extent that funds are legally available therefor. To the extent that funds are not legally available to permit the cash payment of all accrued and unpaid dividends in respect of the participating preferred stock being converted, the holder of such participating preferred stock shall not be permitted to convert, in the case of a contemplated conversion at the option of the holder, and UAP Holdings shall not convert, in the case of a contemplated conversion at the option of UAP Holdings, participating preferred stock into IDSs. In addition, if UAP Holdings is unable to convert participating preferred stock into IDSs upon a contemplated conversion at the option of UAP Holdings, the right of holders of a majority of the participating preferred stock to elect up to four additional directors shall be triggered. Pursuant to the management incentive agreement, the management holders of the participating preferred stock will give their proxy to Apollo to vote on whether to trigger such additional director election right. The number of shares of common stock issuable upon conversion of the participating preferred stock shall be subject to customary adjustments for stock splits, stock combinations and stock dividends. Upon any capital reorganization, reclassification or any consolidation or merger of UAP Holdings, the participating preferred stock will be convertible into the securities which the holders of the IDSs are entitled to upon such event. Shares of Participating Preferred Stock that have been converted will be cancelled, and UAP Holdings will not be permitted to reissue such shares. Prior to the closing of this offering we will enter into a management incentive agreement with certain of our security holders and a recapitalization agreement with our equity sponsor, each of which will contain contractual limitations on the ability of such persons to convert shares of participating preferred stock. See Certain Relationships and Related Transactions Related Party Transactions in Connection with this Offering beginning on page 118. Voting Rights. The holders of the participating preferred stock will be entitled to vote on any and all matters on which holders of UAP Holdings common stock and Class A common stock are entitled to vote on an as if converted basis. In addition, the consent of the holders of 75% of the outstanding shares of participating preferred stock will be required for any action which, by merger or otherwise: amends or alters our certificate of incorporation or by-laws in any manner that adversely affects the rights of the participating preferred stock; creates, authorizes or issues any class or series of stock, ranking as to payment of dividends or upon liquidation, dissolution or winding up of UAP Holdings, pari passu or senior to the participating preferred stock; amends or alters the Certificate of Designations in any manner that adversely affects powers, preferences, or special rights of the participating preferred stock; waives compliance with any provision of the Certificate of Designations; allows for the purchase, redemption, retirement or other acquisition of any equity securities of UAP Holding ranking as to payment of dividends or upon liquidation, dissolution or winding up of UAP Holdings, pari passu or junior to the participating preferred stock, other than any equity securities issued pursuant to bona fide employee benefit plans adopted by our Board of Directors; or increases the amount of authorized and issued participating preferred stock. Table of Contents However, we may, without the vote of any holders of participating preferred stock, amend or supplement the Certificate of Designations to cure any ambiguity, defect or inconsistency or to make any change that would provide any additional rights or benefits to the holders of the participating preferred stock or that does not adversely affect the legal or economic rights under the Certificate of Designations of any such holder. If at any time UAP Holdings shall have failed to pay dividends on any participating preferred stock for six quarters in the aggregate, the holders of participating preferred stock will be entitled to vote separately as a class to elect up to four additional directors by making such increase in the number of directors as shall be necessary to permit their election (provided that the number of such additional directors elected shall be less than the number that would constitute control of a majority of the Board of Directors by Apollo). This right shall extend until such time when all accrued and unpaid dividends for all previous quarterly dividend periods and for the current quarterly dividend period on all shares of participating preferred stock then outstanding shall have been declared and paid or set apart for payment. No Preemptive Rights. No holder of shares of participating preferred stock has by virtue of such ownership any preemptive rights or subscription rights in respect of any of our securities that may be issued. COMPOSITION OF BOARD OF DIRECTORS; ELECTION AND REMOVAL OF DIRECTORS In accordance with our by-laws, the number of directors comprising our board of directors will be as determined from time to time by our board of directors. Upon the closing of the offering it is anticipated that we will have directors. Each director is to hold office until his or her successor is duly elected and qualified or until his or her earlier death, resignation or removal. Except as otherwise required by applicable law, any director or the entire board may be removed, only with cause, at any time by the vote of the holders of a majority of the shares then entitled to vote at an election of directors. Vacancies occurring on the board for any reason may be filled by a vote of the stockholders, or by a vote of the board or by the directors written consent. If the number of directors then in office is less than a quorum, such vacancies may be filled by a vote of a majority of the directors then in office, or, if there shall be only one director remaining, by the sole remaining director. At any meeting of our board of directors, a majority of the total number of directors then in office will constitute a quorum for all purposes. SPECIAL MEETINGS OF STOCKHOLDERS Our by-laws provide that special meetings of the stockholders may be called by the board of directors, a committee of the board of directors, the chairman, the chief executive officer, the president or the record holders of at least a majority of the outstanding common stock, Class A common stock and participating preferred stock, voting as a single class. SECTION 203 OF THE DELAWARE GENERAL CORPORATION LAW In our amended certificate of incorporation, we elected not to be subject to Section 203 of the Delaware General Corporation Law. In general, Section 203 prohibits a publicly held Delaware corporation from engaging in a business combination with an interested stockholder for a three-year period following the time that this stockholder becomes an interested stockholder, unless the business combination is approved in a prescribed manner. A business combination includes a merger, asset sale or other transaction resulting in a financial benefit to the interested stockholder. An interested stockholder is a person who, together with affiliates and associates, owns (or, in some cases, within three years prior, did own) 15% or more of the corporation s voting stock. AMENDMENT OF OUR CERTIFICATE OF INCORPORATION Under applicable law, our amended certificate of incorporation can be amended only with the affirmative vote of a majority of the outstanding stock entitled to vote thereon. Table of Contents AMENDMENT OF OUR BY-LAWS Our by-laws can be amended by the vote of the holders of a majority of the shares then entitled to vote or by the vote of a majority of the board of directors. LIMITATION OF LIABILITY AND INDEMNIFICATION Our amended certificate of incorporation provides that no director shall be personally liable for monetary damages for breach of any fiduciary duty as a director. As required under current Delaware law, our amended certificate of incorporation currently provides that this waiver may not apply to liability: for any breach of the director s duty of loyalty to us or our stockholders; for acts or omissions not in good faith or that involve intentional misconduct or a knowing violation of law; under Section 174 of the Delaware General Corporation Law (governing distributions to stockholders); or for any transaction from which the director derived any improper personal benefit. However, in the event the Delaware General Corporation Law is amended to authorize corporate action further eliminating or limiting the personal liability of directors, then the liability of our directors will be eliminated or limited to the fullest extent permitted by the Delaware General Corporation Law, as so amended. The modification or repeal of this provision of our amended certificate of incorporation shall not adversely affect any right or protection of a director existing at the time of such modification or repeal. Our by-laws provide that we shall, to the fullest extent from time to time permitted by law, indemnify our directors, officers and employees against all liabilities and expenses in any suit or proceeding, arising out of their status as an officer or director or their activities in these capacities. We shall also indemnify any person who, at our request, is or was serving as a director, officer or employee of another corporation, partnership, joint venture, trust or other enterprise. The right to be indemnified shall include the right of an officer or a director to be paid expenses in advance of the final disposition of any proceeding, provided that, if required by law, we receive an undertaking to repay such amount if it shall be determined that he or she is not entitled to be indemnified. Our board of directors may take such action as it deems necessary to carry out these indemnification provisions, including adopting procedures for determining and enforcing indemnification rights and purchasing insurance policies. Our board of directors may also adopt by-laws, resolutions or contracts implementing indemnification arrangements as may be permitted by law. Neither the amendment or repeal of these indemnification provisions, nor the adoption of any provision of our amended certificate of incorporation inconsistent with these indemnification provisions, shall eliminate or reduce any rights to indemnification relating to their status or any activities prior to such amendment, repeal or adoption. We believe these provisions will assist in attracting and retaining qualified individuals to serve as directors. LISTING Our shares of common stock will not be listed for separate trading on the American Stock Exchange until a sufficient number of shares is held separately and not in the form of IDSs as may be necessary to satisfy any applicable listing requirements. If more than such required number of our outstanding shares of common stock is no longer held in the form of IDSs for a period of 30 consecutive trading days, we will apply to list the shares of our common stock for separate trading on the American Stock Exchange. TRANSFER AGENT AND REGISTRAR The transfer agent and registrar for our common stock is Mellon Investor Services LLC. Diluted Table of Contents DESCRIPTION OF SENIOR SUBORDINATED NOTES The following is a description of the terms of the Indenture under which our senior subordinated notes (the Notes ) will be issued, a copy of the form of which has been filed with the SEC as an exhibit to the registration statement of which this prospectus is a part. We refer to UAP Holding Corp. (and not to any of its Subsidiaries) as the Company in this Description of Senior Subordinated Notes section. General The Notes are to be issued under an Indenture, to be dated as of , 2004 (the Indenture ), among the Company, the subsidiary guarantors and JPMorgan Chase Bank, as trustee. The following description is a summary of the material provisions of the Indenture and the Notes. It does not purport to be complete and we urge you to read the Indenture, a form of which has been filed as an exhibit to the registration statement of which this prospectus is a part. This description is subject to, and is qualified in its entirety by reference to, all the provisions of the Indenture, including the definitions of certain terms therein and those terms made a part thereof by the Trust Indenture Act of 1939, as amended. Capitalized terms used in this Description of Senior Subordinated Notes section and not otherwise defined have the meanings set forth in Certain Definitions beginning on page 176 hereafter. The Indenture will provide for the issuance of an unlimited aggregate principal amount of additional senior subordinated notes having identical terms and conditions to the Notes offered hereby (other than issuance date) (the Additional Notes ), subject to compliance with the covenants contained in the Indenture. Additional Notes will vote on all matters with the Notes offered hereby. The Additional Notes will be deemed to have the same accrued current period interest, deferred interest and defaults as the Notes issued in this offering and will be deemed to have expended Payment Blockage Periods, Acceleration Forbearance Periods and interest deferral periods to the same extent as the Notes issued in this offering. The Notes will be issued only in fully-registered form, without coupons, represented by one or more global Notes which will be registered in the name of Cede & Co., the nominee of DTC. See Description of Income Deposit Securities (IDSs) Clearance and Settlement beginning on page 134. Terms of the Notes Maturity The Notes will be unsecured senior subordinated obligations of the Company and will mature on , 2019. Interest The Notes will bear interest at a rate per year of % from , 2004 or from the most recent date to which interest has been paid or provided for, payable quarterly on the 1st day of each February, May, August and November to holders of record at the close of business on the 15th day of January, April, July and October or the immediately preceding Business Day of such month, commencing February 1, 2004, provided that if any such day is not a Business Day, such day shall be the next Business Day. Interest Deferral Prior to , 2009, the Company will be permitted, at its election, on one or more occasions to defer interest payments on the Notes (each an Initial Interest Deferral Period ) by delivering to the trustee a copy of a resolution of the Company s Board of Directors to the effect that, based upon a good-faith determination of the Company s Board of Directors (which determination shall be final), such deferral is reasonably necessary for Table of Contents bona-fide cash management purposes, or to reduce the likelihood of or avoid a default under any Designated Senior Indebtedness; provided, however that no such deferral may be commenced, and any on-going deferral shall cease, if a default in payment of interest, principal or premium, if any, on the Notes has occurred and is continuing, or another Event of Default with respect to the Notes has occurred and is continuing and the Notes have been accelerated as a result of the occurrence of such Event of Default and; provided, further, that interest payments on the Notes may not be deferred under this provision with respect to more than eight quarterly payments in the aggregate or beyond , 2009. After , 2009, the Company will be permitted, at its election, on not more than four occasions (each a Subsequent Interest Deferral Period and each of any initial Interest Deferral Period or Subsequent Interest Deferral Period, an Interest Deferral Period ) to defer interest payments on the Notes by delivering to the trustee a copy of a resolution of the Company s Board of Directors to the effect that, based upon a good-faith determination of the Company s Board of Directors (which determination shall be final), such deferral is reasonably necessary for bona-fide cash management purposes, or to reduce the likelihood of or avoid a default under any Designated Senior Indebtedness; provided, however that no such deferral may be commenced, and any on-going deferral shall cease, if a default in payment of interest, principal or premium, if any, on the Notes has occurred and is continuing, or another Event of Default with respect to the Notes has occurred and is continuing and the Notes have been accelerated as a result of the occurrence of such Event of Default; provided, further, that interest payments on the Notes may not be deferred under this provision for more than two quarters per Subsequent Interest Deferral Period. After the end of the first Subsequent Interest Deferral Period, the Company may not defer interest on the Notes unless and until all deferred interest and interest on deferred interest has been paid in full. Deferred interest on the Notes will bear interest at a rate per annum of % compounded quarterly until paid in full. The Company will pay deferred interest and interest accrued thereon pursuant to the following: for any Initial Interest Deferral Period, the Company must pay all deferred interest and all interest accrued thereon no later than , 2009; and for any Subsequent Interest Deferral Period, the Company must pay all deferred interest and all interest accrued thereon no later than , 2019. Notwithstanding the foregoing, the Company will be obligated to resume quarterly payments of interest on the Notes after the end of any Initial Interest Deferral Period or Subsequent Interest Deferral Period. During any Initial Interest Deferral Period or Subsequent Interest Deferral Period and so long as any deferred interest or interest on deferred interest remains outstanding and has not been paid, the Company will not be permitted to make any payment of dividends on the Company s Common Stock and Participating Preferred Stock or to make payments with respect to vested options to acquire Participating Preferred Stock. Optional Redemption The Company may, at its option, redeem all, but not less than all, of the Notes at any time upon not less than 30 nor more than 60 days prior notice, at a redemption price equal to 100% of the principal amount of the Notes plus accrued and unpaid interest to the redemption date, if for U.S. federal Income tax purposes the Company is not, or would not be, in the opinion of a nationally recognized law firm experienced in such matters, permitted to deduct more than 90% of the interest payable on the Notes from its income. Such an opinion may be requested by any officer of the Company authorized to make such request by the Company s Board of Directors. Except as set forth above, the Company shall not have the option to redeem the Notes prior to , 2011. At any time and from time to time on or after , 2011, the Company may redeem all or a part of the Notes, upon not less than 30 nor more than 60 days notice, at the redemption prices (expressed as percentages of principal amount) set forth below, plus accrued and unpaid interest on the Notes redeemed to the applicable redemption date, if redeemed during the twelve-month period beginning on of the years 2011 % 2012 % 2013 % 2014 and thereafter 100.000 % Notice of any redemption will be mailed at least 30 days but not more than 60 days before the date of redemption to each holder of the Notes to be redeemed. Unless we default in payment of the redemption price, on and after the date of redemption, interest will cease to accrue on such Notes or the portions called for redemption. Any exercise by the Company of its option to redeem the Notes, in whole or in part, will result in an automatic separation of the IDSs upon the redemption date. Ranking The Indebtedness evidenced by the Notes will be unsecured senior subordinated Indebtedness of the Company, will be subordinated in right of payment, as set forth in the Indenture, to all existing and future Senior Indebtedness of the Company, including the Senior Indebtedness of the Company represented by the Company s Guarantee of the Credit Agreements, will rank pari passu in right of payment with all existing and future Pari Passu Indebtedness of the Company and trade payables, except for the impact of the contractual subordination provided in the Indenture which may have the effect of causing the Notes to receive less, ratably, than other general unsecured creditors, including trade payables, that are not subject to contractual subordination, and except for statutory priorities provided under the U.S. federal bankruptcy code or other applicable bankruptcy, insolvency and other laws dealing with creditors rights generally, and will rank senior in right of payment to any Subordinated Indebtedness of the Company. The Notes will also be effectively subordinated to any Secured Indebtedness of the Company to the extent of the value of the assets securing such Indebtedness. However, payment from the money or the proceeds of U.S. Government Obligations held in any defeasance trust described under Legal Defeasance and Covenant Defeasance beginning on page 172 is not subordinated to any Senior Indebtedness or subject to the restrictions described herein. The Indebtedness evidenced by each Note Guarantee will be unsecured senior subordinated Indebtedness of the applicable Guarantor, will be subordinated in right of payment, as set forth in the Indenture, to all existing and future Senior Indebtedness of such Guarantor, including the Senior Indebtedness of United Agri Products, Inc. under the Credit Agreements and Senior Indebtedness of each other Guarantor represented by such other Guarantor s Guarantee of the Credit Agreements, will rank pari passu in right of payment with all existing and future Pari Passu Indebtedness of such Guarantor and trade payables, except for the impact of the contractual subordination provided in the Indenture which may have the effect of causing the guarantees to receive less, ratably, than other general unsecured creditors, including trade payables, that are not subject to contractual subordination, and except for statutory priorities provided under the U.S. federal bankruptcy code or other applicable bankruptcy, insolvency and other laws dealing with creditors rights generally, and will rank senior in right of payment to any Subordinated Indebtedness of such Guarantor. The Note Guarantees will also be effectively subordinated to any Secured Indebtedness of the applicable Guarantor to the extent of the value of the assets securing such Indebtedness. As of May 30, 2004, on a pro forma basis after giving effect to the Transactions, (i) the Company would have had no Senior Indebtedness outstanding other than its Guarantee of the Credit Agreements, (ii) the Company would have had no Pari Passu Indebtedness outstanding other than the Notes, (iii) the Guarantors would have had $294.3 million in Senior Indebtedness outstanding under the Credit Agreements, all of which would have been Secured Indebtedness, and (iv) the Guarantors would have had no Pari Passu Indebtedness Table of Contents outstanding other than the Note Guarantees. Although the Indenture will contain limitations on the amount of additional Indebtedness which the Company and its Restricted Subsidiaries may Incur, under certain circumstances the amount of such Indebtedness could be substantial and, in any case, such Indebtedness may be Senior Indebtedness. See Certain Covenants Incurrence of Indebtedness and Issuance of Disqualified Stock beginning on page 161 below. The operations of the Company are conducted through its Subsidiaries and, therefore, the Company depends on the cash flow of its Subsidiaries to meet its obligations, including its obligations under the Notes. The Company s ability to make any cash payments to the holders of Notes may be limited by the Credit Agreements, each of which limits the ability of the Company s Restricted Subsidiaries to pay dividends or make other distributions to the Company. There can be no assurance that sufficient funds will be available when necessary to make any required cash payments. In addition, the Notes are effectively subordinated in right of payment to all Indebtedness and other liabilities and commitments (including trade payables and lease obligations) of the Company s Subsidiaries that are not Guarantors. On a pro forma basis after giving effect to the Transactions as of May 30, 2004, the Company s Subsidiaries that are not Guarantors would have had approximately $32.4 million of total liabilities, of which approximately $2.9 million was Secured Indebtedness, consisting entirely of borrowings under the Credit Agreements. As of the date hereof, all of our Subsidiaries are Restricted Subsidiaries. However, under the circumstances described below under the caption Certain Covenants Designation of Restricted and Unrestricted Subsidiaries beginning on page 169, we will be permitted to designate certain of our Subsidiaries as Unrestricted Subsidiaries. Our future Unrestricted Subsidiaries will not be subject to many of the restrictive covenants in the Indenture. Only Senior Indebtedness of the Company or a Guarantor will rank senior in right of payment to the Notes or the relevant Note Guarantee, respectively, in accordance with the provisions of the Indenture. The Notes and each Note Guarantee will rank pari passu in right of payment with all other Pari Passu Indebtedness of the Company and the relevant Guarantor, respectively, and senior in right of payment with all Subordinated Indebtedness of the Company and the relevant Guarantor, respectively. The Company may not pay principal of, premium (if any) or interest on, the Notes or make any deposit pursuant to the provisions described under Legal Defeasance and Covenant Defeasance beginning on page 172 below, and may not otherwise purchase, redeem or otherwise retire any Notes (except that holders may receive and retain (a) Permitted Junior Securities and (b) payments made from the trust described under Legal Defeasance and Covenant Defeasance beginning on page 172 below so long as, on the date or dates the respective amounts were paid into the trust, such payments were made with respect to the Notes without violating the subordination provisions described herein or any other material agreement binding on the Company, including the Credit Agreements) (collectively, pay the Notes ) if (i) a default in the payment of the principal of, premium, if any, or interest on any Designated Senior Indebtedness occurs and is continuing or any other amount owing in respect of any Designated Senior Indebtedness is not paid when due, or (ii) any other default on Designated Senior Indebtedness occurs and is continuing and the maturity of such Designated Senior Indebtedness is accelerated in accordance with its terms unless, in either case, the default has been cured or waived and any such acceleration has been rescinded or such Designated Senior Indebtedness has been paid in full. However, the Company may pay the Notes without regard to the foregoing if the Company and the trustee receive written notice approving such payment from the Representative of the Designated Senior Indebtedness with respect to which either of the events set forth in clause (i) or (ii) of the immediately preceding sentence has occurred and is continuing. During the continuance of any default (other than a default described in clause (i) or (ii) of the second preceding sentence) with respect to any Designated Senior Indebtedness pursuant to which the maturity thereof may be accelerated immediately without further notice (except such notice as may be required to effect such acceleration) or upon the expiration of any applicable grace periods, the Company may not pay the Notes for a period (a Payment Blockage Period ) commencing upon the receipt by the trustee (with a copy to the Company) of written notice (a Blockage Notice ) of such default from the Representative of the Designated Net sales $ $ $ 1,035,987 $ 38,362 $ $ 1,074,349 Costs and expenses: Cost of goods sold 898,375 33,389 931,764 Selling, general and administrative expenses 82,311 123 82,434 Third party interest, net 270 270 Other income (expense) (Gain) loss on sale of assets Corporate allocations: Selling, general and administrative expenses 2,950 110 3,060 Finance charges 3,982 Table of Contents Senior Indebtedness specifying an election to effect a Payment Blockage Period and ending 180 days thereafter (or earlier if such Payment Blockage Period is terminated (i) by written notice to the trustee and the Company from the Person or Persons who gave such Blockage Notice, (ii) by repayment in full of such Designated Senior Indebtedness or (iii) because the default giving rise to such Blockage Notice is no longer continuing). Notwithstanding the provisions described in the immediately preceding sentence (but subject to the provisions contained in the first sentence of this paragraph and in the succeeding paragraph), unless the holders of such Designated Senior Indebtedness or the Representative of such holders have accelerated the maturity of such Designated Senior Indebtedness, the Company may resume payments on the Notes after the end of such Payment Blockage Period. In no event may the total number of days during which any Payment Blockage Period or Periods is in effect exceed 180 days in the aggregate during any 360 consecutive day period. For purposes of this provision, no default or event of default that existed or was continuing on the date of the commencement of any Payment Blockage Period with respect to the Designated Senior Indebtedness initiating such Payment Blockage Period shall be, or be made, the basis of the commencement of a subsequent Payment Blockage Period by the Representative of such Designated Senior Indebtedness, unless such default or event of default shall have been cured or waived for a period of not less than 90 consecutive days. During any period in which payments on the Notes are prohibited or blocked in this manner, the Company and the Guarantors will be prohibited from making any payments in respect of the Notes and the Note Guarantees. During any period in which payments on the Notes are prohibited or blocked, all remedies under the Indenture will continue to be available to holders of Notes and Note Guarantees, subject to the provisions of the Indenture described under Acceleration Forebearance Period beginning on page 150. Upon any payment or distribution of the assets of the Company upon a total or partial liquidation or dissolution or reorganization of or similar proceeding relating to the Company or its property, the holders of Senior Indebtedness will be entitled to receive payment in full in cash of the Senior Indebtedness before the holders of the Notes are entitled to receive any payment with respect to the Notes and until the Senior Indebtedness is paid in full in cash, any payment or distribution to which holders of the Notes would be entitled but for the subordination provisions of the Indenture will be made to holders of the Senior Indebtedness as their interests may appear (except that holders of the Notes may receive and retain (i) Permitted Junior Securities and (ii) payments made from the trust described under Legal Defeasance and Covenant Defeasance beginning on page 172 so long as, on the date or dates the respective amounts were paid into the trust, such payments were made with respect to the Notes without violating the subordination provisions described herein or any other material agreement binding on the Company, including the Credit Agreements). If a distribution is made to holders of the Notes that, due to the subordination provisions of the Indenture, should not have been made to them, such holders of the Notes are required to hold it in trust for the holders of Senior Indebtedness and pay it over to them as their interests may appear. After the occurrence of an Event of Default, the Company shall promptly notify the holders of the Designated Senior Indebtedness (or their Representative) of such occurrence. If any Designated Senior Indebtedness is outstanding, the Company may not pay the Notes until five Business Days after such holders or the Representative of the Designated Senior Indebtedness receive notice of such occurrence and, thereafter, may pay the Notes only if the subordination provisions of the Indenture otherwise permit payment at that time. By reason of such subordination provisions contained in the Indenture, in the event of insolvency, creditors of the Company who are holders of Senior Indebtedness may recover more, ratably, than the holders of the Notes and, because of the obligation on the part of the holders of the Notes to turn over distributions to the holders of the Senior Indebtedness, to the extent required to pay Senior Indebtedness in full, trade creditors of the Company and Guarantors may recover more, ratably, than the holders of the Notes. The Indenture will contain identical subordination provisions relating to each Guarantor s obligations under its Note Guarantee. Table of Contents Acceleration Forbearance Period Until the earlier of (a) the date on which no Designated Senior Indebtedness (including any Guarantee of Designated Senior Indebtedness) shall be outstanding and (b) , 2009, if an Event of Default (other than an Event of Default described in clause (7) of the first paragraph under Events of Default and Remedies beginning on page 170) has occurred and is continuing, without in any way limiting the right of any holder to exercise any other remedy such holder may have (including the right to bring suit against the Company for payment of any and all amounts of principal, premium and interest due and payable), the principal of all the Notes may not be declared to be due and payable until the Acceleration Forbearance Period has expired. Acceleration Forbearance Period means the period commencing on the date when the trustee or the holders of at least 25% in principal amount of the Notes outstanding provide the Company with a notice of acceleration and expiring on the earliest of the date on which (a) 90 days shall have elapsed following the commencement of such Acceleration Forbearance Period, (b) any Designated Senior Indebtedness shall be due and payable in full, or shall have been declared to be due in full, or there shall have been a demand for payment in full thereof, or any enforcement or collection action shall have been commenced with respect thereto, (c) holders of any Indebtedness of the Company exceeding $10.0 million in the aggregate, shall have commenced any enforcement or collection action with respect to such Indebtedness and (d) an Event of Default described in clause (7) of the first paragraph under Events of Default and Remedies beginning on page 170 shall have occurred; provided, however, that if there has been any prior Acceleration Forbearance Period in the immediately preceding twelve-month period, the duration of the Acceleration Forbearance Period will be automatically reduced by the cumulative duration of all prior Acceleration Forbearance Periods that occurred during the preceding twelve-month period (it being understood that the Acceleration Forbearance Period may terminate immediately after commencing pursuant to this proviso). For the avoidance of doubt, the provisions set forth above shall not prevent the holders or the trustee from receiving payments on the Notes when due or exercising any other remedies under the Indenture while an Acceleration Forbearance Period is in effect. Note Guarantees Each direct and indirect Wholly-Owned Restricted Subsidiary that is also a Domestic Subsidiary and in existence on the date of the Indenture and certain future Subsidiaries of the Company (as described below), as primary obligors and not merely as sureties, will jointly and severally irrevocably and unconditionally Guarantee on an unsecured senior subordinated basis (as described under Ranking beginning on page 147 above) the performance and punctual payment when due, whether at Stated Maturity, by acceleration or otherwise, of all obligations of the Company under the Indenture and the Notes, whether for payment of principal of, premium, if any, or interest on the Notes, expenses, indemnification or otherwise (all such obligations guaranteed by such Guarantors being herein called the Guaranteed Obligations ). Such Guarantors will agree to pay, in addition to the amount stated above, any and all expenses (including reasonable counsel fees and expenses) incurred by the trustee or the holders in enforcing any rights under the Note Guarantees. Each Note Guarantee will be limited in amount to an amount not to exceed the maximum amount that can be guaranteed by the applicable Guarantor after giving effect to all of its other contingent and fixed liabilities (including, without limitation, all of its obligations under or with respect to the Credit Agreements) without rendering the Note Guarantee, as it relates to such Guarantor, voidable under applicable law relating to fraudulent conveyance or fraudulent transfer or similar laws affecting the rights of creditors generally. After the date of the Indenture, the Company will cause each Restricted Subsidiary that is also a Domestic Subsidiary to execute and deliver to the trustee a supplemental indenture pursuant to which such Restricted Subsidiary will guarantee payment of the Notes in the circumstances and subject to the exceptions described under Certain Covenants Limitations on Issuances of Guarantees of Indebtedness beginning on page 169 below and Certain Covenants Additional Guarantors beginning on page 169 below. Each Note Guarantee is a continuing Guarantee and shall, until released in accordance with the next succeeding paragraph, (i) remain in full force and effect until payment in full of all the Guaranteed Obligations, (ii) be binding upon each such Guarantor and its successors and (iii) inure to the benefit of, and be enforceable by, the trustee, the holders and their successors, transferees and assigns. Table of Contents The Note Guarantee of a Guarantor will be automatically and unconditionally released: (1) in connection with any sale or other disposition of all or substantially all of the assets of that Guarantor (including by way of merger or consolidation) to a Person that is not (either before or after giving effect to such transaction) the Company or a Restricted Subsidiary of the Company, if the sale or other disposition does not violate the Asset Sale provisions of the Indenture; (2) in connection with any sale or other disposition of all of the Capital Stock of that Guarantor to a Person that is not (either before or after giving effect to such transaction) the Company or a Restricted Subsidiary of the Company, if the sale or other disposition does not violate the Asset Sale provisions of the Indenture; (3) if the Company designates that Guarantor to be an Unrestricted Subsidiary in accordance with the applicable provisions of the Indenture; (4) unless such Note Guarantee would otherwise be required under the terms of the covenant described below under the caption Certain Covenants Additional Guarantors, beginning on page 169 upon the release or discharge of the Guarantee, if any, which resulted in the creation of such Note Guarantee pursuant to the terms of the covenant described below under the caption Certain Covenants Limitations on Issuances of Guarantees of Indebtedness, beginning on page 169 except a discharge or release by or as a result of payment under such Guarantee; or (5) upon legal defeasance or satisfaction and discharge of the Indenture as provided below under the captions Legal Defeasance and Covenant Defeasance beginning on page 172 and Satisfaction and Discharge beginning on page 175. Methods of Receiving Payments on the Notes The Indenture will require that payments in respect of the Notes issued in global form (including principal, premium, if any, and interest) be made by wire transfer of immediately available funds to the accounts specified by the nominee for DTC. With respect to certificated Notes, the Company will make all payments of principal, premium, if any, and interest by wire transfer of immediately available funds to the accounts specified by the holders thereof or, if no such account is specified, by mailing a check to each such holder s registered address. Paying Agent and Registrar for the Notes The trustee will initially act as paying agent and registrar. The Company may change the paying agent or registrar without prior notice to the holders of the Notes, and the Company or any of its Subsidiaries may act as paying agent or registrar. Transfer and Exchange A holder may transfer or exchange Notes in accordance with the provisions of the Indenture and applicable securities laws. Each of the Company, the registrar and the trustee may require a holder, among other things, to furnish appropriate endorsements and transfer documents in connection with a transfer or exchange of Notes. Holders will be required to pay all taxes and governmental or other fees due on transfer or exchange. The Company will not be required to transfer or exchange any Note selected for redemption. Also, the Company will not be required to transfer or exchange any Note for a period of 15 days before a selection of Notes to be redeemed. Mandatory Redemption The Company is not required to make mandatory redemption or sinking fund payments with respect to the Notes. Table of Contents Repurchase at the Option of Holders Change of Control If a Change of Control occurs, each holder of Notes will have the right to require the Company to repurchase all or any part (equal to $1,000 or an integral multiple of $1,000) of that holder s Notes pursuant to an offer (the Change of Control Offer ) on the terms set forth in the Indenture for a Change of Control Payment in cash equal to 101% of the aggregate principal amount of the Notes repurchased, plus accrued and unpaid interest on the Notes repurchased to the date of purchase, subject to the rights of holders of the Notes on the relevant record date to receive interest due on the relevant interest payment date. Within 45 days following any Change of Control, the Company will mail a notice to each holder describing the transaction or transactions that constitute the Change of Control and offering to repurchase the Notes on the Change of Control Payment Date specified in the notice, which date will be no earlier than the later of (a) the 51st day after the closing of this offering and (b) 30 days from the date such notice is mailed and no later than 60 days from the date such notice is mailed, pursuant to the procedures required by the Indenture and described in such notice. The Company will comply with the requirements of Rule 14e-1 under the Exchange Act and any other securities laws and regulations thereunder to the extent those laws and regulations are applicable in connection with the repurchase of the Notes pursuant to a Change of Control Offer. To the extent that the provisions of any securities laws or regulations conflict with the Change of Control provisions of the Indenture, the Company will comply with the applicable securities laws and regulations and will not be deemed to have breached its obligations under the Change of Control provisions of the Indenture by virtue of such compliance. On the Change of Control Payment Date, the Company will, to the extent lawful: (1) accept for payment all Notes or portions of Notes properly tendered pursuant to the Change of Control Offer; (2) deposit with the paying agent an amount equal to the Change of Control Payment in respect of all Notes or portions of Notes properly tendered; and (3) deliver or cause to be delivered to the trustee the Notes properly accepted together with an officers certificate stating the aggregate principal amount of Notes or portions of Notes being purchased by the Company. To participate in a Change of Control Offer, a holder of IDSs must separate its IDSs into shares of Common Stock and Notes. The paying agent will promptly mail to each holder of Notes properly tendered the Change of Control Payment for such Notes, and the trustee will promptly authenticate and mail (or cause to be transferred by book entry) to each holder a new Note equal in principal amount to any unpurchased portion of the Notes surrendered, if any; provided that each new Note will be in a principal amount of $1,000 or an integral multiple of $1,000. The provisions described above that require the Company to make a Change of Control Offer following a Change of Control will be applicable whether or not any other provisions of the Indenture are applicable. Except as described above with respect to a Change of Control, the Indenture will not contain provisions that permit the holders of the Notes to require that the Company repurchase or redeem the Notes in the event of a takeover, recapitalization or similar transaction. The Company will not be required to make a Change of Control Offer upon a Change of Control if (1) a third party makes the Change of Control Offer in the manner, at the times and otherwise in compliance with the requirements set forth in the Indenture applicable to a Change of Control Offer made by the Company and purchases all Notes properly tendered and not withdrawn under the Change of Control Offer, or (2) notice of redemption has been given pursuant to the Indenture as described above under the caption Optional Redemption, beginning on page 146 unless and until there is a default in payment of the applicable redemption price. Table of Contents The Company has no present intention to engage in a transaction involving a Change of Control, although it is possible that the Company could decide to do so in the future. The Company could, in the future, enter into certain transactions, including acquisitions, refinancings or other recapitalizations, that would not constitute a Change of Control under the Indenture, but that could increase the amount of Indebtedness outstanding at such time or otherwise affect the Company s capital structure or credit ratings. The trustee will not be able to waive the covenant relating to a holder s right to redemption upon a Change of Control. However, it will be possible for the covenant and other provisions contained in the Indenture relating to the Company s obligation to make a Change of Control Offer to be waived or modified with the written consent of the holders of a majority in principal amount of the Notes. In addition, while restrictions in the Indenture may prohibit certain arrangements that have traditionally been used to effect highly leveraged transactions, the Indenture may not afford holders of the Notes protection in all circumstances from the adverse aspects of a highly leveraged transaction, reorganization, restructuring, merger or similar transaction. The definition of Change of Control includes a phrase relating to the direct or indirect sale, lease, transfer, conveyance or other disposition of all or substantially all of the properties or assets of the Company and its Subsidiaries taken as a whole. Although there is a limited body of case law interpreting the phrase substantially all, there is no precise established definition of the phrase under applicable law. Accordingly, the ability of a holder of the Notes to require the Company to repurchase its Notes as a result of a sale, lease, transfer, conveyance or other disposition of less than all of the assets of the Company and its Subsidiaries taken as a whole to another Person or group may be uncertain. The Credit Agreements will prohibit the Company from voluntarily purchasing any Notes prior to their stated maturity. The Credit Agreements will provide that the occurrence of any of the events that would constitute a Change of Control would also constitute a change of control under the Credit Agreement, which would result in all debt thereunder becoming due and payable. Other future debt of the Company may contain prohibitions of any events that would constitute a Change of Control or require such debt to be repurchased upon a Change of Control. The exercise by holders of the Notes of their right to require the Company to repurchase such Notes following a Change of Control could cause a default under existing or future debt of the Company, even if the Change of Control itself does not, due to the financial effect of such repurchase on the Company. Furthermore, the Company s ability to pay cash to holders of Notes upon a repurchase following a Change of Control may be limited by the Company s then existing financial resources. There can be no assurance that sufficient funds will be available when necessary to make any required repurchases. The Company s failure to purchase Notes in connection with a Change of Control would result in a default under the Indenture which would, in turn, constitute a default under existing (and may constitute a default under future) debt of the Company. The provisions under the Indenture relative to the Company s obligation to make an offer to repurchase the Notes as a result of a Change of Control may be waived or modified (at any time prior to the occurrence of such Change of Control) with the written consent of the holders of a majority in principal amount of the Notes. See Amendment, Supplement and Waiver beginning on page 173. Asset Sales The Company will not, and will not permit any of its Restricted Subsidiaries to, consummate an Asset Sale unless: (1) the Company (or the Restricted Subsidiary, as the case may be) receives consideration at the time of the Asset Sale at least equal to the Fair Market Value (as determined in good faith by the Company s senior management or, in the case of an Asset Sale in excess of $5.0 million, the Company s Board of Directors) of the assets or Equity Interests issued or sold or otherwise disposed of; and (2) at least 75% of the consideration received in the Asset Sale by the Company or such Restricted Subsidiary is in the form of cash or Cash Equivalents. For purposes of this provision, each of the following will be deemed to be cash: (a) any liabilities, as shown on the Company s most recent consolidated balance sheet, of the Company or any Restricted Subsidiary (other than contingent liabilities for which a reserve has Participating preferred stock: Basic Table of Contents not been established in accordance with GAAP and which are not otherwise quantifiable and liabilities that are by their terms subordinated to the Notes or any Note Guarantees) that are assumed by the transferee of any such assets; (b) any securities, Notes, other obligations or other assets received by the Company or any such Restricted Subsidiary from such transferee that are converted by the Company or such Restricted Subsidiary into cash within 180 days after such Asset Sale, to the extent of the cash received in that conversion; and (c) any stock or assets of the kind referred to in clauses (3) or (5) of the next paragraph of this covenant. Within 365 days after the receipt of any Net Proceeds from an Asset Sale, the Company (or the applicable Restricted Subsidiary, as the case may be) may apply such Net Proceeds at its option: (1) to repay Senior Indebtedness and Secured Indebtedness of the Company and the Guarantors and other secured Obligations under Credit Facilities and, if the Indebtedness repaid is revolving credit Indebtedness, to correspondingly reduce commitments with respect thereto; (2) to repay or repurchase Indebtedness of the Company s Restricted Subsidiaries that are not Guarantors and, if the Indebtedness repaid is revolving credit Indebtedness, to correspondingly reduce commitments with respect thereto; provided that if an offer to repay or repurchase any Indebtedness of any such Restricted Subsidiary of the Company is made in accordance with the terms of such Indebtedness, the obligation to permanently reduce Indebtedness of such Restricted Subsidiary will be deemed to be satisfied to the extent of the amount of the offer, whether or not accepted by the holders thereof, and no Excess Proceeds (as defined below) in the amount of such offer will be deemed to exist following such offer; (3) to acquire all or substantially all of the assets of, or any Capital Stock of, another Permitted Business, if, after giving effect to any such acquisition of Capital Stock, the Permitted Business is or becomes a Restricted Subsidiary of the Company; (4) to make capital expenditures; (5) to acquire other assets that are used or useful in a Permitted Business; or (6) to do any combination of the foregoing. Pending the final application of any Net Proceeds, the Company may temporarily reduce revolving credit borrowings or otherwise invest the Net Proceeds in any manner that is not prohibited by the Indenture. Any Net Proceeds from Asset Sales that are not applied or invested as provided in the second paragraph of this covenant will constitute Excess Proceeds. When the aggregate amount of Excess Proceeds exceeds $10.0 million, within five days thereof, the Company will make an offer (an Asset Sale Offer ) to all holders of the Notes and, at the option of the Company, all holders of other Pari Passu Indebtedness to purchase the maximum principal amount of Notes and such other Pari Passu Indebtedness, if applicable, that may be purchased out of the Excess Proceeds. The offer price in any Asset Sale Offer will be equal to 100% of the aggregate principal amount of the Notes on the date of purchase plus accrued and unpaid interest, if any, to the date of purchase, which price will be payable in cash. If any Excess Proceeds remain after consummation of an Asset Sale Offer, the Company may use those Excess Proceeds for any purpose not otherwise prohibited by the Indenture. If the aggregate principal amount of Notes and other Pari Passu Indebtedness tendered into such Asset Sale Offer exceeds the amount of Excess Proceeds, the Notes and such other Pari Passu Indebtedness will be purchased on a pro rata basis. Upon completion of each Asset Sale Offer, the amount of Excess Proceeds will be reset at zero. To participate in an Asset Sale Offer, a holder of IDSs must separate its IDSs into shares of Common Stock and Notes. Table of Contents The Company will comply with the requirements of Rule 14e-1 under the Exchange Act and any other securities laws and regulations thereunder to the extent those laws and regulations are applicable in connection with each repurchase of Notes pursuant to an Asset Sale Offer. To the extent that the provisions of any securities laws or regulations conflict with the Asset Sale provisions of the Indenture, the Company will comply with the applicable securities laws and regulations and will not be deemed to have breached its obligations under the Asset Sale provisions of the Indenture by virtue of such compliance. The covenant and other provisions contained in the Indenture relating to the Company s obligation to make an Asset Sale Offer may be waived or modified with the written consent of the holders of a majority in principal amount of the Notes. The agreements governing the Company s other Indebtedness contain, and future agreements may contain, prohibitions of certain events, including events that would constitute an Asset Sale and including repurchases of or other prepayments in respect of the Notes. The exercise by holders of the Notes of their right to require the Company to repurchase the Notes upon an Asset Sale could cause a default under these other agreements, even if the Asset Sale itself does not, due to the financial effect of such repurchases on the Company. In the event an Asset Sale occurs at a time when the Company is prohibited from purchasing the Notes, the Company could seek the consent of its senior lenders to the purchase of the Notes or could attempt to refinance the borrowings that contain such prohibition. If the Company does not obtain a consent or repay those borrowings, the Company will remain prohibited from purchasing the Notes. In that case, the Company s failure to purchase tendered Notes would constitute an Event of Default under the Indenture which could, in turn, constitute a default under the other indebtedness. Finally, the Company s ability to pay cash to holders of the Notes upon a repurchase may be limited by the Company s then-existing financial resources. There can be no assurance that sufficient funds will be available when necessary to make any required repurchases. See Risk Factors We may not be able to repurchase the senior subordinated notes upon a change of control beginning on page 38. Selection and Notice If less than all of the Notes are to be redeemed at any time, the trustee will select Notes for redemption as follows: (1) if the Notes are listed on any national securities exchange, in compliance with the requirements of the principal national securities exchange on which the Notes are listed; or (2) if the Notes are not listed on any national securities exchange, on a pro rata basis, by lot or by such method as the trustee deems fair and appropriate. No Notes having a principal amount of $1,000 or less can be redeemed in part. Notices of redemption will be mailed by first class mail at least 30 but not more than 60 days before the redemption date to each holder of Notes to be redeemed at its registered address, except that, notwithstanding anything to the contrary herein, redemption notices may be mailed more than 60 days prior to a redemption date if the notice is issued in connection with a defeasance of the Notes or a satisfaction and discharge of the Indenture. Notices of redemption may not be conditional. No Note will be redeemed in part unless all other Notes are also redeemed in part on a pro rata basis. If any Note is to be redeemed in part only, the notice of redemption that relates to that Note will state the portion of the principal amount of that Note that is to be redeemed. A new Note in principal amount equal to the unredeemed portion of the original Note will be issued in the name of the holder of such Note upon cancellation of the original Note. Notes called for redemption become due on the date fixed for redemption. On and after the redemption date, interest shall cease to accrue on the Notes or portions of Notes called for redemption. Covenants Relating to IDSs Recombination of Notes and Common Stock into IDSs. The Indenture will provide that as long as any Notes are outstanding, any holder of the Notes and shares of Common Stock may after 45 days from the date of the Indenture, at any time and from time to time, recombine these securities to form IDSs unless the IDSs have previously been automatically separated as a result of the redemption or maturity of any Notes. Table of Contents Procedures Relating to Subsequent Issuance. The Indenture will provide that, if there is a subsequent issuance of Additional Notes having identical terms as the Notes issued on the date of the Indenture but issued with OID, including an issuance upon a conversion of Participating Preferred Stock, each holder of the Notes or the IDSs (as the case may be) agrees that a portion of such holder s Notes (whether held directly in book-entry form or held as part of IDSs) will be exchanged, without any further action of such holder, for a portion of the Additional Notes purchased by the holders of such Additional Notes, such that following any such additional issuance and exchange each holder of the Notes or the IDSs (as the case may be) owns an indivisible unit composed of the Notes and Additional Notes of each issuance in the same proportion as each other holder, and the records of DTC and the trustee will be revised to reflect each such exchange without any further action of such holder. The aggregate principal amount of the Notes owned by each holder will not change as a result of such exchange. Any Additional Notes will be guaranteed by the Guarantors on the same basis as the Notes. See Material U.S. Federal Income Tax Consequences Consequences to U.S. Holders-Senior Subordinated Notes-Additional Issuances beginning on page 203. There is a possibility that holders of subsequently issued Additional Notes having original issue discount may not be able to collect the unamortized portion of the original issue discount in the event of an acceleration of the Notes or bankruptcy of the Company as described under Risk Factors-Risks Relating to the IDSs, the Shares of Common Stock and Senior Subordinated Notes-Subsequent issuances of senior subordinated notes may cause you to recognize OID and may be treated as a taxable exchange by you beginning on page 35. Any such automatic exchange of the senior subordinated notes should not impair the rights any holder would otherwise have to assert a claim under applicable securities laws against the underwriters or the Company with respect to the full amount of the senior subordinated notes purchased by such holder, including senior subordinated notes purchased in this offering and senior subordinated notes received by such holder in an automatic exchange. See Description of Income Deposit Securities (IDSs) Clearance and Settlement Procedures Relating to Subsequent Issuances beginning on page 137. Certain Covenants Restricted Payments The Company will not, and will not permit any of its Restricted Subsidiaries to, directly or indirectly: (1) declare or pay any dividend or make any other payment or distribution on account of the Company s or any of its Restricted Subsidiaries Equity Interests (including, without limitation, any payment in connection with any merger or consolidation involving the Company) or to the direct or indirect holders of the Company s Equity Interests in their capacity as such (other than (i) dividends or distributions payable in Equity Interests (other than Disqualified Stock) of the Company and (ii) dividends or distributions by a Restricted Subsidiary, provided that, in the case of any dividend or distribution payable on or in respect of any class or series of securities issued by a Restricted Subsidiary other than a Wholly-Owned Restricted Subsidiary, the Company or a Restricted Subsidiary receives at least its pro rata share of such dividend or distribution in accordance with its Equity Interests in such class or series of securities); (2) purchase, redeem or otherwise acquire or retire for value (including, without limitation, in connection with any merger or consolidation involving the Company) any Equity Interests of the Company, any direct or indirect parent of the Company or any Restricted Subsidiary of the Company (other than any such Equity Interests owned by the Company or any Restricted Subsidiary of the Company); (3) make any principal payment on or with respect to, or purchase, redeem, defease or otherwise acquire or retire for value any Subordinated Indebtedness of the Company or any Guarantor (excluding any intercompany Indebtedness between or among the Company and any of its Restricted Subsidiaries), except a payment of principal at the Stated Maturity thereof; or (4) make any Restricted Investment (all such payments and other actions set forth in these clauses (1) through (4) above being collectively referred to as Restricted Payments ), unless, at the time of and after giving effect to such Restricted Payment: (1) no Default or Event of Default has occurred and is continuing or would occur as a consequence of such Restricted Payment; Table of Contents (2) the Company would, at the time of such Restricted Payment and after giving pro forma effect thereto as if such Restricted Payment had been made at the beginning of the applicable four-quarter period, have been permitted to incur at least $1.00 of additional Indebtedness pursuant to the Fixed Charge Coverage Ratio test set forth in clause (i) of the first paragraph of the covenant described below under the caption Incurrence of Indebtedness and Issuance of Disqualified Stock beginning on page 161; and (3) such Restricted Payment, together with the aggregate amount of all other Restricted Payments made by the Company and its Restricted Subsidiaries since the date of the Indenture (excluding Restricted Payments permitted by clauses (2), (3), (5), (7), (10), (11), (12), (13), (17) and (18) of the next succeeding paragraph), is less than the sum, without duplication, of: (a) 50% of the Consolidated Net Income of the Company for the period (taken as one accounting period) from the first day of the fiscal quarter that includes the date of the Indenture to the date on which such Restricted Payment occurs or, if Consolidated Net Income is not reasonably determinable to such date, to the end of the Company s most recently ended fiscal period for which internal financial statements are available at the time of such Restricted Payment (or, if such Consolidated Net Income for such period is a deficit, less 100% of such deficit), plus (b) 100% of the aggregate net cash proceeds, and the Fair Market Value of property other than cash, received by the Company since the date of the Indenture as a contribution to its common equity capital or from the issue or sale of Equity Interests of the Company (other than Disqualified Stock) or from the issue or sale of Disqualified Stock or debt securities of the Company that have been converted into or exchanged for such Equity Interests (other than Equity Interests (or Disqualified Stock or debt securities) sold to a Subsidiary of the Company) less any Excluded Contributions, plus (c) 50% of any dividends or distributions received by the Company or a Restricted Subsidiary of the Company after the date of the Indenture from an Unrestricted Subsidiary of the Company, to the extent that such dividends were not otherwise included in Consolidated Net Income of the Company for such period, plus (d) the net cash proceeds, and the Fair Market Value of property other than cash, received by the Company or any of its Restricted Subsidiaries from the sale or other disposition (other than to the Company or a Subsidiary of the Company) of any Restricted Investment made after the date of the Indenture and repurchases and redemptions of such a Restricted Investment by any Person (other than the Company or a Subsidiary of the Company) and repayments of loans or advances that constituted such a Restricted Investment by any Person (other than the Company or a Subsidiary of the Company), plus (e) to the extent that any Unrestricted Subsidiary of the Company designated as such after the date of the Indenture is redesignated as a Restricted Subsidiary or merges or consolidates with or into, or transfers or conveys its assets to, or is liquidated into, the Company or any of its Restricted Subsidiaries, in each case after the date of the Indenture, the Fair Market Value of the Company s Investment in such Subsidiary as of the date of such redesignation, merger, consolidation, transfer, conveyance or liquidation. The preceding provisions will not prohibit: (1) the payment of any dividend or distribution or the consummation of any irrevocable redemption within 60 days after the date of declaration of the dividend or distribution or giving of the redemption notice, as the case may be, if at the date of declaration or notice, the dividend, distribution or redemption payment would have complied with the provisions of the Indenture; (2) so long as no Default has occurred and is continuing or would be caused thereby, the making of any Restricted Payment in exchange for, or out of the net cash proceeds of the sale within 30 days (other Table of Contents than to a Subsidiary of the Company) of, Equity Interests of the Company (other than Disqualified Stock) or from the contribution within 30 days of common equity capital to the Company; provided that the amount of any such net cash proceeds that are utilized for any such Restricted Payment will be excluded from clause (3)(b) of the preceding paragraph; (3) so long as no Default has occurred and is continuing or would be caused thereby, the repurchase, redemption, defeasance or other acquisition or retirement for value of Subordinated Indebtedness of the Company or any Guarantor with the net cash proceeds from and/or in exchange for, an incurrence within 30 days of Permitted Refinancing Indebtedness and, only in the case of Subordinated Indebtedness of any Guarantor, with the net cash proceeds from and/or in exchange for Equity Interests (other than Disqualified Stock) of such Guarantor; (4) so long as no Default has occurred and is continuing or would be caused thereby, the repurchase, redemption or other acquisition or retirement for value by the Company or any of its Restricted Subsidiaries of (and/or the making of payments on Indebtedness previously issued by the Company representing the consideration for the previous repurchase of) any Equity Interests of the Company or any of its Restricted Subsidiaries held by any current, future or former officer, director, employee or consultant of the Company or any Subsidiary of the Company or their authorized representatives (x) upon the death, disability or termination of employment of such officer, director, employee or consultant or to the extent required pursuant to employee benefit plans, employment agreements or consulting agreements or (y) pursuant to any other agreements with such officer, director, employee or consultant; provided that the aggregate price paid for all such repurchased, redeemed, acquired or retired Equity Interests may not exceed $2.5 million in any calendar year (with unused amounts in any calendar year being carried over to the four succeeding calendar years); provided further, that such amount in any calendar year may be increased by an amount not to exceed (a) the cash proceeds received by the Company or any Restricted Subsidiary of the Company from sales of Equity Interests (other than Disqualified Stock) of the Company or United Agri Products to officers, directors, employees or consultants of the Company and the Restricted Subsidiaries of the Company that occur after the date of the Indenture (provided that the amount of such cash proceeds utilized for any such repurchase, redemption, acquisition or retirement will not increase the amount available for Restricted Payments under clause (3)(b) of the preceding paragraph), plus (b) the cash proceeds of key man life insurance policies received by the Company or any Restricted Subsidiary of the Company after the date of the Indenture (provided that the Company may elect to apply all or any portion of the aggregate increase contemplated by clauses (a) and (b) above in any calendar year); provided, still further, that the cancellation of Indebtedness owing to the Company or any Restricted Subsidiary of the Company from such officers, directors, employees or consultants in connection with a repurchase of Equity Interests of the Company or any Restricted Subsidiary of the Company will not be deemed to constitute a Restricted Payment under the Indenture; (5) the repurchase of Equity Interests deemed to occur upon the exercise of stock options, warrants or other convertible securities to the extent such Equity Interests represent a portion of the exercise price of those stock options, warrants or other convertible securities; (6) so long as no Default has occurred and is continuing or would be caused thereby, the declaration and payment of regularly scheduled or accrued dividends to (a) holders of any class or series of Disqualified Stock of the Company or any class or series of Disqualified Stock or preferred stock of any Restricted Subsidiary of the Company issued on or after the date of the Indenture in accordance with the first paragraph of the covenant described below under the caption Incurrence of Indebtedness and Issuance of Disqualified Stock beginning on page 161 and (b) holders of any class or series of preferred stock (other than Disqualified Stock) of the Company issued after the date of the Indenture; provided that at the time of such issuance and after giving pro forma effect thereto, the Company would have been able to incur at least $1.00 of additional Indebtedness pursuant to the Fixed Charge Coverage Ratio test set forth in the first paragraph of the covenant described below under the caption Incurrence of Indebtedness and Issuance of Disqualified Stock beginning on page 161; Table of Contents (7) Permitted Payments to Parent; (8) other Restricted Payments in an aggregate amount not to exceed $25.0 million since the date of the Indenture; (9) so long as no Default has occurred and is continuing or would be caused thereby, payments or distributions to dissenting stockholders pursuant to applicable law, pursuant to or in connection with a consolidation, merger or transfer of assets that complies with the provisions of the Indenture applicable to mergers, consolidations and transfers of all or substantially all of the property and assets of the Company; (10) Investments that are made with Excluded Contributions; (11) payments made by the Company to satisfy the Company s obligations under the Stock Purchase Agreement, as such agreement is in effect on the date of the Indenture, as amended from time to time so long as such amendment is in the good faith judgment of the Board of Directors of the Company not more disadvantageous to the holders of the Notes in any material respect than such agreement as in effect on the date of the Indenture; (12) (a) the acquisition of any shares of Disqualified Stock of the Company either: (i) solely in exchange for shares of Disqualified Stock of the Company or (ii) through the application of the net proceeds of a substantially concurrent sale for cash (other than to a Subsidiary of the Company) of shares of Disqualified Stock of the Company; provided that the amount of any such net proceeds that are utilized for any such acquisition will be excluded from clause (3)(b) of the preceding paragraph; or (b) the acquisition of any shares of Disqualified Stock of any Restricted Subsidiary of the Company either: (i) solely in exchange for shares of Disqualified Stock of such Restricted Subsidiary or (ii) through the application of the net proceeds of a substantially concurrent sale for cash (other than to the Company or a Subsidiary of the Company) of shares of Disqualified Stock of such Restricted Subsidiary; provided that the amount of any such net proceeds that are utilized for any such acquisition will be excluded from clause (3)(b) of the preceding paragraph; (13) so long as no Default has occurred and is continuing or would be caused thereby, the repurchase, redemption or other acquisition or retirement for value of Subordinated Indebtedness (a) with Excess Proceeds to the extent such Excess Proceeds are permitted to be used for general corporate purposes under the covenant described above under the caption Repurchase at the Option of Holders Asset Sales beginning on page 153 or (b) with, after the completion of a Change in Control Offer pursuant to the terms of the covenant described above under the caption Repurchase at the Option of Holders Change of Control beginning on page 152 cash offered to redeem Notes pursuant to such Change of Control Offer less any cash paid to holders of the Notes pursuant to such Change in Control Offer; (14) so long as no Default or Event of Default has occurred and is continuing or would be caused thereby, payments of cash in lieu of the issuance of fractional shares upon the exercise of warrants or options or upon the conversion or exchange of, or issuance of Capital Stock in lieu of cash dividends on, any Capital Stock of the Company; (15) so long as no Default or Event of Default has occurred and is continuing or would be caused thereby, (i) the payment of dividends on the Participating Preferred Stock to the extent such dividends have a preference over dividends on the Company s Common Stock and payments with respect to vested options to acquire Participating Preferred Stock outstanding on the date of the Indenture (to the extent such payments correspond to dividends on Participating Preferred Stock that have a preference over Table of Contents dividends on the Company s Common Stock) and (ii) the payment of dividends on the Participating Preferred Stock to the extent such dividends do not have a preference over dividends on the Company s Common Stock and dividends on the shares of the Company s Common Stock and payments with respect to vested options to acquire Participating Preferred Stock outstanding on the date of the Indenture (to the extent such payments correspond to dividends on Participating Preferred Stock that do not have a preference over dividends on the Company s Common Stock) up to an aggregate amount in any fiscal quarter not to exceed the Quarterly Base Dividend Level; provided, that the Company may not pay any dividends or make payments with respect to vested options to acquire Participating Preferred Stock pursuant to this clause (15) or clause (16) below if interest on the Notes is being deferred or, after the end of any interest deferral period, so long as any deferred interest and interest on deferred interest has not been paid in full; provided further that if at any time the Company s Fixed Charge Coverage Ratio for the Company s most recently ended four full fiscal quarters for which internal financial statements are available is less than 1.6 to 1, the Company may not declare or pay dividends or make payments with respect to vested options to acquire Participating Preferred Stock pursuant to clause (ii) of this clause (15) and clause (16) below other than, subject to the previous proviso, dividends and payments in an aggregate amount after the Issue Date not to exceed $10 million; (16) so long as no Default or Event of Default has occurred and is continuing or would be caused thereby, other Restricted Payments, taken together with all other Restricted Payments made since the date of the indenture pursuant to this clause (16), in an aggregate amount not to exceed the Base Dividend Restricted Payments Basket; (17) the repurchase of shares of the Company s Series A Redeemable Preferred Stock, the transactions contemplated by the Management Incentive Agreement and the Recapitalization Agreement and the payment of the Transaction Fee; or (18) the acquisition of shares of the Participating Preferred Stock upon the conversion into IDSs or Notes and shares of common stock at any time; provided that, in the case of a conversion other than an Extraordinary Conversion, the Conversion Conditions are satisfied; provided further that such conversion will not increase the amount available for Restricted Payments under clause (3)(b) of the preceding paragraph. The amount of all Restricted Payments (other than cash) will be the Fair Market Value on the date of the Restricted Payment of the asset(s) or securities proposed to be transferred or issued by the Company or such Restricted Subsidiary, as the case may be, pursuant to the Restricted Payment. The Fair Market Value of any assets or securities that are required to be valued by this covenant will be determined in good faith by the Company and (a) in the case of assets or securities with a Fair Market Value in excess of $10 million, shall be set forth in an officer s certificate delivered to the trustee or (b) in the case of assets or securities with a Fair Market Value in excess of $20 million, shall be set forth in a resolution adopted by the Board of Directors of the Company, whose resolution with respect thereto will be delivered to the trustee. For purposes of determining compliance with this covenant, if a Restricted Payment meets the criteria of more than one of the exceptions described in clauses (1) through (18) above or is entitled to be made according to the first paragraph of this covenant, the Company may, in its sole discretion, classify the Restricted Payment in any manner that complies with this covenant. Table of Contents Incurrence of Indebtedness and Issuance of Disqualified Stock The Company will not, and will not permit any of its Restricted Subsidiaries to, directly or indirectly, create, incur, issue, assume, Guarantee or otherwise become directly or indirectly liable, contingently or otherwise, with respect to (collectively, incur ) any Indebtedness (including Acquired Debt), and the Company will not, and will not permit any of its Restricted Subsidiaries to issue any Disqualified Stock; provided, however, that the Company and the Guarantors may incur Indebtedness (including Acquired Debt) or issue Disqualified Stock, and the Restricted Subsidiaries of the Company that are not Guarantors may incur Indebtedness (including Acquired Debt) or issue Disqualified Stock in an aggregate amount not to exceed $50.0 million, if the Fixed Charge Coverage Ratio for the Company s most recently ended four full fiscal quarters for which internal financial statements are available immediately preceding the date on which such additional Indebtedness is incurred or such Disqualified Stock is issued, as the case may be, would have been at least 2.0 to 1, determined on a pro forma basis (including a pro forma application of the net proceeds therefrom), as if the additional Indebtedness had been incurred or the Disqualified Stock had been issued, as the case may be, and the application of proceeds therefrom had occurred at the beginning of such four-quarter period. The first paragraph of this covenant will not prohibit the incurrence of any of the following items of Indebtedness (collectively, Permitted Debt ): (1) the incurrence by the Company, the Guarantors and other Restricted Subsidiaries as of the date of the Indenture of additional Indebtedness and letters of credit under Credit Facilities in an aggregate principal amount at any one time outstanding under this clause (1) (with letters of credit being deemed to have a principal amount equal to the face amount thereof) not to exceed (A) $165.0 million plus (B) the greater of (x) $500.0 million or (y) the amount of the Borrowing Base, in each case less the amount of any Indebtedness outstanding under clause (12) below and in the case of clause (A) less the aggregate amount of all Net Proceeds of Asset Sales applied by the Company or any of its Restricted Subsidiaries since the date of the Indenture to repay any term Indebtedness under a Credit Facility pursuant to the covenant described above under the caption Repurchase at the Option of Holders Asset Sales beginning on page 153, and in the case of clause (B) less the aggregate amount of all Net Proceeds of Asset Sales applied by the Company or any of its Restricted Subsidiaries since the date of the Indenture to repay any revolving credit Indebtedness under a Credit Facility and effect a corresponding commitment reduction thereunder pursuant to such covenant; provided that the amount of Indebtedness permitted to be incurred pursuant to the Credit Agreements in accordance with this clause (1) shall be in addition to any Indebtedness to be incurred pursuant to the Credit Agreements in reliance on and in accordance with clauses (4) and (13) below; (2) the incurrence by the Company and its Restricted Subsidiaries of the Existing Indebtedness; (3) the incurrence by the Company and the Guarantors of Indebtedness represented by the Notes and the related Note Guarantees to be issued (i) on the date of the Indenture and (ii) pursuant to the exercise by the underwriters of their over-allotment option in connection with this offering; (4) the incurrence by the Company or any of its Restricted Subsidiaries of (a) Indebtedness, including Capital Lease Obligations, mortgage financings or purchase money obligations, in each case incurred for the purpose of financing all or any part of the purchase price or cost of design, construction, installation or improvement of property (real or personal), plant or equipment used in the business of the Company or any of its Restricted Subsidiaries or (b) Acquired Debt, in an aggregate principal amount, including all Permitted Refinancing Indebtedness incurred to renew, refund, refinance, replace, defease or discharge any Indebtedness incurred pursuant to this clause (4), not to exceed $30.0 million at any time outstanding; provided that all or a portion of the $30.0 million permitted to be incurred under this clause (4) may, at the option of the Company, be incurred under Credit Facilities (in addition to the amount that would otherwise be permitted to be incurred under clause (1) above) or clause (13) below (in addition to the amount set forth therein); Table of Contents (5) the incurrence by the Company or any of its Restricted Subsidiaries of Permitted Refinancing Indebtedness in exchange for, or the net proceeds of which are used to renew, refund, refinance, replace, defease or discharge any Indebtedness (other than intercompany Indebtedness) that was permitted by the Indenture to be incurred under the first paragraph of this covenant or clauses (2), (3), (4), (5), (13) or (19) of this paragraph; (6) the incurrence by the Company or any of its Restricted Subsidiaries of intercompany Indebtedness between or among the Company and any of its Restricted Subsidiaries; provided, however, that: (a) if the Company or any Guarantor is the obligor on such Indebtedness and the payee is not the Company or any Guarantor, such Indebtedness must be expressly subordinated to the prior payment in full in cash of all Obligations then due with respect to the Notes in the case of the Company, or the Note Guarantees in the case of a Guarantor; and (b) (i) any subsequent issuance or transfer of Equity Interests that results in any such Indebtedness being held by a Person other than (x) the Company, (y) a Restricted Subsidiary of the Company or (z) the lenders or collateral agent under any Credit Facility if such issuance or transfer is in connection with a foreclosure on the collateral securing the Credit Facility and (ii) any sale or other transfer of any such Indebtedness to a Person that is not either (x) the Company, (y) a Restricted Subsidiary of the Company or (z) the lenders or collateral agent under any Credit Facility if such sale or transfer is in connection with a foreclosure on the collateral securing the Credit Facility, will be deemed, in each case, to constitute an incurrence of such Indebtedness by the Company or such Restricted Subsidiary, as the case may be, that was not permitted by this clause (6); (7) the issuance by any of the Company s Restricted Subsidiaries to the Company or to any of its Restricted Subsidiaries of shares of Disqualified Stock; provided, however, that: (a) any subsequent issuance or transfer of Equity Interests that results in any such Disqualified Stock being held by a Person other than (x) the Company, (y) a Restricted Subsidiary of the Company or (z) the lenders or collateral agent under any Credit Facility if such issuance or transfer is in connection with a foreclosure on the collateral securing the Credit Facility; and (b) any sale or other transfer of any such Disqualified Stock to a Person that is not either (x) the Company, (y) a Restricted Subsidiary of the Company or (z) the lenders or collateral agent under any Credit Facility if such sale or transfer is in connection with a foreclosure on the collateral securing the Credit Facility; will be deemed, in each case, to constitute an issuance of such Disqualified Stock by such Restricted Subsidiary that was not permitted by this clause (7); (8) the incurrence by the Company or any of its Restricted Subsidiaries of Hedging Obligations in the ordinary course of business; (9) the Guarantee by (a) the Company or any of the Guarantors of Indebtedness of the Company or a Guarantor or (b) any Restricted Subsidiary of the Company that is not a Guarantor of any Indebtedness of the Company or a Restricted Subsidiary of the Company, in each case that was permitted to be incurred by another provision of this covenant; provided that if the Indebtedness being guaranteed is subordinated to or pari passu with the Notes, then the Guarantee shall be subordinated or pari passu, as applicable, to the same extent as the Indebtedness guaranteed; (10) the incurrence by the Company or any of its Restricted Subsidiaries of Indebtedness constituting reimbursement obligations with respect to letters of credit issued in the ordinary course of business and other Indebtedness in respect of workers compensation claims, self-insurance obligations, bankers acceptances, performance, bid and surety bonds and completion guarantees provided by the Company or any Restricted Subsidiary in the ordinary course of business; Diluted Table of Contents (11) the incurrence by the Company or any of its Restricted Subsidiaries of Indebtedness arising from the honoring by a bank or other financial institution of a check, draft or similar instrument drawn against insufficient funds, so long as such Indebtedness is extinguished within five business days; (12) the incurrence by a Receivables Subsidiary of Indebtedness in a Qualified Receivables Transaction that is without recourse to the Company or to any Restricted Subsidiary of the Company or their assets (other than such Receivables Subsidiary and its assets and, as to the Company or any Restricted Subsidiary of the Company, other than pursuant to representations, warranties, covenants and indemnities customary for such transactions) and is not guaranteed by any such Person; (13) the incurrence by the Company or any of its Restricted Subsidiaries of additional Indebtedness, and the issuance by the Company or any of its Restricted Subsidiaries of Disqualified Stock, in an aggregate amount (or accreted value or liquidation preference, as applicable) at any time outstanding, including all Permitted Refinancing Indebtedness incurred to renew, refund, refinance, replace, defease or discharge any Indebtedness incurred pursuant to this clause (13), not to exceed $50.0 million (which amount may, but need not, be incurred in whole or in part under Credit Facilities) plus up to an additional amount as contemplated by, and to the extent not incurred under, clause (4) above; (14) Indebtedness arising from agreements of the Company or a Restricted Subsidiary of the Company providing for indemnification, adjustment of purchase price or similar obligations, in each case, incurred in connection with the acquisition or disposition of any business, assets or a Subsidiary of the Company in accordance with the terms of the Indenture, other than guarantees of Indebtedness incurred by any Person acquiring all or any portion of such business, assets or Subsidiary for the purpose of financing such acquisition; (15) pledges, deposits or payments made or given in the ordinary course of business in connection with or to secure statutory, regulatory or similar obligations, including obligations under health, safety or environmental obligations, or arising from guarantees to suppliers, lessors, licensees, contractors, franchisees or customers of obligations, other than Indebtedness, made in the ordinary course of business; (16) Indebtedness of the Company or any of its Restricted Subsidiaries consisting of (x) the financing of insurance premiums in the ordinary course of business or (y) take-or-pay obligations contained in supply arrangements entered into in the ordinary course of business; (17) Indebtedness of the Company or any Restricted Subsidiary supported by a letter of credit issued pursuant to any Credit Facility, in a principal amount not in excess of the stated amount of such letter of credit; provided such letter of credit was permitted to be issued under clause (1) above; (18) the incurrence by the Company or any of its Restricted Subsidiaries of Indebtedness, the net proceeds of which are used to defease the Notes as provided below under the caption Legal Defeasance and Covenant Defeasance beginning on page 172; (19) Indebtedness represented by the issuance of Additional Notes and the related Note Guarantees in connection with the conversion of Participating Preferred Stock; provided that, in the case of a conversion other than an Extraordinary Conversion, the Conversion Conditions are satisfied at the time of conversion; and (20) Indebtedness represented by the issuance of Additional Notes and the related Note Guarantees in connection with the issuance of shares of Common Stock of the Company; provided that the ratio of the aggregate principal amount of such Additional Notes to the number of such additional shares shall not exceed the equivalent ratio with respect to the IDSs outstanding prior to such issuance, and, in each case, the related Guarantees. Change in Projected Benefit Obligation Projected benefit obligation at beginning of year $ 1,809 $ 2,419 Exchange rate adjustment 143 288 Service cost 217 220 Interest cost 140 168 Actuarial (gain) loss Table of Contents The Company and the Guarantors will not incur any Indebtedness that is senior in right of payment by its terms to the Notes or any Note Guarantee and subordinate in right of payment by its terms to any other Indebtedness of the Company or such Guarantor, as the case may be. Unsecured Indebtedness will not be deemed to be subordinate in right of payment to Secured Indebtedness merely because it is unsecured, and Indebtedness that is not Guaranteed by a particular Person will not be deemed to be subordinate in right of payment to Indebtedness that is so Guaranteed merely because it is not so Guaranteed. For purposes of determining compliance with this Incurrence of Indebtedness and Issuance of Disqualified Stock covenant, in the event that an item of proposed Indebtedness meets the criteria of more than one of the categories of Permitted Debt described in clauses (1) through (20) above, or is entitled to be incurred pursuant to the first paragraph of this covenant, the Company will be permitted to classify such item of Indebtedness on the date of its incurrence, or later reclassify all or a portion of such item of Indebtedness, in any manner that complies with this covenant. Indebtedness under Credit Facilities outstanding on the date on which Notes are first issued and authenticated under the Indenture will initially be deemed to have been incurred in reliance on the exception provided by clause (1) of the definition of Permitted Debt. The accrual of interest, the accretion or amortization of original issue discount, the payment of interest on any Indebtedness in the form of additional Indebtedness with the same terms, the reclassification of Disqualified Stock as Indebtedness due to a change in accounting principles, and the payment of dividends on Disqualified Stock in the form of additional shares of the same class of Disqualified Stock will not be deemed to be an incurrence of Indebtedness or an issuance of Disqualified Stock for purposes of this covenant. Notwithstanding any other provision of this covenant, the maximum amount of Indebtedness that the Company or any Restricted Subsidiary may incur pursuant to this covenant shall not be deemed to be exceeded solely as a result of fluctuations in exchange rates or currency values. The amount of any Indebtedness outstanding as of any date will be: (1) the accreted value of the Indebtedness, in the case of any Indebtedness issued with original issue discount; (2) the principal amount of the Indebtedness, in the case of any other Indebtedness; and (3) in respect of Indebtedness of another Person secured by a Lien on the assets of the specified Person, the lesser of: (a) the Fair Market Value of such assets at the date of determination; and (b) the amount of the Indebtedness of the other Person. Liens The Company will not, and will not permit any of its Restricted Subsidiaries to, directly or indirectly, create, incur, assume or otherwise cause or suffer to exist or become effective any Lien of any kind (other than Permitted Liens) upon any of its property or assets, now owned or hereafter acquired, unless all payments due under the Indenture and the Notes are secured: (1) in the event that such Lien secures Indebtedness that is subordinate or junior in right of payment to the Notes or any Note Guarantee, by a Lien that is expressly made prior and senior in priority to the Lien securing such other Indebtedness; or (2) in all other cases, on an equal and ratable basis with the obligations so secured until such time as such obligations are no longer secured by a Lien. Table of Contents Dividend and Other Payment Restrictions Affecting Subsidiaries The Company will not, and will not permit any of its Restricted Subsidiaries to, directly or indirectly, create or permit to exist or become effective any consensual encumbrance or restriction on the ability of any Restricted Subsidiary to: (1) pay dividends or make any other distributions on its Capital Stock to the Company or any of the Company s Restricted Subsidiaries, or with respect to any other interest or participation in, or measured by, its profits, or pay any Indebtedness owed to the Company or any of its Restricted Subsidiaries (it being understood that the priority of any preferred stock in receiving dividends or liquidating distributions prior to dividends or liquidating distributions being paid on Common Stock shall not be deemed a restriction on the ability to pay dividends or make any other distributions on Capital Stock); (2) make loans or advances to the Company or any of its Restricted Subsidiaries (it being understood that any requirement for the subordination of loans or advances made to the Company or any Restricted Subsidiary of the Company to other Indebtedness incurred by the Company or such Restricted Subsidiary shall not be deemed a restriction on the ability to make loans or advances); or (3) sell, lease or transfer any of its properties or assets to the Company or any of its Restricted Subsidiaries. However, the preceding restrictions will not apply to encumbrances or restrictions existing under or by reason of: (1) agreements governing Existing Indebtedness and Credit Facilities as in effect on the date of the Indenture; (2) the Indenture and the Notes; (3) applicable law, rule, regulation or order; (4) any instrument governing Indebtedness or Capital Stock of a Person acquired by the Company or any of its Restricted Subsidiaries as in effect at the time of such acquisition (except to the extent such Indebtedness was incurred or such Capital Stock was issued in connection with or in contemplation of such acquisition), which encumbrance or restriction is not applicable to any Person, or the properties or assets of any Person, other than the Person, or the property or assets of the Person, so acquired; provided that, in the case of Indebtedness, such Indebtedness was permitted by the terms of the Indenture to be incurred; (5) customary non-assignment provisions in contracts, leases and licenses entered into in the ordinary course of business; (6) purchase money obligations for property acquired in the ordinary course of business and Capital Lease Obligations that impose restrictions on the property purchased or leased of the nature described in clause (3) of the preceding paragraph; (7) any agreement for the sale or other disposition of all the Capital Stock of, or all or substantially all of the assets of, a Restricted Subsidiary that restricts distributions by that Restricted Subsidiary pending the sale or other disposition; (8) Liens permitted to be incurred under the provisions of the covenant described above under the caption Liens beginning on page 164 that limit the right of the debtor to dispose of the assets subject to such Liens; (9) provisions limiting the disposition or distribution of assets or property in joint venture agreements, asset sale agreements, sale-leaseback agreements, stock sale agreements and other similar agreements entered into with the approval of the Company s Board of Directors, which limitation is applicable only to the assets that are the subject of such agreements; Table of Contents (10) restrictions on cash or other deposits or net worth under contracts entered into in the ordinary course of business; (11) Indebtedness or other contractual requirements of a Receivables Subsidiary in connection with a Qualified Receivables Transaction; provided that such restrictions apply only to such Receivables Subsidiary; (12) Indebtedness incurred by Restricted Subsidiaries of the Company that are not Guarantors pursuant to the first paragraph of the covenant described above under the caption Incurrence of Indebtedness and Issuance of Disqualified Stock beginning on page 161; provided, however, that the Board of Directors of the Company determines in good faith at the time such dividend or other payment restrictions are created that they do not materially adversely affect the Company s ability to fulfill its Obligations under the Notes; (13) Indebtedness incurred pursuant to clause (13) of the second paragraph of the covenant described above under the caption Incurrence of Indebtedness and Issuance of Disqualified Stock beginning on page 161; provided, however, that the Board of Directors of the Company determines in good faith at the time such dividend or other payment restrictions are created that they do not materially adversely affect the Company s ability to fulfill its Obligations under the Notes; and (14) any encumbrances or restrictions of the type referred to in clauses (1), (2) and (3) of the preceding paragraph imposed by any amendments, modifications, restatements, renewals, increases, supplements, refundings, replacements or refinancings of the contracts, instruments or obligations referred to in clauses (1) through (13) of this paragraph; provided that, in the good faith judgment of the Board of Directors of the Company, such amendments, modifications, restatements, renewals, increases, supplements, refundings, replacements or refinancings (i) are, in the good faith judgment of the Board of Directors of the Company, not materially more restrictive with respect to such dividend and other payment restrictions than those contained in those contracts, instruments or obligations prior to such amendment, modification, restatement, renewal, increase, supplement, refunding, replacement or refinancing or (ii) with respect to Indebtedness incurred pursuant to clause (1) of the second paragraph under the caption Incurrence of Indebtedness and Issuance of Disqualified Stock, beginning on page 161 do not materially adversely affect the Company s ability to fulfill its Obligations under the Notes. Merger, Consolidation or Sale of Assets The Company will not, directly or indirectly: (x) consolidate or merge with or into another Person (whether or not the Company is the surviving corporation) or (y) sell, assign, transfer, convey or otherwise dispose of all or substantially all of the properties or assets of the Company and its Restricted Subsidiaries taken as a whole, in one or more related transactions, to another Person, unless: (1) either: (a) the Company is the surviving corporation or (b) the Person formed by or surviving any such consolidation or merger (if other than the Company) or to which such sale, assignment, transfer, conveyance or other disposition has been made is a corporation, partnership or limited liability company organized or existing under the laws of the United States, any state of the United States or the District of Columbia; provided that if the Person is a partnership or limited liability company, a corporation wholly owned by such Person organized or existing under the laws of the United States, any state of the United States or the District of Columbia that does not and will not have any material assets or operations becomes a co-issuer of the Notes pursuant to a supplemental Indenture substantially in the form set forth in the Indenture; (2) the Person formed by or surviving any such consolidation or merger (if other than the Company) or the Person to which such sale, assignment, transfer, conveyance or other disposition has been made assumes all the obligations of the Company under the Notes and the Indenture pursuant to agreements reasonably satisfactory to the trustee; (3) immediately after such transaction, no Default or Event of Default exists; Table of Contents (4) the Company or the Person formed by or surviving any such consolidation or merger (if other than the Company), or to which such sale, assignment, transfer, conveyance or other disposition has been made would, on the date of such transaction after giving pro forma effect thereto and any related financing transactions as if the same had occurred at the beginning of the applicable four-quarter period, be permitted to incur at least $1.00 of additional Indebtedness pursuant to the Fixed Charge Coverage Ratio test set forth in the first paragraph of the covenant described above under the caption Incurrence of Indebtedness and Issuance of Disqualified Stock beginning on page 161; and (5) each Guarantor, if any, unless it is the other party to the transactions described above, shall have by supplemental Indenture confirmed that its Note Guarantee shall apply to such Person s obligations under the Indenture and the Notes. A Guarantor may not sell or otherwise dispose of all or substantially all of its assets to, or consolidate with or merge with or into (whether or not such Guarantor is the surviving Person), another Person, other than the Company or another Guarantor, unless: (1) immediately after giving effect to that transaction, no Default or Event of Default exists; and (2) either: (a) the Person acquiring the assets in any such sale or disposition or the Person formed by or surviving any such consolidation or merger (if other than that Guarantor) assumes all the obligations of that Guarantor under the Indenture and its Note Guarantee pursuant to a supplemental Indenture reasonably satisfactory to the trustee; or (b) the Net Proceeds of such sale or other disposition are applied in accordance with the applicable provisions of the Indenture. This Merger, Consolidation or Sale of Assets covenant will not apply to: (1) a merger of the Company with an Affiliate solely for the purpose of reincorporating the Company in another jurisdiction; (2) any sale, assignment, transfer, conveyance, lease or other disposition of assets between or among the Company and its Wholly-Owned Restricted Subsidiaries that are Domestic Subsidiaries and Guarantors; or (3) any consolidation or merger between or among the Company and any of its Wholly-Owned Restricted Subsidiaries that are Domestic Subsidiaries and Guarantors. Transactions with Affiliates The Company will not, and will not permit any of its Restricted Subsidiaries to, make any payment to, or sell, lease, transfer or otherwise dispose of any of its properties or assets to, or purchase any property or assets from, or enter into or make or amend any transaction, contract, agreement, understanding, loan, advance or Guarantee with, or for the benefit of, any Affiliate of the Company (each, an Affiliate Transaction ), unless: (1) the Affiliate Transaction is on terms that are no less favorable to the Company or the relevant Restricted Subsidiary than those that would reasonably have been obtained in a comparable transaction at such time by the Company or such Restricted Subsidiary with an unrelated Person; and (2) the Company delivers to the trustee: (a) with respect to any Affiliate Transaction or series of related Affiliate Transactions involving aggregate consideration in excess of $5.0 million, an officers certificate attaching a resolution of the Board of Directors of the Company stating that such Affiliate Transaction complies with this covenant and that such Affiliate Transaction has been approved by the Board of Directors of the Company; and Table of Contents (b) with respect to any Affiliate Transaction or series of related Affiliate Transactions involving aggregate consideration in excess of $15.0 million, an opinion as to the fairness to the Company or such Subsidiary of such Affiliate Transaction from a financial point of view issued by an accounting, appraisal or investment banking firm of national standing. The following items will not be deemed to be Affiliate Transactions and, therefore, will not be subject to the provisions of the prior paragraph: (1) any employment or other compensation arrangement or agreement, employee benefit plan, stock option plan, stock ownership plan or any similar arrangement entered into by the Company or any of its Restricted Subsidiaries in the ordinary course of business and payments, awards and grants pursuant thereto; (2) transactions between or among the Company and any of its Restricted Subsidiaries; (3) transactions with a Person (other than an Unrestricted Subsidiary of the Company) that is an Affiliate of the Company solely because the Company owns, directly or through a Restricted Subsidiary, an Equity Interest in, or controls, such Person; (4) payment of reasonable directors fees to Persons who are not otherwise Affiliates of the Company and the payment of customary indemnification to directors, officers, employees and consultants of the Company, any Restricted Subsidiary of the Company or any direct or indirect parent of the Company; (5) any issuance of Equity Interests (other than Disqualified Stock) of the Company to Affiliates of the Company or any contribution to the capital of the Company by Affiliates of the Company; (6) Permitted Investments and Restricted Payments that do not violate the provisions of the Indenture described above under the caption Restricted Payments beginning on page 156; (7) loans or advances to officers, directors, employees or consultants that are approved by the Company s Board of Directors in good faith; (8) any agreement as in effect and entered into as of the date of the Indenture or any amendment thereto or any transaction contemplated thereby (including pursuant to any amendment thereto) in any replacement agreement thereto so long as any such amendment or replacement agreement is not more disadvantageous to the holders of the Notes in any material respect than the original agreement as in effect on the date of the Indenture; (9) the payment of all fees and expenses related to the Acquisition or the Transactions and the payment of the Transaction Fee; (10) transactions with customers, clients, suppliers or purchasers or sellers of goods or services, in each case in the ordinary course of business and otherwise in compliance with the terms of the Indenture that are on terms no less favorable than those that would reasonably have been obtained in a comparable transaction at such time with an unrelated party or that are fair to the Company and its Restricted Subsidiaries in the reasonable determination of the Board of Directors of the Company or the senior management of the Company; (11) transactions in which the Company or any of its Restricted Subsidiaries, as the case may be, delivers to the trustee a letter from an independent financial advisor stating that such transaction is fair to the Company or such Restricted Subsidiary from a financial point of view or meets the requirements of clause (1) of the preceding paragraph; and (12) any tax sharing agreement or arrangement and payments pursuant thereto among the Company and its Subsidiaries and any other Person with which the Company or its Subsidiaries is required or permitted to file a consolidated tax return or with which the Company or any of its Restricted Subsidiaries is or could be part of a consolidated group for tax purposes in amounts not otherwise prohibited by the Indenture. Table of Contents Designation of Restricted and Unrestricted Subsidiaries The Board of Directors of the Company may designate any Restricted Subsidiary to be an Unrestricted Subsidiary if that designation would not cause a Default and if such subsidiary would otherwise meet the definition of an Unrestricted Subsidiary. If a Restricted Subsidiary is designated as an Unrestricted Subsidiary, the aggregate Fair Market Value of all outstanding Investments owned by the Company and its Restricted Subsidiaries in the Subsidiary designated as Unrestricted will be deemed to be an Investment made as of the time of the designation and will reduce the amount available for Restricted Payments under the covenant described above under the caption Restricted Payments beginning on page 156, or under one or more clauses of the definition of Permitted Investments, as determined by the Company. That designation will only be permitted if the Investment would be permitted at that time and if the Restricted Subsidiary otherwise meets the definition of an Unrestricted Subsidiary. The Board of Directors of the Company may redesignate any Unrestricted Subsidiary to be a Restricted Subsidiary if that redesignation would not cause a Default. Any designation of a Subsidiary of the Company as an Unrestricted Subsidiary will be evidenced to the trustee by filing with the trustee a certified copy of a resolution of the Board of Directors giving effect to such designation and an officers certificate certifying that such designation complied with the preceding conditions and was permitted by the covenant described above under the caption Restricted Payments beginning on page 156. If, at any time, any Unrestricted Subsidiary would fail to meet the preceding requirements as an Unrestricted Subsidiary, it will thereafter cease to be an Unrestricted Subsidiary for purposes of the Indenture, and any Indebtedness of such Subsidiary will be deemed to be incurred by a Restricted Subsidiary of the Company as of such date and, if such Indebtedness is not permitted to be incurred as of such date under the covenant described under the caption Incurrence of Indebtedness and Issuance of Disqualified Stock beginning on page 161, the Company will be in default of such covenant. The Board of Directors of the Company may at any time designate any Unrestricted Subsidiary to be a Restricted Subsidiary of the Company; provided that such designation will be deemed to be an incurrence of Indebtedness by a Restricted Subsidiary of the Company of any outstanding Indebtedness of such Unrestricted Subsidiary and such designation will only be permitted if (1) such Indebtedness is permitted under the covenant described under the caption Incurrence of Indebtedness and Issuance of Disqualified Stock beginning on page 161 calculated on a pro forma basis as if such designation had occurred at the beginning of the four-quarter reference period and (2) no Default or Event of Default would be in existence following such designation. Limitation on Issuances of Guarantees of Indebtedness The Company will not permit any of its Domestic Subsidiaries that are not already Guarantors, directly or indirectly, to Guarantee or pledge any assets to secure the payment of any other Indebtedness of the Company (other than Indebtedness and other Obligations under Credit Facilities and other Indebtedness of the Company consisting solely of Guarantees of Indebtedness of one or more of the Company s Restricted Subsidiaries) unless such Domestic Subsidiary simultaneously executes and delivers a supplemental indenture providing for the Guarantee on a senior subordinated basis of the payment of the Notes by such Domestic Subsidiary. Additional Guarantors If the Company or any of its Restricted Subsidiaries acquires or creates another Domestic Subsidiary after the date of the Indenture (each, a New Domestic Restricted Subsidiary ) that, after giving pro forma effect to the acquisition or organization of such New Domestic Restricted Subsidiary or Subsidiaries (if applicable), together with each other New Domestic Restricted Subsidiary, has consolidated assets or EBITDA which exceeds 5 percent of the total consolidated assets, as of the end of the most recently completed fiscal quarter for which financial statements are available, or total EBITDA, for the most recent preceding four fiscal quarters for which financial statements are available, of the Company and its Restricted Subsidiaries, the Company will cause each New Domestic Restricted Subsidiary to execute a supplemental indenture and a Note Guarantee and deliver an opinion of counsel satisfactory to the trustee within 10 business days of the date on which it was acquired or created. Thereafter, such New Domestic Restricted Subsidiary will be a Guarantor for all purposes of the Indenture. Table of Contents Reports Whether or not required by the SEC s rules and regulations, so long as any Notes are outstanding, the Company will furnish to the holders of Notes or, with the consent of the trustee, cause the trustee to furnish to the holders of Notes, within the time periods specified in the SEC s rules and regulations: (1) all quarterly and annual reports that would be required to be filed with the SEC on Forms 10-Q and 10-K if the Company were required to file such reports; and (2) all current reports that would be required to be filed with the SEC on Form 8-K if the Company were required to file such reports. All such reports will be prepared in all material respects in accordance with all the rules and regulations applicable to such reports. Each annual report on Form 10-K will include a report on the Company s consolidated financial statements by the Company s certified independent accountants. If, at any time, the Company is no longer subject to the periodic reporting requirements of the Exchange Act for any reason, the Company will nevertheless continue filing the reports specified in the preceding paragraphs of this covenant with the SEC within the time periods specified above unless the SEC will not accept such a filing. The Company agrees that it will not take any action for the purpose of causing the SEC not to accept any such filings. If, notwithstanding the foregoing, the SEC will not accept the Company s filings for any reason, the Company will post the reports referred to in the preceding paragraphs on its website within the time periods that would apply if the Company were required to file those reports with the SEC. If the Company has designated any of its Subsidiaries as Unrestricted Subsidiaries and such Subsidiary, either individually or taken together with all other Unrestricted Subsidiaries, constitutes a Significant Subsidiary, then the quarterly and annual financial information required by the first paragraph of this covenant will include a reasonably detailed presentation, either on the face of the financial statements or in the footnotes thereto, of the financial condition and results of operations of the Company and its Restricted Subsidiaries separate from the financial condition and results of operations of the Unrestricted Subsidiaries of the Company. In the event that (1) the rules and regulations of the SEC permit the Company and any direct or indirect parent company of the Company to report at such parent entity s level on a consolidated basis and (2) such parent entity of the Company is not engaged in any business in any material respect other than incidental to its ownership, directly or indirectly, of the Capital Stock of the Company and its Affiliates, the information and reports required by this covenant may be those of such parent company on a consolidated basis. Events of Default and Remedies Each of the following is an Event of Default: (1) a default in any payment of interest on any Note when due, whether or not prohibited by the provisions described under Ranking beginning on page 147 above, continued for 30 days, subject to the interest deferral provisions contained in the Indenture; provided, however, that a default in any payment of interest on any Note required to be made on (x) , 2009, and (y) any interest payment date after , 2009, at a time when interest deferral would be prohibited under the Indenture shall immediately constitute an Event of Default (without regard to the length of time for which such default continues); (2) default in the payment when due (at maturity, upon redemption or otherwise) of the principal of, or premium, if any, on the Notes, including the failure to make a payment to purchase Notes called for redemption pursuant to the provisions described above under Optional Redemption beginning on page 146 or to purchase Notes pursuant to a Change of Control Offer or an Asset Sale Offer; Table of Contents (3) failure by the Company or any of its Restricted Subsidiaries to comply with any of the other agreements in the Indenture (including without limitation an Excess Dividend Default) for 45 days after notice to the Company by the trustee or the holders of at least 25% in aggregate principal amount of the Notes then outstanding voting as a single class; (4) default under any mortgage, indenture or instrument under which there may be issued or by which there may be secured or evidenced any Indebtedness for money borrowed by the Company or any of its Restricted Subsidiaries (or the payment of which is guaranteed by the Company or any of its Restricted Subsidiaries), whether such Indebtedness or Guarantee now exists, or is created after the date of the Indenture, if that default: (a) is caused by a failure to pay principal of, or interest or premium, if any, on such Indebtedness prior to the expiration of the grace period provided in such Indebtedness on the date of such default (a Payment Default ); or (b) results in the acceleration of such Indebtedness prior to its express maturity, and, in each case, the principal amount of any such Indebtedness, together with the principal amount of any other such Indebtedness under which there has been a Payment Default or the maturity of which has been so accelerated, aggregates $20.0 million or more; (5) failure by the Company or any of its Restricted Subsidiaries that is a Significant Subsidiary to pay final judgments entered by a court or courts of competent jurisdiction aggregating in excess of $10.0 million (net of any amounts that are covered by enforceable insurance policies issued by solvent carriers), which judgments are not paid, discharged or stayed for a period of 60 days after such judgments become final and nonappealable; (6) except as permitted by the Indenture, any Note Guarantee made by a Guarantor that is a Significant Subsidiary is held in any judicial proceeding to be unenforceable or invalid or ceases for any reason to be in full force and effect or any such Guarantor, or any Person acting on behalf of any such Guarantor, denies or disaffirms its obligations under its Note Guarantee; or (7) certain events of bankruptcy or insolvency described in the Indenture with respect to the Company or any Restricted Subsidiary that is a Significant Subsidiary or any group of Restricted Subsidiaries that, taken together, would constitute a Significant Subsidiary. In the case of an Event of Default arising from certain events of bankruptcy or insolvency, with respect to the Company, all outstanding Notes will become due and payable immediately without further action or notice. If any other Event of Default occurs and is continuing, the trustee or the holders of at least 25% in aggregate principal amount of the then outstanding Notes may, subject to the provisions described under Acceleration Forbearance Period beginning on page 150, declare all the Notes to be due and payable immediately. Subject to certain limitations, holders of a majority in aggregate principal amount of the then outstanding Notes may direct the trustee in its exercise of any trust or power. The trustee may withhold from holders of the Notes notice of any continuing Default or Event of Default if it determines that withholding notice is in their interest, except a Default or Event of Default relating to the payment of principal, interest or premium, if any. Subject to the provisions of the Indenture relating to the duties of the trustee, in case an Event of Default occurs and is continuing, the trustee will be under no obligation to exercise any of the rights or powers under the Indenture at the request or direction of any holders of Notes unless such holders have offered to the trustee reasonable indemnity or security against any loss, liability or expense. Except to enforce the right to receive payment of principal, premium, if any, or interest when due, no holder of a Note may pursue any remedy with respect to the Indenture or the Notes unless: (1) such holder has previously given the trustee notice that an Event of Default is continuing; Table of Contents (2) holders of at least 25% in aggregate principal amount of the then outstanding Notes have requested the trustee to pursue the remedy; (3) such holders have offered the trustee reasonable security or indemnity against any loss, liability or expense; (4) the trustee has not complied with such request within 60 days after the receipt of the request and the offer of security or indemnity; and (5) holders of a majority in aggregate principal amount of the then outstanding Notes have not given the trustee a direction inconsistent with such request within such 60-day period. The holders of a majority in aggregate principal amount of the then outstanding Notes by notice to the trustee may, on behalf of the holders of all of the Notes, rescind an acceleration or waive any existing Default or Event of Default and its consequences under the Indenture except that (i) a continuing Default or Event of Default in the payment of interest or premium, if any, on, or the principal of, the Notes may be waived and an acceleration related thereto rescinded only with the consent of each holder of Notes and (ii) an Excess Dividend Default or any Event of Default resulting therefrom may be waived or an acceleration related thereto rescinded only with the consent of holders of at least 97% of the aggregate principal amount of the then outstanding Notes. The Company is required to deliver to the trustee annually a statement regarding compliance with the Indenture. Upon becoming aware of any Default or Event of Default, the Company is required to deliver to the trustee a statement specifying such Default or Event of Default. No Personal Liability of Directors, Officers, Employees and Stockholders No director, officer, employee, incorporator or stockholder of the Company, any Guarantor or any of their Affiliates, as such, will have any liability for any obligations of the Company or the Guarantors under the Notes, the Indenture, the Note Guarantees or for any claim based on, in respect of, or by reason of, such obligations or their creation. Each holder of Notes by accepting a Note waives and releases all such liability. The waiver and release are part of the consideration for issuance of the Notes. The waiver may not be effective to waive liabilities under the federal securities laws. Legal Defeasance and Covenant Defeasance The Company may, at its option and at any time, elect to have all of its obligations discharged with respect to the outstanding Notes and all obligations of the Guarantors discharged with respect to their Note Guarantees ( Legal Defeasance ) except for: (1) the rights of holders of outstanding Notes to receive payments in respect of the principal of, or interest or premium, if any, on such Notes when such payments are due from the trust referred to below; (2) the Company s obligations with respect to the Notes concerning issuing temporary Notes, registration of Notes, mutilated, destroyed, lost or stolen Notes and the maintenance of an office or agency for payment and money for security payments held in trust; (3) the rights, powers, trusts, duties and immunities of the trustee, and the Company s and the Guarantors obligations in connection therewith; and (4) the Legal Defeasance and Covenant Defeasance provisions of the Indenture. In addition, the Company may, at its option and at any time, elect to have the obligations of the Company and the Guarantors released with respect to certain covenants (including its obligation to make Change of Control Offers and Asset Sale Offers) that are described in the Indenture ( Covenant Defeasance ) and thereafter any omission to comply with those covenants will not constitute a Default or Event of Default with respect to the Table of Contents Pro Forma Table of Contents Notes. In the event Covenant Defeasance occurs, certain events (not including non-payment, bankruptcy, receivership, rehabilitation and insolvency events) described under Events of Default and Remedies beginning on page 170 will no longer constitute an Event of Default with respect to the Notes. In order to exercise either Legal Defeasance or Covenant Defeasance: (1) the Company must irrevocably deposit with the trustee, in trust, for the benefit of the holders of the Notes, cash in U.S. dollars, U.S. Government Obligations, or a combination of cash in U.S. dollars and U.S. Government Obligations, in amounts as will be sufficient, in the opinion of a nationally recognized investment bank, appraisal firm or firm of independent public accountants to pay the principal of, interest and premium, if any, on the outstanding Notes on the stated date for payment thereof or on the applicable redemption date, as the case may be, and the Company must specify whether the Notes are being defeased to such stated date for payment or to a particular redemption date; (2) in the case of Legal Defeasance, the Company must deliver to the trustee an opinion of counsel reasonably acceptable to the trustee confirming that (a) the Company has received from, or there has been published by, the Internal Revenue Service a ruling or (b) since the date of the Indenture, there has been a change in the applicable federal income tax law, in either case to the effect that, and based thereon such opinion of counsel will confirm that, the holders of the outstanding Notes will not recognize income, gain or loss for federal income tax purposes as a result of such Legal Defeasance and will be subject to federal income tax on the same amounts, in the same manner and at the same times as would have been the case if such Legal Defeasance had not occurred; (3) in the case of Covenant Defeasance, the Company must deliver to the trustee an opinion of counsel reasonably acceptable to the trustee confirming that the holders of the outstanding Notes will not recognize income, gain or loss for federal income tax purposes as a result of such Covenant Defeasance and will be subject to federal income tax on the same amounts, in the same manner and at the same times as would have been the case if such Covenant Defeasance had not occurred; (4) no Default or Event of Default has occurred and is continuing on the date of such deposit (other than a Default or Event of Default resulting from the borrowing of funds to be applied to such deposit) and the deposit will not result in a breach or violation of, or constitute a default under, any other material instrument to which the Company or any Guarantor is a party or by which the Company or any Guarantor is bound; (5) such Legal Defeasance or Covenant Defeasance will not result in a breach or violation of, or constitute a default under any material agreement or material instrument (other than the Indenture) to which the Company or any of its Subsidiaries is a party or by which the Company or any of its Subsidiaries is bound; (6) the Company must deliver to the trustee an officers certificate stating that the deposit was not made by the Company with the intent of preferring the holders of Notes over the other creditors of the Company with the intent of defeating, hindering, delaying or defrauding any creditors of the Company or others; and (7) the Company must deliver to the trustee an officers certificate and an opinion of counsel, each stating that all conditions precedent relating to the Legal Defeasance or the Covenant Defeasance have been complied with. Amendment, Supplement and Waiver Except as provided in the next two succeeding paragraphs, the Indenture, the Notes or the Note Guarantees may be amended or supplemented with the consent of the holders of at least a majority in aggregate principal amount of the Notes then outstanding (including, without limitation, consents obtained in connection with a purchase of, or tender offer or exchange offer for, Notes), and any existing Default or Event of Default or (in thousands) Table of Contents compliance with any provision of the Indenture, the Notes or the Note Guarantees may be waived with the consent of the holders of a majority in aggregate principal amount of the then outstanding Notes (including, without limitation, consents obtained in connection with a purchase of, or tender offer or exchange offer for, Notes); provided that an Excess Dividend Default and any Event of Default resulting therefrom may be waived only with the consent of the holders of at least 97% of the aggregate principal amount of the then outstanding Notes. Without the consent of each holder of Notes affected, an amendment, supplement or waiver may not (with respect to any Notes held by a non-consenting holder): (1) reduce the principal amount of Notes whose holders must consent to an amendment, supplement or waiver; (2) reduce the principal of or change the fixed maturity of any Note or alter the provisions with respect to the redemption of the Notes (other than provisions relating to the covenants described above under the caption Repurchase at the Option of Holders beginning on page 152); (3) reduce the rate of or change the time for payment of interest, including default interest, on any Note; (4) waive a Default or Event of Default in the payment of principal of, or interest or premium, if any, on the Notes (except a rescission of acceleration of the Notes by the holders of at least a majority in aggregate principal amount of the then outstanding Notes and a waiver of the payment default that resulted from such acceleration); (5) make any Note payable in money other than that stated in the Notes; (6) make any change in the provisions of the Indenture relating to waivers of past Defaults or the rights of holders of Notes to receive payments of principal of, or interest or premium, if any, on the Notes; (7) waive a redemption payment with respect to any Note (other than a payment required by one of the covenants described above under the caption Repurchase at the Option of Holders beginning on page 152); (8) make any change to the subordination provisions of the Indenture that adversely affects the rights of any holder; (9) release any Guarantor that is a Significant Subsidiary from any of its obligations under its Note Guarantee or the Indenture, except in accordance with the terms of the Indenture, or modify the Note Guarantees in any manner adverse to the holders; or (10) make any change in the preceding amendment and waiver provisions. Notwithstanding the preceding, without the consent of any holder of Notes, the Company, the Guarantors and the trustee may amend or supplement the Indenture, the Notes or the Note Guarantees: (1) to cure any ambiguity, defect or inconsistency; (2) to provide for uncertificated Notes in addition to or in place of certificated Notes; (3) to provide for the assumption of the Company s or a Guarantor s obligations to holders of Notes and Note Guarantees in the case of a merger or consolidation or sale of all or substantially all of the Company s or such Guarantor s assets, as applicable; (4) to make any change that would provide any additional rights or benefits to the holders of Notes or that does not adversely affect the legal rights under the Indenture of any such holder; (5) to comply with requirements of the SEC in order to effect or maintain the qualification of the Indenture under the Trust Indenture Act; (6) to conform the text of the Indenture, the Notes or the Note Guarantees to any provision of this Description of Senior Subordinated Notes to the extent that such provision in this Description of Senior Subordinated Notes was intended to be a verbatim recitation of a provision of the Indenture, the Notes or the Note Guarantees; (7) to provide for the issuance of Additional Notes, in accordance with the limitations set forth in the Indenture as of the date of the Indenture; or Table of Contents (8) to allow any Guarantor to execute a supplemental Indenture and/or a Note Guarantee with respect to the Notes. Notwithstanding the foregoing, no amendment may be made to the subordination provisions of the Indenture that adversely affects the rights of any holder of Senior Indebtedness then outstanding unless the holders of such Senior Indebtedness (or any Representative thereof authorized to give a consent) consent to such change. Satisfaction and Discharge The Indenture will be discharged and will cease to be of further effect as to all Notes issued thereunder when: (1) either: (a) all Notes that have been authenticated, except lost, stolen or destroyed Notes that have been replaced or paid and Notes for whose payment money has been deposited in trust and thereafter repaid to the Company, have been delivered to the trustee for cancellation; or (b) all Notes that have not been delivered to the trustee for cancellation have become due and payable by reason of the mailing of a notice of redemption or otherwise or will become due and payable within one year and the Company or any Guarantor has irrevocably deposited or caused to be deposited with the trustee as trust funds in trust solely for the benefit of the holders, cash in U.S. dollars, U.S. Government Obligations, or a combination of cash in U.S. dollars and U.S. Government Obligations, in amounts as will be sufficient, without consideration of any reinvestment of interest, to pay and discharge the entire Indebtedness on the Notes not delivered to the trustee for cancellation for principal, premium, if any, and accrued interest to the date of maturity or redemption; (2) no Default or Event of Default has occurred and is continuing on the date of the deposit (other than a Default or Event of Default resulting from the borrowing of funds to be applied to such deposit) and the deposit will not result in a breach or violation of, or constitute a default under, any other material instrument to which the Company or any Guarantor is a party or by which the Company or any Guarantor is bound; (3) the Company or any Guarantor has paid or caused to be paid all sums payable by it under the Indenture; and (4) the Company has delivered irrevocable instructions to the trustee under the Indenture to apply the deposited money toward the payment of the Notes at maturity or on the redemption date, as the case may be. In addition, the Company must deliver an officers certificate and an opinion of counsel to the trustee stating that all conditions precedent to satisfaction and discharge have been satisfied. Concerning the Trustee If the trustee becomes a creditor of the Company, the Indenture limits the right of the trustee to obtain payment of claims in certain cases, or to realize on certain property received in respect of any such claim as security or otherwise. The trustee will be permitted to engage in other transactions; however, if it acquires any conflicting interest it must eliminate such conflict within 90 days, apply to the SEC for permission to continue as trustee (if the Indenture has been qualified under the Trust Indenture Act) or resign. The holders of a majority in aggregate principal amount of the then outstanding Notes will have the right to direct the time, method and place of conducting any proceeding for exercising any remedy available to the trustee, subject to certain exceptions. The Indenture provides that in case an Event of Default occurs and is Balance Sheet Data: Working capital $ 169,621 Total assets 1,780,924 Total long-term debt 497,600 Stockholders equity (deficit) (c) (212,295 ) Table of Contents continuing, the trustee will be required, in the exercise of its power, to use the degree of care of a prudent man in the conduct of his own affairs. Subject to such provisions, the trustee will be under no obligation to exercise any of its rights or powers under the Indenture at the request of any holder of Notes, unless such holder has offered to the trustee reasonable security and indemnity against any loss, liability or expense. Certain Definitions Set forth below are certain defined terms used in the Indenture. Reference is made to the Indenture, a copy of which has been filed as an exhibit to the registration statement of which this prospectus forms a part, for a full disclosure of all defined terms used therein, as well as any other capitalized terms used herein for which no definition is provided. Acquired Debt means, with respect to any specified Person: (1) Indebtedness of any other Person existing at the time such other Person is merged or consolidated with or into or became a Restricted Subsidiary of such specified Person, whether or not such Indebtedness is incurred in connection with, or in contemplation of, such other Person merging with or into, or becoming a Restricted Subsidiary of, such specified Person; and (2) Indebtedness secured by a Lien encumbering any asset acquired by such specified Person. Acquisition means the transactions contemplated by the Stock Purchase Agreement and the related borrowings under the Credit Agreements. Affiliate of any specified Person means any other Person directly or indirectly controlling or controlled by or under direct or indirect common control with such specified Person. For purposes of this definition, control, as used with respect to any Person, means the possession, directly or indirectly, of the power to direct or cause the direction of the management or policies of such Person, whether through the ownership of voting securities, by agreement or otherwise. For purposes of this definition, the terms controlling, controlled by and under common control with have correlative meanings. Apollo means Apollo Management V, L.P. and its Affiliates. Asset Sale means: (1) the sale, lease (other than operating leases entered into in the ordinary course of business), conveyance or other disposition of any assets or rights; provided that the sale, lease, conveyance or other disposition of all or substantially all of the assets of the Company and its Restricted Subsidiaries taken as a whole will be governed by the provisions of the Indenture described above under the caption Repurchase at the Option of Holders Change of Control beginning on page 152 and/or the provisions described above under the caption Certain Covenants Merger, Consolidation or Sale of Assets beginning on page 166 and not by the provisions of the Asset Sale covenant; and (2) the issuance or sale of Equity Interests in any of the Company s Restricted Subsidiaries (other than directors qualifying shares). Notwithstanding the preceding, none of the following items will be deemed to be an Asset Sale: (1) any single transaction or series of related transactions that involves assets having a Fair Market Value of less than $3.0 million; (2) a transfer of Capital Stock or other assets or rights between or among the Company and its Wholly-Owned Restricted Subsidiaries, (3) an issuance of Capital Stock by a Restricted Subsidiary of the Company to the Company or to a Wholly-Owned Restricted Subsidiary of the Company; (4) the sale or lease of products, services or accounts receivable in the ordinary course of business and any sale or other disposition of damaged, worn-out or obsolete assets in the ordinary course of business; (a) EBITDA represents net income (loss) before interest expense, finance charges, income taxes, depreciation and amortization. We present EBITDA because we believe it is a useful indicator of our historical debt capacity and ability to service debt, and consider it to be a measure of liquidity. EBITDA, as defined in the indenture, is calculated by adjusting EBITDA for certain items. The adjustments to EBITDA relate to: (1) the add back of losses from discontinued operations, net of taxes, (2) the add back of inventory fair market value adjustments as a result of the Acquisition, (3) the add back of expenses relating to a transition services agreement and (4) the add back/deduction of loss/gain from the sale of certain businesses. We present EBITDA, as defined in the indenture, because a corresponding calculation will be used in the indenture governing the senior subordinated notes. EBITDA is not a measure of financial performance or liquidity under GAAP. Accordingly, EBITDA should not be considered in isolation or as a substitute for net income, cash flows from operations or other income or cash flow data prepared in accordance with GAAP or as a measure of our operating performance or liquidity. For example, although we consider EBITDA a liquidity measure, it does not take into account all cash expenditures which may be necessary to grow our business, such as cash expenditures for capital expenditures and acquisitions. Because of covenants in the Amended Credit Facilities and indenture that are based on EBITDA, including our fixed charge coverage ratio covenants, we will have to maintain our EBITDA at certain levels in order to, among other things, pay dividends on our capital stock and to avoid defaults under our Amended Credit Facilities and deferrals of interest payments on the senior subordinated notes. The following table sets forth a calculation of our EBITDA and EBITDA, as defined in the indenture, and certain financial ratios based on EBITDA, as defined, that we believe are useful indicators of our ability to incur and service debt: (in thousands) Table of Contents (5) the sale or other disposition of cash or Cash Equivalents; (6) a Restricted Payment that does not violate the covenant described above under the caption Certain Covenants Restricted Payments beginning on page 156 or a Permitted Investment; (7) the sale or transfer of accounts receivable pursuant to a Qualified Receivables Transaction; (8) sales or grants of licenses to use the Company s or any Restricted Subsidiary s patents, trade secrets, know-how and technology to the extent that such license does not prohibit the licensor from using the patent, trade secret, know-how or technology; (9) sales of assets received by the Company or any of its Restricted Subsidiaries upon the foreclosure on a Lien; (10) Capacity Arrangements; (11) sales or exchanges of equipment in connection with the purchase or other acquisition of other equipment, in each case used or useful in a Permitted Business; and (12) the disposition of any Capital Stock or other ownership interest in or assets or rights of an Unrestricted Subsidiary. Asset Sale Offer shall have the meaning ascribed to it under Asset Sales beginning on page 153. Base Dividend Restricted Payments Basket shall initially equal $0; provided, however, that if during any fiscal quarter the Company has paid dividends on the Company s Common Stock in an aggregate amount that is less than the Quarterly Base Dividend Level for such quarter, an amount equal to 100% of the difference between (i) the Quarterly Base Dividend Level for such quarter and (ii) the aggregate amount of dividends actually paid pursuant to subclause (ii) of clause (15) of the second paragraph of the covenant entitled Certain Covenants Restricted Payments beginning on page 156 during such quarter shall be added to the Base Dividend Restricted Payments Basket as of the last day of such fiscal quarter. Beneficial Owner has the meaning assigned to such term in Rule 13d-3 and Rule 13d-5 under the Exchange Act, except that in calculating the beneficial ownership of any particular person (as that term is used in Section 13(d)(3) of the Exchange Act), such person will be deemed to have beneficial ownership of all securities that such person has the right to acquire by conversion or exercise of other securities, whether such right is currently exercisable or is exercisable only after the passage of time. The terms Beneficially Owns, Beneficial Ownership, and Beneficially Owned have a corresponding meaning. Board of Directors means: (1) with respect to a corporation, the board of directors of the corporation or any committee thereof duly authorized to act on behalf of such board; (2) with respect to a partnership, the Board of Directors of the general partner of the partnership; (3) with respect to a limited liability company, the managing member or members or any controlling committee of managing members thereof; and (4) with respect to any other Person, the board or committee of such Person serving a similar function. Borrowing Base means, as of any date, an amount equal to: (1) 85% of the face amount of all accounts receivable owned by the Company and its Restricted Subsidiaries as of the end of the most recent fiscal quarter preceding such date that were not more than 60 days past due; plus (2) 55% of the book value of all inventory, net of reserves in accordance with past practices, owned by the Company and its Restricted Subsidiaries as of the end of the most recent fiscal quarter preceding such date; provided, however, that any accounts receivable owned by a Receivables Subsidiary, or which United Agri Products or any of its Subsidiaries has agreed to transfer to a Receivables Subsidiary, shall be excluded for purposes of determining such amount. Business Day means a day other than a Saturday, Sunday or other day on which banking institutions in New York State are authorized or required by law to close. Table of Contents Capacity Arrangements means any agreement or arrangement involving, relating to or otherwise facilitating (1) requirement contracts, (2) tolling arrangements or (3) the reservation or presale of production capacity of the Company or its Restricted Subsidiaries by one or more third parties. Capital Lease Obligation means, at the time any determination is to be made, the amount of the liability in respect of a capital lease that would at that time be required to be capitalized on a balance sheet prepared in accordance with GAAP, and the Stated Maturity thereof shall be the date of the last payment of rent or any other amount due under such lease prior to the first date upon which such lease may be prepaid by the lessee without payment of a penalty. Capital Stock means: (1) in the case of a corporation, corporate stock, including, without limitation, corporate stock represented by IDSs and corporate stock outstanding upon the separation of IDSs into the securities represented thereby (but not the IDSs themselves); (2) in the case of an association or business entity, any and all shares, interests, participations, rights or other equivalents (however designated) of corporate stock; (3) in the case of a partnership or limited liability company, partnership interests (whether general or limited) or membership interests; and (4) any other interest or participation that confers on a Person the right to receive a share of the profits and losses of, or distributions of assets of, the issuing Person, but excluding from all of the foregoing any debt securities convertible into Capital Stock, whether or not such debt securities include any right of participation with Capital Stock. Cash Equivalents means: (1) United States dollars, Canadian dollars, or in the case of any Foreign Subsidiary, such local currencies held by it from time to time in the ordinary course of business; (2) securities issued or directly and fully guaranteed or insured by the United States or Canadian government or any agency or instrumentality thereof (provided that the full faith and credit of the respective country is pledged in support of those securities) having maturities of not more than one year from the date of acquisition; (3) certificates of deposit, time deposits and eurodollar time deposits with maturities of one year or less from the date of acquisition, bankers acceptances with maturities not exceeding one year and overnight bank deposits, in each case, with any United States or Canadian commercial bank having capital and surplus in excess of $250.0 million; (4) repurchase obligations with a term of not more than 30 days for underlying securities of the types described in clauses (2) and (3) above entered into with any financial institution meeting the qualifications specified in clause (3) above; (5) commercial paper having one of the two highest ratings obtainable from Moody s or S&P, or if Moody s and S&P cease to exist, any other nationally recognized statistical rating organization designated by the Board of Directors of the Company, and in each case maturing within one year after the date of acquisition; (6) marketable direct obligations issued by any State of the United States of America or any political subdivision of any such State or any public instrumentality maturing within one year from the date of acquisition and, at the time of acquisition, having one of the two highest ratings obtainable from either Moody s or S&P, or if Moody s and S&P cease to exist, any other nationally recognized statistical rating organization designated by the Board of Directors of the Company; Fourteen Weeks Ended May 30, 2004 Table of Contents (7) Indebtedness issued by other Persons (other than Apollo) maturing within one year from the date of acquisition and, at the time of acquisition, having one of the two highest ratings obtainable from either Moody s or S&P, or if Moody s and S&P cease to exist, any other nationally recognized statistical rating organization designated by the Board of Directors of the Company; (8) money market funds, substantially all of the assets of which constitute Cash Equivalents of the kinds described in clauses (1) through (7) of this definition; and (9) overnight deposits and demand deposit accounts (in the respective local currencies) maintained in the ordinary course of business. Change of Control means the occurrence of any of the following: (1) the direct or indirect sale, lease, transfer, conveyance or other disposition (other than by way of merger or consolidation), in one or a series of related transactions, of all or substantially all of the properties or assets of the Company and its Subsidiaries, taken as a whole, to any person (as that term is used in Section 13(d) of the Exchange Act) other than a Permitted Holder; (2) the adoption of a plan relating to the liquidation or dissolution of the Company; (3) the consummation of any transaction (including, without limitation, any merger or consolidation) the result of which is that any person (as defined above), other than a Permitted Holder, becomes the Beneficial Owner, directly or indirectly, of more than 50% of the Voting Stock of the Company, measured by voting power rather than number of shares (other than a creation of a holding company that does not involve a change in Beneficial Ownership of the Company as a result of such transaction); or (4) the first day on which the majority of the members of the Board of Directors of the Company are not Continuing Directors. Change of Control Offer shall have the meaning ascribed to it under Repurchase at the Option of Holders Change of Control beginning on page 152. Common Stock means any and all shares, interests or other participations in, and other equivalents (however designated and whether voting or nonvoting) of, such Person s common stock, whether outstanding on the date of the Indenture or issued after the date of the Indenture, including all series and classes of such common stock. Consolidated Net Income means, with respect to any specified Person for any period, the aggregate of the Net Income of such Person and its Restricted Subsidiaries for such period, on a consolidated basis, determined in accordance with GAAP; provided that: (1) the Net Income (if positive) of any Person that is not a Restricted Subsidiary of the specified Person or that is accounted for by the equity method of accounting will be included only to the extent of the amount of dividends or similar distributions paid in cash (or to the extent converted into cash) to the specified Person or a Restricted Subsidiary of the Person; (2) (a) the Net Income (but not loss) of any Restricted Subsidiary of the specified Person that is not a Guarantor and (b) solely for purposes of determining the amount available for Restricted Payments under clause (3)(a) of the first paragraph of, and subclause (ii) of clause (15) and clause (16) of the second paragraph of Certain Covenants Restricted Payments beginning on page 156, the Net Income (but not loss) of any Restricted Subsidiary of the specified Person that is a Guarantor will, in each case, be excluded to the extent that the declaration or payment of dividends or similar distributions by that Restricted Subsidiary of that Net Income is not at the date of determination permitted without any prior governmental approval (that has not been obtained) or, directly or indirectly, by operation of the terms of its charter or any agreement, instrument, judgment, decree, order, statute, rule or governmental regulation applicable to that Last Twelve Months Ended May 30, 2004 Table of Contents Restricted Subsidiary or its stockholders, unless such restrictions with respect to the declaration or payment of dividends or similar distributions have been legally waived (other than as permitted by clauses (1), (2), (4), (12), (13) and (14) (but only to the extent such clause (14) applies to clauses (1), (2), (4), (12) and (13)) of the second paragraph of the covenant described under the caption Certain Covenants Dividend and Other Payment Restrictions Affecting Subsidiaries on page 165); (3) the cumulative effect of a change in accounting principles will be excluded; (4) any non-cash impairment charges resulting from the application of Statement of Financial Accounting Standards No. 142 shall be excluded; (5) any non-cash compensation expense realized from grants of, or variable accounting relating to, stock appreciation or similar rights, stock options or other rights to officers, directors and employees of such Person or any of its Restricted Subsidiaries shall be excluded; (6) accruals and reserves that are established within twelve months after the date of the Indenture and that are so required to be established in accordance with GAAP shall be excluded; and (7) solely for purposes of determining the amount available for Restricted Payments under clause 3(a) of the first paragraph of, and subclause (ii) of clause (15) and clause (16) of the second paragraph of Certain Covenants Restricted Payments beginning on page 156, the amortization of original issue discount and the payment of non-cash interest on any 10 % Senior Discount Notes Due 2012 of the Company that are outstanding on the date of the Indenture; and (8) non-cash charges resulting from current or future mark-to-market accounting that the Company may apply with respect to any IDSs, shares of the Company s Common Stock or the Notes issued in connection with the Transactions or at any time thereafter shall be excluded. Continuing Directors means, as of any date of determination, any member of the Company s Board of Directors who: (i) was a member of the Company s Board of Directors on the date of the Indenture; or (ii) was nominated for election or elected to the Board of Directors with the affirmative vote of at least a majority of the Continuing Directors who were members of the Company s Board of Directors at the time of the nomination or election. Conversion Conditions means, with respect to any conversion of Participating Preferred Stock other than an Extraordinary Conversion, (i) no Default or Event of Default has occurred and is continuing at the time of, or would result from, such conversion, (ii) such conversion complies with all applicable laws, including securities laws, (iii) such conversion does not conflict with, or cause a default under, any material financing agreement of the Company, (iv) at the time of such conversion, no interest deferral period under the Indenture is in effect and all previously deferred interest on the Notes and accrued interest thereon has been paid in full, (v) such conversion does not cause a mandatory suspension of dividends or deferral of interest under any material financing agreement of the Company as of the measurement date immediately following the proposed conversion date and (vi) prior to the second anniversary of the date of the Indenture, at least 2,802,750 shares of Participating Preferred Stock (as may be adjusted for stock splits, dividends, combinations or reclassifications) remain outstanding after such conversion, which represents 10% of the fair value of the Company s equity immediately after this offering. Credit Agreements means (i) that certain Credit Agreement, dated as of November 24, 2003 by and among United Agri Products, United Agri Products Canada Inc., the Company, the other persons party thereto that are designated as Credit Parties, General Electric Capital Corporation, as Agent and Lender, GE Canada Finance Holding Company, as Canadian Agent and Lender, GECC Capital Markets Group, Inc., as Co-Lead Arranger, and UBS Securities LLC, as Co-Lead Arranger and Co-Syndication Agent, Co peratieve Centrale Raiffeisen-Boerenleenbank B.A., Rabobank International, New York Branch, as Co-Documentation Agent and Lender, and Merrill Lynch Capital, a division of Merrill Lynch Business Financial Services Inc., as Co-Documentation Agent and Lender, providing for up to $500.0 million of revolving credit borrowings, including Cash flows provided by operating activities $ 341,799 $ (203,651 ) $ 292,939 Interest expense, net of non-cash interest 28,679 12,132 36,411 Net change in operating assets and liabilities (251,766 ) 242,379 (200,183 ) Income tax provision (benefit) 30,857 16,494 26,874 Deferred income tax benefit (provision) (23,858 ) (9,214 ) (33,072 ) Loss from discontinued operations, net (4,708 ) (2,095 ) Other (539 ) (90 ) (629 ) Table of Contents any related Notes, guarantees, collateral documents, instruments and agreements executed in connection therewith, and (ii) that certain Senior Secured Second Lien Term Loan Agreement, dated as of , 2004 among United Agri Products, , as Agent and Lender, and the other financial institutions party thereto, as Lenders, and in each case as amended, restated, modified, renewed, refunded, replaced (whether upon or after termination or otherwise) or refinanced (including by means of sales of debt securities to institutional investors) in whole or in part from time to time. Credit Facilities means, one or more debt facilities (including, without limitation, the Credit Agreements) or commercial paper facilities, in each case with banks or other institutional lenders providing for revolving credit loans, term loans, receivables financing (including through the sale of receivables to such lenders or to special purpose entities formed to borrow from such lenders against such receivables) or letters of credit, in each case, as amended, restated, modified, renewed, refunded, replaced (whether upon or after termination or otherwise) or refinanced (including by means of sales of debt securities to institutional investors) in whole or in part from time to time. Default means any event that is, or with the passage of time or the giving of notice or both would be, an Event of Default (which is an event described under Description of Senior Subordinated Notes Events of Default and Remedies beginning on page 170). Designated Senior Indebtedness means (i) the Indebtedness under or in respect of Credit Facilities and (ii) any other Senior Indebtedness of the Company. Disqualified Stock means any Capital Stock that, by its terms (or by the terms of any security into which it is convertible, or for which it is exchangeable, in each case at the option of the holder of the Capital Stock), or upon the happening of any event, matures or is mandatorily redeemable, pursuant to a sinking fund obligation or otherwise, or redeemable at the option of the holder of the Capital Stock, in whole or in part, on or prior to the date on which the Notes mature; provided that any class of Capital Stock of a Person that by its terms requires such Person to satisfy its obligations thereunder by delivery of Capital Stock that is not Disqualified Stock shall not be deemed Disqualified Stock. Notwithstanding the preceding sentence, any Capital Stock that would constitute Disqualified Stock solely because the holders of the Capital Stock have the right to require the Company to repurchase such Capital Stock upon the occurrence of a change of control or an asset sale will not constitute Disqualified Stock if the terms of such Capital Stock provide that the Company may not repurchase or redeem any such Capital Stock pursuant to such provisions unless such repurchase or redemption complies with the covenant described above under the caption Certain Covenants Restricted Payments beginning on page 156. The amount of Disqualified Stock deemed to be outstanding at any time for purposes of the Indenture will be the maximum amount that the Company and its Restricted Subsidiaries may become obligated to pay upon the maturity of, or pursuant to any mandatory redemption provisions of, such Disqualified Stock, exclusive of accrued dividends. For the avoidance of doubt, the Participating Preferred Stock shall not be deemed to be Disqualified Stock. Domestic Subsidiary means any Restricted Subsidiary of the Company that was formed under the laws of the United States or any state of the United States or the District of Columbia. EBITDA means, with respect to any specified Person for any period, the Consolidated Net Income of such Person for such period plus, without duplication: (1) an amount equal to any extraordinary loss plus any net loss realized by such Person or any of its Restricted Subsidiaries in connection with an Asset Sale, to the extent such losses were deducted in computing such Consolidated Net Income; plus (2) provision for taxes based on income or profits of such Person and its Restricted Subsidiaries for such period, to the extent that such provision for taxes was deducted in computing such Consolidated Net Income; plus Table of Contents (3) the Fixed Charges of such Person and its Restricted Subsidiaries for such period, to the extent that such Fixed Charges were deducted in computing such Consolidated Net Income; plus (4) depreciation, amortization (including amortization of intangibles but excluding amortization of prepaid cash expenses that were paid in a prior period) and other non-cash expenses (excluding any such non- cash expense to the extent that it represents an accrual of or reserve for cash expenses in any future period or amortization of a prepaid cash expense that was paid in a prior period) of such Person and its Restricted Subsidiaries for such period to the extent that such depreciation, amortization and other non-cash expenses were deducted in computing such Consolidated Net Income; minus (5) non-cash items increasing such Consolidated Net Income for such period, other than (a) the accrual of revenue in the ordinary course of business and (b) reversals of prior accruals and reserves for cash items previously excluded from EBITDA pursuant to clause (4) of this definition; in each case, on a consolidated basis and determined in accordance with GAAP. Equity Interests means Capital Stock and all warrants, options or other rights to acquire Capital Stock (but excluding any debt security that is convertible into, or exchangeable for, Capital Stock). Excess Cash shall mean, with respect to any period, EBITDA for such period minus the sum of (i) cash interest expense for such period, (ii) cash income tax expense for such period and (iii) additions to property, plant and equipment and other capital expenditures of the Company and its Restricted Subsidiaries for such period that are (or would be) set forth in a consolidated statement of cash flows for such period prepared in accordance with GAAP ( Capital Expenditures ); provided, however, (A) that with respect to any fiscal quarter of the Company ending on or before February 22, 2004, Capital Expenditures will be deemed to equal $1.525 million for such quarter, (B) that with respect to fiscal quarters of the Company beginning on or after February 23, 2004 and ending on or before the last day of the Company s 2006 fiscal year, Capital Expenditures made to implement the Company s Core Eclipse system in an aggregate amount not to exceed $5.3 million will be excluded, (C) that with respect to fiscal quarters of the Company beginning on or after February 23, 2004 and ending on or before the last day of the Company s 2005 fiscal year, Capital Expenditures made in connection with the separation of the Company from ConAgra Foods in an aggregate amount not to exceed $3.7 million will be excluded, (D) that with respect to fiscal quarters of the Company beginning on or after February 23, 2004 and ending on or before the last day of the Company s 2005 fiscal year, Capital Expenditures made in connection with the automated production project at the Company s Loveland formulating facility in an aggregate amount not to exceed $450,000 will be excluded and (E) that Capital Expenditures shall not include (1) expenditures made in connection with the replacement or restoration of assets to the extent financed from insurance proceeds paid on account of the loss of or damage to the assets being replaced or restored or with awards of compensation arising from the taking by eminent domain or condemnation of the assets being replaced, (2) the purchase price of equipment that is purchased simultaneously with the trade-in of existing equipment to the extent that the gross amount of such purchase price is reduced by the credit granted by the seller of such equipment for the equipment being traded in at such time, (3) the purchase of property, plant or equipment made within one year of the sale of any asset in replacement of such asset to the extent purchased with the proceeds of such sale and (4) expenditures for property, plant and equipment that are financed by the incurrence of Indebtedness. Excess Dividend Default shall occur if the Company pays any dividend on shares of the Company s Common Stock (i) during any Initial Interest Deferral Period or Subsequent Interest Deferral Period or so long as any deferred interest and accrued interest thereon has not been paid in full, or (ii) when, based on the then-available financial statements presented to the Company s Board of Directors, such dividend exceeds the amount available to be paid pursuant to the covenant described under the caption Restricted Payments. Exchange Act means the Securities Exchange Act of 1934, as amended, or any successor statute or statutes thereto. Table of Contents Excluded Contribution means Net Cash Proceeds received by the Company from (a) contributions to its common equity capital and (b) the sale of Capital Stock of the Company (other than Disqualified Stock), in each case designated as Excluded Contributions pursuant to an officers certificate executed on the date such capital contributions are made or the date such Capital Stock (other than Disqualified Stock) is sold, as the case may be, which are excluded from the calculation set forth in clause (3)(b) of the first paragraph of the covenant described above under the caption Certain Covenants Restricted Payments beginning on page 156. Existing Indebtedness means Indebtedness of the Company and its Subsidiaries (other than Indebtedness under the Credit Agreements) in existence on the date of the Indenture, until such amounts are repaid. Extraordinary Conversion means a conversion of Participating Preferred Stock after the date on which the holders of Participating Preferred Stock receive notice from the Company of a Senior Subordinated Notes Redemption Event and prior to the consummation of such Senior Subordinated Notes Redemption Event. Fair Market Value means the value that would be paid by a willing buyer to an unaffiliated willing seller in a transaction not involving distress or necessity of either party, determined in good faith by the Board of Directors of the Company (unless otherwise provided in the Indenture) whose resolution with respect thereto will be delivered to the trustee. Fixed Charge Coverage Ratio means with respect to any specified Person for any period, the ratio of the EBITDA of such Person for such period to the Fixed Charges of such Person for such period. In the event that the specified Person or any of its Restricted Subsidiaries incurs, assumes, Guarantees, repays, repurchases, redeems, defeases or otherwise discharges any Indebtedness (other than ordinary working capital borrowings) or issues, repurchases or redeems preferred stock subsequent to the commencement of the period for which the Fixed Charge Coverage Ratio is being calculated and on or prior to the date on which the event for which the calculation of the Fixed Charge Coverage Ratio is made (the Calculation Date ), then the Fixed Charge Coverage Ratio will be calculated giving pro forma effect to such incurrence, assumption, Guarantee, repayment, repurchase, redemption, defeasance or other discharge of Indebtedness, or such issuance, repurchase or redemption of preferred stock, and the use of the proceeds therefrom, as if the same had occurred at the beginning of the applicable four-quarter reference period. In addition, for purposes of calculating the Fixed Charge Coverage Ratio: (1) acquisitions that have been made by the specified Person or any of its Restricted Subsidiaries, including through mergers or consolidations, or any Person or any of its Restricted Subsidiaries acquired by the specified Person or any of its Restricted Subsidiaries, and including any related financing transactions and including increases in ownership of Restricted Subsidiaries, during the four-quarter reference period or subsequent to such reference period and on or prior to the Calculation Date will be given pro forma effect (including any pro forma expense and cost reductions, adjustments and other operating improvements or synergies both achieved by such Person during such period as a result of the acquisition and to be achieved by such Person as a result of the acquisition, all as determined in good faith by a responsible financial or accounting officer) as if they had occurred on the first day of the four-quarter reference period; (2) the EBITDA (positive or negative) attributable to discontinued operations, as determined in accordance with GAAP, and operations or businesses (and ownership interests therein) disposed of prior to the Calculation Date, will be excluded; (3) the Fixed Charges attributable to discontinued operations, as determined in accordance with GAAP, and operations or businesses (and ownership interests therein) disposed of prior to the Calculation Date, will be excluded, but only to the extent that the obligations giving rise to such Fixed Charges will not be obligations of the specified Person or any of its Restricted Subsidiaries following the Calculation Date; (4) any Person that is a Restricted Subsidiary on the Calculation Date will be deemed to have been a Restricted Subsidiary at all times during such four-quarter period; (5) any Person that is not a Restricted Subsidiary on the Calculation Date will be deemed not to have been a Restricted Subsidiary at any time during such four-quarter period; and Table of Contents (6) if any Indebtedness bears a floating rate of interest, the interest expense on such Indebtedness will be calculated as if the rate in effect on the Calculation Date had been the applicable rate for the entire period (taking into account any Hedging Obligation applicable to such Indebtedness). Fixed Charges means, with respect to any specified Person for any period, the sum, without duplication, of: (1) the consolidated interest expense of such Person and its Restricted Subsidiaries for such period, whether paid or accrued, including, without limitation, amortization of debt issuance costs and original issue discount, non-cash interest payments, the interest component of any deferred payment obligations, the interest component of all payments associated with Capital Lease Obligations, commissions, discounts and other fees and charges incurred in respect of letter of credit or bankers acceptance financings, and net of the effect of all payments made or received pursuant to Hedging Obligations in respect of interest rates (but excluding the amortization or write-off of deferred financing fees in connection with (the Acquisition or the Transactions); plus (2) the consolidated interest expense of such Person and its Restricted Subsidiaries that was capitalized during such period; plus (3) any interest accruing on Indebtedness of another Person that is Guaranteed by such Person or one of its Restricted Subsidiaries or secured by a Lien on assets of such Person or one of its Restricted Subsidiaries, whether or not such Guarantee or Lien is called upon; plus (4) to the extent not included in clause (1) above, the product of (a) all dividends, whether paid or accrued and whether or not in cash, on any series of preferred stock, including, without limitation, the Participating Preferred Stock, of such Person or any of its Restricted Subsidiaries and all payments with respect to vested options to acquire Participating Preferred Stock outstanding on the date of the Indenture, other than (i) dividends on Equity Interests payable solely in Equity Interests of the Company (other than Disqualified Stock) or to the Company or a Restricted Subsidiary of the Company, (ii) dividends on the Participating Preferred Stock to the extent such dividends do not have a preference over dividends on the Company s Common Stock and (iii) payments with respect to vested options to acquire Participating Preferred Stock outstanding on the date of the Indenture (to the extent such payments correspond to dividends on Participating Preferred Stock that do not have a preference over dividends on the Company s Common Stock), times (b) a fraction, the numerator of which is one and the denominator of which is one minus the then current combined federal, state and local statutory tax rate of such Person, expressed as a decimal, in each case, determined on a consolidated basis in accordance with GAAP. Foreign Subsidiary means any Restricted Subsidiary of the Company that is not a Domestic Subsidiary. GAAP means generally accepted accounting principles set forth in the opinions and pronouncements of the Accounting Principles Board of the American Institute of Certified Public Accountants and statements and pronouncements of the Financial Accounting Standards Board or in such other statements by such other entity as have been approved by a significant segment of the accounting profession of the United States, which are in effect on the date of the Indenture. Guarantee means a guarantee other than by endorsement of negotiable instruments for collection in the ordinary course of business, direct or indirect, in any manner including, without limitation, by way of a pledge of assets or through letters of credit or reimbursement agreements in respect thereof, of all or any part of any Indebtedness (whether arising by virtue of partnership arrangements, or by agreements to keep-well, to purchase assets, goods, securities or services, to take or pay or to maintain financial statement conditions or otherwise). Guarantors means: (1) each Domestic Subsidiary of the Company on the date of the Indenture; and Table of Contents (2) any other Subsidiary of the Company that executes a Note Guarantee in accordance with the provisions of the Indenture; and (3) their respective successors and assigns, in each case, until the Note Guarantee of such Person has been released in accordance with the provisions of the Indenture. Hedging Obligations means, with respect to any specified Person, the obligations of such Person under: (1) interest rate swap agreements (whether from fixed to floating or from floating to fixed), interest rate cap agreements and interest rate collar agreements; (2) other agreements or arrangements designed to manage interest rates or interest rate risk; and (3) other agreements or arrangements designed to protect such Person against fluctuations in currency exchange rates or commodity prices. Indebtedness means, with respect to any specified Person, any indebtedness of such Person (excluding accrued expenses and trade payables), whether or not contingent: (1) in respect of borrowed money; (2) evidenced by bonds, notes, debentures or similar instruments or letters of credit (or reimbursement agreements in respect thereof); (3) in respect of banker s acceptances; (4) representing Capital Lease Obligations; (5) representing the balance deferred and unpaid of the purchase price of any property or services due more than six months after such property is acquired or such services are completed; or (6) representing any Hedging Obligations, if and to the extent any of the preceding items (other than letters of credit and Hedging Obligations) would appear as a liability upon a balance sheet (excluding the footnotes thereto) of the specified Person prepared in accordance with GAAP. In addition, the term Indebtedness includes, to the extent not otherwise included (a) the Guarantee by the specified Person of any Indebtedness of any other Person and (b) all Indebtedness of others secured by a Lien on any asset of the specified Person (whether or not such Indebtedness is assumed by the specified Person); provided that the amount of such Indebtedness will be the lesser of (x) the Fair Market Value of such asset at such date of determination and (y) the amount of such Indebtedness of such other Person. Notwithstanding the foregoing, however, Indebtedness shall not include (i) any obligations under the Stock Purchase Agreement or other agreements executed in connection therewith to pay Rebates or estimated or final purchase price adjustments to ConAgra Foods, Inc. or any of its Affiliates, (ii) advances to the Company or any of its Restricted Subsidiaries by its customers in the ordinary course of business or (iii) competitive allowances given by the Company or any of its Restricted Subsidiaries to their customers in the ordinary course of business. Interest Deferral Period means an Initial Interest Deferral Period or a Subsequent Deferral Period. Investments means, with respect to any Person, all direct or indirect investments by such Person in other Persons (including Affiliates) in the forms of loans (including Guarantees or other obligations), advances or capital contributions (excluding accounts receivable, trade credit and advances to customers and commission, travel and similar advances to officers and employees made in the ordinary course of business), purchases or other acquisitions for consideration of Indebtedness, Equity Interests or other securities, together with all items that are or would be classified as investments on a balance sheet prepared in accordance with GAAP. If the Company or any Subsidiary of the Company sells or otherwise disposes of any Equity Interests of any direct or indirect Subsidiary of the Company such that, after giving effect to any such sale or disposition, such Person is no longer a Subsidiary of the Company, the Company will be deemed to have made an Investment on the date of Table of Contents any such sale or disposition equal to the Fair Market Value of the Company s Investments in such Subsidiary that were not sold or disposed of in an amount determined as provided in the second to last paragraph of the covenant described above under the caption Certain Covenants Restricted Payments beginning on page 156. The acquisition by the Company or any Subsidiary of the Company of a Person that holds an Investment in a third Person will be deemed to be an Investment by the Company or such Subsidiary in such third Person in an amount equal to the Fair Market Value of the Investments held by the acquired Person in such third Person in an amount determined as provided in the second to last paragraph of the covenant described above under the caption Certain Covenants Restricted Payments beginning on page 156. Except as otherwise provided in the Indenture, the amount of an Investment will be determined at the time the Investment is made and without giving effect to subsequent changes in value. Lien means, with respect to any asset, any mortgage, lien, pledge, charge, security interest or encumbrance of any kind in respect of such asset, whether or not filed, recorded or otherwise perfected under applicable law, including any conditional sale or other title retention agreement, any lease in the nature thereof, any agreement to sell or give a security interest and, except in connection with any Qualified Receivables Transaction, any filing of or agreement to give any financing statement under the Uniform Commercial Code (or equivalent statutes) of any jurisdiction; provided that in no event shall any operating lease, option or other agreement to sell be deemed to constitute a Lien. Management Incentive Agreement means the Management Incentive Agreement by and among the Company and certain of its security holders, as described elsewhere in the prospectus. Moody s means Moody s Investors Service, Inc. Net Income means, with respect to any specified Person for any period, the net income (loss) of such Person, determined in accordance with GAAP and before any reduction in respect of preferred stock dividends, excluding, however: (1) any gain or loss, together with any related provision for taxes on such gain or loss, realized in connection with: (a) any Asset Sale or (b) the disposition of any securities by such Person or any of its Restricted Subsidiaries or the extinguishment of any Indebtedness of such Person or any of its Restricted Subsidiaries; (2) any extraordinary gain or loss and any nonrecurring gains, losses, income or expenses (including, without limitation, expenses related to the Acquisition and any severance and transition expenses incurred as a direct result of the transition of the Company to an independent operating company in connection with the Acquisition), in each case together with any related provision for taxes on such items; provided that with respect to any such nonrecurring loss or expense, the Company delivers to the trustee an officers certificate specifying and quantifying such item; (3) any expenses of such Person or any of its Restricted Subsidiaries related to the step up to fair market value of inventories at November 23, 2003 in connection with the Acquisition, in an aggregate amount not to exceed $21.027 million; (4) any expenses of such Person or any of its Restricted Subsidiaries related to the fee prepaid to ConAgra Foods, Inc. on November 24, 2003 pursuant to that certain Transition Services Agreement among ConAgra Foods, Inc., the Company and certain of its Subsidiaries, in an aggregate amount not to exceed $7.5 million; and (5) any gain related to the sale of the capital stock of HACCO, Inc. or the sale of the assets of Hess and Clark, Inc., in an aggregate amount not to exceed $10.543 million. Net Proceeds means the aggregate proceeds in the form of cash or Cash Equivalents received by the Company or any of its Restricted Subsidiaries in respect of any Asset Sale (including, without limitation, any cash or Cash Equivalents received upon the sale or other disposition of any non-cash consideration received in any Asset Sale and any cash payments received by way of deferred payment of principal pursuant to a note or installment receivable or otherwise, but only as and when received, but excluding the assumption by the acquiring person of Indebtedness and other liabilities relating to the disposed assets), net of the direct costs relating to such Asset Sale and the sale or disposition of such non-cash consideration, including, without limitation, legal, accounting and investment banking fees, and sales commissions, and any relocation expenses incurred as a result of the Asset Sale, taxes paid or payable as a result of the Asset Sale, in each case, after taking Table of Contents into account any available tax credits or deductions and any tax sharing arrangements, amounts required to be applied to the repayment of Indebtedness, other than Indebtedness under a Credit Facility, secured by a Lien on the asset or assets that were the subject of such Asset Sale and any reserve for adjustment in respect of the sale price of such asset or assets established in accordance with GAAP. Non-Recourse Debt means Indebtedness: (1) as to which neither the Company nor any of its Restricted Subsidiaries (a) provides credit support of any kind (including any undertaking, agreement or instrument that would constitute Indebtedness), (b) is directly or indirectly liable as a guarantor or otherwise, or (c) constitutes the lender; and (2) as to which the lenders have no recourse to any of the assets of the Company or any of its Restricted Subsidiaries. Note Guarantee means the Guarantee by each Guarantor of the Company s obligations under the Indenture and on the Notes, executed pursuant to the provisions of the Indenture. Obligations means any principal, interest, penalties, fees, indemnifications, reimbursements, damages and other liabilities payable under the documentation governing any Indebtedness. Pari Passu Indebtedness means (i) with respect to the Company, the Notes and any other Indebtedness of the Company, other than Senior Indebtedness, Secured Indebtedness or Subordinated Indebtedness of the Company and (ii) with respect to any Guarantor, its Note Guarantee and any other Indebtedness of such Guarantor, other than Senior Indebtedness, Secured Indebtedness or Subordinated Indebtedness of such Guarantor. Participating Preferred Stock means the Participating Preferred Stock of the Company with such terms and conditions as are described in the Certificate of Designation, Preferences and Rights of Participating Preferred Stock filed with the Secretary of State of the State of Delaware on or prior to the date of the Indenture. Permitted Business means the business of the Company and its Subsidiaries as existing on the date of the Indenture and any other businesses that are the same, similar or reasonably related, ancillary or complementary thereto and reasonable extensions thereof. Permitted Holder means (1) Apollo, (2) each investment fund managed, operated or controlled by, or affiliated with, Apollo and (3) any Related Party of Apollo. Permitted Investments means: (1) any Investment in the Company or in a Restricted Subsidiary of the Company, provided that: (a) if such Investment is in a Restricted Subsidiary of the Company that is not a Guarantor, such Restricted Subsidiary is not restricted from paying dividends or any other distributions on its Capital Stock other than as permitted by the covenant described above under the caption Certain Covenants Dividend and Other Payment Restrictions Affecting Subsidiaries beginning on page 165; and (b) if such Investment is in the Company by a Restricted Subsidiary of the Company and consists of Indebtedness, such Indebtedness is unsecured and subordinated, pursuant to a written agreement, to the Company s obligations under the Notes. (2) any Investment in Cash Equivalents; (3) any Investment by the Company or any Restricted Subsidiary of the Company in a Person (including payments to the holders of Equity Interests in such Person), if as a result of such Investment: (a) such Person becomes a Restricted Subsidiary of the Company; provided that in the case of any such Restricted Subsidiary of the Company that is not, or does not become in connection with such Investment, a Guarantor, such Restricted Subsidiary is not restricted from paying dividends or any other distributions on its Capital Stock other than as permitted by the covenant described Table of Contents above under the caption Certain Covenants Dividend and Other Payment Restrictions Affecting Subsidiaries beginning on page 165; or (b) such Person is merged or consolidated with or into, or transfers or conveys substantially all of its assets to, or is liquidated into, the Company or a Restricted Subsidiary of the Company; provided that in the case of any such Restricted Subsidiary of the Company that is not a Guarantor, such Restricted Subsidiary is not restricted from paying dividends or any other distributions on its Capital Stock other than as permitted by the covenant described above under the caption Certain Covenants Dividend and Other Payment Restrictions Affecting Subsidiaries beginning on page 165; (4) any Investment made as a result of the receipt of non-cash consideration from (a) an Asset Sale that was made pursuant to and in compliance with the covenant described above under the caption Repurchase at the Option of Holders Asset Sales beginning on page 153 or (b) a transaction that would be an Asset Sale if not for the threshold set forth in clause (1) of the second paragraph of the definition of Asset Sale; (5) Investments acquired in exchange for, or out of the net cash proceeds of an offering within 30 days of, Capital Stock (other than Disqualified Stock) of the Company; provided that the amount of any such net cash proceeds that are utilized for any such Investment pursuant to this clause (5) will be excluded from clause (3)(b) of the first paragraph of the covenant described above under the caption Certain Covenants Restricted Payments beginning on page 156; (6) any Investments received in compromise or resolution of (a) obligations of trade creditors, suppliers or customers that were incurred in the ordinary course of business of the Company or any of its Restricted Subsidiaries, including pursuant to any plan of reorganization or similar arrangement upon the bankruptcy or insolvency of any trade creditor, supplier or customer, or (b) litigation, arbitration or other disputes with Persons who are not Affiliates; (7) Investments represented by Hedging Obligations; (8) loans or advances to employees and officers of the Company and its Restricted Subsidiaries made (a) in the ordinary course of business in an aggregate principal amount not to exceed $5.0 million at any one time outstanding or (b) to fund purchases of Capital Stock of the Company or United Agri Products under any stock option plan, stock ownership plan or other similar employment arrangements so long as no cash is actually advanced by the Company or any of its Restricted Subsidiaries to such employees and officers to fund such purchases; (9) repurchases of the Notes; (10) Investments existing on the date of the Indenture; (11) Guarantees of Indebtedness to the extent permitted pursuant to the covenants described above under the captions Certain Covenants Incurrence of Indebtedness and Issuance of Disqualified Stock beginning on page 161 and Certain Covenants Limitation on Issuances of Guarantees of Indebtedness beginning on page 169; (12) the acquisition by a Receivables Subsidiary in connection with a Qualified Receivables Transaction of Equity Interests of a trust or other Person established by such Receivables Subsidiary to effect such Qualified Receivables Transaction; and any other Investment by the Company or a Subsidiary of the Company in a Receivables Subsidiary or any Investment by a Receivables Subsidiary in any other Person in connection with a Qualified Receivables Transaction; provided that such other Investment is in the form of a note or other instrument that the Receivables Subsidiary or other Person is required to repay as soon as practicable from available cash collections less amounts required to be established as reserves pursuant to contractual agreements with entities that are not Affiliates of the Company entered into as part of a Qualified Receivables Transaction; Table of Contents (13) Investments of a Person or any of its Subsidiaries existing at the time such Person becomes a Restricted Subsidiary of the Company or at the time such Person merges or consolidates with the Company or any of its Restricted Subsidiaries, in either case in compliance with the Indenture; provided that such Investments were not made in connection with, or in anticipation or contemplation of, such Person becoming a Restricted Subsidiary of the Company or such merger or consolidation; and (14) other Investments having an aggregate Fair Market Value (measured on the date each such Investment was made and without giving effect to subsequent changes in value), when taken together with all other Investments made pursuant to this clause (14) that are at the time outstanding not to exceed $45.0 million; provided that if an Investment pursuant to this clause (14) is made in any Person that is not a Restricted Subsidiary of the Company at the date of the making of the Investment and such Person becomes a Restricted Subsidiary after such date, such Investment shall thereafter be deemed to have been made pursuant to clause (1) above, and shall cease to have been made pursuant to this clause (14). Permitted Junior Securities shall mean debt or equity securities of the Company or any successor corporation issued pursuant to a plan of reorganization or readjustment of the Company that are subordinated to the payment of all then-outstanding Senior Indebtedness of the Company at least to the same extent that the Notes are subordinated to the payment of all Senior Indebtedness of the Company on the date of the Indenture, so long as to the extent that any Senior Indebtedness of the Company outstanding on the date of consummation of any such plan of reorganization or readjustment is not paid in full in cash on such date, either (a) the holders of any such Senior Indebtedness not so paid in full in cash have consented to the terms of such plan of reorganization or readjustment or (b) such holders receive securities which constitute Senior Indebtedness and which have been determined by the relevant court to constitute satisfaction in full in cash of any Senior Indebtedness not paid in full in cash. Permitted Liens means: (1) Liens on assets of the Company or any of its Restricted Subsidiaries securing Indebtedness and other Obligations under Credit Facilities that was incurred pursuant to clause (1), clause (4) or clause (13) of the definition of Permitted Debt and/or securing Hedging Obligations related thereto; (2) Liens in favor of the Company, any Guarantor or any Wholly-Owned Subsidiary; (3) Liens securing Indebtedness of a Restricted Subsidiary of the Company (including, without limitation, Liens created for the benefit of (or to secure) the UAP Senior Notes or the related Guarantees of the UAP Senior Notes); provided such Indebtedness was permitted to be incurred by the covenant described above under the caption Certain Covenants Incurrence of Indebtedness and Issuance of Disqualified Stock beginning on page 161; (4) Liens on property of a Person existing at the time such Person is merged with or into or consolidated with the Company or any Subsidiary of the Company; provided that such Liens were in existence prior to the contemplation of such merger or consolidation and do not extend to any assets other than those of the Person merged into or consolidated with the Company or the Subsidiary; (5) Liens on property (including Capital Stock) existing at the time of acquisition of the property by the Company or any Subsidiary of the Company; provided that such Liens were in existence prior to, and not incurred in contemplation of, such acquisition; (6) Liens to secure Indebtedness (including Capital Lease Obligations) permitted by clause (4) of the second paragraph of the covenant entitled Certain Covenants Incurrence of Indebtedness and Issuance of Disqualified Stock beginning on page 161 covering only the assets acquired with or financed by such Indebtedness; (7) Liens existing on the date of the Indenture; (8) Liens for taxes, assessments or governmental charges or claims that are not yet delinquent or that are being contested in good faith by appropriate proceedings promptly instituted and diligently concluded; provided that any reserve or other appropriate provision as is required in conformity with GAAP has been made therefor; EBITDA 120,464 58,050 120,245 Loss from discontinued operations 4,708 2,095 Table of Contents (9) Liens imposed by law, such as carriers , warehousemen s, landlord s and mechanics Liens, in each case, incurred in the ordinary course of business; (10) survey exceptions, easements or reservations of, or rights of others for, licenses, rights-of-way, sewers, electric lines, telegraph and telephone lines and other similar purposes, or zoning or other restrictions as to the use of real property that were not incurred in connection with Indebtedness and that do not in the aggregate materially adversely affect the value of said properties or materially impair their use in the operation of the business of such Person; (11) Liens created for the benefit of (or to secure) the Notes or the Note Guarantees; (12) Liens to secure any Permitted Refinancing Indebtedness permitted to be incurred under the Indenture; provided, however, that: (a) the new Lien shall be limited to all or part of the same property and assets that secured or, under the written agreements pursuant to which the original Lien arose, could secure the original Lien (plus improvements and accessions to, such property or proceeds or distributions thereof); and (b) the Indebtedness secured by the new Lien is not increased to any amount greater than the sum of (x) the outstanding principal amount or, if greater, committed amount, of the Permitted Referencing Indebtedness and (y) an amount necessary to pay any fees and expenses, including premiums, related to such renewal, refunding, refinancing, replacement, defeasance or discharge; (13) Liens incurred or deposits made in the ordinary course of business in connection with workers compensation, unemployment insurance and other types of social security, including any Lien securing letters of credit issued in the ordinary course or business consistent with past practice in connection therewith, or to secure the performance of tenders, statutory obligations, surety and appeal bonds, bids, leases, government contracts, performance and return-of-money bonds and other similar obligations (exclusive of obligations for the payment of borrowed money); (14) Liens upon specific items of inventory or other goods and proceeds of any Person securing such Person s obligations in respect of bankers acceptances or similar credit transactions issued or created for the account of such Person to facilitate the purchase, shipment, or storage of such inventory or other goods; (15) judgment Liens not giving rise to an Event of Default; (16) Liens on assets of the Company or a Receivables Subsidiary incurred in connection with a Qualified Receivables Transaction; (17) Liens in favor of customs and revenue authorities arising as a matter of law to secure payment of customs duties in connection with the importation of goods; (18) Liens securing Hedging Obligations which Hedging Obligations relate to Indebtedness that is otherwise permitted under the Indenture; (19) Liens arising out of conditional sale, title retention, consignment or similar arrangements for the sale of goods entered into by the Company or any of its Restricted Subsidiaries in the ordinary course of business; (20) leases or subleases granted to others that do not materially interfere with the ordinary course of business of the Company and its Restricted Subsidiaries; (21) Liens arising from filing Uniform Commercial Code financing statements regarding leases; (22) Liens encumbering deposits made to secure obligations arising from statutory, regulatory, contractual, or warranty requirements of the Company or any of its Restricted Subsidiaries, including rights of offset and set-off; (23) Liens securing insurance premium financing arrangements; provided that such Lien is limited to the applicable insurance contracts; Table of Contents (24) Liens securing reimbursement obligations with respect to commercial letters of credit that encumber documents and other property relating to such letters of credit and products and proceeds thereof; (25) Liens securing Indebtedness incurred under clause (18) of the second paragraph of the covenant described above under the caption Certain Covenants Incurrence of Indebtedness and Issuance of Disqualified Stock beginning on page 161; provided that such Liens do not extend to or cover any of the cash or Cash Equivalents that have been deposited with the trustee pursuant to Legal Defeasance and Covenant Defeasance beginning on page 172; (26) Liens incurred in the ordinary course of business of the Company or any Subsidiary of the Company with respect to obligations that do not exceed $10.0 million at any one time outstanding; and (27) Liens securing Senior Indebtedness incurred in accordance with the Indenture. Permitted Payments to Parent means, without duplication as to amounts: (1) payments of dividends or other distributions or amounts by the Company to any direct or indirect parent of the Company in amounts required for such parent or any of its direct or indirect parents to pay franchise taxes and other fees required to maintain its existence and provide for all other operating costs of such parent or any of its direct or indirect parents to operate as a public or private holding company, including, without limitation, in respect of director fees and expenses, administrative, legal and accounting services provided by third parties and other costs and expenses, including all costs and expenses with respect to filings with the SEC; and (2) for so long as the Company files a consolidated, combined, affiliated or unitary tax return with any direct or indirect parent of the Company, payments of dividends or other distributions or amounts by the Company to such parent in amounts required to pay the tax obligations of the Company and its Subsidiaries and the tax obligations of such parent or any of its direct or indirect parents attributable to the Company and its Subsidiaries; provided that the amount of dividends paid pursuant to this clause (2) to enable such parent or any of its direct or indirect parents to pay Federal, state or local income taxes at any time shall not exceed the amount of the relevant tax (including any penalties and interest) that the Company would owe if the Company were filing a separate tax return (or a separate consolidated or combined return with its Subsidiaries that are members of the consolidated or combined group), taking into account any carryovers or carrybacks of tax attributes (such as net operating loses) of the Company and such Subsidiaries from prior years; provided further that any refunds received by such parent or any of its direct or indirect parents attributable to the Company and its Subsidiaries shall be promptly returned by such parent or any of its direct or indirect parents to the Company. Permitted Refinancing Indebtedness means any Indebtedness of the Company or any of its Restricted Subsidiaries issued in exchange for, or the net proceeds of which are used to refund, refinance, replace, defease or discharge other Indebtedness of the Company or any of its Restricted Subsidiaries (other than intercompany Indebtedness); provided that: (1) the principal amount (or accreted value, if applicable) of such Permitted Refinancing Indebtedness does not exceed the principal amount (or accreted value, if applicable) of the Indebtedness renewed, refunded, refinanced, replaced, defeased or discharged (plus all accrued interest on the Indebtedness and the amount of all fees and expenses, including premiums, incurred in connection therewith); (2) such Permitted Refinancing Indebtedness has a final maturity date later than the final maturity date of, and has a Weighted Average Life to Maturity equal to or greater than the Weighted Average Life to Maturity of, the Indebtedness being renewed, refunded, refinanced, replaced, defeased or discharged; provided that this clause (2) will not apply to any Indebtedness incurred to refund, refinance, replace, defease or discharge Senior Indebtedness; Table of Contents (3) if the Indebtedness being renewed, refunded, refinanced, replaced, defeased or discharged is subordinated in right of payment to the Notes, such Permitted Refinancing Indebtedness is subordinated in right of payment to, the Notes on terms at least as favorable to the holders of Notes as those contained in the documentation governing the Indebtedness being renewed, refunded, refinanced, replaced, defeased or discharged; and (4) such Indebtedness is incurred either by the Company or by the Restricted Subsidiary who is the obligor on the Indebtedness being renewed, refunded, refinanced, replaced, defeased or discharged. Person means any individual, corporation, partnership, joint venture, association, joint-stock company, trust, unincorporated organization, limited liability company or government or other entity. Qualified Receivables Transaction means any transaction or series of transactions entered into by the Company or any of its Restricted Subsidiaries pursuant to which the Company or any of its Restricted Subsidiaries sells, conveys or otherwise transfers to (i) a Receivables Subsidiary (in the case of a transfer by the Company or any of its Restricted Subsidiaries) and (ii) any other Person (in the case of a transfer by a Receivables Subsidiary), or grants a security interest in, any accounts receivable (whether now existing or arising in the future) of the Company or any of its Restricted Subsidiaries, and any assets related thereto including, without limitation, all collateral securing such accounts receivable, all contracts and all guarantees or other obligations in respect of such accounts receivable, proceeds of such accounts receivable and other assets which are customarily transferred or in respect of which security interests are customarily granted in connection with asset securitization transactions involving accounts receivable and any Hedging Obligations entered into by the Company or any such Subsidiary in connection with such accounts receivable. Quarterly Base Dividend Level means, for any fiscal quarter, 100% of the Company s Excess Cash for the 12-month period ending on the last day of the Company s then most recently ended fiscal quarter for which internal financial statements are available at the time such dividend is declared and paid divided by four (4). Rebates means rebates, incentives, loyalty and other bonuses, freight or other similar refunds, rebillings, performance or award payments, marketing payments, warehousing and interest payments, program payments, products furnished on a discounted or no-charge basis, and all other such payments and forms of compensation, and the proceeds thereof, that are now or may hereafter be payable by vendors to the Company or any of its Subsidiaries as a result of product sales (whether wholesale, retail or otherwise), service or other performance criteria. Recapitalization Agreement means the Recapitalization Agreement by and between the Company and Apollo Investment Fund V, LP, Apollo Overseas Partners V, L.P., Apollo Netherlands Partners V (A), LP, Apollo Netherlands Partners V (B), LP, Apollo German Partners V GmbH & Co. KG, as described elsewhere in the prospectus. Receivables Subsidiary means a Wholly-Owned Restricted Subsidiary of United Agri Products which engages in no activities other than in connection with the financing of accounts receivable and which is designated by the Board of Directors of the Company (as provided below) as a Receivables Subsidiary (a) no portion of the Indebtedness or any other Obligations (contingent or otherwise) of which (i) is guaranteed by the Company or any Restricted Subsidiary of the Company (excluding guarantees of Obligations (other than the principal of, and interest on, Indebtedness) pursuant to representations, warranties, covenants and indemnities entered into in the ordinary course of business in connection with a Qualified Receivables Transaction), (ii) is recourse to or obligates the Company or any Restricted Subsidiary of the Company in any way other than pursuant to representations, warranties, covenants and indemnities entered into in the ordinary course of business in connection with a Qualified Receivables Transaction or (iii) subjects any property or asset of the Company or any Restricted Subsidiary of the Company (other than accounts receivable and related assets as provided in the definition of Qualified Receivables Transaction ), directly or indirectly, contingently or otherwise, to the satisfaction thereof, other than pursuant to representations, warranties, covenants and indemnities entered into in Table of Contents the ordinary course of business in connection with a Qualified Receivables Transaction, (b) with which neither the Company nor any Restricted Subsidiary of the Company has any material contract, agreement, arrangement or understanding other than on terms no less favorable to the Company or such Restricted Subsidiary than those that might be obtained at the time from Persons who are not Affiliates of the Company, other than fees payable in the ordinary course of business in connection with servicing accounts receivable and (c) with which neither the Company nor any Restricted Subsidiary of the Company has any obligation to maintain or preserve such Subsidiary s financial condition or cause such Subsidiary to achieve certain levels of operating results. Any such designation by the Board of Directors of the Company will be evidenced to the trustee by filing with the trustee a certified copy of the resolution of the Board of Directors of the Company giving effect to such designation and an officers certificate certifying that such designation complied with the foregoing conditions. Related Party of a specified Person means: (1) any controlling stockholder, more than 50%-owned Subsidiary, or immediate family member (in the case of an individual) of such Person; or (2) any trust, corporation, partnership, limited liability company or other entity, the beneficiaries, stockholders, partners, members, owners or Persons beneficially holding a more than 50% interest of which consist of such Person and/or such other Persons referred to in the immediately preceding clause (1). Representative means the trustee, agent or representative (if any) for an issue of Senior Indebtedness. Restricted Investment means an Investment other than a Permitted Investment. Restricted Subsidiary of a Person means any Subsidiary of the referent Person that is not an Unrestricted Subsidiary. S&P means Standard & Poor s Ratings Services. SEC means the United States Securities and Exchange Commission. Secured Indebtedness means any Indebtedness of the Company or any Subsidiary secured by a Lien. Securities Act means the Securities Act of 1933, as amended, or any successor statute or statutes thereto. Senior Indebtedness with respect to the Company or any Guarantor means the Indebtedness under or in respect of the Credit Facilities and all Indebtedness of the Company or such Guarantor, including interest thereon (including interest accruing on or after the filing of any petition in bankruptcy or for reorganization relating to the Company or any Subsidiary of the Company whether or not a claim for post-filing interest is allowed in such proceeding) and other amounts (including make-whole payments, fees, expenses, reimbursement obligations under letters of credit and indemnities) owing in respect thereof, whether outstanding on the date of the Indenture or thereafter incurred, unless in the instrument creating or evidencing the same or pursuant to which the same is outstanding it is provided that such obligations are not superior in right of payment to the Notes or such Guarantor s Note Guarantee, as applicable; provided, however, that Senior Indebtedness shall not include, as applicable, (i) any obligation of the Company to any Subsidiary of the Company or of such Guarantor to the Company or any other Subsidiary of the Company, (ii) any liability for Federal, state, local or other taxes owed or owing by the Company or such Guarantor, (iii) any accounts payable or other liability to trade creditors arising in the ordinary course of business (including guarantees thereof or instruments evidencing such liabilities), (iv) any Indebtedness or obligation of the Company or such Guarantor which is pari passu with the Notes or is Subordinated Indebtedness, (v) any obligations with respect to any Capital Stock, and (vi) that portion of any Indebtedness incurred in violation of the covenant described above under Incurrence of Indebtedness and Issuance of Disqualified Stock; provided that as to any such Indebtedness, no such violation shall be deemed to Table of Contents exist for purposes of this clause (vi) if the holder(s) of such Indebtedness or their representative shall have received an officer s certificate (or representation and warranty) from the Company to the effect that the incurrence of such Indebtedness does not (or in the case of revolving credit Indebtedness, that the incurrence of the entire committed amount thereof at the date on which the initial borrowing thereunder is made would not) violate such covenant. Senior Subordinated Notes Redemption Event means any redemption, optional repurchase or other event (including maturity) following which there will no longer be any Notes (whether or not represented by IDSs) outstanding. Significant Subsidiary means any Subsidiary that would be a significant subsidiary as defined in Article 1, Rule 1-02 of Regulation S-X, promulgated pursuant to the Securities Act, as such Regulation is in effect on the date of the Indenture. Stated Maturity means, with respect to any installment of interest or principal on any series of Indebtedness, the date on which the payment of interest or principal was scheduled to be paid in the documentation governing such Indebtedness as of the date of the Indenture, and will not include any contingent obligations to repay, redeem or repurchase any such interest or principal prior to the date originally scheduled for the payment thereof. Stock Purchase Agreement means the Stock Purchase Agreement by and among the Company, ConAgra Foods, Inc. and United Agri Products, dated as of October 29, 2003, as amended. Subordinated Indebtedness means (a) with respect to the Company, any Indebtedness of the Company which is by its terms subordinated in right of payment to the Notes and (b) with respect to any Guarantor, any Indebtedness of the applicable Guarantor which is by its terms subordinated in right of payment to such Guarantor s Note Guarantee. Subsidiary means, with respect to any specified Person: (1) any corporation, association or other business entity of which more than 50% of the total voting power of shares of Capital Stock entitled (without regard to the occurrence of any contingency and after giving effect to any voting agreement or stockholders agreement that effectively transfers voting power) to vote in the election of directors, managers or trustees of the corporation, association or other business entity is at the time owned or controlled, directly or indirectly, by that Person or one or more of the other Subsidiaries of that Person (or a combination thereof); and (2) any partnership (a) the sole general partner or the managing general partner of which is such Person or a Subsidiary of such Person or (b) the only general partners of which are that Person or one or more Subsidiaries of that Person (or any combination thereof). Transaction Fee means a transaction fee to Apollo pursuant to the Apollo Management Consulting Agreement upon the consummation of this offering in an amount not to exceed 1% of the aggregate value of the shares of Common Stock included in the IDSs sold to the public (not including any IDSs that may be issued upon exercise of the underwriters over-allotment option). Transactions means the transactions occurring in connection with the consummation of this offering, as described elsewhere in the prospectus, including without limitation (a) the consummation of tender offers and consent solicitations for the UAP Senior Notes and the $125.0 million aggregate principal amount at maturity of the Company s 10 % Senior Discount Notes due 2012, (b) the Credit Agreements, (c) the Management Incentive Agreement and (d) the Recapitalization Agreement. UAP Senior Notes means United Agri Products 8 % Senior Notes due 2011 issued pursuant to the UAP Senior Notes Indenture. Table of Contents UAP Senior Notes Indenture means the Indenture, dated as of December 16, 2003, among United Agri Products, the guarantors party thereto and JPMorgan Chase Bank, as trustee, relating to the UAP Senior Notes. United Agri Products means United Agri Products, Inc., a Delaware corporation, and its successors and assigns. Unrestricted Subsidiary means any Subsidiary of the Company that is designated by the Board of Directors of the Company as an Unrestricted Subsidiary pursuant to a resolution of the Board of Directors, but only to the extent that such Subsidiary: (1) has no Indebtedness other than Non-Recourse Debt; (2) except as permitted by the covenant described above under the caption Certain Covenants Transactions with Affiliates beginning on page 167, is not party to any agreement, contract, arrangement or understanding with the Company or any Restricted Subsidiary of the Company unless the terms of any such agreement, contract, arrangement or understanding are no less favorable to the Company or such Restricted Subsidiary than those that might be obtained at the time from Persons who are not Affiliates of the Company; (3) is a Person with respect to which neither the Company nor any of its Restricted Subsidiaries has any direct or indirect obligation (a) to subscribe for additional Equity Interests or (b) to maintain or preserve such Person s financial condition or to cause such Person to achieve any specified levels of operating results; and (4) has not guaranteed or otherwise directly or indirectly provided credit support for any Indebtedness of the Company or any of its Restricted Subsidiaries. U.S. Government Obligations means direct obligations (or certificates representing an ownership interest in such obligations) of the United States of America (including any agency or instrumentality thereof) for the payment of which the full faith and credit of the United States of America is pledged and which are not callable or redeemable at the issuer s option. Voting Stock of any specified Person as of any date means the Capital Stock of such Person that is at the time entitled to vote in the election of the Board of Directors of such Person. Weighted Average Life to Maturity means, when applied to any Indebtedness at any date, the number of years obtained by dividing: (1) the sum of the products obtained by multiplying (a) the amount of each then remaining installment, sinking fund, serial maturity or other required payments of principal, including payment at final maturity, in respect of the Indebtedness, by (b) the number of years (calculated to the nearest one-twelfth) that will elapse between such date and the making of such payment; by (2) the then outstanding principal amount of such Indebtedness. Wholly-Owned Restricted Subsidiary of any specified Person means a Subsidiary of such Person all of the outstanding Capital Stock or other ownership interests of which (other than directors qualifying shares) will at the time be owned by such Person or by one or more Wholly-Owned Restricted Subsidiaries of such Person. Table of Contents IDSs ELIGIBLE FOR FUTURE SALE Future sales or the availability for sale of substantial amounts of IDSs or shares of our common stock or a significant principal amount of our senior subordinated notes in the public market could adversely affect prevailing market prices and could impair our ability to raise capital through future sales of our securities. Upon completion of this offering, 36,500,000 IDSs will be outstanding, assuming no exercise of the underwriters over-allotment option. The number of IDSs to be outstanding after completion of this offering excludes: IDSs issuable upon the conversion of shares of our participating preferred stock in which deferred compensation accounts under our amended and restated 2004 deferred compensation plan will be deemed to be invested; IDSs issuable upon the conversion of shares of our participating preferred stock issued in exchange for shares of our common stock owned by our equity sponsor; IDSs issuable upon the conversion of shares of our participating preferred stock underlying options issued and outstanding under our amended and restated option plans; and IDSs reserved for future grant under the long term incentive plan we intend to adopt concurrently with the closing of this offering. All 36,500,000 IDSs sold in this offering will be freely tradable without restriction or further registration under the Securities Act, except for any IDSs that may be acquired by an affiliate of ours as that term is defined in Rule 144 under the Securities Act, which will be subject to the resale limitations of Rule 144. In general, under Rule 144 as currently in effect, a person (or persons whose IDSs are aggregated) who has beneficially owned its, his or her IDSs or the underlying shares of common stock for at least one year from the date such securities were acquired from us or an affiliate of ours would be entitled to sell within any three-month period a number of IDSs or underlying shares of common stock that does not exceed the greater of one percent of the then outstanding IDSs or underlying shares of common stock, respectively, and the average weekly trading volume of the IDSs or underlying shares of common stock, respectively, during the four calendar weeks preceding a sale by such person. Sales under Rule 144 are also subject to certain manner of sale provisions, notice requirements and the availability of current public information about us. Under Rule 144, however, a person who has held restricted securities for a minimum of two years from the later of the date such securities were acquired from us or an affiliate of ours and who is not, and for the three months prior to the sale of such restricted securities has not been, an affiliate of ours, is free to sell such restricted securities without regard to volume, manner of sale and the other limitations contained in Rule 144. The foregoing summary of Rule 144 is not intended to be a complete discussion thereof. We have agreed that we will not offer, sell, contract to sell, pledge or otherwise dispose of, directly or indirectly, or file with the Securities and Exchange Commission a registration statement under the Securities Act relating to, any IDSs, shares of our common stock, shares of our participating preferred stock, or senior subordinated notes or any securities convertible into or exchangeable or exercisable for any such securities, or publicly disclose the intention to make any offer, sale, pledge, disposition or filing, without the prior written consent of Credit Suisse First Boston LLC for a period of 180 days after the date of this prospectus. Our equity sponsor, who will hold after this offering 6,403,289 shares of our participating preferred stock, has agreed, subject to specified exceptions, that it will not offer, sell, contract to sell, pledge or otherwise dispose of, directly or indirectly, any IDSs, shares of our common stock, shares of our participating preferred stock, or securities convertible into or exchangeable or exercisable for any IDSs, enter into a transaction that would have the same effect, or enter into any swap, hedge or other arrangement that transfers, in whole or in part, any of the economic consequences of ownership of IDSs, our common stock, our participating preferred stock or our senior subordinated notes, whether any of these transactions are to be settled by delivery of IDSs, our common stock, our participating preferred stock, our senior subordinated notes or other securities, in cash or otherwise or Table of Contents publicly disclose the intention to make any offer, sale, pledge or disposition, or to enter into any transaction, swap, hedge or other arrangement without, in each case, the prior written consent of Credit Suisse First Boston LLC for a period of 180 days after the date of this prospectus. In connection with this offering, we and certain security holders (such security holders to include, among others, Mr. L. Kenny Cordell, our Chief Executive Officer, nine members of management who report directly to Mr. Cordell, nineteen members of management who report directly to the nine members who report to Mr. Cordell, and three other members of management) will enter into a management incentive agreement, which will, among other things prohibit the management security holders from offering to sell, contracting to sell, or otherwise selling, disposing of, loaning, pledging or granting any rights with respect to any shares of participating preferred stock acquired pursuant to the amended and restated 2004 deferred compensation plan, any IDSs into which such shares of participating preferred stock are converted, any shares of common stock or senior subordinated notes represented by such IDSs and any securities issued in respect of the foregoing subject to the following exceptions: Upon the closing of this offering, UAP Holdings will use a portion of the proceeds from the senior subordinated notes represented by the IDSs and the senior subordinated notes sold separately from the IDSs to make a cash payment to each management security holder equal to 20% of the sum of: the excess of the value of the common stock underlying his or her vested options (with the per share value equaling the price per share paid to UAP Holdings equity sponsor for shares of common stock sold to the underwriters, after giving effect to underwriting discounts and commissions) over the exercise price of such options; and the value of the common stock in which his or her deferred compensation account under our deferred compensation plans is deemed to be invested (with the per share value equaling the price per share paid to UAP Holdings equity sponsor for shares of common stock sold to the underwriters, after giving effect to underwriting discounts and commissions). In consideration for such payment, UAP Holdings shall first cancel the management security holder s Tranche C options and then, to the extent the value of such security holder s Tranche C options is less than his payment, Tranche B options and then, to the extent the combined value of such security holder s Tranche C options and Tranche B options is less than his payment, shares of common stock in which such security holder s deferred compensation account is deemed to be invested. Upon the closing of this offering, UAP Holdings will cancel each management security holder s remaining vested and unvested options and, in consideration thereof, credit such holder s deferred compensation account under the amended and restated 2004 deferred compensation plan with additional deferred shares of participating preferred stock. The number of additional deferred shares of participating preferred stock to be credited to a holder s deferred compensation account will equal the quotient obtained by dividing: the excess of the value of the common stock underlying his or her remaining options (with the per share value equaling the price per share paid to UAP Holdings equity sponsor for shares of common stock sold to the underwriters, after giving effect to underwriting discounts and commissions) over the exercise price of such options, by the value of one share of participating preferred stock immediately after the completion of the offering (with the per share value of the participating preferred stock equaling the price per IDS paid to us for IDSs sold to the underwriters, after giving effect to the underwriting discounts and commissions). On March 1, June 1, September 1 and December 1 of each year, commencing on December 1, 2006 in the case of management security holders other than Kenneth Cordell and David Bullock and June 1, 2007 in the case of Kenneth Cordell and David Bullock (each such date, a release date ), and until shares no longer remain credited in the deferred compensation accounts, each management security holder will be permitted to sell IDSs received upon conversion of up to 5% of the participating preferred stock that is represented by vested deferred shares immediately after the consummation of the offering, but before giving effect to the cancellation described in the foregoing paragraph. Table of Contents On each release date, each management security holder will be permitted to sell IDSs received upon conversion of up to an additional 5% of the participating preferred stock that is represented by deferred shares that become vested deferred shares after the consummation of the offering and on or before such release date and were credited to such management security holder s deferred compensation account immediately after consummation of the offering, plus all dividends paid in respect of such vested deferred shares in the form of additional shares of participating preferred stock or IDSs. At any time after a release date, in addition to the foregoing, each security holder will be permitted to sell a number of IDSs received upon the conversion of participating preferred stock equal to the number of IDSs that such management security holder was entitled to, but did not, sell as of such release date. At any time, each management security holder will be permitted to sell such number of IDSs received upon the conversion of participating preferred stock as is necessary for him to generate sufficient proceeds, net of any underwriter s commissions and discounts, to satisfy any withholdings tax obligations and federal income tax liabilities (together with interest, penalties and additions to tax) resulting from: certain successful challenges of the tax deferral benefits of the amended and restated 2004 deferred compensation plan by the Internal Revenue Service or the distribution of securities from the amended and restated 2004 deferred compensation plan in connection with such management security holder s termination of employment by us without cause or by such management security holder for good reason. The management incentive agreement will also provide that, within two years of the consummation of this offering, we must file or cause to be filed, and use commercially reasonable efforts to cause to become and remain effective for so long as any management security holder beneficially owns securities covered by the management incentive agreement, a registration statement on Form S-1 or S-3 or other appropriate form with respect to the issuance of IDSs upon the conversion of shares of participating preferred stock received upon distributions from such management security holder s deferred compensation account. We will grant our equity sponsor demand and incidental registration rights with respect to the shares of participating preferred stock owned by it after this offering and the IDSs into which such shares are convertible. In addition, we will agree under the recapitalization agreement that after the 180th day following the consummation of this offering but prior to the first anniversary of the closing date of this offering, at the request of our equity sponsor, we will use our reasonable best efforts to effect one or more registered offerings of IDSs by us in order to fund certain repurchases of our participating preferred stock, subject to certain conditions. We do not expect to issue IDSs other than in transactions registered under the Securities Act. Pro forma EBITDA 125,172 58,050 122,340 Inventory Fair Market Value Adjustment (1) 3,673 17,354 21,027 ConAgra Transition Services Agreement Expense (2) 1,875 1,875 3,750 Gain on sale of businesses (3) (9,181 ) (9,181 ) Table of Contents MATERIAL U.S. FEDERAL INCOME TAX CONSEQUENCES In the opinion of our counsel, O Melveny & Myers LLP, the following discussion describes the material U.S. federal income tax consequences associated with the purchase, ownership, and disposition of IDSs, senior subordinated notes and common stock as of the date hereof by U.S. Holders (as defined below) and Non-U.S. Holders (as defined below). Except where noted, this discussion deals only with IDSs, senior subordinated notes and common stock held as capital assets by holders who acquired IDSs or notes upon their original issuance at their initial offering price and does not address special situations, such as those of: dealers in securities or currencies, financial institutions, regulated investment companies, real estate investment trusts, tax-exempt entities, insurance companies, persons holding IDSs, senior subordinated notes or common stock as a part of a hedging, integrated, conversion or constructive sale transaction or a straddle, traders in securities that elect to use a mark-to-market method of accounting for their securities holdings, persons liable for alternative minimum tax, investors in pass-through entities, or U.S. Holders (as defined below) of IDSs whose functional currency is not the U.S. dollar. Furthermore, the discussion below is based upon the provisions of the Internal Revenue Code of 1986, as amended (the Code ), the Treasury regulations promulgated thereunder and administrative and judicial interpretations thereof, all as of the date hereof, and such authorities may be repealed, revoked, modified or subject to differing interpretations, possibly on a retroactive basis, so as to result in U.S. federal income tax consequences different from those discussed below. A U.S. Holder of IDSs, senior subordinated notes or common stock means a holder that is for U.S. federal income tax purposes: an individual citizen or resident of the United States, a corporation (or other entity taxable as a corporation) created or organized in or under the laws of the United States or any state thereof or the District of Columbia, an estate the income of which is subject to U.S. federal income taxation regardless of its source, or a trust if it (1) is subject to the primary supervision of a court within the United States and one or more U.S. persons have the authority to control all substantial decisions of the trust or (2) has a valid election in effect under applicable Treasury regulations to be treated as a U.S. person. If a partnership or other entity or arrangement treated as a partnership for U.S. federal income tax purposes holds IDSs, senior subordinated notes or common stock, the tax treatment of a partner will generally depend upon the status of the partner and the activities of the partnership. If you are a partner of a partnership purchasing IDSs, senior subordinated notes or common stock, we urge you to consult your own tax advisor. Table of Contents No statutory, administrative or judicial authority directly addresses the treatment of IDSs or instruments similar to IDSs for U.S. federal income tax purposes. As a result, we cannot assure you that the Internal Revenue Service (the IRS ) or the courts will agree with the tax consequences described herein. A different treatment from that assumed below could adversely affect the amount, timing and character of income, gain or loss in respect of an investment in the IDSs, and, in the case of Non-U.S. Holders (as defined below), could subject such holders to U.S. federal withholding taxes with regard to the senior subordinated notes in the same manner as they will be with regard to our common stock. Payments to Non-U.S. Holders would not be grossed-up for any such taxes. In addition, a different treatment could result in the loss by us of all or part of the deduction for interest paid on the senior subordinated notes. If you are considering the purchase of IDSs or senior subordinated notes, we urge you to consult your own tax advisor concerning the particular U.S. federal income tax consequences to you of the ownership of IDSs or senior subordinated notes, as well as any consequences to you arising under the laws of any other taxing jurisdiction. Consequences to U.S. Holders IDSs Allocation of Purchase Price. Your acquisition of IDSs should be treated as if you actually purchased the shares of our common stock and the senior subordinated notes underlying the IDSs and, by purchasing IDSs, you will agree to such treatment. If such treatment is not respected, the acquisition of IDSs may be treated as an acquisition of only our stock, in which case the senior subordinated notes would be treated as equity rather than debt for U.S. federal income tax purposes. See Senior Subordinated Notes Characterization of Notes beginning on page 200. The remainder of this discussion assumes that the acquisition of IDSs will be treated as an acquisition of shares of our common stock and senior subordinated notes. The purchase price of each IDS will be allocated between the shares of common stock and the senior subordinated note in proportion to their respective fair market values at the time of purchase. Such allocation will establish your initial tax basis in the share of common stock and the senior subordinated note underlying each of your IDSs. We expect to report the initial fair market value of each share of common stock as $12.00 and the initial fair market value of each senior subordinated note as $8.00, and by purchasing IDSs, you agree to the actual allocation (determined at the time of the offering) and you agree not to take a position that is contrary to that allocation for any purpose, including tax reporting purposes. If this allocation is not respected, it is possible that the senior subordinated notes will be treated as having been issued with more than a de minimis amount of original issue discount (referred to as OID) or amortizable bond premium and your initial tax basis in our Class A common stock would be higher, or lower, respectively. You generally would have to include original issue discount in income in advance of the receipt of cash attributable to that income, and would be able to elect to amortize bond premium over the remaining term of the notes. The remainder of this discussion assumes that this allocation of the purchase price will be respected. Separation and Recombination. If you separate an IDS into a share of common stock and a senior subordinated note or recombine a share of common stock and a senior subordinated note to form an IDS, you generally should not recognize gain or loss upon the separation of an IDS or a recombination of a share of common stock and senior subordinated note into an IDS. You will continue to take into account items of income otherwise includible, with respect to the share of common stock and the senior subordinated note, and your tax basis in the share of common stock and the senior subordinated note will not be affected by the separation or recombination. Senior Subordinated Notes Characterization of Notes. Our counsel, O Melveny & Myers LLP, is of the opinion that the senior subordinated notes should be treated as debt for U.S. federal income tax purposes, and based upon that opinion, we believe that the senior subordinated notes should be so treated. Such opinion is based on customary representations and determinations, which are discussed in more detail in the following paragraphs, and such opinions are not binding on the IRS or the courts, which could disagree. We intend and, by acquiring senior Table of Contents subordinated notes, directly or in the form of IDSs, each holder agrees, to treat the senior subordinated notes as our indebtedness for all purposes. Assuming such treatment is respected, stated interest on the senior subordinated notes will generally be taxable to you as ordinary income at the time it is paid or accrued in accordance with your method of accounting for U.S. federal income tax purposes. The determination of whether an instrument is treated as debt or equity for U.S. federal income tax purposes is based on all relevant facts and circumstances. There is no clear statutory definition of debt and its characterization is governed by principles developed in case law, which analyzes numerous factors (with no one factor being dispositive) that are intended to identify the economic substance of the investor s interest in the corporation. Our determination that the senior subordinated notes should be treated as debt for U.S. federal income tax purposes, and the opinion of counsel to this effect referred to above, are based upon the terms of the notes and, in addition, rely upon certain representations and determinations by us and an opinion of Houlihan Lokey. The opinion of Houlihan Lokey includes opinions that: when taken together and considered as a whole, the term, interest rate and other material provisions of the senior subordinated notes are commercially reasonable and are substantially similar to those to which an unrelated third party bond market lender bargaining at arm s length would reasonably agree; the aggregate principal amount of the senior subordinated notes in relation to the aggregate fair market value of our equity is commercially reasonable under the circumstances at the completion of this offering; and the ratio of our total outstanding indebtedness to the fair market value of our equity at the completion of this offering will not exceed : to 1. The opinion of Houlihan Lokey relies on, and assumes without independent verification or investigation, the accuracy and completeness of the financial data and other information provided by us and the descriptions of the securities and other information set forth in this prospectus; is being provided for the purpose of assisting us and our counsel regarding certain U.S. federal income tax determinations and legal opinion referred to above and may not be relied on for any other purpose; and does not constitute a recommendation of our securities or an expression of a viewpoint as to our business prospects or the fairness or merits of this offering. Houlihan Lokey is not providing any opinion as to any legal question or tax matters. The opinions of Houlihan Lokey as to commercial reasonableness and valuation of our securities are based solely on a comparison of our securities and this offering to other securities and transaction deemed comparable by Houlihan Lokey and on valuation methodologies deemed appropriate by it. Houlihan Lokey neither reviewed our books and records nor made any physical inspection or independent evaluation or appraisal of our assets and liabilities. The Houlihan Lokey opinion is rendered at, and speaks only as of, the date of this prospectus. Any alteration or inaccuracy of the facts, data, information or assumptions on which Houlihan Lokey s opinion relies could adversely affect such opinion. In light of the representations, determinations and opinions described above and their relevance to several of the factors analyzed in case law, and taking into account the facts and circumstances relating to the issuance of the senior subordinated notes, we (and our counsel) are of the view that the senior subordinated notes should be treated as debt for U.S. federal income tax purposes. However, there is no authority that directly addresses the tax treatment of securities with terms substantially similar to the terms of the senior subordinated notes or offered under circumstances such as the offering (i.e., offered as a unit consisting of senior subordinated notes and common stock). In light of this absence of direct authority, neither we nor our counsel can conclude with certainty that the senior subordinated notes will be treated as debt for U.S. federal income tax purposes. Allowances $ 11,888 $ $ $ 7,092 Inventory 4,688 2,010 Depreciation and amortization 4,233 83 Accrued expenses 4,116 2,025 Other noncurrent liabilities 6,556 Pension and other post-retirement benefits 854 470 Net operating loss 18,293 Other 366 Table of Contents If the senior subordinated notes were treated as equity rather than debt for U.S. federal income tax purposes, then the stated interest on the senior subordinated notes would generally be treated as a dividend to the extent paid out of current or accumulated earnings and profits (as determined under U.S. federal income tax principles), and interest on the senior subordinated notes would not be deductible by us for U.S. federal income tax purposes. Our inability to deduct interest on the senior subordinated notes could materially increase our taxable income and, thus, our U.S. federal income tax liability. This would reduce our after-tax cash flow, thereby adversely affecting our ability to make payments on the senior subordinated notes and the common stock. In addition, as discussed below under Consequences to Non-U.S. Holders Common Stock beginning on page 204, Non-U.S. Holders could be subject to withholding with regard to the senior subordinated notes in the same manner as they will be with regard to our common stock. We would also be liable for withholding taxes on any interest payments previously made by us to Non-U.S. Holders that are recharacterized as dividends for U.S. federal income tax purposes. In addition, repayment of the senior subordinated notes by early redemption or otherwise, would be treated as a redemption of equity, which could be treated as a dividend to Holders pursuant to applicable U.S. federal income tax rules. Additionally, the IRS may challenge the determination that the interest rate on the senior subordinated notes represents an arm s length rate and, if successful, any excess amount over the arm s length could be recharacterized as a non-deductible payment (such as a dividend) instead of an interest payment for U.S. federal income tax purposes, which could materially increase our taxable income and, thus, our U.S. federal income tax liability. In addition, as discussed below under Consequences to Non-U.S. Holders Common Stock, beginning on page 204, Non-U.S. Holders could be subject to withholding tax with regard to payments on the senior subordinated notes in the same manner as they will be with regard to our common stock. We would also be liable for withholding taxes on any interest payments previously made by us to Non-U.S. Holders that are recharacterized as dividends for U.S. federal income tax purposes. If the interest rate were determined to be less than the arm s length rate, the senior subordinated notes could be treated as issued with original issue discount, which you would be required to include in income over the term of the senior subordinated notes prior to the receipt of cash. Except where stated otherwise, the discussion of the consequences to U.S. Holders and Non-U.S. Holders described below assumes the senior subordinated notes will be respected as debt that pays interest at an arm s length rate. Sale, Exchange or Retirement of Senior Subordinated Notes. Upon the sale, exchange, retirement or other disposition of an IDS, you will be treated as having sold, exchanged, retired or disposed of the senior subordinated note underlying the IDS. Upon the sale, exchange, retirement or other disposition of a senior subordinated note, you will recognize gain or loss equal to the difference between the portion of the proceeds allocable to, or received for, your senior subordinated note (less an amount equal to any accrued and unpaid interest which will be treated as a payment of interest for U.S. federal income tax purposes) and your adjusted tax basis in the senior subordinated note. As described above under Consequences to U.S. Holders IDSs Allocation of Purchase Price, beginning on page 200 your tax basis in a senior subordinated note generally will be the portion of the purchase price of your IDSs allocable to the senior subordinated note, or your purchase price for the senior subordinated note, as the case may be, less any principal payments thereon and increased by any OID (if any) previously included in your income. Such gain or loss will generally be capital gain or loss. Capital gains of individuals derived in respect of capital assets held for more than one year are generally eligible for reduced rates of taxation. The deductibility of capital losses is subject to limitations. Deferral of Interest. We believe the likelihood of deferral of interest payments on the senior subordinated notes is remote under applicable U.S. Treasury regulations. Under those U.S. Treasury regulations, a remote contingency that stated interest will not be timely paid is ignored in determining whether a debt instrument is issued with OID. However, if we were to defer payments of interest on the senior subordinated notes, you would be subject to the special OID rules and would be required to include amounts in income before the receipt of cash payments. If deferral of any payment of interest were determined not to be remote, then the senior subordinated notes would be treated as issued with OID at the time of issuance. In such case, all stated interest on the senior subordinated notes would be treated as OID, with the consequence that all holders would be required Table of Contents to include the yield on the senior subordinated notes in income as it accrued on a constant yield basis, possibly in advance of their receipt of the associated cash and regardless of their method of tax accounting. Additional Issuances. Subsequently issued senior subordinated notes may be issued with more than a de minimis amount of OID if they are issued at a discount to their face value. The U.S. federal income tax consequences to you of the subsequent issuance of senior subordinated notes with OID (or any issuance of senior subordinated notes thereafter) upon a subsequent offering by us of IDSs or senior subordinated notes, including an issuance upon conversion of participating preferred stock, are unclear. The indenture governing the senior subordinated notes will provide that, in the event there is a subsequent issuance of senior subordinated notes having identical terms as the senior subordinated notes underlying the IDSs, but issued with OID, each holder of senior subordinated notes or IDSs, as the case may be, agrees that upon such issuance or upon any issuance of senior subordinated notes thereafter, a portion of such holder s senior subordinated notes will be exchanged for a portion of the senior subordinated notes acquired by the holders of such subsequently issued senior subordinated notes. Immediately following such subsequent issuance, each holder of subsequently issued senior subordinated notes, held either as part of IDSs or separately, and each holder of existing senior subordinated notes, held either as part of IDSs or separately, will own an inseparable unit composed of a proportionate percentage of both the old senior subordinated notes and the newly issued senior subordinated notes. Because a subsequent issuance will affect the senior subordinated notes in the same manner, regardless of whether these senior subordinated notes are held as part of IDSs or separately, the combination of senior subordinated notes and shares of common stock to form IDSs, or the separation of IDSs, should not affect your tax treatment. The aggregate stated principal amount of senior subordinated notes owned by each holder will not change as a result of such subsequent issuance and exchange. Whether the receipt of subsequently issued senior subordinated notes in exchange for previously issued senior subordinated notes in this automatic exchange constitutes a taxable exchange for U.S. federal income tax purposes depends on whether the subsequently issued senior subordinated notes are viewed as differing materially from the senior subordinated notes exchanged. Due to a lack of applicable guidance, it is unclear whether the subsequently issued senior subordinated notes would be viewed as differing materially from the previously issued senior subordinated notes for this purpose. Consequently, it is unclear whether an exchange of senior subordinated notes for subsequently issued senior subordinated notes results in a taxable exchange for U.S. federal income tax purposes, and it is possible that the IRS might successfully assert that such an exchange should be treated as a taxable exchange. If the IRS successfully asserted that an automatic exchange following a subsequent issuance is a taxable exchange, an exchanging holder would generally recognize gain or loss in an amount equal to the difference between the fair market value of the subsequently issued senior subordinated notes received and such holder s adjusted tax basis in the senior subordinated notes exchanged. See Senior Subordinated Notes Sale, Exchange or Retirement of Senior Subordinated Notes beginning on page 202. It is also possible that the IRS might successfully assert that any such loss should be disallowed under the wash sale rules, in which case the holder s basis in the subsequently issued senior subordinated notes would be increased to reflect the amount of the disallowed loss. In the case of a taxable exchange, a holder s initial tax basis in the subsequently issued senior subordinated notes received in the exchange would be the fair market value of such senior subordinated notes on the date of exchange (adjusted to reflect any disallowed loss) and a holder s holding period in such senior subordinated notes would begin on the day after such exchange. Regardless of whether a subsequent issuance of senior subordinated notes with OID results in a taxable exchange, such issuance may increase the amount of OID, if any, that you are required to accrue with respect to the senior subordinated notes. Following any subsequent issuance of senior subordinated notes with OID (or any issuance of senior subordinated notes thereafter) and resulting exchange we (and our agents) will report any OID on any subsequently issued senior subordinated notes ratably among all holders of senior subordinated notes and IDSs, and each holder of senior subordinated notes and IDSs will, by purchasing IDSs, agree to report OID in a manner consistent with this approach. Consequently, holders that acquire senior subordinated notes in this offering may be required to report OID as a result of a subsequent issuance (even though they purchased senior Table of Contents subordinated notes having no OID). This will generally result in such holders reporting more interest income over the term of the senior subordinated notes than they would have reported had no such subsequent issuance occurred, and any such additional interest income will be reflected as an increase in the tax basis of the senior subordinated notes, which will generally result in a capital loss (or reduced capital gain) upon a sale, exchange or retirement of the senior subordinated notes. However, the IRS may assert that any OID should be reported only to the persons that initially acquired such subsequently issued senior subordinated notes (and their transferees). In such case, the IRS might further assert that, unless a holder can establish that it is not such a person (or a transferee thereof), all of the senior subordinated notes held by such holder have OID. Any of these assertions by the IRS could create significant uncertainties in the pricing of IDSs and senior subordinated notes and could adversely affect the market for IDSs and senior subordinated notes. If you are required to accrue OID, you will include the amount of OID in income as ordinary income as it accrues, in advance of the receipt of cash attributable to such income. It is possible that senior subordinated notes we issue in a subsequent issuance will be issued at a discount to their face value and, accordingly, may have significant OID and thus be classified as applicable high yield discount obligations . If any such senior subordinated notes were so classified, a portion of the OID on such senior subordinated notes could be nondeductible by us and the remainder would be deductible only when paid. This treatment would have the effect of increasing our taxable income and may adversely affect our cash flow available for interest payments and distributions to our equityholders. Due to the complexity and uncertainty surrounding the U.S. federal income tax treatment of subsequent issuances and exchanges of senior subordinated notes, prospective investors are urged to consult their tax advisors regarding the applicable tax consequences to them in light of their particular circumstances. Common Stock Dividends. The gross amount of dividends paid to you will be treated as dividend income to you to the extent paid out of our current or accumulated earnings and profits (as determined under U.S. federal income tax principles). Such income will be includible in your gross income as ordinary income. Distributions to you in excess of earnings and profits will be treated first as a return of capital that reduces your tax basis in the shares, and after such tax basis is reduced to zero as gain from the sale or exchange of shares of our common stock. Dividends paid through 2008 will generally be taxed to you at the rates applicable to long-term capital gains, which are generally lower than the rates applicable to ordinary income, provided that a minimum holding period and other requirements are satisfied. After 2008, dividends will be taxed at the same rate as ordinary income. Sale or Exchange of Common Stock. Upon the sale, exchange, retirement or other disposition of an IDS, you will be treated as having sold, exchanged or disposed of the shares of our common stock underlying the IDS. Upon the sale, exchange or other disposition of shares of our common stock, you will recognize capital gain or loss in an amount equal to the difference between the portion of the proceeds allocable to your shares of common stock and your tax basis in the shares of common stock. As described above under IDSs Allocation of Purchase Price, beginning on page 200 your tax basis in the shares of common stock generally will be the portion of the purchase price of your IDSs allocable to the shares of common stock, less any prior distributions that reduced such basis. As discussed above, capital gains of individuals derived with respect to capital assets held for more than one year are generally eligible for reduced rates of taxation. The deductibility of capital losses is subject to limitations. Information Reporting and Backup Withholding. In general, information reporting requirements will apply to payments of principal, interest and dividends on our senior subordinated notes and common stock and to the proceeds of sale of IDSs, our senior subordinated notes and common stock paid to a U.S. Holder other than certain exempt recipients (such as corporations). A backup withholding tax will apply to such payments if you fail to provide a taxpayer identification number or certification of other exempt status or fail to report in full dividend and interest income. Table of Contents Any amounts withheld under the backup withholding rules will be allowed as a refund or a credit against your U.S. federal income tax liability provided the required information is furnished to the IRS. Consequences to Non-U.S. Holders The following discussion applies only to Non-U.S. Holders. A Non-U.S. Holder is a holder, other than an entity or arrangement classified as a partnership for U.S. federal income tax purposes, that is not a U.S. Holder. Special rules may apply to certain Non-U.S. Holders, such as: U.S. expatriates, controlled foreign corporations, passive foreign investment companies, foreign personal holding companies, corporations that accumulate earnings to avoid U.S. federal income tax, and investors in pass-through entities that are subject to special treatment under the Code. Such Non-U.S. Holders are urged to consult their own tax advisors to determine the U.S. federal, state, local and other tax consequences that may be relevant to them. Senior Subordinated Notes Characterization of Senior Subordinated Notes. As discussed above under Consequences to U.S. Holders Senior Subordinated Notes Characterization of Notes, beginning on page 200 we believe that the senior subordinated notes should be treated as debt for U.S. federal income tax purposes. However, no ruling on this issue has been requested from the IRS and thus there can be no assurance that such a position would be sustained if challenged by the IRS. If the senior subordinated notes were treated as equity rather than debt for U.S. federal income tax purposes, then the senior subordinated notes would be treated in the same manner as shares of our common stock as described below under Consequences to Non-U.S. Holders Common Stock, beginning on page 204 and payments on the senior subordinated notes (which could include payments in redemption of the senior subordinated notes) would be subject to U.S. federal withholding taxes. Payments to Non-U.S. Holders would not be grossed-up on account of any such taxes. In addition, we would be liable for withholding taxes on any interest payments previously made by us to Non-U.S. Holders that are recharacterized as dividends for U.S. federal income tax purposes. The remainder of this discussion assumes that the characterization of the senior subordinated notes as debt for U.S. federal income tax purposes will be respected. U.S. Federal Withholding Tax. Subject to the discussion below concerning backup withholding, no withholding of U.S. federal income tax should be required with respect to the payment of principal or interest on a senior subordinated note owned by you under the portfolio interest rule, provided that: you do not actually or constructively own 10% or more of the total combined voting power of all classes of our stock entitled to vote within the meaning of section 871(h)(3) of the Code and the Treasury regulations thereunder, you are not a controlled foreign corporation that is related to us through stock ownership, you are not a bank whose receipt of interest on a senior subordinated note is described in section 881(c)(3)(A) of the Code, and you satisfy the statement requirement (described generally below) set forth in section 871(h) and section 881(c) of the Code and the Treasury regulations thereunder. To satisfy the requirement referred to in the final bullet above, you, or a financial institution holding the senior subordinated note on your behalf, must provide, in accordance with specified procedures, our paying agent Table of Contents with a statement to the effect that you are not a U.S. person. Currently, these requirements will be met if (1) you provide your name and address, and certify, under penalties of perjury, that you are not a U.S. person (which certification may be made on an IRS Form W-8BEN), or (2) a financial institution holding the note on your behalf certifies, under penalties of perjury, that such statement has been received by it and furnishes our paying agent with a copy thereof. The statement requirement referred to in the final bullet above may also be satisfied with other documentary evidence with respect to a note held in an offshore account or through certain foreign intermediaries. If you cannot satisfy the requirements of the portfolio interest rule described in the bullets above, payments of interest (including payments in respect of OID) made to you will be subject to a 30% withholding tax unless you provide us or our paying agent, as the case may be, with a properly executed: IRS Form W-8BEN claiming an exemption from or reduction in withholding under the benefit of an applicable income tax treaty, or IRS Form W-8ECI stating that interest paid on the senior subordinated note is not subject to withholding tax because it is effectively connected with your conduct of a trade or business in the United States. Alternative documentation may be applicable in special situations, such as in the case of non-U.S. governments or flow-through entities organized under non-U.S. law. U.S. Federal Income Tax. If you are engaged in a trade or business in the United States and interest on the senior subordinated note is effectively connected with the conduct of such trade or business (and, if certain income tax treaties apply, is attributable to a U.S. permanent establishment), you, although exempt from the withholding tax discussed above (provided the certification requirements described above are satisfied), will be subject to U.S. federal income tax on such interest on a net income basis in the same manner as if you were a U.S. Holder. In addition, if you are a foreign corporation, you may be subject to a branch profits tax equal to 30% (or lesser rate under an applicable income tax treaty) of such amount, subject to adjustments. Sale, Exchange or Retirement of Notes. Upon the sale, exchange, retirement or other disposition of IDSs, you will be treated as having sold, exchanged or disposed of the senior subordinated note represented by the IDSs. Any gain realized upon the sale, exchange, retirement or other disposition of a senior subordinated note generally will not be subject to U.S. federal income tax unless: such gain is effectively connected with your conduct of a trade or business in the United States and, if certain tax treaties apply, is attributable to your U.S. permanent establishment, or you are an individual, you are present in the United States for 183 days or more in the taxable year of such sale, exchange, retirement or other disposition, and certain other conditions are met. If you are an individual and are described in the first bullet above, you will be subject to tax on the net gain derived from the sale under regular graduated U.S. federal income tax rates in the same manner as if you were a U.S. Holder. If you are an individual and are described in the second bullet above, you will be subject to a flat 30% tax on the gain derived from the sale, which may be offset by U.S. source capital losses (even though you are not considered a resident of the United States). If you are a foreign corporation and are described in the first bullet above, you will be subject to tax on your gain under regular graduated U.S. federal income tax rates in the same manner as if you were a U.S. Holder and, in addition, may be subject to the branch profits tax on your effectively connected earnings and profits at a rate of 30% or at such lower rate as may be specified by an applicable income tax treaty. Common Stock Dividends. Dividends paid to you generally will be subject to withholding of U.S. federal income tax at a 30% rate or such lower rate as may be specified by an applicable income tax treaty. However, dividends that are Table of Contents effectively connected with your conduct of a trade or business within the United States and, if certain tax treaties apply, are attributable to your U.S. permanent establishment, are not subject to the withholding tax, but instead are subject to U.S. federal income tax on a net income basis in the same manner as if you were a U.S. Holder. Special certification and disclosure requirements must be satisfied for effectively connected income to be exempt from withholding. If you are a foreign corporation, any such effectively connected dividends received by you may be subject to an additional branch profits tax at a 30% rate or such lower rate as may be specified by an applicable income tax treaty. If you wish to claim the benefit of an applicable treaty rate (and also avoid backup withholding as discussed below) for dividends, you will be required to: complete IRS Form W-8BEN (or other applicable form) and certify under penalties of perjury that you are not a U.S. person and that you are entitled to the benefits of the applicable treaty, or if the shares of our common stock are held through certain foreign intermediaries, satisfy the relevant certification requirements of applicable U.S. Treasury regulations. Special certification and other requirements apply to certain Non-U.S. Holders that are entities rather than individuals. If you are eligible for a reduced rate of U.S. withholding tax pursuant to an income tax treaty, you may obtain a refund of any excess amounts withheld by filing an appropriate claim for refund with the IRS. Sale or Exchange of Common Stock. Upon the sale, exchange, retirement or other disposition of IDSs, you will be treated as having sold, exchanged or disposed of the shares of common stock underlying the IDSs. You generally will not be subject to U.S. federal income tax with respect to gain recognized on a sale or other disposition of shares of our common stock unless: the gain is effectively connected with your conduct of a trade or business in the United States, or, if certain tax treaties apply, is attributable to your U.S. permanent establishment, if you are an individual and hold shares of our common stock as a capital asset, you are present in the United States for 183 or more days in the taxable year of the sale or other disposition, and certain other conditions are met, or we are or have been a U.S. real property holding corporation for U.S. federal income tax purposes. If you are an individual and are described in the first bullet above, you will be subject to tax on the net gain derived from the sale under regular graduated U.S. federal income tax rates in the same manner as if you were a U.S. Holder. If you are an individual and are described in the second bullet above, you will be subject to a flat 30% tax on the gain derived from the sale, which may be offset by U.S. source capital losses (even though you are not considered a resident of the United States). If you are a foreign corporation and are described in the first bullet above, you will be subject to tax on your gain under regular graduated U.S. federal income tax rates in the same manner as if you were a U.S. Holder and, in addition, may be subject to the branch profits tax on your effectively connected earnings and profits at a rate of 30% or at such lower rate as may be specified by an applicable income tax treaty. We believe we are not and do not anticipate becoming a U.S. real property holding corporation for U.S. federal income tax purposes. Information Reporting and Backup Withholding. The amount of interest payments and dividends paid to you and the amount of tax, if any, withheld with respect to such payments will be reported annually to the IRS. Copies of the information returns reporting such interest payments, dividends and withholding may also be made available to the tax authorities in the country in which you reside under the provisions of an applicable income tax treaty. EBITDA, as defined $ 121,539 $ 77,279 $ 137,936 Table of Contents In general, backup withholding will be required with respect to payments made by us or any paying agent to you, unless a statement described in the fourth bullet under Consequences to Non-U.S. Holders Senior Subordinated Notes U.S. Federal Withholding Tax beginning on page 205 has been received (and we or the paying agent do not have actual knowledge or reason to know that you are a U.S. person). Information reporting and, depending on the circumstances, backup withholding will apply to the proceeds of a sale of IDSs, common stock or senior subordinated notes within the United States or conducted through U.S.-related financial intermediaries unless a statement described in the fourth bullet under Consequences to Non-U.S. Holders Senior Subordinated Notes U.S. Federal Withholding Tax beginning on page 205 has been received (and we or the paying agent do not have actual knowledge or reason to know that you are a U.S. person) or you otherwise establish an exemption. However, any payments of interest and dividends to you will be reported on IRS Form 1042-S even if the payments are not otherwise subject to information reporting requirements. Any amounts withheld under the backup withholding rules will be allowed as a refund or a credit against your U.S. federal income tax liability provided the required information is furnished to the IRS. Underwriting discounts and commissions paid by our equity sponsor and us $ $ $ $ $ Expenses payable by us $ $ $ $ $ Table of Contents The representatives have informed us that the underwriters do not expect sales to accounts over which the underwriters have discretionary authority to exceed 5% of the IDSs being offered. The underwriters will not confirm sales to any accounts over which they exercise discretionary authority without first receiving a written consent from those accounts. We have agreed that we will not offer, sell, contract to sell, pledge or otherwise dispose of, directly or indirectly, or file with the SEC a registration statement under the Securities Act relating to, any IDSs, shares of our common stock, shares of our participating preferred stock, or senior subordinated notes or any securities convertible into or exchangeable or exercisable for any such securities, or publicly disclose the intention to make any offer, sale, pledge, disposition or filing, without the prior written consent of Credit Suisse First Boston LLC for a period of 180 days after the date of this prospectus. Our officers, directors and all existing stockholders have agreed that they will not offer, sell, contract to sell, pledge or otherwise dispose of, directly or indirectly, any IDSs, shares of our common stock, shares of participating preferred stock, or any senior subordinated notes or any securities convertible into or exchangeable or exercisable for any such securities, enter into a transaction that would have the same effect, or enter into any swap, hedge or other arrangement that transfers, in whole or in part, any of the economic consequences of ownership of any IDS, our common stock, our participating preferred stock or our senior subordinated notes, whether any of these transactions are to be settled by delivery of any IDS, our common stock, our participating preferred stock, our senior subordinated notes or other securities, in cash or otherwise, or publicly disclose the intention to make any offer, sale, pledge or disposition, or to enter into any transaction, swap, hedge or other arrangement, without, in each case, the prior written consent of Credit Suisse First Boston LLC for a period of 180 days after the date of this prospectus. We and our equity sponsor have agreed to indemnify the underwriters against liabilities under the Securities Act, or contribute to payments that the underwriters may be required to make in that respect. We have applied to list the IDSs on the American Stock Exchange, under the symbol UAP. Prior to this offering, there has been no public market for the IDSs, the shares of our common stock or the senior subordinated notes. The initial public offering price of the IDSs and the senior subordinated notes have been negotiated between the representatives and us. In determining the initial public offering price of our IDSs and our senior subordinated notes, the representatives considered: prevailing market conditions; our historical performance and capital structure; estimates of our business potential and future revenues; an overall assessment of our management; and the consideration of these factors in relation to market valuation of companies in related businesses. In connection with the offering the underwriters may engage in stabilizing transactions, over-allotment transactions, syndicate covering transactions and penalty bids in accordance with Regulation M under the Exchange Act. Stabilizing transactions permit bids to purchase the underlying security so long as the stabilizing bids do not exceed a specified maximum. Over-allotment involves sales by the underwriters of IDSs in excess of the number of IDSs the underwriters are obligated to purchase, which creates a syndicate short position. The short position may be either a covered short position or a naked short position. In a covered short position, the number of IDSs over-allotted by the underwriters is not greater than the number of IDSs that they may purchase in Table of Contents the over-allotment option. In a naked short position, the number of IDSs involved is greater than the number of IDSs in the over-allotment option. The underwriters may close out any covered short position by either exercising their over-allotment option and/or purchasing IDSs in the open market. Syndicate covering transactions involve purchases of IDSs or senior subordinated notes in the open market after the distribution has been completed in order to cover syndicate short positions. In determining the source of IDSs or senior subordinated notes to close out the short position, the underwriters will consider, among other things, the price of IDSs or senior subordinated notes available for purchase in the open market as compared to the price at which they may purchase IDSs or senior subordinated notes through the over-allotment option. If the underwriters sell more IDSs or senior subordinated notes than could be covered by the over-allotment option, a naked short position, the position can only be closed out by buying IDSs or senior subordinated notes in the open market. A naked short position is more likely to be created if the underwriters are concerned that there could be downward pressure on the price of the IDSs or senior subordinated notes in the open market after pricing that could adversely affect investors who purchase in the offering. Penalty bids permit the representatives to reclaim a selling concession from a syndicate member when the IDSs or senior subordinated notes originally sold by the syndicate member is purchased in a stabilizing or syndicate covering transaction to cover syndicate short positions. These stabilizing transactions, syndicate covering transactions and penalty bids may have the effect of raising or maintaining the market price of the IDSs or separate senior subordinated notes or preventing or retarding a decline in the market price of the IDSs or separate senior subordinated notes. As a result the price of the IDSs or separate senior subordinated notes may be higher than the price that might otherwise exist in the open market. These transactions may be effected on the American Stock Exchange or otherwise and, if commenced, may be discontinued at any time. None of the senior subordinated notes sold separately (not in the form of IDSs) in this offering, which we refer to as the separate senior subordinated notes may be purchased, directly or indirectly, by persons who are also (1) purchasing IDSs in this offering or (2) holders of participating preferred stock following the Recapitalization. Furthermore, prior to the closing of this offering, each person purchasing separate senior subordinated notes in this offering will be required to represent to us that: (a) Neither such purchaser nor any entity, investment fund or account over which such purchaser exercises investment control is purchasing IDSs in this offering or owns or has the contractual right to acquire our equity securities (including securities which are convertible, exchangeable or exercisable into or for our equity, which we refer to as our company equity); and (b) there is no plan or pre-arrangement by which such purchaser will acquire any IDSs or our capital stock or separate senior subordinated notes being acquired by such purchaser will be transferred to any holder of the IDSs or company equity. We have been advised by the representatives that Credit Suisse First Boston LLC and the other underwriters of the separate senior subordinated notes currently intend to facilitate a secondary market in the senior subordinated notes sold separately from the IDSs and, following any separation of the IDSs into their component pieces, any such newly-separated senior subordinated notes and shares of common stock, subject to applicable legal and regulatory requirements and limitations, which means that Credit Suisse First Boston LLC and the other underwriters of the separate senior subordinated notes will make a commercially reasonable attempt to match buyers of the applicable securities with sellers of such securities, in each case, as between persons of whom Credit Suisse First Boston LLC and the other underwriters of the separate senior subordinated notes have Table of Contents knowledge that they are potential buyers or sellers of such securities. In addition, with respect to facilitating any market for the senior subordinated notes, Credit Suisse First Boston LLC and the other underwriters of the separate senior subordinated notes will consider relevant credit issues where deemed appropriate. However, Credit Suisse First Boston LLC and the other underwriters of the separate senior subordinated notes are not obligated to facilitate a secondary market in the separate senior subordinated notes and may discontinue any such efforts at any time and without notice for any reason that would cause them in the ordinary course of their high yield debt securities or equity securities businesses to discontinue such facilitation. Moreover, if and to the extent that Credit Suisse First Boston LLC and the other underwriters of the separate senior subordinated notes facilitate any market for any such securities, there can be no assurance that such market would provide sufficient liquidity for any holder of such securities. A prospectus in electronic format may be made available on the web sites maintained by one or more of the underwriters, or selling group members, if any, participating in this offering and one or more of the underwriters participating in this offering may distribute prospectuses electronically. The representatives may agree to allocate a number of IDSs or senior subordinated notes to underwriters and selling group members for sale to their online brokerage account holders. Internet distributions will be allocated by the underwriters and selling group members that will make internet distributions on the same basis as other allocations. Credit Suisse First Boston LLC will make senior subordinated notes being sold separately from the IDSs available for distribution on the Internet through a proprietary Web site and/or a third-party system operated by Market Axess Inc., an Internet-based communications technology provider. Market Axess Inc. is providing the system as a conduit for communications between Credit Suisse First Boston LLC and its customers and is not a party to any transactions. We do not believe that Market Axess Inc. will function as an underwriter or agent of the issuer, nor do we believe that Market Axess Inc. will act as a broker for any customer of Credit Suisse First Boston LLC. Market Axess Inc., a registered broker-dealer, will receive compensation from Credit Suisse First Boston LLC based on transactions the underwriter conducts through the system. Credit Suisse First Boston LLC will make senior subordinated notes being sold separately from the IDSs available to its customers through the Internet distributions, whether made through a proprietary or third party system, on the same terms as distributions made through other channels. IDS Directed Share Program At our request, the underwriters have reserved up to 1,825,000 IDSs, or 5% of our IDSs offered to the public by this prospectus, for sale under a directed share program to our employees. Based on the anticipated offering price of $20, which is the mid-point of the range disclosed on the cover page of this prospectus, 5% of the IDSs will have an aggregate offering price of $36.5 million. We will identify a list of full-time employees, except for our officers and directors, who will be entitled to purchase IDSs in the directed share program and will provide that list to Credit Suisse First Boston LLC which will administer the directed share program. At this time, no indications of interest will be taken. Once the preliminary prospectus has been printed, an invitation package (available online, via regular or overnight mail or facsimile) will be made available or sent to each person listed, attaching a preliminary prospectus and the other directed share program documentation. If a person is interested in participating, that person will be required to complete the required documentation (which will include an IPO Certification form pursuant to NASD Rule 2790) and will be required to return it to Credit Suisse First Boston LLC (via regular or overnight mail or facsimile) so that Credit Suisse First Boston LLC can open an account to receive the IDSs once allocated. There will be no pre-funding or account-funding requirement; Credit Suisse First Boston LLC will not accept funds from any directed share program participant until after the registration statement for this offering is declared effective, this offering is priced, and the participants are notified of their final allocation and given an opportunity to confirm that they wish to purchase the IDSs allocated to them. After the registration statement has been declared effective and this offering is priced, we and Credit Suisse First Boston LLC will prepare a final approved list of allocations. Credit Suisse First Boston LLC will notify each person verbally or by email who has been allocated IDSs of the number of IDSs that have been allocated and the total purchase price due upon confirmation of their indication of interest. Thereafter, participants will be required to wire transfer their funds or send checks to Credit Suisse First Boston LLC. IDSs will be allocated following Table of Contents pricing and settle in the same manner as the IDSs sold to the general public. The number of IDSs available for sale to the general public will be reduced to the extent these persons purchase the reserved IDSs. IDSs committed to be purchased by directed share participants which are not so purchased will be reallocated for sale to the general public in the offering. All sales of IDSs pursuant to the directed share program will be made at the initial public offering price set forth on the cover page of this prospectus. Table of Contents NOTICE TO CANADIAN RESIDENTS Resale Restrictions The distribution of the IDSs or our senior subordinated notes in Canada is being made only on a private placement basis exempt from the requirement that we prepare and file a prospectus with the securities regulatory authorities in each province where trades of IDSs or our senior subordinated notes are made. Any resale of the IDSs or senior subordinated notes in Canada must be made under applicable securities laws which will vary depending on the relevant jurisdiction, and which may require resales to be made under available statutory exemptions or under a discretionary exemption granted by the applicable Canadian securities regulatory authority. Purchasers are advised to seek legal advice prior to any resale of the IDSs or senior subordinated notes. Representations of Purchasers By purchasing IDSs or our senior subordinated notes in Canada and accepting a purchase confirmation a purchaser is representing to us and the dealer from whom the purchase confirmation is received that: the purchaser is entitled under applicable provincial securities laws to purchase the IDSs and our senior subordinated notes without the benefit of a prospectus qualified under those securities laws, where required by law, that the purchaser is purchasing as principal and not as agent, and the purchaser has reviewed the text above under Resale Restrictions. Rights of Action Ontario Purchasers Only Under Ontario securities legislation, a purchaser who purchases a security offered by this prospectus during the period of distribution will have a statutory right of action for damages, or while still the owner of the IDSs or our senior subordinated notes, for rescission against us in the event that this circular contains a misrepresentation. A purchaser will be deemed to have relied on the misrepresentation. The right of action for damages is exercisable not later than the earlier of 180 days from the date the purchaser first had knowledge of the facts giving rise to the cause of action and three years from the date on which payment is made for the IDSs or our senior subordinated notes. The right of action for rescission is exercisable not later than 180 days from the date on which payment is made for the IDSs or our senior subordinated notes. If a purchaser elects to exercise the right of action for rescission, the purchaser will have no right of action for damages against us. In no case will the amount recoverable in any action exceed the price at which the IDSs or our senior subordinated notes were offered to the purchaser and if the purchaser is shown to have purchased the securities with knowledge of the misrepresentation, we will have no liability. In the case of an action for damages, we will not be liable for all or any portion of the damages that are proven to not represent the depreciation in value of the IDSs or our senior subordinated notes as a result of the misrepresentation relied upon. These rights are in addition to, and without derogation from, any other rights or remedies available at law to an Ontario purchaser. The foregoing is a summary of the rights available to an Ontario purchaser. Ontario purchasers should refer to the complete text of the relevant statutory provisions. Enforcement of Legal Rights All of our directors and officers as well as the experts named herein may be located outside of Canada and, as a result, it may not be possible for Canadian purchasers to effect service of process within Canada upon us or those persons. All or a substantial portion of our assets and the assets of those persons may be located outside of Canada and, as a result, it may not be possible to satisfy a judgment against us or those persons in Canada or to enforce a judgment obtained in Canadian courts against us or those persons outside of Canada. Taxation and Eligibility for Investment We recommend that Canadian purchasers of IDSs or our senior subordinated notes consult their own legal and tax advisors with respect to the tax consequences of an investment in the IDSs or our senior subordinated notes in their particular circumstances and about the eligibility of the IDSs or our senior subordinated notes for investment by the purchaser under relevant Canadian legislation. Table of Contents LEGAL MATTERS The validity of the issuance of the IDSs offered hereby and the shares of common stock and senior subordinated notes (including the senior subordinated notes sold separately from the IDSs), as well as the validity of the issuance of the subsidiary guarantees by the Delaware Subsidiary guarantors, will be passed upon for us by O Melveny & Myers LLP, New York, New York. The validity of the issuance of the subsidiary guarantees by the Colorado subsidiary guarantors will be passed upon for us by Faegre & Benson LLP, Denver, Colorado. The validity of the issuance of the subsidiary guarantee by the Florida subsidiary guarantor will be passed upon for us by Holland & Knight LLP, Tallahassee, Florida. The validity of the subsidiary guarantees by the Georgia subsidiary guarantors will be passed upon for us by Hartman, Simons, Spielman & Wood, LLP, Atlanta, Georgia. The validity of the issuance of the subsidiary guarantee by the Idaho subsidiary guarantor will be passed upon for us by Perkins Coie LLP, Boise, Idaho. The validity of the issuance of the subsidiary guarantee by the Illinois subsidiary guarantor will be passed upon for us by Bell, Boyd & Lloyd LLC, Chicago, Illinois. The validity of the issuance of the subsidiary guarantee by the Maryland subsidiary guarantor will be passed upon for us by Venable LLP, Baltimore, Maryland. The validity of the issuance of the subsidiary guarantee by the Mississippi subsidiary guarantor will be passed upon for us by Watkins Ludlam Winter & Stennis, P.A., Jackson, Mississippi. The validity of the issuance of the subsidiary guarantee by the Montana subsidiary guarantor will be passed upon for us by Holland & Hart LLP, Billings, Montana. The validity of the issuance of the subsidiary guarantees by the Nebraska subsidiary guarantors will be passed upon for us by Stinson Morrison Hecker LLP, Omaha, Nebraska. The validity of the issuance of the subsidiary guarantee by the North Dakota subsidiary guarantor will be passed upon for us by Dorsey & Whitney LLP, Fargo, North Dakota. The validity of the issuance of the subsidiary guarantee by the Tennessee subsidiary guarantor will be passed upon for us by Bass, Berry & Sims PLC, Nashville, Tennessee. The validity of the issuance of the subsidiary guarantees by the Texas subsidiary guarantors will be passed upon for us by Baker & Mackenzie LLP, Dallas, Texas. The validity of the issuance of the subsidiary guarantee by the Washington subsidiary guarantor will be passed upon for us by Stoel Rives LLP, Seattle, Washington. Certain legal matters relating to this offering will be passed upon for the underwriters by Skadden, Arps, Slate, Meagher & Flom LLP, New York, New York. EXPERTS The financial statements included in this prospectus and the related financial statement schedules included elsewhere in the registration statement of UAP Holding Corp. as of February 22, 2004 and for the thirteen weeks ended February 22, 2004 and of the ConAgra Agricultural Products Business as of February 23, 2003 and for the thirty-nine weeks ended November 23, 2003 and the fiscal years ended February 23, 2003 and February 24, 2002 have been audited by Deloitte & Touche LLP, an independent registered public accounting firm, as stated in their report (which report expresses an unqualified opinion and includes an explanatory paragraph relating to a change in method of accounting for goodwill and other intangible assets in 2003) appearing herein and have been so included in reliance upon the report of such firm given upon their authority as experts in accounting and auditing. Houlihan Lokey Howard & Zukin Financial Advisors, Inc., in a consent filed with the Registration Statement of which this prospectus forms a part, has consented to the references in the second and third paragraphs of the section of this prospectus entitled Material U.S. Federal Income Tax Considerations Consequences to U.S. Holders Senior Subordinated Notes Characterization of Notes beginning on page 200 to it and its opinions relating to the terms of the notes and our capitalization referenced in such paragraphs rendered to us and our special counsel. Such opinions are for the purpose of assisting us and our special counsel with respect to certain financial matters related to certain U.S. federal income tax determinations and opinions referred to in this prospectus and certain financial accounting matters, and are referred to based on the reputation and experience of said firm in financial advisory matters. Table of Contents WHERE YOU CAN FIND MORE INFORMATION We have filed a Registration Statement on Form S-1 with the SEC regarding this offering. This prospectus, which is part of the registration statement, does not contain all of the information included in the registration statement, and you should refer to the registration statement and its exhibits to read that information. As a result of the effectiveness of the registration statement, we are subject to the informational reporting requirements of the Exchange Act of 1934 and, under that Act, we will file reports, proxy statements and other information with the SEC. You may read and copy the registration statement, the related exhibits and the reports, proxy statements and other information we file with the SEC at the SEC s public reference facilities maintained by the SEC at Judiciary Plaza, 450 Fifth Street, N.W., Washington, D.C. 20549. You can also request copies of those documents, upon payment of a duplicating fee, by writing to the SEC. Please call the SEC at 1-800-SEC-0330 for further information on the operation of the public reference rooms. The SEC also maintains an Internet site that contains reports, proxy and information statements and other information regarding issuers that file with the SEC. The site s Internet address is www.sec.gov. Certain information about our company may also be obtained from our website at www.uap.com. You may also request a copy of these filings, at no cost, by writing or telephoning us at: UAP Holding Corp. 7251 W. 4th St. Greeley, CO 80634 (970) 356-4400 Table of Contents Pro Forma (in thousands) Fourteen Weeks Ended May 30, 2004 Twelve Months Ended May 30, 2004 Interest expense $ 67,386 $ 18,038 $ 68,371 Amortization of deferred financing costs (4,992 ) (1,303 ) (5,048 ) Computed U.S. federal income taxes $ (17,023 ) $ 16,885 $ 23,119 $ 5,405 State income taxes, net of U.S. federal tax benefit (1,264 ) 1,255 1,717 618 Other 768 647 Cash interest expense $ 62,394 $ 16,735 $ 63,323 Table of Contents Combined Predecessor Entity ConAgra Agricultural Products Business Consolidated UAP Holding Corp. Fiscal Year Ended Income from continuing operations before income taxes 47,534 713 48,247 Income tax expense 18,537 2,818,828 2,478,518 1,021,658 2,158,054 212,336 1,216,473 Income (loss) from continuing operations before income taxes (48,636 ) 48,247 52,691 66,053 15,442 42,016 Income tax expense (benefit) (17,519 ) 18,787 20,477 25,068 5,789 16,494 Income (loss) from continuing operations (31,117 ) 29,460 32,214 40,985 9,653 25,522 Loss from discontinued operations, net of tax (5,919 ) (4,221 ) (2,613 ) (4,708 ) Balance at February 23, 2003 588,147 (249 ) 587,898 Comprehensive income: Net income 36,277 36,277 Foreign currency translation adjustment 302 (13,002 ) 14,966 25,068 (18,069 ) Deferred: Federal (4,160 ) 3,519 21,974 State (357 ) Net income (loss) $ (37,036 ) $ 25,239 $ 29,601 $ 36,277 $ 9,653 $ 25,522 Change in Plan Assets Fair value of plan assets at beginning of year $ 1,784 $ 1,858 Exchange rate adjustment 141 288 Actual return on plan assets (310 ) (339 ) Employer contributions 296 Balance Sheet Data: Cash and cash equivalents $ 72,692 $ 28,559 $ 172,647 $ 7,782 Working capital 127,865 455,154 223,953 264,598 Total assets 1,396,155 1,352,025 1,263,963 1,729,502 Total debt 4,464 308,570 353,555 Stockholder s net investment and advances 294,492 587,898 Stockholder s equity 76,788 101,713 Table of Contents EBITDA relate to: (1) the add back of losses from discontinued operations, net of taxes, (2) the add back of inventory fair market value adjustments as a result of the Acquisition, (3) the add back of expenses relating to a transition services agreement and (4) the add back/deduction of loss/gain from the sale of certain businesses. We present EBITDA as defined in the indenture, because a corresponding calculation will be used in the indenture governing the senior subordinated notes. EBITDA is not a measure of financial performance or liquidity under GAAP. Accordingly, EBITDA should not be considered in isolation or as a substitute for net income, cash flows from operations or other income or cash flow data prepared in accordance with GAAP or as a measure of our operating performance or liquidity. For example, although we consider EBITDA a liquidity measure, it does not take into account all cash expenditures which may be necessary to grow our business, such as cash expenditures for capital expenditures and acquisitions. Because of covenants in the Amended Credit Facilities and the indenture that are based on EBITDA, including our fixed charge coverage ratio covenants, we will have to maintain our EBITDA at certain levels in order to, among other things, pay dividends on our capital stock and to avoid defaults under our Amended Credit Facilities and deferrals of interest payments on the senior subordinated notes. The following table sets forth a calculation of our EBITDA and EBITDA, as defined in the indenture: Combined Predecessor Entity Consolidated UAP Holding Corp. ConAgra Agricultural Products Business Fiscal Year Ended Thirteen Weeks Ended Thirty-Nine Weeks Ended Thirteen Weeks Ended Fourteen Weeks Ended (dollars in thousands) Cash flows used in (provided by) Operating activities $ 120,662 $ (266,751 ) $ (154,791 ) $ (104,574 ) $ 446,373 $ (203,651 ) Interest expense, net of non-cash interest 58,370 37,820 4,400 20,254 5,486 7,601 Net change in operating assets and liabilities (140,743 ) 315,492 190,796 155,067 (403,894 ) 246,910 Income tax provision (benefit) (17,519 ) 18,787 20,477 25,068 5,789 16,494 Deferred income tax benefit (provision) 4,517 (3,821 ) (23,858 ) (9,214 ) Loss from discontinued operations, net (5,919 ) (4,221 ) (2,613 ) (4,708 ) Other 1,595 1,246 2,000 (2,539 ) (90 ) EBITDA 20,963 98,552 58,269 93,107 27,357 58,050 Loss from discontinued operations, net 5,919 4,221 2,613 4,708 Inventory fair market value adjustment(1) 3,673 17,354 ConAgra transition services agreement expense(2) 1,875 1,875 Gain on sale of businesses(3) (9,181 ) Non-amortizing intangible assets $ 27 $ $ $ Amortizing intangible assets 11,547 5,549 7,450 Total $ 11,574 $ 5,549 $ 7,450 $ Net Sales $ $ 2,128,545 $ 95,562 $ 2,224,107 Costs and expenses: Cost of goods sold 1,855,723 82,287 1,938,010 Selling, general and administrative expenses 203,075 5,595 208,670 Third party interest expense 704 704 (Gain) loss on sale of assets (10,522 ) (10,522 ) Corporate allocations: Selling, general and administrative expenses 8,705 278 8,983 Finance charges 11,832 EBITDA, as defined $ 26,882 $ 102,773 $ 60,882 $ 88,634 $ 32,905 $ 77,279 Total 127 259 (1) Consists of the additional cost of goods sold expense due to the step up to fair market value of certain inventories on hand at November 23, 2003, as a result of the allocation of the purchase price of the Acquisition to inventory. (2) Consists of the expensing of the prepaid fee to ConAgra Foods for services performed under the Buyer Transition Services Agreement entered into in connection with the Acquisition. (3) Consists of gain on the sale of stock of two divisions, both of which occurred in November, 2003. (e) Cash interest expense represents interest expense less amortization of deferred financing costs. Cash interest expense is presented because it is used by investors to analyze and compare operating performance, which includes a company s ability to service and/or incur debt. However, cash interest expense should not be considered in isolation or as a substitute for cash paid for interest prepared in accordance with GAAP or as a measure of a company s liquidity. Cash interest expense is not calculated under GAAP and therefore is not necessarily comparable to similarly titled measures of other companies. The following table reconciles the differences between cash interest expense and interest expense: Pro Forma (in thousands) Fourteen Weeks Ended May 30, 2004 Twelve Months Ended May 30, 2004 Interest expense $ 67,386 $ 18,038 $ 68,371 Amortization of deferred financing costs (4,992 ) (1,303 ) (5,048 ) Net cash flows from investing activities (8,881 ) Cash interest expense $ 62,394 $ 16,735 $ 63,323 Net sales $ $ $ 1,225,150 $ 33,339 $ $ 1,258,489 Costs and expenses: Cost of goods sold 1,096,806 25,949 1,122,755 Selling general and administrative expenses 145 80,724 2,087 82,956 Interest expense, net 3,704 7,027 349 81 11,161 (Gain) loss on sale of assets (819 ) (819 ) Other income 140 280 Cash flows from investing activities: Additions to property, plant and equipment (7,299 ) (18 ) (7,317 ) Other investing activity (1,582 ) Income from operations 78,966 (55,382 ) 23,584 Corporate allocations: Finance charges 19,550 (4,130 ) 15,420 Finance fee income (7,341 ) 1,709 (5,632 ) Interest expense 704 (270 ) Table of Contents USE OF PROCEEDS The table below sets forth our estimate of the sources and uses of funds required to effect the Transactions, assuming the Transactions all occurred as of May 30, 2004 and 100% of the 8 % Senior Notes and 10 % Senior Discount Notes are repurchased in the Tender Offers. See Prospectus Summary The Transactions beginning on page 4. The estimated sources and uses are based on an assumed initial public offering price of $20.00 per IDS (which represents the mid-point of the range set forth on the cover page of this prospectus) and the sale of $40.6 million aggregate principal amount of our senior subordinated notes that are being sold separately from the IDSs. Actual amounts may vary from the amounts shown below. Sources Amount (in millions) Cash on hand $ 7.8 Amended and restated revolving credit facility 87.2 New term loan facility 165.0 IDSs offered hereby(1) 730.0 Senior subordinated notes offered hereby separately from the IDSs 40.6 Total sources $ 1,030.6 Uses Amount (in millions) Repurchase of 8 % Senior Notes(2) $ 225.0 Repurchase of 10 % Senior Discount Notes(3) 86.4 Repurchase of Series A Redeemable Preferred Stock(4) 35.4 Proceeds to our existing stockholders(5) 566.6 Transaction fees and expenses(6) 117.2 Total uses $ 1,030.6 Table of Contents Estimated Cash Available to Pay Dividends Based on Estimated Minimum EBITDA, as Defined Amount Cash flows from investing activities: Additions to property, plant and equipment (13,654 ) (6,417 ) (8,350 ) (6,970 ) Proceeds from sale of assets 15,057 3,517 Investment in affiliates 372 882 (154 ) Acquisition of ConAgra Agricultural Products Business (656,197 ) Other investing activity Cash flows from investing activities: Additions to property, plant and equipment (13,090 ) (564 ) (13,654 ) Proceeds from sale of assets Investment in affiliates 372 372 Other investing activity 307 152 (dollars in thousands) Estimated minimum EBITDA, as defined(1) $ 112,776 Less: Estimated maintenance capital expenditures(2) 6,000 Estimated cash interest expense on senior subordinated notes(3) 39,909 Estimated cash interest expense on Amended Credit Facilities(4) 15,175 Estimated cash income taxes(5) Estimated cash available to pay dividends on our outstanding common stock and participating preferred stock(6) $ 51,692 Estimated fixed charge coverage ratio under the indenture derived from the above(7) 2.0x Minimum fixed charge coverage ratio under the indenture 1.6x The following table illustrates, for our fiscal year ended February 22, 2004 and for the twelve months ended May 30, 2004, the amount of excess cash, as defined in the indenture governing the senior subordinated notes, that would have been available for distributions to our stockholders, assuming, in each case, that the offering had been consummated at the beginning of such period, subject to the assumptions described in such table. Pro Forma Excess Cash, as Defined, for the Year Ended February 22, 2004 and the Twelve Months Ended May 30, 2004 (in thousands) Net income $ $ 24,776 $ Cash flows provided by operating activities $ 341,799 $ 292,939 Interest expense, net of non-cash interest 28,679 36,411 Net change in operating assets and liabilities(8) (251,766 ) (200,183 ) Income tax provision (benefit) 30,857 26,874 Deferred income tax benefit (provision)(9) (23,858 ) (33,072 ) Loss from discontinued operations, net (4,708 ) (2,095 ) Other (539 ) (629 ) EBITDA(1) 120,484 120,245 Loss from discontinued operations, net 4,708 2,095 Pro forma EBITDA 125,172 122,340 Inventory fair market value adjustment(10) 3,673 21,027 ConAgra transition services agreement expense 1,875 3,750 Gain on sale of businesses (9,181 ) (9,181 ) EBITDA, as defined(1) 121,539 137,936 Estimated cash interest expense on senior subordinated notes(2) (39,909 ) (39,909 ) Estimated cash interest expense on Amended Credit Facilities(3) (15,175 ) (15,175 ) Capital expenditures(2) (15,300 ) (10,700 ) Excess cash, as defined, that would have been available to pay dividends(11) $ 51,155 $ 72,152 Table of Contents (6) Reflects the following: Dividends Number of Shares Adjustment to current deferred income taxes of $32.8 million and long-term deferred income taxes of $12.1 million. Per Share Aggregate (in thousands) Estimated dividends on our common stock 36,500,000 $ 0.9400 $ 34,310 Estimated dividends on our participating preferred stock (including options): Dividends payable based on liquidation preference amount 9,148,290 $ 0.9600 $ 8,782 Dividends payable based on as if converted shares 9,148,290 $ 0.9400 $ 8,600 Total estimated dividends on our participating preferred stock (including options) 9,148,290 $ 1.9000 $ 17,382 Estimated dividends on our outstanding capital stock (including options) $ 51,692 (7) Fixed charge coverage ratio is defined as EBITDA, as defined, divided by cash interest expense. Under the indenture governing the senior subordinated notes, we may not pay dividends on our capital stock if our fixed charge coverage ratio for the four most recent fiscal quarters is less than 1.6 to 1.0. (8) This net change in operating assets and liabilities was financed with borrowings under our existing revolving credit facility. The net change in operating assets and liabilities for the year ended February 22, 2004 was a source of cash of $276.2 million, and is due to lower inventory and higher payables since we participated less in early purchasing programs offered by our suppliers. The net change in operating assets and liabilities for the twelve months ended May 30, 2004 is a source of cash of $205.2 million, and reflects lower inventories due to inventory efficiencies and higher payables due to our lower participation in supplier early purchasing programs, offset by higher receivables due to higher sales. For a more detailed discussion, see Management s Discussion and Analysis of Financial Condition and Results of Operations Liquidity and Capital Resources beginning on page 73. (9) The change in deferred income taxes is based on timing differences associated with the deduction of certain income tax adjustments. These timing differences relate primarily to allowances for bad debt, inventory calculations, and certain accrued expenses. (10) In connection with the Acquisition, there was a step up in value of certain inventory in connection with the allocation of the purchase price of the Acquisition. Inventory associated with the step up in value was primarily sold during the fourteen weeks ended May 30, 2004, as such the step up in value of this inventory was recorded as costs of goods sold in the period in which the sales occurred. (11) Although following this offering we will incur incremental ongoing expenses associated with being a public company, we believe such incremental expenses on an annual basis (including additional professional services, staffing, printing and other fees and expenses) will be lower than the corporate allocations from our former parent, ConAgra Foods, that are already reflected in our historical financial statements. Corporate allocations from our former parent, ConAgra Foods, were $10.8 million for the fiscal year ended February 22, 2003, $9.0 million for the thirty nine weeks ended November 23, 2003, and $5.9 million for the twelve months ended May 30, 2004. Following the payment of dividends as contemplated by our dividend policy, we would have had remaining available funds as follows: Assuming Full Exercise of the Underwriters Over-Allotment Option (in thousands) Fiscal Year Ended February 22, 2004 Twelve Months Ended May 30, 2004 Excess cash, as defined, that would have been available to pay dividends $ 51,155 $ 72,152 Common stock dividends (34,310 ) (34,310 ) Cash available to pay participating preferred stock dividends (including options) 16,845 37,842 Participating preferred stock dividends (17,382 ) (17,382 ) Remaining available funds $ (537 ) $ 20,460 Table of Contents CAPITALIZATION The following table sets forth the cash and cash equivalents and capitalization as of May 30, 2004 of UAP Holdings (i) on an actual basis and (ii) on a pro forma basis giving effect to the Transactions, assuming no exercise of the underwriters over-allotment option and 100% of the 8 % Senior Notes and 10 % Senior Discount Notes are tendered and repurchased in the Tender Offers. The information should be read in conjunction with Prospectus Summary The Transactions beginning on page 4, Use of Proceeds beginning on page 43, Unaudited Pro Forma Condensed Consolidated Financial Data beginning on page 55, Management s Discussion and Analysis of Financial Condition and Results of Operations beginning on page 69, and the unaudited historical condensed consolidated financial statements and the accompanying notes thereto appearing elsewhere in this prospectus. As of May 30, 2004 Actual Pro Forma for the Transactions Product inventories: Raw materials and work in process $ 13,350 $ 14,922 $ 10,189 Finished goods 673,423 625,513 583,352 Supplies 925 574 (in millions) Cash and cash equivalents $ 7.8 $ Debt: Revolving credit facility (1) $ 42.1 $ 129.3 Term loan facility 165.0 8 1/4% senior notes 225.0 10 3/4% senior discount notes 86.4 Separate % senior subordinated notes due 2019 (2) 40.6 IDS % senior subordinated notes due 2019 292.0 Cash flows from financing activities: Net borrowings of short-term debt Bank overdraft 35,628 35,628 Net investments and advances 98,531 Net cash flows from financing activities 134,159 Total debt 353.5 626.9 Series A redeemable preferred stock 35.4 Participating preferred stock (3) 57.2 Stockholders equity (deficit): Participating preferred stock 7.2 Common stock Additional paid-in capital 67.1 Retained earnings (deficit) 35.2 (208.3 ) Unearned compensation expense (10.6 ) Accumulated other comprehensive loss (0.6 ) (0.6 ) Total stockholders equity (deficit) 101.7 (212.3 ) Total capitalization (4) $ 490.6 $ 483.3 Table of Contents DILUTION Dilution is the amount by which the portion of the price paid by the purchasers of the IDSs in the offering that is allocated to our shares of common stock exceeds the net tangible book value or deficiency per share of our common stock after the offering. Net tangible book value or deficiency per share of our common stock is determined at any date by subtracting our total liabilities from our total assets less our intangible assets and dividing the difference by the number of shares of our common stock deemed to be outstanding at that date. For purposes of calculating dilution below, we have assumed that as of , 2004 all of the participating preferred stock to be issued in connection with this offering has been converted into IDSs. Our net tangible book value as of May 30, 2004 was approximately $50.0 million, or $0.74 per share of common stock. After giving effect to the proposed stock split, this offering and the Transactions, including the use of proceeds as described in this prospectus, and assuming that all of the 8 1/4% Senior Notes and 10 3/4% Senior Discount Notes are repurchased in the Tender Offers, our pro forma net tangible book deficiency as of May 30, 2004 would have been approximately $ million, or $ per share of common stock. This represents an immediate increase in net tangible book value of $ per share of our common stock to our existing stockholders and an immediate dilution of $ per share of our common stock to new investors purchasing common stock represented by the IDSs in this offering. The following table illustrates this substantial and immediate dilution to new investors: Per Share of Common Stock Assumed initial public offering price of common stock represented by IDSs $ Dilution attributable to cash paid to existing investors in exchange for shares of stock Dilution attributable to participating preferred stock issued to existing investors in exchange for shares of stock Dilution attributable to vesting of managements options as a result of the transaction Dilution attributable to offering costs, debt prepayment penalties and write off of debt issue costs Increase in net tangible book value per share attributable to new investors Pro forma as adjusted net tangible book deficiency after this offering Dilution in net tangible book value per share to new investors $ Product inventories: Raw materials and work in process $ 16,299 $ 14,922 Finished goods 695,939 625,513 Supplies 962 The following table sets forth on a pro forma basis as of May 30, 2004, assuming no exercise of the underwriters over-allotment option: the total number of shares of our common stock represented by IDSs to be owned by our existing stockholders following the consummation of this offering and the other Transactions (assuming our existing stockholders had converted all participating preferred stock (including shares underlying vested options) into IDSs); the total consideration paid by our existing stockholders (net of distributions paid by us) and the total consideration to be paid by the new investors in this offering; and the average price per share of common stock paid by our existing stockholders (cash and stock) and to be paid by new investors purchasing common stock in this offering: Shares of Common Stock Purchased Average Price Per Share of Common Stock Number % Consideration Table of Contents UNAUDITED PRO FORMA CONDENSED CONSOLIDATED BALANCE SHEET As of May 30, 2004 UAP Holding Corp. Adjustment for the Recapitalization Adjustment for the Transactions (k) Pro Forma for the Transactions (in thousands) ASSETS Current assets: Cash and cash equivalents $ 7,782 $ $ (7,782 )(b) Receivables, net 896,057 896,057 Inventories 594,079 594,079 Deferred income taxes 4,566 5,609 (c) 27,205 (c) 37,380 Other current assets 42,732 42,732 Total current assets 1,391,776 80,346 4,440 1,476,562 PROPERTY, PLANT AND EQUIPMENT net 103,216 3,992 107,208 GOODWILL 2,515 2,426 4,941 INTANGIBLE ASSETS 5,533 5,533 DEFERRED INCOME TAXES 2,323 2,323 OTHER ASSETS 4,368 Total current assets 1,545,216 5,609 19,423 1,570,248 Property, plant and equipment, net 97,165 97,165 Goodwill 43,466 43,466 Intangible assets, net 6,705 6,705 Deferred income taxes 6,605 12,102 (c) 18,707 Debt issue costs 21,607 14,288 (d) 35,895 Other assets 8,738 8,738 $ 1,729,502 $ 17,711 $ 33,711 $ 1,780,924 LIABILITIES AND STOCKHOLDER S EQUITY (DEFICIT) Current liabilities: Amended and restated revolving credit facility $ 42,123 $ $ 87,218 (b) $ 129,341 Accounts payable 996,143 996,143 Other accrued liabilities 233,643 41,500 (b)(e) 275,143 Deferred income taxes 8,709 (8,709 )(c) Total current liabilities 1,280,618 120,009 1,400,627 Long-term debt: 8 % Senior Notes due 2011 225,000 (225,000 )(b) 10 % Senior Discount Notes due 2012 86,432 (86,432 )(b) Term loan 165,000 (b) 165,000 IDS notes 292,000 (b) 292,000 Senior subordinated notes 40,600 (b) 40,600 Series A redeemable preferred stock 35,379 (35,379 )(b) Deferred income taxes 264 264 Other noncurrent liabilities 96 31,847 (p) 31,943 Participating preferred stock 57,235 (f) 57,235 Stockholder s equity (deficit): Participating preferred stock 7,226 (f) 7,226 Common stock 1 43 (f) (7 )(f) 37 Additional paid-in capital 67,139 18,163 (f) (85,302 )(f) Retained earnings (deficit) 35,175 (28,897 )(f) (209,013 )(f) (202,735 ) Unearned compensation expense (10,671 )(f) (10,671 ) Accumulated other comprehensive loss (602 ) (f) (602 ) 101,713 (14,136 ) (294,322 )(f) (206,745 ) Prepaid pension cost $ 587 $ $ 1,729,502 $ 17,711 $ 33,711 $ 1,780,924 Total current assets Net cash flows from operating activities Net change in cash and cash equivalents Cash and cash equivalents at end of period $ Table of Contents UNAUDITED PRO FORMA CONDENSED CONSOLIDATED STATEMENT OF INCOME Fiscal Year Ended February 22, 2004 UAP Holding Corp. Thirteen Weeks Ended February 22, 2004 ConAgra Agricultural Products Business Thirty-Nine Weeks Ended November 23, 2003 Adjustments for the Acquisition Pro Forma for the Acquisition Adjustments for the Transactions (k) Pro Forma for the Acquisition and the Transactions (in thousands, except per share amounts) Net sales $ 227,778 $ 2,224,107 $ $ 2,451,885 $ $ 2,451,885 Costs and expenses: Cost of goods sold 170,730 1,938,010 2,108,740 2,108,740 Selling, general and administrative expenses 36,613 198,148 1,117 (g) 235,878 235,878 Corporate allocations Selling, general and administrative expenses 8,983 8,983 8,983 (dollars in thousands) Statement of Operations Data: Net sales $ 2,770,192 $ 2,526,765 $ 1,074,349 $ 2,224,107 $ 227,778 $ 1,258,489 Costs and expenses: Cost of goods sold 2,428,203 2,166,594 931,764 1,938,010 170,730 1,123,175 Selling, general and administrative expenses 334,626 275,244 82,434 208,670 37,017 82,956 (Gain) loss on sale of assets 606 1,493 (10,522 ) (404 ) (819 ) Corporate allocations: Selling, general and administrative expenses (a) 10,495 10,766 3,060 8,983 Finance charges (b) 39,526 22,494 4,130 12,209 Interest expense 5,372 1,927 270 (dollars in thousands) Statement of Operations Data: Net sales $ 2,247,305 $ 2,771,625 $ 2,770,192 $ 2,526,765 $ 1,074,349 $ 2,224,107 $ 227,778 $ 1,258,489 Costs and expenses: Cost of goods sold 1,841,622 2,401,078 2,428,203 2,166,594 931,764 1,938,010 170,730 1,123,175 Selling, general and administrative expenses 274,117 294,699 334,626 275,244 82,434 208,670 37,017 82,956 Restructuring charge 5,051 (Gain) loss on sale of assets (305 ) (323 ) 606 1,493 (10,522 ) (404 ) (819 ) Corporate allocations: Selling, general and administrative expenses (a) 9,811 10,947 10,495 10,766 3,060 8,983 Finance charges (b) 40,929 57,475 39,526 22,494 4,130 12,209 Interest expense 4,207 4,875 5,372 1,927 270 Income (loss) from continuing operations before income taxes 15,442 66,053 (13,892 ) 67,603 (25,932 ) 41,671 Income tax expense (benefit) 5,789 25,068 (2,706 )(j) 28,151 (11,539 )(j) 16,612 LIABILITIES AND STOCKHOLDERS EQUITY Current liabilities: Accounts payable $ Other accrued liabilities Net Sales $ Costs and expenses: Cost of goods sold Selling, general and administrative expenses Cash flows from operating activities: Net income (loss) $ 9,653 Adjustments to reconcile net income (loss) to net cash provided by operating activities: Depreciation Amortization Equity in earnings of subsidiaries (10,791 ) Deferred income taxes (Gain) loss on sale of assets Other noncash items 1,075 Change in operating assets and liabilities Income (loss) from continuing operations 9,653 40,985 (11,186 ) 39,452 (14,393 ) 25,059 Accretion of participating preferred stock (6,868 )(n) (6,868 ) Dividends on participating preferred stock (6,144 )(o) (6,144 ) Non-amortizing intangible assets $ 27 $ $ $ $ $ Amortizing intangible assets 11,547 6,041 7,450 373 7,450 Total $ 11,574 $ 6,041 $ 7,450 $ 373 $ 7,450 $ Income (loss) available for common stockholders $ 9,653 $ 40,985 $ (11,186 ) $ 39,452 $ (27,405 ) $ 12,047 Income from operations 53,177 53,177 Finance fee income (971 ) (971 ) Interest expense 11,373 6,665 (l) 18,038 Dividends on Series A redeemable preferred stock Income from operations 20,435 53,177 73,612 Finance fee income (3,432 ) (971 ) (4,403 ) Interest expense 7,376 11,373 18,749 Dividends on Series A redeemable preferred stock 1,049 Income per share Common stock: Basic $ Diluted $ Participating preferred stock: Basic $ Diluted $ Weighted average shares outstanding(q) Common stock: Basic Diluted Participating preferred stock: Basic Property, plant and equipment, net 93,099 4,015 97,114 Goodwill 43,465 43,465 Intangible assets, net 7,077 7,077 Deferred income taxes 18,293 18,293 Investment in subsidiaries 190,791 399,151 (589,942 ) Other assets 4,250 18,288 6,930 Property, plant and equipment, net 93,099 4,015 97,114 Goodwill 43,465 43,465 Intangible assets, net 7,077 7,077 Deferred income taxes 18,293 18,293 Debt issue costs Investment in subsidiaries 190,791 399,151 (589,942 ) Other assets 4,250 18,288 6,930 Diluted Table of Contents UNAUDITED PRO FORMA CONDENSED CONSOLIDATED STATEMENT OF INCOME Fourteen Weeks Ended May 30, 2004 UAP Holding Corp. Fourteen Weeks Ended May 30, 2004 Adjustments for the Transactions (k) Pro Forma for the Transactions (in thousands, except per share amounts) Net sales $ 1,258,489 $ $ 1,258,489 Costs and expenses: Cost of goods sold 1,122,755 1,122,755 Selling, general and administrative expenses 82,557 82,557 Table of Contents UAP HOLDING CORP. NOTES TO FINANCIAL STATEMENTS (Continued) Fiscal Years Ended February 22, 2004, February 23, 2003 and February 24, 2002 columnar dollar amounts in thousands 10. Commitments and Contingencies The company leases certain facilities and transportation equipment under agreements that expire at various dates. Management expects that in the normal course of business, leases that expire will be renewed or replaced by other leases. Substantially all leases require payment of property taxes, insurance and maintenance costs in addition to rental payments. Rent expense under all operating leases was $53.3 million and $46.1 million in fiscal 2002 and 2003, respectively, and $30.7 million and $9.5 million in the thirty-nine weeks ended November 23, 2003 and thirteen weeks ended February 22, 2004, respectively. A summary of noncancelable operating lease commitments for fiscal years following February 22, 2004 is as follows: 2005 $ 8,278 2006 4,855 2007 2,076 2008 1,024 2009 Income from continuing operations before income taxes 42,016 (5,906 ) 36,110 Income tax expense 16,494 (4,121 )(j) 12,373 Table of Contents UAP HOLDING CORP. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) For the Quarters Ended May 30, 2004 and May 25, 2003 columnar dollar amounts in thousands unaudited Based on current market rates primarily provided by outside investment bankers, the fair value of this debt at May 30, 2004 was estimated at $332.6 million. 8. Commitments and Contingencies The Company leases certain facilities and transportation equipment under agreements that expire at various dates. Management expects that in the normal course of business, leases that expire will be renewed or replaced by other leases. Substantially all leases require payment of property taxes, insurance and maintenance costs in addition to rental payments. Rent expense under all operating leases was $10.1 million and $10.0 million in the fourteen weeks ended May 30, 2004 and the thirteen weeks ended May 25, 2003, respectively. A summary of noncancelable operating lease commitments for fiscal years following May 30, 2004 is as follows: 2005 $ 7,315 2006 5,378 2007 2,695 2008 1,119 2009 Income from continuing operations 25,522 (1,785 ) 23,737 Accretion of participating preferred stock (1,772 )(n) (1,772 ) Dividends on participating preferred stock (1,654 )(o) (1,654 ) Income (loss) available for common stockholders $ 25,522 $ (5,211 ) $ 20,311 Income per share Common stock: Basic $ Diluted $ Participating preferred stock: Basic $ Diluted $ Weighted average shares outstanding(q) Common stock: Basic Diluted Participating preferred stock: Basic Diluted Table of Contents UNAUDITED PRO FORMA CONDENSED CONSOLIDATED STATEMENT OF INCOME Twelve Months Ended May 30, 2004 UAP Holding Corp. Twenty-Seven Weeks Ended May 30, 2004 (r) ConAgra Agricultural Products Business Twenty-Six Weeks Ended November 23, 2003 (s) Adjustments for the Acquisition Pro Forma for the Acquisition Adjustments for the Transactions (k) Pro Forma for the Acquisition and the Transactions (in thousands, except per share amounts) Net sales $ 1,486,267 $ 1,149,758 $ $ 2,636,025 $ $ 2,636,025 Costs and expenses: Cost of goods sold 1,293,485 1,006,246 2,299,731 2,299,731 Selling, general and administrative expenses 119,170 114,005 745 (g) 233,920 233,920 Corporate allocations Selling, general and administrative expenses 5,923 5,923 5,923 Current: Federal $ (11,975 ) $ 12,574 $ 23,119 $ (15,784 ) State (369 ) 1,515 1,949 (1,803 ) Foreign (658 ) Income (loss) from continuing operations before income taxes 57,458 13,362 (7,012 ) 63,808 (25,693 ) 38,115 Income tax expense (benefit) 22,283 4,591 (980 )(j) 25,894 (12,336 )(j) 13,558 Income (loss) from continuing operations 35,175 8,771 (6,032 ) 37,914 (13,357 ) 24,557 Accretion of participating preferred stock (7,000 )(n) (7,000 ) Dividends on participating preferred stock (6,262 )(o) (6,262 ) Income (loss) available for common stockholders $ 35,175 $ 8,771 $ (6,032 ) $ 37,914 $ (26,619 ) $ 11,295 Income Per Share Common stock: Basic $ Diluted $ Participating preferred stock: Basic $ Diluted $ Weighted average shares outstanding(q) Common stock: Basic Diluted Participating preferred stock: Basic Diluted Table of Contents NOTES TO UNAUDITED PRO FORMA CONDENSED CONSOLIDATED FINANCIAL DATA (dollars in columns in thousands) (a) The unaudited pro forma condensed combined financial statements have been prepared assuming that the Acquisition and certain financing transactions related thereto will be accounted for as a purchase business combination in accordance with SFAS No. 141, Business Combinations. (b) Amounts represent use of cash and additional borrowings to repay the 8 1/4% Senior Notes, the 10 3/4% Senior Discount Notes and the Series A redeemable preferred stock and the fair value of the proceeds from this Offering as follows: Transaction cash inflows: Transaction cash outflows: Cash and cash equivalents 7,782 Repay 8 1/4% Senior Notes due 2011 $ 225,000 Amended and restated revolving credit facility 87,218 Repay 10 3/4% Senior Discount Notes due 2012 86,432 Term Loan 165,000 Redeem Series A redeemable preferred stock 35,379 IDS senior subordinated notes 292,000 Repurchase equity sponsor and management common equity 128,584 Subordinated notes 40,600 Prepayment penalties associated with repayment of 8 1/4% Senior Notes and 10 3/4% Senior Discount Notes 55,000 Repay accrued interest 8,405 Transaction fees and expenses 53,800 $ 592,600 $ 592,600 (c) Amount represents adjustment to deferred income taxes as follows: Impact on taxes of write-off of $14.3 million of deferred finance fees associated with 8 1/4% Senior Notes and 10 3/4% Senior Discount Notes to be repaid in connection with this offering $ 5,444 Impact on taxes of $55.0 million of prepayment penalties associated with 8 1/4% Senior Notes and 10 3/4% Senior Discount Notes to be repaid in connection with this offering 20,900 Impact on taxes of $25.2 million of costs associated with the equity sponsor s sale of equity securities 9,570 Impact on taxes of stock compensation charge 17,711 53,625 Less: reduction in deferred income tax liability (8,709 ) $ 44,916 $ 14,288 Table of Contents (e) Amount represents the reduction of $8.4 million of accrued interest to be repaid upon the consummation of the Transactions and the $49.9 million fair value of the option to convert the participating preferred stock to IDSs, see Management s Discussion and Analysis of Financial Condition and Results of Operations Critical Accounting Policy Accounting Treatment for Participating Preferred Stock beginning on page 79. (f) The following table represents the changes to temporary equity and stockholder s equity (deficit) as a result of this Transaction: Temporary Equity- Participating preferred stock Participating preferred stock Common stock Additional paid-in capital Retained earnings (deficit) Unearned compensation Accumulated other comprehensive loss Total UAP Holding Corp. $ $ $ 1 $ 61,589 $ 35,175 $ $ (602 ) $ 96,163 49.578 for 1 stock split 49 (49 ) Adjustment for the Recapitalization: Stock compensation charge (i) 25,432 (28,897 ) (10,671 ) (14,136 ) Issuance of participating preferred stock in exchange for 6,403,289 shares of common stock, $0.001 par value, of our equity sponsor, at historical cost 7,226 (6 ) (7,220 ) Adjustment for the Recapitalization 7,226 43 18,163 (28,897 ) (10,671 ) (14,136 ) Adjustment for the Transactions: Repurchase of 9,571,666 of common stock, $0.001 par value, from our equity sponsor (6 ) (79,752 ) (35,102 ) (114,860 ) Repurchase 1,143,750 shares of common stock, $0.001 par value, from management (1 ) (13,724 ) (13,725 ) Costs associated with equity sponsor s sale of equity securities, net of tax (15,615 ) (15,615 ) Write-off of deferred finance fees associated with 8 1/4% Senior Notes and 10 3/4% Senior Discount Notes to be repaid in connection with this offering, net of tax (8,882 ) (8,882 ) Prepayment penalties of $55.0 million associated with 8 1/4% Senior Notes and 10 3/4% Senior Discount Notes to be repaid in connection with this offering, net of tax (34,100 ) (34,100 ) Fair value of option (recorded in other accrued liabilities) to convert participating preferred stock to IDSs (iii) (49,905 ) (49,905 ) Fair value of participating preferred stock classified as temporary equity (ii) 57,235 (57,235 ) (57,235 ) Adjustment for the Transactions 57,235 (7 ) (79,752 ) (214,563 ) (294,322 ) $ 57,235 $ 7,226 $ 37 $ $ (208,285 ) $ (10,671 ) $ (602 ) $ (212,295 ) Table of Contents (i) The following is a summary of the stock compensation charges we expect as a result of the Transactions: Additional paid-in capital Retained earnings (deficit) Unearned compensation Issuance of shares of participating preferred stock to the rabbi trust in exchange for shares of common stock currently held in the rabbi trust and related adjustment to other noncurrent liabilities, net of taxes $ $ (19,745 ) $ Exchange of vested common stock options held by management for participating preferred stock options, net of taxes 14,761 (9,152 ) Unearned compensation expense in connection with the exchange of unvested common stock options held by management for participating preferred stock options 10,671 (10,671 ) Adjustment for recapitalization 25,432 (28,897 ) (10,671 ) Compensation expense associated with repurchase of management stock options (13,724 ) Total stock compensation adjustments $ 25,432 $ (42,621 ) $ (10,671 ) Table of Contents NOTES TO UNAUDITED PRO FORMA CONDENSED CONSOLIDATED FINANCIAL DATA (Continued) (dollars in columns in thousands) (h) Represents elimination of the corporate allocation finance charge previously allocated by ConAgra Foods and adjustments to interest expense as follows: Fiscal Year Ended February 22, 2004 Fourteen Weeks Ended May 30, 2004 Twelve Months Ended May 30, 2004 Interest on new borrowings: Amended and restated revolving credit facility (4.25% adjustable rate) (1) $ 7,413 $ $ 4,942 8 % Senior Notes 13,922 9,281 10 % Senior Discount Notes 6,770 4,434 Amortization of deferred financing costs 2,530 1,687 $ 30,635 $ $ 20,344 Fourteen Weeks Ended May 30, 2004 Twelve Months Ended May 30, 2004 Interest on new borrowings: Amended and restated credit facility $ 3,271 $ 881 $ 3,334 Term loan 9,075 2,443 9,250 IDS notes 35,040 9,434 35,714 Senior subordinated notes 4,872 1,312 4,965 Amortization of deferred finance costs 2,861 770 2,916 Elimination of interest in connection with notes to be repaid in connection with this offering 8 % Senior Notes (17,390 ) (2,861 ) (15,610 ) 10 % Senior Discount Notes (7,850 ) (4,937 ) (10,451 ) Amortization of deferred finance costs (1,208 ) (377 ) (1,274 ) $ 28,671 $ 6,665 $ 28,844 Table of Contents NOTES TO UNAUDITED PRO FORMA CONDENSED CONSOLIDATED FINANCIAL DATA (Continued) (dollars in columns in thousands) (m) Represents the elimination of dividends on Series A redeemable preferred stock. (n) Amount represents the accretion in the value of the portion of the participating preferred stock classified as temporary equity. The amount initially classified as temporary equity is equal to the present value of the senior subordinated note s par value that the holder will be entitled to receive upon the earliest possible date of exchange using a discount rate equal to the interest rate on the senior subordinated notes. (o) Amount represents the 12% dividend representing the per annum interest rate on the senior subordinated notes on the liquidation preference portion of the stated outstanding principal amount of the participating preferred stock which represents 40% on an as-converted basis. (p) Amount represents adjustment to fair value of $31.8 million related to the adjustment of participating preferred stock held in the rabbi trust in exchange for shares of common stock currently held in such trust and the related stock compensation charge. (q) Outstanding shares have been affected by the assumed 49.578-for-1 stock split. (r) The following table sets forth the results of UAP Holding Corp. that comprise the twenty-seven weeks ended May 30, 2004: UAP Holding Corp. Thirteen Weeks Ended February 22, 2004 UAP Holding Corp. Fourteen Weeks Ended May 30, 2004 UAP Holding Corp. Twenty-Seven Weeks Ended May 30, 2004 Net sales $ 227,778 $ 1,258,489 $ 1,486,267 Costs and expenses: Costs and goods sold 170,730 1,122,755 1,293,485 Selling, general and administrative expenses 36,613 82,557 119,170 Income (loss) from continuing operations before income taxes 15,442 42,016 57,458 Income tax expense (benefit) 5,789 16,494 22,283 Income (loss) from continuing operations $ 9,653 $ 25,522 $ 35,175 Table of Contents NOTES TO UNAUDITED PRO FORMA CONDENSED CONSOLIDATED FINANCIAL DATA (Continued) (dollars in columns in thousands) (s) The following table sets forth the results of the ConAgra Agricultural Products Business that comprise the twenty-six weeks ended November 23, 2003: ConAgra Agricultural Products Business Thirty-Nine Weeks Ended November 23, 2003 ConAgra Agricultural Products Business Less: Thirteen Weeks Ended May 25, 2003 ConAgra Agricultural Products Business Twenty-Six Weeks Ended November 23, 2003 Net sales $ 2,224,107 $ (1,074,349 ) $ 1,149,758 Costs and expenses Cost of goods sold 1,938,010 (931,764 ) 1,006,246 Selling, general and administrative expenses 198,148 (84,143 ) 114,005 Corporate allocations: Selling, general and administrative expenses 8,983 (3,060 ) 5,923 Income (loss) from continuing operations before income taxes 66,053 (52,691 ) 13,362 Income tax expense (benefit) 25,068 (20,477 ) 4,591 Income (loss) from continuing operations $ 40,985 $ (32,214 ) $ 8,771 Table of Contents Combined Predecessor Entity ConAgra Agricultural Products Business Consolidated UAP Holding Corp. Fiscal Year Ended Thirteen Weeks Ended Thirty-Nine Weeks Ended 2,175,432 2,768,751 2,818,828 2,478,518 1,021,658 2,158,054 212,336 1,216,473 Income (loss) from continuing operations before income taxes 71,873 2,874 (48,636 ) 48,247 52,691 66,053 15,442 42,016 Income tax expense (benefit) 27,166 962 (17,519 ) 18,787 20,477 25,068 5,789 16,494 Income (loss) from continuing operations 44,707 1,912 (31,117 ) 29,460 32,214 40,985 9,653 25,522 Loss from discontinued operations, net of tax (10,170 ) (14,443 ) (5,919 ) (4,221 ) (2,613 ) (4,708 ) Net income (loss) $ 34,537 $ (12,531 ) $ (37,036 ) $ 25,239 $ 29,601 $ 36,277 $ 9,653 $ 25,522 Balance Sheet Data: Cash and cash equivalents $ 113,880 $ 146,335 $ 72,692 $ 28,559 $ 172,647 $ 7,782 Working capital 243,828 363,131 127,865 455,154 223,953 264,598 Total assets 1,469,136 1,820,573 1,396,155 1,352,025 1,263,963 1,729,502 Total debt 3,355 3,861 4,464 308,570 353,555 Stockholder s net investment and advances 407,856 530,735 294,492 587,898 Stockholder s equity 71,238 96,163 Other Operating Data: EBITDA (c) $ 142,792 $ 86,658 $ 20,963 $ 98,552 $ 58,269 $ 93,107 $ 27,357 $ 58,050 Depreciation and amortization 13,220 14,951 17,148 16,706 3,791 11,508 3,490 3,902 Cash flows (used in) provided by operating activities 36,797 (3,059 ) 120,662 (266,751 ) (154,791 ) (104,574 ) 446,373 (203,651 ) Cash flows (used in) provided by financing activities 29,138 48,970 (181,482 ) 226,652 134,704 69,503 (659,650 ) 42,123 Cash flows (used in) provided by investing activities (21,422 ) (13,456 ) (12,823 ) (4,034 ) (8,472 ) 6,512 385,924 (2,731 ) Ratio of earnings to fixed charges (d) 2.17x 1.04x 2.22x 7.80x 3.85x 2.33x 3.72x Table of Contents expenses relating to a transition services agreement and (4) the add back/deduction of gain/loss from the sale of certain businesses. We present EBITDA as defined in the indenture, because a corresponding calculation will be used in the indenture governing the senior subordinated notes. EBITDA is not a measure of financial performance or liquidity under GAAP. Accordingly, EBITDA should not be considered in isolation or as a substitute for net income, cash flows from operations or other income or cash flow data prepared in accordance with GAAP or as a measure of our operating performance or liquidity. For example, although we consider EBITDA a liquidity measure, it does not take into account all cash expenditures which may be necessary to grow our business, such as cash expenditures for acquisitions and capital expenditures. Because of covenants in the Amended Credit Facilities and the indenture that are based on EBITDA, including our fixed charge coverage ratio covenants, we will have to maintain our EBITDA at certain levels in order to, among other things, pay dividends on our capital stock and to avoid defaults under our Amended Credit Facilities and deferrals of interest payments on the senior subordinated notes. The following table sets forth a calculation of our EBITDA and EBITDA, as defined in the indenture: Combined Predecessor Entity Consolidated UAP Holding Corp. ConAgra Agricultural Products Business Fiscal Year Ended (in thousands) Cash flows used in (provided by) Operating Activities $ 36,797 $ (3,059 ) $ 120,662 $ (266,751 ) $ (154,791 ) $ (104,574 ) $ 446,373 $ (203,651 ) Interest Expense, net of non-cash interest 67,869 83,276 58,370 37,820 4,400 20,254 5,486 7,601 Net change in operating assets and liabilities 18,370 27,702 (140,743 ) 315,492 190,796 155,067 (403,894 ) 246,910 Income tax provision (benefit) 27,166 962 (17,519 ) 18,787 20,477 25,068 5,789 16,494 Deferred income tax benefit (provision) 2,565 (8,169 ) 4,517 (3,821 ) (23,858 ) (9,214 ) Loss from discontinued operations, net (10,170 ) (14,443 ) (5,919 ) (4,221 ) (2,613 ) (4,708 ) Other 195 389 1,595 1,246 2,000 (2,539 ) (90 ) EBITDA 142,792 86,658 20,963 98,552 58,269 93,107 27,357 58,050 Loss from discontinued operations, net 10,170 14,443 5,919 4,221 2,613 4,708 Inventory fair market value adjustment(1) 3,673 17,354 ConAgra transition services agreement expense(2) 1,875 1,875 Gain on sale of businesses(3) (9,181 ) EBITDA as defined $ 152,962 $ 101,101 $ 26,882 $ 102,773 $ 60,882 $ 88,634 $ 32,905 $ 77,279 Table of Contents On December 16, 2003, United Agri Products issued $225.0 million aggregate principal amount of 8 % Senior Notes which mature on December 15, 2011. On April 26, 2004, United Agri Products commenced a tender offer and consent solicitation with respect to all its outstanding $225.0 million aggregate principal amount of 8 % Senior Notes. As of May 10, 2004, United Agri Products had received the requisite consents with respect to the 8 1/4% Senior Notes. As of the date of this prospectus, all $225,000,000 aggregate principal amount of the 8 1/4% Senior Notes have been validly tendered and have not been withdrawn in the 8 1/4% Senior Note Tender Offer, and United Agri Products has executed a supplemental indenture with respect to the 8 1/4% Senior Notes, with effectiveness subject to consummation of the Tender Offers. In addition, all of the 8 1/4% Senior Notes will be repurchased in the 8 1/4% Senior Note Tender Offer and the indenture governing the 8 1/4% Senior Notes will be discharged. See Description of Other Indebtedness beginning on page 122 for a more detailed discussion of the terms of the tender offer and consent solicitation with respect to the 8 % Senior Notes and Description of Other Indebtedness 8 % Senior Notes beginning on page 128 for a more detailed discussion of the terms of the 8 % Senior Notes. On January 26, 2004, UAP Holdings issued $125.0 million aggregate principal amount at maturity of 10 % Senior Discount Notes which mature on July 15, 2012. On April 26, 2004, UAP Holdings commenced a tender offer and consent solicitation with respect to all of its outstanding $125.0 million aggregate principal amount at maturity of 10 % Senior Discount Notes. As of May 10, 2004, UAP Holdings had received the requisite consents with respect to the 10 3/4% Senior Discount Notes. As of the date of this prospectus, all $125,000,000 aggregate principal amount at maturity of the 10 3/4% Senior Discount Notes have been validly tendered and have not been withdrawn in the 10 3/4% Senior Discount Note Tender Offer, and UAP Holdings has executed a supplemental indenture with respect to the 10 3/4% Senior Discount Notes, with effectiveness subject to consummation of the Tender Offers. In addition, all of the 10 3/4% Senior Discount Notes will be repurchased in the 10 3/4% Senior Discount Note Tender Offer and the indenture governing the 10 3/4% Senior Discount Notes will be discharged. See Description of Other Indebtedness beginning on page 122 for a more detailed discussion of the terms of the tender offer and consent solicitation with respect to the 10 % Senior Discount Notes and Description of Other Indebtedness 10 % Senior Discount Notes beginning on page 131 for a more detailed discussion of the terms of the 10 % Senior Discount Notes. United Agri Products will enter into the Amended Credit Facilities upon the consummation of their offering. See Description of Other Indebtedness beginning on page 122. OBLIGATIONS AND COMMITMENTS As part of our ongoing operations, we enter into arrangements that obligate us to make future payments under contracts such as lease agreements, debt agreements and unconditional purchase obligations (i.e., obligations to transfer funds in the future for fixed or minimum quantities of goods or services at fixed or minimum prices, such as take-or-pay contracts). We enter into unconditional purchase obligation arrangements in the normal course of business in order to ensure that adequate levels of sourced product are available to us. The following is a summary of our contractual obligations as of February 22, 2004: Payments Due by Period Contractual Obligations Total Less than 1 Year 2-3 Years 4-5 Years After 5 Years (in millions) Long-Term Debt $ 350.0 $ $ $ $ 350.0 Lease Obligations 19.5 8.3 6.9 1.8 2.5 Unconditional Purchase Obligations 1.4 0.6 0.8 Total $ 370.9 $ 8.9 $ 7.7 $ 1.8 $ 352.5 Table of Contents accounted for over 50% of sales by the largest 100 retailers in our industry measured by sales. Consolidation in our industry has been driven by a number of factors, including: increased average farm size; consolidation of suppliers; increasing demand for sales people with high levels of technical expertise; poor performance of co-operatives; overcapacity in the industry; and the need for sufficient scale to realize strong relationships with suppliers. We believe that these trends will continue and will result in greater demands being placed on agricultural input distribution companies. Based on independent consulting work which we sponsored, we believe that independent national distributors (i.e., non-grower owned cooperatives) increased their retail market share amongst the largest 100 retailers measured by sales from 37% in 1998 to 41% in 2003, and that larger companies, such as UAP, will continue to increase their competitive advantage over businesses with fewer resources. OUR COMPETITIVE STRENGTHS We believe our leading market positions, operating model focused on free cash flow, extensive distribution network, strong supplier relationships, diversified product offering and proven and incentivized management team will allow us to increase our net sales, market share and profitability. Leading Market Positions We are the largest private distributor of agricultural input products in major crop-producing regions throughout the United States and Canada. We believe that our emphasis on selling a full range of quality products and consistently providing high quality service has enabled us to achieve our leading market shares. We believe, based on independent consulting work which we sponsored, that we hold the number one market position, based on net retail sales of the largest 100 retailers measured by sales, in each of the core product categories in which we compete: Category Key Products Market Position 2003 Retail Market Share Table of Contents Distribution Division As of February 22, 2004 we had an extensive distribution infrastructure of over 350 facilities, consisting of retail distribution centers, bulk storage, granulation, blending and seed treatment plants, as well as an integrated network of distribution storage terminals and warehouses. We believe our infrastructure, including chemical and seed warehouses, bulk storage for crop protection chemicals and fertilizer loading equipment, delivery vehicles, nurse tanks, trailers and application equipment provides us with a significant competitive advantage over smaller, regional competitors and deters new entrants into this capital intensive market. Our facilities are strategically located throughout the major crop producing regions in the United States and Canada. We believe this market presence provides a number of competitive advantages, including: allowing us to act as a supplier to the country s largest purchasers of crop production inputs; providing us with the opportunity to distribute products for the leading agricultural input producers; and providing market diversity that helps to insulate our overall business from difficult farming conditions as a result of poor weather in any one particular market or adverse market conditions for a specific crop. We have instituted central management controls and utilize our logistical expertise and sophisticated information technology systems to manage our extensive businesses and facilities network. We understand the importance of flexibility at the local level to adapt to local conditions. We aim to achieve the proper balance of central control and direction with local flexibility by utilizing team management and appropriate incentive programs. We operate distribution centers serving both wholesalers and individual growers, and are one of the largest retailers of crop production inputs to growers in North America. Retail centers typically service growers within a 10 to 50 mile radius of their locations. We operate retail centers in each major crop producing region of the United States and Canada. Our distribution network, though centrally organized, is internally divided by region. The following table identifies these various regions, the states served (subject to occasional overlap), the major crops serviced, the approximate number of employees (including hourly and temporary employees) and the total sales for each such region for fiscal 2004: Region States/Provinces Served Major Crops Serviced Employees Fiscal 2004 Pro Forma Net Sales (dollars in millions) Table of Contents As of February 22, 2004, we had approximately 250 proprietary branded products. We have a broad product offering of proprietary brands in each of our segments. Some of our key proprietary branded products in each of our segments are listed in the table below. Segment Key Proprietary Branded Products (as a percentage of net sales) Crop Protection Chemicals 65.9 % 65.7 % 64.4 % Fertilizer 21.0 % 20.2 % 21.5 % Seed 10.2 % 10.7 % 10.6 % Other 2.9 % 3.4 % 3.5 % Total 100.0 % 100.0 % 100.0 % Table of Contents enables us to buy fertilizer from U.S. or international sources, depending on where we can get the best prices. See Certain Relationships and Related Transactions Ancillary Agreements beginning on page 112. EMPLOYEES AND LABOR RELATIONS As of February 22, 2004 we employed approximately 3,050 non-unionized and salaried employees, approximately 95 unionized employees and approximately 150 temporary employees to meet our seasonal needs. We believe we have good relations with our employees. All our unionized employees work at the Platte Chemical Company facility in Greenville, Mississippi and are all subject to a collective bargaining agreement. This collective bargaining agreement is scheduled to expire in August 2004, but is subject to automatic renewals for additional year-long periods unless otherwise terminated. We have not had any work stoppages in the past five years. In connection with the Acquisition, UAP Holdings entered into retention agreements with ten of our top executives. Each of these executives was granted restricted units in UAP Holdings pursuant to these retention agreements. In addition, UAP Holdings issued these same employees stock options that vest in three separate tranches and are subject to UAP Holdings 2003 stock option plan. See Management beginning on page 98. PROPERTIES Our properties are located in the major crop-producing regions of the United States and Canada. We are headquartered in Greeley, Colorado and have five formulation facilities located throughout the United States. Location Owned/Leased Building(s) Square Footage Formulating/ Production Square Footage Function Table of Contents In addition, as of February 22, 2004, we owned or leased 386 properties that are used to maintain inventory and distribute and sell our products to our customers. We determine the number of distribution and storage facilities as those managed by a single location manager. Because there may be more than one property that we own or lease managed by a location manager, our approximately 350 distribution and storage facilities are less than the total number of leased and owned properties. We also utilize other miscellaneous facilities in our distribution business. We operate these properties through our four primary geographic regions, which are further divided into fifteen sub-regions, as noted below: Region Sub-region States Served Owned Leased Total Table of Contents MANAGEMENT Set forth below is certain information as of July 1, 2004 concerning the individuals that are currently serving as executive officers and/or members of the board of directors of UAP Holdings and United Agri Products. Name Age Position Table of Contents Audit Committee. The principal duties and responsibilities of our audit committee are as follows: to monitor our financial reporting process and internal control system; to appoint and replace our independent outside auditors from time to time, determine their compensation and other terms of engagement and oversee their work; to oversee the performance of our internal audit function; and to oversee our compliance with legal, ethical and regulatory matters. The audit committee will have the power to investigate any matter brought to its attention within the scope of its duties. It will also have the authority to retain counsel and advisors to fulfill its responsibilities and duties. Compensation Committee. The principal duties and responsibilities of the compensation committee are as follows: to provide oversight on the development and implementation of the compensation policies, strategies, plans and programs for our key employees and outside directors and disclosure relating to these matters; to review and approve the compensation of our chief executive officer and the other executive officers of us and our subsidiaries; and to provide oversight concerning selection of officers, management succession planning, performance of individual executives and related matters. Nominating Committee. The principal duties and responsibilities of the nominating committee will be as follows: to establish criteria for board and committee membership and recommend to our board of directors proposed nominees for election to the board of directors and for membership on committees of the board of directors; to make recommendations regarding proposals submitted by our shareholders; and to make recommendations to our board of directors regarding board governance matters and practices. EXECUTIVE COMPENSATION As an independent company, we will establish executive compensation plans that will link compensation with the performance of our company. We will continually review our executive compensation programs to ensure that they are competitive. The following table sets forth information concerning total compensation earned or paid to the Chief Executive Officer and the four other most highly compensated executive officers of UAP Holdings who served in such capacities as of February 22, 2004 for services rendered during the fiscal year that ended on that date. Name and Principal Position Year Annual Compensation Long-Term Compensation Deferred IDS Awards(1) All Other Compensation Salary Bonus Table of Contents Table of Contents Number and Percent of Shares of Common Stock Beneficially Owned Prior to this Offering Shares to be Sold in this Offering Number and Percent of Shares Beneficially Owned After this Offering Assuming No Exercise of the Over-Allotment Option Number and Percent of Shares Beneficially Owned After this Offering Assuming Full Exercise of the Over-Allotment Option Common Stock Participating Preferred Stock Common Stock Participating Preferred Stock Number Percentage of Class Number Percentage of Class Number Percentage of Class Number Percentage of Class Number Percentage of Class Apollo Management V, L.P. (a)(b). 59,932,086 94.9 % 36,500,000 % 6,403,289 77.0 % % 928,289 32.7 % L. Kenny Cordell (c) 717,225 1.3 643,353 7.5 643,353 20.8 Bryan S. Wilson (d) 436,284 * 388,419 4.5 388,419 13.0 David W. Bullock (e) 436,284 * 388,419 4.5 388,419 13.0 Dave Tretter (f) 269,373 * 217,665 2.6 217,665 7.5 Robert A. Boyce, Jr. (g) 422,568 * 360,533 4.3 360,533 12.1 Joshua J. Harris (h)(j) 74,367 * 37,120 * 37,120 1.3 Robert Katz (h)(j) 74,367 * 37,120 * 37,120 1.3 Marc E. Becker (i)(j) 74,367 * 37,120 * 37,120 1.3 Stan Parker (i)(j) 74,367 * 37,120 * 37,120 1.3 Carl J. Rickertsen (j) 74,367 * 37,120 * 37,120 1.3 Thomas Miklich (j) 74,367 * 37,120 * 37,120 1.3 Directors and executive officers as a group (10 persons) (k) 2,135,977 3.7 % % 1,672,637 19.6 % % 1,672,637 54.6 % Table of Contents (iii) the achievement of minimum EBITDA levels and minimum cash fixed charge coverage ratios (defined generally, subject to certain adjustments reflecting recent acquisitions and discontinued operations, as the ratio of (i) EBITDA minus income and franchise taxes paid in cash during such period, minus the unfinanced portion of capital expenditures made during such period to (ii) the sum of (a) interest expense paid in cash during such period, plus (b) regularly scheduled principal payments on indebtedness paid in cash during such period each for the trailing twelve months ended as of the last day of the fiscal quarter most recently ended for which financial statements are available prior to such payment, as set forth on the table below: QUARTERS ENDING DURING FISCAL YEARS MINIMUM EBITDA CASH FIXED CHARGE COVERAGE RATIO (dollars in millions) 2005 $95 1.30 2006 $95 1.30 2007 $100 1.35 2008 $100 1.45 2009 and thereafter $105 1.50 The second lien term loan will restrict our ability to pay dividends on our capital stock based on (i) there not being an event of default, (ii) our ability to pay interest on the senior subordinated notes (as set forth above), (iii) there not being any outstanding, unpaid interest on the senior subordinated notes and (iv) the achievement of minimum EBITDA levels and minimum pro forma cash fixed charge-dividends coverage ratios (which will be calculated in the same way as the cash fixed charge coverage ratio described above, except that the fixed charges component of the ratio (the denominator) will include actual dividends for the prior three fiscal quarters and anticipated dividends for the quarter being tested), as set forth on the table below: QUARTERS ENDING DURING FISCAL YEARS MINIMUM EBITDA PRO FORMA CASH FIXED CHARGE-COVERAGE RATIO DIVIDENDS Table of Contents indicated below, subject to the rights of holders of Notes on the relevant record date to receive interest on the relevant interest payment date: Year Percentage Table of Contents UNDERWRITING Under the terms and subject to the conditions contained in an underwriting agreement, dated , 2004, we and our equity sponsor have agreed to sell to the underwriters named below, for whom Credit Suisse First Boston LLC, UBS Securities LLC, CIBC World Markets Corp., Goldman, Sachs & Co. and Merrill Lynch, Pierce, Fenner & Smith Incorporated are acting as representatives, the following respective numbers of IDSs and aggregate principal amount of separate senior subordinated notes: Underwriter Number of IDSs Aggregate Principal Amount of Senior Subordinated Notes Credit Suisse First Boston LLC UBS Securities LLC CIBC World Markets Corp. Goldman, Sachs & Co. Merrill Lynch, Pierce, Fenner & Smith Incorporated Total The underwriting agreement provides that the underwriters are obligated to purchase all the IDSs and separate senior subordinated notes in the offering if any are purchased, other than those IDSs covered by the over-allotment option described below. The underwriting agreement also provides that if an underwriter defaults, the purchase commitments of non-defaulting underwriters may be increased or the offering may be terminated, depending on the circumstances. Any subsequent issuance of IDSs and senior subordinated notes of the same series that results in an automatic exchange of a portion of your senior subordinated notes for a portion of the senior subordinated notes issued in such subsequent issuance, and/or replacement of your IDSs with new IDSs should not impair the rights you would otherwise have to assert a claim under applicable securities laws against us or the underwriters with respect to the full amount of the senior subordinated notes purchased by such holder, including senior subordinated notes purchased in this offering and senior subordinated notes received by such holder in an automatic exchange. See Description of IDSs Clearance and Settlement Procedures Relating to Subsequent Issuances beginning on page 134. We have granted the underwriters an option to purchase up to 5,475,000 additional IDSs to cover over-allotments, if any. The option may be exercised by the underwriters only to cover any over-allotment of IDSs. The underwriters propose to offer the IDSs and senior subordinated notes initially at the public offering price on the cover page of this prospectus and to the selling group members at that price less a selling concession of $ per IDS. The underwriters may allow a discount of $ per IDS and $ per $1,000 aggregate principal amount of the senior subordinated notes on sales to other broker/dealers. After the initial public offering the representatives may change the public offering price and concession and discount to broker/dealers. The following table summarizes the compensation and estimated expenses we and our equity sponsor will pay: Per IDS Combined Total Without Over- allotment With Over- allotment Per $1,000 Aggregate Principal Amount of the Notes Without Over- allotment With Over- allotment Table of Contents INDEX TO FINANCIAL STATEMENTS UAP HOLDING CORP. Page Table of Contents UAP HOLDING CORP. BALANCE SHEETS dollars in thousands Combined Predecessor Entity ConAgra Agricultural Products Business February 23, 2003 Consolidated UAP Holding Corp. February 22, 2004 ASSETS Current assets: Cash and cash equivalents $ 28,559 $ 172,647 Accounts receivable net of allowance of $34,694, and $27,328 204,043 170,769 Inventories 713,200 641,009 Deferred income taxes 21,912 2,681 Other current assets 184,436 80,653 Current assets of discontinued operations 67,012 Total current assets 1,219,162 1,067,759 Property, plant and equipment 230,300 100,207 Less accumulated depreciation (127,505 ) (3,093 ) Property, plant and equipment, net 102,795 97,114 Goodwill 4,731 43,465 Intangible assets, net 6,025 7,077 Deferred income taxes 2,323 18,293 Other assets 7,137 30,255 Noncurrent assets of discontinued operations 9,852 $ 1,352,025 $ 1,263,963 LIABILITIES AND STOCKHOLDER S NET INVESTMENT AND ADVANCES / STOCKHOLDERS EQUITY Current liabilities: Accounts payable $ 642,600 $ 689,455 Other accrued liabilities 86,318 145,234 Deferred income taxes 9,117 Current liabilities of discontinued operations 35,090 Total current liabilities 764,008 843,806 Long-term debt 308,570 Series A redeemable preferred stock 34,620 Deferred income taxes 83 Other noncurrent liabilities 119 96 Commitments and contingencies (Note 10) Stockholder s net investment and advances/stockholders equity: Stockholder s net investment and advances 587,898 Common stock, $.001 par value, 2,000,000 shares authorized, 1,200,000 shares issued and outstanding 1 Additional paid-in capital 67,139 Retained earnings 9,653 Accumulated other comprehensive loss (5 ) Total stockholders equity 76,788 $ 1,352,025 $ 1,263,963 Table of Contents UAP HOLDING CORP. STATEMENTS OF EARNINGS dollars in thousands, except per share amounts Combined Predecessor Entity Consolidated ConAgra Agricultural Products Business UAP Holding Corp. Net Sales $ 2,770,192 $ 2,526,765 $ 2,224,107 $ 227,778 Costs and expenses: Cost of goods sold 2,428,203 2,166,594 1,938,010 170,730 Selling, general and administrative expenses 334,626 275,244 208,670 37,017 Third party interest expense 5,372 1,927 704 4,993 (Gain) loss on sale of assets 606 1,493 (10,522 ) (404 ) Corporate allocations: Selling, general and administrative expenses 10,495 10,766 8,983 Finance charges 39,526 22,494 12,209 Income (loss) from continuing operations before income taxes (48,636 ) 48,247 66,053 15,442 Income tax expense (benefit) (17,519 ) 18,787 25,068 5,789 Income (loss) from continuing operations (31,117 ) 29,460 40,985 9,653 Loss from discontinued operations, net of tax (5,919 ) (4,221 ) (4,708 ) Net income (loss) $ (37,036 ) $ 25,239 $ 36,277 $ 9,653 Table of Contents UAP HOLDING CORP. STATEMENTS OF STOCKHOLDERS EQUITY AND STOCKHOLDER S NET INVESTMENT AND ADVANCES dollars in thousands Combined Predecessor Entity ConAgra Agricultural Products Business Investment and Advances/ (Distributions) Foreign Currency Translation Adjustment Stockholder's Net Investment and Advances Balance at February 25, 2001 $ 530,818 $ (83 ) $ 530,735 Comprehensive loss: Net loss (37,036 ) (37,036 ) Foreign currency translation adjustment (74 ) (74 ) Total comprehensive loss (37,110 ) Net investment and advances/(distributions) (199,133 ) (199,133 ) Balance at February 24, 2002 294,649 (157 ) 294,492 Comprehensive income (loss): Net income 25,239 25,239 Foreign currency translation adjustment (92 ) (92 ) Total comprehensive income 25,147 Net investment and advances 268,259 268,259 Total comprehensive income 36,579 Net investment and advances 27,522 27,522 Consolidated UAP Holding Corp. Thirteen Weeks Ended February 22, 2004 Class A Common Stock Additional Paid-in Capital Retained Earnings Accumulated Other Comprehensive Income Total Stockholders Equity Balance at November 24, 2003 $ $ $ $ $ Acquisition of common stock 1 119,999 120,000 Dividend to stockholders (52,860 ) (52,860 ) Comprehensive income (loss): Net income 9,653 9,653 Foreign currency translation adjustment (5 ) (5 ) Total comprehensive income 9,648 Table of Contents UAP HOLDING CORP. STATEMENTS OF CASH FLOWS dollars in thousands Combined Predecessor Entity Consolidated ConAgra Agricultural Products Business UAP Holding Corp. Fiscal Year Ended, Thirty-Nine Weeks Ended November 23, 2003 Thirteen Weeks Ended February 22, 2004 February 24, 2002 February 23, 2003 Cash flows from operating activities: Net income (loss) $ (37,036 ) $ 25,239 $ 36,277 $ 9,653 Less: Loss from discontinued operations (5,919 ) (4,221 ) (4,708 ) Income (loss) from continuing operations (31,117 ) 29,460 40,985 9,653 Adjustments to reconcile net income (loss) from continuing operations to net cash provided by operating activities: Depreciation 14,474 14,447 9,845 3,103 Amortization 2,674 2,259 1,663 387 Deferred income taxes (4,517 ) 3,821 23,858 (Gain) loss on sale of assets 606 1,493 (10,522 ) (404 ) Other noncash items (2,201 ) (2,739 ) 8,522 2,943 Change in assets and liabilities: Receivables 119,295 5,191 (283,052 ) 316,325 Inventories 198,180 126,618 238,151 (144,933 ) Other current assets (7,580 ) (149,051 ) 164,949 (85,095 ) Accounts payable, accrued liabilities and noncurrent liabilities (169,152 ) (298,250 ) (275,115 ) 320,536 Net cash flows from operating activities 120,662 (266,751 ) (104,574 ) 446,373 February 27, February 27, February 25, February 25, February 24, Basic and diluted earnings per share $ 8.04 $ 19.60 Other Operating Data: Depreciation and amortization $ 17,148 $ 16,706 $ 3,791 $ 11,508 $ 3,490 $ 3,902 EBITDA (d) 20,963 98,552 58,269 93,107 27,357 58,050 Cash paid for interest (e) 5,319 1,980 843 327 860 704 Capital expenditures 13,654 6,417 7,317 8,350 6,970 2,731 Ratio of earnings to fixed charges (c) 2.22x 7.80x 3.85x 2.33x 3.72x As of February 24, February 24, February 24, February 24, Table of Contents protect our proprietary and confidential information. Such nondisclosure agreements specifically address the confidential information disclosed and concern the protection of our intellectual property. The objectives of the trade secret policy are to prevent disclosure of sensitive information and to protect our legal interests if our trade secrets are appropriated. We will continue to aggressively prosecute and enforce all of our intellectual property rights. SEASONALITY Our and our customers businesses are seasonal, based upon the planting, growing and harvesting cycles. During fiscal 2002 through 2004, at least 75% of our net sales occurred during the first and second fiscal quarters of each year because of the condensed nature of the planting season. As a result of the seasonality of sales, we experience significant fluctuations in our revenues, income and net working capital levels. However, our integrated network of formulation and blending, distribution and warehousing facilities and technical expertise allows us to efficiently process, distribute and store product close to our end-users and to supply our customers on a timely basis during the compressed planting and growing season. See Management s Discussion and Analysis of Financial Condition and Results of Operations beginning on page 69. PRODUCTS The following table shows the percentage of our net sales by product line for the fiscal years 2002 and 2003 on an actual basis and fiscal 2004 on a pro forma basis after giving effect to the Transactions, respectively: Year ended February 24, Fiscal Year Ended Thirty-Nine Weeks Ended Thirteen Weeks Ended February 24, Table of Contents UAP HOLDING CORP. NOTES TO FINANCIAL STATEMENTS (Continued) Fiscal Years Ended February 22, 2004, February 23, 2003 and February 24, 2002 columnar dollar amounts in thousands net cash flows expected to be generated by the asset, the asset s carrying amount is reduced to its fair market value. An asset held-for-sale is reported at the lower of the carrying amount or fair market value, less cost to sell. Income Taxes The company recognizes deferred tax assets and liabilities based on the differences between the financial statement and tax bases of assets and liabilities at each balance sheet date using enacted tax rates expected to be in effect in the year the differences are expected to reverse. Prior to the Acquisition, income taxes were paid by the parent company on a consolidated level as the company was included in the consolidated tax returns of ConAgra Foods. The provision for income taxes was computed on a separate legal entity basis. Fair Values of Financial Instruments Unless otherwise specified, the company believes the carrying amount of financial instruments approximates their fair value. Revenue Recognition Revenue is recognized when title and risk of loss are transferred to customers upon delivery based on terms of sale. Revenue is recognized as the net amount to be received after deducting estimated amounts for discounts, trade allowances and product returns. Earnings per Share Earnings per share is based on the weighted average number of shares of common stock outstanding during the period. The weighted average number of shares outstanding for basic and diluted earnings per share for thirteen weeks ended February 22, 2004 was 1,200,000. Stock-Based Compensation The company accounts for employee stock option plans in accordance with Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees. Accordingly, no stock-based compensation expense is reflected in net income, as options granted under these plans have an exercise price equal to the market value of the underlying common stock on the date of grant. In December 2002, the Financial Accounting Standards Board ( FASB ) issued Statement of Financial Accounting Standards ( SFAS ) No. 148, Accounting for Stock-Based Compensation Transition and Disclosure, which became effective for fiscal years ending after December 15, 2002. SFAS No. 148 requires certain pro forma information regarding net income and earnings per share assuming the company recognized expense for its employee stock options using the fair value method. The fair value of options was estimated at the date of the grant using the Black-Scholes option pricing model with the following weighted average assumptions for 2002, 2003 and the thirty-nine weeks ended November 23, 2003, respectively: risk-free interest rate of 4.52%, 4.30% and 4.30%; a dividend yield of 3.9%, 3.9% and 3.9%; expected volatility of 29.0%, 30.0% and 30.0%; and an expected option life of six years. The weighted average fair value of options granted in fiscal 2002, 2003 and the thirty-nine weeks ended November 23, 2003 was $5.08, $5.88 and $5.88, respectively. Pro forma net income (loss) is as follows: February 24, February 24, February 24, Table of Contents UAP HOLDING CORP. NOTES TO FINANCIAL STATEMENTS (Continued) Fiscal Years Ended February 22, 2004, February 23, 2003 and February 24, 2002 columnar dollar amounts in thousands Plan assets are primarily invested in equity securities, corporate and government debt securities and common trust funds. Certain employees of the Predecessor Entity are covered under defined contribution plans administered by ConAgra Foods. The expense related to these plans was $1.9 million and $3.0 million in fiscal 2002 and 2003, respectively, and $2.5 million for the thirty-nine weeks ended November 23, 2003. 12. Successor Stock Plans Certain of the Company s employees participate in the UAP Holdings, Inc. stock option plan. The stock option plan, approved by UAP Holdings, Inc. shareholders, provides for granting of options to employees for the purchase of Common Stock at prices equal to fair market value at the time of grant. Options become exercisable under various vesting schedules and generally expire eight years after the date grant. As of February 22, 2004, 74,300 options have been granted under the plan with an exercise price of $100. No options have vested as of February 22, 2004 and 4,155 options remain available under the plan. 13. Predecessor Stock Plans Prior to the Acquisition, certain of the company s employees participated in ConAgra Foods stock option plans. These stock option plans approved by the ConAgra Foods stockholders provide for granting of options to employees for purchase of Common Stock at prices equal to fair market value at the time of grant. At the date of Acquisition, all options outstanding became fully vested and were exercisable for 90 days after the date of the Acquisition, at which time all unexercised options were canceled. The changes in the outstanding stock options during the years ended February 24, 2002 and February 23, 2003 and the thirty-nine weeks ended November 23, 2003, are summarized below: Thirteen Weeks Ended May 25, Thirty-Nine Weeks Ended November 23, February 23, As of February 23, February 23, May 25, November 23, February 23, May 25, November 23, Thirteen Weeks Ended May 25, Thirty-Nine Weeks Ended November 23, February 23, Year ended February 23, February 23, November 23, Fiscal Year Ended February 23, Thirty-Nine Weeks Ended November 23, 4. Inventories Inventories are comprised of the following: February 23, Table of Contents UAP HOLDING CORP. NOTES TO FINANCIAL STATEMENTS (Continued) Fiscal Years Ended February 22, 2004, February 23, 2003 and February 24, 2002 columnar dollar amounts in thousands 5. Property, Plant and Equipment Property, plant and equipment are comprised of the following: February 23, February 23, February 23, The tax effect of temporary differences and carryforwards that give rise to significant portions of deferred tax assets and liabilities consist of the following: Actuarial Assumptions Discount rate 7.50 % 7.25 % 6.50 % 6.50 % Long-term rate of return on plan assets 9.25 % 7.75 % 7.75 % 7.75 % Long-term rate of compensation increase 5.50 % 5.50 % 5.50 % 5.50 % The change in projected benefit obligation, change in plan assets and funded status of the plans at February 23, 2003 and February 22, 2004: Thirty-Nine Weeks Ended November 23, Thirty-Nine Weeks Ended November 23, Thirty-Nine Weeks Ended November 23, May 25, Thirteen Weeks Ended May 25, Amortizing intangible assets, carrying a weighted average life of approximately 6 years, are comprised primarily of a product marketing agreement. Amortization expense was $0.4 million and $0.5 million for the fourteen-week period ended May 30, 2004 and the thirteen-week period ended May 25, 2003, respectively. Amortization expense is estimated to approximate $1.5 million for each of the next five years. 4. Inventories Inventories are comprised of the following: May 25, Table of Contents UAP HOLDING CORP. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) For the Quarters Ended May 30, 2004 and May 25, 2003 columnar dollar amounts in thousands unaudited 5. Property, Plant and Equipment Property, plant and equipment are comprised of the following: May 25, May 25, Table of Contents The information in this prospectus is not complete and may be changed. We may not sell these securities until the Securities and Exchange Commission declares our Registration Statement effective. This prospectus is not an offer to sell these securities and it is not soliciting an offer to buy these securities in any state where the offer or sale is not permitted. SUBJECT TO COMPLETION, DATED OCTOBER 1, Fiscal Year Ended February 22, May 30, Fiscal Year Ended February 22, Fiscal Year Ended February 22, Thirteen Weeks Ended February 22, Fourteen Weeks Ended May 30, As of February 22, As of May 30, February 22, May 30, Fiscal Year Ended February 22, Fiscal Year Ended February 22, Twelve Months Ended May 30, Thirteen Weeks Ended February 22, Fourteen Weeks Ended May 30, Thirteen Weeks Ended February 22, Fourteen Weeks Ended May 30, Pro Forma Year ended February 22, February 22, Net cash flows from investing activities (12,823 ) (4,034 ) 6,512 (659,650 ) February 22, February 22, Thirteen Weeks Ended February 22, Thirteen Weeks Ended February 22, Unaudited Pro Forma for the Transaction May 30, May 30, Fourteen Weeks Ended May 30, February 22, May 30, February 22, May 30, 6. Related Party Transactions Prior to the Acquisition, ConAgra Foods executive, finance, tax and other corporate departments performed certain administrative and other services for the Company. Expenses incurred by ConAgra Foods and allocated to the Company are determined based on specific services being provided or are allocated based on ConAgra Foods investment in the Company in proportion to ConAgra Foods total investment in its subsidiaries. In addition, ConAgra Foods charged the Company finance charges on ConAgra Foods investment in the Company and net intercompany advances. Management believes that such expense allocations are reasonable. It is not practical to estimate the expenses that would have been incurred by the Company if it had been operated on a stand-alone basis. As part of the Acquisition, ConAgra Foods and the Company entered into a transition services agreement pursuant to which ConAgra Foods would provide certain information technology and other administrative services to the Company for a period of one year. As consideration for these services, the Company paid ConAgra Foods $7.5 million. For the fourteen-week period ended May 30, 2004, $1.9 million in expense was recognized by the Company for services performed pursuant to this agreement. The Company is party to a management consulting agreement dated as of November 21, 2003 with Apollo (the Management Agreement ). Under the terms of the Management Agreement, the Company retained Apollo to provide certain management consulting and financial advisory services, for which the Company pays Apollo an annual management fee of $1.0 million in quarterly payments of $250,000. In addition, as consideration for arranging the Acquisition and services pertaining to certain related financing transactions, the Company paid Apollo a fee of $5.0 million in January 2004, which has been accounted for as part of the Acquisition cost. 7. Debt Long-term debt is comprised of the following at May 30, 2004 and February 22, 2004: February 22, May 30, February 22, May 30, Cash flows from financing activities: Net borrowings on short-term debt 603 (4,464 ) Proceeds from issuance of long-term debt 482,490 Debt issuance costs (23,326 ) Issuance of series A redeemable preferred stock 60,000 Redemption of long-term debt (175,000 ) Issuance of common stock 120,000 Dividends to stockholders (52,860 ) Redemption of series A redeemable preferred stock (25,380 ) Bank overdraft 11,632 Net investments and advances/(distributions) (182,085 ) 231,116 57,871 Net cash flows from financing activities (181,482 ) 226,652 69,503 385,924 Net change in cash and cash equivalents (73,643 ) (44,133 ) (28,559 ) 172,647 Cash and cash equivalents at beginning of period 146,335 72,692 28,559 Cash and cash equivalents at end of period $ 72,692 $ 28,559 $ $ 172,647 Table of Contents UAP HOLDING CORP. NOTES TO FINANCIAL STATEMENTS Fiscal Years Ended February 22, 2004, February 23, 2003 and February 24, 2002 columnar dollar amounts in thousands 1. Description of Business and Transactions UAP Holding Corp. (the Company ), an affiliate of Apollo Management, L.P. ( Apollo ), is a Delaware Corporation which was formed on October 28, 2003. On November 24, 2003, Apollo, UAP Holding Corp. and ConAgra Foods entered into a transaction in which UAP Holding Corp. acquired the ConAgra Agricultural Products Business including its Canadian distribution business and excluding its wholesale fertilizer and other international crop distribution businesses (the Acquisition ) for approximately $596 million of cash and $60 million of Series A redeemable preferred stock which were issued to ConAgra Foods. The entities that were historically operated by ConAgra Foods, Inc. as an integrated business, which include the wholesale fertilizer and other international crop distribution business that were not acquired in the Acquisition are referred to collectively as the ConAgra Agricultural Products Business or Predecessor. Those entities and operations within the ConAgra Agricultural Products Business that were actually acquired in the Acquisition and are being operated by UAP Holding Corp. are referred to as the Successor. In connection with the Acquisition, the Company entered into a five-year $500 million asset-backed revolving credit facility (the Senior Credit Facility ), a $175 million unsecured senior bridge loan facility and $120 million equity contribution from Apollo. On December 16, 2003, the Company completed a $225 million private offering of 8 1/4% of Senior Notes due 2011 which were used to repay the unsecured senior bridge loan facility and accrued interest, repay $45.8 million of the Senior Credit Facility and to pay fees and expenses. On January 26, 2004, the Company completed an offering of $125,000,000 aggregate principal amount at maturity of its 10 3/4% Senior Discount Notes due 2012 which were used to redeem $25.4 million of preferred stock, pay a dividend on common stock for $52.9 million, and to pay fees and expenses. The following table summarizes the estimated fair values of the assets acquired and liabilities assumed at November 24, 2003. The Company is in the process of obtaining a third-party valuation of certain intangible assets to assist the Company with their purchase accounting; thus, the allocation of the purchase price is subject to refinement. November 24, 2003 Accounts Receivable $ 487,094 Inventory 496,076 Property and equipment 97,419 Current and other assets 21,603 Goodwill and Intangibles 50,915 Deferred income taxes 17,339 Total assets acquired 1,170,446 Current liabilities 514,249 Total liabilities assumed 514,249 Net assets acquired $ 656,197 Net income (loss), as reported $ (37,036 ) $ 25,239 $ 36,277 Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects (718 ) (578 ) (434 ) Proforma net income (loss) $ (37,754 ) $ 24,661 $ 35,843 Table of Contents UAP HOLDING CORP. NOTES TO FINANCIAL STATEMENTS (Continued) Fiscal Years Ended February 22, 2004, February 23, 2003 and February 24, 2002 columnar dollar amounts in thousands Use of Estimates Preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions. These estimates or assumptions affect reported amounts of assets, liabilities, revenue and expenses as reflected in the financial statements. Actual results could differ from estimates. 3. Goodwill and Other Identifiable Intangible Assets The company adopted SFAS No. 142, at the beginning of fiscal 2003. Goodwill is not amortized and is tested annually for impairment of value. Impairment occurs when the fair value of the asset is less than its carrying amount. If impaired, the asset is written down to its fair value. Goodwill was $4.8 million at February 23, 2003 and $43.5 million at February 22, 2004. Other identifiable intangible assets are as follows: February 23, 2003 February 22, 2004 Gross Carrying Amount Accumulated Amortization Gross Carrying Amount Accumulated Amortization Non-amortizing intangible assets are comprised of a company brand. Amortizing intangible assets, carrying a weighted average life of approximately 6 years, are principally comprised of a product development agreement. The company recognized amortization expense of $2.8 million, $2.3 million, $1.7 million and $0.4 million in fiscal 2002, 2003, the thirty-nine weeks ended November 23, 2003 and the thirteen weeks ended February 22, 2004, respectively. Based on amortizing assets recognized in the company s balance sheet as of February 22, 2004, amortization expense is estimated to approximate $1.5 million for each of the next five years. The following is comparative earnings information assuming SFAS No. 142 had been in effect for each period presented: Fiscal Year Ended February 24, 2002 Proforma net loss $ (36,744 ) $ 713,200 $ 641,009 Land $ 19,598 $ 13,155 Buildings, machinery and equipment 180,559 70,129 Furniture, fixtures, office equipment and other 28,307 12,471 Construction in progress 1,836 4,452 230,300 100,207 Less: accumulated depreciation (127,505 ) (3,093 ) $ 102,795 $ 97,114 Table of Contents UAP HOLDING CORP. NOTES TO FINANCIAL STATEMENTS (Continued) Fiscal Years Ended February 22, 2004, February 23, 2003 and February 24, 2002 columnar dollar amounts in thousands 7. Debt Long-term debt is comprised of the following at February 22, 2004: 8 1/4% Senior Notes $ 225,000 10 3/4% Senior Discount Notes 83,570 $ 308,570 Table of Contents UAP HOLDING CORP. NOTES TO FINANCIAL STATEMENTS (Continued) Fiscal Years Ended February 22, 2004, February 23, 2003 and February 24, 2002 columnar dollar amounts in thousands Based on current market rates primarily provided by outside investment bankers, the fair value of this debt at February 22, 2004 was estimated at $332.6 million. 8. Capital Stock The Predecessor Entity s capital stock consisted of the following: Par Value Shares Authorized Issued Table of Contents UAP HOLDING CORP. NOTES TO FINANCIAL STATEMENTS (Continued) Fiscal Years Ended February 22, 2004, February 23, 2003 and February 24, 2002 columnar dollar amounts in thousands 9. Income Taxes The provision (benefit) for income taxes includes the following: Fiscal Year Ended Thirty-Nine Weeks Ended November 23, 2003 Thirteen Weeks Ended February 22, 2004 (4,517 ) 3,821 23,858 $ (17,519 ) $ 18,787 $ 25,068 $ 5,789 Income taxes computed by applying statutory rates to income before income taxes are reconciled to the provision for income taxes set forth in the consolidated statements of earnings as follows: Fiscal Year Ended Thirty-Nine Weeks Ended November 23, 2003 Thirteen Weeks Ended February 22, 2004 $ (17,519 ) $ 18,787 $ 25,068 $ 5,789 Assets Liabilities Assets Liabilities $ 28,468 $ 4,233 $ 20,974 $ 9,200 $ 19,505 Table of Contents UAP HOLDING CORP. NOTES TO FINANCIAL STATEMENTS (Continued) Fiscal Years Ended February 22, 2004, February 23, 2003 and February 24, 2002 columnar dollar amounts in thousands Components of pension benefit costs and weighted average actuarial assumptions are: Fiscal Year Ended Fiscal Year Ended Thirty-Nine Weeks Ended November 23, Thirteen Weeks Ended February 22, Projected benefit obligation at end of year $ 2,419 $ 2,700 Fair value of plan assets at end of year 1,858 2,073 Funded Status (561 ) (627 ) Unrecognized actuarial loss 1,148 1,281 Options Weighted Average Exercise Price Options Weighted Average Exercise Price Options Weighted Average Exercise Price Beginning of year 1,167.2 $ 23.73 1,094.9 $ 24.01 941.3 $ 24.40 Granted 153.0 $ 22.00 63.5 $ 25.90 $ Exercised (96.2 ) $ 16.57 (95.0 ) $ 19.38 (68.0 ) $ 17.84 Canceled (129.1 ) $ 24.69 (122.1 ) $ 25.56 (424.7 ) $ 24.36 End of year 1,094.9 $ 24.01 941.3 $ 24.40 448.6 $ 24.96 Exercisable at end of year 717.6 $ 25.01 686.5 $ 25.13 445.5 $ 24.98 Table of Contents UAP HOLDING CORP. NOTES TO FINANCIAL STATEMENTS (Continued) Fiscal Years Ended February 22, 2004, February 23, 2003 and February 24, 2002 columnar dollar amounts in thousands 14. Business Segment and Related Information The company operates in one segment. Net sales and long-lived assets by geographical area are as follows: Fiscal Year Ended Net Sales: United States $ 2,623,064 $ 2,402,887 $ 2,128,545 $ 217,976 Canada 147,128 123,878 95,562 9,802 Total $ 2,770,192 $ 2,526,765 $ 2,224,107 $ 227,778 Long-Lived Assets: United States $ 115,477 $ 122,567 Canada 4,307 4,802 Total $ 119,784 $ 127,369 Net sales by product category are as follows: Fiscal Year Ended Crop protection chemicals $ 1,826,426 $ 1,661,315 $ 1,443,600 $ 136,100 Fertilizer 581,007 510,585 460,336 65,826 Seeds 282,756 270,829 242,123 16,819 Other 80,003 84,036 78,048 9,033 $ 2,770,192 $ 2,526,765 $ 2,224,107 $ 227,778 Table of Contents UAP HOLDING CORP. NOTES TO FINANCIAL STATEMENTS (Continued) Fiscal Years Ended February 22, 2004, February 23, 2003 and February 24, 2002 columnar dollar amounts in thousands The terms of the indenture governing the senior subordinated notes offered hereby will restrict the Company s ability to declare and pay dividends on its capital stock. In addition, United Agri Products amended and restated revolving credit facility and United Agri Products new senior secured second lien term loan facility will restrict the Company s ability to pay interest on the senior subordinated notes and to declare and pay dividends on its capital stock; such facilities will also restrict the Company s subsidiaries from paying dividends, making loans or other distributions and otherwise transferring assets to the Company. Condensed consolidated financial information for the Guarantor and Non-Guarantors is as follows: Financial information for the pre-Transaction and post-Transaction entities reported in the financial statements are as follows: Pre-Transaction Balance Sheets February 23, 2003 UAP Holding Corp. Guarantor Canadian distribution business Non-Guarantor Other- Non- Guarantor Elimination/ Adjustments Total ASSETS Current assets: Cash and cash equivalents $ $ 20,786 $ 7,773 $ $ $ 28,559 Receivables, net 197,164 6,879 204,043 Inventories 678,170 35,030 713,200 Deferred income taxes 21,912 21,912 Other current assets 184,265 171 184,436 Current assets of discontinued operations 67,012 67,012 Total current assets 1,080,385 49,853 67,012 21,912 1,219,162 Property, plant and equipment 223,050 7,250 230,300 Less accumulated depreciation (123,973 ) (3,532 ) (127,505 ) Property, plant and equipment, net 99,077 3,718 102,795 Goodwill 2,515 2,216 4,731 Intangible assets, net 6,025 6,025 Deferred income taxes 2,323 2,323 Other assets 6,548 589 7,137 Net investment and advances in subsidiaries 41,774 (41,774 ) Noncurrent assets of discontinued operations 9,852 9,852 $ $ 1,236,324 $ 56,376 $ 76,864 $ (17,539 ) $ 1,352,025 LIABILITIES AND STOCKHOLDERS' NET INVESTMENT AND ADVANCES / STOCKHOLDER'S EQUITY Current liabilities: Accounts payable $ $ 625,326 $ 17,274 $ $ $ 642,600 Other accrued liabilities 84,827 1,491 86,318 Current liabilities of discontinued operations 35,090 35,090 Total current liabilities 710,153 18,765 35,090 764,008 Other noncurrent liabilities 119 119 Commitments and contingencies Stockholder's net investment and advances 526,052 37,611 41,774 (17,539 ) 587,898 $ $ 1,236,324 $ 56,376 $ 76,864 $ (17,539 ) $ 1,352,025 Table of Contents UAP HOLDING CORP. NOTES TO FINANCIAL STATEMENTS (Continued) columnar dollar amounts in thousands February 22, 2004 UAP Holding Corp. United Agri Products, Inc. Guarantor Canadian distribution business Non-Guarantor Elimination/ Adjustments Total ASSETS Current assets: Cash and cash equivalents $ 662 $ $ 166,304 $ 5,681 $ $ 172,647 Receivables, net 163,656 7,113 170,769 Inventories 621,777 19,232 641,009 Deferred income taxes 2,681 2,681 Other current assets 1,487 77,432 1,734 80,653 Total current assets 662 1,487 1,031,850 33,760 1,067,759 Property, plant and equipment 96,071 4,136 100,207 Less accumulated depreciation (2,972 ) (121 ) (3,093 ) $ 195,703 $ 418,926 $ 1,200,714 $ 38,562 $ (589,942 ) $ 1,263,963 LIABILITIES AND STOCKHOLDERS EQUITY Current liabilities: Accounts payable $ $ $ 679,593 $ 9,862 $ $ 689,455 Other accrued liabilities 725 3,135 139,869 1,505 145,234 Deferred income taxes 9,117 9,117 $ 195,703 $ 418,926 $ 1,200,714 $ 38,562 $ (589,942 ) $ 1,263,963 Table of Contents UAP HOLDING CORP. NOTES TO FINANCIAL STATEMENTS (Continued) columnar dollar amounts in thousands CONDENSED COMBINING STATEMENTS OF EARNINGS Pre-Transaction Statements of Earnings Year Ended February 24, 2002 UAP Holding Corp. Guarantor Canadian distribution business Non- Guarantor Total Net Sales $ $ 2,623,064 $ 147,128 $ 2,770,192 Costs and expenses: Cost of goods sold 2,291,886 136,317 2,428,203 Selling, general and administrative expenses 322,732 11,894 334,626 Third party interest expense 5,372 5,372 (Gain) loss on sale of assets 606 606 Corporate allocations: Selling, general and administrative expenses 10,119 376 10,495 Finance charges 38,108 1,418 39,526 Loss from continuing operations before income taxes (45,759 ) (2,877 ) (48,636 ) Income tax benefit (16,512 ) (1,007 ) (17,519 ) Loss from continuing operations (29,247 ) (1,870 ) (31,117 ) Loss from discontinued operations, net of tax (5,919 ) (5,919 ) Net loss $ $ (35,166 ) $ (1,870 ) $ (37,036 ) Pre-Transaction Statements of Earnings Year Ended February 23, 2003 UAP Holding Corp. Guarantor Canadian distribution business Non- Guarantor Total Net Sales $ $ 2,402,887 $ 123,878 $ 2,526,765 Costs and expenses: Cost of goods sold 2,057,218 109,376 2,166,594 Selling, general and administrative expenses 263,043 12,201 275,244 Third party interest expense 1,927 1,927 (Gain) loss on sale of assets 1,493 1,493 Corporate allocations: Selling, general and administrative expenses 10,252 514 10,766 Finance charges 21,420 1,074 22,494 Income from continuing operations 28,997 463 29,460 Loss from discontinued operations, net of tax (4,221 ) (4,221 ) Table of Contents UAP HOLDING CORP. NOTES TO FINANCIAL STATEMENTS (Continued) columnar dollar amounts in thousands Pre-Transaction Statements of Earnings Thirty-Nine Weeks Ended November 23, 2003 UAP Holding Corp. Guarantor Canadian Distribution Business Non-Guarantor Total Income from continuing operations before income taxes 59,028 7,025 66,053 Income tax expense 22,610 2,458 25,068 Income from continuing operations 36,418 4,567 40,985 Loss from discontinued operations, net of tax (4,708 ) (4,708 ) Net income $ $ 31,710 $ 4,567 $ 36,277 Post-Transaction Statements of Earnings Thirteen Weeks Ended February 22, 2004 UAP Holding Corp. United Agri Products, Inc. Guarantor Canadian Distribution Business Non-Guarantor Elimination/ Adjustments Total Net Sales $ $ $ 217,976 $ 9,802 $ $ 227,778 Costs and expenses: Cost of goods sold 162,239 8,491 170,730 Selling, general and administrative expenses 725 34,556 1,736 37,017 Third party interest expense 1,080 3,913 4,993 (Gain) loss on sale of assets (404 ) (404 ) Income (loss) from continuing operations before income taxes (1,805 ) (3,913 ) 21,585 (425 ) 15,442 Income tax expense (benefit) (667 ) (1,487 ) 8,123 (180 ) 5,789 Income (loss) from continuing operations (1,138 ) (2,426 ) 13,462 (245 ) 9,653 Equity in earnings (loss) of affiliates 10,791 13,217 (24,008 ) Net income (loss) $ 9,653 $ 10,791 $ 13,462 $ (245 ) $ (24,008 ) $ 9,653 Table of Contents UAP HOLDING CORP. NOTES TO FINANCIAL STATEMENTS (Continued) columnar dollar amounts in thousands Pre-Transaction Statements of Cash Flows Year Ended February 24, 2002 UAP Holding Corp. Guarantor Canadian distribution business Non-Guarantor Elimination/ Adjustments Total Cash flows from operating activities: Net loss $ $ (35,166 ) $ (1,870 ) $ $ (37,036 ) Less: Loss from discontinued operations (5,919 ) (5,919 ) Loss from continuing operations (29,247 ) (1,870 ) (31,117 ) Adjustments to reconcile net loss from continuing operations to net cash provided by operating activities: Depreciation 13,985 489 14,474 Amortization 2,525 149 2,674 Deferred income taxes (4,517 ) (4,517 ) (Gain) loss on sale of assets 606 606 Other noncash items (2,131 ) (70 ) (2,201 ) Change in operating assets and liabilities 126,097 14,646 140,743 Net cash flows from operating activities 111,835 13,344 (4,517 ) 120,662 Net cash flows from investing activities (12,411 ) (412 ) (12,823 ) Cash flows from financing activities: Net borrowings of short-term debt 603 603 Net investments and advances/ (distributions) (183,700 ) (2,902 ) 4,517 (182,085 ) Net cash flows from financing activities (183,097 ) (2,902 ) 4,517 (181,482 ) Net cash used in discontinued operations Net change in cash and cash equivalents (83,673 ) 10,030 (73,643 ) Cash and cash equivalents at beginning of period 130,725 15,610 146,335 Cash and cash equivalents at end of period $ $ 47,052 $ 25,640 $ $ 72,692 Table of Contents UAP HOLDING CORP. NOTES TO FINANCIAL STATEMENTS (Continued) columnar dollar amounts in thousands Pre-Transaction Statements of Cash Flows Year Ended February 23, 2003 UAP Holding Corp. Guarantor Canadian distribution business Non- Guarantor Elimination/ Adjustments Total Cash flows from operating activities: Net income $ $ 24,776 $ 463 $ $ 25,239 Less: Loss from discontinued operations (4,221 ) (4,221 ) Income from continuing operations 28,997 463 29,460 Adjustments to reconcile net income from continuing operations to net cash provided by operating activities: Depreciation 13,941 506 14,447 Amortization 2,259 2,259 Deferred income taxes 3,821 3,821 (Gain) loss on sale of assets 1,493 1,493 Other noncash items (2,624 ) (115 ) (2,739 ) Change in operating assets and liabilities (307,505 ) (7,987 ) (315,492 ) Net cash flows from operating activities (263,439 ) (7,133 ) 3,821 (266,751 ) Cash flows from investing activities: Additions to property, plant and equipment (6,265 ) (152 ) (6,417 ) Proceeds from sale of assets Investment in affiliates 882 882 Other investing activity 1,830 (329 ) 1,501 Net cash flows from investing activities (3,553 ) (481 ) (4,034 ) Cash flows from financing activities: Net borrowings of short-term debt (4,464 ) (4,464 ) Net investments and advances/(distributions) 245,190 (10,253 ) (3,821 ) 231,116 Net cash flows from financing activities 240,726 (10,253 ) (3,821 ) 226,652 Net cash used in discontinued operations Net change in cash and cash equivalents (26,266 ) (17,867 ) (44,133 ) Cash and cash equivalents at beginning of period 47,052 25,640 72,692 Cash and cash equivalents at end of period $ $ 20,786 $ 7,773 $ $ 28,559 Table of Contents UAP HOLDING CORP. NOTES TO FINANCIAL STATEMENTS (Continued) columnar dollar amounts in thousands Pre-Transaction Statements of Cash Flows Thirty-Nine Weeks Ended November 23, 2003 UAP Holding Corp. Guarantor Canadian distribution business Non-Guarantor Total Cash flows from operating activities: Net income $ $ 31,710 $ 4,567 $ 36,277 Less: Loss from discontinued operations (4,708 ) (4,708 ) Income from continuing operations 36,418 4,567 40,985 Adjustments to reconcile net income from continuing operations to net cash provided by operating activities: Depreciation 9,491 354 9,845 Amortization 1,663 1,663 (Gain) loss on sale of assets (10,522 ) (10,522 ) Other noncash items 8,522 8,522 Change in operating assets and liabilities (153,445 ) (1,622 ) (155,067 ) Net cash flows from operating activities (107,873 ) 3,299 (104,574 ) Cash flows from investing activities: Additions to property, plant and equipment (8,025 ) (325 ) (8,350 ) Proceeds from sale of assets 15,057 15,057 Investment in affiliates (154 ) (154 ) Other investing activity (41 ) (41 ) Net cash flows from investing activities 6,878 (366 ) 6,512 Cash flows from financing activities: Bank overdraft 10,935 697 11,632 Net investments and advances/(distributions) 69,274 (11,403 ) 57,871 Net cash flows from financing activities 80,209 (10,706 ) 69,503 Net cash used in discontinued operations Net change in cash and cash equivalents (20,786 ) (7,773 ) (28,559 ) Cash and cash equivalents at beginning of period 20,786 7,773 28,559 Cash and cash equivalents at end of period $ $ $ $ Table of Contents UAP HOLDING CORP. NOTES TO FINANCIAL STATEMENTS (Continued) columnar dollar amounts in thousands Post-Transaction Statements of Cash Flows Thirteen Weeks Ended February 22, 2004 UAP Holding Corp. United Agri Products, Inc. Guarantor Canadian Distribution Business Non-Guarantor Elimination/ Adjustments Total Cash flows from operating activities: Net income (loss) $ 9,653 $ 10,791 $ 13,462 $ (245 ) $ (24,008 ) $ 9,653 Adjustments to reconcile net income (loss) to net cash provided by operating activities: Depreciation 2,982 121 3,103 Amortization 387 387 Equity in earnings of subsidiaries (10,791 ) (13,217 ) 24,008 Deferred income taxes 23,858 23,858 (Gain) loss on sale of assets (404 ) (404 ) Other noncash items 1,075 778 1,090 2,943 Change in operating assets and liabilities 725 1,648 394,714 9,746 406,833 Net cash flows from operating activities 662 436,089 9,622 446,373 Cash flows from investing activities: Additions to property, plant and equipment (6,741 ) (229 ) (6,970 ) Proceeds from sale of assets 3,517 3,517 Acquisition of ConAgra Agricultural Products Business (180,000 ) (476,197 ) (656,197 ) Net cash flows from investing activities (180,000 ) (479,421 ) (229 ) (659,650 ) Cash flows from financing activities: Net investment (205,934 ) 209,646 (3,712 ) Proceeds from issuance of long-term debt 82,500 225,000 174,990 482,490 Debt issuance costs (4,260 ) (19,066 ) (23,326 ) Issuance of Series A redeemable preferred stock 60,000 60,000 Redemption of long-term debt (175,000 ) (175,000 ) Issuance of common stock 120,000 120,000 Dividends to stockholders (52,860 ) (52,860 ) Redemption of Series A redeemable preferred stock (25,380 ) (25,380 ) Net cash flows from financing activities 180,000 209,636 (3,712 ) 385,924 Net change in cash and cash equivalents 662 166,304 5,681 172,647 Cash and cash equivalents at beginning of period Cash and cash equivalents at end of period $ 662 $ $ 166,304 $ 5,681 $ $ 172,647 Table of Contents UAP HOLDING CORP. CONDENSED CONSOLIDATED BALANCE SHEETS UNAUDITED dollars in thousands Combined Predecessor Entity Consolidated ConAgra Agricultural Products Business UAP Holding Corp. February 22, 2004 ASSETS Current assets: Cash and cash equivalents $ $ 172,647 $ 7,782 Receivables, less allowance for doubtful accounts of $41,190, $27,881 and $27,398 743,545 170,769 896,057 Inventories 687,698 641,009 594,079 Deferred income taxes 21,912 2,681 4,566 Other current assets 18,967 80,653 42,732 Current assets of discontinued operations 4,440 Total current assets 1,476,562 1,067,759 1,545,216 Property, plant and equipment 232,831 100,207 102,607 Less accumulated depreciation (125,623 ) (3,093 ) (5,442 ) Property, plant and equipment, net 107,208 97,114 97,165 Goodwill 4,941 43,465 43,465 Intangible assets, net 5,533 7,077 6,705 Deferred income taxes 2,323 18,293 6,605 Debt issue costs 22,517 21,607 Other assets 4,957 7,738 8,739 Non-current assets of discontinued operations 1,566 $ 1,603,090 $ 1,263,963 $ 1,729,502 LIABILITIES AND STOCKHOLDERS NET INVESTMENT AND ADVANCES/ STOCKHOLDERS EQUITY Current liabilities: Short-term debt $ $ $ 42,123 Accounts payable 756,756 689,455 996,143 Other accrued liabilities 162,728 145,234 233,643 Deferred income taxes 9,117 8,709 Current liabilities of discontinued operations 406,671 Total current liabilities 1,326,155 843,806 1,280,618 Long-term debt 308,570 311,432 Series A redeemable preferred stock 34,620 35,379 Deferred income taxes 115 83 264 Other noncurrent liabilities 96 96 Commitments and contingencies (Note 8) Stockholders net investment and advances/Stockholders equity: Stockholders net investment/advances 247,219 Common stock, $.001 par value, 2,000,000 shares authorized, 1,208,450 shares issued and outstanding 1 1 Additional paid in capital 67,139 67,139 Retained earnings 29,601 9,653 35,175 Accumulated other comprehensive loss (5 ) (602 ) Total stockholders equity 276,820 76,888 101,713 $ 1,603,090 $ 1,263,963 $ 1,729,502 Table of Contents UAP HOLDING CORP. CONDENSED CONSOLIDATED STATEMENT OF EARNINGS UNAUDITED dollars in thousands, except per share amounts Combined Predecessor Entity Consolidated ConAgra Agricultural Products Business UAP Holding Corp. Net sales $ 1,074,349 $ 1,258,489 Costs and expenses: Cost of goods sold 931,764 1,122,755 Selling, general and administrative expenses 82,434 82,956 Third party interest expense 270 11,161 Gain on sale of assets (819 ) Other income 420 Corporate allocations: Selling, general and administrative expenses 3,060 Finance charges 4,130 Income from continuing operations before income taxes 52,691 42,016 Income tax expense 20,477 16,494 Income from continuing operations 32,214 25,522 Loss from discontinued operations, net of tax 2,613 Net income $ 29,601 $ 25,522 Table of Contents UAP HOLDING CORP. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS UNAUDITED dollars in thousands Combined Predecessor Entity Consolidated ConAgra Agricultural Products Business UAP Holding Corp. Thirteen Weeks Ended May 25, 2003 Fourteen Weeks Ended May 30, 2004 Cash flows from operating activities: Net income $ 29,601 $ 25,522 Loss from discontinued operations 2,613 Income from continuing operations 32,214 25,522 Adjustments to reconcile income from continuing operations to net cash provided by operating activities: Depreciation 3,299 3,499 Amortization 492 403 Other non cash 4,530 Gain on sale of property and equipment (819 ) Deferred income taxes 9,214 Change in operating assets and liabilities (190,796 ) (246,000 ) Net cash flows from operating activities (154,791 ) (203,651 ) Cash flows from investing activities: Additions to property, plant and equipment (7,317 ) (2,731 ) Other investing activity (1,155 ) Net cash flows from investing activities (8,472 ) (2,731 ) Cash flows from financing activities: Net borrowings of short-term debt 42,123 Bank overdraft 35,628 Net investments and advances 99,076 Net cash flows from financing activities 134,704 42,123 Net effect of exchange rate fluctuations (606 ) Net change in cash and cash equivalents (28,559 ) (164,865 ) Cash and cash equivalents at beginning of period (February 22, 2004 and February 23, 2003) 28,559 172,647 Cash and cash equivalents at end of period $ $ 7,782 Table of Contents UAP HOLDING CORP. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS For the Quarters Ended May 30, 2004 and May 25, 2003 columnar dollar amounts in thousands unaudited 1. Description of Business and Transactions UAP Holding Corp. (the Company ), an affiliate of Apollo Management, L.P. ( Apollo ), is a Delaware Corporation which was formed on October 28, 2003. The following table summarizes the estimated fair values of the assets and intangible assets acquired and liabilities assumed at November 24, 2003. The Company is in the process of obtaining a third-party valuation of certain intangible assets to assist the Company with their purchase accounting; thus, the allocation of the purchase price is subject to refinement. November 24, 2003 Accounts Receivable $ 487,094 Inventory 496,076 Property and equipment 99,833 Current and other assets 21,603 Goodwill and Intangibles 50,915 Deferred income taxes 17,339 Total assets acquired $ 1,172,860 Current liabilities 514,249 Total liabilities assumed 514,249 Net assets acquired $ 658,611 Table of Contents UAP HOLDING CORP. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) For the Quarters Ended May 30, 2004 and May 25, 2003 columnar dollar amounts in thousands unaudited Stock-Based Compensation Predecessor Stock Plan The Company accounts for employee stock option plans in accordance with Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees. Accordingly, no stock-based compensation expense is reflected in net income, as options granted under these plans have an exercise price equal to the market value of the underlying common stock on the date of grant. In December 2002, the Financial Accounting Standards Board ( FASB ) issued SFAS No. 148, Accounting for Stock-Based Compensation Transition and Disclosure, which became effective for fiscal years ending after December 15, 2002. SFAS No. 148 requires certain pro forma information regarding net income and earnings per share to be calculated based on the assumption that the Company recognized expenses for its employee stock options using the fair value method. The fair value of options was estimated at the date of the grant using the Black-Scholes option pricing model with the following weighted average assumptions for the thirteen weeks ended May 25, 2003: risk-free interest rate of 4.30%; a dividend yield of 3.9%; expected volatility of 30.0%; and an expected option life of six years. The weighted average fair value of options granted for the thirteen weeks ended May 25, 2003 was $5.88 for ConAgra stock. Pro forma net income (loss) is as follows: Thirteen Weeks Ended May 25, 2003 Net income, as reported $ 29,601 Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects (145 ) Pro forma net income $ 29,456 Table of Contents UAP HOLDING CORP. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) For the Quarters Ended May 30, 2004 and May 25, 2003 columnar dollar amounts in thousands unaudited Recently Issued Accounting Pronouncements In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. SFAS No. 150 establishes standards for classification and measurement in the balance sheets for certain financial instruments which possess characteristics of both a liability and equity. Generally, it requires classification of such financial instruments as a liability. SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003. For financial instruments in existence prior to May 31, 2003, SFAS No. 150 is effective at the beginning of the Company s fiscal 2004. As of May 30, 2004, no transactions have occurred that SFAS No. 150 would have applied to. Use of Estimates Preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions. These estimates or assumptions affect reported amounts of assets, liabilities, revenue and expenses as reflected in the financial statements. Actual results could differ from estimates. 3. Goodwill and Other Identifiable Intangible Assets The Company adopted SFAS No. 142, at the beginning of fiscal 2003. Goodwill is not amortized and is tested annually for impairment of value. Impairment occurs when the fair value of the asset is less than its carrying amount. If impaired, the asset is written down to its fair value. Goodwill was $43.5 million at May 30, 2004 and February 22, 2004. Other identifiable intangible assets are as follows: May 25, 2003 February 22, 2004 May 30, 2004 Gross Carrying Amount Accumulated Amortization Gross Carrying Amount Accumulated Amortization Gross Carrying Amount Accumulated Amortization Total $ 687,698 $ 641,009 $ 594,079 Land $ 19,641 $ 13,155 $ 12,654 Buildings, machinery and equipment 176,524 70,129 71,192 Furniture, fixtures, office equipment and other 28,160 12,471 11,117 Construction in progress 8,506 4,452 7,644 232,831 100,207 102,607 Less: accumulated depreciation (125,623 ) (3,093 ) (5,442 ) $ 107,208 $ 97,114 $ 97,165 8 % Senior Notes $ 225,000 $ 225,000 10 % Senior Discount Notes 83,570 86,432 $ 308,570 $ 311,432 $ 19,820 Table of Contents UAP HOLDING CORP. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) For the Quarters Ended May 30, 2004 and May 25, 2003 columnar dollar amounts in thousands unaudited Predecessor Retirement Pension Plans The Predecessor entity had defined benefit retirement plans ( Plan ) for eligible salaried and hourly employees. Benefits are based on years of credited service and average compensation or stated amounts for each year of service. The Predecessor entity funded these plans in accordance with the minimum and maximum limits established by law. Employees of the Company also participate in defined benefit and defined contribution plans sponsored by ConAgra Foods. 10. Successor Stock Plans As of May 30, 2004, 84,000 options have been approved for the management and employee stock option plans. Of these, 78,455 options were granted with an exercise price of $100.00, of which 4,155 were granted during the fourteen weeks ended May 30, 2004. None of these options have vested. There are 5,545 remaining options to be granted under the plan. An additional 15,000 options were reserved for the non-employee director option plan. Of these, 9,000 options were granted during the current quarter with an exercise price of $100.00. All of the granted options were immediately vested. 11. Business Segment and Related Information The Company operates in one segment. Net sales and long-lived assets by geographical area are as follows: Thirteen Weeks Ended May 25, 2003 Fourteen Weeks Ended May 30, 2004 Net sales: United States $ 1,035,987 $ 1,225,150 Canada 38,362 33,339 Total $ 1,074,349 $ 1,258,489 Long-lived assets: United States $ 109,150 $ 122,567 $ 123,637 Canada 4,581 4,802 3,874 Total $ 113,731 $ 127,369 $ 127,511 Net sales by product category are as follows: Thirteen Weeks Ended May 25, 2003 Fourteen Weeks Ended May 30, 2004 Crop protection chemicals $ 650,626 $ 724,095 Fertilizer 225,531 280,733 Seeds 173,910 233,611 Other 24,282 20,050 Total $ 1,074,349 $ 1,258,489 Table of Contents UAP HOLDING CORP. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) For the Quarter Ended May 25, 2003 columnar amounts in thousands unaudited CONDENSED COMBINING BALANCE SHEETS May 25, 2003 Guarantor Canadian distribution business Non- Guarantor Other Non- Guarantor Total TOTAL 1,509,731 87,353 6,006 1,603,090 LIABILITIES AND STOCKHOLDERS EQUITY CURRENT LIABILITIES: Accounts payable 714,570 42,186 756,756 Accrued expenses 159,128 3,600 162,728 Short-term debt Current liabilities of Discontinued Operations 406,671 406,671 Total liabilities 873,813 45,786 406,671 1,326,270 SHAREHOLDERS EQUITY: Stockholders net investment and advances 606,688 38,583 (398,052 ) 247,219 Retained earnings 29,230 2,984 (2,613 ) 29,601 Total stockholders equity 635,918 41,567 (400,665 ) 276,820 TOTAL 1,509,731 87,353 6,006 1,603,090 Table of Contents UAP HOLDING CORP. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) For the Quarters Ended May 30, 2004 and May 25, 2003 columnar dollar amounts in thousands unaudited CONDENSED CONSOLIDATING BALANCE SHEETS May 30, 2004 UAP Holding Corp United Agri Products, Inc. Guarantor Canadian Distribution Business Non- Guarantor Elimination/ Adjustments Total ASSETS Current assets: Cash and cash equivalents $ 626 $ $ 2,295 $ 4,861 $ $ 7,782 Intercompany receivables, net 865,837 30,220 896,057 Inventories 569,988 24,091 594,079 Deferred income taxes 1,463 2,670 433 4,566 Other current assets 41,343 1,389 42,732 Total current assets 2,089 2,670 1,479,896 60,561 1,545,216 Property, plant and equipment 98,531 4,076 102,607 Less accumulated depreciation (5,236 ) (206 ) (5,442 ) $ 224,126 $ 460,406 $ 1,647,312 $ 64,435 $ (666,777 ) $ 1,729,502 Table of Contents UAP HOLDING CORP. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) For the Quarters Ended May 30, 2004 and May 25, 2003 columnar dollar amounts in thousands unaudited CONDENSED CONSOLIDATING BALANCE SHEETS May 30, 2004 UAP Holding Corp United Agri Products, Inc. Guarantor Canadian Distribution Business Non- Guarantor Elimination/ Adjustments Total LIABILITIES AND STOCKHOLDERS NET INVESTMENT AND ADVANCES/ STOCKHOLDERS EQUITY Current liabilities: Short-term debt $ $ $ 39,172 $ 2,951 $ $ 42,123 Accounts payable 972,319 23,824 996,143 Other accrued liabilities 17,309 210,757 5,577 233,643 Deferred income taxes 8,709 8,709 Total current liabilities 17,309 1,230,957 32,352 1,280,618 $ 224,126 $ 460,406 $ 1,647,312 $ 64,435 $ (666,777 ) $ 1,729,502 Table of Contents UAP HOLDING CORP. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) For the Quarters Ended May 30, 2004 and May 25, 2003 columnar dollar amounts in thousands unaudited CONDENSED CONSOLIDATING BALANCE SHEETS February 22, 2004 UAP Holding Corp United Agri Products, Inc. Guarantor Canadian Distribution Business Non- Guarantor Elimination/ Adjustments Total ASSETS Current assets: Cash and cash equivalents $ 662 $ $ 166,304 $ 5,681 $ $ 172,647 Receivables, net 163,656 7,113 170,769 Inventories 621,777 19,232 641,009 Deferred income taxes 2,681 2,681 Other current assets 1,487 77,432 1,734 80,653 Total current assets 662 1,487 1,031,850 33,760 1,067,759 Property, plant and equipment 96,071 4,136 100,207 Less accumulated depreciation (2,972 ) (121 ) (3,093 ) $ 195,703 $ 418,926 $ 1,200,714 $ 38,562 $ (589,942 ) $ 1,263,963 Table of Contents UAP HOLDING CORP. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) For the Quarter Ended May 30, 2004 and May 25, 2003 columnar dollar amounts in thousands unaudited CONDENSED CONSOLIDATING BALANCE SHEETS February 22, 2004 UAP Holding Corp United Agri Products, Inc. Guarantor Canadian Distribution Business Non- Guarantor Elimination/ Adjustments Total LIABILITIES AND STOCKHOLDERS NET INVESTMENT AND ADVANCES/ STOCKHOLDERS EQUITY Current liabilities: Accounts payable $ $ $ 679,593 $ 9,862 $ $ 689,455 Other accrued liabilities 725 3,135 139,869 1,505 145,234 Deferred income taxes 9,117 9,117 Total stockholders equity 76,788 190,786 371,956 27,195 (589,937 ) 71,238 $ 195,703 $ 418,921 $ 1,200,714 $ 38,562 $ (589,937 ) $ 1,263,963 Table of Contents UAP HOLDING CORP. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) For the Quarters Ended May 30, 2004 and May 25, 2003 columnar dollar amounts in thousands unaudited Post-Transaction CONDENSED CONSOLIDATING STATEMENTS OF EARNINGS AND COMPREHENSIVE INCOME Fourteen weeks ended May 30, 2004 UAP Holding Corp United Agri Products, Inc. Guarantor Canadian Distribution Business Non- Guarantor Elimination/ Adjustments Total Income (loss) from continuing operations before income taxes (3,849 ) (7,027 ) 47,950 4,942 42,016 Income tax expense (benefit) (1,463 ) (2,670 ) 18,256 2,371 16,494 Income (loss) from continuing operations (2,386 ) (4,357 ) 29,694 2,571 25,522 Equity in earnings (loss) of affiliates 27,908 32,265 (60,173 ) Net income (loss) $ 25,522 $ 27,908 $ 29,694 $ 2,571 $ (60,173 ) $ 25,522 Table of Contents UAP HOLDING CORP. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) For the Quarters Ended May 30, 2004 and May 25, 2003 columnar dollar amounts in thousands unaudited Pre-Transaction CONDENSED COMBINING STATEMENTS OF EARNINGS AND COMPREHENSIVE INCOME Thirteen weeks ended May 25, 2003 UAP Holding Corp United Agri Products, Inc. Guarantor Canadian Distribution Business Non- Guarantor Elimination/ Adjustments Total Income (loss) from continuing operations before income taxes 48,099 4,592 52,691 Income tax expense (benefit) 18,870 1,607 20,477 Income (loss) from continuing operations 29,229 2,985 32,214 Loss from discontinued operations, net of tax (2,613 ) (2,613 ) Net income (loss) $ $ $ 26,616 $ 2,985 $ $ 29,601 Table of Contents UAP HOLDING CORP. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) For the Quarters Ended May 30, 2004 and May 25, 2003 columnar dollar amounts in thousands unaudited Post-Transaction CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS Fourteen Weeks Ended May 30, 2004 UAP Holding Corp United Agri Products, Inc. Guarantor Canadian Distribution Business Non- Guarantor Elimination/ Adjustments Total Cash flows from operating activities: Net income (loss) $ 25,522 $ 27,908 $ 29,694 $ 2,571 $ (60,173 ) $ 25,522 Adjustments to reconcile net income (loss) to net cash provided by operating activities: Depreciation 3,400 99 3,499 Amortization 403 403 Equity in earnings of subsidiaries (27,908 ) (32,265 ) 60,173 Other noncash items (1,743 ) (1,480 ) 16,148 12,925 Change in operating assets and liabilities 4,093 5,837 (249,489 ) (6,441 ) (246,000 ) Net cash flows from operating activities (36 ) (199,844 ) (3,771 ) (203,651 ) Cash flows from investing activities: Additions to property, plant and equipment (2,731 ) (2,731 ) Proceeds from sales of assets Investment in affiliates Other investing activity Net cash flows from investing activities (2,731 ) (2,731 ) Cash flows from financing activities: Net borrowings of short-term debt 39,172 2,951 42,123 Bank overdraft Net investments and advances Net cash flows from financing activities 39,172 2,951 42,123 Net effect of exchange rate fluctuations (606 ) (606 ) Net change in cash and cash equivalents (36 ) (164,009 ) (820 ) (164,865 ) Cash and cash equivalents at beginning of period (February 22, 2004) 662 166,304 5,681 172,647 Cash and cash equivalents at end of period $ 626 $ $ 2,295 $ 4,861 $ $ 7,782 Table of Contents UAP HOLDING CORP. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) For the Quarters Ended May 30, 2004 and May 25, 2003 columnar dollar amounts in thousands unaudited Pre-Transaction CONDENSED COMBINING STATEMENT OF CASH FLOWS Thirteen Weeks Ended May 25, 2003 UAP Holding Corp. United Agri Products, Inc. Guarantor Canadian Distribution Business Non- Guarantor Elimination/ Adjustments Total Cash flows from operating activities: Net income (loss) $ $ $ 29,230 $ 2,984 $ $ 32,214 Adjustments to reconcile net income (loss) to net cash provided by operating activities: Depreciation 3,167 132 3,299 Amortization 492 492 Other noncash items Change in operating assets and liabilities (178,953 ) (11,843 ) (190,796 ) Net cash flows from operating activities (146,064 ) (8,727 ) (154,791 ) Net effect of exchange rate fluctuations Net change in cash and cash equivalents (20,786 ) (7,773 ) (28,559 ) Cash and cash equivalents at beginning of period (February 23, 2003) 20,786 7,773 28,559 Cash and cash equivalents at end of period $ $ $ $ $ $ Table of Contents PART II INFORMATION NOT REQUIRED IN PROSPECTUS Item 13. Other Expenses of Issuance and Distribution The following table sets forth the costs and expenses, other than underwriting discounts and commissions, payable by UAP Holding Corp. in connection with the issuance and distribution of the securities being registered. All amounts are estimates except the SEC registration and NASD filing fees. SEC Registration fee $ 116,827 NASD filing fee 30,500 Listing fee 65,000 Transfer agent s fee 13,000 Trustee s fee 12,500 Printing and engraving expenses 400,000 Legal and accounting fees and expenses 3,000,000 Valuation fees and expenses 300,000 Miscellaneous 14,000 Total $ 3,951,827 Item 14. Indemnification of Directors and Officers Section 145 of the Delaware General Corporation Law ( DGCL ) provides that a corporation may indemnify any person who was or is a party or is threatened to be made a party to any threatened, pending or completed action, suit or proceeding whether civil, criminal or investigative (other than an action by or in the right of the corporation) by reason of the fact that he is or was a director, officer, employee or agent of the corporation, or is or was serving at the request of the corporation as a director, officer, employee or agent of another corporation, partnership, joint venture, trust or other enterprise, against expenses (including attorneys fees), judgments, fines and amounts paid in settlement actually and reasonably incurred by him in connection with such action, suit or proceeding if he acted in good faith and in a manner he reasonably believed to be in or not opposed to the best interests of the corporation, and, with respect to any criminal action or proceeding, had no reasonable cause to believe his conduct was unlawful. Section 145 further provides that a corporation similarly may indemnify any such person serving in any such capacity who was or is a party or is threatened to be made a party to any threatened, pending or completed action or suit by or in the right of the corporation to procure a judgment in its favor, against expenses (including attorneys fees) actually and reasonably incurred in connection with the defense or settlement of such action or suit if he acted in good faith and in a manner he reasonably believed to be in or not opposed to the best interests of the corporation and except that no indemnification shall be made in respect of any claim, issue or matter as to which such person shall have been adjudged to be liable to the corporation unless and only to the extent that the Delaware Court of Chancery or such other court in which such action or suit was brought shall determine upon application that, despite the adjudication of liability but in view of all the circumstances of the case, such person is fairly and reasonably entitled to indemnity for such expenses which the Court of Chancery or such other court shall deem proper. Section 102(b)(7) of the DGCL permits a corporation to include in its certificate of incorporation a provision eliminating or limiting the personal liability of a director to the corporation or its stockholders for monetary damages for breach of fiduciary duty as a director, provided that such provision shall not eliminate or limit the liability of a director (i) for any breach of the director s duty of loyalty to the corporation or its stockholders, (ii) for acts or omission not in good faith or which involve intentional misconduct or a knowing violation of law, (iii) under Section 174 of the DGCL (relating to unlawful payment of dividends and unlawful stock purchase and redemption) or (iv) for any transaction from which the director derived an improper personal benefit. II-1 Table of Contents In accordance with the provisions of the Amended Certificate of Incorporation and By-Laws of UAP Holding Corp., UAP Holding Corp. shall indemnify, to the fullest extent permitted by law, any person who is or was a party, or is threatened to be made a party to, any threatened, pending or contemplated action, suit or other type of proceeding (other than an action by or in our right), whether civil, criminal, administrative, investigative or otherwise, and whether formal or informal, by reason of the fact that such person is or was UAP Holding Corp. s director, officer or employee or is or was serving at UAP Holding Corp. s request (as a director, officer, employee or agent of another corporation, partnership, joint venture, trust or other enterprise) against judgments, amounts paid in settlement, penalties, fines (including an excise tax assessed with respect to any employee benefit plan) and expenses (including counsel fees) actually and reasonably incurred in connection with any such action, suit or other proceeding, including any appeal thereof, if such person acted in good faith and in a manner such person reasonably believed to be in, or not opposed to, UAP Holding Corp. s best interests and, with respect to any criminal action or proceeding, had no reasonable cause to believe such person s conduct was unlawful. In addition, UAP Holding Corp. also carries insurance on behalf of its directors, officers, employees or agents that may cover liabilities under the Securities Act. UAP Holding Corp. provides its directors and officers with additional director and officer liability insurance. Item 15. Recent Sales of Unregistered Securities Set forth below in chronological order is certain information regarding securities issued by UAP Holding Corp. since October 23, 2003 (UAP Holding Corp. s date of incorporation) in transactions that were not registered under the Securities Act of 1933, as amended (the Securities Act ), including the consideration, if any, received by UAP Holding Corp. for such issuances. 1. On October 29, 2003, UAP Holding Corp. issued 100 shares of common stock to entities affiliated with Apollo Management V, L.P. for an aggregate purchase price of $1,000. 2. On November 24, 2003, UAP Holding Corp. issued 1,144,500 shares of common stock to entities affiliated with Apollo Management V, L.P. for an aggregate purchase price of $114,450,000. 3. On November 24, 2003, UAP Holding Corp. issued 60,000 shares A Redeemable Preferred Stock to ConAgra Foods, Inc. for an aggregate purchase price of $60,000,000. 4. On November 24, 2003, UAP Holding Corp. issued 55,500 shares of common stock to the plan trustee under UAP Holding Corp. s 2003 Deferred Compensation Plan for an aggregate purchase price of $5,550,000. 5. On November 24, 2003, UAP Holding Corp. granted stock options to certain of its executive officers to purchase 74,300 shares of its common stock for an aggregate exercise price of $7,430,000. 6. On January 20, 2004, UAP Holding Corp. issued $125,000,000 principal amount at maturity ($82,490,000 in gross proceeds) of 10 % Senior Discount Notes due 2012 to UBS Investment Bank, Goldman, Sachs & Co. and Bear Stearns & Co. Inc., as initial purchasers for resale to qualified institutional buyers under Rule 144A of the Securities Act or non U.S. persons pursuant to Regulation S under the Securities Act. The initial purchasers received a discount of $1,650,000. 7. On March 8, 2004, UAP Holding Corp. granted stock options to its non-executive directors to purchase 9,000 shares of its common stock for an aggregate exercise price of $900,000. 8. On April 2, 2004, UAP Holding Corp. s board of directors approved the grant of stock options to purchase 4,155 shares of its common stock for an aggregate exercise price of $415,500. 9. On April 2, 2004, UAP Holding Corp. issued 8,850 shares of common stock to the plan trustee under UAP Holding Corp. s 2004 Deferred Compensation Plan for an aggregate purchase price of $88,850. Each of the above-described transactions were exempt from registration (i) pursuant to Section 4(2) of the Securities Act, or Regulation D promulgated thereunder, as transactions not involving a public offering or (ii) in II-2 Table of Contents the case of stock options, as transactions not involving a sale of securities. With respect to each transaction listed above, no general solicitation was made by either UAP Holding Corp. or any person acting on its behalf; the securities sold are subject to transfer restrictions; and the certificates for the shares contained an appropriate legend stating such securities have not been registered under the Securities Act and may not be offered or sold absent, registration or pursuant to an exemption therefrom. Item 16. Exhibits and Financial Statement Schedules (a) Exhibits Exhibit Number Exhibit 1.1 Form of Underwriting Agreement.* 2.1 Stock Purchase Agreement, dated as of October 29, 2003, by and among UAP Holding Corp., ConAgra Foods, Inc. and United Agri Products, Inc. (incorporated by reference to Exhibit 2.1 to United Agri Products, Inc. s Registration Statement on Form S-4 dated January 5, 2004 (File No. 333-111710)). 2.2 Amendment No. 1, dated as of November 23, 2003, to the Stock Purchase Agreement, dated as of October 29, 2003, by and among UAP Holding Corp., ConAgra Foods, Inc. and United Agri Products, Inc. (incorporated by reference to Exhibit 2.2 to United Agri Products, Inc. s Registration Statement on Form S-4 dated January 5, 2004 (File No. 333-111710)). 3.1 Certificate of Incorporation of UAP Holding Corp. dated as of October 28, 2003 (incorporated by reference to Exhibit 3.1 to UAP Holding Corp. s Registration Statement on Form S-4 dated March 5, 2004 (File No. 333-113345)). 3.2 Certificate of Amendment dated November 24, 2003 to the Certificate of Incorporation of UAP Holding Corp. (incorporated by reference to Exhibit 3.2 to UAP Holding Corp. s Registration Statement on Form S-4 dated March 5, 2004 (File No. 333-113345)). 3.3 Certificate of Designation, Preferences and Rights of Series A Redeemable Preferred Stock dated November 24, 2003 (incorporated by reference to Exhibit 3.3 to UAP Holding Corp. s Registration Statement on Form S-4 dated March 5, 2004 (File No. 333-113345)). 3.4 By-Laws of UAP Holding Corp. as adopted on October 29, 2003 (incorporated by reference to Exhibit 3.4 to UAP Holding Corp. s Registration Statement on Form S-4 dated March 5, 2004 (File No. 333-113345)). 3.5 Form of Amended and Restated Certificate of Incorporation of UAP Holding Corp.* 3.6 Form of Certificate of Designation, Preferences and Rights of Participating Preferred Stock.* 3.7 Form of Amendment to Certificate of Designation, Preferences and Rights of Series A Redeemable Preferred Stock.* 3.8 Form of Amended and Restated By-Laws of UAP Holding Corp.* 3.9 Amended and Restated Articles of Incorporation of AG-CHEM, Inc. dated as of September , 2004.* 3.10 Amended and Restated By-Laws of AG-CHEM, Inc. as adopted on September , 2004.* 3.11 Amended and Restated Articles of Incorporation of Balcom Chemicals, Inc. dated as of September , 2004.* 3.12 Amended and Restated By-Laws of Balcom Chemicals, Inc. as adopted on September , 2004.* II-3 Table of Contents Exhibit Number Exhibit 3.13 Amended and Restated Articles of Incorporation of Cropmate Company dated as of September , 2004.* 3.14 Amended and Restated By-Laws of Cropmate Company as adopted on September , 2004.* 3.15 Amended and Restated Articles of Incorporation of CSK Enterprises, Inc. dated as of September , 2004.* 3.16 Amended and Restated By-Laws of CSK Enterprises, Inc. as adopted on September , 2004.* 3.17 Amended and Restated Articles of Incorporation of GAC 26, Inc. dated as of September , 2004.* 3.18 Amended and Restated By-Laws of GAC 26, Inc. as adopted on September , 2004.* 3.19 Amended and Restated Articles of Incorporation of Genmarks, Inc. dated as of September , 2004.* 3.20 Amended and Restated By-Laws of Genmarks, Inc. as adopted on September , 2004.* 3.21 Amended and Restated Articles of Incorporation of Grower Service Corporation (New York) dated as of September , 2004.* 3.22 Amended and Restated By-Laws of Grower Service Corporation (New York) as adopted on September , 2004.* 3.23 Amended and Restated Articles of Incorporation of HACO, Inc. dated as of September , 2004.* 3.24 Amended and Restated By-Laws of HACO, Inc. as adopted on September , 2004.* 3.25 Amended and Restated Articles of Incorporation of Loveland Industries, Inc. dated as of September , 2004.* 3.26 Amended and Restated By-Laws of Loveland Industries, Inc. as adopted on September , 2004.* 3.27 Amended and Restated Articles of Incorporation of Loveland Products, Inc. dated as of September , 2004.* 3.28 Amended and Restated By-Laws of Loveland Products, Inc. as adopted on September , 2004.* 3.29 Amended and Restated Articles of Incorporation of Midwest Agriculture Warehouse Co. dated as of September , 2004.* 3.30 Amended and Restated By-Laws of Midwest Agriculture Warehouse Co. as adopted on September , 2004.* 3.31 Amended and Restated Articles of Incorporation of Ostlund Chemical Co. dated as of September , 2004.* 3.32 Amended and Restated By-Laws of Ostlund Chemical Co. as adopted on September , 2004.* 3.33 Amended and Restated Articles of Incorporation of Platte Chemical Co. dated as of September , 2004.* 3.34 Amended and Restated By-Laws of Platte Chemical Co. as adopted on September , 2004.* 3.35 Amended and Restated Articles of Incorporation of Pueblo Chemical & Supply Co. dated as of September , 2004.* 3.36 Amended and Restated By-Laws of Pueblo Chemical & Supply Co. as adopted on September , 2004.* 3.37 Amended and Restated Articles of Incorporation of Ravan Products, Inc. as adopted on September , 2004.* 3.38 Amended and Restated By-Laws of Ravan Products, Inc. as adopted on September , 2004.* II-4 Table of Contents Exhibit Number Exhibit 3.39 Amended and Restated Articles of Incorporation of S.E. Enterprises, Inc. dated as of September , 2004.* 3.40 Amended and Restated By-Laws of S.E. Enterprises, Inc. as adopted on September , 2004.* 3.41 Amended and Restated Articles of Incorporation of Snake River Chemicals, Inc. dated as of September , 2004.* 3.42 Amended and Restated By-Laws of Snake River Chemicals, Inc. as adopted on September , 2004.* 3.43 Amended and Restated Articles of Incorporation of Transbas, Inc. dated as of September , 2004.* 3.44 Amended and Restated By-Laws of Transbas, Inc. as adopted on September , 2004.* 3.45 Amended and Restated Articles of Incorporation of Tri-River Chemical Company, Inc. dated as of September , 2004.* 3.46 Amended and Restated By-Laws of Tri-River Chemical Company, Inc. as adopted on September , 2004.* 3.47 Amended and Restated Articles of Incorporation of Tri-State Chemicals, Inc. dated as of September , 2004.* 3.48 Amended and Restated By-Laws of Tri-State Chemicals, Inc. as adopted on September , 2004.* 3.49 Amended and Restated Articles of Incorporation of Tri-State Delta Chemicals, Inc. dated as of September , 2004.* 3.50 Amended and Restated By-Laws of Tri-State Delta Chemicals, Inc. as adopted on September , 2004.* 3.51 Amended and Restated Articles of Incorporation of UAP 22, Inc. dated as of September , 2004.* 3.52 Amended and Restated By-Laws of UAP 22, Inc. as adopted on September , 2004.* 3.53 Amended and Restated Articles of Incorporation of UAP 23, Inc. dated as of September , 2004.* 3.54 Amended and Restated By-Laws of UAP 23, Inc. as adopted on September , 2004.* 3.55 Amended and Restated Articles of Incorporation of UAP 27, Inc. dated as of September , 2004.* 3.56 Amended and Restated By-Laws of UAP 27, Inc. as adopted on September , 2004.* 3.57 Amended and Restated Articles of Incorporation of UAP Receivables Corporation dated as of September , 2004.* 3.58 Amended and Restated By-Laws of UAP Receivables Corporation as adopted on September , 2004.* 3.59 Amended and Restated Articles of Incorporation of UAP/GA AG Chem, Inc. dated as of September , 2004.* 3.60 Amended and Restated By-Laws of UAP/GA AG Chem, Inc. as adopted on September , 2004.* 3.61 Amended and Restated Articles of Incorporation of UAPLP, Inc. dated as of September , 2004.* 3.62 Amended and Restated By-Laws of UAPLP, Inc. as adopted on September , 2004.* 3.63 Amended and Restated Articles of Incorporation of United Agri Products, Inc. dated as of November 24, 2003 (incorporated by reference to Exhibit 3.1 to United Agri Products, Inc. s Registration Statement on Form S-4 dated January 5, 2004 (File No. 333-111710)). II-5 Table of Contents Exhibit Number Exhibit 3.64 Certificate of Amendment of the Certificate Incorporation of United Agri Products, Inc. dated as of December 11, 2003 (incorporated by reference to Exhibit 3.2 to United Agri Products, Inc. s Registration Statement on Form S-4 dated January 5, 2004 (File No. 333-111710)). 3.65 By-Laws of United Agri Products, Inc. as adopted on November 17, 2003 (incorporated by reference to Exhibit 3.3 to United Agri Products, Inc. s Registration Statement on Form S-4 dated January 5, 2004 (File No. 333- 111710)). 3.66 Amended and Restated Articles of Incorporation of United Agri Products Financial Services, Inc. dated as of September , 2004.* 3.67 Amended and Restated By-Laws of United Agri Products Financial Services, Inc. as adopted on September , 2004.* 3.68 Amended and Restated Articles of Incorporation of United Agri Products Florida, Inc. dated as of September , 2004.* 3.69 Amended and Restated By-Laws of United Agri Products-Florida, Inc. as adopted on September , 2004.* 3.70 Amended and Restated Articles of Incorporation of Verdicon, Inc. dated as of September , 2004.* 3.71 Amended and Restated By-Laws of Verdicon, Inc. as adopted on September , 2004.* 3.72 Amended and Restated Articles of Incorporation of YVC, Inc. dated as of September , 2004.* 3.73 Amended and Restated By-Laws of YVC, Inc. as adopted on September , 2004.* 4.1 Credit Agreement dated as of November 24, 2003, by and among United Agri Products, Inc. and United Agri Products Canada Inc., as borrowers, the other credit parties thereto, the lenders party thereto, General Electric Capital Corporation, as agent and GE Canada Finance Holding Company, as Canadian agent (incorporated by reference to Exhibit 4.1 to United Agri Products, Inc. s Registration Statement on Form S-4 dated January 5, 2004 (File No. 333-111710)). 4.2 First Amendment to Credit Agreement dated as of December 9, 2003, by and among United Agri Products, Inc. and United Agri Products Canada Inc., as borrowers, the other credit parties thereto, the lenders party thereto, General Electric Capital Corporation, as agent and GE Canada Finance Holding Company, as Canadian agent (incorporated by reference to Exhibit 4.2 to United Agri Products, Inc. s Registration Statement on Form S-4 dated January 5, 2004 (File No. 333-111710)). 4.3 Second Amendment to Credit Agreement dated as of December 18, 2003, by and among United Agri Products, Inc. and United Agri Products Canada Inc., as borrowers, the other credit parties thereto, the lenders party thereto, General Electric Capital Corporation, as agent and GE Canada Finance Holding Company, as Canadian agent (incorporated by reference to Exhibit 4.3 to United Agri Products, Inc. s Registration Statement on Form S-4 dated January 5, 2004 (File No. 333-111710)). 4.4 Third Amendment to Credit Agreement dated as of January 15, 2004, by and among United Agri Products, Inc. and United Agri Products Canada, Inc., as borrowers, the other credit parties thereto, the lenders party thereto, General Electric Capital Corporation, as agent and GE Canada Finance Holding Company, as Canadian agent (incorporated by reference to Exhibit 4.4 to UAP Holding Corp. s Registration Statement on Form S-4 dated March 5, 2004 (File No. 333-113345)). 4.5 Indenture dated as of January 26, 2004 between UAP Holding Corp. and JPMorgan Chase Bank, as trustee (incorporated by reference to Exhibit 4.5 to UAP Holding Corp. s Registration Statement on Form S-4 dated March 5, 2004 (File No. 333-113345)). II-6 Table of Contents Exhibit Number Exhibit 4.6 Registration Rights Agreement, dated as of January 26, 2004, by and among UAP Holding Corp. and UBS Securities LLC, Goldman, Sachs & Co. and Bear, Stearns & Co. Inc. (incorporated by reference to Exhibit 4.7 to UAP Holding Corp. s Registration Statement on Form S-4 dated March 5, 2004 (File No. 333-113345)). 4.7 Indenture dated as of December 16, 2003, among United Agri Products, Inc., the Guarantors named therein and JPMorgan Chase Bank, as trustee (incorporated by reference to Exhibit 4.4 to United Agri Products, Inc. s Registration Statement on Form S-4 dated January 5, 2004 (File No. 333-111710)). 4.8 Registration Rights Agreement, dated as of December 16, 2003, by and among United Agri Products, Inc., the guarantors listed on the signature pages attached thereto, and UBS Securities LLC, Goldman, Sachs & Co. and Bear, Stearns & Co. Inc. (incorporated by reference to Exhibit 4.6 to United Agri Products, Inc. s Registration Statement on Form S-4 dated January 5, 2004 (File No. 333-111710)). 4.9 Form of Amended and Restated Credit Agreement, by and among United Agri Products, Inc. and United Agri Products Canada, Inc., as borrowers, the other credit parties thereto, the lenders party thereto, General Electric Capital Corporation, as agent and GE Canada Finance Holding Company, as Canadian agent.* 4.10 Form of Senior Secured Second Lien Term Loan Facility, by and among UAP Holding Corp., as borrower, the other credit parties thereto, the lenders party thereto and , as agent and lender.* 4.11 Form of Senior Subordinated Note Indenture, by and among UAP Holding Corp., the Guarantors named therein and JPMorgan Chase Bank, as trustee.* 4.12 Form of global senior subordinated note (included in Exhibit 4.11).* 4.13 Form of global IDS certificate.* 4.14 Form of global stock certificate for Common Stock.* 4.15 First Supplemental Indenture, dated as of May 24, 2004, by and among United Agri Products, Inc. the Guarantors named therein and JPMorgan Chase Bank, as trustee.** 4.16 First Supplemental Indenture, dated as of May 24, 2004, by and between UAP Holding Corp. and JPMorgan Chase Bank, as trustee.** 4.17 Amendment No. 1 to the Registration Rights Agreement, dated as of May 24, 2004, by and among United Agri Products, Inc., each of the subsidiary guarantors party thereto, and the holders of at least a majority in aggregate principal amount at maturity of United Agri Products, Inc. s 8 1/4% Senior Notes due 2011 outstanding as of the date thereof.** 4.18 Amendment No. 1 to the Registration Rights Agreement, dated as of May 24, 2004, by and among UAP Holding Corp. and the holders of at least a majority in aggregate principal amount at maturity of UAP Holding Corp. s 10 3/4% Senior Discount Notes due 2012 outstanding as of the date thereof.** 4.19 Form of Amended and Restated Registration Rights Agreement dated as of , 2004 among UAP Holding Corp., Apollo Investment Fund V, LP, Apollo Netherlands Partners V (A), LP, Apollo Netherlands Partners V (B), LP and Apollo German Partners V GmbH & Co. KG.* 5.1 Opinion of O Melveny & Myers LLP.* 5.2 Opinion of Faegre & Benson LLP, special counsel to the Colorado guarantors.* 5.3 Opinion of Holland & Knight LLP, special counsel to the Florida guarantor.* 5.4 Opinion of Hartman, Simmons, Speilman & Wood, LLP, special counsel to the Georgia guarantors.* II-7 Table of Contents Exhibit Number Exhibit 5.5 Opinion of Perkins Coie LLP, special counsel to the Idaho guarantor.* 5.6 Opinion of Bell, Boyd & Lloyd LLC, special counsel to the Illinois guarantor.* 5.7 Opinion of Venable LLP, special counsel to the Maryland guarantor.* 5.8 Opinion of Watkins Ludlam Winter & Stennis, P.A., special counsel to the Mississippi guarantor.* 5.9 Opinion of Holland & Hart LLP, special counsel to the Montana guarantor.* 5.10 Opinion of Stinson Morrison Hecker LLP, special counsel to the Nebraska guarantors.* 5.11 Opinion of Dorsey & Whitney LLP, special counsel to the North Dakota guarantor.* 5.12 Opinion of Bass, Berry & Sims PLC, special counsel to the Tennessee guarantor.* 5.13 Opinion of Baker & McKenzie LLP, special counsel to the Texas guarantors.* 5.14 Opinion of Stoel Rives LLP, special counsel to the Washington guarantor.* 8.1 Opinion of O Melveny & Myers LLP.* 10.1 Transition Services Agreement, dated as of November 24, 2003, by and between ConAgra Foods, Inc., UAP Holding Corp., United Agri Products, Inc. and each other company listed on the signature pages thereto (incorporated by reference to Exhibit 10.1 to United Agri Products, Inc. s Registration Statement on Form S-4 dated January 5, 2004 (File No. 333-111710)). 10.2 Seller Transition Services Agreement, dated as of November 24, 2003, by and between ConAgra Foods, Inc., UAP Holding Corp., United Agri Products, Inc. and each other company listed on the signature pages thereto (incorporated by reference to Exhibit 10.2 to United Agri Products, Inc. s Registration Statement on Form S-4 dated January 5, 2004 (File No. 333-111710)). 10.3 Indemnification Agreement, dated as of November 24, 2003, by and among ConAgra Foods, Inc., United Agri Products, Inc., United Agri Products Canada Inc., 2326396 Canada, Inc., AG-Chem, Inc., Balcom Chemicals, Inc., UAP 23, Inc., Cropmate Company, CSK Enterprises, Inc., GAC 26, Inc., UAP 27, Inc., Genmarks, Inc., Grower Service Corporation (New York), HACO, Inc., Loveland Industries, Inc., Loveland Products, Inc., Midwest Agriculture Warehouse Co., Ostlund Chemical Co., Platte Chemical Co., Pueblo Chemical & Supply Co., Ravan Products, Inc., S.E. Enterprises, Inc., Snake River Chemicals, Inc., Transbas, Inc., Tri-River Chemical Company, Inc., Tri-State Chemicals, Inc., Tri-State Delta Chemicals, Inc., UAP/GA AG Chem, Inc., UAPLP, Inc., UAP 22, Inc., UAP Receivables Corporation, United Agri Products Florida, Inc., United Agri Products Financial Services, Inc., Verdicon and YVC, Inc. (incorporated by reference to Exhibit 10.3 to United Agri Products, Inc. s Registration Statement on Form S-4 dated January 5, 2004 (File No. 333-111710)). 10.4 Fertilizer Supply Agreement, dated as of November 24, 2003, between ConAgra International Fertilizer Company and United Agri Products, Inc. (incorporated by reference to Exhibit 10.4 to United Agri Products, Inc. s Registration Statement on Form S-4 dated January 5, 2004 (File No. 333-111710)). 10.5 International Supply Agreement, dated as of November 24, 2003, between United Agri Products, Inc. and ConAgra Foods, Inc. (incorporated by reference to Exhibit 10.5 to United Agri Products, Inc. s Registration Statement on Form S-4 dated January 5, 2004 (File No. 333-111710)). 10.6 Buyer Release Agreement, dated as of November 24, 2003, between ConAgra Foods, Inc. and the Acquired Companies (as defined therein) (incorporated by reference to Exhibit 10.6 to United Agri Products, Inc. s Registration Statement on Form S-4 dated January 5, 2004 (File No. 333-111710)). II-8 Table of Contents Exhibit Number Exhibit 10.7 Seller Release Agreement, dated as of November 24, 2003, between ConAgra Foods, Inc. and UAP Holding Corp. (incorporated by reference to Exhibit 10.7 to United Agri Products, Inc. s Registration Statement on Form S-4 dated January 5, 2004 (File No. 333-111710)). 10.8 2003 Stock Option Plan of UAP Holding Corp. (incorporated by reference to Exhibit 10.8 to United Agri Products, Inc. s Registration Statement on Form S-4 dated January 5, 2004 (File No. 333-111710)). 10.9 Retention Agreement, dated as of November 18, 2003 between UAP Holding Corp. and Bryan S. Wilson (incorporated by reference to Exhibit 10.9 to United Agri Products, Inc. s Registration Statement on Form S-4 dated January 5, 2004 (File No. 333-111710)). 10.10 Retention Agreement, dated as of November 18, 2003 between UAP Holding Corp. and David W. Bullock (incorporated by reference to Exhibit 10.10 to United Agri Products, Inc. s Registration Statement on Form S-4 dated January 5, 2004 (File No. 333-111710)). 10.11 Retention Agreement, dated as of November 18, 2003 between UAP Holding Corp. and L. Kenneth Cordell (incorporated by reference to Exhibit 10.11 to United Agri Products, Inc. s Registration Statement on Form S-4 dated January 5, 2004 (File No. 333-111710)). 10.12 Retention Agreement, dated as of November 18, 2003, between UAP Holding Corp. and Dave Tretter (incorporated by reference to Exhibit 10.12 to United Agri Products, Inc. s Registration Statement on Form S-4 dated January 5, 2004 (File No. 333-111710)). 10.13 Retention Agreement, dated as of November 18, 2003 between UAP Holding Corp. and Robert A. Boyce, Jr. (incorporated by reference to Exhibit 10.13 to United Agri Products, Inc. s Registration Statement on Form S-4 dated January 5, 2004 (File No. 333-111710)). 10.14 Investor Rights Agreement, dated as of the Original Issue Date among UAP Holding Corp. and the Holders party thereto (incorporated by reference to Exhibit 10.14 to UAP Holding Corp. s Registration Statement on Form S-4 dated March 5, 2004 (File No. 333-113345)). 10.15 Registration Rights Agreement, dated as of November 24, 2003, between UAP Holding Corp. and the Apollo Investors (incorporated by reference to Exhibit 10.15 to UAP Holding Corp. s Registration Statement on Form S-4 dated March 5, 2004 (File No. 333-113345)). 10.16 Management Consulting Agreement, dated as of November 21, 2003, between UAP Holding Corp. and Apollo Management V, L.P. (incorporated by reference to Exhibit 10.16 to UAP Holding Corp. s Registration Statement on Form S-4 dated March 5, 2004 (File No. 333-113345)). 10.17 2003 Deferred Compensation Plan of UAP Holding Corp. (incorporated by reference to Exhibit 10.17 to UAP Holding Corp. s Registration Statement on Form S-4 dated March 5, 2004 (File No. 333-113345)). 10.18 2004 Deferred Compensation Plan of UAP Holding Corp.** 10.19 2004 Non-Executive Director Stock Option Plan of UAP Holding Corp.** 10.20 Form of Amended and Restated 2004 Non-Executive Director Option Plan.* 10.21 Form of First Amendment to Registration Rights Agreement, by and between UAP Holding Corp. and the Apollo Investors.* 10.22 Form of Termination of Management Consulting Agreement, between UAP Holding Corp. and Apollo Management V, L.P.* 10.23 Form of Amended and Restated 2004 Deferred Compensation Plan.* 10.24 Form of Recapitalization Agreement.* II-9 Table of Contents Exhibit Number Exhibit 10.25 Form of Management Incentive Agreement.* 10.26 Form of Amended and Restated 2003 Stock Option Plan.* 10.27 Form of Long-Term Incentive Plan.* 12.1 Computation of Ratios of Earnings to Fixed Charges.** 12.2 Pro Forma Computation of Ratios of Earnings to Fixed Charges. 21.1 Subsidiaries of UAP Holding Corp. (incorporated by reference to Exhibit 21.1 to UAP Holding Corp. s Registration Statement on Form S-4 dated March 5, 2004 (File No. 333-113345)). 23.1 Consent of Deloitte & Touche LLP. 23.2 Consent of O Melveny & Myers LLP (included in Exhibits 5.1 and 8.1).* 23.3 Consent of Faegre & Benson LLP, special counsel to the Colorado guarantors (included in Exhibit 5.2).* 23.4 Consent of Holland & Knight LLP, special counsel to the Florida guarantor (included in Exhibit 5.3).* 23.5 Consent of Hartman, Simmons, Speilman & Wood, LLP, special counsel to the Georgia guarantors (included in Exhibit 5.4).* 23.6 Consent of Perkins Coie LLP, special counsel to the Idaho guarantor (included in Exhibit 5.5).* 23.7 Consent of Bell, Boyd & Lloyd LLC, special counsel to the Illinois guarantor (included in Exhibit 5.6).* 23.8 Consent of Venable LLP, special counsel to the Maryland guarantor (included in Exhibit 5.7).* 23.9 Consent of Watkins Ludlam Winter & Stennis, P.A., special counsel to the Mississippi guarantor (included in Exhibit 5.8).* 23.10 Consent of Holland & Hart LLP, special counsel to the Montana guarantor (included in Exhibit 5.9).* 23.11 Consent of Stinson Morrison Hecker LLP, special counsel to the Nebraska guarantors (included in Exhibit 5.10).* 23.12 Consent of Dorsey & Whitney LLP, special counsel to the North Dakota guarantor (included in Exhibit 5.11).* 23.13 Consent of Bass, Berry & Sims PLC, special counsel to the Tennessee guarantor (included in Exhibit 5.12).* 23.14 Consent of Baker & McKenzie, special counsel to the Texas guarantors (included in Exhibit 5.13).* 23.15 Consent of Stoel Rives LLP, special counsel to the Washington guarantor (included in Exhibit 5.14).* 23.16 Consent of Houlihan Lokey Howard & Zukin Financial Advisors, Inc., a financial advisory firm.* 24.1 Powers of Attorney (included on signature pages to original registration statement).** 25.1 Statement of Eligibility and Qualification under the Trust Indenture Act of 1939 of JPMorgan Chase Bank.** * To be filed by Amendment. ** Previously filed. II-10 Table of Contents (b) Financial Statement Schedules Schedule I Condensed Financial Information of Registrant Schedule II Valuation and Qualifying Accounts All other schedules have been omitted because they are either not applicable or the required information has been disclosed in the financial statements or notes hereto. Item 17. Undertakings 1. The undersigned registrants hereby undertake to provide to the underwriters at the closing specified in the underwriting agreement certificates in such denominations and registered in such names as required by the underwriters to permit prompt delivery to each purchaser. 2. Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers, and controlling persons of the registrants pursuant to the foregoing provisions, or otherwise, the registrants have been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Securities Act of 1933 and is therefore unenforceable. In the event that a claim for indemnification by the registrants against such liabilities, other than the payment by the registrants of expenses incurred or paid by a director, officer or controlling person of the registrants in the successful defense of any action, suit or proceeding, is asserted by such director, officer or controlling person in connection with the securities being registered, the registrants will, unless in the opinion of their counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Act and will be governed by the final adjudication of such issue. 3. The undersigned registrants hereby undertake that: (1) For purposes of determining any liability under the Securities Act of 1933, the information omitted from the form of prospectus filed as part of this registration statement in reliance upon Rule 430A and contained in a form of prospectus filed by the Registrants pursuant to Rule 424(b)(1) or (4) or 497(h) under the Securities Act of 1933 shall be deemed to be part of this registration statement as of the time it was declared effective. (2) For the purpose of determining any liability under the Securities Act of 1933, each post-effective amendment that contains a form of prospectus shall be deemed to be a new registration statement relating to the securities offered therein, and the offering of such securities at that time shall be deemed to be the initial bona fide offering thereof. II-11 Table of Contents SIGNATURES Pursuant to the requirements of the Securities Act of 1933, the Registrant has duly caused this Amendment No. 3 to the Registration Statement to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Greeley, State of Colorado, on the 30th day of September, 2004. UAP HOLDING CORP. By: /S/ L. KENNY CORDELL L. Kenny Cordell President, Chief Executive Officer and Director Pursuant to the requirements of the Securities Act of 1933, this Amendment No. 3 to the Registration Statement has been signed by the following persons in the capacities and on the dates indicated: Signature Title Date /S/ L. KENNY CORDELL L. Kenny Cordell President, Chief Executive Officer and Director (Principal Executive Officer) September 30th, 2004 /S/ DAVID W. BULLOCK David W. Bullock Executive Vice President and Chief Financial Officer (Principal Financial and Accounting Officer) September 30th, 2004 * Joshua J. Harris Director September 30th, 2004 * Robert Katz Director September 30th, 2004 * Marc E. Becker Director September 30th, 2004 * Stan Parker Director September 30th, 2004 * Carl J. Rickertsen Director September 30th, 2004 * Thomas Miklich Director September 30th, 2004 *By: /S/ DAVID W. BULLOCK David W. Bullock Attorney-in-fact II-12 Table of Contents SIGNATURES Pursuant to the requirements of the Securities Act of 1933, the Registrant has duly caused this Amendment No. 3 to the Registration Statement to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Greeley, State of Colorado, on the 30th day of September, 2004. UNITED AGRI PRODUCTS, INC. By: /S/ L. KENNY CORDELL L. Kenny Cordell President, Chief Executive Officer and Director Pursuant to the requirements of the Securities Act of 1933, this Amendment No. 3 to the Registration Statement has been signed by the following persons in the capacities and on the dates indicated: Signature Title Date /S/ L. KENNY CORDELL L. Kenny Cordell President, Chief Executive Officer and Director (Principal Executive Officer) September 30th, 2004 /S/ DAVID W. BULLOCK David W. Bullock Executive Vice President and Chief Financial Officer (Principal Financial and Accounting Officer) September 30th, 2004 * Joshua J. Harris Director September 30th, 2004 * Robert Katz Director September 30th, 2004 * Marc E. Becker Director September 30th, 2004 * Stan Parker Director September 30th, 2004 * Carl J. Rickertsen Director September 30th, 2004 * Thomas Miklich Director September 30th, 2004 *By: /S/ DAVID W. BULLOCK David W. Bullock Attorney-in-fact II-13 Table of Contents SIGNATURES Pursuant to the requirements of the Securities Act of 1933, each of the Registrants has duly caused this Amendment No. 3 to the Registration Statement to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Greeley, State of Colorado, on the 30th day of September, 2004. AG-CHEM, Inc. Balcom Chemicals, Inc. Cropmate Company CSK Enterprises, Inc. GAC 26, Inc. Genmarks, Inc. Grower Service Corporation (New York) HACO, Inc. Loveland Industries, Inc. Midwest Agriculture Warehouse Co. Ostlund Chemical Co. Pueblo Chemical & Supply Co. Ravan Products, Inc. S.E. Enterprises, Inc. Tri-River Chemical Company, Inc. Tri-State Chemicals, Inc. Tri-State Delta Chemicals, Inc. UAP 22, Inc. UAP 23, Inc. UAP 27, Inc. UAP Receivables Corporation UAP/GA AG Chem, Inc. UAPLP, Inc. United Agri Products Financial Services, Inc. United Agri Products Florida, Inc. YVC, Inc. By: /S/ DAVID W. BULLOCK David W. Bullock Executive Vice President and Director II-14 Table of Contents Pursuant to the requirements of the Securities Act of 1933, this Amendment No.3 to the Registration Statement has been signed by the following persons in the capacities and on the dates indicated: Signature Title Date /S/ DAVID W. BULLOCK David W. Bullock Executive Vice President and Director (Principal Executive, Financial and Accounting Officer) September 30th, 2004 * Todd A. Suko Vice President, Secretary and Director September 30th, 2004 * L. Kenny Cordell Director September 30th, 2004 *By: /S/ DAVID W. BULLOCK David W. Bullock Attorney-in-fact II-15 Table of Contents SIGNATURES Pursuant to the requirements of the Securities Act of 1933, each of the Registrants has duly caused this Amendment No. 3 to the Registration Statement to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Greeley, State of Colorado, on the 30th day of September, 2004. Loveland Products, Inc. Platte Chemical Co. Snake River Chemicals, Inc. Transbas, Inc. Verdicon, Inc. By: /S/ BRYAN S. WILSON Bryan S. Wilson President Pursuant to the requirements of the Securities Act of 1933, this Amendment No. 3 to the Registration Statement has been signed by the following persons in the capacities and on the dates indicated: Signature Title Date /S/ BRYAN S. WILSON Bryan S. Wilson President (Principal Executive Officer) September 30th, 2004 /S/ DAVID W. BULLOCK David W. Bullock Executive Vice President and Director (Principal Financial and Accounting Officer) September 30th, 2004 * Todd A. Suko Vice President, Secretary and Director September 30th, 2004 * L. Kenny Cordell Director September 30th, 2004 *By: /S/ DAVID W. BULLOCK David W. Bullock Attorney-in-fact II-16 Table of Contents Schedule I UAP HOLDING CORP. CONDENSED FINANCIAL INFORMATION OF REGISTRANT The UAP Holding Corp. structure was effected through the capitalization of the Company in connection with the acquisition of the ConAgra Agricultural Products Business on November 24, 2003. The Company has no significant operations other than certain corporate and other administrative functions. The notes to the consolidated financial statements are an integral part of these condensed financial statements and should be read in connection with these financial statements. UAP HOLDING CORP. CONDENSED FINANCIAL INFORMATION OF PARENT COMPANY BALANCE SHEET February 22, 2004 UAP Holding Corp. ASSETS Current assets: Cash and cash equivalents $ 662 Receivables, net Inventories Deferred income taxes Other current assets Property, plant and equipment, net Goodwill Intangible assets, net Deferred income taxes Investment in subsidiaries 190,791 Other assets 4,250 $ 195,703 Total current liabilities 725 Long-term debt 83,570 Series A redeemable preferred stock 34,620 Deferred income taxes Other noncurrent liabilities 5,550 Commitments and contingencies Stockholders Equity: Common stock $.001 par value, 2,000,000 shares authorized, 1,200,000 shares issued and outstanding 1 Additional paid-in capital 61,589 Retained earnings 9,653 Accumulated other comprehensive loss (5 ) Total Stockholders Equity 71,238 $ 195,703 Table of Contents UAP HOLDING CORP. CONDENSED FINANCIAL INFORMATION OF PARENT COMPANY STATEMENTS OF EARNINGS Thirteen Weeks Ended February 22, 2004 UAP Holding Corp. (Loss) from continuing operations before income taxes (1,805 ) Income tax (benefit) (667 ) Income (loss) from continuing operations (1,138 ) Equity in earnings of affiliates 10,791 Net income $ 9,653 Table of Contents Schedule I UAP HOLDING CORP. CONDENSED FINANCIAL INFORMATION OF PARENT COMPANY STATEMENT OF CASH FLOWS Thirteen Weeks Ended February 22, 2004 UAP Holding Corp. Cash flows from investing activities: Additions to property, plant and equipment Proceeds from sale of assets Acquisition of ConAgra Agricultural Products Business (120,000 ) Net cash flows from investing activities (120,000 ) Cash flows from financing activities: Net investment Proceeds from issuance of long-term debt 82,500 Debt issuance costs (4,260 ) Issuance of common stock 120,000 Dividends to stockholders (52,860 ) Redemption of Series A redeemable preferred stock (25,380 ) Net cash flows from financing activities 120,000 Table of Contents Schedule II UAP HOLDING CORP. VALUATION AND QUALIFYING ACCOUNTS For the Fiscal Years Ended February 24, 2002 and February 23, 2003, the Thirty-Nine Weeks Ended November 23, 2003 and the Thirteen Weeks Ended February 22, 2004 (in thousands) Description Balance at Beginning of Period Charged to Income Deductions from Reserves Balance at Close of Period ConAgra Agricultural Products Business: Year ended February 24, 2002 Allowance for doubtful receivables 35,048 55,369 56,893(1) 33,524 Year ended February 23, 2003 Allowance for doubtful receivables 33,524 (293) (1,463)(1) 34,694 Thirty-nine weeks ended November 23, 2003 Allowance for doubtful accounts 34,694 14,093 2,869(1) 45,918 UAP Holding Corp.: Thirteen weeks ended February 22, 2004 Allowance for doubtful accounts 45,918 (12,710) 5,880(1) 27,328 Table of Contents EXHIBIT INDEX Exhibit Number Exhibit Table of Contents Exhibit Number Exhibit Table of Contents Exhibit Number Exhibit Table of Contents Exhibit Number Exhibit Table of Contents Exhibit Number Exhibit Table of Contents Exhibit Number Exhibit Table of Contents Exhibit Number Exhibit Table of Contents Exhibit Number Exhibit 23.9 Consent of Watkins Ludlam Winter & Stennis, P.A., special counsel to the Mississippi guarantor (included in Exhibit 5.8).* 23.10 Consent of Holland & Hart LLP, special counsel to the Montana guarantor (included in Exhibit 5.9).* 23.11 Consent of Stinson Morrison Hecker LLP, special counsel to the Nebraska guarantors (included in Exhibit 5.10).* 23.12 Consent of Dorsey & Whitney LLP, special counsel to the North Dakota guarantor (included in Exhibit 5.11).* 23.13 Consent of Bass, Berry & Sims PLC, special counsel to the Tennessee guarantor (included in Exhibit 5.12).* 23.14 Consent of Baker & McKenzie, special counsel to the Texas guarantors (included in Exhibit 5.13).* 23.15 Consent of Stoel Rives LLP, special counsel to the Washington guarantor (included in Exhibit 5.14).* 23.16 Consent of Houlihan Lokey Howard & Zukin Financial Advisors, Inc., a financial advisory firm.* 24.1 Powers of Attorney (included on signature pages to original registration statement).** 25.1 Statement of Eligibility and Qualification under the Trust Indenture Act of 1939 of JPMorgan Chase Bank.** CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS 110 DESCRIPTION OF OTHER INDEBTEDNESS 122 DESCRIPTION OF INCOME DEPOSIT SECURITIES (IDSS) 133 DESCRIPTION OF CAPITAL STOCK 138 DESCRIPTION OF SENIOR SUBORDINATED NOTES 145 IDSS ELIGIBLE FOR FUTURE SALE 196 MATERIAL U.S. FEDERAL INCOME TAX CONSEQUENCES 199 UNDERWRITING 209 NOTICE TO CANADIAN RESIDENTS 214 LEGAL MATTERS 215 EXPERTS 215 WHERE YOU CAN FIND MORE INFORMATION 216 INDEX TO FINANCIAL STATEMENTS Report of Independent Registered Public Accounting Firm F-2 Audited Financial Statements: Balance Sheets at February 22, 2004 (Successor) and February 23, 2003 (Predecessor) F-3 Statements of Earnings for the thirteen-week period ended February 22, 2004 (Successor), thirty-nine week period ended November 23, 2003 (Predecessor), and the fiscal years ended February 23, 2003 and February 24, 2002 (Predecessor) F-4 Statement of Stockholders Equity for the thirteen-week period ended February 22, 2004 (Successor), and Statements of Stockholder s Net Investment and Advances for the thirty-nine week period ended November 23, 2003 (Predecessor), and the fiscal years ended February 23, 2003 and February 24, 2002 (Predecessor) F-5 Statements of Cash Flows for the thirteen-week period ended February 22, 2004 (Successor), thirty-nine week period ended November 23, 2003 (Predecessor), and the fiscal years ended February 23, 2003 and February 24, 2002 (Predecessor) F-6 Notes to Financial Statements F-7 Unaudited Financial Statements: Unaudited Condensed Consolidated Balance Sheets as of May 30, 2004 (Successor) and May 25, 2003 (Predecessor) F-28 Unaudited Condensed Consolidated Statements of Earnings for the fourteen-week period ended May 30, 2004 (Successor) and the thirteen-week period ended May 25, 2003 F-29 Unaudited Condensed Consolidated Statements of Cash Flows for the fourteen-week period ended May 30, 2004 and the thirteen-week period ended May 25, 2003 F-30 Notes to Condensed Consolidated Financial Statements F-31 The accompanying financial statements do not give effect to a proposed 49.578-for-1 stock split to be effected prior to the effective date of the registration statement to which this prospectus is a part. In order to effect the stock split, we will obtain approval of our Board of Directors and will also obtain stockholder approval of an amendment and restatement of our existing charter to increase the authorized number of common shares. The stock split would become effective upon filing the charter amendment with the Secretary of State of the State of Delaware. While completion of the necessary steps to effect the stock split has not yet taken place, we believe we will obtain all necessary approvals. Table of Contents REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Stockholders and Board of Directors UAP Holding Corp. We have audited the accompanying consolidated balance sheet of UAP Holding Corp. (Successor) (the Company ), as of February 22, 2004, and the related consolidated statements of earnings, stockholders equity and cash flows for the thirteen weeks ended February 22, 2004. We have also audited the accompanying combined balance sheet of ConAgra Agricultural Products Business (a division of ConAgra Foods, Inc.) (the Predecessor ), as of February 23, 2003, and the related combined statements of earnings, stockholder s net investment and advances and cash flows for the thirty-nine weeks ended November 23, 2003 and the fiscal years ended February 23, 2003 and February 24, 2002. The combined financial statements include the accounts of the companies disclosed in Note 8, which are under common ownership and management. Our audits also included the financial statement schedules included in Item 16. These financial statements and the financial statement schedules are the responsibility of the company s management. Our responsibility is to express an opinion on the financial statements and the financial statement schedules based on our audits. We conducted our audits in accordance with standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such financial statements present fairly, in all material respects, the consolidated financial position of UAP Holding Corp. as of February 22, 2004, and the consolidated results of its operations and its consolidated cash flows for the thirteen weeks ended February 22, 2004, the combined financial position of ConAgra Agricultural Products Business as of February 23, 2003, and the combined results of its operations and its combined cash flows for the thirty-nine weeks ended November 23, 2003 and the fiscal years ended February 23, 2003 and February 24, 2002 in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedules, when considered in relation to the basic combined financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note 1 to the financial statements, in 2003 the company changed its method of accounting for goodwill and other intangible assets. /s/ DELOITTE & TOUCHE LLP DELOITTE & TOUCHE LLP Omaha, Nebraska May 13, 2004 The accompanying notes are an integral part of the financial statements. Basic and diluted earnings per share $ 8.04 Weighted average shares outstanding 1,200,000 The accompanying notes are an integral part of the financial statements. The accompanying notes are an integral part of the financial statements. The accompanying notes are an integral part of the financial statements. Table of Contents UAP HOLDING CORP. NOTES TO FINANCIAL STATEMENTS (Continued) Fiscal Years Ended February 22, 2004, February 23, 2003 and February 24, 2002 columnar dollar amounts in thousands The company has allocated the excess of the acquisition cost over the fair value of the assets acquired and liabilities assumed to goodwill, trade names and other finite lived intangible assets based on an independent third-party appraiser. The amount of other finite and indefinite lived intangible assets recognized in this acquisition were $7.5 million. The finite lived intangible assets, including trade names and customer lists, are being amortized over five years based on the estimated remaining useful lives of the intangible assets. Amortization expense for the Company was $0.4 million for the thirteen weeks ended February 22, 2004. Goodwill recognized in this transaction is $43.5 million and is not deductible for tax purposes. 2. Basis of Presentation and Accounting Policies Basis of presentation The acquisition has been accounted for as a purchase business combination in accordance with Statement of Financial Accounting Standards No. 141, Business Combinations. Accounting principles generally accepted in the United States of America require the Company s operating results prior to the Acquisition to be reported as the results of the Predecessor for periods prior to November 24, 2003 in the historical financial statements. UAP Holding Corp s operating results subsequent to the Acquisition are presented as the Successor s results in the historical financial statements. The Successor financial results are presented as of February 22, 2004 and the thirteen-week period ended February 22, 2004. The Predecessor financial results are presented as of February 23, 2003 and the fiscal periods ended February 24, 2002, February 23, 2003 and the thirty-nine weeks ended November 23, 2003. The results of operations for any thirteen or thirty-nine week period or for the periods presented for the Predecessor or Successor are not necessarily indicative of the results to be expected for other periods or the full fiscal year. Inventories Inventories consist primarily of chemicals, fertilizers and seed. The company principally uses the lower of cost, determined using the first-in, first-out method or market to value its inventory. Vendor Rebates Receivables include vendor rebates which represent amounts due from suppliers on crop protection, seed and fertilizer products and are accrued when earned, which is typically at the time of the sale of the related product. Long Lived Assets and Intangible Assets Property, plant and equipment are carried at cost. Depreciation has been calculated using primarily the straight-line method over the estimated useful lives of the respective classes of assets as follows: Land improvements 1 - 40 years Buildings 15 - 40 years Machinery and equipment 3 - 20 years Furniture, fixtures, office equipment and other 5 - 15 years The company reviews long-lived assets for impairment whenever events or changes in business circumstances indicate that the carrying amount of the assets may not be fully recoverable. Recoverability of an asset held-for-use is determined by comparing the carrying amount of the asset to the undiscounted net cash flows expected to be generated from the use of the asset. If the carrying amount is greater than the undiscounted Foreign Currency Translation The translation of foreign currency into U.S. dollars is performed for balance sheet accounts using the current exchange rate in effect at the balance sheet date and for revenue and Table of Contents UAP HOLDING CORP. NOTES TO FINANCIAL STATEMENTS (Continued) Fiscal Years Ended February 22, 2004, February 23, 2003 and February 24, 2002 columnar dollar amounts in thousands expense accounts using the average exchange rate during the period. The gains or losses resulting from translation are included in stockholder s net investment and advances. Exchange adjustments resulting from foreign currency transactions, which were not material in any of the years presented, are generally recognized in earnings. Comprehensive Income Comprehensive income consists of net income and foreign currency translation adjustments. The company deems its foreign investments to be permanent in nature and does not provide for taxes on currency translation adjustments arising from converting the investment in a foreign currency to U.S. dollars. There are no reclassification adjustments to be reported in periods presented. Accounting Changes During the fourth quarter of fiscal 2003, the company adopted Financial Accounting Standards Board Interpretation ( FIN ) No. 45, Guarantor s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. FIN No. 45 clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing certain guarantees. The recognition provisions of FIN No. 45 are applicable to guarantees issued or modified after December 31, 2002. FIN No. 45 also elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. The impact of adoption was not material to the combined financial statements. In June 2001, the FASB approved the issuance of SFAS No. 141, Business Combinations, and SFAS No. 142, Goodwill and Other Intangible Assets. These standards, issued in July 2001, establish accounting and reporting requirements for business combinations. SFAS No. 141 requires all business combinations entered into subsequent to June 30, 2001, to be accounted for using the purchase method of accounting. SFAS No. 142 provides that goodwill and other intangible assets with indefinite lives will not be amortized, but will be tested for impairment on an annual basis. The company adopted SFAS No. 142 at the beginning of fiscal 2003. For further discussion on the company s adoption of SFAS No. 142, see Note 3 to the combined financial statements. Recently Issued Accounting Pronouncements In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. SFAS No. 150 establishes standards for classification and measurement in the balance sheets for certain financial instruments which possess characteristics of both a liability and equity. Generally, it requires classification of such financial instruments as a liability. SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003. For financial instruments in existence prior to May 31, 2003, SFAS No. 150 is effective the beginning of the company s fiscal 2005. The company does not believe the adoption of SFAS No. 150 will have an impact on the company s financial statements. In January 2003, the FASB issued FIN No. 46, Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin No. 51 (ARB 51), which clarifies the consolidation accounting guidance in ARB 51, Consolidated Financial Statements, as it applies to certain entities in which equity investors who do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entities to finance their activities without additional subordinated financial support from other parties. Such entities are known as variable interest entities (VIEs). FIN No. 46 requires that the primary beneficiary of a VIE consolidates the VIE. FIN No. 46 also requires new disclosures for significant relationships with VIEs, whether or not consolidation accounting is used or anticipated. In December 2003, the FASB revised and re-released FIN No. 46 as FIN No. 46(R). The provisions of FIN No. 46(R) are effective for periods ending after March 15, 2004 and upon adoption by the company as of February 22, 2004, did not have a material impact on our financial position or results of operations. 6. Related Party Transactions Prior to the Acquisition, ConAgra Food s executive, finance, tax and other corporate departments perform certain administrative and other services for the company. Expenses incurred by ConAgra Foods and allocated to the company are determined based on specific services being provided or are allocated based on ConAgra Food s investment in the company in proportion to ConAgra Food s total investment in its subsidiaries. In addition, ConAgra Foods charges the company finance charges on ConAgra Food s investment in the company and net intercompany advances. Management believes that such expense allocations are reasonable. It is not practical to estimate the expenses that would have been incurred by the company if it had been operated on a stand-alone basis. Corporate allocations include allocated selling, administrative and general expenses of approximately $10.5 million and $10.8 million for fiscal 2002 and 2003, respectively, and $9.0 million for the thirty-nine weeks ended November 23, 2003, and allocated finance charges of $39.5 million and $22.5 million in fiscal 2002 and 2003, respectively, and $12.2 million for the thirty-nine weeks ended November 23, 2003. Allocated finance charges are presented net of third party finance fee income of $13.4 million and $10.8 million in fiscal 2002 and 2003, respectively, and $7.3 million for the thirty-nine weeks ended November 23, 2003. Prior to the Acquisition, the company also had transactions in the normal course of business with parties under common ownership. Net sales to related parties were $33.8 million and $25.5 million in fiscal years 2002 and 2003, respectively, and $5.8 million for the thirty-nine weeks ended November 23, 2003. Gross margins associated with related party net sales were $2.6 million and $2.5 million in fiscal years 2002 and 2003, respectively, and $2.0 million for the thirty-nine weeks ended November 23, 2003. As part of the Acquisition, ConAgra Foods and the company entered into a transition services agreement in which ConAgra Foods would provide certain information technology and other administrative services to the company for a period of one year. As consideration for these services, the company paid ConAgra Foods $7.5 million. For the thirteen week period ended February 22, 2004, $1.9 million in expense was recognized by the Company for services performed per this agreement. The company is a party to a management consulting agreement dated as of November 21, 2003 with Apollo (the Management Agreement ). Under the terms of the Management Agreement, the company retained Apollo to provide certain management consulting and financial advisory services, for which the company pays Apollo an annual management fee of $1.0 million in quarterly payments of $250,000. In addition, as consideration for arranging the Acquisition and services pertaining to certain related financing transactions, the Company paid Apollo a fee of $5.0 million in January 2004. In connection with the Acquisition, United Agri Products entered into the existing five-year $500.0 million asset-based revolving credit facility. The existing revolving credit facility also provides for a $20.0 million revolving credit sub-facility for UAP Canada, a $50.0 million letter of credit sub-facility, a $25.0 million swingline loan sub-facility and a $25.0 million in-season over-advance sub-facility. The interest rates with respect to revolving loans under the existing revolving credit facility are based, at our option, on either the agent s index rate plus an applicable index margin of 1.50% or upon LIBOR plus an applicable LIBOR margin of 2.75%. The interest rates with respect to in-season overadvances under the existing revolving credit facility are based, at our option, on either the agent s index rate plus an applicable index margin of 2.75% or upon LIBOR plus an applicable LIBOR margin of 4.00%. These applicable margins are in each case subject to prospective reduction on a quarterly basis (other than the margins on in-season overadvances) if we reduce our ratio of funded debt to EBITDA (on a consolidated basis). Overdue principal, interest and other amounts will bear interest at a rate per annum equal to the rate otherwise applicable thereto plus an additional 2.0%. The obligations under the existing revolving credit facility are (or, in the case of future subsidiaries, will be) guaranteed by UAP Holdings and each of its existing and future direct and indirect U.S. subsidiaries. The obligations under the existing revolving credit facility are secured by a first priority lien on, or security interest in, subject to certain exceptions, substantially all of UAP Holdings , United Agri Products and UAP Canada s properties and assets and the properties and assets of each of the guarantors. The existing revolving credit facility contains customary representations, warranties and covenants and events of default. The company s credit agreements include a minimum EBITDA requirement of $70.0 million as measured on a twelve month rolling period. The company is also required to maintain a Fixed Charge Coverage Ratio of not less than 1.1 to 1.0, measured on the last day of each month for the trailing twelve months then ended. The credit agreements also contain certain negative covenants which may restrict the company s ability to, among other items, incur new indebtedness, engage in new business ventures, or complete significant acquisitions or divestitures. On April 26, 2004, United Agri Products commenced a tender offer and consent solicitation with respect to all its outstanding $225.0 million aggregate principal amount of 8 % Senior Notes. Upon receipt of the requisite consents, the company will execute a supplemental indenture with respect to the 8 % Senior Notes, with effectiveness subject to the consummation of the Tender Offers. In addition, on April 26, 2004, UAP Holdings commenced a tender offer and consent solicitation with respect to all of its outstanding $125.0 million aggregate principal amount at maturity of 10 % Senior Discount Notes. Upon receipt of the requisite consents, the company will execute a supplemental indenture with respect to the 10 % Senior Discount Notes, with effectiveness subject to the consummation of the Tender Offers. Net interest paid was $5.0 million and $1.6 million in fiscal 2002 and 2003, respectively. Net interest paid was $0.3 million and $.9 million for the thirty-nine week period ended November 23, 2003 and the thirteen-week period ended February 22, 2004, respectively. United Agri Products, Inc. $ 1.00 1,000 1,000 AG-CHEM, INC. $ 1.00 100,000 1,000 Balcom Chemicals, Inc. $ 1.00 500,000 97,756 CAG 23, Inc. $ 1.00 10,000 1,000 Cropmate Company $ 1.00 10,000 1,000 CSK Enterprises, Inc. $ 1.00 10,000 1,000 GAC 26, Inc. $ 1.00 10,000 1,000 CAG 27, Inc. $ 1.00 1,000 1,000 Genmarks, Inc. $ 1.00 1,000 1,000 Grower Service Corporation (NY) None 1,000 700 HACCO, Inc. $ 1.00 56,000 1,000 HACO, Inc. $ 1.00 10,000 1,000 Hess & Clark, Inc. $ 1.00 750 500 Loveland Industries, Inc. $ 1.00 250,000 81,372 Loveland Products, Inc. (f/k/a Dartec, Inc.) $ 1.00 10,000 1,000 Midwest Agriculture Warehouse Co. $ 100.00 2,000 1,491 Ostlund Chemical Co. $ 1.00 200,000 40,000 Platte Chemical Co. $ 1.00 100,000 80,000 Pueblo Chemical & Supply Co. None 49,000 2,139 Ravan Products, Inc. $ 1.00 10,000 100 S.E. Enterprises, Inc. $ 1.00 10,000 1,000 Snake River Chemicals, Inc. None 100,000 31,010 Transbas, Inc. None 1,000 500 Tri-River Chemical Company, Inc. None 50,000 40,069 Tri-State Chemicals, Inc. None 100,000 11,242 Tri-State Delta Chemicals, Inc. $ 1.00 100,000 100,000 UAP Receivables Corporation $ 1.00 1,000 1,000 UAP/CAG 22, Inc. $ 1.00 1,000 1,000 UAP/GA AG CHEM, INC. $ 1.00 1,000 1 UAP/LP, Inc. $ 1.00 10,000 1,000 United Agri Products - Florida, Inc. $ 1.00 10,000 5,000 United Agri Products Financial Services, Inc. None 50,000 16,451 Verdicon, Inc. $ 1.00 1,000 1,000 YVC, Inc. None 100,000 16,230 2326396 Canada, Inc. (f/k/a Swift Meats Poultry & Feed Co. Ltd) None Unlimited 1 The company had letters of credit outstanding at February 22, 2004 of $27.8 million. The company is a party to a number of lawsuits and claims arising out of the operation of its businesses. After taking into account liabilities recorded management believes the ultimate resolution of such matters should not have a material adverse effect on the company s financial condition, results of operations or liquidity. 11. Employee Benefit Plans Successor Plans The Company assumed the plan assets and obligations of the UAP Canadian pension plan as reported under the Predecessor Entity. As part of the acquisition, benefits due to employees who participated in the ConAgra Foods Pension Plan have been frozen as of the date of the acquisition. Components of the Canadian pension plan are reported below. In addition, the Company has a defined contribution plan for all employees. The Company will match 67% of the each employee s first 6% contribution to the plan. In addition, the Company will make a contribution to the plan for each employee equal to 2% of their calendar year pay. At the Company s option, an additional 1% contribution may be made equally as a percentage of calendar-year payroll to each participant of the plan based on established Company profitability objectives. As part of the acquisition, a transition contribution will be made on an annual basis for five years to all employees over the age of 50 as of the acquisition date. Total contribution expense for the plan for the thirteen weeks ended February 22, 2004 is $0.7 million. Predecessor Retirement Pension Plans The Predecessor Entity had defined benefit retirement plans ( Plan ) for eligible salaried and hourly employees. Benefits are based on years of credited service and average compensation or stated amounts for each year of service. The Predecessor Entity funded these plans in accordance with the minimum and maximum limits established by law. Employees of the company also participate in defined benefit and defined contribution plans sponsored by ConAgra Foods. Actuarial Assumptions Discount rate 6.50 % 6.50 % Long-term rate of compensation increase 4.50 % 4.50 % No single customer accounted for more than 10% of net sales in 2002, 2003, the thirty-nine weeks ended November 23, 2003 or the thirteen weeks ended February 22, 2004. Net sales by geographical area are based on the location of the facility producing the sales. Long-lived assets consist of property, plant and equipment, net of depreciation and other assets. Long-lived assets by geographical area are based on location of facilities. 15. Guarantor/Non-guarantor Financial Information The 8 % Senior Notes due 2011 (the 8 % Senior Notes ) issued by the Company s wholly-owned subsidiary, United Agri Products, are fully and unconditionally guaranteed on a joint and several basis pursuant to guarantees by all of United Agri Products domestic subsidiaries (collectively, the Guarantors ), except as noted below. Each of United Agri Products direct and indirect subsidiaries is 100% owned by United Agri Products. The 8 % Senior Notes are not guaranteed by the Company, the Canadian distribution business and the Businesses Not Acquired (collectively, the Non-Guarantors ). The accompanying notes are an integral part of the financial statements. Basic $ 21.11 Diluted $ 19.60 Shares outstanding 1,208,450 Fully diluted weighted average shares outstanding 1,301,850 The accompanying notes are an integral part of the financial statements. The accompanying notes are an integral part of the financial statements. The Company has allocated the excess of the Acquisition cost over the fair value of the assets acquired and liabilities assumed to goodwill, trade names and other finite lived intangible assets, and has hired an independent third-party appraiser to assist the Company in its determination of fair value. The amount of other finite and indefinite lived intangible assets recognized in this acquisition were $7.5 million. The finite lived intangible assets, including trade names and customer lists, are being amortized over five years based on the estimated remaining useful lives of the intangible assets. Amortization expense for the Company was $0.4 million for the fourteen weeks ended May 30, 2004. As of May 30, 2004, Goodwill recognized in the Acquisition is $43.5 million and is not deductible for tax purposes. 2. Basis of Presentation and Accounting Policies Basis of presentation The Acquisition has been accounted for as a purchase business combination in accordance with Statement of Financial Accounting Standards ( SFAS ) No. 141, Business Combinations. Accounting principles generally accepted in the United States of America require the Company s operating results prior to the Acquisition to be reported as the results of the Predecessor for periods prior to November 24, 2003 in the historical financial statements. The Company s operating results subsequent to the Acquisition are presented as the Successor s results in the historical financial statements. The Successor s financial results are presented as of and for the fourteen-week period ended May 30, 2004 and as of the fiscal year ended February 22, 2004. The Predecessor s financial results are presented as of the thirteen-week period ended May 25, 2003. The results of operations for any fourteen- or thirteen-week period or for the periods presented for the Predecessor or Successor are not necessarily indicative of the results to be expected for other periods or the full fiscal year. Approximately 80% of the Company s net sales occur in the first 6 months of their fiscal year. Accordingly, the Company has presented the balance sheet as of May 25, 2003 for comparative purposes. Table of Contents UAP HOLDING CORP. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) For the Quarters Ended May 30, 2004 and May 25, 2003 columnar dollar amounts in thousands unaudited Unaudited Pro forma Balance Sheet for the Transactions The Unaudited Pro Forma Balance Sheet for the Transaction reflects the planned distributions to Apollo and certain members of management in connection with the Company s issuance of Income Deposit Securities ( IDSs ), separate senior subordinated notes and participating preferred stock.. Inventories Inventories consist primarily of chemicals, fertilizers and seed. The Company principally uses the lower of cost, determined using the first-in, first-out method, or market, to value its inventory. Vendor Rebates Receivables include vendor rebates which represent amounts due from suppliers on crop protection, seed and fertilizer products and are accrued when earned, which is typically at the time of the sale of the related product. Periodically, the Company revisits the methodology to estimate monthly rebates to incorporate the most detailed information available. Long Lived Assets and Intangible Assets Property, plant and equipment are carried at cost. Depreciation has been calculated using primarily the straight-line method over the estimated useful lives of the respective classes of assets as follows: Land improvements 1 - 40 years Buildings 15 - 40 years Machinery and equipment 3 - 20 years Furniture, fixtures, office equipment and other 5 - 15 years The Company reviews long-lived assets for impairment whenever events or changes in business circumstances indicate that the carrying amount of the assets may not be fully recoverable. Recoverability of an asset held-for-use is determined by comparing the carrying amount of the asset to the undiscounted net cash flows expected to be generated from the use of the asset. If the carrying amount is greater than the undiscounted net cash flows expected to be generated by the asset, the asset s carrying amount is reduced to its fair market value. An asset held-for-sale is reported at the lower of the carrying amount or fair market value, less cost to sell. Income Taxes The Company recognizes deferred tax assets and liabilities based on the differences between the financial statement and tax bases of assets and liabilities at each balance sheet date using enacted tax rates expected to be in effect in the year the differences are expected to reverse. Prior to the Acquisition, income taxes were paid by the Company s parent on a consolidated level as the Company was included in the consolidated tax returns of ConAgra Foods. The provision for income taxes was computed on a separate legal entity basis. As of February 22, 2004, the Company had a net operating loss of $18,293 which will likely be used in the current fiscal year. Fair Values of Financial Instruments Unless otherwise specified, the Company believes the carrying amount of financial instruments approximates their fair value. Revenue Recognition Revenue is recognized when title and risk of loss are transferred to customers upon delivery based on terms of sale. Revenue is recognized as the net amount to be received after deducting estimated amounts for discounts, trade allowances and product returns. Earnings per Share Earnings per share is based on the weighted average number of shares of common stock outstanding during the period. The weighted average number of shares outstanding for basic and diluted earnings per share for fourteen weeks ended May 30, 2004 was 1,208,450 and 1,301,850, respectively. Stock-Based Compensation Successor Stock Plan The options issued under this plan had no determinable value as of the date of grant, and approximated the exercise price. Foreign Currency Translation The translation of foreign currency into U.S. dollars is performed for balance sheet accounts using the current exchange rate in effect at the balance sheet date and for revenue and expense accounts using the average exchange rate during the period. The gains or losses resulting from translation are included in stockholder s equity. Exchange adjustments resulting from foreign currency transactions are generally recognized in earnings. For the fourteen weeks ended May 30, 2004, the loss on foreign currency was $597,000. Comprehensive Income Comprehensive income consists of net income and foreign currency translation adjustments. The Company deems its foreign investments to be permanent in nature and does not provide for taxes on currency translation adjustments arising from converting the investment in a foreign currency to U.S. dollars. There are no reclassification adjustments to be reported in the periods presented. Accounting Changes In June 2001, the FASB approved the issuance of SFAS No. 141, Business Combinations, and SFAS No. 142, Goodwill and Other Intangible Assets. These standards, issued in July 2001, establish accounting and reporting requirements for business combinations. SFAS No. 141 requires all business combinations entered into subsequent to June 30, 2001, to be accounted for using the purchase method of accounting. SFAS No. 142 provides that goodwill and other intangible assets with indefinite lives will not be amortized, but will be tested for impairment on an annual basis. The company adopted SFAS No. 142 at the beginning of fiscal 2003. Table of Contents UAP HOLDING CORP. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) For the Quarters Ended May 30, 2004 and May 25, 2003 columnar dollar amounts in thousands unaudited In connection with the Acquisition, United Agri Products entered into its existing five-year $500.0 million asset-based revolving credit facility. The existing revolving credit facility also provides for a $20.0 million revolving credit sub-facility for UAP Canada, a $50.0 million letter of credit sub-facility, a $25.0 million swingline loan sub-facility and a $25.0 million in-season over-advance sub-facility. The interest rates with respect to revolving loans under the existing revolving credit facility are based, at United Agri Products option, on either the agent s index rate plus an applicable index margin of 1.50% or upon LIBOR plus an applicable LIBOR margin of 2.75%. The interest rates with respect to in-season overadvances under the existing revolving credit facility are based, at United Agri Products option, on either the agent s index rate plus an applicable index margin of 2.75% or upon LIBOR plus an applicable LIBOR margin of 4.00%. These applicable margins are in each case subject to prospective reduction on a quarterly basis (other than the margins on in-season overadvances) if we reduce our ratio of funded debt to EBITDA (on a consolidated basis). Overdue principal, interest and other amounts will bear interest at a rate per annum equal to the rate otherwise applicable thereto plus an additional 2.0%. The obligations under the existing revolving credit facility are (or, in the case of future subsidiaries, will be) guaranteed by UAP Holdings and each of its existing and future direct and indirect U.S. subsidiaries. The obligations under the existing revolving credit facility are secured by a first priority lien on, or security interest in, subject to certain exceptions, substantially all of UAP Holdings , United Agri Products and UAP Canada s properties and assets and the properties and assets of each of the guarantors. The existing revolving credit facility contains customary representations, warranties and covenants and events of default. As of May 30, 2004, United Agri Products had drawn on its revolving credit facility in the amount of $42.0 million. The Company s credit agreements include a minimum EBITDA requirement of $70.0 million as measured on a twelve month rolling period. The Company is also required to maintain a Fixed Charge Coverage Ratio of not less than 1.1 to 1.0, measured on the last day of each month for the trailing twelve months then ended. The credit agreements also contain certain negative covenants which may restrict the Company s ability to, among other items, incur new indebtedness, engage in new business ventures, or complete significant acquisitions or divestitures. On April 26, 2004, United Agri Products commenced a tender offer and consent solicitation with respect to all its outstanding $225.0 million aggregate principal amount of 8 % Senior Notes in connection with, and contingent upon, a proposed equity and debt offering. As of May 10, 2004, United Agri Products had received the requisite consents with respect to the 8 % Senior Notes. As of the date hereof, all $225.0 million aggregate principal amount of the 8 % Senior Notes have been validly tendered and have not been withdrawn in the tender offer, and United Agri Products has executed a supplemental indenture with respect to the 8 % Senior Notes, with effectiveness subject to consummation of the tender offer. In addition, on April 26, 2004, UAP Holdings commenced a tender offer and consent solicitation with respect to all of its outstanding $125.0 million aggregate principal amount at maturity of 10 % Senior Discount Notes in connection with, and contingent upon, a proposed equity and debt offering. As of May 10, 2004, UAP Holdings had received the requisite consents with respect to the 10 % Senior Discount Notes. As of the date hereof, all $125.0 million aggregate principal amount at maturity of the 10 % Senior Discount Notes have been validly tendered and have not been withdrawn in the tender offer, and UAP Holdings has executed a supplemental indenture with respect to the 10 % Senior Discount Notes, with effectiveness subject to consummation of the tender offer. Cash interest paid was $0.9 million and $0.3 million for the fourteen-week period ended May 30, 2004 and the thirteen-week period ended May 25, 2003, respectively. The Company had letters of credit outstanding at May 30, 2004 of $27.8 million. The Company is a party to a number of lawsuits and claims arising out of the operation of its businesses. After taking into account liabilities recorded management believes the ultimate resolution of such matters should not have a material adverse effect on the Company s financial condition, results of operations or liquidity. 9. Employee Benefit Plans Successor Plans The Company assumed the plan assets and obligations of the UAP Canadian pension plan as reported under the Predecessor entity. As part of the Acquisition, benefits due to employees who participated in the ConAgra Foods Pension Plan have been frozen as of the date of the Acquisition. The Company pays $0.0595 per payroll dollar. In addition, the Company has a defined contribution plan for all employees. The Company will match 67% of each employee s first 6% contribution to the plan. In addition, the Company will make a contribution to the plan for each employee equal to 2% of their calendar year pay. At the Company s option, an additional 1% contribution may be made equally as a percentage of calendar-year payroll to each participant of the plan based on established Company profitability objectives. As part of the Acquisition, a transition contribution will be made on an annual basis for five years to all employees over the age of 50 as of the Acquisition date. Total contribution expense for the plan for the fourteen weeks ended May 30, 2004 is $1.5 million. Table of Contents UAP HOLDING CORP. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) For the Quarters Ended May 30, 2004 and May 25, 2003 columnar dollar amounts in thousands unaudited No single customer accounted for more than 10% of net sales for the 14 weeks ended May 30, 2004 or the 13 weeks ended May 25, 2003. Net sales by geographical area are based on the location of the facility producing the sales. Long-lived assets consist of property, plant and equipment, net of depreciation and other assets. Long-lived assets by geographical area are based on location of facilities. 12. Guarantor/Non-guarantor Financial Information The 8 % Senior Notes due 2011 (the 8 % Senior Notes ) issued by the Company s wholly-owned subsidiary, United Agri Products, are fully and unconditionally guaranteed on a joint and several basis pursuant to guarantees by all of United Agri Products domestic subsidiaries (collectively, the Guarantors ), except as noted below. Each of United Agri Products direct and indirect subsidiaries is 100% owned by United Agri Products. The 8 % Senior Notes are not guaranteed by the Company, the Canadian distribution business and the Businesses Not Acquired (collectively, the Non-Guarantors ). The terms of the indenture governing the senior subordinated notes offered hereby will restrict the Company s ability to declare and pay dividends on its capital stock. In addition, United Agri Products amended and restated revolving credit facility and United Agri Products new senior secured second lien term loan facility will restrict the Company s ability to pay interest on the senior subordinated notes and to declare and pay dividends on its capital stock; such facilities will also restrict the Company s subsidiaries from paying dividends, making loans or other distributions and otherwise transferring assets to the Company. Condensed consolidated financial information for the Guarantor and Non-Guarantors is as follows: See notes to the consolidated financial statements. Basic and diluted earnings per share $ 8.04 Weighted average shares outstanding 1,200,000 See notes to the consolidated financial statements. See notes to the consolidated financial statements. (1) Bad debts charged off, less recoveries.
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+RISK FACTORS In addition to the other information contained in this prospectus, the following factors should be considered carefully before investing in our common stock. If any of the following risks actually occur, our business, results of operations or financial condition would likely suffer. RISKS RELATING TO THE COMMON STOCK AND THIS OFFERING Our equity sponsor controls us and its interests may conflict with or differ from your interests as a stockholder. Our equity sponsor, as the principal selling stockholder, will realize substantial benefits from the sale of shares in this offering. After the consummation of this offering, our equity sponsor will beneficially own approximately 49.7% of our common stock, assuming the underwriters do not exercise their over-allotment option. If the underwriters exercise in full their over-allotment option, our equity sponsor will beneficially own approximately 42.8% of our common stock. In addition, representatives of our equity sponsor will occupy four of the seven seats on our board of directors. As a result, our equity sponsor will have the ability to prevent any transaction that requires the approval of our board of directors and will have the ability to substantially influence all matters requiring stockholder approval, including the election of our directors and the approval of significant corporate transactions such as mergers, tender offers and the sale of substantially all of our assets. For example, the approval of two-thirds of the members of our board of directors will be required by our amended and restated certificate of incorporation under certain circumstances including, without limitation, amendments to our organizational documents in a manner that adversely affects Apollo. These provisions shall terminate at such time as affiliates of Apollo no longer beneficially own at least one-third of our outstanding common stock and have sold at least one share of our common stock other than in this offering. See Management Supermajority Board Approval of Certain Matters beginning on page 64. The interests of our equity sponsor and its affiliates could conflict with or differ from your interests as a holder of our common stock. For example, the concentration of ownership held by our equity sponsor could delay, defer or prevent a change of control of our company or impede a merger, takeover or other business combination which you as a stockholder, may otherwise view favorably. Our equity sponsor may also pursue acquisition opportunities that may be complementary to our business, and as a result, those acquisition opportunities may not be available to us. Further, our equity sponsor will realize substantial benefits from the sale of their shares in this offering. A sale of a substantial number of shares of stock in the future by funds affiliated with our equity sponsor could cause our stock price to decline in the future. Our common stock price may be volatile. Prior to this offering, there has been no public market for our common stock. We cannot predict the extent to which investor interest will lead to the development of an active and liquid trading market in our common stock. The initial public offering price for our shares of common stock will be determined by negotiations among us, the selling stockholders and the representatives of the underwriters and may not be indicative of the market price of the common stock that will prevail in the trading market. The market price of the common stock may decline below the initial public offering price. Some companies that have had volatile market prices for their securities have had securities class action suits filed against them. If a suit were to be filed against us, regardless of the outcome, it could result in substantial costs and a diversion of management s attention and resources. This could have a material adverse effect on our business, results of operations and financial condition. Our common stock price may fluctuate in response to a number of events, including: our quarterly operating results. weather conditions that impact demand for our products and services. future announcements concerning our business. changes in financial estimates and recommendations by securities analysts. actions of competitors. market and industry perception of our success, or lack thereof, in pursuing our growth strategy. Proceeds to Selling Stockholders Table of Contents changes in government and environmental regulation. general market, economic and political conditions. natural disasters, terrorist attacks and acts of war. You may not receive the intended level of dividends on our common stock or any dividends at all. We currently intend to pay quarterly cash dividends on our common stock at an annual rate of $0.50 per share. However, dividend payments are not mandatory or guaranteed, and our board of directors may never declare a dividend, decrease the level of dividends or entirely discontinue the payment of dividends. Your decision whether to purchase shares of our common stock should allow for the possibility that no dividends will be paid. You may not receive any dividends as a result of the following factors, among others: we are not legally or contractually required to pay dividends; while we currently intend to pay a regular quarterly dividend, this policy could be modified or revoked at any time; even if we do not modify or revoke our dividend policy, the actual amount of dividends distributed and the decision to make any distribution is entirely at the discretion of our board of directors and future dividends with respect to shares of our capital stock, if any, will depend on, among other things, our results of operations, cash requirements, financial condition, business opportunities, provisions of applicable law and other factors that our board of directors may deem relevant; the amount of dividends distributed is and will be subject to contractual restrictions under: the indentures governing the 8 % Senior Notes and the 10 % Senior Discount Notes, the terms of our revolving credit facility, and the terms of any other outstanding indebtedness incurred by us or any of our subsidiaries after the completion of this offering; the amount of dividends distributed is subject to state law restrictions; and our stockholders have no contractual or other legal right to dividends. The terms of our revolving credit facility and the indentures governing the 8 % Senior Notes and the 10 % Senior Discount Notes will prohibit us from paying cash dividends on our common stock if a default or event of default has occurred and is continuing under those agreements. The payment of a cash dividend on our common stock is considered a restricted payment under our revolving credit facility and the indentures, and we are restricted from paying any cash dividend on our common stock unless we satisfy certain conditions. See Description of Capital Stock Common Stock on page 96, Description of Certain Indebtedness 8 % Senior Notes Covenants on page 91 and Description of Certain Indebtedness 10 % Senior Notes Covenants on page 93. Furthermore, we will be permitted under the terms of our debt agreements to incur additional indebtedness that may severely restrict or prohibit the payment of dividends. We cannot assure you that the agreements governing our current and future indebtedness will permit us to pay dividends on our common stock. We may not generate sufficient earnings or have sufficient liquidity to pay dividends at intended levels. As previously mentioned, we currently intend to declare and pay regular quarterly cash dividends on our common stock. Any payment of cash dividends will depend upon our financial condition, earnings and liquidity, among other things. There can be no assurance that we will have sufficient cash in the future to pay dividends on our common stock in the intended amounts or at all. In the past, cash flow provided by our operating activities has been highly variable, resulting in negative net cash flow during certain periods. Because of this variability, we may have to rely on cash provided by financing activities to fund dividend payments, and such financing may or may not be available. If we were to use working capital or permanent borrowings to fund dividends, we would have less cash available for future dividends and other purposes, which could negatively impact our financial condition, our results of operations and our ability to maintain or expand our business. Per Share $ $ $ $ Total $ $ $ $ The underwriters expect to deliver the shares against payment in New York, New York on , 2004. Goldman, Sachs & Co. Credit Suisse First Boston UBS Investment Bank Merrill Lynch & Co. William Blair & Company CIBC World Markets Prospectus dated , 2004. Table of Contents Future sales or the possibility of future sales of a substantial amount of our common stock may depress the price of shares of our common stock. Future sales or the availability for sale of substantial amounts of our common stock in the public market could adversely affect the prevailing market price of our common stock and could impair our ability to raise capital through future sales of equity securities. Upon consummation of this offering, there will be 50,373,244 shares of our common stock outstanding. All shares of common stock sold in this offering will be freely transferable without restriction or further registration under the Securities Act of 1933, as amended (the Securities Act ). The remaining 26,935,744 shares of common stock outstanding, including the shares owned by our equity sponsor, will be restricted securities within the meaning of Rule 144 under the Securities Act, but will be eligible for resale subject to applicable volume, manner of sale, holding period and other limitations of Rule 144. We and the selling stockholders have agreed to a lock-up, pursuant to which neither we nor they will sell any shares without the prior consent of Goldman, Sachs & Co. for 180 days after the date of this prospectus. Following the expiration of the applicable lock-up period, all these shares of our common stock will be eligible for future sale, subject to the applicable volume, manner of sale, holding period and other limitations of Rule 144. In addition, our selling stockholders have certain registration rights with respect to the common stock that they will retain following this offering. See Shares Eligible for Future Sale beginning on page 102 for a discussion of the shares of common stock that may be sold into the public market in the future. We may issue shares of our common stock or other securities from time to time as consideration for future acquisitions and investments. If any such acquisition or investment is significant, the number of shares of our common stock, or the number or aggregate principal amount, as the case may be, of other securities that we may issue may in turn be substantial. We may also grant registration rights covering those shares of our common stock or other securities in connection with any such acquisitions and investments. Our organizational documents may impede or discourage a takeover, which could deprive our investors of the opportunity to receive a premium for their shares. Provisions of our amended and restated certificate of incorporation and bylaws may make it more difficult for, or prevent a third party from, acquiring control of us without the approval of our board of directors. These provisions include: a classified board of directors; the sole power of a majority of the board of directors to fix the number of directors; limitations on the removal of directors; the ability of our board of directors to designate one or more series of preferred stock and issue shares of preferred stock without stockholder approval; the inability of stockholders to act by written consent; advance notice requirements for nominating directors or introducing other business to be conducted at stockholder meetings; and the requirement to obtain approval of two-thirds of our directors to approve certain transactions, including a merger. The foregoing factors could impede a merger, takeover or other business combination or discourage a potential investor from making a tender offer for our common stock, which, under certain circumstances, could reduce the market value of our common stock. Such provisions also may have the effect of preventing changes in our management. See Description of Capital Stock beginning on page 96. Table of Contents Table of Contents You will suffer an immediate and substantial dilution in the net tangible book value of the common stock you purchase. Some prior investors have paid substantially less per share than the price in this offering. The initial offering price is expected to be substantially higher than the net tangible book value per share of the outstanding common stock immediately after this offering. Accordingly, based on an assumed initial public offering price of $16.00 per share (the midpoint of the range set forth on the cover page of this prospectus), purchasers of common stock in this offering will experience immediate and substantial dilution of approximately $14.86 per share in net tangible book value of the common stock. In addition, as of August 29, 2004, there were options outstanding to purchase 3,418,162 shares of common stock, each at an exercise price of approximately $2.56 per share. If all these options were exercised on the date of the closing of this offering, investors purchasing shares in this offering would suffer total dilution of $14.77 per share. See Dilution beginning on page 23. RISKS RELATING TO OUR BUSINESS UAP Holdings is a holding company and we will rely on our subsidiaries for cash to pay dividends on our common stock. UAP Holdings has no direct operations and no significant assets other than ownership of 100% of the stock of United Agri Products. Because UAP Holdings conducts its operations through its subsidiaries, UAP Holdings depends on those entities for dividends and other payments to generate the funds necessary to meet its financial obligations and to pay dividends with respect to the common stock. Legal and contractual restrictions in the revolving credit facility and other agreements governing current and future indebtedness of UAP Holdings subsidiaries, as well as the financial condition and operating requirements of UAP Holdings subsidiaries, may limit UAP Holdings ability to obtain cash from its subsidiaries. All of UAP Holdings subsidiaries are separate and independent legal entities and have no obligation whatsoever to pay any dividends, distributions or other payments to UAP Holdings. Our and our customers businesses are subject to seasonality and this may affect our revenues, carrying costs and collection of receivables. Our and our customers businesses are seasonal, based upon the planting, growing and harvesting cycles, and the inherent seasonality of the industry we serve could have a material adverse effect on our business. During fiscal 2002, 2003 and 2004, at least 75% of our net sales occurred during the first and second fiscal quarters of each year because of the condensed nature of the planting season. Since interim period operating results reflect the seasonal nature of our business, they are not indicative of results expected for the full fiscal year. In addition, quarterly results can vary significantly from one year to the next due primarily to weather-related shifts in planting schedules and purchase patterns. We incur substantial expenditures for fixed costs throughout the year and substantial expenditures for inventory in advance of the spring planting season. Seasonality also relates to the limited windows of opportunity that our customers have to complete required tasks at each stage of crop cultivation. Should events such as adverse weather or transportation interruptions occur during these seasonal windows, we would face the possibility of reduced revenue without the opportunity to recover until the following season. In addition, because of the seasonality of agriculture, we face the risk of significant inventory carrying costs should our customers activities be curtailed during their normal seasons. The seasonality of our industry can also affect the amount of bad debt that may result on our books and can negatively impact our accounts receivable collections. See Management s Discussion and Analysis of Financial Condition and Results of Operations Seasonality beginning on page 36. Weather conditions may materially impact the demand for our products and services. Weather conditions have a significant impact on the farm economy and, consequently, on our operating results. Weather conditions affect the demand for, and in some cases the supply of, products, which, in turn, has Table of Contents Table of Contents an impact on our prices. For example, weather patterns such as flood, drought or frost can cause crop failures that in turn affect the supply of feed and seed and the marketing of grain products, as well as the demand for fertilizer, crop protectants, seeds and other agronomic supplies. In recent years, we have experienced unusually severe weather conditions, including ice storms, floods and wind damage, and a summer dearth of water and pasture in some states. Adverse weather conditions can also impact the financial position of agricultural producers who do business with us, including producers to whom we extend credit. This, in turn, may adversely affect the ability of those producers to repay their obligations to us in a timely manner, or at all. Accordingly, the weather can have a material effect on our business, financial condition, results of operations and liquidity. Our substantial indebtedness could adversely affect our financial condition and impair our ability to operate our business or pay dividends on our common stock. As of August 29, 2004, we had $493.1 million of outstanding indebtedness, including approximately $180.3 million under the revolving credit facility, $225.0 million of the 8 1/4% Senior Notes and $87.8 million of the 10 3/4% Senior Discount Notes. As a result, we are a highly leveraged company and will continue to be highly leveraged following the consummation of this offering. This level of leverage could have important consequences, including the following: It may limit our ability to borrow money or sell stock to fund our working capital, capital expenditures and debt service requirements. It may limit our flexibility in planning for, or reacting to, changes in our business. We may be more highly leveraged than some of our competitors, which may place us at a competitive disadvantage. It may make our financial results more vulnerable to a downturn in our business or the economy. It will require us to dedicate a substantial portion of our cash flow from operations to the repayment of our indebtedness, thereby reducing the availability of our cash flow for other purposes, such as payments of dividends on our common stock. It may materially and adversely effect our business and financial condition if we are unable to service our indebtedness or obtain additional financing, as needed. In addition, the indenture governing the 8 1/4% Senior Notes, the indenture governing the 10 3/4% Senior Discount Notes and the revolving credit facility contain financial and other restrictive covenants discussed below that may limit or ability to engage in activities that may be in our long-term best interests. Our failure to comply with those covenants could result in an event of default which, if not cured or waived, could result in the acceleration of all of our debt. Restrictive covenants in the agreements governing our indebtedness may restrict our ability to pursue our business strategies or pay dividends on our common stock. The revolving credit facility, the indenture governing the 8 1/4% Senior Notes and the indenture governing the 10 3/4% Senior Discount Notes limit our ability and the ability of our restricted subsidiaries, among other things, to: incur additional indebtedness or contingent obligations; pay dividends or make distributions to our stockholders; repurchase or redeem our stock; make investments; TABLE OF CONTENTS Page Table of Contents grant liens; make capital expenditures; enter into transactions with our stockholders and affiliates; sell assets; and acquire the assets of, or merge or consolidate with, other companies. In addition, the revolving credit facility requires us to maintain an interest coverage ratio and minimum EBITDA (as defined in our revolving credit facility), if revolving credit availability drops below $40.0 million. Although we have historically always been able to maintain this financial ratio and minimum EBITDA, we may not be able to maintain this ratio and minimum EBITDA in the future. Covenants in the revolving credit facility may also impair our ability to finance future operations or capital needs or to enter into acquisitions or joint ventures or engage in other favorable business activities. If we default under the revolving credit facility under certain circumstances, the lenders could require immediate payment of the entire principal amount. These circumstances include, among other things, a change of control, default under agreements governing our other indebtedness, material judgments in excess of a specified amount or breach of representations and warranties. Any default under the revolving credit facility or agreements governing our other indebtedness could lead to an acceleration of debt under our other debt instruments that contain cross-acceleration or cross-default provisions. If the lenders under the revolving credit facility require immediate repayment, we will not be able to repay them and also repay our other indebtedness in full. Our ability to comply with these covenants and restrictions contained in the revolving credit facility and other agreements governing our other indebtedness may be affected by changes in the economic or business conditions or other events beyond our control. Our industry is very competitive and increased competition could reduce our sales and profit margins. We operate in a highly competitive industry, particularly with respect to price and service. Our principal competitors in the distribution of crop production inputs include agricultural cooperatives, national fertilizer producers, major grain companies and independent distributors and brokers. Some of our competitors have greater financial, marketing and research and development resources, or better name recognition, than we do and can better withstand adverse economic or market conditions. In addition, as a result of increased pricing pressures caused by competition, we may experience reductions in the profit margins on sales, or may be unable to pass future material price increases on to our customers, which would also reduce profit margins. Our success depends on a limited number of key employees and we may not be able to adequately replace them if they leave. We believe that the success of our business strategy and our ability to operate profitably depend on the continued employment of our senior management team. The loss of the services of some of these key employees could have a material adverse effect on us. See Management beginning on page 62. Government regulation and agricultural policy may affect the demand for our products, and therefore our financial viability. Existing and future government regulations and laws may greatly influence how we operate our business, our business strategy and, ultimately, our financial viability. Existing and future laws may impact the amounts and locations of fertilizer and pesticide applications. The federal Clean Water Act and the equivalent state and local water pollution control laws are designed to protect water quality. The application of fertilizer and pesticides have been identified as a source of water pollution and are currently regulated and may be more closely regulated in the future. This regulation may lead to decreases in the quantity of fertilizer and pesticides Pension Benefit Cost Service cost $ 180 $ 217 $ 165 $ 55 Interest cost 111 140 126 42 Expected return on plan assets (170 ) (159 ) (124 ) (41 ) Recognized net actuarial loss 21 49 Table of Contents applied to crops. The application of fertilizers can also result in the emissions of nitrogen compounds and particulate matter to the air. Compliance with future requirements to limit these emissions under the federal Clean Air Act and state equivalents may affect the quantity of fertilizer used by our customers. U.S. governmental policies and regulations may directly or indirectly influence the number of acres planted, the level of inventories, the mix of crops planted, crop prices and the amounts of and locations where fertilizers and pesticides may be applied. The market for our products could also be affected by challenges brought under the Endangered Species Act and by changes in regulatory policies affecting genetically modified seeds. We are subject to expenses, claims and liabilities under environmental, health and safety laws and regulations. We operate in a highly regulated environment. As a producer and distributor of crop production inputs, we must comply with federal, state and local environmental, health and safety laws and regulations. These regulations govern our operations and our storage, handling, discharge and disposal of a variety of substances. Our operations are regulated at the federal level under the Clean Air Act, the Clean Water Act, the Resource Conservation and Recovery Act, the Occupational Safety and Health Act, and at the state level under analogous state laws and regulations. As a formulator, seller and distributor of crop production inputs, we are also subject to registration requirements under the Federal Insecticide, Fungicide, and Rodenticide Act and related state statutes, which require us to provide information to regulatory authorities regarding the benefits and risks of the products we sell and distribute, and to update that information. Risk information supplied to governmental authorities by us or others could result in the cancellation of products or in limitations on their use. In addition, these laws govern information contained in product labels and in promotional materials, require that products are manufactured in adherence to manufacturing specifications, and impose reporting and recordkeeping requirements relating to production and sale of certain pesticides. Non-compliance with these environmental, health and safety laws can result in significant fines or penalties or restrictions on our ability to sell or transport products. Under the Comprehensive Environmental Response, Compensation and Liability Act of 1980, we could be held jointly and severally responsible for the removal or remediation of any hazardous substance contamination at facilities that we currently own or operate, at facilities that we owned or operated in the past, at neighboring properties to which such contamination has migrated from our facilities, and at third party waste disposal sites to which we have sent wastes. We could also be held liable for natural resource damages. We may incur substantial costs to comply with these environmental, health and safety law requirements. We may also incur substantial costs for liabilities arising from past releases of, or exposure to, hazardous substances. From time to time claims have been made against us for consequences arising out of human exposure to these substances or other damage, including property damages. Currently, four such claims are pending in relation to our Greenville, Mississippi facility. In addition, we may discover currently unknown environmental problems or conditions. The continued compliance with environmental laws, the discovery of currently unknown environmental problems or conditions, changes in environmental, health and safety laws and regulations or other unanticipated events may subject us to material expenditures or liabilities in the future. Our profitability depends significantly on rebates from our vendors. If we are unsuccessful in earning, negotiating or collecting rebates, it could have an adverse impact on our business. We receive rebates from crop protection chemicals and seed vendors based on programs offered by our suppliers to all of their customers. The programs vary based on product type and specific vendor practice. The majority of the rebate programs run on a crop year basis, typically from October 1st to September 30th, although other periods are sometimes utilized. The majority of these rebates are product-specific and are based on our sales of that product in a given crop year. We also negotiate individually with our vendors for additional rebates after the conclusion of the crop year and often several months after we have purchased and sold the products for Table of Contents which we are negotiating rebates. These individually negotiated rebates are based on various goals, such as our ability to grow sales of a particular vendor s products at a faster rate than that vendor s aggregate growth in sales for the same year, as well as increasing the percentage of our aggregate sales represented by a vendor s product line as compared with our sales of the vendor s competitors product lines and rebates in response to lower prices from a vendor s competitors. Our ability to earn, negotiate and collect rebates is critical to the success of our business. Generally, we sell the crop protection chemicals and seed we purchase from vendors at a reduced margin, with the profit from any sales of such products being made primarily from rebates from vendors. We price our products to our customers based on the amount of rebates we expect to receive at year-end. However, the amount of rebates we earn and the nature of our rebate programs are determined by our vendors and are directly related to the performance of our business. If our sales in any crop year are lower than expected, either because of poor weather conditions, increased competition or for any other reason, we will earn fewer rebates, and our gross margins may suffer. Additionally, our vendors may reduce the amount of rebates offered under their programs, or increase the sales goals or other conditions we must meet to earn rebates to levels that we cannot achieve. Finally, our ability to negotiate individually for additional rebates may cease or become limited, and our efforts to collect cash rebates periodically throughout the year may be unsuccessful. The occurrence of any of these events could have an adverse impact on our margins, net income or business. You should rely only on the information contained in this document or to which we have referred you. We have not authorized anyone to provide you with information that is different. This document may only be used where it is legal to sell these securities. Table of Contents DISCLOSURE REGARDING FORWARD-LOOKING STATEMENTS This prospectus includes forward-looking statements that involve risks and uncertainties. Forward-looking statements include statements concerning our plans, objectives, goals, strategies, future events, future revenue or performance, capital expenditures, financing needs, plans or intentions relating to acquisitions, business trends and other information that is not historical information and, in particular, appear under the headings Prospectus Summary, Management s Discussion and Analysis of Financial Condition and Results of Operations and Business. When used in this prospectus, the words estimates, expects, anticipates, projects, plans, intends, believes, forecasts, foresees, likely, may, should, goal, target, and variations of such words or similar expressions are intended to identify forward-looking statements. All forward-looking statements are based upon information available to us on the date of this prospectus. These forward-looking statements are subject to risks, uncertainties and other factors, many of which are outside of our control, that could cause actual results to differ materially from the results discussed in the forward-looking statements, including, among other things, the matters discussed in this prospectus in the sections captioned: Prospectus Summary beginning on page 1, Risk Factors beginning on page 11, and Management s Discussion and Analysis of Financial Condition and Results of Operations beginning on page 35. Such factors may include: general economic and business conditions; industry trends; restrictions contained in our debt agreements; our substantial leverage, including the inability to generate the necessary amount of cash to service our existing debt and the incurrence of substantial indebtedness in the future; the seasonality of our business and weather conditions; the possibility of liability for pollution and other damage that is not covered by insurance or that exceeds our insurance coverage; increased competition in the markets in which we operate; our dependence on rebate programs to attain profitability; our dependence on a limited number of key executives who we may not be able to adequately replace if they leave our company; changes in government regulations, agricultural policy and environmental, health and safety laws and regulations; the cost of developing our own stand-alone systems and infrastructure; changes in business strategy, development plans or cost savings plans; the loss of any of our major suppliers or the bankruptcy or financial distress of our customers; the ability to attain and maintain any price increases for our products; availability, terms and deployment of capital; and other factors over which we have little or no control. There may be other factors that could cause our actual results to differ materially from the results referred to in the forward-looking statements. All forward-looking statements attributable to us or persons acting on our behalf apply only as of the date of this prospectus and are expressly qualified in their entirety by the cautionary statements included in this prospectus. We undertake no obligation to publicly update or revise forward-looking statements to reflect events or circumstances after the date made or to reflect the occurrence of unanticipated events. Table of Contents USE OF PROCEEDS Assuming an initial public offering price of $16.00 per share, which represents the mid-point of the range set forth on the cover page of this prospectus, our net proceeds from this offering are estimated to be approximately $47.0 million after deducting underwriting discounts and commissions. We intend to use the net proceeds from this offering as follows: approximately $16.4 million to redeem all our outstanding Series A Redeemable Preferred Stock from our former parent, ConAgra Foods; approximately $24.1 million to redeem $21.5 million principal amount of 8 1/4% Senior Notes at a redemption price of 108.25%, or approximately $23.2 million, plus accrued and unpaid interest to the date of redemption (which accrued interest we estimate to be approximately $0.9 million at the time of the closing of this offering); and approximately $6.5 million for estimated fees and expenses, with any balance to be used for general corporate purposes. We will not receive any proceeds for the sale of our common stock by the selling stockholders, including if the underwriters exercise the over-allotment option. In the aggregate, the selling stockholders and their affiliates will receive approximately $305.5 million of the net proceeds of this offering, or approximately $358.4 million if the underwriters over-allotment option is exercised in full. Table of Contents DIVIDEND POLICY We intend to pay quarterly cash dividends on our common stock at an annual rate of $0.50 per share. We intend to pay the first quarterly dividend following the thirteen-week period ending February 27, 2005. However, there can be no assurance that we will declare or pay any cash dividends. The declaration and payment of future dividends to holders of our common stock will be at the discretion of our board of directors and will depend upon many factors, including our financial condition, earnings, legal requirements, restrictions in our debt agreements and other factors our board of directors deems relevant. The terms of our indebtedness may also restrict us from paying cash dividends on our common stock under some circumstances. See Management s Discussion and Analysis of Financial Condition and Results of Operations Obligations and Commitments beginning on page 43, Description of Certain Indebtedness beginning on page 87, Description of Capital Stock Common Stock beginning on page 96. We paid a special dividend on our common stock on January 16, 2004 in the aggregate amount of approximately $52.9 million, which was financed with the proceeds of the offering of the 10 3/4% Senior Discount Notes. We paid another special dividend on our common stock on October 4, 2004 in the aggregate amount of $40.0 million, which was financed with borrowings under United Agri Products revolving credit facility. Otherwise, we have not paid any dividends on our capital stock. (1) Due to the seasonal nature of our business, the amount of borrowings outstanding under the revolving credit facility varies throughout the fiscal year. During the period from the date of the Acquisition through October 24, 2004, outstanding borrowings (net of cash on hand) reached a period end peak of $275.2 million as of October 24, 2004. During the same period, utilization of the revolving credit facility was at its lowest when we had $172.6 million of cash on hand as of February 22, 2004. Our average period end borrowings (net of cash on hand) on a historical basis for the twelve-month period ended October 24, 2004 were approximately $76.5 million. (2) Pro forma adjustment consists of $60.0 million of borrowings under the revolving credit facility that were used to fund the Special Dividends. (3) On October 4, 2004, we redeemed 18,683 shares of Series A redeemable preferred stock for approximately $20.0 million and paid a $40.0 million special dividend on our common stock. The remaining 15,254 shares of Series A redeemable preferred stock will be redeemed for approximately $16.4 million with a portion of the net proceeds from this offering. The redemption of 18,683 shares of Series A redeemable preferred stock and the special dividend are reflected in the pro forma financial statements. Income (loss) from continuing operations $ 9,653 $ 40,985 $ (10,645 ) $ 39,993 $ (1) Excludes 20,312,500 shares of our common stock to be sold by the selling stockholders to the new investors in the offering for which we will not receive any net proceeds. The tables above assume no exercise of stock options outstanding on August 29, 2004. As of August 29, 2004, there were options outstanding to purchase 3,418,162 shares of common stock, at an exercise price of approximately $2.56 per share. If all of these outstanding options had been exercised as of August 29, 2004, net tangible book value per share after this offering would have been $1.23 and total dilution per share to new investors would have been $14.77. Table of Contents UNAUDITED PRO FORMA CONDENSED CONSOLIDATED FINANCIAL DATA We derived the unaudited pro forma condensed consolidated financial data set forth below by the application of the pro forma adjustments to the historical consolidated financial statements of UAP Holding Corp. appearing elsewhere in this prospectus. The unaudited pro forma condensed consolidated balance sheet as of August 29, 2004 gives effect to this offering, including the application of the net proceeds therefrom, and the Special Dividends as if they had occurred on such date. The unaudited pro forma condensed consolidated statements of earnings for the fiscal year ended February 22, 2004, the twenty-seven weeks ended August 29, 2004 and the twelve months ended August 29, 2004 give effect to the Acquisition, this offering, including the application of the net proceeds therefrom, and the Special Dividends in each case, as if they occurred on February 24, 2003. The unaudited pro forma condensed consolidated financial data do not purport to represent what our results of operations or financial position would have been if the foregoing transactions had occurred as of the dates indicated or what such results will be for any future periods. The unaudited pro forma condensed consolidated financial data have been prepared giving effect to the Acquisition, which is accounted for in accordance with Statement of Financial Accounting Standards ( SFAS ) No. 141, Business Combinations. The unaudited pro forma adjustments are based upon available information and certain assumptions that we believe are reasonable. The unaudited pro forma condensed consolidated statements of earnings exclude certain non-recurring charges that will be incurred in connection with this offering, including the application of the net proceeds therefrom, consisting of (i) prepayment penalties associated with the repayment of a portion of our 8 1/4% Senior Notes of $1.8 million, (ii) write-off of deferred financing fees of $0.5 million associated with the repayment of a portion of our 8 1/4% Senior Notes and (iii) costs associated with the sale of common stock by our selling stockholders of $5.6 million. As a result of the Acquisition, inventory on hand at the date of the Acquisition was recorded at fair market value, which represented an increase in the recorded value of such inventory of $21.0 million. Cost of goods sold for the thirteen week period ended February 22, 2004, the twenty-seven week period ended August 29, 2004 and the twelve month period ended August 29, 2004 was increased by $3.7 million, $17.3 million, and $21.0 million, respectively, as a result of this fair value adjustment. As these expenses related directly to the Acquisition, we do not expect them to recur. You should read our unaudited pro forma condensed consolidated financial statements and the accompanying notes in conjunction with the historical consolidated financial statements and the accompanying notes thereto of UAP Holding Corp., the other financial information contained in Capitalization beginning on page 22 and Management s Discussion and Analysis of Financial Condition and Results of Operations beginning on page 35. Table of Contents SUMMARY UNAUDITED PRO FORMA CONDENSED CONSOLIDATED FINANCIAL AND OTHER DATA The summary unaudited pro forma condensed consolidated financial data of UAP Holding Corp. give effect, in the manner described under Unaudited Pro Forma Condensed Consolidated Financial Data beginning on page 24 and the notes thereto, to the Acquisition, this offering, including the application of the net proceeds therefrom, and the Special Dividends, in each case, as if they occurred on February 24, 2003 in the case of the unaudited pro forma statements of operations data, and as if they occurred on August 29, 2004 in the case of the unaudited pro forma balance sheet data. The unaudited pro forma financial data do not purport to represent what our results of operations or financial position would have been if the Acquisition, this offering and the Special Dividends had occurred on the dates indicated or what such results will be for future periods. The results of operations for the interim periods are not necessarily indicative of the operating results for the entire year or any future period. You should read the information contained in this table in conjunction with Unaudited Pro Forma Condensed Consolidated Financial Data beginning on page 24, Selected Historical Financial and Other Data beginning on page 32, Management s Discussion and Analysis of Financial Condition and Results of Operations beginning on page 35, and the historical combined financial statements and the accompanying notes thereto of UAP Holding Corp. included elsewhere in this prospectus. Pro Forma (dollars in thousands) Twenty-Seven Weeks Ended August 29, 2004 Existing stockholders 47,248,244 94 % 120,885,000 71 % $ 2.56 New investors (1) 3,125,000 6 % 50,000,000 (e) Represents amortization of intangible assets resulting from the Acquisition. Statement of Operations Data: Net sales $ 2,451,885 $ 1,962,470 $ 2,564,133 Costs and expenses: Cost of goods sold 2,108,740 1,719,714 2,240,119 Selling, general and administrative expenses 235,628 146,503 227,304 Corporate allocations Selling, general and administrative expenses 8,983 2,864 (m) Represents incremental decrease in interest on the 8 1/4% Senior Notes as a result of the redemption of $21.5 million principal amount of the 8 1/4% Senior Notes. (n) Upon consummation of the offering, Apollo will terminate its management consulting agreement. The agreement had called for a $1,000,000 fee payable in quarterly payments of $250,000. (o) Represents the effect of incremental interest expense associated with the $60 million of borrowings under the revolving credit facility used to fund the Special Dividends at 4.21% less the commitment fee of 0.25% on the unused portion of our revolving credit facility offset by the deduction for accrued preferred dividends on the Series A redeemable preferred stock redeemed at a rate per annum of 8%. Table of Contents SELECTED HISTORICAL FINANCIAL AND OTHER DATA The following table sets forth our selected historical financial data at the dates and for the periods indicated. We derived the selected historical statement of operations data for the fiscal years ended February 24, 2002, February 23, 2003 and the thirty-nine week period ended November 23, 2003, and balance sheet data at February 23, 2003 of the Predecessor and the selected historical statement of operations data for the thirteen weeks ended February 22, 2004 and balance sheet data at February 22, 2004 of UAP Holding Corp. from the audited historical financial statements appearing elsewhere in this prospectus. We derived the selected historical statement of operations data for the fiscal year ended February 25, 2001 and balance sheet data at February 24, 2002 from audited historical financial statements of the Predecessor which are not included in this prospectus. We derived the selected historical statement of operations data for the fiscal year ended February 27, 2000, and balance sheet data at February 27, 2000 and February 25, 2001 from the unaudited historical financial statements of the Predecessor which are not included in this prospectus. We derived the summary historical statement of operations data for the twenty-seven weeks ended August 29, 2004 and balance sheet data at August 29, 2004 of UAP Holding Corp. from the unaudited financial statements of UAP Holding Corp. appearing elsewhere in this prospectus. We derived the summary historical statement of operations data for the twenty-six weeks ended August 24, 2003 and balance sheet data at August 24, 2003 from the unaudited financial statements of the Predecessor appearing elsewhere in this prospectus. In the opinion of management, the unaudited financial statements include all adjustments (consisting of normal recurring accruals) necessary for a fair presentation of the financial position and results of operations for these periods. The results of operations for any quarter or a partial fiscal year period or for the periods presented for the Predecessor or Successor (as defined below) are not necessarily indicative of the results of operations to be expected for other periods or for the full fiscal year. Accounting principles generally accepted in the United States of America require our operating results prior to the Acquisition, the periods prior to November 23, 2003, to be reported as the results of the Predecessor in the historical financial statements. Our operating results subsequent to the Acquisition are presented as the Successor s results in the historical financial statements and include the thirteen-week period from November 24, 2003 through February 22, 2004 and the twenty-seven week period from February 23, 2004 through August 29, 2004. The summary historical financial and other data does not give effect to the approximately 39.085-for-1 split of our common stock which was effected prior to the consummation of this offering. To effect the stock split, we obtained the approval of our board of directors and the approval of our stockholders to an amendment and restatement of our existing certificate of incorporation to increase the authorized number of shares of our common stock. The stock split became effective upon the filing of the amendment and restatement of our certificate of incorporation with the Secretary of State of the State of Delaware on November 17, 2004. You should read the information contained in this table in conjunction with Unaudited Pro Forma Condensed Consolidated Financial Data beginning on page 24, Management s Discussion and Analysis of Financial Condition and Results of Operations beginning on page 35 and the historical consolidated and combined financial statements and the accompanying notes thereto of the Successor and Predecessor included elsewhere in this prospectus. (a) Represents expenses incurred by ConAgra Foods and allocated to the ConAgra Agricultural Products Business based on specific services provided or based on ConAgra Foods investment in the ConAgra Agricultural Products Business in proportion to ConAgra Foods total investment in its subsidiaries. (b) Represents amounts charged to the ConAgra Agricultural Products Business by ConAgra Foods on ConAgra Foods investment in and intercompany advances to the ConAgra Agricultural Products Business. (c) EBITDA represents net income (loss) before interest expense, finance charges, income taxes, depreciation and amortization. We present EBITDA because we believe it is a useful indicator of our historical debt capacity and ability to service debt, and consider it to be a measure of liquidity. Adjusted EBITDA, as defined in the indentures governing the 8 1/4% Senior Notes and the 10 3/4% Senior Discount Notes, corresponds to a calculation made in such indentures and is calculated by adjusting EBITDA for certain items. The adjustments to EBITDA relate to: (1) the add back of losses from discontinued operations, net of taxes, (2) the add back of inventory fair market value adjustments as a result of the Acquisition, (3) the add back of expenses relating to a transition services agreement and (4) the add back/deduction of loss/gain from the sale of certain businesses. We present Adjusted EBITDA because a corresponding calculation is used in the indentures for the 8 1/4% Senior Notes and the 10 3/4% Senior Discount Notes to determine whether we may incur additional indebtedness. Adjusted EBITDA is not a measure of financial performance or liquidity under GAAP. Accordingly, Adjusted EBITDA should not be considered in isolation or as a substitute for net income, cash flows from operations or other income or cash flow data prepared in accordance with GAAP or as a measure of our operating performance or liquidity. See Management s Discussion and Analysis of Financial Condition and Results of Operations Obligations and Commitments for a discussion of the application of Adjusted EBITDA as a measure of our ability to incur indebtedness under the indentures. For example, although we consider EBITDA a liquidity measure, it does not take into account (1) Consists of the added cost of goods sold expense due to the step up to fair market value of certain inventories on hand at November 23, 2003, as a result of the allocation of the purchase price of the Acquisition to inventory. (2) Consists of the expensing of the prepaid fee to ConAgra Foods for services performed under a transition services agreement entered into in connection with the Acquisition. (3) Consists of gain on the sale of two divisions, both of which occurred in November 2003. Table of Contents MANAGEMENT S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS On November 24, 2003, UAP Holding Corp. acquired the United States and Canadian agricultural inputs businesses of ConAgra Foods in a series of transactions referred to in this prospectus as the Acquisition and described in this prospectus in this section under the heading Certain Relationships and Related Transactions The Acquisition beginning on page 76. In this prospectus, the term ConAgra Agricultural Products Business means the entities that were historically operated by ConAgra Foods as an integrated business, which included a wholesale fertilizer and other international crop distribution businesses that we did not acquire in the Acquisition. The businesses not acquired are reflected as discontinued operations within the ConAgra Agricultural Products Business financial statements. The following discussion and analysis of our financial condition and results of operations covers periods prior to the Acquisition. Accordingly, the discussion and analysis of historical periods do not reflect the significant impact that the Acquisition had on us. In addition, the statements in the discussion and analysis regarding industry outlook, our expectations regarding the performance of our business, our liquidity and capital resources and the other non-historical statements in the discussion and analysis are forward-looking statements. These forward-looking statements are subject to numerous risks and uncertainties, including, but not limited to, the risks and uncertainties described in Risk Factors beginning on page 11. Our actual results may differ materially from those contained in or implied by any forward-looking statements. You should read the following discussion together with the sections entitled Risk Factors beginning on page 11, Unaudited Pro Forma Condensed Consolidated Financial Data beginning on page 24, Selected Historical Financial and Other Data beginning on page 32, and the historical consolidated and combined financial statements and the accompanying notes thereto of the Successor and Predecessor included elsewhere in this prospectus. BACKGROUND Founded in 1978, we are the largest private distributor of agricultural and non-crop inputs in the United States and Canada. We market a comprehensive line of products including crop protection chemicals, seeds and fertilizers to growers and regional dealers. As part of our product offering, we provide a broad array of value-added services including crop management, biotechnology advisory services, custom blending, inventory management and custom applications of crop inputs. The products and services we offer are critical to growers because they lower the overall cost of crop production and improve crop quality and yield. As a result of our broad scale and scope, we provide leading agricultural input companies with an efficient means to access a highly fragmented customer base of farmers and growers. At the end of fiscal 2002, our new management team began to implement several strategic initiatives to increase our operational efficiency. As part of that strategy, we enhanced our credit policies and information systems, improved inventory management, rationalized headcount and closed unprofitable distribution centers. Our implementation of new credit policies has reduced average trade accounts receivables and overall selling, general and administrative costs by lowering bad debt expense. Improved inventory management, including central purchasing, product mix enhancement, SKU rationalization, and enhanced sharing of existing stocks, have resulted in lower average inventory levels and higher margins. Headcount reductions and location closures have contributed to lower supply chain and selling, general and administrative costs. Our financial and operational success has been driven by providing customers with high quality products at competitive prices, supported by consistent and reliable service and expertise. We will continue to seek to grow our business, improve margins and reduce working capital through the following principal strategies: leveraging our scale; expanding our presence in seeds, branded and non-crop products; and targeting continued margin enhancement and working capital management. Table of Contents Our net sales and our income from continuing operations before income taxes for the twelve-month period ended August 29, 2004 were approximately $2,564.1 million and $62.2 million, respectively, on a pro forma basis for the Acquisition. For fiscal years 2004 and 2003, our net sales were approximately $2,451.9 million and $2,526.8 million, respectively, and our income from continuing operations before income taxes was approximately $68.5 million (on a pro forma basis for the Acquisition) and $48.2 million, respectively. The improvement in income from continuing operations before income taxes since fiscal 2003 is a result of a series of initiatives taken since current management joined in the middle of fiscal 2002. The initiatives taken to improve the overall profitability of the business included rationalized headcount, locations, customers, and product lines. Accordingly, we believe that our income from continuing operations before income taxes for fiscal 2003 is not indicative of our income from continuing operations before income taxes for subsequent periods as the complete impact of those management initiatives was not realized by us until fiscal 2004. SEASONALITY Our and our customers businesses are seasonal, based upon the planting, growing and harvesting cycles. During fiscal 2003 and 2004, at least 75% of our net sales occurred during the first and second fiscal quarters of each year because of the condensed nature of the planting season. As a result of the seasonality of sales, we experience significant fluctuations in our revenues, income and net working capital levels. Since 2002, however, we have taken steps to reduce working capital, including improved inventory payable management, centralized purchasing and SKU reduction programs. In addition, our integrated network of formulation and blending, distribution and warehousing facilities and technical expertise allows us to efficiently process, distribute and store product close to our end-users and to supply our customers on a timely basis during the compressed planting and growing season. Due to the seasonal nature of our business, the amount of borrowings outstanding under the revolving credit facility varies significantly throughout the fiscal year. During the period from the date of the Acquisition through October 24, 2004, outstanding borrowings (net of cash on hand) reached a period end peak of $275.2 million as of October 24, 2004. During the same period, utilization of the revolving credit facility was at its lowest when we had $172.6 million of cash on hand as of February 22, 2004. Our average period end borrowings (net of cash on hand) on a historical basis for the twelve-month period ended October 24, 2004, were approximately $76.5 million. FINANCIAL INFORMATION Accounting principles generally accepted in the United States of America require our operating results prior to the Acquisition, the periods prior to November 23, 2003, to be reported as the results of the Predecessor in our historical financial statements. Our operating results subsequent to the Acquisition are presented as the Successor s results in the historical financial statements and include the thirteen week period from November 24, 2003 through February 22, 2004 and the twenty-seven week period from February 23, 2004 through August 29, 2004. The information presented below for the fiscal year ended February 22, 2004 (Pro Forma) has been derived by combining the historical statement of operations data of UAP Holding Corp. (the Successor ) for the thirteen weeks ended February 22, 2004 with the historical statement of operations data of the Predecessor for the thirty-nine weeks ended November 23, 2003 and applying the pro forma adjustments for the Acquisition. The pro forma statement of operations for the 52 weeks ended February 22, 2004 should be read in conjunction with the Unaudited Pro Forma Condensed Consolidated Financial Data beginning on page 24. The information for the twenty-seven weeks ended August 29, 2004 represent the results of operations of the Successor. The information for the fiscal year ended February 23, 2003 and February 24, 2002, and for the twenty-six week period ended August 24, 2003, represent the results of operations of the Predecessor. The results of operations for any twenty-seven or twenty-six week period are not necessarily indicative of the results to be expected for the full fiscal year. Table of Contents TWENTY-SEVEN WEEKS ENDED AUGUST 29, 2004 COMPARED TO TWENTY-SIX WEEKS ENDED AUGUST 24, 2003 Net Sales. Sales increased to $1,962.5 million in the twenty-seven weeks ended August 29, 2004 compared to $1,850.2 million for the twenty-six weeks ended August 24, 2003. Sales of crop protection chemicals rose to $1,257.7 million in the twenty-seven weeks ended August 29, 2004 from $1,221.7 million in the twenty-six weeks ended August 24, 2003. This increase was due to higher chemical volumes across the mid-south and southwest, and higher sales of proprietary products, offset by lower insecticide sales in the midwest. Sales of fertilizer rose to $409.2 million in the twenty-seven weeks ended August 29, 2004 from $370.5 million for the twenty-six weeks ended August 24, 2003, due to higher pricing, specifically in nitrogen-based fertilizers, and slightly higher volumes. Sales of seed rose to $259.9 million in the twenty-seven weeks ended August 29, 2004 from $208.7 million for the twenty-six weeks ended August 24, 2003, due to volume growth and slightly higher prices due to increased sales of seed with enhanced traits. Sales of other products decreased to $35.5 million in the twenty-seven weeks ended August 29, 2004 from $49.3 million for the twenty-six weeks ended August 24, 2003, due to lower animal feed sales resulting from the divestment of our Montana feed division. Cost of Goods Sold. Cost of goods sold was $1,719.7 million in the twenty-seven weeks ended August 29, 2004 compared to $1,588.3 million for the twenty-six weeks ended August 24, 2003. Gross profit (net sales less cost of goods sold) was $242.8 million in the twenty-seven weeks ended August 29, 2004 compared to $261.9 million for the twenty-six weeks ended August 24, 2003. Gross margin (gross profit as a percentage of net sales) decreased to 12.4% in the twenty-seven weeks ended August 29, 2004 compared to 14.2% for the twenty-six weeks ended August 24, 2003. Gross profits declined for the following reasons: a $17.4 million dollar fair market adjustment to the inventory on hand on the date of the Acquisition that was sold during the twenty-seven week period ended August 29, 2004, higher delivery costs due to the price of fuel, and lower upfront pricing for our sales of glyphosate herbicides due to a product mix shift to lower-priced products. These items were slightly offset by an increase in chemical and seed rebates due to a change in our monthly rebate estimation process. Selling, General and Administrative Expenses. Direct selling, general and administrative ( SG&A ) expenses decreased slightly by $0.7 million to $153.4 million in the twenty-seven weeks ended August 29, 2004 from $154.1 million for the twenty-six weeks ended August 24, 2003. SG&A expenses were 7.8% of sales during the twenty-seven weeks ended August 29, 2004, and 8.3% of sales during for the twenty-six weeks ended August 24, 2003. The lower SG&A expenses are due to lower labor and location expenses as a result of our location rationalization efforts and increased recoveries of bad debts. These were offset by additional expenses associated with our transition services agreement with ConAgra ($3.8 million), and an extra week of expenses in the current quarter. Interest Expense. Interest expense was $18.2 million in the twenty-seven weeks ended August 29, 2004, which related primarily to the 8 1/4% Senior Notes (as defined in Description of Certain Indebtedness 8 1/4% Senior Notes beginning on page 91) and the 10 3/4% Senior Discount Notes (as defined in Description of Certain Indebtedness 10 3/4% Senior Discount Notes beginning on page 93). This expense is net of finance charge income of $3.9 million. Third party interest expense was $0.3 million for the twenty-six weeks ended August 24, 2003, which related to a vendor financing program. Interest expense to ConAgra Foods for the final settlement payment was $1.9 million. Interest included interest and penalty interest on the 8 1/4% Senior Notes, the 10 3/4% Senior Discount Notes, and the revolving credit facility, and amortization of initial revolving credit facility fees and costs relating to the issuance of the 8 1/4% Senior Notes and the 10 3/4% Senior Discount Notes of $1.1 million. Corporate Allocations Selling, General and Administrative. Corporate allocations include charges that have been allocated by ConAgra Foods and recorded as an expense for corporate services, including executive, finance and tax. Expenses incurred by ConAgra Foods and allocated to the ConAgra Agricultural Products Business are determined based on the specific services being provided or are allocated based on ConAgra Foods Table of Contents investment in the ConAgra Agricultural Products Business in proportion to ConAgra Foods total investment in its subsidiaries. Such expenses are included in allocated selling, general and administrative expenses and were $6.1 million in the twenty-six weeks ended August 24, 2003. Corporate Allocations Finance Charges. Corporate allocations also include finance charges that have been allocated by ConAgra Foods based on ConAgra Foods investment in the ConAgra Agricultural Products Business in proportion to ConAgra Foods total investment in its subsidiaries. ConAgra Foods allocated finance costs of $8.3 million in the twenty-six weeks ended August 24, 2003. Income Taxes. The effective income tax rate was 39.0% for the twenty-seven weeks ended August 29, 2004 compared with 38.0% for in the twenty-six weeks ended August 24, 2003. FIFTY-TWO WEEKS ENDED FEBRUARY 22, 2004 (PRO FORMA) COMPARED TO FIFTY-TWO WEEKS ENDED FEBRUARY 23, 2003 Net Sales. Sales declined to $2,451.9 million in fiscal 2004 from $2,526.8 million in fiscal 2003. Sales of crop protection chemicals declined to $1,579.7 million in fiscal 2004 from $1,661.3 million in fiscal 2003. The decline was largely due to the reduced number of locations from our rationalization efforts throughout the year and a more restrictive customer credit policy. Sales of fertilizer rose to $526.2 million in fiscal 2004 from $510.6 million in fiscal 2003, due to slightly higher pricing throughout the year. Sales of seed declined to $258.9 million in fiscal 2004 from $270.8 million as store rationalizations offset volume growth. Sales of other products increased to $87.1 from $84.1 million. Cost of Goods Sold. Cost of goods sold was $2,108.7 million in fiscal 2004 compared with $2,166.6 million in fiscal 2003. Gross profit (net sales less cost of goods sold) was $343.2 million in fiscal 2004 compared with $360.2 million in fiscal 2003; while gross margin (gross profit as a percentage of net sales) was 14.0% in fiscal 2004 compared with 14.3% in fiscal 2003. Gross profits declined due to fewer sales due to location closures and a $3.7 million dollar charge to cost of goods sold from the purchase price allocation of the acquisition. Selling, General and Administrative Expenses. Selling, general and administrative ( SG&A ) expenses decreased to $235.9 million in fiscal 2004 from $275.2 million in the fiscal 2003 period. SG&A expenses were 9.6% of sales during fiscal 2004 and 10.9% of sales during fiscal 2003. The decline in SG&A expenses is the result of reduced location expenses associated with the closure of unprofitable locations, gains from the sale of two formulation facilities and the Montana feed business, and lower expenses in the formulation plants as a result of consolidation efforts. Interest Expense. Interest expense was $37.8 million during fiscal 2004, on a pro forma basis for the Acquisition. Third party interest expense was $1.9 million in fiscal 2003, which related to a vendor financing program. Corporate Allocations Selling, general and administrative. Corporate allocations include charges that have been allocated by ConAgra Foods and recorded as an expense for corporate services, including executive, finance and tax. Expenses incurred by ConAgra Foods and allocated to the ConAgra Agricultural Products Business are determined based on the specific services being provided or are allocated based on ConAgra Foods investment in the ConAgra Agricultural Products Business in proportion to ConAgra Foods total investment in its subsidiaries. Such expenses are included in allocated selling, general and administrative expenses and are $9.0 million and $10.8 million in fiscal 2004 and fiscal 2003, respectively. Corporate Allocations Finance Charges. Corporate allocations also include finance charges that have been allocated by ConAgra Foods based on ConAgra Foods investment in the ConAgra Agricultural Products Business in proportion to ConAgra Foods total investment in its subsidiaries. ConAgra Foods allocated finance costs of $12.2 million and $22.5 million in fiscal 2004 and fiscal 2003, respectively. Table of Contents Income Taxes. The effective income tax rate was 41.6% for fiscal 2004 compared with 38.9% for fiscal 2003. The increase in the effective rate was due to the impact of permanent tax differences. FISCAL 2003 COMPARED TO FISCAL 2002 Net Sales. Net sales were $2,526.8 million in fiscal 2003 compared with $2,770.2 million in fiscal 2002. Net sales of crop protection chemicals declined to $1,661.3 million in fiscal 2003 from $1,826.4 million in fiscal 2002 due largely to the impact of our implementation of strategic initiatives to change customer mix, product mix, and the rationalization of unprofitable locations. Net sales of fertilizer declined to $510.6 million in fiscal 2003 from $581.0 million in fiscal 2002 on lower prices and volumes primarily due to lower fall applications of fertilizer. Net sales of seed declined to $270.8 million in fiscal 2003 from $282.8 million in fiscal 2002 due largely to the impact of our implementation of the previously described strategic initiatives to change customer mix and location rationalization, partially offset by continued volume growth in existing locations. Net sales of other products increased 5.1% to $84.1 million. Cost of Goods Sold. Cost of goods sold was $2,166.6 million in fiscal 2003, compared with $2,428.2 million in fiscal 2002. Gross profit was $360.2 million in fiscal 2003, compared with $342.0 million in fiscal 2002; while gross margin was 14.3% in fiscal 2003 compared with 12.3% in fiscal 2002. Gross margin improved principally due to a more profitable product mix and lower supply chain costs due to the rationalization of unprofitable locations. Gross margin was also favorably impacted by increased rebate income as a percentage of net sales and improved inventory management resulting in lower inventory write-offs and markdowns in fiscal 2003. These improvements helped offset the gross profit impact from the decline in net sales. Fiscal 2002 gross margin was unfavorably impacted by fertilizer inventory write-offs of approximately $29.6 million. Selling, General and Administrative Expenses. SG&A expenses decreased to $275.2 million in fiscal 2003 from $334.6 million in fiscal 2002. SG&A expenses were 10.9% of net sales during fiscal 2003, compared with 12.1% of net sales during fiscal 2002. The decline was due largely to lower bad debt expenses from selling to a more profitable customer mix, and reduced administrative and operating expenses associated with cost management initiatives including the closure of unprofitable locations. Fiscal 2002 selling, general and administrative expenses were unfavorably impacted by bad debt expense of approximately $29.2 million due to unfavorable industry conditions. Interest Expense. Interest expense decreased to $1.9 million in fiscal 2003 from $5.4 million in fiscal 2002, due to decreased purchasing activity under a vendor finance program. Corporate Allocations Selling, General and Administrative. Corporate allocations include charges that have been allocated by ConAgra Foods and recorded as an expense for corporate services, including executive, finance and tax. Expenses incurred by ConAgra Foods and allocated to the ConAgra Agricultural Products Business are determined based on the specific services being provided or are allocated based on ConAgra Foods investment in the ConAgra Agricultural Products Business in proportion to ConAgra Foods total investment in its subsidiaries. Such expenses are included in allocated selling, general and administrative expenses and were $10.8 million and $10.5 million in fiscal 2003 and fiscal 2002, respectively. Corporate Allocations Finance Charges. Corporate allocations also include finance charges that have been allocated by ConAgra Foods based on ConAgra Foods investment in the ConAgra Agricultural Products Business in proportion to ConAgra Foods total investment in its subsidiaries. ConAgra Foods allocated finance costs of $22.5 million and $39.5 million in fiscal 2003 and fiscal 2002, respectively. Income Taxes. The effective income tax rate was 38.9% for fiscal 2003, compared with 36.0% for fiscal 2002. The increase in the effect rate was due to the impact of permanent tax differences. Operating income 98,534 96,253 93,846 Interest expense 38,448 20,950 38,913 Finance fee income (10,773 ) (3,899 ) (10,535 ) Table of Contents LIQUIDITY AND CAPITAL RESOURCES Overview Our principal liquidity requirements following the completion of this offering will be for working capital, consisting primarily of receivables, inventories, pre-paid expenses, reduced by accounts payable and accrued expenses; capital expenditures; debt service; and dividends on our common stock. We will fund our liquidity needs, including dividend payments, with cash generated from operations and, to the extent necessary, through borrowings under our revolving credit facility. In addition, as noted below, we expect to fund any growth capital expenditures with cash generated from operations, reductions in working capital and incremental debt. As of August 29, 2004 and February 22, 2004, we had $180.3 million and $0 million, respectively, outstanding under our revolving credit facility. The revolver is included in our financial statements as part of our short-term debt. We believe that our cash flows from operating activities and borrowing capabilities under our revolving credit facility will be sufficient to meet our liquidity requirements in the foreseeable future, including funding of capital expenditures, payment obligations under our debt service and our intended dividend payments on our common stock. If our cash flows from operating activities are insufficient to fund dividend payments at intended levels, we will need to reduce or eliminate dividends or, to the extent we are permitted to do so under our debt agreements, fund dividends with borrowings or from other sources. If we use working capital or permanent borrowings to fund dividends, we will have less cash available for future dividends and other purposes, which could negatively impact our financial condition, our results of operations and our ability to maintain or expand our business. Additionally, our revolving credit facility will mature in 2008. If we are unable to refinance such indebtedness prior to its stated maturity, we will be required to use cash to repay such indebtedness, and we may not have sufficient cash available to us at that time. Even if we do have sufficient cash, such repayment would significantly decrease the amount of cash, if any, available to pay dividends. Historical Cash Flow from Operating Activities Historically, the ConAgra Agricultural Products Business sources of cash were primarily cash flows from operations and advances received from ConAgra Foods. The information presented below for the fiscal year ended February 22, 2004 (Pro Forma) has been derived by combining the cash flow activity of UAP Holding Corp. (the Successor ) for the thirteen weeks ended February 22, 2004 with the cash flow activity of the Predecessor for the thirty-nine weeks ended November 23, 2003 and applying the pro forma adjustments for the Acquisition. The information for the twenty-seven weeks ended August 29, 2004 represent the cash flow activity of the Successor. The information for the fiscal year ended February 23, 2003 and February 24, 2002 represent the cash flow activity of the Predecessor. Cash flows provided by (used in) operating activities totaled $(313.3) million in the twenty-seven weeks ended August 29, 2004 and $(129.5) million for the twenty-six weeks ended August 24, 2003. The usage in the twenty-seven weeks ended August 29, 2004 was due to higher accounts receivable due to increased sales, offset by lower inventories and higher payables due to better inventory payable management. The usage in the twenty-six weeks ended August 24, 2003 was primarily due to higher accounts receivable and inventories, offset by higher payables. The increased usage in the current period versus the prior period was due to the purchasing of inventory closer to the seasonal use in the current period, as opposed to prepaying for inventory as in the prior period. Cash flows provided by (used in) operating activities totaled $341.8 million, ($266.8) million and $120.7 million in fiscal 2004, 2003 and 2002, respectively. The increase in fiscal 2004 was due to improvements Table of Contents in working capital, including better inventory payable management due to a lower participation by us in early purchasing programs from our suppliers. The decrease in fiscal 2003 was primarily due to prepayments to various suppliers for early payment discounts on crop protection chemicals and lower year-end accounts payable to suppliers. This was partially offset by lower inventories and increased earnings. Cash flows used in investing activities totaled $62.9 million in the twenty-seven weeks ended August 29, 2004 and $5.7 million for the twenty-six weeks ended August 24, 2003. The post-closing settlement in June 2004 accounted for $58.2 million of the investing activity. The remaining investing activities primarily represent expenditures for property, plant and equipment. Cash flows used in investing activities totaled $653.1 million, $4.0 million and $12.8 million in fiscal 2004, 2003 and 2002, respectively. The increase in cash used in investing activities in fiscal 2004 was due to the Acquisition. Cash flows used in investing activities include capital expenditures for property, plant and equipment, which totaled $15.3 million, $6.4 million and $13.6 million in fiscal 2004, 2003 and 2002, respectively. Cash flows provided by financing activities were $216.9 million in the twenty-seven weeks ended August 29, 2004 and $106.6 million in the twenty-six weeks ended August 24, 2003. Cash flows provided by financing activities in the twenty-seven week period ended August 29, 2004 reflect borrowings under the revolving credit facility used to accommodate the seasonal working capital needs of our business. Financing activities in the prior period were primarily limited to net investments by ConAgra Foods and bank overdrafts. Cash flows provided by (used in) financing activities were $455.4 million, $226.7 million and ($181.5) million in fiscal 2004, 2003 and 2002, respectively. Cash flows provided by financing activities in fiscal 2004 included the contribution of equity by Apollo and issuance of long-term debt in connection with the Acquisition. Financing activities have historically been primarily limited to investments by and (distributions) to ConAgra Foods, which totaled $231.1 million and ($182.1) million in fiscal 2003 and 2002 respectively. Capital Expenditures Capital expenditures are expected to be approximately $18.1 million for fiscal 2005, which includes approximately $5.6 million for maintenance capital expenditures. This also includes approximately $3.7 million of capital expenditures for transition projects to enable our separation from our former parent, ConAgra Foods, and approximately $5.3 million for an investment in information systems. The remainder, or approximately $3.5 million, represents growth capital expenditures that are intended to support our strategic growth activities or bring about efficiencies in our formulation facilities. This expected figure represents management s estimate of spending, but may change due to a variety of conditions, including local business conditions, changes in the farm economy, competitive conditions, changes that impact the economics of a given project, and the seasonality of our business. We expect we will finance all capital expenditures from cash generated from operations, reductions in working capital, or incremental debt. Credit Facilities and Other Long Term Debt In connection with the Acquisition, United Agri Products entered into the existing five-year $500.0 million asset-based revolving credit facility. The revolving credit facility also provides for a $20.0 million revolving credit sub-facility for United Agri Products Canada Inc. ( UAP Canada ), a $50.0 million letter of credit sub-facility, a $25.0 million swingline loan sub-facility and a $25.0 million in-season over-advance sub-facility. At August 29, 2004, there were $180.3 million of borrowings outstanding under the revolving credit facility and United Agri Products had additional borrowing capacity thereunder of $300.1 million (after giving effect to $19.1 million of letters of credit under the sub-facility). The interest rates with respect to revolving loans under the revolving credit facility are based, at our option, on either the agent s index rate plus an applicable index margin of 1.50% or upon LIBOR plus an applicable Table of Contents LIBOR margin of 2.75%. The interest rates with respect to in-season over-advances under the revolving credit facility are based, at our option, on either the agent s index rate plus an applicable index margin of 2.75% or upon LIBOR plus an applicable LIBOR margin of 4.0%. These applicable margins are in each case subject to prospective reduction on a quarterly basis (other than the margins on in- season over-advances) if we reduce our ratio of funded debt to EBITDA (on a consolidated basis). Overdue principal, interest and other amounts will bear interest at a rate per annum equal to the rate otherwise applicable thereto plus an additional 2.0%. The obligations under the revolving credit facility are (or, in the case of future subsidiaries, will be) guaranteed by UAP Holdings and each of its existing and future direct and indirect U.S. subsidiaries. The obligations under the revolving credit facility are secured by a first priority lien on, or security interest in, subject to certain exceptions, substantially all of UAP Holdings , United Agri Products and UAP Canada s properties and assets and the properties and assets of each of the guarantors. The revolving credit facility contains customary representations, warranties and covenants and events of default for the type and nature of the Acquisition and a business such as ours. United Agri Products will amend and restate the credit agreement governing the revolving credit facility upon the consummation of this offering. See Description of Certain Indebtedness The Revolving Credit Facility beginning on page 87 for a more detailed discussion of the terms of the revolving credit facility, as amended following this offering. On December 16, 2003, United Agri Products issued $225.0 million aggregate principal amount of 8 % Senior Notes which mature on December 15, 2011. On April 26, 2004, United Agri Products commenced a tender offer and consent solicitation with respect to all its outstanding $225.0 million aggregate principal amount of 8 % Senior Notes. The closing of the tender offer and consent solicitation with respect to the 8 % Senior Notes was conditioned upon, among other things, the closing of our proposed offering of income deposit securities (the Proposed IDS Offering ), which was abandoned in order for us to pursue this offering. Immediately following the filing of Amendment No. 4 to the Registration Statement of which this prospectus forms a part, the tender offer and consent solicitation with respect to the 8 % Senior Notes will be terminated in connection with the abandonment of the Proposed IDS Offering. Accordingly, the 8 % Senior Notes will remain outstanding following the consummation of this offering. See Description of Certain Indebtedness 8 % Senior Notes beginning on page 91 for a more detailed discussion of the terms of the 8 % Senior Notes. On January 26, 2004, UAP Holdings issued $125.0 million aggregate principal amount at maturity of 10 % Senior Discount Notes which mature on July 15, 2012. On April 26, 2004, UAP Holdings commenced a tender offer and consent solicitation with respect to all of its outstanding $125.0 million aggregate principal amount at maturity of 10 % Senior Discount Notes. The closing of the tender offer and consent solicitation with respect to the 10 % Senior Discount Notes was conditioned upon, among other things, the closing of the Proposed IDS Offering, which was abandoned in order for us to pursue this offering. Immediately following the filing of Amendment No. 4 to the Registration Statement of which this prospectus forms a part, the tender offer and consent solicitation with respect to the 10 % Senior Discount Notes will be terminated in connection with the abandonment of the Proposed IDS Offering. Accordingly, the 10 % Senior Discount Notes will remain outstanding following the consummation of this offering. See Description of Certain Indebtedness 10 % Senior Discount Notes beginning on page 93 for a more detailed discussion of the terms of the 10 % Senior Discount Notes. We have excluded lease obligations of $52.8 million from the table above as these are cancelable within one year. The above table also does not include the effects of this offering. As of August 29, 2004, on a pro forma basis after giving effect to this offering and the Special Dividends, our total indebtedness would have been $531.6 million. The revolving credit facility has a five-year term and will mature in 2008. As of August 29, 2004, we had $19.1 million of outstanding commercial commitment arrangements (e.g., guarantees). The 8 % Senior Notes were issued on December 16, 2003 and the proceeds from such offering were used to repay the entire principal amount, plus accrued interest, incurred in connection with a $175.0 million unsecured senior bridge loan facility. United Agri Products entered into the senior bridge loan facility on November 24, 2003 and used borrowings thereunder to fund, in part, the Acquisition. HOLDING COMPANY As a holding company, our investments in our operating subsidiaries, including United Agri Products, constitute substantially all of our operating assets. Consequently, our subsidiaries conduct all of our consolidated operations and own substantially all of our operating assets. Our principal source of the cash required to pay our and our subsidiaries obligations and to repay the principal amount of our and our subsidiaries obligations, including the 8 1/4% Senior Notes and the 10 3/4% Senior Discount Notes, is the cash that our subsidiaries generate from their operations and their borrowings under the revolving credit facility. Our subsidiaries are separate and distinct legal entities and have no obligations to make funds available to us. The terms of the revolving credit facility restrict our subsidiaries from paying dividends, making loans or other distributions and otherwise transferring assets to us. Furthermore, our subsidiaries are permitted under the terms of the revolving credit facility and the indentures governing the 8 1/4% Senior Notes and the 10 3/4% Senior Discount Notes to incur additional indebtedness that may severely restrict or prohibit the making of distributions, the payment of dividends or the making of loans by such subsidiaries to us. We cannot assure you that the agreements governing our current and future indebtedness will permit our subsidiaries to provide us with sufficient dividends, distributions or loans to fund scheduled interest and principal payments on our indebtedness when due. If we consummate an acquisition, our debt service requirements could increase. We may need to refinance all or a portion of our indebtedness, on or before maturity. We cannot assure you that we will be able to refinance any of our indebtedness on commercially reasonable terms or at all. Table of Contents TRADING ACTIVITIES As of August 29, 2004 and August 24, 2003, we had no outstanding derivative contracts. However, subject to limitations set forth in our debt agreements, we may, in the future, enter into derivative contracts to limit our exposure to changes in interest rates, foreign currency exchange rates and energy prices. CRITICAL ACCOUNTING POLICIES The process of preparing financial statements requires the use of estimates on the part of management. The estimates used by management are based on our historical experiences combined with management s understanding of current facts and circumstances. Certain of our accounting policies are considered critical as they are both important to the portrayal of our financial condition and results of operations and require significant or complex judgment on the part of management. The following is a summary of certain accounting policies considered critical by our management. Allowance for Doubtful Accounts. Our allowance for doubtful accounts reflects reserves for customer receivables to reduce receivables to amounts expected to be collected. Management uses significant judgment in estimating uncollectible amounts. In estimating uncollectible amounts, management considers factors such as current overall economic conditions, industry-specific economic conditions, historical customer performance and anticipated customer performance. While management believes our processes effectively address our exposure for doubtful accounts, changes in the economy, industry, or specific customer conditions may require adjustment to the allowance for doubtful accounts recorded by us. Inventory Valuation. Management reviews inventory balances to determine if inventories can be sold at amounts equal to or greater than their carrying amounts. The review includes identification of slow moving inventories, obsolete inventories and discontinued products or lines of products. The identification process includes historical performance of the inventory, current operational plans for the inventory, as well as industry and customer specific trends. If our actual results differ from management expectations with respect to the selling of our inventories at amounts equal to or greater than their carrying amounts, we would be required to adjust our inventory balances accordingly. Impairment of Long-Lived Assets (Including Property, Plant and Equipment), Goodwill and Identifiable Intangible Assets. We reduce the carrying amounts of long-lived assets, goodwill and identifiable intangible assets to their fair values when the fair value of such assets is determined to be less than their carrying amounts (i.e., assets are deemed to be impaired). Fair value is typically estimated using a discounted cash flow analysis, which requires us to estimate the future cash flows anticipated to be generated by the particular asset(s) being tested for impairment as well as select a discount rate to measure the present value of the anticipated cash flows. When determining future cash flow estimates, we consider historical results adjusted to reflect current and anticipated operating conditions. Estimating future cash flows requires significant judgment by us in such areas as future economic conditions, industry-specific conditions, product pricing and necessary capital expenditures. The use of different assumptions or estimates for future cash flows could produce different impairment amounts (or none at all) for long-lived assets, goodwill and identifiable intangible assets. Rebate Receivables. Rebates are received from crop protection and seed products, based on programs offered by our vendors. The programs vary based on the product type and specific vendor practice. Historically, more than 85% of the rebates earned were from our chemical suppliers. The majority of the rebate programs run on a crop year basis, typically from October 1st to September 30th, although other periods are sometimes used. We also negotiate individually with our vendors for additional rebates after the conclusion of the crop year and often several months after we have purchased and sold the products for which we are negotiating rebates. Historically, the majority of the rebates have been earned based on our sales of the suppliers products in a given crop year. The rebate receivable recorded monthly is based on actual sales and the historical rebate percentage received. The actual rebates earned for most programs are finalized in our fourth fiscal quarter and adjustments Table of Contents are made to the accrual as necessary. The majority of our rebate receivables are collected during our fourth quarter. Because of the nature of the programs and the amount of rebates available are determined by our vendors, there can be no assurance that historical rebate trends will continue. Stock-Based Compensation. Certain of our officers, employees and non-executive directors have equity-based compensation arrangements under which they hold options to acquire shares of our common stock. For officers and employees, we account for our stock option plan in accordance with the provisions of Accounting Principles Board ( APB ) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. As such, compensation expense is recorded on the date of grant only if the current market price of the underlying stock exceeds the exercise price. The exercise price for all of the options granted to date was equal to the fair value of our stock at the date of grant. Accordingly, no compensation expense associated with stock option grants has been recognized. If the exercise price on future stock option grants exceeds the underlying stock price, compensation expense will be recognized and expensed over the vesting period in accordance with APB Opinion No. 25. OFF BALANCE SHEET ARRANGEMENTS In January 2003, the FASB issued FIN No. 46, Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin No. 51 (ARB 51), which clarifies the consolidation accounting guidance in ARB 51, Consolidated Financial Statements, as it applies to certain entities in which equity investors who do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entities to finance their activities without additional subordinated financial support from other parties. Such entities are known as variable interest entities (VIEs). FIN No. 46 requires that the primary beneficiary of a VIE consolidates the VIE. FIN No. 46 also requires new disclosures for significant relationships with VIEs, whether or not consolidation accounting is used or anticipated. In December 2003, the FASB revised and re-released FIN No. 46 as FIN No. 46(R). The provisions of FIN No. 46(R) are effective for periods ending after March 15, 2004, and upon adoption by the company as of February 22, 2004, did not have a material impact on our financial position or results of operations. All future cash payments required under our noncancelable leasing arrangements having remaining noncancelable lease terms of more than one year are reflected in the contractual obligations table above under Obligations and Commitments beginning on page 43. RELATED PARTY TRANSACTIONS ConAgra Foods executive, finance, tax and other corporate departments have historically performed services for the ConAgra Agricultural Products Business, and, pursuant to the Transition Services Agreement described in Certain Relationships and Related Transactions Ancillary Agreements beginning on page 77, will continue to perform certain administrative and other services for us. Expenses incurred by ConAgra Foods and allocated to the ConAgra Agricultural Products Business were historically determined based on the specific services that were provided or were allocated based on ConAgra Foods investment in the ConAgra Agricultural Products Business in proportion to ConAgra Foods total investment in its subsidiaries. In addition, ConAgra Foods charged the ConAgra Agricultural Products Business finance charges on ConAgra Foods investment in and advances to the ConAgra Agricultural Products Business. We believe that such expense allocations were reasonable. It is not practical to estimate the expenses that would have been incurred by the ConAgra Agricultural Products Business if it had been operated on a stand-alone basis. Corporate allocations for the twenty-six weeks ended August 24, 2003 totaled $14.4 million, of which $6.1 million represented selling, general and administrative charges and $8.3 million represented finance charges. As part of the Acquisition, we entered into a transition services agreement with ConAgra Foods in which ConAgra Foods would provide certain information technology and other administrative services to us for a Table of Contents period of one year. As consideration for these services, we paid ConAgra Foods $7.5 million. For the twenty- seven week periods ended August 29, 2004, $3.8 million, in expense was recognized by us for services performed pursuant to this agreement. Under the terms of our Management Agreement (as defined in Certain Relationships and Related Transactions Ancillary Agreements Apollo Management Consulting Agreement beginning on page 82), we retained Apollo to provide certain management consulting and financial advisory services, for which we pay Apollo an annual management fee of $1.0 million in quarterly payments of $250,000. In addition, as consideration for arranging the Acquisition and services pertaining to certain related financing transactions, we paid Apollo a fee of $5.0 million in January 2004, which was accounted for as part of the Acquisition. MARKET RISK The principal market risk affecting our business has been exposure to changes in energy prices and, to a lesser extent, foreign currency risks. We are currently exposed to market risks including exposure to changes in energy prices, with respect to which we currently pay market rates. PROSPECTUS SUMMARY 1 RISK FACTORS 11 DISCLOSURE REGARDING FORWARD-LOOKING STATEMENTS 19 USE OF PROCEEDS 20 DIVIDEND POLICY 21 CAPITALIZATION 22 DILUTION 23 UNAUDITED PRO FORMA CONDENSED CONSOLIDATED FINANCIAL DATA 24 SELECTED HISTORICAL FINANCIAL AND OTHER DATA 32 MANAGEMENT S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 35 BUSINESS Table of Contents BUSINESS OVERVIEW We are the largest private distributor of agricultural and non-crop inputs in the United States and Canada. We market a comprehensive line of products including crop protection chemicals, seeds and fertilizers to growers and regional dealers. As part of our product offering, we provide a broad array of value-added services including crop management, biotechnology advisory services, custom blending, inventory management and custom applications of crop inputs. The products and services we offer are critical to growers because they lower the overall cost of crop production and improve crop quality and yield. As a result of our broad scale and scope, we provide leading agricultural input companies with an efficient means to access a highly fragmented customer base of farmers and growers. We have a comprehensive network of approximately 320 distribution and storage facilities and three formulation plants, strategically located in the major crop-producing areas of the United States and Canada. Our integrated sales network covers over 40,000 active stock keeping units, or SKUs, supported by approximately 1,100 salespeople. This network of facilities, together with our technical expertise, enables us to efficiently process, distribute and store products close to our end-users and to supply our customers on a timely basis during the compressed planting and growing season. In addition, our widespread geographical presence provides a diversified base of sales that helps to insulate our overall business from difficult farming conditions in any one area as a result of poor weather or adverse market conditions for specific crops or regions. We distribute products manufactured by the world s leading agricultural input companies, including BASF, Bayer, Dow, DuPont, Monsanto and Syngenta, as well as ConAgra International Fertilizer Company. We believe we are amongst the largest customers of agricultural inputs of these suppliers and have long-standing relationships with these companies. We also distribute products from over 300 other suppliers as well as over 218 of our own proprietary private label products. Our extensive infrastructure is a critical element of our suppliers route-to-market, as it enables them to reach a highly fragmented customer base. As of August 29, 2004, we had approximately 75,000 customers, with our ten largest customers accounting for approximately 3% of our net sales in fiscal 2004. Our customers include commercial growers and regional dealers, as well as consumers in non-crop industries. Our significant scale provides our customers with an efficient and cost-effective method of purchasing agricultural and non-crop inputs. At the end of fiscal 2002, our new management team began to implement several strategic initiatives to increase our operational efficiency. As part of that strategy, we rationalized headcount, enhanced our credit policies and information systems, improved inventory management and closed unprofitable distribution centers. Largely as a result of that strategy, we successfully increased our income before income taxes as a percentage of net sales from 0.1% in fiscal 2001 to 2.8% in fiscal 2004, on a pro forma basis for the Acquisition, while reducing average working capital as a percentage of net sales from approximately 25.5% in fiscal 2001 to approximately 20.4% in fiscal 2004, a reduction of $205.3 million. We believe we are well positioned to drive further efficiencies in working capital and further enhance our margins. UAP was initially formed by ConAgra Foods through a series of acquisitions, beginning in May 1978 with the acquisition of a 49% interest in a group of companies engaged in the domestic distribution of agricultural chemicals. ConAgra Foods purchased the remaining 51% from several remaining stockholders in 1980. In 1983, UAP acquired AgChem, Inc., and in 1985 acquired Cropmate Company Inc. UAP expanded its business into Canada through the 1988 purchase of Pfizer Canada, and in 1991 acquired Donnell Agriculture. After a series of additional acquisitions, on November 24, 2003, ConAgra Foods sold UAP and its related businesses to UAP Holdings. For more information on this transaction see Certain Relationships and Related Transactions The Acquisition beginning on page 76. Balance at February 22, 2004 $ Table of Contents INDUSTRY OVERVIEW AND TRENDS The agricultural inputs market in the United States was estimated at $27.7 billion in 2003 and has grown at a compound annual growth rate of approximately 3.0% over the past ten years, as measured by total revenues, according to the most recent available survey by the USDA National Agricultural Statistics Service. Key drivers of the market include: continued population growth; the use of more effective chemicals and fertilizers; stable planted acreage; the trend towards larger and more efficient farms; and the increased use of biotechnology in the production of seeds. The three primary product areas of the agricultural inputs and non-crop market are crop protection chemicals, seeds and fertilizer. We also operate in the non-crop market that consists of turf and ornamental (golf courses, resorts, nurseries and greenhouses), pest control operators and vegetation management. We estimate this market to be approximately $3.0 billion and believe it is experiencing significant organic growth. Crop Protection Chemicals. Crop protection chemicals expenditures in the United States were approximately $8.4 billion in 2003, according to the most recent available survey by the USDA National Agricultural Statistics Service. Since 1997, the volume of crop protection chemicals sold in the United States has increased, but overall revenues have remained essentially flat as lower-priced generic products have replaced higher-priced patented products, according to the same survey. This product area includes: (i) herbicides, which keep weed infestations from depriving crops of plant nutrients and water; (ii) insecticides, which keep insects from damaging crops; and (iii) fungicides, which guard against plant diseases. Seeds. Seed expenditures in the United States were approximately $9.3 billion in 2003, according to the most recent available survey by the USDA National Agricultural Statistics Service. The seed market in the United States has experienced significant growth since 1997, according to the same survey, driven primarily by increased pricing as a result of improvements in seed technology. In particular, biological traits are becoming genetically engineered into seeds, thus reducing the need for chemical treatment of crops. These traits include providing a plant with the ability to resist pests without a chemical application and the ability of a plant to selectively resist herbicides. These technological improvements, together with the availability of more productive seed hybrids, have resulted in higher crop yields. Fertilizer. Fertilizer expenditures in the United States were approximately $10.0 billion in 2003, according to the most recent available survey by the USDA National Agricultural Statistics Service. Since 1997, the volume of fertilizer sold in the United States has increased, but overall revenues have remained essentially flat, due largely to falling prices as a result of overproduction, according to the same survey. Fertilizers are added to soil to replace or supplement one or more deficient nutrients necessary for plant growth. Nearly all commercial crops grown in the United States and Canada today are produced with the use of a commercial fertilizer, as modern crop varieties and higher yields cannot be sustained by other methods. Agricultural input manufacturers vary by product category and include major international chemical, fertilizer and seed companies such as BASF, Bayer Crop Science, ConAgra International Fertilizer Company, Dow AgroScience, DuPont, Monsanto, and Syngenta. Agricultural input distributors represent the main route-to-market for crop protection chemicals and fertilizer products, and fill a critical need in the U.S. and Canadian agricultural inputs market by allowing suppliers to economically access a highly fragmented customer base of approximately two million growers, dealers and non-crop customers. In addition, we believe that both suppliers and customers value the supplementary services that distributors provide, including inventory management, extension of credit, provision of equipment for the application of agricultural products, custom blending and crop management consulting. The primary channel for seed distribution has historically been through grower dealers who distribute seeds within an area around their farms. We believe the trend in seed sales is migrating towards agricultural distributors who have the technical knowledge and ability to bundle seed sales with complementary chemical products. Income from continuing operations before income taxes 70,859 79,202 65,468 Income tax expense 28,157 30,310 25,215 Crop Protection Chemicals Fungicides, Insecticides and Pesticides #1 18% Seeds Seed and Seed Treatment #1 14% Fertilizers Plant Nutrition #1 9% We are also the only national distributor that holds a position in all the non-crop market segments of pest control, turf and ornamental, forestry, and vegetation management. We believe our leading market shares strengthen our position with our suppliers and enhance our ability to increase sales to existing customers and attract new customers. We believe our scale provides us with several benefits, including: (i) volume purchasing and increased shelf space resulting in additional incentives from our suppliers; (ii) operating efficiencies from leveraging our fixed costs; and (iii) the ability to invest in our infrastructure in a cost-effective manner, including information technology systems. In fiscal 2004, on a pro forma basis, we had net sales of $2.5 billion, including net sales of crop protection chemicals of $1.6 billion, net sales of seeds of $258.9 million and net sales of fertilizer of $526.2 million. In addition, our leading local presence in the markets we serve further benefits us because it allows us to attract and retain salespeople and customers while controlling our risk through geographic diversity. Multiple Opportunities for Growth We believe that as the market leader in our product categories we are well positioned to take advantage of growth opportunities in these product areas. We have recently experienced sales growth in seed, proprietary ConAgra Agricultural Products Business Thirteen Weeks Ended November 23, 2003 Table of Contents branded products and non-crop products through both the growth in these markets and by increasing our market share. Our sales from seed have grown from $196.2 million in fiscal 2001 to $258.9 million in fiscal 2004, as seed has become a larger part of the overall market and we have successfully leveraged our own proprietary DynaGro brand. Our sales of higher margin proprietary branded products have increased by 9% since fiscal 2004 and now represent approximately 13% of our overall sales. This growth has been a result of working with our customers to provide tailored products to fit their individual needs. Extensive Distribution Network We operate the largest distribution network in the industry with approximately 320 retail and wholesale farm distribution and storage facilities and three formulation facilities, strategically located in major crop producing regions. We have a sales presence in all 50 states of the United States and nine of the 10 Canadian provinces, and approximately 75,000 customers as of August 29, 2004. Our geographic diversity helps us to mitigate poor weather patterns or economic volatility in any one region and our exposure to any one crop. We operate an integrated system of distribution warehouses and employ approximately 1,100 salespeople across North America. Our network enables us to provide customers with a broad range of products and reliable service. Our salespeople possess an in-depth knowledge of the industry and have established long-term relationships with their customers. As residents of the areas in which we operate, our salespeople are an integrated part of the community and understand the region-specific needs of their customers. We believe that our approach has helped us to form strong relationships with customers at the local level and has enabled us to generate revenues per retail outlet of $5.0 million versus $3.1 million on average among the largest 100 retailers in 2003 as measured by sales, based on independent consulting work which we sponsored. We believe our distribution network size and reach will continue to contribute to gradually increasing the market share held by us in our core product categories. Strong Supplier Relationships We purchase products from over 300 suppliers, including some of the largest chemical, seed and fertilizer companies in the world. We have strong long-term relationships with our suppliers, and our relationships with our ten largest suppliers date back to the original acquisition of UAP by ConAgra Foods in 1978. We are a critical part of our suppliers route-to-market because we are able to help them access a highly fragmented customer base. We believe we are one of the largest customers of agricultural inputs of our seven largest suppliers, and our purchasing scale provides us with a competitive advantage relative to smaller businesses. We believe that our strategic relationships with our suppliers provide us with reliable access to inventory, volume purchasing benefits and the ability to deliver a diverse product offering on a cost-effective basis. Diversified Product Offering We provide our customers with a comprehensive offering of agricultural inputs, comprised of over 40,000 active SKUs as of August 29, 2004 consisting of a broad variety of crop protection chemicals, seeds, and fertilizers, with no single brand accounting for more than 5% of our pro forma net sales in fiscal 2004. We offer a full line of branded products such as CleanCrop, ACA, Savage, Shotgun, Signature and Dyna-Gro, in areas such as plant nutrition, seed treatment, crop protection, adjuvants and seed. The breadth and diversity of our products and services allows us to act as a one-stop-shop that is tailored to meet the region-specific needs of our customers. In addition, we are the largest independent distributor of agricultural seed products in the United States and Canada, and we believe we are well positioned to benefit from the expected future growth of this market. We believe the trend in seed distribution is migrating towards using agricultural distributors such as ourselves, as this allows formulators supplying bio-engineered seeds with complementary chemical products to reach the market. Table of Contents Flexible Operating Model Focused on Free Cash Flow We believe that our operating model generates significant free cash flow as a result of our variable cost structure, low capital expenditure requirements and efficient working capital management. Our capital expenditures have averaged less than 1% of net sales over the past three fiscal years. We are highly focused on working capital management and have reduced average working capital from approximately 25.5% of net sales in fiscal 2001 to approximately 20.4% of net pro forma sales in fiscal 2004, a reduction of $205.3 million. Our low maintenance capital expenditures, efficient working capital management and focus on reducing costs allows us to continue to generate strong free cash flow. Our operating model is also highly scalable, allowing us to expand our business without significant additional fixed costs. Proven and Incentivized Management Team Our current senior management team has an average of 19 years of experience in the agricultural inputs industry. Kenny Cordell joined the company in 2001 and served as President and Chief Operating Officer from February 2002 until December 2003, when he was promoted to Chief Executive Officer of United Agri Products. Our current senior management team has been responsible for developing our recent business strategy, including store rationalization, enhanced credit policies and an increased focus on working capital management, which has resulted in operational improvements and margin expansion. Largely as a result of initiatives implemented by our management team during fiscal 2002 and fiscal 2003, we successfully increased our margins and reduced working capital. After giving effect to this offering, our management will own approximately 8.9% of our common equity on a fully diluted basis, a portion of which is subject to time vesting criteria. See Principal and Selling Stockholders beginning on page 72. OUR STRATEGY Our financial and operational success has largely been driven by providing customers with high quality products at competitive prices, supported by consistent and reliable service and expertise. We will continue to seek to grow our business, improve profitability and reduce working capital through the principal strategies outlined below. Capitalize on our size, leading market share and North American-wide presence to enhance our position as the distributor of choice for seed, chemical and fertilizer suppliers. Because of our size, leading market share, and our national footprint, UAP continues to be the preferred distributor for agricultural seed, chemical and fertilizer suppliers. Because we are the largest customer of many of our suppliers, we are able to enjoy several purchasing power advantages. These advantages include not only enhanced profitability due to lower purchase prices, but also the ability to increase our free cash flows by working with our suppliers to reduce our working capital needs and increase our revenues by pursuing private label opportunities. Our national footprint also enables us to support key suppliers across the entire breadth of their portfolio by accommodating their bundling of products from across their entire product line. Our extensive network allows us more flexibility to support key suppliers entire portfolios, while still balancing our buying to meet varying weather and planting conditions across the country. Increase revenues by continuing to grow our seed business and expand our presence in non-crop markets. Seed. We increased the net sales of our seed products from $196.2 million in fiscal 2001 to $258.9 million in fiscal 2004 and believe that there is the potential for significant further growth in this area. We believe that seed varieties that have been enhanced through biotechnology will serve as a platform for growth due to the increased value-added nature of their sale to the customer, coupled with an increased need for ancillary services when compared with sales of conventional products. In addition, advancements in seed varieties and technologies have increased our customers needs for real-time information and access to the genetic varieties in branded and Table of Contents non-branded lines, which we believe benefits larger suppliers, such as UAP, who have the resources and capabilities to meet these needs. We intend to leverage our growth in the seed business through: (i) advanced technical training for our salespeople; (ii) hiring and strategically placing experienced salespeople; (iii) using incentive compensation plans for our sales organization that incorporate seed-specific performance goals; (iv) nurturing our relationships with seed suppliers; (v) continuing to focus the resources of our management and sales force on our seed distribution infrastructure; and (vi) targeting new retail and wholesale opportunities to enhance our sales presence in regions where gaps exist. As part of our strategy to increase overall seed sales, we will also focus on increasing sales of our Dyna-Gro brand of proprietary seed products. We believe that Dyna-Gro is recognized in the marketplace for its high quality and yield, and we currently market Dyna-Gro in corn, soybeans, sorghum and alfalfa, as well as other minor crops. Our Dyna-Gro brand contributes higher margins than that of a commodity brand because we use internal resources to source and market it. Non-Crop. We also distribute chemicals, seed and fertilizers for many non-agricultural markets, and are the only distributor in our markets with a presence in the three major non-crop market product areas of turf and ornamental (golf courses, residential and commercial properties, nurseries and greenhouses), pest control operators, forestry, and vegetation management. We believe that many non-crop markets are experiencing significant natural growth alongside general demographic trends. For example, as population growth expands in the Southern United States, we expect increased opportunities for sales to pest control operators. Furthermore, as leisure spending increases, we expect increased opportunities for sales to turf, golf course, resort and nursery businesses. The non-crop market is an important strategic growth area for UAP, and as such we are focused on expansion of our current non-crop business through small acquisitions, increased sales of branded products, introduction of new branded products and improving operational performance through consolidation. Capture market share from competitors through our ability to offer a broader range of products and a higher level of service to our customers We believe that as the largest retailer of agricultural inputs, we stand to benefit from ongoing consolidation of retail locations in our industry. UAP s efficiencies, scale and scope enable us to meet the demands of customers and suppliers that our smaller regional competitors and independent stores cannot meet. For example, the breadth of our portfolio enables our sales force to provide agronomic expertise across the entire range of agricultural inputs, building a stronger relationship between UAP and the grower than that of many of our competitors. As the seed segment grows, our investment in seed technology and sales force training provides us with an advantage over other competitors who are not as adept at handling the complexities of selling and carrying seed. UAP s leadership across all product lines allows us to offer our customers significantly greater convenience and value. We can bundle an entire package of seed, chemical and fertilizer to provide our customers with a one-stop source of all their crop input requirements. As our proprietary and private label portfolio grows, the value-added offerings that UAP can make to the grower increase, allowing better choices for the grower and more profit for UAP. Because we are one of the top customers of many of our suppliers, we enjoy purchasing power advantages over our competition across all of our product lines, which allows us to be the low cost source of inputs for growers around the country. Furthermore, UAP has a national footprint, we also enjoy economies of scale on operating costs, and more logistical efficiencies than our competitors. Increase our margins and free cash flow by expanding our proprietary and private label business, which offers significantly higher margins than those on the branded products that we sell. We intend to focus on increasing sales of our proprietary and private label products, which provide value-added features to benefit customers and higher margins to us as compared with other products we sell for third parties. Increased sales of our proprietary branded products have contributed to our margin improvement since fiscal 2001 largely as a result of providing enhanced formulations and tailoring the products to fit growers needs Table of Contents in specific regions, including unique dry herbicide formulations and specialized Nortrace brand micronutrients and Dyna-Gro seed. We seek to further improve our product mix through internal development and close cooperation with our major suppliers. Through August 29, 2004, proprietary and private label sales of chemicals and seed represented 13.8% of net sales versus 11.7% for the same period the prior year. Continue to reduce the working capital and administrative expense in our business in order to reduce leverage and improve our profitability and cash flow. We believe we are well positioned to continue to improve the financial performance of our business. We monitor performance regularly on key operating statistics such as credit, inventory efficiency, payables efficiency, operating expenses, gross profit generation, and overall return on invested capital. This information will continue to enable us to reduce administrative expense and average levels of working capital by concentrating on the following: Earlier collection of supplier rebates; Extending of payables terms with key suppliers; Continuing our inventory efficiencies through centralized purchasing and the reduction of stock keeping units (SKUs) through our segmentation efforts; Continuing to enhance the relationship with our many suppliers by evaluating them on a total return basis including achievements on working capital reductions; Continuing to focus on credit policies and procedures to maximize profitability; and Using competition and best practice sharing among our operating divisions to drive overall focus on working capital reduction that are tied to variable compensation plans. BUSINESS OPERATIONS We operate our business through two primary divisions: Distribution and Products. The Distribution Division, which accounted for approximately 92% of our pro forma net sales in fiscal 2004, purchases agricultural input products from third parties and resells these products, together with our own proprietary private label products, to growers and regional dealers. As of August 29, 2004, the Distribution Division maintained a network of approximately 320 facilities throughout the United States and Canada. The Products Division, which accounted for approximately 8% of our pro forma net sales in fiscal 2004, markets, sources, formulates and packages our proprietary products and provides formulation and packaging services for the private label brands of our suppliers. As of August 29, 2004, the Products Division consisted of three formulation facilities that produce crop protection adjuvants, and plant nutrition. The proprietary products formulated by the Products Division are sold to our customers through the distribution network of our Distribution Division. Distribution Division As of August 29, 2004 we had an extensive distribution infrastructure of over 320 facilities, consisting of retail distribution centers, bulk storage, granulation, blending and seed treatment plants, as well as an integrated network of distribution storage terminals and warehouses. We believe our infrastructure, including chemical and seed warehouses, bulk storage for crop protection chemicals and fertilizer loading equipment, delivery vehicles, nurse tanks, trailers and application equipment provides us with a significant competitive advantage over smaller, regional competitors and deters new entrants into this capital intensive market. Our facilities are strategically located throughout the major crop producing regions in the United States and Canada. We believe this market presence provides a number of competitive advantages, including: allowing us to act as a supplier to the country s largest purchasers of crop production inputs; providing us with the opportunity to distribute products for the leading agricultural input producers; and providing market diversity that helps to insulate our overall business from difficult farming conditions as a result of poor weather in any one particular market or adverse market conditions for a specific crop. Balance at November 23, 2003 $ 651,946 $ Coastal AK, AZ, CA, CT, DE, FL, MA, MD, ME, NC, NH, NJ, NV, NY, PA, RI, SC, VA, VT, WV Tree fruits, nuts, vines, vegetables, rice, cotton, alfalfa, corn, peanuts, wheat and tobacco 644 $ 663.6 Southern AL, AR, GA, KY, LA, MS, NM, OK, TN, TX Cotton, soybeans, rice, peanuts and corn 664 $ 536.9 Northern CO, HI, IA, ID, IL, IN, KS, MI, MN, MO, MT, ND, NE, OH, OR, SD, UT, WA, WI, WY Corn, soybeans, wheat, sorghum, sunflowers, corn, potatoes and sugarbeets 1,058 $ 1,011.8 Canada AB, BC, MB, NB, NS, ON, PEI, QU, SK Tree fruits, vegetables, soybeans, corn, wheat, canola and tobacco 104 $ 105.4 We sell a complete line of products and services to growers through our distribution facilities, with each site tailoring its product offering to the specific needs of the growers in its service area. Our product offering, coupled with the advice of our sales professionals, provides our customers with a one-stop shop for all their agricultural inputs needs. Crop Protection Chemicals. Crop protection chemicals represent a significant portion of our business, accounting for approximately 65% of fiscal 2004 pro forma net sales. We distribute a full range of crop protection chemicals through our distribution locations, including herbicides, insecticides and fungicides, adjuvants and surfactants. We also provide a variety of services related to the application of crop protection chemicals. Within crop protection chemicals, we have experienced a trend towards bundling chemicals products with complementary seed products, as a result of advances in seed technology. Seed. We have placed an emphasis on new seed technology and provide a complete range of seed and seed treatments to growers through our distribution centers. Increasingly, our seed products are prepared by leading seed companies, and sold both under their brand names and our private labels (for example, Dyna-Gro). For example, we were one of the first companies to distribute Roundup Ready soybean and cotton seeds and technology for Monsanto in the United States. Roundup is a popular crop protection product, and Roundup Ready enables soybeans and cotton plants to be Roundup tolerant. We believe that seed technology based on genetic engineering is an important growth area for agriculture. Fertilizer. We distribute a full range of fertilizer products through our distribution centers, including nitrogen, potassium and phosphorous, and various micronutrients such as iron, boron and calcium. We also provide fertilizer application services, as well as customized fertilizer blending for the specific needs of individual growers. Crop Protection Chemicals/Adjuvants Savage, Shotgun, Salvo, Sword, Mepiquat Extra, LI 700, Choice, Rifle, Liberate, Herbimax Seed and Seed Treatments Dyna-Gro, DynaStart, So-Fast Plant Nutrition ACA, Awaken, Nortrace Non-Crop Signature, Bisect Our proprietary brands allow us to enhance our product offering and provide formulations designed to meet the needs of growers in each region that we serve. As a result, we are able to obtain a higher contribution margin from our proprietary branded products than from commodity brands we distribute from other suppliers. We believe our proprietary branded products represent a significant value for our customers and help increase the overall value of our suppliers products. Many of our proprietary branded products are patented in the U.S. or Canada. The Products Division also provides formulating, blending and packaging services for third parties, primarily our major suppliers such as BASF, Bayer, Dow, DuPont, Monsanto and Syngenta. This relationship with our suppliers allows us to leverage our fixed costs and increase plant efficiencies. In addition, by working in Table of Contents such an integrated manner with our suppliers, we are able to remain at the forefront of the newest product technology and market offerings. As a result of the management initiatives implemented at the end of fiscal 2002, we have streamlined our product offering, focused our resources on driving sales of the most profitable brands within each product segment, and reduced our cost structure. For example, we closed two formulation plants during the current fiscal year as part of these initiatives. With our major initiatives substantially complete and an efficient operating platform in place, we intend to focus on increasing sales and margins in our Products Division by continued enhancement of our product mix and increased offerings in each product segment. New product offerings will be generated through internal development and continued cooperation with our major suppliers. INTELLECTUAL PROPERTY We use a wide array of technological and proprietary processes to enhance our crop protection, seed and fertilizer inputs and product development programs. We believe these technologies and proprietary processes enable us to create novel product concepts and reduce time to market. In certain circumstances, we file for patents on technology that we believe is patentable. As of August 29, 2004, we held approximately 200 trademarks (pending or registered) in the United States either directly or through one of our subsidiaries, and United Agri Products Canada Inc., one of our subsidiaries, held approximately 60 Canadian trademarks (pending or registered) either directly or through one of its subsidiaries. These trademarks pertain to products formulated and distributed by us, including chemicals, plant nutrition products, seed and fertilizers. In addition, we and our subsidiaries possess contractual rights to certain trademarks held by third parties through arrangements with certain of our suppliers and distributors, including licenses to use trademarks owned by Dow AgroSciences, DuPont, FMC, Monsanto, Valent and Gowan. Intellectual property rights help protect our products and technologies from use by competitors and others. In addition to trademarks, intellectual property rights of importance to us include trade secrets, confidential statements of formulation and other proprietary manufacturing information. We use nondisclosure agreements to protect our proprietary and confidential information. Such nondisclosure agreements specifically address the confidential information disclosed and concern the protection of our intellectual property. The objectives of the trade secret policy are to prevent disclosure of sensitive information and to protect our legal interests if our trade secrets are appropriated. We will continue to aggressively prosecute and enforce all of our intellectual property rights. SEASONALITY Our and our customers businesses are seasonal, based upon the planting, growing and harvesting cycles. During fiscal 2002 through 2004, at least 75% of our net sales occurred during the first and second fiscal quarters of each year because of the condensed nature of the planting season. As a result of the seasonality of sales, we experience significant fluctuations in our revenues, income and net working capital levels. However, our integrated network of formulation and blending, distribution and warehousing facilities and technical expertise allows us to efficiently process, distribute and store product close to our end-users and to supply our customers on a timely basis during the compressed planting and growing season. See Management s Discussion and Analysis of Financial Condition and Results of Operations beginning on page 35. Due to the seasonal nature of our business, the amount of borrowings outstanding under the revolving credit facility varies significantly throughout the fiscal year. During the period from the date of the Acquisition through October 24, 2004, outstanding borrowings (net of cash on hand) reached a period end peak of $275.2 million as of October 24, 2004. During the same period, utilization of the revolving credit facility was at its lowest when we had $172.6 million of cash on hand as of February 22, 2004. Our average period end borrowings (net of cash on hand) on a historical basis for the twelve-month period ended October 24, 2004 were approximately $76.5 million. In fiscal 2004, our top ten brands accounted for approximately 15% of net sales. COMPETITION The market for the distribution of crop protection chemicals, seeds, fertilizers and agronomic services is highly competitive. In each of our local markets, we typically compete with two or three other distributors. These distributors include agricultural cooperatives, multinational corporation-owned distribution outlets and other independent distribution companies. Agricultural cooperatives are operated for the benefit of their member growers and include companies such as Agriliance, LLC and Growmark, Inc. Multinational corporation-owned distribution outlets include companies such as Helena Chemical Company (a subsidiary of Marubeni Corporation), and other independent distributors such as Royster-Clark, Inc. Our market has experienced significant consolidation over the past several years as the number of outlets has declined from approximately 12,500 in 1995 to 9,500 in 2001. Based on independent consulting work which we sponsored, we believe that independent national distributors increased their retail market share amongst the top 100 retailers in sales from 37% in 1998 to 41% in 2003, and that larger companies, such as UAP, will continue to increase their competitive advantage over businesses with fewer resources. We generally compete with other distributors on the basis of breadth of product offering, ability to provide one-stop shopping with customized local products and services, our salesforce s knowledge of and relationships with our customers, and price. We believe that we compete successfully in each of these areas. SALES ON CREDIT, EXTENSIONS OF CREDIT AND ACCOUNTS RECEIVABLE A significant portion of our sales to growers and independent retailers are made through the use of credit incentives and programs. Typically, we sell products on cash or credit terms, with credit terms ranging from 30 days to crop terms, which typically require payments in December. Many accounts accrue service or finance charges. The interest rate on such charges varies by state, subject to maximum allowable interest under the particular state s laws. As of August 29, 2004, our aggregate accounts receivable, most of which constituted extensions of credit to trade customers, totaled $706.8 million. We have a dedicated and focused credit department, responsible for all our credit and risk management, and our centralized credit and procurement functions are responsible for coordinating various working capital initiatives. Our credit department is also responsible for establishing credit terms and credit limits, compiling data and generating reports to monitor collections and reserves for bad debt, monitoring progress of credit related initiatives, assuring data integrity and distributing relevant reports to the field credit managers. Beginning in the latter half of fiscal 2002, our new management team, including a new Senior Vice President of Credit, implemented more disciplined and sophisticated credit and collections policies and procedures as part of an effort to increase our operational efficiency. These new credit policies and procedures included detailed computerized analysis of a particular customer s credit prior to the sale, routine monitoring of customer credit limits, systematic inactivation of non-conforming accounts and hiring a dedicated staff of collections specialists. Income from continuing operations $ 42,702 $ 48,892 $ 40,253 Table of Contents MANAGEMENT INFORMATION SYSTEMS Our finance, credit and information technology departments are responsible for all our financial reporting, information technology and systems, treasury and cash management, financial analysis and budgeting, state tax filings, and credit and risk management. In addition, our finance and credit departments perform financial modeling and analysis, due diligence and contract negotiations for acquisitions. Our credit department also establishes credit terms and credit limits, compiles data and generates reports to monitor collections, reserves for bad debt, and progress of credit related initiatives, and to assure data integrity and distribute relevant reports to the field credit managers. Our finance department is currently consolidating from its five current locations to two locations in Greeley, Colorado and Tampa, Florida. We have point-of-sale computer systems at our locations which provide daily reports, including sales and profitability data, credit information and working capital data. We use these systems to provide data for inventory control, credit controls, budgeting, forecasting and working capital management requirements. RAW MATERIALS AND SUPPLIES We purchase our crop protection products and seed primarily from the world s leading agrochemical companies. We have contracts with each of BASF, Bayer Crop Science, Dow AgroSciences, DuPont Nemours, Monsanto, Syngenta and other prominent suppliers in the industry. We act as a leading distributor of crop protection products for major agricultural chemical companies, purchasing crop protection products at the chemical companies distributor price and receiving a cash rebate based on volume and type of product. The cash rebate is typically paid near the end of the calendar year, but may be advanced monthly with the balance paid at year-end. Such rebate programs may be published programs, in which case rebates are calculated similarly among all buyers, or unpublished programs, in which case rebates are structured solely according to our business. Historically we have purchased, and will continue to purchase, our fertilizer primarily from ConAgra International Fertilizer Company, an affiliate of ConAgra Foods, and one of the largest U.S. marketers of fertilizer. In connection with the Acquisition, we entered into a five-year fertilizer supply agreement with ConAgra International Fertilizer Company. Our agreement with ConAgra International Fertilizer Company enables us to buy fertilizer from U.S. or international sources, depending on where we can get the best prices. See Certain Relationships and Related Transactions Ancillary Agreements beginning on page 77. EMPLOYEES AND LABOR RELATIONS As of August 29, 2004 we employed approximately 3,020 non-unionized and salaried employees, approximately 85 unionized employees and approximately 517 temporary employees to meet our seasonal needs. We believe we have good relations with our employees. All our unionized employees work at the Platte Chemical Company facility in Greenville, Mississippi and are all subject to a collective bargaining agreement. This collective bargaining agreement is scheduled to expire in August 2007, but is subject to automatic renewals for additional year-long periods unless otherwise terminated. We have not had any work stoppages in the past five years. In connection with the Acquisition, UAP Holdings entered into retention agreements with ten of our top executives. Each of these executives was granted restricted units in UAP Holdings pursuant to these retention agreements. In addition, UAP Holdings issued these same employees stock options that vest in three separate tranches and are subject to UAP Holdings 2003 stock option plan. See Management beginning on page 62. Mortgages on 36 of our owned properties secure our obligations under the revolving credit facility. See Description of Certain Indebtedness The Revolving Credit Facility beginning on page 87. Table of Contents ENVIRONMENTAL MATTERS Our facilities and operations must comply with a wide variety of federal, state and local environmental laws, regulations and ordinances, including those related to air emissions, water discharges and chemical and hazardous waste management and disposal. Our operations are regulated at the federal level under the Clean Air Act, the Clean Water Act, the Resource Conservation and Recovery Act, the Occupational Safety and Health Act, and at the state level under analogous state laws and regulations. Our operations also are governed by laws relating to workplace safety and worker health and safety, primarily the rules of the Occupational Safety and Health Administration and the United States Department of Transportation. Non-compliance with these environmental, health and safety laws can result in significant fines or penalties or restrictions on our ability to sell or transport products. We manage these regulatory risks by employing a staff of highly trained professionals, by performing periodic compliance audits, and by participating in industry stewardship initiatives. We believe that our operations are in compliance in all material respects with current requirements under environmental laws and employee safety laws, except for matters that are not expected to have a material adverse effect on our business, financial conditions, results of operations or liquidity. Environmental laws may hold current owners or operators of land or businesses liable for their own and for previous owners or operators releases of hazardous or toxic substances, materials or wastes, pollutants or contaminants, including petroleum and petroleum products. Because of our operations, the history of industrial or commercial uses at some of our facilities, the operations of predecessor owners or operators of some of the businesses, and the use, production and release of hazardous substances at these sites, we are affected by the liability provisions of environmental laws. Many of our facilities have experienced some level of regulatory scrutiny in the past and are or may be subject to further regulatory inspections, future requests for investigation or liability for hazardous substance management practices. From time to time, we incur expenses in connection with remediation of hazardous substances, including nitrates, phosphorous and pesticides in soils and/or groundwater at our current and former facilities. Much of this work is conducted on a voluntary basis under state law, which provides for reimbursement of expenses by state agricultural funds. In addition, we are engaged in corrective action under the Resource Conservation and Recovery Act at our facilities in Billings, Montana and Garden City, Kansas, and our former facility in Nichols, Iowa. We have also removed or closed underground storage tanks from some of our facilities and, in some instances, are responding to historic releases at these locations. In total, both voluntary and government ordered cleanups of releases of hazardous substances are planned or being performed at approximately 23 sites. Without consideration of third-party contributions, the cost of these on-going and potential response actions is not expected to have a material adverse effect on our business, financial condition, results of operations or liquidity. In some cases, third parties (including government reimbursement funds and insurers) may contribute to the costs of cleanup at these sites. ConAgra has agreed to provide us with a partial reimbursement of costs that we may incur in the future relating to any cleanup requirements arising out of pre-closing environmental conditions at our Greenville, Mississippi facility. On October 14, 2002, December 23, 2002 and December 31, 2002, three separate lawsuits were filed in the Circuit Court of Washington County, Mississippi against our subsidiary, Platte Chemical Company ( Platte ), and certain former employees of Platte, relating to alleged releases from Platte s Greenville, Mississippi facility. The plaintiffs in such suits are seeking compensation for alleged personal injury and property damage. In connection with the Acquisition, ConAgra agreed to partially reimburse us, subject to a cap, for fees and expenses we incur in connection with such lawsuits. Subsequent to November 23, 2003, another lawsuit not covered by the ConAgra cost sharing agreement was filed in the Circuit Court of Washington County, Mississippi against us and Apollo, which lawsuit relates to the same alleged releases from the Greenville, Mississippi facility. In January 2004, the plaintiffs requested permission from the court to amend their first three complaints to include United Agri Products, UAP Holdings, Apollo and various other Apollo entities as defendants. The plaintiffs request to amend the complaints was denied by the court. While the Greenville litigations are at an early stage, based on information available to us at this time we do not believe that such litigations, if adversely determined, would have a material adverse effect on our business, financial condition, results of operations or liquidity. Table of Contents The Comprehensive Environmental Response, Compensation and Liability Act, as amended ( CERCLA ), provides for responses to, and, in some instances, joint and several liability for releases of, hazardous substances into the environment. At the present time, there are four off-site disposal facilities at which we have been identified as a potentially responsible party under CERCLA. We believe we are a de minimis party at each of the following sites: Denova Rialto, CA; Malone Texas City, TX; Red Panther, Clarksdale, MS; and Aberdeen Pesticide Dump, Aberdeen, N.C. REGULATORY LICENSES AND APPROVALS As a seller and distributor of crop production inputs, we are subject to registration requirements under the Federal Insecticide, Fungicide, and Rodenticide Act and related state statutes, which require us to provide information to regulatory authorities regarding the benefits and risks of the products we sell and distribute, and to periodically update that information. Risk information supplied to governmental authorities by us or others could result in the cancellation of products or in limitations on their use. In addition, these laws regulate information contained in product labels and in promotional materials, require that products are manufactured in adherence to manufacturing specifications, and impose reporting and recordkeeping requirements relating to production and sale of certain pesticides. Non-compliance with these environmental, health and safety laws can result in significant fines or penalties or restrictions on our ability to sell our products. Based on our experience to date, these requirements are not expected to have a material adverse effect on our business, financial condition, results of operations or liquidity. LEGAL PROCEEDINGS In addition to the matters discussed above under Environmental Matters beginning on page 60, we are involved in periodic litigation in the ordinary course of our business, including lawsuits brought by employees and former employees alleging discriminatory practices, intellectual property infringement claims, product liability claims, property damage claims, personal injury claims, contract claims and worker s compensation claims. We do not believe that there are any pending or threatened legal proceedings, including ordinary litigation incidental to the conduct of our business and the ownership of our properties, that, if adversely determined, would have a material adverse effect on our business, financial condition, results of operations or liquidity. However, we cannot assure you that future litigation will not adversely affect our business, financial condition, results of operations or liquidity. L. Kenny Cordell 47 President, Chief Executive Officer and Director Bryan S. Wilson 44 President, Distribution Robert A. Boyce, Jr. 42 President, Verdicon David W. Bullock 40 Executive Vice President and Chief Financial Officer David Tretter 48 Executive Vice President, Procurement Kevin Howard 38 Executive Vice President, Products Company Todd A. Suko 37 Vice President, General Counsel and Secretary Joshua J. Harris 39 Director Robert Katz 36 Director Marc E. Becker 32 Director Stan Parker 28 Director Carl J. Rickertsen 44 Director Thomas R. Miklich 57 Director L. Kenny Cordell has been the President and a director of UAP Holdings and United Agri Products since the closing of the Acquisition on November 24, 2003 and became the Chief Executive Officer of United Agri Products in December 2003 and of UAP Holding Corp. in January 2004. He joined UAP in 2001 and was promoted to President and Chief Operating Officer in February 2002. Prior to joining UAP, Mr. Cordell worked for FMC Agricultural Products Group from 1992 to 2001, serving most recently as Director of the North American Agricultural Products Group. Mr. Cordell also held various positions in the agricultural units of BASF (1989 to 1992) and Rohm & Haas (1979 to 1989). Bryan S. Wilson has been the President, Distribution of UAP Holdings and United Agri Products since January 2004. He joined UAP in September 2002 as President and General Manager, Products and Non-Crop. Prior to joining UAP, Mr. Wilson worked for BASF from 1987 to 2002, holding various positions both domestically and internationally, serving most recently as President of Microflo, Inc., a subsidiary of BASF. Robert A. Boyce, Jr. has been President of Verdicon, the non-crop distribution business of UAP Holdings and United Agri Products, since January 2004. Mr. Boyce joined UAP in 1990 as a Branch Manager. Mr. Boyce served as an Operating Company Manager in two different regional operating companies and as Executive Vice President of Distribution prior to becoming President of Verdicon. Prior to joining UAP, Mr. Boyce worked for Helena Chemical Company from 1989 to 1990 and for ICI Americas from 1985 through 1988. David W. Bullock has been the Executive Vice President of UAP Holdings and United Agri Products since the closing of the Acquisition on November 24, 2003, and became the Chief Financial Officer of United Agri Products in December 2003 and of UAP Holdings in January 2004. He joined UAP in June 2002 as Senior Financial Officer. Prior to joining UAP, Mr. Bullock worked for FMC Agricultural Products Group from 1995 to 2002, serving most recently as Controller of the North American agriculture business. Mr. Bullock also held various financial positions with Air Products and Chemicals (1991 to 1995). David Tretter has been Executive Vice President, Procurement for UAP Holdings and United Agri Products since the closing of the Acquisition on November 24, 2003. He joined UAP in July 1985 as Fertilizer Manager and has held various positions in sales management, general management, and executive management since that time. Prior to joining UAP, Mr. Tretter was Vice President of Operations for Pasquales Food in Birmingham, AL. Table of Contents Kevin Howard has been the Executive Vice President, Products Company of UAP Holdings and United Agri Products since January 2004. Prior to joining UAP, Mr. Howard worked for BASF from 1997 through 2003, serving most recently as Vice President of Operations for Microflo Inc. (a division of BASF). Prior to joining BASF, Mr. Howard held various sales and marketing positions with Sandoz from 1990 through 1996. Todd A. Suko has been the Vice President, General Counsel and Secretary of UAP Holdings and United Agri Products since the Acquisition on November 24, 2003. He joined United Agri Products in February 2001 as Associate Counsel and was promoted to Vice President Legal and Regulatory Services and Corporate Counsel in October 2002. Prior to joining United Agri Products, he practiced law at McKenna & Cuneo, LLP in Washington, D.C. from 1996 to 2001. Joshua J. Harris has been a director of UAP Holdings and United Agri Products since the closing of the Acquisition on November 24, 2003. Mr. Harris has been a founding senior partner of Apollo Management, L.P. since 1990. Prior to that time, Mr. Harris was a member of the Mergers and Acquisitions department of Drexel Burnham Lambert Incorporated. Mr. Harris is also a director of Pacer International, Inc., Compass Minerals Group, Inc., Compass Minerals International, Inc., Resolution Performance Products LLC, Quality Distribution, Inc., Nalco Investment Holdings LLC, General Nutrition Centers, Inc. and Borden Chemicals, Inc. Robert Katz has been a director of UAP Holdings and United Agri Products since the closing of the Acquisition on November 24, 2003. Mr. Katz has been associated with Apollo Management, L.P. since 1990. Mr. Katz is also a director of Vail Resorts, Inc., SpectraSite, Inc. and Horizon PCS, Inc. Marc E. Becker has been a director of UAP Holdings and United Agri Products since the closing of the Acquisition on November 24, 2003. Mr. Becker has also been employed with Apollo Management, L.P. since 1996 and has served as an officer of certain affiliates of Apollo since 1999. Prior to that time, Mr. Becker was employed by Smith Barney Inc. within its Investment Banking division. Mr. Becker serves on several boards of directors including National Financial Partners Corp., Pacer International, Inc. and Quality Distribution, Inc. Stan Parker has been a director of UAP Holdings since March 2004 and a director of United Agri Products since April 2004. Mr. Parker has also been employed with Apollo Management, L.P. since 2000. From 1998 to 2000, Mr. Parker was employed by Salomon Smith Barney, Inc. Carl J. Rickertsen has been a director of UAP Holdings since March 2004 and a director of United Agri Products since April 2004. Mr. Rickertsen has been the managing partner of Pine Creek Partners since January 2004. Prior to that time, Mr. Rickertsen was the Chief Operating Officer and a Partner of Thayer Capital Partners and a General Partner at Hancock Park Associates. Mr. Rickertsen is also a director of MicroStrategy Incorporated and Convera Corporation. Thomas R. Miklich has been a director of UAP Holdings since March 2004 and a director of United Agri Products since April 2004. Mr. Miklich was the Chief Financial Officer of OM Group, Inc. from May 2002 to April 2004. Prior to that time, Mr. Miklich was the Chief Financial Officer and General Counsel of Invacare Corporation. Our board of directors currently consists of seven directors. We currently expect to add an additional independent director after the completion of this offering. If our equity sponsor controls a majority of our outstanding common stock after this offering, we intend to avail ourselves of the controlled company exception under the NASDAQ National Market rules, which eliminates the requirement that we have a majority of independent directors on our board of directors. If our equity sponsor does not control a majority of our outstanding common stock after this offering, we will alter the composition of our board of directors so that, within one year following the completion of this offering, a majority of our directors are independent. Our current board of directors is divided into three classes. The members of each class serve for a three-year term. Messrs. Cordell, Miklich and Rickertsen serve as Class I directors with a term expiring in 2005, Messrs. Table of Contents Parker and Katz serve as Class II directors with a term expiring in 2006, and Messrs. Becker and Harris serve as Class III directors with a term expiring in 2007. At each annual meeting of the stockholders, a class of directors will be elected for a three-year term to succeed the directors of the same class whose terms are then expiring. Supermajority Board Approval of Certain Matters The approval of at least two-thirds of the members of our board of directors is required by our amended and restated certificate of incorporation under certain circumstances. These include, as to us and each of our subsidiaries: amendment, modification or repeal of any provision of the certificate of incorporation, bylaws or similar organizational documents in a manner that adversely affects Apollo; the redemption, purchase or acquisition of any of our securities or those of our subsidiaries; the issuance of additional shares of any class of capital stock (other than the grant of options or the issuance of shares upon the exercise of options or otherwise, in each case, pursuant to the terms of any option plan, long-term incentive plan or other employee benefit plan of ours adopted by our board of directors); the payment or declaration of any dividend or other distribution, with respect to any shares of any class or series of capital stock; a consolidation or merger with or into any other entity, or transfer (by lease, assignment, sale or otherwise) of all or substantially all of our assets to another entity (other than transactions between UAP Holdings and any of its wholly owned subsidiaries or transactions between two or more wholly owned subsidiaries of UAP Holdings); a complete or partial liquidation, dissolution, winding-up, recapitalization, reclassification or reorganization of UAP Holdings; a split, combination or reclassification of any shares of capital stock; a disposition of any assets in excess of $10.0 million in the aggregate other than sales of inventory in the ordinary course of business; consummation of any acquisition of the stock or assets of any other entity involving consideration in excess of $10.0 million in the aggregate outside of the ordinary course of business; the incurrence of indebtedness aggregating more than $10.0 million, except for borrowings under a revolving credit facility that has previously been approved or is in existence (with no increase in maximum availability) on the date of closing of this offering; the appointment, termination and replacement of our chief executive officer; and change in size of our board of directors. This provision of our amended and restated certificate of incorporation shall terminate at such time as Apollo no longer beneficially own at least one-third of our outstanding common stock and Apollo has sold at least one share of our common stock other than in this offering. DIRECTOR COMPENSATION Initial compensation for our directors who are not also employed by us will be $10,000 per director per quarter and $2,000 per director for attending meetings of the board of directors in person ($1,000 if by telephone) and $2,000 per director for attending committee meetings of the board of directors in person ($1,000 if by telephone). COMMITTEES OF THE BOARD OF DIRECTORS Our board of directors currently has an audit committee and a compensation committee. The members of the audit committee are Messrs. Rickertsen, Miklich and Becker. Within one year following the consummation of the Table of Contents offering, we expect that Mr. Becker will be replaced as a member of the audit committee with a new director who will qualify as an independent director under the applicable listing standards of the NASDAQ National Market and the SEC s rules and regulations. The members of the compensation committee are Messrs. Harris, Katz and Rickertsen. If our equity sponsor controls a majority of our outstanding common stock after this offering, we intend to avail ourselves of the controlled company exception under the NASDAQ National Market rules which eliminates the requirement that our compensation committee be composed entirely of independent directors. If our equity sponsor does not control a majority of our outstanding common stock after this offering, we expect that, within ninety days following the completion of this offering, Mr. Katz will be replaced as a member of the compensation committee with a new director who would qualify as an independent director under the applicable listing requirements of the NASDAQ National Market and that, within one year following the completion of this offering, Mr. Harris will be replaced as a member of the compensation committee with a new director who would qualify as an independent director under the applicable listing requirements. Prior to the completion of the offering, we expect that our board of directors will designate a nominating committee. As with the compensation committee, we intend to avail ourselves of the controlled company exception under the NASDAQ National Market rules which eliminates the requirement that our nominating committee be composed entirely of independent directors if our equity sponsor controls a majority of our outstanding common stock after this offering. If our equity sponsor does not control a majority of our outstanding common stock, we expect that the nominating committee s members will meet the applicable listing requirements of the NASDAQ National Market. Audit Committee. The principal duties and responsibilities of our audit committee are as follows: to monitor our financial reporting process and internal control system. to appoint and replace our independent registered public accounting firm from time to time, determine their compensation and other terms of engagement and oversee their work. to oversee the performance of our internal audit function. to oversee our compliance with legal, ethical and regulatory matters. The audit committee will have the power to investigate any matter brought to its attention within the scope of its duties. It will also have the authority to retain counsel and advisors to fulfill its responsibilities and duties. Compensation Committee. The principal duties and responsibilities of the compensation committee are as follows: to provide oversight on the development and implementation of the compensation policies, strategies, plans and programs for our key employees and outside directors and disclosure relating to these matters. to review and approve the compensation of our chief executive officer and the other executive officers of us and our subsidiaries. to provide oversight concerning selection of officers, management succession planning, performance of individual executives and related matters. Nominating Committee. The principal duties and responsibilities of the nominating committee will be as follows: to establish criteria for board and committee membership and recommend to our board of directors proposed nominees for election to the board of directors and for membership on committees of the board of directors. to make recommendations regarding proposals submitted by our shareholders. to make recommendations to our board of directors regarding board governance matters and practices. (1) As described in more detail below under Retention Agreements, we granted Messrs. Cordell, Wilson, Bullock, Tretter, and Boyce deferred share awards in connection with the Acquisition covering 508,108, 312,682, 312,682, 195,426 and 302,911 deferred shares of common stock, respectively. The value set forth above with respect to each such grant represents the number of deferred shares of common stock awarded multiplied by the approximate value of a share of our common stock as of the date of grant of the award. As described in more detail below under 2003 and 2004 Deferred Compensation Plans, each deferred share award is subject to a two-year vesting requirement measured from the date of the consummation of the offering, carries dividend equivalent rights, and if and when payable represents the right to receive one share of common stock from UAP Holdings. Each named executive continued to hold the number of deferred shares of common stock set forth above as of February 22, 2004. The value of these deferred shares of common stock held by Messrs. Cordell, Wilson, Bullock, Tretter, and Boyce as of that date, measured by multiplying the number of deferred shares subject to the award by the approximate value of a share of our common stock on February 22, 2004, was substantially the same as the grant-date value reflected in the table above. (2) Consists of a company contribution to UAP Holdings retirement (401(k)) plan of $6,058, a relocation benefit of $8,787, and, as described in more detail below under Retention Agreements, a special bonus paid in connection with the Acquisition of $712,889. Of the special bonus paid to Mr. Cordell, ConAgra Foods paid Mr. Cordell $389,289 and UAP Holdings paid Mr. Cordell $323,600. UAP Holdings subsequently reimbursed ConAgra Foods for $81,400 of its payment to Mr. Cordell. (3) Consists of a company contribution to UAP Holdings retirement (401(k)) plan of $5,583, a relocation benefit of $63,947, and, as described in more detail below under Retention Agreements, a special bonus paid in connection with the Acquisition of $380,000. (4) Consists of a company contribution to UAP Holdings retirement (401(k)) plan of $6,029, and, as described in more detail below under Retention Agreements, a special bonus paid in connection with the Acquisition of $5,000. (5) Consists of a company contribution to UAP Holdings retirement (401(k)) plan of $6,000, a relocation benefit of $76,291, and, as described in more detail below under Retention Agreements, a special bonus paid in connection with the Acquisition of $365,000. (6) Consists of a company contribution to UAP Holdings retirement (401(k)) plan of $4,931, a relocation benefit of $11,476, and, as described in more detail below under Retention Agreements, a special bonus paid in connection with the Acquisition of $170,000. The table above does not reflect restricted stock awards and options exercisable for the common stock of ConAgra Foods which were awarded by ConAgra Foods prior to the closing of the Acquisition. Table of Contents RETENTION AGREEMENTS In connection with the Acquisition, UAP Holdings entered into retention agreements with ten of its top executives. The terms and conditions of the retention agreements are substantially identical. Under each agreement, the applicable executive received, upon the consummation of the Acquisition, a cash bonus and a bonus payable by crediting deferred shares of common stock to such executive s deferred compensation account under the 2003 deferred compensation plan. Concurrently with the closing of this offering, each of the retention agreements will be terminated and replaced by the management incentive agreement. See Certain Relationships and Related Transactions Related Party Transactions in Connection with This Offering Management Incentive Agreement beginning on page 83. The bonuses received by our named executive officers and number of deferred shares of common stock granted to our officers in connection with the Acquisition are set forth under Executive Compensation above. 2003 AND 2004 DEFERRED COMPENSATION PLANS In connection with the Acquisition and subsequently thereafter, UAP Holdings adopted 2003 and 2004 deferred compensation plans for the benefit of certain of its executives and members of management. The 2003 plan provides for the creation of individual deferred compensation accounts for each executive who entered into a retention agreement, and, as described above, such accounts were credited at the closing of the Acquisition with a specified number of deferred shares of common stock. The 2004 plan provides for the creation of individual deferred compensation accounts for each member of management who waived the right to receive a cash bonus for the 2004 fiscal year and such accounts were credited with a specified number of deferred shares of common stock. Each deferred share represents the right to receive one share of common stock on the applicable payment date. The plans prohibit the assignment of the deferred shares except upon an executive s death. UAP Holdings has agreed to indemnify and reimburse directors, officers and employees in connection with the administration of the plans. Under the 2003 and 2004 deferred compensation plans, if UAP Holdings pays any non-cash dividend on its common stock, each participant s deferred compensation account is credited with an additional number of deferred shares equal to the number obtained by dividing (i) the aggregate value of the dividend that is paid on the shares of common stock represented by the vested deferred shares that such participant s deferred compensation account is credited with as of the record date for such dividend payment by (ii) the fair market value of one share of common stock as of the date such dividend is paid (with such fair market value determined after giving effect to such dividend). If UAP Holdings pays any cash dividend on shares of common stock, it will contemporaneously therewith pay a cash bonus to each participant holding deferred shares. Such cash bonus amount with respect to any such dividend payment will equal to the applicable per share cash dividend paid on the common stock multiplied by the number of deferred shares that such participant s deferred compensation account is credited with as of the record date for such dividend payment (or the payment date if there is no record date). A participant s deferred shares under the 2003 and 2004 deferred compensation plans will become payable as follows: If the participant has the right to transfer shares of common stock pursuant to the exercise of piggyback registration rights in accordance with the Investor Rights Agreement (or the corresponding successor provisions of the Management Incentive Agreement), then the participant will receive payment of a number of deferred shares equal to the maximum number of shares of common stock that the participant is entitled to sell in such public offering (after giving effect to any applicable underwriter cutback provisions). If the participant s employment terminates, the participant s deferred shares will be paid. All of the participant s deferred shares will be paid upon (i) the acquisition of certain percentages of voting power of UAP Holdings common stock by persons other than Apollo and its affiliates, (ii) a merger involving UAP Holdings in which the shareholders of UAP Holdings immediately prior to such Table of Contents Pro Forma Table of Contents merger own less than 50% of the voting securities of the surviving corporation after such merger, (iii) the sale of all or substantially all of the assets of UAP Holdings, or (iv) the occurrence of a change of control as defined in any indenture or agreement to which UAP Holdings or any of its subsidiaries is a party with respect to indebtedness for borrowed money in excess of the aggregate principal amount of $100,000,000. A payment of a deferred share will reduce the number of deferred shares remaining credited to that participant s account under the applicable deferred compensation plan. In connection with this offering and in accordance with the payment provisions described above, each participant will receive payment of a number of deferred shares equal to the number of shares of common stock that the participant is entitled to sell in this offering. 2003 STOCK OPTION PLAN In connection with the Acquisition, UAP Holdings adopted a stock option plan, which we refer to in this prospectus as the 2003 option plan. The purpose of the 2003 option plan is to further the growth and success of UAP Holdings and its subsidiaries by enabling our directors, employees and consultants to acquire shares of UAP Holdings common stock, thereby increasing their personal interest in such growth and success, and to provide a means of rewarding outstanding performance by such persons. The 2003 option plan provides that it may be administered by UAP Holdings board of directors or its compensation committee. A total of 3,283,165 shares of UAP Holdings common stock may be subject to awards granted under the 2003 option plan. As of August 29, 2004, UAP Holdings board of directors had granted options to purchase 3,066,400 shares of UAP Holdings common stock under the 2003 option plan, and 216,765 shares remained available for additional award grant purposes. (The foregoing share numbers are presented after giving effect to the UAP Holdings stock split of approximately 39.085-for-one which was effected on November 17, 2004 in connection with this offering.) Shares that are subject to options that expire or for any reason are cancelled or terminated will again be available for options granted under the plan. The 2003 option plan only allows for the issuance of non-qualified options to purchase shares of UAP Holdings common stock. The exercise price and term of the option are determined by the board of directors (or compensation committee) at the time of grant of the option. The number and type of securities subject to the option may be adjusted in the event of a stock split or similar event affecting UAP Holdings common stock. Options granted under the plan may not be assigned or transferred, except for transfers upon the optionee s death. In the event of any sale of UAP Holdings, each option then outstanding under the 2003 option plan will become exercisable for the consideration per share received by Apollo in connection with such sale. In the event that we, or our successor, terminate an option holder s employment without cause at any time on or within one year following the sale, all of the options under the 2003 option plan held by that optionee will become vested and exercisable as of the date of the termination. In addition, each 2003 option plan option that remains outstanding and is not otherwise vested on the first anniversary of such a sale will generally become fully vested and exercisable on that date. For purposes of the 2003 option plan, a sale of UAP Holdings generally means a sale of UAP Holdings to one or more independent third parties, pursuant to which such party or parties acquire capital stock possessing the voting power to elect a majority of our board of directors, or a sale of all or substantially all of our assets. Furthermore, upon a realization event, we may, but are not obligated to, purchase each outstanding vested 2003 option plan option for an amount equal to the amount per share received in respect of the shares sold in such transaction constituting the realization event less the exercise price of the option. For purposes of the 2003 option plan, a realization event generally means a sale of UAP Holdings as described above or any transaction or series of related transactions in which Apollo sells at least 50% of its interest in the company. Each of the executives that is a party to a retention agreement received options under the 2003 option plan pursuant to individual option agreements, the terms and conditions of which are substantially identical. Each agreement provides for the issuance of three tranches of options to purchase common stock of UAP Holdings. (in thousands) Table of Contents The term of each option expires on the thirtieth day immediately following the eighth anniversary of the grant date of such option, unless otherwise terminated sooner. The Tranche A options vest 20% on each of the first five anniversaries of the grant date. All of the Tranche B options vest on the earlier to occur of the eighth anniversary of the grant date or a realization event whereby the equity sponsor receives an internal rate of return equal to or exceeding 25%. All of the Tranche C options vest on the earlier to occur of the eighth anniversary of the grant date or a realization event whereby the equity sponsor receives an internal rate of return equal to or exceeding 30%. Upon completion of this offering, all Tranche B options and Tranche C options will be fully vested. Tranche A options will continue to vest in accordance with their vesting schedules. Upon an executive s termination of his employment, all of such executive s issued and outstanding options automatically terminate upon the earlier to occur of (i) the thirtieth day following the eighth anniversary of the grant date or (ii) the ninetieth day following any termination of such employee s relationship with UAP Holdings. 2004 NON-EXECUTIVE DIRECTOR STOCK OPTION PLAN On March 8, 2004, UAP Holdings adopted a stock option plan for the benefit of its non-executive directors, which we refer to in this prospectus as the 2004 non-executive director option plan. The purposes of the 2004 non-executive director option plan is to further the growth and success of UAP Holdings and its subsidiaries by enabling directors of UAP Holdings or any of its subsidiaries to acquire shares of UAP Holdings common stock, thereby increasing their personal interest in such growth and success, and to provide a means of rewarding outstanding performance by such persons. All options granted under the plan will be non-qualified stock options. The number and type of securities subject to options granted under the plan may be adjusted in the event of a stock split or similar event affecting UAP Holdings common stock. No option granted under the 2004 non-executive director option plan may be assigned or otherwise transferred by the optionee, except for transfers by will or by the laws of descent and distribution. The 2004 non-executive director option plan will terminate on the tenth anniversary of its adoption, and no options may be granted under the plan thereafter. As of May 30, 2004, UAP Holdings board of directors had granted options to purchase 351,762 shares of UAP Holdings common stock under the 2004 non-executive director option plan, all of which vested immediately, and another 234,517 shares of common stock remained available for future grants. 2004 LONG TERM INCENTIVE PLAN In conjunction with this offering, UAP Holdings adopted a long-term incentive plan (which we refer to in this prospectus as the 2004 incentive plan ) as an additional means to attract, motivate, retain and reward directors, officers, employees and other eligible persons through the grant of awards and incentives for high levels of individual performance and improved financial performance of UAP Holdings. Equity-based awards are also intended to further align the interests of award recipients and UAP Holdings stockholders. A total of 273,598 shares of UAP Holdings common stock are currently available for awards granted under the 2004 incentive plan. Commencing on March 1, 2005 and on each March 1 thereafter during the term of the plan, an additional number of shares will become available for award grant purposes equal to the lesser of (i) 1,172,559 shares, (ii) a number of shares equal to 1% of the number of shares of UAP Holdings common stock outstanding at the close of business on the immediately preceding day, or (iii) such lesser number of shares as determined by UAP Holdings board of directors. (The foregoing share numbers are presented after giving effect to the UAP Holdings stock split of approximately 39.085-for-one effected on November 17, 2004 in connection with this offering.) Any shares subject to awards that are not paid or exercised before they expire or are terminated, as well as shares tendered or withheld to pay the exercise or purchase price of an award or related tax withholding obligations, will become available for other award grants under the plan. As of the date of this prospectus, no awards have been granted under the 2004 incentive plan. Table of Contents UAP Holdings board of directors, or a committee of directors appointed by the board, has the authority to administer the 2004 incentive plan. A committee may delegate some or all of its authority with respect to the plan to another committee of directors, and certain limited authority to grant awards to employees may be delegated to one or more of UAP Holdings officers. (The appropriate acting body is referred to in this prospectus as the administrator. ) The administrator of the plan will have broad authority to: select participants and determine the type(s) of award(s) they are to receive; determine the number of shares that are subject to awards and the terms and conditions of awards, including the price (if any) to be paid for the shares or the award; cancel, modify or waive UAP Holdings rights with respect to, or modify, discontinue, suspend or terminate any or all outstanding awards, subject to any required consents; and accelerate or extend the vesting or exercisability or extend the term of any or all outstanding awards. As is customary in incentive plans of this nature, the number and kind of shares available under the 2004 incentive plan and any outstanding awards, as well as the exercise or purchase prices of awards, are subject to adjustment in the event of certain reorganizations, mergers, combinations, recapitalizations, stock splits, stock dividends or other similar events that change the number or kind of shares outstanding, and extraordinary dividends or distributions of property to the stockholders. In no case (except due to an adjustment referred to above or any repricing that may be approved by UAP Holdings stockholders) will any adjustment be made to a stock option or stock appreciation right award under the 2004 incentive plan (by amendment, cancellation and regrant, exchange or other means) that would constitute a repricing of the per-share exercise or base price of the award. Awards under the 2004 incentive plan may be in the form of stock options (nonqualified or incentive), stock appreciation rights (SARs), restricted stock, stock bonuses and other forms of awards granted or denominated in UAP Holdings common stock or units representing common stock. Awards under the plan generally will not be transferable other than by will or the laws of descent and distribution and are generally exercisable, during the participant s lifetime, only by the participant. The administrator has discretion, however, to establish written conditions and procedures for the transfer of awards to other persons or entities, provided that such transfers comply with applicable federal and state securities laws. Nonqualified stock options and other awards may be granted at prices below the fair market value of the common stock on the date of grant. Incentive stock options must have an exercise price that is at least equal to the fair market value of the common stock, or 110% of fair market value of the common stock for any 10% owner of UAP Holdings common stock, on the date of grant. Restricted stock awards can be issued for nominal or the minimum lawful consideration. These and other awards may also be issued solely or in part for services. The maximum term of options, SARs and other rights to acquire common stock under the plan will be ten years after the initial date of the award, subject to provisions for further deferred payment in certain circumstances. The exercise price of options or other awards may generally be paid in cash or, subject to certain restrictions, shares of common stock. Subject to any applicable limits, we may finance or offset shares to cover any minimum withholding taxes due in connection with an award. Generally, and subject to limited exceptions set forth in the 2004 incentive plan, if any person acquires more than 30% of UAP Holdings outstanding common stock or combined voting power, if certain changes in a majority of UAP Holdings board of directors occur over a period of not longer than two years, if stockholders prior to a transaction do not continue to own more than 50% of UAP Holdings voting securities (or those of a successor or a parent) following a reorganization, merger, statutory share exchange or consolidation or similar corporate transaction involving UAP Holdings or any of its subsidiaries, a sale or other disposition of all or substantially all of UAP Holdings assets or the acquisition of assets or stock of another entity by UAP Holdings or any of its subsidiaries, or if UAP Holdings is dissolved or liquidated, then awards then-outstanding under the 2004 incentive plan may become fully vested or paid, as applicable, and may terminate or be terminated in such Balance Sheet Data: Working capital $ 241,322 Total assets 1,391,980 Total long-term debt 291,289 Stockholders equity 126,469 Table of Contents circumstances. The administrator also has the discretion to establish other change in control provisions with respect to awards granted under the 2004 incentive plan. For example, the administrator could provide for the acceleration of vesting or payment of an award in connection with a change in control event that is not described above and provide that any such acceleration shall be automatic upon the occurrence of any such event. UAP Holdings board of directors may amend or terminate the 2004 incentive plan at any time, but no such action will affect any outstanding award in any manner materially adverse to a participant without the consent of the participant. Stockholder approval for an amendment will be required only to the extent then required by applicable law or any applicable listing agency or required under the U.S. Internal Revenue Code to preserve the intended tax consequences of the plan. The 2004 incentive plan will terminate on November 18, 2014; however, the committee retains its authority until all outstanding awards are exercised or terminated. The plan is not exclusive; UAP Holdings board of directors and compensation committee may grant stock and performance incentives or other compensation, in stock or cash, under other plans or authority. (a) EBITDA represents net income (loss) before interest expense, finance charges, income taxes, depreciation and amortization. We present EBITDA because we believe it is a useful indicator of our historical debt capacity and ability to service debt, and consider it to be a measure of liquidity. Adjusted EBITDA, as defined in the indentures governing the 8 1/4% Senior Notes (as defined in Description of Certain Indebtedness 8 1/4% Senior Notes beginning on page 91) and the 10 3/4% Senior Discount Notes (as defined in Description of Certain Indebtedness 10 3/4% Senior Discount Notes beginning on page 93), corresponds to a calculation made in such indentures and is calculated by adjusting EBITDA for certain items. The adjustments to EBITDA relate to: (1) the add back of losses from discontinued operations, net of taxes, (2) the add back of inventory fair market value adjustments as a result of the Acquisition, (3) the add back of expenses relating to a transition services agreement and (4) the add back/deduction of loss/gain from the sale of certain businesses. We present Adjusted EBITDA because a corresponding calculation is used in the indentures for the 8 1/4% Senior Notes and the 10 3/4% Senior Discount Notes to determine whether we may incur additional indebtedness. Adjusted EBITDA is not a measure of financial performance or liquidity under GAAP. Accordingly, Adjusted EBITDA should not be considered in isolation or as a substitute for net income, cash flows from operations or other income or cash flow data prepared in accordance with GAAP or as a measure of our operating performance or liquidity. See Management s Discussion and Analysis of Financial Condition and Results of Operations Obligations and Commitments for a discussion of the application of Adjusted EBITDA as a measure of our ability to incur indebtedness under the indentures. For example, although we consider EBITDA a liquidity measure, it does not take into account all cash expenditures which may be necessary to grow our business, such as cash expenditures for capital expenditures and acquisitions. Because of covenants in the revolving credit facility and our indentures that are based on Adjusted EBITDA, including our fixed charge coverage ratio covenants, we will have to maintain our Adjusted EBITDA at certain levels to, among other things, pay dividends on our capital stock, incur additional indebtedness and avoid defaults under our revolving credit facility. The following table sets forth a reconciliation from historical cash flows provided by operating activities to historical EBITDA, pro forma EBITDA and Adjusted EBITDA: (in thousands) Apollo Management V, L.P. (a) 46,902,351 99.3 % 19,680,777 25,052,345 49.7 % 21,536,720 42.8 % L. Kenneth Cordell (b) 565,433 1.2 % 147,576 991,107 1.9 % 991,107 1.9 % Bryan S. Wilson (c) 343,950 * 85,825 570,807 1.1 % 570,807 1.1 % David W. Bullock (d) 343,950 * 85,825 570,807 1.1 % 570,807 1.1 % David Tretter (e) 209,757 * 50,397 328,728 * 328,728 * Robert A. Boyce, Jr. (f) 333,136 * 83,062 552,332 1.1 % 552,333 1.1 % William Page (g) 209,757 * 47,153 305,916 * 305,916 * Kent McDaniel (h) 144,615 * 30,250 192,535 * 192,535 * Terry Fuhrman (i) 101,100 * 18,873 116,099 * 116,099 * H. James Benshoof (j) 80,775 * 14,969 91,862 * 91,863 * Todd A. Suko (k) 30,355 * 7,316 46,489 * 46,489 * Kevin Howard (l) 19,542 * 3,417 20,033 * 20,033 * Other employee selling stockholders (m) 326,351 * 57,060 334,549 * 334,549 * Joshua J. Harris (n)(p) 58,627 * 58,627 * 58,627 * Pension benefit cost company plans 121 219 216 Total pension benefit cost $ 5,574 $ 7,267 $ 7,268 $ * Less than one percent. (a) With respect to shares beneficially owned prior to this offering, includes (i) 44,733,122 shares of common stock owned of record by Apollo Investment Fund V, L.P. and its related co-investment partnerships (the Apollo Funds ) and (ii) 2,169,229 shares of common stock beneficially owned by the named executive officers and other members of our management through UAP Holdings 2003 deferred compensation plan. Under the terms of an investor rights agreement entered into in connection with the Acquisition among UAP Holdings and its securityholders, the trustee under the plan must vote the shares subject to the plan at the direction of Apollo Management V, L.P. ( Apollo Management ). Apollo Management serves as investment manager of each of the Apollo Funds and has voting and investment power over the shares owned of record by each of the Apollo Funds. The investor rights agreement also grants Apollo Management the right to require the named executive officers and other members of our management to join in certain sales or transfers of shares to a third party. See Management 2003 and 2004 Deferred Compensation Plans beginning on page 67 and Certain Relationships and Related Transactions Ancillary Agreements Investor Rights Agreement beginning on page 81. With respect to shares beneficially owned after this offering, includes 25,052,345 shares of common stock owned of record by the Apollo Funds (or 21,536,720 shares assuming the underwriters over-allotment option is exercised in full). The general or managing partner of each of the Apollo Funds is Apollo Advisors V, L.P. ( Apollo Advisors ), an affiliate of Apollo Management. The address of each of the Apollo Funds, Apollo Management and Apollo Advisors is c/o Apollo Management V, L.P., Two Manhattanville Road, Purchase, New York 10577. (b) With respect to shares beneficially owned prior to this offering, (i) includes 508,108 deferred shares of common stock under the 2003 deferred compensation plan, (ii) includes 57,325 shares of common stock that are issuable upon exercise of Tranche A options that will vest on November 24, 2004 and (iii) does not include 802,550 shares of common stock that are issuable upon exercise of Tranche A options, Tranche B options and Tranche C options under the 2003 option plan that remain subject to vesting. With respect to shares beneficially owned after this offering, (i) includes 360,532 deferred shares of common stock under the 2003 deferred compensation plan, (ii) includes 57,325 shares of common stock issuable upon exercise of Tranche A options that will vest on November 24, 2004, (iii) includes 573,250 shares of common stock issuable upon exercise of Tranche B and Tranche C options that will vest upon consummation of this offering and (iv) does not include 229,300 shares of common stock issuable upon exercise of Tranche A options that will remain subject to vesting. (c) With respect to shares beneficially owned prior to this offering, (i) includes 312,682 deferred shares of common stock under the 2003 deferred compensation plan, (ii) includes 31,268 shares of common stock that are issuable upon exercise of Tranche A options that will vest on November 24, 2004 and (iii) does not include 437,755 shares of common stock that are issuable upon exercise of Tranche A options, Tranche B options and Tranche C options under the 2003 option plan that remain subject to vesting. With respect to shares beneficially owned after this offering, (i) includes 226,857 deferred shares of common stock under the 2003 deferred compensation plan, (ii) includes 31,268 shares of common stock issuable upon exercise of Tranche A options that will vest on November 24, 2004, (iii) includes 312,682 shares of common stock issuable upon exercise of Tranche B and Tranche C options that will vest upon consummation of this offering and (iv) does not include 125,073 shares of common stock issuable upon exercise of Tranche A options that will remain subject to vesting. (d) With respect to shares beneficially owned prior to this offering, (i) includes 312,682 deferred shares of common stock under the 2003 deferred compensation plan, (ii) includes 31,268 shares of common stock that are issuable upon exercise of Tranche A options that will vest on November 24, 2004 and (iii) does not include 437,755 shares of common stock that are issuable upon exercise of Tranche A options, Tranche B options and Tranche C options under the 2003 option plan that remain subject to vesting. With respect to shares beneficially owned after this offering, (i) includes 226,857 deferred shares of common stock under the 2003 deferred compensation plan, (ii) includes 31,268 shares of common stock issuable upon exercise of Tranche A options that will vest on November 24, 2004, (iii) includes 312,682 shares of common stock issuable upon exercise of Tranche B and Tranche C options that will vest upon consummation of this offering and (iv) does not include 125,073 shares of common stock issuable upon exercise of Tranche A options that will remain subject to vesting. (e) With respect to shares beneficially owned prior to this offering, (i) includes 195,426 deferred shares of common stock under the 2003 deferred compensation plan, (ii) includes 14,331 shares of common stock that are issuable upon exercise of Tranche A options that will vest on November 24, 2004 and (iii) does not include 239,721 shares of common stock that are issuable upon exercise of Tranche A options, Tranche B options and Tranche C options under the 2003 option plan that remain subject to vesting. Table of Contents With respect to shares beneficially owned after this offering, (i) includes 145,029 deferred shares of common stock under the 2003 deferred compensation plan, (ii) includes 14,331 shares of common stock issuable upon exercise of Tranche A options that will vest on November 24, 2004, (iii) includes 169,368 shares of common stock issuable upon exercise of Tranche B and Tranche C options that will vest upon consummation of this offering and (iv) does not include 70,353 shares of common stock issuable upon exercise of Tranche A options that will remain subject to vesting. (f) With respect to shares beneficially owned prior to this offering, (i) includes 302,911 deferred shares of common stock under the 2003 deferred compensation plan, (ii) includes 30,225 shares of common stock that are issuable upon exercise of Tranche A options that will vest on November 24, 2004 and (iii) does not include 423,162 shares of common stock that are issuable upon exercise of Tranche A options, Tranche B options and Tranche C options under the 2003 option plan that remain subject to vesting. With respect to shares beneficially owned after this offering, (i) includes 219,849 deferred shares of common stock under the 2003 deferred compensation plan, (ii) includes 30,225 shares of common stock issuable upon exercise of Tranche A options that will vest on November 24, 2004, (iii) includes 302,258 shares of common stock issuable upon exercise of Tranche B and Tranche C options that will vest upon consummation of this offering and (iv) does not include 120,904 shares of common stock issuable upon exercise of Tranche A options that will remain subject to vesting. (g) With respect to shares beneficially owned prior to this offering, (i) includes 195,426 deferred shares of common stock under the 2003 deferred compensation plan, (ii) includes 14,331 shares of common stock issuable upon exercise of Tranche A options that will vest on November 24, 2004 and (iii) does not include 200,637 shares of common stock issuable upon exercise of Tranche A options, Tranche B options and Tranche C options under the 2003 option plan that remain subject to vesting. With respect to shares beneficially owned after this offering, (i) includes 148,273 deferred shares of common stock under the 2003 deferred compensation plan, (ii) includes 14,331 shares of common stock issuable upon exercise of Tranche A options that will vest on November 24, 2004, (iii) includes 143,312 shares of common stock issuable upon exercise of Tranche B and Tranche C options that will vest upon consummation of this offering and (iv) does not include 57,325 shares of common stock issuable upon exercise of Tranche A options that will remain subject to vesting. (h) With respect to shares beneficially owned prior to this offering, (i) includes 136,798 deferred shares of common stock under the 2003 deferred compensation plan, (ii) includes 7,817 shares of common stock issuable upon exercise of Tranche A options that will vest on November 24, 2004 and (iii) does not include 109,438 shares of common stock issuable upon exercise of Tranche A options, Tranche B options and Tranche C options under the 2003 option plan that remain subject to vesting. With respect to shares beneficially owned after this offering, (i) includes 106,548 deferred shares of common stock under the 2003 deferred compensation plan, (ii) includes 7,817 shares of common stock issuable upon exercise of Tranche A options that will vest on November 24, 2004, (iii) includes 78,170 shares of common stock issuable upon exercise of Tranche B and Tranche C options that will vest upon consummation of this offering and (iv) does not include 31,268 shares of common stock issuable upon exercise of Tranche A options that will remain subject to vesting. (i) With respect to shares beneficially owned prior to this offering, (i) includes 97,713 deferred shares of common stock under the 2003 deferred compensation plan, (ii) includes 3,387 shares of common stock issuable upon exercise of Tranche A options that will vest on November 24, 2004 and (iii) does not include 47,424 shares of common stock issuable upon exercise of Tranche A options, Tranche B options and Tranche C options under the 2003 option plan that remain subject to vesting. With respect to shares beneficially owned after this offering, (i) includes 78,840 deferred shares of common stock under the 2003 deferred compensation plan, (ii) includes 3,387 shares of common stock issuable upon exercise of Tranche A options that will vest on November 24, 2004, (iii) includes 33,872 shares of common stock issuable upon exercise of Tranche B and Tranche C options that will vest upon consummation of this offering and (iv) does not include 13,549 shares of common stock issuable upon exercise of Tranche A options that will remain subject to vesting. (j) With respect to shares beneficially owned prior to this offering, (i) includes 78,170 deferred shares of common stock under the 2003 deferred compensation plan, (ii) includes 2,605 shares of common stock issuable upon exercise of Tranche A options that will vest on November 24, 2004 and (iii) does not include 36,479 shares of common stock issuable upon exercise of Tranche A options, Tranche B options and Tranche C options under the 2003 option plan that remain subject to vesting. With respect to shares beneficially owned after this offering, (i) includes 63,201 deferred shares of common stock under the 2003 deferred compensation plan, (ii) includes 2,605 shares of common stock issuable upon exercise of Tranche A options that will vest on November 24, 2004, (iii) includes 26,056 shares of common stock issuable upon exercise of Tranche B and Tranche C options that will vest upon consummation of this offering and (iv) does not include 10,423 shares of common stock issuable upon exercise of Tranche A options that will remain subject to vesting. (k) With respect to shares beneficially owned prior to this offering, (i) includes 29,313 deferred shares of common stock under the 2003 deferred compensation plan, (ii) includes 1,042 shares of common stock issuable upon exercise of Tranche A options that will vest on November 24, 2004 and (iii) does not include 34,133 shares of common stock issuable upon exercise of Tranche A options, Tranche B options and Tranche C options under the 2003 option plan that remain subject to vesting. With respect to shares beneficially owned after this offering, (i) includes 21,997 deferred shares of common stock under the 2003 deferred compensation plan, (ii) includes 1,042 shares of common stock issuable upon exercise of Tranche A options that will vest on November 24, 2004, (iii) includes 23,450 shares of common stock issuable upon exercise of Tranche B and Tranche C options that will vest upon consummation of this offering and (iv) does not include 10,683 shares of common stock issuable upon exercise of Tranche A options that will remain subject to vesting. Table of Contents (l) With respect to shares beneficially owned prior to this offering, (i) includes 19,542 deferred shares of common stock under the 2004 deferred compensation plan and (ii) does not include 5,862 shares of common stock issuable upon exercise of Tranche A options, Tranche B options and Tranche C options under the 2003 option plan that remain subject to vesting. With respect to shares beneficially owned after this offering, (i) includes 16,125 deferred shares of common stock under the 2004 deferred compensation plan, (ii) includes 3,908 shares of common stock issuable upon exercise of Tranche B and Tranche C options that will vest upon consummation of this offering and (iii) does not include 1,954 shares of common stock issuable upon exercise of Tranche A options that will remain subject to vesting. (m) With respect to shares beneficially owned prior to this offering, (i) includes 326,351 deferred shares of common stock under the 2004 deferred compensation plan and (ii) does not include 97,887 shares of common stock issuable upon exercise of Tranche A options, Tranche B options and Tranche C options under the 2003 option plan that remain subject to vesting. With respect to shares beneficially owned after this offering, (i) includes 269,291 deferred shares of common stock under the 2004 deferred compensation plan, (ii) includes 65,258 shares of common stock issuable upon exercise of Tranche B and Tranche C options that will vest upon consummation of this offering and (iii) does not include 32,629 shares of common stock issuable upon exercise of Tranche A options that will remain subject to vesting. (n) Messrs. Harris and Becker are each principals and officers of certain affiliates of Apollo Management. Although each of Messrs. Harris and Becker may be deemed to be the beneficial owner of shares of common stock beneficially owned by Apollo Management, as the case may be, each of them disclaims beneficial ownership of any such shares. (o) Messrs. Katz and Parker are associated with Apollo Management but disclaim beneficial ownership of any of the shares of common stock beneficially owned by Apollo Management, as the case may be. (p) Includes shares of common stock that are issuable upon exercise of options under UAP Holdings 2004 non-executive director option plan that are immediately exercisable. See Management 2004 Non-Executive Director Stock Option Plan beginning on page 69. (q) With respect to shares beneficially owned prior to this offering, (i) includes 1,680,664 deferred shares of common stock under the 2003 and 2004 deferred compensation plans, (ii) includes 351,762 shares of common stock issuable upon exercise of options under the 2004 non-executive director option plan (iii) includes 165,460 shares of common stock that are issuable upon exercise of Tranche A options that will vest on November 24, 2004 and (iv) does not include 2,380,937 shares of common stock that are issuable upon exercise of Tranche A options, Tranche B options and Tranche C options under the 2003 option plan that remain subject to vesting. With respect to shares beneficially owned after this offering, (i) includes 1,217,246 deferred shares of common stock under the 2003 and 2004 deferred compensation plans, (ii) includes 351,762 shares of common stock issuable upon exercise of options under the 2004 non-executive director option plan, (iii) includes 165,460 shares of common stock issuable upon exercise of Tranche A options that will vest on November 24, 2004, (iv) includes 1,697,598 shares of common stock issuable upon exercise of Tranche B and Tranche C options that will vest upon consummation of this offering and (v) does not include 683,339 shares of common stock issuable upon exercise of Tranche A options that will remain subject to vesting. Cash flows provided by operating activities $ 341,799 $ (313,279 ) $ 158,000 Interest expense 28,679 22,082 38,062 Net change in operating assets and liabilities (251,766 ) 399,092 (44,629 ) Income tax provision (benefit) 30,857 30,252 25,768 Deferred income tax benefit (provision) (23,858 ) (23,658 ) (47,516 ) Loss from discontinued operations, net (4,708 ) (1,681 ) Other (672 ) (7,486 ) (11,280 ) Table of Contents CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The following contains a summary of the Acquisition and related financings, as well as summaries of certain agreements relating to the Acquisition. The descriptions of such agreements do not purport to be complete and are qualified in their entirety by reference to such agreements. Copies of the stock purchase agreement and other material contracts described below are filed or incorporated by reference as exhibits to the registration statement of which this prospectus forms a part. THE ACQUISITION Overview On November 24, 2003, pursuant to the stock purchase agreement, dated as of October 29, 2003, as amended on November 24, 2003, among United Agri Products, ConAgra Foods and UAP Holdings, UAP Holdings acquired United Agri Products and its subsidiaries from ConAgra Foods in a merger and related transactions (the Acquisition ). As part of the Acquisition, UAP Holdings acquired United Agri Products Canadian affiliates and caused its newly formed subsidiary, UAP Acquisition Corp., to merge into United Agri Products. In connection with the merger, UAP Holdings contributed all the outstanding capital stock of United Agri Products Canadian affiliates to United Agri Products. The purchase price was $575.0 million and was subject to post-closing adjustments as described below. On November 24, 2003, the aggregate consideration paid to ConAgra Foods was $560.0 million, of which $500.0 million was paid in cash and $60.0 million was paid in the form of shares of Series A Redeemable Preferred Stock of UAP Holdings. The aggregate consideration paid to ConAgra Foods at the closing of the Acquisition equaled United Agri Products estimated net book value, including the value of United Agri Products Canadian subsidiaries, as of the closing of the Acquisition, less the sum of certain rebate payments, management retention bonuses United Agri Products agreed to assume and a $7.5 million expense paid to ConAgra Foods at the closing of the Acquisition pursuant to a transition services agreement. Pursuant to the stock purchase agreement, we agreed to pay ConAgra Foods, prior to April 30, 2004, and subject to certain post-closing adjustments, the amount equal to the difference between the estimated net book value of the businesses acquired in the Acquisition at the effective time of the closing of the Acquisition, and the amount of consideration actually paid to ConAgra Foods at such closing. Ultimately, we agreed to pay ConAgra Foods an aggregate amount of $60.1 million, which includes interest charges of $1.9 million, as satisfaction in full of all amounts owed in connection with the Acquisition. This payment was funded through a draw on United Agri Products line of credit in June 2004. The Stock Purchase Agreement Indemnity. In the stock purchase agreement, ConAgra Foods agreed to indemnify us from certain liabilities, including: losses or damages arising from the inaccuracy or breach of any representation or warranty of ConAgra Foods contained in the stock purchase agreement, subject to the limitations described below; losses or damages arising from breaches of the covenants and agreements made or to be performed by ConAgra Foods pursuant to the stock purchase agreement; losses or damages related to the assets and businesses retained by ConAgra Foods; and losses or damages related to the restatement of earnings announced by ConAgra Foods on May 23, 2001 and any shareholder litigation or investigations by the SEC related thereto. The stock purchase agreement does not allow us to make a claim for indemnification for any loss or damage relating to a breach of a representation or warranty, unless the damages for any claim or series of related claims Table of Contents exceed $10.0 million (other than for losses relating to certain fundamental representations and warranties). Our indemnification for breaches of representations and warranties (other than for losses arising from breaches of specified representations and warranties to which this cap does not apply) is limited to $150.0 million. In addition, ConAgra Foods agreed to indemnify us for pre-closing income taxes and to reflect liability accruals for pre-closing non-income taxes in the final net book value calculation. We have agreed to indemnify ConAgra Foods for breaches of the applicable agreements and certain pre-closing matters, including the assumed litigation and pre-closing employee benefits. Covenant Not to Compete. ConAgra Foods has agreed, subject to certain exceptions, not to compete with us in the United States and Canada for a five-year period in the businesses of manufacturing, formulating, selling or distributing agricultural or non-crop protection chemicals, selling agricultural seeds for grain crops or selling fertilizer products for retail or developing. We agreed, subject to certain exceptions, not to compete with ConAgra Foods in the same businesses outside the United States and Canada for a three-year period. Non-Solicitation. ConAgra Foods has agreed, subject to certain exceptions, not to solicit our management or sales employees for a period of two years after the closing of the Acquisition. We agreed, subject to certain exceptions, not to solicit ConAgra Foods management or sales employees for the same two-year period. THE RELATED FINANCINGS The Acquisition was financed with approximately $242.0 million of borrowings under United Agri Products secured $500.0 million asset-based revolving credit facility, $175.0 million of borrowings under United Agri Products senior bridge loan facility, the sale of $120.0 million of UAP Holdings common stock to Apollo and members of our management, and the issuance of $60.0 million of UAP Holdings Series A Redeemable Preferred Stock to ConAgra Foods. On December 16, 2003, United Agri Products consummated a private offering of $225.0 million aggregate principal amount of its 8 % Senior Notes, the proceeds of which were used to repay United Agri Products $175.0 million senior bridge loan facility, plus accrued interest, to repay a portion of the revolving credit facility and to pay fees and expenses associated with such offering. See Description of Certain Indebtedness beginning on page 87. THE OFFERING OF SENIOR DISCOUNT NOTES On January 26, 2004, UAP Holdings completed the private offering of its 10 % Senior Discount Notes. The proceeds from the offering of the 10 % Senior Discount Notes were used to pay a dividend of approximately $52.9 million to our existing stockholders, to redeem $26.4 million of our outstanding Series A Redeemable Preferred Stock and to pay fees and expenses associated with the offering of the 10 % Senior Discount Notes. See Description of Certain Indebtedness 10 % Senior Discount Notes beginning on page 93 for a more detailed description of the 10 % Senior Discount Notes. ANCILLARY AGREEMENTS In addition to the stock purchase agreement described above, UAP Holdings and certain of its subsidiaries entered into the following agreements with ConAgra Foods as of the closing of the Acquisition. Transition Services Agreements On November 24, 2003, UAP Holdings and certain of its subsidiaries entered into a transition services agreement with ConAgra Foods (the Buyer Transition Services Agreement ) pursuant to which, among other things, ConAgra Foods will provide us with certain transition services, including information technology, accounting and human resources services. The initial term of the Buyer Transition Services Agreement is one year. As consideration for the services, we paid ConAgra Foods an initial fee of $7.5 million on November 24, Table of Contents 2003 and will be required to pay additional fees to ConAgra Foods based on actual usage of transition services. In addition, the Buyer Transition Services Agreement provides that, until December 31, 2004, employees of our subsidiaries that are a party to the agreement will continue their participation in welfare plans and programs maintained by ConAgra Foods and specified by us that provide health, disability, life and other welfare benefits. Our subsidiaries will reimburse ConAgra Foods for all actual costs associated with their employees continued participation in the plans. Also on November 24, 2003, UAP Holdings, together with United Agri Products and certain of its other subsidiaries, entered into another transition services agreement with ConAgra Foods (the Seller Transition Services Agreement ) pursuant to which, among other things, we will provide ConAgra Foods and certain of its international subsidiaries with certain transition services, including information technology, accounting and office support services. The term of the Seller Transition Services Agreement is one year. In addition, we granted to ConAgra Foods and its international subsidiaries an exclusive two-year license to use certain of our trademarks and trade names outside the United States and Canada. ConAgra Foods will pay us an aggregate fee of $1.3 million for the license and for the services provided under the Seller Transition Services Agreement. The Seller Transition Services Agreement was terminated in accordance with its terms on August 30, 2004. Indemnification Agreement On November 24, 2003, United Agri Products, together with certain of its subsidiaries, entered into an indemnification agreement with ConAgra Foods, pursuant to which United Agri Products and such subsidiaries agreed to be bound by UAP Holdings indemnification and non-competition obligations and certain other covenants under the stock purchase agreement. Fertilizer Supply Agreement On November 24, 2003, United Agri Products entered into a fertilizer supply agreement with ConAgra International Fertilizer Company (the Fertilizer Supply Agreement ) under which United Agri Products agreed to buy fertilizer products from ConAgra International Fertilizer Company. The initial term of the Fertilizer Supply Agreement is five years and automatically renews from year to year after the initial term unless terminated by either party on not less than 180 days notice prior to the end of the initial or any renewal term. Subject to the parties agreeing on prices and producer availability, United Agri Products is obligated to buy an amount of fertilizer products equal to its historical purchases from ConAgra International Fertilizer Company (approximately 70% of our requirements for such products). In addition, United Agri Products granted ConAgra International Fertilizer Company a right of first negotiation with respect to the sale of assets relating to or comprising certain of its fertilizer locations. The Fertilizer Supply Agreement contains customary mutual indemnification provisions, and each party may terminate the agreement upon mutual agreement with the other party, upon the breach of any material terms of the agreement by the other party, or upon the bankruptcy or insolvency of the other party. International Supply Agreement On November 24, 2003, United Agri Products entered into an international supply agreement with ConAgra Foods (the International Supply Agreement ) pursuant to which United Agri Products agreed to sell certain agricultural chemical products to ConAgra Foods non-U.S. distribution companies and certain customers located outside of the United States and Canada who purchased such products during the two year period prior to November 24, 2003. The initial term of the International Supply Agreement is one year and renews automatically for an additional year unless terminated by either party upon 60 days notice. In addition, each party may terminate the International Supply Agreement upon mutual agreement with the other party, upon the breach of any material term of the agreement by the other party (or, in our case, one of ConAgra Foods non-U.S. distribution companies), or upon the other party s insolvency. Under the terms of the International Supply Agreement, United Agri Products is required to sell agricultural chemical products ordered by ConAgra Foods Table of Contents distribution companies at the prices applicable to sales of such products to such distribution companies immediately prior to the date of the agreement. In addition, United Agri Products agreed to sell agricultural chemical products ordered by customers located outside of the United States and Canada at prices established by it after consultation with ConAgra Foods distribution companies. United Agri Products is required to pay to ConAgra Foods, on each sale to customers other than affiliates of ConAgra Foods, the difference (if a positive number) between the amount paid to United Agri Products by such customers and the cost of such products if purchased by a ConAgra Foods distribution company. The International Supply Agreement also limits each party s ability to sell agricultural chemical products in certain geographic areas during the term of the agreement. Con Agra Foods distribution companies can purchase products under the agreement only for resale outside the United States and Canada. Conversely, United Agri Products cannot sell agricultural chemical products within any territory outside the United States and Canada if such territory was served by one of Con Agra Foods distribution companies prior to the date of the agreement. United Agri Products also cannot sell products to any third party that it knows or has reason to know will resell such products within any such territory. Finally, pursuant to the International Supply Agreement United Agri Products granted each Con Agra Foods distribution company that purchases products under the agreement a non-exclusive, non-transferable right to use any trademarks and trade names associated with the products in connection with the marketing, manufacture, distribution and sale of such products. Releases On November 24, 2003, United Agri Products, together with certain of its subsidiaries, entered into a release with ConAgra Foods under which United Agri Products and its subsidiaries party to such release irrevocably released ConAgra Foods, its affiliates and their directors, officers and employees from any liabilities and causes of action, whether known or unknown, relating to, arising out of, or in any way connected with events or happenings that occurred or failed to occur on or prior to the date of the release (other than (i) claims arising under the stock purchase agreement, the ancillary agreements entered into in connection with the stock purchase agreement or any agreement entered into in connection with the Acquisition, (ii) product liability claims for products sold by ConAgra Foods to United Agri Products or any of its subsidiaries prior to the date of the release and (iii) claims arising from any act or omission constituting fraud, gross negligence or willful misconduct). Similarly, ConAgra Foods entered into a release with UAP Holdings under which ConAgra Foods and its subsidiaries irrevocably released United Agri Products, its subsidiaries and their directors, officers and employees from any liabilities and causes of action, whether known or unknown, relating to, arising out of, or in any way connected with the events or happenings that occurred or failed to occur on or prior to the date of the release (other than (i) claims arising under the stock purchase agreement, the ancillary agreements entered into in connection with the stock purchase agreement or any agreement entered into in connection with the Acquisition and (ii) claims arising from any act or omission constituting fraud, gross negligence or willful misconduct). Canadian Operations Assignment and Assumption Agreement On November 18, 2003, UAP Canada, which is one of our subsidiaries purchased in the Acquisition but on November 18, 2003 was a subsidiary of ConAgra Limited, entered into an asset purchase agreement (the UAP Canada Asset Purchase Agreement ) with ConAgra Limited pursuant to which UAP Canada purchased certain assets (including, among other things, owned and leased properties, contracts, inventories, intellectual property and accounts receivable) owned by ConAgra Limited. Such assets related to the UAP Canada business carried on by ConAgra Limited, and excluded ConAgra Limited s bulk wholesale fertilizer business, commodity grain business and imagery technology business. The purchase price equaled Cdn$57.3 million and was paid by the assumption of certain liabilities of ConAgra Limited and the delivery to ConAgra Limited of 99 common shares of the issued and outstanding shares of UAP Canada. In connection with the UAP Canada Asset Purchase Table of Contents Agreement, ConAgra Limited also assigned, and UAP Canada assumed, all assets, liabilities and obligations of the Pension Plan for Employees of United Agri-Products (UAP Canada), a division of ConAgra International (Canada) Limited, and the UAP Canada Savings Plan. Imperial Plant Agreement On November 24, 2003, United Agri Products entered into an imperial plant agreement with ConAgra International Fertilizer Company (the Imperial Plant Agreement ), pursuant to which ConAgra International Fertilizer Company agreed to deliver various agricultural fertilizer materials to United Agri Products plant located in Imperial, Nebraska for United Agri Products to blend, process and store. ConAgra International Fertilizer Company then sells the materials to United Agri Products at the plant at prices determined in accordance with the Fertilizer Supply Agreement. The Imperial Plant Agreement has a term of one year. The Imperial Plant Agreement provides that, at the end of each fiscal quarter of ConAgra International Fertilizer Company during the term of the agreement, the parties will equally share Net Profits or Losses (as defined below) resulting from ConAgra International Fertilizer Company s sales of agricultural fertilizer materials from the Imperial Plant. If there is a Net Profit, then ConAgra International Fertilizer Company must pay United Agri Products 50% of such Net Profit. Conversely, if the plant incurs a Net Loss, then United Agri Products must pay ConAgra International Fertilizer Company 50% of such Net Loss. The Imperial Plant Agreement defines Net Profits or Losses as gross revenues derived from ConAgra International Fertilizer Company s sale of materials from the plant, less ConAgra International Fertilizer Company s depreciation expenses on certain ConAgra International Fertilizer Company assets located at the plant and less any cost or expense ConAgra International Fertilizer Company incurs in replacing, maintaining or repairing such assets, and before any federal or state income taxes. The value of materials lost or damaged while in United Agri Products control at the plant is deducted from United Agri Products share of Net Profits and added to United Agri Products share of Net Losses, provided that United Agri Products is given a shrink allowance of up to one-half of one percent. Mix Plants Agreement On November 24, 2003, United Agri Products also entered into a mix plants agreement with ConAgra International Fertilizer Company (the Mix Plants Agreement ), pursuant to which ConAgra International Fertilizer Company agreed to blend and process various agricultural fertilizer materials for United Agri Products at certain of its plants located in Iowa, Minnesota, Illinois and Indiana. ConAgra International Fertilizer Company then sells the blended and processed materials to United Agri Products at prices determined in accordance with the Fertilizer Supply Agreement. The Mix Plants Agreement has a term of one year, except that United Agri Products may terminate it with respect to any plant if there is a pending or threatened environmental claim or investigation at such plant. As with the Imperial Plant Agreement, the Mix Plants Agreement provides that the parties will share Net Profits or Losses (as defined below) at each plant, based on United Agri Products applicable Margin Contribution (as defined below) at each such plant. If there is a Net Profit, then ConAgra International Fertilizer Company must pay United Agri Products an amount equal to the product of (i) United Agri Products Margin Contribution at the applicable plant multiplied by (ii) the Net Profit at such plant. Conversely, if a plant incurs a Net Loss, then United Agri Products must pay ConAgra International Fertilizer Company the product of (i) United Agri Products Margin Contribution multiplied by (ii) the Net Loss. The Mix Plants Agreement defines Net Profits or Losses as gross revenues derived from the sale of all materials produced at a plant, less all costs associated with operating the plant, and before federal and state income taxes. The agreement defines Margin Contribution as the difference between ConAgra International Fertilizer Company s cost of materials at the plant and the sales price to United Agri Products at the time of such sale. For purposes of computing Net Profits or Losses, all raw materials provided by ConAgra International Fertilizer Company to the plants are deemed to be provided at ConAgra International Fertilizer Company s cost including applicable rebates. Table of Contents Grain Merchandising Agreements On November 24, 2003, one of our indirect, wholly owned subsidiaries entered into six grain merchandising agreements with ConAgra Foods. Each agreement has a one year term beginning on November 24, 2003. The grain merchandising agreements relate to grain elevators that UAP owns and has historically used to perform various storage and delivery services for ConAgra Foods. UAP agreed to purchase grain at these elevators as agent for ConAgra Foods, with ConAgra Foods providing the actual payment amount, while UAP provides the administrative services necessary for such purchases. UAP agreed to then store, ship or deliver such grain as directed by ConAgra Foods. UAP also agreed to provide all labor, equipment and supplies reasonably necessary to handle and transfer the grain and grain products at these elevators. During the term of the grain merchandising agreements, UAP has agreed not to handle or store grain at the grain elevators other than as directed by ConAgra Foods. At the end of every month during the term of these agreements, ConAgra Foods will determine the profit or loss at each elevator for the previous month. If there has been a profit for the previous month, ConAgra Foods will pay United Agri Products three-quarters of such profit. If there has been a loss for the previous month, United Agri Products will pay ConAgra Foods one-quarter of such loss. Leases In connection with the Acquisition, United Agri Products or one of its direct, wholly owned subsidiaries entered into 15-year ground leases with ConAgra Foods and its affiliates for six facilities in the United States and four facilities in Canada. Rent is approximately Cdn$4,667 per month for each Canadian ground lease and between $250 and $1,350 per month for the U.S. ground leases. After the fifth and tenth years of the term of each of the ground leases, rent will be adjusted to the then current market rents. In addition to rent for certain facilities, United Agri Products will pay additional fees based on tonnage unloaded or rail cars spotted. In connection with the Acquisition, United Agri Products or one of its direct, wholly owned subsidiaries also entered into subleases with ConAgra Foods and its affiliates for facilities located in Carrington, North Dakota and Browns, Illinois. Rent is $500 per month under the Browns sublease and $1,000 per month under the Carrington sublease. The subleases expire when the applicable master leases expire or terminate. Scale License Agreements Certain of our wholly owned subsidiaries are party to two scale license agreements with ConAgra Foods. Each agreement allows us to use a scale owned or operated by ConAgra Foods for a monthly fee of $200. In addition, we are responsible for 50% of the maintenance costs of the scales at these locations. Storage Agreement On November 24, 2003, one of our indirect wholly owned subsidiaries entered into a storage agreement with ConAgra Foods providing for the storage by ConAgra Foods of certain fertilizer products owned by UAP or one of its subsidiaries at a ConAgra Foods facility in Dubuque, Iowa. The term of the agreement ends on June 30, 2005. UAP has agreed to pay a minimum of $180,000 to ConAgra Foods for services performed under this storage agreement. If UAP s aggregate payments to ConAgra Foods do not total at least $180,000 by June 30, 2005, UAP has agreed pay to ConAgra Foods the difference between the aggregate amount UAP has paid for services under the agreement and $180,000. Investor Rights Agreement All employees who have deferred compensation accounts under our deferred compensation plans and own stock options are subject to an investor rights agreement with Apollo and UAP Holdings (the Investor Rights Agreement ), which governs certain aspects of UAP Holdings relationship with its security holders. The Investor Rights Agreement, among other things: allows security holders to join, and allows Apollo and its affiliates to require security holders to join, in any sale or transfer of shares of common stock or preferred stock to any third party prior to a qualified Table of Contents public offering of common stock or preferred stock, following which (when aggregated with all prior such sales or transfers) Apollo and its affiliates shall have disposed of at least 10% of the number of shares of common stock or preferred stock, as applicable, that Apollo and its affiliates owned as of November 24, 2003; restricts the ability of security holders to transfer, assign, sell, gift, pledge, hypothecate or encumber, or otherwise dispose of, common stock or preferred stock or of all or part of the voting power associated with common stock or preferred stock; allows security holders to include certain securities in a registration statement filed by the Company with respect to an offering of common stock or preferred stock (i) in connection with the exercise of any demand rights by Apollo and its affiliates or any other security holders possessing such rights, or (ii) in connection with which Apollo and its affiliates exercise piggyback registration rights; allows UAP Holdings and Apollo to repurchase all or any portion of the common stock and preferred stock held by directors, employees and consultants of UAP Holdings upon the termination of their employment with UAP Holdings, their death or their bankruptcy or insolvency; and contains a provision that at any meeting of UAP Holdings stockholders and in any action by written consent of UAP Holdings stockholders, the trustee under UAP Holdings 2003 deferred compensation plan will vote the shares of common stock in which each security holder s deferred compensation account is deemed to be invested at the direction of Apollo. The Investor Rights Agreement terminates upon the earliest to occur of the dissolution of UAP Holdings, the occurrence of any event which reduces the number of security holders to one and the transfer to a person or group other than Apollo and its affiliates of a number of shares of common stock having the power to elect a majority of UAP Holdings Board of Directors. In connection with this offering, the Investor Rights Agreement will be amended and restated in its entirety by the management incentive agreement. See Related Party Transactions in Connection with this Offering Management Incentive Agreement beginning on page 83. Apollo Registration Rights Agreement On November 24, 2003, Apollo entered into a registration rights agreement with UAP Holdings pursuant to which Apollo and its affiliates have certain demand and incidental registration rights with respect to UAP Holdings common stock. Under this agreement, at Apollo s written request, we are obligated to prepare and file a registration statement covering the shares that are requested to be registered by Apollo. Apollo has the right to make up to six demand registration requests provided that after we become eligible to use a registration statement on Form S-3, Apollo will have an unlimited number of Form S-3 demand registration requests. Until we are eligible to use a registration statement on Form S-3, we have the right to defer a demand for registration by up to 90 days if our board of directors determines in good faith that it would be materially adverse to us to file a registration statement. In addition, should we propose in the future to register any of our own common stock for sale to the public, Apollo has the opportunity to include its common stock in the same or concurrent registration statement filed by us, subject to customary cutbacks at the option of any underwriters of such future offerings. All of the 25,052,345 shares of common stock owned by Apollo after this offering (21,536,720 shares if the underwriters over-allotment option is exercised in full), will have registration rights under this agreement. We will bear all expenses, other than selling expenses, incurred in the registration process. The registration rights agreement provides for standard indemnification provisions for an agreement of this type. Apollo Management Consulting Agreement United Agri Products is a party to a management consulting agreement dated as of November 21, 2003 with Apollo (the Management Agreement ). Under the terms of the Management Agreement, United Agri Products Table of Contents retained Apollo to provide certain management consulting and financial advisory services, for which United Agri Products pays Apollo an annual management fee of $1.0 million in quarterly payments of $250,000. In particular, the Management Agreement requires Apollo to advise United Agri Products concerning such management matters that relate to proposed financial transactions, acquisitions and other senior management matters related to the business, administration and policies of United Agri Products and its affiliates, in each case as United Agri Products shall reasonably and specifically request in writing. In addition, as consideration for arranging the Acquisition, certain related financing transactions and the preparation of a registration statement with respect to an exchange offer for the 8 % Senior Notes, United Agri Products paid Apollo a fee of $5.0 million in January 2004. Upon the consummation of this offering, United Agri Products also expects to pay Apollo a transaction fee of $3.5 million. The Management Agreement has an initial term of seven years, which commenced on November 21, 2003. Upon the fourth anniversary of the date of the Management Agreement and the end of each year thereafter (each of such fourth anniversary and the end of each year thereafter, a Year End ), the term is automatically extended for an additional year unless terminated by either party at least 30, but no more than 60, days prior to such year end. Concurrently with the closing of this offering and upon payment of the aforementioned transaction fee and all other amounts payable to Apollo under the Management Agreement, the Management Agreement will be terminated in its entirety. RELATED PARTY TRANSACTIONS PRIOR TO THE ACQUISITION ConAgra Foods executive, finance, tax and other corporate departments have historically performed services for the ConAgra Agricultural Products Business, and, pursuant to the Buyer Transition Services Agreement described in Ancillary Agreements beginning on page 77, will continue to perform certain administrative and other services for us. Expenses incurred by ConAgra Foods and allocated to the ConAgra Agricultural Products Business were historically determined based on the specific services that were provided or were allocated based on ConAgra Foods investment in the ConAgra Agricultural Products Business in proportion to ConAgra Foods total investment in its subsidiaries. In addition, ConAgra Foods charged the ConAgra Agricultural Products Business finance charges on ConAgra Foods investment in and advances to the ConAgra Agricultural Products Business. We believe that such expense allocations were reasonable. It is not practical to estimate the expenses that would have been incurred by the ConAgra Agricultural Products Business if it had been operated on a stand-alone basis. Corporate allocations included allocation of selling, administrative and general expenses of approximately $9.0 million for the thirty-nine weeks ended November 23, 2003, and $10.8 million, $10.5 million and $10.9 million for fiscal 2003, 2002 and 2001, respectively, and allocated finance charges of approximately $12.2 million for the thirty-nine weeks ended November 23, 2003, and $22.5 million, $39.5 million and $57.5 million in fiscal 2003, 2002 and 2001, respectively. Allocated finance charges are presented net of third party finance fee income of $7.3 million for the thirty-nine weeks ended November 23, 2003 and $13.5 million and $13.4 million in fiscal 2003 and 2002, respectively. UAP also has historically entered into transactions in the normal course of business with parties under common ownership of ConAgra Foods. Net sales to related parties were $5.8 million during the thirty-nine weeks ended November 23, 2003, and $25.5 million, $33.8 million and $13.4 million in fiscal years 2003, 2002 and 2001, respectively. Gross margins associated with related party net sales were $2.0 million during the thirty-nine weeks ended November 23, 2003, and $2.5 million, $2.6 million and $1.5 million in fiscal years 2003, 2002 and 2001, respectively. RELATED PARTY TRANSACTIONS IN CONNECTION WITH THIS OFFERING Management Incentive Agreement In connection with this offering, UAP Holdings, its equity sponsor and certain management security holders will enter into a management incentive agreement. That agreement will include piggyback registration rights that continue the similar rights afforded under the Investor Rights Agreement. In connection with this offering, Table of Contents each management security holder will have the right to sell an aggregate number of shares of common stock with a value (based on the price per share paid to UAP Holdings equity sponsor for shares of common stock sold to the underwriters, after giving effect to underwriting discounts and commissions) equal to 15% of the sum of: the excess of the value of the common stock underlying such holder s vested Tranche B options and Tranche C options granted under the 2003 option plan (assuming that such holder s Tranche B options and Tranche C options are fully vested and based on the price per share paid to UAP Holdings equity sponsor for shares of common stock sold to the underwriters, after giving effect to underwriting discounts and commissions) over the exercise price of such options; and the value of the common stock in which such holder s deferred compensation account under our deferred compensation plans is deemed to be invested (based on the price per share paid to UAP Holdings equity sponsor for shares of common stock sold to the underwriters, after giving effect to underwriting discounts and commissions). The management incentive agreement will prohibit the management security holders from offering to sell, contracting to sell, or otherwise selling, disposing of, loaning, using as collateral or otherwise pledging, transferring or granting any interest in or rights with respect to any shares of common stock acquired on the exercise of options granted under the 2003 option plan or the distribution of deferred shares under the 2003 and 2004 deferred compensation plans, except in connection with the exercise of piggyback registration rights and subject to the following additional exceptions: Except as otherwise described below, on and after March 1, June 1, September 1 and December 1 of each year, commencing on December 1, 2006 (each such date, a release date ), each management security holder shall have the right to sell an aggregate number of shares of common stock with a value (based on the price per share paid to UAP Holdings equity sponsor for shares of common stock sold to the underwriters, after giving effect to underwriting discounts and commissions) equal to 6.25% (calculated as of the date of this offering) of the sum of: the excess of the value of the common stock underlying such holder s options granted under the 2003 option plan and held by such holder on the date of consummation of the offering (whether or not such options are then vested and based on the price per share paid to UAP Holdings equity sponsor for shares of common stock sold to the underwriters, after giving effect to underwriting discounts and commissions) over the exercise price of such options; and the value of the common stock in which such holder s deferred compensation accounts under our deferred compensation plans is deemed to be invested on the date of the consummation of the offering (based on the price per share paid to UAP Holdings equity sponsor for shares of common stock sold to the underwriters, after giving effect to underwriting discounts and commissions and calculated before giving effect to the distribution of any deferred shares the holder is permitted to sell in connection with this offering). Messrs. Kenneth Cordell and David Bullock are subject to a somewhat more stringent lock-up provision, which provides for an initial release date of June 1, 2007, but allows Messrs. Cordell and Bullock to sell shares of common stock with a value (as described above) equal to 12.5% (as opposed to 6.25%) of the foregoing value on each of the first two release dates. At any time after a release date, in addition to the foregoing, each management security holder will be permitted to sell a number of shares of common stock equal to the number of shares that such management security holder was entitled to, but did not, sell as of such release date. In the event of a management security holder s death, the beneficiaries of such holder will be permitted to sell all of such holder s shares of common stock at any time. In the event a (i) management security holder s employment is terminated for any reason other than Full Cause or by the holder with Good Reason (as each such term is defined in the management Table of Contents incentive agreement), or (ii) distribution of the common stock in which a holder s deferred compensation account is deemed to be invested occurs as a result of a successful challenge by the Internal Revenue Service of our existing trust arrangement the holder will be permitted to sell shares of common stock in accordance with the schedule of release dates described above. However, the holder will also be permitted to sell such number of shares of common stock as is necessary for him to generate sufficient proceeds, net of any underwriter s commissions and discounts, to satisfy any federal and state income tax liabilities incurred with respect to the distribution of deferred shares from our deferred compensation plans or the exercise of UAP stock options in connection with such termination of employment. In the event a management security holder s employment is terminated for Full Cause or by the holder without Good Reason, the holder will be prohibited from offering to sell, contracting to sell, or otherwise selling, disposing of, loaning, using as collateral or otherwise pledging, transferring or granting any interest in or rights with respect to any shares of common stock acquired on the exercise of options granted under the 2003 option plan or the distribution of deferred shares under the 2003 and 2004 deferred compensation plans (regardless of whether such exercise or such distribution occurs prior to or following such termination of employment) for a period of six years following the date of the termination of employment. The management incentive agreement will also provide that, within two years of the consummation of this offering, UAP Holdings must file or cause to be filed, and use commercially reasonable efforts to cause to become and remain effective for so long as any management security holder beneficially owns securities covered by the management incentive agreement, a registration statement on Form S-8 or other appropriate form with respect to the issuance of shares of common stock in connection with the exercises of options granted under our option plans and deferred compensation plans. Pursuant to the management incentive agreement, each of the retention agreements entered into in connection with the Acquisition will be terminated. Each management security holder that is party to the management incentive agreement will agree not to: disclose or use at any time, either during the term of his employment or thereafter, any confidential information about the business of UAP Holdings and its subsidiaries of which he is or becomes aware, except to the extent that such disclosure or use is directly related to and required by his performance in good faith of duties assigned to him by UAP Holdings and its affiliates or required pursuant to an order of a court of competent jurisdiction; during the period commencing on the date of the management incentive agreement and ending on the first anniversary of the date of termination of employment, induce or attempt to induce any employee of UAP Holdings and its subsidiaries to leave the employ of UAP Holdings and its subsidiaries or in any way interfere with the relationship between UAP Holdings and its subsidiaries, on the one hand, and any employee thereof, on the other hand; during the period commencing on the date of the management incentive agreement and ending on the first anniversary of the date of termination of employment, hire any person who was an employee of UAP Holdings and its subsidiaries until six months after such individual s employment relationship with UAP Holdings and its subsidiaries has been terminated; during the period commencing on the date of the management incentive agreement and ending on the first anniversary of the date of termination of employment, induce or attempt to induce any customer, supplier, licensee or other business relation of UAP Holdings and its subsidiaries to cease doing business with UAP Holdings and its subsidiaries, or in any way interfere with the relationship between any such customer, supplier, licensee or business relation, on the one hand, and UAP Holdings and its subsidiaries, on the other hand; or Table of Contents during the period commencing on the date of the management incentive agreement and ending on the first anniversary of the date of termination of employment, directly or indirectly own, manage, control, participate in, consult with, render services for, or in any manner engage in or represent any business competing with the businesses or the products of UAP Holdings and its subsidiaries as such businesses and/or products exist or are in the process of being formed or acquired as of the date of the termination of employment, within the United States, Canada and any other country in which any product, process, good or service has been manufactured, provided, sold or offered or promoted for sale by UAP Holdings and its subsidiaries on or prior to the date that he ceases to be employed by UAP Holdings and its subsidiaries. Table of Contents DESCRIPTION OF CERTAIN INDEBTEDNESS THE REVOLVING CREDIT FACILITY On November 24, 2003, in connection with the Acquisition, United Agri Products entered into a five-year $500.0 million revolving credit facility with General Electric Capital Corporation as Agent and Lender, GE Canada Finance Holding Company as Canadian Agent, GECC Capital Markets, Group, Inc. as Co-Lead Arranger, UBS Securities LLC, as Co-Lead Arranger and Co-Syndication Agent, Co peratieve Centrale Raiffeisen-Boereleenbank B.A., Rabobank International, New York Branch, as Co-Documentation Agent and Merrill Lynch Capital, a division of Merrill Lynch Business Financial Services Inc., as Co-Documentation Agent. United Agri Products will amend and restate the credit agreement governing the revolving credit facility upon the consummation of this offering. The key terms of the revolving credit facility, as they will be amended and restated, are described below. Such description is not complete and is qualified in its entirety by reference to the complete text of the related credit agreement, a copy of which is filed as an exhibit to the registration statement of which this prospectus forms a part. The revolving credit facility provides for the following: a five-year $500.0 million asset-based revolving credit facility; a $20.0 million revolving credit sub-facility for UAP Canada; a $50.0 million letter of credit sub-facility; a $25.0 million swingline loan sub-facility; and a $25.0 million in-season over-advance sub-facility. United Agri Products used approximately $242.0 million of proceeds of the revolving credit facility to fund a portion of the purchase price of the Acquisition. United Agri Products and UAP Canada use and will continue to use the revolving credit facility for, among other things, United Agri Products and its respective subsidiaries working capital and general corporate purposes, including, without limitation, effecting certain permitted acquisitions and investments. As of August 29, 2004, on a pro forma basis after giving effect to this offering and the Special Dividends, $240.3 million was outstanding under the revolving credit facility, and $240.6 million would have been available for future borrowings, subject to aggregate borrowing base availability and net of $19.1 million in outstanding letters of credit. Borrowing Bases Borrowings by United Agri Products and UAP Canada are subject to borrowing availability under the revolving credit facility. United Agri Products borrowing availability is an amount equal to the lesser of: the maximum amount of the revolving loan commitment, less the outstanding amount of loans of UAP Canada under the Canadian revolving loan sub-facility; or the U.S. borrowing base, plus (if applicable) the maximum in-season over-advance amount; in each case less the sum of the outstanding U.S. revolving loans (including the outstanding amount of letter of credit obligations, swingline loans and in-season over-advances). The U.S. borrowing base is, at any date of determination, an amount equal to the sum of: 85% of the book value (net of reserves) of United Agri Products and its wholly-owned domestic subsidiaries eligible accounts receivable (other than extended accounts receivable and other than those of certain inactive subsidiaries); Table of Contents 75% of the book value (net of reserves) of United Agri Products and its wholly-owned domestic subsidiaries eligible extended accounts receivable (other than those of certain inactive subsidiaries); and the lesser of (1) 55% (or 65% between April 1st and July 31st of each year) of the book value (net of reserves) of United Agri Products and its wholly-owned domestic subsidiaries eligible inventory (other than that of certain inactive subsidiaries) valued at the lower of cost or market or (2) 85% multiplied by a net orderly liquidation value factor multiplied by the book value (net of reserves) of United Agri Products and its wholly-owned domestic subsidiaries eligible inventory (other than that of certain inactive subsidiaries). Borrowings by UAP Canada are also subject to borrowing availability under the revolving credit facility. Its borrowing availability is an amount equal to the lesser of: the maximum amount of the Canadian revolving loan sub-facility; or the U.S. dollar-equivalent of the Canadian borrowing base; in each case less the sum of (1) the U.S. dollar-equivalent of outstanding Canadian revolving loans and (2) the amount of the U.S. revolving loans (including letter of credit obligations, swingline loans and in-season overadvances) outstanding in excess of $480.0 million. The Canadian borrowing base is calculated using a formula identical to the one used to calculate the U.S. borrowing base (except that it is applied only to eligible Canadian accounts receivable and inventory). Interest and Applicable Margins The interest rates with respect to revolving loans under the revolving credit facility are based, at United Agri Products option, on either the agent s index rate plus an applicable index margin of between 0.50% and 1.00% or upon LIBOR plus an applicable LIBOR margin of between 1.75% and 2.25%. At the consummation of this offering, the applicable index margin will be 0.75% and the applicable LIBOR margin will be 2.00%. The interest rates with respect to in-season overadvances under the revolving credit facility are based, at United Agri Products option, on either the agent s index rate plus an applicable index margin of 2.25% or upon LIBOR plus an applicable LIBOR margin of 3.50%. These applicable margins (other than the margin on in-season overadvances) are in each case subject to prospective adjustment on a quarterly basis (with respect to any reduction from current levels, beginning with the third quarter after consummation of this offering) if United Agri Products reduces its ratio of funded debt to EBITDA (on a consolidated basis). Following an event of default, all amounts owing under the revolving credit facility will bear interest at a rate per annum equal to the rate otherwise applicable thereto plus an additional 2.0%. Fees The revolving credit facility requires the payment of the following fees: certain fees specified in a fee letter entered into with GE Capital; an unused line of credit fee in an amount equal to an applicable unused line fee margin of between 0.25% and 0.375% (0.25% at the consummation of this offering) (which margin may be adjusted prospectively on a quarterly basis based on our ratio of funded debt to EBITDA on a consolidated basis) multiplied by the difference between (x) the maximum amount of our revolving credit facility (as it may be reduced from time to time) and (y) the average daily balance of revolving loans (including swingline loans) for the preceding months; a letter of credit fee equal to the average daily undrawn face amount of all outstanding letters of credit during such month multiplied by the applicable margin then in effect with respect to LIBOR loans (other than in-season overadvances); and customary administrative charges. Table of Contents Guaranties and Collateral The obligations under the revolving credit facility are (or, in the case of future subsidiaries, will be) guaranteed by UAP Holdings and each of its existing and future direct and indirect subsidiaries. However, none of the non-U.S. subsidiaries of UAP Holdings have guaranteed or will guarantee any of United Agri Products obligations or those of its U.S. subsidiaries. The obligations of UAP Canada under the revolving credit facility are (or, in the case of future subsidiaries, will be) guaranteed by UAP Holdings and each of its existing and future direct and indirect Canadian and U.S. subsidiaries (including United Agri Products). United Agri Products obligations and the obligations of the U.S. guarantors under the revolving credit facility and the related documents are and will be secured by a first priority lien on or security interest in, subject to certain exceptions, substantially all of UAP Holdings and United Agri Products properties and assets and the properties and assets of each of the U.S. guarantors, in each case whether now owned or hereafter acquired. The obligations of UAP Canada and the obligations of the Canadian guarantors under the revolving credit facility and the related documents are and will be secured by a first priority lien on or security interest in, subject to certain exceptions, substantially all of UAP Holdings , United Agri Products and UAP Canada s properties and assets and the properties and assets of each of the Canadian guarantors in each case whether now owned or hereafter acquired. Such security includes and will include a pledge or all capital stock and certain debt instruments owned by such parties, except that, in general, not more than 66% of the total outstanding voting stock of any non-U.S., non-Canadian subsidiary of UAP Holdings is or will be required to be pledged in support of the obligations of UAP Holdings, United Agri Products or its subsidiaries. Representations, Warranties and Covenants The revolving credit facility contains certain customary representations, warranties and affirmative covenants. In addition, the revolving credit facility contains customary negative covenants restricting, subject to customary exceptions, UAP Holdings ability and the ability of its subsidiaries to, among other things: incur additional indebtedness; incur liens, enter into agreements that limit the ability to incur liens, or permit any encumbrance or restriction on certain inter-company payments and transfers; make investments; become liable for certain contingent obligations; make certain restricted payments in respect of capital stock; amend certain organizational, corporate and other documents; engage in mergers or make acquisitions; sell or dispose of assets or the stock of subsidiaries; enter into transactions with affiliates; engage in any new business; change in fiscal year without notice to the agent; create or establish new subsidiaries without delivering guaranties and security and described above; establish new bank accounts without entering into a control agreement in favor of the agent; permit certain releases of certain hazardous materials; take any actions that could cause an ERISA event that could reasonably be expected to have a material adverse effect (as defined); enter into certain sale-leaseback, lease in-lease out and similar transactions; or voluntarily purchase, redeem, defease or prepay the notes or any subordinated debt; Table of Contents In addition, the revolving credit facility restricts the ability of each of UAP Holdings and United Agri Products to pay dividends on its capital stock. Generally, neither can pay dividends unless: the aggregate amount of dividends does not exceed $25.0 million plus up to 50% of the cumulative positive consolidated net income, as defined (net of losses), of United Agri Products and its subsidiaries since November 24, 2003; immediately prior to and immediately following the dividend, at least $40.0 million is available for borrowing under the revolving credit facility; and no event of default under the revolving credit facility shall have occurred and be continuing or would result after giving effect to the dividend. The revolving credit facility also contains the following financial covenants: If and for so long as aggregate borrowing availability is less than $40.0 million, UAP Holdings and its subsidiaries will be required to have EBITDA of at least $70.0 million, measured as of the last day of each month for the trailing twelve-month period then ended. If and for so long as aggregate borrowing availability is less than $40.0 million, UAP Holdings and its subsidiaries will be required to maintain a fixed charge coverage ratio of not less than 1.1 to 1.0, measured as of the last day of each month for the trailing twelve-month period then ended. Events of Default Events of default under the revolving credit facility include: failure to pay principal when due or pay a reimbursement obligation in respect of a letter of credit; failure to pay interest within three business days after its due date; default with respect to certain other indebtedness; failure to maintain UAP s corporate existence or that of UAP Canada; failure to cause any new subsidiary to guarantee UAP s obligations and/or those of UAP Canada and to collateralize the same with security interests, liens and pledges on the terms and conditions set forth in the revolving credit facility and related documents; failure to comply with the covenants in the revolving credit facility; submission of a borrowing base certificate containing material errors; material breach of any representation or warranty; other defaults under the revolving credit facility documents which are not cured or waived within 30 days; voluntary and involuntary events of bankruptcy; the entrance or filing of a material money judgment or similar process which is not adequately covered by insurance and remains undischarged, unvacated, unbonded or unstayed for a period of 30 days; any order is entered decreeing the dissolution of any borrower or guarantor (other than certain inactive subsidiaries) and the same remains undischarged or unstayed for a period in excess of 30 days; any of the revolving credit facility documents become invalid; and certain changes of control with respect to UAP Holdings, United Agri Products or UAP Canada. Table of Contents 8 % SENIOR NOTES On December 16, 2003, United Agri Products completed a private offering of $225.0 million aggregate principal amount of its 8 1/4% Senior Notes due 2011 (the 8 1/4% Senior Notes ). The net proceeds from the offering of the 8 1/4% Senior Notes were used to repay United Agri Products $175.0 million senior bridge loan facility, plus accrued interest, to repay a portion of the revolving credit facility, and to pay related fees and expenses. The 8 1/4% Senior Notes were issued under an indenture among United Agri Products, certain of its subsidiaries and JPMorgan Chase Bank, as trustee. UAP Holdings has not guaranteed United Agri Products obligations under the 8 1/4% Senior Notes. Interest on the 8 1/4% Senior Notes accrues at the rate of 8 1/4% per annum and is payable semi-annually in arrears on June 15 and December 15 of each year, beginning on June 15, 2004. The 8 1/4% Senior Notes mature on December 15, 2011. United Agri Products is not required to make mandatory redemption or sinking fund payments with respect to the 8 1/4% Senior Notes. Optional Redemption United Agri Products may redeem some or all of the 8 1/4% Senior Notes at any time on or after December 15, 2007 at a redemption price equal to 100% of the principal amount plus a premium declining ratably to par, plus accrued and unpaid interest and liquidated damages, if any, to the redemption date. At any time prior to December 15, 2006, United Agri Products may use the proceeds of certain equity offerings to redeem up to 35% of the aggregate principal amount of the 8 1/4% Senior Notes originally issued under the indenture governing the 8 1/4% Senior Notes and all or a portion of any additional notes issued under such indenture after the date of such indenture, in each case at a redemption price equal to 108.250% of the principal amount, plus accrued and unpaid interest and liquidated damages, if any, to the redemption date. Pursuant to this provision, we intend to use a portion of the net proceeds of this offering to redeem approximately $21.5 million principal amount of the 8 1/4% Senior Notes. In addition, at any time prior to December 15, 2007, United Agri Products may redeem some or all of the 8 % Senior Notes at a redemption price equal to 100% of the principal amount plus a make-whole premium, plus accrued and unpaid interest and liquidated damages, if any, to the redemption date. Guarantees; Ranking The 8 1/4% Senior Notes are United Agri Products general unsecured obligations and rank equally in right of payment with all of United Agri Products existing and future unsecured senior debt. The 8 1/4% Senior Notes are effectively subordinated in right of payment to all of United Agri Products existing and future secured debt, including debt under the revolving credit facility, to the extent of the value of the assets securing that debt. In addition, the 8 1/4% Senior Notes are structurally subordinate to all obligations, including trade payables, of United Agri Products subsidiaries that do not guarantee the 8 1/4% Senior Notes. The 8 1/4% Senior Notes are guaranteed on a senior unsecured basis by United Agri Products current and future domestic restricted subsidiaries. The guarantees are general unsecured obligations of the guarantors and rank equally in right of payment with their existing and future unsecured senior debt. The guarantees are effectively subordinated in right of payment to all of the guarantors existing and future secured debt, including guarantees under the revolving credit facility, to the extent of the value of the assets securing that debt. Covenants The indenture governing the 8 1/4% Senior Notes contains certain limitations and restrictions on United Agri Products and certain of its subsidiaries ability to, among other things: incur additional indebtedness; make certain investments; Table of Contents incur liens; enter into certain types of transactions with affiliates; and limit dividends or other payments by United Agri Products restricted subsidiaries to United Agri Products; and sell all or substantially all of United Agri Products assets or merge with or into other companies. The indenture also restricts United Agri Products ability to pay dividends or make other distributions on its capital stock or repurchase or redeem its capital stock. Specifically, United Agri Products may not make any such payments if a default under the indenture has occurred and is continuing. In addition, the aggregate amount of such payments generally cannot exceed 50% of the cumulative consolidated net income of United Agri Products and its subsidiaries since November 24, 2003 plus 100% of any amounts contributed to United Agri Products common equity capital or received from the sale of equity interests. As a condition to making such payments, United Agri Products must also be able to incur $1.00 of additional indebtedness under the fixed charge coverage ratio test. Notwithstanding the foregoing, United Agri Products is permitted to pay dividends to UAP Holdings to allow UAP Holdings to pay dividends on its common stock, following the first public offering of UAP Holdings common stock, in an amount up to 7.5% per annum of the amount contributed to United Agri Products from the proceeds received by UAP Holdings in such offering. The indenture also contains a provision allowing United Agri Products to make up to $25.0 million of restricted payments generally, which it could use to pay dividends (and was used in connection with the Special Dividends). These covenants are subject to important exceptions and qualifications. Events of Default The indenture governing the 8 1/4% Senior Notes contains certain events of default, including (subject, in some cases, to customary cure periods and materiality thresholds) defaults based on (i) the failure to make payments under the indenture when due, (ii) breach of covenants, (iii) cross-defaults to other material indebtedness, (iv) bankruptcy events and (v) material judgments. Registration Rights The registration rights agreement governing the 8 1/4% Senior Notes (the 8 1/4% Senior Note Registration Rights Agreement ) required United Agri Products to cause its Registration Statement on Form S-4 relating to an exchange offer for the 8 1/4% Senior Notes to be declared effective by the Securities and Exchange Commission on or before July 13, 2004. Because of the Proposed IDS Offering, United Agri Products was precluded from causing its Registration Statement on Form S-4 from being declared effective. In accordance with the terms of the 8 1/4% Senior Note Registration Rights Agreement, United Agri Products accrued liquidated damages on the 8 1/4% Senior Notes at a rate of 0.25% per annum on the outstanding principal amount of such notes from July 14, 2004 through October 12, 2004. Since October 13, 2004, United Agri Products has been accruing liquidated damages on the 8 1/4% Senior Notes at a rate of 0.50% per annum on the outstanding principal amount of the 8 1/4% Senior Notes. As soon as practicable, United Agri Products intends to cause its Registration Statement on Form S-4 to be declared effective by the Securities and Exchange Commission, and to commence an exchange offer relating to its 8 1/4% Senior Notes, at which time liquidated damages will no longer accrue. After consummating this exchange offer, United Agri Products will pay any outstanding liquidated damages using cash generated by its operations. Tender Offer and Consent Solicitation On April 26, 2004, United Agri Products commenced a tender offer and consent solicitation with respect to all its outstanding 8 1/4% Senior Notes. The tender offer and consent solicitation were conditioned upon, among other things, the closing of the Proposed IDS Offering. We abandoned the Proposed IDS Offering, however, to pursue this offering, and on October 29, 2004, the tender offer and consent solicitation was terminated. Table of Contents Accordingly, following the consummation of this offering and the application of the proceeds therefrom to redeem a portion of the 8 1/4% Senior Notes, approximately $203.5 million principal amount of the 8 1/4% Senior Notes will remain outstanding. 10 % SENIOR DISCOUNT NOTES On January 26, 2004, UAP Holdings completed a private offering of $125.0 million aggregate principal amount at maturity of its 10 3/4% Senior Discount Notes due 2012 (the 10 3/4% Senior Discount Notes ). The net proceeds from the offering of the 10 3/4% Senior Discount Notes were used to redeem approximately $26.4 million of the outstanding Series A Redeemable Preferred Stock, to pay a dividend of approximately $52.9 million to the holders of common stock, and to pay related fees and expenses. The 10 3/4% Senior Discount Notes were issued under an indenture between UAP Holdings and JPMorgan Chase Bank, as trustee. No interest will accrue on the 10 3/4% Senior Discount Notes prior to January 15, 2008. Instead, the accreted value of each 10 3/4% Senior Discount Note will increase (representing amortization of original issue discount) from the date of original issuance to but not including January 15, 2008 at a rate of 10 3/4% per annum, such that the accreted value on January 15, 2008 will be equal to the full principal amount at maturity. Beginning on January 15, 2008, interest on the 10 3/4% Senior Discount Notes will accrue at a rate of 10 3/4% per annum and will be payable in cash semi-annually in arrears on January 15 and July 15, commencing on July 15, 2008. Optional Redemption UAP Holdings may redeem some or all of the 10 3/4% Senior Discount Notes at any time on or after January 15, 2008 at a redemption price equal to 100% of the principal amount at maturity thereof plus a premium declining ratably to par, plus accrued and unpaid interest and liquidated damages, if any, to the redemption date. At any time prior to January 15, 2007, UAP Holdings may use the proceeds of certain equity offerings to redeem up to 40% of the aggregate principal amount at maturity of 10 3/4% Senior Discount Notes originally issued under the indenture governing the 10 3/4% Senior Discount Notes and all or a portion of any additional notes issued under such indenture after the date of the indenture, in each case at a redemption price equal to 110.750% of the accreted value thereof, plus liquidated damages, if any, to the redemption date. In addition, if we experience a change of control prior to January 15, 2008, UAP Holdings may redeem the 10 3/4% Senior Discount Notes, in whole but not in part, at a redemption price equal to 100% of the accreted value thereof, plus a premium declining ratably to 8.063%, plus liquidated damages, if any, to the redemption date. If UAP Holdings experiences a change of control, it may be required to offer to repurchase some or all the 10 3/4% Senior Discount Notes at a purchase price equal to 101% of the accreted value thereof, plus liquidated damages, if any, to the repurchase date (if prior to January 15, 2008) or 101% of the principal amount at maturity, plus accrued and unpaid interest and liquidated damages, if any, to the repurchase date (if on or after January 15, 2008). Ranking The 10 3/4% Senior Discount Notes are UAP Holdings general unsecured obligations and rank equally in right of payment with all of UAP Holdings existing and future unsecured senior debt. The 10 3/4% Senior Discount Notes are effectively subordinated in right of payment to all of UAP Holdings existing and future secured debt, including its guarantees of debt under the revolving credit facility, to the extent of the value of the assets securing that debt. The 10 3/4% Senior Discount Notes are structurally subordinated to all obligations of our existing and future subsidiaries, including United Agri Products. Pro forma EBITDA 125,289 107,503 119,155 Inventory fair market value adjustment (2) 3,673 17,354 21,027 ConAgra transition services agreement expense (3) 1,875 3,750 5,625 Gain on sale of businesses (4) (10,543 ) (10,543 ) Table of Contents Covenants The indenture governing the 10 3/4% Senior Discount Notes contains certain limitations and restrictions on UAP Holdings and certain of its subsidiaries ability to, among other things: incur additional indebtedness; pay dividends or make other distributions on UAP Holdings capital stock or repurchase, repay or redeem UAP Holdings capital stock or subordinated debt; make certain investments; incur liens; enter into certain types of transactions with affiliates; limit dividends or other payments by UAP Holdings restricted subsidiaries to us; and sell all or substantially all of UAP Holdings assets or merge with or into other companies. These covenants are subject to important exceptions and qualifications. The indenture also restricts UAP Holdings ability to pay dividends or make other distributions on its capital stock or repurchase or redeem its capital stock. Specifically, UAP Holdings may not make any such payments if a default under the indenture has occurred and is continuing. In addition, the aggregate amount of such payments generally cannot exceed 50% of the cumulative consolidated net income of UAP Holdings and its subsidiaries since November 24, 2003 plus 100% of any amounts contributed to UAP Holdings common equity capital or received from the sale of equity interests. As a condition to making such payments, UAP Holdings must be able to incur $1.00 of additional indebtedness under the fixed charge coverage ratio test. Notwithstanding the foregoing, UAP Holdings is permitted to pay dividends on UAP Holdings common stock, following the first public offering of its common stock, in an amount up to 7.5% per annum of the net proceeds received by UAP Holdings in such offering. The indenture also contains a provision allowing UAP Holdings to make up to $25.0 million of restricted payments generally, which it could use to pay dividends (and was used in connection with the Special Dividends). Events of Default The indenture governing the 10 3/4% Senior Discount Notes contains certain events of default, including (subject, in some cases, to customary cure periods and materiality thresholds) defaults based on (i) the failure to make payments under the indenture when due, (ii) breach of covenants, (iii) cross-defaults to other material indebtedness, (iv) bankruptcy events and (v) material judgments. Registration Rights The registration rights agreement governing the 10 % Senior Discount Notes (the 10 % Senior Discount Note Registration Rights Agreement ) required UAP Holdings to cause its Registration Statement on Form S-4 relating to an exchange offer for the 10 % Senior Discount Notes to be declared effective by the Securities and Exchange Commission on or before August 23, 2004. Because of the Proposed IDS Offering, UAP Holdings was precluded from causing its Registration Statement on Form S-4 from being declared effective. In accordance with the terms of the 10 % Senior Discount Note Registration Rights Agreement, UAP Holdings began accruing liquidated damages on the 10 % Senior Discount Notes at a rate of 0.25% per annum on the accreted value of such notes from August 24, 2004. As soon as practicable, UAP Holdings intends to cause its Registration Statement on Form S-4 to be declared effective by the Securities and Exchange Commission, and to commence an exchange offer relating to its 10 % Senior Discount Notes, at which time liquidated damages will no longer accrue. After consummating this exchange offer, UAP Holdings will pay any outstanding liquidated damages, in cash, using a portion of the proceeds of this offering. Table of Contents Tender Offer and Consent Solicitation On April 26, 2004, UAP Holdings commenced a tender offer and consent solicitation with respect to all its outstanding 10 % Senior Discount Notes. The tender offer and consent solicitation were conditioned upon, among other things, the closing of the Proposed IDS Offering. We abandoned the Proposed IDS Offering, however, to pursue this offering, and on October 29, 2004, the tender offer and consent solicitation was terminated. Accordingly, all the 10 % Senior Discount Notes will remain outstanding following consummation of this offering. Table of Contents DESCRIPTION OF CAPITAL STOCK GENERAL Our capital stock consists of 95,000,000 total authorized shares, of which 90,000,000 shares, $0.001 par value per share, are designated as common stock and 5,000,000 shares, $0.001 par value per share, are designated as preferred stock. There will be no shares of preferred stock outstanding immediately following this offering. We have set forth below a summary description of the material terms and provisions of our amended and restated certificate of incorporation, our amended and restated bylaws and specific provisions of Delaware law. The following description is intended as a summary only and is qualified in its entirety by reference to our amended and restated certificate of incorporation, our amended and restated bylaws and the Delaware General Corporation Law ( DGCL ). COMMON STOCK The holders of our common stock are entitled to dividends as our board of directors may declare from time to time from funds legally available therefor, subject to the preferential rights of the holders of any shares of our preferred stock that we may issue in the future. See Dividend Policy beginning on page 21. Under Delaware law, we can only pay dividends either out of surplus or out of current or the immediately preceding year s net profits. Surplus is defined as the excess, if any, at any given time, of the total assets of a corporation over its total liabilities and statutory capital. The value of a corporation s assets can be measured in a number of ways and may not necessarily equal their book value. The holders of our common stock are entitled to one vote for each share held of record on any matter to be voted upon by stockholders. Our amended and restated certificate of incorporation does not provide for cumulative voting in connection with the election of directors, and, accordingly, holders of more than 50% of the shares voting will be able to elect all the directors. There are no preemptive, conversion, redemption or sinking fund provisions applicable to our common stock. Upon any voluntary or involuntary liquidation, dissolution or winding up of our affairs, the holders of our common stock are entitled to share ratably in all assets remaining after payment to creditors and subject to prior distribution rights of any shares of preferred stock that we may issue in the future. All the outstanding shares of common stock are, and the shares offered by us will be, fully paid and non-assessable. PREFERRED STOCK Shares of preferred stock may be issued from time to time, in one or more series, with the designations, assigned values, voting rights, powers, preferences and relative, participating, optional or other special rights, qualifications, limitations or restrictions thereof as our board of directors from time to time may adopt by resolution, subject to certain limitations. Each series shall consist of that number of shares as shall be stated and expressed in the certificate of designations providing for the issuance of the stock of the series. All shares of any one series of preferred stock shall be identical. Series A Redeemable Preferred Stock In connection with the Acquisition, we issued $60.0 million of Series A Redeemable Preferred Stock to ConAgra Foods. We redeemed approximately $26.4 million of Series A Redeemable Preferred Stock on January 26, 2004 with a portion of the proceeds from the offering of the 10 % Senior Discount Notes. We also redeemed approximately $20.0 million of Series A Redeemable Preferred Stock on October 4, 2004 with a Table of Contents portion of the proceeds of a $60.0 million dividend from United Agri Products. The key terms of the Series A Redeemable Preferred Stock are described below. Such description is not complete and is qualified in its entirety by reference to the complete text of the applicable certificate of designation, a copy of which is filed as an exhibit to the registration statement of which this prospectus forms a part. The authorized number of shares of Series A Redeemable Preferred Stock is 175,000, of which 15,254 are outstanding as of the date of this prospectus. The outstanding Series A Redeemable Preferred Stock was issued by us for $1,000 per share (the Face Amount ) and ranks prior to our common stock and any other class of our capital stock ranking junior to the Series A Redeemable Preferred Stock with respect to dividends, liquidation, dissolution and winding up of UAP Holdings. All shares of Series A Redeemable Preferred Stock will be redeemed with the proceeds of this offering and will no longer be outstanding. Dividends. The holders of outstanding shares of Series A Redeemable Preferred Stock are entitled to receive, when, as and if declared by the board of directors, out of funds legally available therefor, with respect to each share of Series A Redeemable Preferred Stock, semiannual preferred dividends in an amount equal to the product of (i) the Face Amount thereof multiplied by (ii) 50% of the per annum dividend rate. The per annum dividend rate is 8.0% until November 24, 2008, 9.0% from November 24, 2008 to, but not including, November 24, 2009, and 10% from November 24, 2009 and thereafter. Dividends may be paid, at our option, either in cash or by delivering to the record holders of Series A Redeemable Preferred Stock additional shares of Series A Redeemable Preferred Stock (and fractional shares to the extent applicable) having an aggregate Face Amount equal to the amount of the dividend to be paid on the applicable dividend payment date. Liquidation. Upon a liquidation or winding up of UAP Holdings in a single transaction or series of transactions, the holders of Series A Redeemable Preferred Stock will be entitled to be paid, out of the assets of UAP Holdings available for distribution to its shareholders, whether from capital, surplus or earnings ( Available Assets ), an amount equal to the Face Amount plus all accrued and unpaid dividends on each share, if any (in the aggregate, the Liquidation Preference Amount ), before any distribution is made on any other class of our stock ranking junior to the Series A Redeemable Preferred Stock with respect to a liquidation or winding up, including our common stock. If the Available Assets are insufficient to pay the holders of the Series A Redeemable Preferred Stock the full Liquidation Preference Amount, the holders of the Series A Redeemable Preferred Stock shall share ratably in any distribution of assets according to the respective amounts which would be payable in respect of the shares held by them upon such distribution if all amounts payable on or with respect to said shares were paid in full. The Liquidation Preference Amount must be paid to the holders of Series A Redeemable Preferred Stock in cash. Redemption. On December 15, 2012 (the Maturity Date ), we are required to redeem all the Series A Redeemable Preferred Stock then outstanding for an amount equal to the Liquidation Preference Amount. At any time prior to December 15, 2012, we have the option of redeeming, in whole or in part, the outstanding shares of Series A Redeemable Preferred Stock at a price equal to the then current Liquidation Preference Amount. In the case of a redemption of less than all the shares of Series A Redeemable Preferred Stock at the time outstanding, the shares to be redeemed shall be selected pro rata or by lot as reasonably determined by us to be equitable. Upon a change of control, each holder of Series A Redeemable Preferred Stock has the right, at such holder s election, to receive on the date the change of control occurs in respect of each share owned by such holder a sum equal to (a) the then applicable Face Amount multiplied by 1.01 plus (b) all accrued and unpaid dividends on each such share (the Change of Control Redemption Amount ). Also upon a change of control, we may elect to redeem all (but not less than all) the outstanding shares of Series A Redeemable Preferred Stock for an amount equal to the Change of Control Redemption Amount. A change of control means: prior to our initial public offering, any person other than Apollo owns more than 50% of the voting power of our common stock on a fully diluted basis; Table of Contents after our initial public offering, any person other than Apollo owns more than 30% of the voting power of our common stock; a merger or consolidation in which our stockholders own less than 50% of the voting securities of the surviving corporation; sale of all or substantially all our assets; or a change of control under and as defined in any indenture or agreement to which UAP Holdings or any of its subsidiaries is a party with respect to indebtedness for borrowed money in excess of the aggregate principal amount of $100 million. In addition, if Apollo sells its common stock to an entity not affiliated with Apollo and such sale does not result in a change of control, we are required to redeem the Series A Redeemable Preferred Stock in a number and for a price to be determined, in part, by the aggregate consideration received by Apollo in any such sale. Notwithstanding the foregoing, we will not be required to redeem the Series A Redeemable Preferred Stock at any time such redemption is either prohibited by law or is prohibited by, or would be a default under, the terms of the revolving credit facility. No Voting Rights. Except as specifically set forth in the Delaware General Corporation Law, the holders of Series A Redeemable Preferred Stock are not entitled to any voting rights with respect to any matters voted upon by stockholders, provided, however, the consent of the holders of at least two-thirds of the outstanding shares of Series A Redeemable Preferred Stock is required for any action which: (i) alters or changes the rights, preferences or privileges of the Series A Redeemable Preferred Stock in a manner adverse to the holders thereof; (ii) increases or decreases the authorized number of shares of Series A Redeemable Preferred Stock; (iii) creates, by reclassification or otherwise, any new class or series of shares having rights, preferences or privileges on parity or senior to the Series A Redeemable Preferred Stock; or (iv) amends or waives any provisions of our amended certificate of incorporation in a manner adverse to the holders of the outstanding shares of Series A preferred stock. No Preemptive Rights. No holder of shares of Series A Redeemable Preferred Stock has by virtue of such ownership any preemptive or subscription rights in respect of any of our securities that may be issued. COMPOSITION OF BOARD OF DIRECTORS; ELECTION AND REMOVAL OF DIRECTORS In accordance with our amended and restated bylaws, the number of directors comprising our board of directors will be as determined from time to time by our board of directors provided that in no event shall the total number of directors constituting the entire board be less than three nor more than eleven. Upon the closing of the offering, it is anticipated that we will have seven directors. We currently expect to add an additional independent director after the completion of this offering. Each director is to hold office until his or her successor is duly elected and qualified or until his or her earlier death, resignation or removal. At any meeting of our board of directors, a majority of the total number of directors then in office will constitute a quorum for all purposes. Our amended and restated certificate of incorporation provides that our board of directors is divided into three classes of directors, with the classes to be as nearly equal in number as possible. As a result, approximately one-third of our board of directors are elected each year. The classification of directors has the effect of making it more difficult for stockholders to change the composition of our board. Under the DGCL, unless otherwise provided in our amended and restated certificate of incorporation, directors serving on a classified board may be removed by the stockholders only for cause. Our amended and restated certificate of incorporation does not make an exception to this rule. In addition, our amended and restated certificate of incorporation and bylaws provide that any vacancies on our board of directors will be filled only by the affirmative vote of a majority of the remaining directors, although less than a quorum. Table of Contents SPECIAL MEETINGS OF STOCKHOLDERS Our amended and restated bylaws provide that special meetings of the stockholders may be called only by the board of directors, the chairman, the chief executive officer or the president. SECTION 203 OF THE DELAWARE GENERAL CORPORATION LAW In our amended and restated certificate of incorporation, we have elected not to be subject to Section 203 of the Delaware General Corporation Law. In general, Section 203 prohibits a publicly held Delaware corporation from engaging in a business combination with an interested stockholder for a three-year period following the time that this stockholder becomes an interested stockholder, unless the business combination is approved in a prescribed manner. A business combination includes a merger, asset sale or other transaction resulting in a financial benefit to the interested stockholder. An interested stockholder is a person who, together with affiliates and associates, owns (or, in some cases, within three years prior, did own) 15% or more of the corporation s voting stock. PROVISIONS OF OUR AMENDED AND RESTATED CERTIFICATE OF INCORPORATION, AMENDED AND RESTATED BYLAWS THAT MAY HAVE AN ANTI-TAKEOVER EFFECT Certain provisions in our amended and restated certificate of incorporation and amended and restated bylaws summarized below may be deemed to have an anti-takeover effect and may delay, deter or prevent a tender offer or takeover attempt that a stockholder might consider to be in its best interests, including attempts that might result in a premium being paid over the market price for the shares held by stockholders. Preferred Stock Our amended and restated certificate of incorporation contains provisions that permit our board of directors to issue, without any further vote or action by the stockholders, shares of preferred stock in one or more series and, with respect to each such series, to fix the number of shares constituting the series and the designation of the series, the voting powers (if any) of the shares of the series, and the preferences and relative, participating, optional and other special rights, if any, and any qualifications, limitations or restrictions, of the shares of such series. No Stockholder Action by Written Consent Our amended and restated certificate of incorporation and bylaws prohibit stockholder action by written consent. Advance Notice Requirements for Stockholder Proposals and Director Nominations Our amended and restated bylaws provide that stockholders seeking to nominate candidates for election as directors or to bring business before an annual meeting of stockholders must provide timely notice of their proposal in writing to the corporate secretary. Generally, to be timely, a stockholder s notice must be received at our principal executive offices not less than 90 days nor more than 120 days prior to the first anniversary date of the previous year s annual meeting. Our amended and restated bylaws also specify requirements as to the form and content of a stockholder s notice. These provisions may impede stockholders ability to bring matters before an annual meeting of stockholders or make nominations for directors at an annual meeting of stockholders. Supermajority Board Voting Requirements See the discussion under the heading Management Supermajority Board Approval of Certain Matters beginning on page 64, relating to circumstances under which more than a simple majority of our board of directors may be required under our amended and restated certificate of incorporation to approve certain matters. Table of Contents All the foregoing proposed provisions of our amended and restated certificate of incorporation and amended and restated bylaws could discourage potential acquisition proposals and could delay or prevent a change in control. These provisions are intended to enhance the likelihood of continuity and stability in the composition of the board of directors and in the policies formulated by the board of directors and to discourage certain types of transactions that may involve an actual or threatened change of control. These provisions are designed to reduce our vulnerability to an unsolicited acquisition proposal. The provisions also are intended to discourage certain tactics that may be used in proxy fights. However, such provisions could have the effect of discouraging others from making tender offers for our shares and, as a consequence, they also may inhibit fluctuations in the market price of our common stock that could result from actual or rumored takeover attempts. Such provisions also may have the effect of preventing changes in our management. AMENDMENT OF OUR CERTIFICATE OF INCORPORATION Under applicable law, our amended and restated certificate of incorporation may be amended only with the affirmative vote of a majority of the outstanding stock entitled to vote thereon; provided that a supermajority vote of the outstanding stock is required to amend the provisions in our amended and restated certificate of incorporation requiring a supermajority vote of the directors for certain transactions. AMENDMENT OF OUR BYLAWS Our amended and restated bylaws can be amended by the vote of the holders of a majority of the shares then entitled to vote or by the vote of a majority of the board of directors. LIMITATION OF LIABILITY AND INDEMNIFICATION Our amended and restated certificate of incorporation provides that no director shall be personally liable for monetary damages for breach of any fiduciary duty as a director, except with respect to liability: for any breach of the director s duty of loyalty to us or our stockholders; for acts or omissions not in good faith or that involve intentional misconduct or a knowing violation of law; under Section 174 of the Delaware General Corporation Law (governing distributions to stockholders); or for any transaction from which the director derived any improper personal benefit. However, if the Delaware General Corporation Law is amended to authorize corporate action further eliminating or limiting the personal liability of directors, then the liability of our directors will be eliminated or limited to the fullest extent permitted by the Delaware General Corporation Law, as so amended. The modification or repeal of this provision of our amended and restated certificate of incorporation shall not adversely affect any right or protection of a director existing at the time of such modification or repeal. Our amended and restated bylaws provide that we shall, to the fullest extent from time to time permitted by law, indemnify our directors, officers and employees against all liabilities and expenses in any suit or proceeding, arising out of their status as an officer or director or their activities in these capacities. We shall also indemnify any person who, at our request, is or was serving as a director, officer or employee of another corporation, partnership, joint venture, trust or other enterprise. The right to be indemnified shall include the right of an officer or a director to be paid expenses in advance of the final disposition of any proceeding, provided that, if required by law, we receive an undertaking to repay such amount if it shall be determined that he or she is not entitled to be indemnified. Table of Contents Our board of directors may take such action as it deems necessary to carry out these indemnification provisions, including adopting procedures for determining and enforcing indemnification rights and purchasing insurance policies. Our board of directors may also adopt bylaws, resolutions or contracts implementing indemnification arrangements as may be permitted by law. Neither the amendment or repeal of these indemnification provisions, nor the adoption of any provision of our amended and restated certificate of incorporation inconsistent with these indemnification provisions, shall eliminate or reduce any rights to indemnification relating to their status or any activities prior to such amendment, repeal or adoption. We believe these provisions will assist in attracting and retaining qualified individuals to serve as directors. LISTING We have applied for the quotation of our common stock on the NASDAQ National Market under the trading symbol UAPH. TRANSFER AGENT AND REGISTRAR The transfer agent and registrar for our common stock is Mellon Investor Services LLC. Table of Contents SHARES ELIGIBLE FOR FUTURE SALE Future sales or the availability for sale of substantial amounts of our common stock in the public market could adversely affect prevailing market prices and could impair our ability to raise capital through future sales of our securities. Upon completion of this offering, 50,373,244 shares of common stock will be outstanding, excluding 3,418,162 shares reserved at October 1, 2004 for issuance upon exercise of options that have been granted under our stock option plans (none of which were exercisable at such date). Of these shares, the 23,437,500 shares of common stock sold in this offering will be freely tradable without restriction or further registration under the Securities Act, except for any shares which may be acquired by an affiliate of ours as that term is defined in Rule 144 under the Securities Act, which will be subject to the resale limitations of Rule 144. The remaining 26,935,744 shares of common stock outstanding will be restricted securities, as that term is defined in Rule 144, and may in the future be sold without restriction under the Securities Act to the extent permitted by Rule 144 or any applicable exemption under the Securities Act. In general, under Rule 144 as currently in effect, a person (or persons whose shares are aggregated) who has beneficially owned its, his or her shares of common stock for at least one year from the date such securities were acquired from us or an affiliate of ours would be entitled to sell within any three-month period a number of shares that does not exceed the greater of one percent of the then-outstanding shares of common stock (approximately 503,733 shares immediately after this offering) and the average weekly trading volume of the common stock during the four calendar weeks preceding a sale by such person. Sales under Rule 144 are also subject to certain manner-of-sale provisions, notice requirements and the availability of current public information about us. Under Rule 144, however, a person who has held restricted securities for a minimum of two years from the later of the date of such securities were acquired from us or an affiliate of ours and who is not, and for the three months prior to the sale of such restricted securities has not been, an affiliate of ours, is free to sell such shares of common stock without regard to the volume, manner-of-sale and the other limitations contained in Rule 144. The foregoing summary of Rule 144 is not intended to be a complete discussion thereof. Commencing 180 days after the date of this prospectus, approximately 26,935,744 outstanding restricted securities will be eligible for sale under Rule 144 subject to applicable volume limitations, manner of sale and notice requirements. Following the completion of this offering, we intend to file a registration statement on Form S-8 with the SEC to register 4,143,042 shares of our common stock reserved for issuance or sale under our stock option plans and long term incentive plan. As of October 1, 2004, there were outstanding options to purchase a total of 3,418,162 shares of common stock, none of which were vested. Shares of common stock issuable upon the exercise of options granted or to be granted under our plans will be freely tradable without restriction under the Securities Act, unless such shares are held by an affiliate of ours. We have agreed that we will not offer, sell, contract to sell, pledge or otherwise dispose of, directly or indirectly, or file with the Securities and Exchange Commission a registration statement under the Securities Act relating to, any shares of our common stock or any securities convertible into or exchangeable or exercisable for any such shares, or publicly disclose the intention to make any offer, sale, pledge, disposition or filing, without the prior written consent of Goldman, Sachs & Co. for a period of 180 days after the date of this prospectus, subject to specified exceptions. Our officers, directors and all existing stockholders have agreed, subject to specified exceptions, that they will not offer, sell, contract to sell, pledge or otherwise dispose of, directly or indirectly, shares of our common stock or any securities convertible into or exchangeable or exercisable for any such securities, enter into a transaction that would have the same effect, or enter into any swap, hedge or other arrangement that transfers, Adjusted EBITDA $ 120,294 $ 128,607 $ 135,264 Table of Contents in whole or in part, any of the economic consequences of ownership of our common stock, whether any of these transactions are to be settled by delivery of our common stock or other securities, in cash or otherwise, or publicly disclose the intention to make any offer, sale, pledge or disposition, or to enter into any transaction, swap, hedge or other arrangement without, in each case, the prior written consent of Goldman, Sachs & Co. for a period of 180 days after the date of this prospectus. The 180-day restricted period described in the two preceding paragraphs will be automatically extended if: (1) during the last 17 days of the 180-day restricted period we issue an earnings release or announce material news or a material event; or (2) prior to the expiration of the 180-day restricted period, we announce that we will release earnings results during the 16-day period beginning on the last day of the 180-day period, in which case the restrictions described in the preceding paragraph will continue to apply until the expiration of the 18-day period beginning on the issuance of the earnings release of the announcement of the material news or material event. We have granted our equity sponsor demand and incidental registration rights with respect to the 25,052,345 shares of common stock owned by it after this offering (21,536,720 shares if the underwriters exercise the over-allotment option in full). See Certain Relationships and Related Transactions Ancillary Agreements Apollo Registration Rights Agreement beginning on page 82. Prior to this offering, there has been no established market for our common stock, and no predictions can be made about the effect, if any, that market sales of shares of common stock or the availability of such shares for sale will have on the market price prevailing from time to time. Nevertheless, the actual sale of, or the perceived potential for the sale of, common stock in the public market may have an adverse effect on the market price for the common stock. Table of Contents MATERIAL U.S. FEDERAL INCOME TAX CONSEQUENCES The following discussion describes the material U.S. federal income tax consequences associated with the purchase, ownership, and disposition of our common stock as of the date hereof by Non-U.S. Holders (as defined below). Except where noted, this discussion deals only with common stock held as capital assets and does not address special situations, such as those of: dealers in securities or currencies, financial institutions, regulated investment companies, real estate investment trusts, tax-exempt entities, insurance companies, persons holding common stock as a part of a hedging, integrated, conversion or constructive sale transaction or a straddle, traders in securities that elect to use a mark-to-market method of accounting for their securities holdings, persons liable for alternative minimum tax, investors in pass-through entities. Furthermore, the discussion below is based upon the provisions of the Internal Revenue Code of 1986, as amended (the Code ), the Treasury regulations promulgated thereunder and administrative and judicial interpretations thereof, all as of the date hereof, and such authorities may be repealed, revoked, modified or subject to differing interpretations, possibly on a retroactive basis, so as to result in U.S. federal income tax consequences different from those discussed below. A U.S. Holder of common stock means a holder that is for U.S. federal income tax purposes: an individual citizen or resident of the United States, a corporation (or other entity taxable as a corporation) created or organized in or under the laws of the United States or any state thereof or the District of Columbia, an estate the income of which is subject to U.S. federal income taxation regardless of its source, or a trust if it (1) is subject to the primary supervision of a court within the United States and one or more U.S. persons have the authority to control all substantial decisions of the trust or (2) has a valid election in effect under applicable Treasury regulations to be treated as a U.S. person. If a partnership or other entity or arrangement treated as a partnership for U.S. federal income tax purposes holds common stock, the tax treatment of a partner will generally depend upon the status of the partner and the activities of the partnership. If you are a partner of a partnership purchasing common stock, we urge you to consult your own tax advisor. Consequences to Non-U.S. Holders A Non-U.S. Holder is a holder, other than an entity or arrangement classified as a partnership for U.S. federal income tax purposes, that is not a U.S. Holder. Special rules may apply to certain Non-U.S. Holders, such as: U.S. expatriates, controlled foreign corporations, Table of Contents passive foreign investment companies, corporations that accumulate earnings to avoid U.S. federal income tax, and investors in pass-through entities that are subject to special treatment under the Code. Such Non-U.S. Holders are urged to consult their own tax advisors to determine the U.S. federal, state, local and other tax consequences that may be relevant to them. Dividends. Dividends paid to you generally will be subject to withholding of U.S. federal income tax at a 30% rate or such lower rate as may be specified by an applicable income tax treaty. However, dividends that are effectively connected with your conduct of a trade or business within the United States and, if certain tax treaties apply, are attributable to your U.S. permanent establishment, are not subject to the withholding tax, but instead are subject to U.S. federal income tax on a net income basis in the same manner as if you were a U.S. Holder. Special certification and disclosure requirements must be satisfied for effectively connected income to be exempt from withholding. If you are a foreign corporation, any such effectively connected dividends received by you may be subject to an additional branch profits tax at a 30% rate or such lower rate as may be specified by an applicable income tax treaty. If you wish to claim the benefit of an applicable treaty rate (and also avoid backup withholding as discussed below) for dividends, you will be required to: complete IRS Form W-8BEN (or other applicable form) and certify under penalties of perjury that you are not a U.S. person and that you are entitled to the benefits of the applicable treaty, or if the shares of our common stock are held through certain foreign intermediaries, satisfy the relevant certification requirements of applicable U.S. Treasury regulations. Special certification and other requirements apply to certain Non-U.S. Holders that are entities rather than individuals. If you are eligible for a reduced rate of U.S. withholding tax pursuant to an income tax treaty, you may obtain a refund of any excess amounts withheld by filing an appropriate claim for refund with the IRS. Sale or Exchange of Common Stock. You generally will not be subject to U.S. federal income tax with respect to gain recognized on a sale or other disposition of shares of our common stock unless: the gain is effectively connected with your conduct of a trade or business in the United States, and if certain tax treaties apply, is attributable to your U.S. permanent establishment, if you are an individual and hold shares of our common stock as a capital asset, you are present in the United States for 183 or more days in the taxable year of the sale or other disposition, and certain other conditions are met, or we are or have been a U.S. real property holding corporation for U.S. federal income tax purposes. If you are an individual and are described in the first bullet above, you will be subject to tax on the net gain derived from the sale under regular graduated U.S. federal income tax rates in the same manner as if you were a U.S. Holder. If you are an individual and are described in the second bullet above, you will be subject to a flat 30% tax on the gain derived from the sale, which may be offset by U.S. source capital losses (even though you are not considered a resident of the United States). If you are a foreign corporation and are described in the first bullet above, you will be subject to tax on your gain under regular graduated U.S. federal income tax rates in the same manner as if you were a U.S. Holder and, in addition, may be subject to the branch profits tax on your effectively connected earnings and profits at a rate of 30% or at such lower rate as may be specified by an applicable income tax treaty. Table of Contents We believe we are not and do not anticipate becoming a U.S. real property holding corporation for U.S. federal income tax purposes. Information Reporting and Backup Withholding. Under certain circumstances, Treasury regulations require information reporting and backup withholding on certain payments on common stock. Dividends on common stock paid to a Non-U.S. Holder will generally be exempt from backup withholding, provided the Non-U.S. Holder meets applicable certification requirements or otherwise establishes an exemption. We must report annually to the IRS and to each Non-U.S. Holder the amount of dividends paid to that holder and the U.S. federal withholding tax withheld with respect to those dividends. Under United States Treasury Regulations, payments on the sale or redemption of our common stock effected through a foreign office of a broker to its customer generally are not subject to information reporting or backup withholding. However, if the broker is a U.S. person, a controlled foreign corporation, a foreign person 50% or more of whose gross income is effectively connected with a United States trade or business for a specified three-year period, a foreign partnership with significant United States ownership, or a United States branch of a foreign bank or insurance company, then information reporting (but not backup withholding) will be required, unless the broker has in its records documentary evidence that the beneficial owner of the payment is not a U.S. person or is otherwise entitled to an exemption, and other applicable certification requirements are met. Information reporting and backup withholding generally will apply to sale or redemption payments effected at a United States office of any United States or foreign broker, unless the broker has in its records documentary evidence that the beneficial owner of the payment is not a U.S. person or is otherwise entitled to an exemption, and other applicable certification requirements are met. Backup withholding does not represent an additional income tax. Any amounts withheld from a payment to a holder under the backup withholding rules will be allowed as a credit against the holder s United States federal income tax liability and may entitle the holder to a refund, provided that the required information or returns are timely furnished by the holder to the IRS. Per Share $ $ Total $ $ Shares of our common stock sold by the underwriters to the public will initially be offered at the initial public offering price set forth on the cover of this prospectus. Any shares of our common stock sold by the underwriters to securities dealers may be sold at a discount of up to $ per share from the initial public offering price. Any such securities dealers may resell any shares of our common stock purchased from the underwriters to certain other brokers or dealers at a discount of up to $ per share from the initial public offering price. If all the shares of our common stock are not sold at the initial public offering price, the representatives may change the offering price and the other selling terms. We, our officers, our directors and all our existing stockholders have agreed with the underwriters not to dispose of or hedge any of their common stock or securities convertible into or exchangeable for shares of our common stock during the period from the date of this prospectus continuing through the date 180 days after the date of this prospectus, except with the prior written consent of Goldman, Sachs & Co. The 180-day restricted period described in the preceding paragraph will be automatically extended if: (1) during the last 17 days of the 180-day Table of Contents restricted period we issue an earnings release or announce material news or a material event; or (2) prior to the expiration of the 180-day restricted period, we announce that we will release earnings results during the 16-day period beginning on the last day of the 180-day period, in which case the restrictions described in the preceding paragraph will continue to apply until the expiration of the 18-day period beginning on the issuance of the earnings release of the announcement of the material news or material event. This agreement does not apply to any existing employee benefit plans. See Shares Eligible for Future Sale for a discussion of certain transfer restrictions. Prior to the offering, there has been no public market for shares of our common stock. The initial public offering price was negotiated among us, the selling stockholders and the representatives. Among the factors to be considered in determining the initial public offering price of the shares of our common stock, in addition to prevailing market conditions, were our historical performance, estimates of our business potential and earnings prospects, an assessment of our management and the consideration of the above factors in relation to market valuation of companies in related businesses. An application has been made to quote the common stock on the NASDAQ National Market under the symbol UAPH . In connection with the offering, the underwriters may purchase and sell shares of our common stock in the open market. These transactions may include short sales, stabilizing transactions and purchases to cover positions created by short sales. Short sales involve the sale by the underwriters of a greater number of shares than they are required to purchase in the offering. Covered short sales are sales made in an amount not greater than the underwriters option to purchase additional shares from the selling stockholders in the offering. The underwriters may close out any covered short position by either exercising their option to purchase additional shares or purchasing shares in the open market. In determining the source of shares to close out the covered short position, the underwriters will consider, among other things, the price of shares available for purchase in the open market as compared to the price at which they may purchase additional shares pursuant to the option granted to them. Naked short sales are any sales in excess of such option. The underwriters must close out any naked short position by purchasing shares in the open market. A naked short position is more likely to be created if the underwriters are concerned that there may be downward pressure on the price of the common stock in the open market after pricing that could adversely affect investors who purchase in the offering. Stabilizing transactions consist of various bids for or purchases of common stock made by the underwriters in the open market prior to the completion of the offering. The underwriters may also impose a penalty bid. This occurs when a particular underwriter repays to the underwriters a portion of the underwriting discount received by it because the representatives have repurchased shares of our common stock sold by or for the account of such underwriter in stabilizing or short covering transactions. Purchases to cover a short position and stabilizing transactions may have the effect of preventing or retarding a decline in the market price of our stock, and together with the imposition of the penalty bid, may stabilize, maintain or otherwise affect the market price of the common stock. As a result, the price of the common stock may be higher than the price that otherwise might exist in the open market. If these activities are commenced, they may be discontinued at any time. These transactions may be effected on the NASDAQ National Market, in the over-the-counter market or otherwise. Each underwriter has represented, warranted and agreed that: (i) it has not offered or sold and, prior to the expiry of a period of six months from the closing date, will not offer or sell any shares to persons in the United Kingdom except to persons whose ordinary activities involve them in acquiring, holding, managing or disposing of investments (as principal or agent) for the purposes of their businesses or otherwise in circumstances which have not resulted and will not result in an offer to the public in the United Kingdom within the meaning of the Public Offers of Securities Regulations 1995; (ii) it has only communicated or caused to be communicated and will only communicate or cause to be communicated any invitation or inducement to engage in investment Table of Contents activity (within the meaning of section 21 of the Financial Services and Markets Act 2000 ( FSMA )) received by it in connection with the issue or sale of any shares in circumstances in which section 21(1) of the FSMA does not apply to the Issuer; and (iii) it has complied and will comply with all applicable provisions of the FSMA with respect to anything done by it in relation to the shares in, from or otherwise involving the United Kingdom. The shares may not be offered or sold, transferred or delivered, as part of their initial distribution or at any time thereafter, directly or indirectly, to any individual or legal entity in the Netherlands other than to individuals or legal entities who or which trade or invest in securities in the conduct of their profession or trade, which includes banks, securities intermediaries, insurance companies, pension funds, other institutional investors and commercial enterprises which, as an ancillary activity, regularly trade or invest in securities. The shares may not be offered or sold by means of any document other than to persons whose ordinary business is to buy or sell shares or debentures, whether as principal or agent, or in circumstances which do not constitute an offer to the public within the meaning of the Companies Ordinance (Cap. 32) of Hong Kong, and no advertisement, invitation or document relating to the shares may be issued, whether in Hong Kong or elsewhere, which is directed at, or the contents of which are likely to be accessed or read by, the public in Hong Kong (except if permitted to do so under the securities laws of Hong Kong) other than with respect to shares which are or are intended to be disposed of only to persons outside Hong Kong or only to professional investors within the meaning of the Securities and Futures Ordinance (Cap. 571) of Hong Kong and any rules made thereunder. This prospectus has not been registered as a prospectus with the Monetary Authority of Singapore. Accordingly, this prospectus and any other document or material in connection with the offer or sale, or invitation or subscription or purchase, of the shares may not be circulated or distributed, nor may the shares be offered or sold, or be made the subject of an invitation for subscription or purchase, whether directly or indirectly, to persons in Singapore other than under circumstances in which such offer, sale or invitation does not constitute an offer or sale, or invitation for subscription or purchase, of the securities to the public in Singapore. The shares have not been and will not be registered under the Securities and Exchange Law of Japan (the Securities and Exchange Law) and each underwriter has agreed that it will not offer or sell any shares, directly or indirectly, in Japan or to, or for the benefit of, any resident of Japan (which term as used herein means any person resident in Japan, including any corporation or other entity organized under the laws of Japan), or to others for re-offering or resale, directly or indirectly, in Japan or to a resident of Japan, except pursuant to an exemption from the registration requirements of, and otherwise in compliance with, the Securities and Exchange Law and any other applicable laws, regulations and ministerial guidelines of Japan. At our request, the underwriters have reserved up to 1,171,875 shares of our common stock, or 5% of the shares offered to the public by this prospectus, for sale under a directed share program to our employees. Based on the anticipated offering price of $16.00, which is the mid-point of the range disclosed on the cover page of this prospectus, 5% of the shares will have an aggregate offering price of $18.75 million. We will identify a list of full-time employees, except for our officers and directors, who will be entitled to purchase shares in the directed share program and will provide that list to Credit Suisse First Boston LLC, which will administer the directed share program. At this time, no indications of interest will be taken. Once the preliminary prospectus has been printed, an invitation package (available online, via regular or overnight mail or facsimile) will be made available or sent to each person listed, attaching a preliminary prospectus and the other directed share program documentation. If a person is interested in participating, that person will be required to complete the required documentation (which will include an IPO Certification form pursuant to NASD Rule 2790) and will be required to return it to Credit Suisse First Boston LLC (via regular or overnight mail or facsimile) so that Credit Suisse First Boston LLC can open an account to receive the shares once allocated. There will be no pre-funding or account-funding requirement; Credit Suisse First Boston LLC will not accept funds from any directed share program participant until after the registration statement for this offering is declared effective, this offering is priced, and the participants are notified of their final allocation and given an opportunity to confirm that they wish to purchase the shares allocated to them. After the registration statement has been declared effective and Table of Contents this offering is priced, we and Credit Suisse First Boston LLC will prepare a final approved list of allocations. Credit Suisse First Boston LLC will notify each person verbally or by email who has been allocated shares of the number of shares that have been allocated and the total purchase price due upon confirmation of their indication of interest. Thereafter, participants will be required to wire transfer their funds or send checks to Credit Suisse First Boston LLC. Shares of common stock will be allocated following pricing and settle in the same manner as the shares sold to the general public. The number of shares available for sale to the general public will be reduced to the extent these persons purchase the reserved shares. Shares of common stock committed to be purchased by directed share participants which are not so purchased will be reallocated for sale to the general public in the offering. All sales of shares of common stock pursuant to the directed share program will be made at the initial public offering price set forth on the cover page of this prospectus. The underwriters do not expect sales to discretionary accounts to exceed five percent of the total number of shares offered. We and the selling stockholders estimate that our share of the total expenses of the offering, excluding underwriting discounts and commissions, will be approximately $ . We and the selling stockholders have agreed to indemnify the several underwriters against certain liabilities, including liabilities under the Securities Act of 1933. Certain of the underwriters and their respective affiliates have, from time to time, performed, and may in the future perform, various financial advisory and investment banking services for us, for which they received or will receive customary fees and expenses. Table of Contents NOTICE TO CANADIAN RESIDENTS Resale Restrictions The distribution of the shares of common stock in Canada is being made only on a private placement basis exempt from the requirement that we prepare and file a prospectus with the securities regulatory authorities in each province where trades of shares of common stock are made. Any resale of the shares of common stock in Canada must be made under applicable securities laws which will vary depending on the relevant jurisdiction, and which may require resales to be made under available statutory exemptions or under a discretionary exemption granted by the applicable Canadian securities regulatory authority. Purchasers are advised to seek legal advice prior to any resale of the shares of common stock. Representations of Purchasers By purchasing shares of common stock in Canada and accepting a purchase confirmation a purchaser is representing to us and the dealer from whom the purchase confirmation is received that: the purchaser is entitled under applicable provincial securities laws to purchase the shares without the benefit of a prospectus qualified under those securities laws, where required by law, that the purchaser is purchasing as principal and not as agent, and the purchaser has reviewed the text above under Resale Restrictions. Rights of Action Ontario Purchasers Only Under Ontario securities legislation, a purchaser who purchases shares of common stock offered by this prospectus during the period of distribution will have a statutory right of action for damages, or while still the owner of the shares, for rescission against us in the event that this circular contains a misrepresentation. A purchaser will be deemed to have relied on the misrepresentation. The right of action for damages is exercisable not later than the earlier of 180 days from the date the purchaser first had knowledge of the facts giving rise to the cause of action and three years from the date on which payment is made for the shares. The right of action for rescission is exercisable not later than 180 days from the date on which payment is made for the shares. If a purchaser elects to exercise the right of action for rescission, the purchaser will have no right of action for damages against us. In no case will the amount recoverable in any action exceed the price at which the shares of common stock were offered to the purchaser and if the purchaser is shown to have purchased the shares with knowledge of the misrepresentation, we will have no liability. In the case of an action for damages, we will not be liable for all or any portion of the damages that are proven to not represent the depreciation in value of the shares of common stock as a result of the misrepresentation relied upon. These rights are in addition to, and without derogation from, any other rights or remedies available at law to an Ontario purchaser. The foregoing is a summary of the rights available to an Ontario purchaser. Ontario purchasers should refer to the complete text of the relevant statutory provisions. Enforcement of Legal Rights All of our directors and officers as well as the experts named herein may be located outside of Canada and, as a result, it may not be possible for Canadian purchasers to effect service of process within Canada upon us or those persons. All or a substantial portion of our assets and the assets of those persons may be located outside of Canada and, as a result, it may not be possible to satisfy a judgment against us or those persons in Canada or to enforce a judgment obtained in Canadian courts against us or those persons outside of Canada. Taxation and Eligibility for Investment We recommend that Canadian purchasers of shares of our common stock consult their own legal and tax advisors with respect to the tax consequences of an investment in our common stock in their particular circumstances and about the eligibility of our common stock for investment by the purchaser under relevant Canadian legislation. Table of Contents LEGAL MATTERS The validity of the issuance of the shares of common stock offered hereby will be passed upon for us by O Melveny & Myers LLP, New York, New York. Certain legal matters relating to this offering will be passed upon for the underwriters by Skadden, Arps, Slate, Meagher & Flom LLP, New York, New York. EXPERTS The financial statements included in this prospectus and the related financial statement schedules included elsewhere in the registration statement of UAP Holding Corp. as of February 22, 2004 and for the thirteen weeks ended February 22, 2004 and of the ConAgra Agricultural Products Business as of February 23, 2003 and for the thirty-nine weeks ended November 23, 2003 and the fiscal years ended February 23, 2003 and February 24, 2002 have been audited by Deloitte & Touche LLP, an independent registered public accounting firm, as stated in their report (which report expresses an unqualified opinion and includes an explanatory paragraph relating to a change in method of accounting for goodwill and other intangible assets in 2003) appearing herein and have been so included in reliance upon the report of such firm given upon their authority as experts in accounting and auditing. WHERE YOU CAN FIND MORE INFORMATION We have filed a Registration Statement on Form S-1 with the SEC regarding this offering. This prospectus, which is part of the registration statement, does not contain all of the information included in the registration statement, and you should refer to the registration statement and its exhibits to read that information. As a result of the effectiveness of the registration statement, we will be subject to the informational reporting requirements of the Exchange Act of 1934 and, under that Act, we will file reports, proxy statements and other information with the SEC. You may read and copy the registration statement, the related exhibits and the reports, proxy statements and other information we file with the SEC at the SEC s public reference facilities maintained by the SEC at Judiciary Plaza, 450 Fifth Street, N.W., Washington, D.C. 20549. You can also request copies of those documents, upon payment of a duplicating fee, by writing to the SEC. Please call the SEC at 1-800-SEC-0330 for further information on the operation of the public reference rooms. The SEC also maintains an Internet site that contains reports, proxy and information statements and other information regarding issuers that file with the SEC. The site s Internet address is www.sec.gov. Certain information about our company may also be obtained from our website at www.uap.com. You may also request a copy of these filings, at no cost, by writing or telephoning us at: UAP Holding Corp. 7251 W. 4th St. Greeley, CO 80634 (970) 356-4400 We intend to furnish holders of the shares of common stock offered in this offering with annual reports containing audited consolidated financial statements together with a report by our independent registered public accounting firm. Table of Contents Combined Predecessor Entity ConAgra Agricultural Products Business Consolidated UAP Holding Corp. Fiscal Year Ended 2,818,828 2,478,518 1,757,099 2,158,054 212,336 1,884,900 Income (loss) from continuing operations before income taxes (48,636 ) 48,247 93,123 66,053 15,442 77,570 Income tax expense (benefit) (17,519 ) 18,787 35,341 25,068 5,789 30,252 Cash flows from investing activities: Post-closing settlement to ConAgra Foods, Inc. (58,236 ) Additions to property, plant and equipment (4,870 ) (4,817 ) Proceeds from sales of assets 152 Investment in affiliates Income (loss) from continuing operations (31,117 ) 29,460 57,782 40,985 9,653 47,318 Loss from discontinued operations, net of tax (5,919 ) (4,221 ) (3,027 ) (4,708 ) Change in Projected Benefit Obligation Projected benefit obligation at beginning of year $ 1,809 $ 2,419 Exchange rate adjustment 143 288 Service cost 217 220 Interest cost 140 168 Actuarial (gain) loss Net income (loss) $ (37,036 ) $ 25,239 $ 54,755 $ 36,277 $ 9,653 $ 47,318 Balance Sheet Data: Cash and cash equivalents $ 72,692 $ 28,559 $ 172,647 $ 14,615 Working capital 103,784 455,154 223,953 297,636 Total assets 1,345,680 1,352,025 1,263,963 1,389,169 Total debt 4,464 308,570 493,058 Stockholder s net investment and advances 313,929 587,898 Stockholder s equity 76,788 125,672 Allowances $ 11,888 $ $ $ 7,092 Inventory 4,688 2,010 Depreciation and amortization 4,233 83 Accrued expenses 4,116 2,025 Other noncurrent liabilities 6,556 Pension and other post-retirement benefits 854 470 Net operating loss 18,293 Other 366 Table of Contents for a discussion of the application of Adjusted EBITDA as a measure of our ability to incur indebtedness under the indentures. For example, although we consider EBITDA a liquidity measure, it does not take into account all cash expenditures which may be necessary to grow our business, such as cash expenditures for capital expenditures and acquisitions. Because of covenants in the revolving credit facility and our indentures that are based on Adjusted EBITDA, including our fixed charge coverage ratio covenants, we will have to maintain our Adjusted EBITDA at certain levels to, among other things, pay dividends on our capital stock, incur additional indebtedness and avoid defaults under our revolving credit facility. The following table sets forth a reconciliation from historical cash flows used in or provided by operating activities to historical EBITDA and Adjusted EBITDA: Combined Predecessor Entity Consolidated UAP Holding Corp. ConAgra Agricultural Products Business Fiscal Year Ended Twenty Six Weeks Ended Thirty-Nine Weeks Ended Thirteen Weeks Ended Twenty-Seven Weeks Ended (dollars in thousands) Cash flows used in (provided by) operating activities $ 120,662 $ (266,751 ) $ (129,480 ) $ (104,574 ) $ 446,373 $ (313,279 ) Interest expense 58,370 37,820 12,699 20,254 8,425 22,082 Net change in operating assets and liabilities (140,743 ) 315,492 191,955 155,067 (406,833 ) 399,092 Income tax provision (benefit) (17,519 ) 18,787 35,341 25,068 5,789 30,252 Deferred income tax benefit (provision) 4,517 (3,821 ) (23,858 ) (23,658 ) Loss from discontinued operations, net (5,919 ) (4,221 ) (3,027 ) (4,708 ) Other 1,595 1,246 3,122 1,877 (2,549 ) (7,486 ) Computed U.S. federal income taxes $ (17,023 ) $ 16,885 $ 23,119 $ 5,405 State income taxes, net of U.S. federal tax benefit (1,264 ) 1,255 1,717 618 Other 768 647 EBITDA 20,963 98,552 110,610 92,984 27,347 107,003 Loss from discontinued operations, net 5,919 4,221 3,027 4,708 Inventory fair market value adjustment(1) 3,673 17,354 ConAgra transition services agreement expense(2) 1,875 3,750 Gain on sale of businesses(3) (10,543 ) Adjusted EBITDA $ 26,882 $ 102,773 $ 113,637 $ 87,149 $ 32,895 $ 128,107 Actual Pro Forma (in millions) Cash and cash equivalents $ 14.6 $ 14.6 Net income, as reported $ 54,755 Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects Debt: Revolving credit facility (1)(2) $ 180.3 $ 240.3 8 1/4% senior notes 225.0 203.5 10 3/4% senior discount notes 87.8 87.8 Total debt 493.1 531.6 Series A redeemable preferred stock (3) 36.1 Stockholders equity (deficit): Common stock Management stock-rabbi trust 6.4 6.4 Additional paid-in capital 61.6 107.7 Retained earnings (3) 57.0 11.6 Accumulated other comprehensive loss 0.7 0.7 Total stockholders equity (deficit) 125.7 126.4 Balance at February 23, 2003 588,147 (249 ) 587,898 Comprehensive income: Net income 36,277 36,277 Foreign currency translation adjustment 302 (13,002 ) 14,966 25,068 (18,069 ) Deferred: Federal (4,160 ) 3,519 21,974 State (357 ) Total capitalization $ 654.9 $ 658.0 Table of Contents DILUTION Our net tangible book value as of August 29, 2004, after giving effect to the stock split and the Special Dividends, was $56.3 million, or $1.19 per share of common stock. We have calculated this amount by: subtracting our total liabilities from our total tangible assets; and then dividing the difference by the number of shares of common stock outstanding. If we give effect to our sale of 3,125,000 shares of common stock in this offering at the initial public offering price of $16.00 per share, after deducting the underwriting discounts and commissions and the estimated offering expenses payable by us and the Special Dividends, our adjusted net tangible book value as of August 29, 2004 would have been $57.6 million, or $1.14 per share. This amount represents an immediate dilution of $14.86 per share to new investors. The following table illustrates this per share dilution: Initial public offering price per share $ 16.00 Net tangible book value per share as of August 29, 2004 1.19 Decrease in net tangible book value per share attributable to new investors (.05 ) Pro forma net tangible book value per share after this offering 1.14 Dilution per share to new investors $ 14.86 The following table summarizes on the basis described above, as of August 29, 2004, the difference between the number of shares of common stock purchased from us, the total consideration paid to us, and the average price per share paid by existing stockholders and by new investors, at the initial public offering price of $16.00 per share, before deducting underwriting discounts and commissions and estimated offering expenses payable by us: Shares Purchased Total Consideration Average Price Per Share Change in Plan Assets Fair value of plan assets at beginning of year $ 1,784 $ 1,858 Exchange rate adjustment 141 288 Actual return on plan assets (310 ) (339 ) Employer contributions 296 Number Percent Amount Percent Total 50,373,244 100.0 % 170,885,000 100.0 % $ 3.39 Table of Contents UNAUDITED PRO FORMA CONDENSED CONSOLIDATED BALANCE SHEET As of August 29, 2004 UAP Holding Corp. Adjustment for Special Dividend (a) Pro Forma for the Special Dividend Adjustment for the Offering Pro Forma for the Transactions Non-amortizing intangible assets 447 $ $ 4,845 $ $ 4,335 $ Amortizing intangible assets 11,647 6,380 2,350 118 2,350 Total $ 12,094 $ 6,380 $ 7,195 $ 118 $ 6,685 $ Total current assets 1,212,009 1,212,009 3,270 1,215,279 Property, plant and equipment, net 96,338 96,338 96,338 Goodwill 41,407 41,407 41,407 Intangible assets, net 6,332 6,332 6,332 Deferred income taxes 3,256 3,256 3,256 Debt issue costs 21,635 21,635 (459 )(c) 21,176 Other assets 8,192 8,192 8,192 $ 1,389,169 $ $ 1,389,169 $ 2,811 $ 1,391,980 Total 120 252 Non-amortizing intangible assets $ 27 $ $ $ Amortizing intangible assets 11,547 5,549 7,450 Total $ 11,574 $ 5,549 $ 7,450 $ LIABILITIES AND STOCKHOLDERS EQUITY Current liabilities: Checks not yet presented $ 36,561 $ $ 36,561 $ $ 36,561 Short-term debt 180,299 60,000 240,299 240,299 Accounts payable 556,575 556,575 556,575 Other accrued liabilities 126,063 126,063 (416 )(b) 125,647 Deferred income taxes 14,875 14,875 14,875 Income from operations 78,966 (101,685 ) (22,719 ) Corporate allocations: Finance charges 19,550 (12,398 ) 7,152 Finance fee income (7,341 ) 4,137 (3,204 ) Interest expense 704 (301 ) Total stockholder s equity 125,672 (40,000 ) 85,672 40,797 126,469 $ 1,389,169 $ $ 1,389,169 $ 2,811 $ 1,391,980 Adjustments for the Acquisition Pro Forma for the Acquisition Adjustments for Special Dividend(a) Pro Forma for Special Dividend Adjustments for the Offering Pro Forma for the Transactions Product inventories: Raw materials and work in process $ 8,981 $ 14,922 $ 10,504 Finished goods 441,765 625,513 438,658 Supplies 952 574 (in thousands, except per share amounts) Net sales $ 227,778 $ 2,224,107 $ $ 2,451,885 $ $ 2,451,885 $ $ 2,451,885 Costs and expenses: Cost of goods sold 170,730 1,938,010 2,108,740 2,108,740 2,108,740 Selling, general and administrative expenses 36,613 198,148 1,117 (e) 235,878 235,878 (250 )(n) 235,628 Corporate allocations Selling, general and administrative expenses 8,983 8,983 8,983 8,983 (c) Represents the write-off of deferred financing costs associated with the repayment of a portion of our 8 % Senior Notes. (d) Represents adjustments to retained earnings and income taxes as follows: Fees and expenses associated with the sale of common stock by our selling shareholders $ 5,633 Prepayment penalties associated with the repayment of a portion of our 8 % Senior Notes 1,771 Interest expense on our 8 % Senior Notes and accrued dividends on our Series A redeemable preferred stock between August 29, 2004 and the closing of this offering 743 Write-off of deferred financing fees associated with the repayment of a portion of our 8 % Senior Notes Cash flows from investing activities: Additions to property, plant and equipment (13,654 ) (6,417 ) (8,350 ) (6,970 ) Proceeds from sale of assets 15,057 3,517 Investment in affiliates 372 882 (154 ) Acquisition of ConAgra Agricultural Products Business (656,197 ) Other investing activity Income from operations 20,435 78,966 (1,117 ) 98,284 98,284 250 98,534 Corporate allocations Finance charges 19,550 (19,550 )(f) Finance fee income (3,432 ) (7,341 ) (10,773 ) (10,773 ) (10,773 ) Interest expense 7,376 704 29,763 (f) 37,843 2,376 (o) 40,219 (1,771 )(m) 38,448 Dividends on Series A redeemable preferred stock 1,049 1,690 (g) 2,739 (1,495 )(o) 1,244 (1,244 )(i) (in thousands) ASSETS Current assets: Cash and cash equivalents $ 14,615 $ $ 14,615 $ $ 14,615 Receivables, net 706,795 706,795 706,795 Inventories 449,602 449,602 449,602 Other current assets 40,997 40,997 3,270 Income from continuing operations before income taxes 77,570 (487 ) 77,083 2,119 79,202 Income tax expense 30,252 (469 )(h) 29,783 Income per share Common stock: Basic $ 0.85 Diluted $ 0.80 Weighted average shares outstanding(j) Common stock: Basic 50,373,244 Diluted 53,244,819 Table of Contents UNAUDITED PRO FORMA CONDENSED CONSOLIDATED STATEMENT OF INCOME Twenty-Seven Weeks Ended August 29, 2004 UAP Holding Corp. Twenty-Seven Weeks Ended August 29, 2004 Adjustments for Special Dividend(a) Pro Forma for Special Dividend Adjustments for the Offering Pro Forma for the Transactions (in thousands, except per share amounts) Net sales $ 1,962,470 $ $ 1,962,470 $ $ 1,962,470 Costs and expenses: Cost of goods sold 1,719,714 1,719,714 1,719,714 Selling, general and administrative expenses 147,003 147,003 (500 )(n) 146,503 Product inventories: Raw materials and work in process $ 16,299 $ 14,922 Finished goods 695,939 625,513 Supplies 962 Income (loss) from continuing operations before income taxes 15,442 66,053 (13,020 ) 68,475 (881 ) 67,594 3,265 70,859 Income tax expense (benefit) 5,789 25,068 (2,375 )(h) 28,482 (903 )(h) 27,579 Income from continuing operations $ 47,318 $ (18 ) $ 47,300 $ 1,592 $ 48,892 Income per share Common stock: Basic $ 0.97 Diluted $ 0.92 Weighted average shares outstanding(j) Common stock: Basic 50,373,244 Diluted 53,244,819 Table of Contents UNAUDITED PRO FORMA CONDENSED CONSOLIDATED STATEMENT OF INCOME Twelve Months Ended August 29, 2004 UAP Holding Corp. Forty Weeks Ended August 29, 2004 (k) Adjustments for the Acquisition Pro Forma for the Acquisition Adjustments for Special Dividend(a) Pro Forma for Special Dividend Adjustment for the Offering Pro Forma for the Transactions (in thousands, except per share amounts) Net sales $ 2,190,248 $ 373,885 $ $ 2,564,133 $ $ 2,564,133 $ $ 2,564,133 Costs and expenses: Cost of goods sold 1,890,444 349,675 2,240,119 2,240,119 2,240,119 Selling, general and administrative expenses 183,616 44,065 373 (e) 228,054 228,054 (750 )(n) 227,304 Corporate allocations Selling, general and administrative expenses 2,864 2,864 2,864 2,864 Prepaid pension cost $ 587 $ Total current assets Net cash flows from operating activities Net change in cash and cash equivalents Cash and cash equivalents at end of period $ Income from operations 116,188 (22,719 ) (373 ) 93,096 93,096 750 93,846 Corporate allocations Finance charges 7,152 (7,152 )(f) Finance fee income (7,331 ) (3,204 ) (10,535 ) (10,535 ) (10,535 ) Interest expense 27,978 403 9,881 (f) 38,262 2,422 (o) 40,684 (1,771 )(m) 38,913 Dividends on Series A redeemable preferred stock 2,529 Total current liabilities 914,373 60,000 974,373 (416 ) 973,957 Long-term debt: 8 % Senior Notes due 2011 225,000 225,000 (21,470 )(b) 203,530 10 % Senior Discount Notes due 2012 87,759 87,759 87,759 Deferred income taxes 265 265 265 Series A redeemable preferred stock 36,100 (20,000 ) 16,100 (16,100 )(b) Stockholders equity: Common stock 47 47 3 (b) 50 Management stock-rabbi trust 6,435 6,435 6,435 Additional paid-in capital 61,543 61,543 46,130 (b) 107,673 Retained earnings 56,971 (40,000 ) 16,971 (5,336 )(d) 11,635 Accumulated other comprehensive loss 676 676 Total current liabilities 569,780 843,806 914,373 Long-term debt 308,570 312,759 Series A redeemable preferred stock 34,620 36,100 Non-current liabilities 115 96 Other non-current liabilities and advances from discontinued operations 5,077 Deferred income tax 83 265 Commitments and contingencies (note 9) Stockholders net investments and advances/stockholders equity: Common stock, $.001 par value, 90,000,000 shares authorized, 47,248,244 shares issued and outstanding 47 47 Management stock rabbi trust 5,550 6,435 Additional paid-in capital 61,543 61,543 Retained earnings 9,653 56,971 Accumulated other comprehensive loss (5 ) Net Income $ 54,755 $ 47,318 Currency translation adjustment (dollars in thousands) Statement of Operations Data: Net sales $ 2,770,192 $ 2,526,765 $ 1,850,222 $ 2,224,107 $ 227,778 $ 1,962,470 Costs and expenses: Cost of goods sold 2,428,203 2,166,594 1,588,335 1,938,010 170,730 1,719,714 Selling, general and administrative expenses 334,626 275,244 154,083 208,670 37,017 153,392 (Gain) loss on sale of assets 606 1,493 (10,522 ) (404 ) (1,265 ) Other income, net (5,124 ) Corporate allocations: Selling, general and administrative expenses (a) 10,495 10,766 6,119 8,983 Finance charges (b) 39,526 22,494 8,261 12,209 Interest expense, net 5,372 1,927 301 (dollars in thousands) Statement of Operations Data: Net sales $ 2,247,305 $ 2,771,625 $ 2,770,192 $ 2,526,765 $ 1,850,222 $ 2,224,107 $ 227,778 $ 1,962,470 Costs and expenses: Cost of goods sold 1,841,622 2,401,078 2,428,203 2,166,594 1,588,335 1,938,010 170,730 1,719,714 Selling, general and administrative expenses 274,117 294,699 334,626 275,244 154,083 208,670 37,017 153,392 Restructuring charge 5,051 (Gain) loss on sale of assets (305 ) (323 ) 606 1,493 (10,522 ) (404 ) (1,265 ) Other income, net (5,124 ) Corporate allocations: Selling, general and administrative expenses (a) 9,811 10,947 10,495 10,766 6,119 8,983 Finance charges (b) 40,929 57,475 39,526 22,494 8,261 12,209 Interest expense, net 4,207 4,875 5,372 1,927 301 Income (loss) from continuing operations $ 56,971 $ (16,797 ) $ (3,182 ) $ 36,992 $ (7 ) $ 36,985 $ 3,268 $ 40,253 LIABILITIES AND STOCKHOLDERS EQUITY Current liabilities: Accounts payable $ Other accrued liabilities Net Sales $ Costs and expenses: Cost of goods sold Selling, general and administrative expenses Cash flows from operating activities: Net income (loss) $ 9,653 Adjustments to reconcile net income (loss) to net cash provided by operating activities: Depreciation Amortization Equity in earnings of subsidiaries (10,791 ) Deferred income taxes (Gain) loss on sale of assets Other noncash items 1,075 Change in operating assets and liabilities Income Per Share Common stock: Basic $ 0.80 Income from operations 95,753 95,753 500 96,253 Finance fee income (3,899 ) (3,899 ) (3,899 ) Interest expense 20,602 1,234 (o) 21,836 (886 )(m) 20,950 Dividends on Series A redeemable preferred stock 1,480 (747 )(o) Diluted $ 0.76 Weighted average shares outstanding (j) Common stock: Basic 50,373,244 Diluted 53,244,819 Table of Contents NOTES TO UNAUDITED PRO FORMA CONDENSED CONSOLIDATED FINANCIAL DATA (dollars in columns in thousands) (a) Represents the redemption of 18,683 shares of Series A redeemable preferred stock for approximately $20.0 million and the payment of a $40.0 million special dividend to holders of our common stock on October 4, 2004. We used $60.0 million in borrowings under the revolving credit facility to finance the redemption of Series A preferred stock and the special dividend. (b) Represents the net proceeds received by us from this offering and the application of the net proceeds as follows: Proceeds received by us $ 50,000 Less: Underwriting fees and expenses (3,000 ) Other Offering fees and expense (867 ) EBITDA 120,331 107,003 116,724 Loss from discontinued operations 4,708 1,681 Apollo management fee (1) 250 500 Additional paid in capital $ 46,130 Use of Proceeds: Payment of fees and expenses associated with the sale of common stock by our selling stockholders $ 5,633 Repayment of a portion of our 8 % Senior Notes 21,470 Prepayment penalties associated with the repayment of a portion of our 8 % Senior Notes 1,771 Repayment of accrued interest associated with the repayment of a portion of our 8 % Senior Notes, including accrued interest of approximately $0.4 million between August 29, 2004 and the closing of this offering 859 Repayment of our Series A redeemable preferred stock, including dividends of approximately $0.3 million between August 29, 2004 and the closing of this offering 16,400 $ 46,133 8,606 Tax benefit at an estimated 38% effective tax rate 3,270 Net adjustment to retained earning $ 5,336 Table of Contents (f) Represents elimination of the corporate allocation finance charge previously allocated by ConAgra Foods and adjustments to interest expense as follows: Fiscal Year Ended February 22, 2004 Twelve Months Ended August 29, 2004 $ 29,763 $ 9,881 The historical allocated finance charges have been eliminated due to the recapitalization of the Company in connection with the Acquisition. (1) Represents the interest on the average outstanding balance of the amount drawn on the credit facility at LIBOR plus 200 basis points plus the 0.25% commitment fee on the unused portion of the amended and restated credit facility. (g) Represents adjustments to reflect the 8% dividend on the outstanding portion of the Series A redeemable preferred stock. (h) Represents the tax effect of the pro forma adjustments at an estimated 38% effective tax rate. The dividends on the Series A redeemable preferred stock have not been tax effected as they are not tax deductible. (i) Represents the elimination of dividends on Series A redeemable preferred stock. (j) Outstanding shares have been affected by the approximately 39.085-for-1 stock split which occurred on November 17, 2004. (k) The following table sets forth the results of UAP Holding Corp. that comprise the forty weeks ended August 29, 2004: UAP Holding Corp. Thirteen Weeks Ended February 22, 2004 UAP Holding Corp. Forty Weeks Ended August 29, 2004 Net sales $ 227,778 $ 1,962,470 $ 2,190,248 Costs and expenses: Costs and goods sold 170,730 1,719,714 1,890,444 Selling, general and administrative expenses 36,613 147,003 183,616 Income from operations 20,435 95,753 116,188 Finance fee income (3,432 ) (3,899 ) (7,331 ) Interest expense 7,376 20,602 27,978 Dividends on Series A redeemable preferred stock 1,049 1,480 2,529 Income (loss) from continuing operations before income taxes 15,442 77,570 93,012 Income tax expense (benefit) 5,789 30,252 36,041 Table of Contents UAP HOLDING CORP. NOTES TO FINANCIAL STATEMENTS (Continued) Fiscal Years Ended February 22, 2004, February 23, 2003 and February 24, 2002 columnar dollar amounts in thousands 10. Commitments and Contingencies The company leases certain facilities and transportation equipment under agreements that expire at various dates. Management expects that in the normal course of business, leases that expire will be renewed or replaced by other leases. Substantially all leases require payment of property taxes, insurance and maintenance costs in addition to rental payments. Rent expense under all operating leases was $53.3 million and $46.1 million in fiscal 2002 and 2003, respectively, and $30.7 million and $9.5 million in the thirty-nine weeks ended November 23, 2003 and thirteen weeks ended February 22, 2004, respectively. A summary of noncancelable operating lease commitments for fiscal years following February 22, 2004 is as follows: 2005 $ 8,278 2006 4,855 2007 2,076 2008 1,024 2009 Income (loss) from continuing operations $ 9,653 $ 47,318 $ 56,971 Table of Contents (l) The following table sets forth the results of the ConAgra Agricultural Products Business that comprise the thirteen weeks ended November 23, 2003: ConAgra Agricultural Products Business Thirty-Nine Weeks Ended November 23, 2003 ConAgra Agricultural Products Business Less: Twenty-Six Weeks Ended August 24, 2003 ConAgra Agricultural Products Business Thirteen Weeks Ended November 23, 2003 Net sales $ 2,224,107 $ (1,850,222 ) $ 373,885 Costs and expenses Cost of goods sold 1,938,010 (1,588,335 ) 349,675 Selling, general and administrative expenses 198,148 (154,083 ) 44,065 Corporate allocations: Selling, general and administrative expenses 8,983 (6,119 ) 2,864 Income (loss) from continuing operations before income taxes 66,053 (93,123 ) (27,070 ) Income tax expense (benefit) 25,068 (35,341 ) (10,273 ) Interest on new borrowings: Revolving credit facility (4.21% adjustable rate) (1) $ 6,541 $ 2,180 8 % Senior Notes 13,922 4,641 10 % Senior Discount Notes 6,770 2,217 Amortization of deferred financing costs 2,530 Income (loss) from continuing operations $ 40,985 $ (57,782 ) $ (16,797 ) Table of Contents Combined Predecessor Entity ConAgra Agricultural Products Business Consolidated UAP Holding Corp. Fiscal Year Ended Twenty-Six Weeks Ended Thirty-Nine Weeks Ended Current: Federal $ (11,975 ) $ 12,574 $ 23,119 $ (15,784 ) State (369 ) 1,515 1,949 (1,803 ) Foreign (658 ) 2,175,432 2,768,751 2,818,828 2,478,518 1,757,099 2,158,054 212,336 1,884,900 Income (loss) from continuing operations before income taxes 71,873 2,874 (48,636 ) 48,247 93,123 66,053 15,442 77,570 Income tax expense (benefit) 27,166 962 (17,519 ) 18,787 35,341 25,068 5,789 30,252 Income (loss) from continuing operations 44,707 1,912 (31,117 ) 29,460 57,782 40,985 9,653 47,318 Loss from discontinued operations, net of tax (10,170 ) (14,443 ) (5,919 ) (4,221 ) (3,027 ) (4,708 ) Net income (loss) $ 34,537 $ (12,531 ) $ (37,036 ) $ 25,239 $ 54,755 $ 36,277 $ 9,653 $ 47,318 Income (loss) from continuing operations before income taxes 93,012 (27,070 ) (3,773 ) 62,169 (927 ) 61,242 4,226 65,468 Income tax expense (benefit) 36,041 (10,273 ) (591 )(h) 25,177 (920 )(h) 24,257 Balance Sheet Data: Cash and cash equivalents $ 113,880 $ 146,335 $ 72,692 $ 28,559 $ 172,647 $ 14,615 Working capital 275,015 318,584 103,784 455,154 223,953 297,636 Total assets 1,356,323 1,707,496 1,345,680 1,352,025 1,263,963 1,389,169 Total debt 3,355 3,861 4,464 308,570 529,158 Stockholder s net investment and advances 392,487 507,196 313,929 587,898 Stockholder s equity 71,238 125,672 Other Operating Data: EBITDA (c) $ 142,792 $ 86,658 $ 20,963 $ 98,552 $ 110,610 $ 92,984 $ 27,347 $ 107,003 Depreciation and amortization 13,220 14,951 17,148 16,706 7,815 11,385 3,480 7,351 Cash flows (used in) provided by operating activities 36,797 (3,059 ) 120,662 (266,751 ) (129,480 ) (104,574 ) 446,373 (313,279 ) Cash flows (used in) provided by financing activities 29,138 48,970 (181,482 ) 226,652 106,623 69,503 385,924 216,860 Cash flows (used in) provided by investing activities (21,422 ) (13,456 ) (12,823 ) (4,034 ) (5,702 ) 6,512 (659,650 ) (62,901 ) Table of Contents all cash expenditures which may be necessary to grow our business, such as cash expenditures for capital expenditures and acquisitions. Because of covenants in the revolving credit facility and our indentures that are based on Adjusted EBITDA, including our fixed charge coverage ratio covenants, we will have to maintain our Adjusted EBITDA at certain levels to, among other things, pay dividends on our capital stock, incur additional indebtedness and avoid defaults under our revolving credit facility. The following table sets forth a reconciliation from historical cash flows used in or provided by operating activities to historical EBITDA and Adjusted EBITDA: Combined Predecessor Entity Consolidated UAP Holding Corp. ConAgra Agricultural Products Business Fiscal Year Ended (in thousands) Cash flows used in (provided by) operating activities $ 36,797 $ (3,059 ) $ 120,662 $ (266,751 ) $ (129,480 ) $ (104,574 ) $ 446,373 $ (313,279 ) Interest expense 67,869 83,276 58,370 37,820 12,699 20,254 8,425 22,082 Net change in operating assets and liabilities 18,370 27,702 (140,743 ) 315,492 191,955 155,067 (406,833 ) 399,092 Income tax provision (benefit) 27,166 962 (17,519 ) 18,787 35,341 25,068 5,789 30,252 Deferred income tax benefit (provision) 2,565 (8,169 ) 4,517 (3,821 ) (23,858 ) (23,658) Loss from discontinued operations, net (10,170 ) (14,443 ) (5,919 ) (4,221 ) (3,027 ) (4,708 ) Other 195 389 1,595 1,246 3,122 1,877 (2,549 ) (7,486) EBITDA 142,792 86,658 20,963 98,552 110,610 92,984 27,347 107,003 Loss from discontinued operations, net 10,170 14,443 5,919 4,221 3,027 4,708 Inventory fair market value adjustment(1) 3,673 17,354 ConAgra transition services agreement expense(2) 1,875 3,750 Gain on sale of businesses(3) (10,543 ) EBITDA as defined $ 152,962 $ 101,101 $ 26,882 $ 102,773 $ 113,637 $ 87,149 $ 32,895 $ 128,107 Table of Contents OBLIGATIONS AND COMMITMENTS As part of our ongoing operations, we enter into arrangements that obligate us to make future payments under contracts such as lease agreements, debt agreements and unconditional purchase obligations (i.e., obligations to transfer funds in the future for fixed or minimum quantities of goods or services at fixed or minimum prices, such as take-or-pay contracts). We enter into unconditional purchase obligation arrangements in the normal course of business to ensure that adequate levels of sourced product are available to us. The following is a summary of our contractual obligations as of August 29, 2004: Payments Due by Period Contractual Obligations Total Less than 1 Year 2-3 Years 4-5 Years After 5 Years (in millions) Long-Term Debt $ 350.0 $ $ $ $ 350.0 Lease Obligations 21.9 7.8 9.3 2.3 2.5 Unconditional Purchase Obligations 0.3 0.3 Borrowings Under Revolving Credit Facility 180.3 180.3 Total $ 552.5 $ 188.4 $ 9.3 $ 2.3 $ 352.5 Table of Contents Grower-owned co-operatives constitute a significant portion of the agricultural inputs distribution industry, including two of the six largest retailers. The market has consolidated significantly over the last ten years. We believe, based on independent consulting work which we sponsored, that in 2003 the largest six retailers accounted for over 50% of sales by the largest 100 retailers in our industry measured by sales. Consolidation in our industry has been driven by a number of factors, including: increased average farm size; consolidation of suppliers; increasing demand for salespeople with high levels of technical expertise; poor performance of co-operatives; overcapacity in the industry; and the need for sufficient scale to realize strong relationships with suppliers. We believe that these trends will continue and will result in greater demands being placed on agricultural input distribution companies. Based on independent consulting work which we sponsored, we believe that independent national distributors (i.e., non-grower owned cooperatives) increased their retail market share amongst the largest 100 retailers measured by sales from 37% in 1998 to 41% in 2003, and that larger companies, such as UAP, will continue to increase their competitive advantage over businesses with fewer resources. OUR COMPETITIVE STRENGTHS We believe our leading market positions, operating model focused on free cash flow, extensive distribution network, strong supplier relationships, diversified product offering and proven and incentivized management team will allow us to increase our market share, net sales and profitability. Leading Market Positions We are the largest private distributor of agricultural input products in major crop-producing regions throughout the United States and Canada. We believe that our emphasis on selling a full range of quality products and consistently providing high quality service has enabled us to achieve our leading market shares. We believe, based on independent consulting work which we sponsored, that we hold the number one market position, based on net retail sales of the largest 100 retailers measured by sales, in each of the core product categories in which we compete: Category Key Products Market Position 2003 Retail Market Share Table of Contents We have instituted central management controls and utilize our logistical expertise and sophisticated information technology systems to manage our extensive businesses and facilities network. We understand the importance of flexibility at the local level to adapt to local conditions. We aim to achieve the proper balance of central control and direction with local flexibility by utilizing team management and appropriate incentive programs. We operate distribution centers serving both wholesalers and individual growers, and are one of the largest retailers of crop production inputs to growers in North America. Retail centers typically service growers within a 10 to 50 mile radius of their locations. We operate retail centers in each major crop producing region of the United States and Canada. Our distribution network, though centrally organized, is internally divided by region. The following table identifies these various regions, the states served (subject to occasional overlap), the major crops serviced, the approximate number of employees (including hourly and temporary employees) and the total sales for each such region for fiscal 2004: Region States/Provinces Served Major Crops Serviced Employees Fiscal 2004 Pro Forma Net Sales (dollars in millions) Table of Contents Services. In addition to selling traditional crop production inputs, our distribution centers provide agronomic services to growers. These services range from the traditional custom blending and application of crop nutrients to meet the needs of individual growers, to more sophisticated and technologically advanced services on a fee basis such as soil sampling, pest level monitoring and yield monitoring using global position systems satellite grids and satellite-linked variable rate spreaders and applicators to take advantage of the data. Non-Crop. We also distribute agricultural chemicals, seed and fertilizers for many non-agricultural markets, such as turf and ornamental (golf courses, resorts, nurseries and greenhouses), pest control operators and vegetation management. This non-crop business has a distinctly different customer base from the agricultural markets, and requires different service levels and locations closer to suburban or leisure centers. We believe that many non-crop markets are experiencing natural growth with general demographic trends. For example, as population growth expands in the Southern U.S., we expect increased opportunities for sales to pest control operators. As leisure spending increases in the U.S., we expect increased opportunities for sales to turf, golf course, resort and nursery businesses. We are the only distributor in our markets with a presence in the three major non-crop market product areas of turf and ornamental, pest control operators and vegetation management, and as such it is an important strategic growth area for UAP. We are focused on expansion of our current structure through small acquisitions, increased sales of branded products, introduction of new branded products and improving operational performance through consolidation. Products Division The Products Division consists of our marketing, registrations, sourcing, formulation and packaging operations for our proprietary and private label products. Our marketing group works closely with the Products Division to drive its portfolio management, sales activities, advertising and technical service. We operate three formulation facilities throughout the U.S. that produce our proprietary branded products as well as private label products from third parties. Typically, these private label products were developed independently by us or in cooperation with our leading suppliers. We generally distribute the products formulated by our Products Division through our Distribution Division. Additionally, we maintain over 300 federal registrations. As of August 29, 2004, we had approximately 218 proprietary branded products. We have a broad product offering of proprietary brands in each of our segments. Some of our key proprietary branded products in each of our segments are listed in the table below. Segment Key Proprietary Branded Products (as a percentage of net sales) Crop Protection Chemicals 65.9 % 65.7 % 64.4 % Fertilizer 21.0 % 20.2 % 21.5 % Seed 10.2 % 10.7 % 10.6 % Other 2.9 % 3.4 % 3.5 % Total 100.0 % 100.0 % 100.0 % Table of Contents PROPERTIES Our properties are located in the major crop-producing regions of the United States and Canada. We are headquartered in Greeley, Colorado, and we operate three formulation facilities located throughout the United States. Location Owned/Leased Building(s) Square Footage Formulating/ Production Square Footage Function Greeley, Colorado Leased 47,753 N/A Headquarters Greeley, Colorado Owned 67,100 11,500 Formulating Greenville, Mississippi Owned 291,000 57,000 Formulating Billings, Montana Owned 61,071 20,320 Formulating As part of our efforts to rationalize our infrastructure by closing or selling unprofitable facilities, we sold a substantial portion of the assets at a facility located in Fremont, Nebraska in February 2004. Except for a limited amount of toll manufacturing, we have ceased all operations at the Fremont facility. We expect to divest the remaining assets at that facility in the near future and to cease the remaining toll manufacturing activities by the end of fiscal 2005. In addition, we closed a formulation facility located in Caldwell, Idaho in October 2004, and we expect eventually to sell that facility to a third party. In addition, as of August 29, 2004, we owned or leased 372 properties that are used to maintain inventory and distribute and sell our products to our customers. We determine the number of distribution and storage facilities as those managed by a single location manager. Because there may be more than one property that we own or lease managed by a location manager, our approximately 320 distribution and storage facilities are less than the total number of leased and owned properties. We also utilize other miscellaneous facilities in our distribution business. We operate these properties through our four primary geographic regions, which are further divided into fifteen sub-regions, as noted below: Region Sub-region States Served Owned Leased Total Table of Contents MANAGEMENT Set forth below is certain information as of October 1, 2004 concerning the individuals that are currently serving as executive officers and/or members of the board of directors of UAP Holdings and United Agri Products. Name Age Position Table of Contents EXECUTIVE COMPENSATION As an independent company, we will establish executive compensation plans that will link compensation with the performance of our company. We will continually review our executive compensation programs to ensure that they are competitive. The following table sets forth information concerning total compensation earned or paid to the Chief Executive Officer and the four other most highly compensated executive officers of UAP Holdings who served in such capacities as of February 22, 2004 for services rendered during the fiscal year that ended on that date. Name and Principal Position Year Annual Compensation Long-Term Compensation Deferred Common Stock Awards(1) All Other Compensation Salary Bonus Table of Contents PRINCIPAL AND SELLING STOCKHOLDERS The following table sets forth information as of November 15, 2004 regarding the beneficial ownership of UAP Holdings common stock before and after the completion of this offering (in each case, as adjusted to reflect the approximately 39.085-for-1 split of the common stock which occurred on November 17, 2004), and shows the number of shares and percentage owned by (i) each person known to beneficially own more than 5% of the common stock of UAP Holdings before and after completion of this offering, (ii) each of UAP Holdings named executive officers, (iii) the other employee selling stockholders, (iv) each member of the Board of Directors of UAP Holdings and (v) all of the executive officers and members of the Board of Directors of UAP Holdings as a group. As of November 15, 2004, there were six holders of record of our common stock. The amounts and percentages of common stock beneficially owned are reported on the basis of regulations of the SEC governing the determination of beneficial ownership of securities. Under the rules of the SEC, a person is deemed to be a beneficial owner of a security if that person has or shares voting power, which includes the power to vote or to direct the voting of such security, or investment power, which includes the power to dispose of or to direct the disposition of such security. A person is also deemed to be a beneficial owner of any securities of which that person has a right to acquire beneficial ownership within 60 days. Under these rules, more than one person may be deemed a beneficial owner of the same securities and a person may be deemed a beneficial owner of securities as to which he has no economic interest. The column below titled Shares to be Sold in this Offering represents the shares of common stock being sold in this offering by funds affiliated with Apollo Management V, L.P., our equity sponsor, and by the other selling stockholders identified below. Additional information with respect to our equity sponsor and employee selling stockholders and their relationships with our company is provided under the captions Management beginning on page 62 and Certain Relationships and Related Transactions beginning on page 76. Except as indicated by footnote, the persons named in the table below have sole voting and investment power with respect to all shares of common stock shown as beneficially owned by them. In addition, except as indicated by footnote, the shares of common stock beneficially owned by our executive officers and employees, including Mr. Cordell, consist of deferred shares of common stock credited as of November 15, 2004 to the deferred compensation accounts of such persons under the 2003 deferred compensation plan and the 2004 deferred compensation plan. The executive officers and employees do not have voting or investment power over these deferred shares. Number and Percent of Shares Beneficially Owned Prior to this Offering Shares to be Sold in this Offering Number and Percent of Shares Beneficially Owned After this Offering Assuming No Exercise of the Over-Allotment Option Number and Percent of Shares Beneficially Owned After this Offering Assuming Full Exercise of the Over-Allotment Option Number Percent Number Percent Number Percent Table of Contents Number and Percent of Shares Beneficially Owned Prior to this Offering Shares to be Sold in this Offering Number and Percent of Shares Beneficially Owned After this Offering Assuming No Exercise of the Over-Allotment Option Number and Percent of Shares Beneficially Owned After this Offering Assuming Full Exercise of the Over-Allotment Option Number Percent Number Percent Number Percent Robert Katz (o)(p) 58,627 * 58,627 * 58,627 * Marc E. Becker (n)(p) 58,627 * 58,627 * 58,627 * Stan Parker (o)(p) 58,627 * 58,627 * 58,627 * Carl J. Rickertsen (p) 58,627 * 58,627 * 58,627 * Thomas Miklich (p) 58,627 * 58,627 * 58,627 * Directors and executive officers as a group (q) 2,197,885 4.6 % 463,418 3,432,065 6.6 % 3,432,067 6.6 % Table of Contents UNDERWRITING We, the selling stockholders and the underwriters named below have entered into an underwriting agreement with respect to the shares of our common stock being offered. Subject to certain conditions, each underwriter has severally agreed to purchase the number of shares indicated in the following table. Goldman, Sachs & Co., Credit Suisse First Boston LLC, UBS Securities LLC, Merrill Lynch, Pierce, Fenner & Smith Incorporated, William Blair & Company, L.L.C. and CIBC World Markets Corp. are the representatives of the underwriters. Underwriters Number of Shares Goldman, Sachs & Co. Credit Suisse First Boston LLC UBS Securities LLC Merrill Lynch, Pierce, Fenner & Smith Incorporated William Blair & Company, L.L.C. CIBC World Markets Corp. Total 23,437,500 The underwriters are committed to take and pay for all the shares of our common stock being offered, if any are taken, other than the shares covered by the option described below unless and until this option is exercised. If the underwriters sell more shares of our common stock than the total number set forth in the table above, the underwriters have an option to buy up to an additional 3,515,625 shares from the selling stockholders to cover such sales. They may exercise that option for 30 days. If any shares are purchased pursuant to this option, the underwriters will severally purchase shares in approximately the same proportion as set forth in the table above. The following tables show the per share and total underwriting discounts and commissions to be paid to the underwriters by us and the selling stockholders. Such amounts are shown assuming both no exercise and full exercise of the underwriters option to purchase additional shares of our common stock. Paid by Us No Exercise Full Exercise Per Share $ $ Total $ $ Paid by the Selling Stockholders No Exercise Full Exercise Table of Contents INDEX TO FINANCIAL STATEMENTS UAP HOLDING CORP. Page Table of Contents UAP HOLDING CORP. BALANCE SHEETS dollars in thousands Combined Predecessor Entity ConAgra Agricultural Products Business February 23, 2003 Consolidated UAP Holding Corp. February 22, 2004 ASSETS Current assets: Cash and cash equivalents $ 28,559 $ 172,647 Accounts receivable net of allowance of $34,694, and $27,328 204,043 170,769 Inventories 713,200 641,009 Deferred income taxes 21,912 2,681 Other current assets 184,436 80,653 Current assets of discontinued operations 67,012 Total current assets 1,219,162 1,067,759 Property, plant and equipment 230,300 100,207 Less accumulated depreciation (127,505 ) (3,093 ) Property, plant and equipment, net 102,795 97,114 Goodwill 4,731 43,465 Intangible assets, net 6,025 7,077 Deferred income taxes 2,323 18,293 Other assets 7,137 30,255 Noncurrent assets of discontinued operations 9,852 $ 1,352,025 $ 1,263,963 LIABILITIES AND STOCKHOLDER S NET INVESTMENT AND ADVANCES / STOCKHOLDERS EQUITY Current liabilities: Accounts payable $ 642,600 $ 689,455 Other accrued liabilities 86,318 145,234 Deferred income taxes 9,117 Current liabilities of discontinued operations 35,090 Total current liabilities 764,008 843,806 Long-term debt 308,570 Series A redeemable preferred stock 34,620 Deferred income taxes 83 Other noncurrent liabilities 119 96 Commitments and contingencies (Note 10) Stockholder s net investment and advances/stockholders equity: Stockholder s net investment and advances 587,898 Common stock, $.001 par value, 90,000,000 shares authorized, 46,902,351 shares issued and outstanding 47 Additional paid-in capital 67,093 Retained earnings 9,653 Accumulated other comprehensive loss (5 ) Total stockholders equity 76,788 $ 1,352,025 $ 1,263,963 Table of Contents UAP HOLDING CORP. STATEMENTS OF EARNINGS dollars in thousands, except per share amounts Combined Predecessor Entity Consolidated ConAgra Agricultural Products Business UAP Holding Corp. Net Sales $ 2,770,192 $ 2,526,765 $ 2,224,107 $ 227,778 Costs and expenses: Cost of goods sold 2,428,203 2,166,594 1,938,010 170,730 Selling, general and administrative expenses 334,626 275,244 208,670 37,017 Third party interest expense 5,372 1,927 704 4,993 (Gain) loss on sale of assets 606 1,493 (10,522 ) (404 ) Corporate allocations: Selling, general and administrative expenses 10,495 10,766 8,983 Finance charges 39,526 22,494 12,209 Income (loss) from continuing operations before income taxes (48,636 ) 48,247 66,053 15,442 Income tax expense (benefit) (17,519 ) 18,787 25,068 5,789 Income (loss) from continuing operations (31,117 ) 29,460 40,985 9,653 Loss from discontinued operations, net of tax (5,919 ) (4,221 ) (4,708 ) Net income (loss) $ (37,036 ) $ 25,239 $ 36,277 $ 9,653 Table of Contents UAP HOLDING CORP. STATEMENTS OF STOCKHOLDERS EQUITY AND STOCKHOLDER S NET INVESTMENT AND ADVANCES dollars in thousands Combined Predecessor Entity ConAgra Agricultural Products Business Investment and Advances/ (Distributions) Foreign Currency Translation Adjustment Stockholder's Net Investment and Advances Balance at February 25, 2001 $ 530,818 $ (83 ) $ 530,735 Comprehensive loss: Net loss (37,036 ) (37,036 ) Foreign currency translation adjustment (74 ) (74 ) Total comprehensive loss (37,110 ) Net investment and advances/(distributions) (199,133 ) (199,133 ) Balance at February 24, 2002 294,649 (157 ) 294,492 Comprehensive income (loss): Net income 25,239 25,239 Foreign currency translation adjustment (92 ) (92 ) Total comprehensive income 25,147 Net investment and advances 268,259 268,259 Total comprehensive income 36,579 Net investment and advances 27,522 27,522 Consolidated UAP Holding Corp. Thirteen Weeks Ended February 22, 2004 Class A Common Stock Additional Paid-in Capital Retained Earnings Accumulated Other Comprehensive Income Total Stockholders Equity Balance at November 24, 2003 $ $ $ $ $ Acquisition of common stock 47 119,953 120,000 Dividend to stockholders (52,860 ) (52,860 ) Comprehensive income (loss): Net income 9,653 9,653 Foreign currency translation adjustment (5 ) (5 ) Total comprehensive income 9,648 Table of Contents UAP HOLDING CORP. STATEMENTS OF CASH FLOWS dollars in thousands Combined Predecessor Entity Consolidated ConAgra Agricultural Products Business UAP Holding Corp. Fiscal Year Ended, Thirty-Nine Weeks Ended November 23, 2003 Thirteen Weeks Ended February 22, 2004 February 24, 2002 February 23, 2003 Cash flows from operating activities: Net income (loss) $ (37,036 ) $ 25,239 $ 36,277 $ 9,653 Less: Loss from discontinued operations (5,919 ) (4,221 ) (4,708 ) Income (loss) from continuing operations (31,117 ) 29,460 40,985 9,653 Adjustments to reconcile net income (loss) from continuing operations to net cash provided by operating activities: Depreciation 14,474 14,447 9,845 3,103 Amortization 2,674 2,259 1,540 377 Deferred income taxes (4,517 ) 3,821 23,858 (Gain) loss on sale of assets 606 1,493 (10,522 ) (404 ) Other noncash items (2,201 ) (2,739 ) 8,645 2,953 Change in assets and liabilities: Receivables 119,295 5,191 (283,052 ) 316,325 Inventories 198,180 126,618 238,151 (144,933 ) Other current assets (7,580 ) (149,051 ) 164,949 (85,095 ) Accounts payable, accrued liabilities and noncurrent liabilities (169,152 ) (298,250 ) (275,115 ) 320,536 Net cash flows from operating activities 120,662 (266,751 ) (104,574 ) 446,373 Net cash flows from investing activities (12,823 ) (4,034 ) 6,512 (659,650 ) Cash flows from financing activities: Net borrowings on short-term debt 603 (4,464 ) Proceeds from issuance of long-term debt 482,490 Debt issuance costs (23,326 ) Issuance of series A redeemable preferred stock 60,000 Redemption of long-term debt (175,000 ) Issuance of common stock 120,000 Dividends to stockholders (52,860 ) Redemption of series A redeemable preferred stock (25,380 ) Bank overdraft 11,632 Net investments and advances/(distributions) (182,085 ) 231,116 57,871 Net cash flows from financing activities (181,482 ) 226,652 69,503 385,924 Net change in cash and cash equivalents (73,643 ) (44,133 ) (28,559 ) 172,647 Cash and cash equivalents at beginning of period 146,335 72,692 28,559 Cash and cash equivalents at end of period $ 72,692 $ 28,559 $ $ 172,647 Table of Contents UAP HOLDING CORP. NOTES TO FINANCIAL STATEMENTS Fiscal Years Ended February 22, 2004, February 23, 2003 and February 24, 2002 columnar dollar amounts in thousands 1. Description of Business and Transactions UAP Holding Corp. (the Company ), an affiliate of Apollo Management, L.P. ( Apollo ), is a Delaware Corporation which was formed on October 28, 2003. On November 24, 2003, Apollo, UAP Holding Corp. and ConAgra Foods entered into a transaction in which UAP Holding Corp. acquired the ConAgra Agricultural Products Business including its Canadian distribution business and excluding its wholesale fertilizer and other international crop distribution businesses (the Acquisition ) for approximately $596 million of cash and $60 million of Series A redeemable preferred stock which were issued to ConAgra Foods. The entities that were historically operated by ConAgra Foods, Inc. as an integrated business, which include the wholesale fertilizer and other international crop distribution business that were not acquired in the Acquisition are referred to collectively as the ConAgra Agricultural Products Business or Predecessor. Those entities and operations within the ConAgra Agricultural Products Business that were actually acquired in the Acquisition and are being operated by UAP Holding Corp. are referred to as the Successor. In connection with the Acquisition, the Company entered into a five-year $500 million asset-backed revolving credit facility (the Senior Credit Facility ), a $175 million unsecured senior bridge loan facility and $120 million equity contribution from Apollo. On December 16, 2003, the Company completed a $225 million private offering of 8 1/4% of Senior Notes due 2011 which were used to repay the unsecured senior bridge loan facility and accrued interest, repay $45.8 million of the Senior Credit Facility and to pay fees and expenses. On January 26, 2004, the Company completed an offering of $125,000,000 aggregate principal amount at maturity of its 10 3/4% Senior Discount Notes due 2012 which were used to redeem $25.4 million of preferred stock, pay a dividend on common stock for $52.9 million, and to pay fees and expenses. The following table summarizes the estimated fair values of the assets acquired and liabilities assumed at November 24, 2003. The Company is in the process of obtaining a third-party valuation of certain intangible assets to assist the Company with their purchase accounting; thus, the allocation of the purchase price is subject to refinement. November 24, 2003 Accounts Receivable $ 487,094 Inventory 496,076 Property and equipment 97,419 Current and other assets 21,603 Goodwill and Intangibles 50,915 Deferred income taxes 17,339 Total assets acquired 1,170,446 Current liabilities 514,249 Total liabilities assumed 514,249 Net assets acquired $ 656,197 Net income (loss), as reported $ (37,036 ) $ 25,239 $ 36,277 Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects (718 ) (578 ) (434 ) Proforma net income (loss) $ (37,754 ) $ 24,661 $ 35,843 Table of Contents UAP HOLDING CORP. NOTES TO FINANCIAL STATEMENTS (Continued) Fiscal Years Ended February 22, 2004, February 23, 2003 and February 24, 2002 columnar dollar amounts in thousands In January 2003, the FASB issued FIN No. 46, Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin No. 51 (ARB 51), which clarifies the consolidation accounting guidance in ARB 51, Consolidated Financial Statements, as it applies to certain entities in which equity investors who do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entities to finance their activities without additional subordinated financial support from other parties. Such entities are known as variable interest entities (VIEs). FIN No. 46 requires that the primary beneficiary of a VIE consolidates the VIE. FIN No. 46 also requires new disclosures for significant relationships with VIEs, whether or not consolidation accounting is used or anticipated. In December 2003, the FASB revised and re-released FIN No. 46 as FIN No. 46(R). The provisions of FIN No. 46(R) are effective for periods ending after March 15, 2004 and upon adoption by the company as of February 22, 2004, did not have a material impact on our financial position or results of operations. Use of Estimates Preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions. These estimates or assumptions affect reported amounts of assets, liabilities, revenue and expenses as reflected in the financial statements. Actual results could differ from estimates. 3. Goodwill and Other Identifiable Intangible Assets The company adopted SFAS No. 142, at the beginning of fiscal 2003. Goodwill is not amortized and is tested annually for impairment of value. Impairment occurs when the fair value of the asset is less than its carrying amount. If impaired, the asset is written down to its fair value. Goodwill was $4.8 million at February 23, 2003 and $43.5 million at February 22, 2004. Other identifiable intangible assets are as follows: February 23, 2003 February 22, 2004 Gross Carrying Amount Accumulated Amortization Gross Carrying Amount Accumulated Amortization Table of Contents UAP HOLDING CORP. NOTES TO FINANCIAL STATEMENTS (Continued) Fiscal Years Ended February 22, 2004, February 23, 2003 and February 24, 2002 columnar dollar amounts in thousands The following is comparative earnings information assuming SFAS No. 142 had been in effect for each period presented: Fiscal Year Ended February 24, 2002 Proforma net loss $ (36,744 ) $ 713,200 $ 641,009 Land $ 19,598 $ 13,155 Buildings, machinery and equipment 180,559 70,129 Furniture, fixtures, office equipment and other 28,307 12,471 Construction in progress 1,836 4,452 230,300 100,207 Less: accumulated depreciation (127,505 ) (3,093 ) $ 102,795 $ 97,114 Table of Contents UAP HOLDING CORP. NOTES TO FINANCIAL STATEMENTS (Continued) Fiscal Years Ended February 22, 2004, February 23, 2003 and February 24, 2002 columnar dollar amounts in thousands basis. Corporate allocations include allocated selling, administrative and general expenses of approximately $10.5 million and $10.8 million for fiscal 2002 and 2003, respectively, and $9.0 million for the thirty-nine weeks ended November 23, 2003, and allocated finance charges of $39.5 million and $22.5 million in fiscal 2002 and 2003, respectively, and $12.2 million for the thirty-nine weeks ended November 23, 2003. Allocated finance charges are presented net of third party finance fee income of $13.5 million and $13.4 million in fiscal 2002 and 2003, respectively, and $7.3 million for the thirty-nine weeks ended November 23, 2003. Prior to the Acquisition, the company also had transactions in the normal course of business with parties under common ownership. Net sales to related parties were $33.8 million and $25.5 million in fiscal years 2002 and 2003, respectively, and $5.8 million for the thirty-nine weeks ended November 23, 2003. Gross margins associated with related party net sales were $2.6 million and $2.5 million in fiscal years 2002 and 2003, respectively, and $2.0 million for the thirty-nine weeks ended November 23, 2003. As part of the Acquisition, ConAgra Foods and the company entered into a transition services agreement in which ConAgra Foods would provide certain information technology and other administrative services to the company for a period of one year. As consideration for these services, the company paid ConAgra Foods $7.5 million. For the thirteen week period ended February 22, 2004, $1.9 million in expense was recognized by the Company for services performed per this agreement. The company is a party to a management consulting agreement dated as of November 21, 2003 with Apollo (the Management Agreement ). Under the terms of the Management Agreement, the company retained Apollo to provide certain management consulting and financial advisory services, for which the company pays Apollo an annual management fee of $1.0 million in quarterly payments of $250,000. In addition, as consideration for arranging the Acquisition and services pertaining to certain related financing transactions, the Company paid Apollo a fee of $5.0 million in January 2004. 7. Debt Long-term debt is comprised of the following at February 22, 2004: 8 1/4% Senior Notes $ 225,000 10 3/4% Senior Discount Notes 83,570 $ 308,570 Table of Contents UAP HOLDING CORP. NOTES TO FINANCIAL STATEMENTS (Continued) Fiscal Years Ended February 22, 2004, February 23, 2003 and February 24, 2002 columnar dollar amounts in thousands 8. Capital Stock The Predecessor Entity s capital stock consisted of the following: Par Value Shares Authorized Issued Table of Contents UAP HOLDING CORP. NOTES TO FINANCIAL STATEMENTS (Continued) Fiscal Years Ended February 22, 2004, February 23, 2003 and February 24, 2002 columnar dollar amounts in thousands 9. Income Taxes The provision (benefit) for income taxes includes the following: Fiscal Year Ended Thirty-Nine Weeks Ended November 23, 2003 Thirteen Weeks Ended February 22, 2004 (4,517 ) 3,821 23,858 $ (17,519 ) $ 18,787 $ 25,068 $ 5,789 Income taxes computed by applying statutory rates to income before income taxes are reconciled to the provision for income taxes set forth in the consolidated statements of earnings as follows: Fiscal Year Ended Thirty-Nine Weeks Ended November 23, 2003 Thirteen Weeks Ended February 22, 2004 $ (17,519 ) $ 18,787 $ 25,068 $ 5,789 Assets Liabilities Assets Liabilities $ 28,468 $ 4,233 $ 20,974 $ 9,200 $ 19,505 Table of Contents UAP HOLDING CORP. NOTES TO FINANCIAL STATEMENTS (Continued) Fiscal Years Ended February 22, 2004, February 23, 2003 and February 24, 2002 columnar dollar amounts in thousands Components of pension benefit costs and weighted average actuarial assumptions are: Fiscal Year Ended Fiscal Year Ended Thirty-Nine Weeks Ended November 23, Thirteen Weeks Ended February 22, Projected benefit obligation at end of year $ 2,419 $ 2,700 Fair value of plan assets at end of year 1,858 2,073 Funded Status (561 ) (627 ) Unrecognized actuarial loss 1,148 1,281 Options Weighted Average Exercise Price Options Weighted Average Exercise Price Options Weighted Average Exercise Price Beginning of year 1,167.2 $ 23.73 1,094.9 $ 24.01 941.3 $ 24.40 Granted 153.0 $ 22.00 63.5 $ 25.90 $ Exercised (96.2 ) $ 16.57 (95.0 ) $ 19.38 (68.0 ) $ 17.84 Canceled (129.1 ) $ 24.69 (122.1 ) $ 25.56 (424.7 ) $ 24.36 End of year 1,094.9 $ 24.01 941.3 $ 24.40 448.6 $ 24.96 Exercisable at end of year 717.6 $ 25.01 686.5 $ 25.13 445.5 $ 24.98 Table of Contents UAP HOLDING CORP. NOTES TO FINANCIAL STATEMENTS (Continued) Fiscal Years Ended February 22, 2004, February 23, 2003 and February 24, 2002 columnar dollar amounts in thousands 14. Business Segment and Related Information The company operates in one segment. Net sales and long-lived assets by geographical area are as follows: Fiscal Year Ended Net Sales: United States $ 2,623,064 $ 2,402,887 $ 2,128,545 $ 217,976 Canada 147,128 123,878 95,562 9,802 Total $ 2,770,192 $ 2,526,765 $ 2,224,107 $ 227,778 Long-Lived Assets: United States $ 115,477 $ 122,567 Canada 4,307 4,802 Total $ 119,784 $ 127,369 Net sales by product category are as follows: Fiscal Year Ended Crop protection chemicals $ 1,826,426 $ 1,661,315 $ 1,443,600 $ 136,100 Fertilizer 581,007 510,585 460,336 65,826 Seeds 282,756 270,829 242,123 16,819 Other 80,003 84,036 78,048 9,033 $ 2,770,192 $ 2,526,765 $ 2,224,107 $ 227,778 Table of Contents UAP HOLDING CORP. CONDENSED CONSOLIDATED AND COMBINED BALANCE SHEETS UNAUDITED dollars in thousands Combined Predecessor Entity Consolidated ConAgra Agricultural Products Business UAP Holding Corp. August 24, 2003 (Predecessor) ASSETS Current assets: Cash and cash equivalents $ $ 172,647 $ 14,615 Receivables, less allowance for doubtful accounts of $ 21,499, $27,328 and $44,023 666,394 170,769 706,795 Inventories 451,698 641,009 449,602 Deferred income taxes 21,912 2,681 Other current assets 17,214 80,653 40,997 Current assets from discontinued operations 4,991 Total current assets 1,162,209 1,067,759 1,212,009 Property, plant and equipment 231,832 100,207 105,789 Less accumulated depreciation (131,235 ) (3,093 ) (9,451 ) Property, plant and equipment, net 100,597 97,114 96,338 Goodwill 4,894 43,465 41,407 Intangible assets, net 5,714 7,077 6,332 Deferred income taxes 2,323 18,293 3,256 Debt issue costs, net 23,668 21,635 Investment in subsidiaries 2,168 3,958 3,871 Other assets 3,871 2,629 4,321 Long lived assets from discontinued operations 2,036 $ 1,283,812 $ 1,263,963 $ 1,389,169 LIABILITIES AND STOCKHOLDER S NET INVESTMENT AND ADVANCES/STOCKHOLDERS EQUITY Current liabilities: Checks not yet presented $ $ $ 36,561 Short-term debt 180,299 Accounts payable 387,466 689,455 556,575 Other accrued liabilities 180,364 145,234 126,063 Income taxes payable Deferred income taxes 9,117 14,875 Current liabilities from discontinued operations 1,950 February 27, February 27, February 25, February 25, February 24, Basic and diluted earnings per share $ 0.21 $ 1.00 Basic and diluted weighted average shares outstanding 46,902,351 47,248,244 Other Operating Data: Depreciation and amortization $ 17,148 $ 16,706 $ 7,815 $ 11,385 $ 3,480 $ 7,351 EBITDA (c) 20,963 98,552 110,610 92,984 27,347 107,003 Capital expenditures 13,654 6,417 4,870 8,350 6,970 4,817 As of February 24, February 24, February 24, February 24, Table of Contents PRODUCTS The following table shows the percentage of our net sales by product line for the fiscal years 2002, 2003 and 2004, respectively: Year ended February 24, Fiscal Year Ended Thirty-Nine Weeks Ended Thirteen Weeks Ended February 24, Table of Contents UAP HOLDING CORP. NOTES TO FINANCIAL STATEMENTS (Continued) Fiscal Years Ended February 22, 2004, February 23, 2003 and February 24, 2002 columnar dollar amounts in thousands net cash flows expected to be generated by the asset, the asset s carrying amount is reduced to its fair market value. An asset held-for-sale is reported at the lower of the carrying amount or fair market value, less cost to sell. Income Taxes The company recognizes deferred tax assets and liabilities based on the differences between the financial statement and tax bases of assets and liabilities at each balance sheet date using enacted tax rates expected to be in effect in the year the differences are expected to reverse. Prior to the Acquisition, income taxes were paid by the parent company on a consolidated level as the company was included in the consolidated tax returns of ConAgra Foods. The provision for income taxes was computed on a separate legal entity basis. Fair Values of Financial Instruments Unless otherwise specified, the company believes the carrying amount of financial instruments approximates their fair value. Revenue Recognition Revenue is recognized when title and risk of loss are transferred to customers upon delivery based on terms of sale. Revenue is recognized as the net amount to be received after deducting estimated amounts for discounts, trade allowances and product returns. Earnings per Share Earnings per share is based on the weighted average number of shares of common stock outstanding during the period. The weighted average number of shares outstanding for basic and diluted earnings per share for thirteen weeks ended February 22, 2004 was 46,902,360. Stock-Based Compensation The company accounts for employee stock option plans in accordance with Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees. Accordingly, no stock-based compensation expense is reflected in net income, as options granted under these plans have an exercise price equal to the market value of the underlying common stock on the date of grant. In December 2002, the Financial Accounting Standards Board ( FASB ) issued Statement of Financial Accounting Standards ( SFAS ) No. 148, Accounting for Stock-Based Compensation Transition and Disclosure, which became effective for fiscal years ending after December 15, 2002. SFAS No. 148 requires certain pro forma information regarding net income and earnings per share assuming the company recognized expense for its employee stock options using the fair value method. The fair value of options was estimated at the date of the grant using the Black-Scholes option pricing model with the following weighted average assumptions for 2002, 2003 and the thirty-nine weeks ended November 23, 2003, respectively: risk-free interest rate of 4.52%, 4.30% and 4.30%; a dividend yield of 3.9%, 3.9% and 3.9%; expected volatility of 29.0%, 30.0% and 30.0%; and an expected option life of six years. The weighted average fair value of options granted in fiscal 2002, 2003 and the thirty-nine weeks ended November 23, 2003 was $5.08, $5.88 and $5.88, respectively. Pro forma net income (loss) is as follows: February 24, February 24, February 24, Table of Contents UAP HOLDING CORP. NOTES TO FINANCIAL STATEMENTS (Continued) Fiscal Years Ended February 22, 2004, February 23, 2003 and February 24, 2002 columnar dollar amounts in thousands Plan assets are primarily invested in equity securities, corporate and government debt securities and common trust funds. Certain employees of the Predecessor Entity are covered under defined contribution plans administered by ConAgra Foods. The expense related to these plans was $1.9 million and $3.0 million in fiscal 2002 and 2003, respectively, and $2.5 million for the thirty-nine weeks ended November 23, 2003. 12. Successor Stock Plans Certain of the Company s employees participate in the UAP Holdings, Inc. stock option plan. The stock option plan, approved by UAP Holdings, Inc. shareholders, provides for granting of options to employees for the purchase of Common Stock at prices equal to fair market value at the time of grant. Options become exercisable under various vesting schedules and generally expire eight years after the date grant. As of February 22, 2004, 2,904,025 options have been granted under the plan with an exercise price of approximately $2.56. No options have vested as of February 22, 2004 and 379,140 options remain available under the plan. 13. Predecessor Stock Plans Prior to the Acquisition, certain of the company s employees participated in ConAgra Foods stock option plans. These stock option plans approved by the ConAgra Foods stockholders provide for granting of options to employees for purchase of Common Stock at prices equal to fair market value at the time of grant. At the date of Acquisition, all vested options were exercisable for 90 days after the date of the Acquisition, at which time all unexercised options were canceled. The changes in the outstanding stock options during the years ended February 24, 2002 and February 23, 2003 and the thirty-nine weeks ended November 23, 2003, are summarized below: Twenty-Six Weeks Ended August 24, Thirty-Nine Weeks Ended November 23, February 23, As of February 23, February 23, August 24, November 23, ConAgra Agricultural Products Business Thirty-Nine Weeks Ended November 23, February 23, August 24, November 23, Twenty-Six Weeks Ended August 24, Thirty-Nine Weeks Ended November 23, February 23, Year ended February 23, February 23, November 23, Fiscal Year Ended February 23, Thirty-Nine Weeks Ended November 23, 4. Inventories Inventories are comprised of the following: February 23, 5. Property, Plant and Equipment Property, plant and equipment are comprised of the following: February 23, February 23, February 23, The tax effect of temporary differences and carryforwards that give rise to significant portions of deferred tax assets and liabilities consist of the following: Actuarial Assumptions Discount rate 7.50 % 7.25 % 6.50 % 6.50 % Long-term rate of return on plan assets 9.25 % 7.75 % 7.75 % 7.75 % Long-term rate of compensation increase 5.50 % 5.50 % 5.50 % 5.50 % The change in projected benefit obligation, change in plan assets and funded status of the plans at February 23, 2003 and February 22, 2004: Thirty-Nine Weeks Ended November 23, Thirty-Nine Weeks Ended November 23, Thirty-Nine Weeks Ended November 23, August 24, Twenty-Six Weeks Ended August 24, Twenty-Six Weeks Ended August 24, Amortizing intangible assets, carrying a weighted average life of approximately 5 years, are comprised primarily of a product marketing agreement. Amortization expense was $0.2 million and $1.1 million for the twenty-seven week period ended August 29, 2004 and the twenty-six week period ended August 24, 2003, respectively. Amortization expense is estimated to approximate $0.5 million for each of the next five years. 4. Inventories Inventories are comprised of the following: August 24, August 24, Fiscal Year Ended February 22, Twelve Months Ended August 29, August 29, Fiscal Year Ended February 22, Twenty-Seven Weeks Ended August 29, Twelve Months Ended August 29, Thirteen Weeks Ended February 22, Twenty-Seven Weeks Ended August 29, As of February 22, As of August 29, February 22, August 29, Table of Contents CAPITALIZATION The following table sets forth the cash and cash equivalents and capitalization as of August 29, 2004 of UAP Holdings (i) on an actual basis and (ii) on a pro forma basis giving effect to this offering and the use of net proceeds therefrom, and the Special Dividends. The information should be read in conjunction with Use of Proceeds beginning on page 20, Unaudited Pro Forma Condensed Consolidated Financial Data beginning on page 24, Management s Discussion and Analysis of Financial Condition and Results of Operations beginning on page 35, and the unaudited historical condensed consolidated financial statements and the accompanying notes thereto appearing elsewhere in this prospectus. As of August 29, Table of Contents UNAUDITED PRO FORMA CONDENSED CONSOLIDATED STATEMENT OF INCOME Fiscal Year Ended February 22, 2004 UAP Holding Corp. Thirteen Weeks Ended February 22, UAP Holding Corp. Twenty-Seven Weeks Ended August 29, Thirteen Weeks Ended February 22, Twenty-Seven Weeks Ended August 29, Thirteen Weeks Ended February 22, Twenty-Seven Weeks Ended August 29, Year ended February 22, L. Kenny Cordell . . . . . . . . . . . President and Chief Executive Officer 2004 $ 350,000 $ 449,731 $ 1,300,000 $ 726,791 (2) Bryan S. Wilson . . . . . . . . . . . . President, Distribution 2004 $ 250,000 $ 250,940 $ 800,000 $ 449,530 (3) David W. Bullock . . . . . . . . . . . Executive Vice President and Chief Financial Officer 2004 $ 200,000 $ 255,975 $ 800,000 $ 11,029 (4) Dave Tretter . . . . . . . . . . . . . . . Executive Vice President, Procurement 2004 $ 180,000 $ 191,981 $ 500,000 $ 447,291 (5) Robert A. Boyce, Jr. . . . . . . . . Executive Vice President, Verdicon February 22, February 22, February 22, Thirteen Weeks Ended February 22, Thirteen Weeks Ended February 22, February 22, August 29, Twenty-Seven Weeks Ended August 29, Twenty-Seven Weeks Ended August 29, February 22, August 29, Table of Contents UAP HOLDING CORP. NOTES TO CONDENSED CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS (Continued) For the Twenty-Seven Weeks Ended August 29, 2004 and Twenty-Six Weeks Ended August 24, 2003 columnar dollar amounts in thousands unaudited The Company is party to a management consulting agreement dated as of November 21, 2003 with Apollo (the Management Agreement ). Under the terms of the Management Agreement, the Company retained Apollo to provide certain management consulting and financial advisory services, for which the Company pays Apollo an annual management fee of $1.0 million in quarterly payments of $250,000. In addition, as consideration for arranging the Acquisition and services pertaining to certain related financing transactions, the Company paid Apollo a fee of $5.0 million in January 2004, which was capitalized as part of the Acquisition. 6. Debt Long-term debt is comprised of the following at August 29, 2004 and February 22, 2004: February 22, August 29, February 22, August 29, Total stockholders equity 708,840 76,788 125,672 $ 1,283,812 $ 1,263,963 $ 1,389,169 Table of Contents UAP HOLDING CORP. CONDENSED CONSOLIDATED AND COMBINED STATEMENTS OF EARNINGS UNAUDITED dollars in thousands, except per share amounts Combined Predecessor Entity Consolidated ConAgra Agricultural Products Business UAP Holding Corp. Net sales $ 1,850,222 $ 1,962,470 Costs and expenses: Cost of goods sold 1,588,335 1,719,714 Gross profit 261,887 242,756 Selling, general and administrative expenses 154,083 153,392 Third party interest expense 301 18,183 Gain on sale of assets (1,265 ) Other income, net (5,124 ) Corporate allocations: Selling, general and administrative expenses 6,119 Finance charges 8,261 Income from continuing operations before income taxes 93,123 77,570 Income tax expense 35,341 30,252 Income (loss) from continuing operations 57,782 47,318 Loss from discontinued operations, net of tax (3,027 ) Net income $ 54,755 $ 47,318 Table of Contents UAP HOLDING CORP. CONDENSED CONSOLIDATED AND COMBINED STATEMENTS OF CASH FLOWS UNAUDITED dollars in thousands Combined Predecessor Entity Consolidated ConAgra Agricultural Products Business UAP Holding Corp. Cash flows from operating activities: Net income $ 54,755 $ 47,318 Loss from discontinued operations (3,027 ) Net income from continuing operations 57,782 47,318 Adjustments to reconcile net income from continuing operations to net cash provided by operating activities: Depreciation 6,722 6,542 Amortization 1,093 809 Accretion of discount on notes 6,369 Other non-cash items (3,122 ) 1,117 Change in operating assets and liabilities (225,672 ) (375,434 ) Change in operating activities from discontinued operations 33,717 Net cash flows from operating activities (129,480 ) (313,279 ) Net cash flows from investing activities (5,702 ) (62,901 ) Cash flows from financing activities: Net borrowings of short-term debt 180,299 Checks not yet presented 36,561 Net investment and advances 140,293 Change in financing activity from discontinued operations (33,670 ) Net cash flows from financing activities 106,623 216,860 Net effect of exchange rate fluctuations 1,288 Net change in cash and cash equivalents (28,559 ) (158,032 ) Cash and cash equivalents at beginning of period (February 23, 2003 and February 22, 2004) 28,559 172,647 Cash and cash equivalents at end of period $ $ 14,615 Table of Contents UAP HOLDING CORP. NOTES TO CONDENSED CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS For the Twenty-Seven Weeks Ended August 29, 2004 and Twenty-Six Weeks Ended August 24, 2003 columnar dollar amounts in thousands unaudited 1. Description of Business and Transactions UAP Holding Corp. (the Company ), an affiliate of Apollo Management, L.P. ( Apollo ), is a Delaware corporation which was formed on October 28, 2003. The following table summarizes the estimated fair values of the assets acquired and liabilities assumed at November 24, 2003. The Company is in the process of obtaining a third-party valuation of certain intangible assets to assist the Company with their purchase accounting; thus, the allocation of the purchase price is subject to refinement. November 23, 2003 Accounts Receivable $ 487,094 Inventory 474,409 Property and equipment 97,290 Current and other assets 21,459 Goodwill and Intangibles 40,475 Deferred income taxes 17,339 Total assets acquired 1,138,066 Current liabilities 465,755 Total liabilities assumed 465,755 Net assets acquired $ 672,311 Table of Contents UAP HOLDING CORP. NOTES TO CONDENSED CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS (Continued) For the Twenty-Seven Weeks Ended August 29, 2004 and Twenty-Six Weeks Ended August 24, 2003 columnar dollar amounts in thousands unaudited management, necessary for a fair presentation of the financial position, operating results, and cash flows for the interim periods. The consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto, contained elsewhere in this prospectus for the year ended February 22, 2004. All intercompany balances and transactions have been eliminated. The Company s results for the twenty-seven weeks ended August 29, 2004 are not necessarily indicative of what the Company s results will be for other interim periods or for the full fiscal year. Certain amounts in prior fiscal periods have been reclassified for comparative purposes. Vendor Rebates Receivables include vendor rebates which represent amounts due from suppliers on crop protection, seed and fertilizer products and are accrued when earned, which is typically at the time of the sale of the related product. Periodically, the Company revisits the methodology to estimate monthly rebates to incorporate the most detailed information available. Stock-Based Compensation Predecessor Stock Plan The Company accounted for employee stock option plans in accordance with Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees. Accordingly, no stock-based compensation expense is reflected in net income, as options granted under these plans have an exercise price equal to the market value of the underlying common stock on the date of grant. In December 2002, the Financial Accounting Standards Board ( FASB ) issued SFAS No. 148, Accounting for Stock-Based Compensation Transition and Disclosure, which became effective for fiscal years ending after December 15, 2002. SFAS No. 148 requires certain pro forma information regarding net income and earnings per share to be calculated based on the assumption that the Company recognized expenses for its employee stock options using the fair value method. The fair value of options was estimated at the date of the grant using the Black-Scholes option pricing model with the following weighted average assumptions for the twenty-six weeks ended August 24, 2003: risk-free interest rate of 4.30%; a dividend yield of 3.9%; expected volatility of 30.0%; and an expected option life of six years. The weighted average fair value of options granted for the twenty-six weeks ended August 24, 2003 was $5.88 for ConAgra stock. Pro forma net income (loss) is as follows: Twenty-Six Weeks Ended August 24, 2003 Pro forma net income $ 54,465 Table of Contents UAP HOLDING CORP. NOTES TO CONDENSED CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS (Continued) For the Twenty-Seven Weeks Ended August 29, 2004 and Twenty-Six Weeks Ended August 24, 2003 columnar dollar amounts in thousands unaudited Goodwill was $41.4 million at August 29, 2004, $43.5 million at February 22, 2004, and $4.9 million at August 24, 2003. Other identifiable intangible assets are as follows: August 24, 2003 February 22, 2004 August 29, 2004 Gross Carrying Amount Accumulated Amortization Gross Carrying Amount Accumulated Amortization Gross Carrying Amount Accumulated Amortization $ 451,698 $ 641,009 $ 449,602 8 % Senior Notes $ 225,000 $ 225,000 10 % Senior Discount Notes 83,570 87,759 $ 308,570 $ 312,759 Table of Contents UAP HOLDING CORP. NOTES TO CONDENSED CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS (Continued) For the Twenty-Seven Weeks Ended August 29, 2004 and Twenty-Six Weeks Ended August 24, 2003 columnar dollar amounts in thousands unaudited An additional 586,279 options were reserved for the non-employee director option plan. Of these, 351,762 options were granted during the current quarter with an exercise price of approximately $2.56. All of the granted options were immediately vested. 8. Business Segment and Related Information The Company operates in one segment. Net sales and long-lived assets by geographical area are as follows: Twenty-Six Weeks Ended August 24, 2003 Twenty-Seven Weeks Ended August 29, 2004 Net sales: United States $ 1,768,429 $ 1,903,033 Canada 81,793 59,437 Total $ 1,850,222 $ 1,962,470 Long-lived assets: United States $ 115,182 $ 191,402 $ 173,133 Canada 6,421 4,802 4,027 Total $ 121,603 $ 196,204 $ 177,160 Net sales by product category are as follows: Twenty-Six Weeks Ended August 24, 2003 Twenty-Seven Weeks Ended August 29, 2004 Crop protection chemicals $ 1,221,706 $ 1,257,721 Fertilizer 370,535 409,269 Seeds 208,659 259,971 Other 49,322 35,509 Total $ 1,850,222 $ 1,962,470 Table of Contents UAP HOLDING CORP. NOTES TO CONDENSED CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS (Continued) For the Twenty-Seven Weeks Ended August 29, 2004 and Twenty-Six Weeks Ended August 24, 2003 columnar dollar amounts in thousands unaudited 9. Commitments and Contingencies The Company is a party to a number of lawsuits and claims arising out of the operation of its businesses. After taking into account liabilities recorded management believes the ultimate resolution of such matters should not have a material adverse effect on the Company s financial condition, results of operations or liquidity. 10. Comprehensive Income Results of operations for foreign subsidiaries are translated using the average exchange rates during the period. Assets and liabilities are translated at the exchange rates in effect on the balance sheet dates. Currency translation adjustment is our only component of other comprehensive income. ConAgra Agricultural Products Business Twenty-Seven Weeks Ended August 24, 2003 UAP Holding Corp. Twenty-Seven Weeks Ended August 29, 2004 Total comprehensive income $ 54,755 $ 47,999 Table of Contents Table of Contents DEALER PROSPECTUS DELIVERY OBLIGATIONS Through and including , 2004 (the 25th day after the date of this prospectus), all dealers effecting transactions in these securities, whether or not participating in this offering, may be required to deliver a prospectus. This is in addition to a dealer s obligation to deliver a prospectus when acting as an underwriter and with respect to an unsold allotment or subscription. Table of Contents PART II INFORMATION NOT REQUIRED IN PROSPECTUS Item 13. Other Expenses of Issuance and Distribution The following table sets forth the costs and expenses, other than underwriting discounts and commissions, payable by UAP Holding Corp. in connection with the issuance and distribution of the securities being registered. All amounts are estimates except the SEC registration and NASD filing fees. SEC Registration fee $ 58,055 NASD filing fee 30,500 Listing fee 100,000 Transfer agent s fee 13,000 Printing and engraving expenses 400,000 Legal and accounting fees and expenses 2,375,000 Miscellaneous 23,445 Total $ 3,000,000 Item 14. Indemnification of Directors and Officers Section 145 of the Delaware General Corporation Law ( DGCL ) provides that a corporation may indemnify any person who was or is a party or is threatened to be made a party to any threatened, pending or completed action, suit or proceeding whether civil, criminal or investigative (other than an action by or in the right of the corporation) by reason of the fact that he is or was a director, officer, employee or agent of the corporation, or is or was serving at the request of the corporation as a director, officer, employee or agent of another corporation, partnership, joint venture, trust or other enterprise, against expenses (including attorneys fees), judgments, fines and amounts paid in settlement actually and reasonably incurred by him in connection with such action, suit or proceeding if he acted in good faith and in a manner he reasonably believed to be in or not opposed to the best interests of the corporation, and, with respect to any criminal action or proceeding, had no reasonable cause to believe his conduct was unlawful. Section 145 further provides that a corporation similarly may indemnify any such person serving in any such capacity who was or is a party or is threatened to be made a party to any threatened, pending or completed action or suit by or in the right of the corporation to procure a judgment in its favor, against expenses (including attorneys fees) actually and reasonably incurred in connection with the defense or settlement of such action or suit if he acted in good faith and in a manner he reasonably believed to be in or not opposed to the best interests of the corporation and except that no indemnification shall be made in respect of any claim, issue or matter as to which such person shall have been adjudged to be liable to the corporation unless and only to the extent that the Delaware Court of Chancery or such other court in which such action or suit was brought shall determine upon application that, despite the adjudication of liability but in view of all the circumstances of the case, such person is fairly and reasonably entitled to indemnity for such expenses which the Court of Chancery or such other court shall deem proper. Section 102(b)(7) of the DGCL permits a corporation to include in its certificate of incorporation a provision eliminating or limiting the personal liability of a director to the corporation or its stockholders for monetary damages for breach of fiduciary duty as a director, provided that such provision shall not eliminate or limit the liability of a director (i) for any breach of the director s duty of loyalty to the corporation or its stockholders, (ii) for acts or omission not in good faith or which involve intentional misconduct or a knowing violation of law, (iii) under Section 174 of the DGCL (relating to unlawful payment of dividends and unlawful stock purchase and redemption) or (iv) for any transaction from which the director derived an improper personal benefit. II-1 Table of Contents In accordance with the provisions of the Amended Certificate of Incorporation and Bylaws of UAP Holding Corp., UAP Holding Corp. shall indemnify, to the fullest extent permitted by law, any person who is or was a party, or is threatened to be made a party to, any threatened, pending or contemplated action, suit or other type of proceeding (other than an action by or in our right), whether civil, criminal, administrative, investigative or otherwise, and whether formal or informal, by reason of the fact that such person is or was UAP Holding Corp. s director, officer or employee or is or was serving at UAP Holding Corp. s request (as a director, officer, employee or agent of another corporation, partnership, joint venture, trust or other enterprise) against judgments, amounts paid in settlement, penalties, fines (including an excise tax assessed with respect to any employee benefit plan) and expenses (including counsel fees) actually and reasonably incurred in connection with any such action, suit or other proceeding, including any appeal thereof, if such person acted in good faith and in a manner such person reasonably believed to be in, or not opposed to, UAP Holding Corp. s best interests and, with respect to any criminal action or proceeding, had no reasonable cause to believe such person s conduct was unlawful. In addition, UAP Holding Corp. also carries insurance on behalf of its directors, officers, employees or agents that may cover liabilities under the Securities Act. UAP Holding Corp. provides its directors and officers with additional director and officer liability insurance. Item 15. Recent Sales of Unregistered Securities Set forth below in chronological order is certain information regarding securities issued by UAP Holding Corp. since October 23, 2003 (UAP Holding Corp. s date of incorporation) in transactions that were not registered under the Securities Act of 1933, as amended (the Securities Act ), including the consideration, if any, received by UAP Holding Corp. for such issuances (all share and dollar amounts set forth below give effect to the proposed approximately 39.085-for-1 split of the common stock of UAP Holding Corp., which will occur prior to the effective date of this registration statement). 1. On October 29, 2003, UAP Holding Corp. issued 3,908 shares of common stock to entities affiliated with Apollo Management V, L.P. for an aggregate purchase price of $1,000. 2. On November 24, 2003, UAP Holding Corp. issued 44,733,122 shares of common stock to entities affiliated with Apollo Management V, L.P. for an aggregate purchase price of $114,450,000. 3. On November 24, 2003, UAP Holding Corp. issued 60,000 shares A Redeemable Preferred Stock to ConAgra Foods, Inc. for an aggregate purchase price of $60,000,000. 4. On November 24, 2003, UAP Holding Corp. issued 2,169,229 shares of common stock to the plan trustee under UAP Holding Corp. s 2003 Deferred Compensation Plan for an aggregate purchase price of $5,550,000. 5. On November 24, 2003, UAP Holding Corp. granted stock options to certain of its executive officers to purchase 2,904,025 shares of its common stock for an aggregate exercise price of $7,430,000. 6. On January 20, 2004, UAP Holding Corp. issued $125,000,000 principal amount at maturity ($82,490,000 in gross proceeds) of 10 % Senior Discount Notes due 2012 to UBS Investment Bank, Goldman, Sachs & Co. and Bear Stearns & Co. Inc., as initial purchasers for resale to qualified institutional buyers under Rule 144A of the Securities Act or non U.S. persons pursuant to Regulation S under the Securities Act. The initial purchasers received a discount of $1,650,000. 7. On March 8, 2004, UAP Holding Corp. granted stock options to its non-executive directors to purchase 351,762 shares of its common stock for an aggregate exercise price of $900,000. 8. On April 2, 2004, UAP Holding Corp. s board of directors approved the grant of stock options to purchase 162,375 shares of its common stock for an aggregate exercise price of $415,500. 9. On April 2, 2004, UAP Holding Corp. issued 345,893 shares of common stock to the plan trustee under UAP Holding Corp. s 2004 Deferred Compensation Plan for an aggregate purchase price of $88,850. II-2 Table of Contents Each of the above-described transactions were exempt from registration (i) pursuant to Section 4(2) of the Securities Act, or Regulation D promulgated thereunder, as transactions not involving a public offering or (ii) in the case of stock options, as transactions not involving a sale of securities. With respect to each transaction listed above, no general solicitation was made by either UAP Holding Corp. or any person acting on its behalf; the securities sold are subject to transfer restrictions; and the certificates for the shares contained an appropriate legend stating such securities have not been registered under the Securities Act and may not be offered or sold absent, registration or pursuant to an exemption therefrom. Item 16. Exhibits and Financial Statement Schedules (a) Exhibits Exhibit Number Exhibit 1.1 Form of Underwriting Agreement. 2.1 Stock Purchase Agreement, dated as of October 29, 2003, by and among UAP Holding Corp., ConAgra Foods, Inc. and United Agri Products, Inc. (incorporated by reference to Exhibit 2.1 to United Agri Products, Inc. s Registration Statement on Form S-4 dated January 5, 2004 (File No. 333-111710)). 2.2 Amendment No. 1, dated as of November 23, 2003, to the Stock Purchase Agreement, dated as of October 29, 2003, by and among UAP Holding Corp., ConAgra Foods, Inc. and United Agri Products, Inc. (incorporated by reference to Exhibit 2.2 to United Agri Products, Inc. s Registration Statement on Form S-4 dated January 5, 2004 (File No. 333-111710)). 3.1 Certificate of Incorporation of UAP Holding Corp. dated as of October 28, 2003 (incorporated by reference to Exhibit 3.1 to UAP Holding Corp. s Registration Statement on Form S-4 dated March 5, 2004 (File No. 333-113345)). 3.2 Certificate of Amendment dated November 24, 2003 to the Certificate of Incorporation of UAP Holding Corp. (incorporated by reference to Exhibit 3.2 to UAP Holding Corp. s Registration Statement on Form S-4 dated March 5, 2004 (File No. 333-113345)). 3.3 Certificate of Designation, Preferences and Rights of Series A Redeemable Preferred Stock dated November 24, 2003 (incorporated by reference to Exhibit 3.3 to UAP Holding Corp. s Registration Statement on Form S-4 dated March 5, 2004 (File No. 333-113345)). 3.4 Bylaws of UAP Holding Corp. as adopted on October 29, 2003 (incorporated by reference to Exhibit 3.4 to UAP Holding Corp. s Registration Statement on Form S-4 dated March 5, 2004 (File No. 333-113345)). 3.5 Amended and Restated Certificate of Incorporation of UAP Holding Corp. filed with the Secretary of State of the State of Delaware on November 17, 2004. 3.6 Form of Certificate of Elimination of Series A Redeemable Preferred Stock. 3.7 Form of Amended and Restated Bylaws of UAP Holding Corp. 4.1 Credit Agreement dated as of November 24, 2003, by and among United Agri Products, Inc. and United Agri Products Canada Inc., as borrowers, the other credit parties thereto, the lenders party thereto, General Electric Capital Corporation, as agent and GE Canada Finance Company, as Canadian agent (incorporated by reference to Exhibit 4.1 to United Agri Products, Inc. s Registration Statement on Form S-4 dated January 5, 2004 (File No. 333-111710)). 4.2 First Amendment to Credit Agreement dated as of December 9, 2003, by and among United Agri Products, Inc. and United Agri Products Canada Inc., as borrowers, the other credit parties thereto, the lenders party thereto, General Electric Capital Corporation, as agent and GE Canada Finance Company, as Canadian agent (incorporated by reference to Exhibit 4.2 to United Agri Products, Inc. s Registration Statement on Form S-4 dated January 5, 2004 (File No. 333-111710)). II-3 Table of Contents Exhibit Number Exhibit 4.3 Second Amendment to Credit Agreement dated as of December 18, 2003, by and among United Agri Products, Inc. and United Agri Products Canada Inc., as borrowers, the other credit parties thereto, the lenders party thereto, General Electric Capital Corporation, as agent and GE Canada Finance Company, as Canadian agent (incorporated by reference to Exhibit 4.3 to United Agri Products, Inc. s Registration Statement on Form S-4 dated January 5, 2004 (File No. 333-111710)). 4.4 Third Amendment to Credit Agreement dated as of January 15, 2004, by and among United Agri Products, Inc. and United Agri Products Canada, Inc., as borrowers, the other credit parties thereto, the lenders party thereto, General Electric Capital Corporation, as agent and GE Canada Finance Company, as Canadian agent (incorporated by reference to Exhibit 4.4 to UAP Holding Corp. s Registration Statement on Form S-4 dated March 5, 2004 (File No. 333-113345)). 4.5 Form of Amended and Restated Credit Agreement by and among United Agri Products, Inc. and United Agri Products Canada, Inc., as borrowers, the other credit parties thereto, the lenders party thereto, General Electric Capital Corporation, as agent and GE Canada Finance Company, as Canadian agent. 4.6 Indenture dated as of January 26, 2004 between UAP Holding Corp. and JPMorgan Chase Bank, as trustee (incorporated by reference to Exhibit 4.5 to UAP Holding Corp. s Registration Statement on Form S-4 dated March 5, 2004 (File No. 333-113345)). 4.7 Registration Rights Agreement, dated as of January 26, 2004, by and among UAP Holding Corp. and UBS Securities LLC, Goldman, Sachs & Co. and Bear, Stearns & Co. Inc. (incorporated by reference to Exhibit 4.7 to UAP Holding Corp. s Registration Statement on Form S-4 dated March 5, 2004 (File No. 333-113345)). 4.8 Indenture dated as of December 16, 2003, among United Agri Products, Inc., the Guarantors named therein and JPMorgan Chase Bank, as trustee (incorporated by reference to Exhibit 4.4 to United Agri Products, Inc. s Registration Statement on Form S-4 dated January 5, 2004 (File No. 333-111710)). 4.9 Registration Rights Agreement, dated as of December 16, 2003, by and among United Agri Products, Inc., the guarantors listed on the signature pages attached thereto, and UBS Securities LLC, Goldman, Sachs & Co. and Bear, Stearns & Co. Inc. (incorporated by reference to Exhibit 4.6 to United Agri Products, Inc. s Registration Statement on Form S-4 dated January 5, 2004 (File No. 333-111710)). 4.10 Form of stock certificate for Common Stock. 5.1 Opinion of O Melveny & Myers LLP. 10.1 Transition Services Agreement, dated as of November 24, 2003, by and between ConAgra Foods, Inc., UAP Holding Corp., United Agri Products, Inc. and each other company listed on the signature pages thereto (incorporated by reference to Exhibit 10.1 to United Agri Products, Inc. s Registration Statement on Form S-4 dated January 5, 2004 (File No. 333-111710)). 10.2 Seller Transition Services Agreement, dated as of November 24, 2003, by and between ConAgra Foods, Inc., UAP Holding Corp., United Agri Products, Inc. and each other company listed on the signature pages thereto (incorporated by reference to Exhibit 10.2 to United Agri Products, Inc. s Registration Statement on Form S-4 dated January 5, 2004 (File No. 333-111710)). II-4 Table of Contents Exhibit Number Exhibit 10.3 Indemnification Agreement, dated as of November 24, 2003, by and among ConAgra Foods, Inc., United Agri Products, Inc., United Agri Products Canada Inc., 2326396 Canada, Inc., AG-Chem, Inc., Balcom Chemicals, Inc., UAP 23, Inc., Cropmate Company, CSK Enterprises, Inc., GAC 26, Inc., UAP 27, Inc., Genmarks, Inc., Grower Service Corporation (New York), HACO, Inc., Loveland Industries, Inc., Loveland Products, Inc., Midwest Agriculture Warehouse Co., Ostlund Chemical Co., Platte Chemical Co., Pueblo Chemical & Supply Co., Ravan Products, Inc., S.E. Enterprises, Inc., Snake River Chemicals, Inc., Transbas, Inc., Tri-River Chemical Company, Inc., Tri-State Chemicals, Inc., Tri-State Delta Chemicals, Inc., UAP/GA AG Chem, Inc., UAPLP, Inc., UAP 22, Inc., UAP Receivables Corporation, United Agri Products Florida, Inc., United Agri Products Financial Services, Inc., Verdicon and YVC, Inc. (incorporated by reference to Exhibit 10.3 to United Agri Products, Inc. s Registration Statement on Form S-4 dated January 5, 2004 (File No. 333-111710)). 10.4 Fertilizer Supply Agreement, dated as of November 24, 2003, between ConAgra International Fertilizer Company and United Agri Products, Inc. (incorporated by reference to Exhibit 10.4 to United Agri Products, Inc. s Registration Statement on Form S-4 dated January 5, 2004 (File No. 333-111710)). 10.5 International Supply Agreement, dated as of November 24, 2003, between United Agri Products, Inc. and ConAgra Foods, Inc. (incorporated by reference to Exhibit 10.5 to United Agri Products, Inc. s Registration Statement on Form S-4 dated January 5, 2004 (File No. 333-111710)). 10.6 Buyer Release Agreement, dated as of November 24, 2003, between ConAgra Foods, Inc. and the Acquired Companies (as defined therein) (incorporated by reference to Exhibit 10.6 to United Agri Products, Inc. s Registration Statement on Form S-4 dated January 5, 2004 (File No. 333-111710)). 10.7 Seller Release Agreement, dated as of November 24, 2003, between ConAgra Foods, Inc. and UAP Holding Corp. (incorporated by reference to Exhibit 10.7 to United Agri Products, Inc. s Registration Statement on Form S-4 dated January 5, 2004 (File No. 333-111710)). 10.8 2003 Stock Option Plan of UAP Holding Corp. (incorporated by reference to Exhibit 10.8 to United Agri Products, Inc. s Registration Statement on Form S-4 dated January 5, 2004 (File No. 333-111710)). 10.9 Retention Agreement, dated as of November 18, 2003 between UAP Holding Corp. and Bryan S. Wilson (incorporated by reference to Exhibit 10.9 to United Agri Products, Inc. s Registration Statement on Form S-4 dated January 5, 2004 (File No. 333-111710)). 10.10 Retention Agreement, dated as of November 18, 2003 between UAP Holding Corp. and David W. Bullock (incorporated by reference to Exhibit 10.10 to United Agri Products, Inc. s Registration Statement on Form S-4 dated January 5, 2004 (File No. 333-111710)). 10.11 Retention Agreement, dated as of November 18, 2003 between UAP Holding Corp. and L. Kenneth Cordell (incorporated by reference to Exhibit 10.11 to United Agri Products, Inc. s Registration Statement on Form S-4 dated January 5, 2004 (File No. 333-111710)). 10.12 Retention Agreement, dated as of November 19, 2003, between UAP Holding Corp. and Dave Tretter (incorporated by reference to Exhibit 10.12 to United Agri Products, Inc. s Registration Statement on Form S-4 dated January 5, 2004 (File No. 333-111710)). 10.13 Retention Agreement, dated as of November 19, 2003 between UAP Holding Corp. and Robert A. Boyce, Jr. (incorporated by reference to Exhibit 10.13 to United Agri Products, Inc. s Registration Statement on Form S-4 dated January 5, 2004 (File No. 333-111710)). 10.14 Investor Rights Agreement, dated as of the Original Issue Date among UAP Holding Corp. and the Holders party thereto (incorporated by reference to Exhibit 10.14 to UAP Holding Corp. s Registration Statement on Form S-4 dated March 5, 2004 (File No. 333-113345)). II-5 Table of Contents Exhibit Number Exhibit 10.15 Registration Rights Agreement, dated as of November 24, 2003, between UAP Holding Corp. and the Apollo Investors (incorporated by reference to Exhibit 10.15 to UAP Holding Corp. s Registration Statement on Form S-4 dated March 5, 2004 (File No. 333-113345)). 10.16 Management Consulting Agreement, dated as of November 21, 2003, between United Agri Products, Inc. (as successor by merger to UAP Acquisition Corp.) and Apollo Management V, L.P.* 10.17 2003 Deferred Compensation Plan of UAP Holding Corp. (incorporated by reference to Exhibit 10.17 to UAP Holding Corp. s Registration Statement on Form S-4 dated March 5, 2004 (File No. 333-113345)). 10.18 2004 Deferred Compensation Plan of UAP Holding Corp.* 10.19 2004 Non-Executive Director Stock Option Plan of UAP Holding Corp.* 10.20 Form of Management Incentive Agreement. 10.21 Form of Letter Agreement regarding termination of Management Consulting Agreement between United Agri Products, Inc. and Apollo Management V, L.P.* 10.22 Form of 2004 Long-Term Incentive Plan. 21.1 Subsidiaries of UAP Holding Corp.* 23.1 Consent of Deloitte & Touche LLP. 23.2 Consent of O Melveny & Myers LLP (included in Exhibit 5.1). 24.1 Powers of Attorney (included on signature pages to original registration statement).* * Previously filed. (b) Financial Statement Schedules Schedule I Condensed Financial Information of Registrant Schedule II Valuation and Qualifying Accounts All other schedules have been omitted because they are either not applicable or the required information has been disclosed in the financial statements or notes hereto. Item 17. Undertakings 1. The undersigned registrant hereby undertakes to provide to the underwriters at the closing specified in the underwriting agreement certificates in such denominations and registered in such names as required by the underwriters to permit prompt delivery to each purchaser. 2. Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers, and controlling persons of the registrant pursuant to the foregoing provisions, or otherwise, the registrant has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Securities Act of 1933 and is therefore unenforceable. In the event that a claim for indemnification by the registrant against such liabilities, other than the payment by the registrant of expenses incurred or paid by a director, officer or controlling person of the registrant in the successful defense of any action, suit or proceeding, is asserted by such director, officer or controlling person in connection with the securities being registered, the registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Act and will be governed by the final adjudication of such issue. II-6 Table of Contents 3. The undersigned registrant hereby undertakes that: (1) For purposes of determining any liability under the Securities Act of 1933, the information omitted from the form of prospectus filed as part of this registration statement in reliance upon Rule 430A and contained in a form of prospectus filed by the registrant pursuant to Rule 424(b)(1) or (4) or 497(h) under the Securities Act of 1933 shall be deemed to be part of this registration statement as of the time it was declared effective. (2) For the purpose of determining any liability under the Securities Act of 1933, each post-effective amendment that contains a form of prospectus shall be deemed to be a new registration statement relating to the securities offered therein, and the offering of such securities at that time shall be deemed to be the initial bona fide offering thereof. II-7 Table of Contents SIGNATURES Pursuant to the requirements of the Securities Act of 1933, the Registrant has duly caused this Amendment No. 6 to the Registration Statement to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Greeley, State of Colorado, on the 18th day of November, 2004. UAP HOLDING CORP. By: /S/ L. KENNY CORDELL L. Kenny Cordell President, Chief Executive Officer and Director Pursuant to the requirements of the Securities Act of 1933, this Amendment No. 6 to the Registration Statement has been signed by the following persons in the capacities and on the dates indicated: Signature Title Date /S/ L. KENNY CORDELL L. Kenny Cordell President, Chief Executive Officer and Director (Principal Executive Officer) November 18, 2004 /S/ DAVID W. BULLOCK David W. Bullock Executive Vice President and Chief Financial Officer (Principal Financial and Accounting Officer) November 18, 2004 * Joshua J. Harris Director November 18, 2004 * Robert Katz Director November 18, 2004 * Marc E. Becker Director November 18, 2004 * Stan Parker Director November 18, 2004 * Carl J. Rickertsen Director November 18, 2004 * Thomas Miklich Director November 18, 2004 *By: /S/ DAVID W. BULLOCK David W. Bullock Attorney-in-fact II-8 Table of Contents Schedule I UAP HOLDING CORP. CONDENSED FINANCIAL INFORMATION OF REGISTRANT The UAP Holding Corp. structure was effected through the capitalization of the Company in connection with the acquisition of the ConAgra Agricultural Products Business on November 24, 2003. The Company has no significant operations other than certain corporate and other administrative functions. The notes to the consolidated financial statements are an integral part of these condensed financial statements and should be read in connection with these financial statements. UAP HOLDING CORP. CONDENSED FINANCIAL INFORMATION OF PARENT COMPANY BALANCE SHEET February 22, 2004 UAP Holding Corp. ASSETS Current assets: Cash and cash equivalents $ 662 Receivables, net Inventories Deferred income taxes Other current assets Property, plant and equipment, net Goodwill Intangible assets, net Deferred income taxes Investment in subsidiaries 190,791 Other assets 4,250 $ 195,703 Total current liabilities 725 Long-term debt 83,570 Series A redeemable preferred stock 34,620 Deferred income taxes Commitments and contingencies Stockholders Equity: Common stock $.001 par value, 90,000,000 shares authorized, 46,902,351 shares issued and outstanding 47 Additional paid-in capital 67,093 Retained earnings 9,653 Accumulated other comprehensive loss (5 ) Total Stockholders Equity 76,788 $ 195,703 Table of Contents Schedule I UAP HOLDING CORP. CONDENSED FINANCIAL INFORMATION OF PARENT COMPANY STATEMENTS OF EARNINGS Thirteen Weeks Ended February 22, 2004 UAP Holding Corp. (Loss) from continuing operations before income taxes (1,805 ) Income tax (benefit) (667 ) Income (loss) from continuing operations (1,138 ) Equity in earnings of affiliates 10,791 Net income $ 9,653 Table of Contents Schedule I UAP HOLDING CORP. CONDENSED FINANCIAL INFORMATION OF PARENT COMPANY STATEMENT OF CASH FLOWS Thirteen Weeks Ended February 22, 2004 UAP Holding Corp. Cash flows from investing activities: Additions to property, plant and equipment Proceeds from sale of assets Acquisition of ConAgra Agricultural Products Business (120,000 ) Net cash flows from investing activities (120,000 ) Cash flows from financing activities: Net investment Proceeds from issuance of long-term debt 82,500 Debt issuance costs (4,260 ) Issuance of common stock 120,000 Dividends to stockholders (52,860 ) Redemption of Series A redeemable preferred stock (25,380 ) Net cash flows from financing activities 120,000 Table of Contents Schedule II UAP HOLDING CORP. VALUATION AND QUALIFYING ACCOUNTS For the Fiscal Years Ended February 24, 2002 and February 23, 2003, the Thirty-Nine Weeks Ended November 23, 2003 and the Thirteen Weeks Ended February 22, 2004 (in thousands) Description Balance at Beginning of Period Charged to Income Deductions from Reserves Balance at Close of Period ConAgra Agricultural Products Business: Year ended February 24, 2002 Allowance for doubtful receivables 35,048 55,369 56,893(1) 33,524 Year ended February 23, 2003 Allowance for doubtful receivables 33,524 (293) (1,463)(1) 34,694 Thirty-nine weeks ended November 23, 2003 Allowance for doubtful accounts 34,694 14,093 2,869(1) 45,918 UAP Holding Corp.: Thirteen weeks ended February 22, 2004 Allowance for doubtful accounts 45,918 (12,710) 5,880(1) 27,328 Table of Contents EXHIBIT INDEX Exhibit Number Exhibit Table of Contents Exhibit Number Exhibit Table of Contents Exhibit Number Exhibit Table of Contents Exhibit Number Exhibit 10.21 Form of Letter Agreement regarding termination of Management Consulting Agreement between United Agri Products, Inc. and Apollo Management V, L.P.* 10.22 Form of 2004 Long-Term Incentive Plan. 21.1 Subsidiaries of UAP Holding Corp.* 23.1 Consent of Deloitte & Touche LLP. 23.2 Consent of O Melveny & Myers LLP (included in Exhibit 5.1). 24.1 Powers of Attorney (included on signature pages to original registration statement).* MANAGEMENT 62 PRINCIPAL AND SELLING STOCKHOLDERS 72 CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS 76 DESCRIPTION OF CERTAIN INDEBTEDNESS 87 DESCRIPTION OF CAPITAL STOCK 96 SHARES ELIGIBLE FOR FUTURE SALE 102 MATERIAL U.S. FEDERAL INCOME TAX CONSEQUENCES 104 UNDERWRITING 107 NOTICE TO CANADIAN RESIDENTS 111 LEGAL MATTERS 112 EXPERTS 112 WHERE YOU CAN FIND MORE INFORMATION 112 INDEX TO FINANCIAL STATEMENTS Report of Independent Registered Public Accounting Firm F-2 Audited Financial Statements: Balance Sheets at February 22, 2004 (Successor) and February 23, 2003 (Predecessor) F-3 Statements of Earnings for the thirteen-week period ended February 22, 2004 (Successor), thirty-nine week period ended November 23, 2003 (Predecessor), and the fiscal years ended February 23, 2003 and February 24, 2002 (Predecessor) F-4 Statement of Stockholders Equity for the thirteen-week period ended February 22, 2004 (Successor), and Statements of Stockholder s Net Investment and Advances for the thirty-nine week period ended November 23, 2003 (Predecessor), and the fiscal years ended February 23, 2003 and February 24, 2002 (Predecessor) F-5 Statements of Cash Flows for the thirteen-week period ended February 22, 2004 (Successor), thirty-nine week period ended November 23, 2003 (Predecessor), and the fiscal years ended February 23, 2003 and February 24, 2002 (Predecessor) F-6 Notes to Financial Statements F-7 Unaudited Financial Statements: Unaudited Condensed Consolidated Balance Sheets as of August 29, 2004 (Successor), February 22, 2004 (Successor) and August 24, 2003 (Predecessor) F-21 Unaudited Condensed Consolidated Statements of Earnings for the twenty-seven week period ended August 29, 2004 (Successor) and the twenty-six week period ended August 24, 2003 (Predecessor) F-22 Unaudited Condensed Consolidated Statements of Cash Flows for the fourteen-week period ended August 29, 2004 (Successor) and the twenty-six week period ended August 24, 2003 (Predecessor) F-23 Notes to Unaudited Condensed Consolidated Financial Statements F-24 Table of Contents REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Stockholders and Board of Directors UAP Holding Corp. We have audited the accompanying consolidated balance sheet of UAP Holding Corp. (Successor) (the Company ), as of February 22, 2004, and the related consolidated statements of earnings, stockholders equity and cash flows for the thirteen weeks ended February 22, 2004. We have also audited the accompanying combined balance sheet of ConAgra Agricultural Products Business (a division of ConAgra Foods, Inc.) (the Predecessor ), as of February 23, 2003, and the related combined statements of earnings, of stockholder s net investment and advances and of cash flows for the thirty-nine weeks ended November 23, 2003 and the fiscal years ended February 23, 2003 and February 24, 2002. The combined financial statements include the accounts of the companies disclosed in Note 8, which are under common ownership and management. Our audits also included the financial statement schedules included in Item 16. These financial statements and the financial statement schedules are the responsibility of the company s management. Our responsibility is to express an opinion on the financial statements and the financial statement schedules based on our audits. We conducted our audits in accordance with standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such financial statements present fairly, in all material respects, the consolidated financial position of UAP Holding Corp. as of February 22, 2004, and the consolidated results of its operations and its consolidated cash flows for the thirteen weeks ended February 22, 2004, the combined financial position of ConAgra Agricultural Products Business as of February 23, 2003, and the combined results of its operations and its combined cash flows for the thirty-nine weeks ended November 23, 2003 and the fiscal years ended February 23, 2003 and February 24, 2002 in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedules, when considered in relation to the basic combined financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note 1 to the financial statements, in 2003 the company changed its method of accounting for goodwill and other intangible assets. /s/ Deloitte & Touche LLP Omaha, Nebraska May 13, 2004 (November 17, 2004 as to Note 15) The accompanying notes are an integral part of the financial statements. Basic and diluted earnings per share $ 0.21 Weighted average shares outstanding 46,902,351 The accompanying notes are an integral part of the financial statements. The accompanying notes are an integral part of the financial statements. The accompanying notes are an integral part of the financial statements. Table of Contents UAP HOLDING CORP. NOTES TO FINANCIAL STATEMENTS (Continued) Fiscal Years Ended February 22, 2004, February 23, 2003 and February 24, 2002 columnar dollar amounts in thousands The company has allocated the excess of the acquisition cost over the fair value of the assets acquired and liabilities assumed to goodwill, trade names and other finite lived intangible assets based on an independent third-party appraiser. The amount of other finite and indefinite lived intangible assets recognized in this acquisition were $7.5 million. The finite lived intangible assets, including trade names and customer lists, are being amortized over five years based on the estimated remaining useful lives of the intangible assets. Amortization expense for the Company was $0.4 million for the thirteen weeks ended February 22, 2004. Goodwill recognized in this transaction is $43.5 million and is not deductible for tax purposes. 2. Basis of Presentation and Accounting Policies Basis of presentation The acquisition has been accounted for as a purchase business combination in accordance with Statement of Financial Accounting Standards No. 141, Business Combinations. Accounting principles generally accepted in the United States of America require the Company s operating results prior to the Acquisition to be reported as the results of the Predecessor for periods prior to November 24, 2003 in the historical financial statements. UAP Holding Corp s operating results subsequent to the Acquisition are presented as the Successor s results in the historical financial statements. The Successor financial results are presented as of February 22, 2004 and the thirteen-week period ended February 22, 2004. The Predecessor financial results are presented as of February 23, 2003 and the fiscal periods ended February 24, 2002, February 23, 2003 and the thirty-nine weeks ended November 23, 2003. The results of operations for any thirteen or thirty-nine week period or for the periods presented for the Predecessor or Successor are not necessarily indicative of the results to be expected for other periods or the full fiscal year. Inventories Inventories consist primarily of chemicals, fertilizers and seed. The company principally uses the lower of cost, determined using the first-in, first-out method or market to value its inventory. Vendor Rebates Receivables include vendor rebates which represent amounts due from suppliers on crop protection, seed and fertilizer products and are accrued when earned, which is typically at the time of the sale of the related product. Long Lived Assets and Intangible Assets Property, plant and equipment are carried at cost. Depreciation has been calculated using primarily the straight-line method over the estimated useful lives of the respective classes of assets as follows: Land improvements 1 - 40 years Buildings 15 - 40 years Machinery and equipment 3 - 20 years Furniture, fixtures, office equipment and other 5 - 15 years The company reviews long-lived assets for impairment whenever events or changes in business circumstances indicate that the carrying amount of the assets may not be fully recoverable. Recoverability of an asset held-for-use is determined by comparing the carrying amount of the asset to the undiscounted net cash flows expected to be generated from the use of the asset. If the carrying amount is greater than the undiscounted Table of Contents UAP HOLDING CORP. NOTES TO FINANCIAL STATEMENTS (Continued) Fiscal Years Ended February 22, 2004, February 23, 2003 and February 24, 2002 columnar dollar amounts in thousands Stock-Based Compensation Deferred Compensation Plan Certain members of management participate in the Company s 2003 Deferred Compensation Plan. Such plan allowed participants to receive shares of the Company s common stock at a price equal to approximately $2.56 per share, the fair value of the stock on the date of acquisition. Each participant s equity is held in a rabbi trust and is accounted for in accordance with EITF 97-14, Accounting for Deferred Compensation Arrangements Where Amounts Are Held in a Rabbi Trust and Invested. In accordance with the provisions of the rabbi trust, the rabbi trust can only hold investments in the Company s common stock and all participants accounts must be settled in the Company s common stock; accordingly, the Company s common stock held in the rabbi trust is accounted for a component of equity. The rabbi trust held 2,169,229 shares of the Company s common stock as of February 22, 2004. Foreign Currency Translation The translation of foreign currency into U.S. dollars is performed for balance sheet accounts using the current exchange rate in effect at the balance sheet date and for revenue and expense accounts using the average exchange rate during the period. The gains or losses resulting from translation are included in stockholder s net investment and advances. Exchange adjustments resulting from foreign currency transactions, which were not material in any of the years presented, are generally recognized in earnings. Comprehensive Income Comprehensive income consists of net income and foreign currency translation adjustments. The company deems its foreign investments to be permanent in nature and does not provide for taxes on currency translation adjustments arising from converting the investment in a foreign currency to U.S. dollars. There are no reclassification adjustments to be reported in periods presented. Accounting Changes During the fourth quarter of fiscal 2003, the company adopted Financial Accounting Standards Board Interpretation ( FIN ) No. 45, Guarantor s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. FIN No. 45 clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing certain guarantees. The recognition provisions of FIN No. 45 are applicable to guarantees issued or modified after December 31, 2002. FIN No. 45 also elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. The impact of adoption was not material to the combined financial statements. In June 2001, the FASB approved the issuance of SFAS No. 141, Business Combinations, and SFAS No. 142, Goodwill and Other Intangible Assets. These standards, issued in July 2001, establish accounting and reporting requirements for business combinations. SFAS No. 141 requires all business combinations entered into subsequent to June 30, 2001, to be accounted for using the purchase method of accounting. SFAS No. 142 provides that goodwill and other intangible assets with indefinite lives will not be amortized, but will be tested for impairment on an annual basis. The company adopted SFAS No. 142 at the beginning of fiscal 2003. For further discussion on the company s adoption of SFAS No. 142, see Note 3 to the combined financial statements. Recently Issued Accounting Pronouncements In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. SFAS No. 150 establishes standards for classification and measurement in the balance sheets for certain financial instruments which possess characteristics of both a liability and equity. Generally, it requires classification of such financial instruments as a liability. SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003. For financial instruments in existence prior to May 31, 2003, SFAS No. 150 is effective the beginning of the company s fiscal 2005. The company does not believe the adoption of SFAS No. 150 will have an impact on the company s financial statements. Non-amortizing intangible assets are comprised of a company brand. Amortizing intangible assets, carrying a weighted average life of approximately 6 years, are principally comprised of a product development agreement. The company recognized amortization expense of $2.8 million, $2.3 million, $1.7 million and $0.4 million in fiscal 2002, 2003, the thirty-nine weeks ended November 23, 2003 and the thirteen weeks ended February 22, 2004, respectively. Based on amortizing assets recognized in the company s balance sheet as of February 22, 2004, amortization expense is estimated to approximate $1.5 million for each of the next five years. 6. Related Party Transactions Prior to the Acquisition, ConAgra Food s executive, finance, tax and other corporate departments perform certain administrative and other services for the company. Expenses incurred by ConAgra Foods and allocated to the company are determined based on specific services being provided or are allocated based on ConAgra Food s investment in the company in proportion to ConAgra Food s total investment in its subsidiaries. In addition, ConAgra Foods charges the company finance charges on ConAgra Food s investment in the company and net intercompany advances. Management believes that such expense allocations are reasonable. It is not practical to estimate the expenses that would have been incurred by the company if it had been operated on a stand-alone In connection with the Acquisition, United Agri Products entered into the existing five-year $500.0 million asset-based revolving credit facility. The existing revolving credit facility also provides for a $20.0 million revolving credit sub-facility for UAP Canada, a $50.0 million letter of credit sub-facility, a $25.0 million swingline loan sub-facility and a $25.0 million in-season over-advance sub-facility. The interest rates with respect to revolving loans under the existing revolving credit facility are based, at our option, on either the agent s index rate plus an applicable index margin of 1.50% or upon LIBOR plus an applicable LIBOR margin of 2.75%. The interest rates with respect to in-season over-advances under the existing revolving credit facility are based, at our option, on either the agent s index rate plus an applicable index margin of 2.75% or upon LIBOR plus an applicable LIBOR margin of 4.00%. These applicable margins are in each case subject to prospective reduction on a quarterly basis (other than the margins on in-season over-advances) if we reduce our ratio of funded debt to EBITDA (on a consolidated basis). Overdue principal, interest and other amounts will bear interest at a rate per annum equal to the rate otherwise applicable thereto plus an additional 2.0%. The obligations Table of Contents UAP HOLDING CORP. NOTES TO FINANCIAL STATEMENTS (Continued) Fiscal Years Ended February 22, 2004, February 23, 2003 and February 24, 2002 columnar dollar amounts in thousands under the existing revolving credit facility are (or, in the case of future subsidiaries, will be) guaranteed by UAP Holdings and each of its existing and future direct and indirect U.S. subsidiaries. The obligations under the existing revolving credit facility are secured by a first priority lien on, or security interest in, subject to certain exceptions, substantially all of UAP Holdings , United Agri Products and UAP Canada s properties and assets and the properties and assets of each of the guarantors. The existing revolving credit facility contains customary representations, warranties and covenants and events of default. The company s credit agreements include a minimum EBITDA requirement of $70.0 million as measured on a twelve month rolling period. The company is also required to maintain a Fixed Charge Coverage Ratio of not less than 1.1 to 1.0, measured on the last day of each month for the trailing twelve months then ended. The credit agreements also contain certain negative covenants which may restrict the company s ability to, among other items, incur new indebtedness, engage in new business ventures, or complete significant acquisitions or divestitures. On April 26, 2004, United Agri Products commenced a tender offer and consent solicitation with respect to all its outstanding $225.0 million aggregate principal amount of 8 % Senior Notes. Upon receipt of the requisite consents, the company will execute a supplemental indenture with respect to the 8 % Senior Notes, with effectiveness subject to the consummation of the Tender Offers. In addition, on April 26, 2004, UAP Holdings commenced a tender offer and consent solicitation with respect to all of its outstanding $125.0 million aggregate principal amount at maturity of 10 % Senior Discount Notes. Upon receipt of the requisite consents, the company will execute a supplemental indenture with respect to the 10 % Senior Discount Notes, with effectiveness subject to the consummation of the Tender Offers. Net interest paid was $5.0 million and $1.6 million in fiscal 2002 and 2003, respectively. Net interest paid was $0.3 million and $.9 million for the thirty-nine week period ended November 23, 2003 and the thirteen-week period ended February 22, 2004, respectively. Interest expense is presented net of finance charge income of $3.4 million for the thirteen-week period ended February 22, 2004. Based on current market rates primarily provided by outside investment bankers, the fair value of this debt at February 22, 2004 was estimated at $332.6 million. United Agri Products, Inc. $ 1.00 1,000 1,000 AG-CHEM, INC. $ 1.00 100,000 1,000 Balcom Chemicals, Inc. $ 1.00 500,000 97,756 CAG 23, Inc. $ 1.00 10,000 1,000 Cropmate Company $ 1.00 10,000 1,000 CSK Enterprises, Inc. $ 1.00 10,000 1,000 GAC 26, Inc. $ 1.00 10,000 1,000 CAG 27, Inc. $ 1.00 1,000 1,000 Genmarks, Inc. $ 1.00 1,000 1,000 Grower Service Corporation (NY) None 1,000 700 HACCO, Inc. $ 1.00 56,000 1,000 HACO, Inc. $ 1.00 10,000 1,000 Hess & Clark, Inc. $ 1.00 750 500 Loveland Industries, Inc. $ 1.00 250,000 81,372 Loveland Products, Inc. (f/k/a Dartec, Inc.) $ 1.00 10,000 1,000 Midwest Agriculture Warehouse Co. $ 100.00 2,000 1,491 Ostlund Chemical Co. $ 1.00 200,000 40,000 Platte Chemical Co. $ 1.00 100,000 80,000 Pueblo Chemical & Supply Co. None 49,000 2,139 Ravan Products, Inc. $ 1.00 10,000 100 S.E. Enterprises, Inc. $ 1.00 10,000 1,000 Snake River Chemicals, Inc. None 100,000 31,010 Transbas, Inc. None 1,000 500 Tri-River Chemical Company, Inc. None 50,000 40,069 Tri-State Chemicals, Inc. None 100,000 11,242 Tri-State Delta Chemicals, Inc. $ 1.00 100,000 100,000 UAP Receivables Corporation $ 1.00 1,000 1,000 UAP/CAG 22, Inc. $ 1.00 1,000 1,000 UAP/GA AG CHEM, INC. $ 1.00 1,000 1 UAP/LP, Inc. $ 1.00 10,000 1,000 United Agri Products - Florida, Inc. $ 1.00 10,000 5,000 United Agri Products Financial Services, Inc. None 50,000 16,451 Verdicon, Inc. $ 1.00 1,000 1,000 YVC, Inc. None 100,000 16,230 2326396 Canada, Inc. (f/k/a Swift Meats Poultry & Feed Co. Ltd) None Unlimited 1 The company had letters of credit outstanding at February 22, 2004 of $27.8 million. The company is a party to a number of lawsuits and claims arising out of the operation of its businesses. After taking into account liabilities recorded management believes the ultimate resolution of such matters should not have a material adverse effect on the company s financial condition, results of operations or liquidity. 11. Employee Benefit Plans Successor Plans The Company assumed the plan assets and obligations of the UAP Canadian pension plan as reported under the Predecessor Entity. As part of the acquisition, benefits due to employees who participated in the ConAgra Foods Pension Plan have been frozen as of the date of the acquisition. Components of the Canadian pension plan are reported below. In addition, the Company has a defined contribution plan for all employees. The Company will match 67% of the each employee s first 6% contribution to the plan. In addition, the Company will make a contribution to the plan for each employee equal to 2% of their calendar year pay. At the Company s option, an additional 1% contribution may be made equally as a percentage of calendar-year payroll to each participant of the plan based on established Company profitability objectives. As part of the acquisition, a transition contribution will be made on an annual basis for five years to all employees over the age of 50 as of the acquisition date. Total contribution expense for the plan for the thirteen weeks ended February 22, 2004 is $0.7 million. Predecessor Retirement Pension Plans The Predecessor Entity had defined benefit retirement plans ( Plan ) for eligible salaried and hourly employees. Benefits are based on years of credited service and average compensation or stated amounts for each year of service. The Predecessor Entity funded these plans in accordance with the minimum and maximum limits established by law. Employees of the company also participate in defined benefit and defined contribution plans sponsored by ConAgra Foods. Actuarial Assumptions Discount rate 6.50 % 6.50 % Long-term rate of compensation increase 4.50 % 4.50 % No single customer accounted for more than 10% of net sales in 2002, 2003, the thirty-nine weeks ended November 23, 2003 or the thirteen weeks ended February 22, 2004. Net sales by geographical area are based on the location of the facility producing the sales. Long-lived assets consist of property, plant and equipment, net of depreciation and other assets. Long-lived assets by geographical area are based on location of facilities. 15. Subsequent Event In connection with a proposed public offering of the Company s common stock during fiscal 2005, on November 17, 2004 the Board of Directors approved a stock split of approximately 39.085-for-1 stock split of the Company s common stock. All share, per share and conversion amounts related to common stock and stock options included in the accompanying consolidated financial statements and footnotes have been restated to reflect the stock split for all periods presented. The accompanying notes are an integral part of the condensed consolidated and combined financial statements. Basic and diluted earnings per share $ 1.00 Weighted average shares outstanding 47,248,244 The accompanying notes are an integral part of the condensed consolidated and combined financial statements. The accompanying notes are an integral part of the condensed consolidated and combined financial statements. The Company has allocated the excess of the Acquisition cost over the fair value of the assets acquired and liabilities assumed to goodwill, trade names and other finite lived intangible assets, and has hired an independent third-party appraiser to assist with the determination of fair value. The amount of other finite and indefinite lived intangible assets recognized in the Acquisition were $6.7 million. The finite lived intangible assets, including trade names and customer lists, are being amortized over five years based on the estimated remaining useful lives of the intangible assets. Amortization expense for the Company was $0.2 million for the twenty-seven weeks ended August 29, 2004. 2. Basis of Presentation and Accounting Policies Basis of presentation The Acquisition has been accounted for as a purchase business combination in accordance with Statement of Financial Accounting Standards ( SFAS ) No. 141, Business Combinations. Accounting principles generally accepted in the United States of America require the Company s operating results prior to the Acquisition to be reported as the results of the Predecessor for periods prior to November 24, 2003 in the historical financial statements. The Company s operating results subsequent to the Acquisition are presented as the successor s results in the historical financial statements. The Successor s financial results are presented as of and for the twenty-seven week period ended August 29, 2004 and as of the fiscal year ended February 22, 2004. The Predecessor s financial results are presented as of the twenty-six week period ended August 24, 2003. The unaudited consolidated financial statements include the accounts of all the Company s wholly-owned subsidiaries and reflect all adjustments (all of which are normal recurring accruals) which are, in the opinion of Stock-Based Compensation Successor Stock Plan The options issued under this plan have been valued as of the date of grant using the minimum value method and had no fair value at the date of grant. Stock-Based Compensation Deferred Compensation Plan Certain members of management participate in the Company s 2003 and 2004 Deferred Compensation Plans. Such plans have allowed the participants to Table of Contents UAP HOLDING CORP. NOTES TO CONDENSED CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS (Continued) For the Twenty-Seven Weeks Ended August 29, 2004 and Twenty-Six Weeks Ended August 24, 2003 columnar dollar amounts in thousands unaudited purchase shares of the Company s common stock at a price equal to approximately $2.56 per share, the fair value of the stock on the date of acquisition. Each participant s equity is held in a rabbi trust and is accounted for in accordance with EITF 97-14 Accounting for Deferred Compensation Arrangements Where Amounts Earned Are Held in a Rabbi Trust and Invested. In accordance with the provisions of the rabbi trust, the rabbi trust can only hold investments in the Company s common stock and all participants accounts must be settled in the Company s common stock; accordingly, the Company s common stock held in the rabbi trust is accounted for as a component of equity. Changes in the fair value in the Company s common stock are not accounted for. The rabbi trust held 2,515,122 and 2,169,229 shares of the Company s common stock as of August 29, 2004 and February 22, 2004, respectively. Comprehensive Income Comprehensive income consists of net income and foreign currency translation adjustments. The translation of foreign currency into U.S. dollars is performed for balance sheet accounts using the current exchange rate in effect at the balance sheet date and for revenue and expense accounts using the average exchange rate during the period. The gains or losses resulting from translation are included in stockholder s equity. Exchange adjustments resulting from foreign currency transactions are generally recognized in earnings. For the twenty-seven weeks ended August 29, 2004, the gain on foreign currency was $681,000. The Company deems its foreign investments to be permanent in nature and does not provide for taxes on currency translation adjustments arising from converting the investment in a foreign currency to U.S. dollars. There are no reclassification adjustments to be reported in the periods presented. Use of Estimates Preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions. These estimates or assumptions affect reported amounts of assets, liabilities, revenue and expenses as reflected in the financial statements. Actual results could differ from estimates. 3. Goodwill and Other Identifiable Intangible Assets The Company adopted SFAS No. 142, at the beginning of fiscal 2003. Goodwill is not amortized and is tested annually for impairment of value. Impairment occurs when the fair value of the asset is less than its carrying amount. If impaired, the asset is written down to its fair value. 5. Related Party Transactions Prior to the Acquisition, ConAgra Foods executive, finance, tax and other corporate departments performed certain administrative and other services for the Company. Expenses incurred by ConAgra Foods and allocated to the Company are determined based on specific services being provided or are allocated based on ConAgra Foods investment in the Company in proportion to ConAgra Foods total investment in its subsidiaries. In addition, ConAgra Foods charged the Company finance charges on ConAgra Foods investment in the Company and net intercompany advances. Management believes that such expense allocations are reasonable. It is not practical to estimate the expenses that would have been incurred by the Company if it had been operated on a stand-alone basis. Corporate allocations include allocated selling, general and administrative expenses of $6.1 million for the twenty-six weeks ended August 24, 2003 and allocated finance charges of $8.3 million for the twenty-six weeks ended August 24, 2003. Allocated finance charges are presented net of third party finance fee income of $4.1 million. As part of the Acquisition, ConAgra Foods and the Company entered into a transition services agreement pursuant to which ConAgra Foods would provide certain information technology and other administrative services to the Company for a period of one year. As consideration for these services, the Company paid ConAgra Foods $7.5 million. For the twenty-seven week period ended August 29, 2004, $3.8 million in expense was recognized by the Company for services performed pursuant to this agreement. There was no long-term debt as of August 25, 2003. In connection with the Acquisition, United Agri Products entered into its existing five-year $500.0 million asset-based revolving credit facility. The existing revolving credit facility also provides for a $20.0 million revolving credit sub-facility for UAP Canada, a $50.0 million letter of credit sub-facility, a $25.0 million swingline loan sub-facility and a $25.0 million in-season over-advance sub-facility. The interest rates with respect to revolving loans under the existing revolving credit facility are based, at United Agri Products option, on either the agent s index rate plus an applicable index margin of 1.50% or upon LIBOR plus an applicable LIBOR margin of 2.75%. The interest rates with respect to in-season overadvances under the existing revolving credit facility are based, at United Agri Products option, on either the agent s index rate plus an applicable index margin of 2.75% or upon LIBOR plus an applicable LIBOR margin of 4.00%. These applicable margins are in each case subject to prospective reduction on a quarterly basis (other than the margins on in-season over-advances) if we reduce our ratio of funded debt to EBITDA (on a consolidated basis). Overdue principal, interest and other amounts will bear interest at a rate per annum equal to the rate otherwise applicable thereto plus an additional 2.0%. The obligations under the existing revolving credit facility are (or, in the case of future subsidiaries, will be) guaranteed by UAP Holdings and each of its existing and future direct and indirect U.S. subsidiaries. The obligations under the existing revolving credit facility are secured by a first priority lien on, or security interest in, subject to certain exceptions, substantially all of UAP Holdings , United Agri Products and UAP Canada s properties and assets and the properties and assets of each of the guarantors. The existing revolving credit facility contains customary representations, warranties and covenants and events of default. As of August 29, 2004, United Agri Products had drawn on its revolving credit facility in the amount of $180.3 million. The Company s credit agreements include a minimum EBITDA requirement of $70.0 million as measured on a twelve month rolling period. The Company is also required to maintain a Fixed Charge Coverage Ratio of not less than 1.1 to 1.0, measured on the last day of each month for the trailing twelve months then ended. The credit agreements also contain certain negative covenants which may restrict the Company s ability to, among other items, incur new indebtedness, engage in new business ventures, or complete significant acquisitions or divestitures. Table of Contents UAP HOLDING CORP. NOTES TO CONDENSED CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS (Continued) For the Twenty-Seven Weeks Ended August 29, 2004 and Twenty-Six Weeks Ended August 24, 2003 columnar dollar amounts in thousands unaudited On April 26, 2004, United Agri Products commenced a tender offer and consent solicitation with respect to all its outstanding $225.0 million aggregate principal amount of 8 % Senior Notes. As of May 10, 2004, United Agri Products had received the requisite consents with respect to the 8 % Senior Notes. As of the date hereof, all $225.0 million aggregate principal amount of the 8 % Senior Notes have been validly tendered and have not been withdrawn in the tender offer, and United Agri Products has executed a supplemental indenture with respect to the 8 % Senior Notes, with effectiveness subject to consummation of the tender offer. The tender offer is conditioned upon, among other things, the closing of the Proposed IDS Offering. Since an exchange offer registration statement had not yet been declared effective as of July 13, 2004, then as of and including July 14, 2004, United Agri Products is required to pay penalty interest at an annual rate of 0.25% per annum. From and including October 12, 2004, the penalty interest rate increased to 0.50% per annum and will increase by an additional 0.25% per annum each 90 days thereafter up to a maximum of 1.0% per annum on the outstanding principal amount until the registration statement is declared effective and the exchange offer is consummated or until the 8 % Senior Notes are purchased in the tender offer. In addition, on April 26, 2004, UAP Holdings commenced a tender offer and consent solicitation with respect to all of its outstanding $125.0 million aggregate principal amount at maturity of 10 % Senior Discount Notes. As of May 10, 2004, UAP Holdings had received the requisite consents with respect to the 10 % Senior Discount Notes. As of the date hereof, all $125.0 million aggregate principal amount at maturity of the 10 % Senior Discount Notes have been validly tendered and have not been withdrawn in the tender offer, and UAP Holdings has executed a supplemental indenture with respect to the 10 % Senior Discount Notes, with effectiveness subject to consummation of the tender offer. The tender offer is conditioned upon, among other things, the closing of the Proposed IDS Offering. Since an exchange offer registration statement had not yet been declared effective as of August 23, 2004, then as of and including August 24, 2004, UAP Holdings is required to pay penalty interest at an annual rate of 0.25% per annum on the accreted value of the 10 % Senior Discount Notes. From and including November 22, 2004, the penalty interest rate will increase to 0.50% per annum on the accreted value of the 10 % Senior Discount Notes and will increase by an additional 0.25% per annum on the accreted value of the 10 % Senior Discount Notes each 90 days thereafter up to a maximum of 1.0% per annum on the accreted value of the 10 % Senior Discount Notes until the registration statement is declared effective and the exchange offer is consummated or until the 10 % Senior Discount Notes are purchased in the tender offer. Cash interest paid was $13.4 million and $0.3 million for the twenty-seven week period ended August 29, 2004 and the twenty-six week period ended August 24, 2003, respectively. Interest expense is presented net of finance charge income of $3.9 million for the twenty-seven week period ended August 29, 2004. Based on current market rates primarily provided by outside investment bankers and the note consideration provisions in the tender offers, the fair value of the 8 % Senior Notes and the 10 % Senior Discount Notes at August 29, 2004 was estimated at $358.0 million. 7. Successor Stock Plans As of August 29, 2004, 3,283,165 options have been approved for the management and employee stock option plans. Of these, 3,066,400 options were granted with an exercise price of approximately $2.56, of which 162,375 were granted during the twenty-seven weeks ended August 29, 2004. None of these options have vested. There are 216,765 remaining options to be granted under the plan. No single customer accounted for more than 10% of net sales for the twenty-seven weeks ended August 29, 2004 or the twenty-six weeks ended August 24, 2003. Net sales by geographical area are based on the location of the facility producing the sales. Long-lived assets consist of property, plant and equipment, net of depreciation, goodwill, intangibles, non-current deferred tax assets and other assets. Long-lived assets by geographical area are based on location of facilities. 11. Subsequent Event In connection with a proposed public offering of the Company s common stock during fiscal 2005, on November 17, 2004 the Board of Directors approved a stock split of approximately 39.085-for-1 of the Company s common stock. All share, per share and conversion amounts related to common stock and stock options included in the accompanying consolidated financial statements and footnotes have been restated to reflect the stock split for all periods presented. See notes to the consolidated financial statements. Basic and diluted earnings per share $ 0.21 Weighted average shares outstanding 46,902,351 See notes to the consolidated financial statements. See notes to the consolidated financial statements. (1) Bad debts charged off, less recoveries.
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+Risk Factors Before you invest in the IDSs (including the shares of our Class A common stock and our senior subordinated notes represented by the IDSs) or the senior subordinated notes, you should carefully consider the various risks of the investment, including those described below, together with all of the other information included in this prospectus. If any of these risks actually occur, our business, financial condition or operating results could be adversely affected. Risks Relating to the IDSs, the Shares of Class A Common Stock and Senior Subordinated Notes Represented by the IDSs, the Senior Subordinated Notes Offered Separately (not in the Form of IDSs), and our New Credit Facility Our substantial indebtedness could restrict our ability to pay interest and principal on the senior subordinated notes and to pay dividends with respect to shares of our Class A common stock represented by the IDSs and impact our financing options and liquidity position. Upon the consummation of this offering, we will have approximately $ million of total debt outstanding, $ million of which will rank senior to the senior subordinated notes. The degree to which we are leveraged on a consolidated basis could have important consequences to the holders of the IDSs and of separate senior subordinated notes, including: it may be more difficult to satisfy our obligations under the senior subordinated notes and to pay dividends on our Class A common stock; our ability to obtain additional financing in the future for working capital, capital expenditures or acquisitions may be limited; we may be unable to refinance our indebtedness on terms acceptable to us or at all; a significant portion of our cash flow from operations is likely to be dedicated to the payment of the principal of and interest on our indebtedness, thereby reducing funds available for other corporate purposes; and our substantial indebtedness may make us more vulnerable to economic downturns and limit our ability to withstand competitive pressures. We may be able to incur substantially more debt, which could exacerbate the risks associated with our substantial indebtedness described above. While our new credit facility will contain total leverage, senior leverage and interest coverage covenants and the indenture governing the senior subordinated notes will contain incurrence covenants that will restrict our ability to incur debt as described under Description of Certain Indebtedness New Credit Facility, and Description of Senior Subordinated Notes Additional Notes, as long as we meet these financial covenants we will be allowed to incur additional indebtedness, including senior subordinated notes with terms identical to the senior subordinated notes offered hereby. The terms of our new credit facility restrict our ability to pay interest on our senior subordinated notes and dividends on shares of our common stock and we may amend these terms or enter into new agreements that are more restrictive. Our new credit facility contains significant restrictions on our ability to pay interest on the senior subordinated notes and dividends on shares of common stock based on meeting our interest coverage ratio and senior leverage ratio and compliance with other conditions. As a result of general economic conditions, conditions in the lending markets, the results of our business or for any other reason, we may elect or be required to amend or refinance our new credit facility, at or prior to maturity, or enter into additional agreements for senior indebtedness. Regardless of any protection you have in the indenture governing the senior subordinated notes, any such amendment, refinancing or additional indebtedness may contain covenants that could limit in a significant manner our ability to make interest payments and pay dividends to you. Table of Contents Table of Additional Registrant Guarantors Address Including Zip Code, State or Other Telephone Number Jurisdiction of I.R.S. Employer Including Area Code of Exact Name of Registrant Guarantor as Incorporation or Identification Registrant Guarantor s Specified in its Charter Organization Number Principal Executive Offices Table of Contents We are subject to restrictive debt covenants that impose operating and financial restrictions on our operations and could limit our ability to grow our business. The agreements governing our indebtedness impose significant operating and financial restrictions on us. These restrictions prohibit or limit, among other things: the incurrence of additional indebtedness and the issuance of preferred stock and certain redeemable capital stock; a number of other restricted payments, including investments and acquisitions; specified sales of assets; specified transactions with affiliates; the creation of a number of liens; consolidations, mergers and transfers of all or substantially all of our assets; and our ability to change the nature of our business. These restrictions could limit our ability to obtain future financing, make acquisitions, withstand downturns in our business or take advantage of business opportunities. If we fail to comply with the restrictive debt covenants in the agreements governing our indebtedness, our senior lenders may accelerate the payment of indebtedness outstanding under our new credit facility which is senior to the senior subordinated notes. The terms of the new credit facility include several restrictive covenants that prohibit us from prepaying our other indebtedness, including the senior subordinated notes, while indebtedness under the new credit facility is outstanding. The new credit facility also requires us to maintain specified financial ratios and satisfy financial condition tests. Our ability to comply with the ratios or tests may be affected by events beyond our control, including prevailing economic, financial and industry conditions. See the information under Description of Certain Indebtedness for a fuller description of these restrictions and covenants. A breach of any of these covenants, ratios or tests could result in a default under the new credit facility and/or the indenture. Events of default under the new credit facility would prohibit us from making payments on the senior subordinated notes in cash, including payment of interest when due. In addition, upon the occurrence of an event of default under the new credit facility, the lenders could elect to declare all amounts outstanding under the new credit facility, together with accrued interest, to be immediately due and payable. If we were unable to repay those amounts, the lenders could proceed against the security granted to them to secure that indebtedness. If the lenders accelerate the payment of the indebtedness, our assets may not be sufficient to repay in full this indebtedness and our other indebtedness, including the senior subordinated notes. We are a holding company with no operations, and unless we receive dividends and other payments, advances and transfers of funds from our subsidiaries, we will be unable to meet our debt service and other obligations. We are a holding company and conduct all of our operations through our subsidiaries. We currently have no significant assets other than equity interests in our subsidiaries. As a result, we will rely on dividends and other payments or distributions from our subsidiaries to meet our debt service obligations and enable us to pay dividends. The ability of our subsidiaries to pay dividends or make other payments or distributions to us will depend on their respective operating results and may be restricted by, among other things, the laws of their jurisdiction of organization (which may limit the amount of funds available for the payment of dividends), agreements of those subsidiaries, the terms of the new credit facility (under which the equity interests of our subsidiaries will be pledged), and the covenants of any future outstanding indebtedness we or our subsidiaries incur. Table of Contents You may not receive interest payments on your senior subordinated notes on the regularly scheduled payment dates as we may defer the payment of interest to you for a significant period of time, subject to restrictions set forth in the indenture. We may, subject to restrictions set forth in the indenture, defer interest payments on our senior subordinated notes on one or more occasions. For any interest deferred during the first five years, we are not obligated to pay any deferred interest until , 2009. As a result, you may not receive interest payments on the regularly scheduled payment dates and you may be owed a substantial amount of deferred interest that will not be due and payable for a significant period of time. See Description of Senior Subordinated Notes Interest Deferral. You may not receive the level of dividends provided for in the dividend policy that our board of directors is expected to adopt upon the closing of this offering or any dividends at all. Our board of directors may, in its discretion, amend or repeal the dividend policy it is expected to adopt upon the closing of this offering. Our board of directors may decrease the level of dividends provided for in this dividend policy or entirely discontinue the payment of dividends. The amount of future dividends with respect to shares of our capital stock, if any, will depend on, among other things, our results of operations, cash requirements, financial condition, contractual restrictions, business opportunities, provisions of applicable law and other factors that our board of directors may deem relevant. In addition, the indenture governing our senior subordinated notes and the new credit facility each contain significant restrictions which could affect your receipt of dividends, because among other things, if we defer interest on the senior subordinated notes, we may not pay dividends until we have paid all deferred interest and accrued interest thereon. Furthermore, if the senior subordinated notes were treated as equity rather than as debt for United States federal income tax purposes, then the stated interest on the senior subordinated notes could be treated as a dividend and would not be deductible by us for United States federal income tax purposes. Our inability to deduct interest on the senior subordinated notes could materially increase our taxable income and, thus, our United States federal and applicable state income tax liability. If this were to occur, our after-tax cash flow available for dividend and interest payments would be reduced. You will be immediately diluted by $ per share of Class A common stock if you purchase IDSs in this offering. If you purchase IDSs in this offering, based on the book value of the assets and liabilities reflected on our balance sheet, you will experience an immediate dilution of $ per share of Class A common stock represented by the IDSs which exceeds the entire price allocated to each share of Class A common stock represented by the IDSs in this offering because there will be a net tangible book deficit for each share of Class A common stock outstanding immediately after this offering. Our net tangible book value as of March 31, 2004, after giving effect to this offering, was approximately $ million, or $ per share of Class A common stock. Our interest expense may increase significantly and could cause our net income and distributable cash to decline significantly. The new credit facility will be subject to periodic renewal or must otherwise be refinanced. We may not be able to renew or refinance the new credit facility, or if renewed or refinanced, the renewal or refinancing may occur on less favorable terms, including higher interest rates. Borrowings under the revolving facility will be made at a floating rate of interest. In the event of an increase in the base reference interest rates, our interest expense will increase and could have a material adverse effect on our ability to make cash dividend payments to our shareholders. Our ability to continue to expand our business will, to a large extent, be dependent upon our ability to borrow funds under our new credit facility and to obtain other third party financing, including through the sale of IDSs or other securities. We cannot assure you that such financing will be available to us on favorable terms or at all. 2003 $ 168 $ 2004 141 198 2005 86 130 2006 71 107 2007 58 92 2008 62 Thereafter 68 Table of Contents If we are unable to generate sufficient funds from operations we will be unable to pay our indebtedness at maturity or upon the exercise by holders of their rights upon a change of control. Because a significant portion of our cash flow from operations will be dedicated to servicing our debt requirements and making capital expenditures to maintain the quality of our physical plant, we may not have sufficient funds from operations to repay the principal amount of our indebtedness at maturity or in case you exercise your right to require us to purchase your notes upon a change of control. In addition, we currently expect to distribute a significant portion of any remaining cash earnings to our stockholders in the form of quarterly dividends. Moreover, prior to the maturity of our senior subordinated notes, we will not be required to make any payments of principal on our senior subordinated notes. We may, therefore, need to refinance our debt or raise additional capital to meet our obligations. These alternatives may not be available to us when needed or on satisfactory terms due to prevailing market conditions, a decline in our business or restrictions contained in our senior debt obligations. We may pay a significant portion of our free cash flow to stockholders in the form of dividends thereby reducing the amounts available to us to satisfy our obligations on the senior subordinated notes. Our new credit facility and the indenture governing our senior subordinated notes permit us to pay a significant portion of our free cash flow to stockholders in the form of dividends, subject to certain limitations. Following completion of this offering, we intend to pay quarterly dividends. Any amounts paid by us in the form of dividends will not be available in the future to satisfy our obligations under the senior subordinated notes. The limitations on our ability to pay dividends are more fully described in Description of Senior Subordinated Notes Certain Covenants and Description of Certain Indebtedness New Credit Facility. If the realizable value of our assets is insufficient to satisfy claims, you could lose all or part of your investment upon a liquidation of our company. At March 31, 2004, our assets included goodwill of $1,057 million and deferred financing costs of $52 million. Combined, these items represent approximately 54.8% of our total consolidated assets. The value of these assets will continue to depend significantly upon the success of our business as a going concern and the growth in cash flows. As a result, in the event of a default under our new credit facility or on our senior subordinated notes or any bankruptcy or dissolution of our company, the realizable value of these assets may be substantially lower and may be insufficient to satisfy the claims of our creditors. Deferral of interest payments would have adverse tax consequences for you. If we defer interest payments on the senior subordinated notes, you will be required to recognize interest income for United States federal income tax purposes in respect of the senior subordinated notes before you receive any cash payment of this interest. In addition, we will not pay you this cash if you sell the IDSs or the senior subordinated notes, as the case may be, before the end of any deferral period or before the record date relating to interest payments that are to be paid. Deferral of interest payments may also adversely affect the trading price of the senior subordinated notes. The IDSs or the senior subordinated notes may trade at a price that does not fully reflect the value of accrued but unpaid interest on the senior subordinated notes if we defer interest payments. In addition, the requirement that we defer payments of interest on the senior subordinated notes under certain circumstances may mean that the market price for the IDSs or the senior subordinated notes may be more volatile than other securities that do not have this requirement. Because of the subordinated nature of the notes, holders of our senior subordinated notes may not be entitled to be paid in full, if at all, in a bankruptcy, liquidation or reorganization or similar proceeding. As a result of the subordinated nature of our notes and related guarantees, upon any distribution to our creditors or the creditors of the subsidiary guarantors in bankruptcy, liquidation or reorganization or similar proceeding relating to us or the subsidiary guarantors or our or their property, the holders of our senior indebtedness and senior indebtedness of the subsidiary guarantors will be entitled to be paid in full in cash Table of Contents before any payment may be made with respect to our senior subordinated notes or the subsidiary guarantees. Holders of our senior subordinated notes would participate with all other holders of unsecured indebtedness of ours or the subsidiary guarantors that are similarly subordinated in the assets remaining after we and the subsidiary guarantors have paid all senior indebtedness. However, because of the existence of the subordination provisions, including the requirement that holders of the senior subordinated notes pay over distributions to holders of senior indebtedness, holders of the senior subordinated notes may receive less, ratably, than our other unsecured creditors, including trade creditors. In any of these cases, we and the subsidiary guarantors may not have sufficient funds to pay all of our creditors. Holders of our senior subordinated notes may, therefore, receive less, ratably, than the holders of our senior indebtedness. On a pro forma basis as of March 31, 2004, our senior subordinated notes and the associated subsidiary guarantees would have ranked junior, on a consolidated basis, to $ million of outstanding senior secured indebtedness plus approximately $100,000 of letters of credit and the subsidiary guarantees would have ranked junior to no senior unsecured debt and pari passu with approximately $ million of outstanding indebtedness of ours and the subsidiary guarantors. In addition, as of March 31, 2004, on a pro forma basis, we would have had the ability to borrow up to an additional amount of $ million under the new credit facility (less amounts reserved for letters of credit), which would have ranked senior in right of payment to our senior subordinated notes. Holders of our senior subordinated notes will be structurally subordinated to the debt of our non-guarantor subsidiaries. Our partially owned domestic subsidiaries will not be guarantors of our senior subordinated notes. As a result, no payments are required to be made to us from the assets of these subsidiaries. In the event of a bankruptcy, liquidation or reorganization or similar proceeding of any of the non-guarantor subsidiaries, holders of their indebtedness, including their trade creditors, would generally be entitled to payment of their claims from the assets of those subsidiaries before any assets are made available for distribution to us for payment to you. In the event of bankruptcy or insolvency, the senior subordinated notes and guarantees could be adversely affected by principles of equitable subordination or recharacterization. In the event of bankruptcy or insolvency, a party in interest may seek to subordinate the senior subordinated notes or the guarantees under the principles of equitable subordination or to recharacterize the senior subordinated notes as equity. There can be no assurance as to the outcome of such proceedings. In the event a court subordinates the senior subordinated notes or guarantees or recharacterizes the senior subordinated notes as equity, we cannot assure you that you would recover any amounts owed on the senior subordinated notes or the guarantees and you may be required to return any payments made to you within six years before the bankruptcy on account of the senior subordinated notes. In addition, should the court equitably subordinate the senior subordinated notes or the guarantees or recharacterize the senior subordinated notes as equity, you may not be able to enforce the guarantees. The senior subordinated notes and the guarantees may not be enforceable because of fraudulent conveyance laws. Under federal bankruptcy law and comparable provisions of state fraudulent transfer laws, a court could void the obligations under the senior subordinated notes or the guarantees, further subordinate the senior subordinated notes or the guarantees or take other action detrimental to you, if, among other things, at the time the indebtedness under the senior subordinated notes or the guarantees, as applicable, was incurred, we or a guarantor: issued the senior subordinated notes or the guarantee to delay, hinder or defraud present or future creditors; or received less than reasonably equivalent value or fair consideration for issuing the senior subordinated notes or the guarantee and, at the time of the issuance: was insolvent or rendered insolvent by reason of issuing the senior subordinated notes or the guarantee and the application of the proceeds of the senior subordinated notes; Table of Contents 10 .26 Wholesale Solutions Switched Services Agreement, dated as of August 11, 2003, by and between Sprint Communications Company L.P. and Valor Telecommunications Enterprises, LLC. 10 .27 First Amendment to Wholesale Solutions Switched Services Data and Private Line Agreement, dated as of October 3, 2003, between Sprint Communications Company L.P. and Valor Telecommunications Enterprises, LLC. ** 10 .28 Employment Agreement, dated as of June 18, 2000, by and between Valor Telecommunications, LLC and Kenneth R. Cole.** 10 .29 Amendment One to Employment Agreement, dated January 18, 2000, by and between Valor Telecommunications, LLC and Kenneth R. Cole.** 10 .30 Employment Agreement, dated as of January 2, 2002 by and between Valor Telecommunications, LLC and John J. Mueller.* 10 .31 Employment Agreement, dated as of March 20, 2000, by and between Valor Telecommunications, LLC and John A. Butler.** 10 .32 Employment Agreement, dated as of November 13, 2000, by and between Valor Telecommunications, LLC and William M. Ojile, Jr.** 10 .33 Amendment One to Employment Agreement, dated as of January 2, 2002, by and between Valor Telecommunications, LLC and William M. Ojile, Jr. 10 .34 Employment Agreement, dated as of February 28, 2000, by and between Valor Telecommunications, LLC and W. Grant Raney.** 10 .35 Amendment One to Employment Agreement, dated as of January 2, 2002, by and between Valor Telecommunications, LLC and W. Grant Raney.** 10 .36 Amended and Restated Employment Agreement, dated April 9, 2004, between Valor Telecommunications, LLC and John J. Mueller.* 12 .1 Ratio of Earnings to Fixed Charges.** 12 .2 Pro Forma Ratio of Earnings to Fixed Charges.** 23 .1 Consent of Deloitte Touche LLP and report on schedule. 23 .2 Consent of Kirkland Ellis LLP (included in Exhibit 5.1).* 23 .3 Consent of Kirkland Ellis LLP (included in Exhibit 8.1).* 23 .4 Consent of Houlihan Lokey Howard Zukin Financial Advisors, Inc.** 24 .1 Powers of Attorney (included on signature page).** 10 .26 Wholesale Solutions Switched Services Agreement, dated as of August 11, 2003, by and between Sprint Communications Company L.P. and Valor Telecommunications Enterprises, LLC. 10 .27 First Amendment to Wholesale Solutions Switched Services Agreement, dated as of October 3, 2003, between Sprint Communications Company L.P. and Valor Telecommunications Enterprises, LLC. ** 10 .28 Employment Agreement, dated as of June 18, 2000, by and between Valor Telecommunications, LLC and Kenneth R. Cole.** 10 .29 Amendment One to Employment Agreement, dated January 18, 2000, by and between Valor Telecommunications, LLC and Kenneth R. Cole.** 10 .30 Employment Agreement, dated as of January 2, 2002, by and between Valor Telecommunications, LLC and John J. Mueller.* 10 .31 Employment Agreement, dated as of March 20, 2000, by and between Valor Telecommunications, LLC and John A. Butler.** 10 .32 Employment Agreement, dated as of November 13, 2000, by and between Valor Telecommunications, LLC and William M. Ojile, Jr.** 10 .33 Amendment One to Employment Agreement, dated as of January 2, 2002, by and between Valor Telecommunications, LLC and William M. Ojile, Jr.** 10 .34 Employment Agreement, dated as of February 28, 2000, by and between Valor Telecommunications, LLC and W. Grant Raney.** 10 .35 Amendment One to Employment Agreement, dated as of January 2, 2002, by and between Valor Telecommunications, LLC and W. Grant Raney.** 10 .36 Amended and Restated Employment Agreement, dated April 9, 2004, between Valor Telecommunications, LLC and John J. Mueller.* 12 .1 Ratio of Earnings to Fixed Charges.** 12 .2 Pro Forma Ratio of Earnings to Fixed Charges.** 23 .1 Consent and report on schedule of Deloitte Touche LLP. 23 .2 Consent of Kirkland Ellis LLP (included in Exhibit 5.1).* 23 .3 Consent of Kirkland Ellis LLP (included in Exhibit 8.1).* 23 .4 Consent of Houlihan Lokey Howard Zukin Financial Advisors, Inc.** 24 .1 Powers of Attorney (included on signature page).** Valor Telecommunications, LLC Delaware 52-2171586 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Valor Telecommunications of Texas, LP Texas 52-2194219 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Valor Telecommunications Equipment, LP Texas 75-2884400 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Valor Telecommunications Services, LP Texas 75-2884846 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Valor Telecommunications Investments, LLC Delaware 47-0902124 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Valor Telecommunications Enterprises, LLC Delaware 75-2884398 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Valor Telecommunications LD, LP Delaware 75-2884847 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Southwest Enhanced Network Services, LP Delaware 75-2885419 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Western Access Services, LLC Delaware 20-0081823 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Western Access Services of Arizona, LLC Delaware 20-0081863 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Western Access Services of Arkansas, LLC Delaware 20-0081902 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Table of Contents was engaged or about to engage in a business or a transaction for which our or the guarantor s remaining unencumbered assets constituted unreasonably small capital to carry on its business; intended to incur, or believed that it would incur, debts beyond its ability to pay the debts as they mature; or was a defendant in an action for money damages, or had a judgment for money damages docketed against it if, in either case, after final judgment, the judgment is unsatisfied. The measures of insolvency for the purposes of fraudulent transfer laws vary depending upon the law applied in any proceeding to determine whether a fraudulent transfer has occurred. Generally, however, a person would be considered insolvent if, at the time it incurred the debt: the present fair saleable value of its assets was less than the amount that would be required to pay its probable liability on its existing debts, including contingent liabilities, as they become absolute and mature; or it could not pay its debts as they become due. Regardless of the standard that a court uses to determine whether we or a guarantor were solvent at the relevant time, the issuance of the senior subordinated notes or the guarantees may be voided or further subordinated to the claims of creditors if it concludes that we or a guarantor was insolvent. The guarantee of the senior subordinated notes by any subsidiary guarantor could be subject to the claim that, since the guarantee was incurred for our benefit, and only indirectly for the benefit of the guarantor, the guarantee was incurred for less than fair consideration. A court could therefore void the obligations of the subsidiary guarantor, under the guarantees or subordinate these obligations to the subsidiary guarantor s other debt or take action detrimental to holders of the senior subordinated notes. If the guarantee of any subsidiary guarantor were voided, the holders of the senior subordinated notes would not have a debt claim against that subsidiary guarantor. In addition, in the event that we meet any of the fraudulent transfer tests relating to financial condition, as described above, at the time of or as a result of this offering, a court could view the issuance of the senior subordinated notes, the guarantees and other transactions occurring on the issue date, such as repayment of our existing debt and various distributions described under Use of Proceeds as a single transaction and, as a result, conclude that we did not get fair value for the offering. In such a case, a court could hold the debt (including the guarantees) owed to the noteholders void or unenforceable or may further subordinate it to the claims of other creditors. Interest on the senior subordinated notes may not be deductible for United States federal income tax purposes, which could significantly reduce our future cash flow and impair our ability to make interest and dividend payments. No statutory, judicial or administrative authority has directly addressed the treatment of the IDSs or the senior subordinated notes, or instruments similar to the IDSs or the senior subordinated notes, for United States federal income tax purposes. As a result, the United States federal income tax consequences of the purchase, ownership and disposition of IDSs and senior subordinated notes are unclear. We will receive an opinion from our counsel, Kirkland Ellis, LLP, to the effect that an IDS should be treated as a unit representing a share of common stock and senior subordinated notes, and that the senior subordinated notes should be classified as debt for United States federal income tax purposes. However, the IRS or the courts may take the position that the IDSs are a single security classified as equity, or that the senior subordinated notes are properly classified as equity for United States federal income tax purposes, which could adversely affect the amount, timing and character of income, gain or loss in respect of your investment in IDSs or senior subordinated notes, and materially increase our taxable income and, thus, our United States federal and applicable state income tax liability. This would reduce our after-tax cash flow and could materially and adversely impact our ability to make interest and dividend payments on the senior subordinated notes and the common stock. Foreign holders could be subject to withholding or estate taxes with regard to the senior subordinated notes in the same manner as they will be with regard to the common stock. Payments to foreign holders would not be grossed-up for any such taxes. Further, we have Table of Contents Address Including Zip Code, State or Other Telephone Number Jurisdiction of I.R.S. Employer Including Area Code of Exact Name of Registrant Guarantor as Incorporation or Identification Registrant Guarantor s Specified in its Charter Organization Number Principal Executive Offices Table of Contents not received any opinion of counsel as to the treatment of senior subordinated notes that we may issue in any subsequent issuance, including in connection with an exchange of Class B common stock for IDSs and any subsequently issued senior subordinated notes may be treated as equity for United States federal income tax purposes. Apart from the exchanges of Class B common stock for IDSs, subsequent issuances of senior subordinated notes underlying IDSs will be made, subject to certain requirements, at the determination of our board of directors. For discussion of these tax-related risks, see Material United States Federal Income Tax Consequences. The allocation of the purchase price of the IDSs may not be respected, which may lead to you having to include original issue discount in your income even if you have not received the cash attributable to that income. The purchase price of each IDS must be allocated for tax purposes between the share of common stock and senior subordinated notes comprising the IDS in proportion to their respective fair market values at the time of purchase. It is possible that the IRS will successfully challenge our allocation. If the allocation of the purchase price to the senior subordinated notes were determined to be too high, then it is possible that the senior subordinated notes would be treated as having been issued with OID, and you generally would be required to include the OID in income in advance of the receipt of cash attributable to that income. If, on the other hand, the allocation of purchase price to the senior subordinated notes were determined to be too low, then it is possible that the senior subordinated notes would be treated as having been issued with amortizable bond premium, and you would generally be able to elect to amortize such bond premium over the term of the senior subordinated notes. Because of the deferral of interest provisions, the senior subordinated notes may be treated as issued with original issue discount. Under applicable Treasury regulations, a remote contingency that stated interest will not be timely paid is disregarded in determining whether a debt instrument is issued with OID. Although there is no authority directly on point, based on our financial forecasts, we believe that the likelihood of deferral of interest payments on the senior subordinated notes is remote within the meaning of the Treasury regulations. Based on the foregoing determination made by us, although the matter is not free from doubt because of the lack of direct authority, our counsel is of the opinion that the possibility that interest payments on the senior subordinated notes may be deferred should not cause the senior subordinated notes to be considered to be issued with OID at the time of their original issuance. If deferral of any payment of interest were determined not to be remote, then the senior subordinated notes would be treated as issued with OID at the time of issuance. In such case, all stated interest on the senior subordinated notes would be treated as OID, with the consequence that all holders would be required to include the yield on the senior subordinated notes in income as it accrued on a constant yield basis, possibly in advance of their receipt of the associated cash and regardless of their method of tax accounting. Subsequent issuances of senior subordinated notes may cause you to recognize taxable gain and/or original issue discount. The United States federal income tax consequences to you of a subsequent issuance of senior subordinated notes with OID (or any issuance of senior subordinated notes thereafter) are unclear and our counsel is unable to opine on this issue. The indenture governing the senior subordinated notes and our agreements with DTC will provide that, in the event that there is a subsequent issuance of senior subordinated notes with OID, and in connection with each issuance of senior subordinated notes thereafter, including an issuance of senior subordinated notes upon an exchange of shares of Class B common stock, each holder of senior subordinated notes or IDSs, as the case may be, agrees that a portion of such holder s senior subordinated notes will be automatically exchanged for a portion of the senior subordinated notes acquired by the holders of such subsequently issued senior subordinated notes. Such subsequent issuance and exchange will not change the aggregate stated principal amount of senior subordinated notes owned by you and each other holder. Due to the lack of applicable authority, it is unclear whether an exchange of senior subordinated notes for subsequently issued senior subordinated notes will result in a taxable exchange for United States federal income tax purposes. It is possible that the IRS might successfully assert that such an exchange should be Table of Contents treated as a taxable exchange. In such case, you would recognize any gain realized on the exchange, but a loss might be disallowed. For a more complete description of the tax consequences of a subsequent issuance, see Material United States Federal Income Tax Consequences Senior Subordinated Notes Additional Issuances. Regardless of whether the exchange is treated as a taxable event, such exchange may result in an increase in the amount of OID, if any, that you are required to accrue with respect to the senior subordinated notes. Following any subsequent issuance of senior subordinated notes with OID or any issuance of senior subordinated notes thereafter and resulting exchange, we and our agents will report any OID on any subsequently issued senior subordinated notes ratably among all holders of senior subordinated notes and IDSs. By purchasing senior subordinated notes or IDSs, as the case may be, each holder of senior subordinated notes and IDSs agrees to report OID in a manner consistent with this approach. As a result of a subsequent issuance, therefore, you may be required to report OID even though you purchased senior subordinated notes having no OID. This will generally result in you reporting more interest income over the term of the senior subordinated notes than you would have reported had no such subsequent issuance and exchange occurred. The IRS, however, may assert that OID should be reported only to the persons that initially acquired such subsequently issued senior subordinated notes and their transferees. In such case, the IRS might further assert that, unless a holder can establish that it is not an initial holder of subsequently issued senior subordinated notes or a transferee thereof, all senior subordinated notes held by such holder will have OID. Any of these assertions by the IRS could create significant uncertainties in the pricing of IDSs and senior subordinated notes and could adversely affect the market for IDSs and senior subordinated notes. If we subsequently issue senior subordinated notes with significant OID, then we may be unable to deduct all the interest on the senior subordinated notes. It is possible that the senior subordinated notes that we issue in a subsequent issuance will be issued at a discount to their face value and, accordingly, may have significant OID and thus be classified as applicable high yield discount obligations. If any such senior subordinated notes were so treated, then a portion of the OID on such notes could be nondeductible by us and the remainder would be deductible only when paid. This treatment would have the effect of increasing our taxable income and may adversely affect our cash flow available for interest payments and distributions to our shareholders. A subsequent issuance of senior subordinated notes or an allocation of IDS purchase price that results in OID may reduce the amount you can recover upon an acceleration of the payment of principal due on the senior subordinated notes or in the event of our bankruptcy. Under New York and federal bankruptcy law, holders of subsequently issued senior subordinated notes having original issue discount may not be able to collect the portion of the principal face amount of such senior subordinated notes that represents unamortized original issue discount as of the acceleration or filing date, as the case may be, in the event of an acceleration of the senior subordinated notes or in the event of our bankruptcy prior to the maturity date of the senior subordinated notes. As a result, a treatment of the senior subordinated notes as having been issued with OID or an automatic exchange that results in a holder receiving a senior subordinated note with original issue discount could have the effect of ultimately reducing the amount such holder can recover from us in the event of an acceleration or bankruptcy. Before this offering, there has not been a public market for our IDSs. The price of the IDSs may fluctuate substantially, which could negatively affect the value of your investment. Our IDSs have no public market history. In addition, there has not been an established market in the United States or in Canada for securities similar to the IDSs. We cannot assure you that an active trading market for the IDSs will develop in the future. The initial public offering price of the IDSs has been determined by negotiations among us, the existing equity holders and the representatives of the underwriters and may not be indicative of the market price of the IDSs after the offering. Factors such as quarterly variations in our financial results, announcements by Table of Contents us or others, developments affecting us, our clients and our suppliers, general interest rate levels and general market volatility could cause the market price of the IDSs to fluctuate significantly. If the IDSs separate, the limited liquidity of the market for the senior subordinated notes and Class A common stock may adversely affect your ability to sell the senior subordinated notes and Class A common stock. We do not intend to list the senior subordinated notes represented by the IDSs on any exchange or quotation system. Our Class A common stock will not initially be listed for separate trading on the New York Stock Exchange or any other exchange or quotation system other than the Toronto Stock Exchange (on which we do not anticipate an active trading market for the Class A common stock to develop). We will not apply to list our shares of Class A common stock for separate trading on the New York Stock Exchange or any other exchange or quotation system until the number of shares held separately is sufficient to satisfy applicable requirements for separate trading on such exchange or quotation system. The Class A common stock may not be approved for listing at such time. Upon separation of the IDSs, no sizable market for the senior subordinated notes and the Class A common stock may ever develop and the liquidity of any trading market for the notes or the Class A common stock that does develop may be limited. As a result, your ability to sell your notes or Class A common stock, and the market price you can obtain, could be adversely affected. The limited liquidity of the trading market for the senior subordinated notes sold separately (not represented by IDSs) may adversely affect the trading price of the separate senior subordinated notes. We are separately selling (not represented by IDSs) $ million aggregate principal amount of senior subordinated notes, representing approximately 10% of the total principal amount of the outstanding senior subordinated notes. While the senior subordinated notes sold separately (not represented by IDSs) are part of the same series of notes as, and are identical to, the senior subordinated notes represented by IDSs at the time of the issuance of the separate senior subordinated notes, the senior subordinated notes represented by the IDSs will not be separable for at least 45 days and will not be separately tradeable until separated. As a result, the initial trading market for the senior subordinated notes sold separately (not represented by IDSs) will be very limited. Even after holders of the IDSs are permitted to separate their IDSs, a sufficient number of holders of IDSs may not separate their IDSs into shares of our Class A common stock and senior subordinated notes to create a sizable and more liquid trading market for the senior subordinated notes not represented by IDSs. Therefore, a liquid market for the senior subordinated notes may not develop, which may adversely affect the ability of the holders of the separate senior subordinated notes to sell any of their separate senior subordinated notes and the price at which these holders would be able to sell any of the senior subordinated notes sold separately. Future sales or the possibility of future sales of a substantial amount of IDSs, shares of our common stock or our senior subordinated notes may depress the price of the IDSs and the shares of our common stock and our senior subordinated notes. Future sales or the availability for sale of substantial amounts of IDSs or shares of our common stock or a significant principal amount of our senior subordinated notes in the public market could adversely affect the prevailing market price of the IDSs and the shares of our common stock and senior subordinated notes and could impair our ability to raise capital through future sales of our securities. We may issue shares of our Class A common stock and senior subordinated notes, which may be in the form of IDSs, or other securities from time to time as consideration for future acquisitions and investments. In the event any such acquisition or investment is significant, the number of shares of our Class A common stock and the aggregate principal amount of senior subordinated notes, which may be in the form of IDSs, or the number or aggregate principal amount, as the case may be, of other securities that we may issue may in turn be significant. In addition, we may also grant registration rights covering those IDSs, shares of our common stock, senior subordinated notes or other securities in connection with any such acquisitions and investments. Any or all of these occurrences could depress the trading prices of our securities. Balance, March 31, 2004 $ Table of Contents Regulatory Risks We received 24.1% of our 2003 revenues from the Texas and federal Universal Service Funds and any adverse regulatory developments with respect to these funds could curtail our profitability. We receive Texas and federal Universal Service Fund, or USF, revenues to support the high cost of providing affordable telecommunications services in rural markets. Such support payments constituted 24.1% of our revenues for the year ended December 31, 2003 and 23.9% of our revenues for the three months ended March 31, 2004. Of these support payments, in the year ended December 31, 2003, $103.1 million, or 20.7% of our revenues, and in the three months ended March 31, 2004, $25.5 million, or 20.2% of our revenues, were received from the Texas USF. In addition, we are required to make contributions to the Texas USF and federal USF each year. Current state and federal regulations allow us to recover these costs by including a surcharge on our customers bills. Furthermore, we incur no incremental costs associated with the support payments we receive or the contributions we are required to make. Thus, if Texas and/or federal regulations changed and we were unable to receive support, such support was reduced, or we are unable to recover the amounts we contribute to the Texas USF and federal USF from our customers, our earnings would be directly and adversely affected. For a more detailed discussion of the regulations affecting our company, see Regulation. The rules governing USF could be altered or amended as a result of regulatory, legislative or judicial action and impact the amount of USF support that we receive and our ability to recover our USF contributions by assessing surcharges on our customers bills. For example, the enabling statute for the Texas USF will become subject to review and renewal in late 2005 and may be modified. Similarly, the FCC asked the Federal-State Joint Board on Universal Service to review the federal rules relating to universal service support mechanisms for rural carriers, including addressing the relevant costs and the definition of rural telephone company in June 2004. It is not possible to predict at this time whether state or federal regulators, Congress or state legislatures will order modification to those rules or statutes, or the ultimate impact any such modification might have on us. In addition, the Texas USF rules provide that the Texas Public Utility Commission must open an investigation within 90 days after any changes are made to the federal USF. Therefore, changes to the federal USF may prompt similar or conforming changes to the Texas USF. The outcome of any of these legislative or regulatory changes could affect the amount of Texas USF support that we receive, and could have an adverse effect on our business, revenue or profitability. Reductions in the amount of network access revenue that we receive could negatively impact our results of operations. In the year ended December 31, 2003, we derived $132.0 million, or 26.6% of our revenues, and in the three months ended March 31, 2004, we derived $33.0 million, or 26.3% of our revenues, from network access charges. Our network access revenue consists of (1) usage sensitive fees we charge to long distance companies for access to our network in connection with the completion of interstate and intrastate long distance calls, (2) fees charged for use of dedicated circuits and (3) end user fees, which are monthly flat-rate charges assessed on access lines. Federal and state regulatory commissions set these access charges, and they could change the amount of the charges or the manner in which they are charged at any time. The FCC is currently examining proposals to revise interstate access charges and other intercarrier compensation. Also, as people in our markets decide to use Internet, wireless or cable television providers for their local or long distance calling needs, rather than using our wireline network, the reduction in the number of access lines or minutes of use over our network could reduce the amount of access revenue we collect. As penetration rates for these technologies increase in rural markets, our revenues could decline. In addition, if our customers take advantage of favorable calling plans offered by wireless carriers for their long distance calling needs, it could reduce the number of long distance calls made over our network, thereby decreasing our access revenue. Furthermore, disputes are pending as to whether providers of Voice over Internet Protocol, or VoIP technology, which allow customers to make voice calls over the Internet or using Internet Protocol, are subject to FCC or state regulations that would require them to pay network charges. With the emergence of VoIP technology, the FCC and state commissions are considering the Western Access Services of Colorado, LLC Delaware 20-0081934 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Western Access Services of Oklahoma, LLC Delaware 20-0081944 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Western Access Services of New Mexico, LLC Delaware 20-0081922 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Western Access Services of Texas, LP Delaware 20-0081952 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Valor Telecommunications Corporate Group, LP Texas 75-2895493 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Valor Telecommunications Southwest, LLC Delaware 52-2194218 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Valor Telecommunications Southwest II, LLC Delaware 75-2950066 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Valor Telecommunications Enterprises II, LLC Delaware 75-2950064 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Kerrville Communications Corporation Texas 74-2197091 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Kerrville Communications Management, LLC Delaware 30-0135974 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Kerrville Communications Enterprises, LLC Delaware 32-0047694 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Advanced Tel-Com Systems, LP Texas 74-2228603 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Table of Contents status of VoIP and other Internet services and there can be no assurance that the FCC and state regulators will require such providers to pay access charges. Any or all of these developments could reduce the amount of access revenue that we receive which could negatively impact our revenues and profitability. The introduction of new competitors or the better positioning of existing competitors due to regulatory changes could cause us to lose customers and impede our ability to attract new customers. Changes in regulations that open our markets to more competitors offering substitute services could impact our profitability because of increases in the costs of attracting and retaining customers and decreases in revenues due to lost customers and the need to offer competitive prices. We face competition from current and potential market entrants, including: domestic and international long distance providers seeking to enter, reenter or expand entry into the local telecommunications marketplace; other domestic and international competitive telecommunications providers, wireless carriers, resellers, cable television companies and electric utilities; and providers of broadband and Internet services. Regulatory requirements designed to facilitate the introduction of competition, the applicability of different regulatory requirements between our competitors and us, or decisions by legislators or regulators to exempt certain providers or technologies from the same level of regulation that we face, could adversely impact our market position and our ability to offer competitive alternatives. In November 2003, the FCC ordered us and other local exchange carriers to adopt wireline-to-wireless local number portability. This may help wireless carriers compete against us because if customers switch from traditional local telephone service to wireless service, they can now transfer their local telephone number to their wireless provider. In addition, federal and state regulators and courts are addressing many aspects of our obligations to provide unbundled network elements and discounted wholesale rates to competitors. New regulations and changes in existing regulations may force us to incur significant expenses. Our business may also be impacted by legislation and regulation that impose new or greater obligations related to assisting law enforcement, bolstering homeland security, minimizing environmental impacts or addressing other issues that impact our business. For example, existing provisions of the Communications Assistance for Law Enforcement Act, or CALEA, and FCC regulations implementing CALEA require telecommunications carriers to ensure that their equipment, facilities, and services are able to facilitate authorized electronic surveillance. We cannot predict whether and when the FCC might modify its CALEA rules or any other rules or what compliance with new rules might cost. Similarly, we cannot predict whether or when federal or state legislators or regulators might impose new security, environmental or other obligations on our business. For a more thorough discussion of the regulation of our company and how that regulation may affect our business, see Regulation. Certain transactions related to the enforceability of the guarantees of the senior subordinated notes by certain of our subsidiaries may require FCC or state regulatory commission approval, which may not be granted or which may be subject to delays or conditions that could affect your ability to enforce the guarantees. In the event that it becomes necessary to enforce the guarantees of the senior subordinated notes, approvals may be required for certain of our subsidiaries that are subject to federal or state regulatory authority, including approval for the transfer of control of various radio licenses held by our operating subsidiaries or the transfer of control over or sale of the assets of our operating subsidiaries. Such approvals may not be obtained, in which case such guarantees would be unenforceable, or may be subject to delays or conditions that could affect your ability to enforce the guarantees. Table of Contents Address Including Zip Code, State or Other Telephone Number Jurisdiction of I.R.S. Employer Including Area Code of Exact Name of Registrant Guarantor as Incorporation or Identification Registrant Guarantor s Specified in its Charter Organization Number Principal Executive Offices Table of Contents A reduction by a state regulatory body or the FCC of the rates we charge our customers would reduce our revenues and earnings. The prices, terms and conditions of the services that we offer to local telephone customers are subject to state regulatory approval. If a state regulatory body orders us to reduce a price, withdraws our approval to charge a certain price, changes material terms or conditions of a service we offer or refuses to approve or limits our ability to offer a new or existing service, both our revenues and our earnings may be reduced. FCC regulations also affect the rates that are charged to customers. The FCC regulates tariffs for interstate access and subscriber line charges, both of which are components of our revenues. The FCC currently is considering proposals to reduce interstate access charges for carriers like us. If the FCC lowers interstate access charges without adopting an adequate revenue replacement mechanism, we may be required to recover more revenue through subscriber line charges and universal service funds or forego this revenue altogether. This could reduce our revenue or impair our competitive position. Risks Relating to Our Business We provide services to our customers over access lines and if we continue to lose access lines our revenues and earnings may decrease. Our business generates revenue by delivering voice and data services over access lines. We have experienced net access line loss over the past few years, and during the year ended December 31, 2003, the number of access lines we serve declined by 2.6% due to challenging economic conditions and increased competition. We may continue to experience net access line loss in our markets for an unforeseen period of time. Our inability to retain access lines could adversely affect our revenue and earnings. Rapid and significant changes in technology in the telecommunications industry could adversely affect our ability to compete effectively in the markets in which we operate. The rapid introduction and development of enhanced or alternative services that are more cost effective, more efficient or more technologically advanced than the services we offer is a significant source of potential competition in the telecommunications industry. Technological developments may reduce the competitiveness of our networks, make our service offerings less attractive or require expensive and time-consuming capital improvements. If we fail to adapt successfully to technological changes or fail to obtain timely access to important new technologies, we could lose customers and have difficulty attracting new customers or selling new services to our existing customers. We cannot predict the impact of technological changes on our competitive position, profitability or industry. Wireless and cable technologies that have emerged in recent years provide certain advantages over traditional wireline voice and data services. The mobility afforded by wireless voice services and its competitive pricing appeal to many customers. The ability of cable television providers to offer voice, video and data services as an integrated package provides an attractive alternative to traditional voice services from local exchange carriers. In addition, as the emerging VoIP services develop, some customers may be able to bypass network access charges. Increased penetration rates for these technologies in our markets could cause our revenues to decline. The competitive nature of the telecommunications industry could adversely affect our revenues, results of operations and profitability. The telecommunications industry is very competitive. Increased competition could lead to price reductions, declining sales volumes, loss of market share, higher marketing costs and reduced operating margins. Significant and potentially larger competitors could enter our markets at any time, including local service providers, cable television companies and wireless telecommunications providers. For a more thorough discussion of the competition that may affect our business, see Business Competition. Table of Contents Weak economic conditions may decrease demand for our services. We are sensitive to economic conditions and downturns in the economy. Downturns in the economies in the markets we serve could cause our existing customers to reduce their purchases of our basic and enhanced services and make it difficult for us to obtain new customers. We depend on a few key vendors and suppliers to conduct our business and any disruption in our relationship with any one or more of them could adversely affect our results of operations. We rely on vendors and suppliers to support many of our administrative functions and to enable us to provide long distance services. For example, we currently outsource much of our operational support services to ALLTEL, including our billing and customer care services. Transitioning these support services to another provider could take a significant period of time and involve substantial costs. In addition, we have resale agreements with MCI and Sprint to provide our long distance transmission services. Replacing these resale agreements could be difficult as there are a limited number of national long distance providers. Any disruptions in our relationship with these third party providers could have an adverse effect on our business and operations. Disruption in our networks and infrastructure may cause us to lose customers and incur additional expenses. To be successful, we will need to continue to provide our customers with reliable service over our networks. Some of the risks to our networks and infrastructure include: physical damage to access lines, breaches of security, capacity limitations, power surges or outages, software defects and disruptions beyond our control, such as natural disasters and acts of terrorism. Disruptions may cause interruptions in service or reduced capacity for customers, either of which could cause us to lose customers and incur expenses, and thereby adversely affect our business, revenue and cash flow. Recent difficulties in the telecommunications industry could negatively impact our revenues and results of operations. We originate and terminate long distance phone calls on our networks for other interexchange carriers, some of which are our largest customers in terms of revenues. In the year ended December 31, 2003 and the three months ended March 31, 2004, we generated 17.5% and 17.2%, respectively, of our total revenues from originating and terminating phone calls for interexchange carriers. Several of these interexchange carriers have declared bankruptcy during the past two years or are experiencing substantial financial difficulties. MCI WorldCom (now MCI), which declared bankruptcy in 2002, is one of the major interexchange carriers with which we conduct business. We recorded a net $1.6 million charge due to MCI s failure to pay amounts owed to us. Further bankruptcies or disruptions in the businesses of these interexchange carriers could have an adverse effect on our financial results and cash flows. Following the consummation of this offering, our equity sponsors will collectively be able to exercise substantial influence over matters requiring stockholder approval and their interests may diverge from the interests of the holders of the IDSs. Following the consummation of this offering, affiliates of Welsh, Carson, Anderson Stowe, or WCAS, affiliates of Vestar Capital Partners, or Vestar, and affiliates of Citicorp Venture Capital, or CVC, will beneficially own %, % and %, respectively, of our outstanding shares of Class A common stock as part of the IDSs, and %, % and %, respectively, of our outstanding shares of Class B common stock. As a result, WCAS, Vestar and CVC collectively exercise substantial influence over matters requiring stockholder approval, including decisions about our capital structure. In addition, WCAS has two designees and Vestar has one designee serving on our board of directors. The interests of our equity sponsors may conflict with your interests as a holder of the IDSs. Table of Contents Our amended and restated certificate of incorporation and by-laws and several other factors could limit another party s ability to acquire us and deprive our investors of the opportunity to obtain a takeover premium for their securities. A number of provisions in our amended and restated certificate of incorporation and by-laws will make it difficult for another company to acquire us and for you to receive any related takeover premium on our securities. For example, our amended and restated certificate of incorporation provides that stockholders may not act by written consent and that only our board of directors may call a special meeting. In addition, stockholders are required to provide us with advance notice if they wish to nominate any persons for election to our board of directors or if they intend to propose any matters for consideration at an annual stockholders meeting. Our amended and restated certificate of incorporation authorizes the issuance of preferred stock without stockholder approval and upon such terms as the board of directors may determine. The rights of the holders of shares of our common stock will be subject to, and may be adversely affected by, the rights of holders of any class or series of preferred stock that may be issued in the future. Table of Contents
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+Risk Factors Before you invest in the IDSs (including the shares of our Class A common stock and our senior subordinated notes represented by the IDSs) or the senior subordinated notes, you should carefully consider the various risks of the investment, including those described below, together with all of the other information included in this prospectus. If any of these risks actually occur, our business, financial condition or operating results could be adversely affected. Risks Relating to the IDSs, the Shares of Class A Common Stock and Senior Subordinated Notes Represented by the IDSs, the Senior Subordinated Notes Offered Separately (not in the Form of IDSs), and our New Credit Facility Our substantial indebtedness could restrict our ability to pay interest and principal on the senior subordinated notes and to pay dividends with respect to shares of our Class A common stock represented by the IDSs and impact our financing options and liquidity position. Upon the consummation of this offering, we will have approximately $ million of total debt outstanding, $ million of which will rank senior to the senior subordinated notes. The degree to which we are leveraged on a consolidated basis could have important consequences to the holders of the IDSs and of separate senior subordinated notes, including: it may be more difficult to satisfy our obligations under the senior subordinated notes and to pay dividends on our Class A common stock; our ability to obtain additional financing in the future for working capital, capital expenditures or acquisitions may be limited; we may be unable to refinance our indebtedness on terms acceptable to us or at all; a significant portion of our cash flow from operations is likely to be dedicated to the payment of the principal of and interest on our indebtedness, thereby reducing funds available for other corporate purposes; and our substantial indebtedness may make us more vulnerable to economic downturns and limit our ability to withstand competitive pressures. We may be able to incur substantially more debt, which could exacerbate the risks associated with our substantial indebtedness described above. While our new credit facility will contain total leverage, senior leverage and interest coverage covenants and the indenture governing the senior subordinated notes will contain incurrence covenants that will restrict our ability to incur debt as described under Description of Certain Indebtedness New Credit Facility, and Description of Senior Subordinated Notes Additional Notes, as long as we meet these financial covenants we will be allowed to incur additional indebtedness, including senior subordinated notes with terms identical to the senior subordinated notes offered hereby. The terms of our new credit facility restrict our ability to pay interest on our senior subordinated notes and dividends on shares of our common stock and we may amend these terms or enter into new agreements that are more restrictive. Our new credit facility contains significant restrictions on our ability to pay interest on the senior subordinated notes and dividends on shares of common stock based on meeting our interest coverage ratio and senior leverage ratio and compliance with other conditions. As a result of general economic conditions, conditions in the lending markets, the results of our business or for any other reason, we may elect or be required to amend or refinance our new credit facility, at or prior to maturity, or enter into additional agreements for senior indebtedness. Regardless of any protection you have in the indenture governing the senior subordinated notes, any such amendment, refinancing or additional indebtedness may contain covenants that could limit in a significant manner our ability to make interest payments and pay dividends to you. Table of Contents Table of Additional Registrant Guarantors Address Including Zip Code, State or Other Telephone Number Jurisdiction of I.R.S. Employer Including Area Code of Exact Name of Registrant Guarantor as Incorporation or Identification Registrant Guarantor s Specified in its Charter Organization Number Principal Executive Offices Table of Contents We are subject to restrictive debt covenants that impose operating and financial restrictions on our operations and could limit our ability to grow our business. The agreements governing our indebtedness impose significant operating and financial restrictions on us. These restrictions prohibit or limit, among other things: the incurrence of additional indebtedness and the issuance of preferred stock and certain redeemable capital stock; a number of other restricted payments, including investments and acquisitions; specified sales of assets; specified transactions with affiliates; the creation of a number of liens; consolidations, mergers and transfers of all or substantially all of our assets; and our ability to change the nature of our business. These restrictions could limit our ability to obtain future financing, make acquisitions, withstand downturns in our business or take advantage of business opportunities. If we fail to comply with the restrictive debt covenants in the agreements governing our indebtedness, our senior lenders may accelerate the payment of indebtedness outstanding under our new credit facility which is senior to the senior subordinated notes. The terms of the new credit facility include several restrictive covenants that prohibit us from prepaying our other indebtedness, including the senior subordinated notes, while indebtedness under the new credit facility is outstanding. The new credit facility also requires us to maintain specified financial ratios and satisfy financial condition tests. Our ability to comply with the ratios or tests may be affected by events beyond our control, including prevailing economic, financial and industry conditions. See the information under Description of Certain Indebtedness for a fuller description of these restrictions and covenants. A breach of any of these covenants, ratios or tests could result in a default under the new credit facility and/or the indenture. Events of default under the new credit facility would prohibit us from making payments on the senior subordinated notes in cash, including payment of interest when due. In addition, upon the occurrence of an event of default under the new credit facility, the lenders could elect to declare all amounts outstanding under the new credit facility, together with accrued interest, to be immediately due and payable. If we were unable to repay those amounts, the lenders could proceed against the security granted to them to secure that indebtedness. If the lenders accelerate the payment of the indebtedness, our assets may not be sufficient to repay in full this indebtedness and our other indebtedness, including the senior subordinated notes. We are a holding company with no operations, and unless we receive dividends and other payments, advances and transfers of funds from our subsidiaries, we will be unable to meet our debt service and other obligations. We are a holding company and conduct all of our operations through our subsidiaries. We currently have no significant assets other than equity interests in our subsidiaries. As a result, we will rely on dividends and other payments or distributions from our subsidiaries to meet our debt service obligations and enable us to pay dividends. The ability of our subsidiaries to pay dividends or make other payments or distributions to us will depend on their respective operating results and may be restricted by, among other things, the laws of their jurisdiction of organization (which may limit the amount of funds available for the payment of dividends), agreements of those subsidiaries, the terms of the new credit facility (under which the equity interests of our subsidiaries will be pledged), and the covenants of any future outstanding indebtedness we or our subsidiaries incur. Table of Contents You may not receive interest payments on your senior subordinated notes on the regularly scheduled payment dates as we may defer the payment of interest to you for a significant period of time, subject to restrictions set forth in the indenture. We may, subject to restrictions set forth in the indenture, defer interest payments on our senior subordinated notes on one or more occasions. For any interest deferred during the first five years, we are not obligated to pay any deferred interest until , 2009. As a result, you may not receive interest payments on the regularly scheduled payment dates and you may be owed a substantial amount of deferred interest that will not be due and payable for a significant period of time. See Description of Senior Subordinated Notes Interest Deferral. You may not receive the level of dividends provided for in the dividend policy that our board of directors is expected to adopt upon the closing of this offering or any dividends at all. Our board of directors may, in its discretion, amend or repeal the dividend policy it is expected to adopt upon the closing of this offering. Our board of directors may decrease the level of dividends provided for in this dividend policy or entirely discontinue the payment of dividends. The amount of future dividends with respect to shares of our capital stock, if any, will depend on, among other things, our results of operations, cash requirements, financial condition, contractual restrictions, business opportunities, provisions of applicable law and other factors that our board of directors may deem relevant. In addition, the indenture governing our senior subordinated notes and the new credit facility each contain significant restrictions which could affect your receipt of dividends, because among other things, if we defer interest on the senior subordinated notes, we may not pay dividends until we have paid all deferred interest and accrued interest thereon. Furthermore, if the senior subordinated notes were treated as equity rather than as debt for United States federal income tax purposes, then the stated interest on the senior subordinated notes could be treated as a dividend and would not be deductible by us for United States federal income tax purposes. Our inability to deduct interest on the senior subordinated notes could materially increase our taxable income and, thus, our United States federal and applicable state income tax liability. If this were to occur, our after-tax cash flow available for dividend and interest payments would be reduced. You will be immediately diluted by $ per share of Class A common stock if you purchase IDSs in this offering. If you purchase IDSs in this offering, based on the book value of the assets and liabilities reflected on our balance sheet, you will experience an immediate dilution of $ per share of Class A common stock represented by the IDSs which exceeds the entire price allocated to each share of Class A common stock represented by the IDSs in this offering because there will be a net tangible book deficit for each share of Class A common stock outstanding immediately after this offering. Our net tangible book value as of March 31, 2004, after giving effect to this offering, was approximately $ million, or $ per share of Class A common stock. Our interest expense may increase significantly and could cause our net income and distributable cash to decline significantly. The new credit facility will be subject to periodic renewal or must otherwise be refinanced. We may not be able to renew or refinance the new credit facility, or if renewed or refinanced, the renewal or refinancing may occur on less favorable terms, including higher interest rates. Borrowings under the revolving facility will be made at a floating rate of interest. In the event of an increase in the base reference interest rates, our interest expense will increase and could have a material adverse effect on our ability to make cash dividend payments to our shareholders. Our ability to continue to expand our business will, to a large extent, be dependent upon our ability to borrow funds under our new credit facility and to obtain other third party financing, including through the sale of IDSs or other securities. We cannot assure you that such financing will be available to us on favorable terms or at all. 2003 $ 168 $ 2004 141 198 2005 86 130 2006 71 107 2007 58 92 2008 62 Thereafter 68 Table of Contents If we are unable to generate sufficient funds from operations we will be unable to pay our indebtedness at maturity or upon the exercise by holders of their rights upon a change of control. Because a significant portion of our cash flow from operations will be dedicated to servicing our debt requirements and making capital expenditures to maintain the quality of our physical plant, we may not have sufficient funds from operations to repay the principal amount of our indebtedness at maturity or in case you exercise your right to require us to purchase your notes upon a change of control. In addition, we currently expect to distribute a significant portion of any remaining cash earnings to our stockholders in the form of quarterly dividends. Moreover, prior to the maturity of our senior subordinated notes, we will not be required to make any payments of principal on our senior subordinated notes. We may, therefore, need to refinance our debt or raise additional capital to meet our obligations. These alternatives may not be available to us when needed or on satisfactory terms due to prevailing market conditions, a decline in our business or restrictions contained in our senior debt obligations. We may pay a significant portion of our free cash flow to stockholders in the form of dividends thereby reducing the amounts available to us to satisfy our obligations on the senior subordinated notes. Our new credit facility and the indenture governing our senior subordinated notes permit us to pay a significant portion of our free cash flow to stockholders in the form of dividends, subject to certain limitations. Following completion of this offering, we intend to pay quarterly dividends. Any amounts paid by us in the form of dividends will not be available in the future to satisfy our obligations under the senior subordinated notes. The limitations on our ability to pay dividends are more fully described in Description of Senior Subordinated Notes Certain Covenants and Description of Certain Indebtedness New Credit Facility. If the realizable value of our assets is insufficient to satisfy claims, you could lose all or part of your investment upon a liquidation of our company. At March 31, 2004, our assets included goodwill of $1,057 million and deferred financing costs of $52 million. Combined, these items represent approximately 54.8% of our total consolidated assets. The value of these assets will continue to depend significantly upon the success of our business as a going concern and the growth in cash flows. As a result, in the event of a default under our new credit facility or on our senior subordinated notes or any bankruptcy or dissolution of our company, the realizable value of these assets may be substantially lower and may be insufficient to satisfy the claims of our creditors. Deferral of interest payments would have adverse tax consequences for you. If we defer interest payments on the senior subordinated notes, you will be required to recognize interest income for United States federal income tax purposes in respect of the senior subordinated notes before you receive any cash payment of this interest. In addition, we will not pay you this cash if you sell the IDSs or the senior subordinated notes, as the case may be, before the end of any deferral period or before the record date relating to interest payments that are to be paid. Deferral of interest payments may also adversely affect the trading price of the senior subordinated notes. The IDSs or the senior subordinated notes may trade at a price that does not fully reflect the value of accrued but unpaid interest on the senior subordinated notes if we defer interest payments. In addition, the requirement that we defer payments of interest on the senior subordinated notes under certain circumstances may mean that the market price for the IDSs or the senior subordinated notes may be more volatile than other securities that do not have this requirement. Because of the subordinated nature of the notes, holders of our senior subordinated notes may not be entitled to be paid in full, if at all, in a bankruptcy, liquidation or reorganization or similar proceeding. As a result of the subordinated nature of our notes and related guarantees, upon any distribution to our creditors or the creditors of the subsidiary guarantors in bankruptcy, liquidation or reorganization or similar proceeding relating to us or the subsidiary guarantors or our or their property, the holders of our senior indebtedness and senior indebtedness of the subsidiary guarantors will be entitled to be paid in full in cash Table of Contents before any payment may be made with respect to our senior subordinated notes or the subsidiary guarantees. Holders of our senior subordinated notes would participate with all other holders of unsecured indebtedness of ours or the subsidiary guarantors that are similarly subordinated in the assets remaining after we and the subsidiary guarantors have paid all senior indebtedness. However, because of the existence of the subordination provisions, including the requirement that holders of the senior subordinated notes pay over distributions to holders of senior indebtedness, holders of the senior subordinated notes may receive less, ratably, than our other unsecured creditors, including trade creditors. In any of these cases, we and the subsidiary guarantors may not have sufficient funds to pay all of our creditors. Holders of our senior subordinated notes may, therefore, receive less, ratably, than the holders of our senior indebtedness. On a pro forma basis as of March 31, 2004, our senior subordinated notes and the associated subsidiary guarantees would have ranked junior, on a consolidated basis, to $ million of outstanding senior secured indebtedness plus approximately $100,000 of letters of credit and the subsidiary guarantees would have ranked junior to no senior unsecured debt and pari passu with approximately $ million of outstanding indebtedness of ours and the subsidiary guarantors. In addition, as of March 31, 2004, on a pro forma basis, we would have had the ability to borrow up to an additional amount of $ million under the new credit facility (less amounts reserved for letters of credit), which would have ranked senior in right of payment to our senior subordinated notes. Holders of our senior subordinated notes will be structurally subordinated to the debt of our non-guarantor subsidiaries. Our partially owned domestic subsidiaries will not be guarantors of our senior subordinated notes. As a result, no payments are required to be made to us from the assets of these subsidiaries. In the event of a bankruptcy, liquidation or reorganization or similar proceeding of any of the non-guarantor subsidiaries, holders of their indebtedness, including their trade creditors, would generally be entitled to payment of their claims from the assets of those subsidiaries before any assets are made available for distribution to us for payment to you. In the event of bankruptcy or insolvency, the senior subordinated notes and guarantees could be adversely affected by principles of equitable subordination or recharacterization. In the event of bankruptcy or insolvency, a party in interest may seek to subordinate the senior subordinated notes or the guarantees under the principles of equitable subordination or to recharacterize the senior subordinated notes as equity. There can be no assurance as to the outcome of such proceedings. In the event a court subordinates the senior subordinated notes or guarantees or recharacterizes the senior subordinated notes as equity, we cannot assure you that you would recover any amounts owed on the senior subordinated notes or the guarantees and you may be required to return any payments made to you within six years before the bankruptcy on account of the senior subordinated notes. In addition, should the court equitably subordinate the senior subordinated notes or the guarantees or recharacterize the senior subordinated notes as equity, you may not be able to enforce the guarantees. The senior subordinated notes and the guarantees may not be enforceable because of fraudulent conveyance laws. Under federal bankruptcy law and comparable provisions of state fraudulent transfer laws, a court could void the obligations under the senior subordinated notes or the guarantees, further subordinate the senior subordinated notes or the guarantees or take other action detrimental to you, if, among other things, at the time the indebtedness under the senior subordinated notes or the guarantees, as applicable, was incurred, we or a guarantor: issued the senior subordinated notes or the guarantee to delay, hinder or defraud present or future creditors; or received less than reasonably equivalent value or fair consideration for issuing the senior subordinated notes or the guarantee and, at the time of the issuance: was insolvent or rendered insolvent by reason of issuing the senior subordinated notes or the guarantee and the application of the proceeds of the senior subordinated notes; Table of Contents 10 .26 Wholesale Solutions Switched Services Agreement, dated as of August 11, 2003, by and between Sprint Communications Company L.P. and Valor Telecommunications Enterprises, LLC. 10 .27 First Amendment to Wholesale Solutions Switched Services Data and Private Line Agreement, dated as of October 3, 2003, between Sprint Communications Company L.P. and Valor Telecommunications Enterprises, LLC. ** 10 .28 Employment Agreement, dated as of June 18, 2000, by and between Valor Telecommunications, LLC and Kenneth R. Cole.** 10 .29 Amendment One to Employment Agreement, dated January 18, 2000, by and between Valor Telecommunications, LLC and Kenneth R. Cole.** 10 .30 Employment Agreement, dated as of January 2, 2002 by and between Valor Telecommunications, LLC and John J. Mueller.* 10 .31 Employment Agreement, dated as of March 20, 2000, by and between Valor Telecommunications, LLC and John A. Butler.** 10 .32 Employment Agreement, dated as of November 13, 2000, by and between Valor Telecommunications, LLC and William M. Ojile, Jr.** 10 .33 Amendment One to Employment Agreement, dated as of January 2, 2002, by and between Valor Telecommunications, LLC and William M. Ojile, Jr. 10 .34 Employment Agreement, dated as of February 28, 2000, by and between Valor Telecommunications, LLC and W. Grant Raney.** 10 .35 Amendment One to Employment Agreement, dated as of January 2, 2002, by and between Valor Telecommunications, LLC and W. Grant Raney.** 10 .36 Amended and Restated Employment Agreement, dated April 9, 2004, between Valor Telecommunications, LLC and John J. Mueller.* 12 .1 Ratio of Earnings to Fixed Charges.** 12 .2 Pro Forma Ratio of Earnings to Fixed Charges.** 23 .1 Consent of Deloitte Touche LLP and report on schedule. 23 .2 Consent of Kirkland Ellis LLP (included in Exhibit 5.1).* 23 .3 Consent of Kirkland Ellis LLP (included in Exhibit 8.1).* 23 .4 Consent of Houlihan Lokey Howard Zukin Financial Advisors, Inc.** 24 .1 Powers of Attorney (included on signature page).** 10 .26 Wholesale Solutions Switched Services Agreement, dated as of August 11, 2003, by and between Sprint Communications Company L.P. and Valor Telecommunications Enterprises, LLC. 10 .27 First Amendment to Wholesale Solutions Switched Services Agreement, dated as of October 3, 2003, between Sprint Communications Company L.P. and Valor Telecommunications Enterprises, LLC. ** 10 .28 Employment Agreement, dated as of June 18, 2000, by and between Valor Telecommunications, LLC and Kenneth R. Cole.** 10 .29 Amendment One to Employment Agreement, dated January 18, 2000, by and between Valor Telecommunications, LLC and Kenneth R. Cole.** 10 .30 Employment Agreement, dated as of January 2, 2002, by and between Valor Telecommunications, LLC and John J. Mueller.* 10 .31 Employment Agreement, dated as of March 20, 2000, by and between Valor Telecommunications, LLC and John A. Butler.** 10 .32 Employment Agreement, dated as of November 13, 2000, by and between Valor Telecommunications, LLC and William M. Ojile, Jr.** 10 .33 Amendment One to Employment Agreement, dated as of January 2, 2002, by and between Valor Telecommunications, LLC and William M. Ojile, Jr.** 10 .34 Employment Agreement, dated as of February 28, 2000, by and between Valor Telecommunications, LLC and W. Grant Raney.** 10 .35 Amendment One to Employment Agreement, dated as of January 2, 2002, by and between Valor Telecommunications, LLC and W. Grant Raney.** 10 .36 Amended and Restated Employment Agreement, dated April 9, 2004, between Valor Telecommunications, LLC and John J. Mueller.* 12 .1 Ratio of Earnings to Fixed Charges.** 12 .2 Pro Forma Ratio of Earnings to Fixed Charges.** 23 .1 Consent and report on schedule of Deloitte Touche LLP. 23 .2 Consent of Kirkland Ellis LLP (included in Exhibit 5.1).* 23 .3 Consent of Kirkland Ellis LLP (included in Exhibit 8.1).* 23 .4 Consent of Houlihan Lokey Howard Zukin Financial Advisors, Inc.** 24 .1 Powers of Attorney (included on signature page).** Valor Telecommunications, LLC Delaware 52-2171586 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Valor Telecommunications of Texas, LP Texas 52-2194219 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Valor Telecommunications Equipment, LP Texas 75-2884400 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Valor Telecommunications Services, LP Texas 75-2884846 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Valor Telecommunications Investments, LLC Delaware 47-0902124 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Valor Telecommunications Enterprises, LLC Delaware 75-2884398 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Valor Telecommunications LD, LP Delaware 75-2884847 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Southwest Enhanced Network Services, LP Delaware 75-2885419 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Western Access Services, LLC Delaware 20-0081823 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Western Access Services of Arizona, LLC Delaware 20-0081863 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Western Access Services of Arkansas, LLC Delaware 20-0081902 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Table of Contents was engaged or about to engage in a business or a transaction for which our or the guarantor s remaining unencumbered assets constituted unreasonably small capital to carry on its business; intended to incur, or believed that it would incur, debts beyond its ability to pay the debts as they mature; or was a defendant in an action for money damages, or had a judgment for money damages docketed against it if, in either case, after final judgment, the judgment is unsatisfied. The measures of insolvency for the purposes of fraudulent transfer laws vary depending upon the law applied in any proceeding to determine whether a fraudulent transfer has occurred. Generally, however, a person would be considered insolvent if, at the time it incurred the debt: the present fair saleable value of its assets was less than the amount that would be required to pay its probable liability on its existing debts, including contingent liabilities, as they become absolute and mature; or it could not pay its debts as they become due. Regardless of the standard that a court uses to determine whether we or a guarantor were solvent at the relevant time, the issuance of the senior subordinated notes or the guarantees may be voided or further subordinated to the claims of creditors if it concludes that we or a guarantor was insolvent. The guarantee of the senior subordinated notes by any subsidiary guarantor could be subject to the claim that, since the guarantee was incurred for our benefit, and only indirectly for the benefit of the guarantor, the guarantee was incurred for less than fair consideration. A court could therefore void the obligations of the subsidiary guarantor, under the guarantees or subordinate these obligations to the subsidiary guarantor s other debt or take action detrimental to holders of the senior subordinated notes. If the guarantee of any subsidiary guarantor were voided, the holders of the senior subordinated notes would not have a debt claim against that subsidiary guarantor. In addition, in the event that we meet any of the fraudulent transfer tests relating to financial condition, as described above, at the time of or as a result of this offering, a court could view the issuance of the senior subordinated notes, the guarantees and other transactions occurring on the issue date, such as repayment of our existing debt and various distributions described under Use of Proceeds as a single transaction and, as a result, conclude that we did not get fair value for the offering. In such a case, a court could hold the debt (including the guarantees) owed to the noteholders void or unenforceable or may further subordinate it to the claims of other creditors. Interest on the senior subordinated notes may not be deductible for United States federal income tax purposes, which could significantly reduce our future cash flow and impair our ability to make interest and dividend payments. No statutory, judicial or administrative authority has directly addressed the treatment of the IDSs or the senior subordinated notes, or instruments similar to the IDSs or the senior subordinated notes, for United States federal income tax purposes. As a result, the United States federal income tax consequences of the purchase, ownership and disposition of IDSs and senior subordinated notes are unclear. We will receive an opinion from our counsel, Kirkland Ellis, LLP, to the effect that an IDS should be treated as a unit representing a share of common stock and senior subordinated notes, and that the senior subordinated notes should be classified as debt for United States federal income tax purposes. However, the IRS or the courts may take the position that the IDSs are a single security classified as equity, or that the senior subordinated notes are properly classified as equity for United States federal income tax purposes, which could adversely affect the amount, timing and character of income, gain or loss in respect of your investment in IDSs or senior subordinated notes, and materially increase our taxable income and, thus, our United States federal and applicable state income tax liability. This would reduce our after-tax cash flow and could materially and adversely impact our ability to make interest and dividend payments on the senior subordinated notes and the common stock. Foreign holders could be subject to withholding or estate taxes with regard to the senior subordinated notes in the same manner as they will be with regard to the common stock. Payments to foreign holders would not be grossed-up for any such taxes. Further, we have Table of Contents Address Including Zip Code, State or Other Telephone Number Jurisdiction of I.R.S. Employer Including Area Code of Exact Name of Registrant Guarantor as Incorporation or Identification Registrant Guarantor s Specified in its Charter Organization Number Principal Executive Offices Table of Contents not received any opinion of counsel as to the treatment of senior subordinated notes that we may issue in any subsequent issuance, including in connection with an exchange of Class B common stock for IDSs and any subsequently issued senior subordinated notes may be treated as equity for United States federal income tax purposes. Apart from the exchanges of Class B common stock for IDSs, subsequent issuances of senior subordinated notes underlying IDSs will be made, subject to certain requirements, at the determination of our board of directors. For discussion of these tax-related risks, see Material United States Federal Income Tax Consequences. The allocation of the purchase price of the IDSs may not be respected, which may lead to you having to include original issue discount in your income even if you have not received the cash attributable to that income. The purchase price of each IDS must be allocated for tax purposes between the share of common stock and senior subordinated notes comprising the IDS in proportion to their respective fair market values at the time of purchase. It is possible that the IRS will successfully challenge our allocation. If the allocation of the purchase price to the senior subordinated notes were determined to be too high, then it is possible that the senior subordinated notes would be treated as having been issued with OID, and you generally would be required to include the OID in income in advance of the receipt of cash attributable to that income. If, on the other hand, the allocation of purchase price to the senior subordinated notes were determined to be too low, then it is possible that the senior subordinated notes would be treated as having been issued with amortizable bond premium, and you would generally be able to elect to amortize such bond premium over the term of the senior subordinated notes. Because of the deferral of interest provisions, the senior subordinated notes may be treated as issued with original issue discount. Under applicable Treasury regulations, a remote contingency that stated interest will not be timely paid is disregarded in determining whether a debt instrument is issued with OID. Although there is no authority directly on point, based on our financial forecasts, we believe that the likelihood of deferral of interest payments on the senior subordinated notes is remote within the meaning of the Treasury regulations. Based on the foregoing determination made by us, although the matter is not free from doubt because of the lack of direct authority, our counsel is of the opinion that the possibility that interest payments on the senior subordinated notes may be deferred should not cause the senior subordinated notes to be considered to be issued with OID at the time of their original issuance. If deferral of any payment of interest were determined not to be remote, then the senior subordinated notes would be treated as issued with OID at the time of issuance. In such case, all stated interest on the senior subordinated notes would be treated as OID, with the consequence that all holders would be required to include the yield on the senior subordinated notes in income as it accrued on a constant yield basis, possibly in advance of their receipt of the associated cash and regardless of their method of tax accounting. Subsequent issuances of senior subordinated notes may cause you to recognize taxable gain and/or original issue discount. The United States federal income tax consequences to you of a subsequent issuance of senior subordinated notes with OID (or any issuance of senior subordinated notes thereafter) are unclear and our counsel is unable to opine on this issue. The indenture governing the senior subordinated notes and our agreements with DTC will provide that, in the event that there is a subsequent issuance of senior subordinated notes with OID, and in connection with each issuance of senior subordinated notes thereafter, including an issuance of senior subordinated notes upon an exchange of shares of Class B common stock, each holder of senior subordinated notes or IDSs, as the case may be, agrees that a portion of such holder s senior subordinated notes will be automatically exchanged for a portion of the senior subordinated notes acquired by the holders of such subsequently issued senior subordinated notes. Such subsequent issuance and exchange will not change the aggregate stated principal amount of senior subordinated notes owned by you and each other holder. Due to the lack of applicable authority, it is unclear whether an exchange of senior subordinated notes for subsequently issued senior subordinated notes will result in a taxable exchange for United States federal income tax purposes. It is possible that the IRS might successfully assert that such an exchange should be Table of Contents treated as a taxable exchange. In such case, you would recognize any gain realized on the exchange, but a loss might be disallowed. For a more complete description of the tax consequences of a subsequent issuance, see Material United States Federal Income Tax Consequences Senior Subordinated Notes Additional Issuances. Regardless of whether the exchange is treated as a taxable event, such exchange may result in an increase in the amount of OID, if any, that you are required to accrue with respect to the senior subordinated notes. Following any subsequent issuance of senior subordinated notes with OID or any issuance of senior subordinated notes thereafter and resulting exchange, we and our agents will report any OID on any subsequently issued senior subordinated notes ratably among all holders of senior subordinated notes and IDSs. By purchasing senior subordinated notes or IDSs, as the case may be, each holder of senior subordinated notes and IDSs agrees to report OID in a manner consistent with this approach. As a result of a subsequent issuance, therefore, you may be required to report OID even though you purchased senior subordinated notes having no OID. This will generally result in you reporting more interest income over the term of the senior subordinated notes than you would have reported had no such subsequent issuance and exchange occurred. The IRS, however, may assert that OID should be reported only to the persons that initially acquired such subsequently issued senior subordinated notes and their transferees. In such case, the IRS might further assert that, unless a holder can establish that it is not an initial holder of subsequently issued senior subordinated notes or a transferee thereof, all senior subordinated notes held by such holder will have OID. Any of these assertions by the IRS could create significant uncertainties in the pricing of IDSs and senior subordinated notes and could adversely affect the market for IDSs and senior subordinated notes. If we subsequently issue senior subordinated notes with significant OID, then we may be unable to deduct all the interest on the senior subordinated notes. It is possible that the senior subordinated notes that we issue in a subsequent issuance will be issued at a discount to their face value and, accordingly, may have significant OID and thus be classified as applicable high yield discount obligations. If any such senior subordinated notes were so treated, then a portion of the OID on such notes could be nondeductible by us and the remainder would be deductible only when paid. This treatment would have the effect of increasing our taxable income and may adversely affect our cash flow available for interest payments and distributions to our shareholders. A subsequent issuance of senior subordinated notes or an allocation of IDS purchase price that results in OID may reduce the amount you can recover upon an acceleration of the payment of principal due on the senior subordinated notes or in the event of our bankruptcy. Under New York and federal bankruptcy law, holders of subsequently issued senior subordinated notes having original issue discount may not be able to collect the portion of the principal face amount of such senior subordinated notes that represents unamortized original issue discount as of the acceleration or filing date, as the case may be, in the event of an acceleration of the senior subordinated notes or in the event of our bankruptcy prior to the maturity date of the senior subordinated notes. As a result, a treatment of the senior subordinated notes as having been issued with OID or an automatic exchange that results in a holder receiving a senior subordinated note with original issue discount could have the effect of ultimately reducing the amount such holder can recover from us in the event of an acceleration or bankruptcy. Before this offering, there has not been a public market for our IDSs. The price of the IDSs may fluctuate substantially, which could negatively affect the value of your investment. Our IDSs have no public market history. In addition, there has not been an established market in the United States or in Canada for securities similar to the IDSs. We cannot assure you that an active trading market for the IDSs will develop in the future. The initial public offering price of the IDSs has been determined by negotiations among us, the existing equity holders and the representatives of the underwriters and may not be indicative of the market price of the IDSs after the offering. Factors such as quarterly variations in our financial results, announcements by Table of Contents us or others, developments affecting us, our clients and our suppliers, general interest rate levels and general market volatility could cause the market price of the IDSs to fluctuate significantly. If the IDSs separate, the limited liquidity of the market for the senior subordinated notes and Class A common stock may adversely affect your ability to sell the senior subordinated notes and Class A common stock. We do not intend to list the senior subordinated notes represented by the IDSs on any exchange or quotation system. Our Class A common stock will not initially be listed for separate trading on the New York Stock Exchange or any other exchange or quotation system other than the Toronto Stock Exchange (on which we do not anticipate an active trading market for the Class A common stock to develop). We will not apply to list our shares of Class A common stock for separate trading on the New York Stock Exchange or any other exchange or quotation system until the number of shares held separately is sufficient to satisfy applicable requirements for separate trading on such exchange or quotation system. The Class A common stock may not be approved for listing at such time. Upon separation of the IDSs, no sizable market for the senior subordinated notes and the Class A common stock may ever develop and the liquidity of any trading market for the notes or the Class A common stock that does develop may be limited. As a result, your ability to sell your notes or Class A common stock, and the market price you can obtain, could be adversely affected. The limited liquidity of the trading market for the senior subordinated notes sold separately (not represented by IDSs) may adversely affect the trading price of the separate senior subordinated notes. We are separately selling (not represented by IDSs) $ million aggregate principal amount of senior subordinated notes, representing approximately 10% of the total principal amount of the outstanding senior subordinated notes. While the senior subordinated notes sold separately (not represented by IDSs) are part of the same series of notes as, and are identical to, the senior subordinated notes represented by IDSs at the time of the issuance of the separate senior subordinated notes, the senior subordinated notes represented by the IDSs will not be separable for at least 45 days and will not be separately tradeable until separated. As a result, the initial trading market for the senior subordinated notes sold separately (not represented by IDSs) will be very limited. Even after holders of the IDSs are permitted to separate their IDSs, a sufficient number of holders of IDSs may not separate their IDSs into shares of our Class A common stock and senior subordinated notes to create a sizable and more liquid trading market for the senior subordinated notes not represented by IDSs. Therefore, a liquid market for the senior subordinated notes may not develop, which may adversely affect the ability of the holders of the separate senior subordinated notes to sell any of their separate senior subordinated notes and the price at which these holders would be able to sell any of the senior subordinated notes sold separately. Future sales or the possibility of future sales of a substantial amount of IDSs, shares of our common stock or our senior subordinated notes may depress the price of the IDSs and the shares of our common stock and our senior subordinated notes. Future sales or the availability for sale of substantial amounts of IDSs or shares of our common stock or a significant principal amount of our senior subordinated notes in the public market could adversely affect the prevailing market price of the IDSs and the shares of our common stock and senior subordinated notes and could impair our ability to raise capital through future sales of our securities. We may issue shares of our Class A common stock and senior subordinated notes, which may be in the form of IDSs, or other securities from time to time as consideration for future acquisitions and investments. In the event any such acquisition or investment is significant, the number of shares of our Class A common stock and the aggregate principal amount of senior subordinated notes, which may be in the form of IDSs, or the number or aggregate principal amount, as the case may be, of other securities that we may issue may in turn be significant. In addition, we may also grant registration rights covering those IDSs, shares of our common stock, senior subordinated notes or other securities in connection with any such acquisitions and investments. Any or all of these occurrences could depress the trading prices of our securities. Balance, March 31, 2004 $ Table of Contents Regulatory Risks We received 24.1% of our 2003 revenues from the Texas and federal Universal Service Funds and any adverse regulatory developments with respect to these funds could curtail our profitability. We receive Texas and federal Universal Service Fund, or USF, revenues to support the high cost of providing affordable telecommunications services in rural markets. Such support payments constituted 24.1% of our revenues for the year ended December 31, 2003 and 23.9% of our revenues for the three months ended March 31, 2004. Of these support payments, in the year ended December 31, 2003, $103.1 million, or 20.7% of our revenues, and in the three months ended March 31, 2004, $25.5 million, or 20.2% of our revenues, were received from the Texas USF. In addition, we are required to make contributions to the Texas USF and federal USF each year. Current state and federal regulations allow us to recover these costs by including a surcharge on our customers bills. Furthermore, we incur no incremental costs associated with the support payments we receive or the contributions we are required to make. Thus, if Texas and/or federal regulations changed and we were unable to receive support, such support was reduced, or we are unable to recover the amounts we contribute to the Texas USF and federal USF from our customers, our earnings would be directly and adversely affected. For a more detailed discussion of the regulations affecting our company, see Regulation. The rules governing USF could be altered or amended as a result of regulatory, legislative or judicial action and impact the amount of USF support that we receive and our ability to recover our USF contributions by assessing surcharges on our customers bills. For example, the enabling statute for the Texas USF will become subject to review and renewal in late 2005 and may be modified. Similarly, the FCC asked the Federal-State Joint Board on Universal Service to review the federal rules relating to universal service support mechanisms for rural carriers, including addressing the relevant costs and the definition of rural telephone company in June 2004. It is not possible to predict at this time whether state or federal regulators, Congress or state legislatures will order modification to those rules or statutes, or the ultimate impact any such modification might have on us. In addition, the Texas USF rules provide that the Texas Public Utility Commission must open an investigation within 90 days after any changes are made to the federal USF. Therefore, changes to the federal USF may prompt similar or conforming changes to the Texas USF. The outcome of any of these legislative or regulatory changes could affect the amount of Texas USF support that we receive, and could have an adverse effect on our business, revenue or profitability. Reductions in the amount of network access revenue that we receive could negatively impact our results of operations. In the year ended December 31, 2003, we derived $132.0 million, or 26.6% of our revenues, and in the three months ended March 31, 2004, we derived $33.0 million, or 26.3% of our revenues, from network access charges. Our network access revenue consists of (1) usage sensitive fees we charge to long distance companies for access to our network in connection with the completion of interstate and intrastate long distance calls, (2) fees charged for use of dedicated circuits and (3) end user fees, which are monthly flat-rate charges assessed on access lines. Federal and state regulatory commissions set these access charges, and they could change the amount of the charges or the manner in which they are charged at any time. The FCC is currently examining proposals to revise interstate access charges and other intercarrier compensation. Also, as people in our markets decide to use Internet, wireless or cable television providers for their local or long distance calling needs, rather than using our wireline network, the reduction in the number of access lines or minutes of use over our network could reduce the amount of access revenue we collect. As penetration rates for these technologies increase in rural markets, our revenues could decline. In addition, if our customers take advantage of favorable calling plans offered by wireless carriers for their long distance calling needs, it could reduce the number of long distance calls made over our network, thereby decreasing our access revenue. Furthermore, disputes are pending as to whether providers of Voice over Internet Protocol, or VoIP technology, which allow customers to make voice calls over the Internet or using Internet Protocol, are subject to FCC or state regulations that would require them to pay network charges. With the emergence of VoIP technology, the FCC and state commissions are considering the Western Access Services of Colorado, LLC Delaware 20-0081934 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Western Access Services of Oklahoma, LLC Delaware 20-0081944 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Western Access Services of New Mexico, LLC Delaware 20-0081922 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Western Access Services of Texas, LP Delaware 20-0081952 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Valor Telecommunications Corporate Group, LP Texas 75-2895493 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Valor Telecommunications Southwest, LLC Delaware 52-2194218 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Valor Telecommunications Southwest II, LLC Delaware 75-2950066 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Valor Telecommunications Enterprises II, LLC Delaware 75-2950064 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Kerrville Communications Corporation Texas 74-2197091 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Kerrville Communications Management, LLC Delaware 30-0135974 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Kerrville Communications Enterprises, LLC Delaware 32-0047694 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Advanced Tel-Com Systems, LP Texas 74-2228603 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Table of Contents status of VoIP and other Internet services and there can be no assurance that the FCC and state regulators will require such providers to pay access charges. Any or all of these developments could reduce the amount of access revenue that we receive which could negatively impact our revenues and profitability. The introduction of new competitors or the better positioning of existing competitors due to regulatory changes could cause us to lose customers and impede our ability to attract new customers. Changes in regulations that open our markets to more competitors offering substitute services could impact our profitability because of increases in the costs of attracting and retaining customers and decreases in revenues due to lost customers and the need to offer competitive prices. We face competition from current and potential market entrants, including: domestic and international long distance providers seeking to enter, reenter or expand entry into the local telecommunications marketplace; other domestic and international competitive telecommunications providers, wireless carriers, resellers, cable television companies and electric utilities; and providers of broadband and Internet services. Regulatory requirements designed to facilitate the introduction of competition, the applicability of different regulatory requirements between our competitors and us, or decisions by legislators or regulators to exempt certain providers or technologies from the same level of regulation that we face, could adversely impact our market position and our ability to offer competitive alternatives. In November 2003, the FCC ordered us and other local exchange carriers to adopt wireline-to-wireless local number portability. This may help wireless carriers compete against us because if customers switch from traditional local telephone service to wireless service, they can now transfer their local telephone number to their wireless provider. In addition, federal and state regulators and courts are addressing many aspects of our obligations to provide unbundled network elements and discounted wholesale rates to competitors. New regulations and changes in existing regulations may force us to incur significant expenses. Our business may also be impacted by legislation and regulation that impose new or greater obligations related to assisting law enforcement, bolstering homeland security, minimizing environmental impacts or addressing other issues that impact our business. For example, existing provisions of the Communications Assistance for Law Enforcement Act, or CALEA, and FCC regulations implementing CALEA require telecommunications carriers to ensure that their equipment, facilities, and services are able to facilitate authorized electronic surveillance. We cannot predict whether and when the FCC might modify its CALEA rules or any other rules or what compliance with new rules might cost. Similarly, we cannot predict whether or when federal or state legislators or regulators might impose new security, environmental or other obligations on our business. For a more thorough discussion of the regulation of our company and how that regulation may affect our business, see Regulation. Certain transactions related to the enforceability of the guarantees of the senior subordinated notes by certain of our subsidiaries may require FCC or state regulatory commission approval, which may not be granted or which may be subject to delays or conditions that could affect your ability to enforce the guarantees. In the event that it becomes necessary to enforce the guarantees of the senior subordinated notes, approvals may be required for certain of our subsidiaries that are subject to federal or state regulatory authority, including approval for the transfer of control of various radio licenses held by our operating subsidiaries or the transfer of control over or sale of the assets of our operating subsidiaries. Such approvals may not be obtained, in which case such guarantees would be unenforceable, or may be subject to delays or conditions that could affect your ability to enforce the guarantees. Table of Contents Address Including Zip Code, State or Other Telephone Number Jurisdiction of I.R.S. Employer Including Area Code of Exact Name of Registrant Guarantor as Incorporation or Identification Registrant Guarantor s Specified in its Charter Organization Number Principal Executive Offices Table of Contents A reduction by a state regulatory body or the FCC of the rates we charge our customers would reduce our revenues and earnings. The prices, terms and conditions of the services that we offer to local telephone customers are subject to state regulatory approval. If a state regulatory body orders us to reduce a price, withdraws our approval to charge a certain price, changes material terms or conditions of a service we offer or refuses to approve or limits our ability to offer a new or existing service, both our revenues and our earnings may be reduced. FCC regulations also affect the rates that are charged to customers. The FCC regulates tariffs for interstate access and subscriber line charges, both of which are components of our revenues. The FCC currently is considering proposals to reduce interstate access charges for carriers like us. If the FCC lowers interstate access charges without adopting an adequate revenue replacement mechanism, we may be required to recover more revenue through subscriber line charges and universal service funds or forego this revenue altogether. This could reduce our revenue or impair our competitive position. Risks Relating to Our Business We provide services to our customers over access lines and if we continue to lose access lines our revenues and earnings may decrease. Our business generates revenue by delivering voice and data services over access lines. We have experienced net access line loss over the past few years, and during the year ended December 31, 2003, the number of access lines we serve declined by 2.6% due to challenging economic conditions and increased competition. We may continue to experience net access line loss in our markets for an unforeseen period of time. Our inability to retain access lines could adversely affect our revenue and earnings. Rapid and significant changes in technology in the telecommunications industry could adversely affect our ability to compete effectively in the markets in which we operate. The rapid introduction and development of enhanced or alternative services that are more cost effective, more efficient or more technologically advanced than the services we offer is a significant source of potential competition in the telecommunications industry. Technological developments may reduce the competitiveness of our networks, make our service offerings less attractive or require expensive and time-consuming capital improvements. If we fail to adapt successfully to technological changes or fail to obtain timely access to important new technologies, we could lose customers and have difficulty attracting new customers or selling new services to our existing customers. We cannot predict the impact of technological changes on our competitive position, profitability or industry. Wireless and cable technologies that have emerged in recent years provide certain advantages over traditional wireline voice and data services. The mobility afforded by wireless voice services and its competitive pricing appeal to many customers. The ability of cable television providers to offer voice, video and data services as an integrated package provides an attractive alternative to traditional voice services from local exchange carriers. In addition, as the emerging VoIP services develop, some customers may be able to bypass network access charges. Increased penetration rates for these technologies in our markets could cause our revenues to decline. The competitive nature of the telecommunications industry could adversely affect our revenues, results of operations and profitability. The telecommunications industry is very competitive. Increased competition could lead to price reductions, declining sales volumes, loss of market share, higher marketing costs and reduced operating margins. Significant and potentially larger competitors could enter our markets at any time, including local service providers, cable television companies and wireless telecommunications providers. For a more thorough discussion of the competition that may affect our business, see Business Competition. Table of Contents Weak economic conditions may decrease demand for our services. We are sensitive to economic conditions and downturns in the economy. Downturns in the economies in the markets we serve could cause our existing customers to reduce their purchases of our basic and enhanced services and make it difficult for us to obtain new customers. We depend on a few key vendors and suppliers to conduct our business and any disruption in our relationship with any one or more of them could adversely affect our results of operations. We rely on vendors and suppliers to support many of our administrative functions and to enable us to provide long distance services. For example, we currently outsource much of our operational support services to ALLTEL, including our billing and customer care services. Transitioning these support services to another provider could take a significant period of time and involve substantial costs. In addition, we have resale agreements with MCI and Sprint to provide our long distance transmission services. Replacing these resale agreements could be difficult as there are a limited number of national long distance providers. Any disruptions in our relationship with these third party providers could have an adverse effect on our business and operations. Disruption in our networks and infrastructure may cause us to lose customers and incur additional expenses. To be successful, we will need to continue to provide our customers with reliable service over our networks. Some of the risks to our networks and infrastructure include: physical damage to access lines, breaches of security, capacity limitations, power surges or outages, software defects and disruptions beyond our control, such as natural disasters and acts of terrorism. Disruptions may cause interruptions in service or reduced capacity for customers, either of which could cause us to lose customers and incur expenses, and thereby adversely affect our business, revenue and cash flow. Recent difficulties in the telecommunications industry could negatively impact our revenues and results of operations. We originate and terminate long distance phone calls on our networks for other interexchange carriers, some of which are our largest customers in terms of revenues. In the year ended December 31, 2003 and the three months ended March 31, 2004, we generated 17.5% and 17.2%, respectively, of our total revenues from originating and terminating phone calls for interexchange carriers. Several of these interexchange carriers have declared bankruptcy during the past two years or are experiencing substantial financial difficulties. MCI WorldCom (now MCI), which declared bankruptcy in 2002, is one of the major interexchange carriers with which we conduct business. We recorded a net $1.6 million charge due to MCI s failure to pay amounts owed to us. Further bankruptcies or disruptions in the businesses of these interexchange carriers could have an adverse effect on our financial results and cash flows. Following the consummation of this offering, our equity sponsors will collectively be able to exercise substantial influence over matters requiring stockholder approval and their interests may diverge from the interests of the holders of the IDSs. Following the consummation of this offering, affiliates of Welsh, Carson, Anderson Stowe, or WCAS, affiliates of Vestar Capital Partners, or Vestar, and affiliates of Citicorp Venture Capital, or CVC, will beneficially own %, % and %, respectively, of our outstanding shares of Class A common stock as part of the IDSs, and %, % and %, respectively, of our outstanding shares of Class B common stock. As a result, WCAS, Vestar and CVC collectively exercise substantial influence over matters requiring stockholder approval, including decisions about our capital structure. In addition, WCAS has two designees and Vestar has one designee serving on our board of directors. The interests of our equity sponsors may conflict with your interests as a holder of the IDSs. Table of Contents Our amended and restated certificate of incorporation and by-laws and several other factors could limit another party s ability to acquire us and deprive our investors of the opportunity to obtain a takeover premium for their securities. A number of provisions in our amended and restated certificate of incorporation and by-laws will make it difficult for another company to acquire us and for you to receive any related takeover premium on our securities. For example, our amended and restated certificate of incorporation provides that stockholders may not act by written consent and that only our board of directors may call a special meeting. In addition, stockholders are required to provide us with advance notice if they wish to nominate any persons for election to our board of directors or if they intend to propose any matters for consideration at an annual stockholders meeting. Our amended and restated certificate of incorporation authorizes the issuance of preferred stock without stockholder approval and upon such terms as the board of directors may determine. The rights of the holders of shares of our common stock will be subject to, and may be adversely affected by, the rights of holders of any class or series of preferred stock that may be issued in the future. Table of Contents
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+Risk Factors Before you invest in the IDSs (including the shares of our Class A common stock and our senior subordinated notes represented by the IDSs) or the senior subordinated notes, you should carefully consider the various risks of the investment, including those described below, together with all of the other information included in this prospectus. If any of these risks actually occur, our business, financial condition or operating results could be adversely affected. Risks Relating to the IDSs, the Shares of Class A Common Stock and Senior Subordinated Notes Represented by the IDSs, the Senior Subordinated Notes Offered Separately (not in the Form of IDSs), and our New Credit Facility Our substantial indebtedness could restrict our ability to pay interest and principal on the senior subordinated notes and to pay dividends with respect to shares of our Class A common stock represented by the IDSs and impact our financing options and liquidity position. Upon the consummation of this offering, we will have approximately $ million of total debt outstanding, $ million of which will rank senior to the senior subordinated notes. The degree to which we are leveraged on a consolidated basis could have important consequences to the holders of the IDSs and of separate senior subordinated notes, including: it may be more difficult to satisfy our obligations under the senior subordinated notes and to pay dividends on our Class A common stock; our ability to obtain additional financing in the future for working capital, capital expenditures or acquisitions may be limited; we may be unable to refinance our indebtedness on terms acceptable to us or at all; a significant portion of our cash flow from operations is likely to be dedicated to the payment of the principal of and interest on our indebtedness, thereby reducing funds available for other corporate purposes; and our substantial indebtedness may make us more vulnerable to economic downturns and limit our ability to withstand competitive pressures. We may be able to incur substantially more debt, which could exacerbate the risks associated with our substantial indebtedness described above. While our new credit facility will contain total leverage, senior leverage and interest coverage covenants and the indenture governing the senior subordinated notes will contain incurrence covenants that will restrict our ability to incur debt as described under Description of Certain Indebtedness New Credit Facility, and Description of Senior Subordinated Notes Additional Notes, as long as we meet these financial covenants we will be allowed to incur additional indebtedness, including senior subordinated notes with terms identical to the senior subordinated notes offered hereby. The terms of our new credit facility restrict our ability to pay interest on our senior subordinated notes and dividends on shares of our common stock and we may amend these terms or enter into new agreements that are more restrictive. Our new credit facility contains significant restrictions on our ability to pay interest on the senior subordinated notes and dividends on shares of common stock based on meeting our interest coverage ratio and senior leverage ratio and compliance with other conditions. As a result of general economic conditions, conditions in the lending markets, the results of our business or for any other reason, we may elect or be required to amend or refinance our new credit facility, at or prior to maturity, or enter into additional agreements for senior indebtedness. Regardless of any protection you have in the indenture governing the senior subordinated notes, any such amendment, refinancing or additional indebtedness may contain covenants that could limit in a significant manner our ability to make interest payments and pay dividends to you. Table of Contents Table of Additional Registrant Guarantors Address Including Zip Code, State or Other Telephone Number Jurisdiction of I.R.S. Employer Including Area Code of Exact Name of Registrant Guarantor as Incorporation or Identification Registrant Guarantor s Specified in its Charter Organization Number Principal Executive Offices Table of Contents We are subject to restrictive debt covenants that impose operating and financial restrictions on our operations and could limit our ability to grow our business. The agreements governing our indebtedness impose significant operating and financial restrictions on us. These restrictions prohibit or limit, among other things: the incurrence of additional indebtedness and the issuance of preferred stock and certain redeemable capital stock; a number of other restricted payments, including investments and acquisitions; specified sales of assets; specified transactions with affiliates; the creation of a number of liens; consolidations, mergers and transfers of all or substantially all of our assets; and our ability to change the nature of our business. These restrictions could limit our ability to obtain future financing, make acquisitions, withstand downturns in our business or take advantage of business opportunities. If we fail to comply with the restrictive debt covenants in the agreements governing our indebtedness, our senior lenders may accelerate the payment of indebtedness outstanding under our new credit facility which is senior to the senior subordinated notes. The terms of the new credit facility include several restrictive covenants that prohibit us from prepaying our other indebtedness, including the senior subordinated notes, while indebtedness under the new credit facility is outstanding. The new credit facility also requires us to maintain specified financial ratios and satisfy financial condition tests. Our ability to comply with the ratios or tests may be affected by events beyond our control, including prevailing economic, financial and industry conditions. See the information under Description of Certain Indebtedness for a fuller description of these restrictions and covenants. A breach of any of these covenants, ratios or tests could result in a default under the new credit facility and/or the indenture. Events of default under the new credit facility would prohibit us from making payments on the senior subordinated notes in cash, including payment of interest when due. In addition, upon the occurrence of an event of default under the new credit facility, the lenders could elect to declare all amounts outstanding under the new credit facility, together with accrued interest, to be immediately due and payable. If we were unable to repay those amounts, the lenders could proceed against the security granted to them to secure that indebtedness. If the lenders accelerate the payment of the indebtedness, our assets may not be sufficient to repay in full this indebtedness and our other indebtedness, including the senior subordinated notes. We are a holding company with no operations, and unless we receive dividends and other payments, advances and transfers of funds from our subsidiaries, we will be unable to meet our debt service and other obligations. We are a holding company and conduct all of our operations through our subsidiaries. We currently have no significant assets other than equity interests in our subsidiaries. As a result, we will rely on dividends and other payments or distributions from our subsidiaries to meet our debt service obligations and enable us to pay dividends. The ability of our subsidiaries to pay dividends or make other payments or distributions to us will depend on their respective operating results and may be restricted by, among other things, the laws of their jurisdiction of organization (which may limit the amount of funds available for the payment of dividends), agreements of those subsidiaries, the terms of the new credit facility (under which the equity interests of our subsidiaries will be pledged), and the covenants of any future outstanding indebtedness we or our subsidiaries incur. Table of Contents You may not receive interest payments on your senior subordinated notes on the regularly scheduled payment dates as we may defer the payment of interest to you for a significant period of time, subject to restrictions set forth in the indenture. We may, subject to restrictions set forth in the indenture, defer interest payments on our senior subordinated notes on one or more occasions. For any interest deferred during the first five years, we are not obligated to pay any deferred interest until , 2009. As a result, you may not receive interest payments on the regularly scheduled payment dates and you may be owed a substantial amount of deferred interest that will not be due and payable for a significant period of time. See Description of Senior Subordinated Notes Interest Deferral. You may not receive the level of dividends provided for in the dividend policy that our board of directors is expected to adopt upon the closing of this offering or any dividends at all. Our board of directors may, in its discretion, amend or repeal the dividend policy it is expected to adopt upon the closing of this offering. Our board of directors may decrease the level of dividends provided for in this dividend policy or entirely discontinue the payment of dividends. The amount of future dividends with respect to shares of our capital stock, if any, will depend on, among other things, our results of operations, cash requirements, financial condition, contractual restrictions, business opportunities, provisions of applicable law and other factors that our board of directors may deem relevant. In addition, the indenture governing our senior subordinated notes and the new credit facility each contain significant restrictions which could affect your receipt of dividends, because among other things, if we defer interest on the senior subordinated notes, we may not pay dividends until we have paid all deferred interest and accrued interest thereon. Furthermore, if the senior subordinated notes were treated as equity rather than as debt for United States federal income tax purposes, then the stated interest on the senior subordinated notes could be treated as a dividend and would not be deductible by us for United States federal income tax purposes. Our inability to deduct interest on the senior subordinated notes could materially increase our taxable income and, thus, our United States federal and applicable state income tax liability. If this were to occur, our after-tax cash flow available for dividend and interest payments would be reduced. You will be immediately diluted by $ per share of Class A common stock if you purchase IDSs in this offering. If you purchase IDSs in this offering, based on the book value of the assets and liabilities reflected on our balance sheet, you will experience an immediate dilution of $ per share of Class A common stock represented by the IDSs which exceeds the entire price allocated to each share of Class A common stock represented by the IDSs in this offering because there will be a net tangible book deficit for each share of Class A common stock outstanding immediately after this offering. Our net tangible book value as of March 31, 2004, after giving effect to this offering, was approximately $ million, or $ per share of Class A common stock. Our interest expense may increase significantly and could cause our net income and distributable cash to decline significantly. The new credit facility will be subject to periodic renewal or must otherwise be refinanced. We may not be able to renew or refinance the new credit facility, or if renewed or refinanced, the renewal or refinancing may occur on less favorable terms, including higher interest rates. Borrowings under the revolving facility will be made at a floating rate of interest. In the event of an increase in the base reference interest rates, our interest expense will increase and could have a material adverse effect on our ability to make cash dividend payments to our shareholders. Our ability to continue to expand our business will, to a large extent, be dependent upon our ability to borrow funds under our new credit facility and to obtain other third party financing, including through the sale of IDSs or other securities. We cannot assure you that such financing will be available to us on favorable terms or at all. 2003 $ 168 $ 2004 141 198 2005 86 130 2006 71 107 2007 58 92 2008 62 Thereafter 68 Table of Contents If we are unable to generate sufficient funds from operations we will be unable to pay our indebtedness at maturity or upon the exercise by holders of their rights upon a change of control. Because a significant portion of our cash flow from operations will be dedicated to servicing our debt requirements and making capital expenditures to maintain the quality of our physical plant, we may not have sufficient funds from operations to repay the principal amount of our indebtedness at maturity or in case you exercise your right to require us to purchase your notes upon a change of control. In addition, we currently expect to distribute a significant portion of any remaining cash earnings to our stockholders in the form of quarterly dividends. Moreover, prior to the maturity of our senior subordinated notes, we will not be required to make any payments of principal on our senior subordinated notes. We may, therefore, need to refinance our debt or raise additional capital to meet our obligations. These alternatives may not be available to us when needed or on satisfactory terms due to prevailing market conditions, a decline in our business or restrictions contained in our senior debt obligations. We may pay a significant portion of our free cash flow to stockholders in the form of dividends thereby reducing the amounts available to us to satisfy our obligations on the senior subordinated notes. Our new credit facility and the indenture governing our senior subordinated notes permit us to pay a significant portion of our free cash flow to stockholders in the form of dividends, subject to certain limitations. Following completion of this offering, we intend to pay quarterly dividends. Any amounts paid by us in the form of dividends will not be available in the future to satisfy our obligations under the senior subordinated notes. The limitations on our ability to pay dividends are more fully described in Description of Senior Subordinated Notes Certain Covenants and Description of Certain Indebtedness New Credit Facility. If the realizable value of our assets is insufficient to satisfy claims, you could lose all or part of your investment upon a liquidation of our company. At March 31, 2004, our assets included goodwill of $1,057 million and deferred financing costs of $52 million. Combined, these items represent approximately 54.8% of our total consolidated assets. The value of these assets will continue to depend significantly upon the success of our business as a going concern and the growth in cash flows. As a result, in the event of a default under our new credit facility or on our senior subordinated notes or any bankruptcy or dissolution of our company, the realizable value of these assets may be substantially lower and may be insufficient to satisfy the claims of our creditors. Deferral of interest payments would have adverse tax consequences for you. If we defer interest payments on the senior subordinated notes, you will be required to recognize interest income for United States federal income tax purposes in respect of the senior subordinated notes before you receive any cash payment of this interest. In addition, we will not pay you this cash if you sell the IDSs or the senior subordinated notes, as the case may be, before the end of any deferral period or before the record date relating to interest payments that are to be paid. Deferral of interest payments may also adversely affect the trading price of the senior subordinated notes. The IDSs or the senior subordinated notes may trade at a price that does not fully reflect the value of accrued but unpaid interest on the senior subordinated notes if we defer interest payments. In addition, the requirement that we defer payments of interest on the senior subordinated notes under certain circumstances may mean that the market price for the IDSs or the senior subordinated notes may be more volatile than other securities that do not have this requirement. Because of the subordinated nature of the notes, holders of our senior subordinated notes may not be entitled to be paid in full, if at all, in a bankruptcy, liquidation or reorganization or similar proceeding. As a result of the subordinated nature of our notes and related guarantees, upon any distribution to our creditors or the creditors of the subsidiary guarantors in bankruptcy, liquidation or reorganization or similar proceeding relating to us or the subsidiary guarantors or our or their property, the holders of our senior indebtedness and senior indebtedness of the subsidiary guarantors will be entitled to be paid in full in cash Table of Contents before any payment may be made with respect to our senior subordinated notes or the subsidiary guarantees. Holders of our senior subordinated notes would participate with all other holders of unsecured indebtedness of ours or the subsidiary guarantors that are similarly subordinated in the assets remaining after we and the subsidiary guarantors have paid all senior indebtedness. However, because of the existence of the subordination provisions, including the requirement that holders of the senior subordinated notes pay over distributions to holders of senior indebtedness, holders of the senior subordinated notes may receive less, ratably, than our other unsecured creditors, including trade creditors. In any of these cases, we and the subsidiary guarantors may not have sufficient funds to pay all of our creditors. Holders of our senior subordinated notes may, therefore, receive less, ratably, than the holders of our senior indebtedness. On a pro forma basis as of March 31, 2004, our senior subordinated notes and the associated subsidiary guarantees would have ranked junior, on a consolidated basis, to $ million of outstanding senior secured indebtedness plus approximately $100,000 of letters of credit and the subsidiary guarantees would have ranked junior to no senior unsecured debt and pari passu with approximately $ million of outstanding indebtedness of ours and the subsidiary guarantors. In addition, as of March 31, 2004, on a pro forma basis, we would have had the ability to borrow up to an additional amount of $ million under the new credit facility (less amounts reserved for letters of credit), which would have ranked senior in right of payment to our senior subordinated notes. Holders of our senior subordinated notes will be structurally subordinated to the debt of our non-guarantor subsidiaries. Our partially owned domestic subsidiaries will not be guarantors of our senior subordinated notes. As a result, no payments are required to be made to us from the assets of these subsidiaries. In the event of a bankruptcy, liquidation or reorganization or similar proceeding of any of the non-guarantor subsidiaries, holders of their indebtedness, including their trade creditors, would generally be entitled to payment of their claims from the assets of those subsidiaries before any assets are made available for distribution to us for payment to you. In the event of bankruptcy or insolvency, the senior subordinated notes and guarantees could be adversely affected by principles of equitable subordination or recharacterization. In the event of bankruptcy or insolvency, a party in interest may seek to subordinate the senior subordinated notes or the guarantees under the principles of equitable subordination or to recharacterize the senior subordinated notes as equity. There can be no assurance as to the outcome of such proceedings. In the event a court subordinates the senior subordinated notes or guarantees or recharacterizes the senior subordinated notes as equity, we cannot assure you that you would recover any amounts owed on the senior subordinated notes or the guarantees and you may be required to return any payments made to you within six years before the bankruptcy on account of the senior subordinated notes. In addition, should the court equitably subordinate the senior subordinated notes or the guarantees or recharacterize the senior subordinated notes as equity, you may not be able to enforce the guarantees. The senior subordinated notes and the guarantees may not be enforceable because of fraudulent conveyance laws. Under federal bankruptcy law and comparable provisions of state fraudulent transfer laws, a court could void the obligations under the senior subordinated notes or the guarantees, further subordinate the senior subordinated notes or the guarantees or take other action detrimental to you, if, among other things, at the time the indebtedness under the senior subordinated notes or the guarantees, as applicable, was incurred, we or a guarantor: issued the senior subordinated notes or the guarantee to delay, hinder or defraud present or future creditors; or received less than reasonably equivalent value or fair consideration for issuing the senior subordinated notes or the guarantee and, at the time of the issuance: was insolvent or rendered insolvent by reason of issuing the senior subordinated notes or the guarantee and the application of the proceeds of the senior subordinated notes; Table of Contents 10 .26 Wholesale Solutions Switched Services Agreement, dated as of August 11, 2003, by and between Sprint Communications Company L.P. and Valor Telecommunications Enterprises, LLC. 10 .27 First Amendment to Wholesale Solutions Switched Services Data and Private Line Agreement, dated as of October 3, 2003, between Sprint Communications Company L.P. and Valor Telecommunications Enterprises, LLC. ** 10 .28 Employment Agreement, dated as of June 18, 2000, by and between Valor Telecommunications, LLC and Kenneth R. Cole.** 10 .29 Amendment One to Employment Agreement, dated January 18, 2000, by and between Valor Telecommunications, LLC and Kenneth R. Cole.** 10 .30 Employment Agreement, dated as of January 2, 2002 by and between Valor Telecommunications, LLC and John J. Mueller.* 10 .31 Employment Agreement, dated as of March 20, 2000, by and between Valor Telecommunications, LLC and John A. Butler.** 10 .32 Employment Agreement, dated as of November 13, 2000, by and between Valor Telecommunications, LLC and William M. Ojile, Jr.** 10 .33 Amendment One to Employment Agreement, dated as of January 2, 2002, by and between Valor Telecommunications, LLC and William M. Ojile, Jr. 10 .34 Employment Agreement, dated as of February 28, 2000, by and between Valor Telecommunications, LLC and W. Grant Raney.** 10 .35 Amendment One to Employment Agreement, dated as of January 2, 2002, by and between Valor Telecommunications, LLC and W. Grant Raney.** 10 .36 Amended and Restated Employment Agreement, dated April 9, 2004, between Valor Telecommunications, LLC and John J. Mueller.* 12 .1 Ratio of Earnings to Fixed Charges.** 12 .2 Pro Forma Ratio of Earnings to Fixed Charges.** 23 .1 Consent of Deloitte Touche LLP and report on schedule. 23 .2 Consent of Kirkland Ellis LLP (included in Exhibit 5.1).* 23 .3 Consent of Kirkland Ellis LLP (included in Exhibit 8.1).* 23 .4 Consent of Houlihan Lokey Howard Zukin Financial Advisors, Inc.** 24 .1 Powers of Attorney (included on signature page).** 10 .26 Wholesale Solutions Switched Services Agreement, dated as of August 11, 2003, by and between Sprint Communications Company L.P. and Valor Telecommunications Enterprises, LLC. 10 .27 First Amendment to Wholesale Solutions Switched Services Agreement, dated as of October 3, 2003, between Sprint Communications Company L.P. and Valor Telecommunications Enterprises, LLC. ** 10 .28 Employment Agreement, dated as of June 18, 2000, by and between Valor Telecommunications, LLC and Kenneth R. Cole.** 10 .29 Amendment One to Employment Agreement, dated January 18, 2000, by and between Valor Telecommunications, LLC and Kenneth R. Cole.** 10 .30 Employment Agreement, dated as of January 2, 2002, by and between Valor Telecommunications, LLC and John J. Mueller.* 10 .31 Employment Agreement, dated as of March 20, 2000, by and between Valor Telecommunications, LLC and John A. Butler.** 10 .32 Employment Agreement, dated as of November 13, 2000, by and between Valor Telecommunications, LLC and William M. Ojile, Jr.** 10 .33 Amendment One to Employment Agreement, dated as of January 2, 2002, by and between Valor Telecommunications, LLC and William M. Ojile, Jr.** 10 .34 Employment Agreement, dated as of February 28, 2000, by and between Valor Telecommunications, LLC and W. Grant Raney.** 10 .35 Amendment One to Employment Agreement, dated as of January 2, 2002, by and between Valor Telecommunications, LLC and W. Grant Raney.** 10 .36 Amended and Restated Employment Agreement, dated April 9, 2004, between Valor Telecommunications, LLC and John J. Mueller.* 12 .1 Ratio of Earnings to Fixed Charges.** 12 .2 Pro Forma Ratio of Earnings to Fixed Charges.** 23 .1 Consent and report on schedule of Deloitte Touche LLP. 23 .2 Consent of Kirkland Ellis LLP (included in Exhibit 5.1).* 23 .3 Consent of Kirkland Ellis LLP (included in Exhibit 8.1).* 23 .4 Consent of Houlihan Lokey Howard Zukin Financial Advisors, Inc.** 24 .1 Powers of Attorney (included on signature page).** Valor Telecommunications, LLC Delaware 52-2171586 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Valor Telecommunications of Texas, LP Texas 52-2194219 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Valor Telecommunications Equipment, LP Texas 75-2884400 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Valor Telecommunications Services, LP Texas 75-2884846 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Valor Telecommunications Investments, LLC Delaware 47-0902124 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Valor Telecommunications Enterprises, LLC Delaware 75-2884398 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Valor Telecommunications LD, LP Delaware 75-2884847 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Southwest Enhanced Network Services, LP Delaware 75-2885419 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Western Access Services, LLC Delaware 20-0081823 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Western Access Services of Arizona, LLC Delaware 20-0081863 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Western Access Services of Arkansas, LLC Delaware 20-0081902 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Table of Contents was engaged or about to engage in a business or a transaction for which our or the guarantor s remaining unencumbered assets constituted unreasonably small capital to carry on its business; intended to incur, or believed that it would incur, debts beyond its ability to pay the debts as they mature; or was a defendant in an action for money damages, or had a judgment for money damages docketed against it if, in either case, after final judgment, the judgment is unsatisfied. The measures of insolvency for the purposes of fraudulent transfer laws vary depending upon the law applied in any proceeding to determine whether a fraudulent transfer has occurred. Generally, however, a person would be considered insolvent if, at the time it incurred the debt: the present fair saleable value of its assets was less than the amount that would be required to pay its probable liability on its existing debts, including contingent liabilities, as they become absolute and mature; or it could not pay its debts as they become due. Regardless of the standard that a court uses to determine whether we or a guarantor were solvent at the relevant time, the issuance of the senior subordinated notes or the guarantees may be voided or further subordinated to the claims of creditors if it concludes that we or a guarantor was insolvent. The guarantee of the senior subordinated notes by any subsidiary guarantor could be subject to the claim that, since the guarantee was incurred for our benefit, and only indirectly for the benefit of the guarantor, the guarantee was incurred for less than fair consideration. A court could therefore void the obligations of the subsidiary guarantor, under the guarantees or subordinate these obligations to the subsidiary guarantor s other debt or take action detrimental to holders of the senior subordinated notes. If the guarantee of any subsidiary guarantor were voided, the holders of the senior subordinated notes would not have a debt claim against that subsidiary guarantor. In addition, in the event that we meet any of the fraudulent transfer tests relating to financial condition, as described above, at the time of or as a result of this offering, a court could view the issuance of the senior subordinated notes, the guarantees and other transactions occurring on the issue date, such as repayment of our existing debt and various distributions described under Use of Proceeds as a single transaction and, as a result, conclude that we did not get fair value for the offering. In such a case, a court could hold the debt (including the guarantees) owed to the noteholders void or unenforceable or may further subordinate it to the claims of other creditors. Interest on the senior subordinated notes may not be deductible for United States federal income tax purposes, which could significantly reduce our future cash flow and impair our ability to make interest and dividend payments. No statutory, judicial or administrative authority has directly addressed the treatment of the IDSs or the senior subordinated notes, or instruments similar to the IDSs or the senior subordinated notes, for United States federal income tax purposes. As a result, the United States federal income tax consequences of the purchase, ownership and disposition of IDSs and senior subordinated notes are unclear. We will receive an opinion from our counsel, Kirkland Ellis, LLP, to the effect that an IDS should be treated as a unit representing a share of common stock and senior subordinated notes, and that the senior subordinated notes should be classified as debt for United States federal income tax purposes. However, the IRS or the courts may take the position that the IDSs are a single security classified as equity, or that the senior subordinated notes are properly classified as equity for United States federal income tax purposes, which could adversely affect the amount, timing and character of income, gain or loss in respect of your investment in IDSs or senior subordinated notes, and materially increase our taxable income and, thus, our United States federal and applicable state income tax liability. This would reduce our after-tax cash flow and could materially and adversely impact our ability to make interest and dividend payments on the senior subordinated notes and the common stock. Foreign holders could be subject to withholding or estate taxes with regard to the senior subordinated notes in the same manner as they will be with regard to the common stock. Payments to foreign holders would not be grossed-up for any such taxes. Further, we have Table of Contents Address Including Zip Code, State or Other Telephone Number Jurisdiction of I.R.S. Employer Including Area Code of Exact Name of Registrant Guarantor as Incorporation or Identification Registrant Guarantor s Specified in its Charter Organization Number Principal Executive Offices Table of Contents not received any opinion of counsel as to the treatment of senior subordinated notes that we may issue in any subsequent issuance, including in connection with an exchange of Class B common stock for IDSs and any subsequently issued senior subordinated notes may be treated as equity for United States federal income tax purposes. Apart from the exchanges of Class B common stock for IDSs, subsequent issuances of senior subordinated notes underlying IDSs will be made, subject to certain requirements, at the determination of our board of directors. For discussion of these tax-related risks, see Material United States Federal Income Tax Consequences. The allocation of the purchase price of the IDSs may not be respected, which may lead to you having to include original issue discount in your income even if you have not received the cash attributable to that income. The purchase price of each IDS must be allocated for tax purposes between the share of common stock and senior subordinated notes comprising the IDS in proportion to their respective fair market values at the time of purchase. It is possible that the IRS will successfully challenge our allocation. If the allocation of the purchase price to the senior subordinated notes were determined to be too high, then it is possible that the senior subordinated notes would be treated as having been issued with OID, and you generally would be required to include the OID in income in advance of the receipt of cash attributable to that income. If, on the other hand, the allocation of purchase price to the senior subordinated notes were determined to be too low, then it is possible that the senior subordinated notes would be treated as having been issued with amortizable bond premium, and you would generally be able to elect to amortize such bond premium over the term of the senior subordinated notes. Because of the deferral of interest provisions, the senior subordinated notes may be treated as issued with original issue discount. Under applicable Treasury regulations, a remote contingency that stated interest will not be timely paid is disregarded in determining whether a debt instrument is issued with OID. Although there is no authority directly on point, based on our financial forecasts, we believe that the likelihood of deferral of interest payments on the senior subordinated notes is remote within the meaning of the Treasury regulations. Based on the foregoing determination made by us, although the matter is not free from doubt because of the lack of direct authority, our counsel is of the opinion that the possibility that interest payments on the senior subordinated notes may be deferred should not cause the senior subordinated notes to be considered to be issued with OID at the time of their original issuance. If deferral of any payment of interest were determined not to be remote, then the senior subordinated notes would be treated as issued with OID at the time of issuance. In such case, all stated interest on the senior subordinated notes would be treated as OID, with the consequence that all holders would be required to include the yield on the senior subordinated notes in income as it accrued on a constant yield basis, possibly in advance of their receipt of the associated cash and regardless of their method of tax accounting. Subsequent issuances of senior subordinated notes may cause you to recognize taxable gain and/or original issue discount. The United States federal income tax consequences to you of a subsequent issuance of senior subordinated notes with OID (or any issuance of senior subordinated notes thereafter) are unclear and our counsel is unable to opine on this issue. The indenture governing the senior subordinated notes and our agreements with DTC will provide that, in the event that there is a subsequent issuance of senior subordinated notes with OID, and in connection with each issuance of senior subordinated notes thereafter, including an issuance of senior subordinated notes upon an exchange of shares of Class B common stock, each holder of senior subordinated notes or IDSs, as the case may be, agrees that a portion of such holder s senior subordinated notes will be automatically exchanged for a portion of the senior subordinated notes acquired by the holders of such subsequently issued senior subordinated notes. Such subsequent issuance and exchange will not change the aggregate stated principal amount of senior subordinated notes owned by you and each other holder. Due to the lack of applicable authority, it is unclear whether an exchange of senior subordinated notes for subsequently issued senior subordinated notes will result in a taxable exchange for United States federal income tax purposes. It is possible that the IRS might successfully assert that such an exchange should be Table of Contents treated as a taxable exchange. In such case, you would recognize any gain realized on the exchange, but a loss might be disallowed. For a more complete description of the tax consequences of a subsequent issuance, see Material United States Federal Income Tax Consequences Senior Subordinated Notes Additional Issuances. Regardless of whether the exchange is treated as a taxable event, such exchange may result in an increase in the amount of OID, if any, that you are required to accrue with respect to the senior subordinated notes. Following any subsequent issuance of senior subordinated notes with OID or any issuance of senior subordinated notes thereafter and resulting exchange, we and our agents will report any OID on any subsequently issued senior subordinated notes ratably among all holders of senior subordinated notes and IDSs. By purchasing senior subordinated notes or IDSs, as the case may be, each holder of senior subordinated notes and IDSs agrees to report OID in a manner consistent with this approach. As a result of a subsequent issuance, therefore, you may be required to report OID even though you purchased senior subordinated notes having no OID. This will generally result in you reporting more interest income over the term of the senior subordinated notes than you would have reported had no such subsequent issuance and exchange occurred. The IRS, however, may assert that OID should be reported only to the persons that initially acquired such subsequently issued senior subordinated notes and their transferees. In such case, the IRS might further assert that, unless a holder can establish that it is not an initial holder of subsequently issued senior subordinated notes or a transferee thereof, all senior subordinated notes held by such holder will have OID. Any of these assertions by the IRS could create significant uncertainties in the pricing of IDSs and senior subordinated notes and could adversely affect the market for IDSs and senior subordinated notes. If we subsequently issue senior subordinated notes with significant OID, then we may be unable to deduct all the interest on the senior subordinated notes. It is possible that the senior subordinated notes that we issue in a subsequent issuance will be issued at a discount to their face value and, accordingly, may have significant OID and thus be classified as applicable high yield discount obligations. If any such senior subordinated notes were so treated, then a portion of the OID on such notes could be nondeductible by us and the remainder would be deductible only when paid. This treatment would have the effect of increasing our taxable income and may adversely affect our cash flow available for interest payments and distributions to our shareholders. A subsequent issuance of senior subordinated notes or an allocation of IDS purchase price that results in OID may reduce the amount you can recover upon an acceleration of the payment of principal due on the senior subordinated notes or in the event of our bankruptcy. Under New York and federal bankruptcy law, holders of subsequently issued senior subordinated notes having original issue discount may not be able to collect the portion of the principal face amount of such senior subordinated notes that represents unamortized original issue discount as of the acceleration or filing date, as the case may be, in the event of an acceleration of the senior subordinated notes or in the event of our bankruptcy prior to the maturity date of the senior subordinated notes. As a result, a treatment of the senior subordinated notes as having been issued with OID or an automatic exchange that results in a holder receiving a senior subordinated note with original issue discount could have the effect of ultimately reducing the amount such holder can recover from us in the event of an acceleration or bankruptcy. Before this offering, there has not been a public market for our IDSs. The price of the IDSs may fluctuate substantially, which could negatively affect the value of your investment. Our IDSs have no public market history. In addition, there has not been an established market in the United States or in Canada for securities similar to the IDSs. We cannot assure you that an active trading market for the IDSs will develop in the future. The initial public offering price of the IDSs has been determined by negotiations among us, the existing equity holders and the representatives of the underwriters and may not be indicative of the market price of the IDSs after the offering. Factors such as quarterly variations in our financial results, announcements by Table of Contents us or others, developments affecting us, our clients and our suppliers, general interest rate levels and general market volatility could cause the market price of the IDSs to fluctuate significantly. If the IDSs separate, the limited liquidity of the market for the senior subordinated notes and Class A common stock may adversely affect your ability to sell the senior subordinated notes and Class A common stock. We do not intend to list the senior subordinated notes represented by the IDSs on any exchange or quotation system. Our Class A common stock will not initially be listed for separate trading on the New York Stock Exchange or any other exchange or quotation system other than the Toronto Stock Exchange (on which we do not anticipate an active trading market for the Class A common stock to develop). We will not apply to list our shares of Class A common stock for separate trading on the New York Stock Exchange or any other exchange or quotation system until the number of shares held separately is sufficient to satisfy applicable requirements for separate trading on such exchange or quotation system. The Class A common stock may not be approved for listing at such time. Upon separation of the IDSs, no sizable market for the senior subordinated notes and the Class A common stock may ever develop and the liquidity of any trading market for the notes or the Class A common stock that does develop may be limited. As a result, your ability to sell your notes or Class A common stock, and the market price you can obtain, could be adversely affected. The limited liquidity of the trading market for the senior subordinated notes sold separately (not represented by IDSs) may adversely affect the trading price of the separate senior subordinated notes. We are separately selling (not represented by IDSs) $ million aggregate principal amount of senior subordinated notes, representing approximately 10% of the total principal amount of the outstanding senior subordinated notes. While the senior subordinated notes sold separately (not represented by IDSs) are part of the same series of notes as, and are identical to, the senior subordinated notes represented by IDSs at the time of the issuance of the separate senior subordinated notes, the senior subordinated notes represented by the IDSs will not be separable for at least 45 days and will not be separately tradeable until separated. As a result, the initial trading market for the senior subordinated notes sold separately (not represented by IDSs) will be very limited. Even after holders of the IDSs are permitted to separate their IDSs, a sufficient number of holders of IDSs may not separate their IDSs into shares of our Class A common stock and senior subordinated notes to create a sizable and more liquid trading market for the senior subordinated notes not represented by IDSs. Therefore, a liquid market for the senior subordinated notes may not develop, which may adversely affect the ability of the holders of the separate senior subordinated notes to sell any of their separate senior subordinated notes and the price at which these holders would be able to sell any of the senior subordinated notes sold separately. Future sales or the possibility of future sales of a substantial amount of IDSs, shares of our common stock or our senior subordinated notes may depress the price of the IDSs and the shares of our common stock and our senior subordinated notes. Future sales or the availability for sale of substantial amounts of IDSs or shares of our common stock or a significant principal amount of our senior subordinated notes in the public market could adversely affect the prevailing market price of the IDSs and the shares of our common stock and senior subordinated notes and could impair our ability to raise capital through future sales of our securities. We may issue shares of our Class A common stock and senior subordinated notes, which may be in the form of IDSs, or other securities from time to time as consideration for future acquisitions and investments. In the event any such acquisition or investment is significant, the number of shares of our Class A common stock and the aggregate principal amount of senior subordinated notes, which may be in the form of IDSs, or the number or aggregate principal amount, as the case may be, of other securities that we may issue may in turn be significant. In addition, we may also grant registration rights covering those IDSs, shares of our common stock, senior subordinated notes or other securities in connection with any such acquisitions and investments. Any or all of these occurrences could depress the trading prices of our securities. Balance, March 31, 2004 $ Table of Contents Regulatory Risks We received 24.1% of our 2003 revenues from the Texas and federal Universal Service Funds and any adverse regulatory developments with respect to these funds could curtail our profitability. We receive Texas and federal Universal Service Fund, or USF, revenues to support the high cost of providing affordable telecommunications services in rural markets. Such support payments constituted 24.1% of our revenues for the year ended December 31, 2003 and 23.9% of our revenues for the three months ended March 31, 2004. Of these support payments, in the year ended December 31, 2003, $103.1 million, or 20.7% of our revenues, and in the three months ended March 31, 2004, $25.5 million, or 20.2% of our revenues, were received from the Texas USF. In addition, we are required to make contributions to the Texas USF and federal USF each year. Current state and federal regulations allow us to recover these costs by including a surcharge on our customers bills. Furthermore, we incur no incremental costs associated with the support payments we receive or the contributions we are required to make. Thus, if Texas and/or federal regulations changed and we were unable to receive support, such support was reduced, or we are unable to recover the amounts we contribute to the Texas USF and federal USF from our customers, our earnings would be directly and adversely affected. For a more detailed discussion of the regulations affecting our company, see Regulation. The rules governing USF could be altered or amended as a result of regulatory, legislative or judicial action and impact the amount of USF support that we receive and our ability to recover our USF contributions by assessing surcharges on our customers bills. For example, the enabling statute for the Texas USF will become subject to review and renewal in late 2005 and may be modified. Similarly, the FCC asked the Federal-State Joint Board on Universal Service to review the federal rules relating to universal service support mechanisms for rural carriers, including addressing the relevant costs and the definition of rural telephone company in June 2004. It is not possible to predict at this time whether state or federal regulators, Congress or state legislatures will order modification to those rules or statutes, or the ultimate impact any such modification might have on us. In addition, the Texas USF rules provide that the Texas Public Utility Commission must open an investigation within 90 days after any changes are made to the federal USF. Therefore, changes to the federal USF may prompt similar or conforming changes to the Texas USF. The outcome of any of these legislative or regulatory changes could affect the amount of Texas USF support that we receive, and could have an adverse effect on our business, revenue or profitability. Reductions in the amount of network access revenue that we receive could negatively impact our results of operations. In the year ended December 31, 2003, we derived $132.0 million, or 26.6% of our revenues, and in the three months ended March 31, 2004, we derived $33.0 million, or 26.3% of our revenues, from network access charges. Our network access revenue consists of (1) usage sensitive fees we charge to long distance companies for access to our network in connection with the completion of interstate and intrastate long distance calls, (2) fees charged for use of dedicated circuits and (3) end user fees, which are monthly flat-rate charges assessed on access lines. Federal and state regulatory commissions set these access charges, and they could change the amount of the charges or the manner in which they are charged at any time. The FCC is currently examining proposals to revise interstate access charges and other intercarrier compensation. Also, as people in our markets decide to use Internet, wireless or cable television providers for their local or long distance calling needs, rather than using our wireline network, the reduction in the number of access lines or minutes of use over our network could reduce the amount of access revenue we collect. As penetration rates for these technologies increase in rural markets, our revenues could decline. In addition, if our customers take advantage of favorable calling plans offered by wireless carriers for their long distance calling needs, it could reduce the number of long distance calls made over our network, thereby decreasing our access revenue. Furthermore, disputes are pending as to whether providers of Voice over Internet Protocol, or VoIP technology, which allow customers to make voice calls over the Internet or using Internet Protocol, are subject to FCC or state regulations that would require them to pay network charges. With the emergence of VoIP technology, the FCC and state commissions are considering the Western Access Services of Colorado, LLC Delaware 20-0081934 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Western Access Services of Oklahoma, LLC Delaware 20-0081944 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Western Access Services of New Mexico, LLC Delaware 20-0081922 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Western Access Services of Texas, LP Delaware 20-0081952 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Valor Telecommunications Corporate Group, LP Texas 75-2895493 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Valor Telecommunications Southwest, LLC Delaware 52-2194218 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Valor Telecommunications Southwest II, LLC Delaware 75-2950066 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Valor Telecommunications Enterprises II, LLC Delaware 75-2950064 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Kerrville Communications Corporation Texas 74-2197091 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Kerrville Communications Management, LLC Delaware 30-0135974 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Kerrville Communications Enterprises, LLC Delaware 32-0047694 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Advanced Tel-Com Systems, LP Texas 74-2228603 201 E. John Carpenter Freeway, Suite 200 Irving, TX 75062 (972) 373-1000 Table of Contents status of VoIP and other Internet services and there can be no assurance that the FCC and state regulators will require such providers to pay access charges. Any or all of these developments could reduce the amount of access revenue that we receive which could negatively impact our revenues and profitability. The introduction of new competitors or the better positioning of existing competitors due to regulatory changes could cause us to lose customers and impede our ability to attract new customers. Changes in regulations that open our markets to more competitors offering substitute services could impact our profitability because of increases in the costs of attracting and retaining customers and decreases in revenues due to lost customers and the need to offer competitive prices. We face competition from current and potential market entrants, including: domestic and international long distance providers seeking to enter, reenter or expand entry into the local telecommunications marketplace; other domestic and international competitive telecommunications providers, wireless carriers, resellers, cable television companies and electric utilities; and providers of broadband and Internet services. Regulatory requirements designed to facilitate the introduction of competition, the applicability of different regulatory requirements between our competitors and us, or decisions by legislators or regulators to exempt certain providers or technologies from the same level of regulation that we face, could adversely impact our market position and our ability to offer competitive alternatives. In November 2003, the FCC ordered us and other local exchange carriers to adopt wireline-to-wireless local number portability. This may help wireless carriers compete against us because if customers switch from traditional local telephone service to wireless service, they can now transfer their local telephone number to their wireless provider. In addition, federal and state regulators and courts are addressing many aspects of our obligations to provide unbundled network elements and discounted wholesale rates to competitors. New regulations and changes in existing regulations may force us to incur significant expenses. Our business may also be impacted by legislation and regulation that impose new or greater obligations related to assisting law enforcement, bolstering homeland security, minimizing environmental impacts or addressing other issues that impact our business. For example, existing provisions of the Communications Assistance for Law Enforcement Act, or CALEA, and FCC regulations implementing CALEA require telecommunications carriers to ensure that their equipment, facilities, and services are able to facilitate authorized electronic surveillance. We cannot predict whether and when the FCC might modify its CALEA rules or any other rules or what compliance with new rules might cost. Similarly, we cannot predict whether or when federal or state legislators or regulators might impose new security, environmental or other obligations on our business. For a more thorough discussion of the regulation of our company and how that regulation may affect our business, see Regulation. Certain transactions related to the enforceability of the guarantees of the senior subordinated notes by certain of our subsidiaries may require FCC or state regulatory commission approval, which may not be granted or which may be subject to delays or conditions that could affect your ability to enforce the guarantees. In the event that it becomes necessary to enforce the guarantees of the senior subordinated notes, approvals may be required for certain of our subsidiaries that are subject to federal or state regulatory authority, including approval for the transfer of control of various radio licenses held by our operating subsidiaries or the transfer of control over or sale of the assets of our operating subsidiaries. Such approvals may not be obtained, in which case such guarantees would be unenforceable, or may be subject to delays or conditions that could affect your ability to enforce the guarantees. Table of Contents Address Including Zip Code, State or Other Telephone Number Jurisdiction of I.R.S. Employer Including Area Code of Exact Name of Registrant Guarantor as Incorporation or Identification Registrant Guarantor s Specified in its Charter Organization Number Principal Executive Offices Table of Contents A reduction by a state regulatory body or the FCC of the rates we charge our customers would reduce our revenues and earnings. The prices, terms and conditions of the services that we offer to local telephone customers are subject to state regulatory approval. If a state regulatory body orders us to reduce a price, withdraws our approval to charge a certain price, changes material terms or conditions of a service we offer or refuses to approve or limits our ability to offer a new or existing service, both our revenues and our earnings may be reduced. FCC regulations also affect the rates that are charged to customers. The FCC regulates tariffs for interstate access and subscriber line charges, both of which are components of our revenues. The FCC currently is considering proposals to reduce interstate access charges for carriers like us. If the FCC lowers interstate access charges without adopting an adequate revenue replacement mechanism, we may be required to recover more revenue through subscriber line charges and universal service funds or forego this revenue altogether. This could reduce our revenue or impair our competitive position. Risks Relating to Our Business We provide services to our customers over access lines and if we continue to lose access lines our revenues and earnings may decrease. Our business generates revenue by delivering voice and data services over access lines. We have experienced net access line loss over the past few years, and during the year ended December 31, 2003, the number of access lines we serve declined by 2.6% due to challenging economic conditions and increased competition. We may continue to experience net access line loss in our markets for an unforeseen period of time. Our inability to retain access lines could adversely affect our revenue and earnings. Rapid and significant changes in technology in the telecommunications industry could adversely affect our ability to compete effectively in the markets in which we operate. The rapid introduction and development of enhanced or alternative services that are more cost effective, more efficient or more technologically advanced than the services we offer is a significant source of potential competition in the telecommunications industry. Technological developments may reduce the competitiveness of our networks, make our service offerings less attractive or require expensive and time-consuming capital improvements. If we fail to adapt successfully to technological changes or fail to obtain timely access to important new technologies, we could lose customers and have difficulty attracting new customers or selling new services to our existing customers. We cannot predict the impact of technological changes on our competitive position, profitability or industry. Wireless and cable technologies that have emerged in recent years provide certain advantages over traditional wireline voice and data services. The mobility afforded by wireless voice services and its competitive pricing appeal to many customers. The ability of cable television providers to offer voice, video and data services as an integrated package provides an attractive alternative to traditional voice services from local exchange carriers. In addition, as the emerging VoIP services develop, some customers may be able to bypass network access charges. Increased penetration rates for these technologies in our markets could cause our revenues to decline. The competitive nature of the telecommunications industry could adversely affect our revenues, results of operations and profitability. The telecommunications industry is very competitive. Increased competition could lead to price reductions, declining sales volumes, loss of market share, higher marketing costs and reduced operating margins. Significant and potentially larger competitors could enter our markets at any time, including local service providers, cable television companies and wireless telecommunications providers. For a more thorough discussion of the competition that may affect our business, see Business Competition. Table of Contents Weak economic conditions may decrease demand for our services. We are sensitive to economic conditions and downturns in the economy. Downturns in the economies in the markets we serve could cause our existing customers to reduce their purchases of our basic and enhanced services and make it difficult for us to obtain new customers. We depend on a few key vendors and suppliers to conduct our business and any disruption in our relationship with any one or more of them could adversely affect our results of operations. We rely on vendors and suppliers to support many of our administrative functions and to enable us to provide long distance services. For example, we currently outsource much of our operational support services to ALLTEL, including our billing and customer care services. Transitioning these support services to another provider could take a significant period of time and involve substantial costs. In addition, we have resale agreements with MCI and Sprint to provide our long distance transmission services. Replacing these resale agreements could be difficult as there are a limited number of national long distance providers. Any disruptions in our relationship with these third party providers could have an adverse effect on our business and operations. Disruption in our networks and infrastructure may cause us to lose customers and incur additional expenses. To be successful, we will need to continue to provide our customers with reliable service over our networks. Some of the risks to our networks and infrastructure include: physical damage to access lines, breaches of security, capacity limitations, power surges or outages, software defects and disruptions beyond our control, such as natural disasters and acts of terrorism. Disruptions may cause interruptions in service or reduced capacity for customers, either of which could cause us to lose customers and incur expenses, and thereby adversely affect our business, revenue and cash flow. Recent difficulties in the telecommunications industry could negatively impact our revenues and results of operations. We originate and terminate long distance phone calls on our networks for other interexchange carriers, some of which are our largest customers in terms of revenues. In the year ended December 31, 2003 and the three months ended March 31, 2004, we generated 17.5% and 17.2%, respectively, of our total revenues from originating and terminating phone calls for interexchange carriers. Several of these interexchange carriers have declared bankruptcy during the past two years or are experiencing substantial financial difficulties. MCI WorldCom (now MCI), which declared bankruptcy in 2002, is one of the major interexchange carriers with which we conduct business. We recorded a net $1.6 million charge due to MCI s failure to pay amounts owed to us. Further bankruptcies or disruptions in the businesses of these interexchange carriers could have an adverse effect on our financial results and cash flows. Following the consummation of this offering, our equity sponsors will collectively be able to exercise substantial influence over matters requiring stockholder approval and their interests may diverge from the interests of the holders of the IDSs. Following the consummation of this offering, affiliates of Welsh, Carson, Anderson Stowe, or WCAS, affiliates of Vestar Capital Partners, or Vestar, and affiliates of Citicorp Venture Capital, or CVC, will beneficially own %, % and %, respectively, of our outstanding shares of Class A common stock as part of the IDSs, and %, % and %, respectively, of our outstanding shares of Class B common stock. As a result, WCAS, Vestar and CVC collectively exercise substantial influence over matters requiring stockholder approval, including decisions about our capital structure. In addition, WCAS has two designees and Vestar has one designee serving on our board of directors. The interests of our equity sponsors may conflict with your interests as a holder of the IDSs. Table of Contents Our amended and restated certificate of incorporation and by-laws and several other factors could limit another party s ability to acquire us and deprive our investors of the opportunity to obtain a takeover premium for their securities. A number of provisions in our amended and restated certificate of incorporation and by-laws will make it difficult for another company to acquire us and for you to receive any related takeover premium on our securities. For example, our amended and restated certificate of incorporation provides that stockholders may not act by written consent and that only our board of directors may call a special meeting. In addition, stockholders are required to provide us with advance notice if they wish to nominate any persons for election to our board of directors or if they intend to propose any matters for consideration at an annual stockholders meeting. Our amended and restated certificate of incorporation authorizes the issuance of preferred stock without stockholder approval and upon such terms as the board of directors may determine. The rights of the holders of shares of our common stock will be subject to, and may be adversely affected by, the rights of holders of any class or series of preferred stock that may be issued in the future. Table of Contents
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+RISK FACTORS You should recognize that oil and gas drilling and exploration is a high risk venture. Therefore, we recommend that you invest in a partnership only if you are prepared to assume the substantial risks discussed below and elsewhere in this prospectus. The nature of these risks requires persons who purchase interests to be in a position: to hold such investment for a substantial number of years, and to absorb the possible loss of such investment. Particular Risks Relating to the Interests Liability of Limited Partners. Each partnership will be governed by the Delaware Revised Uniform Limited Partnership Act. Under Delaware law, as a general rule, a limited partner s liability for the obligations of a partnership is limited to such limited partner s capital contribution and such limited partner s share of the partnership s assets. A limited partner of the partnership will not otherwise be liable for the obligations of the partnership unless, in addition to the exercise of his or her rights and powers as a limited partner, such limited partner participates in the control of the business of a partnership. In such case the limited partner is liable only to persons who transact business with the partnership with actual knowledge of the limited partner s participation in control. Accordingly, if a limited partner were to take an action which was subsequently determined to constitute participating in the control of the business of a partnership, such limited partner could become liable for the partnership debts and obligations. See Liability of Investor Partners Limited Partners. Liability of Investor General Partners. Under Delaware law, each general partner in a partnership will be liable for all of the liabilities and recourse obligations of the partnership. Furthermore, each partnership will own working interests in oil and gas leases subject to some portion of the costs of development, operation or maintenance. We, and likely others, will also own similar working interests in these oil and gas leases. Therefore, a general partner could be liable for the obligations of all such joint working interest owners. The managing partner will indemnify each general partner from any liability in excess of his share of a partnership s undistributed assets. However, a general partner still could be subject to such liability if we should become bankrupt or for any other reason we are unable to meet our financial commitment to indemnify the general partners. This liability could obligate a general partner to make additional payments to the partnership. The possible amount of such a liability cannot be predicted. The subsequent conversion of a general partner interest into a limited partner interest will have no effect on the converted general partner s liability as to events that occurred prior to the conversion. See Liability of Investor Partners General Partners. Liability of Joint Working Interest Owners. Under the drilling program agreement, each drilling program participant, including the managing partner and each partnership, will hold its working interest in oil and gas leases in its own name and will be a joint working interest owner with the other drilling program participants and also with third parties. It has not been clearly established under the laws of some of the jurisdictions where a portion of each drilling program s properties will be located whether a single joint working interest owner is liable with respect to all obligations relating to the entire jointly owned working interest. The operating agreements relating to drilling program oil and gas leases will specify that the liabilities of joint working interest owners will be limited to their individual joint working interest, though we cannot assure that such a provision would be enforceable against a third party. As a result it is possible that a general partner could be determined liable for all obligations relating to the entire jointly owned working interest. Possibility of Reduction or Unavailability of Insurance Coverage of a Partnership. It is possible that some or all of the insurance coverage which a partnership has available may become unavailable or prohibitively expensive. If the program manager and its affiliates cease to retain the coverage described for any reason for a period of more than 20 days during the subscription period for a partnership, the offering of interests in that partnership shall cease, and subscribers for interests in any partnership in which investors have not been admitted shall receive a refund of their subscription funds. The managing partner will also promptly notify those investors of any material reduction in the insurance coverage of the drilling programs and the partnerships. The managing CURTIS W. MEWBOURNE Copies to: Mewbourne Development Corporation 3901 S. Broadway Tyler, Texas 75701 (903) 561-2900 A. WINSTON OXLEY Vinson Elkins L.L.P. 3700 Trammell Crow Center 2001 Ross Avenue Dallas, Texas 75201 (214) 220-7700 Approximate date of commencement of proposed sale to the public: As soon as practicable after the effective date of this Registration Statement. If any of the securities being registered on this form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, check the following box. CALCULATION OF REGISTRATION FEE Amount of Title of Securities Proposed Maximum Registration to be Registered Aggregate Offering Price Fee Table of Contents partner shall give investors this notice as soon as possible after it learns of such change and if possible at least 30 days in advance of the change in insurance coverage. In addition, if a drilling program or a partnership, after the admission of investors, has its insurance coverage materially reduced for any reason, that partnership will halt all drilling activity until such time as comparable replacement coverage is obtained. If a partnership has its insurance coverage materially reduced after you invest, you could be subject to a greater risk of loss of your investment since less insurance would be available to protect your investment from casualty losses. See Proposed Activities Insurance. Sole Reliance on Us for Management of a Partnership. Under the partnership agreement, Mewbourne Development Corporation is designated as the managing partner of each partnership and is given the exclusive authority to manage and operate each partnership s business. As the managing partner, we will have complete and total authority and broad discretion to determine the manner in which all of the offering proceeds will be expended. Also, we are required to devote only such time as is reasonably needed to the operations of the partnerships. Accordingly, if you invest in a partnership you must rely solely on us to make all decisions on behalf of each partnership. Investors will have no role in the management of the business of either partnership. Therefore, each partnership s success will depend, in part, upon the management we provide, our ability, and the ability of Mewbourne Oil Company as manager of each drilling program to: select and acquire oil and gas leases on which oil and gas wells capable of producing oil and natural gas in commercial quantities may be drilled, successfully drill and develop oil and gas well on the properties selected, and market oil and natural gas produced from such oil and gas wells. Sole Reliance on Our Financial Status. No financial information will be provided to the investors concerning any investor who has elected to invest in a partnership as a general partner. In no event should investors rely on the financial wherewithal of investor general partners, including in the event we should become bankrupt or are otherwise unable to meet our financial commitments. Prospects Not Yet Identified or Selected; No Opportunity to Evaluate Prospects. Although we maintain an inventory of leasehold acreage covering numerous prospects, we have not, as of the date of this prospectus, selected or agreed to transfer from such owned inventory any particular oil and gas leases to a partnership or related drilling program. The drilling program manager will select all oil and gas leases that the partnerships and the related drilling programs will acquire or drill. You will not have an opportunity to review those oil and gas leases before investing in a partnership. You will also not have an opportunity to participate in the selection of oil and gas leases after an investment is made. We may during the course of this offering select, and cause this prospectus to be amended or supplemented to describe, prospects designated for acquisition by participants in a drilling program. If you subscribe for interests prior to any such amendment or supplement you will not be permitted to withdraw your subscription as a result of the selection of any such designated prospect and you may not be notified of the selection of any such designated prospect prior to funding of the partnership or partnerships in which you have invested. See Proposed Activities Acquisition of Leases. Limited Ability to Spread Risk. A partnership could be formed with as little as $5,000,000 in subscriptions from investors. To the extent that the funds available to a partnership are limited, its ability to spread risks over a large number of oil and gas wells and prospects will be reduced. The number of oil and gas wells which can be drilled based on the minimum investment amount cannot be determined because prospects have not been selected. However, even if a drilling program is formed with substantially more than the minimum required capital, investors must rely on us to diversify drilling activities of the related partnership. Additional Partnership Financing May Become Necessary Due to Unforeseen Circumstances. We anticipate that the net proceeds from the sale of interests in a particular partnership will be sufficient to finance that partnership s share of the related drilling program s costs of: drilling and completing oil and gas wells, and Table of Contents providing necessary production equipment and facilities to service such oil and gas wells and plugging and abandoning non-productive oil and gas wells. However, due to unforeseen circumstances, it could become necessary to finance the costs of additional partnership operations through partnership borrowings, utilization of partnership revenues obtained from production or other methods of financing. These additional operations may include the acquisition of additional oil and gas leases and the drilling, completing and equipping of additional wells to further develop drilling program prospects. Each partnership agreement provides that outstanding partnership borrowings may not at any time exceed 20% of its aggregate capital contributions. Furthermore, a partnership may borrow funds only if the lender agrees that it will have no recourse against individual general partners. If the above-described method of financing should prove insufficient to maintain the desired level of development operations for the drilling program, such operations could be continued through farmout arrangements with third parties, including the managing partner and/or its affiliates. These farmouts could result in the drilling program giving up a substantial interest in any oil and gas revenues so developed. Uncertainty of Partnership Cash Distributions. No distributions will be made from a partnership to the general or limited partners of that partnership until that partnership has funds which the managing partner determines are not needed for the operation of the partnership and the drilling program. Accordingly, we cannot assure that any distributions from a partnership will be made to its general and limited partners. Distributions will depend primarily on a partnership s net cash receipts from oil and gas operations. Moreover, distributions could be delayed to repay the principal and interest on partnership borrowings, if any, or to fund partnership costs. Partnership income will be taxable to the general and limited partners in the year earned, even if cash is not distributed. Conflicts of Interest of Managing Partner. Investors will not be involved in the day-to-day operations of the partnerships. Accordingly, if you invest in a partnership, you must rely on our judgment in such matters. Inherent with the exercise of our judgment, we will be faced with conflicts of interest, including: We will participate in the drilling programs in our individual capacity. As a result, actions taken by a partnership may be more beneficial to us than the partnership. We or our affiliates may participate in oil and gas activities on behalf of other programs that we sponsor, will sponsor or are for our account. We owe a duty of good faith to each of the partnerships which we manage, and it is possible that actions taken with regard to other partnerships may not be advantageous to a partnership. We and/or our affiliates may provide services to a partnership. We and/or our affiliates will be compensated for these services at rates competitive with the rates charged by unaffiliated persons for similar services. If we or our affiliates own interests in a partnership, this ownership may dilute the voting power of the other general and limited partners in that partnership. The oil and gas leases that may be contributed to a partnership may be adjacent to acreage or oil and gas leases which we or our affiliates hold or will hold. While the drilling program will not drill any well for the purpose of proving or disproving the existence of oil or gas on any adjacent acreage, such drilling activities may incidentally develop information valuable to us or our affiliates in evaluating our nearby acreage at no cost to us. Accordingly, a conflict of interest will exist between our interests and the interest of a partnership in selecting the location and type of operations which the drilling program will conduct on drilling program oil and gas leases. We will attempt, in good faith, to resolve all conflicts of interest in a fair and equitable manner with respect to all persons affected by those conflicts of interest. However, we cannot assure that transactions between a partnership and its affiliates will be on terms as favorable as could have been negotiated with unaffiliated third parties. You should be aware that we have not formally adopted any procedures or criteria to avoid or to resolve any conflicts of interest that may arise between us and a partnership. You are urged to review the discussion under Conflicts of Interest for a more complete description of possible conflicts of interests. Table of Contents Inside Board of Directors and Other Family Relationships of Managing Partner and Program Director. The Board of Directors of both the managing partner and the program manager are comprised entirely of employees and family members of Mr. Mewbourne. Therefore, the activities of the managing partner and the program manager are not subject to the review and scrutiny of an independent Board of Directors. Limitations on the Fiduciary Obligations of the Managing Partner and the Managing Partner s Responsibility to Determine the Application of the Limitations. The partnership agreement contains provisions which modify what would otherwise be the applicable Delaware law relating to the fiduciary standards of the managing partner to the general and limited partners. The fiduciary standards in the partnership agreement could be less advantageous to the general and limited partners and more advantageous to the managing partner than the corresponding fiduciary standards otherwise applicable under Delaware law, specifically: we and our affiliates may be indemnified and held harmless by a partnership, we are required to devote only so much of its time as is necessary to manage the affairs of a partnership, we and our affiliates may conduct business with a partnership in a capacity other than as a manager of the partnership, we and/or our affiliates may pursue business opportunities that are consistent with a partnership s investment objectives for our own account if we determine that such opportunity cannot be pursued by the partnership either because of insufficient funds or because it is not appropriate for the partnership under the existing circumstances, and we may manage multiple programs simultaneously. In addition, the partnership agreement limits the liability of us or our affiliates to a partnership or to general and limited partners for acts or omissions if we determine in good faith, as of the time of the conduct or omission, that the course of conduct or omission was in the best interest of that partnership and that such conduct or omission did not constitute negligence or misconduct. Your purchase of an interest in a partnership may be deemed as consent to the limitations upon the fiduciary standards set forth in the partnership agreement. As a result of these provisions in the partnership agreement, the general and limited partners may find it more difficult to hold us responsible for not acting in the best interests of a partnership and its general and limited partners than if the fiduciary standards of the otherwise applicable Delaware law governed the situation. Partnership s Joint Activities With Others. We anticipate that the participants in the drilling programs, including the related partnerships, will not own the full working interest in most prospects to be explored and developed under the drilling program agreement. It is likely that a third party or parties will own a partial working interest in a prospect to be developed under the drilling program agreement. These third parties could be either our affiliates or unrelated to us and could also include Mr. Mewbourne. While Mewbourne Oil Company, on behalf of each drilling program, would participate in decisions affecting the development of such prospects, decisions with respect to development activities might be controlled or affected by the other owners of working interests in such prospects. Furthermore, a partnership could be held liable for the joint activity obligations of such other working interest owners, and this liability could in turn result in individual liability for the general partners in that partnership. See Particular Risks Relating to the Interests Liability of Joint Working Interest Owners. Lack of Liquidity for Investors. We anticipate that there will not be any market for resale of the interests. Although the partnership agreement permits the assignment of interests by general and limited partners, transfers of interests are subject to restrictions. As one example, an assignee of an interest may not become a substituted general or limited partner without our consent. Accordingly, if you purchase an interest you should be prepared to bear the investment risks attendant upon your investment for an indefinite period of time. See Summary of Partnership Agreement and Drilling Program Agreement Assignability of Interests for a description of transfer restrictions. General and limited partners will not have the right to withdraw any capital from a partnership or to receive the return of all or any portion of their capital contributions, except out of distributions of operating revenues, upon a sale or other disposition of that partnership s property or the dissolution and liquidation of that partnership. Limited Partner Interests (2 ) (3 ) General Partner Interests (2 ) (3 ) Table of Contents Although general and limited partners may under certain circumstances require us, or an affiliate that we have designated, to purchase their interest in whole but not in part, this obligation is limited and does not assure the liquidity of an investor s investment. See Terms of the Offering Right of Presentment. Indemnification of Managing Partner and its Affiliates. The partnership agreement provides for indemnification of us, our affiliates and the officers and directors of such persons against claims arising from conduct on behalf of a partnership or the related drilling program. In addition, the drilling program agreement provides for indemnification of Mewbourne Oil Company, its affiliates, and the officers and directors of such persons against claims arising from conduct on behalf of the related drilling program. In the event of any such indemnification for losses, liabilities or expenses arising from or out of an alleged violation of federal or state securities laws, a court must approve the indemnification. In all other instances of indemnification, we will decide whether or not indemnification is appropriate under the partnership agreement or drilling program agreement. Therefore, if you invest, in such situations you must rely upon our integrity to cause a partnership to indemnify us and our affiliates only when the indemnification is justified under the partnership agreement or drilling program agreement. You should also bear in mind that in any situation involving indemnification, a partnership s funds could be applied to the indemnification of us and our affiliates rather than to make distributions to the general and limited partners. See Summary of Partnership Agreement and Drilling Program Agreement Indemnification of the Managing Partner and its Affiliates. Investor s Lack of Substantial Voting Rights. In order to preserve the limited liability of the limited partners of the partnerships, the limited partners may not take part in the day to day operations of a partnership. Although those investors who elect to invest as general partners will not initially be limited partners of a partnership, we are presuming that the vast majority, if not all, of the general partner interests will be converted into limited partner interests upon completion of the partnership s drilling activities. In order to preserve the limited liability of the limited partners, limited partners are not permitted to take actions which generally may be taken by stockholders of public corporations, such as annual votes to approve important matters. Because limited partners are not permitted to take part in the day to day operations of a partnership, limited partnerships, such as the partnerships, do not generally hold annual meetings such as those at which stockholders may express their views and confront management directly. As a result of the control of the day to day operations of a partnership is vested exclusively in us, and you must rely on us to fulfill our fiduciary duties to you and the other partners and to maximize the partnership s economic performance. Investor s Lack of Appraisal Rights. Unlike most modern corporation laws and the solid body of judicial case law which provides most corporate stockholders with appraisal rights to have their shares of stock redeemed by the corporation in certain instances, limited partnership acts generally provide no such rights. Although the partnership agreement does provide general and limited partners with limited appraisal rights in the case of mergers and similar events, an investor may not have appraisal rights in as many situations as would some corporate stockholders. There is no extensive judicial case law interpreting and upholding the appraisal rights of limited partners. See Proposed Activities The Managing Partner s Policy Regarding Roll-Up Transactions for a description of the limited appraisal rights provided to general and limited partners. Limitations on Right of Presentment. General and limited partners may under certain circumstances request that we, or an affiliate that we have designated, purchase their interests in whole but not in part. Partners in a partnership formed in 2004 may make this request in each of the years 2008 through 2013 and partners in a partnership formed in 2005 may make this request in each of the years 2009 through 2014. However, our obligation to purchase interests is limited and does not assure the liquidity of an investor s investment. Our obligation to purchase interests in a partnership in any single calendar year is limited to no more than 5% of the total number of interests of that partnership outstanding at the beginning of such calendar year; provided, however, the total amount of funds that we directly and by means of a purchaser designee are required to expend in any calendar year to purchase partnership interests from investors in all of the oil and gas drilling partnerships as to which we or an affiliate serve as sponsor shall not exceed $500,000. Additionally, if subsequent to December 31 of the year immediately preceding the year in which the right of presentment is being exercised, the price for either oil or gas received by a partnership from its program wells decreases by 20% or more as compared to the price being received as of that date, then we may in our sole and absolute discretion refuse to purchase any interests in that partnership. See Terms of the Offering Right of Presentment. Table of Contents Limited Ability to Remove Managing Partner and Difficulty in Finding a Successor Managing Partner. We may be removed from our position as the managing partner and/or Mewbourne Oil Company may be removed from its position as the drilling program manager only by the affirmative vote of investors holding at least 50% of the then outstanding general and limited interests of such partnership. The general and limited partners in certain circumstances must, in order to continue the partnership, elect a successor to the removed managing partner if the removal of the managing partner causes a dissolution of that partnership. In the event the drilling program manager is removed, the related partnership must elect a successor to the removed drilling program manager. There is a risk that the general and limited partners could not find a new managing partner or drilling program manager if we or Mewbourne Oil Company were to be removed from such positions. Withdrawal of Partners. Under the partnership agreement, each general partner will agree that he will not voluntarily withdraw from a partnership. We agree that we will not voluntarily withdraw from a partnership prior to the later to occur of: completion of the partnership s primary drilling activities under the related drilling program, and the fifth anniversary of the date that general and limited partners were admitted to the partnership. In order to exercise its right of withdrawal, the managing partner must give the general and limited partners at least 120 days advance written notice. A general partner who withdraws in violation of this agreement will be obligated to reimburse the partnership and the other partners for any expenses associated with such withdrawal. We expect that such expenses may be substantial and could exceed the amount of the withdrawing general partner s original investment in the partnership. Furthermore, a withdrawing general partner will no longer be entitled to receive any distributions nor shall such general partner have any rights as a partner under the partnership agreement. Dissolution of a Partnership and Termination of the Drilling Program. A partnership will be dissolved and terminated upon the occurrence of any of the events listed under Summary of Partnership Agreement and Drilling Program Agreement Dissolution, Liquidation and Termination. These events include: the expiration of that partnership s term, or the vote or consent in writing at any time by a majority in interest of the general and limited partners. However, a partnership could also be dissolved and both it and the related drilling program terminated as a result of events which do not include the passage of time or the consent of the general and limited partners. These events include our bankruptcy, insolvency, dissolution, or withdrawal from the partnership. The general and limited partners have the right to reconstitute a partnership under such circumstances and, in so doing, avoid termination of that partnership. However, there is no certainty that the general and limited partners could find a new managing partner to replace us in such circumstances. We currently have no intention of withdrawing as the managing partner of a partnership. Ability of the Managing Partner to Cause Dissolution of a Partnership and the Related Drilling Program. The partnership agreement and applicable law provide our withdrawal from a partnership, directly or as a result of bankruptcy, dissolution or similar event, will cause dissolution of that partnership. We have undertaken not to withdraw as the managing partner of a partnership prior to the later to occur of completion of that partnership s primary drilling activities under the related drilling program, and the fifth anniversary of the date that general and limited partners were admitted to that partnership. However, we have the power under applicable law to withdraw from a partnership in violation of the partnership agreement. We currently do not intend to withdraw from a partnership. The partners of each partnership are given the right under the partnership agreement to reconstitute a partnership upon our withdrawal, but there is an additional risk in such event that the partners of a partnership could not find a successor managing partner. TOTAL $ 60,000,000 (1)(2) $ 7,602 (4) Table of Contents Unauthorized Acts of General Partners Could Be Binding Against the Partnership. Under Delaware law, the act of a general partner of a partnership apparently carrying on the business of the partnership binds the partnership, unless the general partner in fact has no authority to act for the partnership and the person with whom the partner is dealing has knowledge in good faith of the fact that such general partner has no such authority. While there is a risk that a general partner might bind a partnership by his acts, we believe that the managing partner will have such exclusive control over the conduct of the business of the partnerships that it is unlikely that a third party, in the absence of bad faith, would deal with a general partner in connection with a partnership s business. The participation by a general partner in the management and control of a partnership s business is expressly prohibited by the partnership agreement, and a violation of such prohibition would give rise to a cause of action by the partnership against such general partner. Nevertheless, there is always the possibility that a general partner could attempt to take unauthorized actions on behalf of a partnership, and if a court were to hold that such actions were binding against the partnership such unauthorized actions could be contrary to the best interests of that partnership and could adversely impact such partnership. General Risks Relating to Oil and Natural Gas Operations Loss of Investment Due to Speculative Nature of Oil and Gas Activities. Development of oil and gas properties is not an exact science and involves a high degree of risk which could result in a loss of a partner s investment or personal liability on the part of a general partner. Under the drilling program agreement, the activities of each partnership will focus upon the acquisition of oil and gas leases, the drilling of development wells, the development of prospects, and the production and operation of the resulting properties. In addition to development wells, at our discretion, up to 20% of a partnership s capital contributions may be expended in connection with activities relating to exploratory wells. All drilling activities involve a high degree of risk with exploratory wells presenting a higher degree of risk than development wells. We cannot assure that the objective formation(s) will be encountered or that any or sufficient oil or gas production will be obtained through drilling program activities, or if production is obtained, that such production will be sold at sufficient prices to enable an investor to recoup his investment in a partnership. During the drilling and completion of wells, a drilling program could encounter hazards such as unusual or unexpected formations, pressures or other conditions, blow-outs, fires, failure of equipment, downhole collapses, and other hazards, whether similar or dissimilar to those enumerated. Although a partnership will maintain the insurance coverage described under Proposed Activities Insurance, the drilling program may suffer losses due to hazards against which it cannot insure or against which it may elect not to insure. Such liabilities could result in personal liability for a general partner. The Partnerships and the General Partners Could be Liable for Environmental Hazards. There are numerous natural hazards involved in the drilling of wells, including unexpected or unusual formations, pressures, blowouts, and accidental leakage involving possible damage to property and third parties. Such hazards may cause substantial liabilities to third parties or governmental entities. Although we anticipate that customary insurance will be obtained, a partnership may be subject to liability for pollution and other damages due to hazards which cannot be insured against or will not be insured against due to prohibitive premium costs or for other reasons. Liabilities to third parties or governmental entities for pollution could reduce funds available for distributions and for drilling operations, result in the loss of partnership property, or result in the personal liability of the general partners if the liability exceeded insurance proceeds, a partnership s assets, and the managing partner s ability to indemnify such general partners. Return on Investment is Dependent on Future Prices, Supply and Demand for Oil and Gas. The revenues generated from the activities of each partnership and the return on the investments made by the partner s will be highly dependent upon the future prices and demand for oil and gas which can be volatile. The high and low average monthly posted price for crude oil received by the drilling program manager during 2003 was approximately $32.38 per barrel and $24.87 per barrel, respectively. The high and low monthly average price received by the drilling program manager for gas produced and sold during 2003 was approximately $8.34 per mmbtu and $4.18 per mmbtu, respectively. Factors which may affect prices and demand include the world-wide supply of oil and gas, the price of foreign imports, the levels of consumer demand, price and availability of alternative fuels and changes in existing and proposed federal regulation and taxation. Also, gas prices remain somewhat seasonal in nature and, for this reason, it is particularly difficult to estimate accurately future prices of gas, and any assumptions concerning future prices may prove to be incorrect. Table of Contents The United States average daily production of oil declined from 9.0 million barrels in 1985 to approximately 5.6 million barrels in 2003. The reduced production level is in part the result of decreased drilling activity in the United States which has only recently increased. Drilling activity is measured by the United States rig count which averaged 1,030 during 2003 compared to 830 for 2002. Another factor contributing to the reduction of United States oil production is the plugging and abandoning of wells which are uneconomical due to the significant decrease in the price of oil. The United States import levels for oil have increased significantly since 1985. In 1985, imports of foreign oil represented 27% of the United States demand. During the year 2003, imports averaged approximately 57% of the United States consumption. Government Regulation of a Partnership s Activities. The oil and gas business is subject to extensive governmental regulation under which, among other things, rates of production from oil and gas wells may be regulated. Governmental regulation also may affect the market for a partnership s production. Governmental regulations relating to environmental matters could also affect a partnership s operations. We cannot predict the nature and extent of various regulations, the nature of other political developments and their overall effect upon a partnership and the related drilling program. Tax Risks General. We have not requested, and we will not request, a ruling from the IRS regarding the tax consequences of investing in interests. Based on our representations and various assumptions and qualifications, our counsel has rendered an opinion that the material federal income tax benefits of an investment in interests, in the aggregate, more likely than not will be realized in substantial part by a partner who is an individual United States citizen and who acquires his interests for profit, provided that an investor who acquires limited partner interests either is not subject to the passive activity loss limitations of Section 469 of the Internal Revenue Code or has sufficient passive income against which he can deduct his share of any partnership deductions and losses. See Tax Aspects Opinion of Counsel. Partnership Classification for Tax Purposes; No IRS Ruling Sought. In order for income and deductions to be passed through to the general and limited partners, a partnership and the related drilling program must be classified as partnerships for federal income tax purposes. If a partnership or the related drilling program were taxed as a corporation for federal income tax purposes, the tax consequences resulting from the ownership of interests would be adversely affected and any anticipated federal income tax benefits would be reduced or eliminated. Based on our representations and various assumptions and qualifications, our counsel is of the opinion that, at the time of formation, each partnership and each related drilling program will be treated as a partnership for federal income tax purposes and that neither partnership will be treated as a corporation under the publicly traded partnership rules of Section 7704 of the Internal Revenue Code. We cannot assure, however, that future legislative, judicial or administrative action will not affect the classification of a partnership or a drilling program for federal income tax purposes. See Tax Aspects Partnership Taxation Partnership Classification. Allocations. The partnership agreement and the drilling program agreement contain provisions that allocate federal income tax consequences of a drilling program s activities among us and the general and limited partners. If such allocation provisions were not recognized for federal income tax purposes: a portion of the federal income tax deductions allocated to and claimed by the general and limited partners, including deductions for intangible drilling costs, could be reallocated to us. This reallocation could occur notwithstanding the fact that such general and limited partners had been charged with the expenditures giving rise to such deductions, and a portion of the taxable income allocated to us could be taxed to the general and limited partners. This allocation could occur notwithstanding the fact that the revenues giving rise to such taxable income had been credited to us. (1) This registration statement covers all limited partner interests that may be acquired by limited partners and all general partner interests that may be acquired by general partners, including additional limited partner interests into which general partner interests are convertible if the maximum aggregate subscriptions contemplated by this offering are obtained. No subscriber will be admitted as an investor partner in a partnership unless, at the end of the subscription period for interests in that partnership, subscription funds have been received and accepted by Mewbourne Development Corporation in an amount of $5,000,000 or more and Mewbourne Development Corporation determines, in its sole discretion, to proceed with the funding of that partnership. (2) The proposed maximum offering price is comprised of any combination of limited partner interests and general partner interests. (3) Pursuant to Rule 457(o), the registration fee is calculated on the basis of the maximum aggregate offering price of all securities listed. (4) Calculated pursuant to Rule 457(o) at the statutory rate of $126.70 per $1,000,000 of securities registered. A portion of this fee equal to $6,335.00 was previously paid in connection with the filing of the Registration Statement. Table of Contents Based on our representations and various assumptions and qualifications, our counsel is of the opinion that, except as noted below, the allocation of income, gains, losses, and deductions between us and the general and limited partners under the partnership agreement and between us and a partnership under the drilling program agreement will be recognized for federal income tax purposes. Our counsel s opinion is not binding on the IRS, however, and we cannot assure that the IRS will not challenge such allocations. Passive Activity Limitations. A limited partner s interest in a partnership will be treated as a passive activity, and any tax losses derived by a limited partner from a partnership will be allowable only to the extent of such limited partner s passive income. Disallowed passive losses in any year can be carried forward indefinitely and used to offset future passive income or can be deducted in full when the limited partner disposes of his entire interest in the partnership to an unrelated person in a fully taxable transaction. A taxpayer s interest in an oil or gas well drilled or operated under a working interest does not constitute a passive activity so long as the taxpayer owns the working interest directly or through an entity that does not limit the taxpayer s liability with respect to such drilling or operation. Based on our representations and various assumptions and qualifications, our counsel is of the opinion that the passive activity loss limitations of Section 469 of the Internal Revenue Code should not apply to general partners in a partnership, prior to any conversion of a general partner interest to a limited partner interest, to the extent that a partnership drills or operates wells under working interests. Consequently, each general partner should be entitled to deduct currently his share of intangible drilling and development costs and other deductible expenses allocable to the drilling or operation of wells under working interests without regard to the passive activity loss limitations. However, a general partner s ability to take deductions will be subject to basis and at risk limitations. The exception for working interests would not be applicable to any operations of a partnership other than the drilling and operation of wells under working interests. Therefore, if a partnership acquires an interest or participates in other activities, such activities will be treated as passive activities to the general partners and any losses derived by them with respect to such activities will be passive losses allowable only to the extent of their passive income. In addition, the exception for working interests will not apply from and after a conversion of a general partner interest to a limited partner interest. See Tax Aspects Special Features of Oil and Gas Taxation Passive Activity Loss Limitations. The treatment of a partnership as a publicly traded partnership for purposes of applying the passive activity loss limitations would even more severely restrict or eliminate a limited partner s ability to use any partnership losses to offset income from other sources. Based on our representations and various assumptions and qualifications, our counsel is of the opinion that neither partnership will be treated as a publicly traded partnership for purposes of the application of the passive activity loss limitations of Section 469 of the Internal Revenue Code. Our counsel s opinion is not binding on the IRS, however, and we cannot assure that the IRS will not assert that a partnership is a publicly traded partnership for purposes of applying the passive activity loss limitations. Tax Shelter Registration. Although an investment in a partnership may generate tax benefits, a partnership should not be considered a tax shelter as that term is commonly understood. Nevertheless, because of the expansive definition of the term tax shelter under applicable Treasury Regulations, we will apply to the IRS for a tax shelter registration number with respect to each partnership. We will furnish the registration number to each partner. Each partner must include the registration number on his individual tax return and must furnish the number and certain other information to any transferee of his interests. We will also maintain and make available to the IRS on request a list of the general and limited partners in each partnership. There may be a greater likelihood that partners in a partnership will be audited by the Internal Revenue Service because the partnership has been registered as a tax shelter. Current Tax Deductions. We will use reasonable efforts to expend or contract for the expenditure of the capital contributions of each partnership in the year such contributions are received. However, some of the expenses may be incurred prior to the actual drilling of the oil and gas wells. We cannot assure that any intangible drilling costs incurred in a year prior to the year of the actual drilling of the oil and gas wells will be deductible in the year incurred. In particular, a partnership might not expend or contract for the expenditure of a substantial portion of its capital contribution in the year in which general and limited partners are admitted to a partnership, in which event no substantial partnership tax deductions would be available in that year. We have sponsored a series of sixteen public limited partnerships similar to the partnerships being offered by this prospectus since December 1992 and, based on the historic results of these previous limited partnerships, we anticipate that no more than 65% of the total intangible The Registrant hereby amends this Registration Statement on such date or dates as may be necessary to delay its effective date until the Registrant shall file a further amendment which specifically states that this Registration Statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933, as amended, or until the Registration Statement shall become effective on such date as the Commission, acting pursuant to said Section 8(a), may determine. Table of Contents drilling costs incurred by a partnership will be incurred and deductible by investors in that partnership in the year they are admitted as general or limited partners to such partnership. See Tax Aspects Anticipated Federal Income Tax Deductions. Organization and Offering Expenses, Sales Commissions and Due Diligence Fees. The organization and offering expenses, sales commissions and due diligence fees incurred in connection with the syndication and organization of each Partnership must be capitalized by the partnership. Syndication costs are not amortizable or otherwise deductible; however, the cost of organizing a partnership may, at the election of the partnership, be amortized for a period of not less than 60 months. The partnerships intend to elect to amortize their organization expenses over a 60 month period. The Treasury Regulations under Section 709 of the Internal Revenue Code provide that non-amortizable syndication costs include brokerage fees, registration fees, legal fees of the underwriter or placement agent and the issuer for securities advice and for advice pertaining to the adequacy of tax disclosures in the prospectus for securities law purposes, printing costs, and other items. It is possible that the IRS may attempt to recharacterize any costs treated as organization costs as non-amortizable syndication costs. Due to the factual nature of this issue, our counsel has not rendered an opinion with respect to the classification of such amounts. Conversion of General Partner Interests. We anticipate that the general partner interests in a partnership will be converted to limited partner interests following the completion of the partnership s drilling activities. We anticipate a partnership will complete drilling activities within approximately 8 to 15 months after the funding of the partnership. The tax consequences of such a conversion will depend upon the law in existence at the time of conversion and upon the results of that partnership s operations prior to that time. Such consequences may be adverse if the conversion is deemed a constructive termination of the partnership for federal income tax purposes or may be adverse under the passive loss rules as a result of a partner s particular circumstances. If we determine that the conversion of the general partner interests in a partnership to limited partner interests will have an adverse effect on the general partners or the partnership, due to adverse tax consequences or other reasons, we may elect not to convert those interests. Accordingly, we cannot assure that any general partner interests will be converted to limited partner interests or when any such conversion will occur. Tax Liabilities in Excess of Cash Distributions. A partner must report and pay income tax on his share of partnership income, regardless of whether such income is retained and used for debt service, working capital, or other reasons, any of which uses may not give rise to deductions for federal income tax purposes. The receipt of cash distributions by the general and limited partners may be delayed due to various factors, such as the use of revenues to finance permitted activities. To the extent that the general and limited partners are credited with net income from a partnership, an income tax liability will be incurred even though the general and limited partners may not yet have received any cash distributions from the partnership. The timing and amount of cash distributions will be determined by us in our complete discretion. If you invest in a partnership, you will be required to report your share of any partnership income on your federal, state and local tax returns and you will be responsible for the payment of taxes attributable to such income. In any year, your resulting tax liability may exceed the amount of cash distributed to you by a partnership. Risks of Borrowings. We are authorized to cause a partnership to obtain additional loans from banks or other financial sources, or from us or our affiliates, provided that the total amount of such loans may not in the aggregate exceed 20% of the capital contributions to the partnership. A partner s share of revenue applied to the repayment of loans, will be included in his taxable income. Although such income may be offset in part by deductions for depletion, cost recovery, depreciation, and intangible drilling costs, such loans could cause a partner to become subject to an income tax liability in excess of the amount of cash distributions he receives from the partnership. Percentage Depletion. Percentage depletion deductions are tax deductions calculated based upon a percentage of gross income from the property, but are limited to 100% of the total taxable income of the partner from the property for each taxable year, and are only available to limited partners qualifying as independent producers. Because depletion deductions must be computed separately by each partner and not at the partnership level, the availability of percentage depletion will depend in part upon a partner s individual circumstances. Therefore, each individual investor may not be eligible to claim percentage depletion deductions. See Tax Aspects Special Features of Oil and Gas Taxation Depletion. Table of Contents Farmouts and Backin Interests. If a partnership acquires working interests in oil and gas leases under the terms of a farmout agreement, a portion of the value of such working interests may have to be reported as taxable income. In addition, the ability of a partnership to deduct all intangible drilling costs paid by it with respect to oil and gas leases burdened by a backin working interest may be limited. A backin working interest is a right held by another party to become a working interest owner in the oil and gas lease on payout of the initial well on the oil and gas lease. See Tax Aspects Special Features of Oil and Gas Taxation Farmouts and Backin Interests. Recapture. Certain deductions for intangible drilling costs, depletion, and depreciation must be recaptured as ordinary income on disposition of property by a partnership or on disposition of interests by a partner. If a partnership disposes of property or a partner transfers an interest, the partnership, and the partners may recognize ordinary income (instead of capital gain) to the extent such deductions for intangible drilling costs, depletion and depreciation must be recaptured. See Tax Aspects Special Features of Oil and Gas Taxation Intangible Drilling and Development Costs, Depletion and Depreciation. Audits. The IRS may audit the tax returns of the partnership you invest in or its related drilling program, in which case an audit of your individual tax returns also may result. If such audits occur, tax adjustments may be made, including adjustments to items on your returns unrelated to the partnership. Furthermore, any settlement or judicial determination of the partnership s or the drilling program s income may be binding on you. This is the case even though you may not have participated directly in the settlement proceedings or litigation. See Tax Aspects Partnership Taxation Elections and Returns. Changes in Federal Income Tax Laws. Significant and fundamental changes in the nation s federal income tax laws have been made in recent years and additional changes are likely. Any such change may affect the partnerships and the general and limited partners. Moreover, judicial decisions, regulations or administrative pronouncements could unfavorably affect the tax consequences of an investment in a partnership. See Tax Aspects Other Tax Consequences Changes in Federal Income Tax Laws. Significance of Tax Aspects. These interests are being offered to parties who may avail themselves of the benefits presently allowed oil and gas activities under federal income tax laws. We cannot assure that: money invested in a partnership will be recovered, any capital contributions to a partnership will be expended and result in any tax deductions in the year such contributions are received by a partnership, federal income tax laws or the present interpretation of those laws will not be changed, or that any position taken by a partnership or a drilling program on its federal income tax returns will not be challenged by the IRS. In addition, federal income tax provisions may: limit deductions, trigger or increase a partner s liability for the alternative minimum tax on tax preference items, increase tax liability on the disposition of interests, or otherwise increase the federal income tax liability of a partner. Notwithstanding enactment of additional legislation or interpretations of legislation which might require different treatment from the discussion under Tax Aspects, a partnership is authorized to expend the proceeds from the sale of interests and to conduct its business and operations as described in this prospectus. Each item of partnership income, gain, loss, or deduction will be shared or borne financially in the manner specified in this prospectus. It is Table of Contents suggested that you obtain professional guidance from your tax advisor in evaluating the tax risks involved in investing in a partnership. Forward Looking Statements Forward-looking statements are inherently uncertain. Some statements under the captions Summary of Offering, Risk Factors, Application of Proceeds, and elsewhere in this prospectus are forward-looking statements. These forward-looking statements include, but are not limited to, statements about our industry, plans, objectives, expectations, intentions and assumptions and other statements contained in the prospectus that are not historical facts. When used in this prospectus, the words expect, anticipate, intend, plan, believe, seek, estimate and similar expressions are generally intended to identify forward-looking statements. Because these forward-looking statements involve risks and uncertainties, including those described in this Risk Factors section, actual results may differ materially from those expressed or implied by these forward-looking statements. We do not intend to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. Market data and forecasts used in this prospectus have been obtained from independent industry sources. Although we believe these sources are reliable, we do not guarantee the accuracy and completeness of historical data obtained from these sources and we have not independently verified these data. Forecasts and other forward-looking information obtained from these sources are subject to the same qualifications and the additional uncertainties accompanying any estimates of future market size. APPLICATION OF PROCEEDS Interests in each partnership may be sold in an aggregate amount from $5,000,000 to $30,000,000. An amount equal to 8.5% of the proceeds realized from the sale of interests to investors will not be received by the partnership and will be deducted to pay sales commissions and due diligence fees to the soliciting dealers. Therefore, not all of such sales proceeds will be available to each partnership for the partnership s operations. The managing partner under the terms of each drilling program agreement will pay all organization and offering expenses. See Application of Proceeds and Participation in Costs and Revenues. A partnership may receive subscriptions by the investor partners ranging from a minimum of $5,000,000 to a maximum of $30,000,000. Regardless of the amount of capital contributions received, each partnership will have sufficient capital to engage in the proposed activities as set forth under Proposed Activities. However, to the extent that a partnership receives the minimum capital contributions from the investor partners, the ability of that partnership to participate in a large number of program wells and prospects will be reduced, and therefore, the partnership may have a concentration of
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+RISK FACTORS An investment in the EISs, shares of our Class A common stock and/or our senior subordinated notes involves a number of risks. In addition to the other information contained in this prospectus, prospective investors should give careful consideration to the following factors. Risks Relating to the EISs, shares of Class A Common Stock and/or Senior Subordinated Notes You may not receive interest or dividends in the amounts contemplated in this prospectus. The terms of our new credit facility will restrict our ability to pay principal and interest on our senior subordinated notes and to pay dividends on shares of our Class A and Class B common stock. The terms of our senior subordinated notes and our franchise agreements with Wendy's International restrict our ability to pay dividends on shares of our Class A and Class B common stock. Our ability to make payments of principal and interest on our senior subordinated notes, pay dividends on our Class A and Class B common stock or make other distributions will be subject to applicable law and contractual restrictions contained in the instruments governing our indebtedness, including the terms of our new credit facility, the indenture governing our senior subordinated notes and our franchise agreements with Wendy's International. The terms of our new credit facility will prevent us from paying principal or interest on our senior subordinated notes during the existence of a payment default thereunder and for 179 days following a default thereunder, other than a payment default. Our new credit facility will also prevent us from paying dividends on our shares of Class A and Class B common stock if an event of default exists thereunder or if certain financial covenant ratios are not met. See "Description of Certain Indebtedness New Credit Facility." The indenture governing our senior subordinated notes contains significant restrictions on our ability to pay dividends on shares of our Class A and Class B common stock based upon meeting certain fixed charge coverage ratios and other conditions, as described under "Description of Senior Subordinated Notes" and prohibits the payment of dividends during the existence of an event of default (including the non-payment of interest on our senior subordinated notes, when due) thereunder. Under the terms of our franchise agreements with Wendy's, we are restricted from paying dividends on our Class A and Class B common stock if at the time of such payment we are not current in our capital expenditure obligations or our royalty fee, advertising contribution or other payment obligations to Wendy's, or if such payment would prevent us from making required payments to Wendy's under our agreements with Wendy's. See "Business Relationship with Wendy's International Ownership and Other Requirements of Wendy's International Dividend restrictions." Accordingly, you may not receive interest or dividends in the amounts contemplated by the senior subordinated notes or the dividend policy to be adopted by our board of directors upon the closing of this offering. You may not receive the level of dividends provided for in the dividend policy our board of directors will adopt upon the closing of this offering or any dividends at all. Dividend payments are not mandatory or guaranteed, and holders of our common stock do not have any legal right to receive, or require us to pay, dividends. Furthermore, our board of directors may, in its sole discretion, amend or repeal the dividend policy to be adopted upon the closing of this offering. Our board of directors may decrease the level of dividends provided for in this dividend policy or entirely discontinue the payment of dividends. Future dividends with respect to shares of our capital stock, if any, will depend on, among other things, our results of operations, cash requirements, financial condition, contractual restrictions, business opportunities, provisions of applicable law and other factors that our board of directors may deem relevant. Under state law, our board of directors may declare DavCo Restaurants Inc. [GRAPHIC OMITTED] dividends only to the extent of our "surplus" (which is defined as total assets at fair market value minus total liabilities, minus statutory capital), or, if there is no surplus, out of the current or immediately preceding fiscal year's earnings. Further, the new credit facility, the indenture governing our senior subordinated notes and our franchise agreements with Wendy's contain significant restrictions on our ability to make dividend payments on our shares of common stock. The reduction or elimination of dividends may negatively affect the market price of the EISs. If we have insufficient cash flow to cover the expected dividend payments under the dividend policy to be adopted by our board of directors we would need to reduce or eliminate dividends or, to the extent permitted under our debt agreements, fund a portion of our dividends with additional borrowings. If our cash flows from operations for future periods were to fall below our minimum expectations (or if our assumptions as to capital expenditures, interest expense or tax expense were too low or our assumptions as to the sufficiency of our new credit facility to finance our new restaurant capital expenditures and any of our seasonal working capital needs and other assumptions were to prove incorrect), we would need either to reduce or eliminate dividends or, to the extent we were permitted to do so under the terms of our new credit facility and the indenture governing our senior subordinated notes, fund a portion of our dividends with borrowings or from other sources. If we were to use our new credit facility or other borrowings to fund dividends, we would have less cash or borrowing capacity available for future dividends and other purposes, which could negatively impact our financial condition, our results of operations and our ability to maintain or expand our business. The degree to which we are leveraged on a consolidated basis may impact our financing options and liquidity position. Following the closing, we will have an aggregate $66.3 million of our senior subordinated notes outstanding (or $75.1 million if the underwriters' over-allotment option is exercised in full) and have entered into the new credit facility. Under certain circumstances, our new credit facility and the indenture governing our senior subordinated notes will permit us to incur additional indebtedness. The degree to which we are leveraged on a consolidated basis could have important consequences to the holders of the EISs or senior subordinated notes, including: it may be more difficult to satisfy our obligations under our new credit facility and the senior subordinated notes and pay dividends on our common stock; our ability in the future to obtain additional financing for working capital, capital expenditures or acquisitions may be limited; we may not be able to refinance our indebtedness on terms acceptable to us or at all; a significant portion of our cash flow from operations is likely to be dedicated to the payment of the principal of and interest on our indebtedness, thereby reducing funds available for future operations, capital expenditures and/or dividends on our common stock; and we may be more vulnerable to economic downturns and be limited in our ability to withstand competitive pressures. We are subject to restrictive debt covenants that limit our business flexibility by imposing operating and financial restrictions on our operations. The agreements governing our indebtedness, including the new credit facility and the indenture governing our senior subordinated notes, impose significant operating and financial restrictions on us. These restrictions prohibit or limit, among other things: the payment of principal and interest on our senior subordinated notes, dividends and distributions on, and purchase or redemption of, capital stock; TABLE OF CONTENTS Page the incurrence of additional indebtedness and the issuance of preferred stock and certain redeemable capital stock; a number of other restricted payments, including the making of certain investments; specified sales of assets; specified sale-leaseback transactions; the creation of a number of liens; specified transactions with affiliates; and consolidations, mergers and transfers of all or substantially all of our assets. These restrictions could limit our ability to obtain future financing, make acquisitions or needed capital expenditures, withstand downturns in our business or take advantage of business opportunities. The terms of the new credit facility include other restrictive covenants and prohibit us from prepaying our other indebtedness, including the senior subordinated notes, while indebtedness under the new credit facility is outstanding. The new credit facility also requires us to maintain certain financial ratios (as defined therein) including, without limitation, the following: a minimum Fixed Charge Coverage Ratio, a maximum Funded Indebtedness to EBITDA ratio, a maximum Adjusted Funded Indebtedness to EBITDAR ratio and a minimum of Adjusted EBITDA. Our ability to comply with the ratios or tests may be affected by events beyond our control, including prevailing economic, financial and industry conditions. A breach of any of these covenants, ratios or tests could result in a default under the new credit facility and/or the indenture. Certain events of default under the new credit facility would prohibit us from making payments on our senior subordinated notes, including payment of interest when due. In addition, upon the occurrence of an event of default under the new credit facility, the lender could elect to declare all amounts outstanding under the new credit facility, together with accrued interest, to be immediately due and payable. If we were unable to repay those amounts, the lender could proceed against the security granted to them to secure that indebtedness. If the lenders accelerate the payment of the indebtedness, our assets may not be sufficient to repay in full this indebtedness and our other indebtedness, including the senior subordinated notes. We are a holding company and rely on dividends, interest and other payments, advances and transfers of funds from our subsidiaries to meet our debt service and other obligations. We are a holding company and conduct all of our operations through our subsidiaries and currently have no significant assets other than the capital stock of DavCo Operations. As a result, we will rely on dividends and other payments or distributions from DavCo Operations and its subsidiaries to meet our debt service obligations and enable us to pay dividends. The ability of DavCo Operations and its subsidiaries to pay dividends or make other payments or distributions to us will depend on their respective operating results and will be restricted by, among other things, the laws of their jurisdiction of organization (which may limit the amount of funds available for the payment of dividends), agreements of those subsidiaries, the terms of the new credit facility and the covenants of any future outstanding indebtedness we or our subsidiaries incur. You may not be able to immediately accelerate the principal amount of the senior subordinated notes prior to their maturity which may delay your right, as a holder of senior subordinated notes, to enforce your remedies and receive payment. The maturity of the principal amount of the senior subordinated notes may not be immediately accelerated and the principal amount will not become due and payable, prior to the scheduled maturity date, for a period beginning on the date notice is provided to Wendy's with respect to the occurrence of certain events of default and ending 45 days after such date, as described in "Description of Senior Subordinated Notes Acceleration Forbearance Periods." This acceleration forbearance period may delay your right, as a holder of senior subordinated notes, to enforce your remedies and receive payments on the senior subordinated notes. Holders of Class B common stock may have conflicting interests from yours. Pursuant to a recapitalization to be effected concurrent with this offering, the management investors and Citicorp Venture Capital will own all of the shares of our Class B common stock. Pursuant to the stockholders agreement, so long as the existing equity investors hold at least 8% or more of the total economic value of the total outstanding equity interests in our company and 8% or more of the total outstanding voting interests in our company, they will be entitled to nominate two individuals for election to our board of directors. As a result, through their director designation right, the management investors and Citicorp Venture Capital will, collectively, exercise influence over matters requiring board approval, including decisions about our capital structure and the payment of dividends on our Class A and Class B common stock. As holders of our Class B common stock, which provide for dividends to be subordinated to the dividends payable to holders of our Class A common stock, their interests may conflict with your interests as a holder of EISs and Class A common stock. You will be immediately diluted by $12.45 per share of Class A common stock if you purchase EISs in this offering. If you purchase EISs in this offering, based on the book value of the assets and liabilities reflected on our balance sheet, you will experience an immediate dilution of $12.45 per share of Class A common stock represented by the EISs which exceeds the entire price allocated to each share of common stock represented by the EISs in this offering because there will be a net tangible book deficit for each share of Class A common stock outstanding immediately after this offering. Our net tangible book deficiency as of June 27, 2004, after giving effect to this offering, was approximately $60.1 million, or $4.80 per share of common stock. Our expansion is dependent on our continued ability to borrow under our new credit facility and our interest expense thereunder may significantly increase and could cause our net income and distributable cash to decline significantly. Our ability to continue to expand our business, including to make new restaurant expenditures, will be dependent upon our ability to borrow funds under our new credit facility and to obtain other third-party financing, including through the sale of EISs or any sale of securities. We cannot assure you that such financing will be available to us on favorable terms or at all. The new credit facility will be subject to periodic renewal or must otherwise be refinanced. We may not be able to renew or refinance the new credit facility, or if renewed or refinanced, the renewal or refinancing may occur on less favorable terms. Any future borrowings under our new credit facility will be made at a floating rate of interest. In the event of an increase in the base reference interest rates, our interest expense will increase and could have a material adverse effect on our ability to make cash dividend payments to our stockholders. We may not generate sufficient funds from operations to pay our indebtedness at maturity or upon the exercise by holders of our senior subordinated notes of their rights upon a change of control. A significant portion of our cash flow from operations will be dedicated to maintaining our restaurants and servicing our debt requirements. In addition, we currently expect to distribute a significant portion of any remaining available cash to our stockholders in the form of quarterly dividends. Moreover, prior to the maturity of our senior subordinated notes, we will not be required to make any payments of principal on our senior subordinated notes. We may not generate sufficient funds from operations to repay the principal amount of our indebtedness at maturity or in case you exercise your right to require us to purchase your senior subordinated notes upon a change of control. In making your investment decision, you should rely only on the information contained in this prospectus or to which we have referred you. We have not authorized anyone to provide you with information that is different. If anyone provided you with different or inconsistent information, you should not rely on it. This prospectus may only be used where it is legal to sell these securities. We may therefore need to refinance our debt or raise additional capital. These alternatives may not be available to us when needed or on satisfactory terms due to prevailing market conditions, a decline in our business or restrictions contained in our senior debt obligations. Your right to receive payments on the senior subordinated notes and the senior subordinated note guarantees is junior to all senior debt of our company and its subsidiaries. We are a holding company and conduct all of our operations through our subsidiaries. The senior subordinated notes and the senior subordinated note guarantees issued by our subsidiary guarantors will be unsecured senior subordinated obligations, junior in right of payment to our senior debt and that of each of our subsidiary guarantors, respectively. As a result of the subordinated nature of our senior subordinated notes and related guarantees, upon any distribution to our creditors or the creditors of the subsidiary guarantors in bankruptcy, liquidation or reorganization or similar proceeding relating to us or the subsidiary guarantors or our or their property, the holders of our senior indebtedness and senior indebtedness of the subsidiary guarantors will be entitled to be paid in full in cash before any payment may be made with respect to our senior subordinated notes or the subsidiary guarantees. In the event of a bankruptcy, liquidation or reorganization or similar proceeding relating to us or the subsidiary guarantors, holders of our senior subordinated notes will participate with all other holders of unsecured indebtedness of ours or the subsidiary guarantors similarly subordinated in the assets remaining after we and the subsidiary guarantors have paid all senior indebtedness. In any of these cases, we and the subsidiary guarantors may not have sufficient funds to pay all of our creditors, and holders of our senior subordinated notes may receive less, ratably, than the holders of senior indebtedness. In such event, we and our subsidiary guarantors would not be able to make all principal payments on our senior subordinated notes. The subordination provisions of the indenture governing the senior subordinated notes will also provide that payments to you under the subsidiary guarantees may be blocked for up to 179 days by holders of designated senior indebtedness (at the closing of this offering, the lenders under the new credit facility) if a default other than a payment default exists under such senior indebtedness. During any period in which payments to you are blocked in this manner, any amounts received by you with respect to the subsidiary guarantees, including as a result of any legal action to enforce such subsidiary guarantees, would be required to be turned over to the holders of senior indebtedness. See "Description of Senior Subordinated Notes Ranking." On a pro forma basis as of June 27, 2004, we would have had approximately $28.0 million of outstanding senior indebtedness, plus approximately $4.6 million of letters of credit and the subsidiary guarantors would have had approximately $28.0 million of outstanding senior indebtedness. In addition, as of June 27, 2004, on a pro forma basis, DavCo Operations would have had the ability to borrow up to an additional amount of $9.1 million under the new credit facility (less amounts reserved for letters of credit), which would have ranked senior in right of payment to our senior subordinated notes. The guarantees of the senior subordinated notes by our subsidiaries may not be enforceable. Under federal bankruptcy law and comparable provisions of state fraudulent transfer laws, a guarantee could be voided, or claims in respect of a guarantee could be subordinated to all other debt of the guarantor, if, among other things, the guarantor, at the time that it assumed the guarantee: issued the guarantee to delay, hinder or defraud present or future creditors; or INDUSTRY AND MARKET DATA Unless otherwise indicated, all United States restaurant industry data in this prospectus is from the Technomic Information Services ("Technomic") 2003 report entitled "Technomic Top 100: Update and Analysis of the Largest U.S. Chain Restaurant Companies" (the "Technomic Report"). received less than reasonably equivalent value or fair consideration for issuing the guarantee and, at the time it issued the guarantee: was insolvent or rendered insolvent by reason of issuing the guarantee and the application of the proceeds of the guarantee; was engaged or about to engage in a business or a transaction for which the guarantor's remaining assets available to carry on its business constituted unreasonably small capital; intended to incur, or believed that it would incur, debts beyond its ability to pay the debts as they mature; or was a defendant in an action for money damages, or had a judgment for money damages docketed against it if, in either case, after final judgment, the judgment is unsatisfied. In addition, any payment by the guarantor under its guarantee could be voided and required to be returned to the guarantor or to a fund for the benefit of the creditors of the guarantor or the guarantee could be subordinated to other debt of the guarantor. The measures of insolvency for the purposes of fraudulent transfer laws vary depending upon the law applied in any proceeding to determine whether a fraudulent transfer has occurred. Generally, however, a person would be considered insolvent if, at the time it incurred the debt: the sum of its debts, including contingent liabilities, was greater than the fair saleable value of its assets; the present fair saleable value of its assets was less than the amount that would be required to pay its probable liability on its existing debts, including contingent liabilities, as they become absolute and mature; or it could not pay its debts as they become due. We believe that immediately after the issuance of the senior subordinated notes and the guarantees, we and each of the subsidiary guarantors will be solvent, will have sufficient capital to carry on our respective businesses and will be able to pay our respective debts as they mature. However, we cannot be sure what standard a court would apply to determine whether the subsidiary guarantors are solvent or that a court would reach the same conclusions with regard to these issues. Regardless of the standard that the court uses, we cannot be sure that the issuance by the subsidiary guarantors of the subsidiary guarantees would not be voided or the subsidiary guarantees would not be subordinated to their other debt. The guarantee of our senior subordinated notes by any subsidiary guarantor could be subject to the claim that, since the guarantee was incurred for the benefit of DavCo Restaurants, and only indirectly for the benefit of the subsidiary guarantor, the obligations of the subsidiary guarantor were incurred for less than fair consideration. If such a claim were successful and it was proven that the subsidiary guarantor was insolvent at the time the guarantee was issued, a court could void the obligations of the subsidiary guarantor under the guarantee or subordinate these obligations to the subsidiary guarantor's other debt or take action detrimental to holders of the senior subordinated notes. If the guarantee of any subsidiary guarantor were voided, our senior subordinated notes would be effectively subordinated to the indebtedness of that subsidiary guarantor. Seasonality and variability of our businesses may cause volatility in the market value of your investment and may hinder our ability to make timely distributions on the EISs. Our business is seasonal in nature, and our net sales and operating results vary significantly from quarter to quarter. This variability results from several factors, including consumer habits driven by changes in the seasons and weather. Consequently, results of operations for any particular quarter may not be indicative of the results of operations of future periods, which make it difficult to forecast our results for an entire year. This variability may cause volatility in the market price of the EISs. In addition, the seasonality and variability of our business means that at certain times of the year our cash receipts are significantly higher than at other times. Given that we are required to make equal quarterly interest payments and expect to pay equal quarterly dividends to EIS holders throughout the year, there is a risk that we will experience cash shortages, which could hinder our ability to make timely distributions to EIS holders. Interest on the senior subordinated notes may not be deductible by us for U.S. federal income tax purposes, which could significantly reduce our future cash flow and impact our ability to make interest and dividend payments. If all or a portion of the senior subordinated notes were treated as equity rather than debt (including if the EISs were treated as an indivisible equity security) for U.S. federal income tax purposes, then a corresponding portion of the interest on the senior subordinated notes would not be deductible by us for U.S. federal income tax purposes. In addition, we would be subject to liability for U.S. withholding taxes on interest payments to non-U.S. holders if such payments were determined to be dividends. Our inability to deduct interest on the senior subordinated notes could materially increase our taxable income and, thus, our U.S. federal and applicable state income tax liability. If the senior subordinated notes were determined to be equity for income tax purposes, our liability for income taxes (and withholding taxes) would materially reduce our after-tax cash flow and would materially and adversely impact our ability to make interest and/or dividend payments. In the case of foreign holders, treatment of the senior subordinated notes as equity for U.S. federal income tax purposes would subject such holders in respect of the senior subordinated notes to withholding or estate taxes in the same manner as with regard to common stock and could subject us to liability for withholding taxes that were not collected on payments of interest. Therefore, foreign holders would receive any such payments net of the tax withheld. Even if the IRS does not challenge the tax treatment of the senior subordinated notes, it is possible that as a result of changes in circumstances, IRS interpretations or the law or other facts that come to light after this offering (including facts indicating the inaccuracy of the representations given by the initial purchasers of the senior subordinated notes not in the form of EISs), we may need to establish an accrual for contingent tax liabilities associated with a potential disallowance of all or part of the interest deductions on the senior subordinated notes, although our present view is that no such accrual is necessary or appropriate. If we were required to maintain a material accrual, our income tax provision, and related income tax liability, could be materially impacted. As a result, our ability to make dividend payments on our common stock could be impaired, due to restrictions under the terms of our new credit facility, in the indenture governing our senior subordinated notes, in our franchise agreements with Wendy's or under applicable law, and the market price or liquidity for the EISs or Class A common stock could be adversely affected. If we subsequently issue senior subordinated notes with significant original issue discount, we may not be able to deduct all of the interest on those senior subordinated notes, which may adversely affect our cash flow available for interest payments and distributions to our equityholders. It is possible that the senior subordinated notes we issue in a subsequent issuance will be issued at a discount to their face value and, accordingly, may have "significant original issue discount" and thus be classified as "applicable high yield discount obligations," or AHYDOs. If any such senior subordinated notes were so treated, a portion of the original issue discount on such senior subordinated notes could be nondeductible by us and the remainder would be deductible only when paid. This treatment would have the effect of increasing our taxable income and may adversely affect our cash flow available for interest payments and distributions to our equityholders. The allocation of the purchase price of the EISs may not be respected, which may adversely affect your tax position. The purchase price of each EIS must be allocated between the share of Class A common stock and senior subordinated notes represented thereby in proportion to their respective fair market values at the time of purchase. We expect to report the initial fair market value of each share of Class A common stock as $7.65 and the initial fair market value of the principal amount of our senior subordinated notes as $7.35 and, by purchasing EISs, under the terms of the indenture, you will agree to and be bound by such allocation, assuming an initial public offering price of $15.00 per EIS, which represents the midpoint of the range set forth on the cover page of this prospectus. If this allocation is not respected, it is possible that the senior subordinated notes will be treated as having been issued with original issue discount (if the allocation to the senior subordinated notes were determined to be too high) or amortizable bond premium (if the allocation to the senior subordinated notes were determined to be too low). You generally would have to include original issue discount in income in advance of the receipt of cash attributable to that income. If the IRS successfully asserts that the senior subordinated notes have a fair market value greater than that which we allocate to such notes, it is possible that the senior subordinated notes will be treated as having amortizable bond premium. If the senior subordinated notes were treated as having amortizable bond premium, you would be able to elect to amortize bond premium over the term of the senior subordinated note. We intend to treat the acquisition of an EIS as an acquisition of the share of Class A common stock and the senior subordinated note represented by the EISs. However, there are no directly applicable legal authorities governing the issue of whether EISs will be treated for U.S. federal income tax purposes as the acquisition of a share of common stock and a separate debt instrument or whether EISs will instead be treated as an indivisible security that is solely an equity security. Consequently, our counsel is unable to opine definitely whether the EISs will be treated for U.S. federal income tax purposes as the acquisition of a share of common stock and a separate debt instrument, although counsel believes they should be so treated. For additional information on the U.S. federal income tax consequences if the EISs were treated as an indivisible equity security, see " Interest on the senior subordinated notes may not be deductible by us for U.S. federal income tax purposes, which could significantly reduce our future cash flow and impact our ability to make interest and dividend payments." Subsequent issuances of senior subordinated notes may cause you to recognize original issue discount and have other adverse consequences. The indenture governing our senior subordinated notes will provide that, in the event there is a subsequent issuance of senior subordinated notes with a new CUSIP number having terms that are substantially identical to the senior subordinated notes (or any issuance of senior subordinated notes thereafter), each holder of EISs or separately held senior subordinated notes (not in the form of EISs), as the case may be, agrees that a portion of such holder's senior subordinated notes will be automatically exchanged for a portion of the senior subordinated notes acquired by the holders of such subsequently issued senior subordinated notes. Consequently, immediately following each such subsequent issuance and exchange, each holder of senior subordinated notes, held either as part of EISs or separately, will own an inseparable unit composed of a proportionate percentage of senior subordinated notes of each separate issuance. Therefore, subsequent issuances of senior subordinated notes with original issue discount pursuant to an EIS offering by us or following exchange by our existing equity investors of Class B common stock for EISs may adversely affect your tax treatment by increasing the original issue discount, if any, that you were previously accruing with respect to your senior subordinated notes. Furthermore, due to the lack of applicable authority, it is unclear whether the exchange of senior subordinated notes for subsequently issued senior subordinated notes will result in a taxable exchange for U.S. federal income tax purposes and our counsel is not able to opine on this issue. It is possible that the IRS might successfully assert that such an exchange should be treated as a taxable exchange. Following any subsequent issuance of senior subordinated notes with original issue discount and exchange, we (and our agents) will report any original issue discount on the subsequently issued senior subordinated notes ratably among all holders of EISs and separately held senior subordinated notes, and each holder of EISs and separately held senior subordinated notes will, by purchasing EISs or senior subordinated notes, agree to report original issue discount in a manner consistent with this approach. However, the Internal Revenue Service may assert that any original issue discount should be reported only to the persons that initially acquired such subsequently issued senior subordinated notes (and their transferees) and thus may challenge the holders' reporting of OID on their tax returns. In such case, the Internal Revenue Service might further assert that, unless a holder can establish that it is not a person that initially acquired such subsequently issued senior subordinated notes (or a transferee thereof), all of the senior subordinated notes held by such holder have original issue discount. Any of these assertions by the Internal Revenue Service could create significant uncertainties in the pricing of EISs and senior subordinated notes and could adversely affect the market for EISs and senior subordinated notes. For a discussion of these and additional tax related risks, see "Material U.S. Federal Income Tax Consequences." Subsequent issuances of senior subordinated notes may adversely affect your treatment in a bankruptcy. The aggregate stated principal amount of the senior subordinated notes owned by each holder will not change as a result of such subsequent issuances of senior subordinated notes or exchanges into EISs. However, under New York and federal bankruptcy law, holders of subsequently issued senior subordinated notes having original issue discount may not be able to collect the portion of their principal face amount that represents unamortized original issue discount as at the acceleration or filing date in the event of an acceleration of the senior subordinated notes or a bankruptcy of DavCo Restaurants prior to the maturity date of the senior subordinated notes. As a result, an automatic exchange that results in a holder receiving a senior subordinated note with original issue discount could have the effect of ultimately reducing the amount such holder can recover from us in the event of an acceleration or bankruptcy. Before this offering, there has not been a public market for our EISs, Class A common stock or senior subordinated notes. The price of the EISs or separately held senior subordinated notes may fluctuate substantially, which could negatively affect EIS holders or holders of senior subordinated notes. None of our EISs, shares of common stock or senior subordinated notes has a relevant public market history. Our shares of common stock were publicly traded from August 13, 1993 to April 1, 1998 but have not publicly traded since that time. In addition, there has not been an active market in the United States for securities similar to the EISs. We cannot assure you that an active trading market for the EISs or our senior subordinated notes will develop in the future, and we currently do not expect that an active trading market for the shares of our Class A common stock will develop, if at all, which may cause the price of EISs to fluctuate substantially. If the senior subordinated notes represented by your EISs are redeemed or mature, the EISs will automatically separate and you will then hold the shares of our Class A common stock. We do not intend to list our senior subordinated notes on any securities exchange. Our Class A common stock initially will not be separately listed on the American Stock Exchange and, until a sufficient number of shares of our Class A common stock are held separately and not in the form of EISs as may be necessary to satisfy applicable listing requirements, we will not apply for such listing. If our senior subordinated notes and shares of our Class A common stock are not listed separately on any securities exchange, the trading market for these securities may be limited, which could adversely affect the trading price of these securities and your ability to transfer these securities. Even if the Class A common stock is listed for separate trading, an active trading market may not develop, or even if it develops, may not last, in which case the trading price of the Class A common stock could be adversely affected and your ability to transfer your shares will be limited. The initial public offering prices of the EISs and senior subordinated notes sold separately in this offering have been determined by negotiations among us, the existing equity investors and the representatives of the underwriters and may not be indicative of the market prices of the EISs and senior subordinated notes after this offering. Factors such as quarterly variations in our financial results, announcements by us or others, developments affecting us or the industry in which we operate, our customers and our suppliers, general interest rate levels and general market volatility could cause the market prices of the EISs and senior subordinated notes sold separately in this offering to fluctuate significantly. In addition, to the extent a market develops for shares of our Class A common stock or our senior subordinated notes, or both, separate from the EISs, the price of your EISs may be affected. The limited liquidity of the trading market for the senior subordinated notes sold separately (not represented by EISs) may adversely affect the trading price of the separate senior subordinated notes. We are separately selling $7.5 million aggregate principal amount of senior subordinated notes (not represented by EISs), representing approximately 10% of the total outstanding senior subordinated notes (including those senior subordinated notes represented by EISs and assuming the underwriters exercise their over-allotment option in full). While the senior subordinated notes sold separately (not represented by EISs) are part of the same series of notes as, and are identical to, the senior subordinated notes represented by the EISs, at the time of the issuance of the separate senior subordinated notes, the senior subordinated notes represented by the EISs will not be separable for at least 45 days and will not be separately tradeable until separated. As a result, the initial trading market for the senior subordinated notes sold separately (not represented by EISs) will be very limited. After the holders of the EISs are permitted to separate their EISs, a sufficient number of holders of EISs may not separate their EISs into shares of our Class A common stock and senior subordinated notes so that a sizable and more liquid trading market for the senior subordinated notes not represented by EISs may not develop or may not develop in a timely manner. Trading markets for debt securities have generally treated debt securities issued in larger aggregate principal amounts more favorably than similar securities issued in smaller aggregate principal amounts because of the increased liquidity created by potentially higher trading volumes associated with larger debt issuances. Given that approximately 90% of the senior subordinated notes will initially be represented by EISs, it is likely that the senior subordinated notes sold separately (not represented by EISs) will not trade at prices reflecting the aggregate principal amount of the combined issuance of senior subordinated notes included in the EIS offering and the separate senior subordinated notes offering. Therefore, a liquid market for the senior subordinated notes sold separately (not represented by EISs) may not develop or may not develop in a timely manner, which may adversely affect the ability of the holders of the separate senior subordinated notes to sell any of their separate senior subordinated notes and the price at which these holders would be able to sell any of the senior subordinated notes sold separately (not represented by EISs). Future sales or the possibility of future sales of a substantial amount of EISs, shares of our Class A common stock or our senior subordinated notes may depress the price of these securities. Future sales or the availability for sale of substantial amounts of EISs or shares of our Class A common stock or a significant principal amount of our senior subordinated notes in the public market could adversely affect the prevailing market price of the EISs, the shares of our Class A common stock and our senior subordinated notes, as applicable, and could impair our ability to raise capital through future sales of our securities. Beginning on the 366th day after the consummation of this offering, holders of shares of our Class B common stock will have certain rights to exchange their shares of our Class B common stock for EISs pursuant to the stockholders agreement. Until the second anniversary of the consummation of this offering, our franchise agreements with Wendy's will prohibit the management investors from exercising this exchange right with respect to all of their shares of our Class B common stock, and our stockholders agreement will restrict the holders of shares of our Class B common stock from exercising this exchange right if, following the exchange, the holders of shares of our Class B common stock would hold less than 1,250,860 shares of our Class B common stock, representing 10% of our common stock equity at the closing of this offering (or less than 1,135,578 shares assuming full exercise of the underwriters' over-allotment option). Any exchange is subject to the terms of our new credit facility, the indenture governing our senior subordinated notes and our franchise agreements with Wendy's. In addition, any issuance of EISs upon exchange must occur pursuant to an effective registration statement under the Securities Act. For a complete description of this exchange right and the terms of our Class A and Class B common stock, see "Related Party Transactions Amendment and Restatement of Stockholders Agreement" and "Description of Capital Stock." We may issue shares of our Class A common stock and senior subordinated notes, which may be in the form of EISs, or other securities from time to time as consideration for future acquisitions and investments. In the event any such acquisition or investment is significant, the number of shares of our Class A common stock and the aggregate principal amount of senior subordinated notes, which may be in the form of EISs, or the number or aggregate principal amount, as the case may be, of other securities that we may issue may in turn be significant. In addition, we may also grant registration rights covering those EISs, shares of our Class A common stock, senior subordinated notes or other securities in connection with any such acquisitions and investments. You may be required to sell your EISs or Class A common stock and may be deprived of an opportunity to obtain a takeover premium for your securities as a result of the 20% ownership limitations imposed on us by Wendy's. Our franchise agreements with Wendy's provide that, if at any time, any person or group acting together (other than the management investors) directly or indirectly owns, controls or exercises control or direction over or is the beneficial owner of more than 20% the total economic value of the total outstanding equity interests in our company or more than 20% of the total outstanding voting interests in our company and we do not within ten days of the date that we first have knowledge of such ownership or control, take steps as may be permitted under our amended and restated certificate of incorporation to reduce such interest to 20% or lower or if such ownership or control remains at more than a 20% of ownership level for more than 90 days after the date we first have knowledge of such ownership or control, such ownership or control shall constitute a default under the franchise agreements with Wendy's International. In such event, Wendy's International has, among other things, the right to terminate any and all of the franchise agreements or exercise its purchase option. Pursuant to our amended and restated certificate of incorporation, in the event that either of the foregoing limitations is or may be contravened, we may take such action with respect to such ownership level over the 20% ownership level as we deem advisable, including refusing to give effect thereto on the stock transfer books, instituting proceedings, redeeming such interest or requiring the sale of such interest in order to reduce the ownership level to or below a 20% ownership level. Upon taking any such action, the affected holders will cease to be holders of that portion of their interest over the 20% ownership level. For the purpose of the foregoing, the 20% ownership limitations will be applicable to holdings of outstanding shares of our Class A common stock, as components of EISs or held separately, as well as all other classes of our capital stock. Our amended and restated certificate of incorporation and amended and restated by-laws contain provisions that could result in adverse consequences to holders of our common stock. Our amended and restated certificate of incorporation authorizes the issuance of preferred stock and Class C common stock without stockholder approval and, in the case of the preferred stock, upon such terms applicable to the preferred stock as the board of directors may determine. The rights of the holders of shares of our common stock will be subject to, and may be adversely affected by, the rights of holders of any class or series of preferred stock that may be issued in the future. If interest rates rise, the trading value of our EISs and senior subordinated notes may decline. Should interest rates rise further or should the threat of rising interest rates continue to develop, debt markets may be adversely affected. As a result, the trading value of our EISs and senior subordinated notes may decline. Risks Related to our Business and Industry The competitive nature of the quick service restaurant market and the effect of fluctuating demographics and consumer trends may harm our business. The restaurant industry generally, and, the quick service restaurant market in particular, is intensely competitive with respect to price, service, location, type and quality of food and personnel. We compete with other well-established companies with extensive financial, technological, marketing and personnel resources and high brand name recognition and awareness. Some of those competitors have been in existence substantially longer than us, have substantially greater financial and other resources than us and have substantially more restaurants or may be better established in the markets where our restaurants are or may be located. McDonald's and Burger King restaurants are our principal competitors in the hamburger segment of the quick service restaurant market and both have substantially more restaurants in our exclusive franchise territory than we do. We also compete with other national and regional restaurant franchises and with non-franchise restaurants. Some of our quick service restaurant competitors have from time to time attempted to draw customer traffic through deep discounting. While we do not believe that this is a profitable long-term strategy, these changes in pricing and other marketing strategies have at times had, and in the future could have, a negative impact on our financial performance. The quick service restaurant market is also affected by changes in demographic trends, traffic patterns, and the type, number and proximity of competing quick service restaurants. In addition, factors such as inflation, increased food, labor and benefits costs, and the availability of experienced management and hourly-paid employees may also adversely affect the financial performance of the quick service restaurant industry in general and the financial performance of our restaurants in particular. Our success also depends on numerous factors affecting discretionary consumer spending, including economic conditions, disposable consumer income and consumer confidence. Adverse changes in these factors could reduce customer traffic or impose limits on pricing, either of which would negatively affect our financial performance. Public health concerns about the safety of beef products and our other menu items could adversely impact our financial performance. Certain events such as the recent report of bovine spongiform encephalopathy, also known as BSE or "mad cow disease," could reduce consumption of our beef products. For the fiscal year 2003, approximately 32% of our sales were derived from beef products. Until now, we have not experienced any decrease in sales that we can trace to public health concerns regarding "mad cow disease" or the safety of the nation's beef supply, however, there can be no assurances that we will not be adversely affected in the future. Changes in the regulation of the beef industry as a result of the discovery of "mad cow disease" in the U.S. may affect the supply of beef or significantly increase the price of beef, which may in turn have a material adverse impact on our financial performance. Other public health concerns about "foot/mouth disease," salmonella or avian flu in chicken also may reduce the consumption of our food products and adversely affect our financial performance. Changes in consumer preferences could adversely affect our financial performance. Our success depends, in part, upon the continued popularity of our hamburgers, chicken breast sandwiches, salads, chili, French fries and soft drinks. In recent years, numerous companies in the quick service restaurant industry have introduced food items positioned to capitalize on the growing consumer preference for food items that are, or are perceived to be, healthy, nutritious or low in calories, carbohydrates or fat content. Shifts in consumer preferences could be based on health concerns related to the cholesterol, carbohydrate or fat content of certain food items, including items featured on our menu. Negative publicity over the health aspects of such food items may adversely affect consumer demand for our menu items and could adversely affect our financial performance. We rely on the availability and quality of raw materials, which, if unavailable, may have a material adverse effect on our financial performance. Our financial performance is dependent on our continuing ability to offer fresh, premium quality food at competitive prices. Various factors beyond our control may affect the availability, quality and price of the raw materials such as fresh beef, chicken or bacon, used in our products. A significant reduction in the availability or quality of the raw materials purchased by us, or an increase in price that cannot be passed on to our customers could have a material adverse effect on our financial performance. We are highly dependent on Wendy's International and our success is tied to the success of Wendy's International. We are a franchisee of Wendy's International and are highly dependent on Wendy's International for our operations. Due to the nature of franchising and our agreements with Wendy's International, our success is, to a large extent, directly related to the success of the Wendy's International restaurant system, including the financial condition, management and marketing success of Wendy's International and the successful operation of Wendy's restaurants owned by other franchisees. In turn, the ability of the Wendy's system to compete effectively depends upon the success of the management of the Wendy's system by Wendy's International. There can be no assurance that Wendy's International will be able to compete effectively with other quick service restaurants. Under our franchise agreements with Wendy's International, we are required to comply with operational programs and standards established by Wendy's International. In particular, Wendy's (Unaudited) Operating activities Net (loss) income $ (18,152 ) $ 5,058 $ 2,735 $ 719 $ (3,291 ) Adjustments to reconcile net (loss) income to net cash provided by operating activities: Depreciation 4,020 3,646 3,676 2,832 2,741 Amortization of leased properties 2,729 2,616 2,866 2,044 2,274 Amortization of franchise rights 180 189 190 143 142 Amortization of goodwill 1,497 Net loss (gain) on disposal of assets held for sale and write-down of impaired long-lived assets 10,784 (757 ) (963 ) (181 ) (455 ) Amortization of deferred financing costs 731 1,497 1,536 1,152 1,152 Write-off of deferred offering and related costs 6,041 Net loss on disposition of fixed assets 2,035 54 55 94 Deferred income taxes 734 307 307 Other 122 Changes in operating assets and liabilities: Receivables 297 99 (420 ) 357 588 Inventories 138 259 34 (42 ) (18 ) Income tax receivable 77 (1,958 ) 1,958 1,958 Prepaid expenses and other assets (192 ) (329 ) 74 658 879 Accounts payable and other accrued expenses 4,119 (76 ) (376 ) (2,321 ) 149 Accrued advertising and royalty fees 2 472 777 800 172 Accrued salaries and wages 17 1,654 International maintains discretion over the menu items that we can offer in our restaurants. We may be under market pressure to adopt price discount promotions that may be unprofitable. We are also required to pay Wendy's International a technical assistance fee upon the opening of each new restaurant, a monthly royalty and a national advertising fee. If we fail to comply with any of the agreements that govern our relationship with Wendy's International for restaurants within our exclusive franchise territory, Wendy's International could terminate the exclusive nature of our franchise rights in such territory or the franchise rights for the restaurant governed by the new unit franchise agreement. The termination of the exclusive nature of our franchise rights in such territory or of franchise rights for the restaurant governed by the new unit franchise agreement could have a material and adverse impact on our operations and would have a material and adverse impact on our future development plans. Wendy's International must approve our opening of any new restaurant, including restaurants opened within our exclusive franchise territory, and the closing of any of our existing restaurants. Wendy's International has a right of first refusal to acquire existing Wendy's restaurants which we may seek to acquire. Although Wendy's International has historically granted its approval for most of our acquisition requests, we cannot be assured that they will continue to do so. Upon their expiration, we may renew the new unit franchise agreements for additional periods equal to the term in Wendy's International's standard form of franchise agreement being executed by other franchisees renewing their franchises on the renewal date, provided that, among other things, we are not in default under any of the franchise agreements, we are up to date on our payments to Wendy's International and we pay a renewal fee. The terms of the new unit franchise agreements are renegotiated upon renewal and we cannot be assured that we will successfully negotiate the terms of the renewal with Wendy's International or that the terms of the new unit franchise agreements we negotiate upon renewal will not differ materially from those in effect during the initial term. See "Business Relationship with Wendy's International." Wendy's International is not selling, offering for sale nor underwriting all or any part of this offering. Wendy's International is not receiving the proceeds of this offering. Wendy's International does not endorse or make any recommendations with respect to this offering or the EISs offered hereby. Wendy's International is not an obligor under the senior subordinated notes which are part of this offering and has no obligation with respect to the payment of principal or interest under the senior subordinated notes. If we fail to comply with the terms of our development agreement or other agreements with Wendy's International, Wendy's International has the right, among other things, to terminate our franchise agreements or exercise its remedies under leasehold mortgages we have granted to Wendy's to secure our obligations under the franchise agreements. Under our development letter with Wendy's International relating to our exclusive franchise territory, we commit to operate a total of 240 restaurants in our franchise territory by December 31, 2015. Should we fail to comply with the development letter or default under any franchise agreement or any other agreement with Wendy's International, its affiliates or its advertising co-operative, or the material provisions of its restaurant supply agreements, Wendy's International could, among other things, terminate the development letter and the exclusive nature of our franchises in our franchise territory. The termination of the exclusive nature of our franchise rights in our territory or the franchise rights for any of our restaurants governed by the new unit franchise agreements could have a material and adverse impact on our operations and our future development plans. See "Business Relationship with Wendy's International." In addition, we have agreed to secure our obligations under the franchise agreements by granting Wendy's International continuing first priority leasehold mortgages on a limited number of our Allocated to Class A common stock $ 4,959 $ (687 ) Allocated to Class B common stock 2,141 restaurants with a value in the aggregate of not less than $10 million. This value is based on a multiple of EBITDA for our most recently completed fiscal year attributable to the restaurants subject to such leasehold mortgages. In the event that we are in default under our franchise agreements and Wendy's or its designees determines to succeed to the leasehold interests pursuant to the leasehold mortgages, Wendy's or its designees will have the right to operate these restaurants. See "Business Relationship with Wendy's International Operating Requirements of Wendy's International Security for our obligations." Finally, Wendy's International is entitled to a right of first refusal, a purchase option and a right of consent in respect of certain transactions described in "Business Relationship with Wendy's International Ownership and Other Requirements of Wendy's International." These entitlements may restrict our ability to undertake certain transactions. We face substantial risks with regard to our plans for growth and development. We intend to grow our business by opening new Wendy's restaurants. Our development letter with Wendy's International requires us to open or commence construction of a prescribed minimum number of restaurants in each year through 2015, and to operate a total of 240 restaurants in our franchise territory by December 31, 2015. Although we currently have no plans to explore other restaurant concepts, subject to obtaining Wendy's prior consent, we may do so in the future. Our growth and development plans involve substantial risks, including the following: our inability to obtain the necessary approvals of Wendy's International; our inability to obtain or self-fund adequate development financing; that our development costs may exceed budgeted amounts; the unavailability of suitable sites; our inability to obtain suitable sites on acceptable lease or purchase terms; our inability to obtain all necessary zoning, construction and other permits; our inability to adequately supervise construction and delays in completion of construction; the incurrence of substantial unrecoverable costs in the event we abandon a development project prior to completion; our inability to recruit, train and retain managers and other employees necessary to staff each new restaurant; that new restaurants may not perform in accordance with targeted sales or cash flow levels or match the performance of our other restaurants; that new restaurants may result in reduced sales at our existing restaurants near newly opened restaurants; changes in governmental rules, regulations and interpretations; and changes in general economic and business conditions. We cannot assure that our growth and development plans can be achieved. If the management investors fail to hold a prescribed interest in us, Wendy's International has the right to, among other things, terminate our franchise agreements. The franchise agreements with Wendy's International require that as of, and at all times following, the closing of this offering, the management investors who, immediately after the recapitalization will be Ronald D. Kirstien, Harvey Rothstein, David J. Norman, Joseph F. Cunnane, III and Richard H. Borchers, own, in the aggregate and free and clear of liens, encumbrances or other restrictions, a prescribed interest in our company. Until the second anniversary of the closing of this offering, the management investors are required to own not less than 10% of the total economic value of the total outstanding equity interests and not less than 10% of the total outstanding voting interests in our company, determined at the closing of this offering. After the second anniversary of the closing of this offering, the management investors are required to own not less than 10% of the outstanding total economic value of the total outstanding equity interests and not less than 10% of the total outstanding voting interests determined at that time. If the management investors' interest level changes solely as a result of the exchange by one or more of the management investors of their shares of our Class B common stock for EISs after the second anniversary of the closing of this offering, the management investors may own less than such 10% interest provided that Citicorp Venture Capital, together with the management investors, own not less than such 10% interest and provided further that the management investors own not less than the greater of the initial 10% interest determined at the closing of this offering or 5% of the total outstanding economic value of the total outstanding equity interests and not less than 5% of the total outstanding voting interests determined at that time. The franchise agreements also impose restrictions on transfer of the interest in our company held by the management investors, and in certain circumstances, provide Wendy's International with a right to consent and a right of first refusal on proposed transfers of such interest. If the management investors fail to hold the prescribed interest, directly or indirectly, in our company, Wendy's International is entitled, among other things, to terminate the franchise agreements. See "Business Relationship with Wendy's International Ownership and Other Requirements of Wendy's International Ownership requirements for management investors." Wendy's International has certain rights of first refusal, purchase rights and consent rights in connection with a change in our ownership, transfers of assets, future offerings of EISs and other securities and certain other events affecting the EISs. Pursuant to the franchise agreements, Wendy's International also has, subject to certain exceptions, a right of first refusal to acquire the interests or assets proposed to be transferred or issued and a right to consent to any such transfer, including on: a proposed transfer by us of any ownership or equity interest in our operating subsidiary, DavCo Operations; a proposed transfer of any portion of the shares of our common stock owned by the management investors; a proposed issuance of securities in any public or private sale of any ownership or equity interest in DavCo Restaurants (other than this offering, as to which Wendy's has consented) or DavCo Operations; a proposed transfer of one or more Wendy's restaurants or any of the franchise agreements; or a proposed direct or indirect transfer of all or substantially all of the Wendy's business or the assets of the Wendy's business or of any part of the Wendy's business or assets such that the assets proposed to be transferred comprise all or substantially all of the assets of one or more Wendy's restaurants; except that, after this offering, this right of first refusal will not be applicable to, among other things, a transfer of outstanding EISs (and the shares of Class A common stock and senior subordinated notes outstanding upon any future separation of any EISs), shares of Class A common stock and/or senior subordinated notes. Failure to comply with the right of first refusal constitutes a default under the franchise agreements, permitting Wendy's International to, among other things, terminate such agreements, as well as to exercise its purchase option. The franchise agreements provide Wendy's International with an option to purchase: (i) all of the equity interests in DavCo Operations; and/or (ii) all of the assets of DavCo Restaurants and all of the assets of DavCo Operations relating to the business, ownership and operation of Wendy's restaurants, at fair market value in the event that, among other things: our company transfers, permits the transfer or suffers a transfer of any direct or indirect interest in DavCo Restaurants or DavCo Operations in violation of any terms and conditions of any right of first refusal held by Wendy's International; any transfer of any direct or indirect interest by or in our company or DavCo Operations in violation of the consent requirements of Wendy's International occurs; any transfer pursuant to, or demand for payment made under, any guarantee by DavCo Restaurants or DavCo Operations, including the guarantee of the senior subordinated notes occurs; any person or group acting together (other than the management investors and Citicorp Venture Capital) acquires more than 20% of the total economic value of the total outstanding equity interests or more than 20% of the total outstanding voting interests in our company in violation of the terms of Wendy's consent; or the terms of the indenture governing our senior subordinated notes are amended in a manner which would be in violation or inconsistent with the provisions of Wendy's consent without the prior written consent of Wendy's International. See "Business Relationship with Wendy's International Ownership and Other Requirements of Wendy's International." We are required to obtain Wendy's consent for certain future public or private offerings of our securities which may affect our ability to raise capital. If, solely as a result of the dilutive effects of the issuance of shares of our Class A common stock or EISs in a proposed follow-on offering, the management investors would own less than 10% of the total economic value of the total outstanding equity interests or total outstanding voting interests in our company, the franchise agreements provide that such reduction in ownership requires the prior consent of Wendy's. As a condition of such consent, Wendy's may require that the management investors own, after giving effect to the proposed follow-on offering, not less than a prescribed interest in our company and that at all times following the second anniversary of the closing of the follow-on offering, the management investors own, together with the holdings of Citicorp Venture Capital, no less than 10% of the total economic value of the total outstanding equity interests or total outstanding voting interests in our company. We are not required to obtain Wendy's consent for future public or private offerings of our senior subordinated notes. Except as described above, Wendy's International has agreed that its right of first refusal will not apply and, subject to the fulfillment of certain conditions (including the condition that subsequent offerings will not materially and adversely affect the rights of Wendy's International under the franchise agreements), its consent will not be required should we undertake offerings of shares of our Class A common stock or EISs to the public in the United States (which offerings may include private placements of shares of our Class A common stock or EISs in the United States in accordance with Rule 144A of the Securities Act) which are consummated not later than December 31, 2015 and all of the net proceeds of which are used in connection with the Wendy's business. The requirement to obtain Wendy's prior consent to certain follow-on offerings of our Class A common stock or EISs and the requirement that the management investors own not less than a prescribed interest in our company may affect our ability to effect follow-on offerings to raise capital. Changes in geographic concentration and regional conditions may negatively impact our operations. All of our restaurants are located in the same region. As a result, a severe or prolonged economic recession or changes in demographic mix, employment levels, population density, weather patterns, real estate market conditions or other factors unique to our geographic region may adversely affect us more than some of our competitors that are more geographically diverse. Increased costs beyond our control may negatively affect our operations and have a material adverse affect on our financial performance. Our labor costs are substantial and we may not be able to offset increased labor costs with increased sales. Our operations are subject to federal and/or state minimum wage laws governing matters such as working conditions and overtime. Significant numbers of our restaurant employees are paid at rates related to the minimum wage and, accordingly, further increases in the minimum wage or mandatory health insurance coverage requirements could increase our labor costs and adversely affect our financial performance. Our success depends on a number of key personnel, the loss of whom could have an adverse effect on our financial performance. Our success depends on the personal efforts of a small group of skilled employees and experienced senior management. Although we believe we will be able to replace key employees within a reasonable time should the need arise, the loss of key personnel could have a material short-term adverse effect on our financial performance. We believe that it would be difficult to replace members of the senior management team with individuals having comparable experience. Consequently, the loss of the services of any member of the senior management team could have a material adverse effect on our financial performance. In addition, under our franchise agreements with Wendy's International, Ronald D. Kirstien, our President and Chief Executive Officer, Harvey Rothstein, our Senior Executive Vice President, and Joseph F. Cunnane, III, our Executive Vice President of Operations, have each been designated by Wendy's International as the individuals responsible for the development and management of our restaurants. If Mr. Kirstien, Mr. Rothstein or Mr. Cunnane (or any other successor approved by Wendy's International) leaves us, any replacement operator must first be approved by Wendy's International. There can be no assurance that Wendy's International will approve the replacement operator we propose. See "Business Relationship with Wendy's International." We may experience labor shortages which may affect the quality level of customer service and lead to reduced customer traffic which could have an adverse effect on our financial performance. In times of high demand for employees, such as during the period of robust economic growth in the U.S. in 2000 and 2001, we experienced labor shortages. A labor shortage may affect the quality level of customer service and lead to reduced customer traffic and can adversely affect our financial performance. There can be no assurance we will not experience labor shortages in the future. We are subject to government regulation and changes to those regulations may affect our operations. We are subject to various federal, state and local laws affecting our business. See "Business Government Regulation." The laws that affect our business include those relating to the preparation and sale of food, employment and discrimination, zoning, building restrictions, and design and operation of our restaurants. Difficulties obtaining or failure to obtain the required licenses or approvals could delay or prevent our development of new restaurants in a particular area and have an adverse impact on our operations and future development plans. We may be subject to significant environmental liabilities. In certain cases, we have agreed to indemnify the purchasers of our former properties for liabilities arising thereon or have agreed to remain liable for certain potential liabilities that were not assumed by the purchaser. Environmental contamination of soil and groundwater by petroleum constituents have been identified at eight properties we currently or formerly operated, although we believe further remedial action will not be required at these properties. Several additional restaurant properties had previous petroleum distribution or industrial uses which may have resulted in contamination, and the prior uses and potential for contamination at a number of additional restaurant properties are unknown. We were one of several defendants in two related lawsuits filed in federal and state court in Missouri in 1995 seeking recovery of petroleum cleanup costs at a former gasoline service station property that we leased in St. Charles, Missouri. The lawsuit was dismissed without prejudice in May 2002 but can be re-filed. Although no specified amount of damages was sought, based on our understanding of the claims in the lawsuits, the total estimated damages would have been expected to be less than $100,000 and the damages sought would be proportionate to the number of the defendants in the chain of title prior to the plaintiffs for restitution of legal and remediation expenses. The parties recently entered into an extension of their standstill agreement to facilitate a potential resolution of the cleanup costs and a determination to what extent such costs would be reimbursed by the state Petroleum Storage Tank Insurance Fund, which the parties believe may pay all or a substantial portion of the cleanup costs. Potential litigation resulting in a significant judgment and/or adverse publicity could have a material adverse affect on our performance. We may be subject to complaints, regulatory proceedings or litigation from customers or other persons alleging food-related illness, injuries suffered on our premises or other food quality, health or operational concerns, including improper handling and preparation in food items and environmental claims. Adverse publicity resulting from such allegations or alleged discrimination or other operating issues stemming from one Wendy's location or a limited number of Wendy's locations could adversely affect our business, regardless of whether the allegations are true, or whether or not our company or another Wendy's restaurant franchisee is ultimately held liable. A significant judgment against us could have a material adverse effect on our financial performance.
\ No newline at end of file
diff --git a/parsed_sections/risk_factors/2004/CIK0001282582_first_risk_factors.txt b/parsed_sections/risk_factors/2004/CIK0001282582_first_risk_factors.txt
new file mode 100644
index 0000000000000000000000000000000000000000..ac47b6fae800ada32af5dce3c94f592ff93596db
--- /dev/null
+++ b/parsed_sections/risk_factors/2004/CIK0001282582_first_risk_factors.txt
@@ -0,0 +1,15640 @@
+risks. See Risk Factors beginning on
+page 7.
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ 
+ 
+ Per Share
+ 
+ Total
+
+ 
+ 
+ 
+ 
+ 
+
+ 
+ 
+ Public offering price
+
+ 
+ 
+ $
+ 
+ 
+ 
+ $
+ 
+ 
+
+ 
+ 
+ Underwriting discount
+
+ 
+ 
+ $
+ 
+ 
+ 
+ $
+ 
+ 
+
+ 
+ 
+ Proceeds to us, before expenses
+
+ 
+ 
+ $
+ 
+ 
+ 
+ $
+ 
+ 
+
+ The common stock
+does not represent a deposit account or other obligation of our
+banking subsidiary. The common stock is not and will not be
+insured by the Federal Deposit Insurance Corporation or any
+other government agency.
+
+ Neither the
+Securities and Exchange Commission nor any state securities
+commission has approved or disapproved of these securities or
+determined if this prospectus is truthful or complete. Any
+representation to the contrary is a criminal offense.
+
+ The underwriters
+are underwriting our shares on a firm commitment basis. We have
+granted the underwriters an option to purchase up to
+319,125 additional shares of common stock to cover
+over-allotments, if any. The underwriters can exercise this
+option at any time within 30 days after the offering.
+
+ The underwriters
+expect to deliver the shares to purchasers, against payment in
+New York, New York on or about , 2004, subject to customary
+closing conditions.
+
+Advest, Inc.
+
+The date of this prospectus
+is ,
+2004
+
+TABLE OF CONTENTS
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ABOUT THIS PROSPECTUS
+
+SUMMARY
+
+Selected Consolidated Financial Data
+
+RISK FACTORS
+
+CAUTIONARY NOTE CONCERNING FORWARD-LOOKING STATEMENTS
+
+USE OF PROCEEDS
+
+CAPITALIZATION
+
+MANAGEMENT TEAM
+
+INFORMATION ABOUT OUR MARKETS
+
+MARKET FOR OUR COMMON STOCK
+
+DIVIDEND POLICY
+
+DILUTION
+
+MANAGEMENT S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION
+
+ BUSINESS
+
+MANAGEMENT
+
+ BENEFICIAL OWNERSHIP OF MANAGEMENT AND PRINCIPAL SHAREHOLDERS
+
+DESCRIPTION OF CAPITAL STOCK
+
+SUPERVISION AND REGULATION
+
+SHARES ELIGIBLE FOR FUTURE SALE
+
+UNDERWRITING
+
+CHANGE OF ACCOUNTANTS
+
+LEGAL MATTERS
+
+EXPERTS
+
+WHERE YOU MAY FIND ADDITIONAL INFORMATION
+
+CONSOLIDATED BALANCE SHEETS
+
+CONSOLIDATED STATEMENTS OF INCOME
+
+ CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS EQUITY
+
+ CONSOLIDATED STATEMENTS OF CASH FLOWS
+
+ NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
+
+REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
+
+CONSOLIDATED BALANCE SHEETS
+
+CONSOLIDATED STATEMENTS OF INCOME
+
+CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS EQUITY
+
+CONSOLIDATED STATEMENTS OF CASH FLOWS
+
+NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
+
+PART II
+
+Item 13. Other Expenses of Issuance and Distribution
+
+Item 14. Indemnification of Directors and Officers
+
+Item 15. Recent Sales of Unregistered Securities
+
+Item 16. Exhibits
+
+Item 17. Undertakings
+
+SIGNATURES
+
+INDEX TO EXHIBITS
+
+Ex-23.1: Consent of Crowe Chizek and Company LLC
+
+Table of Contents
+
+ Graphic of map to be inserted here. This map will consist of a map of Florida,
+
+as well as a magnification of the West Central region, showing the
+
+locations of the Company and of First State Bank s branches. 
+
+ABOUT THIS PROSPECTUS
+
+ You should rely only on the information contained in this document or any
+other document to which we refer you. We have not authorized anyone to provide
+you with information that is different. This document may only be used where
+it is legal to sell these securities.
+
+ Certain persons participating in this offering may engage in transactions
+that stabilize, maintain or otherwise affect the price of our common stock.
+Specifically, the underwriter may over-allot in connection with the offering
+and may bid for, and purchase, shares of our common stock in the open market
+and impose penalty bids. For a description of these activities, see
+ Underwriting. Such stabilizing transactions, if commenced, may be
+discontinued at any time.
+
+ 
+
+Table of Contents
+
+SUMMARY
+
+ This summary only highlights the more detailed information appearing
+elsewhere in this prospectus or incorporated in this prospectus by reference.
+As this is a summary, it may not contain all information that is important to
+you.
+
+ As used in this prospectus, the terms we, us, our, First State
+Financial, and Company mean First State Financial Corporation and its
+subsidiary (unless the context indicates another meaning), the term Bank and
+ First State Bank means First State Bank (unless the context indicates another
+meaning), and the term common stock means our common stock, par value $1.00
+per share.
+
+Introduction
+
+ We are
+offering 2,127,500 shares of our common stock, not including a
+30-day over-allotment option for 319,125 shares which we have granted to the
+underwriters. All of the shares are being offered by us, and not by any of our
+shareholders. The purpose of this offering is to repay amounts outstanding
+under our $4.0 million line of credit, and also to increase our capital as well
+as that of First State Bank in order to support its continued loan and deposit
+growth. Any remaining proceeds will be used by us for general corporate
+purposes.
+
+Our Company
+
+ We are a Florida bank holding company whose business is conducted through
+our sole subsidiary, First State Bank, Sarasota, Florida. The Bank, which
+commenced operations in October 1988, is engaged in a general commercial
+banking business and our primary source of earnings is derived from income
+generated by the Bank. The mission of the Bank is to provide high quality
+financial products with personalized customer service.
+
+ The Bank has its main office in Sarasota, Florida and five branch offices,
+two located in Sarasota, two located in St. Petersburg, and one located in
+Seminole, Florida. As of September 30, 2004, the Company had total consolidated
+assets of $243 million, net total loans of $210 million, deposits of $205
+million, and stockholders equity of $14.5 million. For the first nine months
+of 2004, we earned $1.4 million, more than triple the $433 thousand we earned
+for the same period in 2003. The increase in profitability was primarily due
+to a much stronger rise in net interest income of $1.7 million or 36.7% than
+in non-interest expense of $621,000 or 15.1% over the same nine-month periods
+in 2003 and 2004.
+
+ In July 2002, Corey J. Couglin was hired as President and Chief Executive
+Officer of First State Financial and First State Bank. After numerous board
+and management changes over the prior two years, he brought much needed
+stability to senior management and a well defined strategic direction. The
+most significant change since President and CEO Coughlin joined, is that the
+employees operating in diverse markets, Sarasota and Pinellas counties, now
+work together to accomplish our strategic goals. Our current operating model
+has the advantages of local marketing and decision making with the strength of
+central financial controls and corporate guidance. The ability to operate and
+effectively manage in multiple markets should serve us well as we expand into
+new markets in Sarasota County and the Tampa Bay region.
+
+ We have experienced significant asset growth since the management changes
+in the first half of 2002. From September 30, 2002 to September 30, 2004,
+assets have grown by $88 million or 56.6% and net loans have grown by $92
+million or 78.8%. Due to the strong loan growth, First State Financial and
+First State Bank have had difficulty maintaining a level of regulatory capital
+to be considered well capitalized. At September 30, 2004, First State
+Financial and First State Bank were only adequately capitalized for
+regulatory purposes. The objective of this offering is to provide adequate
+capital for our continued growth while maintaining regulatory capital for First
+State Financial and First State Bank to be considered well capitalized. 
+Maintaining well capitalized regulatory capital will allow us to apply to
+become a financial holding company, which will expand the range of financial
+activities in which we may
+
+1
+
+Table of Contents
+
+engage. While we intend to continue pursuing our
+core banking business and do not have any current plans to expand the range of
+activities in which we engage, financial holding company status would expand
+the financial alternatives that we could pursue.
+
+ The changes in management and operating structure are best reflected in
+the improvement in operating results of the Company as shown below:
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ 
+ 
+ At and For the
+ 
+ 
+
+ 
+ 
+ Nine Months Ended September 30,
+ 
+ % Change From
+
+ (dollars in thousands)
+ 
+ 2004
+ 
+ 2003
+ 
+ 2002
+ 
+ 03-04
+ 
+ 02-04
+
+ Assets
+
+ 
+ $
+ 243,064
+ 
+ 
+ $
+ 195,538
+ 
+ 
+ $
+ 155,176
+ 
+ 
+ 
+ 24.3
+ %
+ 
+ 
+ 56.6
+ %
+
+ Net Loans
+
+ 
+ 
+ 209,656
+ 
+ 
+ 
+ 161,742
+ 
+ 
+ 
+ 117,249
+ 
+ 
+ 
+ 29.6
+ %
+ 
+ 
+ 78.8
+ %
+
+ Deposits
+
+ 
+ 
+ 205,318
+ 
+ 
+ 
+ 168,449
+ 
+ 
+ 
+ 139,740
+ 
+ 
+ 
+ 21.9
+ %
+ 
+ 
+ 46.9
+ %
+
+ Shareholders Equity
+
+ 
+ 
+ 14,460
+ 
+ 
+ 
+ 10,684
+ 
+ 
+ 
+ 10,241
+ 
+ 
+ 
+ 35.3
+ %
+ 
+ 
+ 41.2
+ %
+
+ Net Interest Income
+
+ 
+ 
+ 6,466
+ 
+ 
+ 
+ 4,730
+ 
+ 
+ 
+ 3,410
+ 
+ 
+ 
+ 36.7
+ %
+ 
+ 
+ 89.6
+ %
+
+ Non-Interest Income
+
+ 
+ 
+ 1,132
+ 
+ 
+ 
+ 808
+ 
+ 
+ 
+ 546
+ 
+ 
+ 
+ 40.1
+ %
+ 
+ 
+ 107.3
+ %
+
+ Non-Interest Expense
+
+ 
+ 
+ 4,731
+ 
+ 
+ 
+ 4,110
+ 
+ 
+ 
+ 3,153
+ 
+ 
+ 
+ 15.1
+ %
+ 
+ 
+ 50.0
+ %
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Income before Provision for Loan
+Losses and Income Taxes
+
+ 
+ 
+ 2,867
+ 
+ 
+ 
+ 1,428
+ 
+ 
+ 
+ 803
+ 
+ 
+ 
+ 100.8
+ %
+ 
+ 
+ 257.0
+ %
+
+ Provision for Loan Losses
+
+ 
+ 
+ 518
+ 
+ 
+ 
+ 696
+ 
+ 
+ 
+ 129
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Income before Income Taxes
+
+ 
+ 
+ 2,349
+ 
+ 
+ 
+ 732
+ 
+ 
+ 
+ 674
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Net Income
+
+ 
+ 
+ 1,438
+ 
+ 
+ 
+ 433
+ 
+ 
+ 
+ 400
+ 
+ 
+ 
+ 232.1
+ %
+ 
+ 
+ 259.5
+ %
+
+ Return on Average Assets
+
+ 
+ 
+ 0.85
+ %
+ 
+ 
+ 0.33
+ %
+ 
+ 
+ 0.34
+ %
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Return on Average Equity
+
+ 
+ 
+ 13.61
+ %
+ 
+ 
+ 5.37
+ %
+ 
+ 
+ 5.36
+ %
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Allowance for Loan Losses to
+Total Loans
+
+ 
+ 
+ 1.26
+ %
+ 
+ 
+ 1.26
+ %
+ 
+ 
+ 1.25
+ %
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Nonperforming Loans to Total
+Loans
+
+ 
+ 
+ 0.43
+ %
+ 
+ 
+ 0.50
+ %
+ 
+ 
+ 0.84
+ %
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Net Charge-offs to Average Loans
+
+ 
+ 
+ 0.05
+ %
+ 
+ 
+ 0.22
+ %
+ 
+ 
+ 0.03
+ %
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+Our Strategy
+
+ We plan to capitalize on the opportunities created by the consolidation
+that has taken place in the banking industry in Florida in recent years. We
+believe that the consolidation has reduced the levels of personalized services.
+In addition, the national and regional financial institutions that dominate the
+banking industry in Florida have increasingly focused on larger corporate
+customers, standardized loan and deposit
+products and other services. More specifically, many financial
+institutions have centralized their loan approval practices for small
+businesses. A frequent customer complaint in the banking industry is the lack
+of personalized service and turnover in personnel, which limits the customer s
+ability to develop a relationship with his or her banker. As a result of these
+factors, we believe there currently exists a significant opportunity to attract
+and retain customers who are dissatisfied with their current banking
+relationships.
+
+ We place emphasis on relationship banking so that each customer can
+identify and establish a comfort level with our bank officers and staff. We
+operate our offices as a community bank with sales oriented branch managers and
+staff, emphasizing local leadership and decision-making. Our goal is for each
+of our offices to be the consistent, high service bank for businesses,
+professionals and individuals looking for a more responsive banking
+environment. We seek to build our deposit base and loan portfolio through
+service-oriented relationship banking.
+
+2
+
+Table of Contents
+
+ We have targeted growth markets in West Central Florida that are large,
+centralized markets where a community-based bank can have significant growth
+with a limited number of branch locations. Our investment in operations and
+personnel at the corporate level in Sarasota can provide valuable support to
+these offices in markets throughout West Central Florida.
+
+Market Focus
+
+ Our market focus is to operate as a profitable commercial banking company
+providing a variety of banking and other financial services, with an emphasis
+on commercial business loans to small and medium-sized businesses and consumer
+and residential mortgage lending. We emphasize comprehensive retail and
+business products and responsive, decentralized decision-making which reflects
+our knowledge of our local markets and customers. We offer a wide range of
+commercial and retail banking and financial services to businesses and
+individuals.
+
+ To continue asset growth and profitability, our marketing strategy is
+targeted to:
+
+ 
+ 
+ Provide customers with access to our local executives who
+make key credit and other decisions;
+
+ 
+
+ 
+ 
+ Pursue commercial lending opportunities with small to
+mid-sized businesses that are underserved by our larger competitors;
+
+ 
+
+ 
+ 
+ Develop new products and services to generate additional
+sources of revenue;
+
+ 
+
+ 
+ 
+ Cross-sell our products and services to our existing
+customers to leverage our relationships and enhance profitability;
+and
+
+ 
+
+ 
+ 
+ Adhere to our safe and sound credit standards to maintain the
+continued quality of assets as we implement our growth strategy.
+
+Future Growth
+
+ The bank holding company structure provides flexibility for the future
+expansion of our banking
+business through the possible acquisition of other financial institutions.
+We will pursue financial institutions that will supplement our services to our
+existing customer base or expand our customer base in our markets. The plan is
+also to target capital-constrained community banks with strong management and
+boards of directors where the advantages of our corporate structure and access
+to public capital markets would be viewed favorably. At the current time,
+however, we do not have any agreements or understandings for the acquisition of
+any other financial institutions. The acquisition of any banks will be subject
+to regulatory approvals and other requirements. See Supervision and
+Regulation. 
+
+ In addition to the growth and integration of our current operations in our
+existing markets, we may pursue the acquisition of branch sites that become
+available in markets we are trying to penetrate. Due to the continued
+consolidation in the banking industry, we believe that opportunities for
+acquisition of branch sites will be available. We are currently considering
+other locations in Sarasota and Pinellas Counties, as well as Hillsborough,
+Pasco, Manatee and Charlotte counties. Recent banking consolidation may also
+allow the opportunity to acquire closed branches of larger bank holding
+companies within our market. We will actively pursue the acquisition of select
+attractive locations in key markets.
+
+Recent Developments
+
+ On February 6, 2004, we completed a private offering of 300,000 shares of
+our common stock, at a price of $6.25 per share for a total of $1,875,000
+before deducting expenses of the offering of approximately $25,000. The
+offering price of $6.25 per share had been established by the Board of
+Directors of the Company and is not based on any trading price of the Common
+Stock. The shares were
+
+3
+
+Table of Contents
+
+sold to accredited investors, consisting primarily of
+directors, officers and local residents.
+
+Risk Factors
+
+ Before investing, you should carefully consider the information in the
+ Risk Factors Section.
+
+Our Address and Telephone Number
+
+ Our corporate headquarters is located at 22 South Links Avenue, Sarasota,
+Florida 34236 and our telephone number is (941) 929-9000. First State Bank
+maintains a website at www.firststatefl.com. Information on our website should
+not be considered as part of this prospectus.
+
+The Offering
+
+ 
+ 
+ 
+
+ Common Stock Offered
+
+ 
+ 2,127,500 shares of common stock not including the over allotment
+option for 319,125 shares.
+
+ 
+
+ 
+ 
+
+ Price of Common Stock
+
+ 
+
+$ per share.
+
+ 
+
+ 
+ 
+
+ Shares Outstanding
+
+ After the Offering
+
+ 
+ 5,526,540 shares, assuming no exercise of over-allotment option.
+
+ 
+
+ 
+ 
+
+ Use of Proceeds
+
+ 
+ The net proceeds in this offering
+are expected to be $ million. We
+intend to use the proceeds to repay the amounts outstanding under
+our line of credit up to $4.0 million, and to strengthen the
+capital levels of our banking subsidiary, and for general working
+capital purposes.
+
+ 
+
+ 
+ 
+
+ Proposed Nasdaq Symbol
+
+ 
+ FSTF
+
+4
+
+Table of Contents
+
+Selected Consolidated Financial Data
+
+ You should read the following selected consolidated financial data with
+our consolidated financial statements and notes, and Management s Discussion
+and Analysis of Financial Condition and Results of Operations appearing
+elsewhere in this prospectus. The results for past and interim periods are not
+necessarily indicative of results that may be expected for any future period.
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ 
+ 
+ At and For the Nine
+ 
+ 
+
+ 
+ 
+ Months Ended September 30,
+ 
+ At and For the Year Ended December 31,
+
+ (dollars in thousands except per share data)
+ 
+ 2004
+ 
+ 2003
+ 
+ 2003
+ 
+ 2002
+ 
+ 2001
+ 
+ 2000
+ 
+ 1999
+
+ Statement of Income Data: (2)
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Interest and dividend income
+
+ 
+ $
+ 10,026
+ 
+ 
+ $
+ 7,797
+ 
+ 
+ $
+ 10,898
+ 
+ 
+ $
+ 9,136
+ 
+ 
+ $
+ 9,103
+ 
+ 
+ $
+ 9,407
+ 
+ 
+ $
+ 8,278
+ 
+
+ Interest expense
+
+ 
+ 
+ 3,560
+ 
+ 
+ 
+ 3,067
+ 
+ 
+ 
+ 4,139
+ 
+ 
+ 
+ 4,427
+ 
+ 
+ 
+ 4,839
+ 
+ 
+ 
+ 4,730
+ 
+ 
+ 
+ 3,961
+ 
+
+ Net interest income
+
+ 
+ 
+ 6,466
+ 
+ 
+ 
+ 4,730
+ 
+ 
+ 
+ 6,759
+ 
+ 
+ 
+ 4,709
+ 
+ 
+ 
+ 4,264
+ 
+ 
+ 
+ 4,677
+ 
+ 
+ 
+ 4,317
+ 
+
+ Provision for loan losses
+
+ 
+ 
+ 518
+ 
+ 
+ 
+ 696
+ 
+ 
+ 
+ 1,050
+ 
+ 
+ 
+ 399
+ 
+ 
+ 
+ 340
+ 
+ 
+ 
+ 328
+ 
+ 
+ 
+ 217
+ 
+
+ Net interest income after provision
+for loan losses
+
+ 
+ 
+ 5,948
+ 
+ 
+ 
+ 4,034
+ 
+ 
+ 
+ 5,709
+ 
+ 
+ 
+ 4,310
+ 
+ 
+ 
+ 3,924
+ 
+ 
+ 
+ 4,349
+ 
+ 
+ 
+ 4,100
+ 
+
+ Non-interest income
+
+ 
+ 
+ 1,132
+ 
+ 
+ 
+ 808
+ 
+ 
+ 
+ 1,161
+ 
+ 
+ 
+ 877
+ 
+ 
+ 
+ 976
+ 
+ 
+ 
+ 668
+ 
+ 
+ 
+ 918
+ 
+
+ Non-interest expense
+
+ 
+ 
+ 4,731
+ 
+ 
+ 
+ 4,110
+ 
+ 
+ 
+ 5,568
+ 
+ 
+ 
+ 4,513
+ 
+ 
+ 
+ 4,312
+ 
+ 
+ 
+ 4,485
+ 
+ 
+ 
+ 4,350
+ 
+
+ Income tax expense
+
+ 
+ 
+ 911
+ 
+ 
+ 
+ 299
+ 
+ 
+ 
+ 507
+ 
+ 
+ 
+ 239
+ 
+ 
+ 
+ 223
+ 
+ 
+ 
+ 170
+ 
+ 
+ 
+ 277
+ 
+
+ Net income
+
+ 
+ 
+ 1,438
+ 
+ 
+ 
+ 433
+ 
+ 
+ 
+ 795
+ 
+ 
+ 
+ 435
+ 
+ 
+ 
+ 365
+ 
+ 
+ 
+ 362
+ 
+ 
+ 
+ 391
+ 
+
+ Per Share Data:
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Book value per share at period end
+
+ 
+ $
+ 4.25
+ 
+ 
+ $
+ 3.46
+ 
+ 
+ $
+ 3.60
+ 
+ 
+ $
+ 3.42
+ 
+ 
+ $
+ 3.23
+ 
+ 
+ $
+ 3.07
+ 
+ 
+ $
+ 2.78
+ 
+
+ Basic earnings per share
+
+ 
+ 
+ 0.43
+ 
+ 
+ 
+ 0.14
+ 
+ 
+ 
+ 0.26
+ 
+ 
+ 
+ 0.14
+ 
+ 
+ 
+ 0.12
+ 
+ 
+ 
+ 0.12
+ 
+ 
+ 
+ 0.13
+ 
+
+ Diluted earnings per share (1)
+
+ 
+ 
+ 0.43
+ 
+ 
+ 
+ 0.14
+ 
+ 
+ 
+ 0.26
+ 
+ 
+ 
+ 0.14
+ 
+ 
+ 
+ 0.12
+ 
+ 
+ 
+ 0.12
+ 
+ 
+ 
+ 0.13
+ 
+
+ Basic weighted average common
+shares outstanding
+
+ 
+ 
+ 3,323,989
+ 
+ 
+ 
+ 3,086,240
+ 
+ 
+ 
+ 3,086,240
+ 
+ 
+ 
+ 3,032,262
+ 
+ 
+ 
+ 3,013,324
+ 
+ 
+ 
+ 2,969,799
+ 
+ 
+ 
+ 2,969,962
+ 
+
+ Diluted weighted average common
+equivalent shares outstanding
+
+ 
+ 
+ 3,339,016
+ 
+ 
+ 
+ 3,097,393
+ 
+ 
+ 
+ 3,097,345
+ 
+ 
+ 
+ 3,061,461
+ 
+ 
+ 
+ 3,050,624
+ 
+ 
+ 
+ 3,136,599
+ 
+ 
+ 
+ 2,999,796
+ 
+
+ Balance Sheet Data:
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Total assets
+
+ 
+ $
+ 243,064
+ 
+ 
+ $
+ 195,538
+ 
+ 
+ $
+ 212,315
+ 
+ 
+ $
+ 153,455
+ 
+ 
+ $
+ 147,423
+ 
+ 
+ $
+ 124,460
+ 
+ 
+ $
+ 118,751
+ 
+
+ Gross loans
+
+ 
+ 
+ 213,048
+ 
+ 
+ 
+ 164,219
+ 
+ 
+ 
+ 182,527
+ 
+ 
+ 
+ 121,999
+ 
+ 
+ 
+ 108,423
+ 
+ 
+ 
+ 81,927
+ 
+ 
+ 
+ 83,757
+ 
+
+ Allowance for loan losses
+
+ 
+ 
+ 2,690
+ 
+ 
+ 
+ 2,073
+ 
+ 
+ 
+ 2,275
+ 
+ 
+ 
+ 1,693
+ 
+ 
+ 
+ 1,401
+ 
+ 
+ 
+ 1,481
+ 
+ 
+ 
+ 1,255
+ 
+
+ Deposits
+
+ 
+ 
+ 205,318
+ 
+ 
+ 
+ 168,449
+ 
+ 
+ 
+ 184,734
+ 
+ 
+ 
+ 137,747
+ 
+ 
+ 
+ 133,025
+ 
+ 
+ 
+ 109,369
+ 
+ 
+ 
+ 99,271
+ 
+
+ Shareholders equity
+
+ 
+ 
+ 14,460
+ 
+ 
+ 
+ 10,684
+ 
+ 
+ 
+ 11,110
+ 
+ 
+ 
+ 10,544
+ 
+ 
+ 
+ 9,768
+ 
+ 
+ 
+ 9,119
+ 
+ 
+ 
+ 8,268
+ 
+
+ Selected Financial Ratios and
+Other Data:
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Return on average total assets (2)
+
+ 
+ 
+ 0.85
+ %
+ 
+ 
+ 0.33
+ %
+ 
+ 
+ 0.43
+ %
+ 
+ 
+ 0.28
+ %
+ 
+ 
+ 0.28
+ %
+ 
+ 
+ 0.30
+ %
+ 
+ 
+ 0.35
+ %
+
+ Return on average equity (2)
+
+ 
+ 
+ 13.61
+ 
+ 
+ 
+ 5.37
+ 
+ 
+ 
+ 7.34
+ 
+ 
+ 
+ 4.28
+ 
+ 
+ 
+ 3.86
+ 
+ 
+ 
+ 4.16
+ 
+ 
+ 
+ 4.69
+ 
+
+ Average interest-earning assets
+
+ 
+ $
+ 215,958
+ 
+ 
+ $
+ 167,162
+ 
+ 
+ $
+ 173,247
+ 
+ 
+ $
+ 142,307
+ 
+ 
+ $
+ 116,651
+ 
+ 
+ $
+ 107,491
+ 
+ 
+ $
+ 99,786
+ 
+
+ Yield on average earnings assets (2) (3)
+
+ 
+ 
+ 6.20
+ %
+ 
+ 
+ 6.24
+ %
+ 
+ 
+ 6.29
+ %
+ 
+ 
+ 6.42
+ %
+ 
+ 
+ 7.80
+ %
+ 
+ 
+ 8.75
+ %
+ 
+ 
+ 8.30
+ %
+
+ Net interest margin (2)
+
+ 
+ 
+ 4.00
+ 
+ 
+ 
+ 3.78
+ 
+ 
+ 
+ 3.90
+ 
+ 
+ 
+ 3.31
+ 
+ 
+ 
+ 3.66
+ 
+ 
+ 
+ 4.35
+ 
+ 
+ 
+ 4.33
+ 
+
+ Non-interest income to average assets
+
+ 
+ 
+ 0.67
+ 
+ 
+ 
+ 0.61
+ 
+ 
+ 
+ 0.63
+ 
+ 
+ 
+ 0.57
+ 
+ 
+ 
+ 0.75
+ 
+ 
+ 
+ 0.56
+ 
+ 
+ 
+ 0.83
+ 
+
+ Non-interest expense to average assets
+
+ 
+ 
+ 2.81
+ 
+ 
+ 
+ 3.11
+ 
+ 
+ 
+ 3.05
+ 
+ 
+ 
+ 2.94
+ 
+ 
+ 
+ 3.33
+ 
+ 
+ 
+ 3.76
+ 
+ 
+ 
+ 3.91
+ 
+
+5
+
+Table of Contents
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ 
+ 
+ At and For the Nine
+ 
+ 
+
+ 
+ 
+ Months Ended September 30,
+ 
+ At and For the Year Ended December 31,
+
+ (dollars in thousands except per share data)
+ 
+ 2004
+ 
+ 2003
+ 
+ 2003
+ 
+ 2002
+ 
+ 2001
+ 
+ 2000
+ 
+ 1999
+
+ Net interest income to noninterest
+expenses
+
+ 
+ 
+ 136.67
+ 
+ 
+ 
+ 115.09
+ 
+ 
+ 
+ 121.39
+ 
+ 
+ 
+ 104.34
+ 
+ 
+ 
+ 98.89
+ 
+ 
+ 
+ 104.28
+ 
+ 
+ 
+ 99.24
+ 
+
+ Efficiency ratio (5)
+
+ 
+ 
+ 62.27
+ 
+ 
+ 
+ 74.21
+ 
+ 
+ 
+ 70.30
+ 
+ 
+ 
+ 80.79
+ 
+ 
+ 
+ 82.29
+ 
+ 
+ 
+ 83.91
+ 
+ 
+ 
+ 83.09
+ 
+
+ Nonperforming assets to total assets
+
+ 
+ 
+ 0.38
+ 
+ 
+ 
+ 0.43
+ 
+ 
+ 
+ 0.59
+ 
+ 
+ 
+ 1.22
+ 
+ 
+ 
+ 1.05
+ 
+ 
+ 
+ 1.03
+ 
+ 
+ 
+ 1.36
+ 
+
+ Nonperforming loans to total loans (4)
+
+ 
+ 
+ 0.43
+ 
+ 
+ 
+ 0.50
+ 
+ 
+ 
+ 0.68
+ 
+ 
+ 
+ 1.01
+ 
+ 
+ 
+ 0.92
+ 
+ 
+ 
+ 1.36
+ 
+ 
+ 
+ 0.98
+ 
+
+ Allowance for loan losses to total loans
+
+ 
+ 
+ 1.26
+ 
+ 
+ 
+ 1.26
+ 
+ 
+ 
+ 1.25
+ 
+ 
+ 
+ 1.39
+ 
+ 
+ 
+ 1.29
+ 
+ 
+ 
+ 1.81
+ 
+ 
+ 
+ 1.50
+ 
+
+ Allowance for loan losses as a percent of
+nonperforming loans
+
+ 
+ 
+ 291.44
+ 
+ 
+ 
+ 111.03
+ 
+ 
+ 
+ 182.15
+ 
+ 
+ 
+ 136.75
+ 
+ 
+ 
+ 140.80
+ 
+ 
+ 
+ 132.47
+ 
+ 
+ 
+ 153.61
+ 
+
+ Net charge-offs to average loans
+
+ 
+ 
+ 0.05
+ 
+ 
+ 
+ 0.22
+ 
+ 
+ 
+ 0.32
+ 
+ 
+ 
+ 0.09
+ 
+ 
+ 
+ 0.46
+ 
+ 
+ 
+ 0.12
+ 
+ 
+ 
+ (0.01
+ )
+
+ Capital Ratios:
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Period-end equity to period-end
+total assets
+
+ 
+ 
+ 5.95
+ %
+ 
+ 
+ 5.46
+ %
+ 
+ 
+ 5.23
+ %
+ 
+ 
+ 6.87
+ %
+ 
+ 
+ 6.63
+ %
+ 
+ 
+ 7.33
+ %
+ 
+ 
+ 6.96
+ %
+
+ Total risk-based capital ratio
+
+ 
+ 
+ 8.02
+ 
+ 
+ 
+ 7.86
+ 
+ 
+ 
+ 7.29
+ 
+ 
+ 
+ 9.55
+ 
+ 
+ 
+ N/A
+ 
+ 
+ 
+ N/A
+ 
+ 
+ 
+ N/A
+ 
+
+ Tier 1 risk-based captial ratio
+
+ 
+ 
+ 6.79
+ 
+ 
+ 
+ 6.61
+ 
+ 
+ 
+ 6.06
+ 
+ 
+ 
+ 8.30
+ 
+ 
+ 
+ N/A
+ 
+ 
+ 
+ N/A
+ 
+ 
+ 
+ N/A
+ 
+
+ Leverage ratio (6)
+
+ 
+ 
+ 6.28
+ 
+ 
+ 
+ 5.80
+ 
+ 
+ 
+ 5.58
+ 
+ 
+ 
+ 6.84
+ 
+ 
+ 
+ N/A
+ 
+ 
+ 
+ N/A
+ 
+ 
+ 
+ N/A
+ 
+
+ (1)
+ 
+ Based on common share equivalents.
+
+ 
+
+ (2)
+ 
+ Annualized for interim periods.
+
+ 
+
+ (3)
+ 
+ Reflects interest income as a percent of average interest earning assets.
+
+ 
+
+ (4)
+ 
+ Nonperforming loans consist of nonaccrual loans and accruing loans
+contractually past due ninety days or more.
+
+ 
+
+ (5)
+ 
+ Noninterest expense divided by the sum of net interest income plus
+noninterest income.
+
+ 
+
+ (6)
+ 
+ The leverage ratio is defined as the ratio of Tier 1 capital to total
+assets for the quarter then ended.
+
+6
+
+Table of Contents
+
+RISK FACTORS
+
+ You should carefully consider the risks described below before investing
+in our common stock. If any of the following risks actually occur, our
+business could be harmed. This could cause the price of our stock to decline,
+and you may lose part or all of your investment. This prospectus contains
+forward-looking statements that involve risks and uncertainties, including
+statements about our future plans, objectives, intentions and expectations.
+Many factors, including those described below, could cause actual results to
+differ materially from those discussed in forward-looking statements.
+
+Risks Related to the Company
+
+We may encounter unexpected financial and operating problems due to our rapid
+growth
+
+ Our total assets have grown from $155.2 million as of September 30, 2002
+to $243.1 million as of September 30, 2004. Our growth is attributable to the
+expansion of our loan portfolio, which has grown from $117.2 million to $209.7
+million during this period. Although we believe that we have implemented
+appropriate internal policies and procedures to handle this growth, our rapid
+growth may result in unexpected financial and operating problems, including
+problems in our loan portfolio due to its unseasoned nature, which may affect
+the value of our shares.
+
+Our growth strategy may not be successful
+
+ As a strategy, we have sought to increase the size of our franchise
+through rapid growth and by aggressively pursuing business development
+opportunities. We can provide no assurance that we will continue to be
+successful in increasing the volume of loans and deposits at acceptable risk
+levels and upon acceptable terms and expanding our asset base while managing
+the costs and implementation risks associated with this growth strategy. We may
+use a portion of the net proceeds from the offering for whole bank or branch
+acquisitions, although we currently have no arrangements or understandings
+regarding any such acquisitions. Execution of an external growth strategy
+entails certain risks, such as credit and integration risks, and requires
+careful management and adequate due diligence. Our ability to successfully
+grow externally will depend on a variety of factors including the availability
+of desirable acquisition and business opportunities, and our ability to
+integrate acquisitions and otherwise manage our overall growth. While we
+believe that we have the management resources and internal systems in place to
+successfully manage our future growth, there can be no assurance that growth
+opportunities will be available, that growth will be successfully managed, that
+we will continue to be able to sustain our historical rate of growth, either
+through internal growth or through other successful expansions of our banking
+markets, or that we will be able to maintain capital sufficient to support our
+continued growth.
+
+Losses from loan defaults may exceed the allowance we establish for that
+purpose, which will have an adverse effect on our business
+
+ If a significant number of loans are not repaid, it would have an adverse
+effect on our earnings and overall financial condition. Like all financial
+institutions, we maintain an allowance for loan losses to provide for losses
+inherent in the portfolio. The allowance for loan losses reflects our
+management s best estimate of probable losses in the loan portfolio at the
+relevant balance sheet date. This evaluation is primarily based upon a review
+of our and the banking industry s historical loan loss experience, known risks
+contained in the loan portfolio, composition and growth of the loan portfolio,
+and economic factors.
+
+ However, the determination of an appropriate level of loan loss allowance
+is an inherently difficult process and is based on numerous assumptions. As a
+result, our allowance for loan losses may not be adequate to cover actual
+losses, and future provisions for loan losses may adversely affect our
+earnings.
+
+7
+
+Table of Contents
+
+We do not have employment or noncompete agreements with our employees, and if
+we lose key employees our business may suffer
+
+ Our success is largely dependent on the personal contacts of our officers
+and employees in our market areas. None of our employees are parties to an
+employment or noncompete agreement with us. If we lose key employees,
+temporarily or permanently, our business could be hurt. We could be
+particularly hurt if our key employees went to work for our competitors. Our
+future success depends on the continued contributions of our existing senior
+management personnel.
+
+Our directors and executive officers will continue to have substantial control
+over our company after the offering, which could delay or prevent a change of
+control favored by our other shareholders
+
+ Our directors and executive officers, if acting together, will be able to
+significantly influence all matters requiring approval by our shareholders,
+including elections of directors and the approval of mergers or other business
+combination transactions. After the offering, our executive officers and
+directors expect to beneficially own at least 1,739,086 shares, representing approximately
+31.5% of the total number of shares outstanding and will have options to
+acquire nearly 56,400 additional shares.
+
+ The interest of these shareholders may differ from the interests of other
+shareholders, and these shareholders, acting together, will be able to
+influence significantly all matters requiring approval by shareholders. As a
+result, these shareholders could approve or cause us to take actions of which
+you disapprove or that may be contrary to your interests and those of other
+investors.
+
+If real estate values in our target markets decline, our loan portfolio would
+be impaired
+
+ A significant portion of our loan portfolio consists of mortgages secured
+by commercial real estate located in West Central Florida. Real estate values
+and real estate markets are generally affected by, among other things, changes
+in national, regional or local economic conditions, fluctuations in interest
+rates and the availability of loans to potential purchasers, changes in the tax
+laws and other governmental statutes, regulations and policies, and acts of
+nature. If real estate prices decline in any of these markets, the value of the
+real estate collateral securing our loans could be reduced. Such a reduction in
+the value of our collateral could increase the number of non-performing loans
+and adversely affect our financial performance.
+
+Our exposure to credit risk is increased by our commercial real estate and
+commercial business lending
+
+ Commercial real estate and commercial business lending generally involve
+higher credit risks than single-family residential or consumer lending. Such
+loans involve larger loan balances to a single borrower or groups of related
+borrowers. At September 30, 2004, we had a balance of $121.7 million in
+commercial real estate loans and $34.4 million in commercial business loans.
+
+ Commercial real estate loans may be affected to a greater extent than
+residential loans by adverse conditions in real estate markets or the economy
+because commercial real estate borrowers ability to repay their loans depends
+more on successful development of their properties. These loans also involve
+greater risk because they generally are not fully amortizing over the loan
+period, but have a balloon payment due at maturity. The borrower s ability to
+make a balloon payment typically will depend on being able to either refinance
+the loan or timely sell the underlying property.
+
+ Unlike residential mortgage loans that are based on the borrower s ability
+to repay the loan from the borrower s income and secured by real property with
+a value that is usually readily ascertainable, commercial business loans are
+typically based on the borrowers ability to repay the loans from the cash flow
+of their businesses. Such loans involve greater risk, because the availability
+of funds to repay each loan depends substantially on the success of the
+business itself. In addition, the collateral securing the loans may depreciate
+over time, be difficult to appraise and fluctuate in value based on the success
+of the business.
+
+8
+
+Table of Contents
+
+ Commercial real estate and commercial business loans are more susceptible
+to a risk of loss during a down turn in the business cycle. The underwriting,
+review and monitoring performed by our officers and directors cannot eliminate
+all of the risks relating to these loans.
+
+While the proceeds of the offering will allow us to apply for financial holding
+company status, there is no assurance our application will be granted or that
+we will continue to meet applicable requirements
+
+ The proceeds of this offering will allow us to meet the capital
+requirements to apply to become a financial holding company under the Federal
+Reserve s guidelines. This would allow us to engage in a greater range of
+financial activities than we are currently authorized to conduct, although we
+do not currently have any plans to enter into any new lines of business. If
+this financial holding company status is granted, our capital ratios must
+continue to meet the well capitalized requirements and our periodic
+examinations by the bank regulatory agencies must continue to remain
+satisfactory to them. While we intend to apply for financial holding company
+status, there is no assurance that it will be granted or, if granted, that we
+will continue to meet the capital or other requirements. While this may
+preclude us from pursuing activities that in the future we might deem
+complementary to the services we offer to our customers, we do not believe the
+failure to achieve or maintain this status would materially adversely affect
+our operations as we believe our future prospects are more reliant upon
+pursuing our core banking business including deposit and loan growth.
+
+Risks Related to the Common Stock
+
+An active trading market for the common shares may not develop
+
+ Prior to this offering, a public market for our common stock did not
+exist. We have applied for listing of the common stock on the Nasdaq National
+Market. However, there can be no assurance that an active trading market will
+develop or that purchasers of our common stock will be able to resell their
+common stock at prices equal to or greater than the initial public offering
+price. The development of a public market having the desirable characteristics
+of depth, liquidity and orderliness depends upon the presence of a sufficient
+number of willing buyers and sellers at any given time, over which neither we
+nor any market maker has any control. Accordingly, there can be no assurance
+that an establishes and liquid market for the common stock will develop or be
+maintained.
+
+The offering price may exceed the fair market value of our shares
+
+ Our Board of Directors determined the offering price after consulting with
+the underwriters of this offering and considering our historic and expected
+growth, the prior public sale of our shares and general market conditions,
+among other factors. Nevertheless, the offering price may not bear any
+relationship to the amount of our assets, book value, shareholders equity or
+other typical criteria of value, and may exceed the fair market value of our
+shares and the price at which shares may be sold after the offering.
+Consequently, you may lose a portion of your investment simply as a result of
+an inaccurately determined offering price.
+
+We have not paid dividends to date and are unlikely to pay dividends in the
+future
+
+ We have not paid a cash dividend since our inception. In order to retain
+earnings to finance future growth, we do not expect to pay dividends for the
+foreseeable future. Our ability to pay dividends is primarily contingent on the
+receipt of dividends from our subsidiaries, which are subject to various
+regulatory restrictions on the payment of dividends.
+
+We may need to raise additional capital, which could dilute your ownership
+
+ We may need to raise additional capital in the future to support our
+business, expand our operations, or maintain minimum capital levels required by
+our bank regulatory agencies. Our articles of incorporation authorize the
+issuance of up to 25 million shares of common stock and 5 million shares of
+preferred stock. Our articles of incorporation do not provide shareholders
+with preemptive rights and such
+
+9
+
+Table of Contents
+
+shares may be offered to individuals other than
+shareholders at the discretion of the Board. If we do sell additional shares of
+common or preferred stock to raise capital, the sale may dilute your ownership
+interest and such dilution could be substantial. In addition, our directors
+and employees hold 65,300 outstanding options which have an average exercise
+price of $4.19 per share, and our directors and employees also may receive
+additional options in the future under our 2004 stock plan. See Management 
+Stock Option Plan. 
+
+Certain provisions of Florida law may discourage or prevent a takeover of our
+company and result in a lower market price for our common stock
+
+ Florida law, as well as certain federal regulations, contain anti-takeover
+provisions that apply to us. While these provisions may provide us with
+flexibility in managing our business, they could discourage potential buyers
+from seeking to acquire us, even though certain shareholders may wish to
+participate in such a transaction. These provisions could also adversely affect
+the market price of our common stock.
+
+CAUTIONARY NOTE CONCERNING FORWARD-LOOKING STATEMENTS
+
+ Some discussions in this prospectus may contain forward-looking
+statements. We caution you to be aware of the speculative nature of
+ forward-looking statements. Statements that are not historical in nature,
+including the words anticipate, estimate, should, expect, believe, 
+ intend, assume and similar expressions, are intended to identify
+forward-looking statements. Although these statements reflect our good faith
+belief based on current expectations, estimates and projections about (among
+other things) the industry and the markets in which we operate, they are not
+guarantees of future performance. Whether actual results will conform to our
+expectations and predictions is subject to a number of known and
+unknown risks and uncertainties, including the risks and uncertainties
+discussed in this prospectus; general economic, market, or business conditions;
+changes in interest rates, deposit flow, the cost of funds, and demand for loan
+products and financial services; changes in our competitive position; changes
+in the quality or composition of loan and investment portfolios; our ability to
+manage growth; the opportunities that may be presented to and pursued by us;
+competitive actions by other companies; changes in laws or regulations; changes
+in the policies of federal or state regulators and agencies; and other
+circumstances, many of which are beyond our control. Consequently, all of the
+forward-looking statements made in this prospectus are qualified by these
+cautionary statements and there can be no assurance that the actual results
+anticipated by us will be realized or, even if substantially realized, that
+they will have the expected consequences to, or effects on, us or our business
+or operations. Except as required by applicable laws, we do not intend to
+publish updates or revisions of any forward-looking statements we make to
+reflect new information, future events or otherwise.
+
+USE OF PROCEEDS
+
+ We
+estimate that the net proceeds from the sale of 2,127,500 shares of our
+common stock in this offering will be approximately $21,464,000 (assuming an
+offering price of $11.00 per share) or approximately $24,729,000 if the
+underwriters over-allotment option is exercised in full. In each case, this
+assumes deduction of estimated offering expenses of $300,000 and underwriting
+discounts and commissions. We intend to use up to $4.0 million of these
+proceeds to repay the amounts outstanding on our line of credit and contribute
+substantially all of the remaining net proceeds to First State Bank to provide
+it with capital to support our loan and deposit growth. We also may use a
+portion of the net to pursue acquisition opportunities that may become
+available, although at the current time we do not have any agreements or
+understandings. Any remaining proceeds will be used for general corporate
+purposes.
+
+ Under the line of credit to be repaid from the proceeds of this offering,
+we may borrow up to $4.0 million at an annual interest rate equal to the prime
+rate minus one percent. This credit facility matures on April 30, 2005. As of
+the date of this prospectus, we have received advances of approximately $4.0
+million under this line of credit. These funds were used to provide capital to
+the Bank in support of its continued deposit and loan growth.
+
+10
+
+Table of Contents
+
+CAPITALIZATION
+
+ The following table sets forth our capitalization at September 30, 2004
+and as adjusted to give effect to the sale of 2,127,500 shares of common stock
+offered in this offering, less the underwriting discount and commissions and
+estimated expenses, at an assumed offering price of $11.00 per share. This
+table should be read in conjunction with Management s Discussion and Analysis
+of Financial Condition and Results of Operations and the consolidated
+financial statements and notes thereto included in this prospectus.
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ 
+ 
+ September 30, 2004 (1)
+
+ (dollars in thousands, except per share data)
+ 
+ Actual
+ 
+ As Adjusted (2)
+
+ Shareholders equity (3)
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Preferred stock, no par value; 5,000,000
+shares
+authorized; no shares outstanding
+
+ 
+Common stock, $1.00 par value; 25,000,000
+shares authorized; 3,399,040 shares
+outstanding; 5,526,540 shares
+outstanding as adjusted (4)
+
+ 
+ $
+ 3,399
+ 
+ 
+ $
+ 5,527
+ 
+
+ Additional paid-in capital
+
+ 
+ 
+ 7,222
+ 
+ 
+ 
+ 26,558
+ 
+
+ Retained earnings
+
+ 
+ 
+ 3,932
+ 
+ 
+ 
+ 3,932
+ 
+
+ Accumulated other comprehensive income
+
+ 
+ 
+ (93
+ )
+ 
+ 
+ (93
+ )
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Total shareholders equity
+
+ 
+ $
+ 14,460
+ 
+ 
+ $
+ 35,924
+ 
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Book value per share (5)
+
+ 
+ $
+ 4.25
+ 
+ 
+ $
+ 6.50
+ 
+
+ Capital ratios (6):
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Tier 1 leverage ratio
+
+ 
+ 
+ 6.28
+ %
+ 
+ 
+ 15.53
+ %
+
+ Tier 1 capital to risk-weighted assets
+
+ 
+ 
+ 6.79
+ %
+ 
+ 
+ 16.47
+ %
+
+ Total capital to risk-weighted assets
+
+ 
+ 
+ 8.02
+ %
+ 
+ 
+ 17.70
+ %
+
+ (1)
+ 
+ This table excludes 65,300 shares of common stock issuable upon exercise
+of outstanding options, at an average exercise price of $4.19 per share.
+Also excludes any options that may be issued under our 2004 Stock Plan,
+none of which were outstanding at September 30, 2004.
+
+ 
+
+ 
+
+ (2)
+ 
+ If the underwriters over-allotment option is exercised in full, common
+stock, additional paid-in capital and total shareholders equity would be
+$5,846,000, $29,504,000 and $39,189,000, respectively.
+
+ 
+
+ 
+
+ (3)
+ 
+ Reflects an amendment to the articles of incorporation approved in
+October 2004, authorizing 5,000,000 shares of preferred stock and
+increasing the authorized shares of common stock from 10,000,000 to
+25,000,000 shares
+
+ 
+
+ 
+
+ (4)
+ 
+ Before issuance of up to 319,125 shares of common stock pursuant to the
+underwriters over-allotment option.
+
+ 
+
+ 
+
+ 
+
+ (5)
+ 
+ Actual book value per share equals total shareholders equity of
+$14,460,000, divided by 3,399,040 shares issued and outstanding at
+September 30, 2004. Book value per share as adjusted equals total
+shareholders equity of $35,924,000 (assuming net proceeds of this
+offering of $21,464,000), divided by 5,526,540 shares (assuming issuance
+and sale of 2,127,500 shares).
+
+ 
+
+ 
+
+ (6)
+ 
+ These ratios as adjusted assume that the net proceeds will be invested
+initially in federal funds until utilized by the Company over time.
+
+11
+
+Table of Contents
+
+MANAGEMENT TEAM
+
+ The composition of our management team includes individuals who have
+significant banking experience in our primary markets. Our President and Chief
+Executive Officer is Corey J. Coughlin, who has more than 33 years of banking
+experience, a significant portion of which has been in the Florida market,
+including serving as:
+
+ 
+ 
+ Founder and principal of CJC Financial Services in St.
+Petersburg, Florida, a banking and general management consulting
+firm.
+
+ 
+
+ 
+ 
+ President and Chief Operating Officer at CNB Florida
+Bancshares, Inc., a publicly traded bank holding company in
+Jacksonville, Florida from 1999 to 2002. He increased profitability
+at the company and managed its initial public offering in 1999.
+
+ 
+
+ 
+ 
+ President and Chief Executive Officer of First Bankshares,
+Inc. and its subsidiary bank, First National Bank of Central Florida
+in Orlando, Florida from 1997 to 1998. He developed and implemented
+a strategic plan that returned the bank to profitability.
+
+ 
+
+ 
+ 
+ Chairman, President and Chief Executive Officer at SouthTrust
+Northeast Florida from 1994 to 1997.
+
+ 
+
+ 
+ 
+ Executive Vice President and Chief Operating Officer of
+SouthTrust Bank of West Florida in St. Petersburg, Florida from 1990
+to 1994. Prior to assuming this position in August 1990, he had
+been the Senior Lending Officer since 1987. He managed all
+operating functions of a bank which grew to $4 billion in assets in
+West Central Florida.
+
+ Our Executive Vice President and Senior Lending Officer is Michael K.
+Worthington, who has more than 25 years of banking experience, nearly entirely
+in the lending area and with extensive experience in the West Central Florida
+market. During the approximately two-year departure from First State, he was
+the Senior Lending Officer at Peoples Community Bank of the West Coast.
+
+ Our Executive Vice President and Senior Retail Officer is John Wilkinson,
+who has more than 29 years of banking experience. Prior to assuming his
+position with First State, he had spent about 16 years with SouthTrust in Tampa
+Bay rising to the position of Executive Vice President and Chief Operating
+Officer.
+
+ Our Senior Vice President and Chief Financial Officer is Dennis
+Grinsteiner, who has more than 36 years of banking experience. Prior to
+assuming his current position with First State, he had been Executive Vice
+President, Chief Financial Officer and Cashier at Southern Exchange Bank in
+Tampa from 1997 to May 2003.
+
+INFORMATION ABOUT OUR MARKETS
+
+ We currently consider our principal markets to be West Central Florida
+including Sarasota, Pinellas, Hillsborough, Pasco, Manatee and Charlotte
+Counties. The Counties in First State s principal markets include the five
+largest cities of Tampa, St. Petersburg, Clearwater, Sarasota and Bradenton,
+and the wealthy communities of Harbor Island, Longboat Key and Siesta Key. In
+these six counties in 2004, covering approximately 100 miles from New Port
+Richey in Pasco County to Punta Gorda in Charlotte County, reside 3.2 million
+people with effective buying income of more than $80 billion, and deposits of
+nearly $55 billion at June 30, 2004. While only about 25% of the population
+and market wealth reside in
+the five largest cities of West Central Florida, nearly 61% of the deposit
+accounts are located in these five cities. Of the $16 billion in deposit growth
+over the last five years, approximately 76% of the deposit growth occurred in
+the five largest cities. These are markets in which targeted branching,
+especially commercial banking relationships, can result in significant growth
+in assets and deposits.
+
+12
+
+Table of Contents
+
+ First State Bank currently has three locations in Sarasota County and
+three locations in Pinellas County, Florida. The headquarters of First State
+Financial and First State Bank are located in downtown Sarasota. Sarasota
+County is one of the wealthiest counties in Florida. The County s 2004 average
+household income of $67,460 is 14% higher than the Florida average and is
+projected over the next five years to increase to $75,903. It is a sizable
+market with effective buying income in 2004 of nearly $11 billion and is
+expected to grow by $2.5 billion over the next five years. While only 15% of
+the county population reside in the city of Sarasota, business activity remains
+centered in the city. At June 30, 2004, the City of Sarasota had $7.28 billion
+in deposits or 74% of the $9.87 billion in county deposits and the city s
+deposit base grew by $2.77 billion over the last five years or 83% of the
+approximately $3.34 billion county deposit growth.
+
+ Pinellas County is a much larger banking market with $17 billion in total
+deposits. Pinellas County is the 2nd smallest County in Florida, but is ranked
+5th in population in the state of Florida, making it the most densely populated
+County in the State. The county includes the 2nd and 3rd largest cities in West
+Central Florida of St. Petersburg and Clearwater, respectively. These two
+cities, along with Tampa in Hillsborough County, make up the core markets of
+the Tampa Bay region. The Tampa Bay market is one of the largest markets
+nationwide. It ranks in the top 25 in terms of population, wealth and retail
+sales. The population in the Tampa Bay market has increased by over 20% since
+1990 and is projected to grow by more than 10% over the next five years.
+
+ Between the Tampa Bay market and Sarasota is Manatee County with the city
+of Bradenton. The Manatee County market is the fastest growing both in terms of
+population and average household income in West Central Florida. The County s
+population has grown by 10.2% since 2002 and is expected to grow 11.6% over the
+next five years. During the same period, Manatee County s average household
+income grew by 13.7% and is expected to grow by 14.7%.
+
+ We believe the demographics of our markets strongly support our plan to
+grow assets and deposits with limited, full service locations. We have
+successfully operated in two of the most significant markets in West Central
+Florida, Sarasota and St. Petersburg, and anticipate continued growth in
+existing markets and select expansion to neighboring markets offers significant
+opportunities for continued growth.
+
+MARKET FOR OUR COMMON STOCK
+
+ There is currently no public market for our common stock. Our management
+is aware of certain transactions in our common stock that have occurred,
+although the trading prices of all stock transactions are not known. As to the
+shares of common stock traded since January 1, 2002, management is aware of the
+trading prices for the following transactions: In 2002, there were 18,907
+shares traded at $5.00 per share in 29 transactions; in 2003, there were
+255,963 shares traded in 19 transactions at prices ranging from $4.00 to $5.50
+per share; and during the first nine months of 2004, there were 24,788 shares
+traded in five transactions at prices ranging from $5.25 to $6.00 per share.
+Transactions in the common stock are infrequent and are negotiated privately
+between the persons involved in those transactions.
+
+ In addition, on February 6, 2004, we completed a private offering of
+300,000 shares of our common stock, at a price of $6.25 per share in cash for a
+total of $1,875,000, before deducting expenses of
+the offering of approximately $25,000. The shares were sold to accredited
+investors, consisting primarily of directors, officers and local residents.
+
+ As of September 30, 2004, there were outstanding 3,399,040 shares of
+common stock which were held by approximately 367 shareholders of record.
+
+ We have applied for listing of our common stock on the Nasdaq National
+Market under the proposed trading symbol FSTF. The qualification for quotation
+of the common shares on the Nasdaq National Market requires at least three
+securities firm to make a market in the common stock. Advest, Inc. has
+informed us that it presently intends to make a market in our common stock and
+to encourage other securities firms to do the same, but it has no obligation to
+do so. Making a market involves maintaining bid and ask quotations and being
+able, as principal, to effect transactions in reasonable quantities at those
+
+13
+
+Table of Contents
+
+prices, subject to securities laws and regulatory constraints. Additionally,
+the development of a liquid public market depends on the existence of willing
+buyers and sellers, the presence of which is not within our control.
+Accordingly, there is no assurance that an active and liquid trading market
+will develop or, if developed, that such a market will be sustained. The
+offering price and the number of shares of common stock to be sold in the
+offering have been determined by negotiations among representatives of First
+State Financial and the underwriter, and the offering price of the common stock
+may not be indicative of the market price following the offering.
+
+DIVIDEND POLICY
+
+ To date, we have never declared or paid any stock or cash dividends on our
+common stock, and we do not intend to pay cash dividends in the foreseeable
+future. Instead, we intend to retain any earnings to finance our growth.
+
+ We are a legal entity separate and distinct from our subsidiary. Funds
+available for payment of dividends on our common stock principally consist of
+dividends paid to us by First State Bank. There are statutory and regulatory
+limitations on the amount of dividends that may be paid by First State Bank to
+us. See Supervision and Regulation for a discussion of the regulatory
+restrictions on the payment of dividends by First State Bank.
+
+DILUTION
+
+ Our net tangible book value (stockholders equity less intangible assets)
+totaled approximately $14.5 million at September 30, 2004 or approximately
+$4.25 per share then outstanding. Individuals purchasing shares in this
+offering will experience dilution on a per share basis equal to the difference
+between an assumed offering price of $11.00 per share in this offering and the
+pro forma book value of the shares immediately upon the completion of this
+offering. This dilution to purchasers in this offering is illustrated in the
+following table.
+
+ 
+ 
+ 
+ 
+ 
+
+ 
+ 
+ Sale of 2,127,500
+
+ 
+ 
+ Common Shares (1)
+
+ Book value per share at September 30, 2004
+
+ 
+ $
+ 4.25
+ 
+
+ Offering price per share
+
+ 
+ 
+ 11.00
+ 
+
+ Increase in per share book value attributable to
+new investors
+
+ 
+ 
+ 2.25
+ 
+
+ Pro forma book value per share after this offering
+
+ 
+ 
+ 6.50
+ 
+
+ Per share dilution to new investors
+
+ 
+ 
+ 4.50
+ 
+
+ (1)
+ 
+ Assumes no exercise of the overallotment option, an offering price of
+$11.00 per share, and underwriting discounts and offering expenses of
+$1.94 million.
+
+14
+
+Table of Contents
+
+MANAGEMENT S DISCUSSION AND ANALYSIS OF
+
+FINANCIAL CONDITION AND RESULTS OF OPERATION
+
+ The following discussion of our financial condition and results of
+operations should be read in conjunction with the consolidated financial
+statements and the related notes thereto, as well as the interim statements as
+of and for the nine months ended September 30, 2004 and 2003, included
+elsewhere in this prospectus. This discussion contains forward-looking
+statements that involve risks and uncertainties. Our actual results may differ
+materially from those anticipated in these forward-looking statements as a
+result of certain factors including, but not limited to, those set forth under
+ Risk Factors and elsewhere in this prospectus.
+
+General
+
+ First State Financial Corporation was incorporated in Florida in August
+13, 1997 to serve as a holding company for First State Bank, which it acquired
+in 1998. In 2001, First State Bank and First State Bank of Pinellas, which was
+acquired by First State Financial in 1998, were merged. First State Bank is a
+full service commercial bank that offers a complete range of interest-bearing
+and non-interest bearing accounts, including commercial and retail checking
+accounts, money market accounts, individual retirement accounts, regular
+interest-bearing statement savings accounts, and certificates of deposit.
+Lending products include commercial loans, real estate loans, home equity loans
+and consumer/installment loans. In addition, First State Bank provides
+travelers checks, cashiers checks, safe deposit boxes, bank by mail services,
+direct deposit, on-line banking, and automated teller services. Specialized
+services to commercial customers include cash management, expanded on-line
+banking, lock box and door-to-door banking.
+
+Overview
+
+ Total assets at September 30, 2004 were $243.1 million compared to $212.3
+million at December 31, 2003, an increase of $30.8 million, or 14.5%. The
+increase in total assets was primarily attributable to an increase in net loans
+receivable of $29.9 million, or 16.6%. The increase in loans was funded by the
+deposit growth experienced during the period, Federal Home Loan Bank advances,
+and proceeds from the issuance of common stock. The increase in net loans
+receivable consisted primarily of an increase in commercial real estate loans
+of $17.1 million, or 16.3%.
+
+ Total deposits were $205.3 million at September 30, 2004 compared to
+$184.7 million at December 31, 2003, an increase of $20.6 million, or 11.1%.
+During this period, we experienced an increase in core deposit accounts of $9.0
+million, or 14.3%, and time deposits of $11.6 million, or 9.5%. Consequently,
+the certificate of deposit portfolio as a percent of total deposits declined
+slightly to 65.2% at September 30, 2004 from 66.2% at December 31, 2003.
+Almost all certificates of deposit held by us mature in less than five years
+with approximately 42% maturing in the next year.
+
+ For the nine months ended September 30, 2004, we recorded diluted earnings
+per share of 43 cents. This compares to diluted earnings per share of 14 cents
+in the prior year s comparable period, resulting in an increase in diluted
+earnings per share of 29 cents. Further, net interest margin increased by 22
+basis points from 3.78% for the first nine months of 2003 to 4.00% for the
+current period. Management believes that if interest rates continue to
+increase, the net interest margin should be further positively impacted.
+
+Forward Looking Statements
+
+ Management s Discussion and Analysis of Financial Condition and Results
+of Operation contains various forward-looking statements with respect to
+financial performance and business matters. Such statements are generally
+contained in sentences including the words expect or could or should or
+ would or believe . We caution that these forward-looking statements are
+subject to numerous assumptions, risks and uncertainties, and therefore actual
+results could differ materially from those contemplated by the forward-looking
+statements. In addition, we assume no duty to update forward-looking
+statements.
+
+15
+
+Table of Contents
+
+Critical Accounting Policies
+
+ Our consolidated financial statements are prepared in conformity with
+accounting principles generally accepted in the United States of America. The
+financial information contained within these statements is, to a significant
+extent, based on approximate measures of the financial effects of transactions
+and events that have already occurred. Critical accounting policies are those
+that involve the most complex and subjective decisions and assessments, and
+have the greatest potential impact on our stated results of operations. In
+management s opinion, our critical accounting policies deal with the following
+area: the establishment of our allowance for loan losses, as explained in
+detail in the Loan Quality and Classification of Assets sections of this
+discussion and analysis.
+
+ Our allowance for loan loss methodology incorporates a variety of risk
+considerations, both quantitative and qualitative, that management believes are
+appropriate at each reporting date. Quantitative factors include our
+historical loss experience, delinquency and charge-off trends, collateral
+values, changes in non-performing loans, loan concentrations and other factors.
+Qualitative factors include the general economic conditions in Florida, size
+and complexity of individual credits in relation to loan structure, existing
+loan policies, and pace of portfolio growth. As we add new products and
+increase the complexity of our loan portfolio, we anticipate enhancing our
+methodology accordingly. Management may report a materially different amount
+for the provision for loan loss in the statement of operations to change the
+allowance for loan losses if its assessment of the above factors were
+different. This discussion and analysis should be read in conjunction with our
+consolidated financial statements and the accompanying notes presented
+elsewhere in this prospectus as well as the portions of this discussion and
+analysis section entitled Lending Activities, Loan Quality and
+ Classification of Assets. Although management believes the levels of the
+allowance as of September 30, 2004 are adequate to absorb probable losses
+inherent in the loan portfolio, a decline in local economic conditions, or
+other factors, could result in increasing losses that cannot be reasonably
+predicted at this time.
+
+ This discussion presents management s analysis of the financial condition
+and results of operations of First State Financial for the nine months ended
+September 30, 2004 and 2003 and for each of the years ended December 31, 2003,
+2002 and 2001, and includes the statistical disclosures required by the
+Securities and Exchange Commission Guide 3 ( Statistical Disclosure by Bank
+Holding Companies ). The discussion should be read in conjunction with the
+consolidated financial statements of First State Financial and the notes
+related thereto which appear elsewhere in this prospectus.
+
+Results of Operations
+
+ Net interest income increased to $6.47 million or by $1.74 million (up
+37%) in the first nine months of 2004 compared to the same period in 2003. Net
+interest spread, the difference between the yield on earning assets and the
+rate paid on interest-bearing liabilities, was 3.64% in the first nine months
+of 2004, up 3 basis points from the average for 2003 and up 20 basis points
+from the first nine months of
+2003. The net interest margin was 4.00% for the first nine months of
+2004, an increase of 10 basis points from the average for 2003 and up 22 basis
+points from the first nine months of 2003.
+
+ The following table represents, for the periods indicated, certain
+information related to our average balance sheet and our average yields on
+assets and average cost of liabilities. Such yields are derived by dividing
+income or expenses by the average balance of the corresponding assets or
+liabilities. Average balances have been derived from daily averages.
+
+16
+
+Table of Contents
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ 
+ 
+ For the Nine months Ended September 30,
+
+ 
+ 
+ 2004
+ 
+ 2003
+
+ 
+ 
+ 
+ 
+ 
+ 
+ Interest
+ 
+ Average
+ 
+ 
+ 
+ 
+ 
+ Interest
+ 
+ Average
+
+ 
+ 
+ Average
+ 
+ and
+ 
+ Yield/
+ 
+ Average
+ 
+ and
+ 
+ Yield/
+
+ (dollars in thousands)
+ 
+ Balance
+ 
+ Dividends
+ 
+ Rate
+ 
+ Balance
+ 
+ Dividends
+ 
+ Rate
+
+ Assets:
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Earning assets:
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Loans (a)
+
+ 
+ $
+ 194,362
+ 
+ 
+ $
+ 9,547
+ 
+ 
+ 
+ 6.56
+ %
+ 
+ $
+ 140,618
+ 
+ 
+ $
+ 7,289
+ 
+ 
+ 
+ 6.93
+ %
+
+ Investment securities
+
+ 
+ 
+ 15,204
+ 
+ 
+ 
+ 414
+ 
+ 
+ 
+ 3.64
+ %
+ 
+ 
+ 17,506
+ 
+ 
+ 
+ 412
+ 
+ 
+ 
+ 3.15
+ %
+
+ Other
+
+ 
+ 
+ 6,392
+ 
+ 
+ 
+ 65
+ 
+ 
+ 
+ 1.36
+ %
+ 
+ 
+ 9,038
+ 
+ 
+ 
+ 96
+ 
+ 
+ 
+ 1.42
+ %
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Total interest-earning assets
+
+ 
+ 
+ 215,958
+ 
+ 
+ 
+ 10,026
+ 
+ 
+ 
+ 6.20
+ %
+ 
+ 
+ 167,162
+ 
+ 
+ 
+ 7,797
+ 
+ 
+ 
+ 6.24
+ %
+
+ Non-interest-earning assets
+
+ 
+ 
+ 8,945
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 9,481
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Total assets
+
+ 
+ $
+ 224,903
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ $
+ 176,643
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Liabilities:
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Interest-bearing liabilities:
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ NOW accounts
+
+ 
+ $
+ 14,641
+ 
+ 
+ 
+ 27
+ 
+ 
+ 
+ 0.25
+ %
+ 
+ $
+ 14,455
+ 
+ 
+ 
+ 37
+ 
+ 
+ 
+ 0.34
+ %
+
+ Money market
+
+ 
+ 
+ 20,961
+ 
+ 
+ 
+ 170
+ 
+ 
+ 
+ 1.08
+ %
+ 
+ 
+ 21,454
+ 
+ 
+ 
+ 173
+ 
+ 
+ 
+ 1.08
+ %
+
+ Savings
+
+ 
+ 
+ 8,457
+ 
+ 
+ 
+ 20
+ 
+ 
+ 
+ 0.32
+ %
+ 
+ 
+ 8,178
+ 
+ 
+ 
+ 34
+ 
+ 
+ 
+ 0.56
+ %
+
+ Time deposits
+
+ 
+ 
+ 133,026
+ 
+ 
+ 
+ 3,106
+ 
+ 
+ 
+ 3.12
+ %
+ 
+ 
+ 96,217
+ 
+ 
+ 
+ 2,639
+ 
+ 
+ 
+ 3.67
+ %
+
+ Borrowings
+
+ 
+ 
+ 8,590
+ 
+ 
+ 
+ 237
+ 
+ 
+ 
+ 3.69
+ %
+ 
+ 
+ 6,414
+ 
+ 
+ 
+ 184
+ 
+ 
+ 
+ 3.84
+ %
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Total interest-bearing liabilities
+
+ 
+ 
+ 185,675
+ 
+ 
+ 
+ 3,560
+ 
+ 
+ 
+ 2.56
+ %
+ 
+ 
+ 146,718
+ 
+ 
+ 
+ 3,067
+ 
+ 
+ 
+ 2.79
+ %
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Demand deposits
+
+ 
+ 
+ 23,766
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 18,570
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Other non-interest-bearing liabilities
+
+ 
+ 
+ 1,353
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 578
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Total non-interest-bearing liabilities
+
+ 
+ 
+ 25,119
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 19,148
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Stockholders equity
+
+ 
+ 
+ 14,109
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 10,777
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Total liabilities and stockholders equity
+
+ 
+ $
+ 224,903
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ $
+ 176,643
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Net interest income
+
+ 
+ 
+ 
+ 
+ 
+ $
+ 6,466
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ $
+ 4,730
+ 
+ 
+ 
+ 
+ 
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Interest rate spread
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 3.64
+ %
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 3.44
+ %
+
+ Net interest margin (b)
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 4.00
+ %
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 3.78
+ %
+
+(a) Average loans include nonperforming loans
+
+(b) Net interest margin is net interest income divided by average total interest-earning assets
+
+ The following table represents for the twelve-month periods indicated,
+certain information related to our average balance sheet and our average yields
+on assets and average cost of liabilities. Such yields have been derived by
+dividing income or expenses by the average balance or the corresponding assets
+or liabilities. Average balances have been derived from daily averages.
+
+17
+
+Table of Contents
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ 
+ 
+ For the Twelve Months Ended December 31,
+
+ 
+ 
+ 2003
+ 
+ 2002
+ 
+ 2001
+
+ 
+ 
+ 
+ 
+ 
+ 
+ Interest
+ 
+ Average
+ 
+ 
+ 
+ 
+ 
+ Interest
+ 
+ Average
+ 
+ 
+ 
+ 
+ 
+ Interest
+ 
+ Average
+
+ 
+ 
+ Average
+ 
+ and
+ 
+ Yield/
+ 
+ Average
+ 
+ and
+ 
+ Yield/
+ 
+ Average
+ 
+ and
+ 
+ Yield/
+
+ (dollars in thousands)
+ 
+ Balance
+ 
+ Dividends
+ 
+ Rate
+ 
+ Balance
+ 
+ Dividends
+ 
+ Rate
+ 
+ Balance
+ 
+ Dividends
+ 
+ Rate
+
+ Assets:
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Earning assets:
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Loans (a)
+
+ 
+ $
+ 147,923
+ 
+ 
+ $
+ 10,199
+ 
+ 
+ 
+ 6.89
+ %
+ 
+ $
+ 115,393
+ 
+ 
+ $
+ 8,449
+ 
+ 
+ 
+ 7.32
+ %
+ 
+ $
+ 90,571
+ 
+ 
+ $
+ 8,027
+ 
+ 
+ 
+ 8.86
+ %
+
+ Investment securities
+
+ 
+ 
+ 18,466
+ 
+ 
+ 
+ 598
+ 
+ 
+ 
+ 3.24
+ %
+ 
+ 
+ 8,881
+ 
+ 
+ 
+ 375
+ 
+ 
+ 
+ 4.22
+ %
+ 
+ 
+ 7,912
+ 
+ 
+ 
+ 464
+ 
+ 
+ 
+ 5.86
+ %
+
+ Other
+
+ 
+ 
+ 6,858
+ 
+ 
+ 
+ 101
+ 
+ 
+ 
+ 1.47
+ %
+ 
+ 
+ 18,033
+ 
+ 
+ 
+ 312
+ 
+ 
+ 
+ 1.73
+ %
+ 
+ 
+ 18,168
+ 
+ 
+ 
+ 612
+ 
+ 
+ 
+ 3.37
+ %
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Total interest-earning assets
+
+ 
+ 
+ 173,247
+ 
+ 
+ 
+ 10,898
+ 
+ 
+ 
+ 6.29
+ %
+ 
+ 
+ 142,307
+ 
+ 
+ 
+ 9,136
+ 
+ 
+ 
+ 6.42
+ %
+ 
+ 
+ 116,651
+ 
+ 
+ 
+ 9,103
+ 
+ 
+ 
+ 7.80
+ %
+
+ Non-interest-earning assets
+
+ 
+ 
+ 9,607
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 11,113
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 12,920
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Total assets
+
+ 
+ $
+ 182,854
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ $
+ 153,420
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ $
+ 129,571
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Liabilities:
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Interest-bearing liabilities:
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ NOW accounts
+
+ 
+ $
+ 14,336
+ 
+ 
+ 
+ 46
+ 
+ 
+ 
+ 0.32
+ %
+ 
+ $
+ 14,462
+ 
+ 
+ 
+ 185
+ 
+ 
+ 
+ 1.28
+ %
+ 
+ $
+ 11,492
+ 
+ 
+ 
+ 231
+ 
+ 
+ 
+ 2.01
+ %
+
+ Money market
+
+ 
+ 
+ 21,245
+ 
+ 
+ 
+ 221
+ 
+ 
+ 
+ 1.04
+ %
+ 
+ 
+ 21,338
+ 
+ 
+ 
+ 450
+ 
+ 
+ 
+ 2.11
+ %
+ 
+ 
+ 17,150
+ 
+ 
+ 
+ 602
+ 
+ 
+ 
+ 3.51
+ %
+
+ Savings
+
+ 
+ 
+ 8,116
+ 
+ 
+ 
+ 40
+ 
+ 
+ 
+ 0.49
+ %
+ 
+ 
+ 10,193
+ 
+ 
+ 
+ 148
+ 
+ 
+ 
+ 1.45
+ %
+ 
+ 
+ 6,536
+ 
+ 
+ 
+ 143
+ 
+ 
+ 
+ 2.19
+ %
+
+ Time deposits
+
+ 
+ 
+ 100,798
+ 
+ 
+ 
+ 3,560
+ 
+ 
+ 
+ 3.53
+ %
+ 
+ 
+ 74,063
+ 
+ 
+ 
+ 3,427
+ 
+ 
+ 
+ 4.63
+ %
+ 
+ 
+ 62,300
+ 
+ 
+ 
+ 3,574
+ 
+ 
+ 
+ 5.74
+ %
+
+ Borrowings
+
+ 
+ 
+ 9,828
+ 
+ 
+ 
+ 272
+ 
+ 
+ 
+ 2.77
+ %
+ 
+ 
+ 4,200
+ 
+ 
+ 
+ 217
+ 
+ 
+ 
+ 5.17
+ %
+ 
+ 
+ 4,936
+ 
+ 
+ 
+ 289
+ 
+ 
+ 
+ 5.85
+ %
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Total interest-bearing
+liabilities
+
+ 
+ 
+ 154,323
+ 
+ 
+ 
+ 4,139
+ 
+ 
+ 
+ 2.68
+ %
+ 
+ 
+ 124,256
+ 
+ 
+ 
+ 4,427
+ 
+ 
+ 
+ 3.56
+ %
+ 
+ 
+ 102,414
+ 
+ 
+ 
+ 4,839
+ 
+ 
+ 
+ 4.72
+ %
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Demand deposits
+
+ 
+ 
+ 16,770
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 18,211
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 17,115
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Other non-interest-bearing
+liabilities
+
+ 
+ 
+ 934
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 797
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 596
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Total non-interest-bearing
+liabilities
+
+ 
+ 
+ 17,704
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 19,008
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 17,711
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Stockholders equity
+
+ 
+ 
+ 10,827
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 10,156
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 9,446
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Total liabilities 
+stockholders equity
+
+ 
+ $
+ 182,854
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ $
+ 153,420
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ $
+ 129,571
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Net interest income
+
+ 
+ 
+ 
+ 
+ 
+ $
+ 6,759
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ $
+ 4,709
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ $
+ 4,264
+ 
+ 
+ 
+ 
+ 
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Interest rate spread
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 3.61
+ %
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 2.86
+ %
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 3.08
+ %
+
+ Net interest margin (b)
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 3.90
+ %
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 3.31
+ %
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 3.66
+ %
+
+(a) Average loans include nonperforming loans
+
+(b) Net interest margin is net interest income divided by average total interest-earning assets
+
+ The effect of changes in average balances (volume) and rates on interest
+income, interest expense and net interest income, for the period indicated, is
+shown below. The effect of a change in average balance has been determined by
+applying the average rate in the earlier period to the change in the average
+balance of the later period, as compared with the earlier period. The effect
+of a change in the average rate has been determined by applying the average
+balance in the later period to the change in the average rate in the later
+period, as compared with the earlier period. Changes resulting from average
+balance/rate variances are allocated to the two categories based on the
+proportionate absolute changes in each category.
+
+18
+
+Table of Contents
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ 
+ 
+ For the Nine Months Ended September 30, 2004
+
+ 
+ 
+ Compared to 2003
+
+ 
+ 
+ Increase (Decrease)
+ 
+ 
+
+ 
+ 
+ Due to Change in
+ 
+ Net
+
+ 
+ 
+ Average
+ 
+ Average
+ 
+ Increase
+
+ (in thousands)
+ 
+ Volume
+ 
+ Rate
+ 
+ (Decrease)
+
+ Increase (decrease) in interest income:
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Loans
+
+ 
+ $
+ 2,657
+ 
+ 
+ $
+ (399
+ )
+ 
+ $
+ 2,258
+ 
+
+ Investment securities
+
+ 
+ 
+ (58
+ )
+ 
+ 
+ 60
+ 
+ 
+ 
+ 2
+ 
+
+ Other
+
+ 
+ 
+ (27
+ )
+ 
+ 
+ (4
+ )
+ 
+ 
+ (31
+ )
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Total interest income
+
+ 
+ 
+ 2,572
+ 
+ 
+ 
+ (343
+ )
+ 
+ 
+ 2,229
+ 
+
+ Increase (decrease) in interest expense:
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ NOW accounts
+
+ 
+ 
+ 
+ 
+ 
+ 
+ (10
+ )
+ 
+ 
+ (10
+ )
+
+ Money market
+
+ 
+ 
+ (4
+ )
+ 
+ 
+ 1
+ 
+ 
+ 
+ (3
+ )
+
+ Savings
+
+ 
+ 
+ 1
+ 
+ 
+ 
+ (15
+ )
+ 
+ 
+ (14
+ )
+
+ Time deposits
+
+ 
+ 
+ 901
+ 
+ 
+ 
+ (434
+ )
+ 
+ 
+ 467
+ 
+
+ Borrowings
+
+ 
+ 
+ 60
+ 
+ 
+ 
+ (7
+ )
+ 
+ 
+ 53
+ 
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Total interest expense
+
+ 
+ 
+ 958
+ 
+ 
+ 
+ (465
+ )
+ 
+ 
+ 493
+ 
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Total change in net interest income
+
+ 
+ $
+ 1,614
+ 
+ 
+ $
+ 122
+ 
+ 
+ $
+ 1,736
+ 
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ 
+ 
+ For the Year Ended December 31, 2003
+
+ 
+ 
+ Compared to 2002
+
+ 
+ 
+ Increase (Decrease)
+ 
+ 
+
+ 
+ 
+ Due to Change in
+ 
+ Net
+
+ 
+ 
+ Average
+ 
+ Average
+ 
+ Increase
+
+ (in thousands)
+ 
+ Volume
+ 
+ Rate
+ 
+ (Decrease)
+
+ Increase (decrease) in interest income:
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Loans
+
+ 
+ $
+ 2,267
+ 
+ 
+ $
+ (517
+ )
+ 
+ $
+ 1,750
+ 
+
+ Investment securities
+
+ 
+ 
+ 327
+ 
+ 
+ 
+ (104
+ )
+ 
+ 
+ 223
+ 
+
+ Other
+
+ 
+ 
+ (170
+ )
+ 
+ 
+ (41
+ )
+ 
+ 
+ (211
+ )
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Total interest income
+
+ 
+ 
+ 2,424
+ 
+ 
+ 
+ (662
+ )
+ 
+ 
+ 1,762
+ 
+
+ Increase (decrease) in interest expense:
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ NOW accounts
+
+ 
+ 
+ (2
+ )
+ 
+ 
+ (137
+ )
+ 
+ 
+ (139
+ )
+
+ Money market
+
+ 
+ 
+ (2
+ )
+ 
+ 
+ (227
+ )
+ 
+ 
+ (229
+ )
+
+ Savings
+
+ 
+ 
+ (25
+ )
+ 
+ 
+ (83
+ )
+ 
+ 
+ (108
+ )
+
+ Time deposits
+
+ 
+ 
+ 1,060
+ 
+ 
+ 
+ (927
+ )
+ 
+ 
+ 133
+ 
+
+ Borrowings
+
+ 
+ 
+ 191
+ 
+ 
+ 
+ (136
+ )
+ 
+ 
+ 55
+ 
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Total interest expense
+
+ 
+ 
+ 1,222
+ 
+ 
+ 
+ (1,510
+ )
+ 
+ 
+ (288
+ )
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Total change in net interest income
+
+ 
+ $
+ 1,202
+ 
+ 
+ $
+ 848
+ 
+ 
+ $
+ 2,050
+ 
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+19
+
+Table of Contents
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ 
+ 
+ For the Year Ended December 31, 2002
+
+ 
+ 
+ Compared to 2001
+
+ 
+ 
+ Increase (Decrease)
+ 
+ 
+
+ 
+ 
+ Due to Change in
+ 
+ Net
+
+ 
+ 
+ Average
+ 
+ Average
+ 
+ Increase
+
+ (in thousands)
+ 
+ Volume
+ 
+ Rate
+ 
+ (Decrease)
+
+ Increase (decrease) in interest income:
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Loans
+
+ 
+ $
+ 1,966
+ 
+ 
+ $
+ (1,544
+ )
+ 
+ $
+ 422
+ 
+
+ Investment securities
+
+ 
+ 
+ 52
+ 
+ 
+ 
+ (141
+ )
+ 
+ 
+ (89
+ )
+
+ Other
+
+ 
+ 
+ (5
+ )
+ 
+ 
+ (295
+ )
+ 
+ 
+ (300
+ )
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Total interest income
+
+ 
+ 
+ 2,013
+ 
+ 
+ 
+ (1,980
+ )
+ 
+ 
+ 33
+ 
+
+ Increase (decrease) in interest expense:
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ NOW accounts
+
+ 
+ 
+ 51
+ 
+ 
+ 
+ (97
+ )
+ 
+ 
+ (46
+ )
+
+ Money market
+
+ 
+ 
+ 125
+ 
+ 
+ 
+ (277
+ )
+ 
+ 
+ (152
+ )
+
+ Savings
+
+ 
+ 
+ 63
+ 
+ 
+ 
+ (58
+ )
+ 
+ 
+ 5
+ 
+
+ Time deposits
+
+ 
+ 
+ 610
+ 
+ 
+ 
+ (757
+ )
+ 
+ 
+ (147
+ )
+
+ Borrowings
+
+ 
+ 
+ (40
+ )
+ 
+ 
+ (32
+ )
+ 
+ 
+ (72
+ )
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Total interest expense
+
+ 
+ 
+ 809
+ 
+ 
+ 
+ (1,221
+ )
+ 
+ 
+ (412
+ )
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Total change in net interest income
+
+ 
+ $
+ 1,204
+ 
+ 
+ $
+ (759
+ )
+ 
+ $
+ 445
+ 
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ The nearly $1.7 million increase in the first nine months of 2004 in net
+interest income compared to the comparable period in 2003 and the $2.0 million
+increase in 2003 net interest income compared to 2002 reflect the impact of
+higher earning asset volumes and a stronger reduction in interest expense
+compared to interest income, resulting in an increased net interest spread.
+The $445,000 increase in net interest income in 2002 compared to 2001 reflects
+the impact of higher earning asset volumes, which was offset by a stronger
+reduction in interest income versus interest expense, resulting in a decreased
+net interest spread.
+
+Liquidity and Rate Sensitivity
+
+ Liquidity management involves the ability to meet the cash flow
+requirements of customers who may be either depositors wanting to withdraw
+their funds or borrowers needing assurance that sufficient funds will be
+available to meet their credit needs. In the ordinary course of business, our
+cash flows are generated from interest and fee income, as well as from loan
+repayments, the sale or maturity of investments available-for-sale, and the
+maturity of investment securities held-to-maturity. In addition to cash and
+due from banks, we consider all securities available-for-sale and federal funds
+sold as primary sources of asset liquidity. Many factors affect the ability to
+accomplish these liquidity objectives successfully, including the economic
+environment, the asset/liability mix within the balance sheet, as well as our
+reputation in the community. Our principal sources of funds are net increases
+in deposits, principal and interest payments on loans and proceeds from sales
+and maturities of investments. We use resources primarily to fund existing and
+continuing loan commitments and to purchase investment securities. At
+September 30, 2004 and December 31, 2003, we had commitments to originate loans
+totaling $26,166,000
+and $24,368,000, respectively, and had issued standby letters of credit of
+$312,000 and $138,000, respectively. Scheduled maturities of certificates of
+deposit during the twelve months following September 30, 2004 and December 31,
+2003 totaled $56 million and $44 million, respectively. Management believes
+that at September 30, 2004 we had adequate resources to fund all our
+commitments, that substantially all of our existing commitments will be funded
+in the subsequent twelve months and, if so desired, that we can adjust the
+rates on certificates of deposit and other deposit accounts to retain deposits
+in a changing interest rate environment.
+
+20
+
+Table of Contents
+
+ Closely related to liquidity management is the management of
+interest-earning assets and interest-bearing liabilities. The Company manages
+its rate sensitivity position to avoid wide swings in net interest margins and
+to minimize risk due to changes in interest rates.
+
+ Our interest rate sensitivity position at September 30, 2004 is presented
+in the table below.
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ 
+ 
+ 3 Months
+ 
+ 4 to 6
+ 
+ 7 to 12
+ 
+ 1 to 5
+ 
+ Over 5
+ 
+ 
+
+ 
+ 
+ or Less
+ 
+ Months
+ 
+ Months
+ 
+ Years
+ 
+ Years
+ 
+ Total
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ (Dollars in thousands)
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Interest-earning assets:
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Loans
+
+ 
+ $
+ 80,353
+ 
+ 
+ $
+ 7,952
+ 
+ 
+ $
+ 12,233
+ 
+ 
+ $
+ 107,400
+ 
+ 
+ $
+ 5,110
+ 
+ 
+ $
+ 213,048
+ 
+
+ Investment securities
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 495
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 2,000
+ 
+ 
+ 
+ 13,067
+ 
+ 
+ 
+ 15,562
+ 
+
+ Federal funds sold
+
+ 
+ 
+ 4,022
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 4,022
+ 
+
+ FHLB stock
+
+ 
+ 
+ 900
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 900
+ 
+
+ Interest bearing deposit in other banks
+
+ 
+ 
+ 232
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 232
+ 
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Total interest bearing assets
+
+ 
+ 
+ 85,507
+ 
+ 
+ 
+ 8,447
+ 
+ 
+ 
+ 12,233
+ 
+ 
+ 
+ 109,400
+ 
+ 
+ 
+ 18,177
+ 
+ 
+ 
+ 233,764
+ 
+
+ Interest-bearings liabilities:
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ NOW accounts
+
+ 
+ 
+ 14,351
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 14,351
+ 
+
+ Money market
+
+ 
+ 
+ 22,005
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 22,005
+ 
+
+ Savings deposits
+
+ 
+ 
+ 8,515
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 8,515
+ 
+
+ Time deposits
+
+ 
+ 
+ 16,348
+ 
+ 
+ 
+ 18,027
+ 
+ 
+ 
+ 21,858
+ 
+ 
+ 
+ 77,636
+ 
+ 
+ 
+ 20
+ 
+ 
+ 
+ 133,889
+ 
+
+ Other borrowings
+
+ 
+ 
+ 19,000
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 3,000
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 22,000
+ 
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Total interest-bearing liabilities
+
+ 
+ 
+ 80,219
+ 
+ 
+ 
+ 18,027
+ 
+ 
+ 
+ 21,858
+ 
+ 
+ 
+ 80,636
+ 
+ 
+ 
+ 20
+ 
+ 
+ 
+ 200,760
+ 
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Interest sensitivity gap
+
+ 
+ $
+ 5,288
+ 
+ 
+ $
+ (9,580
+ )
+ 
+ $
+ (9,625
+ )
+ 
+ $
+ 28,764
+ 
+ 
+ $
+ 18,157
+ 
+ 
+ $
+ 33,004
+ 
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Cumulative interest sensitivity gap
+
+ 
+ $
+ 5,288
+ 
+ 
+ $
+ (4,292
+ )
+ 
+ $
+ (13,917
+ )
+ 
+ $
+ 14,847
+ 
+ 
+ $
+ 33,004
+ 
+ 
+ $
+ 33,004
+ 
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Cumulative sensitivity ratio
+
+ 
+ 
+ 2.26
+ %
+ 
+ 
+ (1.84
+ )%
+ 
+ 
+ (5.95
+ )%
+ 
+ 
+ 6.35
+ %
+ 
+ 
+ 14.12
+ %
+ 
+ 
+ 14.12
+ %
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ We are cumulatively liability sensitive through the one-year time period,
+and asset sensitive in the over one year timeframes above. Certain liabilities
+such as NOW and passbook savings accounts, while technically subject to
+immediate repricing in response to changing market rates, historically do not
+reprice as quickly nor to the extent as other interest-sensitive accounts.
+Nevertheless, if market interest rates should decrease, it is anticipated that
+our net interest margin would decrease due to many interest-bearing liabilities
+with current rates so low that further reductions could not be significant.
+Because of non-interest-bearing liabilities, total interest-earning assets are
+substantially greater than the total interest-bearing liabilities and therefore
+it is anticipated that over time the effects on net interest income from
+changes in asset yield will be greater than the change in expense from
+liability cost. Therefore, if rates
+increase it is anticipated that the net interest margin would over time
+increase and this is particularly true over longer time horizons since we have
+more total assets subject to rate changes than total liabilities that are rate
+sensitive.
+
+21
+
+Table of Contents
+
+ Even in the near term, we believe the $13.9 million one year cumulative
+negative sensitivity gap may exaggerate the probable effects on earnings in a
+rising rate environment for two reasons. First, the liabilities subject to
+repricing are predominately not indexed to any specific market rate and
+therefore offer us the opportunity to delay or diminish any rate repricings.
+Further, in this current rate environment, the Company has been originating
+loans with interest rate floors. The effect of this has been to decrease the
+volatility of net interest margin and decrease asset sensitivity due to the
+fact that these loans behave similar to fixed rate loans in periods over a
+significant range of interest rate changes.
+
+ Interest-earning assets and time deposits are presented based on their
+contractual terms. It is anticipated that run off in any deposit category will
+be approximately offset by new deposit generation.
+
+ Since we have experienced steady growth in deposits, no net run off in any
+deposit category is assumed in the interest rate sensitivity table. It is our
+policy to maintain our cumulative one year gap ratio in the 20% to (20)% range.
+At September 30, 2004, the Company was within this range with a one year
+cumulative sensitivity ratio of (6)%.
+
+Capital Resources
+
+ Our consolidated stockholders equity was $14.5 million at September 30,
+2004, $11.1 million at December 31, 2003 and $10.5 million at December 31,
+2002. The net increase in stockholders equity during the first nine months of
+2004 consisted of net proceeds of $1,848,000 from our private offering of
+common stock in early 2004, $1.4 million net income and the change in net
+unrealized loss on securities available-for-sale (from $(121,000) at December
+31, 2003 to $(93,000) at September 30, 2004). The net increase in
+stockholders equity during 2003 consisted of $795,000 net income and the
+change in net unrealized loss on securities available-for-sale (from $108,000
+at December 31, 2002 to $(121,000) at December 31, 2003). Our total
+stockholders equity was 5.95%, 5.23% and 6.87% of total assets as of September
+30, 2004, December 31, 2003 and 2002, respectively. Our average equity to
+average assets for the first nine months of 2004 and 2003, and for the years
+2003, 2002, 2001, was 6.27%, 6.10%, 5.92%, 6.62% and 7.29%, respectively.
+
+ The federal banking regulatory authorities have adopted certain prompt
+corrective action rules with respect to depository institutions. The rules
+establish five capital tiers: well capitalized, adequately capitalized, 
+ undercapitalized, significantly undercapitalized, and critically
+undercapitalized. The various federal banking regulatory agencies have
+adopted regulations to implement the capital rules by, among other things,
+defining the relevant capital measures for the five capital categories. An
+institution is deemed to be well capitalized if it has a total risk-based
+capital ratio of 10% or greater, a Tier 1 risk-based capital ratio of 6% or
+greater, and a Tier 1 leverage ratio of 5% or greater and is not subject to a
+regulatory order, agreement, or directive to meet and maintain a specific
+capital level. At December 31, 2003, the Bank met the capital ratios of an
+ adequately capitalized financial institution with a total risk-based capital
+ratio of 9.34%, a Tier 1 risk-based capital ratio of 8.11%, and a Tier 1
+leverage ratio of 7.45%. At September 30, 2004, the Bank met the capital
+ratios of an adequately capitalized financial institution with a total
+risk-based capital ratio of 9.76%, a Tier 1 risk-based capital ratio of 8.53%,
+and Tier 1 leverage ratio of 7.88%. Depository institutions which fall below
+the adequately capitalized category generally are prohibited from making any
+capital distribution, are subject to growth limitations, and are required to
+submit a capital restoration plan. There are a number of requirements and
+restrictions that may
+be imposed on institutions treated as significantly undercapitalized 
+and, if the institution is critically undercapitalized, the banking
+regulatory agencies have the right to appoint a receiver or conservator.
+
+ In accordance with risk-based capital guidelines issued by the Federal
+Reserve Board and the FDIC, we are required to maintain a minimum standard of
+total capital to risk-weighted assets of 8%. Additionally, the FDIC requires
+banks to maintain a minimum leverage-capital ratio of Tier 1 capital (as
+defined) to total assets. The leverage-capital ratio ranges from 3% to 5%
+based on our rating under the regulatory rating system. The required
+leverage-capital ratio for us at December 31, 2003 and December 31, 2002 was
+4%. The following table summarizes our capital ratios at the dates indicated,
+as well as those required to be maintained by a well-capitalized financial
+institution:
+
+22
+
+Table of Contents
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ Regulatory Requirement
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ to be
+
+ 
+ 
+ Actual
+ 
+ Actual Company
+ 
+ Adequately
+ 
+ 
+
+ 
+ 
+ Bank Ratios
+ 
+ Ratios
+ 
+ Capitalized
+ 
+ Well Capitalized
+
+ At September 30, 2004:
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Total capital to risk-weighted assets
+
+ 
+ 
+ 9.76
+ %
+ 
+ 
+ 8.02
+ %
+ 
+ 
+ 8.00
+ %
+ 
+ 
+ 10.00
+ %
+
+ Tier I capital to risk-weighted assets
+
+ 
+ 
+ 8.53
+ %
+ 
+ 
+ 6.79
+ %
+ 
+ 
+ 4.00
+ %
+ 
+ 
+ 6.00
+ %
+
+ Tier I capital to total assets -
+leverage ratio
+
+ 
+ 
+ 7.88
+ %
+ 
+ 
+ 6.28
+ %
+ 
+ 
+ 4.00
+ %
+ 
+ 
+ 5.00
+ %
+
+ At December 31, 2003:
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Total capital to risk-weighted assets
+
+ 
+ 
+ 9.34
+ %
+ 
+ 
+ 7.29
+ %
+ 
+ 
+ 8.00
+ %
+ 
+ 
+ 10.00
+ %
+
+ Tier I capital to risk-weighted assets
+
+ 
+ 
+ 8.11
+ %
+ 
+ 
+ 6.06
+ %
+ 
+ 
+ 4.00
+ %
+ 
+ 
+ 6.00
+ %
+
+ Tier I capital to total assets -
+leverage ratio
+
+ 
+ 
+ 7.45
+ %
+ 
+ 
+ 5.58
+ %
+ 
+ 
+ 4.00
+ %
+ 
+ 
+ 5.00
+ %
+
+ At December 31, 2002:
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Total capital to risk-weighted assets
+
+ 
+ 
+ 10.26
+ %
+ 
+ 
+ 9.55
+ %
+ 
+ 
+ 8.00
+ %
+ 
+ 
+ 10.00
+ %
+
+ Tier I capital to risk-weighted assets
+
+ 
+ 
+ 9.01
+ %
+ 
+ 
+ 8.30
+ %
+ 
+ 
+ 4.00
+ %
+ 
+ 
+ 6.00
+ %
+
+ Tier I capital to total assets -
+leverage ratio
+
+ 
+ 
+ 7.43
+ %
+ 
+ 
+ 6.84
+ %
+ 
+ 
+ 4.00
+ %
+ 
+ 
+ 5.00
+ %
+
+Lending Activities
+
+ A significant source of our income is the interest earned on the
+loan portfolio. At September 30, 2004, our total assets were $243
+million and loans receivable, net were $210 million or 86.3% of total
+assets. At December 31, 2003, our total assets were $212 million and
+loans receivable, net were $180 million or 84.7% of total assets. At
+December 31, 2002, our total assets were $153 million and our loans
+receivable, net were $120 million or 78.3% of total assets. The
+increase in net loans receivable from December 31, 2002 to December 31,
+2003 was $60 million or 50%.
+
+ Our primary market area consists of the West Central Florida region
+(consisting primarily of Sarasota and Pinellas Counties and surrounding
+areas). Our market area s economic base is diversified. Significant
+industries include hospitality and tourism, service enterprises,
+technology and information concerns, agribusiness and manufacturing.
+The area has experienced considerable growth over the past several
+years. However, there is no assurance that this area will continue to
+experience economic growth. Adverse conditions in any one or more of
+the industries operating in such markets or a slow-down in general
+economic conditions could have an adverse effect on us.
+
+ Lending activities are conducted pursuant to a written policy which
+has been adopted by us. Each loan officer has defined lending authority
+beyond which loans, depending upon their type and size, must be reviewed
+and approved by a loan committee comprised of certain officers and
+directors. Under Florida law, our Bank can lend to any one person up to
+15% of our capital on an unsecured basis, and an additional 10% on a
+secured basis. As of September 30, 2004, our largest credit
+relationship, which did not exceed these limitations, was $3.9 million,
+or 21.4% of total capital.
+
+ At September 30, 2004, December 31, 2003, 2002, 2001, 2000 and
+1999, the composition of our loan portfolio was as follows:
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ 
+ 
+ At September 30,
+ 
+ At December 31,
+
+ (in thousands)
+ 
+ 2004
+ 
+ 2003
+ 
+ 2002
+ 
+ 2001
+ 
+ 2000
+ 
+ 1999
+
+ Commercial
+
+ 
+ $
+ 34,437
+ 
+ 
+ $
+ 31,860
+ 
+ 
+ $
+ 26,338
+ 
+ 
+ $
+ 22,475
+ 
+ 
+ $
+ 22,950
+ 
+ 
+ $
+ 25,879
+ 
+
+ Real estate:
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Residential
+
+ 
+ 
+ 32,452
+ 
+ 
+ 
+ 27,660
+ 
+ 
+ 
+ 22,112
+ 
+ 
+ 
+ 19,417
+ 
+ 
+ 
+ 10,271
+ 
+ 
+ 
+ 12,282
+ 
+
+23
+
+Table of Contents
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ 
+ 
+ At September 30,
+ 
+ At December 31,
+
+ (in thousands)
+ 
+ 2004
+ 
+ 2003
+ 
+ 2002
+ 
+ 2001
+ 
+ 2000
+ 
+ 1999
+
+ Commercial
+
+ 
+ 
+ 121,673
+ 
+ 
+ 
+ 104,586
+ 
+ 
+ 
+ 60,424
+ 
+ 
+ 
+ 52,551
+ 
+ 
+ 
+ 35,481
+ 
+ 
+ 
+ 34,801
+ 
+
+ Construction
+
+ 
+ 
+ 18,778
+ 
+ 
+ 
+ 12,799
+ 
+ 
+ 
+ 9,268
+ 
+ 
+ 
+ 10,468
+ 
+ 
+ 
+ 9,928
+ 
+ 
+ 
+ 7,942
+ 
+
+ Consumer and other
+
+ 
+ 
+ 5,708
+ 
+ 
+ 
+ 5,622
+ 
+ 
+ 
+ 3,857
+ 
+ 
+ 
+ 3,512
+ 
+ 
+ 
+ 3,297
+ 
+ 
+ 
+ 2,853
+ 
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ 
+
+ 
+ 
+ 213,048
+ 
+ 
+ 
+ 182,527
+ 
+ 
+ 
+ 121,999
+ 
+ 
+ 
+ 108,423
+ 
+ 
+ 
+ 81,927
+ 
+ 
+ 
+ 83,757
+ 
+
+ Less: Net deferred loan fees
+
+ 
+ 
+ (702
+ )
+ 
+ 
+ (491
+ )
+ 
+ 
+ (160
+ )
+ 
+ 
+ (98
+ )
+ 
+ 
+ (167
+ )
+ 
+ 
+ (169
+ )
+
+ Allowance
+for loan
+losses
+
+ 
+ 
+ (2,690
+ )
+ 
+ 
+ (2,275
+ )
+ 
+ 
+ (1,693
+ )
+ 
+ 
+ (1,401
+ )
+ 
+ 
+ (1,481
+ )
+ 
+ 
+ (1,255
+ )
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Loans, net
+
+ 
+ $
+ 209,656
+ 
+ 
+ $
+ 179,761
+ 
+ 
+ $
+ 120,146
+ 
+ 
+ $
+ 106,924
+ 
+ 
+ $
+ 80,279
+ 
+ 
+ $
+ 82,333
+ 
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ The contractual maturity distribution of our loan portfolio at
+December 31, 2003 is indicated in the table below. The majority of
+these are amortizing loans.
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ 
+ 
+ Loans Maturing
+
+ 
+ 
+ Within
+ 
+ 1 to 5
+ 
+ After
+ 
+ 
+
+ (in thousands)
+ 
+ 1 Year
+ 
+ Years
+ 
+ 5 Years
+ 
+ Total
+
+ Commercial
+
+ 
+ $
+ 16,798
+ 
+ 
+ $
+ 7,674
+ 
+ 
+ $
+ 7,388
+ 
+ 
+ $
+ 31,860
+ 
+
+ Real estate:
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Residential
+
+ 
+ 
+ 7,237
+ 
+ 
+ 
+ 7,955
+ 
+ 
+ 
+ 12,468
+ 
+ 
+ 
+ 27,660
+ 
+
+ Commercial
+
+ 
+ 
+ 6,660
+ 
+ 
+ 
+ 16,617
+ 
+ 
+ 
+ 81,309
+ 
+ 
+ 
+ 104,586
+ 
+
+ Construction
+
+ 
+ 
+ 5,253
+ 
+ 
+ 
+ 5,139
+ 
+ 
+ 
+ 2,407
+ 
+ 
+ 
+ 12,799
+ 
+
+ Consumer and other
+
+ 
+ 
+ 1,193
+ 
+ 
+ 
+ 2,815
+ 
+ 
+ 
+ 1,614
+ 
+ 
+ 
+ 5,622
+ 
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Total
+
+ 
+ $
+ 37,141
+ 
+ 
+ $
+ 40,200
+ 
+ 
+ $
+ 105,186
+ 
+ 
+ $
+ 182,527
+ 
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ 
+ 
+ Loans Maturing
+
+ 
+ 
+ Within
+ 
+ 1 to 5
+ 
+ After
+ 
+ 
+
+ (in thousands)
+ 
+ 1 Year
+ 
+ Years
+ 
+ 5 Years
+ 
+ Total
+
+ Loans with:
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Predetermined interest rates
+
+ 
+ $
+ 10,249
+ 
+ 
+ $
+ 16,653
+ 
+ 
+ $
+ 4,766
+ 
+ 
+ $
+ 31,668
+ 
+
+ Floating or adjustable rates
+
+ 
+ 
+ 26,891
+ 
+ 
+ 
+ 23,547
+ 
+ 
+ 
+ 100,421
+ 
+ 
+ 
+ 150,859
+ 
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Total
+
+ 
+ $
+ 37,140
+ 
+ 
+ $
+ 40,200
+ 
+ 
+ $
+ 105,187
+ 
+ 
+ $
+ 182,527
+ 
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+Loan Quality
+
+ Management seeks to maintain a high quality of loans through sound
+underwriting and lending practices. As of September 30, 2004 and
+December 31, 2003 and 2002 approximately 81.16%, 79.46% and 75.25%,
+respectively, of the total loan portfolio was collateralized by
+commercial and residential real estate mortgages. The level of
+nonperforming loans also is relevant to the credit quality of a loan
+portfolio. As of September 30, 2004, December 31, 2003 and 2002, total
+nonperforming loans (those 90 days or more past due) totaled $923,000 or
+.43%, $1,249,000 or .68%, and $1,238,000 or 1.01% of total loans,
+respectively. There was no other real estate owned at September 30,
+2004 and December 31, 2003.
+
+ The commercial real estate mortgage loans in our portfolio consist of
+fixed- and adjustable-interest
+
+24
+
+Table of Contents
+
+rate loans which were
+originated at prevailing market interest rates. Our policy has been
+to originate commercial real estate mortgage loans predominantly in
+our primary market area. Commercial real estate mortgage loans are generally made in amounts up to 80% of the
+appraised value of the property securing the loan and entail significant
+additional risks compared to residential mortgage loans. In making commercial
+real estate loans, we primarily consider the net operating income generated by
+the real estate to support the debt service, the financial resources and income
+level and managerial expertise of the borrower, the marketability of the
+collateral and our lending experience with the borrower.
+
+ Unlike residential mortgage loans, which generally are made on the basis
+of the borrower s ability to make repayment from his employment and other
+income and which are collateralized by real property whose value tends to be
+more readily ascertainable, commercial loans typically are underwritten on the
+basis of the borrower s ability to make repayment from the cash flow of his
+business and generally are collateralized by business assets, such as accounts
+receivable, equipment and inventory. As a result, the availability of funds
+for the repayment of commercial loans may be substantially dependent on the
+success of the business itself, which is subject to adverse conditions in the
+economy. Commercial loans also entail certain additional risks since they
+usually involve large loan balances to single borrowers or a related group of
+borrowers, resulting in a more concentrated loan portfolio. Further, the
+collateral underlying the loans may depreciate over time, cannot be appraised
+with as much precision as residential real estate, and may fluctuate in value
+based on the success of the business.
+
+ We make consumer and personal loans on a collateralized and
+noncollateralized basis. These loans are often collateralized by automobiles,
+
+recreational vehicles and mobile homes. Our policy is not to advance more than
+80% of collateral value and that the borrower have established over one year of
+residence and demonstrated an ability to repay a similar debt according to
+credit bureau reports. Consumer and personal loans also are generated. Such
+loans generally have a term of 120 months or less.
+
+ From time to time, we will originate loans on an unsecured basis. At
+September 30, 2004, December 31, 2003 and 2002, unsecured loans totaled $1.35
+million, $2.27 million and $2.94 million, respectively.
+
+ Loan concentrations are defined as amounts loaned to a number of borrowers
+engaged in similar activities which would cause them to be similarly impacted
+by economic or other conditions. As of September 30, 2004 and December 31,
+2003 and 2002, no concentration of loans within any portfolio category to any
+group of borrowers engaged in similar activities or in a similar business
+exceeded 20% of total loans, except that as of such dates loans collateralized
+with mortgages on real estate represented 81.16%, 79.46% and 75.25%,
+respectively, of the loan portfolio and were to borrowers in varying activities
+and businesses.
+
+ The Loan Committee of the Board of Directors concentrates its efforts and
+resources, and that of its senior management and lending officers, on loan
+review and underwriting procedures. Internal controls include ongoing reviews
+of loans made to monitor documentation and the existence and valuations of
+collateral. In addition, management has established a review process with the
+objective of identifying, evaluating, and initiating necessary corrective
+action for marginal loans. The goal of the loan review process is to address
+classified and nonperforming loans as early as possible.
+
+Classification of Assets
+
+ Generally, interest on loans accrues and is credited to income based upon
+the principal balance outstanding. It is management s policy to discontinue
+the accrual of interest income and classify a loan as non-accrual when
+principal or interest is past due 90 days or more unless, in the
+determination of management, the principal and interest on the loan are
+well collateralized and in the process of collection. In all cases, loans are
+placed on nonaccrual or charged-off at an earlier date if collection of
+principal and interest is considered doubtful. Consumer installment loans are
+generally charged-off after 90 days of delinquency unless adequately
+collateralized and in the process of collection. Loans are not returned to
+accrual status until principal and interest payments are brought current and
+future payments appear reasonably certain. Interest accrued and unpaid at the
+time a loan is placed on nonaccrual status is charged
+
+25
+
+Table of Contents
+
+against interest income.
+
+ Real estate acquired by us as a result of foreclosure or by deed in lieu
+of foreclosure is classified as other real estate owned ( OREO ). OREO
+properties are recorded at the lower of cost or fair value less estimated
+selling costs, and the estimated loss, if any, is charged to the allowance for
+credit losses at the time it is transferred to OREO. Further write-downs in
+OREO are recorded at the time management believes additional deterioration in
+value has occurred and are charged to noninterest expense.
+
+ We account for impaired loans under Statements of Financial Accounting
+Standards No. 114 and 118. These Statements address the accounting by
+creditors for impairment of certain loans and generally require us to identify
+loans, for which we probably will not receive full repayment of principal and
+interest, as impaired loans. The Statements require that impaired loans be
+valued at the present value of expected future cash flows, discounted at the
+loan s effective interest rate, or at the observable market price of the loan,
+or the fair value of the underlying collateral if the loan is collateral
+dependent. We have implemented the Statements by modifying its quarterly
+review of the adequacy of the allowance for credit losses to also identify and
+value impaired loans in accordance with guidance in the Statements.
+
+ As of the dates indicated, loans on non-accrual status and other real
+estate owned and certain other related information were as follows:
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ 
+ 
+ 
+ 
+ 
+
+ 
+ 
+ At
+September 30,
+ 
+ At December 31,
+
+ (dollars in thousands)
+ 
+ 2004
+ 
+ 2003
+ 
+ 2002
+ 
+ 2001
+ 
+ 2000
+ 
+ 1999
+
+ Total nonaccrual loans
+
+ 
+ $
+ 923
+ 
+ 
+ $
+ 1,249
+ 
+ 
+ $
+ 866
+ 
+ 
+ $
+ 295
+ 
+ 
+ $
+ 1,017
+ 
+ 
+ $
+ 359
+ 
+
+ Accruing loans delinquent
+90 days or more
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 372
+ 
+ 
+ 
+ 700
+ 
+ 
+ 
+ 101
+ 
+ 
+ 
+ 458
+ 
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Total nonperforming loans
+
+ 
+ 
+ 923
+ 
+ 
+ 
+ 1,249
+ 
+ 
+ 
+ 1,238
+ 
+ 
+ 
+ 995
+ 
+ 
+ 
+ 1,118
+ 
+ 
+ 
+ 817
+ 
+
+ Repossessed personal property
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 63
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Other real estate owned
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 474
+ 
+ 
+ 
+ 487
+ 
+ 
+ 
+ 164
+ 
+ 
+ 
+ 802
+ 
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Total nonperforming assets
+
+ 
+ $
+ 923
+ 
+ 
+ $
+ 1,249
+ 
+ 
+ $
+ 1,712
+ 
+ 
+ $
+ 1,545
+ 
+ 
+ $
+ 1,282
+ 
+ 
+ $
+ 1,619
+ 
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Allowance for loan losses
+
+ 
+ $
+ 2,690
+ 
+ 
+ $
+ 2,275
+ 
+ 
+ $
+ 1,693
+ 
+ 
+ $
+ 1,401
+ 
+ 
+ $
+ 1,481
+ 
+ 
+ $
+ 1,255
+ 
+
+ Nonperforming assets as a
+percent of total assets
+
+ 
+ 
+ 0.38
+ %
+ 
+ 
+ 0.59
+ %
+ 
+ 
+ 1.12
+ %
+ 
+ 
+ 1.05
+ %
+ 
+ 
+ 1.03
+ %
+ 
+ 
+ 1.36
+ %
+
+ Nonperforming loans as a
+percent of total loans
+
+ 
+ 
+ 0.43
+ %
+ 
+ 
+ 0.68
+ %
+ 
+ 
+ 1.01
+ %
+ 
+ 
+ 0.92
+ %
+ 
+ 
+ 1.36
+ %
+ 
+ 
+ 0.98
+ %
+
+ Allowance for loan losses as a
+percent of nonperforming loans
+
+ 
+ 
+ 291.44
+ %
+ 
+ 
+ 182.15
+ %
+ 
+ 
+ 136.75
+ %
+ 
+ 
+ 140.80
+ %
+ 
+ 
+ 132.47
+ %
+ 
+ 
+ 153.61
+ %
+
+ The gross interest income that would have been recorded for the nine
+months ended September 30, 2004, if the above nonperforming loans had been
+current in accordance with their original terms totaled $59,000. The amount
+of interest income on those loans that was included in net income for the
+period was approximately $300.
+
+ In addition to the nonperforming loans identified above, the Company has
+identified $1,187,000 of additional potential problem loans at September 30,
+2004.
+
+ As of September 30, 2004, non-accrual loans totaled $923,000. This figure
+was comprised of nine customer relationships. The two largest customer
+relationships represent $863,000 or 93.5% of nonaccrual loans. The
+relationships consisted of seven commercial real estate investment properties
+with a chronic
+
+26
+
+Table of Contents
+
+delinquency history and borrower/guarantor in bankruptcy.
+
+ Monthly, management evaluates the collectibility of its nonperforming
+loans and the adequacy of its allowance for loan losses to absorb the
+identified and unidentified losses inherent in the loan portfolio. As a result
+of these evaluations, loans considered uncollectible are charged-off and
+adjustments to the reserve considered necessary are provided through a
+provision charged against earnings. These evaluations consider the current
+economic environment, the real estate market and its impact on underlying
+collateral values, trends in the level of nonperforming and past-due loans, and
+changes in the size and composition of the loan portfolio.
+
+ The allowance for loan losses totaled approximately $2,690,000, $2,275,000
+and $1,693,000 at September 30, 2004 and December 31, 2003 and 2002,
+respectively. As of September 30, 2004 net loans charged-off totaled $103,000.
+The years ended December 31, 2003 and 2002 had net loans charged-off of
+$468,000 and $107,000, respectively. At September 30, 2004, December 31, 2003
+and 2002, nonperforming loans totaled $923,000, $1,249,000 and $1,238,000
+respectively, or .43%, .68% and 1.01%, respectively, of total loans
+outstanding. Considering the nature of our loan portfolio, management believes
+that the allowance for credit losses at September 30, 2004 is adequate.
+
+ During the nine months ended September 30, 2004 and 2003 and the years
+ended December 31, 2003, 2002, 2001, 2000 and 1999, the activity in our
+allowance for credit losses was as follows:
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ 
+ 
+ Nine months Ended
+ 
+ 
+
+ 
+ 
+ September 30,
+ 
+ Year Ended December 31,
+
+ (in thousands)
+ 
+ 2004
+ 
+ 2003
+ 
+ 2003
+ 
+ 2002
+ 
+ 2001
+ 
+ 2000
+ 
+ 1999
+
+ Allowance at beginning of period
+
+ 
+ $
+ 2,275
+ 
+ 
+ $
+ 1,693
+ 
+ 
+ $
+ 1,693
+ 
+ 
+ $
+ 1,401
+ 
+ 
+ $
+ 1,481
+ 
+ 
+ $
+ 1,255
+ 
+ 
+ 
+ 1,034
+ 
+
+ Loans charged-off:
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Real estate
+
+ 
+ 
+ 26
+ 
+ 
+ 
+ 184
+ 
+ 
+ 
+ 249
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 25
+ 
+ 
+ 
+ 38
+ 
+ 
+ 
+ 
+ 
+
+ Commercial
+
+ 
+ 
+ 6
+ 
+ 
+ 
+ 60
+ 
+ 
+ 
+ 168
+ 
+ 
+ 
+ 91
+ 
+ 
+ 
+ 303
+ 
+ 
+ 
+ 151
+ 
+ 
+ 
+ 
+ 
+
+ Consumer
+
+ 
+ 
+ 124
+ 
+ 
+ 
+ 103
+ 
+ 
+ 
+ 118
+ 
+ 
+ 
+ 21
+ 
+ 
+ 
+ 135
+ 
+ 
+ 
+ 32
+ 
+ 
+ 
+ 
+ 
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Total loans charged-off
+
+ 
+ 
+ 156
+ 
+ 
+ 
+ 347
+ 
+ 
+ 
+ 535
+ 
+ 
+ 
+ 112
+ 
+ 
+ 
+ 463
+ 
+ 
+ 
+ 221
+ 
+ 
+ 
+ 
+ 
+
+ Recoveries:
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Real estate
+
+ 
+ 
+ 3
+ 
+ 
+ 
+ 7
+ 
+ 
+ 
+ 7
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 113
+ 
+ 
+ 
+ 
+ 
+
+ Commercial
+
+ 
+ 
+ 17
+ 
+ 
+ 
+ 11
+ 
+ 
+ 
+ 46
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 40
+ 
+ 
+ 
+ 6
+ 
+ 
+ 
+ 
+ 
+
+ Consumer
+
+ 
+ 
+ 33
+ 
+ 
+ 
+ 13
+ 
+ 
+ 
+ 14
+ 
+ 
+ 
+ 5
+ 
+ 
+ 
+ 3
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 4
+ 
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Total recoveries
+
+ 
+ 
+ 53
+ 
+ 
+ 
+ 31
+ 
+ 
+ 
+ 67
+ 
+ 
+ 
+ 5
+ 
+ 
+ 
+ 43
+ 
+ 
+ 
+ 119
+ 
+ 
+ 
+ 4
+ 
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Net loans charged-off
+
+ 
+ 
+ 103
+ 
+ 
+ 
+ 316
+ 
+ 
+ 
+ 468
+ 
+ 
+ 
+ 107
+ 
+ 
+ 
+ 420
+ 
+ 
+ 
+ 102
+ 
+ 
+ 
+ (4
+ )
+
+ Provision for credit losses
+charged to expense
+
+ 
+ 
+ 518
+ 
+ 
+ 
+ 696
+ 
+ 
+ 
+ 1,050
+ 
+ 
+ 
+ 399
+ 
+ 
+ 
+ 340
+ 
+ 
+ 
+ 328
+ 
+ 
+ 
+ 217
+ 
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+27
+
+Table of Contents
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ 
+ 
+ Nine months Ended
+ 
+ 
+
+ 
+ 
+ September 30,
+ 
+ Year Ended December 31,
+
+ (in thousands)
+ 
+ 2004
+ 
+ 2003
+ 
+ 2003
+ 
+ 2002
+ 
+ 2001
+ 
+ 2000
+ 
+ 1999
+
+ Allowance at end of period
+
+ 
+ $
+ 2,690
+ 
+ 
+ $
+ 2,073
+ 
+ 
+ $
+ 2,275
+ 
+ 
+ $
+ 1,693
+ 
+ 
+ $
+ 1,401
+ 
+ 
+ $
+ 1,481
+ 
+ 
+ $
+ 1,255
+ 
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Net charge-offs
+as a percentage
+of average loans outstanding
+
+ 
+ 
+ 0.05
+ %
+ 
+ 
+ 0.22
+ %
+ 
+ 
+ 0.32
+ %
+ 
+ 
+ 0.09
+ %
+ 
+ 
+ 0.46
+ %
+ 
+ 
+ 0.12
+ %
+ 
+ 
+ (0.01
+ )%
+
+28
+
+Table of Contents
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ 
+ 
+ Nine months Ended
+ 
+ 
+
+ 
+ 
+ September 30,
+ 
+ Year Ended December 31,
+
+ (dollars in thousands)
+ 
+ 2004
+ 
+ 2003
+ 
+ 2003
+ 
+ 2002
+ 
+ 2001
+ 
+ 2000
+ 
+ 1999
+
+ Allowance for loan losses as
+a percentage of period-end
+total loans
+
+ 
+ 
+ 1.26
+ %
+ 
+ 
+ 1.26
+ %
+ 
+ 
+ 1.25
+ %
+ 
+ 
+ 1.39
+ %
+ 
+ 
+ 1.29
+ %
+ 
+ 
+ 1.81
+ %
+ 
+ 
+ 1.50
+ %
+
+ Allowance for loan losses as
+a percentage of nonperforming
+loans
+
+ 
+ 
+ 291.44
+ %
+ 
+ 
+ 111.03
+ %
+ 
+ 
+ 182.15
+ %
+ 
+ 
+ 136.75
+ %
+ 
+ 
+ 140.80
+ %
+ 
+ 
+ 132.47
+ %
+ 
+ 
+ 153.61
+ %
+
+ Average loans outstanding during
+the period
+
+ 
+ $
+ 194,362
+ 
+ 
+ $
+ 140,618
+ 
+ 
+ $
+ 147,923
+ 
+ 
+ $
+ 115,393
+ 
+ 
+ $
+ 90,571
+ 
+ 
+ $
+ 82,991
+ 
+ 
+ $
+ 74,139
+ 
+
+ Period-end total loans
+
+ 
+ $
+ 213,048
+ 
+ 
+ $
+ 164,219
+ 
+ 
+ $
+ 182,527
+ 
+ 
+ $
+ 121,999
+ 
+ 
+ $
+ 108,423
+ 
+ 
+ $
+ 81,927
+ 
+ 
+ $
+ 83,757
+ 
+
+ Nonperforming loans, end of
+period
+
+ 
+ $
+ 923
+ 
+ 
+ $
+ 1,867
+ 
+ 
+ $
+ 1,249
+ 
+ 
+ $
+ 1,238
+ 
+ 
+ $
+ 995
+ 
+ 
+ $
+ 1,118
+ 
+ 
+ $
+ 817
+ 
+
+ The following table represents management s best estimate of the
+allocation of the allowance for loan losses to the various segments of the loan
+portfolio based on information available as of the dates indicated. Due to the
+ongoing evaluation and changes in the basis for the allowance for loans losses,
+actual future charge offs will not necessarily follow the allocations described
+below.
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ 
+ 
+ September 30,
+ 
+ December 31 ,
+
+ 
+ 
+ 2004
+ 
+ 2003
+ 
+ 
+ 
+ 
+ 
+ 2002
+ 
+ 
+ 
+ 
+ 
+ 2001
+ 
+ 
+ 
+ 
+ 
+ 2000
+ 
+ 
+ 
+ 
+ 
+ 1999
+ 
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ % of
+ 
+ 
+ 
+ 
+ 
+ % of
+ 
+ 
+ 
+ 
+ 
+ % of
+ 
+ 
+ 
+ 
+ 
+ % of
+ 
+ 
+ 
+ 
+ 
+ % of
+ 
+ 
+ 
+ 
+ 
+ % of
+
+ 
+ 
+ 
+ 
+ 
+ 
+ Loans
+ 
+ 
+ 
+ 
+ 
+ Loans
+ 
+ 
+ 
+ 
+ 
+ Loans
+ 
+ 
+ 
+ 
+ 
+ Loans
+ 
+ 
+ 
+ 
+ 
+ Loans
+ 
+ 
+ 
+ 
+ 
+ Loans
+
+ 
+ 
+ 
+ 
+ 
+ 
+ to
+ 
+ 
+ 
+ 
+ 
+ to
+ 
+ 
+ 
+ 
+ 
+ to
+ 
+ 
+ 
+ 
+ 
+ to
+ 
+ 
+ 
+ 
+ 
+ to
+ 
+ 
+ 
+ 
+ 
+ to
+
+ 
+ 
+ 
+ 
+ 
+ 
+ Total
+ 
+ 
+ 
+ 
+ 
+ Total
+ 
+ 
+ 
+ 
+ 
+ Total
+ 
+ 
+ 
+ 
+ 
+ Total
+ 
+ 
+ 
+ 
+ 
+ Total
+ 
+ 
+ 
+ 
+ 
+ Total
+
+ (dollars in thousands)
+ 
+ Allowance
+ 
+ Loans
+ 
+ Allowance
+ 
+ Loans
+ 
+ Allowance
+ 
+ Loans
+ 
+ Allowance
+ 
+ Loans
+ 
+ Allowance
+ 
+ Loans
+ 
+ Allowance
+ 
+ Loans
+
+ Commercial
+
+ 
+ $
+ 577
+ 
+ 
+ 
+ 16.16
+ %
+ 
+ $
+ 277
+ 
+ 
+ 
+ 17.45
+ %
+ 
+ $
+ 305
+ 
+ 
+ 
+ 21.59
+ %
+ 
+ $
+ 221
+ 
+ 
+ 
+ 20.73
+ %
+ 
+ $
+ 226
+ 
+ 
+ 
+ 28.01
+ %
+ 
+ $
+ 236
+ 
+ 
+ 
+ 30.90
+ %
+
+ Real estate:
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Residential
+
+ 
+ 
+ 314
+ 
+ 
+ 
+ 15.23
+ %
+ 
+ 
+ 265
+ 
+ 
+ 
+ 15.15
+ %
+ 
+ 
+ 189
+ 
+ 
+ 
+ 18.12
+ %
+ 
+ 
+ 113
+ 
+ 
+ 
+ 17.91
+ %
+ 
+ 
+ 119
+ 
+ 
+ 
+ 12.54
+ %
+ 
+ 
+ 118
+ 
+ 
+ 
+ 14.66
+ %
+
+ Commercial
+
+ 
+ 
+ 1,061
+ 
+ 
+ 
+ 57.11
+ %
+ 
+ 
+ 1,260
+ 
+ 
+ 
+ 57.30
+ %
+ 
+ 
+ 933
+ 
+ 
+ 
+ 49.53
+ %
+ 
+ 
+ 753
+ 
+ 
+ 
+ 48.47
+ %
+ 
+ 
+ 750
+ 
+ 
+ 
+ 43.31
+ %
+ 
+ 
+ 732
+ 
+ 
+ 
+ 41.55
+ %
+
+ Construction
+
+ 
+ 
+ 112
+ 
+ 
+ 
+ 8.81
+ %
+ 
+ 
+ 63
+ 
+ 
+ 
+ 7.01
+ %
+ 
+ 
+ 35
+ 
+ 
+ 
+ 7.60
+ %
+ 
+ 
+ 63
+ 
+ 
+ 
+ 9.65
+ %
+ 
+ 
+ 48
+ 
+ 
+ 
+ 12.12
+ %
+ 
+ 
+ 47
+ 
+ 
+ 
+ 9.48
+ %
+
+ Consumer and
+other
+
+ 
+ 
+ 226
+ 
+ 
+ 
+ 2.69
+ %
+ 
+ 
+ 84
+ 
+ 
+ 
+ 3.09
+ %
+ 
+ 
+ 78
+ 
+ 
+ 
+ 3.16
+ %
+ 
+ 
+ 38
+ 
+ 
+ 
+ 3.24
+ %
+ 
+ 
+ 48
+ 
+ 
+ 
+ 4.02
+ %
+ 
+ 
+ 47
+ 
+ 
+ 
+ 3.41
+ %
+
+ Unallocated
+
+ 
+ 
+ 400
+ 
+ 
+ NA
+ 
+ 
+ 326
+ 
+ 
+ NA
+ 
+ 
+ 153
+ 
+ 
+ NA
+ 
+ 
+ 213
+ 
+ 
+ NA
+ 
+ 
+ 290
+ 
+ 
+ NA
+ 
+ 
+ 75
+ 
+ 
+ NA
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ 
+
+ 
+ $
+ 2,690
+ 
+ 
+ 
+ 100.00
+ %
+ 
+ $
+ 2,275
+ 
+ 
+ 
+ 100.00
+ %
+ 
+ $
+ 1,693
+ 
+ 
+ 
+ 100.00
+ %
+ 
+ $
+ 1,401
+ 
+ 
+ 
+ 100.00
+ %
+ 
+ $
+ 1,481
+ 
+ 
+ 
+ 100.00
+ %
+ 
+ $
+ 1,255
+ 
+ 
+ 
+ 100.00
+ %
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ While the make-up of our loan portfolio as expressed as a percentage of
+loans to total loans at September 30, 2004 only changed slightly from that at
+December 31, 2003, the allocation of the allowance for loan losses experienced
+greater fluctuation. This fluctuation, most notably in the commercial,
+
+29
+
+Table of Contents
+
+commercial real estate, and consumer and other categories, was a result of
+changes in management s estimate of the quality of the loans comprising these
+categories. In general, management
+noted an improvement in the overall quality of the commercial real estate
+portfolio during the nine months ended September 30, 2004, while the quality of
+the commercial and consumer and other portfolios was determined by management
+to have decreased slightly. However, management still believes the overall
+quality of the Company s loan portfolio at September 30, 2004 is consistent
+with that at December 31, 2003 as evidenced by the consistency of the overall
+allowance for loan losses as a percentage of total loans.
+
+Investment Securities
+
+ The following table sets forth the book value of our investment portfolio
+as of September 30, 2004, December 31, 2003, 2002 and 2001:
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ 
+ 
+ 
+
+ 
+ 
+
+ 
+ 
+ September
+30,
+ 
+ December 31 ,
+
+ (dollars in thousands)
+ 
+ 2004
+ 
+ 2003
+ 
+ 2002
+ 
+ 2001
+
+ Securities available for sale:
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ U.S. Treasury securities
+
+ 
+ $
+ 
+ 
+ 
+ $
+ 
+ 
+ 
+ $
+ 
+ 
+ 
+ $
+ 
+ 
+
+ U.S. Government agency obligations
+
+ 
+ 
+ 2,495
+ 
+ 
+ 
+ 4,039
+ 
+ 
+ 
+ 5,641
+ 
+ 
+ 
+ 1,560
+ 
+
+ Mortgage-backed securities
+
+ 
+ 
+ 13,067
+ 
+ 
+ 
+ 16,182
+ 
+ 
+ 
+ 6,092
+ 
+ 
+ 
+ 981
+ 
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Total securities available for sale
+
+ 
+ 
+ 15,562
+ 
+ 
+ 
+ 20,221
+ 
+ 
+ 
+ 11,733
+ 
+ 
+ 
+ 2,541
+ 
+
+ Securities held to maturity
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Total investment securities
+
+ 
+ $
+ 15,562
+ 
+ 
+ $
+ 20,221
+ 
+ 
+ $
+ 11,733
+ 
+ 
+ $
+ 2,541
+ 
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Federal Home Loan Bank stock
+
+ 
+ $
+ 900
+ 
+ 
+ $
+ 750
+ 
+ 
+ $
+ 250
+ 
+ 
+ $
+ 250
+ 
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ The following table summarizes the maturity distribution and yield by
+classification of securities as of the date indicated:
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ 
+ 
+ September 30, 2004
+
+ 
+ 
+ 
+ 
+ 
+ 
+ Weighted
+
+ 
+ 
+ Book
+ 
+ Average
+
+ (dollars in thousands)
+ 
+ Value
+ 
+ Yield
+
+ U.S. Treasury and Government
+agency obligations
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ One year or less
+
+ 
+ $
+ 495
+ 
+ 
+ 
+ 1.10
+ %
+
+ Over one year through five years
+
+ 
+ 
+ 2,000
+ 
+ 
+ 
+ 3.67
+ %
+
+ Over five years through ten years
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Over ten years
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Mortgage-backed securities
+
+ 
+ 
+ 13,067
+ 
+ 
+ 
+ 3.46
+ %
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ 
+
+ 
+ $
+ 15,562
+ 
+ 
+ 
+ 3.41
+ %
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+30
+
+Table of Contents
+
+ We have adopted Statement of Financial Accounting Standards No. 115 ( FAS
+115 ), which requires companies to classify investments securities, including
+mortgage-backed securities as either held-to-maturity, available-for-sale, or
+trading securities. Securities classified as held-to-maturity are
+carried at amortized cost. Securities classified as available-for-sale are
+reported at fair value, with unrealized gains and losses, net of tax effect,
+reported as a separate component of stockholders equity. Securities classified
+as trading securities are recorded at fair value, with unrealized gains and
+losses included in earnings. As a result of the adoption of FAS 115, under
+which we expect to continue to hold its investment securities classified as
+available-for-sale, changes in the underlying market values of such securities
+can have a material adverse effect on our capital position. Typically, an
+increase in interest rates results in a decrease in underlying market value and
+a decrease in the level of principal repayments on mortgage-backed securities.
+As a result of changes in market interest rates, changes in the market value of
+available-for-sale securities resulted in an increase of $28,000 and a decrease
+of $229,000 in stockholders equity during the nine months ended September 30,
+2004 and the year ended December 31, 2003. These fluctuations in stockholders 
+equity represent the after-tax impact of changes in interest rates on the value
+of these investments.
+
+Deposit Activities
+
+ Deposits are the major source of our funds for lending and other
+investment purposes. Deposits are attracted principally from within our
+primary market area through the offering of a broad variety of deposit
+instruments including checking accounts, money market accounts, regular savings
+accounts, term certificate accounts (including jumbo certificates in
+denominations of $100,000 or more) and retirement savings plans.
+
+ The following table presents the average amount outstanding and the
+average rate paid on deposits by us for period ending September 30, 2004 and
+years ending December 31, 2003, 2002, and 2001.
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ 
+ 
+ Nine months Ended
+ 
+ Year Ended December 31,
+
+ 
+ 
+ September 30, 2004
+ 
+ 2003
+ 
+ 2002
+ 
+ 2001
+
+ 
+ 
+ Average
+ 
+ Average
+ 
+ Average
+ 
+ Average
+ 
+ Average
+ 
+ Average
+ 
+ Average
+ 
+ Average
+
+ (dollars in thousands)
+ 
+ Amount
+ 
+ Rate
+ 
+ Amount
+ 
+ Rate
+ 
+ Amount
+ 
+ Rate
+ 
+ Amount
+ 
+ Rate
+
+ Noninterest-bearing deposits
+
+ 
+ $
+ 23,766
+ 
+ 
+ 
+ 
+ 
+ 
+ $
+ 16,770
+ 
+ 
+ 
+ 
+ 
+ 
+ $
+ 18,211
+ 
+ 
+ 
+ 
+ 
+ 
+ $
+ 17,115
+ 
+ 
+ 
+ 
+ 
+
+ Interest-bearing deposit
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ NOW accounts
+
+ 
+ 
+ 14,641
+ 
+ 
+ 
+ 0.25
+ %
+ 
+ 
+ 14,336
+ 
+ 
+ 
+ 0.32
+ %
+ 
+ 
+ 14,462
+ 
+ 
+ 
+ 1.28
+ %
+ 
+ 
+ 11,492
+ 
+ 
+ 
+ 2.01
+ %
+
+ Money Market
+
+ 
+ 
+ 20,961
+ 
+ 
+ 
+ 1.08
+ %
+ 
+ 
+ 21,245
+ 
+ 
+ 
+ 1.04
+ %
+ 
+ 
+ 21,338
+ 
+ 
+ 
+ 2.11
+ %
+ 
+ 
+ 17,150
+ 
+ 
+ 
+ 3.51
+ %
+
+ Savings accounts
+
+ 
+ 
+ 8,457
+ 
+ 
+ 
+ 0.32
+ %
+ 
+ 
+ 8,116
+ 
+ 
+ 
+ 0.49
+ %
+ 
+ 
+ 10,193
+ 
+ 
+ 
+ 1.45
+ %
+ 
+ 
+ 6,536
+ 
+ 
+ 
+ 2.19
+ %
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Time deposits
+
+ 
+ 
+ 133,026
+ 
+ 
+ 
+ 3.12
+ %
+ 
+ 
+ 100,798
+ 
+ 
+ 
+ 3.53
+ %
+ 
+ 
+ 74,063
+ 
+ 
+ 
+ 4.63
+ %
+ 
+ 
+ 62,300
+ 
+ 
+ 
+ 5.74
+ %
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ 
+
+ 
+ $
+ 200,851
+ 
+ 
+ 
+ 2.21
+ %
+ 
+ $
+ 161,265
+ 
+ 
+ 
+ 2.40
+ %
+ 
+ $
+ 138,267
+ 
+ 
+ 
+ 3.05
+ %
+ 
+ $
+ 114,593
+ 
+ 
+ 
+ 3.97
+ %
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Maturity terms, service fees and withdrawal penalties are established by
+us on a periodic basis. The determination of rates and terms is predicated on
+funds acquisition and liquidity requirements, rates paid by competitors, growth
+goals and federal regulations.
+
+31
+
+Table of Contents
+
+ FDIC regulations limit the ability of certain insured depository
+institutions to accept, renew, or rollover deposits by offering rates of
+interest which are significantly higher than the prevailing rates of interest
+on deposits offered by other insured depository institutions having the same
+type of charter in such depository institutions normal market area. Under
+these regulations,
+ well capitalized depository institutions may accept, renew, or roll over
+deposits at such rates without restriction, adequately capitalized depository
+institutions may accept, renew or roll over deposits at such rates with a
+waiver from the FDIC (subject to certain restrictions on payments of rates),
+and undercapitalized depository institutions may not accept, renew or roll
+over deposits at such rates. The regulations contemplate that the definitions
+of well capitalized, adequately capitalized and undercapitalized will be
+the same as the definitions adopted by the agencies to implement the prompt
+corrective action provisions of applicable law. See Supervision and
+Regulation Capital Requirements. As of September 30, 2004 and December 31,
+2003, First State Bank met the definition of an adequately capitalized 
+depository institution.
+
+ We do not have a concentration of deposits from any one source, the loss
+of which would have a material adverse effect on us. Management believes that
+substantially all of our depositors are residents in our primary market area.
+We currently do not accept brokered deposits.
+
+ Time deposits of $100,000 and over, public fund deposits and other large
+deposit accounts tend to be short-term in nature and more sensitive to changes
+in interest rates than other types of deposits and, therefore, may be a less
+stable source of funds. In the event that existing short-term deposits are not
+renewed, the resulting loss of the deposited funds could adversely affect our
+liquidity. In a rising interest rate market, such short-term deposits may
+prove to be a costly source of funds because their short-term nature
+facilitates renewal at increasingly higher interest rates, which may adversely
+affect our earnings. However, the converse is true in a falling interest-rate
+market where such short-term deposits are more favorable to us.
+
+ The following table presents the maturity of our time deposits at
+September 30, 2004
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ 
+ 
+ Deposits
+ 
+ Deposits
+ 
+ 
+
+ 
+ 
+ $100,000
+ 
+ Less than
+ 
+ 
+
+ (in thousands)
+ 
+ and Greater
+ 
+ $100,000
+ 
+ Total
+
+ Months to maturity
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ 3 or less
+
+ 
+ $
+ 3,291
+ 
+ 
+ $
+ 13,057
+ 
+ 
+ $
+ 16,348
+ 
+
+ 4 to 6
+
+ 
+ 
+ 2,108
+ 
+ 
+ 
+ 15,919
+ 
+ 
+ 
+ 18,027
+ 
+
+ 7 through 12
+
+ 
+ 
+ 6,919
+ 
+ 
+ 
+ 14,939
+ 
+ 
+ 
+ 21,858
+ 
+
+ Over 12
+
+ 
+ 
+ 19,251
+ 
+ 
+ 
+ 58,405
+ 
+ 
+ 
+ 77,656
+ 
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ 
+
+ 
+ $
+ 31,569
+ 
+ 
+ $
+ 102,320
+ 
+ 
+ $
+ 133,889
+ 
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+Off-Balance Sheet Arrangements and Contractual Obligations
+
+ Our off-balance sheet arrangements and contractual obligations at
+September 30, 2004 are summarized in the table that follows. The amounts shown
+for commitments to extend credit and letters of credit are contingent
+obligations, some of which are expected to expire without being drawn upon. As
+a result, the amounts shown for these items do not necessarily represent future
+cash requirements. We believe that our current sources of liquidity are more
+than sufficient to fulfill the obligations we have as of September 30, 2004
+pursuant to off-balance sheet arrangements and contractual obligations.
+
+32
+
+Table of Contents
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ Over
+ 
+ Over
+ 
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ One Year
+ 
+ Three Years
+ 
+ 
+
+ 
+ 
+ Total
+ 
+ One Year
+ 
+ Through
+ 
+ Through
+ 
+ Over Five
+
+ (in thousands)
+ 
+ Amounts
+ 
+ or Less
+ 
+ Three Years
+ 
+ Five Years
+ 
+ Years
+
+ Commitments to extend credit
+
+ 
+ $
+ 26,166
+ 
+ 
+ $
+ 12,978
+ 
+ 
+ $
+ 6,735
+ 
+ 
+ $
+ 471
+ 
+ 
+ $
+ 5,982
+ 
+
+ Standby letters of credit
+
+ 
+ 
+ 312
+ 
+ 
+ 
+ 312
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Capital lease obligations
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Operating lease obligations
+
+ 
+ 
+ 198
+ 
+ 
+ 
+ 74
+ 
+ 
+ 
+ 124
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Purchase obligations
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Long-term debt
+
+ 
+ 
+ 18,000
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 15,000
+ 
+ 
+ 
+ 3,000
+ 
+ 
+ 
+ 
+ 
+
+ Other long-term liabilities reflected
+on the balance sheet under GAAP
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Total
+
+ 
+ $
+ 44,676
+ 
+ 
+ $
+ 13,364
+ 
+ 
+ $
+ 21,859
+ 
+ 
+ $
+ 3,471
+ 
+ 
+ $
+ 5,982
+ 
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ The Company is a party to financial instruments with off-balance sheet
+risk in the normal course of business to meet the financing needs of its
+customers. These financial instruments include commitments to extend credit
+and standby letters of credit. These instruments involve, to varying degrees,
+elements of credit risk in excess of the amount recognized in the consolidated
+balance sheets.
+
+ The Company s exposure to credit loss in the event of nonperformance by
+the other party to financial instruments for commitments to extend credit and
+standby letters of credit is represented by the contractual notional amount of
+these instruments. The Company uses the same credit policies in making
+commitments to extend credit and generally uses the same credit policies for
+letters of credit as it does for on-balance sheet instruments.
+
+ Commitments to extend credit are legally binding agreements to lend to a
+customer as long as there is no violation of any condition established in the
+contract. Since some of these commitments are expected to expire without being
+drawn upon, the total commitment amount does not necessarily represent future
+cash requirements. Unused home equity lines, which comprise a substantial
+portion of these commitments, generally expire five years from their date of
+origination. Other loan commitments generally expire in 30 days. The amount
+of collateral obtained, if any, by the Company upon extension of credit is
+based on management s credit evaluation of the borrower. Collateral held
+varies but may include security interests in business assets, mortgages on
+commercial and residential real estate, deposit accounts with the Company or
+other financial institutions, and securities.
+
+ Standby letters of credit are conditional commitments issued by the
+Company to assure the performance or financial obligations of a customer to a
+third party. The credit risk involved in issuing standby letters of credit is
+essentially the same as that involved in extending loans to customers. The
+Company generally holds collateral and/or obtains personal guarantees
+supporting these commitments.
+
+ The Company is obligated under an operating lease for a banking office
+which expires May 2007. Future minimum lease payments, before considering
+renewal options that generally are present, total $198,000.
+
+ Long term debt consists of Federal Home Loan Bank advances totaling $18
+million. These are further described in Note 6 of the Consolidated Financial
+Statements.
+
+Results of Operation
+
+Nine months ended September 30, 2004 compared to September 30, 2003
+
+ General
+
+ Our net income for the nine months ended September 30, 2004 was $1.4
+million or $.43 per share, as compared to net income of $433,000 or $.14 per
+share for the same period in 2003, an increase of
+
+33
+
+Table of Contents
+
+$1,005,000 or 232.1% or $.29
+per share. The increase in net income was driven by a 36.7% or $1.7 million
+increase in net interest income, a 40.1% or $324,000 increase in non-interest
+income, which more than offset the increase in non-interest expense of $621,000
+or 15.1%.
+
+ Net interest income
+
+ Net interest income, which constitutes our principal source of income,
+represents the excess of interest income on interest-earning assets over
+interest expense on interest-bearing liabilities. The principal
+interest-earning assets are federal funds sold, investment securities and loans
+receivable. Interest-bearing liabilities primarily consist of time deposits,
+interest-bearing checking accounts ( NOW accounts ), savings deposits and money
+market accounts. Funds attracted by these interest-bearing liabilities are
+invested in interest-earning assets. Accordingly, net interest income depends
+upon the volume of average interest-earning assets and average interest-bearing
+liabilities and the interest rates earned or paid on them.
+
+ Net interest income was $6.47 million for the nine months ended September
+30, 2004 compared with $4.73 million for the nine months ended September 30,
+2004, an increase of $1.74 million or 36.7%. The increase resulted from an
+increase in average earning assets of $48.8 million or 29.2%. The increase in
+earning assets was due to average loans rising by $53.7 million or 38.2%
+resulting in the average loans as a percent of average earning assets
+increasing to 90.0% as of September 30, 2004 up from 84.1% at the same period
+in 2003. The growth in the loan portfolio was more than sufficient to offset a
+four basis point decline in the average yield on earning assets between the
+periods. During the same period, the cost of funds paid on interest bearing
+liabilities decreased by 23 basis points, which resulted in an increase in the
+net interest margin of 22 basis points to 4.00% for the nine months ended
+September 30, 2004 from 3.78% for the same period in 2003.
+
+ Provision for loan losses
+
+ The provision for loan losses is charged to earnings to bring the
+allowance for loan losses to a level deemed appropriate by management and is
+based upon historical experience, the volume and type of lending conducted by
+us, the amounts of non-performing loans, general economic conditions,
+particularly as they relate to our market area, and other factors related to
+the collectibility of our loan portfolio.
+
+ For the nine months ended September 30, 2004 the provision for loan losses
+was $518,000, as compared to $696,000 for the same period in 2003. Charge-offs
+to real estate loans declined by $158,000 or 85.9% for the nine months ended
+September 30, 2004 compared to the same period in 2003. Charge-offs to
+commercial loans declined by $54,000 or 90.0% and to consumer loans rose by
+$21,000 or 20.4% during the comparable nine month periods in 2004 and 2003.
+Total recoveries also rose by $22,000 or 70.9% for the nine months ended
+September 30, 2004 compared to the same period in 2003. The reduced net
+charge-offs allowed us to meet our estimated allowance for loan losses with a
+reduced provision for loan losses.
+
+ As of September 30, 2004 and December 31, 2003, the allowance for loan
+losses was 1.26%, and 1.25%, respectively, of total loans receivables, and was
+291.44%, and 182.15%, respectively, of nonperforming loans. From December 31,
+2003 to September 30, 2004, loan balances grew by $30.5 million or 16.7% and
+the allowance for loan losses increased by $415,000 or 18.2%. For the same
+nine month period, commercial real estate loan balances increased by $17.1
+million or 16.3% while the allowance for loan losses applied to commercial real
+estate loans declined by $199,000 or 15.8%. The reason for the decrease in the
+allowance for loan losses applied to commercial real estate loans related to a
+$1.5 million or 43.9% improvement in commercial real estate loans graded by
+management as substandard at September 30, 2004 compared to December 31,
+2003. Shifts in the reserve allocations along with a reduction in net
+charge-offs allowed for a lower reserve to commercial real estate loans.
+
+ Noninterest income
+
+ Noninterest income is primarily composed of deposit service charges and
+fees, and mortgage banking fees. Noninterest income was $1.1 million for the
+nine months ended September 30, 2004
+
+34
+
+Table of Contents
+
+compared to $808,000 for the same period
+in 2003, an increase of $324,000 or 40.1%. The increase was primarily due to
+an increase in mortgage banking fees of $184,000 or 69.7% and service charges
+and other fees of $119,000 or 22.0%.
+
+ Noninterest expense
+
+ For the nine month period ended September 30, 2004, noninterest expense
+increased by $621,000 or 15.1%. Nearly all of the increase was in compensation
+and benefits which rose by $655,000 or 30.6%. The Bank continues to add
+personnel to aid and support its strong asset growth. Other noninterest
+expense rose slightly by $8,000 or 0.7%, while occupancy and equipment fell by
+$42,000 or 5.1%. compared to the same nine month period in 2003.
+
+ Income tax provision
+
+ The income tax provision rose by $612,000 or 204.7% to $911,000 for the
+nine months ended September 30, 2004 from $299,000 for the same period in 2003.
+First State Financial s effective tax rate was 38.8% for the nine months ended
+September 30, 2004 compared to 40.8% for the same period in 2003. This
+increase in the tax provision is commensurate with the increase in net income
+before taxes for the comparable periods.
+
+Years ended December 31, 2003 and December 31, 2002
+
+ General
+
+ Our net income for the year ended December 31, 2003 was $795,000 or $.26
+per share, as compared to net income for the year ended December 31, 2002 of
+$435,000 or $.14 per share, an increase of $360,000 or $.12 per share, or
+82.8%. The increase in 2003 of nearly $2.1 million in net interest income or
+43.5% and the increase of $284,000 in noninterest income or 32.4%, was offset
+by a nearly $1.1 million increase in noninterest expense or 23.4%, and a
+$651,000 increase in the provision for loan losses or 163.2% over the provision
+for loan losses in 2002. The growth in revenue and expenses was primarily due
+to the strong growth in the Bank during 2003.
+
+ Net interest income
+
+ Net interest income, which constitutes our principal source of income,
+represents the excess of interest income on interest-earning assets over
+interest expense on interest-bearing liabilities. The principal
+interest-earning assets are federal funds sold, investment securities and loans
+receivable. Interest-bearing liabilities primarily consist of time deposits,
+interest-bearing checking accounts ( NOW accounts ), savings deposits and money
+market accounts. Funds attracted by these interest-bearing liabilities are
+invested in interest-earning assets. Accordingly, net interest income depends
+upon the volume of average interest-earning assets and average interest-bearing
+liabilities and the interest rates earned or paid on them.
+
+ Net interest income was $6.8 million for the year ended December 31, 2003
+compared with $4.7 million for the year ended December 31, 2002, an increase of
+$2.1 million or 43.5%. The increase resulted from an increase in average
+earning assets of $30.9 million or 21.7%. During 2003, interest expense on
+interest bearing liabilities decreased by $288,000 over 2002. During the same
+period, the cost of funds paid on interest bearing liabilities decreased 88
+basis points, which resulted in an increase in the net interest margin of 59
+basis points to 3.90% for 2003 from 3.31% for 2002.
+
+ Provision for loan losses
+
+ For 2003, the provision for loan losses was $1,050,000, as compared to
+$399,000 for 2002. Charge-offs to real estate loans were $249,000 for the year
+ended December 31, 2003 compared none during 2002. Charge-offs to commercial
+loans rose by $77,000 or 84.6% and to consumer loans rose by $97,000 or 461.9%
+in 2003 compared to 2002. Total recoveries rose by $62,000 for the year ended
+December 31, 2003 compared to 2002. The increase in net charge-offs, combined
+with the growth of the
+
+35
+
+Table of Contents
+
+loan portfolio discussed below, caused us to increase
+our provision for loan losses in order to meet its estimated allowance for loan
+losses.
+
+ As of December 31, 2003 and 2002, the allowance for loan losses was 1.25%,
+and 1.39%, respectively, of total loans receivable, and was 182.15%, and
+136.75%, respectively, of non-performing loans. From December 31, 2002 to
+December 31, 2003, loan balances grew by $60.5 million or 49.6% and the
+allowance for loan losses increased by $582,000 or 34.4%. During 2003,
+commercial real estate loan balances increased by $44.2 million or 73.1% while
+the allowance for loan losses applied to commercial real estate loans increased
+by $327,000 or
+35.0%. The reason for the lower percentage increase in the allowance for
+loan losses applied to commercial real estate loans compared to the overall
+increase in the commercial real estate loan portfolio related to management s
+belief that the overall quality of the commercial real estate improved from
+December 31, 2002 to December 31, 2003. As such,
+a decrease in management s estimate of the required reserves related to the
+portfolio allowed for a lower reserve to commercial real estate loans.
+
+ Noninterest income
+
+ Noninterest income is primarily composed of deposit service charges and
+fees, and mortgage banking fees. Noninterest income was $1,161,000 for 2003
+versus $877,000 for 2002, or an increase of $284,000, or 32.4%. Contributing
+to the increase was a $128,000, or 20.3%, increase in service charges and fees.
+Mortgage banking fees rose by $123,000 or 45.4%.
+
+ Noninterest expenses
+
+ During 2003, noninterest expenses increased to $5.6 million from $4.5
+million during 2002, or an increase of 23.4%. The following narrative sets
+forth additional information on certain noninterest expense categories which
+had significant changes.
+
+ During 2003, compensation and benefits increased to $3.0 million from $2.2
+million for 2002, an increase of $.8 million or 34.7%. The increase was
+primarily due to an increase in the number of employees commensurate with the
+growth of the Bank and annual compensation and benefit increases for employees.
+
+ Occupancy and related furniture and equipment expense decreased to
+$1,015,000 during 2003 from $1,027,000 during 2002, a decrease of $12,000 or
+1.2%. The reason for the decrease in occupancy related expenses from 2002 to
+2003 related to cost reduction.
+
+ Other noninterest expense increased to $1.6 million from $1.3 million for
+2002, an increase of $295,000 or 23.3%. Most of the increase came from
+increased data processing and professional service fees which rose by $119,000
+or 24.1% in 2003 from the same period in 2002.
+
+ FDIC and state assessments increased to $158,000 for 2003 from $77,000 for
+2002, an increase of $81,000 or 105%, due to increase in deposits and change in
+classification.
+
+ Advertising and business development increased to $119,000 for the year
+ended December 31, 2003 from $95,000 for the year ended December 31, 2002, an
+increase of $24,000 or 25.3%. We place importance on effective advertising and
+business development, as well as continuing to support a marketing effort for
+those branch offices already in existence.
+
+ Income tax provision
+
+ During the 2003 the income tax provision increased to $507,000 from
+$239,000 for 2002, an increase of $268,000 or 112.13%. First State Financial s
+effective tax rate for 2003 was approximately 39% compared to 36% for 2002.
+The higher effective tax rate for 2003 was due to a strong increase in the
+provision for loan losses in 2003. The loan loss provision is not totally
+deductible for income tax purposes.
+
+36
+
+Table of Contents
+
+Years ended December 31, 2002 and December 31, 2001
+
+ General
+
+ Our net income for the year ended December 31, 2002 was $435,000 or $.14
+per share, as compared to net income for the year ended December 31, 2001 of
+$365,000 or $.12 per share, an increase of $70,000 or $.02 per share, or 19.2%.
+The increase in 2002 of $455,000 in net interest income or 10.4%, was offset
+by a nearly $201,000 increase in noninterest expense or 4.7%, a $59,000
+increase in the provision for loan losses or 17.4% over the provision for loan
+losses in
+2001, and a $99,000 or 10.1% decline in noninterest income. The resulting
+rise in income before income taxes was only $86,000 or 14.6%. The effective
+tax rate declined slightly from 38% in 2001 to 36% in 2002.
+
+ Net interest income
+
+ Net interest income was $4.7 million for the year ended December 31, 2002
+compared with $4.3 million for the year ended December 31, 2001, an increase of
+$445,000 or 10.4%. The increase resulted from an increase in average earning
+assets of $25.7 million or 22%. During 2002, interest income rose by only
+$33,000 and interest expense declined by $412,000. The average annual cost of
+funds fell by a strong 1.16% from 2001 to 2002, which offset a decline in the
+gross earning asset yield of 1.38%. This resulted in the net interest margin
+declining by only 0.35% from 3.66% in 2001 to 3.31% in 2002.
+
+ Provision for loan losses
+
+ For 2002, the provision for loan losses was $399,000, as compared to
+$340,000 for 2002. There were no charge-offs to real estate loans for the year
+ended December 31, 2002 compared $25,000 during 2001. Charge-offs to
+commercial loans decreased by $212,000 or 70.0% and to consumer loans decreased
+by $114,000 or 84.4% in 2002 compared to 2001. Likewise, total recoveries
+decreased by $38,000 for the year ended December 31, 2002 compared to 2001.
+The decrease in net charge-offs allowed us to keep our provision for loan
+losses relatively stable in order to meet our estimated allowance for loan
+losses in spite of the growth experienced in the portfolio.
+
+ As of December 31, 2002 and 2001, the allowance for loan losses was 1.39%,
+and 1.29%, respectively, of total loans receivable, and was 136.75%, and
+140.80%, respectively, of non-performing loans. From December 31, 2001 to
+December 31, 2002, loan balances grew by $13.6 million or 12.5% and the
+allowance for loan losses increased by $292,000 or 20.8%. During 2002,
+commercial real estate loan balances increased by $7.9 million or 15.0% while
+the allowance for loan losses applied to commercial real estate loans increased
+by $180,000 or 23.9%. The reason for the higher percentage increase in the
+allowance for loan losses applied to commercial real estate loans compared to
+the overall increase in the commercial real estate loan portfolio related to
+management s belief that the overall quality of the commercial real estate had
+declined from December 31, 2001 to December 31, 2002. As such, an increase in
+management s estimate of the required reserves related to the portfolio caused
+an increase to the reserve to commercial real estate loans, which was partially
+offset by a decrease in net charge-offs.
+
+ Noninterest income
+
+ Noninterest income is primarily composed of deposit service charges and
+fees, and mortgage banking fees. Noninterest income was $877,000 for 2002
+versus $976,000 for 2001, or a decline of $99,000, or 10.1%. While service
+charges and other fees rose by $103,000 or 19.5% in 2002 over the same period
+in 2001, mortgage banking fees fell by $67,000 or 19.8% from the same period in
+2001 and the net loss on sale of foreclosed assets was $33,000 in 2002 from no
+net loss in 2001. Additionally, the Company recognized a net gain on sale of
+securities of $76,000 in 2001 compared to no net gain in 2002.
+
+ Noninterest expenses
+
+37
+
+Table of Contents
+
+ During 2002, noninterest expenses increased to $4.5 million from $4.3
+million during 2001, or an increase of 4.7%. The following narrative sets
+forth additional information on certain noninterest expense categories which
+had significant changes.
+
+ During 2002, compensation and benefits increased to $2.2 million from $2.0
+million for 2001, an increase of $220,000 or 11%. The increase was primarily
+due to an increase in the
+number of employees commensurate with the growth of the Bank and annual
+compensation and benefit increases for employees.
+
+ Occupancy and related furniture and equipment expense decreased to $1.03
+million during 2002 from $1.06 million during 2001, a decrease of $31,000 or
+2.9%. The reason for the decrease in occupancy related expenses from 2001 to
+2002 related to cost cuttings.
+
+ Other noninterest expense increased slightly to $1.26 million in 2002 from
+$1.25 million in 2001, an increase of $13,000 or 1.0%.
+
+ Income tax provision
+
+ During the 2002 the income tax provision increased to $239,000 from
+$223,000 for 2001, an increase of only $16,000 or 7.2%. First State
+Financial s effective tax rate for 2002 was approximately 36% compared to 38%
+for 2001.
+
+38
+
+Table of Contents
+
+BUSINESS
+
+General
+
+ We are a bank holding company whose business is conducted primarily
+through our wholly-owned subsidiary, First State Bank. First State Bank, which
+was formed in October 1988, serves the West Central Florida region, principally
+Sarasota and Pinellas counties and surrounding areas. First State Bank is
+headquartered in Sarasota, Florida. We operate six banking offices and six
+ATMs throughout this area. At September 30, 2004, we had approximately $243
+million in total assets, $205 million in total deposits, $210 million in net
+loans and shareholders equity of $14.5 million. First State Bank s deposits
+are insured by the Federal Deposit Insurance Corporation, up to applicable
+limits.
+
+ First State Bank offers a wide range of commercial and retail banking and
+financial services to businesses and individuals. Our account services include
+checking, interest-bearing checking, money market, savings, certificates of
+deposit and individual retirement accounts. We offer all types of commercial
+loans to include: owner-occupied commercial real estate; acquisition,
+development and construction; income-producing properties; short-term working
+capital; inventory and receivable facilities; dealer floor plan loans; and
+equipment loans. We also offer a full complement of consumer loan products to
+include residential real estate, installment loans, home equity and home equity
+loans. Our lending focus is predominantly on small to medium-sized business and
+consumer borrowers. Most importantly, we provide our customers with access to
+local First State Bank officers who are empowered to act with flexibility to
+meet customers needs in an effort to foster and develop long-term loan and
+deposit relationships.
+
+ We are subject to examination and regulation by the Board of Governors of
+the Federal Reserve System, the Florida Office of Financial Regulation, and the
+Federal Deposit Insurance Corporation (FDIC). This regulation is intended for
+the protection of our depositors, not our shareholders.
+
+Business Strategy
+
+ Our business strategy is to operate as a profitable, diversified financial
+services company providing a variety of banking and other financial services,
+with an emphasis on commercial and residential mortgage lending and commercial
+business loans to small and medium sized businesses. As a result of the
+consolidation of small and medium sized financial institutions, we believe
+there is a significant opportunity for a community-focused bank to provide a
+full range of financial services to small and middle-market commercial and
+retail customers. We emphasize comprehensive retail and small business
+products and responsive, decentralized decision-making which reflects our
+knowledge of our local markets and customers.
+
+ To continue asset growth and profitability, our marketing strategy is targeted
+to:
+
+ 
+ 
+ 
+ Provide customers with access to our local executives who make
+key credit and account decisions;
+
+ 
+
+ 
+ 
+ 
+ Pursue commercial lending opportunities with small to mid-sized
+businesses which we believe are underserved by our larger
+competitors;
+
+ 
+
+ 
+ 
+ 
+ Cross-sell our products and services to our existing
+customers to leverage our relationships and enhance
+profitability; and
+
+ 
+
+ 
+ 
+ 
+ Adhere to safe and sound credit standards to maintain the
+continued quality of assets as we implement our growth strategy.
+
+39
+
+Table of Contents
+
+Banking Services
+
+ Commercial Banking. First State Bank focuses its commercial loan
+originations on small and mid-sized business (generally up to $5 million in
+annual sales) and such loans are usually accompanied by significant related
+deposits. Commercial underwriting is driven by cash flow analysis supported by
+collateral analysis and review. Commercial loan products include commercial
+real estate construction and term loans; working capital loans and lines of
+credit; demand, term and time loans; and equipment, inventory and accounts
+receivable financing. First State Bank offers a range of cash management
+services and deposit products to its commercial customers. Computerized banking
+is currently available to First State Bank s commercial customers.
+
+ Retail Banking. First State Bank s retail banking activities emphasize
+consumer deposit and checking accounts. An extensive range of these services is
+offered by First State Bank to meet the varied needs of its customers from
+young persons to senior citizens. In addition to traditional products and
+services, First State Bank offers contemporary products and services, such as
+debit cards, mutual funds and annuities, Internet banking and electronic bill
+payment services. Consumer loan products offered by First State Bank include
+home equity lines of credit, second mortgages, new and used auto loans,
+including indirect loans through auto dealers, new and used boat loans,
+overdraft protection, and unsecured personal credit lines.
+
+ Mortgage Banking. First State Bank s mortgage banking business is
+structured to provide a source of fee income largely from the process of
+originating product for sale on the secondary market (primarily fixed rate
+loans), as well as the origination of primarily adjustable rate loans to be
+held in First State Bank s loan portfolio. Mortgage banking capabilities
+include conventional and nonconforming mortgage underwriting; and construction
+and permanent financing.
+
+Lending Activities
+
+ Loan Portfolio Composition. At September 30, 2004, First State Bank s
+loan portfolio totaled $213 million, representing approximately 88% of our
+total assets of $243 million. For a discussion of our loan portfolio, see
+ Management s Discussion of Financial Condition and Results of Operation
+-Lending Activities. 
+
+ The composition of First State Bank s loan portfolio at September 30,
+2004, December 31, 2003 and 2002 is indicated below, along with the growth from
+the prior year.
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ 
+ 
+ At September 30,
+ 
+ At December 31,
+
+ 
+ 
+ 
+ 
+ 
+ 
+ % of Total
+ 
+ 
+ 
+ 
+ 
+ % of Total
+ 
+ 
+ 
+ 
+ 
+ % of Total
+
+ (dollars in thousands)
+ 
+ 2004
+ 
+ Loans
+ 
+ 2003
+ 
+ Loans
+ 
+ 2002
+ 
+ Loans
+
+ Commercial
+
+ 
+ $
+ 34,437
+ 
+ 
+ 
+ 16.16
+ %
+ 
+ $
+ 31,860
+ 
+ 
+ 
+ 17.45
+ %
+ 
+ $
+ 26,338
+ 
+ 
+ 
+ 21.59
+ %
+
+ Real estate:
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Residential
+
+ 
+ 
+ 32,452
+ 
+ 
+ 
+ 15.23
+ %
+ 
+ 
+ 27,660
+ 
+ 
+ 
+ 15.15
+ %
+ 
+ 
+ 22,112
+ 
+ 
+ 
+ 18.12
+ %
+
+ Commercial
+
+ 
+ 
+ 121,673
+ 
+ 
+ 
+ 57.11
+ %
+ 
+ 
+ 104,586
+ 
+ 
+ 
+ 57.30
+ %
+ 
+ 
+ 60,424
+ 
+ 
+ 
+ 49.53
+ %
+
+ Construction
+
+ 
+ 
+ 18,778
+ 
+ 
+ 
+ 8.81
+ %
+ 
+ 
+ 12,799
+ 
+ 
+ 
+ 7.01
+ %
+ 
+ 
+ 9,268
+ 
+ 
+ 
+ 7.60
+ %
+
+ Consumer and other
+
+ 
+ 
+ 5,708
+ 
+ 
+ 
+ 2.69
+ %
+ 
+ 
+ 5,622
+ 
+ 
+ 
+ 3.09
+ %
+ 
+ 
+ 3,857
+ 
+ 
+ 
+ 3.16
+ %
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ 
+
+ 
+ $
+ 213,048
+ 
+ 
+ 
+ 100.00
+ %
+ 
+ $
+ 182,527
+ 
+ 
+ 
+ 100.00
+ %
+ 
+ $
+ 121,999
+ 
+ 
+ 
+ 100.00
+ %
+
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+40
+
+Table of Contents
+
+ Our non-performing loans as a percentage of gross loans decreased to .43%
+at September 30, 2004 compared to .68% at December 31, 2003 and 1.01% at
+December 31, 2002.
+
+ Commercial Real Estate Mortgage Loans. At September 30, 2004, First State
+Bank s commercial real estate loan portfolio totaled $121.7 million. First
+State Bank originates mortgage loans secured by commercial real estate. Such
+loans are primarily secured by hotels, guesthouses, restaurants, retail
+buildings, and general purpose business space. Although terms may vary, First
+State Bank s commercial mortgages generally are long term in nature,
+owner-occupied, and variable-rate loans. First State Bank seeks to reduce the
+risks associated with commercial mortgage lending by generally lending in its
+market area and obtaining periodic financial statements and tax returns from
+borrowers. It is also First State Bank s general policy to obtain personal
+guarantees from the principals of the borrowers and assignments of all leases
+related to the collateral.
+
+ Commercial Loans. At September 30, 2004, First State Bank s commercial
+loan portfolio totaled $34.4 million. First State Bank originates secured and
+unsecured loans for business purposes. Loans are made for acquisition,
+expansion, and working capital purposes and may be secured by real estate,
+accounts receivable, inventory, equipment or other assets. The financial
+condition and cash flow of commercial borrowers are closely monitored by the
+submission of corporate financial statements, personal financial statements and
+income tax returns. The frequency of submissions of required financial
+information depends on the size and complexity of the credit and the collateral
+that secures the loan. It is First State Bank s general policy to obtain
+personal guarantees from the principals of the commercial loan borrowers.
+
+ Construction Loans. At September 30, 2004, First State Bank s
+construction loan portfolio totaled $18.8 million. First State Bank provides
+interim real estate acquisition development and construction loans to builders,
+developers, and persons who will ultimately occupy the building. Real estate
+development and construction loans to provide interim financing on the property
+are based on acceptable percentages of the appraised value of the property
+securing the loan in each case. Real estate development and construction loan
+funds are disbursed periodically at pre-specified stages of completion.
+Interest rates on these loans are generally adjustable. First State Bank
+carefully monitors these loans with on-site inspections and control of
+disbursements.
+
+ Development and construction loans are secured by the properties under
+development or construction and personal guarantees are typically obtained.
+Further, to assure that reliance is not placed solely in the value of the
+underlying property, First State Bank considers the financial condition and
+reputation of the borrower and any guarantors, the amount of the borrowers
+equity in the project, independent appraisals, costs estimates and
+pre-construction sale information.
+
+ Loans to individuals for the construction of their primary or secondary
+residences are secured by the property under construction. The loan to value
+ratio of construction loans is based on the lesser of the cost to construct or
+the appraised value of the completed home. Construction loans have a maturity
+of 12 months. These construction loans to individuals may be converted to
+permanent loans upon completion of construction.
+
+ Residential Real Estate Mortgage Loans. At September 30, 2004, First
+State Bank s residential loan portfolio totaled $21.0 million. First State
+Bank originates adjustable and fixed-rate residential mortgage loans. Such
+mortgage loans are generally originated under terms, conditions and
+documentation acceptable to the secondary mortgage market. First State Bank
+will place some of these, primarily adjustable rate, loans into its portfolio,
+although the substantial majority are sold to investors.
+
+ Other Consumer Loans and Home Equity Loans. At September 30, 2004, First
+State Bank s consumer loan portfolio totaled $5.7 million, and its home equity
+portfolio totaled $11.5
+million. First State Bank offers a variety of consumer loans. These
+loans are typically secured by residential real estate or personal property,
+including automobiles and boats. Home equity loans (closed-end and lines of
+credit)
+
+41
+
+Table of Contents
+
+are typically made up to 85% of the appraised value of the property
+securing the loan, in each case, less the amount of any existing liens on the
+property. Closed-end loans have terms of up to 15 years. Lines of credit have
+an original maturity of 10 years. The interest rates on closed-end home equity
+loans are fixed, while interest rates on home equity lines of credit are
+variable.
+
+Credit Administration
+
+ First State Bank s lending activities are subject to written policies
+approved by the board of directors to ensure proper management of credit risk.
+Loans are subject to a defined credit process that includes credit evaluation
+of borrowers, risk-rating of credits, establishment of lending limits and
+application of lending procedures, including the holding of adequate collateral
+and the maintenance of compensating balances, as well as procedures for
+on-going identification and management of credit deterioration. Regular
+portfolio reviews are performed to identify potential underperforming credits,
+estimate loss exposure, and to ascertain compliance with First State Bank s
+policies. Management review consists of evaluation of the financial strengths
+of the borrower and the guarantor, the related collateral and the effects of
+economic conditions.
+
+ First State Bank generally does not make commercial or consumer loans
+outside its market area unless the borrower has an established relationship
+with First State Bank and conducts its principal business operations within
+First State Bank s market area. Consequently, First State Bank and its
+borrowers are affected by the economic conditions prevailing in its market
+area.
+
+Employees
+
+ As of September 30, 2004, the Bank employed 68 full-time employees and
+three part-time employees. Neither First State Financial nor First State Bank
+is a party to any collective bargaining agreement, and management believes that
+First State Bank enjoys satisfactory relations with its employees.
+
+Properties
+
+ Executive and administrative offices of First State Financial and First
+State Bank are located at 22 South Links Avenue, Sarasota, Florida 34236 and
+consists of approximately 6,530 square feet on one floor, in the lobby,
+executive and customer service offices, teller stations, safe deposit booths,
+and related non-vault area and vault operations. A drive through facility and
+adequate paid parking also are on the premises. First State Bank owns the
+first floor of the building. The Bank also owns and operates the following
+branch offices: 5700 Clark Road, Sarasota, Florida 34233 (a one story building
+of approximately 4,737 square feet); 7555 Dr. Martin Luther King, Jr. Street
+North, St. Petersburg, Florida 33702 (a two story building of approximately
+10,100 square feet); 2823 4th Street North, St. Petersburg, Florida 33704 (a
+one story building of approximately 2,100 square feet); and 7101 Park Street
+North, Seminole, Florida 33777 (a one story building of approximately 2,544
+square feet). The Bank also leases a banking office at 2323 Stickney Point
+Road, Sarasota, Florida 34231. This branch consists of approximately 6,700
+square feet and is leased until May 31, 2007. The Bank has an option to renew
+this lease until May 31, 2013.
+
+Legal Proceedings
+
+ First State Financial and First State Bank are periodically a party to or
+otherwise involved in legal proceedings arising in the normal course of
+business, such as claims to enforce liens, foreclosure on loan defaults, claims
+involving the making and servicing of real property loans, and other issues
+incident to our business. Management does not believe that there is any
+proceeding threatened or pending against First State Financial or First State
+Bank which, if determined adversely, would have a material adverse effect on
+First State Financial or First State Bank.
+
+42
+
+Table of Contents
+
+MANAGEMENT
+
+Directors and Executive Officers
+
+ The following sets forth certain information regarding the directors and
+executive officers of First State Financial and First State Bank.
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Directors and Executive
+ 
+ 
+ 
+ 
+
+ Officers of First State
+ 
+ 
+ 
+ 
+
+ Financial
+ 
+ Age
+ 
+ Position
+
+ Robert H. Beymer
+
+ 
+ 
+ 76
+ 
+ 
+ Director
+
+ Corey J. Coughlin
+
+ 
+ 
+ 57
+ 
+ 
+ Director; President and Chief
+Executive Officer of First State
+Financial
+
+ Daniel P. Harrington
+
+ 
+ 
+ 48
+ 
+ 
+ Director
+
+ Marshall Reynolds
+
+ 
+ 
+ 67
+ 
+ 
+ Director
+
+ Neal Scaggs
+
+ 
+ 
+ 68
+ 
+ 
+ Director; Chairman of the Board
+
+ Robert L. Shell, Jr.
+
+ 
+ 
+ 60
+ 
+ 
+ Director
+
+ Thomas W. Wright
+
+ 
+ 
+ 52
+ 
+ 
+ Director
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Directors and Executive
+ 
+ 
+ 
+ 
+
+ Officers of First State Bank
+ 
+ Age
+ 
+ Position
+
+ Lester Baynard
+
+ 
+ 
+ 75
+ 
+ 
+ Director
+
+ David Coddington
+
+ 
+ 
+ 73
+ 
+ 
+ Director
+
+ Corey J. Coughlin
+
+ 
+ 
+ 57
+ 
+ 
+ Director; President and Chief
+Executive Officer of First State
+Bank
+
+ JC Bud Felix
+
+ 
+ 
+ 73
+ 
+ 
+ Director
+
+ C. Ted French
+
+ 
+ 
+ 55
+ 
+ 
+ Director
+
+ Dennis Grinsteiner
+
+ 
+ 
+ 59
+ 
+ 
+ Senior Vice President and Chief
+Financial Officer of the Bank
+
+ Wade Harris
+
+ 
+ 
+ 48
+ 
+ 
+ Director
+
+ Richard F. McDaniel
+
+ 
+ 
+ 48
+ 
+ 
+ Director
+
+ Rick Olszewski
+
+ 
+ 
+ 55
+ 
+ 
+ Director
+
+ Nancy Rutland
+
+ 
+ 
+ 46
+ 
+ 
+ Director
+
+ John W. Saputo
+
+ 
+ 
+ 54
+ 
+ 
+ Director
+
+ Terry Seiders
+
+ 
+ 
+ 64
+ 
+ 
+ Director
+
+ Lisa Ulrich
+
+ 
+ 
+ 47
+ 
+ 
+ Director
+
+ John E. Wilkinson
+
+ 
+ 
+ 57
+ 
+ 
+ Executive Vice President and Senior
+Retail Officer of the Bank
+
+ Michael K. Worthington
+
+ 
+ 
+ 47
+ 
+ 
+ Executive Vice President and Senior
+Lending Officer of the Bank
+
+ Thomas W. Wright
+
+ 
+ 
+ 52
+ 
+ 
+ Director; Chairman of the Board
+
+ All of the directors of First State Financial hold office until the next
+annual meeting of shareholders and until their successors have been duly
+elected and qualified. Officers are elected annually by the board of directors
+to hold office until their successors have been duly elected and qualified.
+
+ The following sets forth information on our directors and those of First
+State Bank:
+
+First State Financial Corporation Board of Directors
+
+ Robert H. Beymer currently servies as Chairman of the Board and Director
+of First Sentry Bank in Huntington, West Virginia. He served as President of
+First State Financial Corporation from 1999 to 2002, and President of First
+State Bank from 2000 to 2002. He is a graduate of the University of Wisconsin
+School of Banking and former President and CEO of St. Mary s Bank in Franklin,
+Louisiana and First Guaranty Bank in Hammond, Louisiana.
+
+43
+
+Table of Contents
+
+ Corey J. Coughlin is a native of Florida and currently serves as President
+and CEO of First State Financial Corporation from May 2003 and First State Bank
+from July 2002. He previously served as a founder of CSC Financial Services
+from March 1999 to July 2002, and President and Chief Operating Officer of CNB
+Florida Bancshares, Inc. from July 1998 to March 1999. Mr. Coughlin holds a BA
+in business from Georgetown College and is a graduate of the Graduate School of
+Banking, Louisiana State University as well as the National Commercial Lending
+Graduate School at the University of Oklahoma. Mr. Coughlin has been a banker
+since 1971 and is active in the community having held various board positions
+including Chairman of the Board at Bayfront Medical Center.
+
+ Daniel P. Harrington currently serves as President of HTV Industries in
+Cleveland, Ohio. He received his BBA from Stetson University in DeLand,
+Florida and has an MBA from Xavier University. He is a director of Biopure
+Corp, Churchill Downs Inc. in Louisville, Kentucky, First Guaranty Bank and
+Portec Rail Products, Inc.
+
+ Marshall Reynolds currently serves as Chairman and CEO of Champion
+Industries and has been Director and owner of many businesses including
+agriculture, manufacturing and banking. He is a director of Abigail Adams
+National Bancorp, Inc., First Guaranty Bank, Portec Rail Products, Inc., and
+Premier Financial Bancorp, Inc. His community interests include both the
+former Chairman of the Boys and Girls Club as well as the former Chairman of
+the United Way.
+
+ Neal Scaggs is owner of Logan Auto Parts an after-market auto parts
+company with multiple locations in West Virginia and Orlando, Florida. He is a
+director of Premier Financial Bancorp, Portec Rail Products, and Champion
+Industries, Inc. He is a graduate of Marshall College and currently is
+Chairman of the Board of First State Financial Corporation.
+
+ Robert L. Shell, Jr. is Chairman and Chief Executive Officer of Guyan
+International, a manufacturer of hydraulic pumps.
+
+ Thomas W. Wright is the President and CEO of NexQuest, which is an
+investment and operating company, involved in many types of businesses
+including restaurants, banks and other operating companies.
+
+First State Bank Board of Directors
+
+ In addition to Messrs. Wright, who serves as Chairman of the Board,
+Coughlin, who serves as President and Chief Executive Officer, the following
+are the additional directors of First State Bank:
+
+ Lester Baynard is a long time resident of the St. Petersburg, Florida
+area. He is a partner with Baynard, McCloud and Lang. While not an attorney,
+he provides legal support services at the direction of the law firm. He is a
+graduate of the Florida School of Engineering and holds a Masters from the
+University of South Florida. He has been on the Board since 1995 and also
+serves on the ALCO Committee. He was a former director of Rutland Bank. After
+Rutland Bank was purchased by the First State investor group, its name was
+changed to First State Bank of Pinellas.
+
+ David Coddington is a resident of Sarasota, Florida. He is currently a
+Real Estate Investor and Wireless Engineering Consultant with IBC Services.
+For 30 years he was President of IBC Services and International Business
+Consultants firm. He has served as a Director since 1997 and is currently a
+member of the Audit Committee.
+
+ JC (Bud) Felix is a lifetime resident of the St. Petersburg, Florida area.
+He has served on the Board since 2001 and also on the Audit and Internal
+Controls Committees. He is currently a private investor and was previous owner
+of Felix Construction from 1958 to 1985. He is a graduate of Rawlins College
+with a degree in building construction. He serves as a Director of
+not-for-profit organizations and is a member of the Pinellas County Committee
+of 100, Pinellas County Chamber of Commerce and the Suncoasters. He was a
+former director of Rutland Bank.
+
+44
+
+Table of Contents
+
+ C. Ted French has served on the Board since 1998. He is presently
+Chairman of the Audit Committee and serves on the Executive Loan Committee.
+Mr. French is a private attorney with a undergraduate degree from the
+University of Florida and a law degree from the University of Florida. Mr.
+French is also a CPA and worked with Arthur Anderson prior to private law.
+
+ Wade Harris has been a resident of Sarasota since 1987, and a board member
+since 2002. He is also on the ALCO and Executive Loan Committees. He is
+currently a private investor in the Sarasota market. He also serves on the
+board of Sunnyside Properties, a continuing care community.
+
+ Richard F. McDaniel has a degree in Finance from Ohio State University.
+He owns and operates McDaniel Trading Inc. a livestock feed trading company and
+prior to that held several positions in the commercial brokerage business. Mr.
+McDaniel is very active in the community and is Chairman of the Board of the
+YMCA and he is also very active in his church.
+
+ Richard Olszewski is a member of the Board and holds a Bachelor degree
+from the University of Dayton in mechanical engineering and a Master from
+Cleveland State University. He is currently President of Permco, an
+engineering company headquartered in Cleveland, Ohio.
+
+ Nancy Rutland is a life-long resident of St. Petersburg and has been on
+the Board since 1994. She was a former director of Rutland Bank. She serves
+on the Executive Loan and Internal Controls Committees. Ms. Rutland is a
+private attorney with an undergraduate degree from Flagler College and a law
+degree from Stetson College of Law. She is very active in the community with
+the Suncoasters where she is Chair of the Sun Goddess Selection Committee.
+
+ John W. Saputo has been on the Board since 2003. Mr. Saputo holds a
+degree from Boston College in Accounting and is the President/CEO and owner of
+Gold Coast Eagle Distributors, the exclusive distributor for Anheuser Busch
+products in Manatee and Sarasota Counties. Mr. Saputo serves as a Colonel in
+the USMC and served in Iraq.
+
+ Terry Seiders is a resident of Sarasota and has been on the Board since
+2002. He is a Real Estate Investor and owner of Nexico, an imaging sales and
+service company, and the Winsulator, an energy conservation firm. He
+previously owned DOS Computer a company that deals with the sale and leasing of
+computer products. Mr. Sieders is very active in the community and served as a
+board member of the American Red Cross, Mote Marine Laboratory and the Manatee
+Chamber of Commerce.
+
+ Lisa Ulrich is a resident of St. Petersburg and a real estate broker with
+Vector Realty Management, Inc. and has been on the Board since 2002. She
+serves also on the ALCO and Executive Loan Committees. Ms. Ulrich has a BA
+degree in business from Eckerd College and she is currently employed in
+commercial real estate sales and leasing and income property investing.
+
+Director Compensation
+
+ First State Bank pays directors (including Mr. Coughlin, its President and
+Chief Executive Officer) $200 for attendance at each monthly meeting of the
+board of directors, and $150 for attendance at meetings of committees appointed
+by the board of directors. First State Financial does not pay director fees.
+
+Executive Officer Agreement
+
+ First State Bank has entered into an agreement with Mr. Coughlin, which
+provides for him to serve as President and Chief Executive Officer of First
+State Bank and for Mr. Coughlin to receive a severance payment of one year s
+base salary upon the closing of a change of control, if a mutually satisfactory
+employment agreement cannot be reached with the purchaser at that time. A
+change of control is defined as the sale, transfer or other disposition of 51%
+or more of the outstanding shares of common stock. For 2004, Mr. Coughlin will
+earn a performance bonus of 30% of his $161,200 base earnings, if the Bank
+reports after tax earnings of $1.5 million for 2004 and a December 31, 2004
+asset level of at least $250 million. If the Bank earns more than the income
+amount, or grows greater than the asset level, Mr.
+
+45
+
+Table of Contents
+
+Coughlin is entitled to a
+larger bonus, which will be at the discretion of the Chairman of the Board
+(such bonus to be paid before the end of January 2005). Mr. Coughlin also has
+received options to acquire 30,000 shares of common stock at a price of $5.25
+per share, 12,000 of which are currently vested, and an additional 6,000 shares
+vest on December 31, 2004 (and 6,000 on each December 31 thereafter).
+
+Executive Compensation and Benefits
+
+ The following table sets forth all cash compensation to the President and
+Chief Executive Officer of First State Financial and First State Bank, and the
+Executive Vice President and Senior Loan Officer for First State Bank, the only
+executive officers whose salary and bonus exceeded $100,000 during 2003, for
+services to each.
+
+SUMMARY COMPENSATION TABLE
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ Long Term Compensation
+ 
+ 
+ 
+ 
+
+ Annual Compensation
+ 
+ Awards
+ 
+ Payouts
+ 
+ 
+
+ Name
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ and
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ Other
+ 
+ Restricted
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Principal
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ Annual
+ 
+ Stock
+ 
+ Options/
+ 
+ LTIP
+ 
+ All Other
+
+ Position
+ 
+ Year
+ 
+ Salary
+ 
+ Bonus
+ 
+ Compensation
+ 
+ Award(s)
+ 
+ SARs
+ 
+ Payouts
+ 
+ Compensation
+
+ Corey J. Coughlin
+
+ 
+ 
+ 2003
+ 
+ 
+ $
+ 144,375
+ 
+ 
+ $
+ 30,000
+ 
+ 
+ $
+ 4,200 
+ (1)
+ 
+ 
+ -0-
+ 
+ 
+ 
+ -0-
+ 
+ 
+ 
+ -0-
+ 
+ 
+ $
+ -0-
+ 
+
+ President and Chief
+
+Executive Officer
+
+of the First State
+
+Financial
+and
+
+First State Bank
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ 
+Michael K. Worthington
+
+ 
+ 
+ 2003
+ 
+ 
+ $
+ 90,270
+ 
+ 
+ $
+ 32,827
+ 
+ 
+ $
+ 6,000 
+ (2)
+ 
+ 
+ -0-
+ 
+ 
+ 
+ -0-
+ 
+ 
+ 
+ -0-
+ 
+ 
+ $
+ -0-
+ 
+
+ Executive
+Vice President
+
+and Senior Lending
+
+Officer
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ 
+
+ (1)
+ 
+ Represents amounts paid by First State Bank to Mr. Coughlin for director
+and committee fees (see Director Compensation ).
+
+ 
+
+ 
+
+ (2)
+ 
+ Represents automobile allowance.
+
+Aggregate Options Exercised in Last Fiscal Year and Fiscal Year-End Option
+Values
+
+ The following table sets forth, for each of Messrs. Coughlin and
+Worthington the number of shares of common stock held at December 31, 2003, and
+the realizable gain on the stock options that are in-the-money. The
+in-the-money stock options are those with exercise prices that are below the
+year-end stock price because the stock value increased since the date of the
+grant.
+
+Aggregated Option/SAR Exercises in Last Fiscal Year and FY-End
+
+Option/SAR Values
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ Number of
+ 
+ 
+
+ 
+ 
+ 
+ 
+ 
+ 
+ Securities
+ 
+ Value of
+
+ 
+ 
+ 
+ 
+ 
+ 
+ Underlying
+ 
+ Unexercised
+
+ 
+ 
+ Shares
+ 
+ 
+ 
+ Unexercised
+ 
+ In-the-Money
+
+ 
+ 
+ Acquired
+ 
+ 
+ 
+ Options/SARs
+ 
+ Options/SARs
+
+ 
+ 
+ on
+ 
+ Value
+ 
+ at FY-End (#)
+ 
+ at FY-End($)
+
+ 
+ 
+ Exercise
+ 
+ Realized
+ 
+ Exercisable/
+ 
+ Exercisable/
+
+ Name
+ 
+ (#)
+ 
+ ($)
+ 
+ Unexercisable
+ 
+ Unexercisable (1) (2)
+
+ Corey J. Coughlin
+
+ 
+ 
+
+ 
+ 
+
+ 
+ 12,000/18,000
+
+ 
+ $ /$ 
+
+ Michael K. Worthington
+
+ 
+ 
+
+ 
+ 
+
+ 
+ 1,600/2,400
+
+ 
+ $ /$ 
+
+ (1)
+ 
+ Based upon the initial public offering price of our common shares
+pursuant to this offering.
+
+ 
+
+ (2)
+ 
+ Value represents fair market value at exercise minus exercise price.
+
+46
+
+Table of Contents
+
+Stock Option Plan
+
+ We have a 2004 stock plan which provides for the grants of options to
+purchase our common stock to directors and employees. This plan is intended to
+replace our 1996 non-qualified stock option plan, which provided for the
+issuance of options to directors and employees. There are 35,300 options
+outstanding under that plan at exercise prices between $3.00 and $4.81 per
+share. In addition, Mr. Coughlin was granted options for 30,000 shares as a
+part of his employment, 12,000 of which are vested and the remaining 18,000
+vest over the next three years. The exercise price for these options is $5.25
+per share. No further grants will be made under the 1996 stock option plan.
+Our board of directors continues to believe that stock-based incentives are
+important factors in attracting, retaining and rewarding employees and
+directors and closely aligning their interests with those of the shareholders.
+As of the date of this prospectus, no options had been issued under the 2004
+plan. Options to purchase our common stock may be either incentive stock
+options, which are intended to satisfy the requirements of Section 422 of the
+Internal Revenue Code of 1986, as amended, which we refer to as the Code, or
+options which are not intended to satisfy the requirements of that Code
+section, which we refer to as non-qualified options.
+
+ The number of shares reserved under the plan is 500,000 shares, less the
+amount of the 65,300 outstanding options granted under our 1996 plan and to Mr.
+Coughlin, but only to the extent such options are exercised. The plan is
+administered by a committee of our Board. The committee has the authority to
+grant options, construe, interpret and administer the plan, and determine the
+employees and directors eligible to receive grants, and the number of shares
+granted and the terms of those options. The number of shares reserved under
+the plan may be equitably adjusted by our Board to reflect any changes in our
+capitalization, including as a result of stock dividends or stock splits, or to
+reflect certain corporate transactions. The board may also amend or terminate
+the plan. However, no amendment may be effected without approval of our
+shareholders to the extent such approval is required under applicable law or
+the Code. In no case, can options be revised either by cancellation and
+regrant, or by lowering the exercise price of a previously granted award. The
+price at which an option may be exercised for a share of our common stock may
+not be less than the fair market value on the date the option is granted.
+Except for adjustments related to changes in capital structure, mergers or a
+change in control, the Committee may not, absent the approval of our
+shareholders, reduce the option price of any outstanding options. The
+Committee determines the period during which an option may be exercised. The
+period is determined at the time the option is granted and may not extend more
+than ten years from the date of grant. All or part of an option that is not
+exercised before expiration of the applicable option period will terminate. An
+option agreement may provide for the exercise of an option after the employment
+of an employee or the status of an individual as director has terminated for
+any reason, including death or disability.
+
+ The aggregate fair market value of an incentive stock option granted to an
+employee under the plan and incentive stock options granted under any other
+stock option plan adopted by us which first become exercisable in 2005 or any
+later calendar year may not exceed $100,000. The directors as a group may not
+over the life of the plan be granted options which in the aggregate exceed
+100,000 shares of our common stock. Generally, options are transferable only
+by will or the laws of descent and distribution, unless the Committee deems
+otherwise and in accordance with any tax and securities laws.
+
+Certain Transactions and Relationships
+
+ First State Bank has had, and expects to have in the future, banking
+transactions in the ordinary course of business with certain of its directors
+and executive officers and their associates. As of September 30, 2004,
+December 31, 2003 and 2002, our directors and executive officers and those of
+the Bank and their associates, as a group, were indebted to the Bank in the
+aggregate amount of approximately $858,000, $1.2 million and $2.8 million,
+respectively. All loans included in such transactions were made in the
+ordinary course of business, on substantially the same terms (including
+interest rate and collateral) as those prevailing at the time for comparable
+transactions with other persons, and in the opinion of management of the Bank
+did not involve more than the normal risk of collectibility or present other
+unfavorable features.
+
+47
+
+Table of Contents
+
+BENEFICIAL OWNERSHIP OF MANAGEMENT
+
+AND PRINCIPAL SHAREHOLDERS
+
+ The following table presents information regarding beneficial ownership of
+our common stock as of September 30, 2004 by:
+
+ 
+ 
+ Each person known by us to own more than 5% of our voting common stock;
+
+ 
+
+ 
+ 
+ Our directors and those of First State Bank;
+
+ 
+
+ 
+
+ 
+ 
+ Each of our executive officers and those of First State Bank named in the Summary Compensation Table; and
+
+ 
+
+ 
+
+ 
+ 
+ All of our executive officers and directors as a group.
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ 
+ 
+ Beneficial ownership
+(a)
+
+ Name
+ 
+ Number of shares
+ 
+ Percentage ownership 
+
+ Directors of First State Financial:
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Robert H. Beymer
+
+ 
+ 
+ 129,075
+ (b)
+ 
+ 
+ 3.80%
+ 
+
+ Corey J. Coughlin
+
+ 
+ 
+ 49,815
+ 
+ 
+ 
+ 1.46
+ %
+
+ Daniel Harrington
+
+ 
+ 
+ 296,478
+ (c)
+ 
+ 
+ 8.72
+ %
+
+ Marshall Reynolds
+
+ 
+ 
+ 429,900
+ 
+ 
+ 
+ 12.65
+ %
+
+ Neal Scaggs
+
+ 
+ 
+ 187,125
+ 
+ 
+ 
+ 5.50
+ %
+
+ Robert L. Shell, Jr.
+
+ 
+ 
+ 106,553
+ (d)
+ 
+ 
+ 3.13
+ %
+
+ Thomas W. Wright
+
+ 
+ 
+ 430,413
+ (e)
+ 
+ 
+ 12.66
+ %
+
+ Directors of First State Bank:
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Lester Baynard
+
+ 
+ 
+ 2,000
+ 
+ 
+ 
+ *
+ 
+
+ David Coddington
+
+ 
+ 
+ 7,200
+ (f)
+ 
+ 
+ *
+ 
+
+ Corey J. Coughlin
+
+ 
+ 
+ 49,815
+ 
+ 
+ 
+ 1.46
+ %
+
+ JC Bud Felix
+
+ 
+ 
+ 11,000
+ 
+ 
+ 
+ *
+ 
+
+ C. Ted French
+
+ 
+ 
+ 8,200
+ (g)
+ 
+ 
+ *
+ 
+
+ Wade Harris
+
+ 
+ 
+ 50,000
+ (h)
+ 
+ 
+ 1.47
+ %
+
+ Richard McDaniel
+
+ 
+ 
+ 34,000
+ 
+ 
+ 
+ 1.00
+ %
+
+ Rick Olszewski
+
+ 
+ 
+ 3,400
+ (i)
+ 
+ 
+ *
+ 
+
+ Nancy Rutland
+
+ 
+ 
+ 9,227
+ 
+ 
+ 
+ *
+ 
+
+ John Saputo
+
+ 
+ 
+ 1,000
+ (j)
+ 
+ 
+ *
+ 
+
+ Terry Seiders
+
+ 
+ 
+ 7,500
+ (k)
+ 
+ 
+ *
+ 
+
+ Lisa Ulrich
+
+ 
+ 
+ 1,000
+ 
+ 
+ 
+ *
+ 
+
+ Thomas W. Wright
+
+ 
+ 
+ 430,413
+ (e)
+ 
+ 
+ 12.66
+ %
+
+ Executive Officers
+
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+ 
+
+ Corey J. Coughlin
+
+ 
+ 
+ 49,815
+ 
+ 
+ 
+ 1.46
+ %
+
+ Michael K. Worthington
+
+ 
+ 
+ 17,752
+ (l)
+ 
+ 
+ *
+ 
+
+ All directors and executive officers as a group (19 persons)
+
+ 
+ 
+ 1,781,638
+ 
+ 
+ 
+ 52.01
+ %
+
+ *
+ 
+ Percent share ownership is less than 1% of total shares outstanding.
+
+ 
+
+ (a)
+ 
+ Except as otherwise indicated, the persons named in the above table have
+sole voting and investment power with respect to all shares shown as
+beneficially owned by them. Information relating to beneficial ownership
+of the shares is based upon beneficial ownership concepts set forth in
+the rules
+
+48
+
+Table of Contents
+
+ 
+ 
+ promulgated under the Securities and Exchange Act of 1934, as
+amended. Under such rules, a person is deemed to be a beneficial owner 
+of a security if that person has or shares voting power with respect to
+such security. A person may be deemed to be the beneficial owner of a
+security if that person also has the right to acquire beneficial ownership
+of such security within 60 days. Under the beneficial ownership rules,
+more than one person may be deemed to be a beneficial owner of the same
+securities, and a person may be deemed to be a beneficial owner of
+securities as to which he or she may disclaim any beneficial interest.
+The information as to beneficial ownership has been furnished by the
+respective persons listed in the above table.
+
+ (b)
+ 
+ Includes 104,075 shares owned by his spouse, as to which
+shares Mr. Beymer disclaims any beneficial ownership.
+
+ 
+
+ (c)
+ 
+ Consists of shares held by two companies and a family trust
+as to which Mr. Harrington may be deemed to be the beneficial owner of the shares.
+
+ 
+
+ (d)
+ 
+ Includes currently exercisable options to purchase 7,000
+shares.
+
+ 
+
+ (e)
+ 
+ Includes 201,940 shares owned by a family partnership as to
+which Mr. Wright may be deemed to be the beneficial owner of the shares.
+
+ 
+
+ (f)
+ 
+ Consists of currently exercisable options to purchase 7,200
+shares.
+
+ 
+
+ (g)
+ 
+ Includes currently exercisable options to purchase 7,200
+shares.
+
+ 
+
+ (h)
+ 
+ Consists of shares held jointly with his spouse.
+
+ 
+
+ (i)
+ 
+ Consists of currently exercisable options to purchase 3,400
+shares.
+
+ 
+
+ (j)
+ 
+ Consists of shares held by a company as to which Mr. Saputo
+may be deemed to be the beneficial owner of the shares.
+
+ 
+
+ (k)
+ 
+ Includes 7,000 shares held in a revocable trust as to which
+Mr. Seiders may be deemed to be the beneficial owner of the shares.
+
+ 
+
+ (l)
+ 
+ Includes currently exercisable options to purchase 1,600
+shares.
+
+ 
+
+DESCRIPTION OF CAPITAL STOCK
+
+Common Stock
+
+ We have 25,000,000 shares of authorized common stock, par value $1.00 per
+share. At September 30, 2004, we had 369 registered shareholders of record and
+3,399,040 shares of common stock outstanding. The outstanding shares of common
+stock are fully paid and nonassessable. The shares of common stock offered in
+this offering will, upon their purchase, be fully paid and nonassessable. The
+holders of our common stock have one vote per share in all proceedings in which
+action shall be taken by our shareholders.
+
+Preferred Stock
+
+ Our articles of incorporation authorize us to issue up to five million
+shares of preferred stock. Our Board of Directors has the authority, without
+approval of our shareholders, from time to time to authorize the issuance of
+preferred stock in one or more series for such consideration and, within
+certain limits, with such relative rights, preferences and limitations as our
+Board of Directors may determine. The relative rights, preferences and
+limitations that our Board of Directors has the authority to determine as to
+any such series of preferred stock include, among other things, dividend
+rights, voting rights, conversion rights, redemption rights, and liquidation
+preferences. Because our Board of Directors has the power to establish the
+relative rights, preferences and limitations of each series of preferred stock,
+it may afford to the holders of any such series, preferences and rights senior
+to the rights of the holders of the shares of common stock. Although our Board
+of Directors has no intention at the present time of doing so, it could cause
+the issuance of preferred stock that could discourage an acquisition attempt or
+other transactions that some, or a majority of, the shareholders might believe
+to be in their best interests or in which the shareholders might receive a
+premium for their shares of common stock over the market price of such shares.
+
+Rights to Dividends
+
+ The holders of our common stock will be entitled to dividends when, as,
+and if declared by our Board of Directors out of funds legally available for
+dividends. Under Florida law, dividends may be legally declared or paid only
+if, after their payment, we can pay our debts as they come due in the usual
+course of business, and then only if our total assets equal or exceed the sum
+of our liabilities plus the amount that would be needed to satisfy the
+preferential rights upon dissolution to any holders of preferred stock then
+outstanding whose preferential rights are superior to those receiving the
+distribution.
+
+Rights Upon Liquidation
+
+ In the event of our voluntary or involuntary liquidation or dissolution,
+or the winding-up of our affairs, our assets will be applied first to the
+payment, satisfaction and discharge of our existing debts and obligations,
+including the necessary expenses of dissolution or liquidation, as well as any
+preferential rights for holders of preferred stock then outstanding, and then
+pro rata to the holders of our common stock.
+
+General Voting Requirements
+
+ The affirmative vote of the holders of a majority of the shares of common
+stock entitled to vote is required to approve any action for which stockholder
+approval is required.
+
+49
+
+Table of Contents
+
+Affiliated Transactions
+
+ Unless an exemption is available, the Florida law prohibits certain
+ affiliated transactions (including any merger or similar transaction subject
+to a statutory stockholder vote and additional transactions involving transfers
+of assets or securities in specific amounts) between a Florida corporation and
+certain interested stockholders for a period of five years after the most
+recent date on which that shareholder became an interested stockholder. For
+purposes of this prohibition, an interested stockholder 
+is: (i) any person who beneficially owns 10% or more of the outstanding
+voting shares of the corporation s shares; and (ii) any affiliate or
+ associate of the interested shareholder. Any such affiliated transaction must
+be approved by the affirmative vote of at least two-thirds of the votes
+entitled to be cast by holders of outstanding voting shares of the corporation
+other than shares held by the interested shareholder with whom the affiliated
+transaction is to be effected.
+
+ These provisions of Florida law do not apply, however, to affiliated
+transactions (i) that are approved by a majority of the disinterested
+directors, (ii) where the corporation has not had more than 300 shareholders of
+record at any time during the three years preceding the date of the first
+general public announcement of the proposed affiliated transaction or of the
+intention of the proposed affiliated transaction ( announcement date ), (iii)
+when the interested shareholder is the beneficial owner of at least 80% of the
+corporation s outstanding voting shares for at least five years preceding the
+ announcement date or the intention to propose an affiliated transaction is
+first communicated generally to the shareholders of the corporation, whichever
+is earlier, (iv) when the interested shareholder is the beneficial owner of at
+least 90% of the outstanding voting shares of the corporation, (v) when the
+corporation is an investment company registered under the Investment Company
+Act of 1940, (vi) when consideration is paid to the holders of each class or
+series of voting shares as described in the Florida law, or (vii) if our
+articles of incorporation are amended to specifically provide that we are not
+subject to the foregoing requirements. Under Florida law, such an amendment
+must be approved by an affirmative vote of a majority of the outstanding shares
+of voting stock, excluding interested shareholders and their affiliates and
+associates as defined in the law.
+
+Control Share Acquisitions
+
+ Florida law also provides that control shares of a Florida corporation
+acquired in a control share acquisition have no voting rights except to the
+extent approved by a vote of two-thirds of the shares entitled to be voted on
+the matter, excluding shares of stock owned by the acquirer or by officers or
+directors who are employees of the corporation. Control shares are voting
+shares of stock which, if aggregated with all other such shares of stock
+previously acquired by the acquirer, or in respect of which the acquirer is
+able to exercise or direct the exercise of voting power except solely by virtue
+of a revocable proxy, would entitle the acquirer to exercise voting power in
+electing directors within one of the following ranges of voting power:
+
+ 
+ 
+ one-fifth or more but less than one-third;
+
+ 
+
+ 
+ 
+ one-third or more but less than a majority; or
+
+ 
+
+ 
+ 
+ a majority of all voting power.
+
+ Control shares do not include shares the acquiring person is then entitled
+to vote as a result of having previously obtained stockholder approval. A
+ control share acquisition means the acquisition of control shares, subject to
+certain exceptions.
+
+ A person who has made or proposes to make a control share acquisition,
+upon satisfaction of certain conditions (including an undertaking to pay
+expenses and delivery of an acquiring person statement ), may compel the
+corporation s Board of Directors to call a special meeting of shareholders to
+be held within 50 days of demand to consider the voting rights of the shares.
+If no request for a meeting is made, the corporation may itself present the
+question at the next annual or special shareholders meeting.
+
+ Unless the charter or bylaws provide otherwise, if voting rights are not
+approved at the meeting or if the acquiring person does not deliver an
+acquiring person statement then following the last control share
+
+50
+
+Table of Contents
+
+acquisition,
+subject to certain conditions and limitations, the corporation may at any time
+during the 60 days after the last control share acquisition redeem any or all
+of the control shares (except those for which voting
+rights have previously been approved) for fair value determined, pursuant to
+procedures adopted by the corporation. The fair value of the shares as
+determined for purposes of such appraisal rights may not be less than the
+highest price per share paid by the acquirer in the control share acquisition.
+
+Transfer Agent
+
+ The transfer agent for our common stock will be American Stock Transfer 
+Trust Company.
+
+SUPERVISION AND REGULATION
+
+General
+
+ We are extensively regulated under federal and state law. Generally, these
+laws and regulations are intended to protect depositors, not stockholders. The
+following is a summary description of certain provisions of certain laws that
+affect the regulation of bank holding companies and banks. The discussion is
+qualified in its entirety by reference to applicable laws and regulations.
+Changes in such laws and regulations may have a material effect on our business
+and prospects, as well as those of First State Bank.
+
+Federal Bank Holding Company Regulation and Structure
+
+ We are a bank holding company within the meaning of the Bank Holding
+Company Act of 1956, as amended, and, as such, we are subject to regulation,
+supervision, and examination by the Federal Reserve. We are required to file
+annual and quarterly reports with the Federal Reserve and to provide the
+Federal Reserve with such additional information as it may require. The Federal
+Reserve may examine us and our subsidiaries.
+
+ With certain limited exceptions, we are required to obtain prior approval
+from the Federal Reserve before acquiring direct or indirect ownership or
+control of more than 5% of any voting securities or substantially all of the
+assets of a bank or bank holding company, or before merging or consolidating
+with another bank holding company. In acting on applications for such approval,
+the Federal Reserve must consider various statutory factors, including among
+others, the effect of the proposed transaction on competition in the relevant
+geographical and product markets, each party s financial condition and
+management resources and record of performance under the Community Reinvestment
+Act. Additionally, with certain exceptions any person proposing to acquire
+control through direct or indirect ownership of 25% or more of any of our
+voting securities is required to give 60 days written notice of the
+acquisition to the Federal Reserve, which may prohibit the transaction, and to
+publish notice to the public.
+
+ Generally, a bank holding company may not engage in any activities other
+than banking, managing or controlling its bank and other authorized
+subsidiaries, and providing services to these subsidiaries. With prior approval
+of the Federal Reserve, we may acquire more than 5% of the assets or
+outstanding shares of a company engaging in nonbank activities determined by
+the Federal Reserve to be closely related to the business of banking or of
+managing or controlling banks. Recent changes in law have significantly
+increased the right of an eligible bank holding company, called a financial
+holding company, to engage in a full range of financial activities, including
+insurance and securities activities, as well as merchant banking and other
+financial services. We have not applied to become a financial holding company,
+because our capital ratios have not consistently met the well capitalized
+requirements, which is a requirement for maintenance of financial holding
+company status. Following the closing of this offering, we intend to apply to
+become a financial holding company, although there is no assurance that
+financial holding company status would be granted by the Federal Reserve.
+
+ Subsidiary banks of a bank holding company are subject to certain
+quantitative and qualitative restrictions on extensions of credit to the bank
+holding company or its subsidiaries, investments in their securities, and the
+use of their securities as collateral for loans to any borrower. These
+regulations and restrictions may limit our ability to obtain funds from First
+State Bank for our cash needs, including funds for the payment of dividends,
+interest and operating expenses. Further, a bank holding company and its
+
+51
+
+Table of Contents
+
+subsidiaries are prohibited from engaging in certain tie-in arrangements in
+connection with any extension of credit, lease or sale of property or
+furnishing of services. For example, First State Bank may not generally
+require a customer to obtain other services from itself or us, and may not
+require that a customer promise not to obtain other services from a competitor
+as a condition to an extension of credit to the customer. The Federal Reserve
+has ended the anti-tying rules for bank holding companies and their non-banking
+subsidiaries. Such rules were retained for banks.
+
+ Under Federal Reserve policy, a bank holding company is expected to act as
+a source of financial strength to its subsidiary banks and to make capital
+infusions into a troubled subsidiary bank, and the Federal Reserve may charge
+the bank holding company with engaging in unsafe and unsound practices for
+failure to commit resources to a subsidiary bank when required. A required
+capital injection may be called for at a time when the holding company does not
+have the resources to provide it. In addition, depository institutions insured
+by the FDIC can be held liable for any losses incurred by, or reasonably
+anticipated to be incurred by, the FDIC in connection with the default of, or
+assistance provided to, a commonly controlled FDIC-insured depository
+institution.
+
+Federal and State Bank Regulation
+
+ Our banking subsidiary is a Florida state-chartered bank, with all the
+powers of a commercial bank regulated and examined by the Florida Office of
+Financial Regulation and the FDIC. The FDIC has extensive enforcement authority
+over the institutions it regulates to prohibit or correct activities that
+violate law, regulation or written agreement with the FDIC. Enforcement powers
+also regulate activities that are deemed to constitute unsafe or unsound
+practices. Enforcement actions may include the appointment of a conservator or
+receiver, the issuance of a cease and desist order, the termination of deposit
+insurance, the imposition of civil money penalties on the institution, its
+directors, officers, employees and institution-affiliated parties, the issuance
+of directives to increase capital, the issuance of formal and informal
+agreements, the removal of or restrictions on directors, officers, employees
+and institution-affiliated parties, and the enforcement of any such mechanisms
+through restraining orders or other court actions.
+
+ In its lending activities, the maximum legal rate of interest, fees and
+charges that a financial institution may charge on a particular loan depends on
+a variety of factors such as the type of borrower, the purpose of the loan, the
+amount of the loan and the date the loan is made. Other laws tie the maximum
+amount that may be loaned to any one customer and its related interest to
+capital levels. First State Bank is also subject to certain restrictions on
+extensions of credit to executive officers, directors, principal stockholders
+or any related interest of such persons which generally require that such
+credit extensions be made on substantially the same terms as are available to
+third persons dealing with First State Bank and not involve more than the
+normal risk of repayment. First State Bank is also subject to federal laws
+establishing certain record keeping, customer identification and reporting
+requirements with respect to certain large cash transactions, sales and
+travelers checks or other monetary instruments, and international
+transportation of cash or monetary instruments. Further, under the USA Patriot
+Act of 2001, financial institutions, such as First State Bank, are required to
+implement additional policies and procedures with respect to, or additional
+measures designed to address, any or all of the following matters, among
+others: money laundering, suspicious activities and currency transaction
+reporting, and currency crimes.
+
+ The Community Reinvestment Act requires that, in connection with the
+examination of a financial institution within its jurisdiction, the FDIC
+evaluate the record of the financial institution in meeting the
+credit needs of its communities including low and moderate income
+neighborhoods, consistent with the safe and sound operation of those banks.
+These factors are also considered by all regulatory agencies in evaluating
+mergers, acquisitions and applications to open a branch or facility. As of the
+date of its most recent examination report, First State Bank has a Community
+Reinvestment Act rating of Satisfactory. Generally, a financial institution
+which maintains a Community Reinvestment Act rating of Satisfactory or
+ Outstanding is allowed to engage in continued expansion and other programs as
+a part of its operation and is otherwise precluded from such activities if its
+rating is below either of these standards.
+
+ Pursuant to the Federal Deposit Insurance Corporation Improvement Act of
+1991, the federal banking agencies, including the FDIC, have adopted safety and
+soundness standards covering internal controls,
+
+52
+
+Table of Contents
+
+information systems and
+internal audit systems, loan documentation, credit underwriting, interest rate
+exposure, asset growth, and compensation, fees and benefits. An institution
+that fails to meet those standards may subject the institution to regulatory
+sanctions if required by the agency to develop a plan acceptable to the agency,
+specifying the steps that the institution will take to meet the standards. We,
+on behalf of First State Bank, believe that we meet substantially all standards
+that have been adopted. This law also imposes capital standards on insured
+depository institutions. See Capital Requirements below.
+
+Deposit Insurance
+
+ As a FDIC member institution, deposits of First State Bank are currently
+insured to a maximum of $100,000 per category of ownership of depositor through
+the Bank Insurance Fund, which is administered by the FDIC.
+
+Limits on Dividends and Other Payments
+
+ Our current ability to pay dividends is largely dependent upon the receipt
+of dividends from First State Bank. Both federal and state laws impose
+restrictions on the ability of First State Bank to pay dividends. Federal law
+prohibits the payment of a dividend by an insured depository institution like
+First State Bank if the depository institution is considered undercapitalized 
+or if the payment of the dividend would make the institution
+ undercapitalized. See Capital Requirements below. The Federal Reserve has
+issued a policy statement that provides that bank holding companies should pay
+dividends only out of the prior year s net income, and then only if their
+prospective rate of earnings retention appears consistent with their capital
+needs, asset quality, and overall financial condition. For a Florida
+state-chartered bank, dividends may be paid out of so much of the bank s
+aggregate net profits for the current year combined with its retained earnings
+for the preceding two years as the board deems appropriate. No dividends may
+be paid at a time when a bank s net income from the preceding two years is a
+loss or if the dividend payment would cause the capital accounts of First State
+Bank to fall below the minimum amount required by law. In addition to these
+specific restrictions, bank regulatory agencies also have the ability to
+prohibit proposed dividends by a financial institution that would otherwise be
+permitted under applicable regulations if the regulatory body determines that
+such distribution would constitute an unsafe or unsound practice.
+
+Capital Requirements
+
+ The Federal Reserve and FDIC have adopted certain risk-based capital
+guidelines to assist in the assessment of the capital adequacy of a banking
+organization s operations for both transactions reported on the balance sheet
+as assets and transactions, such as letters of credit and recourse arrangements
+which are recorded as off balance sheet items. Under these guidelines, nominal
+dollar amounts of assets and credit equivalent amounts of off balance sheet
+items are multiplied by one of several risk adjustment percentages, which range
+from 0% for assets with low credit risk, such as certain U.S. Treasury
+securities to 100% for assets with relatively high credit risk, such as
+business loans.
+
+ A banking organization s risk-based capital ratio is obtained by dividing
+its qualifying capital by its total risk adjusted assets. The regulators
+measure risk-adjusted assets, which include off balance sheet items, against
+both total qualifying capital (the sum of Tier 1 capital and limited amounts of
+Tier 2 capital) and Tier 1 capital. Tier 1, or core capital includes common
+equity, perpetual preferred stock (excluding auction rate issues), trust
+preferred securities (subject to certain limitations), and minority interest in
+equity accounts of consolidated subsidiaries less goodwill and other
+intangibles (subject to certain exceptions). Tier 2, or supplementary
+capital, includes, among other things, limited-life preferred stock, hybrid
+capital instruments, mandatory convertible securities and trust preferred
+securities, qualifying and subordinated debt, and the allowance for loan and
+lease losses, subject to certain limitations and less required deductions. The
+inclusion of elements of Tier 2 capital is subject to certain other
+requirements and limitations of the federal banking agencies.
+
+ In addition to the risk-based capital guidelines, the Federal Reserve and
+the FDIC have established minimum leverage ratio (Tier 1 capital to average
+total assets) guidelines for bank holding companies and banks, respectively.
+These requirements provide for a minimum leverage ratio of 3% for those bank
+holding
+
+53
+
+Table of Contents
+
+companies and banks that have the highest regulatory examination
+ratings and are not contemplating or experiencing significant growth or
+expansion. All other bank holding companies and banks are required to maintain
+a leverage ratio of at least 1% to 2% above the 3% stated minimum. For the
+compliance of First State Financial and First State Bank with the risk-based
+and leverage capital ratios, see Management s Discussion and Analysis of
+Financial Condition and Results of Operation Capital Resources. 
+
+ The federal banking agencies are required to take prompt corrective
+action with respect to depository institutions that do not meet minimum
+capital requirements. As a result, the federal bank regulatory authorities
+have adopted regulations setting forth a five tiered system for measuring the
+capital adequacy of the depository institutions that they supervise. Under
+these regulations, a depository institution is classified in one of the
+following capital categories: well capitalized, adequately capitalized, 
+ undercapitalized, significantly undercapitalized, and critically
+undercapitalized. An institution may be deemed by the regulators to be in a
+capitalization category that is lower than is indicated by its actual capital
+position if, among other things, it receives an unsatisfactory examination
+rating with respect to asset quality, management, earnings or liquidity. As of
+September 30, 2004, First State Bank met the definition of an adequately
+capitalized institution.
+
+ A depository institution generally is prohibited from making any capital
+distribution (including payment of a cash dividend) or paying any management
+fees to its holding company if the depository institution would thereafter be
+undercapitalized. Undercapitalized depository institutions are subject to
+growth limitations and are required to submit capital restoration plans. If a
+depository institution fails to submit an acceptable plan, it is treated as if
+it is significantly undercapitalized. Significantly undercapitalized depository
+institutions may be subject to a number of other requirements and restrictions
+including orders to sell sufficient voting stock to become adequately
+capitalized, requirements to reduce total assets and stop accepting deposits
+from correspondent banks. Critically undercapitalized institutions are subject
+to the appointment of a receiver or conservator, generally within 90 days of
+the date such institution is determined to be critically undercapitalized.
+
+ The federal banking agencies also have significantly expanded powers to
+take enforcement action against institutions that fail to comply with capital
+or other standards. Such action may include limitations on the right to pay
+dividends, the issuance by the applicable regulatory authority of a capital
+directive to increase capital and, in the case of depository institutions, the
+termination of deposit insurance by the FDIC. The circumstances under which
+the FDIC is permitted to provide financial assistance to an insured institution
+before appointment of a conservator or receiver also is limited under law. In
+addition, future changes in regulations or practices could further reduce the
+amount of capital recognized for purposes of capital
+adequacy. Such a change could affect the ability of First State Bank to grow
+and could restrict the amount of profits, if any, available for the payment of
+dividends to us.
+
+Interstate Banking Legislation
+
+ The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994
+( Riegle-Neal ), subject to certain restrictions, allows adequately capitalized
+and managed bank holding companies to acquire existing banks across state
+lines, regardless of state statutes that would prohibit acquisitions by
+out-of-state institutions. Further, a bank holding company may consolidate
+interstate bank subsidiaries into branches and a bank may merge with an
+unaffiliated bank across state lines unless an applicable state has opted out
+of the interstate merger conditions of Riegle-Neal. Florida has enacted a law
+which permits interstate branching through merger transactions under the
+federal interstate laws. Under the Florida law, with the prior approval of the
+Florida Office of Financial Regulation, a Florida bank may establish, maintain
+and operate one or more branches in a state other than the State of Florida
+pursuant to a merger transaction in which the Florida bank is the resulting
+bank. In addition, Florida law provides that one or more Florida banks may
+enter into a merger transaction with one or more out-of-state banks, and an
+out-of-state bank resulting from such transaction may maintain and operate
+branches of a Florida bank that participated in such merger.
+
+Financial Services Modernization
+
+54
+
+Table of Contents
+
+ Enacted in 1999, the Gramm-Leach-Bliley Act reforms and modernizes certain
+areas of financial services regulations and repeals the affiliation provisions
+of the federal Glass-Steagall Act of 1933, which, taken together, limited the
+securities, insurance and other non-banking activities of any company that
+controls a FDIC insured financial institution. The Act provides that a
+financial holding company may engage in a full range of financial activities,
+including insurance and securities sales and underwriting activities, real
+estate development, and, with certain exceptions, merchant banking activities,
+with new expedited notice procedures. The Act also permits certain qualified
+national banks to form financial subsidiaries, which have broad authority to
+engage in all financial activities except insurance underwriting, insurance
+investments, real estate investment or development, and merchant banking, and
+expands the potential financial activities of subsidiaries of state banks,
+subject to applicable state law. The range of activities in which bank holding
+companies and their subsidiaries may engage is not as broad, and the Act may
+increase the competition that we face. The law also includes substantive
+requirements for maintenance of customer financial privacy.
+
+Sarbanes-Oxley Act
+
+ In 2002, the Sarbanes-Oxley Act was enacted which imposes a myriad of
+corporate governance and accounting measures designed that shareholders are
+treated and have full and accurate information about the public companies in
+which they invest. All public companies are affected by the Act. Some of the
+principal provisions of the Act include:
+
+ 
+ 
+ the creation of an independent accounting oversight board to oversee the audit of public companies and auditors who perform
+such audits;
+
+ 
+
+ 
+ 
+ auditor independence provisions which restrict non-audit services that independent accountants may provide to their audit
+clients;
+
+ 
+
+ 
+ 
+ additional corporate governance and responsibility measures which (a) require the chief executive officer and chief
+financial officer to certify financial statements and internal controls and to forfeit salary and bonuses in certain
+situations, and (b) protect whistleblowers and informants;
+
+ 
+
+ 
+ 
+ expansion of the authority and responsibilities of the company s audit, nominating and compensation committees;
+
+ 
+
+ 
+ 
+ mandatory disclosure by analysts of potential conflicts of interest; and
+
+ 
+
+ 
+ 
+ enhanced penalties for fraud and other violations.
+
+Other Legislative Considerations
+
+ The United States Congress and the Florida Legislature periodically
+consider and may adopt legislation that results in additional deregulation,
+among other matters, of banks and other financial institutions. Such
+legislation could modify or eliminate current prohibitions with other financial
+institutions, including mutual funds, securities, brokerage firms, insurance
+companies, banks from other states, and investment banking firms. The effect
+of any such legislation on our business or that of First State Bank cannot be
+accurately predicted. We cannot predict what legislation might be enacted or
+what other implementing regulations might be adopted, and if enacted or
+adopted, the effect on us.
+
+SHARES ELIGIBLE FOR FUTURE SALE
+
+ Upon
+completion of this offering, we will have 5,526,540 shares of common
+stock outstanding (5,845,665 if the over-allotment option is exercised in
+full), assuming no stock options are exercised, 5,226,540 of which will be
+freely tradable securities unless they were acquired by our directors,
+executive officers or other affiliates (collectively, affiliates ). Our
+affiliates generally will be able to sell the common stock only in accordance
+with the limitations of Rule 144 under the Securities Act.
+
+55
+
+Table of Contents
+
+ In general, under Rule 144 as currently in effect, an affiliate (as
+defined in Rule 144) may sell common stock within any three-month period in an
+amount limited to the greater of 1% of our outstanding common stock or the
+average weekly trading volume in our common stock during the four calendar
+weeks preceding such sale. Sales under Rule 144 also are subject to certain
+manner-of-sale provisions, notice requirements and the availability of current
+public information about us. However, our directors and executive officers
+have agreed not to sell, contract to sell, or otherwise dispose of any of their
+common stock for a period of 180 days after the date of this prospectus without
+the prior written consent of the underwriter.
+
+ As of the date of this prospectus, we had outstanding options under our
+stock option plan to purchase an aggregate of 65,300 shares of common stock.
+The resale of the shares acquired upon exercise of these options will be
+subject to a 90 day holding period under Rule 701 unless such shares are
+registered with the Commission on Form S-8 under the Securities Act. We intend
+to file a registration statement on Form S-8 following this offering to cover
+these commons shares.
+
+UNDERWRITING
+
+ Subject to the terms and conditions of an underwriting agreement dated
+ , 2004, Advest, Inc., as representative of the underwriters named
+below, and the underwriters have agreed, severally and not jointly, to
+purchase, and we have agreed to sell to the underwriters, the number of shares
+of common stock set forth opposite their respective names below:
+
+ 
+ 
+ 
+
+ Name
+ 
+ Number of shares
+
+ Total
+
+ 
+ 
+
+ The underwriting agreement provides that the obligations of underwriters
+are subject to various conditions, including approval of certain legal matters
+by underwriters counsel. The nature of the underwriters obligation is that
+they are committed to purchase and pay for all shares of common stock offered
+by this prospectus, other than those shares covered by the over-allotment
+option described below, if any of the shares are not purchased.
+
+ The following table shows the per share and total underwriting discounts
+and commissions we will pay to underwriters. These amounts are shown assuming
+both no exercise and full exercise of underwriters over-allotment option to
+purchase additional shares of common stock.
+
+ 
+ 
+ 
+ 
+ 
+
+ 
+ 
+ Without
+ 
+ With
+
+ 
+ 
+ over-allotment exercise
+ 
+ over-allotment exercise
+
+ Per Share
+
+Total
+
+ 
+ $ 
+ 
+
+$ 
+ 
+
+ 
+ $ 
+ 
+
+$ 
+ 
+
+ We estimate that the total expenses of this offering, excluding
+underwriting discounts and commissions, will be approximately $ .
+
+ The underwriters propose to offer the shares of common stock directly to
+the public at the public offering price listed on the cover page of this
+prospectus and to selected securities dealers at the same price less a
+concession not in excess of
+$ per share. The underwriters may allow, and
+the selected dealers may re-allow, a concession not in excess of
+$ per
+share to selected brokers and dealers. After this offering, the underwriters
+may change the price to the public, concession, allowance and re-allowance.
+
+56
+
+Table of Contents
+
+ We have granted to the underwriters an option, exercisable no later than
+30 days after the date of this prospectus, to purchase up to an aggregate of
+319,125 additional shares of common stock at the public offering price, less
+underwriting discounts and commissions, listed on the cover page of this
+prospectus solely to cover over-allotments, if any.
+
+ The offering of the shares of common stock is made for delivery when, as
+and if accepted by the underwriters subject to prior sale and to withdrawal,
+cancellation or modification of the offering without notice. The underwriters
+reserve the right to reject any order for the purchase of shares in whole or in
+part.
+
+ We have agreed to indemnify the underwriters against liabilities,
+including liabilities under the Securities Act, and to contribute to payments
+the underwriters may be required to make with respect to these liabilities.
+
+ Our directors and executive officers and certain of our significant
+shareholders have agreed not to offer, pledge (except in connection with the
+exercise of stock options), sell, contract to sell, or otherwise transfer or
+dispose of, directly or indirectly, any shares of our capital stock or any of
+our other equity securities for a period of 180 days after the date of this
+prospectus without the prior written consent of Advest.
+
+ We have also agreed that we will not, without the prior written consent of
+Advest, offer or sell any shares of common stock, options or warrants to
+acquire shares of our common stock or securities exchangeable for or
+convertible into shares of common stock during the 180-day period following the
+date of this prospectus. This restriction does not apply to the sale to the
+underwriters of the shares of common stock under the underwriting agreement or
+to transactions by any person other than the Company relating to shares of
+common stock or other securities acquired in open market transactions. In
+addition, we may issue shares upon the exercise of options granted prior to the
+date of this prospectus, and we may grant additional options under our stock
+option plans, provided that, without the prior written consent of Advest, the
+additional options shall not be exercisable during the 180-day period.
+
+ In the course of their business, certain of the underwriters provide
+brokerage and other services to us and our affiliates, including the execution
+of securities transactions and the making of margin loans.
+
+ The underwriters may over-allot or effect transactions that stabilize,
+maintain or otherwise affect the market price of the common stock at levels
+above those that might otherwise prevail in the open market, including by
+entering stabilizing bids, effecting syndicate covering transactions, or
+imposing penalty bids. A stabilizing bid means the placing of any bid or
+effecting of any purchase, for the purpose of pegging, fixing or maintaining
+the price of the common stock. A syndicate covering transaction means the
+placing of any bid on behalf of the underwriting syndicate or the effecting of
+any purchase to reduce a short position created in connection with the
+offering. A penalty bid means an arrangement that permits the underwriters to
+reclaim a selling concession from a syndicate member in connection with the
+offering when shares of common stock sold by the syndicate member are purchased
+in syndicate covering transactions. These transactions may be effected on the
+Nasdaq Market, in the over-the-counter market, or otherwise. Stabilizing, if
+commenced, may be discontinued at any time.
+
+CHANGE OF ACCOUNTANTS
+
+ On August 31, 2004, the Company dismissed CPA Associates as its
+accountants and retained the accounting firm of Crowe Chizek and Company LLC.
+CPA Associates report on the financial statements for the Company for 2003 and
+2002 did not contain an adverse opinion or disclaimer of opinion nor was such
+report qualified or modified as to uncertainty, audit scope or accounting
+principles. During such calendar years and the subsequent interim period
+preceding the change in its accountants, there were no disagreements with the
+former accountants on any matter of accounting principle or practices,
+financial statement disclosure or auditing scope or procedure, which
+disagreement or disagreements, if not resolved to the satisfaction of the
+former accountants, would have caused them to make a reference to the subject
+matter of the disagreement in connection with their report. The decision to
+dismiss CPA Associates was recommended and approved by the Board of Directors
+of the Company.
+
+57
+
+Table of Contents
+
+LEGAL MATTERS
+
+ The validity of the issuance of the shares of our common stock offered in
+this offering will be passed upon for us by the law firm of Smith Mackinnon,
+PA, Orlando, Florida. Certain legal matters in connection with this offering
+will be passed upon for the underwriters by the law firm of Malizia Spidi 
+Fisch, PC, Washington, D.C.
+
+EXPERTS
+
+ The consolidated financial statements and schedules of the Company and its
+subsidiaries as of December 31, 2003 and 2002 and for each of the three years
+in the period ended December 31, 2003
+included in this prospectus have been audited by Crowe Chizek and Company LLC,
+independent auditors, as stated in their report, which is included in this
+prospectus, and has been so included in reliance upon the report of such firm
+given upon their authority as experts in accounting and auditing.
+
+WHERE YOU MAY FIND ADDITIONAL INFORMATION
+
+ We do not currently file reports with the SEC. We have filed with the SEC
+a registration statement on
\ No newline at end of file
diff --git a/parsed_sections/risk_factors/2004/CIK0001283827_fairpoint_risk_factors.txt b/parsed_sections/risk_factors/2004/CIK0001283827_fairpoint_risk_factors.txt
new file mode 100644
index 0000000000000000000000000000000000000000..c01d22a884921fac9197186e532f1b43635ba44c
--- /dev/null
+++ b/parsed_sections/risk_factors/2004/CIK0001283827_fairpoint_risk_factors.txt
@@ -0,0 +1 @@
+Risk Factors An investment in the IDSs and the shares of our class A common stock and/or our senior subordinated notes involves a number of risks. In addition to the other information contained in this prospectus, prospective investors should give careful consideration to the following factors. Any of the following risks could materially and adversely affect our business, consolidated financial conditions, results of operations or liquidity. In such case, you may lose all or part of your original investment. The risks described below are not the only risks facing us. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial may also materially and adversely affect our business operations. Risks Relating to the IDSs, the Shares of Class A Common Stock and the Senior Subordinated Notes You may not receive the level of dividends provided for in the dividend policies our board of directors expects to adopt upon the closing of this offering or any dividends at all. Our board of directors may, in its discretion, amend or repeal the dividend policies it expects to adopt upon the closing of this offering. Future dividends with respect to shares of our class A common stock, if any, will depend on, among other things, our cash flows, cash requirements, financial condition, contractual restrictions, business opportunities, provisions of applicable law and other factors that our board of directors may deem relevant. Our board of directors may decrease the level of dividends provided for in the dividend policies or entirely discontinue the payment of dividends. The indenture governing our senior subordinated notes and the new credit facility contain significant restrictions on our ability to make dividend payments, including, if we have been required to defer interest on the senior subordinated notes under the new credit facility or the indenture, restrictions on the payment of dividends until we have paid all deferred interest. We have reported a loss from continuing operations in each of our last five fiscal years. We cannot assure you that we will generate sufficient cash from continuing operations in the future, or have sufficient surplus or net profits, as the case may be, under Delaware law, to pay dividends on our class A common stock in accordance with the dividend policy established by our board of directors. In addition, the subordination of the dividends on our class B common stock will terminate upon our achieving certain specified financial performance targets (including Adjusted EBITDA of at least $143.5 million in any fiscal year). If we satisfy such targets and subordination terminates, there can be no assurance that we will generate cash flow in future periods at the same or higher levels than such performance targets, which could result in our inability to pay the target dividends on our class A common stock. If we were unable to generate sufficient cash to pay the target dividends on our class A common stock and class B common stock in any period after subordination has terminated, dividends on each class would be reduced by the same percentage until the aggregate dividends paid in such period equaled the cash available for distribution. If we were to use borrowings under our new credit facility's revolving facility to fund dividends, we would have less cash available for future dividends. For the year ended December 31, 2003, on a pro forma basis after giving effect to the transactions as if they had occurred on January 1, 2003, we would not have been able to pay dividends on both our outstanding shares of class A common stock and class B common stock in accordance with the dividend policies established by our board of directors. To expand our business through acquisitions and service our indebtedness, we will require a significant amount of cash. Our ability to generate cash depends on many factors beyond our control. We may not generate sufficient funds from operations to consummate acquisitions, pay interest on the senior subordinated notes, pay dividends with respect to shares of our class A common stock or repay or refinance our indebtedness at maturity or otherwise. Our ability to consummate acquisitions and to make payments on our indebtedness, including the senior subordinated notes, will depend on our ability to generate cash flow from operations in the future. This ability, to a certain extent, is subject to general economic, financial, competitive, legislative, regulatory and other factors that are beyond our control. Our ability to continue to expand through State of Incorporation/Formation acquisitions will, to a certain extent, be dependent upon our ability to borrow funds under our new credit facility and to obtain other third-party financing, including through the sale of IDSs or other securities. We cannot assure you, however, that our business will generate sufficient cash flow from operations or that future borrowings will be available to us in an amount sufficient to enable us to pay our indebtedness, including the senior subordinated notes, or to fund our other liquidity needs. A significant portion of our cash flow from operations will be dedicated to capital expenditures and debt service. In addition, we currently expect to distribute a significant portion of our cash earnings to our stockholders in the form of periodic dividends. As a result, we may not retain a sufficient amount of cash to finance growth opportunities, including acquisitions, or unanticipated capital expenditures or to fund our operations. In addition, if we reduce capital expenditures, the regulatory settlement payments we receive may decline. Borrowings under our new credit facility will bear interest at variable interest rates. In connection with this offering, we intend to purchase an interest rate cap which will fix the interest rates on such borrowings for a period of three years after the closing of this offering. After the interest rate cap expires, our annual debt service obligations under our new credit facility will vary from year to year unless we purchase a new interest rate cap or interest rate hedge. An increase of one percentage point in the annual interest rate applicable to borrowings under our new credit facility which would be outstanding on the closing date of this offering would result in an increase of approximately $4.0 million in our annual cash interest expense, and a corresponding decrease in cash available to pay dividends on our common stock. If we choose to purchase a new interest rate cap or interest rate hedge in the future, the amount of cash available to pay dividends on our common stock would decrease. However, to the extent interest rates increase in the future, we may not be able to purchase a new interest rate cap or interest rate hedge on acceptable terms. In addition, prior to the maturity of our new credit facility and the senior subordinated notes, we will not be required to make any payments of principal on our senior subordinated notes or our new credit facility, and it is not likely that we will generate sufficient funds from operations to repay the principal amount of our indebtedness at maturity. We therefore will need to refinance our debt. We may not be able to refinance our new credit facility, or if refinanced, the refinancing may occur on less favorable terms, which may materially adversely affect our ability to pay dividends. In particular, some of the terms of the senior subordinated notes that may be viewed as favorable to the senior lenders, such as our ability to defer interest, become less favorable in 2009, which may materially adversely affect our ability to refinance our new credit facility. If we were unable to refinance our new credit facility, our failure to repay all amounts due on the maturity date would cause a default under our new credit facility and the indenture governing the senior subordinated notes. We expect our required principal repayments under our new credit facility to be approximately $400.0 million at its maturity in 2009. Our interest expense may increase significantly if we refinance our new credit facility on terms that are less favorable to us than the terms of our new credit facility. We may also be forced to raise additional capital or sell assets and, if we are forced to pursue any of these options under distressed conditions, our business and the value of your investment in our IDSs or senior subordinated notes could be adversely affected. In addition, these alternatives may not be available to us when needed or on satisfactory terms due to prevailing market conditions, a decline in our business, legislative and regulatory factors or restrictions contained in our senior indebtedness. If we have insufficient cash flow to cover the expected dividend payments under the dividend policy to be adopted by our board of directors we would need to reduce or eliminate dividends or, to the extent permitted under our debt agreements, fund a portion of our dividends with additional borrowings. If we do not have sufficient cash to fund dividend payments, we would either reduce or eliminate dividends or, to the extent we were permitted to do so under the indenture governing the senior subordinated notes and the new credit facility, fund a portion of our dividends with borrowings or from CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 121,568 $ 97,369 $ 67,220 Adjustments to reconcile net income to net cash provided by operating activities: Provision for uncollectible accounts receivable, net of recoveries 30 0 (31 ) Depreciation and amortization 5,179 4,225 3,583 Changes in certain assets and liabilities: Accounts receivable 14 378 1,795 Unbilled revenue 259 420 (433 ) Prepaid expenses and other current assets (14 ) 104 (30 ) Deferred charges and other assets 1 3 2 Accounts payable and accrued liabilities (887 ) 901 (1,646 ) Advance billings 63 51 Primary Standard Industrial Classification Code Number other sources. If we were to use working capital or permanent borrowings under our new credit facility's revolving facility to fund dividends, we would have less cash available for future dividends and other purposes, which could negatively impact our financial condition, our results of operations and our ability to maintain or expand our business. In addition, we will need to generate additional cash flow in the future to fund dividend payments on 1,266,132 IDSs issued under our new retention and incentive plan to the extent such IDSs are distributed from the trust created in connection with our new retention and incentive plan. These IDSs are subject to certain vesting requirements and will begin to vest and be distributed from the trust as early as the second anniversary of the closing of this offering. See "Management New Retention and Incentive Plan." If we are unable to generate additional cash flow in the future to fund dividends on these IDSs, we may be forced to reduce or eliminate dividends or, to the extent we are permitted by the indenture governing our senior subordinated notes and the new credit facility, fund these additional dividends from borrowings. The indenture governing our senior subordinated notes and our new credit facility permit us to pay a significant portion of our free cash flow to stockholders in the form of dividends. Our senior subordinated notes and our new credit facility permit us to pay a significant portion of our cash flow to stockholders in the form of dividends and, following completion of this offering, we currently expect to pay periodic dividends per share on our class A common stock in the aggregate of $0.9450 per year. The indenture governing our senior subordinated notes and our new credit facility permit us to pay such dividends as long as we meet specified thresholds. See "Description of Senior Subordinated Notes Certain Covenants" and "Description of Certain Indebtedness New Credit Facility." Any amounts paid by us in the form of dividends will not be available in the future to satisfy our obligations under the senior subordinated notes. Standard & Poor's Corporation, or Standard & Poor's, has adopted a policy of downgrading certain issuers of IDSs or similar securities as a result of the high dividend payout provisions of such securities and the liberal restrictive payment covenants contained in the agreements governing the indebtedness of such issuers. Accordingly, Standard & Poor's has advised us that it has placed our "B+" corporate credit rating on creditwatch with negative implications and that it intends to downgrade our corporate credit rating from "B+" to "B" if we consummate this offering. Subject to certain limitations, we may defer interest on our senior subordinated notes at any time at our option. If we defer interest we will not be permitted to make any payment of dividends on our class A common stock so long as any deferred interest or interest on deferred interest remains outstanding. Prior to 2009, subject to certain limitations, we may, at our option, defer interest payments on the senior subordinated notes, and such deferred interest will not be required to be repaid until , 2009. Consequently, you may be owed a substantial amount of deferred interest that will not be due and payable until such date. In addition, after , 2009, subject to certain limitations, we may, at our option, defer interest on the senior subordinated notes, and such deferred interest will not be required to be repaid until , 2019. Consequently, you may be owed a substantial amount of deferred interest that will not be due and payable until such date. During any interest deferral period and so long as any deferred interest or interest on deferred interest remains outstanding, we will not be permitted to make any payment of dividends with respect to our class A common stock. Deferral of interest payments would have adverse tax consequences for you and may adversely affect the trading price of the IDSs or the separately held senior subordinated notes. If interest payments on the senior subordinated notes are deferred, you will be required to recognize interest income for U.S. federal income tax purposes under the rules related to original issue discount in respect of interest payments on the senior subordinated notes represented by the IDSs or IRS Employer Identification No. the separately-held senior subordinated notes, as the case may be, held by you before you receive any cash payment of this interest. In addition, you will not receive any cash in respect of accrued and unpaid interest if you sell the IDSs or the separately held senior subordinated notes, as the case may be, before the end of any deferral period or before the record date relating to interest payments that are to be paid. If interest is deferred, the IDSs or the separately-held senior subordinated notes may trade at a price that does not fully reflect the value of accrued but unpaid interest on the senior subordinated notes. In addition, the requirement that we defer payments of interest on the senior subordinated notes under certain circumstances may mean that the market price for the IDSs or the separately held senior subordinated notes may be more volatile than other securities that do not have this requirement. The U.S. federal income tax consequences of the purchase, ownership and disposition of IDSs are uncertain and our cash available for dividends and interest could be reduced if the senior subordinated notes were treated as equity for tax purposes. No statutory, judicial or administrative authority directly addresses the treatment of the IDSs or instruments similar to the IDSs for U.S. federal income tax purposes. As a result, the U.S. federal income tax consequences of the purchase, ownership and disposition of IDSs are uncertain. We have received an opinion from our counsel, Paul, Hastings, Janofsky & Walker LLP, that an IDS should be treated as representing both a share of class A common stock and senior subordinated notes, and that the senior subordinated notes should be treated as debt, for U.S. federal income tax purposes. However, the Internal Revenue Service or a court of law may take the position that the IDSs are a single equity investment for tax purposes, or that both the class A common stock and the senior subordinated notes represented by IDSs are equity, which, if such position were to prevail, would result in our inability to take tax deductions on the interest that accrues on such senior subordinated notes and could adversely affect the amount, timing and character of income, gain or loss in respect of your investment in IDSs. In addition, it would materially increase our taxable income and, thus, our U.S. federal and applicable state income tax liability. This could reduce our after-tax cash flow and materially and adversely impact our ability to make interest and dividend payments on the senior subordinated notes and the class A common stock represented by the IDSs. In such an event, the interest paid on the senior subordinated notes could be treated as a dividend (or a return of capital, depending on our current and accumulated earnings and profits). Foreign holders would be subject to withholding or estate taxes with regard to the senior subordinated notes in the same manner as they will be with regard to the class A common stock. Payments to foreign holders would not be grossed-up for any such taxes. For discussion of these tax-related risks, see "Certain United States Federal Tax Considerations Considerations for U.S. Holders Senior Subordinated Notes Characterization of Senior Subordinated Notes" and "Certain United States Federal Tax Considerations Considerations for Non-U.S. Holders Senior Subordinated Notes Characterization of Senior Subordinated Notes." If the Internal Revenue Service challenges the allocation of the purchase price of the IDSs, there may be adverse U.S. federal income tax consequences. The purchase price of each IDS must be allocated between the share of class A common stock and senior subordinated note represented by such IDS. The purchase price of each IDS will be so allocated on the basis of the fair market value of the class A common stock and senior subordinated note at the time of purchase. On the cover page of this prospectus, we set forth a range within which we expect the actual initial public offering price of an IDS to fall. The midpoint of that range is $16.00. Assuming that $16.00 is the actual initial public offering price of an IDS, we expect to report the initial fair market value of each share of class A common stock represented by an IDS as $11.50 and the initial fair market value of each senior subordinated note represented by an IDS as $4.50. By purchasing IDSs, you agree to be bound by this allocation. However, this allocation is not binding on the Internal Revenue Service and the Internal Revenue Service may challenge this allocation (including by asserting ST Enterprises, Ltd. Kansas 4813 480996774 MJD Ventures, Inc. Delaware 4813 481177379 MJD Services Corp. Delaware 4813 561922213 FairPoint Carrier Services, Inc. Delaware 4813 621729497 FairPoint Broadband, Inc. Delaware 4813 582256315 MJD Capital Corp. South Dakota 4813 562047160 The address, including zip code, of the principal offices of the additional registrants listed above is: c/o FairPoint Communications, Inc., 521 East Morehead Street, Suite 250, Charlotte, North Carolina 28202 and the telephone number, including area code, of such additional registrants at that address is (704) 344-8150. that the interest rate on the senior subordinated notes does not represent an arms-length rate). If the Internal Revenue Service successfully challenges our allocation of the purchase price of an IDS between the share of class A common stock and senior subordinated note represented by such IDS on the basis that the senior subordinated note actually has a fair market value that is less than that which we allocated to it, or that the stated interest rate is too low, it is possible that the senior subordinated notes will be treated as having been issued with original issue discount. If the senior subordinated notes were treated as having original issue discount, you generally would have to include original issue discount in income in advance of the receipt of cash attributable to that income. If the Internal Revenue Service successfully asserts that the senior subordinated note actually has a fair market value greater than that which we allocate to it, it is possible that the senior subordinated notes will be treated as having been issued with amortizable bond premium. If the senior subordinated notes were treated as having amortizable bond premium, you would be able to elect to amortize bond premium over the term of the senior subordinated notes. If we subsequently issue senior subordinated notes with significant original issue discount, we may not be able to deduct all of the interest on those senior subordinated notes. It is possible that senior subordinated notes we issue in a subsequent issuance (including senior subordinated notes represented by IDSs issued in exchange for our class B common stock) will be issued at a discount to their face value and, accordingly, may have "significant original issue discount" and thus be classified as "applicable high yield discount obligations." If any such senior subordinated notes were so treated, a portion of the original issue discount on such notes could be nondeductible by us and the remainder would be deductible only when paid. This treatment would have the effect of increasing our taxable income and, depending on the availability of net operating loss carryovers, may adversely affect our cash flow available for interest payments and distributions to our stockholders. Subsequent issuances of senior subordinated notes may cause you to recognize original issue discount and subject you to other adverse consequences. A subsequent issuance of senior subordinated notes issued with original issue discount (including senior subordinated notes represented by IDSs issued in exchange for our class B common stock) may adversely affect your tax treatment. As discussed in "Prospectus Summary The Offering What will happen if we issue additional IDSs or senior subordinated notes of the same series in the future?" and "Certain United States Federal Tax Considerations Considerations for U.S. Holders Senior Subordinated Notes Additional Issuances", upon a subsequent issuance of senior subordinated notes with original issue discount (and upon each subsequent issuance of senior subordinated notes thereafter), there will be an automatic exchange of a portion of the senior subordinated notes you held prior to such subsequent issuance for new senior subordinated notes that will be identical except that a different amount of original issue discount may exist between the different issues of senior subordinated notes. If you were already accruing original issue discount into your income with respect to the senior subordinated notes that you held prior to such subsequent issuance, you may have to increase the amount of accrual of such original issue discount due to the automatic exchange into the new senior subordinated notes that may have greater original issue discount than the senior subordinated notes you held prior to such automatic exchange. If you were not already accruing original issue discount, you may have to begin accruing original issue discount as a result of such automatic exchange. This could happen if the subsequent issuance of senior subordinated notes occurs pursuant to an IDS offering or a separate offering of senior subordinated notes. In addition, the Internal Revenue Service may assert that the exchange of a portion of your senior subordinated notes for the newly-issued senior subordinated notes is a taxable exchange for U.S. federal income tax purposes. This could apply whether the senior subordinated notes are held as part of an IDS or separately. EXPLANATORY NOTE This Registration Statement contains three forms of prospectus. One is to be used in connection with the initial public offering of IDSs (the "IDS Prospectus"), one is to be used in connection with the offer to exchange certain shares of the Company's existing class A common stock and class C common stock for IDSs (the "Common Stock Prospectus") and one is to be used in connection with the offer to exchange certain of the Company's existing stock options and restricted stock units for IDSs or awards of IDSs under the Company's new retention and incentive plan (the "Option Prospectus"), as applicable. The IDS Prospectus follows. The additional pages relating to the Common Stock Prospectus and the Option Prospectus follow the IDS Prospectus. The IDS Prospectus, the Common Stock Prospectus and the Option Prospectus are identical in all material respects with the exception that the additional pages relating to the Common Stock Prospectus will be used solely in connection with the offers to certain of the Company's common stockholders and the additional pages relating to the Option Prospectus will be used solely in connection with the offers to certain of the Company's optionholders and restricted stock unitholders. Upon a subsequent issuance of senior subordinated notes with original issue discount, we will report any original issue discount on the newly-issued senior subordinated notes ratably among all holders, and by purchasing IDSs, you agree to report original issue discount in a manner consistent with this approach. We cannot assure you that the Internal Revenue Service will not assert that any original issue discount should be reported only to the persons that initially acquired the newly-issued senior subordinated notes and their transferees and further claim that, unless a holder can establish that it is not a person that initially acquired the newly-issued senior subordinated notes or their transferee, all of the senior subordinated notes held by such holder have original issue discount. These potential actions by the Internal Revenue Service could create significant uncertainties in the pricing of IDSs and senior subordinated notes and could adversely affect the market for IDSs and senior subordinated notes. For a discussion of these tax related risks, see "Certain United States Federal Tax Considerations." We may have to establish a reserve for contingent tax liabilities in the future, which could adversely affect our ability to make dividend payments on our class A common stock. Even if the Internal Revenue Service does not challenge the tax treatment of the senior subordinated notes, it is possible that as a result of changes in circumstances or facts that come to light after this offering, we may in the future need to change our anticipated accounting treatment and establish a reserve for contingent tax liabilities associated with a disallowance of all or part of the interest deductions on the senior subordinated notes, although our present view is that no such reserve is necessary or appropriate. If we were required to maintain such a reserve, our ability to make dividend payments on our class A common stock could be materially impaired and the market for the IDSs or our class A common stock would be adversely affected. A subsequent issuance of senior subordinated notes may reduce the amount you can recover upon an acceleration of the payment of principal due on the senior subordinated notes or in the event of our bankruptcy. Under New York and federal bankruptcy law, holders of subsequently issued senior subordinated notes having original issue discount (including the recipients of such senior subordinated notes in the involuntary exchanges pursuant to the indenture governing the senior subordinated notes) may not be able to collect the portion of their principal face amount that represents unamortized original issue discount as of the acceleration or filing date, as the case may be, in the event of an acceleration of the senior subordinated notes or in the event of our bankruptcy prior to the maturity date of the senior subordinated notes. As a result, an automatic exchange that results in a holder receiving a senior subordinated note with original issue discount could have the effect of ultimately reducing the amount such holder can recover from us in the event of an acceleration or bankruptcy. If interest rates rise, the trading value of our IDSs or senior subordinated notes or class A common stock represented thereby may decline. We cannot predict the interest rate environment or guarantee that interest rates will not rise in the near future. Should interest rates rise or should the threat of rising interest rates develop, debt markets may be adversely affected. As a result, the trading value of our IDSs or senior subordinated notes or class A common stock represented thereby may decline. Our substantial indebtedness could restrict our ability to pay interest and principal on the senior subordinated notes and to pay dividends on our class A common stock and have an adverse impact on our financing options and liquidity position. As of June 30, 2004, after giving pro forma effect to the transactions, we would have had approximately $677.5 million of total consolidated indebtedness (excluding the senior subordinated notes represented by IDSs that will be held in a Company controlled trust, which IDSs are subject to The information in this prospectus is not complete and may be changed. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is declared effective. This prospectus is not an offer to sell these securities and is not soliciting an offer to buy these securities in any state where the offer or sale is not permitted. Subject to Completion, Dated November 9, 2004 40,937,500 Income Deposit Securities (IDSs) representing 40,937,500 Shares of Class A Common Stock and $184.2 million % Senior Subordinated Notes due 2019 and $30.0 million % Senior Subordinated Notes due 2019 This is an offering of 40,937,500 IDSs by us. The IDSs represent 40,937,500 shares of our class A common stock and $184.2 million aggregate principal amount of our % senior subordinated notes due 2019. Each IDS represents: one share of our class A common stock; and a % senior subordinated note with $4.50 principal amount. We are also offering separately (not in the form of IDSs) $30.0 million aggregate principal amount of our % senior subordinated notes due 2019. The senior subordinated notes will be fully and unconditionally guaranteed by our first tier subsidiaries on an unsecured senior subordinated basis. This is the initial public offering of our IDSs and senior subordinated notes. We anticipate that the public offering price per IDS will be between $15.00 and $17.00 and the public offering price of the senior subordinated notes sold separately (not in the form of IDSs) will be % of their stated principal amount. Holders of IDSs will have the right to separate IDSs into the shares of class A common stock and senior subordinated notes represented thereby at any time after the earlier of 45 days from the closing of this offering or the occurrence of a change of control. Similarly holders of our class A common stock and senior subordinated notes may, at any time, unless the IDSs have automatically separated, combine the applicable number of shares of class A common stock and principal amount of senior subordinated notes to form IDSs. Separation of IDSs will occur automatically upon a redemption or upon the maturity of the senior subordinated notes. Upon a subsequent issuance by us of IDSs or senior subordinated notes of the same series (not in the form of IDSs), a portion of your senior subordinated notes may be automatically exchanged for an identical principal amount of the senior subordinated notes issued in such subsequent issuance and, in such event, your IDSs or senior subordinated notes will be replaced with new IDSs or new senior subordinated notes, as the case may be. In addition to the senior subordinated notes offered hereby, the registration statement of which this prospectus is a part also registers the senior subordinated notes and new IDSs to be issued to you upon any such subsequent issuance. For more information regarding these automatic exchanges and the effect they may have on your investment, see "Risk Factors Subsequent issuances of senior subordinated notes may cause you to recognize original issue discount and subject you to other adverse consequences" on page 27, "Risk Factors A subsequent issuance of senior subordinated notes may reduce the amount you can recover upon an acceleration of the payment of principal due on the senior subordinated notes or in the event of our bankruptcy" on page 28, "Description of Senior Subordinated Notes Additional Notes" on page 148 and "Certain United States Federal Tax Considerations Considerations for U.S. Holders Senior Subordinated Notes Additional Issuances" on page 201. Our IDSs have been approved for listing on the New York Stock Exchange under the trading symbol "FRP", subject to official notice of issuance. We have applied to list the IDSs on the Toronto Stock Exchange under the Trading symbol "FPC.un" and we have applied to list our shares of class A common stock on the Toronto Stock Exchange under the trading symbol "FPC". Investing in the IDSs, our class A common stock and/or our senior subordinated notes involves risks. See "Risk Factors" beginning on page 23. Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense. Per IDS certain vesting requirements and are not considered outstanding under generally accepted accounting principles). Our substantial indebtedness could have important adverse consequences to the holders of the IDSs and to the holders of the senior subordinated notes, including: limiting our ability to pay interest and principal on the senior subordinated notes, pay dividends on our class A common stock or make payments in connection with our other obligations, including, under our new credit facility; limiting our ability in the future to obtain additional financing for working capital, capital expenditures or acquisitions; we may not be able to refinance our indebtedness on terms acceptable to us or at all; limiting our flexibility in planning for, or reacting to, changes in our business and the communications industry; a significant portion of our cash flow from operations is likely to be dedicated to the payment of the principal of and interest on our indebtedness, thereby reducing funds available for future operations, acquisitions, dividends on our class A common stock and/or capital expenditures; we may be more vulnerable to economic and industry downturns and conditions, including changes in interest rates; and placing us at a competitive disadvantage compared to those of our competitors that have less indebtedness. Despite our substantial indebtedness, we may still be able to incur substantially more debt, which could further exacerbate the risks described above. Subject to certain covenants, the indenture governing our senior subordinated notes and our new credit facility will permit us to incur additional indebtedness. The indenture governing the senior subordinated notes will also permit our subsidiaries to incur certain additional indebtedness. Any additional indebtedness that we may incur would exacerbate the risks described in the preceding risk factor. Our new credit facility will contain significant limitations on distributions and other payments. Our new credit facility contains significant restrictions on our ability to pay interest on the senior subordinated notes and dividends on the class A common stock based on meeting our total leverage ratio, interest coverage ratio and compliance with other conditions, as described in detail under "Description of Certain Indebtedness New Credit Facility." We may amend the terms of our new credit facility, or we may enter into new agreements that govern our senior indebtedness, and the amended terms or new agreements may further significantly affect our ability to pay interest to holders of our IDSs and our senior subordinated notes and dividends to holders of our IDSs. As a result of general economic conditions, conditions in the lending markets, the results of our business or for any other reason, we may elect or be required to amend or refinance our new credit facility, at or prior to maturity, or enter into additional agreements for senior indebtedness. Regardless of any protection you have in the indenture governing the senior subordinated notes, any such amendment, refinancing or additional agreement may contain covenants which could limit in a significant manner our ability to pay interest payments and dividends to you. Total The Company and the subsidiary guarantors are holding companies and rely on dividends, interest and other payments, advances and transfers of funds from the Company's non-guarantor operating subsidiaries and investments to meet their debt service and other obligations. The Company and the subsidiary guarantors are holding companies and conduct all of their operations through the Company's non-guarantor operating subsidiaries. The Company currently has no significant assets other than equity interests in its first tier subsidiaries, all of which will be subject to the first priority claims of the lenders under our new credit facility. The subsidiary guarantors have no significant assets other than direct or indirect equity interest in the Company's non-guarantor operating subsidiaries. As a result, the Company and the subsidiary guarantors will rely on dividends and other payments or distributions from the Company's non-guarantor operating subsidiaries to pay interest on the senior subordinated notes, pay dividends with respect to our class A common stock and to meet their debt service obligations generally. The ability of the Company's subsidiaries to pay dividends or make other payments or distributions to the Company and/or the subsidiary guarantors will depend on their respective operating results and may be restricted by, among other things: the laws of their jurisdiction of organization, which may limit the amount of funds available for the payment of dividends; agreements of those subsidiaries; the terms of our new credit facility; and the covenants of any future outstanding indebtedness we or our subsidiaries incur. The Company's non-guarantor operating subsidiaries have no obligation, contingent or otherwise, to pay amounts pursuant to the senior subordinated notes or to make funds available to the Company and/or the subsidiary guarantors, whether in the form of loans, dividends or other distributions. In addition, we have a number of minority investments and investments in joint ventures from which we receive distributions. For example, in 2003 we received $10.8 million of distributions from such investments, which represented a material portion of our cash flow. These investments represent passive ownership interests in partnerships. We do not control the timing or amount of distributions from such investments and we may not have access to the cash flows of these entities. Accordingly, our ability to pay interest on the senior subordinated notes, pay dividends with respect to shares of our class A common stock and to repay the senior subordinated notes at maturity or otherwise may be dependent upon factors beyond our control. Subject to limitations in the indenture governing the senior subordinated notes, the Company's subsidiaries may also enter into agreements that contain covenants prohibiting them from distributing or advancing funds or transferring assets to us under certain circumstances, including to fund interest payments in respect of the senior subordinated notes and pay dividends. We may not have sufficient funds to purchase the senior subordinated notes upon the exercise by holders of their rights upon a change of control. Under the indenture governing the senior subordinated notes, upon the occurrence of specified change of control events, we will be required to offer to repurchase all outstanding senior subordinated notes. However, we may not have sufficient funds at the time of the change of control event to make the required repurchase of the senior subordinated notes. In addition, a change of control would require the repayment of all borrowings under our new credit facility. Our failure to make or complete an offer to repurchase the senior subordinated notes would place us in default under the indenture governing the senior subordinated notes. We may therefore need to refinance our debt, raise additional capital or sell assets and, if we are forced to pursue any of these options under distressed conditions, our business and the value of your investment in our IDSs or senior subordinated notes could be adversely affected. In addition, these alternatives may not be available to us when needed or on satisfactory terms due to prevailing market conditions, a decline in our business, legislative and Per Senior Subordinated Note(1) regulatory factors or restrictions contained in our senior indebtedness. You should also be aware that a number of important corporate events, such as leveraged recapitalizations that would increase the level of our indebtedness, would not constitute a change of control under the indenture governing the senior subordinated notes. We are subject to covenants related to our outstanding debt that limit our business flexibility by imposing operating and financial restrictions on our operations. Covenants in the indenture governing the senior subordinated notes impose significant operating and financial restrictions on us. These restrictions prohibit or limit, among other things: the incurrence of additional indebtedness and the issuance by our restricted subsidiaries of preferred stock; the ability to incur layered indebtedness; the payment of dividends on, and purchase or redemption of, capital stock; a number of other restricted payments, including investments; the creation of liens; the ability of our restricted subsidiaries to guarantee our and their indebtedness; specified sales of assets; the creation of encumbrances or restrictions on the ability of restricted subsidiaries to distribute and advance funds or transfer assets to us or any other restricted subsidiary; specified transactions with affiliates; sale and leaseback transactions; our ability to designate restricted and unrestricted subsidiaries; our ability to enter lines of business outside the communications business; and certain consolidations, mergers and sales and transfers of assets by or involving us. The new credit facility includes most of these covenants and other and more restrictive covenants and prohibits us from prepaying our other indebtedness, including the senior subordinated notes, while indebtedness under the new credit facility is outstanding. The new credit facility also contains covenants which require us to maintain specified financial ratios and satisfy financial condition tests, including, without limitation, the following: a maximum total leverage ratio, a maximum senior secured leverage ratio and a minimum interest coverage ratio. If we are unable to comply with the covenants governing our outstanding debt, we could be in default under our indebtedness which could result in our inability to make payments under the senior subordinated notes or the acceleration of our indebtedness. Our ability to comply with the covenants, ratios or tests contained in the agreements governing our indebtedness may be affected by events beyond our control, including prevailing economic, financial and industry conditions. A breach of any of these covenants, ratios or tests could result in a default under the new credit facility and/or the indenture governing the senior subordinated notes. Certain events of default under the new credit facility would prohibit us from making payments on the senior subordinated notes, including payment of interest when due. In addition, upon the occurrence of an event of default under the new credit facility, the lenders could elect to declare all amounts outstanding under the new credit facility, together with accrued interest, to be immediately due and payable. If we were unable to repay those amounts, the lenders could proceed against the security granted to them to secure that indebtedness. An acceleration by the lenders of payments of indebtedness under the new credit facility may cause an acceleration of amounts outstanding under the senior subordinated notes which we may not be able to repay. If the lenders accelerate the payment of the indebtedness under Total the new credit facility, our assets may not be sufficient to repay in full the indebtedness under our new credit facility and our other indebtedness, including the senior subordinated notes. Because of the subordinated nature of the senior subordinated notes and the related note guarantees, holders of our senior subordinated notes may not be entitled to be paid in full, if at all, in the event of a payment default on our senior indebtedness or senior indebtedness of the subsidiary guarantors or a bankruptcy, liquidation or reorganization or similar proceeding. As a result of the subordinated nature of our senior subordinated notes and related note guarantees, in the event of a payment default on our senior indebtedness or senior indebtedness of the subsidiary guarantors or upon any distribution to our creditors or the creditors of the subsidiary guarantors in bankruptcy, liquidation or reorganization or similar proceeding relating to us or the subsidiary guarantors or our or their property, the holders of our senior indebtedness and senior indebtedness of the subsidiary guarantors will be entitled to be paid in full in cash before any payment may be made with respect to our senior subordinated notes or the note guarantees. In such case, we and the subsidiary guarantors may not have sufficient funds to pay all of our creditors, and holders of our senior subordinated notes may receive less, ratably, than the holders of senior indebtedness. The senior subordinated notes will be senior subordinated obligations of the Company ranking equal in right of payment to all of the Company's existing and future senior subordinated indebtedness, senior to all of the Company's future subordinated indebtedness and junior in right of payment to all of the Company's existing and future senior indebtedness. As of June 30, 2004, on a pro forma basis after giving effect to the transactions, the Company would have had $400.0 million of senior indebtedness outstanding and would have had the ability to borrow up to an additional $100.0 million under the new credit facility, all of which would have ranked senior in right of payment to our senior subordinated notes. If we are unable to repurchase all of the outstanding 91/2% notes, floating rate notes, 121/2% notes and 117/8% notes in the tender offers for such notes, the mix of our senior and senior subordinated indebtedness outstanding may change. See "Description of Certain Indebtedness." In addition, the subsidiary guarantors are guarantors under our new credit facility, so any claims of holders of the senior subordinated notes will be subordinated in right of payment to the satisfaction of the claims that the lenders may have under the guarantees granted pursuant to our new credit facility. Holders of our senior subordinated notes and the note guarantees will be structurally subordinated to the debt of our non-guarantor subsidiaries. The Company and the subsidiary guarantors are holding companies, which means that they conduct substantially all of their operations through subsidiaries. The Company's operating subsidiaries will not be guarantors of the senior subordinated notes. As a result, no payments are required to be made to the Company from the assets of these subsidiaries. Claims of holders of the notes and the note guarantees will be structurally subordinated to the indebtedness and other liabilities and commitments of the Company's non-guarantor subsidiaries, and claims by the Company and any subsidiary guarantor as an equity holder in such subsidiaries will be limited to the extent of their respective direct or indirect investment in such entities. The ability of creditors, including the holders of the senior subordinated notes, to participate in the assets of any of the Company's non-guarantor subsidiaries upon any bankruptcy, liquidation or reorganization or similar proceeding of any such entity will be subject to the prior claims of that entity's creditors, including trade creditors, and any prior or equal claim of any other equity holder. In addition, the ability of the Company's creditors, including the holders of senior subordinated notes, to participate in distributions of assets of the Company's non-guarantor subsidiaries will be limited to the extent that the outstanding shares of any of the Company's subsidiaries are either pledged to secure other creditors (including lenders under our new credit facility) or are not owned by the Company. Cash flows from financing activities of continuing operations: Proceeds from issuance of long-term debt 295,180 295,180 Repayment of long-term debt (278,452 ) (2,053 ) (974 ) (281,479 ) Repurchase of shares of common stock subject to put options (1,000 ) (1,000 ) Repurchase of redeemable preferred stock (8,645 ) (8,645 ) Loan origination costs (14,826 ) (14,826 ) Investment in subsidiaries /from parent 31,349 (31,349 ) Common Stock dividends paid 29,258 (29,258 ) Capital contributed from parent (1,570 ) 1,538 Public offering price(2) $ $ % $ Underwriting discount $ $ % $ Proceeds to FairPoint Communications, Inc. (before expenses) $ $ % $ In the event of the bankruptcy or insolvency of the Company or one or more of the subsidiary guarantors, the senior subordinated notes and the senior subordinated note guarantees could be adversely affected by principles of equitable subordination or recharacterization. In the event of the bankruptcy or insolvency of the Company or one or more of the subsidiary guarantors, a party in interest may seek to subordinate our debt, including the senior subordinated notes or the senior subordinated note guarantees, under principles of equitable subordination or to recharacterize the senior subordinated notes as equity. In the event a court exercised its equitable powers to subordinate the senior subordinated notes or the senior subordinated note guarantees, or recharacterize the senior subordinated notes as equity, you may not recover any amounts owed on the senior subordinated notes or the senior subordinated note guarantees and you may be required to return any payments made to you within six years before the bankruptcy on account of the senior subordinated notes or the senior subordinated note guarantees. In addition, should the court treat the senior subordinated notes or the senior subordinated note guarantees as equity either under principles of equitable subordination or recharacterization, you may not be able to enforce your rights under the senior subordinated notes or the senior subordinated note guarantees. If the note guarantees of the senior subordinated notes by the subsidiary guarantors are held to be invalid or unenforceable or are limited in accordance with their terms, the senior subordinated notes also would be structurally subordinated to the debt of the subsidiary guarantors. Under federal bankruptcy law and comparable provisions of state fraudulent transfer laws, a note guarantee could be voided, or claims in respect of a note guarantee could be subordinated to all other debt of a subsidiary guarantor, if, among other things, the subsidiary guarantor, at the time that it assumed the guarantee: issued the note guarantee to delay, hinder or defraud present or future creditors; or received less than reasonably equivalent value or fair consideration for issuing the note guarantee and, at the time it issued the note guarantee: was insolvent or rendered insolvent by reason of issuing the note guarantee and the application of the proceeds of the note guarantee; was engaged or about to engage in a business or a transaction for which the subsidiary guarantor's remaining assets available to carry on its business constituted unreasonably small capital; intended to incur, or believed that it would incur, debts beyond its ability to pay the debts as they mature; or was a defendant in an action for money damages, or had a judgment for money damages docketed against it if, in either case, after final judgment, the judgment is unsatisfied. In addition, any payment by a subsidiary guarantor under its note guarantee could be voided and required to be returned to the guarantor or to a fund for the benefit of the creditors of the subsidiary guarantor or the note guarantee could be subordinated to other debt of such subsidiary guarantor. Ownership change will limit our ability to use certain losses for U.S. federal income tax purposes and may increase our tax liability. The transactions will result in an "ownership change" within the meaning of the U.S. federal income tax laws addressing net operating loss carryforwards, alternative minimum tax credits and other similar tax attributes. As a result of such ownership change, there will be specific limitations on our ability to use our net operating loss carryforwards and other tax attributes from periods prior to the transactions. Although it is not expected that such limitations will materially affect our U.S. federal income tax liability in the near-term, it is possible in the future that such limitations could limit our ability to utilize such tax attributes and, therefore, result in an increase in our U.S. federal income tax (1)We are selling $30.0 million aggregate principal amount of senior subordinated notes separately (not in the form of IDSs) in this offering. (2)The public offering price in Canada for the IDSs is payable in Canadian dollars and is the approximate equivalent of the U.S. dollar public offering price based on the noon buying rate on the date of this prospectus as quoted by the Federal Reserve Bank of New York. We have granted the underwriters an option to purchase up to 3,275,000 additional IDSs at the public offering price, less the underwriting discount, within 30 days from the date of this prospectus, to cover over-allotments. This prospectus also relates to 2,242,862 IDSs representing 2,242,862 shares of our class A common stock and $10.1 million aggregate principal amount of our % senior subordinated notes due 2019 being issued to certain of our stockholders, optionholders, restricted stock unitholders and employees. See "The Transactions." The underwriters expect to deliver the IDSs and the senior subordinated notes sold separately to purchasers on or about , 2004. liability. Such an increase would reduce the funds available for the payment of dividends and might require us to reduce or eliminate the dividends on our class A common stock. Before this offering, there has not been a public market for our IDSs, class A common stock or senior subordinated notes. The price of the IDSs may fluctuate substantially, which could negatively affect holders of IDSs or holders of senior subordinated notes sold separately. None of the IDSs, class A common stock or senior subordinated notes has a public market history. In addition, there has not been an active market in the United States or in Canada for securities similar to the IDSs. We cannot assure you that an active trading market for the IDSs and the senior subordinated notes sold separately in this offering will develop in the future, which may cause the price of the IDSs and the senior subordinated notes sold separately in this offering to fluctuate substantially, and we currently do not expect that an active trading market for the shares of our class A common stock will develop until the senior subordinated notes are redeemed or mature. We do not intend to list our shares of class A common stock for separate trading on the New York Stock Exchange until the number of shares of our class A common stock held separately and not represented by IDSs is sufficient to satisfy applicable requirements for separate trading on the New York Stock Exchange. If the senior subordinated notes represented by your IDSs are redeemed or mature, your IDSs will automatically separate and you will then hold the shares of our class A common stock. We do not intend to list our senior subordinated notes on any securities exchange. Accordingly, we cannot assure you that there will be a market for the senior subordinated notes. The initial public offering price of the IDSs and the senior subordinated notes sold separately in this offering has been determined by negotiations among us, the existing equity investors and the representatives of the underwriters and may not be indicative of the market price of the IDSs and the senior subordinated notes sold separately in this offering after the offering. Factors such as announcements by us or others, developments affecting us, general interest rate levels and general market volatility could cause the market price of the IDSs and the senior subordinated notes sold separately in this offering to fluctuate significantly. The limited liquidity of the trading market for the senior subordinated notes sold separately (not in the form of IDSs) may adversely affect the trading price of the separate senior subordinated notes. We are separately selling $30.0 million aggregate principal amount of senior subordinated notes (not in the form of IDSs), representing approximately 10% of the total outstanding senior subordinated notes (assuming all of the shares of class B common stock are exchanged for IDSs). While the senior subordinated notes sold separately (not in the form of IDSs) are part of the same series of senior subordinated notes as, and identical to, the senior subordinated notes represented by the IDSs, at the time of the issuance of the separate senior subordinated notes, the senior subordinated notes represented by the IDSs will not be separable for at least 45 days and will not be separately tradeable until separated. As a result, the initial trading market for the senior subordinated notes sold separately (not in the form of IDSs) will be very limited. Even after holders of the IDSs are permitted to separate their IDSs, a sufficient number of holders of IDSs may not separate their IDSs into the shares of our class A common stock and senior subordinated notes represented thereby to create a sizable and more liquid trading market for the senior subordinated notes not represented by IDSs. Therefore, a liquid market for the senior subordinated notes may not develop, which may adversely affect the ability of the holders of the separate senior subordinated notes to sell any of their separate senior subordinated notes and the price at which these holders would be able to sell any of the senior subordinated notes sold separately (not in the form of IDSs). ASSETS CURRENT ASSETS: Accounts receivable, net of allowances of $20 and $1 in 2003 and 2002, respectively $ 73 $ 117 Unbilled revenue 866 1,125 Due from general partner 19,766 33,881 Prepaid expenses and other current assets 48 CIBC World Markets Deutsche Bank Securities UBS Investment Bank Future sales or the possibility of future sales of a substantial amount of IDSs, shares of our class A common stock or our senior subordinated notes may depress the price of the IDSs and the shares of our class A common stock and our senior subordinated notes. Future sales or the availability for sale of substantial amounts of IDSs or shares of our class A common stock or a significant principal amount of our senior subordinated notes in the public market could adversely affect the prevailing market price of the IDSs and the shares of our class A common stock and our senior subordinated notes and could impair our ability to raise capital through future sales of our securities. Upon consummation of this offering and assuming the exchange of all of our class B common stock for IDSs, we anticipate that our existing equity investors will own % of the outstanding shares of our class A common stock, or % if the underwriters exercise their over-allotment option in full. Sales of IDSs by our existing equity investors could cause a decline in the market price of the IDSs. Subject to certain limitations set forth under our indebtedness and our amended and restated by-laws, we may issue additional shares of our class A common stock and senior subordinated notes, which may be in the form of IDSs, or other securities as consideration for future acquisitions and investments. In the event that an acquisition or investment is significant, the number of shares of our class A common stock and the aggregate principal amount of senior subordinated notes, which may be in the form of IDSs, or the number or aggregate principal amount of other securities that we may issue may be significant. In addition, we may also grant registration rights covering those IDSs, shares of our class A common stock, senior subordinated notes or other securities in connection with any such acquisitions and investments. Our restated certificate of incorporation and amended and restated by-laws and several other factors could limit another party's ability to acquire us and deprive our investors of the opportunity to obtain a takeover premium for their securities. A number of provisions in our restated certificate of incorporation and amended and restated by-laws will make it difficult for another company to acquire us and for you to receive any related takeover premium for your securities. For example, our restated certificate of incorporation provides that certain provisions of our restated certificate of incorporation can only be amended by a vote of two-thirds or more in voting power of all the outstanding shares of capital stock and that stockholders generally may not act by written consent and only stockholders representing at least 50% in voting power may request that our board of directors call a special meeting. Our restated certificate of incorporation provides for a classified board of directors and authorizes the issuance of preferred stock without stockholder approval and upon such terms as the board of directors may determine. The rights of the holders of shares of our class A common stock will be subject to, and may be adversely affected by, the rights of holders of any class or series of preferred stock that may be issued in the future. We may, under certain circumstances, suspend your rights of stock ownership the exercise of which would result in any inconsistency with, or violation of, any applicable communications law. Our restated certificate of incorporation will provide that so long as we hold any authorization, license, permit, order, filing or consent from the Federal Communications Commission or any state regulatory commission having jurisdiction over us, we will have the right to request certain information from our stockholders. If any stockholder from whom such information is requested should fail to respond to such a request or we conclude that the ownership of, or the existence or exercise of any rights of stock ownership with respect to, shares of our capital stock by such stockholder, could result in any inconsistency with, or violation of, any applicable communications law, we may suspend those rights of stock ownership the existence or exercise of which would result in any inconsistency with, or violation of, any applicable communications law, and we may exercise any and all appropriate remedies, at law or in equity, in any court of competent jurisdiction, against any stockholder, with a view towards obtaining such information or preventing or curing any situation which would cause an inconsistency Banc of America Securities LLC Citigroup Credit Suisse First Boston RBC Capital Markets Wachovia Securities , 2004 with, or violation of, any provision of any applicable communications law. See "Description of Capital Stock Regulatory Ownership Provisions." Risks Related to our Business We provide services to our customers over access lines, and if we lose access lines, our business and results of operations may be adversely affected. Our business generates revenue by delivering voice and data services over access lines. We have experienced net voice access line loss of 0.5% for the period from December 31, 2000 through December 31, 2003 and 2.3% for the period from June 30, 2003 through June 30, 2004 due to challenging economic conditions and increased competition. We may continue to experience net access line loss in our markets. Our inability to retain access lines could adversely affect our business and results of operations. We are subject to competition that may adversely impact us. As an incumbent carrier, we historically have experienced little competition in our rural telephone company markets. Nevertheless, the market for telecommunications services is highly competitive. Regulation and technological innovation change quickly in the telecommunications industry, and changes in these factors historically have had, and may in the future have, a significant impact on competitive dynamics. In certain of our rural markets, we face competition from wireless telephone system operators, which may increase as wireless technology improves. We also face competition from cable television operators. In the future, we may face additional competition from new market entrants, such as providers of wireless broadband, voice over internet protocol, satellite telecommunications and electric utilities. The Internet services market is also highly competitive, and we expect that competition will intensify. Some of our competitors have brand recognition and financial, personnel, marketing and other resources that are significantly greater than ours. In addition, consolidation and strategic alliances within the communications industry or the development of new technologies could affect our competitive position. We cannot predict the number of competitors that will emerge, especially as a result of existing or new federal and state regulatory or legislative actions, but increased competition from existing and new entities could have a material adverse effect on our business. Competition may lead to loss of revenues and profitability as a result of numerous factors, including: loss of customers (in general, when we lose a customer for local service we also lose that customer for all related services); reduced usage of our network by our existing customers who may use alternative providers for long distance and data services; reductions in the prices for our services which may be necessary to meet competition; and/or increases in marketing expenditures and discount and promotional campaigns. In addition, our provision of long distance service is subject to a highly competitive market served by large nation-wide carriers that enjoy brand name recognition. We may not be able to successfully integrate new technologies, respond effectively to customer requirements or provide new services. The communications industry is subject to rapid and significant changes in technology, frequent new service introductions and evolving industry standards. We cannot predict the effect of these changes on our competitive position, profitability or industry. Technological developments may reduce the competitiveness of our networks and require unbudgeted upgrades or the procurement of additional products that could be expensive and time consuming. In addition, new products and services arising out of technological developments may reduce the attractiveness of our services. If we fail to adapt successfully to technological changes or obsolescence or fail to obtain access to important new [Map of United States indicating the locations of our operations and the names by which certain companies do business] technologies, we could lose customers and be limited in our ability to attract new customers and/or sell new services to our existing customers. An element of our business strategy is to deliver enhanced and ancillary services to customers. The successful delivery of new services is uncertain and dependent on many factors, and we may not generate anticipated revenues from such services. We rely on a limited number of key suppliers and vendors to operate our business. If these suppliers or vendors experience problems or favor our competitors, we could fail to obtain sufficient quantities of products and services we require to operate our business successfully. We depend on a limited number of suppliers and vendors for equipment and services relating to our network infrastructure. If these suppliers experience interruptions or other problems delivering these network components on a timely basis, subscriber growth and our operating results could suffer significantly. If proprietary technology of a supplier is an integral component of our network, we could be effectively locked into one of a few suppliers for key network components. As a result we have become reliant upon a limited number of network equipment manufacturers, including Nortel Networks Corporation and Siemens Information and Communication Networks, Inc. In addition, when our new billing platform is completed, we will rely on a single outsourced supplier to support our billing and related customer care services. In the event it becomes necessary to seek alternative suppliers and vendors, we may be unable to obtain satisfactory replacement suppliers or vendors on economically attractive terms, on a timely basis, or at all, which could increase costs and may cause disruptions in services. Our relationships with other telecommunications companies are material to our operations and their financial difficulties may adversely affect our business and results of operations. We originate and terminate calls for long distance carriers and other interexchange carriers over our network and for that service we receive payments for access charges. These payments represent a significant portion of our revenues. Should these carriers go bankrupt or experience substantial financial difficulties, our inability to then collect access charges from them could have a negative effect on our business and results of operations. We face risks associated with acquired businesses and potential acquisitions. We have grown rapidly by acquiring other businesses. Since 1993, we have acquired 30 rural telephone businesses and we continue to own and operate 26 such businesses. We expect that a portion of our future growth will result from additional acquisitions, some of which may be material. Growth through acquisitions entails numerous risks, including: strain on our financial, management and operational resources, including the distraction of our management team in identifying potential acquisition targets, conducting due diligence and negotiating acquisition agreements; difficulties in integrating the network, operations, personnel, products, technologies and financial, computer, payroll and other systems of acquired businesses; difficulties in enhancing our customer support resources to adequately service our existing customers and the customers of acquired businesses; the potential loss of key employees or customers of the acquired businesses; unanticipated liabilities or contingencies of acquired businesses; not achieving projected cost savings or cash flow from acquired businesses; fluctuations in our operating results caused by incurring considerable expenses to acquire businesses before receiving the anticipated revenues expected to result from the acquisitions; difficulties in finding suitable acquisition candidates; Investment tax credits 138 85 TABLE OF CONTENTS Page difficulties in making acquisitions based on attractive terms due to increased competitiveness; and difficulties in obtaining and maintaining any required regulatory authorizations in connection with acquisitions. We cannot assure you that we will be able to successfully complete the integration of the businesses that we have already acquired or successfully integrate any businesses that we might acquire in the future. If we fail to do so, or if we do so but at greater cost than we anticipated, or if our acquired businesses do not experience significant growth, there will be a risk that our business may be adversely affected. We may need additional capital to continue growing through acquisitions. We may need additional financing to continue growing through acquisitions. Such additional financing may be in the form of additional debt, which would increase our leverage. We may not be able to raise sufficient additional capital at all or on terms that we consider acceptable. In addition, sellers may not accept IDSs as acquisition currency to finance future acquisitions. Moreover, as a result of the restrictions in the indenture governing the senior subordinated notes and the restrictions in the other agreements governing our indebtedness, we may be prevented from issuing additional IDSs. If we are unable to issue additional IDSs, we may be forced to rely on equity-only securities as an additional source of capital. Although we are not contractually restricted from issuing certain equity-only securities, as a result of this offering, most of our equity holders will hold their investment in us in the form of IDSs, and consequently equity-only securities may be a comparatively less attractive investment. A system failure could cause delays or interruptions of service, which could cause us to lose customers. To be successful, we will need to continue to provide our customers reliable service over our network. Some of the risks to our network and infrastructure include: physical damage to access lines; power surges or outages; software defects; and disruptions beyond our control. Disruptions may cause interruptions in service or reduced capacity for customers, either of which could cause us to lose customers and incur expenses. We depend on third parties for our provision of long distance services. Our provision of long distance services is dependent on underlying agreements with other carriers that provide us with transport and termination services. These agreements are based, in part, on our estimate of future supply and demand and may contain minimum volume commitments. If we overestimate demand, we may be forced to pay for services we do not need. If we underestimate demand, we may need to acquire additional capacity on a short-term basis at unfavorable prices, assuming additional capacity is available. If additional capacity is not available, we will not be able to meet this demand. In addition, if we cannot meet any minimum volume commitments, we may be subject to underutilization charges, termination charges, or rate increases which may adversely affect our results of operations. We may face significant future liabilities or compliance costs in connection with environmental and worker health and safety matters. Our operations and properties are subject to federal, state and local laws and regulations relating to protection of the environment, natural resources, and worker health and safety, including laws and regulations governing the management, storage and disposal of hazardous substances, materials and wastes. Under certain environmental laws, we could be held liable, jointly and severally and without regard to fault, for the costs of investigating and remediating any contamination at owned or operated properties; or for contamination arising from the disposal by us or our predecessors of hazardous wastes at formerly-owned properties or at third-party waste disposal sites. In addition, we could be held responsible for third-party property or personal injury claims relating to any such contamination or relating to violations of environmental laws. Changes in existing laws or regulations or future acquisitions of businesses could require us to incur substantial costs in the future relating to such matters. Risks Related to our Regulatory Environment We are subject to significant regulations that could change in a manner adverse to us. We operate in a heavily regulated industry, and the majority of our revenues generally have been supported by regulations, including access revenue and Universal Service Fund support for the provision of telephone services in rural areas. Laws and regulations applicable to us and our competitors may be, and have been, challenged in the courts, and could be changed by Congress or regulators. In addition, any of the following have the potential to have a significant impact on us: Risk of loss or reduction of network access charge revenues. Almost 48% of our revenues come from network access charges, which are paid to us by intrastate and interstate long distance carriers for originating and terminating calls in the regions served. In recent years, several of these long distance carriers have declared bankruptcy. Future declarations of bankruptcy by a carrier that utilizes our access services could negatively impact our financial results. The amount of access charge revenues that we receive is based on rates set by federal and state regulatory bodies, and such rates could change. Further, from time to time federal and state regulatory bodies conduct rate cases and/or "earnings" reviews, which may result in rate changes. The Federal Communications Commission has reformed and continues to reform the federal access charge system. States often mirror these federal rules in establishing intrastate access charges. In October 2001, the Federal Communications Commission reformed the system to reduce interstate access charges and shift a portion of cost recovery, which historically have been based on minutes-of-use, to flat-rate, monthly per line charges on end-user customers rather than long distance carriers. As a result, the aggregate amount of access charges paid by long distance carriers to access providers, such as our rural local exchange carriers, has decreased and may continue to decrease. Although these changes were implemented on a revenue neutral basis (with commensurate increases in other charges and Universal Service Fund support), there is no assurance that future changes in access charge rates will be implemented on a revenue neutral basis. It is unknown at this time what additional changes, if any, the Federal Communications Commission may eventually adopt. Furthermore, to the extent our rural local exchange carriers become subject to competition, such access charges could be paid to competing communications providers rather than to us. Additionally, the intrastate access charges we receive may be reduced as a result of wireless competition. Regulatory developments of this type could adversely affect our business, revenue or profitability. Risk of loss or reduction of Universal Service Support. We receive Universal Service Fund revenues to support the high cost of our operations in rural markets. For the year ended December 31, 2003, approximately 8% of our revenues resulted from the high cost loop support we received from the Universal Service Fund and was based upon our average cost per loop compared to the national average cost per loop. For example, if the national average cost per loop increases and our operating costs (and average cost per loop) remain constant or decrease, the payments we receive from the Universal Service Fund would decline. Conversely, if the national average cost per loop decreases and our operating costs (and average cost per loop) remain constant or increase, the payments we receive from the Universal Service Fund would increase. Over the past year, the national average cost per loop in relation to our average cost per loop has increased and management believes the national average In making your investment decision, you should rely only on the information contained in this prospectus or to which we have referred you. We have not authorized anyone to provide you with information that is different. If anyone provided you with different or inconsistent information, you should not rely on it. This prospectus may only be used where it is legal to sell these securities. You should assume the information appearing in this prospectus is accurate only as of the date on the front cover of this prospectus. Our business, consolidated financial condition, results of operations, liquidity and prospects may have changed since that date. Neither the delivery of this prospectus nor any sale made hereunder shall under any circumstances imply that the information in this prospectus is correct as of any date subsequent to the date on the cover of this prospectus. cost per loop may continue to increase in relation to our average cost per loop and, as a result, the payments we receive from the Universal Service Fund could decline. This support fluctuates based upon the historical costs of our operating companies. In addition to the Universal Service Fund high cost loop support, we also receive Universal Service Fund support payments, which include local switching support, long term support, and interstate common line support that used to be included in our interstate access charge revenues (the Federal Communications Commission has recently merged long term support into interstate common line support). If our rural local exchange carriers were unable to receive support from the Universal Service Fund, or if such support was reduced, many of our rural local exchange carriers would be unable to operate as profitably as they have historically, in the absence of our implementation of increases in charges for other services. Moreover, if we raise prices for services to offset loss of Universal Service Fund payments, the increased pricing of our services may disadvantage us competitively in the marketplace, resulting in additional potential revenue loss. The Telecommunications Act of 1996, or the Telecommunications Act, provides that eligible telecommunications carriers, including competitors to rural local exchange carriers, may obtain the same per line support as the rural local exchange carriers receive if a state commission determines that granting such support to competitors would be in the public interest. In fact, wireless telecommunications providers in certain of our markets have obtained matching support payments from the Universal Service Fund, but that has not led to a loss of revenues for our rural local exchange carriers under existing regulations. Any shift in universal service regulation, however, could have an adverse effect on our business, revenue or profitability. During the last three years, pursuant to recommendations made by the Multi-Association Group and the Rural Task Force, the Federal Communications Commission has made certain modifications to the universal service support system that changed the sources of support and the method for determining the level of support. These changes have been revenue neutral to our operations. It is unclear whether the changes in methodology will continue to accurately reflect the costs incurred by our rural local exchange carriers, and whether it will provide for the same amount of universal service support that our rural local exchange carriers have received in the past. In addition, several parties have raised objections to the size of the universal service support fund and the types of services eligible for support. A number of issues regarding the source and amount of contributions to, and eligibility for payments from, the Universal Service Fund are pending and will likely be addressed by the Federal Communications Commission or Congress in the near future. The outcome of any regulatory proceedings or legislative changes could affect the amount of universal service support that we receive, and could have an adverse effect on our business, revenue or profitability. The Federal State Joint Board has recently issued recommendations for the resolution of portability of Universal Service Fund support. The Federal State Joint Board recommended that: a set of permissive federal guidelines be developed to ensure that the public interest is served before eligible telecommunications carriers are designated; support be limited to a single connection that provides access to the public telephone network; and the basis for providing support be considered and further clarified during the comprehensive review of the Universal Service Fund to be completed in 2006. The Federal Communications Commission statutorily must act on these recommendations by February 27, 2005. In addition, the Federal Communications Commission is considering resolution of the method by which contributions to the Universal Service Fund are determined. Risk of loss of statutory exemption from burdensome interconnection rules imposed on incumbent local exchange carriers. Our rural local exchange carriers are exempt from the Telecommunications Act's more burdensome requirements governing the rights of competitors to interconnect to incumbent local (unaudited) Net income (loss), as reported $ (211,600 ) 13,239 1,671 790 (8,701 ) Stock-based compensation expense included in reported net income (loss) 2,203 1,260 15 88 Stock-based compensation determined under fair value based method exchange carrier networks and to utilize discrete network elements of the incumbent's network at favorable rates. If state regulators decide that it is in the public's interest to impose these more burdensome interconnection requirements on us, we would be required to provide unbundled network elements to competitors. As a result, more competitors could enter our traditional telephone markets than are currently expected and we could incur additional administrative and regulatory expenses, and experience additional revenue losses. Risks posed by costs of regulatory compliance. Regulations create significant compliance costs for us. Our subsidiaries that provide intrastate services are generally subject to certification, tariff filing and other ongoing regulatory requirements by state regulators. Our interstate access services are provided in accordance with tariffs filed with the Federal Communications Commission. Challenges to our tariffs by regulators or third parties or delays in obtaining certifications and regulatory approvals could cause us to incur substantial legal and administrative expenses, and, if successful, such challenges could adversely affect the rates that we are able to charge our customers. Our business also may be impacted by legislation and regulation imposing new or greater obligations related to assisting law enforcement, bolstering homeland security, minimizing environmental impacts, or addressing other issues that impact our business. For example, existing provisions of the Communications Assistance for Law Enforcement Act and Federal Communications Commission regulations implementing the Communications Assistance for Law Enforcement Act require telecommunications carriers to ensure that their equipment, facilities, and services are able to facilitate authorized electronic surveillance. We cannot predict whether and when the Federal Communications Commission might modify its Communications Assistance for Law Enforcement Act rules or any other rules or what compliance with new rules might cost. Similarly, we cannot predict whether or when federal or state legislators or regulators might impose new security, environmental or other obligations on our business. For a more thorough discussion of the regulatory issues that may affect our business, see "Regulation." Regulatory changes in the telecommunications industry could adversely affect our business by facilitating greater competition against us, reducing potential revenues or raising our costs. The Telecommunications Act provides for significant changes and increased competition in the telecommunications industry, including the local telecommunications and long distance industries. This statute and the Federal Communications Commission's implementing regulations remain subject to judicial review and additional rulemakings of the Federal Communications Commission, thus making it difficult to predict what effect the legislation will have on us, including our operations and our revenues and expenses, and our competitors. Several regulatory and judicial proceedings have recently concluded, are underway or may soon be commenced, that address issues affecting our operations and those of our competitors. We cannot predict the outcome of these developments, nor can we assure that these changes will not have a material adverse effect on us or our industry. For a more thorough discussion of the regulatory issues that may affect our business, see "Regulation." The failure to obtain necessary regulatory approvals could impede the consummation of a potential acquisition. Our acquisitions likely will be subject to federal, state and local regulatory approvals. We cannot assure you that we will be able to obtain any necessary approvals, in which case a potential acquisition could be delayed or not consummated. For example, in June 2003, we executed an agreement and plan of merger with respect to the Berkshire acquisition and we have not yet received the regulatory approvals required to consummate that transaction.
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+RISK FACTORS You should carefully consider the following risk factors and all other information contained in this prospectus before investing in shares of our common stock. Investing in our common stock involves a high degree of risk. If any of the following risks actually occur, our business, financial condition and results of operations could be materially and adversely affected. In that event, the trading price of our common stock could decline and you may lose part or all of your investment. Risks Related to Our Industry and Our Company Changes in federal laws and regulations relating to education loans, particularly legislation affecting federally guaranteed consolidation loans, could materially adversely affect our results of operations. The Higher Education Act of 1965 must be reauthorized by Congress every five years and the FFEL Program is periodically amended. The United States Congress is currently considering reauthorization of the Act, which is scheduled to expire in 2004. Changes in the Higher Education Act made in the two most recent reauthorizations have resulted in reductions in education loan yields paid to lenders, increased fees paid by lenders and a decreased level of federal guarantee. Federally guaranteed consolidation loans made up 94.9% of our loan originations for the year ended December 31, 2003 and 99.9% of our loan portfolio as of March 31, 2004, and efforts underway to pass legislation that affects federal consolidation loans would have a significant impact on us. Some of the key changes that may be considered in the reauthorization debate that could have a negative effect on our business include: Eliminating fixed-rate consolidation loans and requiring that all consolidation loans be made at a variable rate. If consolidation loans are required to be made at a variable rate rather than a fixed rate, as virtually all consolidation loans are currently made, it could reduce the amount of income we can earn on the loans we originate in the future and reduce the demand for consolidation loans. A bill recently introduced by the Chair of the House Committee on Education and the Workforce contains this provision. Permitting borrowers to refinance consolidation loans. If borrowers holding consolidation loans are permitted to refinance their consolidation loans under the FFEL Program, this would open the consolidation loans in our portfolio to refinancing. Any of these legislative changes, if enacted, could materially reduce our loan originations and earnings. Senator John Kerry, the presumptive Democratic candidate for president, has proposed as part of his presidential campaign, a requirement that lenders bid in an auction in order to offer FFELP loans, effectively replacing the current government guaranteed minimum interest rate. This proposal would also eliminate the Special Allowance Payments made by the federal government to lenders to provide them a guaranteed rate of return on FFELP loans made after enactment of such proposal. If the Kerry proposal is enacted, it could materially reduce our loan originations and earnings. In addition, legislation has been introduced proposing a number of initiatives aimed at supporting the William D. Ford Federal Direct Loan Program, which we refer to as the FDL Program or FDLP. Under the FDL Program, the U.S. Department of Education, or DOE, makes loans directly to student borrowers through the educational institutions they attend. If legislation promoting the FDL Program to the detriment of the FFEL Program were to be enacted, it could materially reduce our loan originations and earnings. Further amendments, the nature of which we cannot currently anticipate, could also hurt our business and our results of operations. Moreover, there can be no assurance that the provisions of the Higher Education Act will be reauthorized this year. While Congress has consistently extended the effective date of the Higher Education Act, it may elect not to reauthorize the DOE s ability to provide interest Proposed Maximum Title of Each Class Amount to be Proposed Maximum Aggregate Offering Amount of of Securities to be Registered Registered(1) Offering Price Per Unit Price(2) Registration Fee(3) Table of Contents subsidies and federal guarantees for student loans. Such a failure to reauthorize would reduce the number of federally guaranteed student loans available for us to originate in the future and could materially reduce our results of operations. Changes in the interpretations of the Higher Education Act issued by the U.S. Department of Education could negatively impact our loan originations. The U.S. Department of Education oversees and implements the Higher Education Act and periodically issues regulations and interpretations of that Act. Changes in such regulations and interpretations could negatively impact our business. Currently, if only one lender holds all of a student s FFELP loans, then another lender cannot consolidate the loans away from the current holder unless the current holder refuses to, or does not offer to, consolidate the loans for the borrower. We refer to this as the single holder rule. Historically, we did not believe the single holder rule limited the ability of a borrower to consolidate FFELP loans held by a single lender with FDLP loans. However, the U.S. Department of Education issued a letter on April 29, 2004 that limits the ability of borrowers having FFELP loans that are held by a single lender and FDLP loans to obtain a FFELP consolidation loan with any lender other than the lender holding all of the borrower s FFELP loans. This new ruling is scheduled to go into effect in September 2004. During the second half of 2003 and the first quarter of 2004, we marketed to borrowers who had FDLP loans and FFELP loans made by a single lender. In May 2004, as a result of this ruling, we reduced marketing to these types of borrowers and increased our marketing efforts to other types of borrowers. We estimate that our loan originations of this type peaked in the fourth quarter of 2003 at approximately $133 million and declined to approximately $94 million in the first quarter of 2004. Unless our new marketing campaigns are as successful as the prior ones, this new ruling could adversely affect the volume of our loan originations. In addition, until recently, we marketed and offered FFELP consolidation loans to borrowers seeking to refinance only their FDLP consolidation loans. However, in June 2004, the U.S. Department of Education s servicers for the FDL Program informed us and, we believe, other FFELP loan originators that FFELP loans which refinance only FDLP consolidation loans will no longer be permitted. We can provide no assurance that this position will not be officially endorsed by the U.S. Department of Education or that we will be able to originate these loans in the future. As a result, we have currently ceased marketing loans to these types of borrowers and are reallocating marketing resources to other types of borrowers. For 2002, 2003 and the first quarter of 2004, we estimate that approximately $0, $250 million and $140 million, respectively, of our loan originations were FFELP consolidation loans that refinanced only FDLP consolidation loans. Because this change is effective immediately, we expect that, in the short term, this change will adversely affect the volume of our loan originations. Furthermore, unless our new marketing campaigns are as successful as the prior ones, this new ruling could adversely affect the volume of our loan originations in the future. Significantly decreased demand for consolidation loans would materially reduce our revenue. A combination of increased consumer awareness, rising education debt volume and historically low interest rates available to borrowers in the last three years has increased the number of borrowers seeking to consolidate their variable-rate education loans into one loan. For the year ended December 31, 2003, 94.9% of our loan originations were consolidation loans. One of the advantages of consolidation loans is that borrowers are able to fix the interest rate on their variable rate student loans at the then existing rate. If rates rise, students may have less incentive to consolidate their loans at a fixed rate. Demand for consolidation loans could also decrease in the future as a result of a decrease in the pool of potential borrowers eligible to consolidate their loans. The DOE projects that FFELP consolidation loan volume will decrease from $35.3 billion in federal fiscal year 2003 to an estimated $25.9 billion in federal fiscal year 2004 and to $22.3 billion in federal fiscal year 2005. A significant portion of the borrowers eligible to consolidate their loans have loans held by one lender and, as a result of the single holder rule discussed in the prior risk factor, those loans are not available for consolidation by other lenders unless the original Common Stock, par value $.001 per share 10,781,250 shares $ 17.00 $ 183,281,250 $ 23,222.00 Table of Contents lender does not offer or refuses to consolidate those loans. Demand for consolidation loans could also decrease as a result of regulatory changes or if any of the legislative proposals described above are enacted. A significant decrease in demand for consolidation loans would have a material adverse effect upon our revenue, particularly our fees on loan sales. We must comply with governmental regulations relating to our FFELP loans and guaranty agency rules and our business and results of operations could be materially adversely affected if we fail to meet these requirements. Our principal business is comprised of originating, holding and servicing education loans made and guaranteed pursuant to the FFEL Program. Most significant aspects of our lines of business are governed by the Higher Education Act. We must also meet various requirements of the guaranty agencies, which are private not-for-profit organizations or state agencies that have entered into federal reinsurance contracts with the DOE, in order to maintain the federal guarantee on our FFELP loans. These requirements establish origination and servicing requirements and procedural guidelines and specify school and borrower eligibility criteria. The federal guarantee of FFELP loans is conditioned on compliance with origination, servicing and collection standards set by the DOE and guaranty agencies. FFELP loans that are not originated, disbursed or serviced in accordance with DOE regulations risk loss of their guarantee, in full or in part. Our failure to comply with the regulatory regimes described above may arise from: breaches of our internal control system, such as a failure to adjust manual or automated servicing functions following a change in regulatory requirements; unintentional employee errors, such as inputting erroneous data or failure to adhere to established company processes; technological defects, such as a malfunction in or destruction of our computer systems; fraud by third parties who refer loan applications to us or from whom we acquire originated loan applications; or fraud by our employees or other persons in activities such as origination or borrower payment processing. If we fail to comply with any of the above requirements, we could incur penalties or lose the federal guarantee on some or all of our FFELP loans. In addition, even if we comply with the above requirements, a failure to comply by third parties with whom we conduct business may be attributable to us and result in us incurring penalties or losing the federal guarantee on some or all of our FFELP loans. If we experience a high rate of servicing deficiencies, we could incur costs associated with remedial servicing, and, if we are unsuccessful in curing such deficiencies, the eventual losses on the loans that are not cured could be material. In addition, failure to comply with these laws and regulations could result in our liability to borrowers and potential class action suits. Our actual loss experience on denied guarantee claims historically has not been material to our operations, but the impact on us could become material if denied guarantee claims were to increase substantially in future periods. In 2002, we lost $32,000 and, in 2003, we lost $8,000 due to denied guarantee claims. We have only recently begun retaining a significant portion of the loans we originate in our portfolio and servicing loans and we cannot predict whether we will suffer losses as a result of the performance of our assets and operations over the long term. We were formed in June 1998. Prior to 2002, we did not retain in our portfolio a significant amount of the loans we originated. We retained approximately 50% and 21% of the FFELP loans we originated in 2003 and 2002, respectively. Although we believe that the retained loans are valuable assets, due to their long duration and high quality (due to the federal guarantee), we cannot assure you that over the long term our earnings from retaining loans in our portfolio will exceed the value of the income we would have Table of Contents received from selling those loans. The loans retained in our portfolio may be repaid prior to maturity which would reduce the amount of interest we earn and expose us to reinvestment risk. Moreover, the loans retained in our portfolio could perform poorly in the future and our allowance for loan losses could be insufficient, which could materially reduce our earnings and impair our ability to access the asset-backed securitization market in the future on favorable terms. In addition, we only began servicing loans in April 2003, following our acquisition of SunTech. Although SunTech has been in business for more than 15 years and has serviced a significant portion of the loans we have originated since our formation in 1998, we have operated as a vertically integrated company offering loan servicing for only one year. If SunTech does not perform at the level of its historical performance, our business and results of operations could be materially adversely affected. Our quarterly results of operations have varied significantly in the past and are expected to continue to do so, which may cause our stock price to fluctuate. Our quarterly results of operations have varied significantly in the past and are expected to continue to do so in the future. Over the past two fiscal years, our quarterly income (loss) before income tax provision (benefit) and accretion of dividends on preferred stock has ranged from a low of a $13.5 million loss in the second quarter of 2003 to a high of $18.2 million of income in the third quarter of 2002. In addition, over this period, our quarterly originations as a percentage of total annual originations have ranged from a low of 9.4% to a high of 36.4%. The market price of our common stock may decline significantly if our future quarterly results of operations fall below the expectations of securities or industry analysts or investors. Our quarterly results of operations in any period will be particularly affected by the amount and timing of our loan sales. Because we target a percentage of our loan originations to be retained on an annual, rather than quarterly basis, our quarterly results of operations will fluctuate. A number of additional factors, some of which are outside of our control, will also cause our quarterly results to fluctuate, including: an increase in loan consolidation in November and December, as a result of the expiration of the six-month grace period; the effects of the July 1 reset in borrower interest rates. We give borrowers who complete loan applications during the second quarter the option to fund their loans prior to July 1, when the old rate is effective, or after July 1, when the new rate is effective. Accordingly, if any year s borrower rate decreases over the prior year s borrower rate, the origination of a significant portion of the loan applications completed in the second quarter will be shifted to the third quarter; conversely, if any year s borrower rate increases from the prior year s borrower rate, a higher percentage of completed applications will be originated in the second quarter. seasonal patterns affecting private in-school loans, primarily an increase in private in-school loan originations in the third and fourth quarter as students obtain loans to pay tuition, and a decrease in private in-school loan activity in the second quarter; seasonal patterns affecting marketing expenses, as we generally market most heavily in the second and third quarters of the year in an effort to inform recent college graduates of their consolidation options and offer private in-school loans to students paying tuition; the impact of general economic conditions; changes in interest rates; and the introduction of new product offerings. (1) Includes 1,406,250 shares subject to the underwriters over-allotment option. (2) Estimated solely for the purpose of calculating the amount of the registration fee pursuant to Rule 457(a). (3) $21,856 of which was previously paid. The registrant hereby amends this registration statement on such date or dates as may be necessary to delay its effective date until the registrant shall file a further amendment which specifically states that this registration statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933, or until this registration statement shall become effective on such date as the Securities And Exchange Commission, acting pursuant to said Section 8(a), may determine. Table of Contents We forecast the volume and timing of our loan originations for our operational and financial planning on the basis of many factors and subjective judgments. Therefore, failure to generate originations according to our expectations in a particular quarter could materially decrease our net income for that quarter and the next, at a minimum. Do not call registries may limit our ability to market our products and services. Our direct marketing operations are subject to various federal and state do not call list requirements and may become subject to additional state do not call list requirements. The Federal Trade Commission has recently amended its rules to provide for a centralized national do not call registry. Under these new federal regulations, consumers may have their phone numbers added to the national do not call registry. Generally, we are prohibited from calling anyone on that registry unless we have an existing relationship with that person. We also are required to pay a fee to access the registry on a quarterly basis. Federal enforcement of the do not call provisions began in the fall of 2003, and the rule provides for fines of up to $11,000 per violation and other possible penalties. This rule may restrict our ability to market effectively our products and services to new customers. Furthermore, compliance with this new rule may prove difficult, and we may incur penalties for improperly conducting our marketing activities. In addition, failure to comply with the terms of this new rule could have a negative impact on our reputation. Nineteen states continue to maintain state do not call lists with varying penalties and fines for noncompliance. Compliance and coordination with these state lists and with federal lists may prove difficult and we may incur additional penalties for failure to comply with any of these lists, which could also have a negative impact on our business. We derive a significant portion of our fee income under a small number of forward purchase agreements, and if we are not able to retain these agreements, or if our counterparties under these agreements reduce their willingness to acquire originated loans from us, our net revenue would be reduced and our results of operations would suffer. We enter into forward purchase agreements with financial institutions who agree to purchase and require that we sell to them, a portion of the FFELP consolidation loan applications we originate. We also enter into forward purchase agreements with financial institutions who agree to purchase all of the private consolidation applications we originate. Under these agreements, which are typically one- to three-year agreements, we generate loan applications that are then forwarded to partnering financial institutions over pre-determined periods of time and for agreed upon fees. Three of our forward purchase agreements accounted for approximately 72.5% of our fee income and 60.5% of our net revenue in fiscal 2003. Revenue under our largest forward purchase agreement in fiscal 2003, with Citibank (New York State), represented 43.4% of our fee income and 36.2% of our net revenue for that year. We may not be able to retain or renew our key forward purchase agreements or our counterparties may decrease the level of originated loans they are willing to acquire from us. If a large forward purchase contract were cancelled or not renewed and not replaced, our fee income would significantly decline, and the loss of or a significant reduction of purchases by, one or more of our significant forward purchase agreement counterparties could materially adversely affect our business, operating results and financial condition. We can provide no assurance that we will be able to renew these agreements or that suitable replacements can be found at acceptable rates or on acceptable terms. Our inability to maintain relationships with our eligible lender or with lenders that originate our private loans could have material adverse effect on our ability to sustain or increase our business. When we originate FFELP loans on our own behalf or when we acquire FFELP loans from others, we engage U.S. Bank National Association as our eligible lender, as defined in the Higher Education Act, to act as our trustee to hold title to all such originated and acquired FFELP loans. This eligible lender trustee holds the legal title to our FFELP loans, and we hold 100% of the beneficial interests in Table of Contents those loans. If we are unable to renew our contract with U.S. Bank, or if the contract is terminated, we would have to find another institution to serve as our eligible lender. We can provide no assurance that we will be able to renew this contract or that a replacement eligible lender can be found at acceptable rates or on acceptable terms. Moreover, we have a relationship with a lender for whom we market and facilitate the origination of private in-school loans. The number of financial institutions willing to originate and finance these private in-school loans will be a significant factor in the growth of this market. As the market is less mature than that for federally guaranteed loans, there are, at present, fewer institutions originating and acquiring these loans. Accordingly, we can provide no assurance that we will be able to renew this contract or that suitable replacements could be found or that we will find additional lenders willing to finance the volume of private loans that we may seek to market or originate. Any failure to maintain or replace contractual relationships with these financial institutions or lenders could seriously impair our ability to originate loans and generate revenue from originated loans, and to sustain or increase our business. If we are unable to increase our private education loan originations and expand our channels of distribution as we plan, our business may not grow. Our strategy includes increasing the amount of private loans we originate or whose origination we facilitate, as well as expanding our channels of distribution. We have much more limited experience in these products and channels than in our business of marketing and originating FFELP consolidation loans through our DTC channel. In connection with these strategies, we have invested and will continue to invest resources in market research and technology and have hired and trained and will continue to hire and train additional personnel, when necessary. If these strategies are not successful, our earnings may be adversely affected. We may not be able to successfully make acquisitions or increase our profits from these acquisitions. We intend to pursue continued growth through acquisitions in the education finance industry. Such an acquisition strategy includes certain risks. For example: we may be unable to identify acquisition candidates, negotiate definitive agreements on acceptable terms or, as necessary, secure additional financing; we may encounter unforeseen expenses, difficulties, complications or delays in connection with the integration of acquired entities; we may fail to achieve acquisition synergies; our acquisition strategy, including the focus on the integration of operations of acquired entities, may divert management s attention from the day-to-day operation of our businesses; acquired loan or servicing portfolios may have unforeseen problems; or key personnel at acquired companies may leave employment. In addition, we may compete for certain acquisition targets with companies having greater financial resources than us. We cannot assure you that we will be able to successfully make future acquisitions or what effects those acquisitions may have on our financial condition and results of operations. Inherent in any future acquisition is the risk of transitioning company cultures and facilities. The failure to efficiently and effectively achieve such transitions could have a material adverse effect on our financial condition and results of operations, particularly during the period immediately following any acquisitions. Table of Contents We anticipate that we would finance potential acquisitions through cash provided by operating activities and/or borrowings, which would reduce our cash available for other purposes and our debt capacity, as well as our debt service requirements. We cannot assure you, however, that we would be able to obtain needed financing in the event acquisition opportunities are identified. We may also consider financing acquisitions by issuing additional shares of common stock to raise capital or as consideration, which would dilute your ownership. Our inability to maintain our relationships with third parties for whom we service loans could reduce our net income. Our inability to maintain strong relationships with servicing customers could result in loss of loan servicing volume generated by some of our loan servicing customers. We cannot assure you that these relationships will continue. As of December 31, 2003, approximately 69.4% of the loans we serviced were owned by third parties. Of these, a majority are governed by agreements with terms of three years or less. To the extent that our third-party servicing clients reduce the volume of education loans that we service on their behalf, our income would be reduced, and, to the extent the related costs could not be reduced correspondingly, our net income could be reduced. We might lose third-party servicing volume for a variety of reasons, including if our third-party servicing clients begin or increase internal servicing activities, shift volume to another service provider, exit the FFEL Program completely or if we fail to comply with applicable laws and regulations. The loss of such loan servicing volume could result in an adverse effect on our business. If loan applications for federally guaranteed loans that we sell are subsequently found to be ineligible for the federal guarantee, we may be required to purchase such loans and reimburse the DOE for certain fees. Pursuant to the terms of our forward purchase agreements, FFELP loans that we originate must comply with all applicable laws and regulations and must be eligible for federal guarantee. A portion of the loan applications that we originate and sell are generated by third-party marketing entities with whom we have marketing contracts. If any of the loan applications that we sell under our forward purchase agreements, whether marketed by us or by a third-party marketer, are deemed ineligible for federal guarantee by a guaranty agency, we may be obligated to purchase those loans. We would also be required to reimburse the DOE for fees associated with those loans. Prior to 2001, a portion of the loan applications we originated were generated by referrals from collection agencies, including approximately $3.9 million in principal amount of loans generated by referrals from the Valley Acceptance Corporation. Individuals associated with Valley Acceptance have been charged with improper processing of loans, including loan applications which we originated and sold to third parties. To date, a small number of claims relating to these loans have been returned to us by the applicable guarantee agency, and, accordingly, we may be required to purchase these loans and reimburse the DOE for the associated fees. If any loan applications which we originated are found to be ineligible for federal guarantee after they are funded, including loans referred by other third-party marketers, we may be required to purchase additional loans in the future and reimburse the DOE for the associated fees which could have an adverse effect on our results of operations. We could experience cash flow problems if a guaranty agency defaults on its guarantee obligation. A deterioration in the financial status of guaranty agencies, which are private not-for-profit organizations or state agencies, or in their ability to honor guarantee claims on defaulted student loans could result in a failure of these guaranty agencies to make their guarantee payments in a timely manner, if at all. If the DOE has determined that a guaranty agency is unable to meet its guarantee obligations, we may submit claims directly to the DOE, and the DOE would be required to pay the full guarantee claim. In such event, payment of the guarantee claims may not be made in a timely manner, which could adversely affect our liquidity. Table of Contents The information in this preliminary prospectus is not complete and may be changed. The securities may not be sold until the registration statement filed with the Securities and Exchange Commission is effective. This preliminary prospectus is not an offer to sell nor does it seek an offer to buy these securities in any state where the offer or sale is not permitted. Subject to Completion. Preliminary Prospectus dated July 13, 2004 PROSPECTUS 9,375,000 Shares Common Stock This is an initial public offering of shares of common stock of Collegiate Funding Services, Inc. All of the shares of common stock are being sold by us. The Lightyear Fund, L.P. and its affiliates and other investors will receive approximately $93.4 million of the net proceeds of this offering as described in this prospectus. We are a vertically integrated education finance company that markets, originates, finances and services education loans. We market education loans primarily through direct-to-consumer programs, which involve marketing campaigns where we acquire customers through direct contact with us, including targeted direct mail, telemarketing and the Internet. As described in this prospectus, our net revenue was $118.2 million for 2003 and $34.6 million for the first quarter of 2004, which was primarily generated through the origination and financing of federally guaranteed consolidation education loans. We had a net loss of $7.5 million in 2003 and net income of $1.2 million for the first quarter of 2004. Prior to this offering, there has been no public market for the common stock. We currently estimate that the initial public offering price per share will be between $15.00 and $17.00. We have applied for quotation of our common stock on the Nasdaq National Market under the symbol CFSI . See Risk Factors beginning on page 8 to read about factors you should consider before buying shares of the common stock. Per Share Total Table of Contents Fluctuations in interest rates may materially and adversely affect our net income. Because we expect to generate a significant portion of our earnings from the difference, or spread, between the yield we receive on our portfolio of loans and the cost of financing these loans, changes in interest rates could have a material effect on our results of operations. Substantially all the loans in our portfolio are FFELP consolidation loans which bear interest at a fixed rate, however, the yield we receive is the higher of the fixed rate or a variable rate determined under the FFEL Program. For consolidation loans in our portfolio, the FFELP-determined variable rate is 2.64% over the 91-day financial commercial paper rate. Substantially all interest costs on our debt obligations are determined based upon LIBOR, commercial paper or the result of auctions. Using the portfolio as of December 31, 2003 and assuming normal portfolio payment patterns for the following 12-month period, an increase in interest rates of 200 basis points would decrease our net interest income for that period by approximately $20.3 million and an increase in interest rates of 100 basis points would decrease our net interest income for that period by approximately $13.5 million, while a corresponding decrease in these interest rates of 100 basis points would increase our net interest income for that period by approximately $21.8 million. Changes in interest rates, the composition of our loan portfolio and derivative instruments will impact the effect of interest rates on our earnings, and we cannot predict any such impact with any level of certainty. See Management s Discussion and Analysis of Financial Condition and Results of Operations Interest Rate Risk. The effect of our borrower benefit programs may adversely affect our net interest income. Our borrower benefit programs, which reduce the interest rates borrowers pay on their loans, could significantly reduce our net interest income. We offer borrower benefits as incentives to attract new borrowers and to improve our borrowers payment behavior. One incentive program reduces a borrower s interest rate by 0.25% per annum for so long as the borrower makes monthly payments through automatic deductions from his or her checking or savings account. Approximately 30% of our borrowers currently participate in this program. In addition, we offer borrowers an on-time incentive program that reduces their interest rates by 1.00% per annum after they have made their initial 36 payments on time and for so long as they continue to make subsequent payments on time. Although the on-time program has not been in place for sufficient time to have had any impact on our net interest income, our borrower benefits will in the future reduce the yield on our loan portfolio and reduce our net interest income. Our derivative instruments may not be successful in managing our interest rate risk and failure of counterparties to perform under certain derivative instruments could harm our business. When we utilize derivative instruments, we utilize them to manage our interest rate sensitivity. Although we do not use derivative instruments for speculative purposes, our derivative instruments do not meet the criteria set forth in Statement of Financial Accounting Standards, or SFAS, No. 133, Accounting for Derivatives Instruments and Hedging Activities, which allow offset of the changes in the fair value of the derivative instrument against the effects of the changes in the hedged item in the statement of income. Therefore, we only mark-to-market the derivative instruments with changes reflected in the income statement. The derivative instruments we use are typically in the form of interest rate swaps and interest rate caps, which have a duration of between twelve and twenty four months. Our interest rate hedging strategy is designed to address fluctuations in the short term, rather than the long term. Developing an effective strategy for dealing with movements in interest rates is complex, and no strategy can completely insulate us from risks associated with such fluctuations. In addition, a counterparty to a derivative instrument could default on its obligation, thereby exposing us to credit risk. Further, we may have to repay certain costs, such as transaction fees or brokerage costs, if a derivative instrument is terminated by us. As a result, we cannot assure you that our economic hedging activities will not have an adverse impact on our results of operations or financial condition. Table of Contents If we fail to renew our warehouse facility and revolving line of credit, our liquidity and results of operations could be adversely affected. Our primary funding needs are those required to finance our loan portfolio and satisfy our cash requirements for acquisitions, operating expenses and technological development. We rely upon a conduit warehouse facility to support our funding needs on a short-term basis. The term of the facility is one year, and it is renewable at the option of the lender and may be terminated at any time for cause. Currently, the aggregate short-term availability under our warehouse facility is $500 million. There can be no assurance that we will be able to maintain such conduit facility, increase the availability under such facility or find alternative funding, if necessary. Our revolving line of credit may be terminated at any time upon the occurrence of an event of default. Unavailability of warehouse or revolving financing sources may subject us to the risk that we may be unable to meet our financial commitments to borrowers and creditors when due, unless we find alternative funding mechanisms. If the availability under our warehouse facility were to decrease or terminate, our ability to retain loans could be adversely affected, which could adversely affect our results of operation on a short- and/ or long-term basis. If we are unable to access the asset-backed securitization market, which we rely on for substantially all our long-term funding of loan originations, our liquidity and results of operations could be adversely affected. We have begun to rely upon, and expect to rely increasingly upon, asset-backed securitizations as our most significant source of long-term funding for our loan portfolio. We have issued approximately $4.0 billion in asset-backed notes since 2001. Our access to the asset-backed securitization market is subject to conditions in the asset-backed securitization market over which we have no control. If the loans in our securitizations perform poorly, our ability to access the asset-backed securitization market may be impaired or the terms of future securitization may be more costly. If our access to the asset-backed securitization market were to decrease, we would have to find other methods to finance our loan originations on a long-term basis or be required to sell a larger portion of our originated loan applications either of which option, if available, may be less favorable than the asset-backed securitization market has been historically. In such event, our liquidity and results of operations could be adversely affected on a short- and/or long-term basis. Our right to receive cash in excess of the principal balance of the loans funded from our securitizations is limited by their terms and performance. As part of our securitization transactions since 2002, we borrowed funds in excess of the principal balance of the loans included in the applicable securitization transactions. A portion of these additional funds was used to repay other indebtedness and to fund our operations. We are also entitled to receive excess spread from securitizations in the future, generally after the principal balance of the loans and restricted cash held in the securitizations equals the outstanding indebtedness. We currently expect to receive excess spread from our November 2001, February 2003 and November 2003 issuances in September 2006, October 2005 and April 2008, respectively. However, our rights to cash flows from securitized loans are subordinate to noteholder interests, and these loans may fail to generate any cash flows beyond what is due to pay noteholders. Moreover, the cash generated from these loans may be restricted by these securitization vehicles for certain periods. Accordingly, adverse developments in the performance of our current and future securitizations could adversely affect our liquidity and cash flows. Higher rates of prepayments of student loans could reduce our profits. Pursuant to the Higher Education Act, borrowers may prepay loans made under the FFEL Program at any time. Prepayments may result from consolidating student loans, which has historically tended to occur more frequently in low interest rate environments, from borrower defaults, which will result in the receipt of a guarantee payment and from voluntary full or partial prepayments, among other things. The Initial public offering price $ $ Underwriting discount $ $ Proceeds, before expenses, to Collegiate Funding Services, Inc. $ $ To the extent that the underwriters sell more than 9,375,000 shares of common stock, the underwriters have the option to purchase up to an additional 1,406,250 shares from us at the initial public offering price less the underwriting discount. Neither the Securities and Exchange Commission nor any other regulatory body has approved or disapproved of these securities or passed upon the accuracy or adequacy of this prospectus. Any representation to the contrary is a criminal offense. The shares will be ready for delivery on or about July , 2004. Table of Contents rate of voluntary prepayments of student loans may be influenced by a variety of economic, social and other factors affecting borrowers, including interest rates, the availability of alternative financing and legislative changes. Any legislation that permits borrowers to refinance existing consolidation loans at possibly lower interest rates could significantly increase the rate of prepayments on our student loans. Higher loan prepayments reduce the amount of cash generated in our securitizations, which, as described above, would adversely affect the amount of excess cash we receive from securitizations. In addition, loan prepayments generally result in a reduction in aggregate net interest income over the life of the loan. If auctions for our auction-rate asset-backed notes are not successful, our cost of funding will increase and future securitizations may become more costly. The interest rates on certain of our asset-backed securities are set and periodically reset via a dutch auction utilizing remarketing agents for varying intervals ranging from seven to 91 days. Of our $3.9 billion of asset-backed notes outstanding at April 30, 2004, 54% bear interest at rates based on auction rates. If there are insufficient potential bid orders in the auctions to purchase all of the notes offered for sale or being repriced, we could be subject to interest costs substantially above the anticipated and historical rates paid on these types of securities. A failed auction or remarketing could also reduce the investor base of our future securitizations and other financing and debt instruments. Future losses due to defaults on loans held by us present credit risk which could adversely affect our earnings. As of March 31, 2004, 100% our loan portfolio was comprised of FFELP loans. These loans benefit from a federal guarantee of 98% of their principal balance and accrued interest. We bear full risk of losses experienced with respect to the 2% non-guaranteed portion of the loans. The performance of the FFELP loans in our portfolio is affected by the economy and other factors outside of our control, and a prolonged economic downturn may have an adverse effect on the credit performance of these loans. While we provide allowances estimated to cover losses that may be experienced in our loans that are federally guaranteed under the FFEL Program, there can be no assurance that such allowances will be sufficient to cover actual losses in the future, particularly since we do not have a long history of holding these loans. Increases in losses in excess of our allowance could adversely affect our results of operations in the future. Access to alternative means of financing the costs of education may reduce demand for government guaranteed and private education loans. The demand for government guaranteed and private education loans could weaken if borrowers use other sources of funds to finance their post-secondary education. These sources include, among others: home equity loans or lines of credit, under which families borrow money based on the value of their real estate; Federal Direct Loan Program loans, if the DOE or schools increase the education loans available through the FDL Program; pre-paid tuition plans, which allow students to pay tuition at today s rates to cover tuition costs in the future; 529 plans, which are state-sponsored investment plans that allow a family to save funds for education expenses; and education IRAs, now known as Coverdell Education Savings Accounts, under which a holder can make annual contributions for education savings. JPMorgan Merrill Lynch Co. Table of Contents If demand for government guaranteed or private education loans weakens, we would experience reduced demand for our products and services. Competition from other originators, lenders and servicers and competition created by the Federal Direct Loan Program may materially adversely impact our business. We face significant competition from SLM Corporation, the parent company of Sallie Mae. SLM Corporation originated $15.2 billion of education loans through its preferred channel in 2003, services nearly half of all outstanding FFELP loans and is the largest holder of education loans, with a managed portfolio of approximately $92 billion as of March 31, 2004. We also face intense competition from other education-related entities, such as Education Lending Group and College Loan Corporation. As we seek to further expand our business, we will face numerous other competitors, many of which will be well established in the markets we seek to penetrate. Some of our current and potential competitors are much larger than we are, have better name recognition than we do and have greater financial and other resources than we do. Several of these competitors have large market capitalizations or cash reserves and are better positioned to acquire companies or portfolios in order to gain market share than we are. Consequently, such competitors may have more flexibility to address the risks inherent in the education finance business. Finally, some of our competitors are tax-exempt organizations that do not pay federal or state income taxes. As a result of their tax-exempt status, these organizations may have access to a lower cost of funding their education loans than we do. These factors could give our competitors significant advantages. In 1992, Congress created the William D. Ford Federal Direct Loan Program, which we refer to as the FDL Program or the FDLP. Under the FDL Program, the DOE makes loans directly to student borrowers through the educational institutions they attend. FDL loans are available to students only if the institution they attend participates in the FDL Program. The volume of student loans made under the FFEL Program and available for us to originate may be reduced to the extent loans are made to students under the FDL Program. Failures in our information technology system could materially disrupt our business. Our servicing and operating processes are highly dependent upon our information technology system infrastructure, and we face the risk of business disruption if failures in our information systems occur, which could have a material impact upon our business and operations. We depend heavily on our own computer-based data processing systems in servicing both our own loans and those of third-party servicing customers. Problems or errors may occur in the future in connection with the conversion of newly originated and acquired loans to our platform. If servicing errors do occur, they may result in a loss of the federal guarantee on the FFELP loans that we service or in a failure to collect amounts due on the student loans that we service. A major physical disaster or other calamity that causes significant damage to our information systems could adversely affect our business. Additionally, loss of our information systems for a sustained period of time could have a negative impact on our performance and ultimately on our cash flow in the event we were unable to process borrower payments. If we fail to comply with governmental regulations relating to our private loan business, our business and results of operations could be adversely affected. We are expanding our private loan business and currently originate and facilitate the origination of private loans for third parties. The origination of private loans is subject to federal and state consumer protection laws and regulations, including state usury and disclosure laws and related regulations, and the Federal Truth in Lending Act. These laws and regulations impose substantial requirements upon lenders and their agents and servicers involved in consumer finance. Failure to comply with these governmental regulations could have an adverse effect on our business and results of operations. Citigroup Credit Suisse First Boston Table of Contents If we become subject to the licensing laws of any jurisdiction or any additional government regulation, our compliance costs could increase significantly. In addition to being subject to certain state and federal consumer protection laws, which may change, we are currently licensed as telemarketers in two states. We could also become subject to other licensing laws due to changes in existing federal and state regulations. As a result, we could be required to (1) implement additional or different programs and information technology systems, (2) meet new licensing capital and reserve requirements or (3) incur additional administrative, compliance and third-party service costs. Furthermore, we could become subject to licensing laws in other states if we engage in licensable activities in the future. This includes the risk that even if we were not physically present, a state could assert jurisdiction over our operations for services we provide through the mail, by phone, through the Internet or by other remote means. Our failure to comply with such requirements could subject us to civil or criminal penalties and could curtail our ability to continue to conduct business in that jurisdiction. Moreover, compliance with such requirements could involve additional costs. Either of these consequences could have a material adverse effect on our business. Additionally, other organizations with which we work are subject to licensing and extensive governmental regulations, including truth-in-lending laws and other consumer protection regulations. From time to time we have, and we may in the future, become responsible for compliance with these regulations under contractual arrangements with our clients. If we fail to comply with these regulations, we could be subject to civil or criminal penalties. A failure to obtain trademark registrations and potential trademark infringement claims could cause us to incur additional costs and impede our marketing efforts. We believe that our success depends to a degree upon our ability to develop and maintain awareness of our corporate identifiers and brand names. We have applied for a U.S. service mark registration to protect our corporate name and will continue to evaluate the registration of additional service marks and trademarks, as appropriate. We cannot guarantee that any of our pending applications will be approved by the applicable governmental authorities, and we are aware that one of our applications has initially been rejected and is now under appeal. We may be subject to claims of alleged infringement of the trademarks or other intellectual property rights of third parties. Any such claims, whether or not meritorious, could result in litigation and divert the efforts of our personnel. Moreover, should we be found liable for infringement, we may be required to enter into licensing agreements (if available on acceptable terms or at all) or to pay damages and to cease using certain names or identifiers. Any of the foregoing could cause us to incur additional costs and impede our marketing efforts. Failure to comply with restrictions on inducements under the Higher Education Act could harm our business. The Higher Education Act generally prohibits a lender from providing inducements to educational institutions or individuals in order to secure applicants for FFELP loans. However, the DOE permits de minimis gifts in connection with advertising FFELP loans. If the DOE were to change its position on these matters, this could potentially result in the DOE imposing sanctions upon us if we fail to adapt our policies to comply with the new guidelines, and such failure could impact our business. We have also entered into various agreements to use marketing lists of prospective borrowers from sources such as associations. On occasion, we pay to acquire these lists and for completed loan applications resulting from these lists. We believe that such arrangements are permissible and do not violate restrictions on inducements, as they fit within a regulatory exception recognized by the DOE for generalized marketing and advertising activities. The DOE has provided subregulatory guidance that such arrangements do not raise any improper inducement issues, since such arrangements fall within the generalized marketing exception. If the DOE were to change its position, this could hurt our reputation and potentially result in the DOE imposing sanctions on us. These sanctions could negatively impact our business. Banc of America Securities LLC Keefe, Bruyette Woods The date of this prospectus is July , 2004. Table of Contents Risks Related to This Offering Future sales of our common stock may depress our stock price. The market price of our common stock could decline as a result of sales of substantial amounts of our common stock in the public market after this offering or the perception that these sales could occur. In addition, these factors could make it more difficult for us to raise funds through future equity offerings. There will be 30,446,523 shares of our common stock and warrants to purchase 1,430,099 shares of common stock for nominal consideration outstanding immediately after this offering. All of the shares of our common stock sold in this offering will be freely transferable by persons other than our affiliates without restriction or further registration under the Securities Act of 1933. Substantially all of the remaining shares of our outstanding common stock will be eligible for immediate sale in the public market pursuant to Rule 144 under the Securities Act of 1933 (other than shares of common stock held by our affiliates, who after completion of this offering will own approximately 51.8% of our outstanding common stock, and who will be subject to volume limitations), subject to 180-day lock-up agreements with the underwriters described below. See Shares Eligible for Future Sale. We and our executive officers and directors and substantially all of our existing stockholders intend to enter into 180-day lock-up agreements. The lock-up agreements prohibit each of us from selling or otherwise disposing of shares of common stock except in limited circumstances. The lock-up agreements are only contractual agreements, and J.P. Morgan Securities Inc. and Merrill Lynch, Pierce, Fenner Smith Incorporated, at their discretion, can waive the restrictions of any lock-up agreement at an earlier time without prior notice or announcement and allow any of us to sell shares of our common stock. If the restrictions in the lock-up agreement are waived, shares of our common stock will be available earlier for sale into the public market, subject to applicable securities laws, which could reduce the market price for shares of our common stock. In addition, we cannot assure you that our directors or stockholders will maintain their ownership position of our common stock after the end of the lock-up period. Under the terms of a stockholders agreement between Lightyear, our other principal stockholders and the Company, holders of our common stock that are party to the agreement holding at least 50% of our common stock will have the ability to require us to register the resale of its shares. Lightyear will beneficially own approximately 15,346,079 shares, or 50.4%, of our common stock after this offering, assuming the underwriters do not exercise their over-allotment option. In addition, TCW, which will beneficially own approximately 2,151,191 shares of our common stock, or 6.9%, after this offering, will also have the ability to require us to register the resale of its shares. Lightyear and minority investors will have the ability to exercise certain piggyback registration rights in connection with other registered offerings. See Certain Relationships and Related Transactions and Shares Eligible for Future Sale. In addition, pursuant to our stock incentive plan, we have granted options to purchase approximately 450,481 shares of common stock. Of these granted options, as of May 31, 2004, options for 81,087 shares were vested and exercisable and, on or about July 6, 2004, in connection with the execution of new employment agreements with our management, options for 184,697 shares became vested and exercisable. Upon consummation of this offering, we expect to grant certain of our officers and employees approximately 314,575 shares of restricted and unrestricted stock and options to purchase 1,013,646 shares of common stock. We have reserved an additional 2,788,250 shares for future issuance under our stock incentive plan. We intend to file one or more registration statements on Form S-8 under the Securities Act to register the sale of shares issued or issuable upon the exercise of stock options. In the future, we may issue our common stock in connection with acquisitions. The amount of such common stock issued could constitute a material portion of our then outstanding common stock. The issuance of additional shares of common stock could result in dilution to our stockholders and a decline in the market price of our common stock. Cash payments (receipts) for income taxes $ 28 $ TABLE OF CONTENTS Page Table of Contents Lightyear controls us and may have conflicts of interest with us or you in the future and is party to agreements with us which provide additional benefits to them. Prior to this offering, Lightyear beneficially owned approximately 72.8% of our outstanding shares of common stock, and, after giving effect to this offering, Lightyear will beneficially own 50.4% of our common stock, or 48.2% if the underwriters exercise their over-allotment option in full. As a result, Lightyear will have the ability to control or strongly influence the outcome of the election of our directors, which may give Lightyear substantial influence over our decisions to enter into any corporate transaction. For example, Lightyear, through their control of our board of directors, could cause us to make acquisitions that increase the amount of our indebtedness or dilute our equity. Lightyear also will have the effective ability to prevent any transaction that requires the approval of stockholders, regardless of whether or not other stockholders believe that any such transactions are in their own best interests. Additionally, Lightyear is in the business of making investments in companies and may from time to time acquire and hold interests in businesses that compete directly or indirectly with our business. Lightyear may also pursue acquisition opportunities that may be complementary to our business, and, as a result, those acquisition opportunities may not be available to us. So long as Lightyear continues to own a significant amount of the outstanding shares of our common stock, it will continue to be able to strongly influence or effectively control our decisions. In addition, Lightyear, or shareholders owning in the aggregate 50% of our common stock, will have the right to demand registration of all or part of its common stock beginning 180 days after the consummation of this offering, so long as the shares to be offered pursuant to the request have an aggregate offering price of at least $5.0 million (based on the then current market price). We will be required to fulfill such obligations except in limited circumstances. We are obligated to pay certain expenses and indemnify Lightyear against certain liabilities, including liabilities under the Securities Act, in connection with any such registration. Pursuant to the terms of a management agreement with Lightyear, we have agreed to pay Lightyear an annual management fee of $1.25 million plus reasonable out-of-pocket expenses until May 17, 2012, as well as customary fees for advisory services rendered to us, which fees will be negotiated with independent members of our board of directors. Under the management agreement, we paid Lightyear $312,500 for the three months ended March 31, 2004, $1.25 million in 2003 and $625,000 in 2002. Our board of directors will have the ability to terminate the management agreement at any time and pay Lightyear an amount equal to the discounted present value of future fees payable under the agreement. See Certain Relationships and Related Transactions. There is no existing market for our common stock, and we do not know if one will develop to provide you with adequate liquidity. There has not been a public market for our common stock. We cannot predict the extent to which investor interest in our company will lead to the development of a trading market on the Nasdaq National Market or otherwise or how liquid that market might become. The initial public offering price for the shares will be determined by negotiations between us and the representatives of the underwriters and may not be indicative of prices that will prevail in the open market following this offering. After this offering, our stock price may vary significantly from the initial offering price in response to the risk factors described in this section as well as other factors which are beyond our control. Provisions in our certificate of incorporation and bylaws and Delaware corporate law may discourage a takeover attempt. Provisions contained in our certificate of incorporation and bylaws, as they will be in effect immediately prior to the consummation of this offering, and the corporate law of Delaware, the state in which we are incorporated, could make it more difficult for a third party to acquire us, even if doing so might be beneficial to our stockholders. Provisions of our certificate of incorporation and bylaws will Prospectus Summary 1 Risk Factors 8
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+Risk Factors An investment in the IDSs and the shares of our Class A common stock and/or our notes involves a number of risks. In addition to the other information contained in this prospectus, prospective investors should give careful consideration to the following factors. Risks Relating to the IDSs, the Shares of Class A Common Stock and the Notes We have substantial indebtedness and may incur additional indebtedness in the future, which could restrict our ability to pay interest and principal on the notes and to pay dividends with respect to shares of our Class A common stock represented by the IDSs and could impact our financing options and liquidity position. At March 5, 2004, we had $517.1 million of consolidated indebtedness and $142.2 million of consolidated stockholders' equity, and on a pro forma basis after giving effect to the offering and the use of proceeds described in this prospectus, we would have had $ million of consolidated indebtedness and $ million of consolidated stockholders' equity. Our indebtedness after the offering will consist primarily of the CMBS loan, borrowings under our revolving credit facility and our notes. We may incur additional indebtedness in the future, subject to the limitations contained in the instruments governing our indebtedness. Accordingly, we will continue to have significant debt service obligations in the future. In addition, we may enter into additional debt agreements or other financing arrangements in the future that could impose additional financial and operational restrictions upon us. Our ability to make distributions, pay dividends or make other payments will be subject to applicable law and contractual restrictions contained in the instruments governing any indebtedness of ours and our subsidiaries, including our revolving credit facility. The degree to which we are leveraged on a consolidated basis could have important consequences to the holders of the IDSs, including: our ability in the future to obtain additional financing for working capital, capital expenditures or acquisitions may be limited; we may not be able to refinance our indebtedness on terms acceptable to us or at all; a significant portion of our cash flow from operations is likely to be dedicated to the payment of the principal of and interest on our indebtedness, thereby reducing funds available for future operations, capital expenditures and/or dividends on our common stock; and we may be more vulnerable to economic downturns or changes in interest rates and be limited in our ability to withstand competitive pressures. A failure to comply with the obligations contained in our borrowing agreements could result in an event of default under our borrowing agreements, which could result in acceleration of the debt related to the particular borrowing agreement, as well as the debt under other borrowing instruments that contain cross-acceleration or cross-default provisions. If we are unable to service our debt, we may be required to refinance all or a portion of our existing debt, to sell assets or to obtain additional financing. Such refinancing might not be possible, and such sales of assets or additional financing might not be achieved, which could lead to a bankruptcy proceeding. Holders of our notes will be structurally subordinated to the debt of our non-guarantor subsidiaries, including the CMBS loan borrower, which owns the CMBS centers. In July 2003, one of our subsidiaries entered into a $300.0 million loan agreement with various lenders to refinance our existing borrowings, referred to as the CMBS loan. The balance outstanding at March 5, 2004 was $298.1 million. The loan is secured by mortgages or deeds of trust on 475 of our child care centers that are owned by that subsidiary borrower, referred to as the CMBS centers, as well as by certain cash collateral reserve accounts. Cash flows from investing activities: Purchases of property and equipment (94,269 ) (95,843 ) (83,114 ) Acquisitions of previously constructed centers (17,257 ) Acquisition of new subsidiary, net of cash acquired (15,189 ) Investments accounted for under the cost method (10,074 ) Issuance of notes receivable (4,836 ) (114 ) Proceeds from sales of property and equipment 7,948 11,537 95,172 Proceeds from notes receivable 145 Cash flows from investing activities: Purchases of property and equipment (91,162 ) (4,746 ) 65 (95,843 ) Proceeds from sales of property and equipment 3,114 7,660 763 11,537 Proceeds from notes receivable (14 ) 40 We have granted the underwriters an option to purchase up to additional IDSs to cover over-allotments. The underwriters expect to deliver the IDSs and notes in book-entry form only through the facilities of The Depository Trust Company to purchasers on or about , 2004. CIBC World Markets , 2004 Certain of our subsidiaries, including the CMBS loan borrower, will not be guarantors of our notes. As a result, no payments are required to be made to us from the assets of these subsidiaries. In the event of bankruptcy, liquidation or reorganization of any of the non-guarantor subsidiaries, holders of their indebtedness, including their trade creditors and the lenders of the CMBS loan, would generally be entitled to payment of their claims from the assets of those subsidiaries before any assets are made available for distribution to us for payment to you. As a result, our notes are effectively subordinated to the indebtedness of the non-guarantor subsidiaries. At March 5, 2004, our non-guarantor subsidiaries had total assets of $417.0 million and total liabilities, excluding liabilities owed to us, of $311.5 million. For the forty weeks ended March 5, 2004, our non-guarantor subsidiaries had net revenues of $211.5 million. The percentage of our assets, the amount of total liabilities and net revenues on a consolidated basis attributable to the non-guarantor subsidiaries that operate the CMBS centers and borrow under the CMBS loan were 41.6%, $299.9 million and $208.7 million, respectively, for the forty weeks ended and at March 5, 2004. The CMBS loan contains restrictive covenants that could materially affect our cash flow and operations. The CMBS loan contains restrictive covenants that could materially affect our cash flow and operations. For example, if the net operating income, as defined in the CMBS loan agreement, from the CMBS centers falls below $60.0 million in any year, we must escrow 50% of the operating cash flows from the CMBS centers, or 100% of the cash flows from those centers if their net operating income falls below $50.0 million. These thresholds are adjusted as centers are released from the loan collateral. The net operating income of the CMBS centers for the 52 week period ended March 5, 2004 was approximately $80.2 million. To the extent that these provisions are triggered, we will not have any cash distributed up to us from the CMBS centers and, thus, this escrow requirement may limit the amount of cash we have available to make interest payments on the notes or to declare or pay dividends on our Class A common stock. The CMBS loan contains other provisions that may limit our operating or financial flexibility and that of the subsidiary borrower, including a prohibition on making alterations to the CMBS centers without the lenders' consent if such alterations could adversely affect the value of the CMBS centers, restrictions on transfer of the subsidiary borrower and a requirement to maintain certain levels of insurance. We are also required to maintain an interest rate cap agreement until the loan matures. If the CMBS loan is accelerated, we will be subject to restrictions on our ability to compete with the CMBS centers in their geographic regions, which could limit our ability to open and operate centers in these regions. Because of the subordinated nature of the notes, holders of our notes may not be entitled to be paid in full, if at all, in a bankruptcy, liquidation or reorganization or similar proceeding. As a result of the subordinated nature of our notes and related guarantees, upon any distribution to our creditors or the creditors of the subsidiary guarantors in a bankruptcy, liquidation, reorganization or similar proceeding relating to us or the subsidiary guarantors or our or their property, the holders of our senior indebtedness and senior indebtedness of the subsidiary guarantors will be entitled to be paid in full in cash before any payment may be made with respect to our notes or the subsidiary guarantees. In the event of a bankruptcy, liquidation, reorganization or similar proceeding relating to us or the subsidiary guarantors, holders of our notes will participate with all other holders of unsecured indebtedness of ours or the subsidiary guarantors similarly subordinated in the assets remaining after we and the subsidiary guarantors have paid all senior indebtedness. However, because of the existence of the subordination provisions, including the requirement that holders of the notes pay over distributions to holders of senior indebtedness, holders of the notes may receive less, ratably, than our other unsecured creditors, including trade creditors. In any of these cases, we and the subsidiary Table of Contents Page guarantors may not have sufficient funds to pay all of our creditors, and holders of our notes may receive less, ratably, than the holders of senior indebtedness. Further, in the event of such bankruptcy proceedings, a party in interest may seek to subordinate the notes to all creditors under principles of equitable subordination or to recharacterize the notes as equity. While we believe that any such attempt should fail, there can be no assurance as to the outcome of such proceedings. In the event of such a subordination or recharacterization, you may not recover any amounts owing on the notes until all senior claims have been paid. Further, in the event of such a recharacterization you might be required to return any payments made to you on account of the notes, potentially up to six years prior to our bankruptcy, if it can be shown that at the time of such payment we were insolvent or rendered insolvent by reason of issuing the guarantee and the application of the proceeds of the guarantee, were engaged or about to engage in a business or a transaction for which the guarantor's remaining assets available to carry on its business constituted unreasonably small capital, or intended to incur, or believed that we would incur, debts beyond our ability to pay the debts as they mature. On a pro forma basis at March 5, 2004, our notes and the associated subsidiary guarantees would have ranked junior, on a consolidated basis, to $ million of outstanding senior secured indebtedness (including the amount outstanding under the CMBS loan) plus approximately $ million of letters of credit, and the subsidiary guarantees would have ranked junior to $ senior unsecured debt and pari passu with approximately $ million of outstanding indebtedness of ours and the subsidiary guarantors. In addition, at March 5, 2004, we had the ability to borrow up to an additional $58.9 million under our revolving credit facility (less amounts reserved for letters of credit), which would have ranked senior in right of payment to our notes. In the event of bankruptcy or insolvency, the notes and guarantees could be adversely affected by principles of equitable subordination or recharacterization. In the event of bankruptcy or insolvency, a party in interest may seek to subordinate the notes or the guarantees under principles of equitable subordination or to recharacterize the subordinated notes as equity. There can be no assurance as to the outcome of such proceedings. In the event a court subordinates the notes or the guarantees, or recharacterizes the notes as equity, we cannot assure you that you would recover any amounts owed on the notes or the guarantees and you may be required to return any payments made to you within six years before the bankruptcy on account of the notes or the guarantees. In addition, should the court equitably subordinate the notes or the guarantees, or recharacterize the notes as equity, you may not be able to enforce the guarantees. The notes or the guarantees of the notes by our subsidiaries may not be enforceable. Under federal bankruptcy law and comparable provisions of state fraudulent transfer laws, the notes or the guarantees could be voided, or claims in respect of the notes or the guarantees could be subordinated to all other debt of ours or the guarantor, as applicable, if, among other things, we or the guarantor, at the time that we issued the notes or it assumed the guarantee: received less than reasonably equivalent value or fair consideration for issuing the notes or the guarantee and, at the time we issued the notes or it issued the guarantee: was insolvent or rendered insolvent by reason of issuing the notes or the guarantee and the application of the proceeds of the notes or the guarantee; was engaged or about to engage in a business or a transaction for which our or such guarantor's remaining assets available to carry on its business constituted unreasonably small capital; intended to incur, or believed that we or such guarantor would incur, debts beyond our or such guarantor's ability to pay the debts as they mature; or Number of centers at the beginning of the fiscal year 1,242 1,264 Openings 35 was a defendant in an action for money damages, or had a judgment for money damages docketed against us or such guarantor if, in either case, after final judgment, the judgment is unsatisfied. The proceeds of the offering will be used to pay the cash portion of the recapitalization consideration and to pre-fund payment of debt of our subsidiaries, which may subject the note holders to the claim that we did not receive fair consideration for the notes. In the event that we meet any of the financial conditions of the fraudulent transfer tests described above at the time of or as a result of this offering, a court could view the issuance of our notes with the distribution to our stockholders and the payment of our subsidiaries' debt as a single integrated offering, and therefore, conclude that we did not receive fair value for the offering. In such a case, a court could conclude that the obligations represented by the notes are void, unenforceable or subordinate to the claims of other creditors. In addition, any payment by us or the guarantor pursuant to the notes or the guarantees could be voided and required to be returned to us or the guarantor or to a fund for the benefit of the creditors of ours or the guarantor or the notes or the guarantee could be subordinated to other debt of ours or the guarantor. The measures of insolvency for the purposes of fraudulent transfer laws vary depending upon the law applied in any proceeding to determine whether a fraudulent transfer has occurred. Generally, however, a person would be considered insolvent if, at the time it incurred the debt: the sum of its debts, including contingent liabilities, was greater than the fair saleable value of its assets; the present fair saleable value of its assets was less than the amount that would be required to pay its probable liability on its existing debts, including contingent liabilities, as they become absolute and mature; or it could not pay its debts as they become due. We believe that before and immediately after the issuance of the notes and the guarantees, we and each of the guarantors will be solvent, will have sufficient capital to carry on our respective businesses and will be able to pay our respective debts as they mature. However, we cannot be sure as to what standard a court would apply in making these determinations or that a court would reach the same conclusions with regard to these issues. Regardless of the standard that the court uses, we cannot be sure that the issuance by us of the notes or by the subsidiary guarantors of the subsidiary guarantees would not be voided or that the notes or the subsidiary guarantees would not be subordinated to our or their other debt. If the guarantee of any subsidiary guarantor were voided, our notes would be effectively subordinated to the indebtedness of that subsidiary guarantor. The guarantee of our notes by any subsidiary guarantor could be subject to the claim that, since the guarantee was incurred for our benefit, and only indirectly for the benefit of the subsidiary guarantor, the obligations of the subsidiary guarantor were incurred for less than fair consideration. If such a claim were successful and it was proven that the subsidiary guarantor was insolvent at the time the guarantee was issued, a court could void the obligations of the subsidiary guarantor under the guarantee or subordinate these obligations to the subsidiary guarantor's other debt or take action detrimental to holders of the notes. If the guarantee of any subsidiary guarantor were voided, our notes would be effectively subordinated to the indebtedness of that subsidiary guarantor. We may amend the terms of our revolving credit facility, or we may enter into new agreements that govern our senior indebtedness, and the amended or new terms may significantly affect our ability to pay interest and/or dividends to you. Our revolving credit facility contains significant restrictions on our ability to pay dividends on the shares of Class A common stock based on meeting certain tests and compliance with other conditions (including timely delivery of applicable financial statements), as described in detail under "Description In making your investment decision, you should rely only on the information contained in this prospectus or to which we have referred you. We have not authorized anyone to provide you with information that is different. If anyone provided you with different or inconsistent information, you should not rely on it. This prospectus may only be used where it is legal to sell these securities. You should assume the information appearing in this prospectus is accurate only as of the date on the front cover of this prospectus. Our business, consolidated financial condition, results of operations, liquidity and prospects may have changed since that date. Neither the delivery of this prospectus nor any sale made hereunder shall under any circumstances imply that the information in this prospectus is correct as of any date subsequent to the date on the cover of this prospectus. of Certain Indebtedness Revolving Credit Facility." As a result of general economic conditions, conditions in the lending markets, the results of our operations or for any other reason, we may elect or be required to amend or refinance our revolving credit facility, at or prior to maturity, or enter into additional agreements for senior indebtedness. Regardless of any protection you have in the indenture governing the notes, any such amendment, refinancing or additional agreement may contain covenants that could limit in a significant manner our ability to pay interest payments and/or dividends to you. We are subject to restrictive debt covenants and other requirements related to our outstanding debt that limit our business flexibility by imposing operating and financial restrictions on our operations. The agreements governing our indebtedness impose significant operating and financial restrictions on us. These restrictions prohibit or limit, among other things: the incurrence of additional indebtedness and the issuance of preferred stock and certain redeemable capital stock; the payment of dividends on, and purchase or redemption of, capital stock; a number of other restricted payments, including investments; specified sales of assets; specified transactions with affiliates; the creation of liens; and consolidations, mergers and transfers of all or substantially all of our assets. The terms of our revolving credit facility include other and more restrictive covenants and prohibit us from prepaying our other indebtedness, including the notes, while indebtedness under our revolving credit facility is outstanding. The revolving credit facility also requires us to maintain specified financial ratios and satisfy financial condition tests. Our ability to comply with the ratios or tests may be affected by events beyond our control, including prevailing economic, financial and industry conditions. A breach of any of these covenants, ratios or tests could result in a default under our revolving credit facility, the CMBS loan and/or the indenture. Certain events of default under our revolving credit facility would prohibit us from making payments on the notes, including payment of interest when due. In addition, upon the occurrence of an event of default under our revolving credit facility, the lenders could elect to declare all amounts outstanding under the revolving credit facility, together with accrued interest, to be immediately due and payable. If we were unable to repay those amounts, the lenders could proceed against the security granted to them to secure that indebtedness. If the lenders accelerate the payment of the indebtedness, our assets may not be sufficient to repay in full this indebtedness and our other indebtedness, including the notes. We have the right to defer interest at any time prior to , 2009, in which case you may not be paid any deferred interest until , 2009, and if we were to defer interest at any time after , 2009, you may not be paid all of the deferred interest owed to you until , 2019. The indenture governing our notes grants us the right to defer interest, subject to certain limitations. During the first five years that the notes are outstanding, we may defer interest for up to an aggregate period of eight quarters. In addition, after , 2009, interest payments may be deferred on up to occasions for up to two quarters per occasion. Deferred interest will bear interest at the same rate as the notes. For any interest deferred during the first five years, we are not obligated to pay any deferred interest until , 2009, so you may be owed a substantial amount of deferred interest that will not be due and payable until such date. For any interest deferred after , 2009, we are not obligated to pay all of the deferred interest until maturity, so you may be owed a substantial amount of deferred interest that will not be due and payable until such date. If you sell your IDSs or separate notes during the interest deferral period, you will not receive any payment of deferred interest. In addition, we will not be permitted to pay, and you will not receive, any dividend payments on our common stock until we have paid all the deferred interest. Our board of directors may, in its discretion, amend or repeal the dividend policy it is expected to adopt upon the closing of this offering, and you may not receive the level of dividends provided for in the dividend policy or any dividends at all. Our board of directors may, in its discretion, amend or repeal the dividend policy it is expected to adopt upon the closing of this offering. Our board of directors may decrease the level of dividends provided for in this dividend policy or entirely discontinue the payment of dividends. Future dividends with respect to shares of our capital stock, if any, will depend on, among other things, our results of operations, cash requirements, financial condition, contractual restrictions, business opportunities, provisions of applicable law and other factors that our board of directors may deem relevant. The indenture governing our notes and our revolving credit facility contain significant restrictions on our ability to make dividend payments, including, if we defer interest on the notes, restrictions on the payment of dividends until we have paid all deferred interest. The treatment of the notes for U.S. federal income tax purposes could affect our after-tax cash flow. Our after-tax cash flow available for dividend and interest payments would be reduced if the notes were treated as equity rather than debt for U.S. federal income tax purposes. In that event, the stated interest on the notes could be treated as a dividend, and interest on the notes would not be deductible by us for U.S. federal income tax purposes. Our inability to deduct interest on the notes could materially increase our taxable income and, thus, our U.S. federal and applicable state income tax liability. Our interest expense may increase significantly and could cause our net income and distributable cash to decline significantly. The revolving credit facility will be subject to periodic renewal or must otherwise be refinanced. We may also be required to refinance the CMBS loan when it matures in 2008, or, if extended, 2009. We may not be able to renew or refinance the revolving credit facility or CMBS loan, or if either is renewed or refinanced, the renewal or refinancing may occur on less favorable terms. Borrowings under the revolving facility and the CMBS loan are made at a floating rate of interest, subject to interest rate hedging arrangements. In the event of an increase in the base reference interest rates or inability to replace our interest rate hedging arrangements, our interest expense will increase and could have a material adverse effect on our ability to make cash dividend payments to our stockholders. Our ability to continue to expand our business will, to a large extent, be dependent upon our ability to borrow funds under our revolving credit facility and to obtain other third-party financing, including through the sale of IDSs or any sale of securities. Such financing may not be available to us on favorable terms or at all. We may not generate sufficient funds from operations to pay our indebtedness at maturity or upon the exercise by holders of their rights upon a change of control. A significant portion of our cash flow from operations will be dedicated to maintaining our child care centers and servicing our debt requirements. In addition, we currently expect to distribute a significant portion of any remaining cash earnings to our stockholders in the form of quarterly dividends. Moreover, prior to the maturity of our notes, we will not be required to make any payments of principal on our notes. We may not generate sufficient funds from operations to repay the principal amount of our indebtedness at maturity or in case you exercise your right to require us to purchase your notes upon a change of control. We may therefore need to refinance our debt or raise additional capital. These alternatives may not be available to us when needed or on satisfactory terms due to prevailing market conditions, a decline in our business or restrictions contained in our senior debt obligations. The indenture governing our notes and our revolving credit facility permit us to pay a significant portion of our free cash flow to stockholders in the form of dividends. Although the indenture governing our notes and our revolving credit facility have some limitations on our payment of dividends, they permit us to pay a significant portion of our free cash flow to stockholders in the form of dividends and, following completion of this offering, we intend to pay quarterly dividends. Specifically, the indenture governing our notes permits us to pay all of our excess cash, as defined in the indenture, for the 52 week period divided by four, as more fully described in "Summary Interest and Allowed Dividend Payments to IDS Holders under the Indenture" and "Description of Notes Certain Covenants." The revolving credit facility will permit us to use all of our distributable cash, as defined in the revolving credit facility, to pay dividends on the shares of our common stock as described in detail in "Description of Certain Indebtedness Revolving Credit Facility." Any amounts paid by us in the form of dividends will not be available in the future to satisfy our obligations under the notes. You will be immediately diluted by $ per share of Class A common stock if you purchase IDSs in this offering. If you purchase IDSs in this offering, based on the book value of the assets and liabilities reflected on our balance sheet, you will experience an immediate dilution of $ per share of Class A common stock represented by the IDSs which exceeds the entire price allocated to each share of Class A common stock represented by the IDSs in this offering because the net tangible book value will be lower for each share of Class A common stock outstanding immediately after this offering. Our net tangible book value at March 5, 2004, after giving effect to this offering, was approximately $ million, or $ per share of Class A common stock. Because we will use a significant portion of the proceeds of this offering to pay the cash portion of the recapitalization consideration with respect to shares of our existing common stock and to cancel options held by our existing equity investors, we will have less of the proceeds of this offering available to repay our existing debt and for corporate purposes. We will use a significant portion of the net proceeds from this offering to pay the cash portion of the recapitalization consideration with respect to shares of our existing common stock and to cancel options held by our existing equity investors. Assuming an initial public offering price of $ per IDS (the midpoint of the range set forth on the cover of this prospectus) and the sale of $ million aggregate principal amount of our notes being sold separately from the IDSs, we estimate aggregate net proceeds of $ million, approximately $ million of which will be used to fund the recapitalization. As a result of these transactions with our existing equity investors, our total indebtedness will be higher after the offering and the amount of net proceeds from this offering that remain available to us for working capital or debt retirement will be less than if we had not undertaken these transactions. Having less of the net proceeds from this offering on a going forward basis may require us to borrow more money under our revolving credit facility or seek other sources of capital to repay debt, fund our operations or continue to expand our business. Credit ratings may affect our ability to obtain financing and the cost of such financing. Our ability to obtain external and, in particular, debt financing, is affected by our corporate credit ratings and our debt ratings, which are periodically reviewed by the major credit rating agencies. We anticipate that Moody's and S&P will provide ratings for the notes. In determining our credit ratings, the rating agencies generally consider a number of both quantitative and qualitative factors. These factors include earnings, fixed charges such as interest, cash flows, total debt outstanding, off-balance sheet obligations and other commitments, total capitalization and various ratios calculated from these factors. The ratings provided to us by Moody's and S&P for the notes could be at or below Caa1 and CCC+, respectively. A debt rating of Caa1 or below by Moody's or CCC+ or below by S&P would indicate that the rating agency has determined that our notes have a currently identifiable vulnerability to default and that we are dependent upon favorable business, financial and economic conditions to make timely payment of interest and repayment of principal on the notes. Deferral of interest payments would have adverse tax consequences for you. If we defer interest payments on the notes, you will be required to recognize interest income for U.S. federal income tax purposes in respect of interest payments on the notes represented by the IDSs or the notes, as the case may be, held by you before you receive any cash payment of this interest. In addition, we will not pay you this cash if you sell the IDSs or the notes, as the case may be, before the end of any deferral period or before the record date relating to interest payments that are to be paid. The U.S. federal income tax consequences of the purchase, ownership and disposition of IDSs are unclear. No statutory, judicial or administrative authority directly addresses the treatment of the IDSs or instruments similar to the IDSs for U.S. federal income tax purposes. As a result, the U.S. federal income tax consequences of the purchase, ownership and disposition of IDSs are unclear. The IRS or the courts could successfully assert a treatment of the IDSs different than our intended treatment, which could affect our tax liability. We believe that an IDS should be treated as a unit representing a share of common stock and notes. However, the IRS or the courts may take the position that the notes are equity, or there could be a change in law, either of which could adversely affect the amount, timing and character of income, gain or loss in respect of your investment in IDSs, and materially increase our taxable income and, thus, our U.S. federal and applicable state income tax liability. This would reduce our after-tax cash flow and materially and adversely impact our ability to make interest and dividend payments on the notes and the common stock. Foreign holders could be subject to withholding or estate taxes with regard to the notes in the same manner as they will be with regard to the common stock. Payments to foreign holders would not be grossed-up for any such taxes. For discussion of these tax related risks, see "Material U.S. Federal Income Tax Consequences." The allocation of the purchase price of the IDSs may not be respected. The purchase price of each IDS must be allocated between the share of Class A common stock and notes in proportion to their respective fair market values at the time of purchase. If our allocation is not respected, it is possible that the notes will be treated as having been issued with OID (if the allocation to the notes were determined to be too high) or amortizable bond premium (if the allocation to the notes were determined to be too low). You generally would have to include OID in income in advance of the receipt of cash attributable to that income and would be able to elect to amortize bond premium over the term of the notes. Because of the deferral of interest provisions, the notes may be treated as issued with original issue discount. Under applicable Treasury regulations, a "remote" contingency that stated interest will not be timely paid will be ignored in determining whether a debt instrument is issued with OID. Although there is no authority directly on point, we believe that the likelihood of deferral of interest payments on the notes is remote within the meaning of the Treasury regulations. Based on the foregoing, although the matter is not free from doubt because of the lack of direct authority, the notes would not be considered issued with OID at the time of their original issuance. If deferral of any payment of interest were determined not to be "remote," the notes would be treated as issued with OID at the time of issuance. In such case, all stated interest on the notes would be treated as OID, and all holders, regardless of their method of tax accounting, would be required to include stated interest in income on a constant accrual basis, possibly in advance of their receipt of the associated cash. A subsequent issuance of notes may reduce the amount you can recover upon an acceleration of the payment of principal due on the notes or in the event of our bankruptcy. Under New York and federal bankruptcy law, holders of subsequently issued notes having original issue discount may be limited to an amount equal to the sum of (1) the initial offering price for the notes and (2) that portion of the OID that is not deemed to constitute "unmatured interest" for purposes of the United States Bankruptcy Code. Any OID that was not amortized as of the date of the commencement of this bankruptcy filing would constitute "unmatured interest." As a result, an automatic exchange that results in a holder receiving a note with OID could have the effect of ultimately reducing the amount such holder can recover from us in the event of an acceleration or bankruptcy. If we subsequently issue notes with significant OID, we may not be able to deduct all of the interest on those notes. It is possible that notes we issue in a subsequent issuance will be issued at a discount to their face value and, accordingly, may have "significant original issue discount" and thus be classified as "applicable high yield discount obligations," or AHYDOs. If any such notes were so treated, a portion of the OID on such notes could be nondeductible by us and the remainder would be deductible only when paid. This treatment would have the effect of increasing our taxable income and may adversely affect our cash flow available for interest payments and distributions to our equity holders. Subsequent issuances of notes may adversely affect your tax treatment. The indenture governing our notes will provide that, in the event there is a subsequent issuance of notes and such additional notes are issued with OID or after a subsequent issuance of notes with OID, each holder of IDSs or separately held notes, as the case may be, agrees that a portion of such holder's notes will be exchanged for a portion of the notes acquired by the holders of such subsequently issued notes. Consequently, immediately following such subsequent issuance, each holder of subsequently issued notes, held either as part of IDSs or separately, and each holder of existing notes, held either as part of IDSs or separately, will own an inseparable unit composed of a proportionate percentage of both the old notes and the newly issued notes. Therefore, subsequent issuances of notes with OID may adversely affect your tax treatment by increasing the OID, if any, that you were previously accruing with respect to the notes, resulting in your having to accrue interest income in advance of receiving the related cash payments. Following any subsequent issuance of notes with OID (or any issuance of notes thereafter), we (and our agents) will report any OID on the subsequently issued notes ratably among all holders of IDSs and separately held notes, and each holder of IDSs and separately held notes will, by purchasing IDSs, agree to report OID in a manner consistent with this approach. However, the Internal Revenue Service may assert that any OID should be reported only to the persons that initially acquired such subsequently issued notes (and their transferees). In such case, the Internal Revenue Service might further assert that, unless a holder can establish that it is not a person that initially acquired such subsequently issued notes (or a transferee thereof), all of the notes held by such holder have OID. Any of these assertions by the Internal Revenue Service could create significant uncertainties in the pricing of IDSs and notes and could adversely affect the market for IDSs and notes. For a discussion of these tax related risks, see "Material U.S. Federal Income Tax Consequences." If interest rates rise, the trading value of our IDSs and the notes sold separately in this offering may decline. We cannot predict the interest rate environment or guarantee that interest rates will not rise in the near future. Should interest rates rise or should the threat of rising interest rates develop, debt markets may be adversely affected. As a result, the trading value of our IDSs and notes may decline. There is not an active trading market for IDSs in the United States. IDSs are a novel type of security and there is not an active market for IDSs, or securities similar to the IDSs, in the United States. Because of this, investors may be unfamiliar with these new securities and the demand for them may be lower than for securities that have been actively traded for a number of years. We cannot assure you that an active trading market for the IDSs will develop in the future, which may cause the price of the IDSs to fluctuate substantially. Before this offering, there was no public market for our IDSs, notes or Class A common stock and an inactive public market for shares of our then outstanding common stock. The IDSs, notes and Class A common stock have not had a public market history and prior to this offering, the shares of our then outstanding common stock, while registered under the Securities Act and traded in the over-the-counter markets, have not traded actively. We cannot assure you that an active trading market for the IDSs and the notes sold separately in this offering will develop in the future, which may cause the price of the IDSs and the notes sold separately in this offering to fluctuate substantially, and we currently do not expect that an active trading market for the shares of our Class A common stock will develop until the notes are redeemed or mature. We will not apply to list our shares of Class A common stock for separate trading on the New York Stock Exchange or any other exchange until the number of shares held separately and not represented by IDSs is sufficient to satisfy applicable requirements for separate trading on such exchange. The Class A common stock may not be approved for listing at such time. We do not intend to list our notes on any securities exchange. Accordingly, we cannot assure you that there will be a market for the notes. If the notes represented by your IDSs are redeemed or mature, or if there is a payment default on the notes for 90 days, the IDSs will automatically separate, and you will then hold the shares of our Class A common stock. The price of the IDSs or notes may fluctuate substantially, which could negatively affect holders of IDSs or holders of notes sold separately. The initial public offering price of the IDSs and the notes sold separately in this offering will be determined by negotiations among us, the existing equity investors and the representatives of the underwriters and may not be indicative of the market price of the IDSs and the notes sold separately after the offering. Factors such as quarterly variations in our financial results, announcements by us or others, developments affecting us or the child care industry, general interest rate levels and general market volatility could cause the market price of the IDSs and the notes sold separately in this offering to fluctuate significantly. If the IDSs automatically separate, the limited liquidity of the market for the notes and Class A common stock may adversely affect your ability to sell the notes and Class A common stock. Although we will use our reasonable efforts to list our Class A common stock for separate trading on the New York Stock Exchange under certain circumstances, we may not be successful in listing the Class A common stock due to listing requirements. The notes represented by the IDSs will not be listed on any exchange. Upon separation of the IDSs, no sizable market for the notes and the Class A common stock may ever develop and the liquidity of any trading market for the notes or the Class A common stock that does develop may be limited. As a result, your ability to sell your notes and Class A common stock, and the market price you can obtain, could be adversely affected. The limited liquidity of the trading market for the notes sold separately (not represented by IDSs) may adversely affect the trading price of the separate notes. We are separately selling (not represented by IDSs) $ million aggregate principal amount of notes, representing approximately 10% of the total outstanding notes (assuming the underwriters do not exercise their over-allotment option). While the notes sold separately (not represented by IDSs) are part of the same series of notes as, and identical to, the notes represented by the IDSs at the time of the issuance of the separate notes, the notes represented by the IDSs will not be separable for at least 45 days and will not be separately tradeable until separated. As a result, the initial trading market for the notes sold separately (not represented by IDSs) will be very limited. Even after holders of the IDSs are permitted to separate their IDSs, a sufficient number of holders of IDSs may not separate their IDSs into shares of our Class A common stock and notes to create a sizable and more liquid trading market for the notes not represented by IDSs. Therefore, a liquid market for the notes may not develop, which may adversely affect the ability of the holders of the separate notes to sell any of their separate notes and the price at which these holders would be able to sell any of the notes sold separately. If we defer interest payments on the notes, the trading price of the IDSs or notes may be adversely affected. Subject to certain limitations, we have the option to defer interest payments on the notes for certain periods pursuant to the terms of the indenture. If we defer interest payments on the notes, holders of the notes will continue to accrue, but will not be paid, interest. In addition, we will not be permitted to pay, and you will not receive, any dividend payments on the shares of our Class A common stock until we have paid all the deferred interest. Therefore, if we have elected to defer interest payments on the notes and we have stopped paying dividends on the Class A common stock during the same period, the IDSs and the notes may trade at prices that do not fully reflect the value of any accrued but unpaid interest on the notes and, in the case of the IDSs, will most likely trade at lower prices due to no dividends being paid on the Class A common stock. This deferral feature and dividend stopper may mean that the market prices for the IDSs and the notes may be more volatile than other securities that do not have such deferral features. Future sales or the possibility of future sales of a substantial amount of IDSs, shares of our Class A common stock or our notes may depress the price of the IDSs and the shares of our Class A common stock and our notes. Future sales or the availability for sale of substantial amounts of IDSs or shares of our Class A common stock or a significant principal amount of our notes in the public market, including by the existing equity investors as described below, could adversely affect the prevailing market price of the IDSs and the shares of our Class A common stock and our notes and could impair our ability to raise capital through future sales of our securities. Our existing equity investors will own IDSs and shares of Class B common stock representing % of voting power of all of our outstanding shares of our common stock after the offering. Subject to the applicable contractual lock-up period and any securities law limits on affiliate resales, their IDSs (including IDSs after any conversion of their shares of Class B common stock) will be eligible for resale from time to time in any form of at-the-market, block or underwritten sales, whether as IDSs, shares of our common stock or our notes. We may issue shares of our Class A common stock and notes, which may be in the form of IDSs, or other securities from time to time as consideration for future acquisitions and investments. In the event any such acquisition or investment is significant, the number of shares of our Class A common stock and the aggregate principal amount of notes, which may be in the form of IDSs, or the number or aggregate principal amount, as the case may be, of other securities that we may issue may in turn be significant. In addition, we may also grant registration rights covering those IDSs, shares of our Class A common stock, notes or other securities in connection with any such acquisitions and investments. Our certificate of incorporation and by-laws and several other factors could limit another party's ability to acquire us and deprive our investors of the opportunity to obtain a takeover premium for their securities. Several provisions in our certificate of incorporation and by-laws will make it difficult for another company to acquire us and for you to receive any related takeover premium for your securities. For example, our by-laws do not allow stockholders to call a special meeting. In addition, there is no provision allowing stockholders to act by written consent. Our certificate of incorporation authorizes the issuance of preferred stock without stockholder approval and upon such terms as the board of directors may determine. Our annual and quarterly results of operations reflect seasonal fluctuations. Our revenues and the initial success of new centers are subject to seasonal fluctuations because enrollments are generally highest in September and January when children return to child care and/or school after summer and holiday vacations. Accordingly, July, August and December are particularly important times for new enrollments. In addition, enrollment generally decreases 5% to 10% during holiday periods and summer months. If we achieve less than satisfactory enrollment during these key months, we may not be able to compensate sufficiently for lower enrollment during the rest of the year. We may also be unable to adjust our expenses on a short-term basis to offset these fluctuations in revenues. This may cause us to experience insufficient cash flow to meet our ongoing capital needs during our low seasons. This imbalance in our cash flows may lead to seasonal volatility in the trading price of the IDSs due to a market reaction to our lower cash flow levels or any curtailment in our dividend payments to IDS holders or the commencement of any interest deferral. Risks Relating to our Business and the Industry We face intense competition in the early childhood education and care services industry from numerous other types of providers. The early childhood education and care services industry is competitive and highly fragmented, with the most important competitive factors generally based upon reputation, location and price. Our competition consists principally of the following: other for-profit, center-based child care providers, including franchise organizations; preschool, kindergarten and before- and after-school programs provided by public schools; local nursery schools and child care centers, including church-affiliated and other non-profit centers; providers of child care services that operate out of homes; and substitutes for organized child care, such as relatives, nannies and one parent caring full-time for a child. In many markets, we face competition from preschool services and before- and after-school programs offered by public schools that offer such services at little or no cost to parents. The number of school districts offering these services is growing, and we expect this form of competition to increase in the future. We also face competition from large, national, for-profit companies providing child care and education services, many of which offer these services at a lower price than we do. These other for-profit providers continue to expand in many of the same markets where we currently operate or plan to operate. According to a July 2001 study published by Marketdata Enterprises, the 40 largest providers of child care services totaled less than 5% of total licensed child care centers. Local nursery schools, child care centers and in-home providers generally charge less for their services than we do. Many denominational and other non-profit child care centers have lower operating expenses than we do and may receive donations and/or other funding to subsidize operating expenses. Consequently, operators of such centers often charge tuition rates that are less than our rates. In addition, fees for home-based care are normally substantially lower than fees for center-based care. Litigation and adverse publicity concerning incidents at child care centers could hurt our reputation and limit our ability to obtain insurance. We believe our success in the child care business, where personal trust and parent referrals play a key role, is directly related to our reputation and favorable brand identity. We are periodically subject to claims and litigation alleging negligence, inadequate supervision and other grounds for liability arising from injuries or other harm to children. In addition, claimants may seek damages from us for child abuse, sexual abuse or other criminal acts arising out of alleged incidents at our centers. Any adverse publicity concerning such incidents at one of our child care centers, or child care centers generally, could greatly damage our reputation and could have an adverse effect on occupancy levels at our centers. Operators of child care centers have had difficulty obtaining general liability insurance or other liability insurance that covers child abuse, or have been able to obtain such insurance only at substantially higher rates, because of the adverse publicity risks discussed above and because the statutes of limitations for the bringing of child abuse and personal injury claims typically do not expire until a number of years after the child reaches the age of majority. To date, we have been able to obtain insurance in amounts we believe to be appropriate. However, insurance premiums may increase in the future as a consequence of conditions in the insurance business generally, or our situation in particular, and continuing publicity with respect to alleged instances of child abuse in the child care industry may result in our inability to obtain insurance. Furthermore, our current insurance coverage may not be sufficient in amount or type of coverage to protect us against all of such claims. We are subject to claims and litigation arising in the ordinary course of business, including claims and litigation involving allegations of physical or sexual abuse of children. We are aware of such allegations that have not yet resulted in claims or litigation. Any such allegations, claims or lawsuits, either individually or in the aggregate, may have a material adverse effect on our financial position, operating results or cash flows. Our failure to comply with present or future governmental regulation and licensing requirements for child care centers could have a material adverse effect on our operations. Our centers are subject to numerous state and local regulations and licensing requirements. We have policies and procedures in place to assist in complying with such regulations and requirements. Although these regulations vary from jurisdiction to jurisdiction, government agencies generally review the fitness and adequacy of buildings and equipment, the ratio of staff personnel to enrolled children, staff training, record keeping, children's dietary program, the daily curriculum, compliance with health and safety standards and transportation safety. In most jurisdictions, these agencies conduct scheduled and unscheduled inspections of the centers and licenses must be renewed periodically. Most jurisdictions establish requirements for background checks or other clearance procedures for new employees of child care centers. Repeated failures of a center to comply with applicable regulations can subject it to sanctions, which might include probation or, in more serious cases, suspension or revocation of the center's license to operate and could also lead to sanctions against our other centers located in the same jurisdiction. In addition, this type of action could lead to negative publicity extending beyond that jurisdiction. A licensing authority may determine that a particular center is in violation of applicable regulations and may take action against that center and possibly other centers in the same jurisdiction. In addition, there may be unforeseen changes in regulations and licensing requirements, such as changes in the required ratio of child center staff personnel to enrolled children, that could increase our center staff operating expenses and, therefore have a material adverse effect on our operations. States in which we operate routinely review the adequacy of regulatory and licensing requirements and implement changes which may significantly increase our costs to operate in those states. State and local licensing regulations often provide that the licenses held by us may not be transferred. As a result, any transferee of a child care business must apply to the appropriate administrative body for a new license. The change in ownership of our equity capital effected pursuant to this offering and the recapitalization may be considered a transfer of our business under some applicable state and local regulations. As a result, we may, in certain circumstances, be required to apply for relicensing in certain jurisdictions. If relicensing is required, we may have to incur material expenditures to relicense our centers in such jurisdictions. Failure to comply with such laws or regulations or changes in such laws or regulations could have a material adverse effect on our operations. See "Business Governmental Laws and Regulations Affecting Us." Any reduction in, or other changes to, the general labor force reduces the need for our child care services. Demand for our child care services may be subject to fluctuations in general economic conditions, and our revenues depend, in part, on the number of working mothers and working single parents who require child care services. Recessionary pressure on the economy, and a consequent reduction in the general labor force, may adversely impact us because of the tendency of out-of-work parents to stop using child care services. In addition, demographic trends, including the increasing percentage of mothers in the workforce, as well as trends in the preference of working parents and employers for center-based child care, may not continue. Children attending our facilities are enrolled on a weekly basis. Accordingly, any change in economic conditions will impact us more quickly than it would businesses in which contracts are for a longer time period. A loss or reduction of government funding for child care assistance programs or food reimbursement programs could adversely affect us. During fiscal year 2003 and the forty weeks ended March 5, 2004, approximately 21.6% and 20.1%, respectively, of our net revenues were generated from federal and state child care assistance programs, primarily the Child Care and Development Block Grant and At-Risk Programs. These programs are designed to assist low-income families with child care expenses and are administered through various state agencies. Although additional funding for child care may be available for low income families as part of welfare reform and the reauthorization of the Block Grant, we may not benefit from any such additional funding. Federal or state child care assistance programs may not continue to be funded at current levels. Many states have recently experienced fiscal problems and have reduced or may in the future reduce spending on social services. A termination or reduction of child care assistance programs could have a material adverse effect on our business. Adverse changes to the national or local economies may result in an increase in the number of families eligible for child care assistance. In order to compensate for such increases, state or local governments have in the past, and may in the future, increase parent co-payments required under such programs or change the eligibility requirements to reduce the number of families eligible to participate in such programs. Because our rates are at the higher end of child care providers, an increase in the required parent co-payments may create a disincentive for parents to send their children to our centers. An increase in required parent co-payments also increases our exposure to the risk of nonpayment by these parents. In addition, states which reduce funding for child care may be unable to qualify to receive funds under the Temporary Assistance for Needy Families, or TANF, program. Such states may utilize funds under the Child Care and Development Block Grant to provide child care assistance to needy families in lieu of TANF funds, thereby reducing the amount of funds available to other families, including families that utilize our child care centers. At March 5, 2004, approximately 500 of our centers were entitled to receive reimbursement for meals and snacks that meet certain USDA nutritional guidelines through the Child and Adult Care Food Program (CACFP). During fiscal year 2003 and the forty weeks ended March 5, 2004, our CACFP reimbursements were $7.8 million and $6.3 million, respectively, which were recorded as a reduction of operating expense. If the CACFP is not funded at current levels or if changes to the program result in any of our centers no longer qualifying for the CACFP, we would experience a decline in reimbursements and a resultant inability to reduce our operating expense, which could have a material adverse effect on our business. A termination or reduction of tax credits for child care could have a material adverse effect on our business. Tax incentives for child care programs can potentially benefit us. Section 21 of the Internal Revenue Code of 1986, as amended, referred to as the Code, provides a federal income tax credit ranging from 20% to 35% of specified child care expenses with maximum eligible expenses of $3,000 for one child and $6,000 for two or more children. The fees paid to us by eligible taxpayers for child care services qualify for these tax credits, subject to the limitations of Section 21 of the Code. However, these tax incentives are subject to change. Many states offer tax credits in addition to the federal credits discussed above. Credit programs vary by state and may apply to both the individual taxpayer and the employer. A termination or reduction of such tax credits could have a material adverse effect on our business. Because we will distribute a significant portion of our available cash in the form of interest payments on the notes and dividends with respect to the shares of Class A common stock, our ability to execute our growth strategy may be adversely affected. To the extent we do not defer interest payment on the notes and as long as the board of directors declares dividends with respect to the shares of our common stock, we will distribute a significant portion of our available cash in the form of interest and dividend payments. This will limit the amount of funds we have available to build and/or acquire new centers, which is a critical component of our growth strategy. Additional capital may therefore be required, which may be financed through borrowings under our revolving credit facility, issuances of additional IDSs, notes or other securities of ours, other third party financing or a combination of these alternatives, and such capital may not be available to us on acceptable terms or at all. If we are unable to successfully execute our growth strategy, our revenue growth, earnings and cash flow could be diminished. Our ability to increase revenues and operating cash flow significantly over time depends, in part, on our success in building and/or acquiring new centers on satisfactory terms, successfully integrating them into our operations and achieving operational maturity represented by stable revenues and cash flow within our targeted time frame. Acceptable acquisition opportunities and appropriate sites for our expansion program might not be available. The availability and price of sites and acquisition opportunities could be adversely impacted by the expansion activities of our competitors. In addition, our ability to take successful advantage of any available acquisition opportunity will be dependent, in part, on the availability of adequate financial resources, to which we may not have access. We also may have to incur material expenditures to relicense centers that we acquire in the future because state and local licensing regulations often do not allow family services companies, such as child care centers, to transfer their licenses. Our growth strategy also contemplates investing in or acquiring education-related businesses with which we may not have significant prior experience. Competition for such investment or acquisition opportunities has been significant and has driven up prices for such opportunities. Accordingly, such opportunities may not be available on reasonable terms, or, if available, may not be executed successfully. As our business develops and expands, we may need to implement enhanced operational and financial systems and may require additional employees and management, operational and financial resources. Failure to implement such systems successfully and to use such resources effectively could have a material adverse effect on us. Since the fourth quarter of fiscal year 2002 until the present, we have relied on our real estate sale-leaseback transactions as a source of cash flow, and the availability of such transactions may be limited in the future. During the fourth quarter of fiscal year 2002, we began selling centers to individual real estate investors and concurrently signing long term leases to continue operating the centers. At March 5, 2004, sale-leaseback transactions contributed $162.7 million in gross proceeds. Subsequent to March 5, 2004, we closed $26.0 million in sales, which included ten centers, and are currently in the process of negotiating another $45.4 million of sales related to 17 centers. However, the sale-leaseback market may cease to be a reliable source of cash flow for us in the future if capitalization rates become less attractive or other unfavorable market conditions develop. In addition, although new center construction is a potential source of assets for sale-leaseback transactions, our current inventory of assets suitable for sale-leaseback transactions is a limiting factor on future sale-leaseback transaction volume. In addition to the transactions relating to the 17 centers referred to above, we estimate that we have additional marketable inventory at May 21, 2004 of 52 centers with a market value of approximately $116.2 million. Our insurance policies may prove inadequate to cover claims, and we may be unable to maintain our existing coverage in the future at current prices. Our insurance program currently includes the following types of policies: workers' compensation, comprehensive general liability, automobile liability, property, excess "umbrella" liability, directors' and officers' liability and employment practices liability. These policies provide for a variety of coverages, are subject to various limits, and include substantial deductibles or self-insured retentions. Special insurance is sometimes obtained with respect to specific hazards, if deemed appropriate and available at reasonable cost. Our owned centers are covered by blanket insurance policies, including property insurance with an aggregate coverage limit of $100,000,000. Claims in excess of, or not included within, our coverage may be asserted. To the extent that any claims are not covered by insurance, we will be forced to cover the associated costs ourselves, which will reduce the amount of cash we have available for other business purposes. We expect our insurance costs to continue to increase in the near future due partially to higher premiums, which will further reduce the amount of cash we will have available for other business purposes. After the terrorist attacks of September 11, 2001, insurance premiums for all new insurance policies increased dramatically. Prior to the attacks, we had entered into three-year insurance policies with fixed premiums, which expired in May 2002. The combined effect of these circumstances impacted the increase in our insurance costs. We successfully renewed our insurance policies in May 2004. We experienced a slight decrease in the overall cost of coverage with premiums increasing for some lines of coverage and decreasing for others. Market conditions beyond our control will continue to dictate future insurance costs. We are subject to audits by tax authorities which, if determined adversely, could have a material adverse effect on our cash flow and results of operations. From time to time, we are subject to audits of our tax returns by the IRS and state taxing authorities. We are currently in the review process of an IRS audit with respect to our fiscal years 1998, 1999 and 2000. We are unable to predict the outcome of this review. The results of this review and any future audits by the IRS or other taxing authorities could result in adjustments that could have a material adverse effect on our cash flows and results of operations. If we are unable to attract and retain sufficient qualified employees, if minimum wage rates increase or if our employees unionize, our results of operations may be adversely affected. We believe that our success is largely dependent on our ability to attract and retain qualified employees. Many of our child care center staff are entry-level wage earning employees. Expenses for salaries, wages and benefits represented approximately 55.3% of net revenues for the forty weeks ended March 5, 2004. If we are unable to hire sufficient numbers of quality employees or are only able to hire such employees by providing significantly greater salaries, wages and benefits than we currently do as a result of increases in the federal or state minimum wage rates or other market conditions, our operations may be adversely affected. Since early 1998, union organization efforts in the child care industry have received considerable publicity. While union officials associated with the American Federation of State, County and Municipal Employees and Service Employees International have announced their intention to engage in a national effort to organize child care workers, organization efforts to date have been principally localized in Philadelphia and Seattle. Although we are not aware of any organization efforts at any of our centers, such efforts may occur and, if successful, could have an adverse effect on our relationships with employees and our labor costs. In addition, the general publicity surrounding such efforts, even if not focused on our centers, could result in increased wages for child care workers and, as a result, increase our labor costs. The loss of any of our key management employees could adversely affect our business. Our success and growth strategy depend upon our senior management, particularly David J. Johnson, our chief executive officer. However, we do not have employment agreements with, or key man life insurance for, Mr. Johnson or any of our senior management. If any of our key employees becomes unable or unwilling to participate in the business and operations of our company and/or we are unable to continue to attract and retain additional highly qualified senior management personnel, our future business and operations could be materially and adversely affected. Because we own or lease a substantial number of real properties, our results of operations could be adversely affected if environmental contamination is discovered on our properties. We are subject to federal, state and local environmental laws, regulations and ordinances that may impose liability for the costs of cleaning up, and damages resulting from, past spills, disposals and other releases of hazardous substances. In particular, under applicable environmental laws, we may be responsible for investigating and remediating environmental conditions and may be subject to associated liability, including lawsuits brought by private litigants, relating to our properties. These obligations could arise whether we own or lease the property at issue and regardless of whether the environmental conditions were created by us or by a prior owner or tenant. Environmental conditions unknown to us at this time relating to prior, existing or future properties may be discovered and have a material adverse effect on our results of operations. See "Business Properties."
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+Risk Factors An investment in the IDSs and the shares of our Class A common stock and/or our notes involves a number of risks. In addition to the other information contained in this prospectus, prospective investors should give careful consideration to the following factors. Risks Relating to the IDSs, the Shares of Class A Common Stock and the Notes We have substantial indebtedness and may incur additional indebtedness in the future, which could restrict our ability to pay interest and principal on the notes and to pay dividends with respect to shares of our Class A common stock represented by the IDSs and could impact our financing options and liquidity position. At March 5, 2004, we had $517.1 million of consolidated indebtedness and $142.2 million of consolidated stockholders' equity, and on a pro forma basis after giving effect to the offering and the use of proceeds described in this prospectus, we would have had $ million of consolidated indebtedness and $ million of consolidated stockholders' equity. Our indebtedness after the offering will consist primarily of the CMBS loan, borrowings under our revolving credit facility and our notes. We may incur additional indebtedness in the future, subject to the limitations contained in the instruments governing our indebtedness. Accordingly, we will continue to have significant debt service obligations in the future. In addition, we may enter into additional debt agreements or other financing arrangements in the future that could impose additional financial and operational restrictions upon us. Our ability to make distributions, pay dividends or make other payments will be subject to applicable law and contractual restrictions contained in the instruments governing any indebtedness of ours and our subsidiaries, including our revolving credit facility. The degree to which we are leveraged on a consolidated basis could have important consequences to the holders of the IDSs, including: our ability in the future to obtain additional financing for working capital, capital expenditures or acquisitions may be limited; we may not be able to refinance our indebtedness on terms acceptable to us or at all; a significant portion of our cash flow from operations is likely to be dedicated to the payment of the principal of and interest on our indebtedness, thereby reducing funds available for future operations, capital expenditures and/or dividends on our common stock; and we may be more vulnerable to economic downturns or changes in interest rates and be limited in our ability to withstand competitive pressures. A failure to comply with the obligations contained in our borrowing agreements could result in an event of default under our borrowing agreements, which could result in acceleration of the debt related to the particular borrowing agreement, as well as the debt under other borrowing instruments that contain cross-acceleration or cross-default provisions. If we are unable to service our debt, we may be required to refinance all or a portion of our existing debt, to sell assets or to obtain additional financing. Such refinancing might not be possible, and such sales of assets or additional financing might not be achieved, which could lead to a bankruptcy proceeding. Holders of our notes will be structurally subordinated to the debt of our non-guarantor subsidiaries, including the CMBS loan borrower, which owns the CMBS centers. In July 2003, one of our subsidiaries entered into a $300.0 million loan agreement with various lenders to refinance our existing borrowings, referred to as the CMBS loan. The balance outstanding at March 5, 2004 was $298.1 million. The loan is secured by mortgages or deeds of trust on 475 of our child care centers that are owned by that subsidiary borrower, referred to as the CMBS centers, as well as by certain cash collateral reserve accounts. Cash flows from investing activities: Purchases of property and equipment (94,269 ) (95,843 ) (83,114 ) Acquisitions of previously constructed centers (17,257 ) Acquisition of new subsidiary, net of cash acquired (15,189 ) Investments accounted for under the cost method (10,074 ) Issuance of notes receivable (4,836 ) (114 ) Proceeds from sales of property and equipment 7,948 11,537 95,172 Proceeds from notes receivable 145 Cash flows from investing activities: Purchases of property and equipment (91,162 ) (4,746 ) 65 (95,843 ) Proceeds from sales of property and equipment 3,114 7,660 763 11,537 Proceeds from notes receivable (14 ) 40 We have granted the underwriters an option to purchase up to additional IDSs to cover over-allotments. The underwriters expect to deliver the IDSs and notes in book-entry form only through the facilities of The Depository Trust Company to purchasers on or about , 2004. CIBC World Markets , 2004 Certain of our subsidiaries, including the CMBS loan borrower, will not be guarantors of our notes. As a result, no payments are required to be made to us from the assets of these subsidiaries. In the event of bankruptcy, liquidation or reorganization of any of the non-guarantor subsidiaries, holders of their indebtedness, including their trade creditors and the lenders of the CMBS loan, would generally be entitled to payment of their claims from the assets of those subsidiaries before any assets are made available for distribution to us for payment to you. As a result, our notes are effectively subordinated to the indebtedness of the non-guarantor subsidiaries. At March 5, 2004, our non-guarantor subsidiaries had total assets of $417.0 million and total liabilities, excluding liabilities owed to us, of $311.5 million. For the forty weeks ended March 5, 2004, our non-guarantor subsidiaries had net revenues of $211.5 million. The percentage of our assets, the amount of total liabilities and net revenues on a consolidated basis attributable to the non-guarantor subsidiaries that operate the CMBS centers and borrow under the CMBS loan were 41.6%, $299.9 million and $208.7 million, respectively, for the forty weeks ended and at March 5, 2004. The CMBS loan contains restrictive covenants that could materially affect our cash flow and operations. The CMBS loan contains restrictive covenants that could materially affect our cash flow and operations. For example, if the net operating income, as defined in the CMBS loan agreement, from the CMBS centers falls below $60.0 million in any year, we must escrow 50% of the operating cash flows from the CMBS centers, or 100% of the cash flows from those centers if their net operating income falls below $50.0 million. These thresholds are adjusted as centers are released from the loan collateral. The net operating income of the CMBS centers for the 52 week period ended March 5, 2004 was approximately $80.2 million. To the extent that these provisions are triggered, we will not have any cash distributed up to us from the CMBS centers and, thus, this escrow requirement may limit the amount of cash we have available to make interest payments on the notes or to declare or pay dividends on our Class A common stock. The CMBS loan contains other provisions that may limit our operating or financial flexibility and that of the subsidiary borrower, including a prohibition on making alterations to the CMBS centers without the lenders' consent if such alterations could adversely affect the value of the CMBS centers, restrictions on transfer of the subsidiary borrower and a requirement to maintain certain levels of insurance. We are also required to maintain an interest rate cap agreement until the loan matures. If the CMBS loan is accelerated, we will be subject to restrictions on our ability to compete with the CMBS centers in their geographic regions, which could limit our ability to open and operate centers in these regions. Because of the subordinated nature of the notes, holders of our notes may not be entitled to be paid in full, if at all, in a bankruptcy, liquidation or reorganization or similar proceeding. As a result of the subordinated nature of our notes and related guarantees, upon any distribution to our creditors or the creditors of the subsidiary guarantors in a bankruptcy, liquidation, reorganization or similar proceeding relating to us or the subsidiary guarantors or our or their property, the holders of our senior indebtedness and senior indebtedness of the subsidiary guarantors will be entitled to be paid in full in cash before any payment may be made with respect to our notes or the subsidiary guarantees. In the event of a bankruptcy, liquidation, reorganization or similar proceeding relating to us or the subsidiary guarantors, holders of our notes will participate with all other holders of unsecured indebtedness of ours or the subsidiary guarantors similarly subordinated in the assets remaining after we and the subsidiary guarantors have paid all senior indebtedness. However, because of the existence of the subordination provisions, including the requirement that holders of the notes pay over distributions to holders of senior indebtedness, holders of the notes may receive less, ratably, than our other unsecured creditors, including trade creditors. In any of these cases, we and the subsidiary Table of Contents Page guarantors may not have sufficient funds to pay all of our creditors, and holders of our notes may receive less, ratably, than the holders of senior indebtedness. Further, in the event of such bankruptcy proceedings, a party in interest may seek to subordinate the notes to all creditors under principles of equitable subordination or to recharacterize the notes as equity. While we believe that any such attempt should fail, there can be no assurance as to the outcome of such proceedings. In the event of such a subordination or recharacterization, you may not recover any amounts owing on the notes until all senior claims have been paid. Further, in the event of such a recharacterization you might be required to return any payments made to you on account of the notes, potentially up to six years prior to our bankruptcy, if it can be shown that at the time of such payment we were insolvent or rendered insolvent by reason of issuing the guarantee and the application of the proceeds of the guarantee, were engaged or about to engage in a business or a transaction for which the guarantor's remaining assets available to carry on its business constituted unreasonably small capital, or intended to incur, or believed that we would incur, debts beyond our ability to pay the debts as they mature. On a pro forma basis at March 5, 2004, our notes and the associated subsidiary guarantees would have ranked junior, on a consolidated basis, to $ million of outstanding senior secured indebtedness (including the amount outstanding under the CMBS loan) plus approximately $ million of letters of credit, and the subsidiary guarantees would have ranked junior to $ senior unsecured debt and pari passu with approximately $ million of outstanding indebtedness of ours and the subsidiary guarantors. In addition, at March 5, 2004, we had the ability to borrow up to an additional $58.9 million under our revolving credit facility (less amounts reserved for letters of credit), which would have ranked senior in right of payment to our notes. In the event of bankruptcy or insolvency, the notes and guarantees could be adversely affected by principles of equitable subordination or recharacterization. In the event of bankruptcy or insolvency, a party in interest may seek to subordinate the notes or the guarantees under principles of equitable subordination or to recharacterize the subordinated notes as equity. There can be no assurance as to the outcome of such proceedings. In the event a court subordinates the notes or the guarantees, or recharacterizes the notes as equity, we cannot assure you that you would recover any amounts owed on the notes or the guarantees and you may be required to return any payments made to you within six years before the bankruptcy on account of the notes or the guarantees. In addition, should the court equitably subordinate the notes or the guarantees, or recharacterize the notes as equity, you may not be able to enforce the guarantees. The notes or the guarantees of the notes by our subsidiaries may not be enforceable. Under federal bankruptcy law and comparable provisions of state fraudulent transfer laws, the notes or the guarantees could be voided, or claims in respect of the notes or the guarantees could be subordinated to all other debt of ours or the guarantor, as applicable, if, among other things, we or the guarantor, at the time that we issued the notes or it assumed the guarantee: received less than reasonably equivalent value or fair consideration for issuing the notes or the guarantee and, at the time we issued the notes or it issued the guarantee: was insolvent or rendered insolvent by reason of issuing the notes or the guarantee and the application of the proceeds of the notes or the guarantee; was engaged or about to engage in a business or a transaction for which our or such guarantor's remaining assets available to carry on its business constituted unreasonably small capital; intended to incur, or believed that we or such guarantor would incur, debts beyond our or such guarantor's ability to pay the debts as they mature; or Number of centers at the beginning of the fiscal year 1,242 1,264 Openings 35 was a defendant in an action for money damages, or had a judgment for money damages docketed against us or such guarantor if, in either case, after final judgment, the judgment is unsatisfied. The proceeds of the offering will be used to pay the cash portion of the recapitalization consideration and to pre-fund payment of debt of our subsidiaries, which may subject the note holders to the claim that we did not receive fair consideration for the notes. In the event that we meet any of the financial conditions of the fraudulent transfer tests described above at the time of or as a result of this offering, a court could view the issuance of our notes with the distribution to our stockholders and the payment of our subsidiaries' debt as a single integrated offering, and therefore, conclude that we did not receive fair value for the offering. In such a case, a court could conclude that the obligations represented by the notes are void, unenforceable or subordinate to the claims of other creditors. In addition, any payment by us or the guarantor pursuant to the notes or the guarantees could be voided and required to be returned to us or the guarantor or to a fund for the benefit of the creditors of ours or the guarantor or the notes or the guarantee could be subordinated to other debt of ours or the guarantor. The measures of insolvency for the purposes of fraudulent transfer laws vary depending upon the law applied in any proceeding to determine whether a fraudulent transfer has occurred. Generally, however, a person would be considered insolvent if, at the time it incurred the debt: the sum of its debts, including contingent liabilities, was greater than the fair saleable value of its assets; the present fair saleable value of its assets was less than the amount that would be required to pay its probable liability on its existing debts, including contingent liabilities, as they become absolute and mature; or it could not pay its debts as they become due. We believe that before and immediately after the issuance of the notes and the guarantees, we and each of the guarantors will be solvent, will have sufficient capital to carry on our respective businesses and will be able to pay our respective debts as they mature. However, we cannot be sure as to what standard a court would apply in making these determinations or that a court would reach the same conclusions with regard to these issues. Regardless of the standard that the court uses, we cannot be sure that the issuance by us of the notes or by the subsidiary guarantors of the subsidiary guarantees would not be voided or that the notes or the subsidiary guarantees would not be subordinated to our or their other debt. If the guarantee of any subsidiary guarantor were voided, our notes would be effectively subordinated to the indebtedness of that subsidiary guarantor. The guarantee of our notes by any subsidiary guarantor could be subject to the claim that, since the guarantee was incurred for our benefit, and only indirectly for the benefit of the subsidiary guarantor, the obligations of the subsidiary guarantor were incurred for less than fair consideration. If such a claim were successful and it was proven that the subsidiary guarantor was insolvent at the time the guarantee was issued, a court could void the obligations of the subsidiary guarantor under the guarantee or subordinate these obligations to the subsidiary guarantor's other debt or take action detrimental to holders of the notes. If the guarantee of any subsidiary guarantor were voided, our notes would be effectively subordinated to the indebtedness of that subsidiary guarantor. We may amend the terms of our revolving credit facility, or we may enter into new agreements that govern our senior indebtedness, and the amended or new terms may significantly affect our ability to pay interest and/or dividends to you. Our revolving credit facility contains significant restrictions on our ability to pay dividends on the shares of Class A common stock based on meeting certain tests and compliance with other conditions (including timely delivery of applicable financial statements), as described in detail under "Description In making your investment decision, you should rely only on the information contained in this prospectus or to which we have referred you. We have not authorized anyone to provide you with information that is different. If anyone provided you with different or inconsistent information, you should not rely on it. This prospectus may only be used where it is legal to sell these securities. You should assume the information appearing in this prospectus is accurate only as of the date on the front cover of this prospectus. Our business, consolidated financial condition, results of operations, liquidity and prospects may have changed since that date. Neither the delivery of this prospectus nor any sale made hereunder shall under any circumstances imply that the information in this prospectus is correct as of any date subsequent to the date on the cover of this prospectus. of Certain Indebtedness Revolving Credit Facility." As a result of general economic conditions, conditions in the lending markets, the results of our operations or for any other reason, we may elect or be required to amend or refinance our revolving credit facility, at or prior to maturity, or enter into additional agreements for senior indebtedness. Regardless of any protection you have in the indenture governing the notes, any such amendment, refinancing or additional agreement may contain covenants that could limit in a significant manner our ability to pay interest payments and/or dividends to you. We are subject to restrictive debt covenants and other requirements related to our outstanding debt that limit our business flexibility by imposing operating and financial restrictions on our operations. The agreements governing our indebtedness impose significant operating and financial restrictions on us. These restrictions prohibit or limit, among other things: the incurrence of additional indebtedness and the issuance of preferred stock and certain redeemable capital stock; the payment of dividends on, and purchase or redemption of, capital stock; a number of other restricted payments, including investments; specified sales of assets; specified transactions with affiliates; the creation of liens; and consolidations, mergers and transfers of all or substantially all of our assets. The terms of our revolving credit facility include other and more restrictive covenants and prohibit us from prepaying our other indebtedness, including the notes, while indebtedness under our revolving credit facility is outstanding. The revolving credit facility also requires us to maintain specified financial ratios and satisfy financial condition tests. Our ability to comply with the ratios or tests may be affected by events beyond our control, including prevailing economic, financial and industry conditions. A breach of any of these covenants, ratios or tests could result in a default under our revolving credit facility, the CMBS loan and/or the indenture. Certain events of default under our revolving credit facility would prohibit us from making payments on the notes, including payment of interest when due. In addition, upon the occurrence of an event of default under our revolving credit facility, the lenders could elect to declare all amounts outstanding under the revolving credit facility, together with accrued interest, to be immediately due and payable. If we were unable to repay those amounts, the lenders could proceed against the security granted to them to secure that indebtedness. If the lenders accelerate the payment of the indebtedness, our assets may not be sufficient to repay in full this indebtedness and our other indebtedness, including the notes. We have the right to defer interest at any time prior to , 2009, in which case you may not be paid any deferred interest until , 2009, and if we were to defer interest at any time after , 2009, you may not be paid all of the deferred interest owed to you until , 2019. The indenture governing our notes grants us the right to defer interest, subject to certain limitations. During the first five years that the notes are outstanding, we may defer interest for up to an aggregate period of eight quarters. In addition, after , 2009, interest payments may be deferred on up to occasions for up to two quarters per occasion. Deferred interest will bear interest at the same rate as the notes. For any interest deferred during the first five years, we are not obligated to pay any deferred interest until , 2009, so you may be owed a substantial amount of deferred interest that will not be due and payable until such date. For any interest deferred after , 2009, we are not obligated to pay all of the deferred interest until maturity, so you may be owed a substantial amount of deferred interest that will not be due and payable until such date. If you sell your IDSs or separate notes during the interest deferral period, you will not receive any payment of deferred interest. In addition, we will not be permitted to pay, and you will not receive, any dividend payments on our common stock until we have paid all the deferred interest. Our board of directors may, in its discretion, amend or repeal the dividend policy it is expected to adopt upon the closing of this offering, and you may not receive the level of dividends provided for in the dividend policy or any dividends at all. Our board of directors may, in its discretion, amend or repeal the dividend policy it is expected to adopt upon the closing of this offering. Our board of directors may decrease the level of dividends provided for in this dividend policy or entirely discontinue the payment of dividends. Future dividends with respect to shares of our capital stock, if any, will depend on, among other things, our results of operations, cash requirements, financial condition, contractual restrictions, business opportunities, provisions of applicable law and other factors that our board of directors may deem relevant. The indenture governing our notes and our revolving credit facility contain significant restrictions on our ability to make dividend payments, including, if we defer interest on the notes, restrictions on the payment of dividends until we have paid all deferred interest. The treatment of the notes for U.S. federal income tax purposes could affect our after-tax cash flow. Our after-tax cash flow available for dividend and interest payments would be reduced if the notes were treated as equity rather than debt for U.S. federal income tax purposes. In that event, the stated interest on the notes could be treated as a dividend, and interest on the notes would not be deductible by us for U.S. federal income tax purposes. Our inability to deduct interest on the notes could materially increase our taxable income and, thus, our U.S. federal and applicable state income tax liability. Our interest expense may increase significantly and could cause our net income and distributable cash to decline significantly. The revolving credit facility will be subject to periodic renewal or must otherwise be refinanced. We may also be required to refinance the CMBS loan when it matures in 2008, or, if extended, 2009. We may not be able to renew or refinance the revolving credit facility or CMBS loan, or if either is renewed or refinanced, the renewal or refinancing may occur on less favorable terms. Borrowings under the revolving facility and the CMBS loan are made at a floating rate of interest, subject to interest rate hedging arrangements. In the event of an increase in the base reference interest rates or inability to replace our interest rate hedging arrangements, our interest expense will increase and could have a material adverse effect on our ability to make cash dividend payments to our stockholders. Our ability to continue to expand our business will, to a large extent, be dependent upon our ability to borrow funds under our revolving credit facility and to obtain other third-party financing, including through the sale of IDSs or any sale of securities. Such financing may not be available to us on favorable terms or at all. We may not generate sufficient funds from operations to pay our indebtedness at maturity or upon the exercise by holders of their rights upon a change of control. A significant portion of our cash flow from operations will be dedicated to maintaining our child care centers and servicing our debt requirements. In addition, we currently expect to distribute a significant portion of any remaining cash earnings to our stockholders in the form of quarterly dividends. Moreover, prior to the maturity of our notes, we will not be required to make any payments of principal on our notes. We may not generate sufficient funds from operations to repay the principal amount of our indebtedness at maturity or in case you exercise your right to require us to purchase your notes upon a change of control. We may therefore need to refinance our debt or raise additional capital. These alternatives may not be available to us when needed or on satisfactory terms due to prevailing market conditions, a decline in our business or restrictions contained in our senior debt obligations. The indenture governing our notes and our revolving credit facility permit us to pay a significant portion of our free cash flow to stockholders in the form of dividends. Although the indenture governing our notes and our revolving credit facility have some limitations on our payment of dividends, they permit us to pay a significant portion of our free cash flow to stockholders in the form of dividends and, following completion of this offering, we intend to pay quarterly dividends. Specifically, the indenture governing our notes permits us to pay all of our excess cash, as defined in the indenture, for the 52 week period divided by four, as more fully described in "Summary Interest and Allowed Dividend Payments to IDS Holders under the Indenture" and "Description of Notes Certain Covenants." The revolving credit facility will permit us to use all of our distributable cash, as defined in the revolving credit facility, to pay dividends on the shares of our common stock as described in detail in "Description of Certain Indebtedness Revolving Credit Facility." Any amounts paid by us in the form of dividends will not be available in the future to satisfy our obligations under the notes. You will be immediately diluted by $ per share of Class A common stock if you purchase IDSs in this offering. If you purchase IDSs in this offering, based on the book value of the assets and liabilities reflected on our balance sheet, you will experience an immediate dilution of $ per share of Class A common stock represented by the IDSs which exceeds the entire price allocated to each share of Class A common stock represented by the IDSs in this offering because the net tangible book value will be lower for each share of Class A common stock outstanding immediately after this offering. Our net tangible book value at March 5, 2004, after giving effect to this offering, was approximately $ million, or $ per share of Class A common stock. Because we will use a significant portion of the proceeds of this offering to pay the cash portion of the recapitalization consideration with respect to shares of our existing common stock and to cancel options held by our existing equity investors, we will have less of the proceeds of this offering available to repay our existing debt and for corporate purposes. We will use a significant portion of the net proceeds from this offering to pay the cash portion of the recapitalization consideration with respect to shares of our existing common stock and to cancel options held by our existing equity investors. Assuming an initial public offering price of $ per IDS (the midpoint of the range set forth on the cover of this prospectus) and the sale of $ million aggregate principal amount of our notes being sold separately from the IDSs, we estimate aggregate net proceeds of $ million, approximately $ million of which will be used to fund the recapitalization. As a result of these transactions with our existing equity investors, our total indebtedness will be higher after the offering and the amount of net proceeds from this offering that remain available to us for working capital or debt retirement will be less than if we had not undertaken these transactions. Having less of the net proceeds from this offering on a going forward basis may require us to borrow more money under our revolving credit facility or seek other sources of capital to repay debt, fund our operations or continue to expand our business. Credit ratings may affect our ability to obtain financing and the cost of such financing. Our ability to obtain external and, in particular, debt financing, is affected by our corporate credit ratings and our debt ratings, which are periodically reviewed by the major credit rating agencies. We anticipate that Moody's and S&P will provide ratings for the notes. In determining our credit ratings, the rating agencies generally consider a number of both quantitative and qualitative factors. These factors include earnings, fixed charges such as interest, cash flows, total debt outstanding, off-balance sheet obligations and other commitments, total capitalization and various ratios calculated from these factors. The ratings provided to us by Moody's and S&P for the notes could be at or below Caa1 and CCC+, respectively. A debt rating of Caa1 or below by Moody's or CCC+ or below by S&P would indicate that the rating agency has determined that our notes have a currently identifiable vulnerability to default and that we are dependent upon favorable business, financial and economic conditions to make timely payment of interest and repayment of principal on the notes. Deferral of interest payments would have adverse tax consequences for you. If we defer interest payments on the notes, you will be required to recognize interest income for U.S. federal income tax purposes in respect of interest payments on the notes represented by the IDSs or the notes, as the case may be, held by you before you receive any cash payment of this interest. In addition, we will not pay you this cash if you sell the IDSs or the notes, as the case may be, before the end of any deferral period or before the record date relating to interest payments that are to be paid. The U.S. federal income tax consequences of the purchase, ownership and disposition of IDSs are unclear. No statutory, judicial or administrative authority directly addresses the treatment of the IDSs or instruments similar to the IDSs for U.S. federal income tax purposes. As a result, the U.S. federal income tax consequences of the purchase, ownership and disposition of IDSs are unclear. The IRS or the courts could successfully assert a treatment of the IDSs different than our intended treatment, which could affect our tax liability. We believe that an IDS should be treated as a unit representing a share of common stock and notes. However, the IRS or the courts may take the position that the notes are equity, or there could be a change in law, either of which could adversely affect the amount, timing and character of income, gain or loss in respect of your investment in IDSs, and materially increase our taxable income and, thus, our U.S. federal and applicable state income tax liability. This would reduce our after-tax cash flow and materially and adversely impact our ability to make interest and dividend payments on the notes and the common stock. Foreign holders could be subject to withholding or estate taxes with regard to the notes in the same manner as they will be with regard to the common stock. Payments to foreign holders would not be grossed-up for any such taxes. For discussion of these tax related risks, see "Material U.S. Federal Income Tax Consequences." The allocation of the purchase price of the IDSs may not be respected. The purchase price of each IDS must be allocated between the share of Class A common stock and notes in proportion to their respective fair market values at the time of purchase. If our allocation is not respected, it is possible that the notes will be treated as having been issued with OID (if the allocation to the notes were determined to be too high) or amortizable bond premium (if the allocation to the notes were determined to be too low). You generally would have to include OID in income in advance of the receipt of cash attributable to that income and would be able to elect to amortize bond premium over the term of the notes. Because of the deferral of interest provisions, the notes may be treated as issued with original issue discount. Under applicable Treasury regulations, a "remote" contingency that stated interest will not be timely paid will be ignored in determining whether a debt instrument is issued with OID. Although there is no authority directly on point, we believe that the likelihood of deferral of interest payments on the notes is remote within the meaning of the Treasury regulations. Based on the foregoing, although the matter is not free from doubt because of the lack of direct authority, the notes would not be considered issued with OID at the time of their original issuance. If deferral of any payment of interest were determined not to be "remote," the notes would be treated as issued with OID at the time of issuance. In such case, all stated interest on the notes would be treated as OID, and all holders, regardless of their method of tax accounting, would be required to include stated interest in income on a constant accrual basis, possibly in advance of their receipt of the associated cash. A subsequent issuance of notes may reduce the amount you can recover upon an acceleration of the payment of principal due on the notes or in the event of our bankruptcy. Under New York and federal bankruptcy law, holders of subsequently issued notes having original issue discount may be limited to an amount equal to the sum of (1) the initial offering price for the notes and (2) that portion of the OID that is not deemed to constitute "unmatured interest" for purposes of the United States Bankruptcy Code. Any OID that was not amortized as of the date of the commencement of this bankruptcy filing would constitute "unmatured interest." As a result, an automatic exchange that results in a holder receiving a note with OID could have the effect of ultimately reducing the amount such holder can recover from us in the event of an acceleration or bankruptcy. If we subsequently issue notes with significant OID, we may not be able to deduct all of the interest on those notes. It is possible that notes we issue in a subsequent issuance will be issued at a discount to their face value and, accordingly, may have "significant original issue discount" and thus be classified as "applicable high yield discount obligations," or AHYDOs. If any such notes were so treated, a portion of the OID on such notes could be nondeductible by us and the remainder would be deductible only when paid. This treatment would have the effect of increasing our taxable income and may adversely affect our cash flow available for interest payments and distributions to our equity holders. Subsequent issuances of notes may adversely affect your tax treatment. The indenture governing our notes will provide that, in the event there is a subsequent issuance of notes and such additional notes are issued with OID or after a subsequent issuance of notes with OID, each holder of IDSs or separately held notes, as the case may be, agrees that a portion of such holder's notes will be exchanged for a portion of the notes acquired by the holders of such subsequently issued notes. Consequently, immediately following such subsequent issuance, each holder of subsequently issued notes, held either as part of IDSs or separately, and each holder of existing notes, held either as part of IDSs or separately, will own an inseparable unit composed of a proportionate percentage of both the old notes and the newly issued notes. Therefore, subsequent issuances of notes with OID may adversely affect your tax treatment by increasing the OID, if any, that you were previously accruing with respect to the notes, resulting in your having to accrue interest income in advance of receiving the related cash payments. Following any subsequent issuance of notes with OID (or any issuance of notes thereafter), we (and our agents) will report any OID on the subsequently issued notes ratably among all holders of IDSs and separately held notes, and each holder of IDSs and separately held notes will, by purchasing IDSs, agree to report OID in a manner consistent with this approach. However, the Internal Revenue Service may assert that any OID should be reported only to the persons that initially acquired such subsequently issued notes (and their transferees). In such case, the Internal Revenue Service might further assert that, unless a holder can establish that it is not a person that initially acquired such subsequently issued notes (or a transferee thereof), all of the notes held by such holder have OID. Any of these assertions by the Internal Revenue Service could create significant uncertainties in the pricing of IDSs and notes and could adversely affect the market for IDSs and notes. For a discussion of these tax related risks, see "Material U.S. Federal Income Tax Consequences." If interest rates rise, the trading value of our IDSs and the notes sold separately in this offering may decline. We cannot predict the interest rate environment or guarantee that interest rates will not rise in the near future. Should interest rates rise or should the threat of rising interest rates develop, debt markets may be adversely affected. As a result, the trading value of our IDSs and notes may decline. There is not an active trading market for IDSs in the United States. IDSs are a novel type of security and there is not an active market for IDSs, or securities similar to the IDSs, in the United States. Because of this, investors may be unfamiliar with these new securities and the demand for them may be lower than for securities that have been actively traded for a number of years. We cannot assure you that an active trading market for the IDSs will develop in the future, which may cause the price of the IDSs to fluctuate substantially. Before this offering, there was no public market for our IDSs, notes or Class A common stock and an inactive public market for shares of our then outstanding common stock. The IDSs, notes and Class A common stock have not had a public market history and prior to this offering, the shares of our then outstanding common stock, while registered under the Securities Act and traded in the over-the-counter markets, have not traded actively. We cannot assure you that an active trading market for the IDSs and the notes sold separately in this offering will develop in the future, which may cause the price of the IDSs and the notes sold separately in this offering to fluctuate substantially, and we currently do not expect that an active trading market for the shares of our Class A common stock will develop until the notes are redeemed or mature. We will not apply to list our shares of Class A common stock for separate trading on the New York Stock Exchange or any other exchange until the number of shares held separately and not represented by IDSs is sufficient to satisfy applicable requirements for separate trading on such exchange. The Class A common stock may not be approved for listing at such time. We do not intend to list our notes on any securities exchange. Accordingly, we cannot assure you that there will be a market for the notes. If the notes represented by your IDSs are redeemed or mature, or if there is a payment default on the notes for 90 days, the IDSs will automatically separate, and you will then hold the shares of our Class A common stock. The price of the IDSs or notes may fluctuate substantially, which could negatively affect holders of IDSs or holders of notes sold separately. The initial public offering price of the IDSs and the notes sold separately in this offering will be determined by negotiations among us, the existing equity investors and the representatives of the underwriters and may not be indicative of the market price of the IDSs and the notes sold separately after the offering. Factors such as quarterly variations in our financial results, announcements by us or others, developments affecting us or the child care industry, general interest rate levels and general market volatility could cause the market price of the IDSs and the notes sold separately in this offering to fluctuate significantly. If the IDSs automatically separate, the limited liquidity of the market for the notes and Class A common stock may adversely affect your ability to sell the notes and Class A common stock. Although we will use our reasonable efforts to list our Class A common stock for separate trading on the New York Stock Exchange under certain circumstances, we may not be successful in listing the Class A common stock due to listing requirements. The notes represented by the IDSs will not be listed on any exchange. Upon separation of the IDSs, no sizable market for the notes and the Class A common stock may ever develop and the liquidity of any trading market for the notes or the Class A common stock that does develop may be limited. As a result, your ability to sell your notes and Class A common stock, and the market price you can obtain, could be adversely affected. The limited liquidity of the trading market for the notes sold separately (not represented by IDSs) may adversely affect the trading price of the separate notes. We are separately selling (not represented by IDSs) $ million aggregate principal amount of notes, representing approximately 10% of the total outstanding notes (assuming the underwriters do not exercise their over-allotment option). While the notes sold separately (not represented by IDSs) are part of the same series of notes as, and identical to, the notes represented by the IDSs at the time of the issuance of the separate notes, the notes represented by the IDSs will not be separable for at least 45 days and will not be separately tradeable until separated. As a result, the initial trading market for the notes sold separately (not represented by IDSs) will be very limited. Even after holders of the IDSs are permitted to separate their IDSs, a sufficient number of holders of IDSs may not separate their IDSs into shares of our Class A common stock and notes to create a sizable and more liquid trading market for the notes not represented by IDSs. Therefore, a liquid market for the notes may not develop, which may adversely affect the ability of the holders of the separate notes to sell any of their separate notes and the price at which these holders would be able to sell any of the notes sold separately. If we defer interest payments on the notes, the trading price of the IDSs or notes may be adversely affected. Subject to certain limitations, we have the option to defer interest payments on the notes for certain periods pursuant to the terms of the indenture. If we defer interest payments on the notes, holders of the notes will continue to accrue, but will not be paid, interest. In addition, we will not be permitted to pay, and you will not receive, any dividend payments on the shares of our Class A common stock until we have paid all the deferred interest. Therefore, if we have elected to defer interest payments on the notes and we have stopped paying dividends on the Class A common stock during the same period, the IDSs and the notes may trade at prices that do not fully reflect the value of any accrued but unpaid interest on the notes and, in the case of the IDSs, will most likely trade at lower prices due to no dividends being paid on the Class A common stock. This deferral feature and dividend stopper may mean that the market prices for the IDSs and the notes may be more volatile than other securities that do not have such deferral features. Future sales or the possibility of future sales of a substantial amount of IDSs, shares of our Class A common stock or our notes may depress the price of the IDSs and the shares of our Class A common stock and our notes. Future sales or the availability for sale of substantial amounts of IDSs or shares of our Class A common stock or a significant principal amount of our notes in the public market, including by the existing equity investors as described below, could adversely affect the prevailing market price of the IDSs and the shares of our Class A common stock and our notes and could impair our ability to raise capital through future sales of our securities. Our existing equity investors will own IDSs and shares of Class B common stock representing % of voting power of all of our outstanding shares of our common stock after the offering. Subject to the applicable contractual lock-up period and any securities law limits on affiliate resales, their IDSs (including IDSs after any conversion of their shares of Class B common stock) will be eligible for resale from time to time in any form of at-the-market, block or underwritten sales, whether as IDSs, shares of our common stock or our notes. We may issue shares of our Class A common stock and notes, which may be in the form of IDSs, or other securities from time to time as consideration for future acquisitions and investments. In the event any such acquisition or investment is significant, the number of shares of our Class A common stock and the aggregate principal amount of notes, which may be in the form of IDSs, or the number or aggregate principal amount, as the case may be, of other securities that we may issue may in turn be significant. In addition, we may also grant registration rights covering those IDSs, shares of our Class A common stock, notes or other securities in connection with any such acquisitions and investments. Our certificate of incorporation and by-laws and several other factors could limit another party's ability to acquire us and deprive our investors of the opportunity to obtain a takeover premium for their securities. Several provisions in our certificate of incorporation and by-laws will make it difficult for another company to acquire us and for you to receive any related takeover premium for your securities. For example, our by-laws do not allow stockholders to call a special meeting. In addition, there is no provision allowing stockholders to act by written consent. Our certificate of incorporation authorizes the issuance of preferred stock without stockholder approval and upon such terms as the board of directors may determine. Our annual and quarterly results of operations reflect seasonal fluctuations. Our revenues and the initial success of new centers are subject to seasonal fluctuations because enrollments are generally highest in September and January when children return to child care and/or school after summer and holiday vacations. Accordingly, July, August and December are particularly important times for new enrollments. In addition, enrollment generally decreases 5% to 10% during holiday periods and summer months. If we achieve less than satisfactory enrollment during these key months, we may not be able to compensate sufficiently for lower enrollment during the rest of the year. We may also be unable to adjust our expenses on a short-term basis to offset these fluctuations in revenues. This may cause us to experience insufficient cash flow to meet our ongoing capital needs during our low seasons. This imbalance in our cash flows may lead to seasonal volatility in the trading price of the IDSs due to a market reaction to our lower cash flow levels or any curtailment in our dividend payments to IDS holders or the commencement of any interest deferral. Risks Relating to our Business and the Industry We face intense competition in the early childhood education and care services industry from numerous other types of providers. The early childhood education and care services industry is competitive and highly fragmented, with the most important competitive factors generally based upon reputation, location and price. Our competition consists principally of the following: other for-profit, center-based child care providers, including franchise organizations; preschool, kindergarten and before- and after-school programs provided by public schools; local nursery schools and child care centers, including church-affiliated and other non-profit centers; providers of child care services that operate out of homes; and substitutes for organized child care, such as relatives, nannies and one parent caring full-time for a child. In many markets, we face competition from preschool services and before- and after-school programs offered by public schools that offer such services at little or no cost to parents. The number of school districts offering these services is growing, and we expect this form of competition to increase in the future. We also face competition from large, national, for-profit companies providing child care and education services, many of which offer these services at a lower price than we do. These other for-profit providers continue to expand in many of the same markets where we currently operate or plan to operate. According to a July 2001 study published by Marketdata Enterprises, the 40 largest providers of child care services totaled less than 5% of total licensed child care centers. Local nursery schools, child care centers and in-home providers generally charge less for their services than we do. Many denominational and other non-profit child care centers have lower operating expenses than we do and may receive donations and/or other funding to subsidize operating expenses. Consequently, operators of such centers often charge tuition rates that are less than our rates. In addition, fees for home-based care are normally substantially lower than fees for center-based care. Litigation and adverse publicity concerning incidents at child care centers could hurt our reputation and limit our ability to obtain insurance. We believe our success in the child care business, where personal trust and parent referrals play a key role, is directly related to our reputation and favorable brand identity. We are periodically subject to claims and litigation alleging negligence, inadequate supervision and other grounds for liability arising from injuries or other harm to children. In addition, claimants may seek damages from us for child abuse, sexual abuse or other criminal acts arising out of alleged incidents at our centers. Any adverse publicity concerning such incidents at one of our child care centers, or child care centers generally, could greatly damage our reputation and could have an adverse effect on occupancy levels at our centers. Operators of child care centers have had difficulty obtaining general liability insurance or other liability insurance that covers child abuse, or have been able to obtain such insurance only at substantially higher rates, because of the adverse publicity risks discussed above and because the statutes of limitations for the bringing of child abuse and personal injury claims typically do not expire until a number of years after the child reaches the age of majority. To date, we have been able to obtain insurance in amounts we believe to be appropriate. However, insurance premiums may increase in the future as a consequence of conditions in the insurance business generally, or our situation in particular, and continuing publicity with respect to alleged instances of child abuse in the child care industry may result in our inability to obtain insurance. Furthermore, our current insurance coverage may not be sufficient in amount or type of coverage to protect us against all of such claims. We are subject to claims and litigation arising in the ordinary course of business, including claims and litigation involving allegations of physical or sexual abuse of children. We are aware of such allegations that have not yet resulted in claims or litigation. Any such allegations, claims or lawsuits, either individually or in the aggregate, may have a material adverse effect on our financial position, operating results or cash flows. Our failure to comply with present or future governmental regulation and licensing requirements for child care centers could have a material adverse effect on our operations. Our centers are subject to numerous state and local regulations and licensing requirements. We have policies and procedures in place to assist in complying with such regulations and requirements. Although these regulations vary from jurisdiction to jurisdiction, government agencies generally review the fitness and adequacy of buildings and equipment, the ratio of staff personnel to enrolled children, staff training, record keeping, children's dietary program, the daily curriculum, compliance with health and safety standards and transportation safety. In most jurisdictions, these agencies conduct scheduled and unscheduled inspections of the centers and licenses must be renewed periodically. Most jurisdictions establish requirements for background checks or other clearance procedures for new employees of child care centers. Repeated failures of a center to comply with applicable regulations can subject it to sanctions, which might include probation or, in more serious cases, suspension or revocation of the center's license to operate and could also lead to sanctions against our other centers located in the same jurisdiction. In addition, this type of action could lead to negative publicity extending beyond that jurisdiction. A licensing authority may determine that a particular center is in violation of applicable regulations and may take action against that center and possibly other centers in the same jurisdiction. In addition, there may be unforeseen changes in regulations and licensing requirements, such as changes in the required ratio of child center staff personnel to enrolled children, that could increase our center staff operating expenses and, therefore have a material adverse effect on our operations. States in which we operate routinely review the adequacy of regulatory and licensing requirements and implement changes which may significantly increase our costs to operate in those states. State and local licensing regulations often provide that the licenses held by us may not be transferred. As a result, any transferee of a child care business must apply to the appropriate administrative body for a new license. The change in ownership of our equity capital effected pursuant to this offering and the recapitalization may be considered a transfer of our business under some applicable state and local regulations. As a result, we may, in certain circumstances, be required to apply for relicensing in certain jurisdictions. If relicensing is required, we may have to incur material expenditures to relicense our centers in such jurisdictions. Failure to comply with such laws or regulations or changes in such laws or regulations could have a material adverse effect on our operations. See "Business Governmental Laws and Regulations Affecting Us." Any reduction in, or other changes to, the general labor force reduces the need for our child care services. Demand for our child care services may be subject to fluctuations in general economic conditions, and our revenues depend, in part, on the number of working mothers and working single parents who require child care services. Recessionary pressure on the economy, and a consequent reduction in the general labor force, may adversely impact us because of the tendency of out-of-work parents to stop using child care services. In addition, demographic trends, including the increasing percentage of mothers in the workforce, as well as trends in the preference of working parents and employers for center-based child care, may not continue. Children attending our facilities are enrolled on a weekly basis. Accordingly, any change in economic conditions will impact us more quickly than it would businesses in which contracts are for a longer time period. A loss or reduction of government funding for child care assistance programs or food reimbursement programs could adversely affect us. During fiscal year 2003 and the forty weeks ended March 5, 2004, approximately 21.6% and 20.1%, respectively, of our net revenues were generated from federal and state child care assistance programs, primarily the Child Care and Development Block Grant and At-Risk Programs. These programs are designed to assist low-income families with child care expenses and are administered through various state agencies. Although additional funding for child care may be available for low income families as part of welfare reform and the reauthorization of the Block Grant, we may not benefit from any such additional funding. Federal or state child care assistance programs may not continue to be funded at current levels. Many states have recently experienced fiscal problems and have reduced or may in the future reduce spending on social services. A termination or reduction of child care assistance programs could have a material adverse effect on our business. Adverse changes to the national or local economies may result in an increase in the number of families eligible for child care assistance. In order to compensate for such increases, state or local governments have in the past, and may in the future, increase parent co-payments required under such programs or change the eligibility requirements to reduce the number of families eligible to participate in such programs. Because our rates are at the higher end of child care providers, an increase in the required parent co-payments may create a disincentive for parents to send their children to our centers. An increase in required parent co-payments also increases our exposure to the risk of nonpayment by these parents. In addition, states which reduce funding for child care may be unable to qualify to receive funds under the Temporary Assistance for Needy Families, or TANF, program. Such states may utilize funds under the Child Care and Development Block Grant to provide child care assistance to needy families in lieu of TANF funds, thereby reducing the amount of funds available to other families, including families that utilize our child care centers. At March 5, 2004, approximately 500 of our centers were entitled to receive reimbursement for meals and snacks that meet certain USDA nutritional guidelines through the Child and Adult Care Food Program (CACFP). During fiscal year 2003 and the forty weeks ended March 5, 2004, our CACFP reimbursements were $7.8 million and $6.3 million, respectively, which were recorded as a reduction of operating expense. If the CACFP is not funded at current levels or if changes to the program result in any of our centers no longer qualifying for the CACFP, we would experience a decline in reimbursements and a resultant inability to reduce our operating expense, which could have a material adverse effect on our business. A termination or reduction of tax credits for child care could have a material adverse effect on our business. Tax incentives for child care programs can potentially benefit us. Section 21 of the Internal Revenue Code of 1986, as amended, referred to as the Code, provides a federal income tax credit ranging from 20% to 35% of specified child care expenses with maximum eligible expenses of $3,000 for one child and $6,000 for two or more children. The fees paid to us by eligible taxpayers for child care services qualify for these tax credits, subject to the limitations of Section 21 of the Code. However, these tax incentives are subject to change. Many states offer tax credits in addition to the federal credits discussed above. Credit programs vary by state and may apply to both the individual taxpayer and the employer. A termination or reduction of such tax credits could have a material adverse effect on our business. Because we will distribute a significant portion of our available cash in the form of interest payments on the notes and dividends with respect to the shares of Class A common stock, our ability to execute our growth strategy may be adversely affected. To the extent we do not defer interest payment on the notes and as long as the board of directors declares dividends with respect to the shares of our common stock, we will distribute a significant portion of our available cash in the form of interest and dividend payments. This will limit the amount of funds we have available to build and/or acquire new centers, which is a critical component of our growth strategy. Additional capital may therefore be required, which may be financed through borrowings under our revolving credit facility, issuances of additional IDSs, notes or other securities of ours, other third party financing or a combination of these alternatives, and such capital may not be available to us on acceptable terms or at all. If we are unable to successfully execute our growth strategy, our revenue growth, earnings and cash flow could be diminished. Our ability to increase revenues and operating cash flow significantly over time depends, in part, on our success in building and/or acquiring new centers on satisfactory terms, successfully integrating them into our operations and achieving operational maturity represented by stable revenues and cash flow within our targeted time frame. Acceptable acquisition opportunities and appropriate sites for our expansion program might not be available. The availability and price of sites and acquisition opportunities could be adversely impacted by the expansion activities of our competitors. In addition, our ability to take successful advantage of any available acquisition opportunity will be dependent, in part, on the availability of adequate financial resources, to which we may not have access. We also may have to incur material expenditures to relicense centers that we acquire in the future because state and local licensing regulations often do not allow family services companies, such as child care centers, to transfer their licenses. Our growth strategy also contemplates investing in or acquiring education-related businesses with which we may not have significant prior experience. Competition for such investment or acquisition opportunities has been significant and has driven up prices for such opportunities. Accordingly, such opportunities may not be available on reasonable terms, or, if available, may not be executed successfully. As our business develops and expands, we may need to implement enhanced operational and financial systems and may require additional employees and management, operational and financial resources. Failure to implement such systems successfully and to use such resources effectively could have a material adverse effect on us. Since the fourth quarter of fiscal year 2002 until the present, we have relied on our real estate sale-leaseback transactions as a source of cash flow, and the availability of such transactions may be limited in the future. During the fourth quarter of fiscal year 2002, we began selling centers to individual real estate investors and concurrently signing long term leases to continue operating the centers. At March 5, 2004, sale-leaseback transactions contributed $162.7 million in gross proceeds. Subsequent to March 5, 2004, we closed $26.0 million in sales, which included ten centers, and are currently in the process of negotiating another $45.4 million of sales related to 17 centers. However, the sale-leaseback market may cease to be a reliable source of cash flow for us in the future if capitalization rates become less attractive or other unfavorable market conditions develop. In addition, although new center construction is a potential source of assets for sale-leaseback transactions, our current inventory of assets suitable for sale-leaseback transactions is a limiting factor on future sale-leaseback transaction volume. In addition to the transactions relating to the 17 centers referred to above, we estimate that we have additional marketable inventory at May 21, 2004 of 52 centers with a market value of approximately $116.2 million. Our insurance policies may prove inadequate to cover claims, and we may be unable to maintain our existing coverage in the future at current prices. Our insurance program currently includes the following types of policies: workers' compensation, comprehensive general liability, automobile liability, property, excess "umbrella" liability, directors' and officers' liability and employment practices liability. These policies provide for a variety of coverages, are subject to various limits, and include substantial deductibles or self-insured retentions. Special insurance is sometimes obtained with respect to specific hazards, if deemed appropriate and available at reasonable cost. Our owned centers are covered by blanket insurance policies, including property insurance with an aggregate coverage limit of $100,000,000. Claims in excess of, or not included within, our coverage may be asserted. To the extent that any claims are not covered by insurance, we will be forced to cover the associated costs ourselves, which will reduce the amount of cash we have available for other business purposes. We expect our insurance costs to continue to increase in the near future due partially to higher premiums, which will further reduce the amount of cash we will have available for other business purposes. After the terrorist attacks of September 11, 2001, insurance premiums for all new insurance policies increased dramatically. Prior to the attacks, we had entered into three-year insurance policies with fixed premiums, which expired in May 2002. The combined effect of these circumstances impacted the increase in our insurance costs. We successfully renewed our insurance policies in May 2004. We experienced a slight decrease in the overall cost of coverage with premiums increasing for some lines of coverage and decreasing for others. Market conditions beyond our control will continue to dictate future insurance costs. We are subject to audits by tax authorities which, if determined adversely, could have a material adverse effect on our cash flow and results of operations. From time to time, we are subject to audits of our tax returns by the IRS and state taxing authorities. We are currently in the review process of an IRS audit with respect to our fiscal years 1998, 1999 and 2000. We are unable to predict the outcome of this review. The results of this review and any future audits by the IRS or other taxing authorities could result in adjustments that could have a material adverse effect on our cash flows and results of operations. If we are unable to attract and retain sufficient qualified employees, if minimum wage rates increase or if our employees unionize, our results of operations may be adversely affected. We believe that our success is largely dependent on our ability to attract and retain qualified employees. Many of our child care center staff are entry-level wage earning employees. Expenses for salaries, wages and benefits represented approximately 55.3% of net revenues for the forty weeks ended March 5, 2004. If we are unable to hire sufficient numbers of quality employees or are only able to hire such employees by providing significantly greater salaries, wages and benefits than we currently do as a result of increases in the federal or state minimum wage rates or other market conditions, our operations may be adversely affected. Since early 1998, union organization efforts in the child care industry have received considerable publicity. While union officials associated with the American Federation of State, County and Municipal Employees and Service Employees International have announced their intention to engage in a national effort to organize child care workers, organization efforts to date have been principally localized in Philadelphia and Seattle. Although we are not aware of any organization efforts at any of our centers, such efforts may occur and, if successful, could have an adverse effect on our relationships with employees and our labor costs. In addition, the general publicity surrounding such efforts, even if not focused on our centers, could result in increased wages for child care workers and, as a result, increase our labor costs. The loss of any of our key management employees could adversely affect our business. Our success and growth strategy depend upon our senior management, particularly David J. Johnson, our chief executive officer. However, we do not have employment agreements with, or key man life insurance for, Mr. Johnson or any of our senior management. If any of our key employees becomes unable or unwilling to participate in the business and operations of our company and/or we are unable to continue to attract and retain additional highly qualified senior management personnel, our future business and operations could be materially and adversely affected. Because we own or lease a substantial number of real properties, our results of operations could be adversely affected if environmental contamination is discovered on our properties. We are subject to federal, state and local environmental laws, regulations and ordinances that may impose liability for the costs of cleaning up, and damages resulting from, past spills, disposals and other releases of hazardous substances. In particular, under applicable environmental laws, we may be responsible for investigating and remediating environmental conditions and may be subject to associated liability, including lawsuits brought by private litigants, relating to our properties. These obligations could arise whether we own or lease the property at issue and regardless of whether the environmental conditions were created by us or by a prior owner or tenant. Environmental conditions unknown to us at this time relating to prior, existing or future properties may be discovered and have a material adverse effect on our results of operations. See "Business Properties."
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+Table of Contents Following the subsequent issuance of notes with OID (or any issuance of notes thereafter) and resulting exchange, we (and our agents) will report any OID on the subsequently issued notes ratably among all holders of notes and IDSs, and each holder of notes or IDSs will, by purchasing notes or IDSs, agree to report OID in a manner consistent with this approach. However, the IRS may assert that any OID should be reported only to the persons that initially acquired such subsequently issued notes (and their transferees) and thus may challenge the holders reporting of OID on their tax returns. Such a challenge by the IRS could create significant uncertainties in the pricing of IDSs and notes and could adversely affect the market for IDSs and notes. For a discussion of these tax related risks, see Material U.S. Federal Income Tax Consequences. Holders of subsequently issued notes may not be able to collect their full stated principal amount prior to maturity. Under New York and federal bankruptcy law, holders of subsequently issued notes having OID (including the recipients of such notes pursuant to the automatic exchange under the indenture) may not be able to collect the portion of their principal amount that represents unaccrued OID in the event of an acceleration of the notes or our bankruptcy prior to the maturity date of the notes. As a result, an automatic exchange that results in a holder receiving an interest in notes with OID in exchange for notes that do not have OID could have the effect of ultimately reducing the amount such holder can recover from us in the event of an acceleration or bankruptcy to an amount that is less than the amount paid for the notes in this offering. If the IDSs separate, the limited liquidity of the market for the notes and Class A common stock may adversely affect your ability to sell the notes and Class A common stock. We do not intend to list the notes represented by the IDSs on any exchange or quotation system. Our shares of Class A common stock will be listed on the Toronto Stock Exchange, but holders of shares of Class A common stock will not be able to trade such shares on the Toronto Stock Exchange until the applicable requirements for separate trading are satisfied, including that a sufficient number of shares are held separately, not represented by IDSs, by a sufficient number of holders. Our Class A common stock will not initially be listed on any other exchange or quotation system, including the New York Stock Exchange. We will not apply to list our shares of Class A common stock for separate trading on the New York Stock Exchange or on any other exchange or quotation system on which the IDSs are then listed until a sufficient number of shares is held separately, not represented by IDSs, by a sufficient number of holders to satisfy applicable requirements for separate trading on such exchange or quotation system for 30 consecutive trading days. The Class A common stock may not be approved for listing at such time. Upon separation of the IDSs, no sizable market for the notes and the Class A common stock may ever develop and the liquidity of any trading market for the notes or the Class A common stock that does develop may be limited. As a result, your ability to sell your notes or Class A common stock, and the market price you can obtain, could be adversely affected. The limited liquidity of the trading market for the notes sold separately (not represented by IDSs) may adversely affect the trading price of the separate notes. We are separately selling $45.3 million aggregate principal amount of notes (not represented by IDSs), representing approximately 10.0% of the total outstanding notes (assuming the exchange of all outstanding Class B common stock for IDSs). While the notes sold separately (not represented by IDSs) are part of the same series of notes as, and identical to, the notes represented by IDSs at the time of the issuance of the separate notes, the notes represented by the IDSs will not be separable for at least 45 days and will not be separately tradeable until separated. As a result, the initial trading market for the notes sold separately (not represented by IDSs) will be very limited. Even after holders of the IDSs are permitted to separate their IDSs, a sufficient number of holders of IDSs may not separate their IDSs into shares of our Class A common stock and notes to create a sizable and more liquid trading market for the notes not represented by IDSs. Therefore, a liquid market for the separate notes may not develop, which may adversely affect the ability of the holders of the separate notes to sell any of their separate notes and the price at which these holders would be able to sell any of the notes sold separately. Table of Contents Required payments with respect to our indebtedness and payments pursuant to our dividend policy will reduce the amount of funds available for other corporate purposes, which could harm our competitiveness and/or limit opportunities to grow our business. Upon completion of this offering, we expect that the cash generated by our business in excess of operating needs, reserves for contingencies and capital expenditures (including an amount sufficient to maintain our operations, properties and other assets and a limited amount to finance growth opportunities) will be dedicated to the payment of the principal of and interest on our indebtedness and dividends on our common stock, thereby reducing funds available for other purposes, including research and development, additional capital expenditures and acquisitions. Accordingly, such interest and dividend payments may mean: we will have less funds available to devote to research and development, which could reduce our ability to develop new and innovative technologies and products and ultimately affect our ability to remain competitive; we will have less funds available for capital expenditures, which could inhibit our ability to invest in new or upgraded production equipment and other capabilities, thereby restricting efforts to improve our manufacturing processes, reduce our operating costs, expand product offerings and conduct business in new markets; and we will have reduced flexibility to finance growth opportunities such as acquisitions, which could limit or cause us to forego future opportunities to grow our business. We may be able to incur substantially more debt, which would increase the risks described above associated with our substantial leverage. We may be able to incur substantial additional indebtedness in the future. Specifically, the indenture governing the notes will permit us to incur additional debt, including issuances of additional notes under the indenture, unless our total leverage ratio exceeds 5.55:1. The indenture governing the notes will also permit us to incur other amounts of additional debt without regard to such total leverage ratio, including certain capitalized lease obligations, refinancing indebtedness, hedging obligations and issuances of additional notes in connection with the exercise of the underwriters over-allotment option or upon exchange of the shares of Class B common stock outstanding immediately following the completion of this offering. The new credit facility provides up to $100 million of borrowing from undrawn commitments under our revolving credit facility and for the incurrence of $20,000,000 of additional indebtedness with respect to capital leases and purchase money obligations, $15,000,000 of general additional indebtedness and certain other additional indebtedness. As of June 30, 2004, on a pro forma basis after giving effect to this offering and the related transactions contemplated by this prospectus, based on the covenants in the indenture governing the notes and our new credit facility, we would have had the ability to incur an additional $109.2 million aggregate principal amount of indebtedness, all of which could be senior indebtedness. Shortly following the completion of this offering, we expect to borrow approximately $40 million under our revolving credit facility to fund the legal reorganization of a portion of our international operations. For details regarding the circumstances under which we would be able to incur additional indebtedness, see Description of Certain Indebtedness New Credit Facility Covenants, Description of Notes Additional Notes and Description of Notes Certain Covenants Limitations on Incurrence of Indebtedness and Issuance of Disqualified Stock and Preferred Stock. Any additional indebtedness incurred by us could increase the risks associated with our substantial leverage. Table of Contents You may not receive any dividends. Dividend payments are not guaranteed and are within the absolute discretion of our board of directors. You may not receive any dividends as a result of any of the following factors: nothing requires us to pay dividends; while the dividend policy to be adopted by our board of directors upon the closing of this offering contemplates the distribution of our excess cash, up to the intended dividend rate set forth in Dividend Policy and Restrictions, our board of directors could modify or revoke the policy at any time and for any reason. The policy to distribute our excess cash is based upon our current assessment of the cash needs of our business and the environment in which it operates. That assessment could change due to, among other things, changes in our results of operations, cash requirements, financial condition, contractual restrictions, growth opportunities, competitive or technological developments, provisions of applicable law and other factors that our board of directors may deem relevant; even if the dividend policy is not modified or revoked, our board of directors could decide to reduce dividends or not to pay any dividends at all, at any time and for any reason; the amount of dividends distributed is subject to debt covenant restrictions under the indenture governing the notes and our new credit facility. In particular, we will be prohibited from paying dividends during any interest deferral period under the indenture or while any deferred interest (including interest on deferred interest) from a prior interest deferral period remains unpaid or if certain interest coverage and leverage ratios are not met; the amount of dividends distributed is subject to state law restrictions; our stockholders have no contractual or other legal right to dividends; and we may not have enough cash to pay dividends due to changes to our operating earnings, working capital requirements and anticipated cash needs. See Dividend Policy and Restrictions. The reduction or elimination of dividends may negatively affect the market price of the IDSs. The amount we expect to pay in dividends on our shares of Class A common stock in respect of the first year following the offering represents approximately 46% of the total distributions we expect to make to IDS holders in respect of the first year following the offering, including dividends on our shares of Class A common stock represented thereby and interest on our notes represented thereby. We may be required to make payments to our senior officers under our Long Term Incentive Plan even if we make no dividend payments, as the requirement to make payments under the Long Term Incentive Plan is tied to our financial performance and not to the level of dividend payments to holders of IDSs. See Management Long Term Incentive Plan. We may need to borrow funds to make our anticipated dividend payments, which could adversely affect our financial condition and/or reduce our ability to pay interest or dividends in the future. If we do not generate enough cash from our operations to pay dividends at the anticipated level, we may borrow funds to do so. Because our new credit facility and the indenture governing our notes each restrict the amount of indebtedness we are permitted to have outstanding, such borrowings would reduce the amount of money we would be able to borrow for other purposes, which could negatively impact our financial condition, our results of operations and our ability to maintain or expand our business. In addition, because any such borrowings would increase our debt and interest expense, our the leverage ratios would increase and our interest coverage ratios would decrease. An increase in the leverage ratios above the levels set forth in our new credit facility or a decrease in the interest coverage ratios below the levels set forth in the new credit facility or the indenture governing the notes would cause us to be prohibited from paying interest on the notes or dividends on our Class A common stock. If the offering and the related transactions had been completed on July 1, 2003 and we had wanted to pay dividends at the level anticipated after the offering, we would have needed to borrow approximately $15.3 million in the twelve month period ended June 30, 2004, given the actual levels of capital expenditures during such periods. Table of Contents We are subject to restrictive debt covenants that limit our business flexibility by imposing operating and financial restrictions on our operations. Although credit facilities of similarly situated borrowers customarily prohibit payments of dividends, our new credit facility will permit us, subject to certain restrictions, to pay dividends. Because the payment of dividends will decrease the amount of cash available to service our senior debt, the new credit facility will impose significant operating and financial restrictions on our operations that may be more restrictive than customary for credit facilities of similarly situated borrowers that prohibit or substantially limit payments of dividends. These restrictions imposed by our new credit facility, as described in detail under Description of Certain Indebtedness New Credit Facility, will prohibit or limit, among other things: the incurrence of additional indebtedness and the issuance of preferred stock and certain redeemable capital stock; investments and acquisitions; disposition of assets in subsidiary interests; transactions with affiliates; the creation of liens on our assets; consolidations, mergers and transfers of all or substantially all of our assets; and our ability to change the nature of our business. The terms of the new credit facility will include other restrictive covenants and prohibit us from prepaying our other indebtedness, including the notes, while indebtedness under the new credit facility is outstanding. These restrictions could limit our ability to obtain future financing, make acquisitions or needed capital expenditures, withstand downturns in our business or take advantage of business opportunities. Furthermore, the new credit facility also requires us to maintain specified financial ratios and satisfy financial condition tests, including a maximum senior leverage ratio, maximum total leverage ratio and minimum senior interest coverage ratio. Our ability to comply with the ratios or tests may be affected by events beyond our control, including prevailing economic, financial and industry conditions. A breach of any of these covenants, ratios or tests could result in a default under the new credit facility and/or the indenture. Upon the occurrence of an event of default under the new credit facility, the lenders could elect to declare all amounts outstanding under the new credit facility to be immediately due and payable. If the lenders accelerate the payment of the indebtedness under the new credit facility, our assets may not be sufficient to repay in full this indebtedness and our other indebtedness, including the notes. We are subject to significant restrictions on our ability to pay interest and dividends, and expect to continue to be subject to such restrictions. Our new credit facility will contain significant restrictions on our ability to pay interest on the notes and dividends on our common stock based on meeting a maximum senior leverage ratio, maximum total leverage ratio and minimum senior interest coverage ratio and compliance with other conditions (including timely delivery of applicable financial statements), as described in detail under Description of Certain Indebtedness New Credit Facility Restricted Payments. As a result of general economic conditions, conditions in the lending markets, the results of our business or for any other reason, we may elect or be required to amend or refinance our new credit facility, at or prior to maturity, or enter into additional agreements for senior indebtedness. Regardless of any protection you have in the indenture governing the notes, any such amendment, refinancing or additional agreement may contain covenants which could limit in a significant manner our ability to pay interest on the notes and/or dividends on our common stock. Table of Contents Our ability to pay dividends may reduce the amount of funds available to make payments on our debt. Both our new credit facility and the indenture governing our notes will permit us, subject to certain restrictions, to pay a significant portion of our cash flow to stockholders in the form of dividends on our common stock, including the Class A common stock represented by IDSs. Specifically, the indenture governing our notes permits us to pay dividends of up to 100% of our excess cash, as defined in the indenture, plus $45 million, subject to compliance with an interest coverage test, as more fully described under Description of Notes Certain Covenants. Our new credit facility permits us to use up to 100% of excess cash, as defined in the new credit facility with the same meaning as set forth in the indenture, plus $45 million, subject to compliance with senior interest coverage, senior leverage and total leverage tests to fund dividends on our shares of common stock, as more fully described under Description of Certain Indebtedness New Credit Facility Restricted Payments. Following completion of the offering, we intend to pay quarterly dividends. Holders of notes held separately from the IDSs may be adversely affected by such provisions because any amounts paid by us in the form of dividends will not be available in the future to satisfy our obligations under the notes. We may not be able to refinance our new credit facility at maturity on favorable terms or at all. The new credit facility will have a 4.5 year maturity except for that portion of the new term loan facility allocated to Canadian borrowers, which will have a 5 year maturity. We may not be able to renew or refinance the new credit facility, or if renewed or refinanced, the renewal or refinancing may occur on less favorable terms. In particular, our ability to defer interest on our notes is limited and such limitations may be viewed as favorable to the senior lenders, and at the time we seek to renew or refinance our new credit facility we may not have the same ability to defer interest on our notes that we will have immediately following completion of this offering. If we are unable to refinance or renew our new credit facility, our failure to repay all amounts due on the maturity date would cause a default under the new credit facility. In addition, our interest expense may increase significantly if we refinance our new credit facility on terms that are less favorable to us than the terms of our new credit facility, which could reduce the amount of funds available to make interest payments on the notes and pay dividends on our common stock, including the Class A common stock represented by IDSs. We will require a significant amount of cash, which may not be available to us, to service our debt, including the notes, and to fund our liquidity needs. Our ability to make payments on, refinance or repay our debt, including the notes, to fund planned capital expenditures or expand our business will depend largely upon our future operating performance. Our future operating performance is dependent upon our ability to execute our business strategy successfully. Such performance is also subject to general economic, financial and competitive factors, as well as other factors that are beyond our control. Assuming the transactions contemplated by this offering are completed on November 12, 2004, interest payments on our notes are scheduled to be approximately $58.1 million in 2005, interest payments on term loan borrowings under our new credit facility are scheduled to be approximately $3.7 million in 2004 and $26.4 million in 2005 and interest payments on revolver borrowings under our new credit facility are scheduled to be approximately $0.4 million in 2004 and $1.0 million in 2005, including approximately $0.3 million in 2004 and $0.7 million in 2005 associated with temporary borrowings to finance a planned legal reorganization of a portion of our international operations. See Dividend Policy and Restrictions Minimum Adjusted EBITDA. In addition, we estimate that interest payments under lines of credit in foreign countries that are used to facilitate short-term operating needs will be $0.2 million in 2004 and $1.2 million in 2005. If we are unable to generate sufficient cash to service our debt requirements, we will be required to refinance our new credit facility. If we are unable to refinance our debt or obtain new financing, we would have to consider other options, including: sales of assets to meet our debt service requirements; sales of equity; negotiations with our lenders to restructure the applicable debt; and Marketable equities 72 % 71 % Fixed income securities 28 Table of Contents and sole bookrunner. In this prospectus, we refer to this credit facility as the new credit facility. The new credit facility will consist of a revolving credit facility in an aggregate principal amount of up to $100 million (to be reduced to $50 million after the first anniversary of the closing date) and a $435 million term loan facility. While the new credit facility will permit us to pay interest and dividends to our security holders, including IDS holders, it will contain significant restrictions on our ability to make such interest and dividend payments. The new credit facility will have a 4.5 year maturity, except the portion of the term loan allocated to Canadian borrowers, which will have a 5 year maturity. See Description of Certain Indebtedness New Credit Facility. Our Existing Equity Investors We are an indirect, wholly-owned subsidiary of Xerium S.A. prior to this offering. Apax Europe IV GP, L.P., which, together with its affiliates, we refer to as Apax in this prospectus, is manager, directly or indirectly, of investment funds holding the majority of the outstanding common stock of Xerium S.A. Affiliates of CIBC World Markets Corp., the lead managing underwriter for this offering, own approximately 5.6% of the common stock of Xerium S.A. prior to this offering. We refer to CIBC World Markets Corp. as CIBC in this prospectus. Our senior management and certain other investors also own equity interests in Xerium S.A. We refer to Apax, CIBC and these other investors in Xerium S.A. as our existing equity investors in this prospectus. Xerium 3 S.A. is our direct parent company and, prior to our recapitalization and the offering, owns 100% of our capital stock. The Recapitalization and the Offering This offering consists of an offering by us of 28,125,000 IDSs, representing 28,125,000 shares of Class A common stock and $201.1 million aggregate principal amount of % senior subordinated notes due 2019, and an offering by us of $45.3 million aggregate principal amount of % senior subordinated notes due 2019 sold separately (not represented by IDSs). We refer to the % senior subordinated notes due 2019 (whether or not represented by IDSs) as the notes in this prospectus. The completion of the offering of the IDSs and the offering of the separate notes are conditioned on each other. Prior to the closing of this offering, our existing common stock, all of which is held by Xerium 3 S.A., will be reclassified as Class A common stock. In connection with the reclassification, the directors and members of our senior management who own equity interests in Xerium S.A. will exchange such interests for shares of our Class A common stock. The other existing equity investors will, through their ownership interests in Xerium S.A., continue to own all economic rights of the shares of Class A common stock held by Xerium 3 S.A. After the reclassification, and in connection with the offering, we will undergo a recapitalization in which all of the shares of Class A common stock held (directly or indirectly) by the existing equity investors will be exchanged for cash, IDSs and shares of Class B common stock, as described in the following table: Prior to the Offering Table of Contents seeking protection under the U.S. federal bankruptcy code or other applicable bankruptcy, insolvency or other applicable laws dealing with creditors rights generally. If we are forced to pursue any of the above options under distressed conditions, our business and/or the value of your investment in our IDSs and notes would be adversely affected. We are a holding company and rely on dividends, interest and other payments, advances and transfers of funds from our subsidiaries to meet our debt service and other obligations. We are a holding company and conduct all of our operations through our subsidiaries and currently have no significant assets other than the capital stock of our subsidiaries. As a result, we will rely on dividends, interest and other payments or distributions from our subsidiaries to meet our debt service obligations and enable us to pay interest and dividends. The ability of our subsidiaries to pay dividends or interest or make other payments or distributions to us will depend substantially on their respective operating results and will be subject to restrictions under, among other things, the laws of their jurisdiction of organization (which may limit the amount of funds available for the payment of dividends), agreements of those subsidiaries, the terms of the new credit facility and the covenants of any future outstanding indebtedness we or our subsidiaries incur. Interest on the notes may not be deductible by us for U.S. federal and applicable state income tax purposes, which could adversely affect our financial condition, significantly reduce our future cash flow and impact our ability to make interest and dividend payments. Our position that the notes should be treated as debt for U.S. federal income tax purposes may not be sustained if challenged by the IRS. If the notes were treated as equity rather than debt for U.S. federal and applicable state income tax purposes, then the stated interest on the notes could be treated as a dividend, and interest on the notes would not be deductible by us for U.S. federal and applicable state income tax purposes. Our inability to deduct interest on the notes on an on-going basis could materially increase our taxable income and, thus, our U.S. federal and applicable state income tax liability. In addition, to the extent any portion of our interest expense from prior years is determined not to be deductible, we could be required to pay a significant amount of additional income tax for such years, together with interest and possible penalties. Any increase in tax liabilities for prior or future periods as a result of a determination that interest on the notes is not deductible would materially and adversely affect our financial condition and our after-tax cash flow, which in turn would materially and adversely affect our ability to meet our obligations on the notes and to pay dividends. We do not expect to maintain any reserve in our financial statements for the possibility of there being a determination that interest on the notes would not be deductible for U.S. federal and applicable state income tax purposes. In addition, if a challenge to the deductibility of interest on the notes were to prevail, the amount, timing and character of any income, gain, or loss that you recognize in respect of your IDSs could be adversely affected. In the case of foreign holders, treatment of the notes as equity for U.S. federal income tax purposes would subject payments to such holders in respect of the notes to withholding or estate taxes in the same manner as payments made with regard to Class A common stock and could subject us to liability for withholding taxes that were not collected on payments of interest. Payments to foreign holders would not be grossed-up for any such taxes. For a discussion of these tax related risks, see Material U.S. Federal Income Tax Consequences. We may have to establish a reserve for contingent tax liabilities in the future, which could adversely affect our ability to make interest and dividend payments on the IDSs. Even if the IRS does not challenge the tax treatment of the notes, it is possible that as a result of a change in law relied upon at the time of issuance of the notes, we will in the future need to change our anticipated accounting treatment and establish a reserve for contingent tax liabilities associated with a disallowance of all or part of the interest deductions on the notes. If we were required to maintain such a reserve, our ability to make interest and dividend payments could be materially impaired and the market for the IDSs, Class A common stock and notes could be adversely affected. In addition, any resulting restatement of our financial statements could lead to defaults under our new credit facility. Table of Contents You will be immediately diluted by $16.65 per share of Class A common stock if you purchase IDSs in this offering. If you purchase IDSs in this offering, based on the book value of the assets and liabilities reflected on our balance sheet at June 30, 2004, you will experience an immediate dilution of $16.65 per share of Class A common stock represented by the IDSs (assuming all Class B common stock has been exchanged), which exceeds the entire price allocated to each share of Class A common stock represented by the IDSs in this offering because there will be a net tangible book deficit for each share of Class A common stock outstanding immediately after this offering. Our net tangible book deficit as of June 30, 2004, after giving effect to this offering, would have been approximately $444.2 million, or $7.80 per share of Class A common stock represented by IDSs (assuming all Class B common stock has been exchanged). Subject to certain limitations, we may defer interest on the notes at any time at our option if we reasonably believe it is necessary to avoid a default under our senior indebtedness. If we defer interest, we will not be permitted to make any payment of dividends so long as any deferred interest or interest on deferred interest remains outstanding. Prior to , 2009, we may, subject to certain limitations set forth in the indenture governing the notes, defer interest payments on the notes on one or more occasions for eight quarters in the aggregate if we reasonably believe such deferral is necessary to avoid a default under our senior indebtedness. After , 2009, we may, subject to certain limitations set forth in the indenture governing the notes, defer interest payment on up to four occasions for up to two quarters per occasion if we reasonably believe such deferral is necessary to avoid a default under our senior indebtedness provided that we may not defer additional interest until all previously deferred interest has been paid in full. After the end of any interest deferral period occurring before , 2009, deferred interest, together with any accrued interest thereon, will be required to be repaid on , 2009. Consequently, you may be owed a substantial amount of deferred interest that will not be due and payable until such date. All interest deferred after , 2009, together with any accrued interest thereon, must be repaid on or before maturity. Consequently, you may be owed a substantial amount of deferred interest that will not be due and payable until such date. During any interest deferral period and so long as any deferred interest or interest on deferred interest remains outstanding, we will not be permitted to make any payment of dividends with respect to shares of common stock. Deferral of interest payments would have adverse tax consequences for you by causing you to recognize interest income and pay taxes before you receive any cash payment of such interest, and may adversely affect the trading price of the IDSs or the separately held notes. If interest payments on the notes are deferred, the notes will be treated as issued with OID at the time of such occurrence. As a result, you will be required to recognize interest income for U.S. federal income tax purposes in respect of the notes represented by the IDSs or the separately held notes, as the case may be, held by you before you receive any cash payment of this interest. See Material U.S. Federal Income Tax Consequences Consequences to U.S. Holders Notes Deferral of Interest. In addition, you will not receive any cash payment with respect to the accrued interest if you sell the IDSs or the notes, as the case may be, before the record date relating to interest payments that are to be paid. If interest is deferred, the IDSs or separately held notes may trade at a price that does not fully reflect the value of accrued but unpaid interest on the notes. In addition, the existence of the right to defer payments of interest on the notes under certain circumstances may mean that the market price for the IDSs or separately held notes may be more volatile than other securities that do not have such provisions. The realizable value of our assets upon liquidation may be insufficient to satisfy claims. At June 30, 2004, our assets included intangible assets in the amount of approximately $332 million, representing approximately 34% of our total consolidated assets and consisting primarily of goodwill (the excess of the Table of Contents The Recapitalization and the Offering Table of Contents acquisition cost over the fair market value of the net assets acquired in purchase transactions). The value of these intangible assets will continue to depend significantly upon the success of our business as a going concern and the growth in cash flows. As a result, in the event of a default under our new credit facility or on our notes or any bankruptcy or dissolution of our Company, the realizable value of these assets may be substantially lower and may be insufficient to satisfy the claims of our creditors, including holders of notes. Claims of holders of the notes and the guarantees will be structurally subordinated to claims of creditors of our non-guarantor subsidiaries. We are a holding company and conduct all of our operations through our subsidiaries. Certain of our subsidiaries will not be guarantors of the notes. As a result, no payments are required to be made to us from the assets of these subsidiaries. Claims of holders of the notes and the guarantees will be structurally subordinated to the indebtedness and other liabilities and commitments of our non-guarantor subsidiaries. The ability of our creditors, including the holders of the notes, to participate in the assets of any of our non-guarantor subsidiaries upon any bankruptcy, liquidation or reorganization or similar proceeding of any such entity will be subject to the prior claims of that entity s creditors, including trade creditors, and any prior or equal claim of any other equity holder. In addition, the ability of our creditors, including the holders of our notes, to participate in distributions of assets of our non-guarantor subsidiaries will be limited to the extent that the outstanding shares of any of our subsidiaries are either pledged to secure other creditors (including lenders under our new credit facility) or are not owned by us. Our non-guarantor subsidiaries accounted for approximately 53% of our net sales in 2003 and, as of December 31, 2003, they held approximately 53% of our total consolidated assets. For the six months ended June 30, 2004, such non-guarantor subsidiaries accounted for approximately 52% of our net sales and, as of June 30, 2004, they held approximately 53% of our total consolidated assets. See Note 17 of the audited consolidated financial statements included elsewhere in this prospectus and Note 13 of the accompanying unaudited consolidated financial statements included elsewhere in this prospectus. Your right to receive payments on the notes and the guarantees is junior to all of our senior debt and the senior debt of our subsidiaries. The notes and the related guarantees will be unsecured senior subordinated obligations, junior in right of payment to all of our senior debt and the senior debt of each subsidiary guarantor, respectively. As a result of the subordinated nature of our notes and the related guarantees, upon any distribution to our creditors or the creditors of the subsidiary guarantors in bankruptcy, liquidation or reorganization or similar proceedings relating to us or the subsidiary guarantors or our or their property or assets, the holders of such entities senior indebtedness will be entitled to be paid in full in cash before any payment may be made with respect to the notes or the subsidiary guarantees (and before any distribution may be made by our subsidiaries to us). In the event of a bankruptcy, liquidation or reorganization or similar proceeding relating to us or the subsidiary guarantors, the subordinated noteholders would participate in available distributions with other holders of unsecured senior subordinated indebtedness after the payment in full of all senior indebtedness. In any of these cases, we and our subsidiary guarantors may not have sufficient funds to pay all of our creditors and the holders of the notes may receive less, ratably than the holders of our senior indebtedness or the senior indebtedness of our subsidiary guarantors. Furthermore, because of the existence of subordination provisions, including the obligation to turn over distributions to holders of our senior indebtedness or the senior indebtedness of our subsidiary guarantors, the holders of notes may receive less, ratably, than holders of trade payables and other general unsecured indebtedness. In such event we and the guarantors would not be able to make all principal payments on the notes. The subordination provisions of the indenture will also provide that payments to you under the notes will be prohibited while a payment default exists under designated senior indebtedness or if such designated senior indebtedness has been accelerated. In addition, these payments to you may be blocked for up to 179 days by holders of designated senior indebtedness if a default other than a payment default exists under such senior IDSs to be issued to the existing equity investors in connection with the recapitalization and the offering 23,934,267 (1) Shares of Class B common stock to be issued to the existing equity investors in connection with the recapitalization and the offering 4,912,500 shares Cash to be paid to the existing equity investors in connection with the recapitalization and the offering $ 62,613,390 Voting power held by the existing equity investors after the recapitalization and the offering (includes Class A common stock represented by IDSs and Class B common stock and assumes no exercise of the underwriters over-allotment option to purchase additional IDSs) 50.6 % Table of Contents indebtedness. During any period in which payments to you are prohibited or blocked in this manner, any amounts received by you with respect to the notes or guarantees, including as a result of any legal action to enforce the notes or guarantees, would be required to be turned over to the holders of senior indebtedness. As of June 30, 2004, on a pro forma basis after giving effect to the transactions contemplated by this prospectus: Xerium Technologies, Inc. would have had $302.6 million aggregate principal amount of senior indebtedness outstanding, all of which would have been senior secured indebtedness to which the notes would be junior in right of payment; Xerium Technologies, Inc. would have had an additional $417.5 million aggregate principal amount of indebtedness outstanding, consisting exclusively of the notes; our subsidiary guarantors would have had $69.4 million aggregate principal amount of senior indebtedness outstanding, all of which would have been senior secured indebtedness to which the guarantees of the notes would be junior in right of payment; our subsidiary guarantors would have had $72.8 million aggregate principal amount of other indebtedness outstanding, including trade payables, all of which would have ranked pari passu with the guarantees, except as discussed in Risk Factors Risks Related to Capital Structure and Description of Notes Ranking ; and our non-guarantor subsidiaries would have had $172.1 million aggregate principal amount of indebtedness outstanding, including trade payables, to which the notes and the guarantees would be structurally subordinated. In addition, as of June 30, 2004, on a pro forma basis after giving effect to the transactions contemplated by this prospectus, based on the covenants in the indenture and our new credit facility, we would have had the ability to incur an additional $109.2 million aggregate principal amount of indebtedness, all of which could be senior in right of payment to the notes. Shortly after the completion of this offering we expect to borrow approximately $40 million under our revolving credit facility to fund the legal reorganization of a portion of our international operations. The validity and enforceability of the notes and the guarantees of the notes by our subsidiaries may be limited by fraudulent conveyance laws and foreign laws restricting guarantees. Our obligations under the notes will be guaranteed by certain of our subsidiaries, including our domestic subsidiaries organized under Delaware law and our foreign subsidiaries organized under the laws of Australia, Canada, Japan, Mexico and the United Kingdom. These guarantees provide the holders of the notes with a direct claim against the assets of the subsidiary guarantors. The offering of the notes and the guarantees of the notes by certain of our subsidiaries may be subject to legal challenge and review based on various laws and defenses relating to fraudulent conveyance or transfer, voidable preferences, financial assistance, corporate purpose, capital maintenance, the payment of legally sufficient consideration and other laws and defenses affecting the rights of creditors generally. The laws of various foreign jurisdictions, including the jurisdictions in which the subsidiary guarantors are organized and those in which the subsidiary guarantors own assets or otherwise conduct business, may be applicable to the notes and the guarantees. Accordingly, we cannot assure you that a third party creditor or bankruptcy trustee would not challenge the notes or one or more of these subsidiary guarantees in court and prevail in whole or in part. Although laws differ among various jurisdictions, in general, under fraudulent conveyance or transfer laws, a court could void or subordinate the notes or the guarantees issued by our subsidiaries if it found that: we or the subsidiary guarantors intended to hinder, delay or defraud our creditors; we or the subsidiary guarantors knew or should have known that the transactions were to the detriment of our creditors; Table of Contents the transactions had the effect of giving a preference to one creditor or class of creditors over another; or we or the subsidiary guarantors did not receive fair consideration and reasonably equivalent value for incurring such indebtedness or guarantee obligations and we or the subsidiary guarantors (i) were insolvent or rendered insolvent by reason of the incurrence of such indebtedness or obligations, (ii) were engaged or about to engage in a business or transaction for which our or the subsidiary guarantors remaining assets constituted unreasonably insufficient capital or (iii) intended to incur, or believed that we or the subsidiary guarantors would incur, debts beyond our or their ability to pay as they mature. The measure of insolvency for purposes of fraudulent transfer laws varies depending on the law applied. Generally, however, an entity would be considered insolvent if: the sum of its debts, including contingent liabilities, was greater than the fair saleable value of all of its assets; the present fair saleable value of its assets was less than the amount that would be required to pay its existing debts and liabilities, including contingent liabilities, as they become absolute and mature; or it could not or would not pay its debts as they become due. We cannot assure you that a court would reach the conclusion that, upon the issuance of the notes and the subsidiary guarantees, we and each of the subsidiary guarantors will be solvent, will have sufficient capital to carry on our business and will be able to pay our debts as they mature. If a court were to find that the issuance of the notes or a subsidiary guarantee was a fraudulent conveyance or transfer or constituted an illegal preference, the court could void the payment obligations under the notes or the guarantee, further subordinate the notes or the subsidiary guarantee to presently existing and future indebtedness of ours or the subsidiary guarantor, or require the holders of the notes to repay any amounts received with respect to the notes or guarantee. The guarantees issued by certain of our foreign subsidiaries will contain language limiting the amount of debt guaranteed so that applicable local law restrictions will not be violated, although there can be no assurance that such limitation is enforceable. As a result, a subsidiary s liability under its guarantee could be materially reduced or eliminated depending on the amount of its other obligations and the effect of applicable laws. In particular, in certain jurisdictions, a guarantee that is not in the guarantor s corporate interest or the burden of which exceeds the benefit to the guarantor may not be valid and enforceable. It is possible that a creditor of a subsidiary guarantor, or a bankruptcy trustee in the case of a bankruptcy of a subsidiary guarantor, may contest the validity or enforceability of the subsidiary s guarantee of the notes and that a court may determine that the guarantee should be limited or voided. To the extent that any subsidiary guarantee is determined to be void or unenforceable, or the agreed limitations on the guaranteed obligations become applicable, the notes would not have a claim under the guarantee and would accordingly be effectively subordinated to all other liabilities of the applicable subsidiary. Although the insolvency laws of the jurisdiction of incorporation of the respective subsidiaries would most likely apply to the insolvency of the relevant subsidiary, a subsidiary could conceivably enter into an insolvency procedure in another jurisdiction. Therefore, the validity and enforceability of the subsidiary guarantees may be affected by the insolvency, administration and other laws of various foreign jurisdictions, including the jurisdictions in which the subsidiary guarantors are organized and those in which the subsidiary guarantors own assets or otherwise conduct business. The laws of these jurisdictions are in many cases materially different from, and conflict with each other and with the laws of the United States, including in the areas of bankruptcy, creditors rights, fraudulent transfers, priority of governmental and other creditors, ability to obtain post petition interest, duration of proceeding and preference periods. For example, in the United Kingdom an administrator or liquidator of a company may apply to the court for an order to recover preferred payments made to creditors within certain periods prior to a company s insolvency only in circumstances where it can be shown that the insolvent entity was, among other factors, motivated by a desire to put the creditor in a better position than it would have been in an insolvency proceeding. However, in a U.S. bankruptcy proceeding, a debtor or its trustee in bankruptcy may recover sums paid to creditors within a 90 day period prior to bankruptcy irrespective of the Table of Contents motivation for such payments. The application of these and other similar laws, and any conflict between laws of various jurisdictions, could call into question whether, and to what extent, the laws of any particular jurisdiction should apply, which may adversely affect your ability to enforce your rights under the guarantees of the notes by our subsidiaries in these jurisdictions or limit any amounts that you may receive. You may have difficulty effecting service of process upon our foreign subsidiary guarantors and/or our directors and executive officers who reside outside of the United States. Several of the subsidiary guarantors are organized under laws outside of the United States and certain of our directors and officers reside outside of the United States. In addition, a substantial portion of the assets of such guarantors and our directors and officers are located outside of the United States. As a result, it may be difficult for holders of our securities to effect service of process upon the guarantors or such directors or officers within the United States or to enforce against them the United States judgments of courts of the United States predicated upon the civil liability provisions of the United States federal securities laws or other laws of the United States. In addition, we have been advised by legal counsel in certain foreign jurisdictions that there is doubt as to the enforcement in such jurisdictions of liabilities predicated upon United States federal securities laws against our guarantors and our directors and executive officers who are not residents of the United States, in original actions or in actions for enforcements of judgments of U.S. courts. In the event of bankruptcy or insolvency, the notes and guarantees could be adversely affected by principles of equitable subordination or recharacterization, which may eliminate your ability to recover any amounts owed on the notes or require you to return any prior payments you received on the notes. In the event of bankruptcy or insolvency, a party in interest may seek to subordinate the notes or the guarantees under principles of equitable subordination or to recharacterize the notes as equity. There can be no assurance as to the outcome of such proceedings. In the event a court subordinates the notes or the guarantees, or recharacterizes the notes as equity, we cannot assure you that you would recover any amounts owed on the notes or the guarantees and you may be required to return any payments made to you on account of the notes or guarantees within six years before the bankruptcy. In addition, should the court equitably subordinate the notes or the guarantees, or recharacterize the notes as equity, you may not be able to enforce the notes or the guarantees. While generally speaking, equitable subordination would require a showing of inequitable conduct on the part of the lender, under certain circumstances, courts have recognized the potential for so-called no-fault equitable subordination; that is, equitable subordination without the necessity to show inequitable conduct. This doctrine has mainly been employed to subordinate tax and penalties claims, punitive damage claims and claims relating to stock redemption/repurchase obligations. As such, even absent a finding of inequitable conduct, it is possible that a court could conclude that the debt represented by the notes represented by IDSs should be equitably subordinated to the extent such notes were originally issued in exchange for equity. The notes represented by IDSs to be issued to our existing equity investors in connection with the recapitalization and the offering, as described in The Transactions The Recapitalization and the Offering and Related Party Transactions Proceeds from the Recapitalization and the Offering, will be issued in exchange for equity. To the extent that particular notes can be traced to notes represented by IDSs that were issued to our existing equity investors in connection with the recapitalization and the offering, such notes could be subject to a no-fault equitable subordination claim. The allocation of the purchase price of the IDSs may not be respected. The purchase price of each IDS must be allocated among the underlying shares of Class A common stock and notes in proportion to their respective fair market values at the time of purchase. We expect to report the initial fair market value of each share of Class A common stock as $8.85 and the initial fair market value of each of our notes represented by IDSs as $7.15, assuming an initial public offering price of $16.00 per IDS, which represents the mid-point of the range set forth on the cover page of this prospectus. By purchasing IDSs, you will agree to Table of Contents be bound by such allocation. If our allocation is not respected, it is possible that the notes will be treated as having been issued with OID (if the allocation to the notes is determined to be too high) or amortizable bond premium (if the allocation to the notes is determined to be too low). You generally would have to include OID in income in advance of the receipt of cash attributable to that income and would be able to elect to amortize bond premium over the term of the notes. Because of the deferral of interest provisions, the notes may be treated as issued with original issue discount. Under applicable Treasury regulations, a remote contingency that stated interest will not be timely paid will be ignored in determining whether a debt instrument is issued with OID. Although there is no authority directly on point, based on our financial forecasts and the fact that we have no present plan or intention to exercise our right to defer interest after , 2009, we believe that the likelihood of deferral of interest payments on the notes is remote within the meaning of the Treasury regulations. Based on the foregoing, although the matter is not free from doubt because of the lack of direct authority, we believe the notes will not be considered issued with OID at the time of their original issuance. If deferral of any payment of interest were determined not to be remote, or if the interest payment deferral actually occurred, the notes would be treated as issued with OID at the time of issuance or at the time of such occurrence, as the case may be. In that case, all stated interest on the notes would thereafter be treated as OID, and all holders, regardless of their method of tax accounting, would be required to include stated interest in income on a constant accrual basis. If we subsequently issue notes with significant original issue discount, we may not be able to deduct all of the interest on those notes. It is possible that notes we issue in a subsequent issuance will be issued at a discount to their face value and, accordingly, may have significant original issue discount and thus be classified as applicable high yield discount obligations, or AHYDOs. If any such notes were so treated, a portion of the OID on such notes could be nondeductible by us and the remainder would be deductible only when paid. This treatment would have the effect of increasing our taxable income and may adversely affect our cash flow available for interest payments and distributions to our equityholders. Subsequent issuances of notes pursuant to an offering by us or in connection with an exchange of Class B common stock may cause you to recognize original issue discount. The indenture governing our notes and agreements with DTC will provide that, in the event there is a subsequent issuance of notes with OID, and upon each subsequent issuance of notes thereafter, each holder of notes or IDSs, as the case may be, agrees that a portion of such holder s notes will be automatically exchanged for a portion of the notes acquired by the holders of such subsequently issued notes. Consequently, immediately following each such subsequent issuance and exchange, each holder of notes, held either as part of IDSs or separately, as the case may be, will own an inseparable unit composed of notes of each separate issuance in the same proportion as each other holder. However, the aggregate stated principal amount of notes owned by each holder will not change as a result of such subsequent issuance and exchange. We are not able to predict the likelihood that an automatic exchange would occur because we are unable to predict the selling price of any subsequent issuance of notes, and therefore whether the notes would be issued with OID. It is unclear whether the exchange of notes for subsequently issued notes will result in a taxable exchange for U.S. federal income tax purposes, and it is possible that the IRS might successfully assert that such an exchange should be treated as a taxable exchange. Regardless of whether the exchange is treated as a taxable event, such exchange may result in holders having to include OID in taxable income prior to the receipt of cash as described below, and may result in other potentially adverse tax consequences to holders. See Material U.S. Federal Income Tax Consequences Consequences to U.S. Holders Notes Additional Issuances. In addition, the potential amount of OID that would be required to be included in taxable income by holders as a result of an automatic exchange is indefinite and may be a significant amount, in part due to our ability to engage in numerous subsequent issuances. Table of Contents Following the subsequent issuance of notes with OID (or any issuance of notes thereafter) and resulting exchange, we (and our agents) will report any OID on the subsequently issued notes ratably among all holders of notes and IDSs, and each holder of notes or IDSs will, by purchasing notes or IDSs, agree to report OID in a manner consistent with this approach. However, the IRS may assert that any OID should be reported only to the persons that initially acquired such subsequently issued notes (and their transferees) and thus may challenge the holders reporting of OID on their tax returns. Such a challenge by the IRS could create significant uncertainties in the pricing of IDSs and notes and could adversely affect the market for IDSs and notes. For a discussion of these tax related risks, see Material U.S. Federal Income Tax Consequences. Holders of subsequently issued notes may not be able to collect their full stated principal amount prior to maturity. Under New York and federal bankruptcy law, holders of subsequently issued notes having OID (including the recipients of such notes pursuant to the automatic exchange under the indenture) may not be able to collect the portion of their principal amount that represents unaccrued OID in the event of an acceleration of the notes or our bankruptcy prior to the maturity date of the notes. As a result, an automatic exchange that results in a holder receiving an interest in notes with OID in exchange for notes that do not have OID could have the effect of ultimately reducing the amount such holder can recover from us in the event of an acceleration or bankruptcy to an amount that is less than the amount paid for the notes in this offering. If the IDSs separate, the limited liquidity of the market for the notes and Class A common stock may adversely affect your ability to sell the notes and Class A common stock. We do not intend to list the notes represented by the IDSs on any exchange or quotation system. Our shares of Class A common stock will be listed on the Toronto Stock Exchange, but holders of shares of Class A common stock will not be able to trade such shares on the Toronto Stock Exchange until the applicable requirements for separate trading are satisfied, including that a sufficient number of shares are held separately, not represented by IDSs, by a sufficient number of holders. Our Class A common stock will not initially be listed on any other exchange or quotation system, including the New York Stock Exchange. We will not apply to list our shares of Class A common stock for separate trading on the New York Stock Exchange or on any other exchange or quotation system on which the IDSs are then listed until a sufficient number of shares is held separately, not represented by IDSs, by a sufficient number of holders to satisfy applicable requirements for separate trading on such exchange or quotation system for 30 consecutive trading days. The Class A common stock may not be approved for listing at such time. Upon separation of the IDSs, no sizable market for the notes and the Class A common stock may ever develop and the liquidity of any trading market for the notes or the Class A common stock that does develop may be limited. As a result, your ability to sell your notes or Class A common stock, and the market price you can obtain, could be adversely affected. The limited liquidity of the trading market for the notes sold separately (not represented by IDSs) may adversely affect the trading price of the separate notes. We are separately selling $45.3 million aggregate principal amount of notes (not represented by IDSs), representing approximately 10.0% of the total outstanding notes (assuming the exchange of all outstanding Class B common stock for IDSs). While the notes sold separately (not represented by IDSs) are part of the same series of notes as, and identical to, the notes represented by IDSs at the time of the issuance of the separate notes, the notes represented by the IDSs will not be separable for at least 45 days and will not be separately tradeable until separated. As a result, the initial trading market for the notes sold separately (not represented by IDSs) will be very limited. Even after holders of the IDSs are permitted to separate their IDSs, a sufficient number of holders of IDSs may not separate their IDSs into shares of our Class A common stock and notes to create a sizable and more liquid trading market for the notes not represented by IDSs. Therefore, a liquid market for the separate notes may not develop, which may adversely affect the ability of the holders of the separate notes to sell any of their separate notes and the price at which these holders would be able to sell any of the notes sold separately. Table of Contents Prior to the completion of this offering, there was no public market for our IDSs, shares of our Class A common stock or notes which may cause the price of the IDSs or notes to fluctuate substantially and negatively affect the value of your investment. Our IDSs, the shares of our Class A common stock and the notes have no public market history in the United States or in Canada. In addition, there has not been an active market for securities similar to the IDSs. An active trading market for the IDSs or notes might not develop in the future, which may cause the price of the IDSs or notes to fluctuate substantially, and we currently do not expect that an active trading market for the shares of our Class A common stock will develop until the notes mature. If the notes represented by your IDSs mature or are redeemed pursuant to the terms of the indenture, the IDSs will be automatically separated and you will then hold the shares of our Class A common stock. If interest rates rise, the trading value of our IDSs and notes may decline. Should interest rates rise or should the threat of rising interest rates develop, debt markets may be adversely affected. As a result, the trading value of our IDSs and notes may decline. Future sales or the possibility of future sales of a substantial amount of IDSs, shares of our Class A common stock or our notes may depress the price of the IDSs, the shares of our Class A common stock and our notes. Future sales or the availability for sale of substantial amounts of IDSs or shares of our Class A common stock or a significant principal amount of our notes in the public market could adversely affect the prevailing market price of the IDSs, the shares of our Class A common stock and our notes and could impair our ability to raise capital through future sales of our securities. The holders of the 23,934,267 IDS and the 4,912,500 shares of Class B common stock exchangeable into IDSs that will be issued to our existing equity investors in the recapitalization in connection with this offering will have three demand and unlimited piggyback registration rights, which, if exercised, will allow them to sell their IDSs to the public. The registration rights may not be exercised during the lock-up period. See Underwriting. In addition, we may issue shares of our Class A common stock and notes, which may be represented by IDSs, or other securities from time to time as consideration for future acquisitions and investments. In the event any such acquisition or investment is significant, the number of shares of our Class A common stock and the aggregate principal amount of notes, which may be represented by IDSs, or the number or aggregate principal amount, as the case may be, of other securities that we may issue may in turn be significant. In addition, we may also grant registration rights covering those IDSs, shares of our Class A common stock, notes or other securities in connection with any such acquisitions and investments. Our organizational documents, Delaware laws and/or our indenture could limit another party s ability to acquire us and deprive our investors of the opportunity to obtain a takeover premium for their securities. A number of provisions in our amended and restated certificate of incorporation and amended and restated by- laws will make it difficult for another company to acquire us and for you to receive any related takeover premium for your securities. For example, our organizational documents provide that stockholders may not act by written consent and do not provide our stockholders with the power to call or to request that our board of directors call a special meeting. Our organizational documents authorize the issuance of preferred stock without stockholder approval and upon such terms as the board of directors may determine. The rights of the holders of shares of our Class A common stock will be subject to, and may be adversely affected by, the rights of holders of any class or series of preferred stock that may be issued in the future. We are also subject to Section 203 of the Delaware General Corporation Law, which restricts the ability of a publicly held Delaware corporation to engage Table of Contents in a business combination such as a merger or sale of assets with any stockholder who, together with affiliates, owns 15% or more of the corporation s voting stock. The restrictions imposed by Section 203 could prohibit or delay the accomplishment of an acquisition transaction, or discourage attempts to acquire us. In addition, the indenture governing the notes provides that the notes are not redeemable at our option until the seventh anniversary of the offering, and are redeemable thereafter at our option subject to the payment of certain premiums prior to , 2016. These provisions will effectively increase the cost to acquire us, especially prior to the seventh anniversary of the offering, because we or the acquiror would need to conduct a tender offer for the notes that would likely require payment of a significant premium. For additional details, see Description of Capital Stock Anti-Takeover Effects of Various Provisions of Delaware Law and Our Restated Certificate of Incorporation and Amended and Restated By-Laws, as well as provisions in our indenture. We may not be able to repurchase the notes upon a change of control. Upon the occurrence of certain change of control events, we will be required to offer to repurchase the outstanding notes at 101% of their principal amount at the date of repurchase unless such notes have been previously called for redemption. We may not have sufficient financial resources to purchase all of the notes that are tendered upon a change of control offer. Furthermore, our new credit facility, with certain limited exceptions, will prohibit the repurchase or redemption of the notes before their stated maturity. Consequently, lenders thereunder may have the right to prohibit any such purchase or redemption, in which event we will seek to obtain waivers from the required lenders. We may not be able to obtain such waivers or refinance our indebtedness on terms acceptable to us, or at all. Finally, the occurrence of a change of control could also constitute an event of default under our new credit facility, which could result in the acceleration of all amounts due thereunder. See Description of Notes Change of Control. Furthermore, we may enter into transactions which do not constitute a change of control as defined in the indenture governing the notes and which are otherwise permitted under the indenture governing the notes. Any such transactions would not give note holders the right to demand redemption of their notes and may have the effect of increasing the amount of indebtedness outstanding or otherwise affect our capital structure, credit ratings or the note holders. Our existing equity investors will retain an aggregate of approximately 50.6% of the voting power in us, and their interests may differ from your interests. Upon the completion of the transactions contemplated by this offering, Apax and our other existing equity investors, through their ownership of IDSs and Class B common stock, will collectively, own approximately 50.6% of the voting power in us, or approximately 43.2% of the voting power if the over-allotment option is exercised in full. If the over-allotment option is not exercised, our existing equity investors could, if they act together as a group, control our business, policies and affairs and will be able to elect our entire board of directors, determine, without consent of the holders of IDSs or Class A common stock, the outcome of any corporate transaction or other matter submitted to our stockholders for approval, including mergers, consolidations and sales of substantially all of our assets. They will also, if they act together, be able to prevent or cause a change of control of our company and/or an amendment to our certificate of incorporation and by-laws. We cannot assure you that the interests of Apax and our other existing equity investors will be consistent with the interests of other holders of IDSs, Class A common stock or notes. Even if the over-allotment option is not exercised or our existing equity investors do not act together as a group, this concentration of ownership could have the effect of delaying, deferring or preventing a change in control, merger or tender offer, which would deprive you of an opportunity to receive a premium for your IDSs and may negatively affect the market price of the IDSs. Moreover, Apax either alone or with other existing owners could effectively receive a premium for transferring ownership to third parties that would not inure to your benefit. Severance $ 70 $ 3,583 $ $ (1,885 ) $ 1,768 Facility costs 295 2,619 (1,356 ) (1,519 ) Table of Contents Furthermore, we expect that Apax will own approximately 37.7% of the voting power in us, or 31.8% if the over-allotment option is exercised, and will be our largest stockholder after the offering. As a result, Apax and its affiliates will have a strong ability to influence our business, policies and affairs. One representative of Apax will serve on our seven-member board of directors immediately after the offering, although Apax will have no contractual rights to nominate any directors. We cannot assure you that the interests of Apax will be consistent with the interests of other holders of IDSs, Class A common stock or notes. Risks Relating to our Business and the Industry Our industry is competitive and our future success will depend on our ability to effectively develop and market competitive products. The paper-making consumables industry is highly competitive. Some of our competitors are larger than us, have greater financial and other resources and are well-established as suppliers to the markets we serve. In addition, some of our competitors also manufacture paper-making machines and have the ability to initially package sales of their clothing and roll cover products with the sale of their machines and/or to tie the warranties on their machines to the use of their clothing and roll cover products. Our products may not be able to compete successfully with the products of our competitors, which could result in a loss of customers and, as a result, decreased revenues and profitability. We compete primarily based on the technology and performance of our products, including the ability of our products to help reduce our customers production costs and increase the quality of the paper they produce. Our competitors could develop new technology or products that lead to a reduced demand for our products. In addition, our business depends on our customers regularly needing to replace the clothing and roll covers used on their paper-making machines. Either we or our competitors could develop new technologies that increase the useful life of clothing or roll covers, which could reduce the frequency with which our customers would need to replace their clothing and refurbish or replace their roll covers, and consequently lead to fewer sales. Increased price competition in our industry could adversely affect our gross margins and revenues. We and our competitors have been able to sell clothing and roll covers products and services at favorable prices that reflect the value they deliver to customers. This favorable pricing has been particularly available for our more technically advanced products, such as forming fabrics, press felts and roll covers. If our competitors reduce the prices of such products, we may be required to decrease our prices to compete successfully, which could adversely affect our gross margins and revenues. Fluctuations in currency exchange rates could adversely affect our revenues and profitability. Our foreign operations expose us to fluctuations in currency exchange rates and currency devaluations. We report our financial results in US Dollars, but a substantial portion of our sales are denominated in Euros and other currencies. As a result, changes in the relative values of US Dollars, Euros and these other currencies will affect our levels of revenues and profitability. In particular, if the value of the US Dollar increases relative to the value of the Euro and these other currencies, our levels of revenue and profitability will decline since the translation of a certain number of Euros or units of such other currencies into US Dollars for financial reporting purposes will represent fewer US Dollars. In addition, in certain locations, our sales are denominated in US Dollars or Euros but a substantial portion of our associated costs are denominated in a different currency. As a result, changes in the relative values of US Dollars, Euros and any such different currency will affect our profitability. Fluctuations in currency exchange rates may cause volatility in our results of operations. Although in certain circumstances we attempt to hedge our exposure to fluctuations in currency exchange rates, our hedging strategies may not be effective. Interest and dividend payments on our IDSs and interest payments on our notes sold separately are to be paid in US Dollars. We do not expect to generate sufficient cash flows denominated in US Dollars to make such Table of Contents payments and will therefore rely, in part, on the conversion to US Dollars of cash flows generated in other currencies. After the completion of this offering, we will estimate the extent to which we will need to rely on cash flows denominated in foreign currencies in order to make interest payments on our notes and to pay dividends on our Class A common stock for the first year following this offering in accordance with the initial dividend policy adopted by our board of directors upon the closing of this offering, and we believe that we will be able to enter into fixed-rate currency contracts that will effectively fix the exchange rate applicable to such cash flows at the then current rate. There can be no assurance that these hedging transactions will be sufficient to enable us to pay interest on the notes and dividends on our Class A common stock in accordance with such initial dividend policy, in part because our actual results of operations and liquidity may differ from the estimates relied upon at the time we enter into the fixed rate currency contracts. In addition, our new credit facility contains requirements that we defer paying cash interest on the notes based upon certain financial tests and our new credit facility and the indenture governing our notes contain restrictions on our ability to pay dividends on our Class A common stock based upon certain financial tests. These financial tests depend in part upon our reported financial results, which as indicated above are directly affected by currency fluctuations. Except to the extent that the hedging transactions discussed above result in gains for financial reporting purposes that directly and fully offset any reductions in reported profitability attributable to currency fluctuations, we may be required by our new credit facility to defer the payment of cash interest on the notes or may be prohibited by the indenture governing our notes or the new credit facility from paying dividends on our Class A common stock. This result may be obtained even if our results of operations meet our expectations when viewed in local currencies. See Description of Certain Indebtedness New Credit Facility Restricted Payments, Description of Notes Certain Covenants and Dividend Policy and Restrictions. A sustained downturn in the paper industry could reduce our sales and adversely affect our revenues and profitability. Our ability to sell our products depends primarily on the volume of paper produced on a worldwide basis. The profitability of paper producers has historically been highly cyclical due to wide swings in the price of paper, and the paper industry is currently experiencing a period of lower prices that began in 2001. A sustained downturn in the paper industry could cause paper manufacturers to reduce production or cease operations, which could reduce our sales and adversely affect our revenues and profitability. A paradigm shift in the paper manufacturing industry or the demand for paper could adversely affect our revenues and profitability. Because our products are used on paper-making machines, a paradigm shift in the paper manufacturing industry or the demand for paper could materially reduce the demand for our products. For example, if someone were to develop a new paper production process that did not require clothing or roll covers, the demand for our products could decline or cease. In addition, many people have predicted a decrease in the global demand for paper due to the emergence of the so-called electronic office in which documents are stored electronically rather than in paper format. We cannot assure you that the demand for paper will continue to grow, or that the increased reliance on computers and the electronic storage of documents will not cause the demand for paper to decline. Any material decline in the worldwide demand for paper could cause a reduced demand for our products and ultimately adversely affect our revenues and profitability. We must continue to innovate and improve our products to maintain our competitive advantage and our use of cash to service our debt and pay dividends may limit our ability to do so. Our ability to maintain our customers and increase our business depends on our ability to continually develop new, technologically superior products. We cannot assure you that our investments in technological development will be sufficient, that we will be able to create and market new products or that we will be successful in competing against new technologies developed by competitors. In addition, after the offering, a substantial Table of Contents portion of our cash flow will be required to service our debt and we currently intend to pay quarterly dividends, which may use a significant portion of any remaining cash flow. If there is a sustained downturn in our business, our new capital structure following this offering may have the effect of reducing the amount of money available for investment in new technologies, products and manufacturing processes, which could ultimately affect our ability to remain competitive. Furthermore, members of our senior management may have an incentive to limit certain expenditures, including expenditures that may be necessary for us to remain competitive or to grow our business, because payments to them under our Long Term Incentive Plan are tied to the amount by which our EBITDA less capital expenditures, interest expense and cash income taxes, plus or minus certain working capital and other adjustments exceeds a target determined by our board of directors. See Management Long Term Incentive Plan. The loss of our major customers could have a material adverse effect on our sales and profitability. Our top ten customers generated 28% of our net sales during 2003. The loss of one or more of our major customers, or a substantial decrease in such customers purchases from us, could have a material adverse effect on our sales and profitability. Because we do not generally have binding long term purchasing agreements with our customers, there can be no assurance that our existing customers will continue to purchase products from us. Because we have substantial operations outside the United States, we are subject to the economic and political conditions of foreign nations. We have manufacturing facilities in 15 countries. In 2003, we sold products in approximately 61 countries other than the United States, which represented approximately 71% of our net sales. Our foreign operations are subject to a number of risks and uncertainties, including risks that: foreign governments may impose limitations on our ability to repatriate funds; foreign governments may impose withholding or other taxes on remittances and other payments to us, or the amount of any such taxes may increase; an outbreak or escalation of any insurrection or armed conflict may occur; or foreign governments may impose or increase investment barriers or other restrictions affecting our business. The occurrence of any of these conditions could disrupt our business in particular countries or regions of the world, or prevent us from conducting business in particular countries or regions, which could reduce our sales and affect our net sales and profitability. In addition, we will rely on dividends and other payments or distributions from our subsidiaries to meet our debt obligations and enable us to pay interest and dividends on the IDSs. If foreign governments impose limitations on our ability to repatriate funds or impose or increase taxes on remittances or other payments to us, the amount of dividends and other distributions we receive from our subsidiaries could be reduced, which could reduce the amount of cash available to us to meet our debt obligations and pay dividends. We may fail to adequately protect our proprietary technology, which would allow competitors or others to take advantage of our research and development efforts. We rely upon trade secrets, proprietary know-how, and continuing technological innovation to develop new products and remain competitive. If our competitors learn of our proprietary technology, they may use this information to produce products that are equivalent or superior to our products, which could reduce the sales of our products. Our employees, consultants, and corporate collaborators may breach their obligations not to reveal our confidential information, and any remedies available to us may be insufficient to compensate our damages. Even in the absence of such breaches, our trade secrets and proprietary know-how may otherwise become known to our competitors, or be independently discovered by our competitors, which could reduce our competitive position. We may be liable for product defects or other claims relating to our products. Our products could be defective, fail to perform as designed or otherwise cause harm to our customers, their equipment or their products. If our customers believe that they have suffered harm caused by our products, they 2001: Net sales $ 312,944 $ 186,902 $ $ $ 499,846 Depreciation and amortization (1) 35,842 33,423 362 69,627 Segment Earnings (Loss) 95,925 70,139 (13,732 ) Total assets 522,114 401,695 320,456 (355,272 ) 888,993 Capital expenditures 23,683 8,843 132 32,658 2002: Net sales $ 321,864 $ 193,081 $ 514,945 Depreciation and amortization (1) 31,617 15,584 378 47,579 Segment Earnings 103,062 69,503 449 Total assets 545,588 419,084 336,687 (376,083 ) 925,276 Capital expenditures 18,957 9,103 235 28,295 2003: Net sales $ 361,966 $ 198,702 $ 560,668 Depreciation and amortization (1) 32,387 15,627 221 48,235 Segment Earnings (Loss) 118,505 66,490 (10,471 ) Total assets 595,620 443,384 342,550 (394,748 ) 986,806 Capital expenditures 34,579 9,802 Table of Contents could bring claims against us that could result in significant liability. A failure of our products could cause substantial damage to a paper-making machine. Any claims brought against us by customers may result in: diversion of management s time and attention; expenditure of large amounts of cash on legal fees, expenses, and payment of damages; decreased demand for our products and services; and injury to our reputation. Our insurance may not sufficiently cover a large judgment against us or settlement payment, and is subject to customary deductibles, limits and exclusions. We could incur substantial costs as a result of violations of or liabilities under laws protecting the environment and human health. Our operations and facilities are subject to a number of national, state and local laws and regulations protecting the environment and human health in the United States and foreign countries that govern, among other things, the handling, storage and disposal of hazardous materials, discharges of pollutants into the air and water and workplace safety. We cannot assure you that we have been or will be at all times in complete compliance with such laws and regulations. We could incur substantial costs, including clean-up costs, fines and sanctions and third party property damage or personal injury claims, as a result of violations of or liabilities under environmental laws, relevant common law or the environmental permits required for our operations. We have been named as a defendant in lawsuits in the United States filed by persons alleging injuries caused by asbestos contained in clothing produced by other manufacturers. We may be required to spend a significant amount of money to defend against such claims. Adverse labor relations could harm our operations and reduce our profitability. We currently have approximately 4,000 employees, approximately 48% of whom are subject to protection of various collective bargaining agreements and approximately 22% of whom are subject to protection as members of trade unions, employee associations or workers councils. Approximately 64% of the employees subject to collective bargaining agreements (or approximately 31% of our total employees) are covered by collective bargaining agreements that expire prior to June 30, 2005. We cannot assure you that we will be able to renew such collective bargaining agreements, or enter into new collective bargaining agreements on the same or more favorable terms or at all and without production interruptions, including labor stoppages. In addition, approximately 41% of the employees subject to protection as members of trade unions, employer associations or workers councils (or approximately 9% of our total employees) are subject to arrangements that expire prior to June 30, 2005. We cannot assure you that the terms of employment applicable to such employees will remain the same or become more favorable. We cannot assure you that we will not experience disruptions in our operations as a result of labor disputes or experience other labor relations issues. If we are unable to maintain good relations with our employees, our ability to produce our products and provide services to our customers could be reduced and/or our production costs could increase, either of which could disrupt our business and reduce our profitability. If we are unable to successfully complete our current plant closure and cost reduction program, our revenues and profitability could decline. We are in the process of closing a significant clothing plant located in Virginia and transferring production to our other facilities. If we are unable to successfully transition our customers and production from this facility to our other facilities, we may not be able to retain these customers, or we may experience a loss of sales to such customers, which could adversely affect our revenues and profitability. Table of Contents
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+Table of Contents Following the subsequent issuance of notes with OID (or any issuance of notes thereafter) and resulting exchange, we (and our agents) will report any OID on the subsequently issued notes ratably among all holders of notes and IDSs, and each holder of notes or IDSs will, by purchasing notes or IDSs, agree to report OID in a manner consistent with this approach. However, the IRS may assert that any OID should be reported only to the persons that initially acquired such subsequently issued notes (and their transferees) and thus may challenge the holders reporting of OID on their tax returns. Such a challenge by the IRS could create significant uncertainties in the pricing of IDSs and notes and could adversely affect the market for IDSs and notes. For a discussion of these tax related risks, see Material U.S. Federal Income Tax Consequences. Holders of subsequently issued notes may not be able to collect their full stated principal amount prior to maturity. Under New York and federal bankruptcy law, holders of subsequently issued notes having OID (including the recipients of such notes pursuant to the automatic exchange under the indenture) may not be able to collect the portion of their principal amount that represents unaccrued OID in the event of an acceleration of the notes or our bankruptcy prior to the maturity date of the notes. As a result, an automatic exchange that results in a holder receiving an interest in notes with OID in exchange for notes that do not have OID could have the effect of ultimately reducing the amount such holder can recover from us in the event of an acceleration or bankruptcy to an amount that is less than the amount paid for the notes in this offering. If the IDSs separate, the limited liquidity of the market for the notes and Class A common stock may adversely affect your ability to sell the notes and Class A common stock. We do not intend to list the notes represented by the IDSs on any exchange or quotation system. Our shares of Class A common stock will be listed on the Toronto Stock Exchange, but holders of shares of Class A common stock will not be able to trade such shares on the Toronto Stock Exchange until the applicable requirements for separate trading are satisfied, including that a sufficient number of shares are held separately, not represented by IDSs, by a sufficient number of holders. Our Class A common stock will not initially be listed on any other exchange or quotation system, including the New York Stock Exchange. We will not apply to list our shares of Class A common stock for separate trading on the New York Stock Exchange or on any other exchange or quotation system on which the IDSs are then listed until a sufficient number of shares is held separately, not represented by IDSs, by a sufficient number of holders to satisfy applicable requirements for separate trading on such exchange or quotation system for 30 consecutive trading days. The Class A common stock may not be approved for listing at such time. Upon separation of the IDSs, no sizable market for the notes and the Class A common stock may ever develop and the liquidity of any trading market for the notes or the Class A common stock that does develop may be limited. As a result, your ability to sell your notes or Class A common stock, and the market price you can obtain, could be adversely affected. The limited liquidity of the trading market for the notes sold separately (not represented by IDSs) may adversely affect the trading price of the separate notes. We are separately selling $45.3 million aggregate principal amount of notes (not represented by IDSs), representing approximately 10.0% of the total outstanding notes (assuming the exchange of all outstanding Class B common stock for IDSs). While the notes sold separately (not represented by IDSs) are part of the same series of notes as, and identical to, the notes represented by IDSs at the time of the issuance of the separate notes, the notes represented by the IDSs will not be separable for at least 45 days and will not be separately tradeable until separated. As a result, the initial trading market for the notes sold separately (not represented by IDSs) will be very limited. Even after holders of the IDSs are permitted to separate their IDSs, a sufficient number of holders of IDSs may not separate their IDSs into shares of our Class A common stock and notes to create a sizable and more liquid trading market for the notes not represented by IDSs. Therefore, a liquid market for the separate notes may not develop, which may adversely affect the ability of the holders of the separate notes to sell any of their separate notes and the price at which these holders would be able to sell any of the notes sold separately. Table of Contents Required payments with respect to our indebtedness and payments pursuant to our dividend policy will reduce the amount of funds available for other corporate purposes, which could harm our competitiveness and/or limit opportunities to grow our business. Upon completion of this offering, we expect that the cash generated by our business in excess of operating needs, reserves for contingencies and capital expenditures (including an amount sufficient to maintain our operations, properties and other assets and a limited amount to finance growth opportunities) will be dedicated to the payment of the principal of and interest on our indebtedness and dividends on our common stock, thereby reducing funds available for other purposes, including research and development, additional capital expenditures and acquisitions. Accordingly, such interest and dividend payments may mean: we will have less funds available to devote to research and development, which could reduce our ability to develop new and innovative technologies and products and ultimately affect our ability to remain competitive; we will have less funds available for capital expenditures, which could inhibit our ability to invest in new or upgraded production equipment and other capabilities, thereby restricting efforts to improve our manufacturing processes, reduce our operating costs, expand product offerings and conduct business in new markets; and we will have reduced flexibility to finance growth opportunities such as acquisitions, which could limit or cause us to forego future opportunities to grow our business. We may be able to incur substantially more debt, which would increase the risks described above associated with our substantial leverage. We may be able to incur substantial additional indebtedness in the future. Specifically, the indenture governing the notes will permit us to incur additional debt, including issuances of additional notes under the indenture, unless our total leverage ratio exceeds 5.55:1. The indenture governing the notes will also permit us to incur other amounts of additional debt without regard to such total leverage ratio, including certain capitalized lease obligations, refinancing indebtedness, hedging obligations and issuances of additional notes in connection with the exercise of the underwriters over-allotment option or upon exchange of the shares of Class B common stock outstanding immediately following the completion of this offering. The new credit facility provides up to $100 million of borrowing from undrawn commitments under our revolving credit facility and for the incurrence of $20,000,000 of additional indebtedness with respect to capital leases and purchase money obligations, $15,000,000 of general additional indebtedness and certain other additional indebtedness. As of June 30, 2004, on a pro forma basis after giving effect to this offering and the related transactions contemplated by this prospectus, based on the covenants in the indenture governing the notes and our new credit facility, we would have had the ability to incur an additional $109.2 million aggregate principal amount of indebtedness, all of which could be senior indebtedness. Shortly following the completion of this offering, we expect to borrow approximately $40 million under our revolving credit facility to fund the legal reorganization of a portion of our international operations. For details regarding the circumstances under which we would be able to incur additional indebtedness, see Description of Certain Indebtedness New Credit Facility Covenants, Description of Notes Additional Notes and Description of Notes Certain Covenants Limitations on Incurrence of Indebtedness and Issuance of Disqualified Stock and Preferred Stock. Any additional indebtedness incurred by us could increase the risks associated with our substantial leverage. Table of Contents You may not receive any dividends. Dividend payments are not guaranteed and are within the absolute discretion of our board of directors. You may not receive any dividends as a result of any of the following factors: nothing requires us to pay dividends; while the dividend policy to be adopted by our board of directors upon the closing of this offering contemplates the distribution of our excess cash, up to the intended dividend rate set forth in Dividend Policy and Restrictions, our board of directors could modify or revoke the policy at any time and for any reason. The policy to distribute our excess cash is based upon our current assessment of the cash needs of our business and the environment in which it operates. That assessment could change due to, among other things, changes in our results of operations, cash requirements, financial condition, contractual restrictions, growth opportunities, competitive or technological developments, provisions of applicable law and other factors that our board of directors may deem relevant; even if the dividend policy is not modified or revoked, our board of directors could decide to reduce dividends or not to pay any dividends at all, at any time and for any reason; the amount of dividends distributed is subject to debt covenant restrictions under the indenture governing the notes and our new credit facility. In particular, we will be prohibited from paying dividends during any interest deferral period under the indenture or while any deferred interest (including interest on deferred interest) from a prior interest deferral period remains unpaid or if certain interest coverage and leverage ratios are not met; the amount of dividends distributed is subject to state law restrictions; our stockholders have no contractual or other legal right to dividends; and we may not have enough cash to pay dividends due to changes to our operating earnings, working capital requirements and anticipated cash needs. See Dividend Policy and Restrictions. The reduction or elimination of dividends may negatively affect the market price of the IDSs. The amount we expect to pay in dividends on our shares of Class A common stock in respect of the first year following the offering represents approximately 46% of the total distributions we expect to make to IDS holders in respect of the first year following the offering, including dividends on our shares of Class A common stock represented thereby and interest on our notes represented thereby. We may be required to make payments to our senior officers under our Long Term Incentive Plan even if we make no dividend payments, as the requirement to make payments under the Long Term Incentive Plan is tied to our financial performance and not to the level of dividend payments to holders of IDSs. See Management Long Term Incentive Plan. We may need to borrow funds to make our anticipated dividend payments, which could adversely affect our financial condition and/or reduce our ability to pay interest or dividends in the future. If we do not generate enough cash from our operations to pay dividends at the anticipated level, we may borrow funds to do so. Because our new credit facility and the indenture governing our notes each restrict the amount of indebtedness we are permitted to have outstanding, such borrowings would reduce the amount of money we would be able to borrow for other purposes, which could negatively impact our financial condition, our results of operations and our ability to maintain or expand our business. In addition, because any such borrowings would increase our debt and interest expense, our the leverage ratios would increase and our interest coverage ratios would decrease. An increase in the leverage ratios above the levels set forth in our new credit facility or a decrease in the interest coverage ratios below the levels set forth in the new credit facility or the indenture governing the notes would cause us to be prohibited from paying interest on the notes or dividends on our Class A common stock. If the offering and the related transactions had been completed on July 1, 2003 and we had wanted to pay dividends at the level anticipated after the offering, we would have needed to borrow approximately $15.3 million in the twelve month period ended June 30, 2004, given the actual levels of capital expenditures during such periods. Table of Contents We are subject to restrictive debt covenants that limit our business flexibility by imposing operating and financial restrictions on our operations. Although credit facilities of similarly situated borrowers customarily prohibit payments of dividends, our new credit facility will permit us, subject to certain restrictions, to pay dividends. Because the payment of dividends will decrease the amount of cash available to service our senior debt, the new credit facility will impose significant operating and financial restrictions on our operations that may be more restrictive than customary for credit facilities of similarly situated borrowers that prohibit or substantially limit payments of dividends. These restrictions imposed by our new credit facility, as described in detail under Description of Certain Indebtedness New Credit Facility, will prohibit or limit, among other things: the incurrence of additional indebtedness and the issuance of preferred stock and certain redeemable capital stock; investments and acquisitions; disposition of assets in subsidiary interests; transactions with affiliates; the creation of liens on our assets; consolidations, mergers and transfers of all or substantially all of our assets; and our ability to change the nature of our business. The terms of the new credit facility will include other restrictive covenants and prohibit us from prepaying our other indebtedness, including the notes, while indebtedness under the new credit facility is outstanding. These restrictions could limit our ability to obtain future financing, make acquisitions or needed capital expenditures, withstand downturns in our business or take advantage of business opportunities. Furthermore, the new credit facility also requires us to maintain specified financial ratios and satisfy financial condition tests, including a maximum senior leverage ratio, maximum total leverage ratio and minimum senior interest coverage ratio. Our ability to comply with the ratios or tests may be affected by events beyond our control, including prevailing economic, financial and industry conditions. A breach of any of these covenants, ratios or tests could result in a default under the new credit facility and/or the indenture. Upon the occurrence of an event of default under the new credit facility, the lenders could elect to declare all amounts outstanding under the new credit facility to be immediately due and payable. If the lenders accelerate the payment of the indebtedness under the new credit facility, our assets may not be sufficient to repay in full this indebtedness and our other indebtedness, including the notes. We are subject to significant restrictions on our ability to pay interest and dividends, and expect to continue to be subject to such restrictions. Our new credit facility will contain significant restrictions on our ability to pay interest on the notes and dividends on our common stock based on meeting a maximum senior leverage ratio, maximum total leverage ratio and minimum senior interest coverage ratio and compliance with other conditions (including timely delivery of applicable financial statements), as described in detail under Description of Certain Indebtedness New Credit Facility Restricted Payments. As a result of general economic conditions, conditions in the lending markets, the results of our business or for any other reason, we may elect or be required to amend or refinance our new credit facility, at or prior to maturity, or enter into additional agreements for senior indebtedness. Regardless of any protection you have in the indenture governing the notes, any such amendment, refinancing or additional agreement may contain covenants which could limit in a significant manner our ability to pay interest on the notes and/or dividends on our common stock. Table of Contents Our ability to pay dividends may reduce the amount of funds available to make payments on our debt. Both our new credit facility and the indenture governing our notes will permit us, subject to certain restrictions, to pay a significant portion of our cash flow to stockholders in the form of dividends on our common stock, including the Class A common stock represented by IDSs. Specifically, the indenture governing our notes permits us to pay dividends of up to 100% of our excess cash, as defined in the indenture, plus $45 million, subject to compliance with an interest coverage test, as more fully described under Description of Notes Certain Covenants. Our new credit facility permits us to use up to 100% of excess cash, as defined in the new credit facility with the same meaning as set forth in the indenture, plus $45 million, subject to compliance with senior interest coverage, senior leverage and total leverage tests to fund dividends on our shares of common stock, as more fully described under Description of Certain Indebtedness New Credit Facility Restricted Payments. Following completion of the offering, we intend to pay quarterly dividends. Holders of notes held separately from the IDSs may be adversely affected by such provisions because any amounts paid by us in the form of dividends will not be available in the future to satisfy our obligations under the notes. We may not be able to refinance our new credit facility at maturity on favorable terms or at all. The new credit facility will have a 4.5 year maturity except for that portion of the new term loan facility allocated to Canadian borrowers, which will have a 5 year maturity. We may not be able to renew or refinance the new credit facility, or if renewed or refinanced, the renewal or refinancing may occur on less favorable terms. In particular, our ability to defer interest on our notes is limited and such limitations may be viewed as favorable to the senior lenders, and at the time we seek to renew or refinance our new credit facility we may not have the same ability to defer interest on our notes that we will have immediately following completion of this offering. If we are unable to refinance or renew our new credit facility, our failure to repay all amounts due on the maturity date would cause a default under the new credit facility. In addition, our interest expense may increase significantly if we refinance our new credit facility on terms that are less favorable to us than the terms of our new credit facility, which could reduce the amount of funds available to make interest payments on the notes and pay dividends on our common stock, including the Class A common stock represented by IDSs. We will require a significant amount of cash, which may not be available to us, to service our debt, including the notes, and to fund our liquidity needs. Our ability to make payments on, refinance or repay our debt, including the notes, to fund planned capital expenditures or expand our business will depend largely upon our future operating performance. Our future operating performance is dependent upon our ability to execute our business strategy successfully. Such performance is also subject to general economic, financial and competitive factors, as well as other factors that are beyond our control. Assuming the transactions contemplated by this offering are completed on November 12, 2004, interest payments on our notes are scheduled to be approximately $58.1 million in 2005, interest payments on term loan borrowings under our new credit facility are scheduled to be approximately $3.7 million in 2004 and $26.4 million in 2005 and interest payments on revolver borrowings under our new credit facility are scheduled to be approximately $0.4 million in 2004 and $1.0 million in 2005, including approximately $0.3 million in 2004 and $0.7 million in 2005 associated with temporary borrowings to finance a planned legal reorganization of a portion of our international operations. See Dividend Policy and Restrictions Minimum Adjusted EBITDA. In addition, we estimate that interest payments under lines of credit in foreign countries that are used to facilitate short-term operating needs will be $0.2 million in 2004 and $1.2 million in 2005. If we are unable to generate sufficient cash to service our debt requirements, we will be required to refinance our new credit facility. If we are unable to refinance our debt or obtain new financing, we would have to consider other options, including: sales of assets to meet our debt service requirements; sales of equity; negotiations with our lenders to restructure the applicable debt; and Marketable equities 72 % 71 % Fixed income securities 28 Table of Contents and sole bookrunner. In this prospectus, we refer to this credit facility as the new credit facility. The new credit facility will consist of a revolving credit facility in an aggregate principal amount of up to $100 million (to be reduced to $50 million after the first anniversary of the closing date) and a $435 million term loan facility. While the new credit facility will permit us to pay interest and dividends to our security holders, including IDS holders, it will contain significant restrictions on our ability to make such interest and dividend payments. The new credit facility will have a 4.5 year maturity, except the portion of the term loan allocated to Canadian borrowers, which will have a 5 year maturity. See Description of Certain Indebtedness New Credit Facility. Our Existing Equity Investors We are an indirect, wholly-owned subsidiary of Xerium S.A. prior to this offering. Apax Europe IV GP, L.P., which, together with its affiliates, we refer to as Apax in this prospectus, is manager, directly or indirectly, of investment funds holding the majority of the outstanding common stock of Xerium S.A. Affiliates of CIBC World Markets Corp., the lead managing underwriter for this offering, own approximately 5.6% of the common stock of Xerium S.A. prior to this offering. We refer to CIBC World Markets Corp. as CIBC in this prospectus. Our senior management and certain other investors also own equity interests in Xerium S.A. We refer to Apax, CIBC and these other investors in Xerium S.A. as our existing equity investors in this prospectus. Xerium 3 S.A. is our direct parent company and, prior to our recapitalization and the offering, owns 100% of our capital stock. The Recapitalization and the Offering This offering consists of an offering by us of 28,125,000 IDSs, representing 28,125,000 shares of Class A common stock and $201.1 million aggregate principal amount of % senior subordinated notes due 2019, and an offering by us of $45.3 million aggregate principal amount of % senior subordinated notes due 2019 sold separately (not represented by IDSs). We refer to the % senior subordinated notes due 2019 (whether or not represented by IDSs) as the notes in this prospectus. The completion of the offering of the IDSs and the offering of the separate notes are conditioned on each other. Prior to the closing of this offering, our existing common stock, all of which is held by Xerium 3 S.A., will be reclassified as Class A common stock. In connection with the reclassification, the directors and members of our senior management who own equity interests in Xerium S.A. will exchange such interests for shares of our Class A common stock. The other existing equity investors will, through their ownership interests in Xerium S.A., continue to own all economic rights of the shares of Class A common stock held by Xerium 3 S.A. After the reclassification, and in connection with the offering, we will undergo a recapitalization in which all of the shares of Class A common stock held (directly or indirectly) by the existing equity investors will be exchanged for cash, IDSs and shares of Class B common stock, as described in the following table: Prior to the Offering Table of Contents seeking protection under the U.S. federal bankruptcy code or other applicable bankruptcy, insolvency or other applicable laws dealing with creditors rights generally. If we are forced to pursue any of the above options under distressed conditions, our business and/or the value of your investment in our IDSs and notes would be adversely affected. We are a holding company and rely on dividends, interest and other payments, advances and transfers of funds from our subsidiaries to meet our debt service and other obligations. We are a holding company and conduct all of our operations through our subsidiaries and currently have no significant assets other than the capital stock of our subsidiaries. As a result, we will rely on dividends, interest and other payments or distributions from our subsidiaries to meet our debt service obligations and enable us to pay interest and dividends. The ability of our subsidiaries to pay dividends or interest or make other payments or distributions to us will depend substantially on their respective operating results and will be subject to restrictions under, among other things, the laws of their jurisdiction of organization (which may limit the amount of funds available for the payment of dividends), agreements of those subsidiaries, the terms of the new credit facility and the covenants of any future outstanding indebtedness we or our subsidiaries incur. Interest on the notes may not be deductible by us for U.S. federal and applicable state income tax purposes, which could adversely affect our financial condition, significantly reduce our future cash flow and impact our ability to make interest and dividend payments. Our position that the notes should be treated as debt for U.S. federal income tax purposes may not be sustained if challenged by the IRS. If the notes were treated as equity rather than debt for U.S. federal and applicable state income tax purposes, then the stated interest on the notes could be treated as a dividend, and interest on the notes would not be deductible by us for U.S. federal and applicable state income tax purposes. Our inability to deduct interest on the notes on an on-going basis could materially increase our taxable income and, thus, our U.S. federal and applicable state income tax liability. In addition, to the extent any portion of our interest expense from prior years is determined not to be deductible, we could be required to pay a significant amount of additional income tax for such years, together with interest and possible penalties. Any increase in tax liabilities for prior or future periods as a result of a determination that interest on the notes is not deductible would materially and adversely affect our financial condition and our after-tax cash flow, which in turn would materially and adversely affect our ability to meet our obligations on the notes and to pay dividends. We do not expect to maintain any reserve in our financial statements for the possibility of there being a determination that interest on the notes would not be deductible for U.S. federal and applicable state income tax purposes. In addition, if a challenge to the deductibility of interest on the notes were to prevail, the amount, timing and character of any income, gain, or loss that you recognize in respect of your IDSs could be adversely affected. In the case of foreign holders, treatment of the notes as equity for U.S. federal income tax purposes would subject payments to such holders in respect of the notes to withholding or estate taxes in the same manner as payments made with regard to Class A common stock and could subject us to liability for withholding taxes that were not collected on payments of interest. Payments to foreign holders would not be grossed-up for any such taxes. For a discussion of these tax related risks, see Material U.S. Federal Income Tax Consequences. We may have to establish a reserve for contingent tax liabilities in the future, which could adversely affect our ability to make interest and dividend payments on the IDSs. Even if the IRS does not challenge the tax treatment of the notes, it is possible that as a result of a change in law relied upon at the time of issuance of the notes, we will in the future need to change our anticipated accounting treatment and establish a reserve for contingent tax liabilities associated with a disallowance of all or part of the interest deductions on the notes. If we were required to maintain such a reserve, our ability to make interest and dividend payments could be materially impaired and the market for the IDSs, Class A common stock and notes could be adversely affected. In addition, any resulting restatement of our financial statements could lead to defaults under our new credit facility. Table of Contents You will be immediately diluted by $16.65 per share of Class A common stock if you purchase IDSs in this offering. If you purchase IDSs in this offering, based on the book value of the assets and liabilities reflected on our balance sheet at June 30, 2004, you will experience an immediate dilution of $16.65 per share of Class A common stock represented by the IDSs (assuming all Class B common stock has been exchanged), which exceeds the entire price allocated to each share of Class A common stock represented by the IDSs in this offering because there will be a net tangible book deficit for each share of Class A common stock outstanding immediately after this offering. Our net tangible book deficit as of June 30, 2004, after giving effect to this offering, would have been approximately $444.2 million, or $7.80 per share of Class A common stock represented by IDSs (assuming all Class B common stock has been exchanged). Subject to certain limitations, we may defer interest on the notes at any time at our option if we reasonably believe it is necessary to avoid a default under our senior indebtedness. If we defer interest, we will not be permitted to make any payment of dividends so long as any deferred interest or interest on deferred interest remains outstanding. Prior to , 2009, we may, subject to certain limitations set forth in the indenture governing the notes, defer interest payments on the notes on one or more occasions for eight quarters in the aggregate if we reasonably believe such deferral is necessary to avoid a default under our senior indebtedness. After , 2009, we may, subject to certain limitations set forth in the indenture governing the notes, defer interest payment on up to four occasions for up to two quarters per occasion if we reasonably believe such deferral is necessary to avoid a default under our senior indebtedness provided that we may not defer additional interest until all previously deferred interest has been paid in full. After the end of any interest deferral period occurring before , 2009, deferred interest, together with any accrued interest thereon, will be required to be repaid on , 2009. Consequently, you may be owed a substantial amount of deferred interest that will not be due and payable until such date. All interest deferred after , 2009, together with any accrued interest thereon, must be repaid on or before maturity. Consequently, you may be owed a substantial amount of deferred interest that will not be due and payable until such date. During any interest deferral period and so long as any deferred interest or interest on deferred interest remains outstanding, we will not be permitted to make any payment of dividends with respect to shares of common stock. Deferral of interest payments would have adverse tax consequences for you by causing you to recognize interest income and pay taxes before you receive any cash payment of such interest, and may adversely affect the trading price of the IDSs or the separately held notes. If interest payments on the notes are deferred, the notes will be treated as issued with OID at the time of such occurrence. As a result, you will be required to recognize interest income for U.S. federal income tax purposes in respect of the notes represented by the IDSs or the separately held notes, as the case may be, held by you before you receive any cash payment of this interest. See Material U.S. Federal Income Tax Consequences Consequences to U.S. Holders Notes Deferral of Interest. In addition, you will not receive any cash payment with respect to the accrued interest if you sell the IDSs or the notes, as the case may be, before the record date relating to interest payments that are to be paid. If interest is deferred, the IDSs or separately held notes may trade at a price that does not fully reflect the value of accrued but unpaid interest on the notes. In addition, the existence of the right to defer payments of interest on the notes under certain circumstances may mean that the market price for the IDSs or separately held notes may be more volatile than other securities that do not have such provisions. The realizable value of our assets upon liquidation may be insufficient to satisfy claims. At June 30, 2004, our assets included intangible assets in the amount of approximately $332 million, representing approximately 34% of our total consolidated assets and consisting primarily of goodwill (the excess of the Table of Contents The Recapitalization and the Offering Table of Contents acquisition cost over the fair market value of the net assets acquired in purchase transactions). The value of these intangible assets will continue to depend significantly upon the success of our business as a going concern and the growth in cash flows. As a result, in the event of a default under our new credit facility or on our notes or any bankruptcy or dissolution of our Company, the realizable value of these assets may be substantially lower and may be insufficient to satisfy the claims of our creditors, including holders of notes. Claims of holders of the notes and the guarantees will be structurally subordinated to claims of creditors of our non-guarantor subsidiaries. We are a holding company and conduct all of our operations through our subsidiaries. Certain of our subsidiaries will not be guarantors of the notes. As a result, no payments are required to be made to us from the assets of these subsidiaries. Claims of holders of the notes and the guarantees will be structurally subordinated to the indebtedness and other liabilities and commitments of our non-guarantor subsidiaries. The ability of our creditors, including the holders of the notes, to participate in the assets of any of our non-guarantor subsidiaries upon any bankruptcy, liquidation or reorganization or similar proceeding of any such entity will be subject to the prior claims of that entity s creditors, including trade creditors, and any prior or equal claim of any other equity holder. In addition, the ability of our creditors, including the holders of our notes, to participate in distributions of assets of our non-guarantor subsidiaries will be limited to the extent that the outstanding shares of any of our subsidiaries are either pledged to secure other creditors (including lenders under our new credit facility) or are not owned by us. Our non-guarantor subsidiaries accounted for approximately 53% of our net sales in 2003 and, as of December 31, 2003, they held approximately 53% of our total consolidated assets. For the six months ended June 30, 2004, such non-guarantor subsidiaries accounted for approximately 52% of our net sales and, as of June 30, 2004, they held approximately 53% of our total consolidated assets. See Note 17 of the audited consolidated financial statements included elsewhere in this prospectus and Note 13 of the accompanying unaudited consolidated financial statements included elsewhere in this prospectus. Your right to receive payments on the notes and the guarantees is junior to all of our senior debt and the senior debt of our subsidiaries. The notes and the related guarantees will be unsecured senior subordinated obligations, junior in right of payment to all of our senior debt and the senior debt of each subsidiary guarantor, respectively. As a result of the subordinated nature of our notes and the related guarantees, upon any distribution to our creditors or the creditors of the subsidiary guarantors in bankruptcy, liquidation or reorganization or similar proceedings relating to us or the subsidiary guarantors or our or their property or assets, the holders of such entities senior indebtedness will be entitled to be paid in full in cash before any payment may be made with respect to the notes or the subsidiary guarantees (and before any distribution may be made by our subsidiaries to us). In the event of a bankruptcy, liquidation or reorganization or similar proceeding relating to us or the subsidiary guarantors, the subordinated noteholders would participate in available distributions with other holders of unsecured senior subordinated indebtedness after the payment in full of all senior indebtedness. In any of these cases, we and our subsidiary guarantors may not have sufficient funds to pay all of our creditors and the holders of the notes may receive less, ratably than the holders of our senior indebtedness or the senior indebtedness of our subsidiary guarantors. Furthermore, because of the existence of subordination provisions, including the obligation to turn over distributions to holders of our senior indebtedness or the senior indebtedness of our subsidiary guarantors, the holders of notes may receive less, ratably, than holders of trade payables and other general unsecured indebtedness. In such event we and the guarantors would not be able to make all principal payments on the notes. The subordination provisions of the indenture will also provide that payments to you under the notes will be prohibited while a payment default exists under designated senior indebtedness or if such designated senior indebtedness has been accelerated. In addition, these payments to you may be blocked for up to 179 days by holders of designated senior indebtedness if a default other than a payment default exists under such senior IDSs to be issued to the existing equity investors in connection with the recapitalization and the offering 23,934,267 (1) Shares of Class B common stock to be issued to the existing equity investors in connection with the recapitalization and the offering 4,912,500 shares Cash to be paid to the existing equity investors in connection with the recapitalization and the offering $ 62,613,390 Voting power held by the existing equity investors after the recapitalization and the offering (includes Class A common stock represented by IDSs and Class B common stock and assumes no exercise of the underwriters over-allotment option to purchase additional IDSs) 50.6 % Table of Contents indebtedness. During any period in which payments to you are prohibited or blocked in this manner, any amounts received by you with respect to the notes or guarantees, including as a result of any legal action to enforce the notes or guarantees, would be required to be turned over to the holders of senior indebtedness. As of June 30, 2004, on a pro forma basis after giving effect to the transactions contemplated by this prospectus: Xerium Technologies, Inc. would have had $302.6 million aggregate principal amount of senior indebtedness outstanding, all of which would have been senior secured indebtedness to which the notes would be junior in right of payment; Xerium Technologies, Inc. would have had an additional $417.5 million aggregate principal amount of indebtedness outstanding, consisting exclusively of the notes; our subsidiary guarantors would have had $69.4 million aggregate principal amount of senior indebtedness outstanding, all of which would have been senior secured indebtedness to which the guarantees of the notes would be junior in right of payment; our subsidiary guarantors would have had $72.8 million aggregate principal amount of other indebtedness outstanding, including trade payables, all of which would have ranked pari passu with the guarantees, except as discussed in Risk Factors Risks Related to Capital Structure and Description of Notes Ranking ; and our non-guarantor subsidiaries would have had $172.1 million aggregate principal amount of indebtedness outstanding, including trade payables, to which the notes and the guarantees would be structurally subordinated. In addition, as of June 30, 2004, on a pro forma basis after giving effect to the transactions contemplated by this prospectus, based on the covenants in the indenture and our new credit facility, we would have had the ability to incur an additional $109.2 million aggregate principal amount of indebtedness, all of which could be senior in right of payment to the notes. Shortly after the completion of this offering we expect to borrow approximately $40 million under our revolving credit facility to fund the legal reorganization of a portion of our international operations. The validity and enforceability of the notes and the guarantees of the notes by our subsidiaries may be limited by fraudulent conveyance laws and foreign laws restricting guarantees. Our obligations under the notes will be guaranteed by certain of our subsidiaries, including our domestic subsidiaries organized under Delaware law and our foreign subsidiaries organized under the laws of Australia, Canada, Japan, Mexico and the United Kingdom. These guarantees provide the holders of the notes with a direct claim against the assets of the subsidiary guarantors. The offering of the notes and the guarantees of the notes by certain of our subsidiaries may be subject to legal challenge and review based on various laws and defenses relating to fraudulent conveyance or transfer, voidable preferences, financial assistance, corporate purpose, capital maintenance, the payment of legally sufficient consideration and other laws and defenses affecting the rights of creditors generally. The laws of various foreign jurisdictions, including the jurisdictions in which the subsidiary guarantors are organized and those in which the subsidiary guarantors own assets or otherwise conduct business, may be applicable to the notes and the guarantees. Accordingly, we cannot assure you that a third party creditor or bankruptcy trustee would not challenge the notes or one or more of these subsidiary guarantees in court and prevail in whole or in part. Although laws differ among various jurisdictions, in general, under fraudulent conveyance or transfer laws, a court could void or subordinate the notes or the guarantees issued by our subsidiaries if it found that: we or the subsidiary guarantors intended to hinder, delay or defraud our creditors; we or the subsidiary guarantors knew or should have known that the transactions were to the detriment of our creditors; Table of Contents the transactions had the effect of giving a preference to one creditor or class of creditors over another; or we or the subsidiary guarantors did not receive fair consideration and reasonably equivalent value for incurring such indebtedness or guarantee obligations and we or the subsidiary guarantors (i) were insolvent or rendered insolvent by reason of the incurrence of such indebtedness or obligations, (ii) were engaged or about to engage in a business or transaction for which our or the subsidiary guarantors remaining assets constituted unreasonably insufficient capital or (iii) intended to incur, or believed that we or the subsidiary guarantors would incur, debts beyond our or their ability to pay as they mature. The measure of insolvency for purposes of fraudulent transfer laws varies depending on the law applied. Generally, however, an entity would be considered insolvent if: the sum of its debts, including contingent liabilities, was greater than the fair saleable value of all of its assets; the present fair saleable value of its assets was less than the amount that would be required to pay its existing debts and liabilities, including contingent liabilities, as they become absolute and mature; or it could not or would not pay its debts as they become due. We cannot assure you that a court would reach the conclusion that, upon the issuance of the notes and the subsidiary guarantees, we and each of the subsidiary guarantors will be solvent, will have sufficient capital to carry on our business and will be able to pay our debts as they mature. If a court were to find that the issuance of the notes or a subsidiary guarantee was a fraudulent conveyance or transfer or constituted an illegal preference, the court could void the payment obligations under the notes or the guarantee, further subordinate the notes or the subsidiary guarantee to presently existing and future indebtedness of ours or the subsidiary guarantor, or require the holders of the notes to repay any amounts received with respect to the notes or guarantee. The guarantees issued by certain of our foreign subsidiaries will contain language limiting the amount of debt guaranteed so that applicable local law restrictions will not be violated, although there can be no assurance that such limitation is enforceable. As a result, a subsidiary s liability under its guarantee could be materially reduced or eliminated depending on the amount of its other obligations and the effect of applicable laws. In particular, in certain jurisdictions, a guarantee that is not in the guarantor s corporate interest or the burden of which exceeds the benefit to the guarantor may not be valid and enforceable. It is possible that a creditor of a subsidiary guarantor, or a bankruptcy trustee in the case of a bankruptcy of a subsidiary guarantor, may contest the validity or enforceability of the subsidiary s guarantee of the notes and that a court may determine that the guarantee should be limited or voided. To the extent that any subsidiary guarantee is determined to be void or unenforceable, or the agreed limitations on the guaranteed obligations become applicable, the notes would not have a claim under the guarantee and would accordingly be effectively subordinated to all other liabilities of the applicable subsidiary. Although the insolvency laws of the jurisdiction of incorporation of the respective subsidiaries would most likely apply to the insolvency of the relevant subsidiary, a subsidiary could conceivably enter into an insolvency procedure in another jurisdiction. Therefore, the validity and enforceability of the subsidiary guarantees may be affected by the insolvency, administration and other laws of various foreign jurisdictions, including the jurisdictions in which the subsidiary guarantors are organized and those in which the subsidiary guarantors own assets or otherwise conduct business. The laws of these jurisdictions are in many cases materially different from, and conflict with each other and with the laws of the United States, including in the areas of bankruptcy, creditors rights, fraudulent transfers, priority of governmental and other creditors, ability to obtain post petition interest, duration of proceeding and preference periods. For example, in the United Kingdom an administrator or liquidator of a company may apply to the court for an order to recover preferred payments made to creditors within certain periods prior to a company s insolvency only in circumstances where it can be shown that the insolvent entity was, among other factors, motivated by a desire to put the creditor in a better position than it would have been in an insolvency proceeding. However, in a U.S. bankruptcy proceeding, a debtor or its trustee in bankruptcy may recover sums paid to creditors within a 90 day period prior to bankruptcy irrespective of the Table of Contents motivation for such payments. The application of these and other similar laws, and any conflict between laws of various jurisdictions, could call into question whether, and to what extent, the laws of any particular jurisdiction should apply, which may adversely affect your ability to enforce your rights under the guarantees of the notes by our subsidiaries in these jurisdictions or limit any amounts that you may receive. You may have difficulty effecting service of process upon our foreign subsidiary guarantors and/or our directors and executive officers who reside outside of the United States. Several of the subsidiary guarantors are organized under laws outside of the United States and certain of our directors and officers reside outside of the United States. In addition, a substantial portion of the assets of such guarantors and our directors and officers are located outside of the United States. As a result, it may be difficult for holders of our securities to effect service of process upon the guarantors or such directors or officers within the United States or to enforce against them the United States judgments of courts of the United States predicated upon the civil liability provisions of the United States federal securities laws or other laws of the United States. In addition, we have been advised by legal counsel in certain foreign jurisdictions that there is doubt as to the enforcement in such jurisdictions of liabilities predicated upon United States federal securities laws against our guarantors and our directors and executive officers who are not residents of the United States, in original actions or in actions for enforcements of judgments of U.S. courts. In the event of bankruptcy or insolvency, the notes and guarantees could be adversely affected by principles of equitable subordination or recharacterization, which may eliminate your ability to recover any amounts owed on the notes or require you to return any prior payments you received on the notes. In the event of bankruptcy or insolvency, a party in interest may seek to subordinate the notes or the guarantees under principles of equitable subordination or to recharacterize the notes as equity. There can be no assurance as to the outcome of such proceedings. In the event a court subordinates the notes or the guarantees, or recharacterizes the notes as equity, we cannot assure you that you would recover any amounts owed on the notes or the guarantees and you may be required to return any payments made to you on account of the notes or guarantees within six years before the bankruptcy. In addition, should the court equitably subordinate the notes or the guarantees, or recharacterize the notes as equity, you may not be able to enforce the notes or the guarantees. While generally speaking, equitable subordination would require a showing of inequitable conduct on the part of the lender, under certain circumstances, courts have recognized the potential for so-called no-fault equitable subordination; that is, equitable subordination without the necessity to show inequitable conduct. This doctrine has mainly been employed to subordinate tax and penalties claims, punitive damage claims and claims relating to stock redemption/repurchase obligations. As such, even absent a finding of inequitable conduct, it is possible that a court could conclude that the debt represented by the notes represented by IDSs should be equitably subordinated to the extent such notes were originally issued in exchange for equity. The notes represented by IDSs to be issued to our existing equity investors in connection with the recapitalization and the offering, as described in The Transactions The Recapitalization and the Offering and Related Party Transactions Proceeds from the Recapitalization and the Offering, will be issued in exchange for equity. To the extent that particular notes can be traced to notes represented by IDSs that were issued to our existing equity investors in connection with the recapitalization and the offering, such notes could be subject to a no-fault equitable subordination claim. The allocation of the purchase price of the IDSs may not be respected. The purchase price of each IDS must be allocated among the underlying shares of Class A common stock and notes in proportion to their respective fair market values at the time of purchase. We expect to report the initial fair market value of each share of Class A common stock as $8.85 and the initial fair market value of each of our notes represented by IDSs as $7.15, assuming an initial public offering price of $16.00 per IDS, which represents the mid-point of the range set forth on the cover page of this prospectus. By purchasing IDSs, you will agree to Table of Contents be bound by such allocation. If our allocation is not respected, it is possible that the notes will be treated as having been issued with OID (if the allocation to the notes is determined to be too high) or amortizable bond premium (if the allocation to the notes is determined to be too low). You generally would have to include OID in income in advance of the receipt of cash attributable to that income and would be able to elect to amortize bond premium over the term of the notes. Because of the deferral of interest provisions, the notes may be treated as issued with original issue discount. Under applicable Treasury regulations, a remote contingency that stated interest will not be timely paid will be ignored in determining whether a debt instrument is issued with OID. Although there is no authority directly on point, based on our financial forecasts and the fact that we have no present plan or intention to exercise our right to defer interest after , 2009, we believe that the likelihood of deferral of interest payments on the notes is remote within the meaning of the Treasury regulations. Based on the foregoing, although the matter is not free from doubt because of the lack of direct authority, we believe the notes will not be considered issued with OID at the time of their original issuance. If deferral of any payment of interest were determined not to be remote, or if the interest payment deferral actually occurred, the notes would be treated as issued with OID at the time of issuance or at the time of such occurrence, as the case may be. In that case, all stated interest on the notes would thereafter be treated as OID, and all holders, regardless of their method of tax accounting, would be required to include stated interest in income on a constant accrual basis. If we subsequently issue notes with significant original issue discount, we may not be able to deduct all of the interest on those notes. It is possible that notes we issue in a subsequent issuance will be issued at a discount to their face value and, accordingly, may have significant original issue discount and thus be classified as applicable high yield discount obligations, or AHYDOs. If any such notes were so treated, a portion of the OID on such notes could be nondeductible by us and the remainder would be deductible only when paid. This treatment would have the effect of increasing our taxable income and may adversely affect our cash flow available for interest payments and distributions to our equityholders. Subsequent issuances of notes pursuant to an offering by us or in connection with an exchange of Class B common stock may cause you to recognize original issue discount. The indenture governing our notes and agreements with DTC will provide that, in the event there is a subsequent issuance of notes with OID, and upon each subsequent issuance of notes thereafter, each holder of notes or IDSs, as the case may be, agrees that a portion of such holder s notes will be automatically exchanged for a portion of the notes acquired by the holders of such subsequently issued notes. Consequently, immediately following each such subsequent issuance and exchange, each holder of notes, held either as part of IDSs or separately, as the case may be, will own an inseparable unit composed of notes of each separate issuance in the same proportion as each other holder. However, the aggregate stated principal amount of notes owned by each holder will not change as a result of such subsequent issuance and exchange. We are not able to predict the likelihood that an automatic exchange would occur because we are unable to predict the selling price of any subsequent issuance of notes, and therefore whether the notes would be issued with OID. It is unclear whether the exchange of notes for subsequently issued notes will result in a taxable exchange for U.S. federal income tax purposes, and it is possible that the IRS might successfully assert that such an exchange should be treated as a taxable exchange. Regardless of whether the exchange is treated as a taxable event, such exchange may result in holders having to include OID in taxable income prior to the receipt of cash as described below, and may result in other potentially adverse tax consequences to holders. See Material U.S. Federal Income Tax Consequences Consequences to U.S. Holders Notes Additional Issuances. In addition, the potential amount of OID that would be required to be included in taxable income by holders as a result of an automatic exchange is indefinite and may be a significant amount, in part due to our ability to engage in numerous subsequent issuances. Table of Contents Following the subsequent issuance of notes with OID (or any issuance of notes thereafter) and resulting exchange, we (and our agents) will report any OID on the subsequently issued notes ratably among all holders of notes and IDSs, and each holder of notes or IDSs will, by purchasing notes or IDSs, agree to report OID in a manner consistent with this approach. However, the IRS may assert that any OID should be reported only to the persons that initially acquired such subsequently issued notes (and their transferees) and thus may challenge the holders reporting of OID on their tax returns. Such a challenge by the IRS could create significant uncertainties in the pricing of IDSs and notes and could adversely affect the market for IDSs and notes. For a discussion of these tax related risks, see Material U.S. Federal Income Tax Consequences. Holders of subsequently issued notes may not be able to collect their full stated principal amount prior to maturity. Under New York and federal bankruptcy law, holders of subsequently issued notes having OID (including the recipients of such notes pursuant to the automatic exchange under the indenture) may not be able to collect the portion of their principal amount that represents unaccrued OID in the event of an acceleration of the notes or our bankruptcy prior to the maturity date of the notes. As a result, an automatic exchange that results in a holder receiving an interest in notes with OID in exchange for notes that do not have OID could have the effect of ultimately reducing the amount such holder can recover from us in the event of an acceleration or bankruptcy to an amount that is less than the amount paid for the notes in this offering. If the IDSs separate, the limited liquidity of the market for the notes and Class A common stock may adversely affect your ability to sell the notes and Class A common stock. We do not intend to list the notes represented by the IDSs on any exchange or quotation system. Our shares of Class A common stock will be listed on the Toronto Stock Exchange, but holders of shares of Class A common stock will not be able to trade such shares on the Toronto Stock Exchange until the applicable requirements for separate trading are satisfied, including that a sufficient number of shares are held separately, not represented by IDSs, by a sufficient number of holders. Our Class A common stock will not initially be listed on any other exchange or quotation system, including the New York Stock Exchange. We will not apply to list our shares of Class A common stock for separate trading on the New York Stock Exchange or on any other exchange or quotation system on which the IDSs are then listed until a sufficient number of shares is held separately, not represented by IDSs, by a sufficient number of holders to satisfy applicable requirements for separate trading on such exchange or quotation system for 30 consecutive trading days. The Class A common stock may not be approved for listing at such time. Upon separation of the IDSs, no sizable market for the notes and the Class A common stock may ever develop and the liquidity of any trading market for the notes or the Class A common stock that does develop may be limited. As a result, your ability to sell your notes or Class A common stock, and the market price you can obtain, could be adversely affected. The limited liquidity of the trading market for the notes sold separately (not represented by IDSs) may adversely affect the trading price of the separate notes. We are separately selling $45.3 million aggregate principal amount of notes (not represented by IDSs), representing approximately 10.0% of the total outstanding notes (assuming the exchange of all outstanding Class B common stock for IDSs). While the notes sold separately (not represented by IDSs) are part of the same series of notes as, and identical to, the notes represented by IDSs at the time of the issuance of the separate notes, the notes represented by the IDSs will not be separable for at least 45 days and will not be separately tradeable until separated. As a result, the initial trading market for the notes sold separately (not represented by IDSs) will be very limited. Even after holders of the IDSs are permitted to separate their IDSs, a sufficient number of holders of IDSs may not separate their IDSs into shares of our Class A common stock and notes to create a sizable and more liquid trading market for the notes not represented by IDSs. Therefore, a liquid market for the separate notes may not develop, which may adversely affect the ability of the holders of the separate notes to sell any of their separate notes and the price at which these holders would be able to sell any of the notes sold separately. Table of Contents Prior to the completion of this offering, there was no public market for our IDSs, shares of our Class A common stock or notes which may cause the price of the IDSs or notes to fluctuate substantially and negatively affect the value of your investment. Our IDSs, the shares of our Class A common stock and the notes have no public market history in the United States or in Canada. In addition, there has not been an active market for securities similar to the IDSs. An active trading market for the IDSs or notes might not develop in the future, which may cause the price of the IDSs or notes to fluctuate substantially, and we currently do not expect that an active trading market for the shares of our Class A common stock will develop until the notes mature. If the notes represented by your IDSs mature or are redeemed pursuant to the terms of the indenture, the IDSs will be automatically separated and you will then hold the shares of our Class A common stock. If interest rates rise, the trading value of our IDSs and notes may decline. Should interest rates rise or should the threat of rising interest rates develop, debt markets may be adversely affected. As a result, the trading value of our IDSs and notes may decline. Future sales or the possibility of future sales of a substantial amount of IDSs, shares of our Class A common stock or our notes may depress the price of the IDSs, the shares of our Class A common stock and our notes. Future sales or the availability for sale of substantial amounts of IDSs or shares of our Class A common stock or a significant principal amount of our notes in the public market could adversely affect the prevailing market price of the IDSs, the shares of our Class A common stock and our notes and could impair our ability to raise capital through future sales of our securities. The holders of the 23,934,267 IDS and the 4,912,500 shares of Class B common stock exchangeable into IDSs that will be issued to our existing equity investors in the recapitalization in connection with this offering will have three demand and unlimited piggyback registration rights, which, if exercised, will allow them to sell their IDSs to the public. The registration rights may not be exercised during the lock-up period. See Underwriting. In addition, we may issue shares of our Class A common stock and notes, which may be represented by IDSs, or other securities from time to time as consideration for future acquisitions and investments. In the event any such acquisition or investment is significant, the number of shares of our Class A common stock and the aggregate principal amount of notes, which may be represented by IDSs, or the number or aggregate principal amount, as the case may be, of other securities that we may issue may in turn be significant. In addition, we may also grant registration rights covering those IDSs, shares of our Class A common stock, notes or other securities in connection with any such acquisitions and investments. Our organizational documents, Delaware laws and/or our indenture could limit another party s ability to acquire us and deprive our investors of the opportunity to obtain a takeover premium for their securities. A number of provisions in our amended and restated certificate of incorporation and amended and restated by- laws will make it difficult for another company to acquire us and for you to receive any related takeover premium for your securities. For example, our organizational documents provide that stockholders may not act by written consent and do not provide our stockholders with the power to call or to request that our board of directors call a special meeting. Our organizational documents authorize the issuance of preferred stock without stockholder approval and upon such terms as the board of directors may determine. The rights of the holders of shares of our Class A common stock will be subject to, and may be adversely affected by, the rights of holders of any class or series of preferred stock that may be issued in the future. We are also subject to Section 203 of the Delaware General Corporation Law, which restricts the ability of a publicly held Delaware corporation to engage Table of Contents in a business combination such as a merger or sale of assets with any stockholder who, together with affiliates, owns 15% or more of the corporation s voting stock. The restrictions imposed by Section 203 could prohibit or delay the accomplishment of an acquisition transaction, or discourage attempts to acquire us. In addition, the indenture governing the notes provides that the notes are not redeemable at our option until the seventh anniversary of the offering, and are redeemable thereafter at our option subject to the payment of certain premiums prior to , 2016. These provisions will effectively increase the cost to acquire us, especially prior to the seventh anniversary of the offering, because we or the acquiror would need to conduct a tender offer for the notes that would likely require payment of a significant premium. For additional details, see Description of Capital Stock Anti-Takeover Effects of Various Provisions of Delaware Law and Our Restated Certificate of Incorporation and Amended and Restated By-Laws, as well as provisions in our indenture. We may not be able to repurchase the notes upon a change of control. Upon the occurrence of certain change of control events, we will be required to offer to repurchase the outstanding notes at 101% of their principal amount at the date of repurchase unless such notes have been previously called for redemption. We may not have sufficient financial resources to purchase all of the notes that are tendered upon a change of control offer. Furthermore, our new credit facility, with certain limited exceptions, will prohibit the repurchase or redemption of the notes before their stated maturity. Consequently, lenders thereunder may have the right to prohibit any such purchase or redemption, in which event we will seek to obtain waivers from the required lenders. We may not be able to obtain such waivers or refinance our indebtedness on terms acceptable to us, or at all. Finally, the occurrence of a change of control could also constitute an event of default under our new credit facility, which could result in the acceleration of all amounts due thereunder. See Description of Notes Change of Control. Furthermore, we may enter into transactions which do not constitute a change of control as defined in the indenture governing the notes and which are otherwise permitted under the indenture governing the notes. Any such transactions would not give note holders the right to demand redemption of their notes and may have the effect of increasing the amount of indebtedness outstanding or otherwise affect our capital structure, credit ratings or the note holders. Our existing equity investors will retain an aggregate of approximately 50.6% of the voting power in us, and their interests may differ from your interests. Upon the completion of the transactions contemplated by this offering, Apax and our other existing equity investors, through their ownership of IDSs and Class B common stock, will collectively, own approximately 50.6% of the voting power in us, or approximately 43.2% of the voting power if the over-allotment option is exercised in full. If the over-allotment option is not exercised, our existing equity investors could, if they act together as a group, control our business, policies and affairs and will be able to elect our entire board of directors, determine, without consent of the holders of IDSs or Class A common stock, the outcome of any corporate transaction or other matter submitted to our stockholders for approval, including mergers, consolidations and sales of substantially all of our assets. They will also, if they act together, be able to prevent or cause a change of control of our company and/or an amendment to our certificate of incorporation and by-laws. We cannot assure you that the interests of Apax and our other existing equity investors will be consistent with the interests of other holders of IDSs, Class A common stock or notes. Even if the over-allotment option is not exercised or our existing equity investors do not act together as a group, this concentration of ownership could have the effect of delaying, deferring or preventing a change in control, merger or tender offer, which would deprive you of an opportunity to receive a premium for your IDSs and may negatively affect the market price of the IDSs. Moreover, Apax either alone or with other existing owners could effectively receive a premium for transferring ownership to third parties that would not inure to your benefit. Severance $ 70 $ 3,583 $ $ (1,885 ) $ 1,768 Facility costs 295 2,619 (1,356 ) (1,519 ) Table of Contents Furthermore, we expect that Apax will own approximately 37.7% of the voting power in us, or 31.8% if the over-allotment option is exercised, and will be our largest stockholder after the offering. As a result, Apax and its affiliates will have a strong ability to influence our business, policies and affairs. One representative of Apax will serve on our seven-member board of directors immediately after the offering, although Apax will have no contractual rights to nominate any directors. We cannot assure you that the interests of Apax will be consistent with the interests of other holders of IDSs, Class A common stock or notes. Risks Relating to our Business and the Industry Our industry is competitive and our future success will depend on our ability to effectively develop and market competitive products. The paper-making consumables industry is highly competitive. Some of our competitors are larger than us, have greater financial and other resources and are well-established as suppliers to the markets we serve. In addition, some of our competitors also manufacture paper-making machines and have the ability to initially package sales of their clothing and roll cover products with the sale of their machines and/or to tie the warranties on their machines to the use of their clothing and roll cover products. Our products may not be able to compete successfully with the products of our competitors, which could result in a loss of customers and, as a result, decreased revenues and profitability. We compete primarily based on the technology and performance of our products, including the ability of our products to help reduce our customers production costs and increase the quality of the paper they produce. Our competitors could develop new technology or products that lead to a reduced demand for our products. In addition, our business depends on our customers regularly needing to replace the clothing and roll covers used on their paper-making machines. Either we or our competitors could develop new technologies that increase the useful life of clothing or roll covers, which could reduce the frequency with which our customers would need to replace their clothing and refurbish or replace their roll covers, and consequently lead to fewer sales. Increased price competition in our industry could adversely affect our gross margins and revenues. We and our competitors have been able to sell clothing and roll covers products and services at favorable prices that reflect the value they deliver to customers. This favorable pricing has been particularly available for our more technically advanced products, such as forming fabrics, press felts and roll covers. If our competitors reduce the prices of such products, we may be required to decrease our prices to compete successfully, which could adversely affect our gross margins and revenues. Fluctuations in currency exchange rates could adversely affect our revenues and profitability. Our foreign operations expose us to fluctuations in currency exchange rates and currency devaluations. We report our financial results in US Dollars, but a substantial portion of our sales are denominated in Euros and other currencies. As a result, changes in the relative values of US Dollars, Euros and these other currencies will affect our levels of revenues and profitability. In particular, if the value of the US Dollar increases relative to the value of the Euro and these other currencies, our levels of revenue and profitability will decline since the translation of a certain number of Euros or units of such other currencies into US Dollars for financial reporting purposes will represent fewer US Dollars. In addition, in certain locations, our sales are denominated in US Dollars or Euros but a substantial portion of our associated costs are denominated in a different currency. As a result, changes in the relative values of US Dollars, Euros and any such different currency will affect our profitability. Fluctuations in currency exchange rates may cause volatility in our results of operations. Although in certain circumstances we attempt to hedge our exposure to fluctuations in currency exchange rates, our hedging strategies may not be effective. Interest and dividend payments on our IDSs and interest payments on our notes sold separately are to be paid in US Dollars. We do not expect to generate sufficient cash flows denominated in US Dollars to make such Table of Contents payments and will therefore rely, in part, on the conversion to US Dollars of cash flows generated in other currencies. After the completion of this offering, we will estimate the extent to which we will need to rely on cash flows denominated in foreign currencies in order to make interest payments on our notes and to pay dividends on our Class A common stock for the first year following this offering in accordance with the initial dividend policy adopted by our board of directors upon the closing of this offering, and we believe that we will be able to enter into fixed-rate currency contracts that will effectively fix the exchange rate applicable to such cash flows at the then current rate. There can be no assurance that these hedging transactions will be sufficient to enable us to pay interest on the notes and dividends on our Class A common stock in accordance with such initial dividend policy, in part because our actual results of operations and liquidity may differ from the estimates relied upon at the time we enter into the fixed rate currency contracts. In addition, our new credit facility contains requirements that we defer paying cash interest on the notes based upon certain financial tests and our new credit facility and the indenture governing our notes contain restrictions on our ability to pay dividends on our Class A common stock based upon certain financial tests. These financial tests depend in part upon our reported financial results, which as indicated above are directly affected by currency fluctuations. Except to the extent that the hedging transactions discussed above result in gains for financial reporting purposes that directly and fully offset any reductions in reported profitability attributable to currency fluctuations, we may be required by our new credit facility to defer the payment of cash interest on the notes or may be prohibited by the indenture governing our notes or the new credit facility from paying dividends on our Class A common stock. This result may be obtained even if our results of operations meet our expectations when viewed in local currencies. See Description of Certain Indebtedness New Credit Facility Restricted Payments, Description of Notes Certain Covenants and Dividend Policy and Restrictions. A sustained downturn in the paper industry could reduce our sales and adversely affect our revenues and profitability. Our ability to sell our products depends primarily on the volume of paper produced on a worldwide basis. The profitability of paper producers has historically been highly cyclical due to wide swings in the price of paper, and the paper industry is currently experiencing a period of lower prices that began in 2001. A sustained downturn in the paper industry could cause paper manufacturers to reduce production or cease operations, which could reduce our sales and adversely affect our revenues and profitability. A paradigm shift in the paper manufacturing industry or the demand for paper could adversely affect our revenues and profitability. Because our products are used on paper-making machines, a paradigm shift in the paper manufacturing industry or the demand for paper could materially reduce the demand for our products. For example, if someone were to develop a new paper production process that did not require clothing or roll covers, the demand for our products could decline or cease. In addition, many people have predicted a decrease in the global demand for paper due to the emergence of the so-called electronic office in which documents are stored electronically rather than in paper format. We cannot assure you that the demand for paper will continue to grow, or that the increased reliance on computers and the electronic storage of documents will not cause the demand for paper to decline. Any material decline in the worldwide demand for paper could cause a reduced demand for our products and ultimately adversely affect our revenues and profitability. We must continue to innovate and improve our products to maintain our competitive advantage and our use of cash to service our debt and pay dividends may limit our ability to do so. Our ability to maintain our customers and increase our business depends on our ability to continually develop new, technologically superior products. We cannot assure you that our investments in technological development will be sufficient, that we will be able to create and market new products or that we will be successful in competing against new technologies developed by competitors. In addition, after the offering, a substantial Table of Contents portion of our cash flow will be required to service our debt and we currently intend to pay quarterly dividends, which may use a significant portion of any remaining cash flow. If there is a sustained downturn in our business, our new capital structure following this offering may have the effect of reducing the amount of money available for investment in new technologies, products and manufacturing processes, which could ultimately affect our ability to remain competitive. Furthermore, members of our senior management may have an incentive to limit certain expenditures, including expenditures that may be necessary for us to remain competitive or to grow our business, because payments to them under our Long Term Incentive Plan are tied to the amount by which our EBITDA less capital expenditures, interest expense and cash income taxes, plus or minus certain working capital and other adjustments exceeds a target determined by our board of directors. See Management Long Term Incentive Plan. The loss of our major customers could have a material adverse effect on our sales and profitability. Our top ten customers generated 28% of our net sales during 2003. The loss of one or more of our major customers, or a substantial decrease in such customers purchases from us, could have a material adverse effect on our sales and profitability. Because we do not generally have binding long term purchasing agreements with our customers, there can be no assurance that our existing customers will continue to purchase products from us. Because we have substantial operations outside the United States, we are subject to the economic and political conditions of foreign nations. We have manufacturing facilities in 15 countries. In 2003, we sold products in approximately 61 countries other than the United States, which represented approximately 71% of our net sales. Our foreign operations are subject to a number of risks and uncertainties, including risks that: foreign governments may impose limitations on our ability to repatriate funds; foreign governments may impose withholding or other taxes on remittances and other payments to us, or the amount of any such taxes may increase; an outbreak or escalation of any insurrection or armed conflict may occur; or foreign governments may impose or increase investment barriers or other restrictions affecting our business. The occurrence of any of these conditions could disrupt our business in particular countries or regions of the world, or prevent us from conducting business in particular countries or regions, which could reduce our sales and affect our net sales and profitability. In addition, we will rely on dividends and other payments or distributions from our subsidiaries to meet our debt obligations and enable us to pay interest and dividends on the IDSs. If foreign governments impose limitations on our ability to repatriate funds or impose or increase taxes on remittances or other payments to us, the amount of dividends and other distributions we receive from our subsidiaries could be reduced, which could reduce the amount of cash available to us to meet our debt obligations and pay dividends. We may fail to adequately protect our proprietary technology, which would allow competitors or others to take advantage of our research and development efforts. We rely upon trade secrets, proprietary know-how, and continuing technological innovation to develop new products and remain competitive. If our competitors learn of our proprietary technology, they may use this information to produce products that are equivalent or superior to our products, which could reduce the sales of our products. Our employees, consultants, and corporate collaborators may breach their obligations not to reveal our confidential information, and any remedies available to us may be insufficient to compensate our damages. Even in the absence of such breaches, our trade secrets and proprietary know-how may otherwise become known to our competitors, or be independently discovered by our competitors, which could reduce our competitive position. We may be liable for product defects or other claims relating to our products. Our products could be defective, fail to perform as designed or otherwise cause harm to our customers, their equipment or their products. If our customers believe that they have suffered harm caused by our products, they 2001: Net sales $ 312,944 $ 186,902 $ $ $ 499,846 Depreciation and amortization (1) 35,842 33,423 362 69,627 Segment Earnings (Loss) 95,925 70,139 (13,732 ) Total assets 522,114 401,695 320,456 (355,272 ) 888,993 Capital expenditures 23,683 8,843 132 32,658 2002: Net sales $ 321,864 $ 193,081 $ 514,945 Depreciation and amortization (1) 31,617 15,584 378 47,579 Segment Earnings 103,062 69,503 449 Total assets 545,588 419,084 336,687 (376,083 ) 925,276 Capital expenditures 18,957 9,103 235 28,295 2003: Net sales $ 361,966 $ 198,702 $ 560,668 Depreciation and amortization (1) 32,387 15,627 221 48,235 Segment Earnings (Loss) 118,505 66,490 (10,471 ) Total assets 595,620 443,384 342,550 (394,748 ) 986,806 Capital expenditures 34,579 9,802 Table of Contents could bring claims against us that could result in significant liability. A failure of our products could cause substantial damage to a paper-making machine. Any claims brought against us by customers may result in: diversion of management s time and attention; expenditure of large amounts of cash on legal fees, expenses, and payment of damages; decreased demand for our products and services; and injury to our reputation. Our insurance may not sufficiently cover a large judgment against us or settlement payment, and is subject to customary deductibles, limits and exclusions. We could incur substantial costs as a result of violations of or liabilities under laws protecting the environment and human health. Our operations and facilities are subject to a number of national, state and local laws and regulations protecting the environment and human health in the United States and foreign countries that govern, among other things, the handling, storage and disposal of hazardous materials, discharges of pollutants into the air and water and workplace safety. We cannot assure you that we have been or will be at all times in complete compliance with such laws and regulations. We could incur substantial costs, including clean-up costs, fines and sanctions and third party property damage or personal injury claims, as a result of violations of or liabilities under environmental laws, relevant common law or the environmental permits required for our operations. We have been named as a defendant in lawsuits in the United States filed by persons alleging injuries caused by asbestos contained in clothing produced by other manufacturers. We may be required to spend a significant amount of money to defend against such claims. Adverse labor relations could harm our operations and reduce our profitability. We currently have approximately 4,000 employees, approximately 48% of whom are subject to protection of various collective bargaining agreements and approximately 22% of whom are subject to protection as members of trade unions, employee associations or workers councils. Approximately 64% of the employees subject to collective bargaining agreements (or approximately 31% of our total employees) are covered by collective bargaining agreements that expire prior to June 30, 2005. We cannot assure you that we will be able to renew such collective bargaining agreements, or enter into new collective bargaining agreements on the same or more favorable terms or at all and without production interruptions, including labor stoppages. In addition, approximately 41% of the employees subject to protection as members of trade unions, employer associations or workers councils (or approximately 9% of our total employees) are subject to arrangements that expire prior to June 30, 2005. We cannot assure you that the terms of employment applicable to such employees will remain the same or become more favorable. We cannot assure you that we will not experience disruptions in our operations as a result of labor disputes or experience other labor relations issues. If we are unable to maintain good relations with our employees, our ability to produce our products and provide services to our customers could be reduced and/or our production costs could increase, either of which could disrupt our business and reduce our profitability. If we are unable to successfully complete our current plant closure and cost reduction program, our revenues and profitability could decline. We are in the process of closing a significant clothing plant located in Virginia and transferring production to our other facilities. If we are unable to successfully transition our customers and production from this facility to our other facilities, we may not be able to retain these customers, or we may experience a loss of sales to such customers, which could adversely affect our revenues and profitability. Table of Contents
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+Table of Contents Following the subsequent issuance of notes with OID (or any issuance of notes thereafter) and resulting exchange, we (and our agents) will report any OID on the subsequently issued notes ratably among all holders of notes and IDSs, and each holder of notes or IDSs will, by purchasing notes or IDSs, agree to report OID in a manner consistent with this approach. However, the IRS may assert that any OID should be reported only to the persons that initially acquired such subsequently issued notes (and their transferees) and thus may challenge the holders reporting of OID on their tax returns. Such a challenge by the IRS could create significant uncertainties in the pricing of IDSs and notes and could adversely affect the market for IDSs and notes. For a discussion of these tax related risks, see Material U.S. Federal Income Tax Consequences. Holders of subsequently issued notes may not be able to collect their full stated principal amount prior to maturity. Under New York and federal bankruptcy law, holders of subsequently issued notes having OID (including the recipients of such notes pursuant to the automatic exchange under the indenture) may not be able to collect the portion of their principal amount that represents unaccrued OID in the event of an acceleration of the notes or our bankruptcy prior to the maturity date of the notes. As a result, an automatic exchange that results in a holder receiving an interest in notes with OID in exchange for notes that do not have OID could have the effect of ultimately reducing the amount such holder can recover from us in the event of an acceleration or bankruptcy to an amount that is less than the amount paid for the notes in this offering. If the IDSs separate, the limited liquidity of the market for the notes and Class A common stock may adversely affect your ability to sell the notes and Class A common stock. We do not intend to list the notes represented by the IDSs on any exchange or quotation system. Our shares of Class A common stock will be listed on the Toronto Stock Exchange, but holders of shares of Class A common stock will not be able to trade such shares on the Toronto Stock Exchange until the applicable requirements for separate trading are satisfied, including that a sufficient number of shares are held separately, not represented by IDSs, by a sufficient number of holders. Our Class A common stock will not initially be listed on any other exchange or quotation system, including the New York Stock Exchange. We will not apply to list our shares of Class A common stock for separate trading on the New York Stock Exchange or on any other exchange or quotation system on which the IDSs are then listed until a sufficient number of shares is held separately, not represented by IDSs, by a sufficient number of holders to satisfy applicable requirements for separate trading on such exchange or quotation system for 30 consecutive trading days. The Class A common stock may not be approved for listing at such time. Upon separation of the IDSs, no sizable market for the notes and the Class A common stock may ever develop and the liquidity of any trading market for the notes or the Class A common stock that does develop may be limited. As a result, your ability to sell your notes or Class A common stock, and the market price you can obtain, could be adversely affected. The limited liquidity of the trading market for the notes sold separately (not represented by IDSs) may adversely affect the trading price of the separate notes. We are separately selling $45.3 million aggregate principal amount of notes (not represented by IDSs), representing approximately 10.0% of the total outstanding notes (assuming the exchange of all outstanding Class B common stock for IDSs). While the notes sold separately (not represented by IDSs) are part of the same series of notes as, and identical to, the notes represented by IDSs at the time of the issuance of the separate notes, the notes represented by the IDSs will not be separable for at least 45 days and will not be separately tradeable until separated. As a result, the initial trading market for the notes sold separately (not represented by IDSs) will be very limited. Even after holders of the IDSs are permitted to separate their IDSs, a sufficient number of holders of IDSs may not separate their IDSs into shares of our Class A common stock and notes to create a sizable and more liquid trading market for the notes not represented by IDSs. Therefore, a liquid market for the separate notes may not develop, which may adversely affect the ability of the holders of the separate notes to sell any of their separate notes and the price at which these holders would be able to sell any of the notes sold separately. Table of Contents Required payments with respect to our indebtedness and payments pursuant to our dividend policy will reduce the amount of funds available for other corporate purposes, which could harm our competitiveness and/or limit opportunities to grow our business. Upon completion of this offering, we expect that the cash generated by our business in excess of operating needs, reserves for contingencies and capital expenditures (including an amount sufficient to maintain our operations, properties and other assets and a limited amount to finance growth opportunities) will be dedicated to the payment of the principal of and interest on our indebtedness and dividends on our common stock, thereby reducing funds available for other purposes, including research and development, additional capital expenditures and acquisitions. Accordingly, such interest and dividend payments may mean: we will have less funds available to devote to research and development, which could reduce our ability to develop new and innovative technologies and products and ultimately affect our ability to remain competitive; we will have less funds available for capital expenditures, which could inhibit our ability to invest in new or upgraded production equipment and other capabilities, thereby restricting efforts to improve our manufacturing processes, reduce our operating costs, expand product offerings and conduct business in new markets; and we will have reduced flexibility to finance growth opportunities such as acquisitions, which could limit or cause us to forego future opportunities to grow our business. We may be able to incur substantially more debt, which would increase the risks described above associated with our substantial leverage. We may be able to incur substantial additional indebtedness in the future. Specifically, the indenture governing the notes will permit us to incur additional debt, including issuances of additional notes under the indenture, unless our total leverage ratio exceeds 5.55:1. The indenture governing the notes will also permit us to incur other amounts of additional debt without regard to such total leverage ratio, including certain capitalized lease obligations, refinancing indebtedness, hedging obligations and issuances of additional notes in connection with the exercise of the underwriters over-allotment option or upon exchange of the shares of Class B common stock outstanding immediately following the completion of this offering. The new credit facility provides up to $100 million of borrowing from undrawn commitments under our revolving credit facility and for the incurrence of $20,000,000 of additional indebtedness with respect to capital leases and purchase money obligations, $15,000,000 of general additional indebtedness and certain other additional indebtedness. As of June 30, 2004, on a pro forma basis after giving effect to this offering and the related transactions contemplated by this prospectus, based on the covenants in the indenture governing the notes and our new credit facility, we would have had the ability to incur an additional $109.2 million aggregate principal amount of indebtedness, all of which could be senior indebtedness. Shortly following the completion of this offering, we expect to borrow approximately $40 million under our revolving credit facility to fund the legal reorganization of a portion of our international operations. For details regarding the circumstances under which we would be able to incur additional indebtedness, see Description of Certain Indebtedness New Credit Facility Covenants, Description of Notes Additional Notes and Description of Notes Certain Covenants Limitations on Incurrence of Indebtedness and Issuance of Disqualified Stock and Preferred Stock. Any additional indebtedness incurred by us could increase the risks associated with our substantial leverage. Table of Contents You may not receive any dividends. Dividend payments are not guaranteed and are within the absolute discretion of our board of directors. You may not receive any dividends as a result of any of the following factors: nothing requires us to pay dividends; while the dividend policy to be adopted by our board of directors upon the closing of this offering contemplates the distribution of our excess cash, up to the intended dividend rate set forth in Dividend Policy and Restrictions, our board of directors could modify or revoke the policy at any time and for any reason. The policy to distribute our excess cash is based upon our current assessment of the cash needs of our business and the environment in which it operates. That assessment could change due to, among other things, changes in our results of operations, cash requirements, financial condition, contractual restrictions, growth opportunities, competitive or technological developments, provisions of applicable law and other factors that our board of directors may deem relevant; even if the dividend policy is not modified or revoked, our board of directors could decide to reduce dividends or not to pay any dividends at all, at any time and for any reason; the amount of dividends distributed is subject to debt covenant restrictions under the indenture governing the notes and our new credit facility. In particular, we will be prohibited from paying dividends during any interest deferral period under the indenture or while any deferred interest (including interest on deferred interest) from a prior interest deferral period remains unpaid or if certain interest coverage and leverage ratios are not met; the amount of dividends distributed is subject to state law restrictions; our stockholders have no contractual or other legal right to dividends; and we may not have enough cash to pay dividends due to changes to our operating earnings, working capital requirements and anticipated cash needs. See Dividend Policy and Restrictions. The reduction or elimination of dividends may negatively affect the market price of the IDSs. The amount we expect to pay in dividends on our shares of Class A common stock in respect of the first year following the offering represents approximately 46% of the total distributions we expect to make to IDS holders in respect of the first year following the offering, including dividends on our shares of Class A common stock represented thereby and interest on our notes represented thereby. We may be required to make payments to our senior officers under our Long Term Incentive Plan even if we make no dividend payments, as the requirement to make payments under the Long Term Incentive Plan is tied to our financial performance and not to the level of dividend payments to holders of IDSs. See Management Long Term Incentive Plan. We may need to borrow funds to make our anticipated dividend payments, which could adversely affect our financial condition and/or reduce our ability to pay interest or dividends in the future. If we do not generate enough cash from our operations to pay dividends at the anticipated level, we may borrow funds to do so. Because our new credit facility and the indenture governing our notes each restrict the amount of indebtedness we are permitted to have outstanding, such borrowings would reduce the amount of money we would be able to borrow for other purposes, which could negatively impact our financial condition, our results of operations and our ability to maintain or expand our business. In addition, because any such borrowings would increase our debt and interest expense, our the leverage ratios would increase and our interest coverage ratios would decrease. An increase in the leverage ratios above the levels set forth in our new credit facility or a decrease in the interest coverage ratios below the levels set forth in the new credit facility or the indenture governing the notes would cause us to be prohibited from paying interest on the notes or dividends on our Class A common stock. If the offering and the related transactions had been completed on July 1, 2003 and we had wanted to pay dividends at the level anticipated after the offering, we would have needed to borrow approximately $15.3 million in the twelve month period ended June 30, 2004, given the actual levels of capital expenditures during such periods. Table of Contents We are subject to restrictive debt covenants that limit our business flexibility by imposing operating and financial restrictions on our operations. Although credit facilities of similarly situated borrowers customarily prohibit payments of dividends, our new credit facility will permit us, subject to certain restrictions, to pay dividends. Because the payment of dividends will decrease the amount of cash available to service our senior debt, the new credit facility will impose significant operating and financial restrictions on our operations that may be more restrictive than customary for credit facilities of similarly situated borrowers that prohibit or substantially limit payments of dividends. These restrictions imposed by our new credit facility, as described in detail under Description of Certain Indebtedness New Credit Facility, will prohibit or limit, among other things: the incurrence of additional indebtedness and the issuance of preferred stock and certain redeemable capital stock; investments and acquisitions; disposition of assets in subsidiary interests; transactions with affiliates; the creation of liens on our assets; consolidations, mergers and transfers of all or substantially all of our assets; and our ability to change the nature of our business. The terms of the new credit facility will include other restrictive covenants and prohibit us from prepaying our other indebtedness, including the notes, while indebtedness under the new credit facility is outstanding. These restrictions could limit our ability to obtain future financing, make acquisitions or needed capital expenditures, withstand downturns in our business or take advantage of business opportunities. Furthermore, the new credit facility also requires us to maintain specified financial ratios and satisfy financial condition tests, including a maximum senior leverage ratio, maximum total leverage ratio and minimum senior interest coverage ratio. Our ability to comply with the ratios or tests may be affected by events beyond our control, including prevailing economic, financial and industry conditions. A breach of any of these covenants, ratios or tests could result in a default under the new credit facility and/or the indenture. Upon the occurrence of an event of default under the new credit facility, the lenders could elect to declare all amounts outstanding under the new credit facility to be immediately due and payable. If the lenders accelerate the payment of the indebtedness under the new credit facility, our assets may not be sufficient to repay in full this indebtedness and our other indebtedness, including the notes. We are subject to significant restrictions on our ability to pay interest and dividends, and expect to continue to be subject to such restrictions. Our new credit facility will contain significant restrictions on our ability to pay interest on the notes and dividends on our common stock based on meeting a maximum senior leverage ratio, maximum total leverage ratio and minimum senior interest coverage ratio and compliance with other conditions (including timely delivery of applicable financial statements), as described in detail under Description of Certain Indebtedness New Credit Facility Restricted Payments. As a result of general economic conditions, conditions in the lending markets, the results of our business or for any other reason, we may elect or be required to amend or refinance our new credit facility, at or prior to maturity, or enter into additional agreements for senior indebtedness. Regardless of any protection you have in the indenture governing the notes, any such amendment, refinancing or additional agreement may contain covenants which could limit in a significant manner our ability to pay interest on the notes and/or dividends on our common stock. Table of Contents Our ability to pay dividends may reduce the amount of funds available to make payments on our debt. Both our new credit facility and the indenture governing our notes will permit us, subject to certain restrictions, to pay a significant portion of our cash flow to stockholders in the form of dividends on our common stock, including the Class A common stock represented by IDSs. Specifically, the indenture governing our notes permits us to pay dividends of up to 100% of our excess cash, as defined in the indenture, plus $45 million, subject to compliance with an interest coverage test, as more fully described under Description of Notes Certain Covenants. Our new credit facility permits us to use up to 100% of excess cash, as defined in the new credit facility with the same meaning as set forth in the indenture, plus $45 million, subject to compliance with senior interest coverage, senior leverage and total leverage tests to fund dividends on our shares of common stock, as more fully described under Description of Certain Indebtedness New Credit Facility Restricted Payments. Following completion of the offering, we intend to pay quarterly dividends. Holders of notes held separately from the IDSs may be adversely affected by such provisions because any amounts paid by us in the form of dividends will not be available in the future to satisfy our obligations under the notes. We may not be able to refinance our new credit facility at maturity on favorable terms or at all. The new credit facility will have a 4.5 year maturity except for that portion of the new term loan facility allocated to Canadian borrowers, which will have a 5 year maturity. We may not be able to renew or refinance the new credit facility, or if renewed or refinanced, the renewal or refinancing may occur on less favorable terms. In particular, our ability to defer interest on our notes is limited and such limitations may be viewed as favorable to the senior lenders, and at the time we seek to renew or refinance our new credit facility we may not have the same ability to defer interest on our notes that we will have immediately following completion of this offering. If we are unable to refinance or renew our new credit facility, our failure to repay all amounts due on the maturity date would cause a default under the new credit facility. In addition, our interest expense may increase significantly if we refinance our new credit facility on terms that are less favorable to us than the terms of our new credit facility, which could reduce the amount of funds available to make interest payments on the notes and pay dividends on our common stock, including the Class A common stock represented by IDSs. We will require a significant amount of cash, which may not be available to us, to service our debt, including the notes, and to fund our liquidity needs. Our ability to make payments on, refinance or repay our debt, including the notes, to fund planned capital expenditures or expand our business will depend largely upon our future operating performance. Our future operating performance is dependent upon our ability to execute our business strategy successfully. Such performance is also subject to general economic, financial and competitive factors, as well as other factors that are beyond our control. Assuming the transactions contemplated by this offering are completed on November 12, 2004, interest payments on our notes are scheduled to be approximately $58.1 million in 2005, interest payments on term loan borrowings under our new credit facility are scheduled to be approximately $3.7 million in 2004 and $26.4 million in 2005 and interest payments on revolver borrowings under our new credit facility are scheduled to be approximately $0.4 million in 2004 and $1.0 million in 2005, including approximately $0.3 million in 2004 and $0.7 million in 2005 associated with temporary borrowings to finance a planned legal reorganization of a portion of our international operations. See Dividend Policy and Restrictions Minimum Adjusted EBITDA. In addition, we estimate that interest payments under lines of credit in foreign countries that are used to facilitate short-term operating needs will be $0.2 million in 2004 and $1.2 million in 2005. If we are unable to generate sufficient cash to service our debt requirements, we will be required to refinance our new credit facility. If we are unable to refinance our debt or obtain new financing, we would have to consider other options, including: sales of assets to meet our debt service requirements; sales of equity; negotiations with our lenders to restructure the applicable debt; and Marketable equities 72 % 71 % Fixed income securities 28 Table of Contents and sole bookrunner. In this prospectus, we refer to this credit facility as the new credit facility. The new credit facility will consist of a revolving credit facility in an aggregate principal amount of up to $100 million (to be reduced to $50 million after the first anniversary of the closing date) and a $435 million term loan facility. While the new credit facility will permit us to pay interest and dividends to our security holders, including IDS holders, it will contain significant restrictions on our ability to make such interest and dividend payments. The new credit facility will have a 4.5 year maturity, except the portion of the term loan allocated to Canadian borrowers, which will have a 5 year maturity. See Description of Certain Indebtedness New Credit Facility. Our Existing Equity Investors We are an indirect, wholly-owned subsidiary of Xerium S.A. prior to this offering. Apax Europe IV GP, L.P., which, together with its affiliates, we refer to as Apax in this prospectus, is manager, directly or indirectly, of investment funds holding the majority of the outstanding common stock of Xerium S.A. Affiliates of CIBC World Markets Corp., the lead managing underwriter for this offering, own approximately 5.6% of the common stock of Xerium S.A. prior to this offering. We refer to CIBC World Markets Corp. as CIBC in this prospectus. Our senior management and certain other investors also own equity interests in Xerium S.A. We refer to Apax, CIBC and these other investors in Xerium S.A. as our existing equity investors in this prospectus. Xerium 3 S.A. is our direct parent company and, prior to our recapitalization and the offering, owns 100% of our capital stock. The Recapitalization and the Offering This offering consists of an offering by us of 28,125,000 IDSs, representing 28,125,000 shares of Class A common stock and $201.1 million aggregate principal amount of % senior subordinated notes due 2019, and an offering by us of $45.3 million aggregate principal amount of % senior subordinated notes due 2019 sold separately (not represented by IDSs). We refer to the % senior subordinated notes due 2019 (whether or not represented by IDSs) as the notes in this prospectus. The completion of the offering of the IDSs and the offering of the separate notes are conditioned on each other. Prior to the closing of this offering, our existing common stock, all of which is held by Xerium 3 S.A., will be reclassified as Class A common stock. In connection with the reclassification, the directors and members of our senior management who own equity interests in Xerium S.A. will exchange such interests for shares of our Class A common stock. The other existing equity investors will, through their ownership interests in Xerium S.A., continue to own all economic rights of the shares of Class A common stock held by Xerium 3 S.A. After the reclassification, and in connection with the offering, we will undergo a recapitalization in which all of the shares of Class A common stock held (directly or indirectly) by the existing equity investors will be exchanged for cash, IDSs and shares of Class B common stock, as described in the following table: Prior to the Offering Table of Contents seeking protection under the U.S. federal bankruptcy code or other applicable bankruptcy, insolvency or other applicable laws dealing with creditors rights generally. If we are forced to pursue any of the above options under distressed conditions, our business and/or the value of your investment in our IDSs and notes would be adversely affected. We are a holding company and rely on dividends, interest and other payments, advances and transfers of funds from our subsidiaries to meet our debt service and other obligations. We are a holding company and conduct all of our operations through our subsidiaries and currently have no significant assets other than the capital stock of our subsidiaries. As a result, we will rely on dividends, interest and other payments or distributions from our subsidiaries to meet our debt service obligations and enable us to pay interest and dividends. The ability of our subsidiaries to pay dividends or interest or make other payments or distributions to us will depend substantially on their respective operating results and will be subject to restrictions under, among other things, the laws of their jurisdiction of organization (which may limit the amount of funds available for the payment of dividends), agreements of those subsidiaries, the terms of the new credit facility and the covenants of any future outstanding indebtedness we or our subsidiaries incur. Interest on the notes may not be deductible by us for U.S. federal and applicable state income tax purposes, which could adversely affect our financial condition, significantly reduce our future cash flow and impact our ability to make interest and dividend payments. Our position that the notes should be treated as debt for U.S. federal income tax purposes may not be sustained if challenged by the IRS. If the notes were treated as equity rather than debt for U.S. federal and applicable state income tax purposes, then the stated interest on the notes could be treated as a dividend, and interest on the notes would not be deductible by us for U.S. federal and applicable state income tax purposes. Our inability to deduct interest on the notes on an on-going basis could materially increase our taxable income and, thus, our U.S. federal and applicable state income tax liability. In addition, to the extent any portion of our interest expense from prior years is determined not to be deductible, we could be required to pay a significant amount of additional income tax for such years, together with interest and possible penalties. Any increase in tax liabilities for prior or future periods as a result of a determination that interest on the notes is not deductible would materially and adversely affect our financial condition and our after-tax cash flow, which in turn would materially and adversely affect our ability to meet our obligations on the notes and to pay dividends. We do not expect to maintain any reserve in our financial statements for the possibility of there being a determination that interest on the notes would not be deductible for U.S. federal and applicable state income tax purposes. In addition, if a challenge to the deductibility of interest on the notes were to prevail, the amount, timing and character of any income, gain, or loss that you recognize in respect of your IDSs could be adversely affected. In the case of foreign holders, treatment of the notes as equity for U.S. federal income tax purposes would subject payments to such holders in respect of the notes to withholding or estate taxes in the same manner as payments made with regard to Class A common stock and could subject us to liability for withholding taxes that were not collected on payments of interest. Payments to foreign holders would not be grossed-up for any such taxes. For a discussion of these tax related risks, see Material U.S. Federal Income Tax Consequences. We may have to establish a reserve for contingent tax liabilities in the future, which could adversely affect our ability to make interest and dividend payments on the IDSs. Even if the IRS does not challenge the tax treatment of the notes, it is possible that as a result of a change in law relied upon at the time of issuance of the notes, we will in the future need to change our anticipated accounting treatment and establish a reserve for contingent tax liabilities associated with a disallowance of all or part of the interest deductions on the notes. If we were required to maintain such a reserve, our ability to make interest and dividend payments could be materially impaired and the market for the IDSs, Class A common stock and notes could be adversely affected. In addition, any resulting restatement of our financial statements could lead to defaults under our new credit facility. Table of Contents You will be immediately diluted by $16.65 per share of Class A common stock if you purchase IDSs in this offering. If you purchase IDSs in this offering, based on the book value of the assets and liabilities reflected on our balance sheet at June 30, 2004, you will experience an immediate dilution of $16.65 per share of Class A common stock represented by the IDSs (assuming all Class B common stock has been exchanged), which exceeds the entire price allocated to each share of Class A common stock represented by the IDSs in this offering because there will be a net tangible book deficit for each share of Class A common stock outstanding immediately after this offering. Our net tangible book deficit as of June 30, 2004, after giving effect to this offering, would have been approximately $444.2 million, or $7.80 per share of Class A common stock represented by IDSs (assuming all Class B common stock has been exchanged). Subject to certain limitations, we may defer interest on the notes at any time at our option if we reasonably believe it is necessary to avoid a default under our senior indebtedness. If we defer interest, we will not be permitted to make any payment of dividends so long as any deferred interest or interest on deferred interest remains outstanding. Prior to , 2009, we may, subject to certain limitations set forth in the indenture governing the notes, defer interest payments on the notes on one or more occasions for eight quarters in the aggregate if we reasonably believe such deferral is necessary to avoid a default under our senior indebtedness. After , 2009, we may, subject to certain limitations set forth in the indenture governing the notes, defer interest payment on up to four occasions for up to two quarters per occasion if we reasonably believe such deferral is necessary to avoid a default under our senior indebtedness provided that we may not defer additional interest until all previously deferred interest has been paid in full. After the end of any interest deferral period occurring before , 2009, deferred interest, together with any accrued interest thereon, will be required to be repaid on , 2009. Consequently, you may be owed a substantial amount of deferred interest that will not be due and payable until such date. All interest deferred after , 2009, together with any accrued interest thereon, must be repaid on or before maturity. Consequently, you may be owed a substantial amount of deferred interest that will not be due and payable until such date. During any interest deferral period and so long as any deferred interest or interest on deferred interest remains outstanding, we will not be permitted to make any payment of dividends with respect to shares of common stock. Deferral of interest payments would have adverse tax consequences for you by causing you to recognize interest income and pay taxes before you receive any cash payment of such interest, and may adversely affect the trading price of the IDSs or the separately held notes. If interest payments on the notes are deferred, the notes will be treated as issued with OID at the time of such occurrence. As a result, you will be required to recognize interest income for U.S. federal income tax purposes in respect of the notes represented by the IDSs or the separately held notes, as the case may be, held by you before you receive any cash payment of this interest. See Material U.S. Federal Income Tax Consequences Consequences to U.S. Holders Notes Deferral of Interest. In addition, you will not receive any cash payment with respect to the accrued interest if you sell the IDSs or the notes, as the case may be, before the record date relating to interest payments that are to be paid. If interest is deferred, the IDSs or separately held notes may trade at a price that does not fully reflect the value of accrued but unpaid interest on the notes. In addition, the existence of the right to defer payments of interest on the notes under certain circumstances may mean that the market price for the IDSs or separately held notes may be more volatile than other securities that do not have such provisions. The realizable value of our assets upon liquidation may be insufficient to satisfy claims. At June 30, 2004, our assets included intangible assets in the amount of approximately $332 million, representing approximately 34% of our total consolidated assets and consisting primarily of goodwill (the excess of the Table of Contents The Recapitalization and the Offering Table of Contents acquisition cost over the fair market value of the net assets acquired in purchase transactions). The value of these intangible assets will continue to depend significantly upon the success of our business as a going concern and the growth in cash flows. As a result, in the event of a default under our new credit facility or on our notes or any bankruptcy or dissolution of our Company, the realizable value of these assets may be substantially lower and may be insufficient to satisfy the claims of our creditors, including holders of notes. Claims of holders of the notes and the guarantees will be structurally subordinated to claims of creditors of our non-guarantor subsidiaries. We are a holding company and conduct all of our operations through our subsidiaries. Certain of our subsidiaries will not be guarantors of the notes. As a result, no payments are required to be made to us from the assets of these subsidiaries. Claims of holders of the notes and the guarantees will be structurally subordinated to the indebtedness and other liabilities and commitments of our non-guarantor subsidiaries. The ability of our creditors, including the holders of the notes, to participate in the assets of any of our non-guarantor subsidiaries upon any bankruptcy, liquidation or reorganization or similar proceeding of any such entity will be subject to the prior claims of that entity s creditors, including trade creditors, and any prior or equal claim of any other equity holder. In addition, the ability of our creditors, including the holders of our notes, to participate in distributions of assets of our non-guarantor subsidiaries will be limited to the extent that the outstanding shares of any of our subsidiaries are either pledged to secure other creditors (including lenders under our new credit facility) or are not owned by us. Our non-guarantor subsidiaries accounted for approximately 53% of our net sales in 2003 and, as of December 31, 2003, they held approximately 53% of our total consolidated assets. For the six months ended June 30, 2004, such non-guarantor subsidiaries accounted for approximately 52% of our net sales and, as of June 30, 2004, they held approximately 53% of our total consolidated assets. See Note 17 of the audited consolidated financial statements included elsewhere in this prospectus and Note 13 of the accompanying unaudited consolidated financial statements included elsewhere in this prospectus. Your right to receive payments on the notes and the guarantees is junior to all of our senior debt and the senior debt of our subsidiaries. The notes and the related guarantees will be unsecured senior subordinated obligations, junior in right of payment to all of our senior debt and the senior debt of each subsidiary guarantor, respectively. As a result of the subordinated nature of our notes and the related guarantees, upon any distribution to our creditors or the creditors of the subsidiary guarantors in bankruptcy, liquidation or reorganization or similar proceedings relating to us or the subsidiary guarantors or our or their property or assets, the holders of such entities senior indebtedness will be entitled to be paid in full in cash before any payment may be made with respect to the notes or the subsidiary guarantees (and before any distribution may be made by our subsidiaries to us). In the event of a bankruptcy, liquidation or reorganization or similar proceeding relating to us or the subsidiary guarantors, the subordinated noteholders would participate in available distributions with other holders of unsecured senior subordinated indebtedness after the payment in full of all senior indebtedness. In any of these cases, we and our subsidiary guarantors may not have sufficient funds to pay all of our creditors and the holders of the notes may receive less, ratably than the holders of our senior indebtedness or the senior indebtedness of our subsidiary guarantors. Furthermore, because of the existence of subordination provisions, including the obligation to turn over distributions to holders of our senior indebtedness or the senior indebtedness of our subsidiary guarantors, the holders of notes may receive less, ratably, than holders of trade payables and other general unsecured indebtedness. In such event we and the guarantors would not be able to make all principal payments on the notes. The subordination provisions of the indenture will also provide that payments to you under the notes will be prohibited while a payment default exists under designated senior indebtedness or if such designated senior indebtedness has been accelerated. In addition, these payments to you may be blocked for up to 179 days by holders of designated senior indebtedness if a default other than a payment default exists under such senior IDSs to be issued to the existing equity investors in connection with the recapitalization and the offering 23,934,267 (1) Shares of Class B common stock to be issued to the existing equity investors in connection with the recapitalization and the offering 4,912,500 shares Cash to be paid to the existing equity investors in connection with the recapitalization and the offering $ 62,613,390 Voting power held by the existing equity investors after the recapitalization and the offering (includes Class A common stock represented by IDSs and Class B common stock and assumes no exercise of the underwriters over-allotment option to purchase additional IDSs) 50.6 % Table of Contents indebtedness. During any period in which payments to you are prohibited or blocked in this manner, any amounts received by you with respect to the notes or guarantees, including as a result of any legal action to enforce the notes or guarantees, would be required to be turned over to the holders of senior indebtedness. As of June 30, 2004, on a pro forma basis after giving effect to the transactions contemplated by this prospectus: Xerium Technologies, Inc. would have had $302.6 million aggregate principal amount of senior indebtedness outstanding, all of which would have been senior secured indebtedness to which the notes would be junior in right of payment; Xerium Technologies, Inc. would have had an additional $417.5 million aggregate principal amount of indebtedness outstanding, consisting exclusively of the notes; our subsidiary guarantors would have had $69.4 million aggregate principal amount of senior indebtedness outstanding, all of which would have been senior secured indebtedness to which the guarantees of the notes would be junior in right of payment; our subsidiary guarantors would have had $72.8 million aggregate principal amount of other indebtedness outstanding, including trade payables, all of which would have ranked pari passu with the guarantees, except as discussed in Risk Factors Risks Related to Capital Structure and Description of Notes Ranking ; and our non-guarantor subsidiaries would have had $172.1 million aggregate principal amount of indebtedness outstanding, including trade payables, to which the notes and the guarantees would be structurally subordinated. In addition, as of June 30, 2004, on a pro forma basis after giving effect to the transactions contemplated by this prospectus, based on the covenants in the indenture and our new credit facility, we would have had the ability to incur an additional $109.2 million aggregate principal amount of indebtedness, all of which could be senior in right of payment to the notes. Shortly after the completion of this offering we expect to borrow approximately $40 million under our revolving credit facility to fund the legal reorganization of a portion of our international operations. The validity and enforceability of the notes and the guarantees of the notes by our subsidiaries may be limited by fraudulent conveyance laws and foreign laws restricting guarantees. Our obligations under the notes will be guaranteed by certain of our subsidiaries, including our domestic subsidiaries organized under Delaware law and our foreign subsidiaries organized under the laws of Australia, Canada, Japan, Mexico and the United Kingdom. These guarantees provide the holders of the notes with a direct claim against the assets of the subsidiary guarantors. The offering of the notes and the guarantees of the notes by certain of our subsidiaries may be subject to legal challenge and review based on various laws and defenses relating to fraudulent conveyance or transfer, voidable preferences, financial assistance, corporate purpose, capital maintenance, the payment of legally sufficient consideration and other laws and defenses affecting the rights of creditors generally. The laws of various foreign jurisdictions, including the jurisdictions in which the subsidiary guarantors are organized and those in which the subsidiary guarantors own assets or otherwise conduct business, may be applicable to the notes and the guarantees. Accordingly, we cannot assure you that a third party creditor or bankruptcy trustee would not challenge the notes or one or more of these subsidiary guarantees in court and prevail in whole or in part. Although laws differ among various jurisdictions, in general, under fraudulent conveyance or transfer laws, a court could void or subordinate the notes or the guarantees issued by our subsidiaries if it found that: we or the subsidiary guarantors intended to hinder, delay or defraud our creditors; we or the subsidiary guarantors knew or should have known that the transactions were to the detriment of our creditors; Table of Contents the transactions had the effect of giving a preference to one creditor or class of creditors over another; or we or the subsidiary guarantors did not receive fair consideration and reasonably equivalent value for incurring such indebtedness or guarantee obligations and we or the subsidiary guarantors (i) were insolvent or rendered insolvent by reason of the incurrence of such indebtedness or obligations, (ii) were engaged or about to engage in a business or transaction for which our or the subsidiary guarantors remaining assets constituted unreasonably insufficient capital or (iii) intended to incur, or believed that we or the subsidiary guarantors would incur, debts beyond our or their ability to pay as they mature. The measure of insolvency for purposes of fraudulent transfer laws varies depending on the law applied. Generally, however, an entity would be considered insolvent if: the sum of its debts, including contingent liabilities, was greater than the fair saleable value of all of its assets; the present fair saleable value of its assets was less than the amount that would be required to pay its existing debts and liabilities, including contingent liabilities, as they become absolute and mature; or it could not or would not pay its debts as they become due. We cannot assure you that a court would reach the conclusion that, upon the issuance of the notes and the subsidiary guarantees, we and each of the subsidiary guarantors will be solvent, will have sufficient capital to carry on our business and will be able to pay our debts as they mature. If a court were to find that the issuance of the notes or a subsidiary guarantee was a fraudulent conveyance or transfer or constituted an illegal preference, the court could void the payment obligations under the notes or the guarantee, further subordinate the notes or the subsidiary guarantee to presently existing and future indebtedness of ours or the subsidiary guarantor, or require the holders of the notes to repay any amounts received with respect to the notes or guarantee. The guarantees issued by certain of our foreign subsidiaries will contain language limiting the amount of debt guaranteed so that applicable local law restrictions will not be violated, although there can be no assurance that such limitation is enforceable. As a result, a subsidiary s liability under its guarantee could be materially reduced or eliminated depending on the amount of its other obligations and the effect of applicable laws. In particular, in certain jurisdictions, a guarantee that is not in the guarantor s corporate interest or the burden of which exceeds the benefit to the guarantor may not be valid and enforceable. It is possible that a creditor of a subsidiary guarantor, or a bankruptcy trustee in the case of a bankruptcy of a subsidiary guarantor, may contest the validity or enforceability of the subsidiary s guarantee of the notes and that a court may determine that the guarantee should be limited or voided. To the extent that any subsidiary guarantee is determined to be void or unenforceable, or the agreed limitations on the guaranteed obligations become applicable, the notes would not have a claim under the guarantee and would accordingly be effectively subordinated to all other liabilities of the applicable subsidiary. Although the insolvency laws of the jurisdiction of incorporation of the respective subsidiaries would most likely apply to the insolvency of the relevant subsidiary, a subsidiary could conceivably enter into an insolvency procedure in another jurisdiction. Therefore, the validity and enforceability of the subsidiary guarantees may be affected by the insolvency, administration and other laws of various foreign jurisdictions, including the jurisdictions in which the subsidiary guarantors are organized and those in which the subsidiary guarantors own assets or otherwise conduct business. The laws of these jurisdictions are in many cases materially different from, and conflict with each other and with the laws of the United States, including in the areas of bankruptcy, creditors rights, fraudulent transfers, priority of governmental and other creditors, ability to obtain post petition interest, duration of proceeding and preference periods. For example, in the United Kingdom an administrator or liquidator of a company may apply to the court for an order to recover preferred payments made to creditors within certain periods prior to a company s insolvency only in circumstances where it can be shown that the insolvent entity was, among other factors, motivated by a desire to put the creditor in a better position than it would have been in an insolvency proceeding. However, in a U.S. bankruptcy proceeding, a debtor or its trustee in bankruptcy may recover sums paid to creditors within a 90 day period prior to bankruptcy irrespective of the Table of Contents motivation for such payments. The application of these and other similar laws, and any conflict between laws of various jurisdictions, could call into question whether, and to what extent, the laws of any particular jurisdiction should apply, which may adversely affect your ability to enforce your rights under the guarantees of the notes by our subsidiaries in these jurisdictions or limit any amounts that you may receive. You may have difficulty effecting service of process upon our foreign subsidiary guarantors and/or our directors and executive officers who reside outside of the United States. Several of the subsidiary guarantors are organized under laws outside of the United States and certain of our directors and officers reside outside of the United States. In addition, a substantial portion of the assets of such guarantors and our directors and officers are located outside of the United States. As a result, it may be difficult for holders of our securities to effect service of process upon the guarantors or such directors or officers within the United States or to enforce against them the United States judgments of courts of the United States predicated upon the civil liability provisions of the United States federal securities laws or other laws of the United States. In addition, we have been advised by legal counsel in certain foreign jurisdictions that there is doubt as to the enforcement in such jurisdictions of liabilities predicated upon United States federal securities laws against our guarantors and our directors and executive officers who are not residents of the United States, in original actions or in actions for enforcements of judgments of U.S. courts. In the event of bankruptcy or insolvency, the notes and guarantees could be adversely affected by principles of equitable subordination or recharacterization, which may eliminate your ability to recover any amounts owed on the notes or require you to return any prior payments you received on the notes. In the event of bankruptcy or insolvency, a party in interest may seek to subordinate the notes or the guarantees under principles of equitable subordination or to recharacterize the notes as equity. There can be no assurance as to the outcome of such proceedings. In the event a court subordinates the notes or the guarantees, or recharacterizes the notes as equity, we cannot assure you that you would recover any amounts owed on the notes or the guarantees and you may be required to return any payments made to you on account of the notes or guarantees within six years before the bankruptcy. In addition, should the court equitably subordinate the notes or the guarantees, or recharacterize the notes as equity, you may not be able to enforce the notes or the guarantees. While generally speaking, equitable subordination would require a showing of inequitable conduct on the part of the lender, under certain circumstances, courts have recognized the potential for so-called no-fault equitable subordination; that is, equitable subordination without the necessity to show inequitable conduct. This doctrine has mainly been employed to subordinate tax and penalties claims, punitive damage claims and claims relating to stock redemption/repurchase obligations. As such, even absent a finding of inequitable conduct, it is possible that a court could conclude that the debt represented by the notes represented by IDSs should be equitably subordinated to the extent such notes were originally issued in exchange for equity. The notes represented by IDSs to be issued to our existing equity investors in connection with the recapitalization and the offering, as described in The Transactions The Recapitalization and the Offering and Related Party Transactions Proceeds from the Recapitalization and the Offering, will be issued in exchange for equity. To the extent that particular notes can be traced to notes represented by IDSs that were issued to our existing equity investors in connection with the recapitalization and the offering, such notes could be subject to a no-fault equitable subordination claim. The allocation of the purchase price of the IDSs may not be respected. The purchase price of each IDS must be allocated among the underlying shares of Class A common stock and notes in proportion to their respective fair market values at the time of purchase. We expect to report the initial fair market value of each share of Class A common stock as $8.85 and the initial fair market value of each of our notes represented by IDSs as $7.15, assuming an initial public offering price of $16.00 per IDS, which represents the mid-point of the range set forth on the cover page of this prospectus. By purchasing IDSs, you will agree to Table of Contents be bound by such allocation. If our allocation is not respected, it is possible that the notes will be treated as having been issued with OID (if the allocation to the notes is determined to be too high) or amortizable bond premium (if the allocation to the notes is determined to be too low). You generally would have to include OID in income in advance of the receipt of cash attributable to that income and would be able to elect to amortize bond premium over the term of the notes. Because of the deferral of interest provisions, the notes may be treated as issued with original issue discount. Under applicable Treasury regulations, a remote contingency that stated interest will not be timely paid will be ignored in determining whether a debt instrument is issued with OID. Although there is no authority directly on point, based on our financial forecasts and the fact that we have no present plan or intention to exercise our right to defer interest after , 2009, we believe that the likelihood of deferral of interest payments on the notes is remote within the meaning of the Treasury regulations. Based on the foregoing, although the matter is not free from doubt because of the lack of direct authority, we believe the notes will not be considered issued with OID at the time of their original issuance. If deferral of any payment of interest were determined not to be remote, or if the interest payment deferral actually occurred, the notes would be treated as issued with OID at the time of issuance or at the time of such occurrence, as the case may be. In that case, all stated interest on the notes would thereafter be treated as OID, and all holders, regardless of their method of tax accounting, would be required to include stated interest in income on a constant accrual basis. If we subsequently issue notes with significant original issue discount, we may not be able to deduct all of the interest on those notes. It is possible that notes we issue in a subsequent issuance will be issued at a discount to their face value and, accordingly, may have significant original issue discount and thus be classified as applicable high yield discount obligations, or AHYDOs. If any such notes were so treated, a portion of the OID on such notes could be nondeductible by us and the remainder would be deductible only when paid. This treatment would have the effect of increasing our taxable income and may adversely affect our cash flow available for interest payments and distributions to our equityholders. Subsequent issuances of notes pursuant to an offering by us or in connection with an exchange of Class B common stock may cause you to recognize original issue discount. The indenture governing our notes and agreements with DTC will provide that, in the event there is a subsequent issuance of notes with OID, and upon each subsequent issuance of notes thereafter, each holder of notes or IDSs, as the case may be, agrees that a portion of such holder s notes will be automatically exchanged for a portion of the notes acquired by the holders of such subsequently issued notes. Consequently, immediately following each such subsequent issuance and exchange, each holder of notes, held either as part of IDSs or separately, as the case may be, will own an inseparable unit composed of notes of each separate issuance in the same proportion as each other holder. However, the aggregate stated principal amount of notes owned by each holder will not change as a result of such subsequent issuance and exchange. We are not able to predict the likelihood that an automatic exchange would occur because we are unable to predict the selling price of any subsequent issuance of notes, and therefore whether the notes would be issued with OID. It is unclear whether the exchange of notes for subsequently issued notes will result in a taxable exchange for U.S. federal income tax purposes, and it is possible that the IRS might successfully assert that such an exchange should be treated as a taxable exchange. Regardless of whether the exchange is treated as a taxable event, such exchange may result in holders having to include OID in taxable income prior to the receipt of cash as described below, and may result in other potentially adverse tax consequences to holders. See Material U.S. Federal Income Tax Consequences Consequences to U.S. Holders Notes Additional Issuances. In addition, the potential amount of OID that would be required to be included in taxable income by holders as a result of an automatic exchange is indefinite and may be a significant amount, in part due to our ability to engage in numerous subsequent issuances. Table of Contents Following the subsequent issuance of notes with OID (or any issuance of notes thereafter) and resulting exchange, we (and our agents) will report any OID on the subsequently issued notes ratably among all holders of notes and IDSs, and each holder of notes or IDSs will, by purchasing notes or IDSs, agree to report OID in a manner consistent with this approach. However, the IRS may assert that any OID should be reported only to the persons that initially acquired such subsequently issued notes (and their transferees) and thus may challenge the holders reporting of OID on their tax returns. Such a challenge by the IRS could create significant uncertainties in the pricing of IDSs and notes and could adversely affect the market for IDSs and notes. For a discussion of these tax related risks, see Material U.S. Federal Income Tax Consequences. Holders of subsequently issued notes may not be able to collect their full stated principal amount prior to maturity. Under New York and federal bankruptcy law, holders of subsequently issued notes having OID (including the recipients of such notes pursuant to the automatic exchange under the indenture) may not be able to collect the portion of their principal amount that represents unaccrued OID in the event of an acceleration of the notes or our bankruptcy prior to the maturity date of the notes. As a result, an automatic exchange that results in a holder receiving an interest in notes with OID in exchange for notes that do not have OID could have the effect of ultimately reducing the amount such holder can recover from us in the event of an acceleration or bankruptcy to an amount that is less than the amount paid for the notes in this offering. If the IDSs separate, the limited liquidity of the market for the notes and Class A common stock may adversely affect your ability to sell the notes and Class A common stock. We do not intend to list the notes represented by the IDSs on any exchange or quotation system. Our shares of Class A common stock will be listed on the Toronto Stock Exchange, but holders of shares of Class A common stock will not be able to trade such shares on the Toronto Stock Exchange until the applicable requirements for separate trading are satisfied, including that a sufficient number of shares are held separately, not represented by IDSs, by a sufficient number of holders. Our Class A common stock will not initially be listed on any other exchange or quotation system, including the New York Stock Exchange. We will not apply to list our shares of Class A common stock for separate trading on the New York Stock Exchange or on any other exchange or quotation system on which the IDSs are then listed until a sufficient number of shares is held separately, not represented by IDSs, by a sufficient number of holders to satisfy applicable requirements for separate trading on such exchange or quotation system for 30 consecutive trading days. The Class A common stock may not be approved for listing at such time. Upon separation of the IDSs, no sizable market for the notes and the Class A common stock may ever develop and the liquidity of any trading market for the notes or the Class A common stock that does develop may be limited. As a result, your ability to sell your notes or Class A common stock, and the market price you can obtain, could be adversely affected. The limited liquidity of the trading market for the notes sold separately (not represented by IDSs) may adversely affect the trading price of the separate notes. We are separately selling $45.3 million aggregate principal amount of notes (not represented by IDSs), representing approximately 10.0% of the total outstanding notes (assuming the exchange of all outstanding Class B common stock for IDSs). While the notes sold separately (not represented by IDSs) are part of the same series of notes as, and identical to, the notes represented by IDSs at the time of the issuance of the separate notes, the notes represented by the IDSs will not be separable for at least 45 days and will not be separately tradeable until separated. As a result, the initial trading market for the notes sold separately (not represented by IDSs) will be very limited. Even after holders of the IDSs are permitted to separate their IDSs, a sufficient number of holders of IDSs may not separate their IDSs into shares of our Class A common stock and notes to create a sizable and more liquid trading market for the notes not represented by IDSs. Therefore, a liquid market for the separate notes may not develop, which may adversely affect the ability of the holders of the separate notes to sell any of their separate notes and the price at which these holders would be able to sell any of the notes sold separately. Table of Contents Prior to the completion of this offering, there was no public market for our IDSs, shares of our Class A common stock or notes which may cause the price of the IDSs or notes to fluctuate substantially and negatively affect the value of your investment. Our IDSs, the shares of our Class A common stock and the notes have no public market history in the United States or in Canada. In addition, there has not been an active market for securities similar to the IDSs. An active trading market for the IDSs or notes might not develop in the future, which may cause the price of the IDSs or notes to fluctuate substantially, and we currently do not expect that an active trading market for the shares of our Class A common stock will develop until the notes mature. If the notes represented by your IDSs mature or are redeemed pursuant to the terms of the indenture, the IDSs will be automatically separated and you will then hold the shares of our Class A common stock. If interest rates rise, the trading value of our IDSs and notes may decline. Should interest rates rise or should the threat of rising interest rates develop, debt markets may be adversely affected. As a result, the trading value of our IDSs and notes may decline. Future sales or the possibility of future sales of a substantial amount of IDSs, shares of our Class A common stock or our notes may depress the price of the IDSs, the shares of our Class A common stock and our notes. Future sales or the availability for sale of substantial amounts of IDSs or shares of our Class A common stock or a significant principal amount of our notes in the public market could adversely affect the prevailing market price of the IDSs, the shares of our Class A common stock and our notes and could impair our ability to raise capital through future sales of our securities. The holders of the 23,934,267 IDS and the 4,912,500 shares of Class B common stock exchangeable into IDSs that will be issued to our existing equity investors in the recapitalization in connection with this offering will have three demand and unlimited piggyback registration rights, which, if exercised, will allow them to sell their IDSs to the public. The registration rights may not be exercised during the lock-up period. See Underwriting. In addition, we may issue shares of our Class A common stock and notes, which may be represented by IDSs, or other securities from time to time as consideration for future acquisitions and investments. In the event any such acquisition or investment is significant, the number of shares of our Class A common stock and the aggregate principal amount of notes, which may be represented by IDSs, or the number or aggregate principal amount, as the case may be, of other securities that we may issue may in turn be significant. In addition, we may also grant registration rights covering those IDSs, shares of our Class A common stock, notes or other securities in connection with any such acquisitions and investments. Our organizational documents, Delaware laws and/or our indenture could limit another party s ability to acquire us and deprive our investors of the opportunity to obtain a takeover premium for their securities. A number of provisions in our amended and restated certificate of incorporation and amended and restated by- laws will make it difficult for another company to acquire us and for you to receive any related takeover premium for your securities. For example, our organizational documents provide that stockholders may not act by written consent and do not provide our stockholders with the power to call or to request that our board of directors call a special meeting. Our organizational documents authorize the issuance of preferred stock without stockholder approval and upon such terms as the board of directors may determine. The rights of the holders of shares of our Class A common stock will be subject to, and may be adversely affected by, the rights of holders of any class or series of preferred stock that may be issued in the future. We are also subject to Section 203 of the Delaware General Corporation Law, which restricts the ability of a publicly held Delaware corporation to engage Table of Contents in a business combination such as a merger or sale of assets with any stockholder who, together with affiliates, owns 15% or more of the corporation s voting stock. The restrictions imposed by Section 203 could prohibit or delay the accomplishment of an acquisition transaction, or discourage attempts to acquire us. In addition, the indenture governing the notes provides that the notes are not redeemable at our option until the seventh anniversary of the offering, and are redeemable thereafter at our option subject to the payment of certain premiums prior to , 2016. These provisions will effectively increase the cost to acquire us, especially prior to the seventh anniversary of the offering, because we or the acquiror would need to conduct a tender offer for the notes that would likely require payment of a significant premium. For additional details, see Description of Capital Stock Anti-Takeover Effects of Various Provisions of Delaware Law and Our Restated Certificate of Incorporation and Amended and Restated By-Laws, as well as provisions in our indenture. We may not be able to repurchase the notes upon a change of control. Upon the occurrence of certain change of control events, we will be required to offer to repurchase the outstanding notes at 101% of their principal amount at the date of repurchase unless such notes have been previously called for redemption. We may not have sufficient financial resources to purchase all of the notes that are tendered upon a change of control offer. Furthermore, our new credit facility, with certain limited exceptions, will prohibit the repurchase or redemption of the notes before their stated maturity. Consequently, lenders thereunder may have the right to prohibit any such purchase or redemption, in which event we will seek to obtain waivers from the required lenders. We may not be able to obtain such waivers or refinance our indebtedness on terms acceptable to us, or at all. Finally, the occurrence of a change of control could also constitute an event of default under our new credit facility, which could result in the acceleration of all amounts due thereunder. See Description of Notes Change of Control. Furthermore, we may enter into transactions which do not constitute a change of control as defined in the indenture governing the notes and which are otherwise permitted under the indenture governing the notes. Any such transactions would not give note holders the right to demand redemption of their notes and may have the effect of increasing the amount of indebtedness outstanding or otherwise affect our capital structure, credit ratings or the note holders. Our existing equity investors will retain an aggregate of approximately 50.6% of the voting power in us, and their interests may differ from your interests. Upon the completion of the transactions contemplated by this offering, Apax and our other existing equity investors, through their ownership of IDSs and Class B common stock, will collectively, own approximately 50.6% of the voting power in us, or approximately 43.2% of the voting power if the over-allotment option is exercised in full. If the over-allotment option is not exercised, our existing equity investors could, if they act together as a group, control our business, policies and affairs and will be able to elect our entire board of directors, determine, without consent of the holders of IDSs or Class A common stock, the outcome of any corporate transaction or other matter submitted to our stockholders for approval, including mergers, consolidations and sales of substantially all of our assets. They will also, if they act together, be able to prevent or cause a change of control of our company and/or an amendment to our certificate of incorporation and by-laws. We cannot assure you that the interests of Apax and our other existing equity investors will be consistent with the interests of other holders of IDSs, Class A common stock or notes. Even if the over-allotment option is not exercised or our existing equity investors do not act together as a group, this concentration of ownership could have the effect of delaying, deferring or preventing a change in control, merger or tender offer, which would deprive you of an opportunity to receive a premium for your IDSs and may negatively affect the market price of the IDSs. Moreover, Apax either alone or with other existing owners could effectively receive a premium for transferring ownership to third parties that would not inure to your benefit. Severance $ 70 $ 3,583 $ $ (1,885 ) $ 1,768 Facility costs 295 2,619 (1,356 ) (1,519 ) Table of Contents Furthermore, we expect that Apax will own approximately 37.7% of the voting power in us, or 31.8% if the over-allotment option is exercised, and will be our largest stockholder after the offering. As a result, Apax and its affiliates will have a strong ability to influence our business, policies and affairs. One representative of Apax will serve on our seven-member board of directors immediately after the offering, although Apax will have no contractual rights to nominate any directors. We cannot assure you that the interests of Apax will be consistent with the interests of other holders of IDSs, Class A common stock or notes. Risks Relating to our Business and the Industry Our industry is competitive and our future success will depend on our ability to effectively develop and market competitive products. The paper-making consumables industry is highly competitive. Some of our competitors are larger than us, have greater financial and other resources and are well-established as suppliers to the markets we serve. In addition, some of our competitors also manufacture paper-making machines and have the ability to initially package sales of their clothing and roll cover products with the sale of their machines and/or to tie the warranties on their machines to the use of their clothing and roll cover products. Our products may not be able to compete successfully with the products of our competitors, which could result in a loss of customers and, as a result, decreased revenues and profitability. We compete primarily based on the technology and performance of our products, including the ability of our products to help reduce our customers production costs and increase the quality of the paper they produce. Our competitors could develop new technology or products that lead to a reduced demand for our products. In addition, our business depends on our customers regularly needing to replace the clothing and roll covers used on their paper-making machines. Either we or our competitors could develop new technologies that increase the useful life of clothing or roll covers, which could reduce the frequency with which our customers would need to replace their clothing and refurbish or replace their roll covers, and consequently lead to fewer sales. Increased price competition in our industry could adversely affect our gross margins and revenues. We and our competitors have been able to sell clothing and roll covers products and services at favorable prices that reflect the value they deliver to customers. This favorable pricing has been particularly available for our more technically advanced products, such as forming fabrics, press felts and roll covers. If our competitors reduce the prices of such products, we may be required to decrease our prices to compete successfully, which could adversely affect our gross margins and revenues. Fluctuations in currency exchange rates could adversely affect our revenues and profitability. Our foreign operations expose us to fluctuations in currency exchange rates and currency devaluations. We report our financial results in US Dollars, but a substantial portion of our sales are denominated in Euros and other currencies. As a result, changes in the relative values of US Dollars, Euros and these other currencies will affect our levels of revenues and profitability. In particular, if the value of the US Dollar increases relative to the value of the Euro and these other currencies, our levels of revenue and profitability will decline since the translation of a certain number of Euros or units of such other currencies into US Dollars for financial reporting purposes will represent fewer US Dollars. In addition, in certain locations, our sales are denominated in US Dollars or Euros but a substantial portion of our associated costs are denominated in a different currency. As a result, changes in the relative values of US Dollars, Euros and any such different currency will affect our profitability. Fluctuations in currency exchange rates may cause volatility in our results of operations. Although in certain circumstances we attempt to hedge our exposure to fluctuations in currency exchange rates, our hedging strategies may not be effective. Interest and dividend payments on our IDSs and interest payments on our notes sold separately are to be paid in US Dollars. We do not expect to generate sufficient cash flows denominated in US Dollars to make such Table of Contents payments and will therefore rely, in part, on the conversion to US Dollars of cash flows generated in other currencies. After the completion of this offering, we will estimate the extent to which we will need to rely on cash flows denominated in foreign currencies in order to make interest payments on our notes and to pay dividends on our Class A common stock for the first year following this offering in accordance with the initial dividend policy adopted by our board of directors upon the closing of this offering, and we believe that we will be able to enter into fixed-rate currency contracts that will effectively fix the exchange rate applicable to such cash flows at the then current rate. There can be no assurance that these hedging transactions will be sufficient to enable us to pay interest on the notes and dividends on our Class A common stock in accordance with such initial dividend policy, in part because our actual results of operations and liquidity may differ from the estimates relied upon at the time we enter into the fixed rate currency contracts. In addition, our new credit facility contains requirements that we defer paying cash interest on the notes based upon certain financial tests and our new credit facility and the indenture governing our notes contain restrictions on our ability to pay dividends on our Class A common stock based upon certain financial tests. These financial tests depend in part upon our reported financial results, which as indicated above are directly affected by currency fluctuations. Except to the extent that the hedging transactions discussed above result in gains for financial reporting purposes that directly and fully offset any reductions in reported profitability attributable to currency fluctuations, we may be required by our new credit facility to defer the payment of cash interest on the notes or may be prohibited by the indenture governing our notes or the new credit facility from paying dividends on our Class A common stock. This result may be obtained even if our results of operations meet our expectations when viewed in local currencies. See Description of Certain Indebtedness New Credit Facility Restricted Payments, Description of Notes Certain Covenants and Dividend Policy and Restrictions. A sustained downturn in the paper industry could reduce our sales and adversely affect our revenues and profitability. Our ability to sell our products depends primarily on the volume of paper produced on a worldwide basis. The profitability of paper producers has historically been highly cyclical due to wide swings in the price of paper, and the paper industry is currently experiencing a period of lower prices that began in 2001. A sustained downturn in the paper industry could cause paper manufacturers to reduce production or cease operations, which could reduce our sales and adversely affect our revenues and profitability. A paradigm shift in the paper manufacturing industry or the demand for paper could adversely affect our revenues and profitability. Because our products are used on paper-making machines, a paradigm shift in the paper manufacturing industry or the demand for paper could materially reduce the demand for our products. For example, if someone were to develop a new paper production process that did not require clothing or roll covers, the demand for our products could decline or cease. In addition, many people have predicted a decrease in the global demand for paper due to the emergence of the so-called electronic office in which documents are stored electronically rather than in paper format. We cannot assure you that the demand for paper will continue to grow, or that the increased reliance on computers and the electronic storage of documents will not cause the demand for paper to decline. Any material decline in the worldwide demand for paper could cause a reduced demand for our products and ultimately adversely affect our revenues and profitability. We must continue to innovate and improve our products to maintain our competitive advantage and our use of cash to service our debt and pay dividends may limit our ability to do so. Our ability to maintain our customers and increase our business depends on our ability to continually develop new, technologically superior products. We cannot assure you that our investments in technological development will be sufficient, that we will be able to create and market new products or that we will be successful in competing against new technologies developed by competitors. In addition, after the offering, a substantial Table of Contents portion of our cash flow will be required to service our debt and we currently intend to pay quarterly dividends, which may use a significant portion of any remaining cash flow. If there is a sustained downturn in our business, our new capital structure following this offering may have the effect of reducing the amount of money available for investment in new technologies, products and manufacturing processes, which could ultimately affect our ability to remain competitive. Furthermore, members of our senior management may have an incentive to limit certain expenditures, including expenditures that may be necessary for us to remain competitive or to grow our business, because payments to them under our Long Term Incentive Plan are tied to the amount by which our EBITDA less capital expenditures, interest expense and cash income taxes, plus or minus certain working capital and other adjustments exceeds a target determined by our board of directors. See Management Long Term Incentive Plan. The loss of our major customers could have a material adverse effect on our sales and profitability. Our top ten customers generated 28% of our net sales during 2003. The loss of one or more of our major customers, or a substantial decrease in such customers purchases from us, could have a material adverse effect on our sales and profitability. Because we do not generally have binding long term purchasing agreements with our customers, there can be no assurance that our existing customers will continue to purchase products from us. Because we have substantial operations outside the United States, we are subject to the economic and political conditions of foreign nations. We have manufacturing facilities in 15 countries. In 2003, we sold products in approximately 61 countries other than the United States, which represented approximately 71% of our net sales. Our foreign operations are subject to a number of risks and uncertainties, including risks that: foreign governments may impose limitations on our ability to repatriate funds; foreign governments may impose withholding or other taxes on remittances and other payments to us, or the amount of any such taxes may increase; an outbreak or escalation of any insurrection or armed conflict may occur; or foreign governments may impose or increase investment barriers or other restrictions affecting our business. The occurrence of any of these conditions could disrupt our business in particular countries or regions of the world, or prevent us from conducting business in particular countries or regions, which could reduce our sales and affect our net sales and profitability. In addition, we will rely on dividends and other payments or distributions from our subsidiaries to meet our debt obligations and enable us to pay interest and dividends on the IDSs. If foreign governments impose limitations on our ability to repatriate funds or impose or increase taxes on remittances or other payments to us, the amount of dividends and other distributions we receive from our subsidiaries could be reduced, which could reduce the amount of cash available to us to meet our debt obligations and pay dividends. We may fail to adequately protect our proprietary technology, which would allow competitors or others to take advantage of our research and development efforts. We rely upon trade secrets, proprietary know-how, and continuing technological innovation to develop new products and remain competitive. If our competitors learn of our proprietary technology, they may use this information to produce products that are equivalent or superior to our products, which could reduce the sales of our products. Our employees, consultants, and corporate collaborators may breach their obligations not to reveal our confidential information, and any remedies available to us may be insufficient to compensate our damages. Even in the absence of such breaches, our trade secrets and proprietary know-how may otherwise become known to our competitors, or be independently discovered by our competitors, which could reduce our competitive position. We may be liable for product defects or other claims relating to our products. Our products could be defective, fail to perform as designed or otherwise cause harm to our customers, their equipment or their products. If our customers believe that they have suffered harm caused by our products, they 2001: Net sales $ 312,944 $ 186,902 $ $ $ 499,846 Depreciation and amortization (1) 35,842 33,423 362 69,627 Segment Earnings (Loss) 95,925 70,139 (13,732 ) Total assets 522,114 401,695 320,456 (355,272 ) 888,993 Capital expenditures 23,683 8,843 132 32,658 2002: Net sales $ 321,864 $ 193,081 $ 514,945 Depreciation and amortization (1) 31,617 15,584 378 47,579 Segment Earnings 103,062 69,503 449 Total assets 545,588 419,084 336,687 (376,083 ) 925,276 Capital expenditures 18,957 9,103 235 28,295 2003: Net sales $ 361,966 $ 198,702 $ 560,668 Depreciation and amortization (1) 32,387 15,627 221 48,235 Segment Earnings (Loss) 118,505 66,490 (10,471 ) Total assets 595,620 443,384 342,550 (394,748 ) 986,806 Capital expenditures 34,579 9,802 Table of Contents could bring claims against us that could result in significant liability. A failure of our products could cause substantial damage to a paper-making machine. Any claims brought against us by customers may result in: diversion of management s time and attention; expenditure of large amounts of cash on legal fees, expenses, and payment of damages; decreased demand for our products and services; and injury to our reputation. Our insurance may not sufficiently cover a large judgment against us or settlement payment, and is subject to customary deductibles, limits and exclusions. We could incur substantial costs as a result of violations of or liabilities under laws protecting the environment and human health. Our operations and facilities are subject to a number of national, state and local laws and regulations protecting the environment and human health in the United States and foreign countries that govern, among other things, the handling, storage and disposal of hazardous materials, discharges of pollutants into the air and water and workplace safety. We cannot assure you that we have been or will be at all times in complete compliance with such laws and regulations. We could incur substantial costs, including clean-up costs, fines and sanctions and third party property damage or personal injury claims, as a result of violations of or liabilities under environmental laws, relevant common law or the environmental permits required for our operations. We have been named as a defendant in lawsuits in the United States filed by persons alleging injuries caused by asbestos contained in clothing produced by other manufacturers. We may be required to spend a significant amount of money to defend against such claims. Adverse labor relations could harm our operations and reduce our profitability. We currently have approximately 4,000 employees, approximately 48% of whom are subject to protection of various collective bargaining agreements and approximately 22% of whom are subject to protection as members of trade unions, employee associations or workers councils. Approximately 64% of the employees subject to collective bargaining agreements (or approximately 31% of our total employees) are covered by collective bargaining agreements that expire prior to June 30, 2005. We cannot assure you that we will be able to renew such collective bargaining agreements, or enter into new collective bargaining agreements on the same or more favorable terms or at all and without production interruptions, including labor stoppages. In addition, approximately 41% of the employees subject to protection as members of trade unions, employer associations or workers councils (or approximately 9% of our total employees) are subject to arrangements that expire prior to June 30, 2005. We cannot assure you that the terms of employment applicable to such employees will remain the same or become more favorable. We cannot assure you that we will not experience disruptions in our operations as a result of labor disputes or experience other labor relations issues. If we are unable to maintain good relations with our employees, our ability to produce our products and provide services to our customers could be reduced and/or our production costs could increase, either of which could disrupt our business and reduce our profitability. If we are unable to successfully complete our current plant closure and cost reduction program, our revenues and profitability could decline. We are in the process of closing a significant clothing plant located in Virginia and transferring production to our other facilities. If we are unable to successfully transition our customers and production from this facility to our other facilities, we may not be able to retain these customers, or we may experience a loss of sales to such customers, which could adversely affect our revenues and profitability. Table of Contents
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+RISK FACTORS An investment in the IUs, the shares of our class A common stock and/or our senior subordinated notes involves a number of risks. In addition to the other information contained in this prospectus, prospective investors should give careful consideration to the following factors. Any of the following risks could materially adversely affect our business, financial condition, results of operations, cash flows or liquidity. In such case you may lose all or part of your original investment. Risks Relating to the IUs, the Shares of Class A Common Stock and the Senior Subordinated Notes We have substantial indebtedness, which could restrict our ability to pay interest and principal on the senior subordinated notes and dividends with respect to shares of our class A common stock represented by the IUs and impact our financing options and liquidity position. As of December 27, 2003 after giving pro forma effect to the Transactions, we would have had total consolidated indebtedness of $ million and a shareholders deficit of $ million. The degree to which we are leveraged on a consolidated basis could have important consequences to the holders of the IUs or the separate senior subordinated notes, including: making it more difficult for us to satisfy our obligations with respect to the senior subordinated notes and our other indebtedness and/or pay dividends on our class A common stock; increasing our vulnerability to general adverse economic and industry conditions; placing us at a competitive disadvantage to many of our competitors who are less leveraged than we are; limiting our ability to issue new IUs or other equity; limiting our ability to borrow additional amounts for working capital, capital expenditures or future business opportunities, including strategic acquisitions and other general corporate requirements, or hindering us from obtaining such financing on terms favorable to us or at all; requiring us to dedicate a substantial portion of our cash flow from operations to payments on our indebtedness, thereby reducing the availability of our cash flow to fund working capital, capital expenditures, future business opportunities and other general corporate purposes; limiting our flexibility in planning for, or reacting to, changes in our business and the industry and markets in which we operate; and limiting our ability to refinance our indebtedness. Despite our substantial indebtedness, we and our subsidiaries may be able to incur substantial additional indebtedness in the future that could intensify the risks described above and would make it more difficult for us to satisfy obligations on the senior subordinated notes and our other indebtedness and pay dividends on our class A common stock and further reduce the cash we have available to invest in our operations. If we do not generate sufficient cash flow to meet our debt service obligations and to fund our working capital requirements, we may need to seek additional financing or sell certain of our assets. Our new credit facility will contain significant limitations on distributions and other payments. In addition, we may amend the terms of our new credit facility, or we may enter into new agreements that govern our senior indebtedness, and the amended terms or new agreements may further significantly affect our ability to pay interest to holders of our IUs and/or our senior subordinated notes and/or dividends to holders of our IUs. Our new credit facility will contain significant restrictions on our ability to pay interest on the senior subordinated notes and dividends on the shares of class A common stock based on meeting certain financial ratios and compliance with other conditions. As a result of general economic conditions, conditions in the lending markets, the results of our business or for any other reason, we may elect or be Table of Contents required to amend or refinance our new credit facility, at or prior to maturity, or enter into additional agreements for senior indebtedness. Regardless of any protection you have in the indenture governing the senior subordinated notes, any such amendment, refinancing or additional agreement may contain covenants that could limit in a significant manner our ability to make interest payments on the senior subordinated notes and to pay dividends on our class A common stock. We are subject to restrictive debt covenants and other requirements related to our outstanding debt that limit our business flexibility by imposing operating and financial restrictions on us. The agreements governing our indebtedness impose significant operating and financial restrictions on us. These restrictions prohibit or limit, among other things, our ability and the ability of our restricted subsidiaries to: pay dividends or distributions on, or redeem or repurchase our capital stock; make certain types of investments, loans or advances; incur additional debt; issue additional shares of preferred or redeemable capital stock; enter into transactions with affiliates; create liens; sell certain assets and subsidiary stock; make certain restrictions on distributions from our restricted subsidiaries; or merge, consolidate or sell all or substantially all our assets. The terms of the new credit facility will include other and more restrictive covenants and may prohibit us from prepaying our other indebtedness, including the senior subordinated notes, while indebtedness under the new credit facility is outstanding. The new credit facility will also require us to maintain specified financial ratios and satisfy financial condition tests. Our ability to comply with the ratios or tests may be affected by events beyond our control, including prevailing economic, financial and industry conditions. A breach of any of these covenants, ratios or tests could result in a default under the new credit facility and/or the indenture. Certain events of default under the new credit facility would prohibit us from making payments on the senior subordinated notes, including payment of interest when due. In addition, upon the occurrence of an event of default under the new credit facility, the lenders could elect to declare all amounts outstanding under the new credit facility, together with accrued interest, to be immediately due and payable. If we were unable to repay those amounts, the lenders could proceed against the security granted to them to secure that indebtedness. An acceleration by the lenders of payments of indebtedness under the new credit facility may cause an acceleration of amounts outstanding under the senior subordinated notes or other indebtedness which we may not be able to repay. If the lenders accelerate the payment of the indebtedness, our assets may not be sufficient to repay in full this indebtedness and our other indebtedness, including the senior subordinated notes. We are a holding company and rely on dividends, interest and other payments, advances and transfers of funds from our subsidiaries to meet our debt service and other obligations. We are a holding company and conduct all of our operations through our subsidiaries and currently have no significant assets other than the capital stock of our subsidiaries, all of which will be pledged to the creditors under the new credit facility. As a result, we will rely on dividends and other payments or distributions from our subsidiaries to meet our debt service obligations and enable us to pay interest on the senior subordinated notes and dividends on our class A common stock. The ability of our subsidiaries to pay dividends or make other payments or distributions to us will depend on their respective operating 21 .1 List of subsidiaries of Eye Care Centers of America, Inc.** 23 .1 Consent of Ernst Young LLP.* 23 .2 Consent of Weil, Gotshal Manges LLP (included in Exhibit 5.1 and 8.1)** 24 .1 Powers of Attorney (included on signature pages).* 10 .33 Amendment to Retail Business Management Agreement by and between Visionary Retail Management, Inc. and Dr. Mark Lynn Associates, PLLC, dated June 1, 1999.(f) 10 .34 Amendment to Retail Business Management Agreement by and between Visionary Retail Management, Inc. and Dr. Mark Lynn Associates, PLLC, dated August 31, 2000.(f) 10 .35 Professional Business Management Agreement, dated October 1, 1998, by and between Visionary MSO, Inc., a Delaware Corporation, and Dr. Mark Lynn Associates, PLLC.+** 10 .36 Amendment to Professional Business Management Agreement by and between Visionary MSO, Inc. and Dr. Mark Lynn Associates, PLLC, dated June 1, 1999.(f) 10 .37 Amendment Professional Business Management Agreement by and between Visionary MSO, Inc. and Dr. Mark Lynn Associates, PLLC, dated August 1, 2000.(f) 10 .38 Professional Business Management Agreement, dated June 19, 2000, by and between Visionary Retail Management, Inc., a Delaware corporation, and Dr. Tom Sowash, O.D. and Associates, LLC, a Colorado limited liability company.(d) 10 .39 Business Management Agreement by and between Vision Twenty-One, Inc. and Charles M. Cummins, O.D. and Elliot L. Shack, O.D., P.A., dated January 1, 1998.(l) 10 .40 Amendment No. 1 to Business Management Agreement by and between Charles M. Cummins, O.D., P.A., and Eye Drx Retail Management, Inc., dated August 31, 1999.(l) 10 .41 Amendment No. 2 to Business Management Agreement by and between Charles M. Cummins, O.D., P.A. and Eye Drx Retail Management, Inc., dated February 29, 2000.(f) 10 .42 Amendment No. 3 to Business Management Agreement by and between Charles M. Cummins, O.D., P.A. and Eye Drx Retail Management, Inc., dated May 1, 2000.(f) 10 .43 Amendment No. 4 to Business Management Agreement by and between Charles M. Cummins, O.D., P.A. and Eye Drx Retail Management, Inc., dated February 1, 2001.(f) 10 .44 Amendment No. 5 to Business Management Agreement by and between Charles M. Cummins, O.D. P.A. and Eye Drx Retail Management, Inc., dated February 28, 2002.(l) 10 .45 Amendment No. 6 to Business Management Agreement by and between Charles M. Cummins O.D., P.A. and Eye Drx Retail Management, Inc., dated February 28, 2003.(l) 10 .46 Professional Business Management Agreement, dated May 25, 2003, by and between EyeMasters, Inc., a Delaware corporation, and S.L. Christensen, O.D. and Associates, P.C., an Arizona professional corporation.(n) 10 .47 Professional Business Management Agreement, dated May 12, 2003, by and between EyeMasters, Inc., a Delaware corporation, and Michael J. Martin, O.D. and Associates, P.C., P.C., a Georgia professional corporation.(n) 10 .48 Professional Business Management Agreement, dated August 3, 2003, by and between EyeMasters, Inc., a Delaware corporation, and Jason Wonch, O.D. and Associates, P.C., a Louisiana professional optometry corporation.(o) 12 .1 Statement re Computation of Ratios.** 21 .1 List of subsidiaries of Eye Care Centers of America, Inc.** 23 .1 Consent of Ernst Young LLP.* 23 .2 Consent of Weil, Gotshal Manges LLP (included in Exhibit 5.1 and 8.1)** 24 .1 Powers of Attorney (included on signature pages).* Table of Contents results and may be restricted by, among other things, the laws of their jurisdiction of organization (which may limit the amount of funds available for the payment of dividends), agreements of those subsidiaries, the terms of the new credit facility and the covenants of any future outstanding indebtedness we or our subsidiaries incur. Deferral of interest payments would have adverse tax consequences for you and may adversely affect the trading price of the IUs or the separate senior subordinated notes. If interest payments on the senior subordinated notes are deferred, you will be required to recognize interest income for U.S. federal income tax purposes in respect of interest payments on the senior subordinated notes represented by the IUs or the separate senior subordinated notes, as the case may be, held by you before you receive any cash payment of this interest. In addition, you will not receive this cash if you sell the IUs or the separate senior subordinated notes, as the case may be, before the end of any deferral period or before the record date relating to interest payments that are to be paid. If interest is deferred, the IUs or the separate senior subordinated notes may trade at a price that does not fully reflect the value of accrued but unpaid interest on the senior subordinated notes. In addition, our right to defer payments of interest on the senior subordinated notes under certain circumstances may mean that the market price for the IUs or the separate senior subordinated notes may be more volatile than other securities that do not have these provisions. You may not receive the level of dividends provided for in the dividend policy our Board of Directors is expected to adopt upon the closing of this offering or any dividends at all. Our Board of Directors may, in its discretion, amend or repeal the dividend policy it is expected to adopt upon the closing of this offering. Our Board of Directors may decrease the level of dividends provided for in this dividend policy or entirely discontinue the payment of dividends. Future dividends with respect to shares of our capital stock, if any, will depend on, among other things, our results of operations, cash requirements, financial condition, contractual restrictions, business opportunities, provisions of applicable law and other factors that our Board of Directors may deem relevant. The indenture governing our senior subordinated notes and the new credit facility will allow us to declare and make dividend payments only to the extent that we satisfy certain restrictive covenants in the indenture and the new credit facility. We cannot guarantee that these restrictive covenants will allow us to declare and pay dividends on our class A common stock at the levels anticipated by our dividend policy or at all. Under Texas law, our Board of Directors, and the Board of Directors of our corporate subsidiaries, may declare dividends only to the extent of our surplus, which is defined as total assets at fair market value minus total liabilities, minus statutory capital, or if there is no surplus, out of our net profits for the fiscal year in which the dividend is declared and/or the preceding fiscal year. We may not have such a surplus or net profits available to make dividend distributions. In addition, funds available for dividend and interest payments would be reduced if the senior subordinated notes were treated as equity rather than debt for U.S. federal income tax purposes. In that event, the stated interest on the senior subordinated notes could be treated as a dividend, and interest on the senior subordinated notes would not be deductible by us for U.S. federal income tax purposes. Our inability to deduct interest on the senior subordinated notes would materially increase our taxable income and, thus, our U.S. federal and applicable state income tax liability. The reduction or elimination of dividends may negatively affect the market price of the IUs or our class A common stock. Our interest expense may increase significantly and could cause our net income and distributable cash to decline significantly. The new credit facility will be subject to periodic renewal or must otherwise be refinanced. We may not be able to renew or refinance the new credit facility, or, if renewed or refinanced, the renewal or refinancing may occur on less favorable terms. Borrowings under the revolving facility will be made at a Public offering price $ $ % $ Underwriting discount $ $ % $ Proceeds to Eye Care Centers of America, Inc. (before expenses) $ $ % $ Table of Contents floating rate of interest. In the event of an increase in the base reference interest rates, our interest expense will increase and could have a material adverse effect on our ability to make cash dividend payments to our shareholders. Also, as discussed above, we may issue additional senior subordinated notes under certain circumstances, creating additional interest payment obligations. In such cases, we may elect to defer interest payments and postpone or cancel dividend payments. We may not generate sufficient funds from operations to pay our indebtedness at maturity. A significant portion of our cash flow from operations will be dedicated to maintaining our client base and servicing our debt requirements. In addition, we currently expect to distribute a significant portion of any remaining cash earnings to our shareholders in the form of quarterly dividends. Moreover, prior to the maturity of our senior subordinated notes, we will not be required to make any payments of principal on our senior subordinated notes. We may not generate sufficient funds from operations to repay the principal amount of our indebtedness at maturity. We may therefore need to refinance our debt or raise additional capital. These alternatives may not be available to us when needed or on satisfactory terms due to prevailing market conditions, a decline in our business or restrictions contained in our senior debt obligations. In addition, to the extent we do not generate sufficient funds from operations, our ability to continue to expand our business will, to a large extent, be dependent upon our ability to borrow funds under our new credit facility and to obtain other third-party financing, including through the sale of IUs or any sale of securities. We cannot assure you that such financing will be available to us on favorable terms or at all. The indenture governing our senior subordinated notes and our new credit facility permit us to pay a significant portion of our free cash flow to shareholders in the form of dividends. Although the indenture governing our senior subordinated notes and our new credit facility have some limitations on our payment of dividends, they permit us to pay a significant portion of our free cash flow to shareholders in the form of dividends and, following completion of this offering, we intend to pay quarterly dividends. Specifically, the indenture governing our senior subordinated notes permits us to pay up to the quarterly base dividend level in any fiscal quarter, which equals % of our excess cash (which is Distributable Cash Flow, as defined in the indenture), minus Consolidated Interest Expense, as defined in the indenture for the prior fiscal quarter, as more fully described in Description of Senior Subordinated Notes Certain Covenants. In addition, if the actual dividends paid in any fiscal quarter are less than the quarterly base dividend level, the indenture generally permits us to use the difference between the aggregate amount of dividends actually paid and the quarterly base dividend level for such quarter for the payment of dividends at a later date. Any amounts paid by us in the form of dividends will not be available in the future to satisfy our obligations under the senior subordinated notes. The realizable value of our assets upon liquidation may be insufficient to satisfy claims. At December 27, 2003, our assets included intangible assets in the amount of $107.4 million, representing approximately 47.6% of our total consolidated assets and consisting primarily of goodwill. The value of these intangible assets will continue to depend significantly upon the success of our business as a going concern. As a result, in the event of a default on our senior subordinated notes or any bankruptcy or dissolution of us, the realizable value of these assets may be substantially lower and may be insufficient to satisfy the claims of our creditors. Because of the subordinated nature of the senior subordinated notes, holders of our senior subordinated notes may not be entitled to be paid in full, if at all, in a bankruptcy, liquidation or reorganization or similar proceeding. The senior subordinated notes and the guarantees are unsecured and rank junior to all of our and the guarantors existing and the future senior indebtedness, including borrowings and related guarantees under the new credit facility. As of December 27, 2003, after giving effect to the Transactions, the senior subordinated notes and guarantees would have been subordinated to approximately $ million of our (1) Comprised of $ allocated to each share of class A common stock and $ allocated to each senior subordinated note, representing % of its stated principal amount. We have granted the underwriters an option to purchase up to additional IUs to cover overallotments, if any. We will use all of the proceeds from the sale of any additional IUs upon the exercise of the underwriters overallotment option to repurchase additional shares of outstanding class B common stock from our existing shareholders. The underwriters expect to deliver the securities to purchasers in book-entry form only through the facilities of The Depository Trust Company on or about , 2004. Table of Contents and our guarantors senior indebtedness. In addition, approximately $ million would have been available to us for borrowing as additional senior indebtedness. We would also be permitted to incur substantial additional indebtedness, including senior indebtedness, in the future. As a result of the subordinated nature of our notes and related guarantees, upon any distribution to our creditors or the creditors of the subsidiary guarantors in bankruptcy, liquidation or reorganization or similar proceeding relating to us or the subsidiary guarantors or our or their property, the holders of our senior indebtedness will be entitled to be paid in full in cash before any payment may be made with respect to our senior subordinated notes or the subsidiary guarantees. All payments on the senior subordinated notes will be blocked in the event of a payment default on senior indebtedness and may be blocked for up to consecutive days in the event of certain non-payment defaults on certain designated senior indebtedness, which will include indebtedness under our new credit facility. In addition, the principal amount of the senior subordinated notes will not be due and payable from us or the subsidiary guarantors without the prior written consent of the holders of our senior indebtedness for a period of up to days from the date of the occurrence of certain events of default with respect to our senior subordinated notes. In the event of a bankruptcy, liquidation or reorganization or similar proceeding relating to us or the subsidiary guarantors, the indenture relating to the senior subordinated notes will require that amounts otherwise payable to holders of senior subordinated notes in a bankruptcy or similar proceeding instead be paid to the holders of senior indebtedness until the holders of senior indebtedness are repaid in full. In any of these cases, if there are insufficient funds to pay all of our creditors, then the holders of the senior subordinated notes may receive less, ratably, than the holders of our senior indebtedness and, because of the obligation to turn over distributions to holders of senior indebtedness, the holders of our senior subordinated notes may receive less, ratably, than the holders of trade payable and other unsubordinated indebtedness in any such proceeding. The guarantees of the senior subordinated notes by our subsidiaries may not be enforceable and could require subordinated note holders to return payments received from us or the guarantors. Under federal bankruptcy law and comparable provisions of state fraudulent transfer laws, a guarantee could be voided, or claims in respect of the senior subordinated notes or a guarantee could be subordinated to all other debt of us or a guarantor, if, among other things, we or the guarantor, at the time that it assumed the guarantee: issued the senior subordinated notes or the guarantee to delay, hinder or defraud present or future creditors; received less than reasonably equivalent value or fair consideration for issuing the guarantee and, at the time it issued the senior subordinated notes or the guarantee: was insolvent or rendered insolvent by reason of issuing the senior subordinated notes or the guarantee and the application of the proceeds of the guarantee; was engaged or about to engage in a business or a transaction for which our or the guarantor s remaining assets available to carry on its business constituted unreasonably small capital; intended to incur, or believed that it would incur, debts beyond its ability to pay the debts as they mature; or was a defendant in an action for money damages, or had a judgment for money damages docketed against it if, in either case, after final judgment, the judgment is unsatisfied. In addition, any payment by us or a guarantor under its guarantee could be voided and required to be returned to the guarantor or to a fund for the benefit of the creditors of us or the guarantor. Joint Book-Running Managers Banc of America Securities LLC Merrill Lynch Co. Table of Contents The measures of insolvency for the purposes of fraudulent transfer laws vary depending upon the law applied in any proceeding to determine whether a fraudulent transfer has occurred. Generally, however, a person would be considered insolvent if, at the time it incurred the debt: the sum of its debts, including contingent liabilities, was greater than the fair saleable value of its assets; the present fair saleable value of its assets was less than the amount that would be required to pay its probable liability on its existing debts, including contingent liabilities, as they become absolute and mature; or it could not pay its debts as they become due. We believe that immediately after the issuance of the senior subordinated notes and the guarantees, we and each of the guarantors will be solvent, will have sufficient capital to carry on our respective businesses and will be able to pay our respective debts as they mature. However, we cannot be sure as to what standard a court would apply in making these determinations or that a court would reach the same conclusions with regard to these issues. Regardless of the standard that the court uses, we cannot be sure that the issuance by the subsidiary guarantors of the subsidiary guarantees would not be voided or the subsidiary guarantees would not be subordinated to their other debt. The guarantee of our senior subordinated notes by any subsidiary guarantor could be subject to the claim that, since the guarantee was incurred for our benefit, and only indirectly for the benefit of the subsidiary guarantor, the obligations of the subsidiary guarantor were incurred for less than fair consideration. If such a claim were successful and it was proven that the subsidiary guarantor was insolvent at the time the guarantee was issued, a court could void the obligations of the subsidiary guarantor under the guarantee or subordinate these obligations to the subsidiary guarantor s other debt or take action detrimental to holders of the senior subordinated notes. If the guarantee of any subsidiary guarantor were voided, our senior subordinated notes would be effectively subordinated to the indebtedness of that subsidiary guarantor. If we or one of our guarantors should become subject to a bankruptcy case, payments made to you may be recoverable as preferences under federal bankruptcy law (and, if applicable, certain state laws regulating assignments for the benefit of creditors and/or receivers) if those payments were made to you on account of the senior subordinated notes or other existing debt of ours, were made at a time when we were insolvent, were made within 90 days (but perhaps as long as one year) of the bankruptcy, and resulted in you receiving more than you would receive if we were simply liquidated under Chapter 7 of the Bankruptcy Code. The U.S. federal income tax consequences of the purchase, ownership and disposition of IUs are unclear and our cash available for dividends and interest could be reduced if the senior subordinated notes were treated as equity for tax purposes. No statutory, judicial or administrative authority directly addresses the treatment of the IUs or instruments similar to the IUs for U.S. federal income tax purposes. As a result, the U.S. federal income tax consequences of the purchase, ownership and disposition of IUs are unclear. We believe that an IU should be treated as a unit representing a share of class A common stock and a senior subordinated note. However, the Internal Revenue Service ( IRS ) or the courts may take the position that the senior subordinated notes included in the IUs are equity, which would result in our inability to take tax deductions on the interest that accrues on such senior subordinated notes and could adversely affect the amount, timing and character of income, gain or loss in respect of your investment in IUs, and materially increase our taxable income and, thus, our U.S. federal and applicable state income tax liability. This would reduce our after-tax cash flow and materially and adversely impact our ability to make interest and dividend payments on the senior subordinated notes, including the separate senior subordinated notes, and the class A common stock. Foreign holders could be subject to withholding or estate taxes with regard to the senior subordinated notes included in the IUs in the same manner as they will be with regard to the Table of Contents class A common stock and it could subject us to liability for withholding taxes that were not collected. Payments to foreign holders would not be grossed-up for any such taxes. For a discussion of these tax related risks, see Material United States Federal Income Tax Considerations. The allocation of the purchase price of the IUs may not be respected. The purchase price of each IU must be allocated between the share of class A common stock and senior subordinated note comprising an IU in proportion to their respective fair market values at the time of purchase. By purchasing the IUs, you will agree to and be bound by the allocation we make. If this allocation is not respected, it is possible that the senior subordinated notes will be treated as issued with OID, to the extent such notes were not already so treated, or with increased OID or with amortizable bond premium, to the extent the notes were not already so treated, or with increased amortizable bond premium. You generally would have to include OID in income in advance of the receipt of cash attributable to that income and would be able to elect to amortize bond premium over the term of the senior subordinated notes. The IRS may not view the interest rate on the senior subordinated notes as an arm s-length rate. We plan to deduct the interest expense on the senior subordinated notes from taxable income for income tax purposes, except to the extent of any bond issuance premium, and to report the full benefit of the income tax deductions in our consolidated financial statements. If the IRS were to determine that the interest rate on the senior subordinated notes did not represent an arm s-length rate, any excess amount over arm s length would not be deductible and could be recharacterized as a dividend payment instead of an interest payment. In addition, the reclassification of interest payments as dividend payments may give rise to an event of default under our new credit facility. In such case, our taxable income and, thus, our U.S. federal income tax liability could be materially increased and we would have to provide an additional liability in our consolidated financial statements for the previously recorded benefit for the interest deductions. In addition, foreign holders could be subject to withholding or estate taxes with regard to the senior subordinated notes in the same manner as they will be with regard to the class A common stock and it could subject us to liability for withholding taxes that were not collected. Payments to foreign holders would not be grossed-up for any such taxes. If the interest rate were determined to be less than the arm s-length rate, the senior subordinated notes could be treated as issued with OID, which you would be required to include in income over the term of the senior subordinated notes in advance of the receipt of cash attributable to that income. Because of the deferral of interest provisions, the senior subordinated notes may be treated as issued with OID. Under applicable Treasury regulations, a remote contingency that stated interest will not be timely paid will be ignored in determining whether a debt instrument is issued with OID. Although there is no authority directly on point, based on our financial forecasts, we believe that the likelihood of deferral of interest payments on the senior subordinated notes is remote within the meaning of the Treasury regulations. Based on the foregoing, although the matter is not free from doubt because of the lack of direct authority, we believe the senior subordinated notes should not be considered issued with OID at the time of their original issuance. If deferral of any payment of interest were determined not to be remote, the senior subordinated notes would be treated as issued with OID at the time of issuance. In such case, all stated interest on the senior subordinated notes would be treated as OID, and all holders, regardless of their method of tax accounting, would be required to include stated interest in income on a constant accrual basis. If we subsequently issue senior subordinated notes with significant original issue discount, we may not be able to deduct all of the interest on those senior subordinated notes. It is possible that senior subordinated notes we issue in a subsequent issuance will be issued at a discount to their face value and, accordingly, may have significant original issue discount and thus be Table of Contents Table of Contents classified as applicable high yield discount obligations, or AHYDOs. If any such senior subordinated notes were so treated, a portion of the OID on such senior subordinated notes would be nondeductible by us and the remainder would be deductible only when paid. This treatment would have the effect of increasing our taxable income and may adversely affect our cash flow available for interest payments and distributions to our equity holders. Subsequent issuances of IUs may cause you to recognize OID and may have other adverse consequences. The indenture governing our senior subordinated notes will provide that, in the event there is a subsequent issuance of IUs containing senior subordinated notes having terms that are identical (except for the issuance date) to the senior subordinated notes represented by the IUs, and such subsequently issued senior subordinated notes are treated as issued with OID or are issued subsequent to an automatic exchange of senior subordinated notes described below or if we otherwise determine that such senior subordinated notes are required to have a new CUSIP number, each holder of IUs or separate senior subordinated notes, as the case may be, agrees that a portion of such holder s senior subordinated notes will be exchanged for a portion of the senior subordinated notes acquired by the holders of such subsequently issued senior subordinated notes. Consequently, immediately following such subsequent issuance, each holder of subsequently issued senior subordinated notes, held either as part of IUs or separately, and each holder of existing senior subordinated notes, held either as part of IUs or separately, will own an inseparable unit composed of a proportionate percentage of both the old senior subordinated notes and the newly issued senior subordinated notes. Therefore, subsequent issuances of senior subordinated notes with OID pursuant to an IU offering by us or following an exchange of our class B common stock for IUs with existing shareholders or their transferees may adversely affect your tax treatment by requiring you to recognize OID or increasing the OID, if any, that you were previously accruing with respect to the senior subordinated notes held by you. However, because a subsequent issuance will affect the senior subordinated notes in the same manner, regardless of whether these senior subordinated notes are held as part of IUs or separately, the combination of senior subordinated notes and shares of class A common stock to form IUs, or the separation of IUs, should not affect your tax treatment. Because any newly issued senior subordinated notes may be issued with OID in amounts different from the senior subordinated notes represented by the already existing IUs, the IRS may assert that you have exchanged a portion of your senior subordinated notes, whether held as part of IUs or separately, for the newly issued senior subordinated notes in a taxable exchange for U.S. federal income tax purposes. In such case, although the deemed exchange would be taxable, you would generally not be expected to realize any gain on the deemed exchange, and any loss realized would likely be disallowed. We intend to take the position that any subsequent issuance of senior subordinated notes with a new CUSIP number, whether or not such senior subordinated notes are issued with OID, will not result in a taxable exchange of your senior subordinated notes for U.S. federal income tax purposes, but because of a lack of legal authority on point, our counsel is unable to opine on the matter. Following any subsequent issuance of IUs containing senior subordinated notes with OID, we (and our agents) will report any OID on the subsequently issued notes ratably among all holders of IUs and separately held senior subordinated notes, and each holder of IUs and separately held senior subordinated notes will, by purchasing IUs, agree to report OID in a manner consistent with this approach. However, there can be no assurance that the IRS will not assert that any OID should be reported only to the persons that initially acquired such subsequently issued notes (and their transferees). In such case, the IRS might further assert that, unless a holder can establish that it is not a person that initially acquired such subsequently issued senior subordinated notes (or a transferee thereof), all of the senior subordinated notes held by such holder have OID. Any of these assertions by the IRS could create significant uncertainties in the pricing of IUs and senior subordinated notes and could adversely affect the market for IUs and senior subordinated notes. For a discussion of these tax related risks, see Material United States Federal Income Tax Considerations. Table of Contents NOTICE TO PURCHASERS OF SEPARATE SENIOR SUBORDINATED NOTES AND ACKNOWLEDGMENT OF PURCHASER INTENT None of the separate senior subordinated notes purchased in connection with this offering may be purchased, directly or indirectly, by persons who are also (1) purchasing IUs in this offering or (2) otherwise receiving IUs or shares of class B common stock in connection with the transactions contemplated by this prospectus. Accordingly, each investor purchasing separate senior subordinated notes in this offering must not purchase IUs in this offering and must not concurrently enter into any plan or pre-arrangement whereby it would (1) acquire any IUs or any equity securities of our company or (2) transfer the separate senior subordinated notes to any holder of IUs or any equity securities of our company. In addition, each person receiving IUs or shares of class B common stock must not purchase separate senior subordinated notes in this offering. Each investor in this offering assumes sole responsibility for ensuring that it complies with the restrictions above. Neither we nor the underwriters will assume any responsibility to ensure that any investor complies with these restrictions. If you are unsure whether the restrictions above would prohibit you from purchasing the separate senior subordinated notes or IUs in this offering, you should consult your own legal advisor regarding the application of these restrictions to your individual circumstances. Furthermore, each person purchasing separate senior subordinated notes in this offering, by acquiring the separate senior subordinated notes, thereby represents to us and the underwriters that: (a) neither such purchaser nor any entity, investment fund or account over which such purchaser exercises investment control is purchasing IUs in this offering; (b) neither such purchaser nor any entity, investment fund or account over which such purchaser exercises investment control owns, or has the contractual right to acquire, our equity securities, including securities which are convertible, exchangeable or exercisable into or for our common stock; and (c) such purchaser is not party to any plan or pre-arrangement whereby it would (1) acquire any IUs or any equity securities of our company or (2) transfer the separate senior subordinated notes to any holder of IUs or any equity securities of our company. For purposes of these representations, the purchaser shall be deemed to be (1) the person who initially purchases the separate senior subordinated notes from the underwriters in this offering and (2) the person(s), if any, pursuant to whose instructions such purchase of separate senior subordinated notes is being made. Table of Contents Holders of subsequently issued senior subordinated notes may not be able to collect their full stated principal amount prior to maturity. Under New York and federal bankruptcy law, holders of subsequently issued senior subordinated notes having OID may not be able to collect the portion of their principal amount that represents unamortized OID as at the acceleration or filing date in the event of an acceleration of the senior subordinated notes or a bankruptcy of us, prior to the maturity date of the senior subordinated notes. As a result, an automatic exchange that results in a holder receiving a subordinated note with OID could have the effect of ultimately reducing the amount such holder can recover from us in the event of an acceleration or bankruptcy. You will be immediately diluted by $ per share of class A common stock if you purchase IUs in this offering. If you purchase IUs in this offering, you will experience an immediate dilution of $ per share of class A common stock represented by the IUs, which exceeds the entire price allocated to each share of class A common stock represented by the IUs in this offering because there will be a net tangible book deficit for each share of class A common stock outstanding immediately after this offering. Our net tangible book deficiency as of December 27, 2003, after giving effect to this offering, would have been approximately $ million, or $ per share of class A common stock. Our capital structure after consummation of this offering may limit our ability to market and issue equity-only securities. As a result of the restrictions in the indenture governing the senior subordinated notes and the restrictions in the other agreements governing our indebtedness, we may be prevented from issuing additional IUs in the future to raise additional capital. If we are unable to issue additional IUs, we may be forced to rely on equity-only securities as an additional source of capital. Although we are not contractually restricted from issuing certain equity-only securities, all of our equity holders except our existing shareholders will initially hold their investment in us in the form of IUs, which are compromised of both our class A common stock and our senior subordinated notes and consequently, equity-only securities may be a comparatively less attractive investment. Therefore, we cannot assure you that we will be able to issue equity-only securities on commercially reasonable terms, or at all. We may not have the ability to raise the funds necessary to fulfill our obligations under the senior subordinated notes following a change of control. This would place us in default under the indenture governing the senior subordinated notes. Upon the occurrence of certain specific kinds of change of control events, we will be required to offer to repurchase all of the outstanding senior subordinated notes. However, it is possible that we will not have sufficient funds at the time of the change of control to make the required repurchase or that restrictions in our new credit facility will not allow such repurchases. Our ability to repurchase these senior subordinated notes upon certain specific kinds of change of control events may be limited by the terms of our senior indebtedness and the subordination provisions of the indenture governing the senior subordinated notes. For example, our new credit facility will prohibit us from repurchasing these notes after certain specific kinds of change of control events until we first repay debt under the new credit agreement in full or obtain a waiver from the lenders under our new credit facility. If we fail to repurchase these senior subordinated notes in that circumstance, we will be in default under the indenture related to the senior subordinated notes and under the new credit facility. Any future debt that we incur may also contain restrictions on repayment which come into effect upon certain specific kinds of change of control events. If a change of control occurs, we cannot assure you that we will have sufficient funds to repay other debt obligations which will be required to be repaid, in addition to the senior subordinated notes. TABLE OF CONTENTS Page Table of Contents Before this offering, there has not been a public market for our IUs, shares of our class A common stock or senior subordinated notes. The market price of our IUs or our separate senior subordinated notes may fluctuate substantially, which could negatively affect IU holders or the separate senior subordinated notes. None of the IUs, the shares of our class A common stock or senior subordinated notes has a public market history. In addition, as the IU is a new security, there has not been an active market in the United States for similar securities. We cannot assure you that an active trading market for the IUs will develop in the future, and we currently do not expect that an active trading market for the shares of our class A common stock or the senior subordinated notes will develop. If the senior subordinated notes represented by your IUs are redeemed or mature, certain bankruptcy events affecting us occur, or there is a payment default that continues for more than 90 days, the IUs will automatically separate and you will then hold the shares of our class A common stock. We do not expect to list our class A common stock on any securities exchange until a sufficient number of shares are no longer held in the form of IUs to satisfy the minimum listing criteria of the , as described in Description of Capital Stock Listing. We currently do not intend to list our senior subordinated notes on any securities exchange. The initial public offering price of the IUs and the initial public offering price of the separate senior subordinated notes will be determined by negotiations among us, the existing equity investors and the representatives of the underwriters and may not be indicative of the market price of the IUs or the separate senior subordinated notes after the offering. Factors such as quarterly variations in our financial results, announcements by us or others, developments affecting us, our clients and our suppliers, general interest rate levels and general market volatility could cause the market price of the IUs or the separate senior subordinated notes to fluctuate significantly. Future sales or the possibility of future sales of a substantial number of IUs, shares of our class A common stock or our senior subordinated notes may depress the price of the IUs and the shares of our class A common stock and our senior subordinated notes. Future sales or the availability for sale of substantial number of IUs or shares of our class A common stock or a significant principal amount of our senior subordinated notes could adversely affect the prevailing market price of the IUs and the shares of our class A common stock and our senior subordinated notes and could impair our ability to raise capital through future sales of our securities. Upon consummation of this offering, we anticipate that our existing shareholders will own million shares of our outstanding class B common stock, representing approximately % of our outstanding common stock (or million shares of our class B common stock, representing % of our common stock if the underwriters overallotment option with respect to the IUs is exercised in full). In circumstances permitted by the indenture governing the senior subordinated notes and the new credit facility, holders of our class B common stock will have certain rights to exchange their class B common stock for the equivalent value of IUs, which IUs could be sold pursuant to an underwritten or other registered offering under a registration rights agreement with us. Such sales could cause a decline in the market price of the IUs. We may issue shares of our class A common stock and senior subordinated notes, which may be in the form of IUs, or other securities from time to time as consideration for future acquisitions and investments. In the event any such acquisition or investment is significant, the number of shares of our class A common stock and the aggregate principal amount of senior subordinated notes, which may be in the form of IUs, or the number or aggregate principal amount, as the case may be, of other securities that we may issue may in turn be significant. In addition, we may also grant registration rights covering those IUs, shares of our class A common stock, senior subordinated notes or other securities in connection with any such acquisitions and investments. Table of Contents Our articles of incorporation and bylaws and several other factors could limit another party s ability to acquire us and could deprive our investors of the opportunity to obtain a takeover premium for their securities. Upon amending and restating our articles of incorporation, a number of provisions in our articles of incorporation and bylaws, and certain provisions of Texas law will make it difficult for another company to acquire us and for you to receive any related takeover premium for your securities. For example, our articles of incorporation will provide that certain provisions of our articles of incorporation can only be amended by a vote of two-thirds or more in voting power of all the outstanding shares of capital stock and that shareholders generally may not act by written consent and only shareholders representing at least 50% in voting power may request that our Board of Directors call a special meeting. Our articles of incorporation will provide for a classified Board of Directors and authorize the issuance of preferred stock without shareholder approval and upon such terms as the Board of Directors may determine. In addition, the rights of the holders of shares of our class A common stock will be subject to, and may be adversely affected by, the rights of holders of any class or series of preferred stock that may be issued in the future. The separate senior subordinated notes may suffer from illiquidity compared to the IUs. We are offering $ million aggregate principal amount of the senior subordinated notes separately, which represents % of the total outstanding senior subordinated notes. The capital markets generally have treated securities issued as part of a larger series more favorably than similar securities offered as part of a smaller series. While the separate senior subordinated notes are part of the same series of senior subordinated notes as the senior subordinated notes represented by the IUs, the separate senior subordinated notes may suffer from an illiquidity discount because they will not be as readily tradeable as the IUs. Such an illiquidity discount may be a feature of the separate senior subordinated notes so long as there are insufficient shares of our class A common stock outstanding as not part of IUs at any time for the separate senior subordinated notes to be combined with shares of our class A common stock to form IUs. Risks Relating to our Business and the Optical Retail Industry If we do not compete successfully in the competitive optical retail industry, our business and revenues may be adversely affected and competitive pressures in our industry may lower profit margins. The optical retail market is highly competitive and is continuing to undergo rapid consolidation. We compete directly with national, regional and local retailers, independent practitioners, warehouse clubs and mass merchandisers located in our markets within the U.S. Many potential competitors for our products and services have, and some potential competitors are likely to enjoy, substantial competitive advantages, including the following: greater name recognition; greater financial, technical, marketing and other resources; more extensive knowledge of the optical retail business and industry; and well-established relationships with a larger base of current and potential customers and suppliers and managed care providers. For example, at times when our major competitors offer significantly lower prices for their products, we are often required to do the same. Certain of our major competitors offer promotional incentives to their customers including free eye exams, 50% Off on designer frames and Buy One, Get One Free eye care promotions. In response to these promotions, we have offered the same or similar incentives to our customers. This practice has resulted in lower profit margins and these competitive promotional incentives may further reduce our revenues, gross margins and cash flows. Several of the other large optical retail chains have greater financial resources than we do. Therefore, we may not be able to Table of Contents continue to deliver cost efficient products in the event of aggressive pricing by our competitors, which would adversely affect our profit margins, net income and cash flow. We may also encounter increased competition in the future from industry consolidation and from new competitors that enter our market. Increased competition could result in lower sales or downward price pressure on our products and services, which may adversely affect our results of operations. Any termination or dispute relating to our long term professional corporation management agreements could have a material adverse effect on our business. Sixty-four of our stores are subleased to a professional corporation or other entity controlled by an optometrist (an OD PC ). The OD PC owns the store (consisting of both the optical dispensary and the professional eye examination practice) and employs the optometrists, and we manage these stores under management agreements (including management of the professional practice and optical retail business). Each of the OD PCs sublease between 12 and 24 stores. No assurances can be given as to the likelihood of an agreement being terminated by an OD PC, a dispute arising between us and the OD PC or a challenge to our operating structure by a state or federal regulatory agency and the resulting impact on our results of operations and cash flows. In addition, a finding that an OD PC does not comply with applicable laws could have a material adverse effect on our results of operations. See Business Government Regulation. Any events resulting in a change in our relationship with the optometrist located in or adjacent to our stores could have a material adverse effect on our business. At 227 of our stores, the optometrists are independent optometrists who lease space within or adjacent to each store to operate their eye examination practices. We also license the use of our trademark Master Eye Associates at the 191 locations operating within or adjacent to our EyeMasters stores. Most of these independent optometrists pay us monthly rent or a license fee consisting of a percentage of gross receipts or base rental. At 36 of these stores, we also provide management services to the optometrist s professional eye exam practice for an additional management fee. Most of these optometrists operate one practice location, but seven optometrists operate an aggregate of 97 locations. The location of optometrists within or adjacent to our stores is an important part of our operating strategy. No assurances can be given as to the likelihood of events adversely affecting the relationship with these optometrists or our ability to locate optometrists within or adjacent to our stores including, without limitation (i) a dispute with an optometrist or group of optometrists controlling multiple practice locations, (ii) a government or regulatory authority challenging our operating structure or our relationship with the optometrists or (iii) other changes to applicable laws or regulations (or interpretations of the same), resulting in changes to our operating structures. Any of these events could have a material adverse affect on our results of operations. See Business Government Regulation. Adverse changes in economic conditions generally or in our markets, and changes in consumer tastes, could reduce demand for our products and services which could adversely affect our results of operations. The optical retail industry is cyclical. Downturns in general economic conditions or uncertainties regarding future economic prospects, which affect consumer disposable income, have historically adversely affected consumer spending habits in our principal markets. Therefore, future economic downturns or uncertainties could have a material adverse effect on our business, results of operations, financial condition and cash flows. The optical retail industry is also subject to rapidly changing consumer preferences. While eyewear has achieved widespread acceptance as a fashion accessory, leading to overall growth in our sales, there can be no assurance that this growth will continue or that consumer preferences will not change in a manner which will adversely affect us or the optical retail industry as a whole. Table of Contents Our future success will depend in part on our ability to build and maintain managed care relationships. As an increasing percentage of patients enter into health care coverage arrangements with managed care payors, we believe that our success will be, in part, dependent upon our ability to participate in the managed vision care plans of employer groups and other private third party payors. Our existing managed vision care relationships are not contractual and may be terminated with little or no notice. Currently, we participate in a managed care network that we anticipate being removed from in fiscal 2004, which presently accounts for approximately $4.0 million in annual revenues. There is no certainty that we will be able to establish or maintain satisfactory relationships with managed care and other third party payors, many of which have existing provider structures in place and may not be able or willing to change their provider networks. Our inability to maintain our current relationships or enter into such arrangements in the future could have a material adverse effect on our results of operations. Technological advances may reduce the demand for our products or allow other manufacturers to produce eyewear at lower cost than we can, which could have a material adverse effect on our results of operations. Corneal refractive surgery procedures such as radial-keratotomy, photo-refractive keratotomy, Laser In-Situ Keratomileusis, or LASIK, and future drug development, may change the demand for our products. As traditional eyewear users undergo laser vision correction procedures or other vision correction techniques, the demand for certain contact lenses and eyeglasses will decrease. Because the marketing and sale of eyeglasses and contact lenses is a significant part of our business, a decrease in customer demand for these products could have a material adverse effect on sales of prescription eyewear. In addition, technological developments such as wafer technology and lens casting may render our current lens manufacturing method uncompetitive or obsolete. There can be no assurance that medical advances and technological developments will not have a material adverse effect on our results of operations. After completion of this offering, certain of our directors and shareholders affiliated with Thomas H. Lee Partners, L.P. will own approximately % in the aggregate of our outstanding common stock on a fully diluted basis, will initially have representatives on our member Board of Directors and could influence actions taken by our Board of Directors or matters presented to our shareholders. After completion of our offering, certain of our directors and shareholders affiliated with Thomas H. Lee Partners, L.P., or THL, will own approximately % in the aggregate of our outstanding common stock, on a fully diluted basis. Additionally, THL will initially have representatives on our member Board of Directors. Consequently, THL may be able to influence matters submitted for shareholder action, including the election of our Board of Directors and approval of significant corporate transactions, including business combinations, consolidations and mergers and the determination of our day-to-day corporate and management policies. This substantial influence could be exercised in a manner that may be in conflict with the interests of our other shareholders. In addition, our existing equity investors have and may, in the future, make significant investments in other companies, some of which may be competitors. None of our existing equity investors are obligated to advise us of any investment or business opportunities of which they are aware and they are not restricted or prohibited from competing with us. See Related Party Transactions. We depend on the ability and experience of certain members of our management team and their departure may have a material adverse effect on our results of operations. To guide our operations, we rely on the skills of certain members of our senior management team, the loss of whom could have an adverse effect on our operations. Furthermore, the members of our senior management team have annual employment agreements with us that automatically renew unless either party gives at least thirty days notice. Accordingly, key executives may not continue to work for us, and we may not have adequate time to hire qualified replacements, which could have a material adverse effect on us. Table of Contents We could be subject to franchise claims by optometrists that could limit our ability to conduct our business in the manner we deem appropriate. We sublease office space to certain optometrists who enter into Trademark License Agreements with Enclave Advancement Group, Inc., one of our subsidiaries ( Enclave ). We may be subject to claims that this leasing of space from us, coupled with the license from Enclave of certain trademarks, constitutes a franchise and thereby gives the tenant optometrists certain rights as franchisees. No assurance can be given that a claim, action or proceeding will not be brought against us or Enclave asserting that a franchise exists or that the success of any such claim would not impair the way in which we currently structure our relationships with optometrists. We may be exposed to a significant risk from liability claims if we are unable to obtain adequate insurance, at acceptable costs, to protect us against potential liability claims. The provision of professional eye care services entails an inherent risk of professional malpractice and other similar claims. We do not influence or control the practice of optometry by the optometrists that we employ or affiliate with, nor do we have responsibility for their compliance with certain regulatory and other requirements directly applicable to these individual professionals. However, as a result of the relationship between affiliated optometrists and us, we may become subject to professional malpractice actions or claims under various theories relating to the professional services provided by these individuals. Premiums for medical malpractice insurance may significantly increase which could adversely affect our results of operations and cash flow or force us to self insure against these potential claims. We may not be able to continue to obtain adequate liability insurance to cover claims asserted against us, in which event, our financial condition and results of operations could be adversely affected and our ability to continue operations could be jeopardized. We rely on third-party reimbursement for many of our customers costs, the future reduction of which could adversely effect our results of operations. The cost of a significant portion of medical care in the United States is funded by government and private insurance programs, such as Medicare, Medicaid and corporate health insurance plans. According to governmental projections, it is expected that more medical beneficiaries who are significant consumers of eye care services will enroll in managed care organizations. The health care industry is experiencing a trend toward cost-containment with governmental and private third party payors seeking to impose lower reimbursement, utilization restrictions and risk-based compensation arrangements. Private third-party reimbursement plans are also developing increasingly sophisticated methods of controlling health care costs through redesign of benefits and explorations of more cost-effective methods of delivering health care. Accordingly, there can be no assurance that reimbursement for purchase and use of eye care services will not be limited or reduced and thereby adversely affect our results of operations, financial condition and cash flows. Government revenue sources are subject to statutory and regulatory changes, administrative rulings, interpretations of policy, determinations by fiscal intermediaries and carriers, and government funding limitations, all of which may materially increase or decrease the rates of payment and cash flow to us. There is no assurance that payments made under such programs will remain at levels comparable to the present levels or be sufficient to cover all operating and fixed costs. Government or third party payors may retrospectively and/or prospectively adjust previous payments to us in amounts which would have a material adverse effect on us. Table of Contents Risks Relating to our Regulatory Environment We are subject to extensive state, local and federal laws and regulations that affect the health care industry, which may affect our ability to generate revenue or subject us to additional expenses. The delivery of health care, including the relationships between health care providers such as optometrists, opticians and optical retailers, is subject to extensive federal and state regulation. Our relationships with optometrists are subject to these laws and regulations. These laws and regulations are subject to interpretation, and a finding that we are not in compliance could have a material adverse effect on our financial condition and results of operations. Furthermore, we cannot predict the impact of future developments or changes to the regulatory environment or the impact such developments or changes would have on our operations, our compliance costs, our relationships with optometrists or the implementation of our business plan. Regulation of the healthcare industry is constantly changing, which affects our opportunities, competition and other aspects of our business. State Optometric Laws. The laws and regulations governing the relationship between optometrists and optical retailers vary from state to state and are enforced by both courts and regulatory authorities, each with broad discretion. In certain circumstances, private parties may also be able to bring actions for violations of these laws and regulations. Except in states which allow us to employ optometrists, the state optometric laws generally prohibit us from controlling the practice of optometry or practicing optometry, which may include, among other things, exercising control over practice hours, patient scheduling, employment of optometrists, protocols, examination fees and other matters requiring the professional judgment of the optometrist. In most states where we are located, the activities constituting control of the practice of optometry are not described or enumerated in the statutes or the regulations, and there is no written guidance issued by the applicable regulatory authorities, resulting in uncertainty as to the interpretation and applications of such laws and regulations. In addition to this broad prohibition, many states have specific restrictions and requirements applicable to the relationships between optometrists and optical retailers. The independent optometrists who sublease space within or adjacent to each store to operate their eye examination practices enter into sublease agreements and, in some instances, license our trademark Master Eye Associates. The subleases contain certain provisions, including restrictions on selling optical goods and maintaining licensing. Our previous standard form of sublease contained a representation by the optometrist relating to maintaining certain specified operating hours. In the form of sublease we began using in November 2003, the optometrist represents to us that his or her office hours will be consistent with both industry standards for optometry practices and the hours of operation of the shopping center or mall (as specified in the sublease) within which the subleased premises are located. Some states have regulatory restrictions with respect to setting the hours of operation of an optometrist and our subleases could be determined to conflict with these restrictions. At 36 of our stores, we also provide management services to the optometrist s professional eye exam practice for a management fee. A court or regulatory authority could conclude that our contractual arrangements under the subleases, trademark license agreements and management agreements, and our day-to-day operational practices in managing these relationships, results in the improper control of an optometric practice or otherwise do not comply with applicable laws and regulations. The impact of such a finding could adversely affect our results of operations, financial condition and cash flows. At the 64 of our stores that are owned by an OD PC, we provide management services under business management agreements. Courts and regulatory authorities are likely to look at all of the agreements relating to the operating structure and the actual day-to-day operating procedures employed at each store location in making a determination as to whether or not our operations result in the improper control of an optometric practice. Our close involvement with the day-to-day operations of the OD PC increases the risk that a court or other regulatory authority could allege that we are controlling the optometry practice or otherwise violating the applicable laws and regulations. We have not requested, and have not received, from any governmental agency an advisory opinion finding that our relationships with the OD PCs are in Table of Contents compliance with applicable laws and regulations, and all such relationships may not be found to comply with such laws and regulations. Violations of these laws and regulations may result in censure or delicensing of optometrists, substantial civil or criminal damages and penalties, including double and triple monetary damages and penalties, and, in the case of violations of federal laws and regulations, exclusion from the Medicare and Medicaid programs, or other sanctions. Such exclusions and penalties, if applied to us, could have a material adverse effect on us. In addition, a determination in any state that we are controlling an optometric practice or engaged in the corporate practice of medicine or any unlawful fee-splitting arrangement could render any sublease, management or service agreement between us and optometrists located in such state unenforceable or subject to modification, or necessitate a buy-out of an OD PC, which could have a material adverse effect on our financial condition and results of operations. Fraud and Abuse and Anti-Referral Laws. We and the optometrists we employ or with whom we contract for space and/or management services receive payments from the federal Medicare and state Medicaid programs for services and goods. As such, we are subject to the reimbursement rules and fraud and abuse provisions of those programs which prohibit the solicitation, payment, receipt, or offering of any direct or indirect remuneration in return for, or as an inducement to, certain referrals of patients, items or services. These same provisions of the federal Medicare and Medicaid laws also impose significant penalties for false or improper billings to Medicare and Medicaid, and many states have adopted similar laws applicable to any payor of health care services. In addition, the federal Stark Self-Referral Law imposes restrictions on physicians referrals for designated health services reimbursable by Medicare or Medicaid to entities with which the physicians have financial relationships, including the rental of space if certain requirements have not been satisfied. Many states have adopted similar self-referral laws which are not limited to Medicare or Medicaid reimbursed services. Violations of any of these laws may result in substantial civil or criminal penalties, including double and treble civil monetary penalties, and, in the case of violations of federal laws, exclusion from participation in the Medicare and Medicaid programs. Licensure of Opticians. We must obtain licenses or certifications to operate our business in certain states. To obtain and maintain such licenses, we must satisfy certain licensure standards. In addition, we employ opticians in our stores to assist in dispensing eyeglasses and other optical goods. The laws and regulations governing opticians and their relationship with optical retailers vary from state to state. Some states require a licensed optician to be on the premises, while other states do not require licensed opticians or permit the licensed optician (or an optometrist) to supervise other unlicensed opticians. Generally, licensed opticians demand a higher salary so we staff our stores with unlicensed opticians as permitted by applicable law. Changes in licensure standards or requirements could increase our costs or prevent us from providing certain services, both of which could have a material adverse effect on our financial condition and results of operations. Insurance Licensure. Most states impose strict licensure requirements on health insurance companies, HMOs and other companies that engage in the business of insurance. In the event that we are required to become licensed under these laws, the licensure process can be lengthy and time consuming. In addition, many of the licensing requirements mandate strict financial and other requirements which we may not be able to meet. Any Willing Provider Laws. Some states have adopted, and others are considering, legislation that requires managed care payors to include any provider who is willing to abide by the terms of the managed care payor s contracts and/or prohibit termination of providers without cause. These types of laws limit our ability to develop effective managed care provider networks in such states. This could adversely affect our ability to implement our business plan. Antitrust Laws. We and our networks of providers are subject to a range of antitrust laws that prohibit anti-competitive conduct, including price-fixing, concerted refusals to deal and divisions of markets. There may be a challenge to our operations on the basis of an antitrust violation in the future. Table of Contents OUR ORGANIZATIONAL STRUCTURE AFTER THIS OFFERING The chart below depicts our organizational structure immediately after the Transactions. Table of Contents Advertising. The laws and regulations governing advertising in general, and with respect to optometrists and optical retailers in particular, vary from state to state and are also governed by various federal regulations, including regulations promulgated by the Federal Trade Commission ( FTC ). State advertising statutes and regulations prohibit false or misleading advertisements and restrict our ability to advertise for independent optometrists subleasing space from us. In addition, the FTC has promulgated regulations which limit the frequency of free offers in order to avoid potential deceptive advertising. Courts and regulatory agencies could conclude that our advertising practices do not comply with applicable laws and regulations and a change in our advertising practices could have a material effect on the results of our operations. HIPAA. The Health Insurance Portability and Accountability Act of 1996 ( HIPAA ) covers a variety of subjects which impacts our businesses and the business of the optometrists. Some of those subjects include the privacy of patient health care information, the security of such information and the standardization of electronic data transactions for purposes of medical billing. The Department of Health and Human Services promulgated HIPAA regulations which became effective during 2003. We have devoted, and continue to devote, resources to implement operating procedures within the stores and the corporate office to ensure compliance with the HIPAA regulations. Penalties under HIPAA, if applied to us, or a determination that we or any affiliated optometrists or OD PCs are not in compliance with such laws, could have a material adverse effect on our results of operations. Proposed and future health care reform initiatives could require us to make costly modifications to our business arrangements. There have been numerous initiatives at the federal and state levels for comprehensive reforms affecting the payment for and availability of healthcare services. We believe that such initiatives will continue during the foreseeable future. Aspects of certain of these reforms as proposed in the past or others that may be introduced could, if adopted, adversely affect us. The federal government has issued proposed regulations which further describe prohibited referrals, the nature of financial relationships and permitted exceptions. We believe that we are in material compliance with these regulations as proposed. The federal government has not yet issued final regulations. We cannot assure you that future interpretations of such laws and regulations will not require modifications to our business arrangements. Table of Contents
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+RISK FACTORS An investment in the IUs, the shares of our class A common stock and/or our senior subordinated notes involves a number of risks. In addition to the other information contained in this prospectus, prospective investors should give careful consideration to the following factors. Any of the following risks could materially adversely affect our business, financial condition, results of operations, cash flows or liquidity. In such case you may lose all or part of your original investment. Risks Relating to the IUs, the Shares of Class A Common Stock and the Senior Subordinated Notes We have substantial indebtedness, which could restrict our ability to pay interest and principal on the senior subordinated notes and dividends with respect to shares of our class A common stock represented by the IUs and impact our financing options and liquidity position. As of December 27, 2003 after giving pro forma effect to the Transactions, we would have had total consolidated indebtedness of $ million and a shareholders deficit of $ million. The degree to which we are leveraged on a consolidated basis could have important consequences to the holders of the IUs or the separate senior subordinated notes, including: making it more difficult for us to satisfy our obligations with respect to the senior subordinated notes and our other indebtedness and/or pay dividends on our class A common stock; increasing our vulnerability to general adverse economic and industry conditions; placing us at a competitive disadvantage to many of our competitors who are less leveraged than we are; limiting our ability to issue new IUs or other equity; limiting our ability to borrow additional amounts for working capital, capital expenditures or future business opportunities, including strategic acquisitions and other general corporate requirements, or hindering us from obtaining such financing on terms favorable to us or at all; requiring us to dedicate a substantial portion of our cash flow from operations to payments on our indebtedness, thereby reducing the availability of our cash flow to fund working capital, capital expenditures, future business opportunities and other general corporate purposes; limiting our flexibility in planning for, or reacting to, changes in our business and the industry and markets in which we operate; and limiting our ability to refinance our indebtedness. Despite our substantial indebtedness, we and our subsidiaries may be able to incur substantial additional indebtedness in the future that could intensify the risks described above and would make it more difficult for us to satisfy obligations on the senior subordinated notes and our other indebtedness and pay dividends on our class A common stock and further reduce the cash we have available to invest in our operations. If we do not generate sufficient cash flow to meet our debt service obligations and to fund our working capital requirements, we may need to seek additional financing or sell certain of our assets. Our new credit facility will contain significant limitations on distributions and other payments. In addition, we may amend the terms of our new credit facility, or we may enter into new agreements that govern our senior indebtedness, and the amended terms or new agreements may further significantly affect our ability to pay interest to holders of our IUs and/or our senior subordinated notes and/or dividends to holders of our IUs. Our new credit facility will contain significant restrictions on our ability to pay interest on the senior subordinated notes and dividends on the shares of class A common stock based on meeting certain financial ratios and compliance with other conditions. As a result of general economic conditions, conditions in the lending markets, the results of our business or for any other reason, we may elect or be Table of Contents required to amend or refinance our new credit facility, at or prior to maturity, or enter into additional agreements for senior indebtedness. Regardless of any protection you have in the indenture governing the senior subordinated notes, any such amendment, refinancing or additional agreement may contain covenants that could limit in a significant manner our ability to make interest payments on the senior subordinated notes and to pay dividends on our class A common stock. We are subject to restrictive debt covenants and other requirements related to our outstanding debt that limit our business flexibility by imposing operating and financial restrictions on us. The agreements governing our indebtedness impose significant operating and financial restrictions on us. These restrictions prohibit or limit, among other things, our ability and the ability of our restricted subsidiaries to: pay dividends or distributions on, or redeem or repurchase our capital stock; make certain types of investments, loans or advances; incur additional debt; issue additional shares of preferred or redeemable capital stock; enter into transactions with affiliates; create liens; sell certain assets and subsidiary stock; make certain restrictions on distributions from our restricted subsidiaries; or merge, consolidate or sell all or substantially all our assets. The terms of the new credit facility will include other and more restrictive covenants and may prohibit us from prepaying our other indebtedness, including the senior subordinated notes, while indebtedness under the new credit facility is outstanding. The new credit facility will also require us to maintain specified financial ratios and satisfy financial condition tests. Our ability to comply with the ratios or tests may be affected by events beyond our control, including prevailing economic, financial and industry conditions. A breach of any of these covenants, ratios or tests could result in a default under the new credit facility and/or the indenture. Certain events of default under the new credit facility would prohibit us from making payments on the senior subordinated notes, including payment of interest when due. In addition, upon the occurrence of an event of default under the new credit facility, the lenders could elect to declare all amounts outstanding under the new credit facility, together with accrued interest, to be immediately due and payable. If we were unable to repay those amounts, the lenders could proceed against the security granted to them to secure that indebtedness. An acceleration by the lenders of payments of indebtedness under the new credit facility may cause an acceleration of amounts outstanding under the senior subordinated notes or other indebtedness which we may not be able to repay. If the lenders accelerate the payment of the indebtedness, our assets may not be sufficient to repay in full this indebtedness and our other indebtedness, including the senior subordinated notes. We are a holding company and rely on dividends, interest and other payments, advances and transfers of funds from our subsidiaries to meet our debt service and other obligations. We are a holding company and conduct all of our operations through our subsidiaries and currently have no significant assets other than the capital stock of our subsidiaries, all of which will be pledged to the creditors under the new credit facility. As a result, we will rely on dividends and other payments or distributions from our subsidiaries to meet our debt service obligations and enable us to pay interest on the senior subordinated notes and dividends on our class A common stock. The ability of our subsidiaries to pay dividends or make other payments or distributions to us will depend on their respective operating 21 .1 List of subsidiaries of Eye Care Centers of America, Inc.** 23 .1 Consent of Ernst Young LLP.* 23 .2 Consent of Weil, Gotshal Manges LLP (included in Exhibit 5.1 and 8.1)** 24 .1 Powers of Attorney (included on signature pages).* 10 .33 Amendment to Retail Business Management Agreement by and between Visionary Retail Management, Inc. and Dr. Mark Lynn Associates, PLLC, dated June 1, 1999.(f) 10 .34 Amendment to Retail Business Management Agreement by and between Visionary Retail Management, Inc. and Dr. Mark Lynn Associates, PLLC, dated August 31, 2000.(f) 10 .35 Professional Business Management Agreement, dated October 1, 1998, by and between Visionary MSO, Inc., a Delaware Corporation, and Dr. Mark Lynn Associates, PLLC.+** 10 .36 Amendment to Professional Business Management Agreement by and between Visionary MSO, Inc. and Dr. Mark Lynn Associates, PLLC, dated June 1, 1999.(f) 10 .37 Amendment Professional Business Management Agreement by and between Visionary MSO, Inc. and Dr. Mark Lynn Associates, PLLC, dated August 1, 2000.(f) 10 .38 Professional Business Management Agreement, dated June 19, 2000, by and between Visionary Retail Management, Inc., a Delaware corporation, and Dr. Tom Sowash, O.D. and Associates, LLC, a Colorado limited liability company.(d) 10 .39 Business Management Agreement by and between Vision Twenty-One, Inc. and Charles M. Cummins, O.D. and Elliot L. Shack, O.D., P.A., dated January 1, 1998.(l) 10 .40 Amendment No. 1 to Business Management Agreement by and between Charles M. Cummins, O.D., P.A., and Eye Drx Retail Management, Inc., dated August 31, 1999.(l) 10 .41 Amendment No. 2 to Business Management Agreement by and between Charles M. Cummins, O.D., P.A. and Eye Drx Retail Management, Inc., dated February 29, 2000.(f) 10 .42 Amendment No. 3 to Business Management Agreement by and between Charles M. Cummins, O.D., P.A. and Eye Drx Retail Management, Inc., dated May 1, 2000.(f) 10 .43 Amendment No. 4 to Business Management Agreement by and between Charles M. Cummins, O.D., P.A. and Eye Drx Retail Management, Inc., dated February 1, 2001.(f) 10 .44 Amendment No. 5 to Business Management Agreement by and between Charles M. Cummins, O.D. P.A. and Eye Drx Retail Management, Inc., dated February 28, 2002.(l) 10 .45 Amendment No. 6 to Business Management Agreement by and between Charles M. Cummins O.D., P.A. and Eye Drx Retail Management, Inc., dated February 28, 2003.(l) 10 .46 Professional Business Management Agreement, dated May 25, 2003, by and between EyeMasters, Inc., a Delaware corporation, and S.L. Christensen, O.D. and Associates, P.C., an Arizona professional corporation.(n) 10 .47 Professional Business Management Agreement, dated May 12, 2003, by and between EyeMasters, Inc., a Delaware corporation, and Michael J. Martin, O.D. and Associates, P.C., P.C., a Georgia professional corporation.(n) 10 .48 Professional Business Management Agreement, dated August 3, 2003, by and between EyeMasters, Inc., a Delaware corporation, and Jason Wonch, O.D. and Associates, P.C., a Louisiana professional optometry corporation.(o) 12 .1 Statement re Computation of Ratios.** 21 .1 List of subsidiaries of Eye Care Centers of America, Inc.** 23 .1 Consent of Ernst Young LLP.* 23 .2 Consent of Weil, Gotshal Manges LLP (included in Exhibit 5.1 and 8.1)** 24 .1 Powers of Attorney (included on signature pages).* Table of Contents results and may be restricted by, among other things, the laws of their jurisdiction of organization (which may limit the amount of funds available for the payment of dividends), agreements of those subsidiaries, the terms of the new credit facility and the covenants of any future outstanding indebtedness we or our subsidiaries incur. Deferral of interest payments would have adverse tax consequences for you and may adversely affect the trading price of the IUs or the separate senior subordinated notes. If interest payments on the senior subordinated notes are deferred, you will be required to recognize interest income for U.S. federal income tax purposes in respect of interest payments on the senior subordinated notes represented by the IUs or the separate senior subordinated notes, as the case may be, held by you before you receive any cash payment of this interest. In addition, you will not receive this cash if you sell the IUs or the separate senior subordinated notes, as the case may be, before the end of any deferral period or before the record date relating to interest payments that are to be paid. If interest is deferred, the IUs or the separate senior subordinated notes may trade at a price that does not fully reflect the value of accrued but unpaid interest on the senior subordinated notes. In addition, our right to defer payments of interest on the senior subordinated notes under certain circumstances may mean that the market price for the IUs or the separate senior subordinated notes may be more volatile than other securities that do not have these provisions. You may not receive the level of dividends provided for in the dividend policy our Board of Directors is expected to adopt upon the closing of this offering or any dividends at all. Our Board of Directors may, in its discretion, amend or repeal the dividend policy it is expected to adopt upon the closing of this offering. Our Board of Directors may decrease the level of dividends provided for in this dividend policy or entirely discontinue the payment of dividends. Future dividends with respect to shares of our capital stock, if any, will depend on, among other things, our results of operations, cash requirements, financial condition, contractual restrictions, business opportunities, provisions of applicable law and other factors that our Board of Directors may deem relevant. The indenture governing our senior subordinated notes and the new credit facility will allow us to declare and make dividend payments only to the extent that we satisfy certain restrictive covenants in the indenture and the new credit facility. We cannot guarantee that these restrictive covenants will allow us to declare and pay dividends on our class A common stock at the levels anticipated by our dividend policy or at all. Under Texas law, our Board of Directors, and the Board of Directors of our corporate subsidiaries, may declare dividends only to the extent of our surplus, which is defined as total assets at fair market value minus total liabilities, minus statutory capital, or if there is no surplus, out of our net profits for the fiscal year in which the dividend is declared and/or the preceding fiscal year. We may not have such a surplus or net profits available to make dividend distributions. In addition, funds available for dividend and interest payments would be reduced if the senior subordinated notes were treated as equity rather than debt for U.S. federal income tax purposes. In that event, the stated interest on the senior subordinated notes could be treated as a dividend, and interest on the senior subordinated notes would not be deductible by us for U.S. federal income tax purposes. Our inability to deduct interest on the senior subordinated notes would materially increase our taxable income and, thus, our U.S. federal and applicable state income tax liability. The reduction or elimination of dividends may negatively affect the market price of the IUs or our class A common stock. Our interest expense may increase significantly and could cause our net income and distributable cash to decline significantly. The new credit facility will be subject to periodic renewal or must otherwise be refinanced. We may not be able to renew or refinance the new credit facility, or, if renewed or refinanced, the renewal or refinancing may occur on less favorable terms. Borrowings under the revolving facility will be made at a Public offering price $ $ % $ Underwriting discount $ $ % $ Proceeds to Eye Care Centers of America, Inc. (before expenses) $ $ % $ Table of Contents floating rate of interest. In the event of an increase in the base reference interest rates, our interest expense will increase and could have a material adverse effect on our ability to make cash dividend payments to our shareholders. Also, as discussed above, we may issue additional senior subordinated notes under certain circumstances, creating additional interest payment obligations. In such cases, we may elect to defer interest payments and postpone or cancel dividend payments. We may not generate sufficient funds from operations to pay our indebtedness at maturity. A significant portion of our cash flow from operations will be dedicated to maintaining our client base and servicing our debt requirements. In addition, we currently expect to distribute a significant portion of any remaining cash earnings to our shareholders in the form of quarterly dividends. Moreover, prior to the maturity of our senior subordinated notes, we will not be required to make any payments of principal on our senior subordinated notes. We may not generate sufficient funds from operations to repay the principal amount of our indebtedness at maturity. We may therefore need to refinance our debt or raise additional capital. These alternatives may not be available to us when needed or on satisfactory terms due to prevailing market conditions, a decline in our business or restrictions contained in our senior debt obligations. In addition, to the extent we do not generate sufficient funds from operations, our ability to continue to expand our business will, to a large extent, be dependent upon our ability to borrow funds under our new credit facility and to obtain other third-party financing, including through the sale of IUs or any sale of securities. We cannot assure you that such financing will be available to us on favorable terms or at all. The indenture governing our senior subordinated notes and our new credit facility permit us to pay a significant portion of our free cash flow to shareholders in the form of dividends. Although the indenture governing our senior subordinated notes and our new credit facility have some limitations on our payment of dividends, they permit us to pay a significant portion of our free cash flow to shareholders in the form of dividends and, following completion of this offering, we intend to pay quarterly dividends. Specifically, the indenture governing our senior subordinated notes permits us to pay up to the quarterly base dividend level in any fiscal quarter, which equals % of our excess cash (which is Distributable Cash Flow, as defined in the indenture), minus Consolidated Interest Expense, as defined in the indenture for the prior fiscal quarter, as more fully described in Description of Senior Subordinated Notes Certain Covenants. In addition, if the actual dividends paid in any fiscal quarter are less than the quarterly base dividend level, the indenture generally permits us to use the difference between the aggregate amount of dividends actually paid and the quarterly base dividend level for such quarter for the payment of dividends at a later date. Any amounts paid by us in the form of dividends will not be available in the future to satisfy our obligations under the senior subordinated notes. The realizable value of our assets upon liquidation may be insufficient to satisfy claims. At December 27, 2003, our assets included intangible assets in the amount of $107.4 million, representing approximately 47.6% of our total consolidated assets and consisting primarily of goodwill. The value of these intangible assets will continue to depend significantly upon the success of our business as a going concern. As a result, in the event of a default on our senior subordinated notes or any bankruptcy or dissolution of us, the realizable value of these assets may be substantially lower and may be insufficient to satisfy the claims of our creditors. Because of the subordinated nature of the senior subordinated notes, holders of our senior subordinated notes may not be entitled to be paid in full, if at all, in a bankruptcy, liquidation or reorganization or similar proceeding. The senior subordinated notes and the guarantees are unsecured and rank junior to all of our and the guarantors existing and the future senior indebtedness, including borrowings and related guarantees under the new credit facility. As of December 27, 2003, after giving effect to the Transactions, the senior subordinated notes and guarantees would have been subordinated to approximately $ million of our (1) Comprised of $ allocated to each share of class A common stock and $ allocated to each senior subordinated note, representing % of its stated principal amount. We have granted the underwriters an option to purchase up to additional IUs to cover overallotments, if any. We will use all of the proceeds from the sale of any additional IUs upon the exercise of the underwriters overallotment option to repurchase additional shares of outstanding class B common stock from our existing shareholders. The underwriters expect to deliver the securities to purchasers in book-entry form only through the facilities of The Depository Trust Company on or about , 2004. Table of Contents and our guarantors senior indebtedness. In addition, approximately $ million would have been available to us for borrowing as additional senior indebtedness. We would also be permitted to incur substantial additional indebtedness, including senior indebtedness, in the future. As a result of the subordinated nature of our notes and related guarantees, upon any distribution to our creditors or the creditors of the subsidiary guarantors in bankruptcy, liquidation or reorganization or similar proceeding relating to us or the subsidiary guarantors or our or their property, the holders of our senior indebtedness will be entitled to be paid in full in cash before any payment may be made with respect to our senior subordinated notes or the subsidiary guarantees. All payments on the senior subordinated notes will be blocked in the event of a payment default on senior indebtedness and may be blocked for up to consecutive days in the event of certain non-payment defaults on certain designated senior indebtedness, which will include indebtedness under our new credit facility. In addition, the principal amount of the senior subordinated notes will not be due and payable from us or the subsidiary guarantors without the prior written consent of the holders of our senior indebtedness for a period of up to days from the date of the occurrence of certain events of default with respect to our senior subordinated notes. In the event of a bankruptcy, liquidation or reorganization or similar proceeding relating to us or the subsidiary guarantors, the indenture relating to the senior subordinated notes will require that amounts otherwise payable to holders of senior subordinated notes in a bankruptcy or similar proceeding instead be paid to the holders of senior indebtedness until the holders of senior indebtedness are repaid in full. In any of these cases, if there are insufficient funds to pay all of our creditors, then the holders of the senior subordinated notes may receive less, ratably, than the holders of our senior indebtedness and, because of the obligation to turn over distributions to holders of senior indebtedness, the holders of our senior subordinated notes may receive less, ratably, than the holders of trade payable and other unsubordinated indebtedness in any such proceeding. The guarantees of the senior subordinated notes by our subsidiaries may not be enforceable and could require subordinated note holders to return payments received from us or the guarantors. Under federal bankruptcy law and comparable provisions of state fraudulent transfer laws, a guarantee could be voided, or claims in respect of the senior subordinated notes or a guarantee could be subordinated to all other debt of us or a guarantor, if, among other things, we or the guarantor, at the time that it assumed the guarantee: issued the senior subordinated notes or the guarantee to delay, hinder or defraud present or future creditors; received less than reasonably equivalent value or fair consideration for issuing the guarantee and, at the time it issued the senior subordinated notes or the guarantee: was insolvent or rendered insolvent by reason of issuing the senior subordinated notes or the guarantee and the application of the proceeds of the guarantee; was engaged or about to engage in a business or a transaction for which our or the guarantor s remaining assets available to carry on its business constituted unreasonably small capital; intended to incur, or believed that it would incur, debts beyond its ability to pay the debts as they mature; or was a defendant in an action for money damages, or had a judgment for money damages docketed against it if, in either case, after final judgment, the judgment is unsatisfied. In addition, any payment by us or a guarantor under its guarantee could be voided and required to be returned to the guarantor or to a fund for the benefit of the creditors of us or the guarantor. Joint Book-Running Managers Banc of America Securities LLC Merrill Lynch Co. Table of Contents The measures of insolvency for the purposes of fraudulent transfer laws vary depending upon the law applied in any proceeding to determine whether a fraudulent transfer has occurred. Generally, however, a person would be considered insolvent if, at the time it incurred the debt: the sum of its debts, including contingent liabilities, was greater than the fair saleable value of its assets; the present fair saleable value of its assets was less than the amount that would be required to pay its probable liability on its existing debts, including contingent liabilities, as they become absolute and mature; or it could not pay its debts as they become due. We believe that immediately after the issuance of the senior subordinated notes and the guarantees, we and each of the guarantors will be solvent, will have sufficient capital to carry on our respective businesses and will be able to pay our respective debts as they mature. However, we cannot be sure as to what standard a court would apply in making these determinations or that a court would reach the same conclusions with regard to these issues. Regardless of the standard that the court uses, we cannot be sure that the issuance by the subsidiary guarantors of the subsidiary guarantees would not be voided or the subsidiary guarantees would not be subordinated to their other debt. The guarantee of our senior subordinated notes by any subsidiary guarantor could be subject to the claim that, since the guarantee was incurred for our benefit, and only indirectly for the benefit of the subsidiary guarantor, the obligations of the subsidiary guarantor were incurred for less than fair consideration. If such a claim were successful and it was proven that the subsidiary guarantor was insolvent at the time the guarantee was issued, a court could void the obligations of the subsidiary guarantor under the guarantee or subordinate these obligations to the subsidiary guarantor s other debt or take action detrimental to holders of the senior subordinated notes. If the guarantee of any subsidiary guarantor were voided, our senior subordinated notes would be effectively subordinated to the indebtedness of that subsidiary guarantor. If we or one of our guarantors should become subject to a bankruptcy case, payments made to you may be recoverable as preferences under federal bankruptcy law (and, if applicable, certain state laws regulating assignments for the benefit of creditors and/or receivers) if those payments were made to you on account of the senior subordinated notes or other existing debt of ours, were made at a time when we were insolvent, were made within 90 days (but perhaps as long as one year) of the bankruptcy, and resulted in you receiving more than you would receive if we were simply liquidated under Chapter 7 of the Bankruptcy Code. The U.S. federal income tax consequences of the purchase, ownership and disposition of IUs are unclear and our cash available for dividends and interest could be reduced if the senior subordinated notes were treated as equity for tax purposes. No statutory, judicial or administrative authority directly addresses the treatment of the IUs or instruments similar to the IUs for U.S. federal income tax purposes. As a result, the U.S. federal income tax consequences of the purchase, ownership and disposition of IUs are unclear. We believe that an IU should be treated as a unit representing a share of class A common stock and a senior subordinated note. However, the Internal Revenue Service ( IRS ) or the courts may take the position that the senior subordinated notes included in the IUs are equity, which would result in our inability to take tax deductions on the interest that accrues on such senior subordinated notes and could adversely affect the amount, timing and character of income, gain or loss in respect of your investment in IUs, and materially increase our taxable income and, thus, our U.S. federal and applicable state income tax liability. This would reduce our after-tax cash flow and materially and adversely impact our ability to make interest and dividend payments on the senior subordinated notes, including the separate senior subordinated notes, and the class A common stock. Foreign holders could be subject to withholding or estate taxes with regard to the senior subordinated notes included in the IUs in the same manner as they will be with regard to the Table of Contents class A common stock and it could subject us to liability for withholding taxes that were not collected. Payments to foreign holders would not be grossed-up for any such taxes. For a discussion of these tax related risks, see Material United States Federal Income Tax Considerations. The allocation of the purchase price of the IUs may not be respected. The purchase price of each IU must be allocated between the share of class A common stock and senior subordinated note comprising an IU in proportion to their respective fair market values at the time of purchase. By purchasing the IUs, you will agree to and be bound by the allocation we make. If this allocation is not respected, it is possible that the senior subordinated notes will be treated as issued with OID, to the extent such notes were not already so treated, or with increased OID or with amortizable bond premium, to the extent the notes were not already so treated, or with increased amortizable bond premium. You generally would have to include OID in income in advance of the receipt of cash attributable to that income and would be able to elect to amortize bond premium over the term of the senior subordinated notes. The IRS may not view the interest rate on the senior subordinated notes as an arm s-length rate. We plan to deduct the interest expense on the senior subordinated notes from taxable income for income tax purposes, except to the extent of any bond issuance premium, and to report the full benefit of the income tax deductions in our consolidated financial statements. If the IRS were to determine that the interest rate on the senior subordinated notes did not represent an arm s-length rate, any excess amount over arm s length would not be deductible and could be recharacterized as a dividend payment instead of an interest payment. In addition, the reclassification of interest payments as dividend payments may give rise to an event of default under our new credit facility. In such case, our taxable income and, thus, our U.S. federal income tax liability could be materially increased and we would have to provide an additional liability in our consolidated financial statements for the previously recorded benefit for the interest deductions. In addition, foreign holders could be subject to withholding or estate taxes with regard to the senior subordinated notes in the same manner as they will be with regard to the class A common stock and it could subject us to liability for withholding taxes that were not collected. Payments to foreign holders would not be grossed-up for any such taxes. If the interest rate were determined to be less than the arm s-length rate, the senior subordinated notes could be treated as issued with OID, which you would be required to include in income over the term of the senior subordinated notes in advance of the receipt of cash attributable to that income. Because of the deferral of interest provisions, the senior subordinated notes may be treated as issued with OID. Under applicable Treasury regulations, a remote contingency that stated interest will not be timely paid will be ignored in determining whether a debt instrument is issued with OID. Although there is no authority directly on point, based on our financial forecasts, we believe that the likelihood of deferral of interest payments on the senior subordinated notes is remote within the meaning of the Treasury regulations. Based on the foregoing, although the matter is not free from doubt because of the lack of direct authority, we believe the senior subordinated notes should not be considered issued with OID at the time of their original issuance. If deferral of any payment of interest were determined not to be remote, the senior subordinated notes would be treated as issued with OID at the time of issuance. In such case, all stated interest on the senior subordinated notes would be treated as OID, and all holders, regardless of their method of tax accounting, would be required to include stated interest in income on a constant accrual basis. If we subsequently issue senior subordinated notes with significant original issue discount, we may not be able to deduct all of the interest on those senior subordinated notes. It is possible that senior subordinated notes we issue in a subsequent issuance will be issued at a discount to their face value and, accordingly, may have significant original issue discount and thus be Table of Contents Table of Contents classified as applicable high yield discount obligations, or AHYDOs. If any such senior subordinated notes were so treated, a portion of the OID on such senior subordinated notes would be nondeductible by us and the remainder would be deductible only when paid. This treatment would have the effect of increasing our taxable income and may adversely affect our cash flow available for interest payments and distributions to our equity holders. Subsequent issuances of IUs may cause you to recognize OID and may have other adverse consequences. The indenture governing our senior subordinated notes will provide that, in the event there is a subsequent issuance of IUs containing senior subordinated notes having terms that are identical (except for the issuance date) to the senior subordinated notes represented by the IUs, and such subsequently issued senior subordinated notes are treated as issued with OID or are issued subsequent to an automatic exchange of senior subordinated notes described below or if we otherwise determine that such senior subordinated notes are required to have a new CUSIP number, each holder of IUs or separate senior subordinated notes, as the case may be, agrees that a portion of such holder s senior subordinated notes will be exchanged for a portion of the senior subordinated notes acquired by the holders of such subsequently issued senior subordinated notes. Consequently, immediately following such subsequent issuance, each holder of subsequently issued senior subordinated notes, held either as part of IUs or separately, and each holder of existing senior subordinated notes, held either as part of IUs or separately, will own an inseparable unit composed of a proportionate percentage of both the old senior subordinated notes and the newly issued senior subordinated notes. Therefore, subsequent issuances of senior subordinated notes with OID pursuant to an IU offering by us or following an exchange of our class B common stock for IUs with existing shareholders or their transferees may adversely affect your tax treatment by requiring you to recognize OID or increasing the OID, if any, that you were previously accruing with respect to the senior subordinated notes held by you. However, because a subsequent issuance will affect the senior subordinated notes in the same manner, regardless of whether these senior subordinated notes are held as part of IUs or separately, the combination of senior subordinated notes and shares of class A common stock to form IUs, or the separation of IUs, should not affect your tax treatment. Because any newly issued senior subordinated notes may be issued with OID in amounts different from the senior subordinated notes represented by the already existing IUs, the IRS may assert that you have exchanged a portion of your senior subordinated notes, whether held as part of IUs or separately, for the newly issued senior subordinated notes in a taxable exchange for U.S. federal income tax purposes. In such case, although the deemed exchange would be taxable, you would generally not be expected to realize any gain on the deemed exchange, and any loss realized would likely be disallowed. We intend to take the position that any subsequent issuance of senior subordinated notes with a new CUSIP number, whether or not such senior subordinated notes are issued with OID, will not result in a taxable exchange of your senior subordinated notes for U.S. federal income tax purposes, but because of a lack of legal authority on point, our counsel is unable to opine on the matter. Following any subsequent issuance of IUs containing senior subordinated notes with OID, we (and our agents) will report any OID on the subsequently issued notes ratably among all holders of IUs and separately held senior subordinated notes, and each holder of IUs and separately held senior subordinated notes will, by purchasing IUs, agree to report OID in a manner consistent with this approach. However, there can be no assurance that the IRS will not assert that any OID should be reported only to the persons that initially acquired such subsequently issued notes (and their transferees). In such case, the IRS might further assert that, unless a holder can establish that it is not a person that initially acquired such subsequently issued senior subordinated notes (or a transferee thereof), all of the senior subordinated notes held by such holder have OID. Any of these assertions by the IRS could create significant uncertainties in the pricing of IUs and senior subordinated notes and could adversely affect the market for IUs and senior subordinated notes. For a discussion of these tax related risks, see Material United States Federal Income Tax Considerations. Table of Contents NOTICE TO PURCHASERS OF SEPARATE SENIOR SUBORDINATED NOTES AND ACKNOWLEDGMENT OF PURCHASER INTENT None of the separate senior subordinated notes purchased in connection with this offering may be purchased, directly or indirectly, by persons who are also (1) purchasing IUs in this offering or (2) otherwise receiving IUs or shares of class B common stock in connection with the transactions contemplated by this prospectus. Accordingly, each investor purchasing separate senior subordinated notes in this offering must not purchase IUs in this offering and must not concurrently enter into any plan or pre-arrangement whereby it would (1) acquire any IUs or any equity securities of our company or (2) transfer the separate senior subordinated notes to any holder of IUs or any equity securities of our company. In addition, each person receiving IUs or shares of class B common stock must not purchase separate senior subordinated notes in this offering. Each investor in this offering assumes sole responsibility for ensuring that it complies with the restrictions above. Neither we nor the underwriters will assume any responsibility to ensure that any investor complies with these restrictions. If you are unsure whether the restrictions above would prohibit you from purchasing the separate senior subordinated notes or IUs in this offering, you should consult your own legal advisor regarding the application of these restrictions to your individual circumstances. Furthermore, each person purchasing separate senior subordinated notes in this offering, by acquiring the separate senior subordinated notes, thereby represents to us and the underwriters that: (a) neither such purchaser nor any entity, investment fund or account over which such purchaser exercises investment control is purchasing IUs in this offering; (b) neither such purchaser nor any entity, investment fund or account over which such purchaser exercises investment control owns, or has the contractual right to acquire, our equity securities, including securities which are convertible, exchangeable or exercisable into or for our common stock; and (c) such purchaser is not party to any plan or pre-arrangement whereby it would (1) acquire any IUs or any equity securities of our company or (2) transfer the separate senior subordinated notes to any holder of IUs or any equity securities of our company. For purposes of these representations, the purchaser shall be deemed to be (1) the person who initially purchases the separate senior subordinated notes from the underwriters in this offering and (2) the person(s), if any, pursuant to whose instructions such purchase of separate senior subordinated notes is being made. Table of Contents Holders of subsequently issued senior subordinated notes may not be able to collect their full stated principal amount prior to maturity. Under New York and federal bankruptcy law, holders of subsequently issued senior subordinated notes having OID may not be able to collect the portion of their principal amount that represents unamortized OID as at the acceleration or filing date in the event of an acceleration of the senior subordinated notes or a bankruptcy of us, prior to the maturity date of the senior subordinated notes. As a result, an automatic exchange that results in a holder receiving a subordinated note with OID could have the effect of ultimately reducing the amount such holder can recover from us in the event of an acceleration or bankruptcy. You will be immediately diluted by $ per share of class A common stock if you purchase IUs in this offering. If you purchase IUs in this offering, you will experience an immediate dilution of $ per share of class A common stock represented by the IUs, which exceeds the entire price allocated to each share of class A common stock represented by the IUs in this offering because there will be a net tangible book deficit for each share of class A common stock outstanding immediately after this offering. Our net tangible book deficiency as of December 27, 2003, after giving effect to this offering, would have been approximately $ million, or $ per share of class A common stock. Our capital structure after consummation of this offering may limit our ability to market and issue equity-only securities. As a result of the restrictions in the indenture governing the senior subordinated notes and the restrictions in the other agreements governing our indebtedness, we may be prevented from issuing additional IUs in the future to raise additional capital. If we are unable to issue additional IUs, we may be forced to rely on equity-only securities as an additional source of capital. Although we are not contractually restricted from issuing certain equity-only securities, all of our equity holders except our existing shareholders will initially hold their investment in us in the form of IUs, which are compromised of both our class A common stock and our senior subordinated notes and consequently, equity-only securities may be a comparatively less attractive investment. Therefore, we cannot assure you that we will be able to issue equity-only securities on commercially reasonable terms, or at all. We may not have the ability to raise the funds necessary to fulfill our obligations under the senior subordinated notes following a change of control. This would place us in default under the indenture governing the senior subordinated notes. Upon the occurrence of certain specific kinds of change of control events, we will be required to offer to repurchase all of the outstanding senior subordinated notes. However, it is possible that we will not have sufficient funds at the time of the change of control to make the required repurchase or that restrictions in our new credit facility will not allow such repurchases. Our ability to repurchase these senior subordinated notes upon certain specific kinds of change of control events may be limited by the terms of our senior indebtedness and the subordination provisions of the indenture governing the senior subordinated notes. For example, our new credit facility will prohibit us from repurchasing these notes after certain specific kinds of change of control events until we first repay debt under the new credit agreement in full or obtain a waiver from the lenders under our new credit facility. If we fail to repurchase these senior subordinated notes in that circumstance, we will be in default under the indenture related to the senior subordinated notes and under the new credit facility. Any future debt that we incur may also contain restrictions on repayment which come into effect upon certain specific kinds of change of control events. If a change of control occurs, we cannot assure you that we will have sufficient funds to repay other debt obligations which will be required to be repaid, in addition to the senior subordinated notes. TABLE OF CONTENTS Page Table of Contents Before this offering, there has not been a public market for our IUs, shares of our class A common stock or senior subordinated notes. The market price of our IUs or our separate senior subordinated notes may fluctuate substantially, which could negatively affect IU holders or the separate senior subordinated notes. None of the IUs, the shares of our class A common stock or senior subordinated notes has a public market history. In addition, as the IU is a new security, there has not been an active market in the United States for similar securities. We cannot assure you that an active trading market for the IUs will develop in the future, and we currently do not expect that an active trading market for the shares of our class A common stock or the senior subordinated notes will develop. If the senior subordinated notes represented by your IUs are redeemed or mature, certain bankruptcy events affecting us occur, or there is a payment default that continues for more than 90 days, the IUs will automatically separate and you will then hold the shares of our class A common stock. We do not expect to list our class A common stock on any securities exchange until a sufficient number of shares are no longer held in the form of IUs to satisfy the minimum listing criteria of the , as described in Description of Capital Stock Listing. We currently do not intend to list our senior subordinated notes on any securities exchange. The initial public offering price of the IUs and the initial public offering price of the separate senior subordinated notes will be determined by negotiations among us, the existing equity investors and the representatives of the underwriters and may not be indicative of the market price of the IUs or the separate senior subordinated notes after the offering. Factors such as quarterly variations in our financial results, announcements by us or others, developments affecting us, our clients and our suppliers, general interest rate levels and general market volatility could cause the market price of the IUs or the separate senior subordinated notes to fluctuate significantly. Future sales or the possibility of future sales of a substantial number of IUs, shares of our class A common stock or our senior subordinated notes may depress the price of the IUs and the shares of our class A common stock and our senior subordinated notes. Future sales or the availability for sale of substantial number of IUs or shares of our class A common stock or a significant principal amount of our senior subordinated notes could adversely affect the prevailing market price of the IUs and the shares of our class A common stock and our senior subordinated notes and could impair our ability to raise capital through future sales of our securities. Upon consummation of this offering, we anticipate that our existing shareholders will own million shares of our outstanding class B common stock, representing approximately % of our outstanding common stock (or million shares of our class B common stock, representing % of our common stock if the underwriters overallotment option with respect to the IUs is exercised in full). In circumstances permitted by the indenture governing the senior subordinated notes and the new credit facility, holders of our class B common stock will have certain rights to exchange their class B common stock for the equivalent value of IUs, which IUs could be sold pursuant to an underwritten or other registered offering under a registration rights agreement with us. Such sales could cause a decline in the market price of the IUs. We may issue shares of our class A common stock and senior subordinated notes, which may be in the form of IUs, or other securities from time to time as consideration for future acquisitions and investments. In the event any such acquisition or investment is significant, the number of shares of our class A common stock and the aggregate principal amount of senior subordinated notes, which may be in the form of IUs, or the number or aggregate principal amount, as the case may be, of other securities that we may issue may in turn be significant. In addition, we may also grant registration rights covering those IUs, shares of our class A common stock, senior subordinated notes or other securities in connection with any such acquisitions and investments. Table of Contents Our articles of incorporation and bylaws and several other factors could limit another party s ability to acquire us and could deprive our investors of the opportunity to obtain a takeover premium for their securities. Upon amending and restating our articles of incorporation, a number of provisions in our articles of incorporation and bylaws, and certain provisions of Texas law will make it difficult for another company to acquire us and for you to receive any related takeover premium for your securities. For example, our articles of incorporation will provide that certain provisions of our articles of incorporation can only be amended by a vote of two-thirds or more in voting power of all the outstanding shares of capital stock and that shareholders generally may not act by written consent and only shareholders representing at least 50% in voting power may request that our Board of Directors call a special meeting. Our articles of incorporation will provide for a classified Board of Directors and authorize the issuance of preferred stock without shareholder approval and upon such terms as the Board of Directors may determine. In addition, the rights of the holders of shares of our class A common stock will be subject to, and may be adversely affected by, the rights of holders of any class or series of preferred stock that may be issued in the future. The separate senior subordinated notes may suffer from illiquidity compared to the IUs. We are offering $ million aggregate principal amount of the senior subordinated notes separately, which represents % of the total outstanding senior subordinated notes. The capital markets generally have treated securities issued as part of a larger series more favorably than similar securities offered as part of a smaller series. While the separate senior subordinated notes are part of the same series of senior subordinated notes as the senior subordinated notes represented by the IUs, the separate senior subordinated notes may suffer from an illiquidity discount because they will not be as readily tradeable as the IUs. Such an illiquidity discount may be a feature of the separate senior subordinated notes so long as there are insufficient shares of our class A common stock outstanding as not part of IUs at any time for the separate senior subordinated notes to be combined with shares of our class A common stock to form IUs. Risks Relating to our Business and the Optical Retail Industry If we do not compete successfully in the competitive optical retail industry, our business and revenues may be adversely affected and competitive pressures in our industry may lower profit margins. The optical retail market is highly competitive and is continuing to undergo rapid consolidation. We compete directly with national, regional and local retailers, independent practitioners, warehouse clubs and mass merchandisers located in our markets within the U.S. Many potential competitors for our products and services have, and some potential competitors are likely to enjoy, substantial competitive advantages, including the following: greater name recognition; greater financial, technical, marketing and other resources; more extensive knowledge of the optical retail business and industry; and well-established relationships with a larger base of current and potential customers and suppliers and managed care providers. For example, at times when our major competitors offer significantly lower prices for their products, we are often required to do the same. Certain of our major competitors offer promotional incentives to their customers including free eye exams, 50% Off on designer frames and Buy One, Get One Free eye care promotions. In response to these promotions, we have offered the same or similar incentives to our customers. This practice has resulted in lower profit margins and these competitive promotional incentives may further reduce our revenues, gross margins and cash flows. Several of the other large optical retail chains have greater financial resources than we do. Therefore, we may not be able to Table of Contents continue to deliver cost efficient products in the event of aggressive pricing by our competitors, which would adversely affect our profit margins, net income and cash flow. We may also encounter increased competition in the future from industry consolidation and from new competitors that enter our market. Increased competition could result in lower sales or downward price pressure on our products and services, which may adversely affect our results of operations. Any termination or dispute relating to our long term professional corporation management agreements could have a material adverse effect on our business. Sixty-four of our stores are subleased to a professional corporation or other entity controlled by an optometrist (an OD PC ). The OD PC owns the store (consisting of both the optical dispensary and the professional eye examination practice) and employs the optometrists, and we manage these stores under management agreements (including management of the professional practice and optical retail business). Each of the OD PCs sublease between 12 and 24 stores. No assurances can be given as to the likelihood of an agreement being terminated by an OD PC, a dispute arising between us and the OD PC or a challenge to our operating structure by a state or federal regulatory agency and the resulting impact on our results of operations and cash flows. In addition, a finding that an OD PC does not comply with applicable laws could have a material adverse effect on our results of operations. See Business Government Regulation. Any events resulting in a change in our relationship with the optometrist located in or adjacent to our stores could have a material adverse effect on our business. At 227 of our stores, the optometrists are independent optometrists who lease space within or adjacent to each store to operate their eye examination practices. We also license the use of our trademark Master Eye Associates at the 191 locations operating within or adjacent to our EyeMasters stores. Most of these independent optometrists pay us monthly rent or a license fee consisting of a percentage of gross receipts or base rental. At 36 of these stores, we also provide management services to the optometrist s professional eye exam practice for an additional management fee. Most of these optometrists operate one practice location, but seven optometrists operate an aggregate of 97 locations. The location of optometrists within or adjacent to our stores is an important part of our operating strategy. No assurances can be given as to the likelihood of events adversely affecting the relationship with these optometrists or our ability to locate optometrists within or adjacent to our stores including, without limitation (i) a dispute with an optometrist or group of optometrists controlling multiple practice locations, (ii) a government or regulatory authority challenging our operating structure or our relationship with the optometrists or (iii) other changes to applicable laws or regulations (or interpretations of the same), resulting in changes to our operating structures. Any of these events could have a material adverse affect on our results of operations. See Business Government Regulation. Adverse changes in economic conditions generally or in our markets, and changes in consumer tastes, could reduce demand for our products and services which could adversely affect our results of operations. The optical retail industry is cyclical. Downturns in general economic conditions or uncertainties regarding future economic prospects, which affect consumer disposable income, have historically adversely affected consumer spending habits in our principal markets. Therefore, future economic downturns or uncertainties could have a material adverse effect on our business, results of operations, financial condition and cash flows. The optical retail industry is also subject to rapidly changing consumer preferences. While eyewear has achieved widespread acceptance as a fashion accessory, leading to overall growth in our sales, there can be no assurance that this growth will continue or that consumer preferences will not change in a manner which will adversely affect us or the optical retail industry as a whole. Table of Contents Our future success will depend in part on our ability to build and maintain managed care relationships. As an increasing percentage of patients enter into health care coverage arrangements with managed care payors, we believe that our success will be, in part, dependent upon our ability to participate in the managed vision care plans of employer groups and other private third party payors. Our existing managed vision care relationships are not contractual and may be terminated with little or no notice. Currently, we participate in a managed care network that we anticipate being removed from in fiscal 2004, which presently accounts for approximately $4.0 million in annual revenues. There is no certainty that we will be able to establish or maintain satisfactory relationships with managed care and other third party payors, many of which have existing provider structures in place and may not be able or willing to change their provider networks. Our inability to maintain our current relationships or enter into such arrangements in the future could have a material adverse effect on our results of operations. Technological advances may reduce the demand for our products or allow other manufacturers to produce eyewear at lower cost than we can, which could have a material adverse effect on our results of operations. Corneal refractive surgery procedures such as radial-keratotomy, photo-refractive keratotomy, Laser In-Situ Keratomileusis, or LASIK, and future drug development, may change the demand for our products. As traditional eyewear users undergo laser vision correction procedures or other vision correction techniques, the demand for certain contact lenses and eyeglasses will decrease. Because the marketing and sale of eyeglasses and contact lenses is a significant part of our business, a decrease in customer demand for these products could have a material adverse effect on sales of prescription eyewear. In addition, technological developments such as wafer technology and lens casting may render our current lens manufacturing method uncompetitive or obsolete. There can be no assurance that medical advances and technological developments will not have a material adverse effect on our results of operations. After completion of this offering, certain of our directors and shareholders affiliated with Thomas H. Lee Partners, L.P. will own approximately % in the aggregate of our outstanding common stock on a fully diluted basis, will initially have representatives on our member Board of Directors and could influence actions taken by our Board of Directors or matters presented to our shareholders. After completion of our offering, certain of our directors and shareholders affiliated with Thomas H. Lee Partners, L.P., or THL, will own approximately % in the aggregate of our outstanding common stock, on a fully diluted basis. Additionally, THL will initially have representatives on our member Board of Directors. Consequently, THL may be able to influence matters submitted for shareholder action, including the election of our Board of Directors and approval of significant corporate transactions, including business combinations, consolidations and mergers and the determination of our day-to-day corporate and management policies. This substantial influence could be exercised in a manner that may be in conflict with the interests of our other shareholders. In addition, our existing equity investors have and may, in the future, make significant investments in other companies, some of which may be competitors. None of our existing equity investors are obligated to advise us of any investment or business opportunities of which they are aware and they are not restricted or prohibited from competing with us. See Related Party Transactions. We depend on the ability and experience of certain members of our management team and their departure may have a material adverse effect on our results of operations. To guide our operations, we rely on the skills of certain members of our senior management team, the loss of whom could have an adverse effect on our operations. Furthermore, the members of our senior management team have annual employment agreements with us that automatically renew unless either party gives at least thirty days notice. Accordingly, key executives may not continue to work for us, and we may not have adequate time to hire qualified replacements, which could have a material adverse effect on us. Table of Contents We could be subject to franchise claims by optometrists that could limit our ability to conduct our business in the manner we deem appropriate. We sublease office space to certain optometrists who enter into Trademark License Agreements with Enclave Advancement Group, Inc., one of our subsidiaries ( Enclave ). We may be subject to claims that this leasing of space from us, coupled with the license from Enclave of certain trademarks, constitutes a franchise and thereby gives the tenant optometrists certain rights as franchisees. No assurance can be given that a claim, action or proceeding will not be brought against us or Enclave asserting that a franchise exists or that the success of any such claim would not impair the way in which we currently structure our relationships with optometrists. We may be exposed to a significant risk from liability claims if we are unable to obtain adequate insurance, at acceptable costs, to protect us against potential liability claims. The provision of professional eye care services entails an inherent risk of professional malpractice and other similar claims. We do not influence or control the practice of optometry by the optometrists that we employ or affiliate with, nor do we have responsibility for their compliance with certain regulatory and other requirements directly applicable to these individual professionals. However, as a result of the relationship between affiliated optometrists and us, we may become subject to professional malpractice actions or claims under various theories relating to the professional services provided by these individuals. Premiums for medical malpractice insurance may significantly increase which could adversely affect our results of operations and cash flow or force us to self insure against these potential claims. We may not be able to continue to obtain adequate liability insurance to cover claims asserted against us, in which event, our financial condition and results of operations could be adversely affected and our ability to continue operations could be jeopardized. We rely on third-party reimbursement for many of our customers costs, the future reduction of which could adversely effect our results of operations. The cost of a significant portion of medical care in the United States is funded by government and private insurance programs, such as Medicare, Medicaid and corporate health insurance plans. According to governmental projections, it is expected that more medical beneficiaries who are significant consumers of eye care services will enroll in managed care organizations. The health care industry is experiencing a trend toward cost-containment with governmental and private third party payors seeking to impose lower reimbursement, utilization restrictions and risk-based compensation arrangements. Private third-party reimbursement plans are also developing increasingly sophisticated methods of controlling health care costs through redesign of benefits and explorations of more cost-effective methods of delivering health care. Accordingly, there can be no assurance that reimbursement for purchase and use of eye care services will not be limited or reduced and thereby adversely affect our results of operations, financial condition and cash flows. Government revenue sources are subject to statutory and regulatory changes, administrative rulings, interpretations of policy, determinations by fiscal intermediaries and carriers, and government funding limitations, all of which may materially increase or decrease the rates of payment and cash flow to us. There is no assurance that payments made under such programs will remain at levels comparable to the present levels or be sufficient to cover all operating and fixed costs. Government or third party payors may retrospectively and/or prospectively adjust previous payments to us in amounts which would have a material adverse effect on us. Table of Contents Risks Relating to our Regulatory Environment We are subject to extensive state, local and federal laws and regulations that affect the health care industry, which may affect our ability to generate revenue or subject us to additional expenses. The delivery of health care, including the relationships between health care providers such as optometrists, opticians and optical retailers, is subject to extensive federal and state regulation. Our relationships with optometrists are subject to these laws and regulations. These laws and regulations are subject to interpretation, and a finding that we are not in compliance could have a material adverse effect on our financial condition and results of operations. Furthermore, we cannot predict the impact of future developments or changes to the regulatory environment or the impact such developments or changes would have on our operations, our compliance costs, our relationships with optometrists or the implementation of our business plan. Regulation of the healthcare industry is constantly changing, which affects our opportunities, competition and other aspects of our business. State Optometric Laws. The laws and regulations governing the relationship between optometrists and optical retailers vary from state to state and are enforced by both courts and regulatory authorities, each with broad discretion. In certain circumstances, private parties may also be able to bring actions for violations of these laws and regulations. Except in states which allow us to employ optometrists, the state optometric laws generally prohibit us from controlling the practice of optometry or practicing optometry, which may include, among other things, exercising control over practice hours, patient scheduling, employment of optometrists, protocols, examination fees and other matters requiring the professional judgment of the optometrist. In most states where we are located, the activities constituting control of the practice of optometry are not described or enumerated in the statutes or the regulations, and there is no written guidance issued by the applicable regulatory authorities, resulting in uncertainty as to the interpretation and applications of such laws and regulations. In addition to this broad prohibition, many states have specific restrictions and requirements applicable to the relationships between optometrists and optical retailers. The independent optometrists who sublease space within or adjacent to each store to operate their eye examination practices enter into sublease agreements and, in some instances, license our trademark Master Eye Associates. The subleases contain certain provisions, including restrictions on selling optical goods and maintaining licensing. Our previous standard form of sublease contained a representation by the optometrist relating to maintaining certain specified operating hours. In the form of sublease we began using in November 2003, the optometrist represents to us that his or her office hours will be consistent with both industry standards for optometry practices and the hours of operation of the shopping center or mall (as specified in the sublease) within which the subleased premises are located. Some states have regulatory restrictions with respect to setting the hours of operation of an optometrist and our subleases could be determined to conflict with these restrictions. At 36 of our stores, we also provide management services to the optometrist s professional eye exam practice for a management fee. A court or regulatory authority could conclude that our contractual arrangements under the subleases, trademark license agreements and management agreements, and our day-to-day operational practices in managing these relationships, results in the improper control of an optometric practice or otherwise do not comply with applicable laws and regulations. The impact of such a finding could adversely affect our results of operations, financial condition and cash flows. At the 64 of our stores that are owned by an OD PC, we provide management services under business management agreements. Courts and regulatory authorities are likely to look at all of the agreements relating to the operating structure and the actual day-to-day operating procedures employed at each store location in making a determination as to whether or not our operations result in the improper control of an optometric practice. Our close involvement with the day-to-day operations of the OD PC increases the risk that a court or other regulatory authority could allege that we are controlling the optometry practice or otherwise violating the applicable laws and regulations. We have not requested, and have not received, from any governmental agency an advisory opinion finding that our relationships with the OD PCs are in Table of Contents compliance with applicable laws and regulations, and all such relationships may not be found to comply with such laws and regulations. Violations of these laws and regulations may result in censure or delicensing of optometrists, substantial civil or criminal damages and penalties, including double and triple monetary damages and penalties, and, in the case of violations of federal laws and regulations, exclusion from the Medicare and Medicaid programs, or other sanctions. Such exclusions and penalties, if applied to us, could have a material adverse effect on us. In addition, a determination in any state that we are controlling an optometric practice or engaged in the corporate practice of medicine or any unlawful fee-splitting arrangement could render any sublease, management or service agreement between us and optometrists located in such state unenforceable or subject to modification, or necessitate a buy-out of an OD PC, which could have a material adverse effect on our financial condition and results of operations. Fraud and Abuse and Anti-Referral Laws. We and the optometrists we employ or with whom we contract for space and/or management services receive payments from the federal Medicare and state Medicaid programs for services and goods. As such, we are subject to the reimbursement rules and fraud and abuse provisions of those programs which prohibit the solicitation, payment, receipt, or offering of any direct or indirect remuneration in return for, or as an inducement to, certain referrals of patients, items or services. These same provisions of the federal Medicare and Medicaid laws also impose significant penalties for false or improper billings to Medicare and Medicaid, and many states have adopted similar laws applicable to any payor of health care services. In addition, the federal Stark Self-Referral Law imposes restrictions on physicians referrals for designated health services reimbursable by Medicare or Medicaid to entities with which the physicians have financial relationships, including the rental of space if certain requirements have not been satisfied. Many states have adopted similar self-referral laws which are not limited to Medicare or Medicaid reimbursed services. Violations of any of these laws may result in substantial civil or criminal penalties, including double and treble civil monetary penalties, and, in the case of violations of federal laws, exclusion from participation in the Medicare and Medicaid programs. Licensure of Opticians. We must obtain licenses or certifications to operate our business in certain states. To obtain and maintain such licenses, we must satisfy certain licensure standards. In addition, we employ opticians in our stores to assist in dispensing eyeglasses and other optical goods. The laws and regulations governing opticians and their relationship with optical retailers vary from state to state. Some states require a licensed optician to be on the premises, while other states do not require licensed opticians or permit the licensed optician (or an optometrist) to supervise other unlicensed opticians. Generally, licensed opticians demand a higher salary so we staff our stores with unlicensed opticians as permitted by applicable law. Changes in licensure standards or requirements could increase our costs or prevent us from providing certain services, both of which could have a material adverse effect on our financial condition and results of operations. Insurance Licensure. Most states impose strict licensure requirements on health insurance companies, HMOs and other companies that engage in the business of insurance. In the event that we are required to become licensed under these laws, the licensure process can be lengthy and time consuming. In addition, many of the licensing requirements mandate strict financial and other requirements which we may not be able to meet. Any Willing Provider Laws. Some states have adopted, and others are considering, legislation that requires managed care payors to include any provider who is willing to abide by the terms of the managed care payor s contracts and/or prohibit termination of providers without cause. These types of laws limit our ability to develop effective managed care provider networks in such states. This could adversely affect our ability to implement our business plan. Antitrust Laws. We and our networks of providers are subject to a range of antitrust laws that prohibit anti-competitive conduct, including price-fixing, concerted refusals to deal and divisions of markets. There may be a challenge to our operations on the basis of an antitrust violation in the future. Table of Contents OUR ORGANIZATIONAL STRUCTURE AFTER THIS OFFERING The chart below depicts our organizational structure immediately after the Transactions. Table of Contents Advertising. The laws and regulations governing advertising in general, and with respect to optometrists and optical retailers in particular, vary from state to state and are also governed by various federal regulations, including regulations promulgated by the Federal Trade Commission ( FTC ). State advertising statutes and regulations prohibit false or misleading advertisements and restrict our ability to advertise for independent optometrists subleasing space from us. In addition, the FTC has promulgated regulations which limit the frequency of free offers in order to avoid potential deceptive advertising. Courts and regulatory agencies could conclude that our advertising practices do not comply with applicable laws and regulations and a change in our advertising practices could have a material effect on the results of our operations. HIPAA. The Health Insurance Portability and Accountability Act of 1996 ( HIPAA ) covers a variety of subjects which impacts our businesses and the business of the optometrists. Some of those subjects include the privacy of patient health care information, the security of such information and the standardization of electronic data transactions for purposes of medical billing. The Department of Health and Human Services promulgated HIPAA regulations which became effective during 2003. We have devoted, and continue to devote, resources to implement operating procedures within the stores and the corporate office to ensure compliance with the HIPAA regulations. Penalties under HIPAA, if applied to us, or a determination that we or any affiliated optometrists or OD PCs are not in compliance with such laws, could have a material adverse effect on our results of operations. Proposed and future health care reform initiatives could require us to make costly modifications to our business arrangements. There have been numerous initiatives at the federal and state levels for comprehensive reforms affecting the payment for and availability of healthcare services. We believe that such initiatives will continue during the foreseeable future. Aspects of certain of these reforms as proposed in the past or others that may be introduced could, if adopted, adversely affect us. The federal government has issued proposed regulations which further describe prohibited referrals, the nature of financial relationships and permitted exceptions. We believe that we are in material compliance with these regulations as proposed. The federal government has not yet issued final regulations. We cannot assure you that future interpretations of such laws and regulations will not require modifications to our business arrangements. Table of Contents
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+Risk Factors Before you invest in the IDSs (including the shares of our Class A common stock and our senior subordinated notes represented by the IDSs) or the senior subordinated notes offered separately (not in the form of IDSs), you should carefully consider the various risks of the investment, including those described below, together with all of the other information included in this prospectus. If any of these risks actually occur, our business, financial condition or operating results could be adversely affected. In that case, the trading price of the IDSs and the senior subordinated notes (not in the form of IDSs) could decline and you could lose all or part of your investment. Risks Relating to the IDSs, the Shares of Class A Common Stock and Senior Subordinated Notes Represented by the IDSs and the Senior Subordinated Notes Offered Separately (not in the form of IDSs) Under certain circumstances set forth in the indenture and the new credit facility, we may defer the payment of interest to you for a significant period of time. Prior to , 2009, we may, under certain circumstances set forth in the indenture and the new credit facility, defer interest payments on our senior subordinated notes on one or more occasions for up to an aggregate period of eight quarters. In addition, after , 2009, we may, under certain circumstances set forth in the indenture defer interest payments on our senior subordinated notes on four occasions for not more than an aggregate of two quarters on each occasion. Deferred interest will bear interest at the same rate as the senior subordinated notes. For any interest deferred during the first five years, we are not obligated to pay any deferred interest until , 2009, so you may be owed a substantial amount of deferred interest that will not be due and payable until such date. For any interest deferred after , 2009, we are not obligated to pay all of the deferred interest until , 2019, so you may be owed a substantial amount of deferred interest that will not be due and payable until such date. Our dividend policy may negatively impact our ability to maintain or expand our network infrastructure and finance capital expenditures or operations. Upon the closing of this offering, our board of directors will adopt a dividend policy pursuant to which substantially all of the cash generated by our business in excess of operating needs, interest and principal payments on indebtedness, and capital expenditures sufficient to maintain our network infrastructure, would in general be distributed as regular quarterly cash dividends (up to the intended dividend rates set forth under "Dividend Policy and Restrictions") to the holders of our Class A common stock and not be retained by us. As a result, we may not have a sufficient amount of cash to fund our operations in the event of a significant business downturn, finance growth of our network or unanticipated capital expenditure needs. We may have to forego growth opportunities or capital expenditures that would otherwise be necessary or desirable if we do not find alternative sources of financing. If we do not have sufficient cash for these purposes, our financial condition and our business will suffer. You may not receive the level of dividends provided for in the dividend policy our board of directors will adopt upon the closing of this offering or any dividends at all. Our board of directors may, in its discretion, amend or repeal the dividend policy that it will adopt upon the closing of this offering. Our board of directors may decrease the level of dividends provided for in this dividend policy or entirely discontinue the payment of dividends at any time. Future dividends with respect to shares of our capital stock, if any, will depend on, among other things, our results of operations, cash requirements, financial condition, contractual restrictions, business opportunities, provisions of applicable law and other factors that our board of directors may deem relevant. The indenture governing our senior subordinated notes and the new credit facility contain significant restrictions on our ability to make dividend payments, including, if we defer interest on the senior subordinated notes under the new credit facility or the indenture, restrictions on the payment of dividends until we have paid all deferred interest. There can be no assurance that we will have sufficient cash in the future to pay dividends on our capital stock in the intended amounts or at all. If we do not generate sufficient cash from our operating activities in the future to pay dividends, we may have to rely on cash provided by financing activities in order to fund dividend payments, and such financing may not be available. However, if we use working capital or borrowings under the new credit facility to fund dividends, we would have less cash available for future dividends and we may not have sufficient cash to pursue growth opportunities such as the expansion of our high-speed Internet service area, the introduction of new services and the acquisition of other telephone companies, or to respond to unanticipated events such as the failure of a portion of our switching or network facilities. If we do not have sufficient cash to finance growth opportunities or capital expenditures that would otherwise be necessary or desirable, and cannot find alternative sources of financing, our financial condition and our business will suffer. In addition, our after-tax cash flow available for dividend and interest payments would be reduced if the senior subordinated notes were treated as equity rather than debt for United States federal income tax purposes. In that event, the stated interest on the senior subordinated notes could be treated as a dividend, and interest on the senior subordinated notes would not be deductible by us for United States federal income tax purposes. Our inability to deduct interest on the senior subordinated notes could materially increase our taxable income and, thus, our United States federal and applicable state income tax liability. Deferral of interest payments would have adverse tax consequences for you and may adversely affect the trading price of the IDSs or the senior subordinated notes. If we defer interest payments on the senior subordinated notes, the senior subordinated notes will be treated as issued with OID and you will be required to recognize interest income for United States federal income tax purposes in respect of the senior subordinated notes before you receive any cash payment of this interest. In addition, we will not pay you this cash if you sell the IDSs or the senior subordinated notes, as the case may be, before the end of any deferral period or before the record date relating to interest payments that are to be paid. The IDSs or the senior subordinated notes may trade at a price that does not fully reflect the value of accrued but unpaid interest on the senior subordinated notes. In addition, the requirement that we defer payments of interest on the senior subordinated notes under certain circumstances may mean that the market price for the IDSs or the senior subordinated notes may be more volatile than other securities that do not have this requirement. The United States federal income tax consequences of the purchase, ownership and disposition of IDSs are unclear. No statutory, judicial or administrative authority directly addresses the treatment of the IDSs or the senior subordinated notes, or instruments similar to the IDSs or the senior subordinated notes for United States federal income tax purposes. As a result, the United States federal income tax consequences of the purchase, ownership and disposition of IDSs and senior subordinated notes are unclear. We will receive an opinion from our counsel, O'Melveny & Myers LLP, to the effect that an IDS should be treated as a unit representing a share of common stock and senior subordinated notes, We and our existing equity investors are offering 8,659,000 IDSs in the United States and Canada representing an aggregate of 8,659,000 shares of our Class A common stock and $65,115,680 aggregate principal amount of our % senior subordinated notes due 2019. Each IDS initially represents: one share of our Class A common stock; and a % senior subordinated note due 2019 with a $7.52 principal amount. Of the 8,659,000 IDSs offered hereby, 860,657 IDSs are being offered by us and 7,798,343 IDSs are being offered by our affiliates who are existing equity investors. The selling stockholders are deemed to be underwriters in this offering. We are also offering $8,500,000 aggregate principal amount of our % senior subordinated notes separately (not in the form of IDSs) in the United States and Canada. The offering of IDSs and the offering of separate senior subordinated notes (not in the form of IDSs) are each conditioned upon each other. This is our initial public offering of IDSs and senior subordinated notes. We anticipate that the public offering price of the IDSs will be between $15.20 and $16.80 per IDS and the public offering price of the senior subordinated notes will be 100% of the stated principal amount. Holders of IDSs may separate the IDSs into the shares of our Class A common stock and senior subordinated notes represented thereby at any time after the earlier of 45 days from the closing of this offering or the occurrence of a change of control. Similarly, except as described below, any holder of shares of our Class A common stock and senior subordinated notes may, at any time, combine the applicable number of shares of Class A common stock and principal amount of senior subordinated notes to form IDSs. We will be permitted to defer interest payments on our senior subordinated notes subject to the limitations described in "Description of Senior Subordinated Notes Maturity and Interest Interest Deferral." Our obligations under the senior subordinated notes will be fully and unconditionally guaranteed by certain of our direct and indirect wholly owned subsidiaries. Upon a subsequent issuance by us of IDSs or senior subordinated notes of the same series (not in the form of IDSs), a portion of your senior subordinated notes may be automatically exchanged for an identical principal amount of the senior subordinated notes issued in such subsequent issuance, and in that event your IDSs will be replaced with new IDSs. The IDSs have been approved for listing on the American Stock Exchange under the trading symbol "OTT," subject to official notice of issuance. In addition, we have applied to list our IDSs on the Toronto Stock Exchange under the symbol "OTT.un" and the shares of our Class A common stock under the trading symbol "OTT." We currently do not anticipate an active trading market for the Class A common stock to develop. Investing in our IDSs and in our senior subordinated notes (not in the form of IDSs) involves risks. See "Risk Factors" beginning on page 25. Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense. Per IDS(1) and that the senior subordinated notes should be classified as debt for United States federal income tax purposes. However, the IRS or the courts may take the position that the IDSs are a single security classified as equity, which could adversely affect the amount, timing and character of income, gain or loss in respect of your investment in IDSs or senior subordinated notes, and materially increase our taxable income and, thus, our United States federal and applicable state income tax liability. This would reduce our after-tax cash flow and materially and adversely impact our ability to make interest and dividend payments on the senior subordinated notes and the common stock. Foreign holders could be subject to withholding taxes with regard to the senior subordinated notes in the same manner as they will be with regard to the common stock. Payments to foreign holders would not be grossed-up for any such taxes. For discussion of these tax related risks, see "Material United States Federal Income Tax Considerations." The allocation of the purchase price of the IDSs may not be respected. The purchase price of each IDS must be allocated between the share of common stock and senior subordinated notes comprising the IDS in proportion to their respective fair market values at the time of purchase. If our allocation is not respected (because, for example, the separately issued senior subordinated notes are sold to the public for a price that differs materially from our allocation), then it is possible that the senior subordinated notes will be treated as having been issued with original issue discount, or OID (if the allocation to the senior subordinated notes were determined to be too high), or amortizable bond premium (if the allocation to the senior subordinated notes were determined to be too low). You generally would have to include OID in income in advance of the receipt of cash attributable to that income and would be able to elect to amortize bond premium over the term of the senior subordinated notes. Futhermore, in the event that the senior subordinated notes were determined to be issued at a premium, we would effectively be required to reduce our tax deduction for interest payments by the amount of that premium over the term of the senior subordinated notes, which would increase our tax liability and reduce our cash available for interest and dividend payments. Because of the deferral of interest provisions, our senior subordinated notes may be treated as issued with OID. Under applicable Treasury regulations, a "remote" contingency that stated interest will not be timely paid will be ignored in determining whether a debt instrument is issued with OID. Although there is no authority directly on point, based on our financial forecasts, we believe that the likelihood of deferral of interest payments on the senior subordinated notes is "remote" within the meaning of the Treasury regulations. Based on the foregoing, although the matter is not free from doubt because of the lack of direct authority, the senior subordinated notes would not be considered issued with OID at the time of their original issuance. If deferral of any payment of interest were determined not to be "remote," then the senior subordinated notes would be treated as issued with OID at the time of issuance. In such case, all stated interest on the senior subordinated notes would be treated as OID, with the consequence that all holders would be required to include the yield on the senior subordinated notes in income as it is accrued on a constant yield basis, possibly in advance of their receipt of the associated cash and regardless of their method of tax accounting. Subsequent issuances of senior subordinated notes may cause you to recognize taxable gain and/or original issue discount and may reduce your recovery in the event of bankruptcy. Subsequently issued senior subordinated notes may be issued with OID if they are issued at a discount to their face value (for example, as a result of changes in prevailing interest rates). The indenture governing the senior subordinated notes and the agreements with DTC will provide that, in the event that there is a subsequent issuance of senior subordinated notes with OID, and in connection with each Total issuance of senior subordinated notes thereafter, each holder of senior subordinated notes or IDSs, as the case may be, agrees that a portion of such holder's senior subordinated notes will be automatically exchanged for a portion of the senior subordinated notes acquired by the holders of such subsequently issued senior subordinated notes. The aggregate stated principal amount of senior subordinated notes owned by you and each other holder will not change as a result of such subsequent issuance and exchange. However, under federal bankruptcy law, holders of senior subordinated notes will not be entitled to a claim for the portion of their principal amount that represents unaccrued OID. As a result, an automatic exchange that results in a holder receiving an OID note could have the effect of ultimately reducing the amount such holder can recover from us in the event of an acceleration or bankruptcy. The United States federal income tax consequences to you of the subsequent issuance of senior subordinated notes with OID (or any issuance of senior subordinated notes thereafter) are unclear. Due to a lack of applicable authority, it is unclear whether an exchange of senior subordinated notes for subsequently issued senior subordinated notes will result in a taxable exchange for United States federal income tax purposes, and it is possible that the IRS might successfully assert that such an exchange should be treated as a taxable exchange. In such case, you would recognize any gain realized on the exchange, but a loss realized might be disallowed. Regardless of whether the exchange is treated as a taxable event, such exchange may result in an increase in the amount of OID, if any, that you are required to accrue with respect to the senior subordinated notes. Consequently, you may be required to report OID as a result of a subsequent issuance (even though you purchased senior subordinated notes having no OID). This will generally result in you reporting more interest income over the term of the senior subordinated notes than you would have reported had no such subsequent issuance and exchange occurred. However, the IRS may assert that any OID should be reported only to the persons that initially acquired such subsequently issued senior subordinated notes (and their transferees). In such case, the IRS might further assert that, unless a holder can establish that it is not such a person (or a transferee thereof), all of the senior subordinated notes held by such holder will have OID. Any of these assertions by the IRS could create significant uncertainties in the pricing of IDSs and senior subordinated notes and could adversely affect the market for IDSs and senior subordinated notes. For a more complete description of the tax consequences of a subsequent issuance, see "Material United States Federal Income Tax Considerations Consequences to U.S. Holders Senior Subordinated Notes Additional Issuances." If we subsequently issue subordinated notes with significant OID, then we may be unable to deduct all the interest on the senior subordinated notes. It is possible that senior subordinated notes we issue in a subsequent issuance will be issued at a discount to their face value and, accordingly, may have "significant OID" and thus be classified as "applicable high yield discount obligations." If any such senior subordinated notes were so treated, then a portion of the OID on such notes would be nondeductible by us and the remainder would be deductible only when paid. This treatment would have the effect of increasing our taxable income and may adversely affect our cash flow available for interest payments and distributions to our equity investors. We have substantial indebtedness, which could restrict our ability to pay interest and principal on the senior subordinated notes and to pay dividends with respect to shares of our Class A common stock represented by the IDSs, and may impact our financing options and liquidity position. Our ability to make distributions, pay dividends or make other payments will be subject to applicable law, our certificate of incorporation and contractual restrictions contained in the instruments governing Per Senior Subordinated Note(2) our indebtedness, including the new credit facility which certain of our subsidiaries will guarantee on a senior secured basis. The degree to which we are leveraged on a consolidated basis could have important consequences to the holders of the IDSs and of the separate senior subordinated notes, including: our ability to obtain additional financing in the future for working capital, capital expenditures or acquisitions may be limited; we may not be able to refinance our indebtedness on terms acceptable to us or at all; a significant portion of our cash flow from operations is likely to be dedicated to the payment of the principal of and interest on our indebtedness, thereby reducing funds available for other corporate purposes; and our substantial indebtedness may make us more vulnerable to economic downturns and limit our ability to withstand competitive pressures. Although the new credit facility will contain, among other things, senior leverage and fixed charge coverage covenants and incurrence tests based on total leverage that will restrict our ability to incur debt as described under "Description of New Credit Facility Other Covenants," the indenture governing the senior subordinated notes allows us to issue an unlimited amount of senior subordinated notes so long as we issue additional shares of Class A common stock in the appropriate proportionate amounts to represent additional IDSs. We may amend the terms of our new credit facility, or we may enter into new agreements that govern our senior indebtedness, and the amended or new terms may significantly affect our ability to pay interest on our senior subordinated notes and dividends on shares of our common stock. The new credit facility will contain significant restrictions on our ability to pay interest on the senior subordinated notes and dividends on shares of common stock based on meeting certain financial tests and compliance with other conditions. As a result of general economic conditions, conditions in the lending markets, the results of our business or for any other reason, we may elect or be required to amend or refinance our new credit facility, at or prior to maturity, or enter into additional agreements for senior indebtedness. Regardless of any protection you have in the indenture governing the senior subordinated notes, any such amendment, refinancing or additional agreement may contain covenants that could limit in a significant manner our ability to make interest payments and dividends to you. We are subject to restrictive debt covenants that limit our business flexibility by imposing operating and financial restrictions on our operations. The agreements governing our indebtedness impose significant operating and financial restrictions on us. These restrictions prohibit or limit, among other things: the incurrence of additional indebtedness and the issuance of preferred stock and certain redeemable capital stock; a number of other restricted payments, including investments and acquisitions; specified sales of assets; specified transactions with affiliates; the creation of a number of liens; consolidations, mergers and transfers of all or substantially all of our assets; and our ability to change the nature of our business. Total The terms of the new credit facility will include other and more restrictive covenants and will restrict us from prepaying our other indebtedness, including the senior subordinated notes, while indebtedness under the new credit facility is outstanding. A breach of any of these covenants, ratios or tests could result in a default under the new credit facility and/or the indenture. Events of default under the new credit facility would prohibit us from refinancing the senior subordinated notes in cash. If the lenders accelerate the payment of the indebtedness and proceed against the security granted to them, our assets may not be sufficient to repay in full this indebtedness and our other indebtedness, including the senior subordinated notes. We are a holding company and rely on dividends and other payments, advances and transfers of funds from our subsidiaries to meet our debt service and other obligations. We are a holding company and conduct all of our operations through our subsidiaries. We currently have no significant assets other than the capital stock and equity interests in our subsidiaries and intercompany debt owed by our subsidiaries, all of which will be pledged to the creditors under the new credit facility. As a result, we will rely on dividends and other payments or distributions from our subsidiaries to meet our debt service obligations and enable us to pay dividends. The ability of our subsidiaries to pay dividends or make other payments or distributions to us will depend on their respective operating results and may be restricted by, among other things, agreements of those subsidiaries, the terms of the new credit facility and the covenants of any future outstanding indebtedness we or our subsidiaries incur. Payments on the senior subordinated notes may be blocked if we default under our senior indebtedness, including the new credit facility. If we default in the payment of any of our senior indebtedness, including the new credit facility, we will be prohibited from making any payments on the senior subordinated notes until the payment default has been cured or waived. In addition, even if we are making payments on our senior indebtedness on a timely basis, payments on the senior subordinated notes may be blocked for up to 179 days if we default on our senior indebtedness in some other manner. After this offering, our existing equity holders will have sold most of their interest in our company and, after repayment of our existing indebtedness, repurchasing IDSs and Class B common stock and payment of expenses, we will not receive any net proceeds from this offering for future operations. In connection with this offering, our existing equity holders will sell approximately 84.4% (or approximately 93.7% if the underwriters' over-allotment option is exercised in full) of their interest in our company. Most of the net proceeds from this offering will be received by our existing equity holders. The net proceeds we receive from this offering will be used to repay existing indebtedness, repurchase IDSs and Class B common stock and to pay fees and expenses. Since we will receive no net proceeds that can be used for future operations and we currently intend to use a significant portion of our cash from operations to pay dividends, we may not have sufficient cash to pursue growth opportunities such as the expansion of our high-speed Internet access service area, the introduction of new services and the acquisition of other telephone companies, or to respond to unanticipated events such as a failure of a portion of our switching or network facilities. If we do not have sufficient cash to finance growth opportunities or capital expenditures that would otherwise be necessary or desirable, and cannot find alternative sources of financing, our financial condition and our business will suffer. Public offering price $ $ % $ Underwriting discount $ $ % $ Proceeds to Otelco Inc. (before expenses)(3) $ $ % $ Proceeds to selling securityholders $ $ $ You will be immediately diluted by $20.58 per share of Class A common stock if you purchase IDSs in this offering. If you purchase IDSs in this offering, based on the pro forma net tangible book value of the assets and liabilities reflected on our balance sheet and assuming an initial public offering price of $16.00 per IDS (the midpoint of the range set forth on the cover page of this prospectus), you will experience an immediate dilution of $20.58 per share of Class A common stock represented by the IDSs, which exceeds the entire price allocated to each share of Class A common stock represented by the IDSs in this offering because there will be a pro forma net tangible book deficiency for each share of Class A common stock outstanding immediately after this offering. Our net tangible book deficiency as of September 30, 2004, after giving effect to this offering, was approximately $123.7 million, or $12.10 per share of Class A common stock. Our interest expense may increase significantly and could cause our net income and distributable cash to decline significantly. The new credit facility will be subject to periodic renewal or must otherwise be refinanced. We may not be able to renew or refinance the new credit facility, or if renewed or refinanced, the renewal or refinancing may occur on less favorable terms. Borrowings under the revolving portion of the new credit facility will be made at a floating rate of interest. In the event of an increase in the base reference interest rates or LIBOR, our interest expense will increase and could have a material adverse effect on our ability to make cash dividend payments to our stockholders. Our ability to continue to expand our business will, to a large extent, be dependent upon our ability to borrow funds under our new credit facility and to obtain other third-party financing, including through the sale of IDSs or other securities. We cannot assure you that such financing will be available to us on favorable terms or at all. We may not generate sufficient funds from operations to pay our indebtedness at maturity. A significant portion of our cash flow from operations will be dedicated to servicing our debt requirements and making capital expenditures to maintain the quality of our physical plant. In addition, we currently expect to distribute a significant portion of any remaining cash earnings to our stockholders in the form of quarterly dividends. Moreover, prior to the maturity of our senior subordinated notes, we will not be required to make any payments of principal on our senior subordinated notes. We may not generate sufficient funds from operations to repay the principal amount of our indebtedness at maturity. We may therefore need to refinance our debt or raise additional capital. These alternatives may not be available to us when needed or on satisfactory terms due to prevailing market conditions, a decline in our business or restrictions contained in our senior debt obligations. The indenture governing our senior subordinated notes and the new credit facility permit us to pay a significant portion of our free cash flow to stockholders in the form of dividends. Although the indenture governing our senior subordinated notes and the new credit facility have some limitations on our payment of dividends, they permit us to pay a significant portion of our free cash flow to stockholders in the form of dividends and, following completion of this offering, we intend to pay quarterly dividends. Specifically, the indenture governing our senior subordinated notes permits us to pay up to 100% of our excess cash (which is Adjusted EBITDA, as defined in the indenture, minus the sum of cash interest expense, cash income tax expense and certain capital expenditures) from and including the first fiscal quarter beginning after the date of the indenture to the end of our most recently ended fiscal quarter for which internal financial statements are available at the time of such payment, as more fully described in "Description of Senior Subordinated Notes Certain Covenants." (1)The price per IDS is comprised of $8.48 allocated to each share of Class A common stock and $7.52 allocated to each senior subordinated note, assuming an initial public offering price of $16.00 per IDS, the mid-point of our offering price range. (2)Relates to $8,500,000 aggregate principal amount of senior subordinated notes that we are selling separately (not in the form of IDSs). (3)We are selling 860,657 IDSs in this offering. We will not receive any proceeds from the sale by our existing equity investors of 7,798,343 IDSs being sold in this offering. Certain of our affiliates who are existing equity investors have granted the underwriters an option to purchase up to 865,940 additional IDSs at the public offering price, less the underwriting discount, within 30 days from the date of this prospectus to cover over-allotments, if any. The underwriters expect to deliver the IDSs and senior subordinated notes to purchasers on or about , 2004. CIBC World Markets RBC Capital Markets UBS Investment Bank Deutsche Bank SecuritiesHarris NesbittKeyBanc Capital MarketsRaymond James , 2004 The new credit facility permits us to use excess cash, as defined in the new credit facility, to fund dividends on our shares of common stock. Any amounts paid by us in the form of dividends will not be available in the future to satisfy our obligations under the senior subordinated notes. The realizable value of our assets upon liquidation may be insufficient to satisfy claims. At September 30, 2004, our assets included intangible assets in the amount of $102.2 million, consisting primarily of goodwill. These intangible assets represent approximately 66.4% of our total consolidated assets. The value of these intangible assets will continue to depend significantly upon the success of our business as a going concern. As a result, in the event of a default on our senior subordinated notes or under the new credit facility or any bankruptcy or dissolution of our company, the realizable value of these assets may be substantially lower and may be insufficient to satisfy the claims of our creditors. Because of the subordinated nature of the senior subordinated notes, holders of our senior subordinated notes may not be entitled to be paid in full, or at all, in a bankruptcy, liquidation or reorganization or similar proceeding. As a result of the subordinated nature of our senior subordinated notes and related guarantees, upon any distribution to our creditors or the creditors of the subsidiary guarantors in bankruptcy, liquidation or reorganization or similar proceeding relating to us or the subsidiary guarantors or our or their property, the holders of our senior indebtedness and senior indebtedness of the subsidiary guarantors will be entitled to be paid in full in cash before any payment may be made with respect to our senior subordinated notes or the subsidiary guarantees. In any of these cases, we and the subsidiary guarantors may not have sufficient funds to pay all of our creditors. Holders of our senior subordinated notes may, therefore, receive less, ratably, than the holders of senior indebtedness and, in some cases, less than other unsecured creditors. On a pro forma basis as of September 30, 2004, our senior subordinated notes and the associated subsidiary guarantees would have ranked junior, on a consolidated basis, to $80.0 million of outstanding senior secured indebtedness, and the subsidiary guarantees would have ranked junior to no senior unsecured debt and pari passu to no indebtedness of ours and the subsidiary guarantors. In addition, as of September 30, 2004 on a pro forma basis, we would have had the ability to borrow up to an additional amount of $15.0 million under the new credit facility (less amounts reserved for letters of credit), which would have ranked senior in right of payment to our senior subordinated notes. In the event of bankruptcy or insolvency, the senior subordinated notes and guarantees could be adversely affected by principles of equitable subordination or recharacterization. In the event of bankruptcy or insolvency, a party in interest may seek to subordinate our debt, including the senior subordinated notes or the guarantees, under principles of equitable subordination or to recharacterize the senior subordinated notes as equity. The possible recharacterization of the senior subordinated notes as equity results because of the structure of the IDSs and our conversion. In the event a court exercised its equitable powers to subordinate the senior subordinated notes or the guarantees, or recharacterizes the senior subordinated notes as equity, you may not recover any amounts owed on the senior subordinated notes or the guarantees and you may be required to return any payments made to you within six years before the bankruptcy on account of the senior subordinated notes or the guarantees. In addition, should the court treat the senior subordinated notes or the guarantees as equity either under principles of equitable subordination or recharacterization, you may not be able to enforce the senior subordinated notes or the guarantees. The senior subordinated notes and the guarantees may not be enforceable because of fraudulent conveyance laws. Under federal bankruptcy law and comparable provisions of state fraudulent transfer laws, a court could void the obligations under the senior subordinated notes or the guarantees, further subordinate the senior subordinated notes or the guarantees or take other action detrimental to you, if, among other things, at the time the indebtedness under the senior subordinated notes or the guarantees, as applicable, was incurred, we or a guarantor: issued the senior subordinated notes or the guarantee to delay, hinder or defraud present or future creditors; or received less than reasonably equivalent value or fair consideration for issuing the senior subordinated notes or the guarantee and, at the time of the issuance: was insolvent or rendered insolvent by reason of issuing the senior subordinated notes or the guarantee and the application of the proceeds of the senior subordinated notes; was engaged or about to engage in a business or a transaction for which the issuer's or the guarantor's remaining unencumbered assets constituted unreasonably small capital to carry on its business; intended to incur, or believed that it would incur, debts beyond its ability to pay the debts as they mature; or was a defendant in an action for money damages, or had a judgment for money damages docketed against it if, in either case, after final judgment, the judgment is unsatisfied. The measures of insolvency for the purposes of fraudulent transfer laws vary depending upon the law applied in any proceeding to determine whether a fraudulent transfer has occurred. Generally, however, a person would be considered insolvent if, at the time it incurred the debt: the present fair saleable value of its assets was less than the amount that would be required to pay its probable liability on its existing debts, including contingent liabilities, as they become absolute and mature; or it could not pay its debts as they become due. Regardless of the standard that a court uses to determine whether we or a guarantor were solvent at the relevant time, the issuance of the senior subordinated notes or the guarantees may be voided or further subordinated to the claims of creditors if it concludes the issuer or a guarantor was insolvent. The guarantee of the senior subordinated notes by any subsidiary guarantor could be subject to the claim that, since the guarantee was incurred for our benefit, and only indirectly for the benefit of the guarantor, the guarantee was incurred for less than fair consideration. A court could therefore void the obligations of the subsidiary guarantor, under the guarantees or subordinate these obligations to the subsidiary guarantor's other debt or take action detrimental to holders of the senior subordinated notes. If the of any subsidiary guarantor were voided, the holders of the senior subordinated notes would not have a debt claim against that subsidiary guarantor. In addition, in the event that we meet any of the financial condition fraudulent transfer tests described above at the time of or as a result of this offering, a court could view our conversion, the issuance of the senior subordinated notes, the guarantees and the other transactions occurring on the issue date, such as repayment of our existing debt and various distributions described under "Use of Proceeds" as a single transaction and, as a result, conclude that we did not get fair value for the offering. In such a Table of Contents Page case, a court could hold the debt (including the guarantees) owed to the noteholders void or unenforceable or may further subordinate it to the claims of other creditors. Before this offering, there has not been a public market for our IDSs, shares of our Class A common stock or senior subordinated notes. The price of the IDSs may fluctuate substantially, which could negatively affect IDS holders. None of the IDSs, the shares of our Class A common stock or senior subordinated notes has a public market history. In addition, there has not been an established market in the United States or Canada for securities similar to the IDSs. We cannot assure you that an active trading market for the IDSs will develop in the future or at all, and we currently do not expect that an active trading market for the shares of our Class A common stock will develop until the senior subordinated notes are redeemed or mature. If the senior subordinated notes represented by your IDSs are redeemed or mature, the IDSs will automatically separate and you will then hold shares of our Class A common stock. We do not intend to list our senior subordinated notes on any securities exchange. The initial public offering price of the IDSs has been determined by negotiations among us, our existing equity investors and the representatives of the underwriters and may not be indicative of the market price of the IDSs after the offering. Factors such as quarterly variations in our financial results, announcements by us or others, developments affecting us, our clients and our suppliers, general interest rate levels and general market volatility could cause the market price of the IDSs to fluctuate significantly. If the IDSs separate, the limited liquidity of the market for the senior subordinated notes and Class A common stock may adversely affect your ability to sell the senior subordinated notes and Class A common stock. We do not intend to list the senior subordinated notes represented by the IDSs on any exchange or quotation system. Our Class A common stock will not initially be listed for separate trading on the American Stock Exchange or any other exchange or quotation system other than the Toronto Stock Exchange (on which we do not anticipate an active trading market for the Class A common stock to develop). We will not apply to list our shares of Class A common stock for separate trading on the American Stock Exchange or any other exchange or quotation system until the number of shares held separately is sufficient to satisfy applicable requirements for separate trading on such exchange or quotation system. Upon separation of the IDSs, no sizable market for the senior subordinated notes and the Class A common stock may ever develop and the liquidity of any trading market for the notes or the Class A common stock that does develop may be limited. As a result, your ability to sell your notes or Class A common stock, and the market price you can obtain, could be adversely affected. The limited liquidity of the trading market for the senior subordinated notes sold separately (not represented by IDSs) may adversely affect the trading price of the separate senior subordinated notes. We are separately selling (not in the form of IDSs) $8.5 million aggregate principal amount of senior subordinated notes, representing approximately 10% of the total principal amount of the outstanding senior subordinated notes. While the senior subordinated notes sold separately (not in the form of IDSs) are part of the same series of notes as, and are identical to, the senior subordinated notes represented by IDSs at the time of the issuance of the separate senior subordinated notes, the senior subordinated notes represented by the IDSs will not be separable for at least 45 days and will not be separately tradeable until separated. As a result, the initial trading market for the senior subordinated notes sold separately (not represented by IDSs) will be very limited. Even after holders of the IDSs are permitted to separate their IDSs, a sufficient number of holders of IDSs may not separate their IDSs into shares of our Class A common stock and senior subordinated notes to create a sizable and more liquid trading market for the senior subordinated notes not represented by IDSs. Therefore, a liquid market for the senior subordinated notes may not develop, which may adversely affect the ability of the holders of the separate senior subordinated notes to sell any of their separate senior subordinated notes and the price at which these holders would be able to sell any of the senior subordinated notes sold separately. Future sales or the possibility of future sales of a substantial amount of IDSs, shares of our common stock or our senior subordinated notes may depress the price of the IDSs and the shares of our common stock and our senior subordinated notes. Future sales or the availability for sale of substantial amounts of IDSs or shares of our common stock or a significant principal amount of our senior subordinated notes in the public market could adversely affect the prevailing market price of the IDSs and the shares of our common stock and our senior subordinated notes and could impair our ability to raise capital through future sales of our securities. We may issue shares of our common stock and senior subordinated notes, which may be in the form of IDSs, or other securities from time to time as consideration for future acquisitions and investments. In the event that any such acquisition or investment is significant, the number of shares of our common stock and the aggregate principal amount of senior subordinated notes, which may be in the form of IDSs, or the number or aggregate principal amount, as the case may be, of other securities that we may issue may in turn be significant. In addition, we may also grant registration rights covering those IDSs, shares of our common stock, senior subordinated notes or other securities in connection with any such acquisitions and investments. If interest rates rise, the trading value of our IDSs and the senior subordinated notes sold separately in this offering may decline. We cannot predict the interest rate environment or guarantee that interest rates will not rise in the near future. Should interest rates rise or should the threat of rising interest rates develop, debt markets may be adversely affected. As a result, the trading value of our IDSs and senior subordinated notes may decline. Our certificate of incorporation and by-laws could limit another party's ability to acquire us and deprive our investors of the opportunity to obtain a takeover premium for their securities. A number of provisions in our certificate of incorporation and by-laws will make it difficult for another company to acquire us and for you to receive any related takeover premium for your securities. For example, our certificate of incorporation will provide that stockholders generally may not act by written consent and only stockholders representing at least a majority in voting power may request that our board of directors call a special meeting. Stockholders will not be able to cumulate votes and must give advanced written notice of stockholder proposals and director nominations. In addition, our certificate of incorporation will provide for a classified board of directors and will authorize the issuance of preferred stock without stockholder approval and upon such terms as our board of directors may determine. The rights of the holders of shares of our common stock will be subject to, and may be adversely affected by, the rights of holders of any class or series of preferred stock that may be issued in the future. We may not be able to repurchase the senior subordinated notes upon a change of control. Upon the occurrence of specific kinds of change of control events, we will be required to offer to repurchase the outstanding senior subordinated notes at 101% of their principal amount at the date of repurchase unless such senior subordinated notes have been previously called for redemption. We may not have sufficient financial resources to purchase all of the senior subordinated notes that are tendered upon a change of control offer. Furthermore, the new credit facility will prohibit the repurchase or redemption of the senior subordinated notes following a change of control. Consequently, lenders thereunder may have the right to prohibit any such purchase or redemption, in which event we will seek to obtain waivers from the required lenders. We cannot assure you that we would be able to obtain such waivers or refinance our indebtedness on terms acceptable to us, or at all. Finally, the occurrence of a change of control could also constitute an event of default under the new credit facility, which could result in the acceleration of all amounts due thereunder. See "Description of Senior Subordinated Notes Change of Control." Risks Relating to Our Business and the Industry Our business is concentrated geographically and dependent on regional economic conditions. Our business is conducted primarily in north central Alabama and central Missouri and, accordingly, our business is dependent upon the general economic conditions of these regions. There can be no assurance that future economic conditions in these regions will not impact demand for our services or cause residents to relocate to other regions, which may adversely impact our business, revenue and cash flow. The telecommunications industry has experienced increased competition. Although we have historically experienced no wireline telephone competition in our rural local exchange carrier territories, the market for telecommunications services is highly competitive. Certain competitors benefit from brand recognition and financial, personnel, marketing and other resources that are significantly greater than ours. We cannot predict the number of competitors that will emerge, especially as a result of existing or new federal and state regulatory or legislative actions. Increased competition from existing and new entities could have an adverse effect on our business, revenue and cash flow. In our markets, we face competition from wireless carriers. We believe that we have experienced a minor decrease in our minutes of use, primarily due to flat rate "free minutes and long distance calling" offers from certain wireless carriers. As wireless carriers continue to build-out their networks, we may experience increased competition, which could have an adverse effect on our business, revenue and cash flow. Our current and potential competitors could include competitive local exchange carriers and other providers of telecommunications and information services, including Internet and voice over Internet protocol, or VoIP, service providers, wireless carriers, satellite television companies, alternate access providers, neighboring incumbent local exchange carriers, long distance companies, electric utilities and cable television companies that may provide services competitive with those products and services that we provide or intend to provide. Although our long distance operations have historically been modest in relation to our competitors, we intend to continue to expand our long distance business within our territories, through marketing to our existing telephone services customers. Our existing long distance competitors can be expected to respond to such initiatives, including those with significantly greater resources than us. There can be no assurance that our revenue from long distance services will not decrease in the future as competition and/or the cost of providing long distance services increase. The FCC has recently adopted regulations requiring wireline telephone carriers to provide portability of telephone numbers to wireless carriers when a customer substitutes wireless service for wireline service. Wireline to wireless portability may enhance the competitive position of wireless carriers. We may not be able to integrate new technologies and provide new services in a cost-efficient manner. The telecommunications industry is subject to rapid and significant changes in technology, frequent new service introductions and evolving industry standards. We cannot predict the effect of these changes on our competitive position, our profitability or the industry generally. Technological developments may reduce the competitiveness of our networks and require additional capital expenditures or the procurement of additional products that could be expensive and time consuming. In addition, new products and services arising out of technological developments may reduce the attractiveness of our services. If we fail to adapt successfully to technological advances or fail to obtain access to new technologies, we could lose customers and be limited in our ability to attract new customers and/or sell new services to our existing customers. In addition, delivery of new services in a cost-efficient manner depends upon many factors, and we may not generate anticipated revenue from such services. We may have difficulty acquiring businesses, managing growth and integrating acquired businesses. We have grown rapidly by acquiring other businesses. Since 1999, we have acquired four rural local exchange carrier businesses and immediately prior to the closing of this offering, will acquire Mid-Missouri Holding. We face competition acquiring rural local exchange carriers, including from businesses that are larger or have access to more financing than us. There can be no assurance that owners of rural local exchange carriers will want to sell at all or to us. If we fail to expand our business, make acquisitions or successfully integrate the operations of any acquired companies with our own operations, the rate of our future growth, if any, will likely be lower than our historical growth rate. There can be no assurance that we will be able to successfully expand our business through acquisitions or otherwise. In addition, the pursuit of future acquisitions could lead to a diversion of resources and management attention from operational matters. Disruptions in our networks and infrastructure may cause us to lose customers and incur additional expenses. To be successful, we will need to continue to provide our customers with reliable and timely service over our networks. We face the following risks to our networks and infrastructure: our territory can have significant weather events which physically damage access lines; our rural geography creates the risk of security breaches, break-ins and sabotage; power surges and outages, computer viruses or hacking, and software or hardware defects which are beyond our control; and unusual spikes in demand or capacity limitations in our or our suppliers' networks. Disruptions may cause interruptions in service or reduced capacity for customers, either of which could cause us to lose customers and incur expenses, and thereby adversely affect our business, revenue and cash flow. In addition, the Alabama and Missouri Public Service Commissions could require us to issue credits on customer bills for such service interruptions, further impacting revenue and cash. Our success depends on a small number of key personnel. Our success depends on the personal efforts of a small group of skilled employees and senior management. The rural nature of our service area provides for a smaller pool of skilled telephone employees and increases the challenge of hiring employees from metropolitan areas. Although we believe we will be able to replace our key employees within a reasonable time should the need arise, the loss of key personnel could have a material short-term adverse effect on our financial performance. We provide services to our customers over access lines, and if we lose access lines, our business and results of operations may be adversely affected. Our business generates revenue by delivering voice and data services over access lines. We have experienced net access line loss due to challenging economic conditions and increased competition. Our access line count declined by 2.2% from September 2003 to September 2004. We may continue to experience net access line loss in our markets for an unforeseen period of time. Continued access line losses could adversely affect our business and results of operations. Our performance is subject to a number of other economic and non-economic factors, which we may not be able to predict accurately. There are factors that may be beyond our control that could affect our operations and business. Such factors include adverse changes in the conditions in the specific markets for our products and services, the conditions in the broader market for telecommunications services and the conditions in the domestic and global economies, generally. Although our performance is affected by the general condition of the economy, not all of our services are affected equally. Local services revenue is generally linked to relatively consistent variables such as population changes, housing starts and general economic activity levels in the areas served. Internet and cable television revenue is generally related to more variable factors such as changing levels of discretionary spending on entertainment, the adoption of e-commerce and other on-line activities by our current or prospective customers. It is not possible for management to accurately predict all of these factors and the impact of such factors on our performance. Changes in the regulatory, competitive and technological environments may also impact our ability to increase revenue and/or earnings from the provision of local wireline services. We may therefore have to place increased emphasis on developing and realizing revenue through the provision of new and enhanced services with higher growth potential. In such a case, there is a risk that these revenue sources as well as our cost savings efforts through further efficiency gains will not grow or develop at a fast enough pace to offset slowing growth in local services. It is also possible that as we invest in new technologies and services, demand for those new services may not develop. There can be no assurance that we will be able to successfully expand our service offerings through the development of new services, and our efforts to do so may have a material adverse effect on our financial performance. Risks Relating to Our Regulatory Environment Changes in the regulation of the telecommunications industry could adversely affect our business, revenue or cash flow. We operate in a heavily regulated industry. The majority of our revenue has been generally supported by and subject to regulation at the federal, state and local level. Certain federal, Alabama and Missouri regulations and local franchise requirements have been, are currently, and may in the future be, the subject of judicial proceedings, legislative hearings and administrative proposals. Such proceedings may relate to, among other things, the rates we may charge for our local, network access and other services, the manner in which we offer and bundle our services, the terms and conditions of interconnection, federal and state universal service funds (including the Universal Service Fund High Cost, or USF HC), unbundled network elements and resale rates, and could change the manner in which telecommunications companies operate. We cannot predict the outcome of these proceedings or the impact they will have on our business, revenue and cash flow. Governmental authorities could decrease network access charges or rates for local services, which would adversely affect our revenue. Approximately 20.4% and 18.1% of our pro forma revenue for the nine months ended September 30, 2004 and for the year ended December 31, 2003, respectively, was derived from network access charges paid by long distance carriers for use of our facilities to originate and terminate interstate and intrastate telephone calls. The interstate network access rates that we can charge are regulated by the Federal Communications Commission, or FCC, and the intrastate network access rates that we can charge are regulated by the Alabama Public Service Commission, or APSC, and the Missouri Public Service Commission, or MPSC. Those rates may change from time to time. The FCC has reformed and continues to reform the federal network access charge system. It is unknown at this time what additional changes, if any, the FCC, APSC or MPSC may adopt. Such regulatory developments could adversely affect our business, revenue and cash flow. The local services rates and intrastate access charges charged by our rural local exchange carriers are regulated by state regulatory commissions which have the power to grant and revoke authorization to companies to provide telecommunications services and to impose other conditions and penalties. If we fail to comply with regulations set forth by the APSC or the MPSC, we may face revocation of our authorizations in Alabama or Missouri, as applicable, or other conditions and penalties. The APSC is considering several proposals that would result in greater pricing flexibility for our Alabama rural local exchange carriers in regard to most services, as well as the expansion of local calling options. It is possible that a new plan would require us to reduce our rates, forego future rate increases, provide greater features as part of our basic service plan or limit our rates for certain offerings. We cannot predict the ultimate outcome of the review process or the impact that it will have on our business, revenue and cash flow. Mid-Missouri Telephone charges rates for local services and intrastate access service based in part upon a rate-of-return authorized by the MPSC. These authorized rates are subject to audit by the MPSC at any time and may be reduced if the MPSC finds them excessive. If Mid-Missouri Telephone is ordered to reduce its rates or if its applications to increase rates are denied or delayed, our business, revenue and cash flow may be negatively impacted. Various transactions related to this offering require regulatory approval or may be subject to other regulatory reviews. Such approvals may not be granted to us or may be subject to conditions that could adversely affect our business. The FCC must approve various transactions related to this offering, including the transfer of control of various radio licenses and domestic and international operational authorizations held by the rural local exchange carriers which will result from the change in current ownership. We cannot assure you that we will receive FCC approvals free of conditions that could adversely affect our business. It is possible that the MPSC may assert jurisdiction to approve certain aspects of the proposed transactions. Certain transactions involving a Missouri telecommunications company require prior MPSC approval. We do not believe that the transactions related to this offering will require MPSC approval. If the MPSC reviews any of the transactions related to this offering, we may not receive approval of these transactions or we may have conditions imposed that could adversely affect our business. Certain transactions related to the enforceability of the guarantees of the senior subordinated notes by certain of our subsidiaries may require FCC, APSC or MPSC approval, which may not be granted or which may be subject to delays or conditions that could affect your ability to enforce the guarantees. The FCC, MPSC and APSC may need to approve certain transactions related to the enforceability of the guarantees of the senior subordinated notes by certain of our subsidiaries, including the transfer of control of various radio licenses held by the rural local exchange carriers or the transfer of control over or sale of the assets of our rural local exchange carriers. Such approvals may not be obtained, in which case such guarantees would be unenforceable, or may be subject to delays or conditions that could affect your ability to enforce the guarantees. A reduction in Universal Service Fund High Cost support would adversely affect our business, revenue and cash flow. Hopper, Blountsville and Mid-Missouri Telephone receive federal USF HC revenue to support their high cost of operations. Such support payments represented approximately 11.4% and 12.2% of our pro forma revenue for the nine months ended September 30, 2004 and for the year ended December 31, 2003, respectively, and were based upon each participating rural local exchange carrier's average cost per loop as compared to the national average cost per loop. These support payments fluctuate based upon the historical costs of our participating rural local exchange carriers as compared to the national average cost per loop. If our participating rural local exchange carriers are unable to receive support from the USF HC, or if such support is reduced, our business, revenue and cash flow would be negatively affected. During the past two years, the FCC made certain modifications to the USF HC support system that changed the sources of support and the method for determining the level of support. There is a cap on the total USF HC payments nationwide. It is unclear whether the changes in methodology will continue to accurately reflect the costs incurred by our participating rural local exchange carriers, and whether they will provide for the same amount of USF HC support that we have received in the past. In addition, a number of issues regarding source and amount of contributions to, and eligibility for, payments from USF HC are currently being reviewed by the FCC. A joint board of federal and state commissioners made recommendations to change various aspects of the USF HC, and the FCC has until February 2005 to act on these recommendations. Similarly, the FCC in September 2004 asked the Federal-State Joint Board on Universal Service to review the federal rules relating to universal service support mechanisms for rural carriers, including addressing the relevant costs and the definition of rural telephone company for the purpose of determining the appropriate universal service support. The outcome of these proceedings or other regulatory changes could affect the amount of USF HC support that we receive, and could have an adverse effect on our business, revenue and cash flow. If a wireless or other telecommunications carrier receives ETC status in our service areas or even outside of our service areas, the amount of support we receive from the USF HC could decline under current rules, and under some proposed USF HC rule changes, could be significantly reduced. Recently, some disbursements to another class of universal service fund recipients, schools and libraries, were suspended to comply with the Anti-Deficiency Act (31 U.S.C. 1341) (2000)). Some analysts have suggested that disbursements under the USF HC could also be suspended to comply with the Anti-Deficiency Act. We cannot predict the impact these actions may have on us, including on our receipts from, and contributions to, the universal service fund. If we were to lose our protected status under interconnection rules, we would incur additional administrative and regulatory expenses and face more competition. As a "rural telephone company" under the Communications Act, each of our rural local exchange carriers is exempt from the obligation to lease its unbundled facilities to competitive local exchange carriers, to offer retail services at wholesale prices for resale, to permit competitive collocation at its facilities and to comply with certain other requirements applicable to larger incumbent local exchange carriers. However, we eventually may be required to comply with these requirements in some or all of our service areas if: (i) we receive a bona fide request from a telecommunications carrier; and (ii) the APSC or MPSC, as applicable, determines that it is in the public interest to impose such requirements. In addition, we may be required to comply with some or all of these requirements in order to achieve greater pricing flexibility from state regulators. If we are required to comply with these requirements, we could incur additional administrative and regulatory expenses and face more competition which could adversely affect our business, revenue and cash flow. Changes in the regulation of cable television franchises and services may adversely impact our cable television operations. Cable television systems are operated under franchises granted by local government authorities. Franchises may contain various conditions, including time limitations on commencement or completion of construction, approval of initial fees charged to customers for basic service, the number of channels offered and the types of programming to be provided. The regulation of cable television at the federal, state and local levels is subject to a political process and has been in constant flux over the past decade. This process continues in the context of new legislative proposals and the adoption or deletion of administrative regulations and policies. We anticipate further material developments in these areas, but cannot anticipate their direction or impact on our cable television operations. In addition, the regulatory approach to the utilization of cable television facilities for the provision of services beyond video programming is also in flux, rendering it impossible to anticipate the extent or scope of future regulatory requirements or limitations.
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+RISK FACTORS Investing in our common stock involves a high degree of risk. You should carefully consider the risks described below with all of the other information included in this prospectus before deciding to invest in shares of our common stock. If any of the following risks actually occur, they may materially harm our business and our financial condition and results of operations. In that event, the market price of our common stock could decline, and you could lose part or all of your investment. RISKS RELATED TO OUR BUSINESS We have a history of operating losses and expect to incur losses for the foreseeable future. We may never generate revenues or, if we are able to generate revenues, achieve profitability. We are focused on product development, and we have not generated any revenues to date utilizing our Carrierwave technology. Since the end of 1997, we have incurred losses in each year of our operations, and we expect to continue to incur operating losses for the foreseeable future. These operating losses have adversely affected and are likely to continue to adversely affect our working capital, total assets and shareholders equity. The process of developing our products requires significant clinical, development and laboratory testing and clinical trials. In addition, commercialization of our product candidates will require that we obtain necessary regulatory approvals and establish sales, marketing and manufacturing capabilities, either through internal hiring or through contractual relationships with others. We expect to incur substantial losses for the foreseeable future as a result of anticipated increases in our research and development costs, including costs associated with conducting preclinical testing and clinical trials, and regulatory compliance activities. We have incurred operating losses of approximately $8.9 million for the fiscal year ended December 30, 2001, $4.7 million for the fiscal year ended December 29, 2002, $4.8 million for the fiscal year ended December 28, 2003, and $1.8 million for the three months ended March 28, 2004, and at March 28, 2004 we had an accumulated deficit of approximately $27.5 million. Our net cash used in operations during the first three months of 2004 was $1.6 million. We expect our average monthly net cash used in operations to increase during the remainder of 2004. Our ability to generate revenues and achieve profitability will depend on numerous factors, including success in: developing and testing product candidates; receiving regulatory approvals; commercializing our products; and establishing a favorable competitive position. Many of these factors will depend on circumstances beyond our control. We cannot assure you that we will ever have a product approved by the FDA, that we will bring any product to market or, if we are successful in doing so, that we will ever become profitable. Our product candidates are based on a technology that could ultimately prove ineffective. Our product candidates are created using our proprietary Carrierwave technology. Our test results to date are limited to laboratory tests and preclinical trials in animals, and we have not fully characterized the mechanism of absorption of our prodrugs. While our preliminary studies in animals have supported our belief that our product candidates are as efficacious as the originally-approved drugs in addition to offering abuse resistance and overdose protection, we have not tested our product Public Offering Price $8.00 $33,600,000 Underwriting Discount $0.56 $ 2,352,000 Proceeds to New River Pharmaceuticals $7.44 $31,248,000 We have granted the underwriters the right to purchase up to 630,000 additional shares from us within 30 days after the date of this prospectus to cover any over-allotments. The underwriters expect to deliver shares of common stock to purchasers on August 10, 2004. Nasdaq National Market Symbol: NRPH OpenIPO : The method of distribution used by the underwriters in this offering differs somewhat from that traditionally employed in firm commitment underwritten public offerings. In particular, the public offering price and allocation of shares were determined primarily by an auction process conducted by the underwriters and other securities dealers participating in this offering. A more detailed description of this process, known as an OpenIPO, is included in Underwriting beginning on page 94. This offering involves a high degree of risk. You should purchase shares only if you can afford a complete loss of your investment. See Risk Factors beginning on page 11. Table of Contents candidates in humans, other than in a recently completed pharmacokinetic study of NRP104. The preclinical results that we have obtained to date may not be indicative of results we may attain in future preclinical studies or in clinical trials. Ultimately, our research and preclinical findings, which currently indicate that our Carrierwave technology possesses beneficial properties, may prove to be incorrect, in which case the product candidates created using our Carrierwave technology may not differ substantially from competing drugs and may in fact be inferior to them. If these products are substantially identical or inferior to drugs already available, the market for our Carrierwave drugs would be reduced or eliminated. Based our studies to date, we believe our product candidates are safe and have no known side effects other than those associated generally with therapeutic amounts of amphetamine and opioids. However, we may not be able to prove that our product candidates are safe. No assessment of the efficacy, safety or side effects of a product candidate can be considered definitive until all clinical trials needed to support a submission for marketing approval are complete. Our product candidates will require additional laboratory, animal and human testing. Success in earlier clinical trials does not mean that subsequent trials will confirm the earlier findings. If we find that any of our products is not safe, we may not be able to commercialize the product. The safety of our Carrierwave formulations may vary with each drug and the ingredients used in each formulation, and therefore even if safety is established for one of our prodrugs, this would not necessarily be predictive of the safety of any of our other product candidates, which would need to be separately established. Our product candidates are at an early stage of development. If we are unable to develop and commercialize our product candidates successfully, we may never generate revenues or, if we are able to generate revenues, achieve profitability. We have not commercialized any products or recognized any revenue from product sales utilizing our Carrierwave technology. All of the compounds produced using our Carrierwave technology are in early stages of development. In March 2004, we filed an investigational new drug (IND) application with the FDA for NRP104, and in May 2004, we concluded a pharmacokinetic trial in humans with respect to NRP104. We expect to file IND applications to allow for clinical testing of our other lead product candidates, NRP290 and NRP369, in late 2004 and in 2005, respectively. Once an IND is filed with the FDA, the IND will ordinarily become effective 30 days following receipt by the FDA. However, if the results of the preclinical investigations are not deemed adequate to support these applications, the FDA may place an IND on clinical hold until the sponsor generates and supplies the FDA with additional data. In the case of a clinical hold, the sponsor of the IND is prohibited from commencing the clinical studies until the clinical hold has been removed by the FDA. We must conduct significant additional research and development activities before we will be able to apply for regulatory approval to commercialize any products utilizing our Carrierwave technology. We must successfully complete adequate and well-controlled studies designed to demonstrate the safety and efficacy of the product candidates and obtain regulatory approval before we are able to commercialize these product candidates. Because of the lack of external funding for these development programs, we may not be able to fund all of these programs to completion or provide the support necessary to perform the clinical trials, seek regulatory approvals or market any approved products. Even if we succeed in developing and commercializing one or more of our product candidates utilizing our Carrierwave technology, we may never generate sufficient or sustainable revenue to enable us to be profitable. Total direct costs 773 1,096 Indirect costs 16 Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense. First Albany Capital Wells Fargo Securities, LLC Punk, Ziegel & Company The date of this prospectus is August 5, 2004 Table of Contents We face intense competition in the markets targeted by our lead product candidates. Many of our competitors have substantially greater resources than we do, and we expect that all of our product candidates under development will face intense competition from existing or future drugs. We have devoted substantial research efforts and capital to the development of our Carrierwave technology and our lead product candidates. We expect that all of our product candidates under development, if approved, will face intense competition from existing and future drugs marketed by large companies. The markets for amphetamines and other stimulants to treat ADHD and opioids to treat acute and chronic pain are well developed and populated with established drugs marketed by large pharmaceutical, biotechnology and generic drug companies. Amphetamines or other stimulants currently-marketed for ADHD include Ritalin (Novartis AG), Concerta (McNeil Consumer & Specialty Pharmaceuticals), Dexedrine (GlaxoSmithKline PLC), Dextrostat (Shire Pharmaceuticals Group plc), Cylert (Abbott Laboratories) and Adderall (Shire Pharmaceuticals Group plc). In addition, Eli Lilly and Company markets a non-stimulant drug, Strattera, for ADHD. Opioids currently-marketed for acute pain include Anexsia (Mallinckrodt Inc.), Endocet (Endo Laboratories), Hydrocet (Amarin Pharmaceuticals, Inc.), Lortab (UCB Pharma Inc.), Norco (Watson Pharmaceuticals, Inc.), and Vicodin (Abbott Laboratories, Inc.). Opioids currently-marketed for chronic pain include OxyContin (Purdue Pharmaceuticals LP), Duragesic (Janssen Pharmaceutica Products, L.P.), MSContin (Purdue Frederick Company) and Avinza (Ligand Pharmaceuticals Inc.). Each of these companies has significantly greater financial and other resources than we do. If we obtain regulatory approval to market one or more of our product candidates, we will compete with these established drugs and will need to show that our drugs have safety or efficacy advantages in order to take market share and be successful. Currently, and as a direct consequence of the public debate of the social and economic costs of illegal diversion and abuse of, addiction to, and overdose from stimulants and narcotics, several companies are pursuing formulations that are less prone to abuse and are less toxic. Companies specifically engaged in developing abuse resistant drugs include Purdue Pharma LP, Nastech Pharmaceutical Company Inc. and Pain Therapeutics Inc. Other companies, including Johnson & Johnson and Noven Pharmaceuticals, Inc., are investigating alternative delivery mechanisms to control the delivery and availability of scheduled drugs. These technologies include transdermal skin patches, metered dose inhalers and extended release subcutaneous injections and implants. These competitors may: successfully market products that compete with our products; successfully identify drug candidates or develop products earlier than we do; or develop products that are more effective, have fewer side effects or cost less than our products. Additionally, if a competitor receives FDA approval before we do for a drug that is similar to one of our product candidates, FDA approval for our product candidate may be precluded or delayed due to periods of non-patent exclusivity and/or the listing with the FDA by the competitor of patents covering its newly-approved drug product. Periods of non-patent exclusivity for new versions of existing drugs such as our current product candidates can extend up to three and one-half years. See Business Government Regulation. These competitive factors could require us to conduct substantial new research and development activities to establish new product targets, which would be costly and time consuming. These activities would adversely affect our ability to commercialize products and achieve revenue and profits. Table of Contents Table of Contents If we fail to protect our intellectual property rights, our ability to pursue the development of our technologies and products would be negatively affected. Our success will depend in part on our ability to obtain patents and maintain adequate protection of our technologies and products. If we do not adequately protect our intellectual property, competitors may be able to use our technologies to produce and market drugs in direct competition with us and erode our competitive advantage. Some foreign countries lack rules and methods for defending intellectual property rights and do not protect proprietary rights to the same extent as the United States. Many companies have had difficulty protecting their proprietary rights in these foreign countries. We may not be able to prevent misappropriation of our proprietary rights. Patent positions can be uncertain and involve complex legal and factual questions. We can protect our proprietary rights from unauthorized use by third parties only to the extent that our proprietary technologies are covered by valid and enforceable patents or are effectively maintained as trade secrets. To date, we hold one issued United States patent relating to our core Carrierwave technology. In addition to the core patent, we have two issued U.S. patents for an earlier developed delivery technology related to Carrierwave, and one directed to iodothyronine compounds. We have applied for additional patents relating to our technologies and our products and plan to file additional patent applications in the future. We have U.S. patent applications pending covering each of our product candidates. Additionally, we have Patent Cooperation Treaty stage patent applications pending covering our product candidates and national stage applications covering our core technology in Europe, Japan, China, South Korea, Canada, Australia, India and Israel. Others may challenge our patents, or our patent applications may not result in issued patents. Moreover, any patents issued to us may not provide us with meaningful protection, or others may challenge, circumvent or narrow our patents. Third parties may also independently develop products similar to our products, duplicate our unpatented products or design around any patents on products we develop. Additionally, extensive time is required for development, testing and regulatory review of a potential product. While extensions of patent term due to regulatory delays may be available, it is possible that, before any of our product candidates can be commercialized, any related patent, even with an extension, may expire or remain in force for only a short period following commercialization, thereby reducing any advantages of the patent. In addition to patents, we rely on a combination of trade secrets, confidentiality, nondisclosure and other contractual provisions, and security measures to protect our confidential and proprietary information. These measures may not adequately protect our trade secrets or other proprietary information. If they do not adequately protect our rights, third parties could use our technology, and we could lose any competitive advantage we may have. In addition, others may independently develop similar proprietary information or techniques or otherwise gain access to our trade secrets, which could impair any competitive advantage we may have. We have not commissioned an extensive investigation concerning our freedom to practice or the validity or enforceability of our Carrierwave technology or product candidates, and we may be held to infringe the intellectual property rights of others. Our ability to freely practice our product candidates is dependent upon the duration and scope of patents held by third parties. Our patent, prior art and infringement investigations have been conducted primarily by us. Although we have consulted with our patent counsel in connection with our intellectual property investigations, our patent counsel has not undertaken an extensive independent analysis to determine whether our Carrierwave technology or product candidates infringe upon any issued patents or whether our issued patents or patent applications relating to our Carrierwave technology could be invalidated or rendered unenforceable for any reason or could be subject to interference proceedings. Table of Contents There may be patents or patent applications of which we are unaware, and avoiding patent infringement may be difficult. We may inadvertently infringe third-party patents. Third-party patents may impair or block our ability to conduct our business. There are no unresolved communications, allegations, complaints or threats of litigation related to the possibility that we might infringe patents held by others. Claims may be asserted against us that our products or technology infringes patents or other intellectual property owned by others. We may be exposed to future litigation by third parties based on claims that our products or activities infringe the intellectual property rights of others. In the event of litigation, any claims may not be resolved in our favor. Any litigation or claims against us, whether or not valid, may result in substantial costs and may result in an award of damages, lost profits, attorneys fees, and tripling of those damages in the event that a court finds an infringement to have been willful. A lawsuit could also place a significant strain on our financial resources, divert the attention of management and harm our reputation. In addition, intellectual property litigation or claims could force us to do one or more of the following: cease making, using, selling, offering to sell or importing any products that infringe a third party s intellectual property through an injunction; obtain a license or an assignment from the holder of the infringed intellectual property right, which license or assignment may be costly or may not be available on reasonable terms, if at all; or redesign our products, which would be costly and time-consuming and may not be possible. We may be involved in lawsuits to protect or enforce our patents, which could be expensive and time consuming. Our intellectual property includes four U.S. patents and 49 pending U.S., Patent Cooperation Treaty or national stage applications. Currently, we are not licensing any technology. We have three applications covering anti-abuse aspects of NRP104, NRP290 and NRP369 generally. Additionally, NRP 104 is covered specifically by four applications, NRP290 is covered by one application, and NRP369 is covered by one application. Competitors may infringe our patents, and we may file infringement claims to counter infringement or unauthorized use. This can be expensive, particularly for a company of our size, and time-consuming. In addition, in an infringement proceeding, a court may decide that a patent of ours is not valid or is unenforceable, or may refuse to stop the other party from using the technology at issue on the grounds that our patents do not cover its technology. An adverse determination of any litigation or defense proceedings could put one or more of our patents at risk of being invalidated or interpreted narrowly. Also, a third party may assert that our patents are invalid and/or unenforceable. There are no unresolved communications, allegations, complaints or threats of litigation related to the possibility that our patents are invalid or unenforceable. Any litigation or claims against us, whether or not merited, may result in substantial costs, place a significant strain on our financial resources, divert the attention of management and harm our reputation. An adverse decision in a litigation could result in inadequate protection for our product candidates and/or reduce the value of any license agreements we have with third parties. Interference proceedings brought before the U.S. Patent and Trademark Office may be necessary to determine priority of invention with respect to our patents or patent applications. During an interference proceeding it may be determined that we do not have priority of invention for one or more aspects in our patents or patent applications and could result in the invalidation in part or whole of a Table of Contents patent or could put a patent application at risk of not issuing. Even if successful, an interference may result in substantial costs and distraction to our management. Furthermore, because of the substantial amount of discovery required in connection with intellectual property litigation or interference proceedings, there is a risk that some of our confidential information could be compromised by disclosure. In addition, there could be public announcements of the results of hearings, motions or other interim proceedings or developments. If investors perceive these results to be negative, the price of our common stock could be adversely affected. If preclinical testing or clinical trials for our product candidates are unsuccessful or delayed, we will be unable to meet our anticipated development and commercialization timelines. Our potential drug products require preclinical testing and clinical trials prior to submission of any regulatory application for commercial sales. We only completed our first clinical trial of our most advanced product candidate, NRP104, in May 2004 and as a result have very limited experience conducting clinical trials. We do not currently employ any clinical trial managers. We rely and expect to continue to rely on third parties, including clinical research organizations and outside consultants, to conduct, supervise or monitor some or all aspects of preclinical testing or clinical trials involving our product candidates. We have less control over the timing and other aspects of these preclinical testing or clinical trials than if we performed the monitoring and supervision entirely on our own. Third parties may not perform their responsibilities for our preclinical testing or clinical trials on our anticipated schedule or, for clinical trials, consistent with a clinical trial protocol. Delays in preclinical and clinical testing could significantly increase our product development costs and delay product commercialization. In addition, many of the factors that may cause, or lead to, a delay in the clinical trials may also ultimately lead to denial of regulatory approval of a product candidate. The commencement of clinical trials can be delayed for a variety of reasons, including delays in: demonstrating sufficient safety and efficacy to obtain regulatory approval to commence a clinical trial; reaching agreement on acceptable terms with prospective contract research organizations and trial sites; manufacturing sufficient quantities of a product candidate; and obtaining institutional review board approval to conduct a clinical trial at a prospective site. Once a clinical trial has begun, it may be delayed, suspended or terminated by us or the FDA or other regulatory authorities due to a number of factors, including: ongoing discussions with the FDA or other regulatory authorities regarding the scope or design of our clinical trials; failure to conduct clinical trials in accordance with regulatory requirements; lower than anticipated recruitment or retention rate of patients in clinical trials; inspection of the clinical trial operations or trial sites by the FDA or other regulatory authorities resulting in the imposition of a clinical hold; lack of adequate funding to continue clinical trials; or negative results of clinical trials. If clinical trials are unsuccessful, and we are not able to obtain regulatory approvals for our product candidates under development, we will not be able to commercialize these products, and therefore may not be able to generate sufficient revenues to support our business. Table of Contents We have received an observation from the FDA noting that we did not submit an IND before conducting certain clinical studies in 2001. FDA has the authority to inspect a company s drug manufacturing and testing processes and to take enforcement actions, with varying degrees of severity, in the event that it determines that violations of the Federal Food, Drug and Cosmetic Act and FDA regulations have occurred. In late April 2004, representatives of the FDA inspected our laboratory facility in Blacksburg, Virginia. In connection with this inspection, the FDA issued an observation on Form FDA-483 relating to our conduct of pharmacokinetic studies on thyroid compounds in humans in 2001. The observation noted that we did not submit an IND application before conducting these studies. Such an observation on Form FDA-483 does not constitute a finding by FDA that a violation has occurred. We have responded to this observation, explaining our basis for believing in 2001 that these studies were exempt from FDA regulations requiring submission of an IND, and agreeing to submit an IND to cover any such studies that we conduct in the future. Based on our explanation for our actions in 2001, on our commitment to submit IND applications to cover similar studies in the future and on the fact that we are not pursuing further studies or approval for the thyroid compounds that were the subject of the 2001 studies, we do not believe that any enforcement action against us by the FDA based on this observation would be warranted or that, if pursued, any such action would have a material effect on us or our business. If we are unable to file for approval under Section 505(b)(2) of the Federal Food, Drug and Cosmetic Act or if we are required to generate additional data related to safety and efficacy in order to obtain approval under Section 505(b)(2), we may be unable to meet our anticipated development and commercialization timelines. Our current plans for filing NDAs for our product candidates include efforts to minimize the data we will be required to generate in order to obtain marketing approval for our product candidates and therefore possibly obtain a shortened review period for the applications. We have not yet discussed or agreed with the FDA as to the nature or extent of any studies we may be required to conduct in order to achieve approval for any of our product candidates. The timeline for filing and review of our NDAs is based on our plan to submit those NDAs under Section 505(b)(2) of the Federal Food, Drug and Cosmetic Act, wherein we will rely in part on data in the public domain or elsewhere. We have not yet filed an NDA under Section 505(b)(2) for any of our lead product candidates. Depending on the data that may be required by the FDA for approval, some of the data may be related to products already approved by the FDA. If the data relied upon is related to products already approved by the FDA and covered by third-party patents we would be required to certify that we do not infringe the listed patents or that such patents are invalid or unenforceable. As a result of the certification, the third-party would have 45 days from notification of our certification to initiate an action against us. In the event that an action is brought in response to such a certification, the approval of our NDA could be subject to a stay of up to 30 months or more while we defend against such a suit. Approval of our product candidates under Section 505(b)(2) may therefore be delayed until patent exclusivity expires or until we successfully challenge the applicability of those patents to our product candidates. Alternatively, we may elect to generate sufficient additional clinical data so that we no longer rely on data which triggers a potential stay of the approval of our product candidates. Even if no exclusivity periods apply to our applications under Section 505(b)(2), the FDA has broad discretion to require us to generate additional data on the safety and efficacy of our product candidates to supplement third-party data on which we may be permitted to rely. In either event, we could be required, before obtaining marketing approval for any of our product candidates, to conduct substantial new research and development activities beyond those we currently plan to engage in order to obtain approval of our product candidates. Such additional new research and development activities would be costly and time consuming. We may not be able to obtain shortened review of our applications, and the FDA may not agree that our products qualify for marketing approval. If we are required to generate additional data to Table of Contents support approval, we may be unable to meet our anticipated development and commercialization timelines, may be unable to generate the additional data at a reasonable cost, or at all, and may be unable to obtain marketing approval of our product candidates. There can be no assurance that any of our product candidates will obtain Fast Track status or, even if any of our product candidates obtain Fast Track status, that development of the product candidate will be accelerated. We believe that some of our product candidates may be eligible for Fast Track status under FDA procedures. These procedures may help to abbreviate the size and scope of the trials required for submission and approval of an NDA and may help shorten the review time of any such filing. If the FDA grants this status to any of our product candidates, we may then negotiate with the FDA with respect to any further development program and corresponding regulatory strategy. We have not yet applied for Fast Track status for any of our lead product candidates. There can be no assurance that any of our product candidates will obtain Fast Track status or, even if any of our product candidates obtain Fast Track status, that development of the product candidate will be accelerated. If the FDA requires that NRP104 be scheduled by the DEA before the product is commercially sold, we will be unable to begin commercial sale of that product until the DEA completes scheduling proceedings, and if NRP104 is scheduled by the DEA in Schedule II under the Controlled Substances Act, the potential market for the drug may be significantly reduced. The DEA has indicated that NRP104 is not a scheduled drug at the present time. Based on data generated in our studies of the potential for abuse, however, and on the fact that the drug is designed to deliver quantities of amphetamine, the FDA and the DEA may, pursuant to their statutory responsibilities under the Controlled Substances Act, conclude that the drug should be scheduled in one of the Controlled Substances Act schedules at the time it is first approved for commercial sale. The process for scheduling a drug under these circumstances involves the forwarding by the FDA to the DEA of its medical and scientific findings, and its recommendation that the drug be scheduled on the appropriate schedule level. The DEA then publishes a notice in the Federal Register of a proposal to place the drug in an appropriate Controlled Substances Act schedule. Interested persons are then afforded an opportunity to comment on the proposal and to request a hearing. After consideration of the comments received, and potentially the holding of a formal administrative hearing, the DEA then publishes a regulation placing the drug in an appropriate Controlled Substances Act schedule. If the FDA is unwilling to permit the sale of the drug until it is placed in an appropriate Controlled Substances Act schedule, it may not grant NDA approval until completion of scheduling proceedings by the DEA. We intend to seek timely conclusion of any consideration of the Controlled Substances Act scheduling of NRP104 so that these considerations do not result in any delay in our ability to market the drug. Because of the opportunity for public participation in the process, however, we cannot predict how long the FDA and the DEA may take to conclude any scheduling actions with respect to the drug that they may believe are warranted. The drug products with which our lead product candidate NRP104 is expected to compete are amphetamine products currently classified by the DEA under the Controlled Substances Act on Schedule II, the most restrictive schedule applicable to drug products marketed for legitimate medical use. The DEA has concluded that, based on its chemical structure, NRP104 is not a scheduled substance at the present time. Our commercialization strategy for this product depends in large part on our ability to obtain approval to market the drug either as an unscheduled drug or as a drug classified by the DEA in a less restrictive schedule than Schedule II. A decision as to whether and how NRP104 should be scheduled at the time it is approved for commercial sale will be made by the DEA based on the medical and scientific determinations of the FDA which, in turn, will be based in large part on data we generate regarding the relative potential for abuse of the drug compared to existing Schedule II Table of Contents drugs. If the determination is made that the drug should be controlled in Schedule II, the potential market for our drug may be significantly reduced, which may have a material adverse effect on us. Furthermore, because amphetamine is a Schedule II substance, the amount of it that we can obtain for clinical trials and commercialization of NRP104 is limited by the DEA and our quota may not be sufficient to complete clinical trials or meet commercial demand. We cannot predict the outcome of the studies of the potential for abuse of our drug or of the consideration by the FDA and the DEA of the results of those studies. We have engaged in extensive financial and operational transactions with Randal J. Kirk, our Chairman, President and Chief Executive Officer, and his affiliates. Our company was formed by, and has historically been controlled and managed and principally funded by, Randal J. Kirk, our Chairman, President and Chief Executive Officer, and affiliates of Mr. Kirk. As a result, we have engaged in a variety of financial and operational transactions with Mr. Kirk and these affiliates. While we believe that each of these transactions was on terms no less favorable to us than terms we could have obtained from unaffiliated third parties, none of these transactions was negotiated on an arm s length basis. Accordingly, their terms may not be as favorable to us as if we had negotiated them with unaffiliated third parties. It is our intention to ensure that all future transactions, if any, between us and our officers, directors, principal shareholders and their affiliates, are approved by the nominating and governance committee or a majority of the independent and disinterested members of the board of directors, and are on terms no less favorable to us than those that we could obtain from unaffiliated third parties. Randal J. Kirk will control approximately 64.9% of our common stock after completion of this offering and will be able to control or significantly influence corporate actions, which may result in Mr. Kirk taking actions that advance his interests to the detriment of our other shareholders. After this offering, Randal J. Kirk, Chairman, President and Chief Executive Officer, and shareholders affiliated with him will control approximately 64.9% of our common stock, based on their beneficial ownership as of July 30, 2004. Mr. Kirk will be able to control or significantly influence all matters requiring approval by our shareholders, including the election of directors and the approval of mergers or other business combination transactions. The interests of Mr. Kirk may not always coincide with the interests of other shareholders, and he may take actions that advance his interests to the detriment of our other shareholders. We have relied on Third Security, LLC, to provide us with general and administrative services. If we are unable to establish and maintain the necessary infrastructure to be self-sufficient and meet the demands of a public company, our business will be adversely affected. We have historically relied on Third Security for accounting, finance, information technology, human resources and executive management services. Third Security is owned by Randal J. Kirk, our Chairman, President and Chief Executive Officer, who, with shareholders affiliated with him, will control approximately 64.9% of our common stock after this offering based on their beneficial ownership on July 30, 2004. In anticipation of this offering, we plan to add personnel and information systems sufficient to perform most of these functions ourselves, although we may experience transition problems in doing so. Upon the closing of this offering, we intend to enter into an administrative services agreement with Third Security pursuant to which Third Security will continue to provide support for tax, legal and market research functions as well as provide the miscellaneous services that we may need from time to time until the earlier of 12 months after the completion of this offering or our termination of the agreement. We intend to negotiate the administrative services agreement on terms Table of Contents no less favorable than those that we would have entered into with an unaffiliated third party, and the agreement will be subject to the approval of the nominating and governance committee of our board of directors or a majority of the independent and disinterested members of our board of directors. See Relationships and Related Party Transactions. As a public company, we will need to meet stringent reporting obligations as well as comply with the requirements of the Sarbanes-Oxley Act of 2002 and the rules and regulations of the Securities and Exchange Commission (SEC) and The Nasdaq National Market. Such requirements will place significant additional demands on our management and financial and accounting staff, on our financial, accounting and information systems and on our internal controls. Although we intend to hire financial, accounting and administrative personnel prior to completion of the offering, we will need to expend significant additional resources to expand our management team and build the financial, accounting and information systems and internal controls necessary for a public company. Our executive officers and other key personnel are critical to our business, and our future success depends on our ability to retain them. We are highly dependent on the principal members of our management and scientific team, particularly, Mr. Kirk, our Chairman President and Chief Executive Officer, Krish S. Krishnan, our Chief Financial Officer, and Suma M. Krishnan, our Vice President, Product Development and chief scientist. In order to pursue our product development, marketing and commercialization plans, we will need to hire additional personnel with experience in clinical testing, government regulation, manufacturing, marketing and business development. We may not be able to attract and retain personnel on acceptable terms given the intense competition for such personnel among biotechnology, pharmaceutical and healthcare companies, universities and non-profit research institutions. We are not aware of any present intention of any of our key personnel to leave our company or to retire. However, we have no employment agreements with any of our executive officers and while we have employment agreements with certain of our employees, all of our employees are at-will employees who may terminate their employment at any time. We do not currently have key personnel insurance on any of our officers or employees. The loss of any of our key personnel, or the inability to attract and retain qualified personnel, may significantly delay or prevent the achievement of our research, development or business objectives and could materially adversely affect our business, financial condition and results of operations. We rely on third parties to manufacture the compounds used in our trials, and we intend to rely on them for the manufacture of any approved products for commercial sale. If these third parties do not manufacture our product candidates in sufficient quantities and at an acceptable cost, clinical development and commercialization of our product candidates could be delayed, prevented or impaired. We have no manufacturing facilities, and we have no experience in the clinical or commercial-scale manufacture of drugs or in designing drug manufacturing processes. Certain specialized manufacturers provide us with modified and unmodified pharmaceutical compounds, including finished products, for use in our preclinical and clinical studies. We do not have any short-term or long-term manufacturing agreements with any of these manufacturers. If we fail to contract for manufacturing on acceptable terms or if third-party manufacturers do not perform as we expect, our development programs could be materially adversely affected. This may result in delays in filing for and receiving FDA approval for one or more of our products. Any such delays could cause our prospects to suffer significantly. We intend to rely on third parties to manufacture some or all of our products that reach commercialization. We believe that there are a variety of manufacturers that we may be able to retain Table of Contents to produce these products. However, once we retain a manufacturing source, if our manufacturers do not perform in a satisfactory manner, we may not be able to develop or commercialize potential products as planned. Failure by our third-party manufacturers to comply with the regulatory guidelines set forth by the FDA and DEA with respect to our product candidates could delay or prevent the completion of clinical trials, the approval of any product candidates or the commercialization of our products. Our reliance on third-party manufacturers exposes us to the following additional risks, any of which could delay or prevent the completion of our clinical trials, the approval of our product candidates by the FDA or other regulatory agencies or the commercialization of our products, result in higher costs or deprive us of potential product revenues: Manufacturers are obligated to operate in accordance with FDA-mandated current good manufacturing practice (cGMP) requirements. A failure of any of our third-party manufacturers to establish and follow cGMP requirements and to document their adherence to such practices may lead to significant delays in the availability of material for clinical trials, may delay or prevent filing or approval of marketing applications for our products, and may cause delays or interruptions in the availability of our products for commercial distribution following FDA approval. Replacing our third-party manufacturers or contracting with additional manufacturers may require re-validation of the manufacturing processes and procedures in accordance with cGMP and compliance with supplemental approval requirements. Any such necessary re-validation and supplemental approvals may be costly and time-consuming. Drug manufacturers are subject to ongoing periodic unannounced inspections by the FDA, the DEA and corresponding state and foreign agencies to ensure strict compliance with cGMP requirements and other requirements under Federal drug laws, other government regulations and corresponding foreign standards. If our third-party manufacturers or we fail to comply with applicable regulations, sanctions could be imposed on us, including fines, injunctions, civil penalties, failure by the government to grant marketing approval of drugs, delays, suspension or withdrawal of approvals, seizures or recalls of product, operating restrictions and criminal prosecutions. We may need additional capital in the future. If additional capital is not available or is available at unattractive terms, we may be forced to delay, reduce the scope of or eliminate our research and development programs, reduce our commercialization efforts or curtail our operations. In order to develop and bring our product candidates to market, we must commit substantial resources to costly and time-consuming research, preclinical and clinical trials and marketing activities. We anticipate that our existing cash and cash equivalents, including the net proceeds of this offering, and interest earned on such proceeds, will enable us to maintain our current operations for at least the next 24 months. We anticipate using our cash and cash equivalents to fund further research and development with respect to our lead product candidates. We may, however, need to raise additional funding sooner if our business or operations change in a manner that consumes available resources more rapidly than we anticipate, which may include if we are granted Fast Track status with respect to any of our product candidates. Our requirements for additional capital will depend on many factors, including: successful commercialization of our product candidates; continued progress of research and development of product candidates utilizing our Carrierwave technology; Table of Contents the time and costs involved in obtaining regulatory approval for our product candidates; costs associated with protecting our intellectual property rights; development of marketing and sales capabilities; payments received under future collaborative agreements, if any; and market acceptance of our products. On April 23, 2004, we entered into a credit agreement with Randal J. Kirk (2000) Limited Partnership, an entity controlled by our current Chairman, President and Chief Executive Officer, Randal J. Kirk. Under the terms of the credit agreement, the partnership has provided an irrevocable line of credit to us for up to the principal amount of $5,000,000. The proceeds from the credit line are to be used by us for general working capital and operating expenses. Amounts advanced to us under this credit agreement bear interest at 12% and payments made by us are applied first to any accrued interest. The entire amount of credit extended, plus any interest, is due the earlier of April 1, 2005 or upon the completion of an initial public offering of our common stock. As of July 30, 2004, there is $0 borrowed under this line of credit. We will have no committed sources of additional capital immediately following our initial public offering. To the extent our capital resources are insufficient to meet future capital requirements, we will need to raise additional funds to continue the development of our product candidates. We anticipate that we will need significant additional funds in order for us to commercialize NRP104 and continue the development of NRP290 and NRP369. Funds may not be available to us on favorable terms, if at all. To the extent we raise additional capital through the sale of equity securities, the issuance of those securities could result in dilution to our shareholders. In addition, if we obtain debt financing, a substantial portion of our operating cash flow may be dedicated to the payment of principal and interest on such indebtedness, thus limiting funds available for our business activities. If adequate funds are not available, we may be required to delay, reduce the scope of or eliminate our research and development programs, reduce our commercialization efforts or curtail our operations. In addition, we may be required to obtain funds through arrangements with collaborative partners or others that may require us to relinquish rights to technologies, product candidates or products that we would otherwise seek to develop or commercialize ourselves or license rights to technologies, product candidates or products on terms that are less favorable to us than might otherwise be available. Even if we obtain regulatory approval to market our product candidates, our product candidates may not be accepted by the market. Even if we obtain regulatory approval to market our product candidates, our product candidates may not gain market acceptance among physicians, patients, healthcare payors and the medical community. The degree of market acceptance of any pharmaceutical product that we develop will depend on a number of factors, including: cost-effectiveness; the safety and effectiveness of our products, including any potential side effects, as compared to alternative products or treatment methods; the timing of market entry as compared to competitive products; the rate of adoption of our products by doctors and nurses; product labeling or product insert required by the FDA for each of our products; determination of scheduled or unscheduled status by the FDA and DEA; reimbursement policies of government and third-party payors; Table of Contents 10,000 shares of our common stock issuable upon the exercise of stock options to be granted by us upon completion of this offering at an exercise price equal to the initial public offering price to two director nominees who will be appointed to our board of directors upon completion of this offering; 160,000 shares of our common stock issuable upon the exercise of stock options to be granted by us upon completion of this offering at an exercise price equal to the initial public offering price to members of our management; and a total of 780,937 shares reserved for issuance under our Incentive Compensation Plan. The information in this prospectus, unless otherwise noted, has been adjusted to reflect a one-for-two reverse stock split effective as of August 3, 2004. Unless otherwise indicated, all information contained in this prospectus assumes no exercise of the underwriters option to purchase up to 630,000 additional shares of common stock to cover over-allotments. This offering is made through the OpenIPO process, in which the allocation of shares and the public offering price are primarily based on an auction in which prospective purchasers are required to bid for the shares. This process is described under Underwriting beginning on page 94. Table of Contents effectiveness of our sales, marketing and distribution capabilities and the effectiveness of such capabilities of our collaborative partners, if any; and unfavorable publicity concerning our products or any similar products. Our product candidates, if successfully developed, will compete with a number of products manufactured and marketed by major pharmaceutical companies, biotechnology companies and manufacturers of generic drugs. Our products may also compete with new products currently under development by others. Physicians, patients, third-party payors and the medical community may not accept and utilize any of our product candidates. Physicians may not be inclined to prescribe the drugs created utilizing our Carrierwave technology unless our drugs bring substantial and demonstrable advantages over other drugs currently-marketed for the same indications. If our products do not achieve market acceptance, we will not be able to generate significant revenues or become profitable. If we fail to establish marketing, sales and distribution capabilities, or fail to enter into arrangements with third parties, we will not be able to create a market for our product candidates. Our strategy with our lead product candidates is to control, directly or through contracted third parties, all or most aspects of the product development process, including marketing, sales and distribution. Currently, we do not have any sales, marketing or distribution capabilities. In order to generate sales of any product candidates that receive regulatory approval, we must either acquire or develop an internal marketing and sales force with technical expertise and with supporting distribution capabilities or make arrangements with third parties to perform these services for us. The acquisition or development of a sales and distribution infrastructure would require substantial resources, which may divert the attention of our management and key personnel and defer our product development efforts. To the extent that we enter into marketing and sales arrangements with other companies, our revenues will depend on the efforts of others. These efforts may not be successful. If we fail to develop sales, marketing and distribution channels, or enter into arrangements with third parties, we will experience delays in product sales and incur increased costs. In the event that we are successful in bringing any products to market, our revenues may be adversely affected if we fail to obtain acceptable prices or adequate reimbursement for our products from third-party payors. Our ability to commercialize pharmaceutical products successfully may depend in part on the availability of reimbursement for our products from: government and health administration authorities; private health insurers; and other third party payors, including Medicare. We cannot predict the availability of reimbursement for newly-approved health care products. Third-party payors, including Medicare, are challenging the prices charged for medical products and services. Government and other third-party payors increasingly are limiting both coverage and the level of reimbursement for new drugs. Third-party insurance coverage may not be available to patients for any of our products. The continuing efforts of government and third-party payors to contain or reduce the costs of health care may limit our commercial opportunity. If government and other third-party payors do not provide adequate coverage and reimbursement for any prescription product we bring to market, doctors may not prescribe them or patients may ask to have their physicians prescribe competing Table of Contents drugs with more favorable reimbursement. In some foreign markets, pricing and profitability of prescription pharmaceuticals are subject to government control. In the United States, we expect that there will continue to be federal and state proposals for similar controls. In addition, we expect that increasing emphasis on managed care in the United States will continue to put pressure on the pricing of pharmaceutical products. Cost control initiatives could decrease the price that we receive for any products in the future. Further, cost control initiatives could impair our ability to commercialize our products and our ability to earn revenues from this commercialization. We could be forced to pay substantial damage awards if product liability claims that may be brought against us are successful. The use of any of our product candidates in clinical trials, and the sale of any approved products, may expose us to liability claims and financial losses resulting from the use or sale of our products. We have obtained limited product liability insurance coverage for our clinical trials of $10 million per occurrence and in the aggregate, subject to a deductible of $50,000 per occurrence and $500,000 per year in the aggregate. However, such insurance may not be adequate to cover any claims made against us. In addition, we may not be able to maintain insurance coverage at a reasonable cost or in sufficient amounts or scope to protect us against losses. We use hazardous chemicals in our business. Potential claims relating to improper handling, storage or disposal of these chemicals could be time consuming and costly. Our research and development processes involve the controlled use of hazardous chemicals. These hazardous chemicals are reagents and solvents typically found in a chemistry laboratory. Our operations also produce hazardous waste products. Federal, state and local laws and regulations govern the use, manufacture, storage, handling and disposal of hazardous materials. While we attempt to comply with all environmental laws and regulations, including those relating to the outsourcing of the disposal of all hazardous chemicals and waste products, we cannot eliminate the risk of accidental contamination from or discharge of hazardous materials and any resultant injury. Compliance with environmental laws and regulations may be expensive. Current or future environmental regulations may impair our research, development or production efforts. We might have to pay civil damages in the event of an improper or unauthorized release of, or exposure of individuals to, hazardous materials. We are not insured against these environmental risks. If we enter into collaborations with third parties, they might also work with hazardous materials in connection with our collaborations. We may agree to indemnify our collaborators in some circumstances against damages and other liabilities arising out of development activities or products produced in connection with these collaborations. If we retain collaborative partners and our partners do not satisfy their obligations, we will be unable to develop our partnered product candidates. Currently, we do not have any collaborative agreements. Although we recently entered into a non-binding letter of intent with Elan Corporation, plc, to collaborate with respect to the development and commercialization of formulated, sustained-release hydromorphone-Carrierwave conjugates, there can be no assurance that we will actually enter into a collaborative agreement with Elan. In the event we enter into any collaborative agreements, we may not have day-to-day control over the activities of our collaborative partners with respect to any of these product candidates. Any collaborative partner may not fulfill its obligations under these agreements. If a collaborative partner fails to fulfill its obligations under an agreement with us, we may be unable to assume the development of the products covered by that agreement or enter into alternative arrangements with a third party. In addition, we may encounter delays in the commercialization of the product candidate that is the subject of the Table of Contents Summary Consolidated Financial Data The following summary consolidated financial data for the years ended December 30, 2001, December 29, 2002 and December 28, 2003 have been derived from our audited consolidated financial statements. The summary consolidated financial data for the three months ended March 30, 2003 and March 28, 2004 have been derived from our unaudited consolidated financial statements appearing elsewhere in this prospectus. The unaudited summary consolidated financial data include, in the opinion of management, all adjustments, consisting of only normal recurring adjustments, that are necessary for a fair presentation of the results for the interim unaudited periods. Operating results for the three months ended March 28, 2004 are not necessarily indicative of the results that may be expected for the year ending January 2, 2005. The summary financial data set forth below should be read together with the consolidated financial statements and the related notes to those statements, as well as Management s Discussion and Analysis of Financial Condition and Results of Operations, appearing elsewhere in this prospectus. Years ended Table of Contents agreement. Accordingly, our ability to receive any revenue from the product candidates covered by these agreements will be dependent on the efforts of our collaborative partner. We could also become involved in disputes with a collaborative partner, which could lead to delays in or termination of our development and commercialization programs and time- consuming and expensive litigation or arbitration. In addition, any such dispute could diminish our collaborators commitment to us and reduce the resources they devote to developing and commercializing our products. Conflicts or disputes with our collaborators, and competition from them, could harm our relationships with our other collaborators, restrict our ability to enter future collaboration agreements and delay the research, development or commercialization of our product candidates. If any collaborative partner terminates or breaches its agreement, or otherwise fails to complete its obligations in a timely manner, our chances of successfully developing or commercializing these product candidates would be materially and adversely affected. We may not be able to enter into collaborative agreements with partners on terms favorable to us, or at all. Our inability to enter into collaborative arrangements with collaborative partners, or our failure to maintain such arrangements, would limit the number of product candidates that we could develop and ultimately, decrease our sources of any future revenues. RISKS RELATED TO THIS OFFERING There has been no prior public market for our common stock, and you may not be able to resell shares of our common stock for a profit or at all. Prior to this offering, there has been no public market for our common stock. We will determine the initial public offering price with the underwriters. This price may not be the price at which the common stock will trade after this offering. The market price of our common stock may decline below the initial public offering price. Although we have applied to have our common stock quoted on The Nasdaq National Market, an active trading market for our common stock may not develop after this offering. We cannot assure you of the extent to which an active trading market will develop or how liquid that market may become. The market price for our common stock may be volatile, and your investment in our common stock could decline in value. The stock market in general has experienced extreme price and volume fluctuations. The market prices of the securities of biotechnology and specialty pharmaceutical companies, particularly companies like ours without product revenues and earnings, have been highly volatile and may continue to be highly volatile in the future. This volatility has often been unrelated to the operating performance of particular companies. The following factors, in addition to other risk factors described in this section, may have a significant impact on the market price of our common stock: announcements of technological innovations or new products by us or our competitors; announcement of FDA approval or disapproval of our products or other product-related actions; decisions by the DEA regarding the assignment of scheduling to our products; developments involving our discovery efforts and clinical trials; developments or disputes concerning patents or proprietary rights, including announcements of infringement, interference or other litigation against us or our potential licensees; developments involving our efforts to commercialize our products, including developments impacting the timing of commercialization; announcements concerning our competitors, or the biotechnology, pharmaceutical or drug delivery industry in general; Three months ended Table of Contents public concerns as to the safety or efficacy of our products or our competitors products; changes in government regulation of the pharmaceutical or medical industry; changes in the reimbursement policies of third party insurance companies or government agencies; actual or anticipated fluctuations in our operating results; changes in financial estimates or recommendations by securities analysts; developments involving corporate collaborators, if any; changes in accounting principles; and the loss of any of our key scientific or management personnel. As a result of this volatility, you may not be able to resell your shares at or above the public offering price. In the past, securities class action litigation has often been brought against companies that experience volatility in the market price of their securities. Whether or not meritorious, litigation brought against us could result in substantial costs and a diversion of management s attention and resources, which could adversely affect our business, operating results and financial condition. We do not anticipate paying dividends on our common stock. We have never declared or paid cash dividends on our common stock and do not expect to do so in the foreseeable future. The declaration of dividends is subject to the discretion of our board of directors and will depend on various factors, including our operating results, financial condition, future prospects and any other factors deemed relevant by our board of directors. You should not rely on an investment in our company if you require dividend income from your investment in our company. The success of your investment will likely depend entirely upon any future appreciation of the market price of our common stock, which is uncertain and unpredictable. There is no guarantee that our common stock will appreciate in value after this offering or even maintain the price at which you purchased your shares. We expect that our quarterly results of operations will fluctuate, and this fluctuation could cause our stock price to decline. Our quarterly operating results are likely to fluctuate in the future. These fluctuations could cause our stock price to decline. The nature of our business involves variable factors, such as the timing of the research, development and regulatory pathways of our product candidates, that could cause our operating results to fluctuate. Due to the possibility of fluctuations in our revenues and expenses, we believe that quarter-to-quarter comparisons of our operating results are not a good indication of our future performance. If we or our existing shareholders sell a substantial number of shares of our common stock in the public market, our stock price may decline. Immediately after this offering, we will have outstanding 17,762,888 shares of common stock. All of the shares being sold in this offering will be freely tradable without restriction or further registration under the federal securities laws, unless purchased by our affiliates as that term is defined in Rule 144 under the Securities Act of 1933. Of the remaining shares, 13,292,038 shares are subject to lock-up agreements, which expire 180 days after this offering. Of these shares, 12,322,938 shares will Table of Contents generally be available for resale to the public in accordance with Rule 144 upon expiration of the lock-up agreements. The 269,950 shares not subject to lock-up agreements will generally be available for resale to the public in accordance with Rule 144. See Shares Eligible for Future Sale. If we or our existing shareholders sell a large number of shares of our common stock, or the public market perceives that we or our existing shareholders might sell shares of common stock, particularly with respect to our affiliates, directors, executive officers or other insiders, the market price of our common stock could decline significantly. In the future, we may issue additional shares to our employees, directors or consultants, in connection with corporate alliances or acquisitions, or to raise capital. Due to these factors, sales of a substantial number of shares of our common stock in the public market could occur at any time. Certain provisions of Virginia law, and our amended and restated articles of incorporation and amended and restated bylaws could make it more difficult for our shareholders to remove our board of directors and management. Certain provisions of Virginia law, the state in which we are incorporated, and our amended and restated articles of incorporation and amended and restated bylaws could make it more difficult for our shareholders, should they choose to do so, to remove our board of directors or management. These provisions include: a provision allowing our board of directors to issue preferred stock with rights senior to those of the common stock without any vote or action by the holders of our common stock. The issuance of preferred stock could adversely affect the rights and powers, including voting rights, of the holders of common stock; a provision allowing the removal of directors only for cause; the requirement in our bylaws that shareholders provide advance notice when nominating our directors or submitting other shareholder proposals; and the inability of shareholders to convene a shareholders meeting without the chairman of the board, the chief executive officer or a majority of the board of directors first calling the meeting. See Description of Capital Stock. We may spend a substantial portion of the net proceeds of this offering in ways which do not yield a favorable return. We have broad discretion to allocate the net proceeds from this offering. As a result, investors in this offering will be relying upon our judgment with only limited information about our specific intentions regarding the use of proceeds. We may not invest the proceeds from this offering in a manner that yields a favorable return. Investors in this offering will experience immediate and substantial dilution of their investment. We expect the initial public offering price of our common stock to be substantially higher than the book value per share of the outstanding common stock. Investors purchasing shares of common stock in this offering will incur immediate dilution in the amount of $6.18 per share based upon the initial public offering price of $8 per share. See Dilution. Table of Contents
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+RISK FACTORS You should carefully consider the risks described below, together with the other information in this prospectus, before deciding whether to invest in the notes. If any of the events described in the risk factors below actually occur, our business, financial condition, operating results and prospects could be materially adversely affected, which in turn could adversely affect our ability to repay the notes. In such case, you may lose all or part of your original investment. Risks Related To Our Leverage Our substantial leverage could harm our business by limiting our available cash and our access to additional capital. As a result of the Transactions, we are highly leveraged. As of June 30, 2004, our total consolidated indebtedness was $3,166.4 million and we had $250.0 million of borrowing capacity available under our revolving credit facility (excluding $34.7 million of outstanding standby letters of credit). The following chart shows our level of indebtedness and certain other information as of June 30, 2004. As of June 30, 2004 (dollars in millions) Revolving credit facility $ — Term loan A facility(1) 224.0 Term loan B facility 1,186.0 Senior notes(2) 908.2 Senior subordinated notes(2) 708.2 Receivables facility 92.0 Assumed debt(3) 48.0 Total indebtedness $ 3,166.4 (1) Includes the U.S. dollar equivalent of 64.2 million term loan A borrowings. (2) Includes the U.S. dollar equivalent of the euro notes. (3) Includes $27.8 million of aggregate principal amount of Nalco Company's 6¼% notes due 2008, $4.3 million of indebtedness of certain non-U.S. subsidiaries and $15.9 million of short-term bank overdrafts. Our high degree of leverage could have important consequences for you, including the following: It may limit our and our subsidiaries' ability to obtain additional financing for working capital, capital expenditures, product development, debt service requirements, acquisitions and general corporate or other purposes on favorable terms or at all; A substantial portion of our cash flows from operations must be dedicated to the payment of principal and interest on our indebtedness and thus will not be available for other purposes, including operations, capital expenditures and future business opportunities; The debt service requirements of our other indebtedness could make it more difficult for us to make payments on the notes; It may limit our ability to adjust to changing market conditions and place us at a competitive disadvantage compared to those of our competitors that are less highly-leveraged; It may restrict our ability to make strategic acquisitions or cause us to make non-strategic divestitures; and We may be more vulnerable than a less leveraged company to a downturn in general economic conditions or in our business, or we may be unable to carry out capital spending that is important to our growth. Our pro forma cash interest expense for the year ended December 31, 2003 was $199.2 million. At June 30, 2004, we had $1,516.4 million of variable rate debt. A 1% increase in the average interest rate would increase future interest expense by approximately $15.2 million per year. Our and our subsidiaries' debt agreements contain restrictions that limit our flexibility in operating our business. Nalco Company's senior credit agreement and the indentures under which the notes were issued and other financing arrangements contain a number of significant covenants that, among other things, restrict our or our subsidiaries' ability to: incur additional indebtedness; pay dividends on or make other distributions or repurchase certain capital stock; make certain investments; enter into certain types of transactions with our affiliates; limit dividends or other payments by restricted subsidiaries; use assets as security in other transactions; and sell certain assets or merge with or into other companies. In addition, under the senior credit agreement, Nalco Holdings is required to satisfy and maintain specified financial ratios and tests. Events beyond our control may affect its ability to comply with those provisions and Nalco Holdings may not be able to meet those ratios and tests. The breach of any of these covenants would result in a default under the senior credit agreement and the lenders could elect to declare all amounts borrowed under the senior credit agreement, together with accrued interest, to be due and payable and could proceed against the collateral securing that indebtedness. Borrowings under the senior credit facilities are effectively senior in right of payment to the senior notes and the senior subordinated notes to the extent of the value of the collateral securing the senior credit facilities and are senior in right of payment to the senior subordinated notes. If any of our indebtedness were to be accelerated, our assets may not be sufficient to repay in full that indebtedness and the notes. Our variable rate indebtedness subjects us to interest rate risk, which could cause our debt service obligations to increase significantly. Certain of our borrowings, primarily borrowings under our senior credit facilities, are at variable rates of interest and expose us to interest rate risk. If interest rates increase, our debt service obligations on the variable rate indebtedness would increase even though the amount borrowed remained the same, and our net income and cash available for servicing our indebtedness, including the notes, would decrease. Our pro forma cash interest expense for the year ended December 31, 2003 was $199.2 million. At June 30, 2004, we had $1,516.4 million of variable rate debt. A 1% increase in the average interest rate would increase future interest expense by approximately $15.2 million per year. Risks Related to Our Business If we are unable to respond to the changing needs of a particular industry and to anticipate, respond to or utilize changing technologies and develop new offerings , it could become more difficult for us to respond to our customers' needs and cause us to be less competitive. We have historically been able to maintain our market positions and margins through continuous innovation of products and development of new offerings to create value for our customers. Recent innovations and development that we have relied on include our 3D TRASAR system for controlling and monitoring chemical feed and our recent relationship with US Filter, which permits us to sell equipment solutions as part of a bundled offering to our water treatment customers. We may not be successful in continuing to make similar innovations in the future. Our future operating results will depend to a significant extent on our ability to continue to introduce new products and applications and to develop new offerings that offer distinct value for our customers. Many of our products may be affected by rapid technological change and new product introductions and enhancements. We expect to continue to enhance our existing products and identify, develop and manufacture new products with improved capabilities and make improvements in our productivity in order to maintain our competitive position. We intend to devote sizeable resources to the development of new technologically advanced products and systems and to continue to devote a substantial amount of expenditures to the research and development functions of our business. However, we cannot assure you that: we will be successful in developing new products or systems or bringing them to market in a timely manner; products or technologies developed by others will not render our offerings obsolete or non-competitive; the market will accept our innovations; our competitors will not be able to produce our core non-patented products at a lower cost; we will have sufficient resources to research and develop all promising new technologies and products; or significant research and development efforts and expenditures for products will ultimately prove successful. Our ability to anticipate, respond to and utilize changing technologies is crucial because we compete with many companies in each of the markets in which we operate. For example, we compete with hundreds of companies in the water treatment chemicals market, including our primary global competitor, GE Water Technologies. Other companies, including Ecolab, Inc. are expected to enter or increase their presence in our markets. Our ability to compete effectively is based on a number of considerations, such as product and service innovation, product and service quality, distribution capability and price. Moreover, water treatment for industrial customers depends on the particular needs of the industry. For example, the paper industry requires a specific water quality for bleaching paper; certain industrial boilers require demineralized water; the pharmaceuticals industry requires ultra pure water for processing; and, in the case of municipal services, water treatment includes clarification for re-use, sludge dewatering and membrane ultra filtration. We may not have sufficient financial resources to respond to the changing needs of a particular industry and to continue to make investments in our business, which could cause us to become less competitive. Our significant non-U.S. operations expose us to global economic and political changes that could impact our profitability. We have significant operations outside the United States, including joint ventures and other alliances. We conduct business in 130 countries and in 2003, approximately 52% of our net sales originated outside the United States. There are inherent risks in our international operations, including: exchange controls and currency restrictions; currency fluctuations and devaluations, such as the recent currency crisis in Argentina; tariffs and trade barriers; export duties and quotas; changes in local economic conditions, such as the economic decline in Venezuela; changes in laws and regulations; difficulties in managing international operations and the burden of complying with foreign laws; exposure to possible expropriation or other government actions; restrictions on our ability to repatriate dividends from our subsidiaries; and unsettled political conditions, such as those found in Nigeria, and possible terrorist attacks against American interests. Our international operations also expose us to different local political and business risks and challenges. For example, in certain countries we are faced with periodic political issues which could result in currency risks or the risk that we are required to include local ownership or management in our businesses. We are also periodically faced with the risk of economic uncertainty, such as recent strikes and currency exchange controls in Venezuela, which has impacted our business in these countries. Other risks in international business also include difficulties in staffing and managing local operations, including our obligations to design local solutions to manage credit risk to local customers and distributors. Our overall success as a global business depends, in part, upon our ability to succeed in differing economic, social and political conditions. We may not continue to succeed in developing and implementing policies and strategies that are effective in each location where we do business, which could negatively affect our profitability. Environmental, safety and production and product regulations or concerns could subject us to liability for fines or damages, require us to modify our operations and increase our manufacturing and delivery costs. We are subject to the requirements of environmental and occupational safety and health laws and regulations in the United States and other countries. These include obligations to investigate and clean up environmental contamination on or from properties or at off-site locations where we are identified as a responsible party. For example, we are currently identified as a potentially responsible party at certain waste management sites. Additionally, the U.S. Environmental Protection Agency is conducting a civil and criminal investigation of environmental practices at our Louisiana manufacturing facility. No claims or charges have been issued and we are unable to predict the results of such investigation. We have also been named as a defendant in a series of multi-party and individual lawsuits based on claims of exposure to hazardous materials. We cannot predict with certainty the outcome of any such tort claims or the involvement we might have in such matters in the future and there can be no assurance that the discovery of previously unknown conditions will not require significant expenditures. In each of these chemical exposure cases, our insurance carriers have accepted the claims on our behalf and our financial exposure is limited to the amount of our deductible (not exceeding $1 million per occurrence); however, we cannot predict the number of claims that we may have to defend in the future and we may not be able to continue to maintain such insurance. We have made and will continue to make capital and other expenditures to comply with environmental requirements. Although we believe we are in material compliance with environmental law requirements, we may not have been and will not at all times be in complete compliance with all of these requirements, and may incur material costs, including fines or damages, or liabilities in connection with these requirements in excess of amounts we have reserved. In addition, these requirements are complex, change frequently and have tended to become more stringent over time. In the future, we may discover previously unknown contamination that could subject us to additional expense and liability. In addition, future requirements could be more onerous than current requirements. For more information about our environmental compliance and potential environmental liabilities, see "Business—Environmental Matters." The activities and plants at our production facilities are subject to a variety of federal, state, local and foreign laws and regulations ("production regulations"). Similarly, the solid, air and liquid waste streams produced from our production facilities are subject to a variety of regulations ("waste regulations") and many of our products and the handling of our products are governmentally regulated or registered ("product regulations"). Each of the production, waste and product regulations is subject to expansion or enhancement. Any new or tightened regulations could lead to increases in the direct and indirect costs we incur in manufacturing and delivering products to our customers. For example, the European Commission is currently considering imposing new chemical registration requirements on the manufacturers and users of all chemicals, not just those which are considered to be harmful or hazardous. Should such regulations, referred to as REACH, be imposed, all chemical companies will be faced with additional costs to conduct their businesses in European Commission countries. Similarly, certain of our products are used to assist in the generation of tax credits for our customers, and the termination or expiration of such tax credits could impact the sale of these products. In addition to an increase in costs in manufacturing and delivering products, a change in production regulations or product regulations could result in interruptions to our business and potentially cause economic or consequential losses should we be unable to meet the demands of our customers for products. We may not be able to achieve all of our expected cost savings. We initiated a comprehensive cost reduction plan immediately upon consummation of the Acquisition. However, a variety of risks could cause us not to achieve the benefits of the expected cost savings, including, among others, the following: higher than expected severance costs related to staff reductions; higher than expected retention costs for employees that will be retained; delays in the anticipated timing of activities related to our cost-saving plan, including the reduction of inefficiencies in our administrative and overhead functions; and other unexpected costs associated with operating the business. We have experienced, and may continue to experience, difficulties in securing the supply of certain raw materials we and our competitors need to manufacture some of our products. During 2004, certain of the raw materials used by us and other chemical companies have faced supply limitation. In some cases because of unexpectedly large demand and in other instances because of plant and equipment problems, certain of our raw material vendors have placed us and their other customers "on allocation," proportionately reducing the amounts of raw materials supplied to us as against our past requirements. If these limitations continue or become more severe, we risk shortfalls in our sales and the potential of claims from our customers if we are unable to fully meet contractual requirements. Our pension plans are currently underfunded and we may have to make significant cash payments to the plans, reducing the cash available for our business. We sponsor various pension plans worldwide that are underfunded and require significant cash payments. For example, in 2003, we contributed $31.2 million to our pension plans and in 2002, we contributed $100.9 million to our pension plans, including a $90.0 million voluntary contribution to our U.S. pension plan. We contributed $4.1 million to our U.S. pension plan in 2004 and do not currently plan to make additional contributions to that plan this year. We are required to contribute at least $21.0 million to the U.S. pension plan in 2005. We may also opt to make additional voluntary contributions to various pension plans worldwide in 2004 and 2005. Additionally, if the performance of the assets in our pension plans does not meet our expectations, or if other actuarial assumptions are modified, our contributions for those years could be even higher than we expect. For example, our U.S. pension assets had a fair value of $210.1 million as of December 31, 2003. We expect to earn an 8.5% investment return on our U.S. pension assets. In the event actual investment returns are 1% lower than expected for one year, we expect our long-term cash requirements to increase by $2.1 million. If our cash flow from operations is insufficient to fund our worldwide pension liability, we may be forced to reduce or delay capital expenditures, seek additional capital or seek to restructure or refinance our indebtedness, including the notes. As of December 31, 2003, our worldwide pension plans were underfunded by $359.6 million (based on the actuarial assumptions used for FAS 87 purposes). Our U.S. pension plans are subject to the Employee Retirement Income Security Act of 1974, or ERISA. Under ERISA, the Pension Benefit Guaranty Corporation, or PBGC, has the authority to terminate an underfunded pension plan under limited circumstances. In the event our U.S. pension plans are terminated for any reason while the plans are underfunded, we will incur a liability to the PBGC that may be equal to the entire amount of the underfunding. Prior to the closing of the Acquisition, the PBGC requested and received information from us regarding our business, the Transactions and our pension plans. The PBGC took no further action with respect to their inquiry. We have recorded a significant amount of goodwill and other identifiable intangible assets, and we may never realize the full value of our intangible assets. In connection with the Acquisition, we have recorded a significant amount of goodwill and other identifiable intangible assets, including customer relationships, trademarks and developed technologies. Goodwill and other net identifiable intangible assets were approximately $3.7 billion as of June 30, 2004, or 63% of our total assets. Goodwill, which represents the excess of cost over the fair value of the net assets of the businesses acquired, was approximately $2.3 billion as of June 30, 2004, or 39% of our total assets. Goodwill and net identifiable intangible assets are recorded at fair value on the date of acquisition and, in accordance with Financial Accounting Standards Board Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible Assets, will be reviewed at least annually for impairment. Impairment may result from, among other things, deterioration in our performance, adverse market conditions, adverse changes in applicable laws or regulations, including changes that restrict the activities of or affect the products and services sold by our business, and a variety of other factors. The amount of any quantified impairment must be expensed immediately as a charge to results of operations. Depending on future circumstances, it is possible that we may never realize the full value of our intangible assets. Any future determination of impairment of a significant portion of goodwill or other identifiable intangible assets would have an adverse effect on our financial condition and results of operations. Our future success will depend in part on our ability to protect our intellectual property rights, and our inability to enforce these rights could permit others to offer products competitive with ours, which could reduce our ability to maintain our market position and maintain our margins. We rely on the patent, trademark, copyright and trade secret laws of the United States and other countries to protect our intellectual property rights. However, we may be unable to prevent third parties from using our intellectual property without authorization. The use of our intellectual property by others could reduce any competitive advantage we have developed or otherwise harm our business. If we had to litigate to protect these rights, any proceedings could be costly, and we may not prevail. We have obtained and applied for several U.S. and foreign trademark registrations, and will continue to evaluate the registration of additional service marks and trademarks, as appropriate. Our pending applications may not be approved by the applicable governmental authorities and, even if the applications are approved, third parties may seek to oppose or otherwise challenge these registrations. A failure to obtain trademark registrations in the United States and in other countries could limit our ability to protect our trademarks and impede our marketing efforts in those jurisdictions. Our Sponsors control us and may have conflicts of interest with us or you in the future. Our Sponsors beneficially own approximately 97% of the equity interests of Nalco LLC, the ultimate parent company of Nalco Holdings, Nalco Company's direct parent. As a result, our Sponsors have control over our decisions to enter into any corporate transaction and have the ability to prevent any transaction that requires the approval of equityholders regardless of whether or not other equityholders or noteholders believe that any such transactions are in their own best interests. For example, our Sponsors could cause us to make acquisitions that increase the amount of indebtedness that is secured or senior to the senior subordinated notes or sell revenue-generating assets, impairing our ability to make payments under the notes. Additionally, our Sponsors are in the business of making investments in companies and may from time to time acquire and hold interests in businesses that compete directly or indirectly with us. Our Sponsors may also pursue acquisition opportunities that may be complementary to our business, and as a result, those acquisition opportunities may not be available to us. So long as our Sponsors continue to own a significant amount of the equity of our parent, Nalco Holdings, even if such amount is less than 50%, they will continue to be able to significantly influence or effectively control our decisions. Risks Related To The Notes We may not be able to generate sufficient cash to service all of our indebtedness, including the notes, and may be forced to take other actions to satisfy our obligations under our indebtedness, which may not be successful. Our ability to make scheduled payments or to refinance our debt obligations depends on our financial and operating performance, which is subject to prevailing economic and competitive conditions and to certain financial, business and other factors beyond our control. We may not be able to maintain a level of cash flows from operating activities sufficient to permit us to pay the principal, premium, if any, and interest on our indebtedness. See "Management's Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources." If our cash flows and capital resources are insufficient to fund our debt service obligations, we may be forced to reduce or delay capital expenditures, seek additional capital or seek to restructure or refinance our indebtedness, including the notes. These alternative measures may not be successful and may not permit us to meet our scheduled debt service obligations. In the absence of such operating results and resources, we could face substantial liquidity problems and might be required to sell material assets or operations to attempt to meet our debt service and other obligations. The senior credit facilities and the indentures under which the notes were issued restrict our ability to use the proceeds from asset sales. We may not be able to consummate those asset sales to raise capital or sell assets at prices that we believe are fair and proceeds that we do receive may not be adequate to meet any debt service obligations then due. See "Description of Other Indebtedness—Senior Credit Facilities," "Description of Senior Notes" and "Description of Senior Subordinated Notes." Despite our current leverage, we may still be able to incur substantially more debt. This could further exacerbate the risks related to significant leverage that we and our subsidiaries face. We and our subsidiaries may be able to incur substantial additional indebtedness in the future. The terms of the indentures do not fully prohibit us or our subsidiaries from doing so. Our revolving credit facility provides borrowing capacity of up to $250.0 million. As of June 30, 2004, there were no outstanding borrowings under the revolving credit facility (excluding $34.7 million of outstanding standby letters of credit). All of those borrowings would be secured, and as a result, would be effectively senior to the notes and the guarantees of the notes by our subsidiary guarantors. If we incur any additional indebtedness that ranks equally with the senior notes or senior subordinated notes, the holders of that debt will be entitled to share ratably with the holders of the senior notes or the holders of the senior subordinated notes, respectively, in any proceeds distributed in connection with any insolvency, liquidation, reorganization, dissolution or other winding-up of us. This may have the effect of reducing the amount of proceeds paid to you. If new debt is added to our current debt levels, the related risks that we and our subsidiaries now face could intensify. Your right to receive payments on each issue of notes is effectively junior to those lenders who have a security interest in our assets and, as a result, in the event of a foreclosure on those assets, we may not be able to satisfy your claims after satisfying the claims of secured lenders. Our obligations under the notes and our guarantors' obligations under their guarantees of the notes are unsecured, but our obligations under our senior credit facilities and each guarantor's obligations under their respective guarantees of the senior credit facilities are secured by a security interest in substantially all of our domestic tangible and intangible assets and the assets and a portion of the stock of certain of our non-U.S. subsidiaries. If we are declared bankrupt or insolvent, or if we default under our senior credit facilities, the lenders could declare all of the funds borrowed thereunder, together with accrued interest, immediately due and payable. If we were unable to repay such indebtedness, the lenders could foreclose on the pledged assets to the exclusion of holders of the notes, even if an event of default exists under the indentures under which the notes were issued at such time. Furthermore, if the lenders foreclose and sell the pledged equity interests in any subsidiary guarantor under the notes, then that guarantor will be released from its guarantee of the notes automatically and immediately upon such sale. In any such event, because the notes will not be secured by any of our assets or the equity interests in subsidiary guarantors, it is possible that there would be no assets remaining from which your claims could be satisfied or, if any assets remained, they might be insufficient to satisfy your claims fully. Additionally, after any such foreclosure, it is likely that we would not continue operating our business, in which case we could not generate any additional funds to satisfy your claims. See "Description of Other Indebtedness." As of June 30, 2004, we had $1,502.0 million of senior secured indebtedness (of which $1,410.0 million was indebtedness under our senior credit facilities and which did not include the undrawn portion under the revolving credit facility of $250.0 million, and $92.0 million of which was indebtedness under our receivables facility). The indentures permit the incurrence of substantial additional indebtedness by us and our restricted subsidiaries in the future, including secured indebtedness. Claims of noteholders will be structurally subordinate to claims of creditors of all of our non-U.S. subsidiaries and some of our U.S. subsidiaries and, as a result, in the event of our dissolution or similar event, we may not be able to satisfy your claims after satisfying the claims of our non-guarantor subsidiaries. The notes are not guaranteed by any of our non-U.S. subsidiaries, our less than wholly-owned U.S. subsidiaries or certain other U.S. subsidiaries. Accordingly, claims of holders of the notes will be structurally subordinate to the claims of creditors of these non-guarantor subsidiaries, including trade creditors. Without limiting the generality of the foregoing, claims of holders of the notes will also be structurally subordinate to claims of the lenders under our senior credit facilities to the extent of the guarantees by non-U.S. subsidiaries of the senior credit facilities. All obligations of our non-guarantor subsidiaries will have to be satisfied before any of the assets of such subsidiaries would be available for distribution, upon a liquidation or otherwise, to us or a guarantor of the notes. We also have joint ventures and subsidiaries in which we own less than 100% of the equity so that, in addition to the structurally senior claims of creditors of those entities, the equity interests of our joint venture partners or other shareholders in any dividend or other distribution made by these entities would need to be satisfied on a proportionate basis with us. These joint ventures and less than wholly-owned subsidiaries may also be subject to restrictions on their ability to distribute cash to us in their financing or other agreements and, as a result, we may not be able to access their cash flow to service our debt obligations, including in respect of the notes. Your right to receive payments on the senior subordinated notes is junior to all of Nalco Company's and the guarantors' senior indebtedness, including Nalco Company's and the guarantors' obligations under the senior credit facilities, the senior notes and other existing and future senior debt. The senior subordinated notes are general unsecured obligations that are junior in right of payment to all our existing and future senior indebtedness. The senior subordinated guarantees are general unsecured obligations of the guarantors that are junior in right of payment to all of the applicable guarantor's existing and future senior indebtedness. Nalco Company and the guarantors may not pay principal, premium, if any, interest or other amounts on account of the senior subordinated notes or the senior subordinated guarantees in the event of a payment default or certain other defaults in respect of certain of our senior indebtedness, including debt under the senior credit facilities and senior notes, unless the senior indebtedness has been paid in full or the default has been cured or waived. In addition, in the event of certain other defaults with respect to the senior indebtedness, Nalco Company or the guarantors may not be permitted to pay any amount on account of the senior subordinated notes or the senior subordinated guarantees for a designated period of time. Because of the subordination provisions in the senior subordinated notes and the senior subordinated guarantees, in the event of a bankruptcy, liquidation or dissolution of Nalco Company or any guarantor, Nalco Company's or the guarantor's assets will not be available to pay obligations under the senior subordinated notes or the applicable senior subordinated guarantee until Nalco Company or the guarantor has made all payments on its respective senior indebtedness. Nalco Company and the guarantors may not have sufficient assets after all these payments have been made to make any payments on the senior subordinated notes or the applicable senior subordinated guarantee, including payments of principal or interest when due. As of June 30, 2004, we had $956.2 million of senior indebtedness. The senior subordinated note indenture permits the incurrence of substantial additional indebtedness, including senior debt, by Nalco Company and our restricted subsidiaries in the future. If we default on our obligations to pay our other indebtedness, we may not be able to make payments on the notes. Any default under the agreements governing our indebtedness, including a default under our senior credit facilities that is not waived by the required lenders, and the remedies sought by the holders of such indebtedness could make us unable to pay principal, premium, if any, and interest on the notes and substantially decrease the market value of the notes. If we are unable to generate sufficient cash flow and are otherwise unable to obtain funds necessary to meet required payments of principal, premium, if any, and interest on our indebtedness, or if we otherwise fail to comply with the various covenants, including financial and operating covenants, in the instruments governing our indebtedness (including our senior credit facilities), we could be in default under the terms of the agreements governing such indebtedness. In the event of such default, the holders of such indebtedness could elect to declare all the funds borrowed thereunder to be due and payable, together with accrued and unpaid interest, the lenders under our revolving credit facility could elect to terminate their commitments, cease making further loans and institute foreclosure proceedings against our assets, and we could be forced into bankruptcy or liquidation. If our operating performance declines, we may in the future need to seek to obtain waivers from the required lenders under our senior credit facilities to avoid being in default. If we breach our covenants under our senior credit facilities and seek a waiver, we may not be able to obtain a waiver from the required lenders. If this occurs, we would be in default under our senior credit facilities, the lenders could exercise their rights as described above, and we could be forced into bankruptcy or liquidation. See "Description of Other Indebtedness—Senior Credit Facilities," "Description of Senior Notes" and "Description of Senior Subordinated Notes." Although Nalco Company will be required to offer to repurchase the notes upon a change of control, it may not have sufficient financial resources to purchase all notes that are tendered. Upon the occurrence of specific kinds of change of control events, including the sale, lease or transfer of "all or substantially" all the assets of Nalco Holdings and its subsidiaries taken as a whole, Nalco Company will be required to offer to repurchase all outstanding notes at 101% of their principal amount, plus accrued and unpaid interest, unless such notes have been previously called for redemption. However, Nalco Company may not have sufficient financial resources to purchase all of the notes that are tendered upon a change of control offer. Any such failure to repurchase the notes could constitute a default under the indentures governing the notes. As mentioned above, under the indentures governing the notes, the sale, lease or transfer of "all or substantially all" the assets of Nalco Holdings and its subsidiaries taken as a whole constitutes a change of control that will require Nalco Company to offer to repurchase the notes. Although there is a developing body of case law interpreting the phrase "substantially all," there is no precise established definition of the phrase under applicable law. Accordingly, the ability of a holder of senior notes to require Nalco Company to repurchase such senior notes as a result of a sale, lease or transfer of less than all of the assets of Nalco Holdings and its subsidiaries taken as a whole to another person or group may be uncertain. See "Description of Senior Notes—Change of Control" and "Description of Senior Subordinated Notes—Change of Control." In addition, it is possible that we could, in the future, enter into certain transactions, including acquisitions, refinancings or other recapitalizations or highly leveraged transactions, that would not constitute a change of control under the indentures, but that could increase the amount of indebtedness outstanding at such time or otherwise affect our capital structure or credit ratings or otherwise adversely affect holders of the notes. Furthermore, because of the potential restrictions on a change of control, we could be prevented from completing a transaction which might otherwise benefit the noteholders. The occurrence of a change of control could also constitute an event of default under our senior credit facilities. Our bank lenders may have the right to prohibit any such purchase or redemption, in which event we will seek to obtain waivers from the required lenders under the senior credit facilities, but may not be able to do so. You may face foreign exchange risks or tax consequences as a result of investing in the euro notes. A portion of each of the senior notes and the senior subordinated notes will be denominated and payable in euros. If you are a U.S. investor, an investment in the euro notes will entail foreign exchange-related risks due to, among other factors, possible significant changes in the value of the euro relative to the U.S. dollar because of economic, political and other factors over which we have no control. Depreciation of the euro against the U.S. dollar could cause a decrease in the effective yield of the euro notes below their stated coupon rates and could result in a loss to you on a U.S. dollar basis. Investing in the euro notes by U.S. investors may also have important tax consequences. Federal and state fraudulent transfer laws may permit a court to void the notes and the guarantees, and, if that occurs, you may not receive any payments on the notes. The issuance of the notes and the guarantees may be subject to review under federal and state fraudulent transfer and conveyance statutes. While the relevant laws may vary from state to state, under such laws the payment of consideration will be a fraudulent conveyance if (1) Nalco Company paid the consideration with the intent of hindering, delaying or defrauding creditors or (2) Nalco Company or any of the guarantors, as applicable, received less than reasonably equivalent value or fair consideration in return for issuing either the notes or a guarantee, and, in the case of (2) only, one of the following is also true: Nalco Company or any of the guarantors was insolvent or rendered insolvent by reason of the incurrence of the indebtedness; or payment of the consideration left Nalco Company or any of the guarantors with an unreasonably small amount of capital to carry on the business; or Nalco Company or any of the guarantors intended to, or believed that it would, incur debts beyond its ability to pay as they mature. If a court were to find that the issuance of the notes or a guarantee was a fraudulent conveyance, the court could void the payment obligations under the notes or such guarantee or further subordinate the notes or such guarantee to presently existing and future indebtedness of Nalco Company or such guarantor, or require the holders of the notes to repay any amounts received with respect to the notes or such guarantee. In the event of a finding that a fraudulent conveyance occurred, you may not receive any repayment on the notes. Further, the voidance of the notes could result in an event of default with respect to our and our subsidiaries' other debt that could result in acceleration of such debt. Generally, an entity would be considered insolvent if, at the time it incurred indebtedness: the sum of its debts, including contingent liabilities, was greater than the fair salable value of all its assets; or the present fair salable value of its assets was less than the amount that would be required to pay its probable liability on its existing debts and liabilities, including contingent liabilities, as they become absolute and mature; or it could not pay its debts as they become due. We cannot be certain as to the standards a court would use to determine whether or not Nalco Company or the guarantors were solvent at the relevant time, or regardless of the standard that a court uses, that the issuance of the notes and the guarantees would not be further subordinated to our or any of our guarantors' other debt. If the guarantees were legally challenged, any guarantee could also be subject to the claim that, since the guarantee was incurred for our benefit, and only indirectly for the benefit of the applicable guarantor, the obligations of the applicable guarantor were incurred for less than fair consideration. A court could thus void the obligations under the guarantees, subordinate them to the applicable guarantor's other debt or take other action detrimental to the holders of the notes. Your ability to transfer the notes may be limited by the absence of an active trading market, and there is no assurance that any active trading market will develop for the notes. The notes are new issues of securities for which there is no established public market. We expect the euro notes to be listed on the Luxembourg Stock Exchange. The initial purchasers have advised us that they intend to make a market in the notes as permitted by applicable laws and regulations; however, the initial purchasers are not obligated to make a market in the notes, and they may discontinue their market-making activities at any time without notice. Therefore, we cannot assure you that an active market for the notes will develop or, if developed, that it will continue. Historically, the market for noninvestment grade debt has been subject to disruptions that have caused substantial volatility in the prices of securities similar to the notes. The market, if any, for the notes may experience similar disruptions and any such disruptions may adversely affect the prices at which you may sell your notes. In addition, subsequent to their initial issuances, the notes may trade at discounts from their initial offering prices, depending upon prevailing interest rates, the market for similar notes, our financial and operating performance and other factors.
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+RISK FACTORS You should carefully consider the risks described below, together with the other information in this prospectus, before deciding whether to invest in the notes. If any of the events described in the risk factors below actually occur, our business, financial condition, operating results and prospects could be materially adversely affected, which in turn could adversely affect our ability to repay the notes. In such case, you may lose all or part of your original investment. Risks Related To Our Leverage Our substantial leverage could harm our business by limiting our available cash and our access to additional capital. As a result of the Transactions, we are highly leveraged. As of June 30, 2004, our total consolidated indebtedness was $3,166.4 million and we had $250.0 million of borrowing capacity available under our revolving credit facility (excluding $34.7 million of outstanding standby letters of credit). The following chart shows our level of indebtedness and certain other information as of June 30, 2004. As of June 30, 2004 (dollars in millions) Revolving credit facility $ — Term loan A facility(1) 224.0 Term loan B facility 1,186.0 Senior notes(2) 908.2 Senior subordinated notes(2) 708.2 Receivables facility 92.0 Assumed debt(3) 48.0 Total indebtedness $ 3,166.4 (1) Includes the U.S. dollar equivalent of 64.2 million term loan A borrowings. (2) Includes the U.S. dollar equivalent of the euro notes. (3) Includes $27.8 million of aggregate principal amount of Nalco Company's 6¼% notes due 2008, $4.3 million of indebtedness of certain non-U.S. subsidiaries and $15.9 million of short-term bank overdrafts. Our high degree of leverage could have important consequences for you, including the following: It may limit our and our subsidiaries' ability to obtain additional financing for working capital, capital expenditures, product development, debt service requirements, acquisitions and general corporate or other purposes on favorable terms or at all; A substantial portion of our cash flows from operations must be dedicated to the payment of principal and interest on our indebtedness and thus will not be available for other purposes, including operations, capital expenditures and future business opportunities; The debt service requirements of our other indebtedness could make it more difficult for us to make payments on the notes; It may limit our ability to adjust to changing market conditions and place us at a competitive disadvantage compared to those of our competitors that are less highly-leveraged; It may restrict our ability to make strategic acquisitions or cause us to make non-strategic divestitures; and We may be more vulnerable than a less leveraged company to a downturn in general economic conditions or in our business, or we may be unable to carry out capital spending that is important to our growth. Our pro forma cash interest expense for the year ended December 31, 2003 was $199.2 million. At June 30, 2004, we had $1,516.4 million of variable rate debt. A 1% increase in the average interest rate would increase future interest expense by approximately $15.2 million per year. Our and our subsidiaries' debt agreements contain restrictions that limit our flexibility in operating our business. Nalco Company's senior credit agreement and the indentures under which the notes were issued and other financing arrangements contain a number of significant covenants that, among other things, restrict our or our subsidiaries' ability to: incur additional indebtedness; pay dividends on or make other distributions or repurchase certain capital stock; make certain investments; enter into certain types of transactions with our affiliates; limit dividends or other payments by restricted subsidiaries; use assets as security in other transactions; and sell certain assets or merge with or into other companies. In addition, under the senior credit agreement, Nalco Holdings is required to satisfy and maintain specified financial ratios and tests. Events beyond our control may affect its ability to comply with those provisions and Nalco Holdings may not be able to meet those ratios and tests. The breach of any of these covenants would result in a default under the senior credit agreement and the lenders could elect to declare all amounts borrowed under the senior credit agreement, together with accrued interest, to be due and payable and could proceed against the collateral securing that indebtedness. Borrowings under the senior credit facilities are effectively senior in right of payment to the senior notes and the senior subordinated notes to the extent of the value of the collateral securing the senior credit facilities and are senior in right of payment to the senior subordinated notes. If any of our indebtedness were to be accelerated, our assets may not be sufficient to repay in full that indebtedness and the notes. Our variable rate indebtedness subjects us to interest rate risk, which could cause our debt service obligations to increase significantly. Certain of our borrowings, primarily borrowings under our senior credit facilities, are at variable rates of interest and expose us to interest rate risk. If interest rates increase, our debt service obligations on the variable rate indebtedness would increase even though the amount borrowed remained the same, and our net income and cash available for servicing our indebtedness, including the notes, would decrease. Our pro forma cash interest expense for the year ended December 31, 2003 was $199.2 million. At June 30, 2004, we had $1,516.4 million of variable rate debt. A 1% increase in the average interest rate would increase future interest expense by approximately $15.2 million per year. Risks Related to Our Business If we are unable to respond to the changing needs of a particular industry and to anticipate, respond to or utilize changing technologies and develop new offerings , it could become more difficult for us to respond to our customers' needs and cause us to be less competitive. We have historically been able to maintain our market positions and margins through continuous innovation of products and development of new offerings to create value for our customers. Recent innovations and development that we have relied on include our 3D TRASAR system for controlling and monitoring chemical feed and our recent relationship with US Filter, which permits us to sell equipment solutions as part of a bundled offering to our water treatment customers. We may not be successful in continuing to make similar innovations in the future. Our future operating results will depend to a significant extent on our ability to continue to introduce new products and applications and to develop new offerings that offer distinct value for our customers. Many of our products may be affected by rapid technological change and new product introductions and enhancements. We expect to continue to enhance our existing products and identify, develop and manufacture new products with improved capabilities and make improvements in our productivity in order to maintain our competitive position. We intend to devote sizeable resources to the development of new technologically advanced products and systems and to continue to devote a substantial amount of expenditures to the research and development functions of our business. However, we cannot assure you that: we will be successful in developing new products or systems or bringing them to market in a timely manner; products or technologies developed by others will not render our offerings obsolete or non-competitive; the market will accept our innovations; our competitors will not be able to produce our core non-patented products at a lower cost; we will have sufficient resources to research and develop all promising new technologies and products; or significant research and development efforts and expenditures for products will ultimately prove successful. Our ability to anticipate, respond to and utilize changing technologies is crucial because we compete with many companies in each of the markets in which we operate. For example, we compete with hundreds of companies in the water treatment chemicals market, including our primary global competitor, GE Water Technologies. Other companies, including Ecolab, Inc. are expected to enter or increase their presence in our markets. Our ability to compete effectively is based on a number of considerations, such as product and service innovation, product and service quality, distribution capability and price. Moreover, water treatment for industrial customers depends on the particular needs of the industry. For example, the paper industry requires a specific water quality for bleaching paper; certain industrial boilers require demineralized water; the pharmaceuticals industry requires ultra pure water for processing; and, in the case of municipal services, water treatment includes clarification for re-use, sludge dewatering and membrane ultra filtration. We may not have sufficient financial resources to respond to the changing needs of a particular industry and to continue to make investments in our business, which could cause us to become less competitive. Our significant non-U.S. operations expose us to global economic and political changes that could impact our profitability. We have significant operations outside the United States, including joint ventures and other alliances. We conduct business in 130 countries and in 2003, approximately 52% of our net sales originated outside the United States. There are inherent risks in our international operations, including: exchange controls and currency restrictions; currency fluctuations and devaluations, such as the recent currency crisis in Argentina; tariffs and trade barriers; export duties and quotas; changes in local economic conditions, such as the economic decline in Venezuela; changes in laws and regulations; difficulties in managing international operations and the burden of complying with foreign laws; exposure to possible expropriation or other government actions; restrictions on our ability to repatriate dividends from our subsidiaries; and unsettled political conditions, such as those found in Nigeria, and possible terrorist attacks against American interests. Our international operations also expose us to different local political and business risks and challenges. For example, in certain countries we are faced with periodic political issues which could result in currency risks or the risk that we are required to include local ownership or management in our businesses. We are also periodically faced with the risk of economic uncertainty, such as recent strikes and currency exchange controls in Venezuela, which has impacted our business in these countries. Other risks in international business also include difficulties in staffing and managing local operations, including our obligations to design local solutions to manage credit risk to local customers and distributors. Our overall success as a global business depends, in part, upon our ability to succeed in differing economic, social and political conditions. We may not continue to succeed in developing and implementing policies and strategies that are effective in each location where we do business, which could negatively affect our profitability. Environmental, safety and production and product regulations or concerns could subject us to liability for fines or damages, require us to modify our operations and increase our manufacturing and delivery costs. We are subject to the requirements of environmental and occupational safety and health laws and regulations in the United States and other countries. These include obligations to investigate and clean up environmental contamination on or from properties or at off-site locations where we are identified as a responsible party. For example, we are currently identified as a potentially responsible party at certain waste management sites. Additionally, the U.S. Environmental Protection Agency is conducting a civil and criminal investigation of environmental practices at our Louisiana manufacturing facility. No claims or charges have been issued and we are unable to predict the results of such investigation. We have also been named as a defendant in a series of multi-party and individual lawsuits based on claims of exposure to hazardous materials. We cannot predict with certainty the outcome of any such tort claims or the involvement we might have in such matters in the future and there can be no assurance that the discovery of previously unknown conditions will not require significant expenditures. In each of these chemical exposure cases, our insurance carriers have accepted the claims on our behalf and our financial exposure is limited to the amount of our deductible (not exceeding $1 million per occurrence); however, we cannot predict the number of claims that we may have to defend in the future and we may not be able to continue to maintain such insurance. We have made and will continue to make capital and other expenditures to comply with environmental requirements. Although we believe we are in material compliance with environmental law requirements, we may not have been and will not at all times be in complete compliance with all of these requirements, and may incur material costs, including fines or damages, or liabilities in connection with these requirements in excess of amounts we have reserved. In addition, these requirements are complex, change frequently and have tended to become more stringent over time. In the future, we may discover previously unknown contamination that could subject us to additional expense and liability. In addition, future requirements could be more onerous than current requirements. For more information about our environmental compliance and potential environmental liabilities, see "Business—Environmental Matters." The activities and plants at our production facilities are subject to a variety of federal, state, local and foreign laws and regulations ("production regulations"). Similarly, the solid, air and liquid waste streams produced from our production facilities are subject to a variety of regulations ("waste regulations") and many of our products and the handling of our products are governmentally regulated or registered ("product regulations"). Each of the production, waste and product regulations is subject to expansion or enhancement. Any new or tightened regulations could lead to increases in the direct and indirect costs we incur in manufacturing and delivering products to our customers. For example, the European Commission is currently considering imposing new chemical registration requirements on the manufacturers and users of all chemicals, not just those which are considered to be harmful or hazardous. Should such regulations, referred to as REACH, be imposed, all chemical companies will be faced with additional costs to conduct their businesses in European Commission countries. Similarly, certain of our products are used to assist in the generation of tax credits for our customers, and the termination or expiration of such tax credits could impact the sale of these products. In addition to an increase in costs in manufacturing and delivering products, a change in production regulations or product regulations could result in interruptions to our business and potentially cause economic or consequential losses should we be unable to meet the demands of our customers for products. We may not be able to achieve all of our expected cost savings. We initiated a comprehensive cost reduction plan immediately upon consummation of the Acquisition. However, a variety of risks could cause us not to achieve the benefits of the expected cost savings, including, among others, the following: higher than expected severance costs related to staff reductions; higher than expected retention costs for employees that will be retained; delays in the anticipated timing of activities related to our cost-saving plan, including the reduction of inefficiencies in our administrative and overhead functions; and other unexpected costs associated with operating the business. We have experienced, and may continue to experience, difficulties in securing the supply of certain raw materials we and our competitors need to manufacture some of our products. During 2004, certain of the raw materials used by us and other chemical companies have faced supply limitation. In some cases because of unexpectedly large demand and in other instances because of plant and equipment problems, certain of our raw material vendors have placed us and their other customers "on allocation," proportionately reducing the amounts of raw materials supplied to us as against our past requirements. If these limitations continue or become more severe, we risk shortfalls in our sales and the potential of claims from our customers if we are unable to fully meet contractual requirements. Our pension plans are currently underfunded and we may have to make significant cash payments to the plans, reducing the cash available for our business. We sponsor various pension plans worldwide that are underfunded and require significant cash payments. For example, in 2003, we contributed $31.2 million to our pension plans and in 2002, we contributed $100.9 million to our pension plans, including a $90.0 million voluntary contribution to our U.S. pension plan. We contributed $4.1 million to our U.S. pension plan in 2004 and do not currently plan to make additional contributions to that plan this year. We are required to contribute at least $21.0 million to the U.S. pension plan in 2005. We may also opt to make additional voluntary contributions to various pension plans worldwide in 2004 and 2005. Additionally, if the performance of the assets in our pension plans does not meet our expectations, or if other actuarial assumptions are modified, our contributions for those years could be even higher than we expect. For example, our U.S. pension assets had a fair value of $210.1 million as of December 31, 2003. We expect to earn an 8.5% investment return on our U.S. pension assets. In the event actual investment returns are 1% lower than expected for one year, we expect our long-term cash requirements to increase by $2.1 million. If our cash flow from operations is insufficient to fund our worldwide pension liability, we may be forced to reduce or delay capital expenditures, seek additional capital or seek to restructure or refinance our indebtedness, including the notes. As of December 31, 2003, our worldwide pension plans were underfunded by $359.6 million (based on the actuarial assumptions used for FAS 87 purposes). Our U.S. pension plans are subject to the Employee Retirement Income Security Act of 1974, or ERISA. Under ERISA, the Pension Benefit Guaranty Corporation, or PBGC, has the authority to terminate an underfunded pension plan under limited circumstances. In the event our U.S. pension plans are terminated for any reason while the plans are underfunded, we will incur a liability to the PBGC that may be equal to the entire amount of the underfunding. Prior to the closing of the Acquisition, the PBGC requested and received information from us regarding our business, the Transactions and our pension plans. The PBGC took no further action with respect to their inquiry. We have recorded a significant amount of goodwill and other identifiable intangible assets, and we may never realize the full value of our intangible assets. In connection with the Acquisition, we have recorded a significant amount of goodwill and other identifiable intangible assets, including customer relationships, trademarks and developed technologies. Goodwill and other net identifiable intangible assets were approximately $3.7 billion as of June 30, 2004, or 63% of our total assets. Goodwill, which represents the excess of cost over the fair value of the net assets of the businesses acquired, was approximately $2.3 billion as of June 30, 2004, or 39% of our total assets. Goodwill and net identifiable intangible assets are recorded at fair value on the date of acquisition and, in accordance with Financial Accounting Standards Board Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible Assets, will be reviewed at least annually for impairment. Impairment may result from, among other things, deterioration in our performance, adverse market conditions, adverse changes in applicable laws or regulations, including changes that restrict the activities of or affect the products and services sold by our business, and a variety of other factors. The amount of any quantified impairment must be expensed immediately as a charge to results of operations. Depending on future circumstances, it is possible that we may never realize the full value of our intangible assets. Any future determination of impairment of a significant portion of goodwill or other identifiable intangible assets would have an adverse effect on our financial condition and results of operations. Our future success will depend in part on our ability to protect our intellectual property rights, and our inability to enforce these rights could permit others to offer products competitive with ours, which could reduce our ability to maintain our market position and maintain our margins. We rely on the patent, trademark, copyright and trade secret laws of the United States and other countries to protect our intellectual property rights. However, we may be unable to prevent third parties from using our intellectual property without authorization. The use of our intellectual property by others could reduce any competitive advantage we have developed or otherwise harm our business. If we had to litigate to protect these rights, any proceedings could be costly, and we may not prevail. We have obtained and applied for several U.S. and foreign trademark registrations, and will continue to evaluate the registration of additional service marks and trademarks, as appropriate. Our pending applications may not be approved by the applicable governmental authorities and, even if the applications are approved, third parties may seek to oppose or otherwise challenge these registrations. A failure to obtain trademark registrations in the United States and in other countries could limit our ability to protect our trademarks and impede our marketing efforts in those jurisdictions. Our Sponsors control us and may have conflicts of interest with us or you in the future. Our Sponsors beneficially own approximately 97% of the equity interests of Nalco LLC, the ultimate parent company of Nalco Holdings, Nalco Company's direct parent. As a result, our Sponsors have control over our decisions to enter into any corporate transaction and have the ability to prevent any transaction that requires the approval of equityholders regardless of whether or not other equityholders or noteholders believe that any such transactions are in their own best interests. For example, our Sponsors could cause us to make acquisitions that increase the amount of indebtedness that is secured or senior to the senior subordinated notes or sell revenue-generating assets, impairing our ability to make payments under the notes. Additionally, our Sponsors are in the business of making investments in companies and may from time to time acquire and hold interests in businesses that compete directly or indirectly with us. Our Sponsors may also pursue acquisition opportunities that may be complementary to our business, and as a result, those acquisition opportunities may not be available to us. So long as our Sponsors continue to own a significant amount of the equity of our parent, Nalco Holdings, even if such amount is less than 50%, they will continue to be able to significantly influence or effectively control our decisions. Risks Related To The Notes We may not be able to generate sufficient cash to service all of our indebtedness, including the notes, and may be forced to take other actions to satisfy our obligations under our indebtedness, which may not be successful. Our ability to make scheduled payments or to refinance our debt obligations depends on our financial and operating performance, which is subject to prevailing economic and competitive conditions and to certain financial, business and other factors beyond our control. We may not be able to maintain a level of cash flows from operating activities sufficient to permit us to pay the principal, premium, if any, and interest on our indebtedness. See "Management's Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources." If our cash flows and capital resources are insufficient to fund our debt service obligations, we may be forced to reduce or delay capital expenditures, seek additional capital or seek to restructure or refinance our indebtedness, including the notes. These alternative measures may not be successful and may not permit us to meet our scheduled debt service obligations. In the absence of such operating results and resources, we could face substantial liquidity problems and might be required to sell material assets or operations to attempt to meet our debt service and other obligations. The senior credit facilities and the indentures under which the notes were issued restrict our ability to use the proceeds from asset sales. We may not be able to consummate those asset sales to raise capital or sell assets at prices that we believe are fair and proceeds that we do receive may not be adequate to meet any debt service obligations then due. See "Description of Other Indebtedness—Senior Credit Facilities," "Description of Senior Notes" and "Description of Senior Subordinated Notes." Despite our current leverage, we may still be able to incur substantially more debt. This could further exacerbate the risks related to significant leverage that we and our subsidiaries face. We and our subsidiaries may be able to incur substantial additional indebtedness in the future. The terms of the indentures do not fully prohibit us or our subsidiaries from doing so. Our revolving credit facility provides borrowing capacity of up to $250.0 million. As of June 30, 2004, there were no outstanding borrowings under the revolving credit facility (excluding $34.7 million of outstanding standby letters of credit). All of those borrowings would be secured, and as a result, would be effectively senior to the notes and the guarantees of the notes by our subsidiary guarantors. If we incur any additional indebtedness that ranks equally with the senior notes or senior subordinated notes, the holders of that debt will be entitled to share ratably with the holders of the senior notes or the holders of the senior subordinated notes, respectively, in any proceeds distributed in connection with any insolvency, liquidation, reorganization, dissolution or other winding-up of us. This may have the effect of reducing the amount of proceeds paid to you. If new debt is added to our current debt levels, the related risks that we and our subsidiaries now face could intensify. Your right to receive payments on each issue of notes is effectively junior to those lenders who have a security interest in our assets and, as a result, in the event of a foreclosure on those assets, we may not be able to satisfy your claims after satisfying the claims of secured lenders. Our obligations under the notes and our guarantors' obligations under their guarantees of the notes are unsecured, but our obligations under our senior credit facilities and each guarantor's obligations under their respective guarantees of the senior credit facilities are secured by a security interest in substantially all of our domestic tangible and intangible assets and the assets and a portion of the stock of certain of our non-U.S. subsidiaries. If we are declared bankrupt or insolvent, or if we default under our senior credit facilities, the lenders could declare all of the funds borrowed thereunder, together with accrued interest, immediately due and payable. If we were unable to repay such indebtedness, the lenders could foreclose on the pledged assets to the exclusion of holders of the notes, even if an event of default exists under the indentures under which the notes were issued at such time. Furthermore, if the lenders foreclose and sell the pledged equity interests in any subsidiary guarantor under the notes, then that guarantor will be released from its guarantee of the notes automatically and immediately upon such sale. In any such event, because the notes will not be secured by any of our assets or the equity interests in subsidiary guarantors, it is possible that there would be no assets remaining from which your claims could be satisfied or, if any assets remained, they might be insufficient to satisfy your claims fully. Additionally, after any such foreclosure, it is likely that we would not continue operating our business, in which case we could not generate any additional funds to satisfy your claims. See "Description of Other Indebtedness." As of June 30, 2004, we had $1,502.0 million of senior secured indebtedness (of which $1,410.0 million was indebtedness under our senior credit facilities and which did not include the undrawn portion under the revolving credit facility of $250.0 million, and $92.0 million of which was indebtedness under our receivables facility). The indentures permit the incurrence of substantial additional indebtedness by us and our restricted subsidiaries in the future, including secured indebtedness. Claims of noteholders will be structurally subordinate to claims of creditors of all of our non-U.S. subsidiaries and some of our U.S. subsidiaries and, as a result, in the event of our dissolution or similar event, we may not be able to satisfy your claims after satisfying the claims of our non-guarantor subsidiaries. The notes are not guaranteed by any of our non-U.S. subsidiaries, our less than wholly-owned U.S. subsidiaries or certain other U.S. subsidiaries. Accordingly, claims of holders of the notes will be structurally subordinate to the claims of creditors of these non-guarantor subsidiaries, including trade creditors. Without limiting the generality of the foregoing, claims of holders of the notes will also be structurally subordinate to claims of the lenders under our senior credit facilities to the extent of the guarantees by non-U.S. subsidiaries of the senior credit facilities. All obligations of our non-guarantor subsidiaries will have to be satisfied before any of the assets of such subsidiaries would be available for distribution, upon a liquidation or otherwise, to us or a guarantor of the notes. We also have joint ventures and subsidiaries in which we own less than 100% of the equity so that, in addition to the structurally senior claims of creditors of those entities, the equity interests of our joint venture partners or other shareholders in any dividend or other distribution made by these entities would need to be satisfied on a proportionate basis with us. These joint ventures and less than wholly-owned subsidiaries may also be subject to restrictions on their ability to distribute cash to us in their financing or other agreements and, as a result, we may not be able to access their cash flow to service our debt obligations, including in respect of the notes. Your right to receive payments on the senior subordinated notes is junior to all of Nalco Company's and the guarantors' senior indebtedness, including Nalco Company's and the guarantors' obligations under the senior credit facilities, the senior notes and other existing and future senior debt. The senior subordinated notes are general unsecured obligations that are junior in right of payment to all our existing and future senior indebtedness. The senior subordinated guarantees are general unsecured obligations of the guarantors that are junior in right of payment to all of the applicable guarantor's existing and future senior indebtedness. Nalco Company and the guarantors may not pay principal, premium, if any, interest or other amounts on account of the senior subordinated notes or the senior subordinated guarantees in the event of a payment default or certain other defaults in respect of certain of our senior indebtedness, including debt under the senior credit facilities and senior notes, unless the senior indebtedness has been paid in full or the default has been cured or waived. In addition, in the event of certain other defaults with respect to the senior indebtedness, Nalco Company or the guarantors may not be permitted to pay any amount on account of the senior subordinated notes or the senior subordinated guarantees for a designated period of time. Because of the subordination provisions in the senior subordinated notes and the senior subordinated guarantees, in the event of a bankruptcy, liquidation or dissolution of Nalco Company or any guarantor, Nalco Company's or the guarantor's assets will not be available to pay obligations under the senior subordinated notes or the applicable senior subordinated guarantee until Nalco Company or the guarantor has made all payments on its respective senior indebtedness. Nalco Company and the guarantors may not have sufficient assets after all these payments have been made to make any payments on the senior subordinated notes or the applicable senior subordinated guarantee, including payments of principal or interest when due. As of June 30, 2004, we had $956.2 million of senior indebtedness. The senior subordinated note indenture permits the incurrence of substantial additional indebtedness, including senior debt, by Nalco Company and our restricted subsidiaries in the future. If we default on our obligations to pay our other indebtedness, we may not be able to make payments on the notes. Any default under the agreements governing our indebtedness, including a default under our senior credit facilities that is not waived by the required lenders, and the remedies sought by the holders of such indebtedness could make us unable to pay principal, premium, if any, and interest on the notes and substantially decrease the market value of the notes. If we are unable to generate sufficient cash flow and are otherwise unable to obtain funds necessary to meet required payments of principal, premium, if any, and interest on our indebtedness, or if we otherwise fail to comply with the various covenants, including financial and operating covenants, in the instruments governing our indebtedness (including our senior credit facilities), we could be in default under the terms of the agreements governing such indebtedness. In the event of such default, the holders of such indebtedness could elect to declare all the funds borrowed thereunder to be due and payable, together with accrued and unpaid interest, the lenders under our revolving credit facility could elect to terminate their commitments, cease making further loans and institute foreclosure proceedings against our assets, and we could be forced into bankruptcy or liquidation. If our operating performance declines, we may in the future need to seek to obtain waivers from the required lenders under our senior credit facilities to avoid being in default. If we breach our covenants under our senior credit facilities and seek a waiver, we may not be able to obtain a waiver from the required lenders. If this occurs, we would be in default under our senior credit facilities, the lenders could exercise their rights as described above, and we could be forced into bankruptcy or liquidation. See "Description of Other Indebtedness—Senior Credit Facilities," "Description of Senior Notes" and "Description of Senior Subordinated Notes." Although Nalco Company will be required to offer to repurchase the notes upon a change of control, it may not have sufficient financial resources to purchase all notes that are tendered. Upon the occurrence of specific kinds of change of control events, including the sale, lease or transfer of "all or substantially" all the assets of Nalco Holdings and its subsidiaries taken as a whole, Nalco Company will be required to offer to repurchase all outstanding notes at 101% of their principal amount, plus accrued and unpaid interest, unless such notes have been previously called for redemption. However, Nalco Company may not have sufficient financial resources to purchase all of the notes that are tendered upon a change of control offer. Any such failure to repurchase the notes could constitute a default under the indentures governing the notes. As mentioned above, under the indentures governing the notes, the sale, lease or transfer of "all or substantially all" the assets of Nalco Holdings and its subsidiaries taken as a whole constitutes a change of control that will require Nalco Company to offer to repurchase the notes. Although there is a developing body of case law interpreting the phrase "substantially all," there is no precise established definition of the phrase under applicable law. Accordingly, the ability of a holder of senior notes to require Nalco Company to repurchase such senior notes as a result of a sale, lease or transfer of less than all of the assets of Nalco Holdings and its subsidiaries taken as a whole to another person or group may be uncertain. See "Description of Senior Notes—Change of Control" and "Description of Senior Subordinated Notes—Change of Control." In addition, it is possible that we could, in the future, enter into certain transactions, including acquisitions, refinancings or other recapitalizations or highly leveraged transactions, that would not constitute a change of control under the indentures, but that could increase the amount of indebtedness outstanding at such time or otherwise affect our capital structure or credit ratings or otherwise adversely affect holders of the notes. Furthermore, because of the potential restrictions on a change of control, we could be prevented from completing a transaction which might otherwise benefit the noteholders. The occurrence of a change of control could also constitute an event of default under our senior credit facilities. Our bank lenders may have the right to prohibit any such purchase or redemption, in which event we will seek to obtain waivers from the required lenders under the senior credit facilities, but may not be able to do so. You may face foreign exchange risks or tax consequences as a result of investing in the euro notes. A portion of each of the senior notes and the senior subordinated notes will be denominated and payable in euros. If you are a U.S. investor, an investment in the euro notes will entail foreign exchange-related risks due to, among other factors, possible significant changes in the value of the euro relative to the U.S. dollar because of economic, political and other factors over which we have no control. Depreciation of the euro against the U.S. dollar could cause a decrease in the effective yield of the euro notes below their stated coupon rates and could result in a loss to you on a U.S. dollar basis. Investing in the euro notes by U.S. investors may also have important tax consequences. Federal and state fraudulent transfer laws may permit a court to void the notes and the guarantees, and, if that occurs, you may not receive any payments on the notes. The issuance of the notes and the guarantees may be subject to review under federal and state fraudulent transfer and conveyance statutes. While the relevant laws may vary from state to state, under such laws the payment of consideration will be a fraudulent conveyance if (1) Nalco Company paid the consideration with the intent of hindering, delaying or defrauding creditors or (2) Nalco Company or any of the guarantors, as applicable, received less than reasonably equivalent value or fair consideration in return for issuing either the notes or a guarantee, and, in the case of (2) only, one of the following is also true: Nalco Company or any of the guarantors was insolvent or rendered insolvent by reason of the incurrence of the indebtedness; or payment of the consideration left Nalco Company or any of the guarantors with an unreasonably small amount of capital to carry on the business; or Nalco Company or any of the guarantors intended to, or believed that it would, incur debts beyond its ability to pay as they mature. If a court were to find that the issuance of the notes or a guarantee was a fraudulent conveyance, the court could void the payment obligations under the notes or such guarantee or further subordinate the notes or such guarantee to presently existing and future indebtedness of Nalco Company or such guarantor, or require the holders of the notes to repay any amounts received with respect to the notes or such guarantee. In the event of a finding that a fraudulent conveyance occurred, you may not receive any repayment on the notes. Further, the voidance of the notes could result in an event of default with respect to our and our subsidiaries' other debt that could result in acceleration of such debt. Generally, an entity would be considered insolvent if, at the time it incurred indebtedness: the sum of its debts, including contingent liabilities, was greater than the fair salable value of all its assets; or the present fair salable value of its assets was less than the amount that would be required to pay its probable liability on its existing debts and liabilities, including contingent liabilities, as they become absolute and mature; or it could not pay its debts as they become due. We cannot be certain as to the standards a court would use to determine whether or not Nalco Company or the guarantors were solvent at the relevant time, or regardless of the standard that a court uses, that the issuance of the notes and the guarantees would not be further subordinated to our or any of our guarantors' other debt. If the guarantees were legally challenged, any guarantee could also be subject to the claim that, since the guarantee was incurred for our benefit, and only indirectly for the benefit of the applicable guarantor, the obligations of the applicable guarantor were incurred for less than fair consideration. A court could thus void the obligations under the guarantees, subordinate them to the applicable guarantor's other debt or take other action detrimental to the holders of the notes. Your ability to transfer the notes may be limited by the absence of an active trading market, and there is no assurance that any active trading market will develop for the notes. The notes are new issues of securities for which there is no established public market. We expect the euro notes to be listed on the Luxembourg Stock Exchange. The initial purchasers have advised us that they intend to make a market in the notes as permitted by applicable laws and regulations; however, the initial purchasers are not obligated to make a market in the notes, and they may discontinue their market-making activities at any time without notice. Therefore, we cannot assure you that an active market for the notes will develop or, if developed, that it will continue. Historically, the market for noninvestment grade debt has been subject to disruptions that have caused substantial volatility in the prices of securities similar to the notes. The market, if any, for the notes may experience similar disruptions and any such disruptions may adversely affect the prices at which you may sell your notes. In addition, subsequent to their initial issuances, the notes may trade at discounts from their initial offering prices, depending upon prevailing interest rates, the market for similar notes, our financial and operating performance and other factors.
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+RISK FACTORS You should carefully consider the risks described below, together with the other information in this prospectus, before deciding whether to invest in the notes. If any of the events described in the risk factors below actually occur, our business, financial condition, operating results and prospects could be materially adversely affected, which in turn could adversely affect our ability to repay the notes. In such case, you may lose all or part of your original investment. Risks Related To Our Leverage Our substantial leverage could harm our business by limiting our available cash and our access to additional capital. As a result of the Transactions, we are highly leveraged. As of June 30, 2004, our total consolidated indebtedness was $3,166.4 million and we had $250.0 million of borrowing capacity available under our revolving credit facility (excluding $34.7 million of outstanding standby letters of credit). The following chart shows our level of indebtedness and certain other information as of June 30, 2004. As of June 30, 2004 (dollars in millions) Revolving credit facility $ — Term loan A facility(1) 224.0 Term loan B facility 1,186.0 Senior notes(2) 908.2 Senior subordinated notes(2) 708.2 Receivables facility 92.0 Assumed debt(3) 48.0 Total indebtedness $ 3,166.4 (1) Includes the U.S. dollar equivalent of 64.2 million term loan A borrowings. (2) Includes the U.S. dollar equivalent of the euro notes. (3) Includes $27.8 million of aggregate principal amount of Nalco Company's 6¼% notes due 2008, $4.3 million of indebtedness of certain non-U.S. subsidiaries and $15.9 million of short-term bank overdrafts. Our high degree of leverage could have important consequences for you, including the following: It may limit our and our subsidiaries' ability to obtain additional financing for working capital, capital expenditures, product development, debt service requirements, acquisitions and general corporate or other purposes on favorable terms or at all; A substantial portion of our cash flows from operations must be dedicated to the payment of principal and interest on our indebtedness and thus will not be available for other purposes, including operations, capital expenditures and future business opportunities; The debt service requirements of our other indebtedness could make it more difficult for us to make payments on the notes; It may limit our ability to adjust to changing market conditions and place us at a competitive disadvantage compared to those of our competitors that are less highly-leveraged; It may restrict our ability to make strategic acquisitions or cause us to make non-strategic divestitures; and We may be more vulnerable than a less leveraged company to a downturn in general economic conditions or in our business, or we may be unable to carry out capital spending that is important to our growth. Our pro forma cash interest expense for the year ended December 31, 2003 was $199.2 million. At June 30, 2004, we had $1,516.4 million of variable rate debt. A 1% increase in the average interest rate would increase future interest expense by approximately $15.2 million per year. Our and our subsidiaries' debt agreements contain restrictions that limit our flexibility in operating our business. Nalco Company's senior credit agreement and the indentures under which the notes were issued and other financing arrangements contain a number of significant covenants that, among other things, restrict our or our subsidiaries' ability to: incur additional indebtedness; pay dividends on or make other distributions or repurchase certain capital stock; make certain investments; enter into certain types of transactions with our affiliates; limit dividends or other payments by restricted subsidiaries; use assets as security in other transactions; and sell certain assets or merge with or into other companies. In addition, under the senior credit agreement, Nalco Holdings is required to satisfy and maintain specified financial ratios and tests. Events beyond our control may affect its ability to comply with those provisions and Nalco Holdings may not be able to meet those ratios and tests. The breach of any of these covenants would result in a default under the senior credit agreement and the lenders could elect to declare all amounts borrowed under the senior credit agreement, together with accrued interest, to be due and payable and could proceed against the collateral securing that indebtedness. Borrowings under the senior credit facilities are effectively senior in right of payment to the senior notes and the senior subordinated notes to the extent of the value of the collateral securing the senior credit facilities and are senior in right of payment to the senior subordinated notes. If any of our indebtedness were to be accelerated, our assets may not be sufficient to repay in full that indebtedness and the notes. Our variable rate indebtedness subjects us to interest rate risk, which could cause our debt service obligations to increase significantly. Certain of our borrowings, primarily borrowings under our senior credit facilities, are at variable rates of interest and expose us to interest rate risk. If interest rates increase, our debt service obligations on the variable rate indebtedness would increase even though the amount borrowed remained the same, and our net income and cash available for servicing our indebtedness, including the notes, would decrease. Our pro forma cash interest expense for the year ended December 31, 2003 was $199.2 million. At June 30, 2004, we had $1,516.4 million of variable rate debt. A 1% increase in the average interest rate would increase future interest expense by approximately $15.2 million per year. Risks Related to Our Business If we are unable to respond to the changing needs of a particular industry and to anticipate, respond to or utilize changing technologies and develop new offerings , it could become more difficult for us to respond to our customers' needs and cause us to be less competitive. We have historically been able to maintain our market positions and margins through continuous innovation of products and development of new offerings to create value for our customers. Recent innovations and development that we have relied on include our 3D TRASAR system for controlling and monitoring chemical feed and our recent relationship with US Filter, which permits us to sell equipment solutions as part of a bundled offering to our water treatment customers. We may not be successful in continuing to make similar innovations in the future. Our future operating results will depend to a significant extent on our ability to continue to introduce new products and applications and to develop new offerings that offer distinct value for our customers. Many of our products may be affected by rapid technological change and new product introductions and enhancements. We expect to continue to enhance our existing products and identify, develop and manufacture new products with improved capabilities and make improvements in our productivity in order to maintain our competitive position. We intend to devote sizeable resources to the development of new technologically advanced products and systems and to continue to devote a substantial amount of expenditures to the research and development functions of our business. However, we cannot assure you that: we will be successful in developing new products or systems or bringing them to market in a timely manner; products or technologies developed by others will not render our offerings obsolete or non-competitive; the market will accept our innovations; our competitors will not be able to produce our core non-patented products at a lower cost; we will have sufficient resources to research and develop all promising new technologies and products; or significant research and development efforts and expenditures for products will ultimately prove successful. Our ability to anticipate, respond to and utilize changing technologies is crucial because we compete with many companies in each of the markets in which we operate. For example, we compete with hundreds of companies in the water treatment chemicals market, including our primary global competitor, GE Water Technologies. Other companies, including Ecolab, Inc. are expected to enter or increase their presence in our markets. Our ability to compete effectively is based on a number of considerations, such as product and service innovation, product and service quality, distribution capability and price. Moreover, water treatment for industrial customers depends on the particular needs of the industry. For example, the paper industry requires a specific water quality for bleaching paper; certain industrial boilers require demineralized water; the pharmaceuticals industry requires ultra pure water for processing; and, in the case of municipal services, water treatment includes clarification for re-use, sludge dewatering and membrane ultra filtration. We may not have sufficient financial resources to respond to the changing needs of a particular industry and to continue to make investments in our business, which could cause us to become less competitive. Our significant non-U.S. operations expose us to global economic and political changes that could impact our profitability. We have significant operations outside the United States, including joint ventures and other alliances. We conduct business in 130 countries and in 2003, approximately 52% of our net sales originated outside the United States. There are inherent risks in our international operations, including: exchange controls and currency restrictions; currency fluctuations and devaluations, such as the recent currency crisis in Argentina; tariffs and trade barriers; export duties and quotas; changes in local economic conditions, such as the economic decline in Venezuela; changes in laws and regulations; difficulties in managing international operations and the burden of complying with foreign laws; exposure to possible expropriation or other government actions; restrictions on our ability to repatriate dividends from our subsidiaries; and unsettled political conditions, such as those found in Nigeria, and possible terrorist attacks against American interests. Our international operations also expose us to different local political and business risks and challenges. For example, in certain countries we are faced with periodic political issues which could result in currency risks or the risk that we are required to include local ownership or management in our businesses. We are also periodically faced with the risk of economic uncertainty, such as recent strikes and currency exchange controls in Venezuela, which has impacted our business in these countries. Other risks in international business also include difficulties in staffing and managing local operations, including our obligations to design local solutions to manage credit risk to local customers and distributors. Our overall success as a global business depends, in part, upon our ability to succeed in differing economic, social and political conditions. We may not continue to succeed in developing and implementing policies and strategies that are effective in each location where we do business, which could negatively affect our profitability. Environmental, safety and production and product regulations or concerns could subject us to liability for fines or damages, require us to modify our operations and increase our manufacturing and delivery costs. We are subject to the requirements of environmental and occupational safety and health laws and regulations in the United States and other countries. These include obligations to investigate and clean up environmental contamination on or from properties or at off-site locations where we are identified as a responsible party. For example, we are currently identified as a potentially responsible party at certain waste management sites. Additionally, the U.S. Environmental Protection Agency is conducting a civil and criminal investigation of environmental practices at our Louisiana manufacturing facility. No claims or charges have been issued and we are unable to predict the results of such investigation. We have also been named as a defendant in a series of multi-party and individual lawsuits based on claims of exposure to hazardous materials. We cannot predict with certainty the outcome of any such tort claims or the involvement we might have in such matters in the future and there can be no assurance that the discovery of previously unknown conditions will not require significant expenditures. In each of these chemical exposure cases, our insurance carriers have accepted the claims on our behalf and our financial exposure is limited to the amount of our deductible (not exceeding $1 million per occurrence); however, we cannot predict the number of claims that we may have to defend in the future and we may not be able to continue to maintain such insurance. We have made and will continue to make capital and other expenditures to comply with environmental requirements. Although we believe we are in material compliance with environmental law requirements, we may not have been and will not at all times be in complete compliance with all of these requirements, and may incur material costs, including fines or damages, or liabilities in connection with these requirements in excess of amounts we have reserved. In addition, these requirements are complex, change frequently and have tended to become more stringent over time. In the future, we may discover previously unknown contamination that could subject us to additional expense and liability. In addition, future requirements could be more onerous than current requirements. For more information about our environmental compliance and potential environmental liabilities, see "Business—Environmental Matters." The activities and plants at our production facilities are subject to a variety of federal, state, local and foreign laws and regulations ("production regulations"). Similarly, the solid, air and liquid waste streams produced from our production facilities are subject to a variety of regulations ("waste regulations") and many of our products and the handling of our products are governmentally regulated or registered ("product regulations"). Each of the production, waste and product regulations is subject to expansion or enhancement. Any new or tightened regulations could lead to increases in the direct and indirect costs we incur in manufacturing and delivering products to our customers. For example, the European Commission is currently considering imposing new chemical registration requirements on the manufacturers and users of all chemicals, not just those which are considered to be harmful or hazardous. Should such regulations, referred to as REACH, be imposed, all chemical companies will be faced with additional costs to conduct their businesses in European Commission countries. Similarly, certain of our products are used to assist in the generation of tax credits for our customers, and the termination or expiration of such tax credits could impact the sale of these products. In addition to an increase in costs in manufacturing and delivering products, a change in production regulations or product regulations could result in interruptions to our business and potentially cause economic or consequential losses should we be unable to meet the demands of our customers for products. We may not be able to achieve all of our expected cost savings. We initiated a comprehensive cost reduction plan immediately upon consummation of the Acquisition. However, a variety of risks could cause us not to achieve the benefits of the expected cost savings, including, among others, the following: higher than expected severance costs related to staff reductions; higher than expected retention costs for employees that will be retained; delays in the anticipated timing of activities related to our cost-saving plan, including the reduction of inefficiencies in our administrative and overhead functions; and other unexpected costs associated with operating the business. We have experienced, and may continue to experience, difficulties in securing the supply of certain raw materials we and our competitors need to manufacture some of our products. During 2004, certain of the raw materials used by us and other chemical companies have faced supply limitation. In some cases because of unexpectedly large demand and in other instances because of plant and equipment problems, certain of our raw material vendors have placed us and their other customers "on allocation," proportionately reducing the amounts of raw materials supplied to us as against our past requirements. If these limitations continue or become more severe, we risk shortfalls in our sales and the potential of claims from our customers if we are unable to fully meet contractual requirements. Our pension plans are currently underfunded and we may have to make significant cash payments to the plans, reducing the cash available for our business. We sponsor various pension plans worldwide that are underfunded and require significant cash payments. For example, in 2003, we contributed $31.2 million to our pension plans and in 2002, we contributed $100.9 million to our pension plans, including a $90.0 million voluntary contribution to our U.S. pension plan. We contributed $4.1 million to our U.S. pension plan in 2004 and do not currently plan to make additional contributions to that plan this year. We are required to contribute at least $21.0 million to the U.S. pension plan in 2005. We may also opt to make additional voluntary contributions to various pension plans worldwide in 2004 and 2005. Additionally, if the performance of the assets in our pension plans does not meet our expectations, or if other actuarial assumptions are modified, our contributions for those years could be even higher than we expect. For example, our U.S. pension assets had a fair value of $210.1 million as of December 31, 2003. We expect to earn an 8.5% investment return on our U.S. pension assets. In the event actual investment returns are 1% lower than expected for one year, we expect our long-term cash requirements to increase by $2.1 million. If our cash flow from operations is insufficient to fund our worldwide pension liability, we may be forced to reduce or delay capital expenditures, seek additional capital or seek to restructure or refinance our indebtedness, including the notes. As of December 31, 2003, our worldwide pension plans were underfunded by $359.6 million (based on the actuarial assumptions used for FAS 87 purposes). Our U.S. pension plans are subject to the Employee Retirement Income Security Act of 1974, or ERISA. Under ERISA, the Pension Benefit Guaranty Corporation, or PBGC, has the authority to terminate an underfunded pension plan under limited circumstances. In the event our U.S. pension plans are terminated for any reason while the plans are underfunded, we will incur a liability to the PBGC that may be equal to the entire amount of the underfunding. Prior to the closing of the Acquisition, the PBGC requested and received information from us regarding our business, the Transactions and our pension plans. The PBGC took no further action with respect to their inquiry. We have recorded a significant amount of goodwill and other identifiable intangible assets, and we may never realize the full value of our intangible assets. In connection with the Acquisition, we have recorded a significant amount of goodwill and other identifiable intangible assets, including customer relationships, trademarks and developed technologies. Goodwill and other net identifiable intangible assets were approximately $3.7 billion as of June 30, 2004, or 63% of our total assets. Goodwill, which represents the excess of cost over the fair value of the net assets of the businesses acquired, was approximately $2.3 billion as of June 30, 2004, or 39% of our total assets. Goodwill and net identifiable intangible assets are recorded at fair value on the date of acquisition and, in accordance with Financial Accounting Standards Board Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible Assets, will be reviewed at least annually for impairment. Impairment may result from, among other things, deterioration in our performance, adverse market conditions, adverse changes in applicable laws or regulations, including changes that restrict the activities of or affect the products and services sold by our business, and a variety of other factors. The amount of any quantified impairment must be expensed immediately as a charge to results of operations. Depending on future circumstances, it is possible that we may never realize the full value of our intangible assets. Any future determination of impairment of a significant portion of goodwill or other identifiable intangible assets would have an adverse effect on our financial condition and results of operations. Our future success will depend in part on our ability to protect our intellectual property rights, and our inability to enforce these rights could permit others to offer products competitive with ours, which could reduce our ability to maintain our market position and maintain our margins. We rely on the patent, trademark, copyright and trade secret laws of the United States and other countries to protect our intellectual property rights. However, we may be unable to prevent third parties from using our intellectual property without authorization. The use of our intellectual property by others could reduce any competitive advantage we have developed or otherwise harm our business. If we had to litigate to protect these rights, any proceedings could be costly, and we may not prevail. We have obtained and applied for several U.S. and foreign trademark registrations, and will continue to evaluate the registration of additional service marks and trademarks, as appropriate. Our pending applications may not be approved by the applicable governmental authorities and, even if the applications are approved, third parties may seek to oppose or otherwise challenge these registrations. A failure to obtain trademark registrations in the United States and in other countries could limit our ability to protect our trademarks and impede our marketing efforts in those jurisdictions. Our Sponsors control us and may have conflicts of interest with us or you in the future. Our Sponsors beneficially own approximately 97% of the equity interests of Nalco LLC, the ultimate parent company of Nalco Holdings, Nalco Company's direct parent. As a result, our Sponsors have control over our decisions to enter into any corporate transaction and have the ability to prevent any transaction that requires the approval of equityholders regardless of whether or not other equityholders or noteholders believe that any such transactions are in their own best interests. For example, our Sponsors could cause us to make acquisitions that increase the amount of indebtedness that is secured or senior to the senior subordinated notes or sell revenue-generating assets, impairing our ability to make payments under the notes. Additionally, our Sponsors are in the business of making investments in companies and may from time to time acquire and hold interests in businesses that compete directly or indirectly with us. Our Sponsors may also pursue acquisition opportunities that may be complementary to our business, and as a result, those acquisition opportunities may not be available to us. So long as our Sponsors continue to own a significant amount of the equity of our parent, Nalco Holdings, even if such amount is less than 50%, they will continue to be able to significantly influence or effectively control our decisions. Risks Related To The Notes We may not be able to generate sufficient cash to service all of our indebtedness, including the notes, and may be forced to take other actions to satisfy our obligations under our indebtedness, which may not be successful. Our ability to make scheduled payments or to refinance our debt obligations depends on our financial and operating performance, which is subject to prevailing economic and competitive conditions and to certain financial, business and other factors beyond our control. We may not be able to maintain a level of cash flows from operating activities sufficient to permit us to pay the principal, premium, if any, and interest on our indebtedness. See "Management's Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources." If our cash flows and capital resources are insufficient to fund our debt service obligations, we may be forced to reduce or delay capital expenditures, seek additional capital or seek to restructure or refinance our indebtedness, including the notes. These alternative measures may not be successful and may not permit us to meet our scheduled debt service obligations. In the absence of such operating results and resources, we could face substantial liquidity problems and might be required to sell material assets or operations to attempt to meet our debt service and other obligations. The senior credit facilities and the indentures under which the notes were issued restrict our ability to use the proceeds from asset sales. We may not be able to consummate those asset sales to raise capital or sell assets at prices that we believe are fair and proceeds that we do receive may not be adequate to meet any debt service obligations then due. See "Description of Other Indebtedness—Senior Credit Facilities," "Description of Senior Notes" and "Description of Senior Subordinated Notes." Despite our current leverage, we may still be able to incur substantially more debt. This could further exacerbate the risks related to significant leverage that we and our subsidiaries face. We and our subsidiaries may be able to incur substantial additional indebtedness in the future. The terms of the indentures do not fully prohibit us or our subsidiaries from doing so. Our revolving credit facility provides borrowing capacity of up to $250.0 million. As of June 30, 2004, there were no outstanding borrowings under the revolving credit facility (excluding $34.7 million of outstanding standby letters of credit). All of those borrowings would be secured, and as a result, would be effectively senior to the notes and the guarantees of the notes by our subsidiary guarantors. If we incur any additional indebtedness that ranks equally with the senior notes or senior subordinated notes, the holders of that debt will be entitled to share ratably with the holders of the senior notes or the holders of the senior subordinated notes, respectively, in any proceeds distributed in connection with any insolvency, liquidation, reorganization, dissolution or other winding-up of us. This may have the effect of reducing the amount of proceeds paid to you. If new debt is added to our current debt levels, the related risks that we and our subsidiaries now face could intensify. Your right to receive payments on each issue of notes is effectively junior to those lenders who have a security interest in our assets and, as a result, in the event of a foreclosure on those assets, we may not be able to satisfy your claims after satisfying the claims of secured lenders. Our obligations under the notes and our guarantors' obligations under their guarantees of the notes are unsecured, but our obligations under our senior credit facilities and each guarantor's obligations under their respective guarantees of the senior credit facilities are secured by a security interest in substantially all of our domestic tangible and intangible assets and the assets and a portion of the stock of certain of our non-U.S. subsidiaries. If we are declared bankrupt or insolvent, or if we default under our senior credit facilities, the lenders could declare all of the funds borrowed thereunder, together with accrued interest, immediately due and payable. If we were unable to repay such indebtedness, the lenders could foreclose on the pledged assets to the exclusion of holders of the notes, even if an event of default exists under the indentures under which the notes were issued at such time. Furthermore, if the lenders foreclose and sell the pledged equity interests in any subsidiary guarantor under the notes, then that guarantor will be released from its guarantee of the notes automatically and immediately upon such sale. In any such event, because the notes will not be secured by any of our assets or the equity interests in subsidiary guarantors, it is possible that there would be no assets remaining from which your claims could be satisfied or, if any assets remained, they might be insufficient to satisfy your claims fully. Additionally, after any such foreclosure, it is likely that we would not continue operating our business, in which case we could not generate any additional funds to satisfy your claims. See "Description of Other Indebtedness." As of June 30, 2004, we had $1,502.0 million of senior secured indebtedness (of which $1,410.0 million was indebtedness under our senior credit facilities and which did not include the undrawn portion under the revolving credit facility of $250.0 million, and $92.0 million of which was indebtedness under our receivables facility). The indentures permit the incurrence of substantial additional indebtedness by us and our restricted subsidiaries in the future, including secured indebtedness. Claims of noteholders will be structurally subordinate to claims of creditors of all of our non-U.S. subsidiaries and some of our U.S. subsidiaries and, as a result, in the event of our dissolution or similar event, we may not be able to satisfy your claims after satisfying the claims of our non-guarantor subsidiaries. The notes are not guaranteed by any of our non-U.S. subsidiaries, our less than wholly-owned U.S. subsidiaries or certain other U.S. subsidiaries. Accordingly, claims of holders of the notes will be structurally subordinate to the claims of creditors of these non-guarantor subsidiaries, including trade creditors. Without limiting the generality of the foregoing, claims of holders of the notes will also be structurally subordinate to claims of the lenders under our senior credit facilities to the extent of the guarantees by non-U.S. subsidiaries of the senior credit facilities. All obligations of our non-guarantor subsidiaries will have to be satisfied before any of the assets of such subsidiaries would be available for distribution, upon a liquidation or otherwise, to us or a guarantor of the notes. We also have joint ventures and subsidiaries in which we own less than 100% of the equity so that, in addition to the structurally senior claims of creditors of those entities, the equity interests of our joint venture partners or other shareholders in any dividend or other distribution made by these entities would need to be satisfied on a proportionate basis with us. These joint ventures and less than wholly-owned subsidiaries may also be subject to restrictions on their ability to distribute cash to us in their financing or other agreements and, as a result, we may not be able to access their cash flow to service our debt obligations, including in respect of the notes. Your right to receive payments on the senior subordinated notes is junior to all of Nalco Company's and the guarantors' senior indebtedness, including Nalco Company's and the guarantors' obligations under the senior credit facilities, the senior notes and other existing and future senior debt. The senior subordinated notes are general unsecured obligations that are junior in right of payment to all our existing and future senior indebtedness. The senior subordinated guarantees are general unsecured obligations of the guarantors that are junior in right of payment to all of the applicable guarantor's existing and future senior indebtedness. Nalco Company and the guarantors may not pay principal, premium, if any, interest or other amounts on account of the senior subordinated notes or the senior subordinated guarantees in the event of a payment default or certain other defaults in respect of certain of our senior indebtedness, including debt under the senior credit facilities and senior notes, unless the senior indebtedness has been paid in full or the default has been cured or waived. In addition, in the event of certain other defaults with respect to the senior indebtedness, Nalco Company or the guarantors may not be permitted to pay any amount on account of the senior subordinated notes or the senior subordinated guarantees for a designated period of time. Because of the subordination provisions in the senior subordinated notes and the senior subordinated guarantees, in the event of a bankruptcy, liquidation or dissolution of Nalco Company or any guarantor, Nalco Company's or the guarantor's assets will not be available to pay obligations under the senior subordinated notes or the applicable senior subordinated guarantee until Nalco Company or the guarantor has made all payments on its respective senior indebtedness. Nalco Company and the guarantors may not have sufficient assets after all these payments have been made to make any payments on the senior subordinated notes or the applicable senior subordinated guarantee, including payments of principal or interest when due. As of June 30, 2004, we had $956.2 million of senior indebtedness. The senior subordinated note indenture permits the incurrence of substantial additional indebtedness, including senior debt, by Nalco Company and our restricted subsidiaries in the future. If we default on our obligations to pay our other indebtedness, we may not be able to make payments on the notes. Any default under the agreements governing our indebtedness, including a default under our senior credit facilities that is not waived by the required lenders, and the remedies sought by the holders of such indebtedness could make us unable to pay principal, premium, if any, and interest on the notes and substantially decrease the market value of the notes. If we are unable to generate sufficient cash flow and are otherwise unable to obtain funds necessary to meet required payments of principal, premium, if any, and interest on our indebtedness, or if we otherwise fail to comply with the various covenants, including financial and operating covenants, in the instruments governing our indebtedness (including our senior credit facilities), we could be in default under the terms of the agreements governing such indebtedness. In the event of such default, the holders of such indebtedness could elect to declare all the funds borrowed thereunder to be due and payable, together with accrued and unpaid interest, the lenders under our revolving credit facility could elect to terminate their commitments, cease making further loans and institute foreclosure proceedings against our assets, and we could be forced into bankruptcy or liquidation. If our operating performance declines, we may in the future need to seek to obtain waivers from the required lenders under our senior credit facilities to avoid being in default. If we breach our covenants under our senior credit facilities and seek a waiver, we may not be able to obtain a waiver from the required lenders. If this occurs, we would be in default under our senior credit facilities, the lenders could exercise their rights as described above, and we could be forced into bankruptcy or liquidation. See "Description of Other Indebtedness—Senior Credit Facilities," "Description of Senior Notes" and "Description of Senior Subordinated Notes." Although Nalco Company will be required to offer to repurchase the notes upon a change of control, it may not have sufficient financial resources to purchase all notes that are tendered. Upon the occurrence of specific kinds of change of control events, including the sale, lease or transfer of "all or substantially" all the assets of Nalco Holdings and its subsidiaries taken as a whole, Nalco Company will be required to offer to repurchase all outstanding notes at 101% of their principal amount, plus accrued and unpaid interest, unless such notes have been previously called for redemption. However, Nalco Company may not have sufficient financial resources to purchase all of the notes that are tendered upon a change of control offer. Any such failure to repurchase the notes could constitute a default under the indentures governing the notes. As mentioned above, under the indentures governing the notes, the sale, lease or transfer of "all or substantially all" the assets of Nalco Holdings and its subsidiaries taken as a whole constitutes a change of control that will require Nalco Company to offer to repurchase the notes. Although there is a developing body of case law interpreting the phrase "substantially all," there is no precise established definition of the phrase under applicable law. Accordingly, the ability of a holder of senior notes to require Nalco Company to repurchase such senior notes as a result of a sale, lease or transfer of less than all of the assets of Nalco Holdings and its subsidiaries taken as a whole to another person or group may be uncertain. See "Description of Senior Notes—Change of Control" and "Description of Senior Subordinated Notes—Change of Control." In addition, it is possible that we could, in the future, enter into certain transactions, including acquisitions, refinancings or other recapitalizations or highly leveraged transactions, that would not constitute a change of control under the indentures, but that could increase the amount of indebtedness outstanding at such time or otherwise affect our capital structure or credit ratings or otherwise adversely affect holders of the notes. Furthermore, because of the potential restrictions on a change of control, we could be prevented from completing a transaction which might otherwise benefit the noteholders. The occurrence of a change of control could also constitute an event of default under our senior credit facilities. Our bank lenders may have the right to prohibit any such purchase or redemption, in which event we will seek to obtain waivers from the required lenders under the senior credit facilities, but may not be able to do so. You may face foreign exchange risks or tax consequences as a result of investing in the euro notes. A portion of each of the senior notes and the senior subordinated notes will be denominated and payable in euros. If you are a U.S. investor, an investment in the euro notes will entail foreign exchange-related risks due to, among other factors, possible significant changes in the value of the euro relative to the U.S. dollar because of economic, political and other factors over which we have no control. Depreciation of the euro against the U.S. dollar could cause a decrease in the effective yield of the euro notes below their stated coupon rates and could result in a loss to you on a U.S. dollar basis. Investing in the euro notes by U.S. investors may also have important tax consequences. Federal and state fraudulent transfer laws may permit a court to void the notes and the guarantees, and, if that occurs, you may not receive any payments on the notes. The issuance of the notes and the guarantees may be subject to review under federal and state fraudulent transfer and conveyance statutes. While the relevant laws may vary from state to state, under such laws the payment of consideration will be a fraudulent conveyance if (1) Nalco Company paid the consideration with the intent of hindering, delaying or defrauding creditors or (2) Nalco Company or any of the guarantors, as applicable, received less than reasonably equivalent value or fair consideration in return for issuing either the notes or a guarantee, and, in the case of (2) only, one of the following is also true: Nalco Company or any of the guarantors was insolvent or rendered insolvent by reason of the incurrence of the indebtedness; or payment of the consideration left Nalco Company or any of the guarantors with an unreasonably small amount of capital to carry on the business; or Nalco Company or any of the guarantors intended to, or believed that it would, incur debts beyond its ability to pay as they mature. If a court were to find that the issuance of the notes or a guarantee was a fraudulent conveyance, the court could void the payment obligations under the notes or such guarantee or further subordinate the notes or such guarantee to presently existing and future indebtedness of Nalco Company or such guarantor, or require the holders of the notes to repay any amounts received with respect to the notes or such guarantee. In the event of a finding that a fraudulent conveyance occurred, you may not receive any repayment on the notes. Further, the voidance of the notes could result in an event of default with respect to our and our subsidiaries' other debt that could result in acceleration of such debt. Generally, an entity would be considered insolvent if, at the time it incurred indebtedness: the sum of its debts, including contingent liabilities, was greater than the fair salable value of all its assets; or the present fair salable value of its assets was less than the amount that would be required to pay its probable liability on its existing debts and liabilities, including contingent liabilities, as they become absolute and mature; or it could not pay its debts as they become due. We cannot be certain as to the standards a court would use to determine whether or not Nalco Company or the guarantors were solvent at the relevant time, or regardless of the standard that a court uses, that the issuance of the notes and the guarantees would not be further subordinated to our or any of our guarantors' other debt. If the guarantees were legally challenged, any guarantee could also be subject to the claim that, since the guarantee was incurred for our benefit, and only indirectly for the benefit of the applicable guarantor, the obligations of the applicable guarantor were incurred for less than fair consideration. A court could thus void the obligations under the guarantees, subordinate them to the applicable guarantor's other debt or take other action detrimental to the holders of the notes. Your ability to transfer the notes may be limited by the absence of an active trading market, and there is no assurance that any active trading market will develop for the notes. The notes are new issues of securities for which there is no established public market. We expect the euro notes to be listed on the Luxembourg Stock Exchange. The initial purchasers have advised us that they intend to make a market in the notes as permitted by applicable laws and regulations; however, the initial purchasers are not obligated to make a market in the notes, and they may discontinue their market-making activities at any time without notice. Therefore, we cannot assure you that an active market for the notes will develop or, if developed, that it will continue. Historically, the market for noninvestment grade debt has been subject to disruptions that have caused substantial volatility in the prices of securities similar to the notes. The market, if any, for the notes may experience similar disruptions and any such disruptions may adversely affect the prices at which you may sell your notes. In addition, subsequent to their initial issuances, the notes may trade at discounts from their initial offering prices, depending upon prevailing interest rates, the market for similar notes, our financial and operating performance and other factors.
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+RISK FACTORS You should read and consider carefully each of the following factors, as well as the other information contained in this prospectus before deciding whether to invest in the notes. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties not presently known to us or that we currently believe to be immaterial may also adversely affect our business. For purposes of this Risk Factors section, the terms we, us, our, the Company and Portola refer to Portola Packaging, Inc. and its subsidiaries, unless the context signifies otherwise. Risks Related to the Notes Our level of indebtedness could, from time to time, limit cash flow available for our operations and could adversely affect our ability to service our debt or obtain additional financing. As of February 29, 2004, our total indebtedness was approximately $192.8 million. $180.0 million of this amount represented the principal amount of the notes, $11.1 million represented funds drawn down under our amended and restated senior secured credit facility, and $0.2 million was principally composed of capital leases. In addition, our total indebtedness included the redeemable warrants with a carrying value of $1.5 million that we have subsequently repurchased. Moreover, we have a total shareholders deficit of $37.8 million. Our level of indebtedness could from time to time restrict our operations and make it more difficult for us to fulfill our obligations under our senior notes. Among other things, our indebtedness may: limit our ability to obtain additional financing for working capital, capital expenditures, strategic acquisitions and general corporate purposes; require us to dedicate all or a substantial portion of our cash flow to service our debt, which will reduce funds available for other business purposes, such as capital expenditures or acquisitions; limit our flexibility in planning for or reacting to changes in the markets in which we compete; place us at a competitive disadvantage relative to our competitors with less indebtedness; render us more vulnerable to general adverse economic and industry conditions; and make it more difficult for us to satisfy our financial obligations, including those relating to the notes. Nonetheless, we and our subsidiaries may still be able to incur substantially more debt in the future. The terms of our amended and restated senior secured credit facility and the indenture governing the notes permit additional borrowings and such borrowings may be secured debt and effectively senior in right of payment to the notes and the related guarantees. Our incurrence of additional debt could further exacerbate the risks described in this prospectus. The subsidiaries that guarantee the notes are also guarantors under the amended and restated senior secured credit facility. See Description of notes and Description of other indebtedness. There has not been a public market for the notes, and we do not know if a market for the notes will ever develop or, if a market does develop, whether it will be sustained. The notes have been registered under the Securities Act, but constitute a new issue of securities with no established trading market. Although the initial purchasers of the notes have informed us that they intend to make a market in the notes, they have no obligation to do so and may discontinue making a market at any time without notice. J.P. Morgan Securities Inc. is an affiliate of ours, and its ability to make a market in the notes will depend on our maintaining a current market making prospectus. Accordingly, we cannot assure you that a liquid market will develop for the notes, that you will be able to sell your notes at any particular time or that the prices that you receive when you sell the notes will be favorable. The liquidity of any market for the notes will depend on a number of factors, including: the number of holders of notes; our operating performance and financial condition; Income (loss) from operations (918 ) 2,024 (36 ) 1,070 Interest income (93 ) (7 ) (1 ) (101 ) Interest expense 3,108 4 (11 ) 3,101 Amortization of debt financing costs 189 4 193 Loss on warrant redemption Foreign currency transaction (gain) loss (142 ) (142 ) Intercompany interest (income) expense (204 ) 168 36 Other (income) expense, net (148 ) (20 ) 61 (1) Estimated solely for the purpose of calculating the registration fee pursuant to Rule 457(f) under the Securities Act. (2) No filing fee is required pursuant to Rule 457(q) under the Securities Act. (3) No separate filing fee is required pursuant to Rule 457(n) under the Securities Act. The Registrant hereby amends this Registration Statement on such date or dates as may be necessary to delay its effective date until the Registrant shall file a further amendment which specifically states that this Registration Statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933 or until the Registration Statement shall become effective on such date as the Commission, acting pursuant to said Section 8(a), may determine. (Dollars in thousands) Loss on warrant redemption (including $1,639 loss on redemption paid to JPMorgan)(9) 1,867 Foreign currency transaction (gain) loss 50 285 (348 ) 252 (2,255 ) Other expense (income), net 108 (39 ) 194 (20 ) Table of Contents the market for similar securities; the interest of securities dealers in making a market in the notes; and prevailing interest rates. Historically, the market for non-investment grade debt has been subject to disruptions that have caused substantial volatility in the prices of these securities. We cannot assure you that the market for the notes will be free from similar disruptions. Any such disruptions could have an adverse effect on holders of the notes. Our ability to service our debt and meet our cash requirements depends on many factors, some of which are beyond our control. Our ability to satisfy our obligations will depend on our future operating performance and financial results, which will be subject, in part, to factors beyond our control, such as interest rates and general economic, financial and business conditions. If we are unable to generate sufficient cash flow to service our debt, we may be required to: refinance all or a portion of our debt, including the notes; obtain additional financing; sell certain of our assets or operations; reduce or delay capital expenditures; or revise or delay our strategic plans. If we are required and if we take any of these actions, it could have a material adverse effect on our business, financial condition and results of operations. In addition, we cannot assure you that we would be able to take any of these actions, that these actions would enable us to continue to satisfy our capital requirements or that these actions would be permitted under the terms of our various debt instruments, including the indenture governing the notes, then in effect. The covenants in our amended and restated senior secured credit facility and the indenture governing the notes impose restrictions that may from time to time limit our operating and financial flexibility. Our amended and restated senior secured credit facility and the indenture governing the notes contain a number of significant restrictions and covenants that limit our ability to: incur liens and debt or provide guarantees in respect of obligations of any other person; issue redeemable preferred stock and subsidiary preferred stock; make redemptions and repurchases of capital stock; make loans, investments and capital expenditures; prepay, redeem or repurchase debt; engage in mergers, consolidations and asset dispositions; engage in sale/leaseback transactions and affiliate transactions; change our business, amend certain debt and other material agreements, and issue and sell capital stock of subsidiaries; and make distributions to shareholders. Adverse changes in our operating results or other adverse factors, including a significant increase in interest rates or in resin prices, a severe shortage of resin supply or a significant decrease in demand for our products, could result in our being unable to comply with the financial covenants in our amended and restated senior secured credit facility. If we violate these covenants and are unable to obtain waivers from our lenders, Other (income) expense: Interest income (31 ) (46 ) (77 ) 60 (7) (17 ) Interest expense 6,268 776 (4) 7,044 298 (8) 7,342 Warrant interest income (68 ) (68 ) (68 ) Amortization of debt financing costs 373 84 (5) 457 536 (9) 993 Loss (gain) from sale of property, plant and equipment 29 (649 ) 632 (2) 12 12 Loss on warrant redemptions Foreign currency transaction (gain) loss 252 252 252 Other (income) expense, net (34 ) Income (loss) from operations 13,628 9,374 11,889 18,160 13,075 2,808 (2,446 ) Interest income(5) (181 ) (75 ) (75 ) (1,083 ) (120 ) (99 ) (81 ) Interest expense 14,443 14,486 14,453 13,251 12,544 6,268 7,410 Amortization of debt financing costs 546 428 718 756 777 373 1,560 Minority interest expense(6) (97 ) (118 ) 278 113 73 38 27 Equity (income) loss of unconsolidated affiliates, net(7) 120 469 37 (340 ) (415 ) (52 ) (6 ) Loss (gain) on sale of property plant and equipment(8) 82 106 (6,784 ) (20 ) 30 29 5 Income on dissolution of joint venture(9) (475 ) Income on recovery of investment(10) (1,103 ) Loss on warrant redemption(11) 1,867 Foreign currency transaction (gain) loss (165 ) 31 50 285 (348 ) 252 (2,255 ) Other (income) expense, net (152 ) (45 ) 108 (39 ) 194 (20 ) Table of Contents we would be in default under these agreements and our lenders could accelerate our obligations thereunder. If our indebtedness is accelerated, we may not be able to repay our debt or borrow sufficient funds to refinance it. Even if we are able to obtain new financing, it may not be on commercially reasonable terms, or terms that are acceptable to us. If our expectations of future operating results are not achieved, or our debt is in default for any reason, our business, financial condition and results of operations would be materially and adversely affected. In addition, complying with these covenants may make it more difficult for us to successfully execute our business strategy and compete against companies who are not subject to such restrictions. See Description of notes and Description of other indebtedness. The notes are effectively subordinate to all of our secured debt, and, if a default occurs, we may not have sufficient funds to fulfill our obligations under the notes. The notes are not secured by any of our assets. The indenture governing the notes permits us to incur certain secured indebtedness, including indebtedness under our amended and restated senior secured credit facility. If we become insolvent or are liquidated, or if payment under the credit facility or other secured indebtedness is accelerated, the lenders under the credit facility and the holders of any other secured indebtedness would be entitled to exercise the remedies available to them as secured creditors under applicable laws and pursuant to instruments governing such indebtedness. Accordingly, such secured indebtedness would have a prior claim on the collateral and would effectively be senior to the notes to the extent that the value of such collateral is sufficient to satisfy the indebtedness secured thereby. To the extent that the value of such collateral is not sufficient to satisfy the secured indebtedness, amounts remaining outstanding on such indebtedness would be entitled to share with holders of the notes and other claims on us with respect to any of our other assets. In either event, because the notes are not secured by any of our assets, it is possible that there will be insufficient assets remaining from which claims of the holders of the notes could be satisfied. In addition, the notes are our obligations and not of any of our subsidiaries, although the indenture requires that any of our restricted subsidiaries having assets with an aggregate fair market value in excess of $0.1 million execute a guarantee in respect of the notes. We cannot assure you that such guarantees, or any guarantee delivered by a restricted subsidiary formed in the future, would not be subject to avoidance by another creditor as a fraudulent transfer or for other reasons. Our unrestricted subsidiaries do not guarantee our obligations under the notes. Upon liquidation of any unrestricted subsidiary, such obligations would be effectively subordinated to claims of such subsidiary s creditors upon its assets. It is likely that this will also be the case for other unrestricted subsidiaries that we may form in the future. The notes are structurally subordinate to all indebtedness of our subsidiaries that are not guarantors of the notes. You will not have any claim as a creditor against our subsidiaries that are not guarantors of the notes. Indebtedness and other liabilities, including trade payables, whether secured or unsecured, of those subsidiaries will be effectively senior to your claims against those subsidiaries. For fiscal 2003, on a pro forma basis, our non-guarantor subsidiaries represented approximately 2.3% of our net sales, approximately 0.3% of our operating income, approximately 1.1% of our EBITDA, and approximately (3.8%) of our cash flows from operating activities. At February 29, 2004, our non-guarantor subsidiaries represented approximately 1.2% of our total assets and had approximately $1.0 million of outstanding total liabilities, including trade payables, but excluding intercompany obligations. In addition, the indenture governing the notes, subject to some limitations, permits these subsidiaries to incur additional indebtedness and does not contain any limitation on the amount of other liabilities, such as trade payables, that may be incurred by these subsidiaries. We may incur additional indebtedness ranking equal to the notes. If we incur any additional indebtedness that ranks equally with the notes, including trade payables, the holders of that debt will be entitled to share ratably with you in any proceeds distributed in connection with any insolvency, liquidation, reorganization, dissolution or other winding-up of us. This may have the effect of reducing the amount of proceeds paid to you. Table of Contents We may be unable to purchase the notes upon a change of control as required under the Indenture. Upon a change of control, we would be required to offer to purchase all of the notes then outstanding for cash at 101% of the principal amount thereof plus accrued and unpaid interest. If a change of control were to occur, we cannot assure you that we would have sufficient funds to pay the repurchase price for all notes tendered by the holders thereof. In addition, a change of control would constitute a default under our senior secured credit facility and, since indebtedness under the credit facility effectively ranks senior in priority to indebtedness under the notes, we would be obligated to repay indebtedness under the credit facility in advance of indebtedness under our notes. Our repurchase of notes as a result of the occurrence of a change of control may be prohibited or limited by, or create an event of default under, the terms of other agreements relating to borrowings which we may enter into from time to time, including agreements relating to secured indebtedness. Failure by us to make or consummate a change of control offer would constitute an immediate event of default under the indenture governing the notes, thereby entitling the trustee or holders of at least 25% in principal amount of the then outstanding notes to declare all of the notes to be due and payable immediately; provided, however, that so long as any indebtedness permitted to be incurred pursuant to the senior secured credit facility is outstanding, such acceleration shall not be effective until the earlier of (i) an acceleration of any such indebtedness under the credit facility or (ii) five business days after receipt by us of written notice of such acceleration. In the event all of the notes are declared due and payable, our ability to repay the notes would be subject to the limitations referred to above. The change of control provisions in the indenture may not protect you in the event we consummate a highly leveraged transaction, reorganization, restructuring, merger or other similar transaction, unless such transaction constitutes a change of control under the indenture. Such a transaction may not involve a change in voting power or beneficial ownership or, even if it does, may not involve a change in the magnitude required under the definition of change of control in the indenture to trigger our obligation to repurchase the notes. Except as described above, the indenture does not contain provisions that permit the holders of the notes to require us to repurchase or redeem the notes in an event of a takeover, recapitalization or similar transaction. A subsidiary guarantee could be voided or subordinated because of federal bankruptcy law or comparable foreign and state law provisions. Our obligations under the notes are guaranteed by our existing and future subsidiaries that guarantee other indebtedness of Portola, including our amended and restated senior secured credit facility, until such guarantees of other indebtedness are released. Under the federal bankruptcy law and comparable provisions of foreign and state fraudulent transfer laws or laws that require reimbursement of a guarantor of amounts paid out under a guarantee, one or more of the subsidiary guarantees could be voided, or claims in respect of a subsidiary guarantee could be subordinated to all other debts of that guarantor if, among other things the guarantor, at the time it incurred the indebtedness evidenced by its guarantee received less than reasonably equivalent value or fair consideration for the incurrence of such guarantee and was insolvent or rendered insolvent by reason of such incurrence; or was engaged in a business or transaction for which the guarantor s remaining assets constituted unreasonably small capital; or intended to incur, or believed that it would incur, debts beyond its ability to pay such debts as they mature. In addition, any payment by that guarantor pursuant to its guarantee could be voided and required to be returned to the guarantor or to a fund for the benefit of the creditors of the guarantor. The measure of insolvency for purposes of these fraudulent transfer laws will vary depending upon the law applied in any proceeding to determine whether a fraudulent transfer has occurred. Generally, however, a guarantor would be considered insolvent if: the sum of its debts, including contingent liabilities, was greater than the fair saleable value of all of its assets; Table of Contents SCHEDULE A GUARANTORS: Exact Name of Additional Registrants State or Other Jurisdiction of I.R.S. Employer as Specified in Their Charters Incorporation or Organization Identification Number Table of Contents the present fair saleable value of its assets was less than the amount that would be required to pay its probable liability on its existing debts, including contingent liabilities, as they become absolute and mature; or it could not pay its debts as they become due. We cannot be sure as to the standards that a court would use to determine whether or not the guarantors were solvent at the relevant time, or, regardless of the standard that the court uses, that the issuance of the guarantee of the notes would not be voided or the guarantee of the notes would not be subordinated to that guarantor s other debt. If the guarantees were legally challenged, any guarantee could also be subject to the claim that, since the guarantee was incurred for our benefit, and only indirectly for the benefit of the guarantor, the obligations of the applicable guarantor were incurred for less than fair consideration. A court could thus void the obligations under the guarantee or subordinate the guarantee to the applicable guarantor s other debt or take other action detrimental to holders of the notes. Risks Related to our Business The integration of Portola and Tech Industries may not be successful and may adversely affect our results of operations. We could have difficulty completing the integration of Tech Industries operations into our own and could incur unanticipated disruption and expenses related to that integration. The continuing integration of Tech Industries will require a substantial amount of our management s time to the detriment of their other duties. Our management is not experienced in the sales and marketing of CFT closures, and we depend on the sales and marketing capabilities of Tech Industries management. Although most of Tech Industries management are continuing in their current functions, we cannot assure you that they will continue to do so in the future. The integration of Portola and Tech Industries may take longer and be more disruptive to our business than anticipated. Integration may also result in unanticipated expenses, which could adversely affect our results of operations. We may not succeed in implementing new manufacturing processes at Tech Industries facilities at the rate anticipated, and as a result, we may not realize the expected operating efficiencies, growth opportunities and other benefits of the transaction or may realize them later than planned. Problems that may arise in connection with the integration of Tech Industries operations with our operations may have a material adverse impact on our business and results of operations. Tech Industries was a family-owned enterprise prior to its acquisition by us. We have not fully completed the process of integrating Tech Industries accounting records and systems into our own information and reporting systems. This process is time-consuming and has resulted in adjustments to Tech Industries historical financial statements. We filed a form 8-K/ A with the SEC on February 9, 2004 amending historical financial statements of Tech Industries to adjust the amount of revenue and cost of sales previously reported on a Form 8-K/A filed with the SEC on December 4, 2003. We may be subject to pricing pressures and credit risks due to consolidation in our customers industries, and we do not have long-term contracts with most of our customers. The dairy, water and juice industries, which constitute our largest customer base from a revenue perspective, have experienced consolidations through mergers and acquisitions in recent years and this trend may continue. As a result, we could experience increased customer concentration, and our results of operations would be increasingly sensitive to changes in the business of customers that represent an increasingly large portion of our sales, or any deterioration of their financial condition. During fiscal 2003 and the six months ended February 29, 2004, our top ten customers accounted for approximately 35% and 36% of our sales, respectively. Consolidation has resulted in pricing pressures, as larger customers often have been able to make greater pricing and other demands over us. Consolidations in the dairy and water industries had a negative impact on our gross margins during fiscal 2003 and in fiscal 2004. Table of Contents In addition, one of our major accounts consists of the Canadian and U.S. subsidiaries of the large Italian dairy company, Parmalat, representing approximately $4.3 million in sales for fiscal 2003. The United States subsidiary of Parmalat declared Chapter 11 bankruptcy during 2004. We are monitoring the situation carefully and have instituted strict credit controls to manage our exposure in Canada. See Management s discussion and analysis of financial condition and results of operations Results of operations. We do not have firm long-term contracts covering a majority of our sales. Although customers that are not under firm contracts provide indications of their product needs and purchases on a periodic basis, they generally purchase our products on an order-by-order basis, and the relationship, as well as particular orders, can be terminated at any time. The loss of or significant decrease in business or a change in the procurement practices of any of our major customers may produce pricing pressures that could have a material adverse effect on our business, results of operations and financial condition. We are subject to strong competition in our markets. We face direct competition in each of our product lines from a number of companies, many of which have financial and other resources that are substantially greater than ours. We can expect to meet significant competition from existing competitors with entrenched positions, and new competitors with respect to our existing product lines as well as with respect to new products we might introduce. We have experienced a negative impact due to competitor pricing, and this impact has accelerated during the past and current fiscal years. Further, numerous well-capitalized competitors might expand their product offerings, either through internal product development or acquisitions of our direct competitors. Such competitors could introduce products or establish prices for their products in a manner that could adversely affect our ability to compete. Additionally, from time to time, we also face direct competition from bottling companies, carton manufacturers and other food and beverage providers that elect to produce their own closures rather than purchase them from outside sources. We are subject to risks caused by changes in prices and supply of resin. Our products are molded from various plastic materials, primarily low density polyethylene ( LDPE ) resin. LDPE resin, which is a broadly traded commodity, accounts for a significant portion of our cost of sales for closures. Plastic resins, including LDPE, are subject to substantial price fluctuations resulting from shortages in supply or changes in the prices of natural gas, crude oil and other petrochemical products from which resins are produced, as well as other factors. Instability in the world markets for petroleum and natural gas could materially adversely affect the price and timely availability of raw materials. We have contracts with our three principal resin suppliers that provide for the adjustment of prices payable by us depending on periodic increases or decreases in published indices of national resin bulk pricing. Accordingly, the price effects of resin on us lag the market. In the past, in the event of a significant increase in resin prices, we have not always been able to pass such increases on to customers promptly, in whole or in part, and we cannot assure you that we will be able to do so in every or most cases in the future. Such inability to pass on such increases, or delays in passing them on, have had and would have a material adverse effect on our sales and margins on a current or delayed basis. Most of our sales are either made to customers on a purchase order basis, which provide us with no assurance that we can pass on price increases to these customers, or pursuant to contracts which generally allow only quarterly price adjustments, which could delay our ability to pass on price increases to these customers, if at all. Moreover, even if the full amount of such price increases were to be passed on to customers, the increases would have the effect of reducing our gross margins. On the other hand, if resin prices decrease, customers typically would expect rapid pass-through of the decrease, and we cannot assure you that we would be able to maintain our gross margins. Changes in resin prices had a negative impact on our business during fiscal 2004 and 2003. We may not be able to arrange for sources of resin from our regular vendors, or alternative sources, in the event of an industry-wide general shortage of resins used by us, or a shortage or discontinuation of certain types of grades of resin purchased from one or more of our suppliers. Table of Contents The integration of future acquisitions may result in substantial costs, delays and other problems. We may not be able to successfully integrate future acquisitions, if any, without substantial costs, delays or other problems. Future acquisitions would require us to expend substantial managerial, operating, financial and other resources to integrate any new businesses. The costs of such integrations could have a material adverse effect on our operating results and financial condition. Such costs would likely include non-recurring acquisition costs, investment banking fees, recognition of transaction-related obligations, plant closings and similar costs and various other acquisition-related costs. In addition, each transaction inherently carries an unavoidable level of risk regarding the actual condition of the acquired business, regardless of the investigation we may conduct beforehand. Until we assume operating control of such businesses, we may not be able to ascertain the actual value or understand the potential liabilities of the acquired entities. If and when we acquire a business, we would likely be subject to risks including: the possibility that it would be difficult to integrate the operations into our existing operations; the possibility that we had acquired substantial undisclosed liabilities; the risks of entering markets, producing products or offering services for which we had no prior experience; the potential loss of customers of the acquired business; and the possibility we might be unable to recruit managers with the necessary skills to supplement or replace the incumbent management of the acquired business. We may not be successful in overcoming these risks. We depend on new business development, international expansion and acquisitions. We believe that growth has slowed in the domestic markets for our traditional beverage products and that, in order to increase our sales, we must continue to develop new products in the markets we currently serve and new products in different markets, to make acquisitions and to expand in our international markets. Developing new products, expanding into new markets and identifying and completing acquisitions will require a substantial investment and involve additional risks. We cannot assure you that our efforts to achieve such development and expansion or to identify and complete potential acquisitions will be successful. Expansion poses risks and potential adverse effects on our operating results, such as the diversion of management s attention, the loss of key personnel and the risks of unanticipated problems and liabilities. We may be unsuccessful in making acquisitions because of competition for acquisition candidates, which could result in fewer opportunities and higher acquisition prices, and because in many instances candidates may have difficulty in continuing to operate in the U.S. Moreover, as described above, our debt instruments impose significant restrictions under certain circumstances on our ability to make investments in or acquire other companies. Difficulties presented by non-U.S. economic, political, legal, accounting and business factors could negatively affect our interests and business efforts. Approximately 43% of our sales for fiscal 2003 were derived from shipments to destinations outside of the United States or from our operations outside the United States. We intend to expand such exports and our international operations and customer base. Increasingly, we are determining that most new and some existing manufacturing operations must be conducted outside the U.S. Our sales outside of the United States generally involve longer payment cycles from customers than our United States sales. Our operations outside the United States require us to comply with the legal requirements of foreign jurisdictions and expose us to the political consequences of operating in foreign jurisdictions. Our operations outside the United States are also subject to the following potential risks: difficulty in managing and operating such operations because of distance, and, in some cases, language and cultural differences; Portola Allied Tool, Inc. Delaware 38-3461811 Portola Limited England and Wales 98-0403791 Portola Packaging, Inc. Mexico, S.A. de C.V. Mexico PPI971111D9A Portola Packaging Canada Ltd. Yukon Territory, Canada 897554465RC0002 Portola Packaging Limited England and Wales 2607146 Tech Industries, Inc. Rhode Island 05-0301487 The address for each of the Additional Registrants is: c/o Portola Packaging, Inc. 898A Faulstich Court San Jose, California 95112 Telephone (408) 453-8840. The (i) primary standard industrial classification code number and (ii) name, address and telephone number of the agent for service for each of the Additional Registrants is the same as that for Portola Packaging. Table of Contents fluctuations in the value of the U.S. dollar that could increase or decrease the effective price of our products sold in U.S. dollars and might have a material adverse effect on sales or costs, require us to raise or lower our prices or affect our reported sales or margins in respect of sales conducted in foreign currencies; difficulty entering new international markets due to greater regulatory barriers than those of the United States and differing political systems; increased costs due to domestic and foreign customs and tariffs, adverse tax legislation, imposition or increases of withholding and other taxes on remittances and other payments by subsidiaries; credit risk or financial condition of local customers and distributors; potential difficulties in staffing and labor disputes; risk of nationalization of private enterprises; government embargoes or foreign trade restrictions such as anti-dumping duties; increased costs of transportation or shipping; ability to obtain supplies from foreign vendors and ship products internationally during times of crisis or otherwise; difficulties in protecting intellectual property; increased worldwide hostilities; potential imposition of restrictions on investments; and local political, economic and social conditions such as hyper-inflationary conditions and political instability. As we continue to expand our international operations, these and other risks might increase. As we enter new geographic markets, we may encounter competition from the primary participants in those markets that may have significantly greater market knowledge and that may have substantially greater resources than we do. In addition, we conduct some of our international operations through joint venture arrangements in which our operational and financial control of the business are limited. Adverse weather conditions could adversely impact our financial results. Weather conditions around the world can have a significant impact on our sales. Unusually cool temperatures during a hot weather season in one or more of our markets have and could again adversely affect sales of our products in those markets. We are subject to risks that our intellectual property may not be adequately protected, and we may be adversely affected by the intellectual property rights of others. We rely on a combination of patents and trademarks, licensing agreements and unpatented proprietary know-how and trade secrets to establish and protect our intellectual property rights. We enter into confidentiality agreements with customers, vendors, employees, consultants and potential acquisition candidates as necessary to protect our know-how, trade secrets and other proprietary information. However, these measures and our patents and trademarks may not afford complete protection of our intellectual property, and it is possible that third parties may copy or otherwise obtain and use our proprietary information and technology without authorization or otherwise infringe on our intellectual property rights. We cannot assure you that our competitors will not independently develop equivalent or superior know-how, trade secrets or production methods. We are involved in litigation from time to time in the course of our business to protect and enforce our intellectual property rights, and third parties from time to time initiate litigation against us asserting that our business infringes or violates their intellectual property rights. We cannot assure you that our intellectual Table of Contents property rights have the value that we believe them to have or that our products will not be found to infringe upon the intellectual property rights of others. Further, we cannot assure you that we will prevail in any such litigation, or that the results or costs of any such litigation will not have a material adverse effect on our business. Any litigation concerning intellectual property could be protracted and costly and is inherently unpredictable and could have a material adverse effect on our business and results of operations regardless of its outcome. We are currently a defendant in a suit filed by Blackhawk Molding Co., Inc. on August 28, 2003 in the U.S. District Court for the Northern District of Illinois, Eastern Division. Blackhawk Molding alleges that a single-stick label attached to our five-gallon caps infringes a patent held by it. We have answered the complaint denying all allegations and asserting that the Blackhawk patent is invalid and that we have not infringed Blackhawk Molding s patents. Discovery is in an early stage. The court held a hearing on claim construction at the end of May 2004, but has not rendered a decision. While we believe that we have substantial defenses in this matter, the ultimate outcome of any litigation is uncertain, and an unfavorable result could result in our sustaining material damages. A number of our patents relating to one of our closure product lines have expired in recent years. We believe that such expirations have, to varying effect, adversely affected our margins, as competitors who have become free to imitate our designs have begun to compete aggressively against us in the pricing of certain products. These adverse effects will only be partially ameliorated to the extent that we continue to obtain new patents. The laws of certain countries in which our products or technology are or may be licensed may not protect our intellectual property rights to the same extent as the laws of the United States. The protection offered by the patent laws of foreign countries may be less protective than the United States patent laws. Defects in our products could result in litigation and harm our reputation. Many of our products are used to cap beverage and food products. From time to time in the past, we and other producers of similar products have received complaints from customers and end consumers claiming that such products might cause or almost caused injury to the end consumer. In some instances, such claims have alleged defects in manufacture or faulty design of our closures. In the event an end consumer suffers a harmful accident, we could incur substantial costs in responding to complaints or litigation. Further, if any of our products were found to be defective, we could incur damages and significant costs in correcting any defects, lose sales and suffer damage to our reputation. Our customers products could be contaminated through tampering, which could harm our reputation and business. Terrorist activities or vandalism could result in contamination or adulteration of our customers products, as our products are tamper resistant but not tamper proof. We cannot assure you that a disgruntled employee or third party could not introduce an infectious substance into packages of our finished products, either at our manufacturing plants or during shipment of our products. Were our products or our customers products to be tampered with in a manner not readily capable of detection, we could experience a material adverse effect to our reputation, business, operations and financial condition. Changes to government regulations affecting our products could harm our business. Our products are subject to governmental regulation, including regulation by the Federal Food and Drug Administration and other agencies in the United States and elsewhere. A change in government regulation could adversely affect our business. We cannot assure you that federal, state or foreign authorities will not issue regulations in the future that could materially increase our costs of manufacturing certain of our products. Our failure to comply with applicable laws and regulations could subject us to civil remedies, including fines, injunctions, recalls or seizures as well as to potential criminal sanctions, which could have a material adverse effect on us. Effect of exchange rate changes on cash 21 1 TABLE OF CONTENTS Page Table of Contents Our business may be adversely affected by compliance obligations or liabilities under environmental, health and safety laws and regulations. We are subject to federal, state, local and foreign environmental and health and safety laws and regulations that could result in liability, affect ongoing operations and increase capital costs and operating expenses in order to maintain compliance with such requirements. Some of these laws and regulations provide for strict and joint and several liability regarding contaminated sites. Such sites may include properties currently or formerly owned or operated by us and properties to which we disposed of, or arranged to dispose of, wastes or hazardous substances. Based on the information presently known to us, we do not expect environmental costs or contingencies to have a material adverse effect on us. We may, however, be affected by hazards or other conditions presently unknown to us. In addition, we may become subject to new requirements pursuant to evolving environmental, and health and safety, laws and regulations. Accordingly, we cannot assure you that we will not incur material environmental costs or liabilities in the future. We depend upon key personnel. We believe that our future success depends upon the knowledge, ability and experience of our personnel. The loss of key personnel responsible for managing Portola or for advancing our product development could adversely affect our business and financial condition. We are controlled by Jack L. Watts, the Chairman of our Board of Directors and Chief Executive Officer, and JPMorgan Partners 23A, an affiliate of J.P. Morgan Securities Inc. Their interests as equity holders may conflict with your interests as a creditor. Jack L. Watts (the Chairman of our Board of Directors and our Chief Executive Officer) and JPMorgan Partners 23A (an affiliate of J.P. Morgan Securities Inc., one of the initial purchasers of the notes) own a majority of our common stock. Robert Egan, a member of our Board of Directors, is a Senior Advisor to J.P. Morgan Partners, LLC and a Partner of J.P. Morgan Entertainment Partners, LLC, each of which is an affiliate of JPMorgan Partners 23A. The interests of Mr. Watts, Mr. Egan and JPMorgan Partners 23A may not in all cases be aligned with your interests as a holder of the notes. There is only one independent director (as defined under the federal securities laws) on our Board of Directors and, as a result, our Board of Directors, Audit Committee and Compensation Committee have not met, and do not meet, the standard independence requirements that would be applicable if our equity securities were traded on NASDAQ or the New York Stock Exchange, when they have considered numerous issues of importance to us. We have engaged in a number of related party transactions. For example, from 1999 through 2002, we engaged in several transactions with Sand Hill Systems, Inc., an entity in which Mr. Watts and other of our officers and directors had a financial interest. See Related party transactions and Note 15 of the Notes to consolidated financial statements.
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+Radiosurgery Centers, Inc. Delaware 33-0522445 Table of Contents insolvent at the time the guarantee was issued, a court could void the obligations of the subsidiary guarantor under the guarantee or subordinate these obligations to the subsidiary guarantor s other debt or take action detrimental to holders of the senior subordinated notes. If the guarantee of any subsidiary guarantor were voided, the senior subordinated notes would be effectively subordinated to the indebtedness of that subsidiary guarantor. The United States federal income tax consequences of the purchase, ownership and disposition of IDSs and senior subordinated notes are uncertain and our cash available for dividends and interest could be reduced if the senior subordinated notes were treated as equity for tax purposes. No statutory, judicial or administrative authority has directly addressed the treatment of the IDSs or the senior subordinated notes, or instruments similar to the IDSs or the senior subordinated notes, for United States federal income tax purposes. As a result, the United States federal income tax consequences of the purchase, ownership and disposition of IDSs and the senior subordinated notes are uncertain. Based on the opinion of tax counsel, we believe that an IDS should be treated as a unit representing a share of common stock and senior subordinated notes, and that the senior subordinated notes should be classified as debt for United States federal income tax purposes and we intend to deduct interest on such senior subordinated notes for tax purposes. However, the IRS or the courts may take the position that the IDSs are a single security classified as equity, that the senior subordinated notes are properly classified as equity for United States federal income tax purposes, or that the senior subordinated notes are payable in equity, each of which could adversely affect the amount, timing and character of income, gain or loss in respect of your investment in IDSs or senior subordinated notes, and materially increase our taxable income and, thus, our United States federal and applicable state income tax liability. This would adversely affect our financial position, cash flow, and liquidity, and could affect our ability to make interest or dividend payments on the senior subordinated notes and the common stock and may affect our ability to continue as a going concern. Our tax deduction for interest may be put at risk in the future as a result of a future ruling by the IRS, including an adverse determination with respect to other IDSs or an adverse ruling for our own IDSs issued now or subsequently and in the event of any such ruling or determination, we may need to consider the effect of such developments on the determination of our future tax provisions and obligations. Foreign holders could be subject to withholding or estate taxes with regard to the senior subordinated notes in the same manner as they will be with regard to the common stock. Payments to foreign holders would not be grossed-up for any such taxes. For discussion of these tax-related risks, see Material United States Federal Income Tax Consequences. The allocation of the purchase price of the IDSs may not be respected, which may lead to you having to include original issue discount in your income even if you have not received the cash attributable to that income. The purchase price of each IDS must be allocated for tax purposes between the share of common stock and senior subordinated notes comprising the IDS in proportion to their respective fair market values at the time of purchase. If our allocation is not respected, then it is possible that the senior subordinated notes will be treated as having been issued with original issue discount, or OID (if the allocation to the senior subordinated notes were determined to be too high) or amortizable bond premium (if the allocation to the senior subordinated notes were determined to be too low). You generally would be required to include OID in income in advance of the receipt of cash attributable to that income and would be able to elect to amortize bond premium over the term of the senior subordinated notes. In the event the senior subordinated notes are issued with OID, they could be considered to have significant OID and thus be classified as applicable high yield discount obligations. If any such senior subordinated notes were so treated, a portion of the OID on such notes would be nondeductible by us and the remainder would be deductible only when paid. This treatment would have the effect of increasing our taxable income and may adversely affect our cash flow available for interest payments and distributions to our shareholders. I.R.S. Employer Exact Name of Registrant Guarantor State or Other Jurisdiction of Identification as Specified in its Charter Incorporation or Organization Number Table of Contents We may amend the terms of our new credit facility, or we may enter into new agreements that govern our senior indebtedness and the amended or new terms may significantly affect our ability to pay interest on our senior subordinated notes and dividends on shares of our common stock. Our new credit facility contains significant restrictions on our ability to pay interest on the senior subordinated notes and dividends on shares of common stock based on us meeting certain performance measures and compliance with other conditions. As a result of general economic conditions, conditions in the lending markets, the results of our business or for any other reason, we may elect or be required to amend or refinance our new credit facility, at or prior to maturity, or enter into additional agreements for senior indebtedness. Regardless of any protection you have in the indenture governing the senior subordinated notes, any such amendment, refinancing or additional indebtedness may contain covenants that could limit, in a significant manner, our ability to make interest payments and pay dividends to you. We are subject to restrictive debt covenants that impose operating and financial restrictions on our operations and could limit our business flexibility. The agreements governing our indebtedness impose significant operating and financial restrictions on us. These restrictions prohibit or limit, among other things: the incurrence of additional indebtedness and the issuance of preferred stock and certain redeemable capital stock; a number of other restricted payments, including investments; specified sales of assets; specified transactions with affiliates; the creation of a number of liens; consolidations, mergers and transfers of all or substantially all of our assets; and our ability to change the nature of our business. These restrictions could limit our ability to obtain future financing, make acquisitions, withstand downturns in our business or take advantage of business opportunities. The terms of the new credit facility include several restrictive covenants that prohibit us from prepaying our other indebtedness, including the senior subordinated notes, while indebtedness under the new credit facility is outstanding. The new credit facility also requires us to maintain certain specified financial ratios and satisfy financial condition tests. Our ability to comply with the ratios or tests may be affected by events beyond our control, including prevailing economic, financial and industry conditions. See the information under Description of Certain Indebtedness for a fuller description of these restrictions and covenants. A breach of any of these covenants, ratios or tests could result in a default under the new credit facility and/or the indenture. Events of default under the new credit facility would prohibit us from making payments on the senior subordinated notes in cash, including payment of interest when due. In addition, upon the occurrence of an event of default under the new credit facility, the lenders could elect to declare all amounts outstanding under the new credit facility, together with accrued interest, to be immediately due and payable. If we were unable to repay those amounts, the lenders could proceed against the security granted to them to secure that indebtedness. If the lenders accelerate the payment of the indebtedness, our assets may not be sufficient to repay in full this indebtedness and our other indebtedness, including the senior subordinated notes. We may not be able to refinance our new credit facility at maturity on favorable terms or at all. We expect that the new credit facility will mature in full in 2009. We may not be able to renew or refinance the new credit facility, or if renewed or refinanced, the renewal or refinancing may occur on less favorable terms. In particular, some of the terms of the senior subordinated notes that may be viewed as InSight Health Services Corp. Delaware 33-0702770 Table of Contents favorable to the lenders under the new credit facility, such as our ability to defer interest and acceleration of forbearance periods, become less favorable in 2009, which may materially adversely affect our ability to refinance or renew our new credit facility beyond such date. If we are unable to refinance or renew our new credit facility, our failure to repay all amounts due on the maturity date would cause a default under the new credit facility. In addition, our interest expense may increase significantly if we refinance our new credit facility on terms that are less favorable to us than the terms of our new credit facility. We are a holding company with no operations, and unless we receive dividends and other payments, advances and transfers of funds from our subsidiaries we will be unable to meet our debt service and other obligations. We are a holding company and conduct all of our operations through our subsidiaries. We currently have no significant assets other than equity interests in our subsidiaries, all of which will be pledged to the creditors under the new credit facility which we guarantee. As a result, we will rely on dividends and other payments or distributions from our subsidiaries to meet our debt service obligations and enable us to pay dividends. The ability of our subsidiaries to pay dividends or make other payments or distributions to us will depend on their respective operating results and may be restricted by, among other things, the laws of their jurisdiction of organization (which may limit the amount of funds available for the payment of dividends), agreements of those subsidiaries, the terms of the new credit facility (under which the equity interests of our subsidiaries will be pledged) and the covenants of any future outstanding indebtedness we or our subsidiaries incur. Subject to restrictions set forth in the indenture, we may defer the payment of interest to you for a significant period of time. Prior to , 2009, we may, subject to restrictions set forth in the indenture, defer interest payments on our senior subordinated notes on one or more occasions for up to an aggregate period of eight quarters. In addition, after , 2009 we may, subject to certain restrictions, defer interest payments on our senior subordinated notes for up to four occasions for up to two consecutive quarters per occasion. Deferred interest will bear interest at the same rate as the senior subordinated notes. For any interest deferred during the first five years, we are not obligated to pay any deferred interest until , 2009; so you may be owed a substantial amount of deferred interest that will not be due and payable until such date. For any interest deferred after , 2009, we are not obligated to pay all of the deferred interest until maturity so you may be owed a substantial amount of deferred interest that will not be due and payable until such date. You may not receive the level of dividends provided for in our initial dividend policy that our board of directors is expected to adopt upon the closing of this offering or any dividends at all. Our board of directors may, in its discretion, amend or repeal our initial dividend policy it is expected to adopt upon the closing of this offering. Our board of directors may decrease the level of dividends provided for in this dividend policy or entirely discontinue the payment of dividends. The amount of future dividends with respect to shares of our common stock, if any, will depend on, among other things, our results of operations, cash requirements, financial condition, contractual restrictions, level of indebtedness, business opportunities, provisions of applicable law and other factors that our board of directors may deem relevant. In addition, the indenture governing our senior subordinated notes and the agreement governing the new credit facility each contain significant restrictions which could affect your receipt of dividends. For instance, if we defer interest on the senior subordinated notes, we will be restricted from paying dividends until we have paid all deferred interest and accrued interest thereon. Furthermore, if the senior subordinated notes were treated as equity rather than as debt for United States federal income tax purposes, then the stated interest on the senior subordinated notes could be treated as a dividend and would not be deductible by us for United States federal income tax purposes. Our inability to deduct interest on the senior subordinated notes could materially increase our taxable income and, thus, Income (loss) before minority interest 277 (3,378 ) 2,863 Minority interest 10 InSight Health Corp. Delaware 52-1278857 Table of Contents our United States federal and applicable state income tax liability. If this were to occur, our after-tax cash flow available for dividend and interest payments would be reduced. You will be immediately diluted by $ per share of Class A common stock if you purchase IDSs in this offering. If you purchase IDSs in this offering, based on the book value of the assets and liabilities reflected on our balance sheet, you will experience an immediate dilution of $ per share of Class A common stock represented by the IDSs which exceeds the entire price allocated to each share of Class A common stock represented by the IDSs in this offering because there will be a net tangible book deficit for each share of Class A common stock outstanding immediately after this offering. Our net tangible book value as of , 2004, on a pro forma basis after giving effect to the CMI acquisition, the offering and the related transactions, was approximately $ million, or $ per share of Class A common stock. Our interest expense may increase significantly and could cause our net income and distributable cash to decline significantly. The new credit facility will be subject to periodic renewal or must otherwise be refinanced. We may not be able to renew or refinance the new credit facility, or if renewed or refinanced, the renewal or refinancing may occur on less favorable terms, including higher interest rates. Borrowings under the revolving facility will be made at a floating rate of interest. In the event of an increase in the base reference interest rates, our interest expense will increase and could have a material adverse effect on our ability to make cash dividend payments to our shareholders. Our ability to continue to expand our business will, to a large extent, be dependent upon our ability to borrow funds under our new credit facility and to obtain other third party financing, including through the sale of IDSs or other securities. We cannot assure you that such financing will be available to us on favorable terms or at all. If we are unable to generate sufficient funds from operations we will be unable to pay our indebtedness at maturity or upon the exercise by holders of their rights upon a change of control. Because a significant portion of our cash flow from operations will be dedicated to servicing our debt requirements, we may not have sufficient funds from operations to repay the principal amount of our indebtedness at maturity or to purchase your notes upon a change of control. In addition, we currently expect to distribute a significant portion of any remaining cash earnings to our stockholders in the form of quarterly dividends. Moreover, prior to the maturity of our senior subordinated notes, we will not be required to make any payments of principal on our senior subordinated notes. We may therefore need to refinance our debt or raise additional capital to meet our obligations. These alternatives may not be available to us when needed or on satisfactory terms due to prevailing market conditions, a decline in our business or restrictions contained in our senior debt obligations. The indenture governing our senior subordinated notes and our new credit facility permit us to pay a significant portion of our cash flow to stockholders in the form of dividends. Although the indenture governing our senior subordinated notes and our new credit facility have some limitations on our payment of dividends, they permit us to pay a significant portion of our cash flow to stockholders in the form of dividends. Following completion of this offering, we intend to pay quarterly dividends. Specifically, the indenture governing our senior subordinated notes permits us to pay up to 100% of our excess cash (as defined in the indenture) subject to compliance with an interest coverage test, as more fully described in Description of Senior Subordinated Notes Certain Covenants. The new credit facility permits us to use up to 100% of the excess cash flow, as defined in the new credit facility plus certain other amounts under certain limited circumstances to fund dividends on our shares of common stock. Any amounts paid by us in the form of dividends will not be available in the future to satisfy our obligations under the senior subordinated notes. Signal Medical Services, Inc. Delaware 33-0802413 Table of Contents Because we will use a significant portion of the proceeds of this offering to purchase our common stock held by our existing equity investors, we will have only the remaining portion of the proceeds of this offering to repay our existing debt and for corporate purposes and will have to incur more debt. We will use a significant portion of the net proceeds from this offering to purchase equity interests in our subsidiaries from our existing equity investors as part of our recapitalization. Therefore, we will not have these funds available to us (1) to repay our existing debt, and will therefore have to borrow more under our new credit facility to repay the existing credit facility than we would have had we not undertaken these purchases, or (2) to fund our operations or to continue to expand our business. The realizable value of our assets upon liquidation may be insufficient to satisfy claims. On a pro forma basis at March 31, 2004, our assets included intangible assets in the amount of $323.7 million, representing approximately 47.7% of our total consolidated assets and consisting primarily of the excess of the acquisition cost over the fair market value of the net assets acquired in purchase transactions. The value of these intangible assets will continue to depend significantly upon the success of our business as a going concern and the growth in cash flows. As a result, in the event of a default under our new credit facility or on our senior subordinated notes or any bankruptcy or dissolution of our company, the realizable value of these assets may be substantially lower and may be insufficient to satisfy the claims of our creditors. Deferral of interest payments would have adverse tax consequences for you and may adversely affect the trading price of the senior subordinated notes. If we defer interest payments on the senior subordinated notes, you will be required to recognize interest income for United States federal income tax purposes in respect of the senior subordinated notes before you receive any cash payment of this interest. In addition, we will not pay you this cash if you sell the IDSs or the senior subordinated notes, as the case may be, before the end of any deferral period or before the record date relating to interest payments that are to be paid. The IDSs or the senior subordinated notes may trade at a price that does not fully reflect the value of accrued but unpaid interest on the senior subordinated notes if we defer interest payments. In addition, the requirement that we defer payments of interest on the senior subordinated notes under certain circumstances may mean that the market price for the IDSs or the senior subordinated notes may be more volatile than other securities that do not have this requirement. Because of the subordinated nature of the senior subordinated notes, holders of our senior subordinated notes may not be entitled to be paid in full, if at all, in a bankruptcy, liquidation or reorganization or similar proceeding. As a result of the subordinated nature of our notes and related guarantees, upon any distribution to our creditors or the creditors of the subsidiary guarantors in bankruptcy, liquidation or reorganization or similar proceeding relating to us or the subsidiary guarantors or our or their property, the holders of our senior indebtedness and senior indebtedness of the subsidiary guarantors will be entitled to be paid in full in cash before any payment may be made with respect to our senior subordinated notes or the subsidiary guarantees. In the event of a bankruptcy, liquidation or reorganization or similar proceeding relating to us or the subsidiary guarantors, holders of our senior subordinated notes will participate with all other holders of unsecured indebtedness of ours or the subsidiary guarantors that are similarly subordinated in the assets remaining after we and the subsidiary guarantors have paid all senior indebtedness. However, because of the existence of the subordination provisions, including the requirement that holders of the senior subordinated notes pay over distributions to holders of senior indebtedness, holders of the senior subordinated notes may receive less, ratably, than our other unsecured creditors, including trade creditors. In any of these cases, we and the subsidiary guarantors may not have sufficient funds to pay all of our OPERATING ACTIVITIES: Net income (loss) $ 4,922 $ 9 $ (4,648 ) $ 13,801 Adjustments to reconcile net income (loss) to net cash provided by operating activities: Write-off of debt issuance costs 7,378 Depreciation and amortization 49,345 26,462 9,823 41,134 Acquisition related compensation charge 15,616 Cash provided by (used in) changes in operating assets and liabilities: Trade accounts receivables, net (2,237 ) 1,874 (2,378 ) (2,757 ) Other current assets 4,907 590 (3,616 ) 782 Accounts payable and other accrued expenses 4,819 3,288 OPERATING ACTIVITIES: Net income (loss) $ (4,648 ) $ (4,648 ) $ 2,281 $ 2,367 $ (4,648 ) Adjustments to reconcile net income (loss) to net cash provided by operating activities: Depreciation and amortization 8,250 1,573 9,823 Acquisition related compensation charge 15,616 15,616 Equity in income (loss) of consolidated subsidiaries 4,648 (2,281 ) (2,367 ) Cash provided by (used in) changes in operating assets and liabilities: Trade accounts receivables, net (1,932 ) (446 ) (2,378 ) Intercompany receivables, net 5,058 (5,090 ) 32 Other current assets (3,515 ) (101 ) (3,616 ) Accounts payable and other accrued expenses 53 (30 ) Open MRI, Inc. Delaware 94-3251529 Table of Contents creditors. Holders of our senior subordinated notes may, therefore, receive less, ratably, than the holders of our senior indebtedness. On a pro forma basis after giving effect to the CMI acquisition, the offering and the related transactions, as of March 31, 2004, our senior subordinated notes and the subsidiary guarantees would have ranked junior, on a consolidated basis, to $ million of outstanding senior secured indebtedness plus approximately $ million of letters of credit and the subsidiary guarantees would have ranked junior or pari passu to $ million of senior unsecured debt and pari passu with approximately $ million of outstanding indebtedness of ours and the subsidiary guarantors. In addition, as of , 2004, on a pro forma basis, we would have had the ability to borrow up to an additional amount of $ million under the new credit facility (less amounts reserved for letters of credit), which would have ranked senior in right of payment to our senior subordinated notes. If any of the $ million in our existing senior subordinated notes are not tendered to us by the closing of this offering, such notes will rank pari passu to our senior subordinated notes and the subsidiary guarantees until such time as we redeem such notes. In the event of a bankruptcy, liquidation or reorganization or similar proceeding of any of the non-guarantor subsidiaries, holders of their indebtedness, including their trade creditors, would generally be entitled to payment of their claims from the assets of those subsidiaries before any assets are made available for distribution to us for payment to you. Holders of our senior subordinated notes will be structurally subordinated to the debt of our non-guarantor subsidiaries. Our partially owned domestic subsidiaries will not be guarantors of our senior subordinated notes. As a result, no payments are required to be made to us from the assets of these subsidiaries. In the event of bankruptcy or insolvency, the senior subordinated notes and guarantees could be equitably subordinated or recharacterized as equity. In the event of bankruptcy or insolvency, a party in interest may seek to subordinate the senior subordinated notes under principles of equitable subordination or to recharacterize the senior subordinated notes as equity. While we believe that any such attempt should fail, the outcome of such proceedings are uncertain. In the event a court subordinates the senior subordinated notes or recharacterizes them as equity, you may not recover any amounts owed on the senior subordinated notes and you may be required to return any payments made to you on account of the senior subordinated notes, potentially for up to six years prior to our bankruptcy. In addition, should the court recharacterize the senior subordinated notes as equity you may not be able to enforce the guarantees. Not all of our subsidiaries guarantee our obligations under the senior subordinated notes, and the assets of our non-guarantor subsidiaries may not be available to make payments on the senior subordinated notes. Our subsidiaries that are not wholly-owned by us will not be guarantors of the senior subordinated notes. Our present and future wholly-owned domestic subsidiaries will guarantee the senior subordinated notes. Payments on the senior subordinated notes are only required to be made by us and the guarantors. As a result, no payments are required to be made from assets of subsidiaries that do not guarantee the senior subordinated notes, unless those assets are transferred by dividend or otherwise to us or a subsidiary guarantor. If the guarantees of the senior subordinated notes by our subsidiaries were determined to be unenforceable, holders of the senior subordinated notes may be unable to recover their investment in the event of a bankruptcy or liquidation proceeding. Under federal bankruptcy law and comparable provisions of state fraudulent transfer laws, a guarantee or any payment by a guarantor could be voided, or claims in respect of a guarantee could be subordinated to Maxum Health Corp. Delaware 75-2287276 Table of Contents all other debt of the guarantor, if, among other things, the guarantor, at the time that it assumed the guarantee: issued the guarantee to delay, hinder or defraud present or future creditors; received less than reasonably equivalent value or fair consideration for issuing the guarantee and, at the time it issued the guarantee; was insolvent or rendered insolvent by reason of issuing the guarantee and the application of the proceeds of the guarantee; was engaged or about to engage in a business or a transaction for which the guarantor s remaining assets available to carry on its business constituted unreasonably small capital; was engaged or about to engage in a business or a transaction for which the guarantor s remaining assets available to carry on its business constituted unreasonably small capital; intended to incur, or believed that it would incur, debts beyond its ability to pay the debts as they mature; or was a defendant in an action for money damages, or had a judgment for money damages docketed against it if, in either case, after final judgment, the judgment is unsatisfied. The proceeds of the offering will be used to repurchase a portion of our common stock from the existing equity investors and pay debt of our subsidiaries, which may subject the note holders to the claim that we did not receive fair consideration for the notes. In the event that we meet any of the financial condition fraudulent transfer tests described above at the time of or as a result of this offering, a court could integrate the issuance of our notes with the distribution to our stockholders and the payment of our subsidiaries debt, and therefore conclude that we did not get fair value for the offering viewed as an integrated transaction. In such a case, a court could hold the debt owed to the note holders void, unenforceable or may subordinate it to the claims of other creditors. In addition, any payment by the guarantor under its guarantee could be voided and required to be returned to the guarantor or to a fund for the benefit of the creditors of the guarantor or the guarantee could be subordinated to other debt of the guarantor. What constitutes insolvency for the purposes of fraudulent transfer laws varies depending upon the law applied in any proceeding to determine if a fraudulent transfer has occurred. Generally, however, a person would be considered insolvent if, at the time such person incurred the debt: the sum of its debts, including contingent liabilities, was greater than the fair saleable value of its assets; the present fair saleable value of its assets was less than the amount that would be required to pay its probable liability on its existing debts, including contingent liabilities, as they become absolute and mature; or it could not pay its debts as they become due. We believe that before and immediately after the issuance of the senior subordinated notes and the guarantees, we and each of the guarantors will be solvent, have sufficient capital to carry on our respective businesses and be able to pay our respective debts as they mature. We cannot be sure, however, as to what standard a court would apply in making these determinations or that a court would reach the same conclusions with regard to these issues. Regardless of the standard that the court uses, we cannot be sure that the issuance by the subsidiary guarantors of the subsidiary guarantees would not be voided or the subsidiary guarantees would not be subordinated to their other debt. The guarantee of our senior subordinated notes by any subsidiary guarantor could be subject to the claim that since the guarantee was incurred for the benefit of InSight and only indirectly for the benefit of the subsidiary guarantor, the obligations of the subsidiary guarantor were incurred for less than fair consideration. If such a claim were successful and it was proven that the subsidiary guarantor was Radiosurgery Centers, Inc. Delaware 33-0522445 Table of Contents insolvent at the time the guarantee was issued, a court could void the obligations of the subsidiary guarantor under the guarantee or subordinate these obligations to the subsidiary guarantor s other debt or take action detrimental to holders of the senior subordinated notes. If the guarantee of any subsidiary guarantor were voided, the senior subordinated notes would be effectively subordinated to the indebtedness of that subsidiary guarantor. The United States federal income tax consequences of the purchase, ownership and disposition of IDSs and senior subordinated notes are uncertain and our cash available for dividends and interest could be reduced if the senior subordinated notes were treated as equity for tax purposes. No statutory, judicial or administrative authority has directly addressed the treatment of the IDSs or the senior subordinated notes, or instruments similar to the IDSs or the senior subordinated notes, for United States federal income tax purposes. As a result, the United States federal income tax consequences of the purchase, ownership and disposition of IDSs and the senior subordinated notes are uncertain. Based on the opinion of tax counsel, we believe that an IDS should be treated as a unit representing a share of common stock and senior subordinated notes, and that the senior subordinated notes should be classified as debt for United States federal income tax purposes and we intend to deduct interest on such senior subordinated notes for tax purposes. However, the IRS or the courts may take the position that the IDSs are a single security classified as equity, that the senior subordinated notes are properly classified as equity for United States federal income tax purposes, or that the senior subordinated notes are payable in equity, each of which could adversely affect the amount, timing and character of income, gain or loss in respect of your investment in IDSs or senior subordinated notes, and materially increase our taxable income and, thus, our United States federal and applicable state income tax liability. This would adversely affect our financial position, cash flow, and liquidity, and could affect our ability to make interest or dividend payments on the senior subordinated notes and the common stock and may affect our ability to continue as a going concern. Our tax deduction for interest may be put at risk in the future as a result of a future ruling by the IRS, including an adverse determination with respect to other IDSs or an adverse ruling for our own IDSs issued now or subsequently and in the event of any such ruling or determination, we may need to consider the effect of such developments on the determination of our future tax provisions and obligations. Foreign holders could be subject to withholding or estate taxes with regard to the senior subordinated notes in the same manner as they will be with regard to the common stock. Payments to foreign holders would not be grossed-up for any such taxes. For discussion of these tax-related risks, see Material United States Federal Income Tax Consequences. The allocation of the purchase price of the IDSs may not be respected, which may lead to you having to include original issue discount in your income even if you have not received the cash attributable to that income. The purchase price of each IDS must be allocated for tax purposes between the share of common stock and senior subordinated notes comprising the IDS in proportion to their respective fair market values at the time of purchase. If our allocation is not respected, then it is possible that the senior subordinated notes will be treated as having been issued with original issue discount, or OID (if the allocation to the senior subordinated notes were determined to be too high) or amortizable bond premium (if the allocation to the senior subordinated notes were determined to be too low). You generally would be required to include OID in income in advance of the receipt of cash attributable to that income and would be able to elect to amortize bond premium over the term of the senior subordinated notes. In the event the senior subordinated notes are issued with OID, they could be considered to have significant OID and thus be classified as applicable high yield discount obligations. If any such senior subordinated notes were so treated, a portion of the OID on such notes would be nondeductible by us and the remainder would be deductible only when paid. This treatment would have the effect of increasing our taxable income and may adversely affect our cash flow available for interest payments and distributions to our shareholders. Maxum Health Services Corp. Delaware 75-2135957 Table of Contents Because of the deferral of interest provisions, the senior subordinated notes may be treated as issued with OID. Under applicable Treasury regulations, a remote contingency that stated interest will not be timely paid is disregarded in determining whether a debt instrument is issued with OID. Although there is no authority directly on point, based on our financial forecasts, we believe that the likelihood of deferral of interest payments on the senior subordinated notes is remote. Based on the foregoing, although the matter is not free from doubt because of the lack of direct authority, we intend to take the position that the senior subordinated notes are not issued with OID at the time of their original issuance. If deferral of any payment of interest were determined not to be remote, then the senior subordinated notes would be treated as issued with OID at the time of issuance. In such case, all stated interest on the senior subordinated notes would be treated as OID, with the consequence that all holders would be required to include the yield on the senior subordinated notes in income as it accrued on a constant yield basis, possibly in advance of their receipt of the associated cash and regardless of their method of tax accounting. If we subsequently issue senior subordinated notes with significant OID, we may be unable to deduct all of the interest on the senior subordinated notes. It is possible that senior subordinated notes we issue in a subsequent issuance will be issued at a discount to their face value and, accordingly, may have significant OID and thus be classified as applicable high yield discount obligations. If any such senior subordinated notes were so treated, a portion of the OID on such notes would be nondeductible by us and the remainder would be deductible only when paid. Any limit on our ability to deduct interest for tax purposes would have the effect of increasing our taxable income and may adversely affect our cash flow available for interest payments and distributions to our shareholders. Subsequent issuances of senior subordinated notes may cause you to recognize taxable gain and/or OID and may reduce your recovery in the event of bankruptcy. The United States federal income tax consequences to you of the subsequent issuance of senior subordinated notes with OID (or any issuance of senior subordinated notes thereafter) are unclear. In the future, we may issue senior subordinated notes as part of IDSs in exchange for shares of our Class B common stock. The indenture governing the senior subordinated notes and the agreements with DTC will provide that, in the event that there is a subsequent issuance of senior subordinated notes having terms substantially identical to the senior subordinated notes offered hereby, each holder of senior subordinated notes or IDSs, as the case may be, agrees that a portion of such holder s senior subordinated notes will be automatically exchanged for a portion of the senior subordinated notes acquired by the holders of such subsequently issued senior subordinated notes. The aggregate stated principal amount of senior subordinated notes owned by you and each other holder will not change as a result of such subsequent issuance and exchange. However, under applicable law, it is possible that the holders of subsequently issued senior subordinated notes (to the extent issued with OID) will not be entitled to a claim for the portion of their principal amount that represents unaccrued OID in the event of an acceleration of the senior subordinated notes or a bankruptcy proceeding occurring prior to the maturity of the senior subordinated notes. Whether the receipt of subsequently issued senior subordinated notes in exchange for previously issued senior subordinated notes in this automatic exchange constitutes a taxable exchange for United States federal income tax purposes depends on whether the subsequently issued senior subordinated notes are viewed as differing materially from the senior subordinated notes exchanged. Due to a lack of applicable authority, it is unclear whether the subsequently issued senior subordinated notes will result in a taxable exchange for United States federal income tax purposes. If such an exchange is treated as a taxable exchange, you would recognize any gain realized on the exchange, but a loss realized generally would be disallowed in which case your basis in the subsequently issued senior subordinated notes would be increased to reflect the amount of the disallowed loss. Regardless of whether the exchange is treated as a taxable event, such exchange may result in an increase in the amount of OID, if any, that you are required to accrue with respect to senior subordinated notes. MRI Associates, L.P. Indiana 35-1881106 Table of Contents Following any subsequent issuance of senior subordinated notes with OID (or any issuance of senior subordinated notes thereafter) and resulting exchange, we and our agents will report any OID on any subsequently issued senior subordinated notes ratably among all holders of senior subordinated notes and IDSs, and each holder of senior subordinated notes and IDSs will, by purchasing senior subordinated notes or IDSs, as the case may be, agree to report OID in a manner consistent with this approach. Consequently, you may be required to report OID as a result of a subsequent issuance even though you purchased senior subordinated notes having no OID. This will generally result in you reporting more interest income over the term of the senior subordinated notes than you would have reported had no such subsequent issuance and exchange occurred. However, the IRS may assert that any OID should be reported only to the persons that initially acquired such subsequently issued senior subordinated notes and their transferees. In such case, the IRS might further assert that, unless a holder can establish that it is not such a person or a transferee thereof, all of the senior subordinated notes held by such holder will have OID. Any of these assertions by the IRS could create significant uncertainties in the pricing of IDSs and senior subordinated notes and could adversely affect the market for IDSs and senior subordinated notes. A subsequent issuance of senior subordinated notes or an allocation of IDS purchase price that results in OID may reduce the amount you can recover upon an acceleration of the payment of principal due on the senior subordinated notes or in the event of our bankruptcy. Under New York and federal bankruptcy law, holders of subsequently issued senior subordinated notes having original issue discount may not be able to collect the portion of the principal face amount of such senior subordinated notes that represents unamortized original issue discount as of the acceleration or filing date, as the case may be, in the event of an acceleration of the senior subordinated notes or in the event of our bankruptcy prior to the maturity date of the senior subordinated notes. As a result, a treatment of the senior subordinated notes as having been issued with OID or an automatic exchange that results in a holder receiving a senior subordinated note with original issue discount could have the effect of ultimately reducing the amount such holder can recover from us in the event of an acceleration or bankruptcy. Before this offering, there has not been a public market for our IDSs, shares of our Class A common stock or senior subordinated notes. The price of the IDSs, shares of our Class A common stock or senior subordinated notes may fluctuate substantially, which could negatively affect the value of your investment. None of the IDSs, the shares of our Class A common stock or the senior subordinated notes has a public market history. In addition, there has not been an established market in the United States for securities similar to the IDSs. An active trading market for the IDSs may not develop in the future, and we currently do not expect that an active trading market for the shares of our Class A common stock will develop until the senior subordinated notes are redeemed or mature. If the senior subordinated notes represented by your IDSs are redeemed or mature, the IDSs will automatically separate and you will then hold the shares of our Class A common stock. We will not apply to list our shares of Class A common stock for separate trading on the American Stock Exchange or any other exchange until the number of shares held separately and not represented by IDSs is sufficient to satisfy the then applicable requirements for separate trading on such exchange. The Class A common stock may not be approved for listing at such time. We do not intend to list our senior subordinated notes on any securities exchange. The initial public offering price of the IDSs has been determined by negotiations among us, the existing equity investors and the representatives of the underwriters and may not be indicative of the market price of the IDSs after the offering. Factors such as quarterly variations in our financial results, announcements by us or others, developments affecting us, our clients and our suppliers, general interest rate levels and general market volatility could cause the market price of the IDSs to fluctuate significantly. The limited liquidity of the trading market for the notes sold separately (not represented by IDSs) may adversely affect the trading price of the separate notes. We are separately selling $ million aggregate principal amount of senior subordinated notes (not represented by IDSs), representing approximately 10% of the total outstanding senior subordinated notes Maxum Health Services of North Texas, Inc. Texas 75-2435797 Table of Contents (assuming the exchange of all outstanding Class B common stock for IDSs). While the senior subordinated notes sold separately (not represented by IDSs) are part of the same series of notes as, and identical to, the senior subordinated notes represented by IDSs at the time of the issuance of the separate senior subordinated notes, the senior subordinated notes represented by the IDSs will not be separable for at least 45 days and will not be separately tradeable until separated. As a result, the initial trading market for the senior subordinated notes sold separately (not represented by IDSs) will be very limited. Even after holders of the IDSs are permitted to separate their IDSs, a sufficient number of holders of IDSs may not separate their IDSs into shares of our Class A common stock and senior subordinated notes to create a sizable and more liquid trading market for the senior subordinated notes not represented by IDSs. Therefore, a liquid market for the senior subordinated notes may not develop, which may adversely affect the ability of the holders of the separate senior subordinated notes to sell any of their separate senior subordinated notes and the price at which these holders would be able to sell any of the senior subordinated notes sold separately. Deferral of interest payments would have adverse tax consequences for you and may adversely affect the trading price of the IDSs or the separately held senior subordinated notes. If interest payments on the senior subordinated notes are deferred, you will be required to recognize interest income for United States federal income tax purposes under the rules related to OID in respect of interest payments on the senior subordinated notes represented by the IDSs or the separately held senior subordinated notes, as the case may be, held by you before you receive any cash payment of this interest. In addition, the requirement that we defer payments of interest on the senior subordinated notes under certain circumstances may mean that the market price for the IDSs or the separately held senior subordinated notes may be more volatile than other securities that do not have this requirement. If interest rates rise, the trading value of our IDSs or senior subordinated notes or Class A common stock represented thereby may decline. We cannot predict the interest rate environment or guarantee that interest rates will not rise in the near future. Should interest rates rise or should the threat of rising interest rates develop, debt markets may be adversely affected. As a result, the trading value of our IDSs or senior subordinated notes or Class A common stock represented thereby may decline. Future sales or the possibility of future sales of a substantial amount of IDSs, shares of our common stock or our senior subordinated notes may depress the price of the IDSs and the shares of our common stock and our senior subordinated notes. Future sales or the availability for sale of substantial amounts of IDSs or shares of our common stock or a significant principal amount of our senior subordinated notes in the public market could adversely affect the prevailing market price of the IDSs and the shares of our common stock and senior subordinated notes and could impair our ability to raise capital through future sales of our securities. We may issue shares of our Class A common stock and senior subordinated notes, which may be in the form of IDSs, or other securities from time to time as consideration for future acquisitions and investments. In the event any such acquisition or investment is significant, the number of shares of our Class A common stock and the aggregate principal amount of senior subordinated notes, which may be in the form of IDSs, or the number or aggregate principal amount, as the case may be, of other securities that we may issue may in turn be significant. In addition, we may also grant registration rights covering those IDSs, shares of our common stock, senior subordinated notes or other securities in connection with any such acquisitions and investments. Any or all of these occurrences could depress the trading prices of our securities. Maxum Health Services of Dallas, Inc. Texas 75-2615132 Table of Contents Risks Relating to our Business and the Industry Changes in the rates or methods of third-party reimbursements for diagnostic imaging and therapeutic services could result in reduced demand for our services or create downward pricing pressure, which would result in a decline in our revenues and harm our financial position. For the nine months ended March 31, 2004, we derived approximately 54% of our revenues from direct billings to patients and third-party payors such as Medicare, Medicaid, managed care and private health insurance companies. Changes in the rates or methods of reimbursement for the services we provide could have a significant negative impact on those revenues. Moreover, our healthcare provider customers on whom we depend for approximately 46% of our revenues generally rely on reimbursement from third-party payors. In the past, initiatives have been proposed and implemented which have the effect of substantially decreasing reimbursement rates for diagnostic imaging services provided at non-hospital facilities. Similar initiatives enacted in the future may have an adverse impact on our financial condition and our operations. Under Medicare s outpatient prospective payment system, or OPPS, and similar programs adopted by states for Medicaid, the payment due to a hospital for performing an outpatient service will be an amount based on the ambulatory payment classification, or APC, groups rather than on a hospital s cost. Because the OPPS appeared to have a severe adverse economic effect on hospitals, Congress enacted additional legislation in the Balanced Budget Refinement Act of 1999, or BBRA, to soften the negative financial effects. Under the BBRA, hospitals may receive additional payments for new technologies, transitional pass-through for innovative medical devices, drugs and biologics, outlier adjustments and transitional payment corridors. As some of these transitional payments phase out or expire, some of our hospital customers may decide to discontinue or restructure their arrangements with providers of diagnostic imaging services, which may have a material adverse effect on our operations. Any changes in the rates of or conditions for reimbursement could substantially reduce the number of procedures for which we or our customers can obtain reimbursement or the amounts reimbursed to us or our customers for services provided by us. If third-party payors reduce the amount of their payments to our customers, our customers may seek to reduce their payments to us or seek an alternate supplier of diagnostic imaging services. Because unfavorable reimbursement policies have constricted and may continue to constrict the profit margins of the hospitals, group practices and clinics we bill directly, we have lowered and may continue to need to lower our fees to retain existing customers and attract new ones. These reductions could have a significant adverse effect on our revenues and financial results by decreasing demand for our services or creating downward pricing pressure. The regulatory framework is uncertain and evolving. Healthcare laws and regulations may change significantly in the future. We continuously monitor these developments and modify our operations from time to time as the regulatory environment changes. However, we may not be able to adapt our operations to address new regulations, which could adversely affect our business. In addition, although we believe that we are operating in compliance with applicable federal and state laws, neither our current or anticipated business operations nor the operations of the contracted radiology practices have been the subject of judicial or regulatory interpretation. A review of our business by courts or regulatory authorities may result in a determination that could adversely affect our operations or the healthcare regulatory environment may change in a way that restricts our operations. If we are unable to renew our existing customer contracts on favorable terms or at all, our financial results would be adversely affected. Our financial results depend on our ability to sustain and grow our revenues from existing customers. Our revenues would decline if we are unable to renew our existing customer contracts or renew these contracts on favorable terms. For our mobile facilities, we generally enter into contracts with hospitals having three to five year terms. Approximately 33% of our mobile contracts will expire each fiscal year. Our mobile facility contract renewal rate was 80% in fiscal 2003. We may not, however, achieve these renewal rates in Land $ 3 $ 3 Building and improvements 109 89 Equipment and vehicles owned 2,406 4,020 Equipment and vehicles capital leases 24,903 19,994 Office furniture 59 NDDC, Inc. Texas 75-2407830 Table of Contents the future. To the extent we do not renew a customer contract, it is not always possible to immediately obtain replacement customers. Historically, many replacement customers have been smaller facilities which have lower procedure volumes. In addition, attractive financing from original equipment manufacturers may cause hospitals and physician groups who have utilized shared mobile services from our company and our competitors to purchase and operate their own equipment. If attractive financing causes hospitals and physician groups to establish their own diagnostic imaging centers, our business, financial condition and results of operations would be materially adversely affected. Although the non-renewal of a single customer contract would not have a material impact on our contract services revenues, non-renewal of several contracts on favorable terms or at all could have a significant negative impact on our revenues. We may experience competition from hospitals, physician groups, other diagnostic imaging companies and this competition could adversely affect our revenues and our business. The healthcare industry in general, and the market for diagnostic imaging services in particular, is highly competitive and fragmented, with only a few national providers. We compete principally on the basis of our service reputation, state-of-the-art equipment, breadth of managed care contracts and convenient locations. Our operations must compete with groups of radiologists, established hospitals and certain other independent organizations, including equipment manufacturers and leasing companies that own and operate imaging equipment. We will also encounter competition from hospitals and physician groups that purchase their own diagnostic imaging equipment from original equipment manufacturers who provide low-cost financing. Some of our direct competitors that provide contract diagnostic imaging services may have access to greater financial resources than we do. If we are unable to successfully compete, our customer base would decline and our business, financial condition and results of operations would be adversely effected. Managed care organizations may limit healthcare providers from using our services, causing us to lose procedure volume. Our fixed-site centers are principally dependent on our ability to attract referrals from physicians and other healthcare providers representing a variety of specialties. Our eligibility to provide service in response to a referral is often dependent on the existence of a contractual arrangement with the referred patient s managed care organization. We currently have more than 1,000 contracts with managed care organizations for diagnostic imaging services provided at our fixed-site centers. Despite having a large number of contracts with managed care organizations, healthcare providers may be inhibited from referring patients to us in cases where the patient is not associated with one of the managed care organizations with which we have contracted. The loss of patient referrals causes us to lose procedure volume which adversely impacts our revenues. A significant decline in referrals would have a material adverse effect on our business, financial condition and results of operations. A failure to maintain a competitive equipment base can adversely affect our business. We operate in a competitive, capital intensive, high fixed-cost industry that requires significant amounts of capital to fund operations. We incur capital expenditures to, among other things: upgrade our existing imaging systems and software; invest in new imaging technologies; and purchase our existing imaging systems upon termination of operating leases. To the extent we are unable to generate sufficient cash from our operations or obtain additional funds through bank financing or the issuance of equity or debt securities, we may be unable to maintain a competitive equipment base. As a result, we may not be able to maintain our competitive position in our targeted regions or achieve our estimated operating income growth. Diagnostic Solutions Corp. Delaware 75-2565249 Table of Contents Technological change in our industry could reduce the demand for our services and require us to incur significant costs to upgrade our equipment. The development of new technologies or refinements of existing ones might make our existing systems technologically or economically obsolete, or cause a reduction in the value of, or reduce the need for, our systems. MRI and other diagnostic imaging systems are currently manufactured by numerous companies. Competition among manufacturers for a greater share of the MRI and other diagnostic imaging systems market may result in technological advances in the speed and imaging capacity of these new systems. Consequently, the obsolescence of our systems may be accelerated. Although we are aware of no imminent substantial technological changes, other than ultra-high field MRI systems (a 3.0 Tesla MRI scanner costs approximately 40% to 60% more than a 1.5 Tesla MRI scanner plus higher annual maintenance costs) and PET/ CT or fusion scanners (a PET/ CT scanner costs approximately 35% to 50% more than a standard PET scanner plus higher annual maintenance costs), should such changes occur, we may not be able to acquire the new or improved systems. The development of new scanning technology or new diagnostic applications for existing technology may require us to adapt our existing technology or acquire new or technologically improved systems in order to successfully compete. In the future, however, we may not have the financial resources to do so, particularly given the extent of our indebtedness and dividend policy. In addition, advancing technology may enable hospitals, physicians or other diagnostic service providers to perform procedures without the assistance of diagnostic service providers such as ourselves. Our ability to maximize the utilization of our diagnostic imaging equipment may be adversely impacted by harsh weather conditions. Harsh weather conditions can adversely impact our operations and financial condition. To the extent severe weather patterns affect our targeted regions, potential patients may find it difficult to travel to our centers and we may have difficulty moving our mobile facilities along their scheduled routes. As a result, we would experience a decrease in procedure volume during that period. For example, during the winter of 2003, harsh weather in the eastern United States negatively affected our procedure volume during January and February which adversely impacted our revenues. Our equipment utilization, procedure volume or revenues could be adversely affected by similar conditions in the future. Because a high percentage of our operating expenses are fixed, a relatively small decrease in revenues could have a significant negative impact on our financial results. A high percentage of our expenses are fixed, meaning they do not vary significantly with the increase or decrease in revenues. Such expenses include, but are not limited to, debt service and capital lease payments, rent and operating lease payments, salaries, maintenance, insurance and vehicle operation costs. As a result, a relatively small reduction in the prices we charge for our services and/or procedure volume could have a disproportionate negative effect on our financial results. We may be subject to professional liability risks which could be costly and negatively impact our business and financial results. We have not experienced any material losses due to claims for malpractice. However, claims for malpractice have been asserted against us in the past and any future claims, if successful, could entail significant defense costs and could result in substantial damage awards to the claimants, which may exceed the limits of any applicable insurance coverage. Successful malpractice claims asserted against us, to the extent not covered by its liability insurance, could have a material adverse affect on our business, financial condition and results of operations. In addition to being exposed to claims for malpractice, there are other professional liability risks to which we are exposed through our operation of diagnostic imaging systems, including liabilities associated with the improper use or malfunction of our diagnostic imaging equipment. To protect against possible professional liability from malpractice claims, we maintain professional liability insurance in amounts that we believe are appropriate in light of the risks and industry practice. However, if Wilkes-Barre Imaging, L.L.C. Pennsylvania 52-2238781 Table of Contents we are unable to maintain insurance in the future at an acceptable cost or at all or if our insurance does not fully cover us in the event a successful claim was made against us, we could incur substantial losses. Any successful malpractice or other professional liability claim made against us not fully covered by insurance could be costly to defend against, result in a substantial damage award against us and divert the attention of our management from our operations, which could have a material adverse effect on our business, financial condition and results of operations. Our failure to effectively integrate acquisitions and establish joint venture arrangements through partnerships with hospitals and other healthcare providers could impair our business. As part of our business strategy, we have pursued selective acquisitions and arrangements through partnerships and joint ventures with hospitals and other healthcare providers. Our acquisition and joint venture strategies require substantial capital which may exceed the funds available to us from internally generated funds and the new credit facility. We may not be able to raise any necessary additional funds through bank financing or through the issuance of additional IDSs, equity or debt securities on terms acceptable to us, if at all. Additionally, acquisitions involve the integration of acquired operations with our operations. Integration involves a number of risks, including: demands on management related to the increase in our size after an acquisition; the diversion of our management s attention from the management of daily operations to the integration of operations; integration of information systems; risks associated with unanticipated events or liabilities; difficulties in the assimilation and retention of employees; potential adverse effects on operating results; challenges in retaining customers and referral sources; and amortization or write-offs of acquired intangible assets. Although we believe we have successfully integrated acquisitions in the past, we may not be able to successfully integrate the operations from any future acquisitions. If we do not successfully integrate our acquisitions, we may not realize anticipated operating advantages, economies of scale and cost savings. Also, we may not be able to maintain the levels of operating efficiency that the acquired companies would have achieved or might have achieved separately. Successful integration of each of their operations will depend upon our ability to manage those operations and to eliminate excess costs. Loss of key executives and failure to attract qualified managers, technologists and salespeople could limit our growth and negatively impact our operations. We depend upon our management team to a substantial extent. As we grow, we will increasingly require field managers and salespeople experienced in our industry and skilled technologists to operate our diagnostic equipment. It is impossible to predict the availability of qualified field managers, salespeople and technologists or the compensation levels that will be required to hire or retain them. In particular, there is a very high demand for qualified technologists who are necessary to operate our systems. We may not be able to hire and retain a sufficient number of technologists, and we may be required to pay bonuses and higher salaries to our technologists, which would increase our expenses. The loss of the services of any member of our senior management or our inability to hire qualified field managers, salespeople and skilled technologists at economically reasonable compensation levels could adversely affect our ability to operate and grow our business. ASSETS CURRENT ASSETS: Cash and cash equivalents $ 1,105 $ 1,936 Trade accounts receivable, net 2,926 3,182 Securities, available for sale at market 1,031 2,012 Other current assets 126 Table of Contents Our PET service and some of our other imaging services require the use of radioactive materials, which could subject us to regulation, related costs and delays and potential liabilities for injuries or violations of environmental, health and safety laws. Our PET service and some of our other imaging and therapeutic services require the use of radioactive materials to produce the images. While this radioactive material has a short half-life, meaning it quickly breaks down into non-radioactive substances, storage, use and disposal of these materials present the risk of accidental environmental contamination and physical injury. We are subject to federal, state and local regulations governing storage, handling and disposal of these materials and waste products. Although we believe that our safety procedures for storing, handling and disposing of these hazardous materials comply with the standards prescribed by law and regulation, we cannot completely eliminate the risk of accidental contamination or injury from those hazardous materials. In the event of an accident, we would be held liable for any resulting damages, and any liability could exceed the limits of or fall outside the coverage of our insurance. In addition, we may not be able to maintain insurance on acceptable terms, or at all. We could incur significant costs and the diversion of our management s attention in order to comply with current or future environmental, health and safety laws and regulations. Our substantial indebtedness could adversely affect our financial health. As of March 31, 2004, on a pro forma basis giving effect to the CMI acquisition, the offering and the related transactions, we would have had total indebtedness of approximately $ million which comprised approximately % of our total capitalization. Our substantial indebtedness could have important consequences to us. For example, it could: make it more difficult for us to satisfy our obligations with respect to the senior subordinated notes and the new credit facility; increase our vulnerability to general adverse economic and industry conditions; require us to dedicate a substantial portion of our cash flow from operations to payments on our indebtedness, thereby reducing the availability of our cash flow to fund working capital, capital expenditures, acquisitions and investments and other general corporate purposes; limit our flexibility in planning for, or reacting to, changes in our business and the markets in which we operate; place us at a competitive disadvantage compared to our competitors that have less debt; and limit our ability to borrow additional funds. In addition, we may incur substantial additional indebtedness in the future. The terms of the indenture governing the senior subordinated notes and the credit agreement governing the new credit facility allow us to issue and incur additional debt upon satisfaction of certain conditions. If new debt is added to current debt levels, the related risks described above could intensify. Complying with federal and state regulations pertaining to our business is an expensive and time-consuming process, and any failure to comply could result in substantial penalties. We are directly or indirectly through our customers subject to extensive regulation by both the federal government and the states in which we conduct our business, including: the federal False Claims Act; the federal Medicare and Medicaid Anti-kickback Law, and state anti-kickback prohibitions; the federal Civil Money Penalty Law; the federal Health Insurance Portability and Accountability Act of 1996; (in thousands) Compensated absences, principally due to accrual for financial reporting purposes $ 108 $ 137 Accounts receivable, due to allowance for doubtful accounts 1,832 1,675 Accrued liabilities, primarily due to employee benefits and other accruals for financial reporting purposes 800 1,158 Deferred compensation, due to accrual for financial reporting purposes 57 San Fernando Valley Regional PET Center, LLC California 91-2070191 Table of Contents the federal physician self-referral prohibition commonly known as the Stark Law and the state law equivalents of the Stark Law; state laws that prohibit the practice of medicine by non-physicians, and prohibit fee-splitting arrangements involving physicians; federal FDA requirements; state licensing and certification requirements, including certificates of need; and federal and state laws governing the diagnostic imaging and therapeutic equipment used in our business concerning patient safety, equipment operating specifications and radiation exposure levels. If our operations are found to be in violation of any of the laws and regulations to which we or our customers are subject, we may be subject to the applicable penalty associated with the violation, including civil and criminal penalties, damages, fines and the curtailment of our operations. Any penalties, damages, fines or curtailment of our operations, individually or in the aggregate, could adversely affect our ability to operate our business and our financial results. The risks of our being found in violation of these laws and regulations is increased by the fact that many of them have not been fully interpreted by the regulatory authorities or the courts, and their provisions are open to a variety of interpretations. Any action brought against us for violation of these laws or regulations, even if we successfully defend against it, could cause us to incur significant legal expenses and divert our management s attention from the operation of our business. An earthquake could adversely affect our business and operations. Our corporate headquarters and a significant portion of our integrated network are located in California, which has a high risk for earthquakes. Depending upon its magnitude, an earthquake could severely damage our facilities or prevent potential patients from traveling to our centers. Damage to our equipment or any interruption in our business would adversely affect our financial condition. While we presently carry earthquake insurance, the amount of our earthquake insurance coverage may not be sufficient to cover losses from earthquakes. In addition, we may discontinue earthquake insurance on some or all of our facilities in the future if the cost of premiums for earthquake insurance exceeds the value of the coverage discounted for the risk of loss. If we experience a loss which is uninsured or which exceeds policy limits, we could lose the capital invested in the damaged facilities as well as the anticipated future cash flows from those facilities. Periodic increases in unemployment could adversely affect our business. A deterioration in general economic conditions and an increase in the unemployment rate may result in a loss of health insurance coverage for many of our potential patients. Without health insurance, patients may be less likely to use our services, causing a reduction in our procedure volume and adversely effecting our financial condition. Valencia MRI, LLC California 91-2070193 Table of Contents
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+Risk Factors You should carefully consider the information under the heading "Risk Factors" and all other information in this prospectus before investing in the IDSs (including the shares of our Class A common stock and senior subordinated notes represented by the IDSs) or in our senior subordinated notes. General Information About This Prospectus Throughout this prospectus, unless otherwise noted, we have assumed: that our reorganization will be consummated; no exercise of the underwriters' over-allotment option; the purchase or redemption of all of the 91/4% notes for aggregate consideration of $ million plus accrued interest, and the pro forma offering numbers give effect to the purchase or redemption of all of these notes; repayment of the existing credit facility and entering into the new credit facility or amendment of the existing credit facility; a % annual interest rate on the senior subordinated notes, which is subject to change depending on market conditions prior to the pricing date; an initial public offering price of $ per IDS, the midpoint of the range set forth on the cover page of this prospectus, comprised of $ allocated to one share of Class A common stock and $ allocated to the $ principal amount of senior subordinated notes included in each IDS, which equals 100% of the principal amount thereof; and an initial public offering price of the senior subordinated notes that are being offered separately (not represented by IDSs) of % of their stated principal amount. In this prospectus, unless otherwise indicated, all references to dollars are to U.S. dollars, and all references to GAAP are to U.S. generally accepted accounting principles. Unless the context otherwise requires, references in this prospectus to the "offering" refer collectively to the offering of: an aggregate of IDSs to the public; and $ aggregate principal amount of senior subordinated notes to the public separately (not represented by IDSs). Furthermore, unless the context otherwise requires, references in this prospectus to "senior subordinated notes" refer to both senior subordinated notes represented by IDSs and senior subordinated notes issued separately (not represented by IDSs). Computer equipment and software 3 $ 645,549 $ 500,557 Furniture and fixtures 5 147,428 131,898 Office equipment 5 55,112 48,862 Leasehold improvements 7 102,105 88,255 Plates, dies and molds 7 312,705 133,191 Manufacturing equipment You should rely only on the information contained in this prospectus. We have not authorized anyone to provide you with different information. We are not making an offer of these securities in any state where the offer is not permitted. You should not assume that the information contained in this prospectus is accurate as of any date other than the date on the front of this prospectus. We may amend the terms of the new credit facility, or we may enter into new agreements that govern our senior indebtedness and the amended new credit facility or the terms of the new agreements may significantly affect our ability to pay interest on our senior subordinated notes and dividends on shares of our common stock. The new credit facility contains significant restrictions on our ability to pay interest on the senior subordinated notes and dividends on shares of common stock based on us meeting certain performance measures and compliance with other conditions. As a result of general economic conditions, conditions in the lending markets, the results of our business or for any other reason, we may elect or be required to amend or refinance the new credit facility, at or prior to maturity, or enter into additional agreements for senior indebtedness. Regardless of any protection you have in the indenture governing the senior subordinated notes, any such amendment, refinancing or additional indebtedness may contain covenants that could limit, in a significant manner, our ability to make interest payments and pay dividends to you. We are subject to restrictive debt covenants that limit our business flexibility by imposing operating and financial restrictions on our operations and could limit our ability to grow our business. The agreements governing our indebtedness impose significant operating and financial restrictions on us. These restrictions prohibit or limit, among other things: the incurrence of additional indebtedness and the issuance of preferred stock and certain redeemable capital stock; a number of other restricted payments, including investments; specified sales of assets; specified transactions with affiliates; the creation of a number of liens; consolidations, mergers and transfers of all or substantially all of our assets; and our ability to change the nature of our business. The terms of the new credit facility include other and more restrictive covenants and prohibit us from prepaying our other indebtedness, including the senior subordinated notes, while indebtedness under the new credit facility is outstanding. The new credit facility also requires us to maintain certain specified financial ratios and satisfy financial condition tests. Our ability to comply with the ratios or tests may be affected by events beyond our control, including prevailing economic, financial and industry conditions. A breach of any of these covenants, ratios or tests could result in a default under the new credit facility and/or the indenture. Events of default under the new credit facility would prohibit us from making payments on the senior subordinated notes in cash, including payment of interest when due. In addition, upon the occurrence of an event of default under the new credit facility, the lenders could elect to declare all amounts outstanding under the new credit facility, together with accrued interest, to be immediately due and payable. If we were unable to repay those amounts, the lenders could proceed against the security granted to them to secure that indebtedness. If the lenders accelerate the payment of the indebtedness, our assets may not be sufficient to repay in full this indebtedness and our other indebtedness, including the senior subordinated notes. TABLE OF CONTENTS Page We are a holding company and rely on dividends and other payments, advances and transfers of funds from our subsidiaries to meet our debt service and other obligations. We are a holding company and conduct all of our operations through our subsidiaries. We currently have no significant assets other than direct and indirect equity interests in our subsidiaries. All of our equity interests in our domestic subsidiaries will be pledged to the creditors under the new credit facility which we guarantee. As a result, we will rely on dividends and other payments or distributions from our subsidiaries to meet our debt service obligations and enable us to pay dividends. The ability of our subsidiaries to pay dividends or make other payments or distributions to us will depend on their respective operating results and may be restricted by, among other things, the laws of their jurisdiction of organization (which may limit the amount of funds available for the payment of dividends), agreements of those subsidiaries, the terms of the new credit facility and the covenants of any future outstanding indebtedness we or our subsidiaries incur. Subject to restrictions set forth in the indenture, we may defer the payment of interest to you for a significant period of time. Prior to , 2009, we may, subject to restrictions set forth in the indenture, defer interest payments on our senior subordinated notes on one or more occasions for up to an aggregate period of eight quarters. In addition, after , 2009, we may, subject to certain restrictions, defer interest payments on our senior subordinated notes on four occasions for up to two consecutive quarters on each occasion. Deferred interest will bear interest at the same rate as the senior subordinated notes. For any interest deferred during the first five years, we are not obligated to pay any deferred interest until , 2009, so you may be owed a substantial amount of deferred interest that will not be due and payable until such time. For any interest deferred after , 2009, we are not obligated to pay all of the deferred interest until , 2019, so you may be owed a substantial amount of deferred interest that will not be due and payable until such time. Deferral of interest payments would have adverse tax consequences for you and may adversely affect the trading price of the senior subordinated notes. If we defer interest payments on the senior subordinated notes, you will be required to recognize interest income for United States federal income tax purposes in respect of the senior subordinated notes before you receive any cash payment of this interest. In addition, we will not pay you this cash if you sell the IDSs or the senior subordinated notes, as the case may be, before the end of any deferral period or before the record date relating to interest payments that are to be paid. The IDSs or the senior subordinated notes may trade at a price that does not fully reflect the value of accrued but unpaid interest on the senior subordinated notes if we defer interest payments. In addition, the requirement that we defer payments of interest on the senior subordinated notes under certain circumstances may mean that the market price for the IDSs or the senior subordinated notes may be more volatile than other securities that do not have this requirement. You may not receive the level of dividends provided for in the dividend policy our board of directors is expected to adopt upon the closing of this offering or any dividends at all. Our board of directors may, in its discretion, amend or repeal the dividend policy it is expected to adopt upon the closing of this offering. Our board of directors may decrease the level of dividends provided for in this dividend policy or entirely discontinue the payment of dividends. Future dividends with respect to shares of our capital stock, if any, will depend on, among other things, our results of operations, cash requirements, financial condition, contractual restrictions, business opportunities, provisions of applicable law and other factors that our board of directors may deem relevant. The indenture governing our senior subordinated notes and the new credit facility contain significant restrictions on our ability to make dividend payments, including, if we defer interest on the senior subordinated notes under the indenture, restrictions on the payment of dividends until we have paid all deferred interest. In addition, our after-tax cash flow available for dividend and interest payments would be reduced if the senior subordinated notes were treated as equity rather than debt for United States federal income tax purposes. In that event, the stated interest on the senior subordinated notes could be treated as a dividend and interest on the senior subordinated notes would not be deductible by us for United States federal income tax purposes. Our inability to deduct interest on the senior subordinated notes could materially increase our taxable income and, thus, our United States federal and applicable state income tax liability. If this were to occur, our after-tax cash flow available for dividend and interest payments would be reduced. Ownership change will limit our ability to use certain losses for U.S. federal income tax purposes and may increase our tax liability. The transactions contemplated herein will result in an "ownership change" within the meaning of the U.S. federal income tax laws addressing net operating loss carryforwards, alternative minimum tax credits and other similar tax attributes. As a result of such ownership change, as well as any prior ownership changes, there will be specific limitations on our ability to use our net operating loss carryforwards and other tax attributes from periods prior to this offering. It is possible in the future that such limitations could limit our ability to utilize such tax attributes and, therefore, result in an increase in our U.S. federal income tax liability. Such an increase would reduce the funds available for the payments of dividends and might require us to reduce or eliminate the dividends on our IDSs and Class A common stock. You will be immediately diluted by $ per share of Class A common stock if you purchase IDSs in this offering. If you purchase IDSs in this offering, based on the book value of the assets and liabilities reflected on our balance sheet, you will experience an immediate dilution of $ per share of Class A common stock represented by the IDSs which exceeds the entire price allocated to each share of Class A common stock represented by the IDSs in this offering because there will be a net tangible book deficit for each share of Class A common stock outstanding immediately after this offering. Our net tangible book value as of March 31, 2004, after giving effect to this offering, was approximately $ million, or $ per share of Class A common stock. Our interest expense may increase significantly and could cause our net income and distributable cash to decline significantly. The new credit facility will be subject to periodic renewal or must otherwise be refinanced. We may not be able to renew or refinance the new credit facility, or if renewed or refinanced, the renewal or refinancing may occur on less favorable terms. Borrowings under the revolving facility will be made at a floating rate of interest. In the event of an increase in the base reference interest rates, our interest expense will increase and could have a material adverse effect on our ability to make cash dividend payments to our stockholders. Our ability to continue to expand our business will, to a large extent, be dependent upon our ability to borrow funds under our new credit facility and to obtain other third party financing, including through the sale of IDSs or other securities. We cannot assure you that such financing will be available to us on favorable terms or at all. We may not generate sufficient funds from operations to pay our indebtedness at maturity or upon the exercise by holders of their rights upon a change of control. A significant portion of our cash flow from operations will be dedicated to servicing our debt requirements. In addition, we currently expect to distribute a significant portion of any remaining cash earnings to our stockholders in the form of quarterly dividends. Moreover, prior to the maturity of our senior subordinated notes, we will not be required to make any payments of principal on our senior subordinated notes. We may not generate sufficient funds from operations to repay the principal amount of our indebtedness at maturity or in case you exercise your right to require us to purchase your notes upon a change of control. We may therefore need to refinance our debt or raise additional capital. These alternatives may not be available to us when needed or on satisfactory terms due to prevailing market conditions, a decline in our business or restrictions contained in our senior debt obligations. The indenture governing our senior subordinated notes and our new credit facility permit us to pay a significant portion of our cash flow to stockholders in the form of dividends, thereby reducing the amounts available to satisfy our obligations under the senior subordinated notes. Although the indenture governing our senior subordinated notes and our new credit facility have some limitations on our payment of dividends, they permit us to pay a significant portion of our cash flow to stockholders in the form of dividends. Following completion of this offering, we intend to pay quarterly dividends. Specifically, the indenture governing our senior subordinated notes permits us to pay up to 100% of our excess cash (as defined in the indenture) subject to compliance with a fixed charge coverage test as more fully described in "Description of Senior Subordinated Notes Certain Covenants." The new credit facility permits us to use up to 100% of the excess cashflow, as defined in the new credit facility plus certain other amounts under certain limited circumstances to fund dividends on our shares of common stock. Any amounts paid by us in the form of dividends will not be available in the future to satisfy our obligations under the senior subordinated notes. Because we will use a significant portion of the proceeds of this offering to purchase equity interests from existing equity investors, we will have only the remaining portion of the proceeds of this offering to repay our existing debt and for corporate purposes and will have to incur more debt. We will use a significant portion of the net proceeds from this offering to purchase equity interests from existing equity investors as part of our reorganization. Therefore, we will not have these funds available to us (1) to repay our existing debt, and will therefore have to borrow more under our new credit facility to repay the existing credit facility than we would have had we not undertaken these purchases, or (2) to fund our operations or to expand our business. The realizable value of our assets upon liquidation may be insufficient to satisfy claims. At March 31, 2004, on a pro forma basis for the Acquisitions, our assets included intangible assets in the amount of $855.2 million, representing approximately 89.7% of our total consolidated assets and consisting primarily of value assigned to trademarks and brand names. The value of these intangible assets will continue to depend significantly upon the success of our business as a going concern and the growth in cash flows. As a result, in the event of a default under our new credit facility or on our senior subordinated notes or our bankruptcy or dissolution, the realizable value of these assets may be substantially lower and may be insufficient to satisfy the claims of our creditors. Because of the subordinated nature of the senior subordinated notes, holders of our senior subordinated notes may not be entitled to be paid in full, or at all, in a bankruptcy, liquidation or reorganization or similar proceeding. As a result of the subordinated nature of our notes and related guarantees, upon any distribution to our creditors or the creditors of the subsidiary guarantors in bankruptcy, liquidation or reorganization or similar proceeding relating to us or the subsidiary guarantors or our or their property, the holders of our senior indebtedness and senior indebtedness of the subsidiary guarantors will be entitled to be paid in full in cash before any payment may be made with respect to our senior subordinated notes or the subsidiary guarantees. In the event of a bankruptcy, liquidation or reorganization or similar proceeding relating to us or the subsidiary guarantors, holders of our senior subordinated notes will participate with all other holders of unsecured indebtedness of ours or the subsidiary guarantors that are similarly subordinated in the assets remaining after we and the subsidiary guarantors have paid all senior indebtedness. However, because of the existence of the subordination provisions, including the requirement that holders of the senior subordinated notes pay over distributions to holders of senior indebtedness, holders of the senior subordinated notes may receive less, ratably, than our other unsecured creditors, including trade creditors. In any of these cases, we and the subsidiary guarantors may not have sufficient funds to pay all of our creditors. Holders of our senior subordinated notes may, therefore, receive less, ratably, than the holders of our senior indebtedness. On a pro forma basis as of March 31, 2004, our senior subordinated notes and the subsidiary guarantees would have ranked junior, on a consolidated basis, to $ million of outstanding senior secured indebtedness and the subsidiary guarantees would have ranked junior to no senior unsecured debt and pari passu with approximately $ million of outstanding indebtedness of ours and the subsidiary guarantors. In addition, as of March 31, 2004, on a pro forma basis, we would have had the ability to borrow up to an additional amount of $ million under the new credit facility, which would have ranked senior in right of payment to our senior subordinated notes. If any of the 91/4% notes are not purchased or redeemed by us by the closing of this offering, such notes will rank pari passu to our senior subordinated notes and the subsidiary guarantees until such time as we purchase or redeem such notes. In the event of a bankruptcy, liquidation or reorganization or similar proceeding of any of the non-guarantor subsidiaries, holders of their indebtedness, including their trade creditors, would generally be entitled to payment of their claims from the assets of those subsidiaries before any assets are made available for distribution to us for payment to you. Holders of our senior subordinated notes will be structurally subordinated to the debt of our non-guarantor subsidiaries. In the event of bankruptcy or insolvency, the senior subordinated notes and guarantees could be adversely affected by principles of equitable subordination or recharacterization. In the event of bankruptcy or insolvency, a party in interest may seek to subordinate the senior subordinated notes or the guarantees under principles of equitable subordination or to recharacterize the senior subordinated notes as equity. There can be no assurance as to the outcome of such proceedings. In the event a court subordinates the senior subordinated notes or the guarantees, or recharacterizes the senior subordinated notes as equity, we cannot assure you that you would recover any amounts owed on the senior subordinated notes or the guarantees and you may be required to return any payments made to you within six years before the bankruptcy on account of the senior subordinated notes or the guarantees. In addition, should the court equitably subordinate the senior subordinated notes or the guarantees, or recharacterize the senior subordinated notes as equity you may not be able to enforce the guarantees. $ 406 $ SUMMARY The following is a summary of the principal features of this offering of IDSs and senior subordinated notes and should be read together with the more detailed information and financial data and statements contained elsewhere in this prospectus. Our Business We are a leading branded consumer products company with a diversified portfolio of well-recognized brands in the over-the-counter drug, household cleaning and personal care categories. Our core brands have established high levels of consumer awareness and strong retail distribution across all major channels. Approximately 65% of our combined sales for the most recent fiscal year are from products that have a number one market share position. The following table outlines the leadership position of our major brands: Major Brands The guarantees of the senior subordinated notes by our subsidiaries may be unenforceable because of fraudulent conveyance laws. Under federal bankruptcy law and comparable provisions of state fraudulent transfer laws, a guarantee could be voided, or claims in respect of a guarantee could be subordinated to all other debt of the guarantor, if, among other things, the guarantor, at the time that it assumed the guarantee: issued the guarantee to delay, hinder or defraud present or future creditors; received less than reasonably equivalent value or fair consideration for issuing the guarantee and, at the time it issued the guarantee; was insolvent or rendered insolvent by reason of issuing the guarantee and the application of the proceeds of the guarantee; was engaged or about to engage in a business or a transaction for which the guarantor's remaining assets available to carry on its business constituted unreasonably small capital; intended to incur, or believed that it would incur, debts beyond its ability to pay the debts as they mature; or was a defendant in an action for money damages, or had a judgment for money damages docketed against it if, in either case, after final judgment, the judgment is unsatisfied. In addition, any payment by the guarantor under its guarantee could be voided and required to be returned to the guarantor or to a fund for the benefit of the creditors of the guarantor or the guarantee could be subordinated to other debt of the guarantor. What constitutes insolvency for the purposes of fraudulent transfer laws varies depending upon the law applied in any proceeding to determine if a fraudulent transfer has occurred. Generally, however, a person would be considered insolvent if, at the time such person incurred the debt: the sum of its debts, including contingent liabilities, was greater than the fair saleable value of its assets; the present fair saleable value of its assets was less than the amount that would be required to pay its probable liability on its existing debts, including contingent liabilities, as they become absolute and mature; or it could not pay its debts as they become due. We believe that immediately after the issuance of the senior subordinated notes and the guarantees, we and each of the guarantors will be solvent, have sufficient capital to carry on our respective businesses and be able to pay our respective debts as they mature. We cannot be sure, however, as to what standard a court would apply in making these determinations or that a court would reach the same conclusions with regard to these issues. Regardless of the standard that the court uses, we cannot be sure that the issuance by the subsidiary guarantors of the subsidiary guarantees would not be voided or the subsidiary guarantees would not be subordinated to their other debt. The guarantee of our senior subordinated notes by any subsidiary guarantor could be subject to the claim that since the guarantee was incurred for the benefit of Prestige Holdings and only indirectly for the benefit of the subsidiary guarantor, the obligations of the subsidiary guarantor were incurred for less than fair consideration. If such a claim were successful and it was proven that the subsidiary guarantor was insolvent at the time the guarantee was issued, a court could void the obligations of the subsidiary guarantor under the guarantee or subordinate these obligations to the subsidiary guarantor's other debt or take action detrimental to holders of the senior subordinated notes. If the guarantee of any subsidiary guarantor were voided, our senior subordinated notes would be effectively subordinated to the indebtedness and other credit obligations of that subsidiary guarantor. Market Position(1) The United States federal income tax consequences of the purchase, ownership and disposition of IDSs and senior subordinated notes are uncertain. No statutory, judicial or administrative authority directly addresses the treatment of the IDSs or the senior subordinated notes, or instruments similar to the IDSs or the senior subordinated notes, for United States federal income tax purposes. As a result, the United States federal income tax consequences of the purchase, ownership and disposition of IDSs and the senior subordinated notes are uncertain. We will receive an opinion from our counsel, Kirkland & Ellis LLP, to the effect that an IDS should be treated as a unit representing a share of common stock and senior subordinated notes, and that the senior subordinated notes should be classified as debt for United States federal income tax purposes and we intend to deduct interest on such senior subordinated notes for tax purposes. However, the IRS or the courts may take the position that the IDSs are a single security classified as equity, or that the senior subordinated notes are properly classified as equity for United States federal income tax purposes, which could adversely affect the amount, timing and character of income, gain or loss in respect of your investment in IDSs or senior subordinated notes, and materially increase our taxable income and, thus, our United States federal and applicable state income tax liability. This would adversely affect our financial position, cash flow, and liquidity, and could affect our ability to make interest or dividend payments on the senior subordinated notes and the common stock and may affect our ability to continue as a going concern. Our tax deduction for interest may be put at risk in the future as a result of a future ruling by the IRS, including an adverse ruling for other IDSs or an adverse ruling for our own IDSs issued now or subsequently and in the event of any such ruling, we may need to consider the effect of such developments on the determination of our future tax provisions and obligations. Foreign holders could be subject to withholding or estate taxes with regard to the senior subordinated notes in the same manner as they will be with regard to the common stock. Payments to foreign holders would not be grossed-up for any such taxes. For discussion of these tax-related risks, see "Material United States Federal Income Tax Consequences." The allocation of the purchase price of the IDSs may not be respected, which may require you to include original issue discount in your income even if you have not received the cash attributable to that income. The purchase price of each IDS must be allocated for tax purposes between the share of common stock and senior subordinated notes comprising the IDS in proportion to their respective fair market values at the time of purchase. If our allocation is not respected, then it is possible that the senior subordinated notes will be treated as having been issued with original issue discount, or OID (if the allocation to the senior subordinated notes were determined to be too high) or amortizable bond premium (if the allocation to the senior subordinated notes were determined to be too low). You generally would be required to include OID in income in advance of the receipt of cash attributable to that income and would be able to elect to amortize bond premium over the term of the senior subordinated notes. Because of the deferral of interest provisions, the senior subordinated notes may be treated as issued with original issue discount. Under applicable Treasury regulations, a "remote" contingency that stated interest will not be timely paid is disregarded in determining whether a debt instrument is issued with OID. Although there is no authority directly on point, based on our financial forecasts, we believe that the likelihood of deferral of interest payments on the senior subordinated notes is remote within the meaning of the Treasury regulations. Based on the foregoing determination made by us, although the matter is not free from doubt because of the lack of direct authority, our counsel is of the opinion that the possibility that interest payments on the senior subordinated notes may be deferred should not cause the senior subordinated notes to be considered to be issued with OID at the time of their original issuance. If IRI/ ACNielsen Market Share(1) deferral of any payment of interest were determined not to be "remote," then the senior subordinated notes would be treated as issued with OID at the time of issuance. In such case, all stated interest on the senior subordinated notes would be treated as OID, with the consequence that all holders would be required to include the yield on the senior subordinated notes in income as it accrued on a constant yield basis, possibly in advance of their receipt of the associated cash and regardless of their method of tax accounting. If we subsequently issue senior subordinated notes with significant OID, we may not be able to deduct all of the interest on the senior subordinated notes. It is possible that senior subordinated notes we issue in a subsequent issuance will be issued at a discount to their face value and, accordingly, may have "significant OID" and thus be classified as "applicable high yield discount obligations." If any such senior subordinated notes were so treated, a portion of the OID on such notes would be nondeductible by us and the remainder would be deductible only when paid. It is also possible that senior subordinated notes we issue in a subsequent issuance will be treated as equity for tax purposes. If any such senior subordinated notes were so treated, the interest payable on such senior subordinated notes would be non-deductible by us. Any limit on our ability to deduct interest for tax purposes would have the effect of increasing our taxable income and may adversely affect our cash flow available for interest payments and distributions to our shareholders. Subsequent issuances of senior subordinated notes may cause you to recognize taxable gain and/or original issue discount. The United States federal income tax consequences to you of a subsequent issuance of senior subordinated notes with OID (or any issuance of senior subordinated notes thereafter) are unclear and our counsel is unable to opine on this issue. The indenture governing the senior subordinated notes and our agreements with DTC will provide that, in the event that there is a subsequent issuance of senior subordinated notes with OID, and in connection with each issuance of senior subordinated notes thereafter, including an issuance of senior subordinated notes upon an exchange of shares of Class B common stock or Class C common stock, each holder of senior subordinated notes or IDSs, as the case may be, agrees that a portion of such holder's senior subordinated notes will be automatically exchanged for a portion of the senior subordinated notes acquired by the holders of such subsequently issued senior subordinated notes. Such subsequent issuance and exchange will not change the aggregate stated principal amount of senior subordinated notes owned by you and each other holder. Due to the lack of applicable authority, it is unclear whether an exchange of senior subordinated notes for subsequently issued senior subordinated notes will result in a taxable exchange for United States federal income tax purposes. It is possible that the IRS might successfully assert that such an exchange should be treated as a taxable exchange. In such case, you would recognize any gain realized on the exchange, but a loss might be disallowed. For a more complete description of the tax consequences of a subsequent issuance, see "Material United States Federal Income Tax Consequences Senior Subordinated Notes Additional Issuances." Regardless of whether the exchange is treated as a taxable event, such exchange may result in an increase in the amount of OID, if any, that you are required to accrue with respect to the senior subordinated notes. Following any subsequent issuance of senior subordinated notes with OID or any issuance of senior subordinated notes thereafter and resulting exchange, we and our agents will report any OID on any subsequently issued senior subordinated notes ratably among all holders of senior subordinated notes and IDSs. By purchasing senior subordinated notes or IDSs, as the case may be, each holder of senior subordinated notes and IDSs agrees to report OID in a manner consistent with this approach. As a result of a subsequent issuance, therefore, you may be required to report OID even though you purchased senior subordinated notes having no OID. This will generally result in you Gross Sales for the Most Recent Fiscal Year(2) reporting more interest income over the term of the senior subordinated notes than you would have reported had no such subsequent issuance and exchange occurred. The IRS, however, may assert that OID should be reported only to the persons that initially acquired such subsequently issued senior subordinated notes and their transferees. In such case, the IRS might further assert that, unless a holder can establish that it is not an initial holder of subsequently issued senior subordinated notes or a transferee thereof, all senior subordinated notes held by such holder will have OID. Any of these assertions by the IRS could create significant uncertainties in the pricing of IDSs and senior subordinated notes and could adversely affect the market for IDSs and senior subordinated notes. A subsequent issuance of senior subordinated notes or an allocation of IDS purchase price that results in OID may reduce the amount you can recover upon an acceleration of the payment of principal due on the senior subordinated notes or in the event of our bankruptcy. Under New York and federal bankruptcy law, holders of subsequently issued senior subordinated notes having original issue discount may not be able to collect the portion of the principal face amount of such senior subordinated notes that represents unamortized original issue discount as of the acceleration or filing date, as the case may be, in the event of an acceleration of the senior subordinated notes or in the event of our bankruptcy prior to the maturity date of the senior subordinated notes. As a result, a treatment of the senior subordinated notes as having been issued with OID or an automatic exchange that results in a holder receiving a senior subordinated note with original issue discount could have the effect of ultimately reducing the amount such holder can recover from us in the event of an acceleration or bankruptcy. Before this offering, there has not been a public market for our IDSs, shares of our Class A common stock or senior subordinated notes. The price of the IDSs, shares of our Class A common stock or senior subordinated notes may fluctuate substantially, which could negatively affect the value of your investment. None of the IDSs, the shares of our Class A common stock or the senior subordinated notes has a public market history. In addition, there has not been an established market in the United States for securities similar to the IDSs. We cannot assure you that an active trading market for the IDSs will develop in the future, and we currently do not expect that an active trading market for the shares of our Class A common stock will develop until the senior subordinated notes are redeemed or mature. If the senior subordinated notes represented by your IDSs are redeemed or mature, the IDSs will automatically separate and you will then hold the shares of our Class A common stock. We will not apply to list our shares of Class A common stock for separate trading on the or any other exchange until the number of shares held separately and not represented by IDSs is sufficient to satisfy the then applicable requirements for separate trading on such exchange. The Class A common stock may not be approved for listing at such time. We do not intend to list our senior subordinated notes on any securities exchange. The initial public offering price of the IDSs has been determined by negotiations among us, the existing equity investors and the representatives of the underwriters and may not be indicative of the market price of the IDSs after the offering. Factors such as quarterly variations in our financial results, announcements by us or others, developments affecting us, our clients and our suppliers, general interest rate levels and general market volatility could cause the market price of the IDSs to fluctuate significantly. (successor basis) (predecessor basis) Income tax provision at statutory rate $ 967 $ 1,386 $ 2,349 $ 319 State income taxes (net of federal income tax benefit) 81 71 139 31 Change in effective state tax rate 190 (505 ) Amortization of intangible assets 94 193 Valuation allowance 321 992 427 Other 6 (188 ) 39 Percentage of Gross Sales for the Most Recent Fiscal Year(2) If the IDSs separate, the limited liquidity of the market for the senior subordinated notes and Class A common stock may adversely affect your ability to sell the senior subordinated notes and Class A common stock. We do not intend to list the senior subordinated notes represented by the IDSs on any exchange or quotation system. We will not apply to list our shares of Class A common stock for separate trading on the or any other exchange or quotation system until the number of shares held separately is sufficient to satisfy applicable requirements for separate trading on such exchange or quotation system. The Class A common stock may not be approved for listing at such time. Upon separation of the IDSs, no sizable market for the senior subordinated notes and the Class A common stock may ever develop and the liquidity of any trading market for the notes or the Class A common stock that does develop may be limited. As a result, your ability to sell your notes or Class A common stock, and the market price you can obtain, could be adversely affected. The limited liquidity of the trading market for the senior subordinated notes sold separately (not represented by IDSs) may adversely affect the trading price of the separate senior subordinated notes. We are separately selling $ million aggregate principal amount of senior subordinated notes (not represented by IDSs), representing approximately 10% of the total outstanding senior subordinated notes (assuming the exchange of all outstanding Class B common stock and Class C common stock for IDSs). While the senior subordinated notes sold separately (not represented by IDSs) are part of the same series of notes as, and identical to, the senior subordinated notes represented by IDSs at the time of the issuance of the separate senior subordinated notes, the senior subordinated notes represented by the IDSs will not be separable for at least 45 days and will not be separately tradable until separated. As a result, the initial trading market for the senior subordinated notes sold separately (not represented by IDSs) will be very limited. Even after holders of the IDSs are permitted to separate their IDSs, a sufficient number of holders of IDSs may not separate their IDSs into shares of our Class A common stock and senior subordinated notes to create a sizable and more liquid trading market for the senior subordinated notes not represented by IDSs. Therefore, a liquid market for the senior subordinated notes may not develop, which may adversely affect the ability of the holders of the separate senior subordinate notes to sell any of their separate senior subordinated notes and the price at which these holders would be able to sell any of the senior subordinated notes sold separately. Future sales or the possibility of future sales of a substantial amount of IDSs, shares of our Class A common stock or our senior subordinated notes may depress the price of the IDSs and the shares of our Class A common stock and our senior subordinated notes. Future sales or the availability for sale of substantial amounts of IDSs or shares of our Class A common stock or a significant principal amount of our senior subordinated notes in the public market could adversely affect the prevailing market price of the IDSs and the shares of our Class A common stock and senior subordinated notes and could impair our ability to raise capital through future sales of our securities. We may issue shares of our common stock and senior subordinated notes, which may be in the form of IDSs, or other securities from time to time as consideration for future acquisitions and investments. In the event any such acquisition or investment is significant, the number of shares of our common stock and the aggregate principal amount of senior subordinated notes, which may be in the form of IDSs, or the number or aggregate principal amount, as the case may be, of other securities that we may issue may in turn be significant. In addition, we may also grant registration rights covering those IDSs, shares of our common stock, senior subordinated notes or other securities in connection with any such acquisitions and investments. (%) ($ thousands) (%) Over-the-Counter Drug: Clear eyes #2 Selling Redness Relief Brand 16.2 $ 44,974 15.0 Chloraseptic #1 Sore Throat Spray Brand 47.2 40,297 13.4 Compound W #1 Wart Removal Brand 38.0 29,163 9.7 New-Skin #1 Liquid Bandages Brand 40.4 (3) 11,307 3.8 Murine #1 Personal Ear Care Brand 17.1 5,767 1.9 Household Cleaning: Comet #1 Abrasive Tub and Tile Cleaner Brand 42.2 (3) 84,672 28.2 Spic and Span #5 Dilutable Cleanser Brand 3.6 24,978 8.3 Personal Care: Cutex #1 Nail Polish Remover Brand 27.2 15,782 5.3 Denorex #3 Medicated Shampoo Brand 12.1 14,669 4.9 Risks Relating to our Business and the Industry The high level of competition in our industry could adversely affect our business. The business of selling branded consumer products in the over-the-counter drug, household cleaning and personal care categories is highly competitive. These markets include numerous manufacturers, distributors, marketers and retailers that actively compete for consumers' business both in the United States and abroad. Some of these competitors are larger and have substantially greater resources than we do, and may therefore have the ability to spend more aggressively on advertising and marketing and to respond more flexibly to changing business and economic conditions than us. We compete on the basis of numerous factors, including brand recognition, product quality, performance, price and product availability at the retail stores. Advertising, promotion, merchandising and packaging, the timing of new product introductions and line extensions also have a significant impact on customer's buying decisions and, as a result, on our sales. The structure and quality of the sales force, as well as consumer consumption of our products, affects in-store position, wall display space and inventory levels in retail outlets. Our markets also are highly sensitive to the introduction of new products, which may rapidly capture a significant share of the market. An increase in the amount of competition that we face could have a material adverse effect on our operating results. In addition, competitors may attempt to gain market share by offering products at prices at or below those typically offered by us. Competitive pricing may require price reductions by us and may result in lost sales. There can be no assurance that future price or product changes by our competitors will not have a material adverse effect on us or that we will be able to react with price or product changes of our own to maintain our current market position. We are dependent on third parties for the manufacture of the products we sell. All of our products are manufactured by third parties. Without adequate supplies of merchandise to sell to our customers, sales would decrease materially and our business would suffer. In the event that manufacturers are unable or unwilling to ship products to us in a timely manner or continue to manufacture products for us, we would have to rely on other current manufacturing sources or identify and qualify new manufacturers. We might not be able to identify or qualify such manufacturers for existing or new products in a timely manner and such manufacturers might not allocate sufficient capacity to us in order to meet our requirements. In addition, identifying alternative vendors without adequate lead times can compromise required product validation and stability work, which may involve additional manufacturing expense, delay in production or product disadvantage in the marketplace. The consequences of not securing adequate and timely supplies of merchandise would negatively impact inventory levels, sales and gross margin rates, and ultimately our results of operations. In addition, even if our current manufacturers continue to manufacture our products, they may not maintain adequate controls with respect to product specifications and quality and may not continue to produce products that are consistent with our standards or applicable regulatory requirements. If we are forced to rely on products of inferior quality, then our brand recognition and customer satisfaction would likely suffer. These manufacturers may also increase the cost of the products we purchase from them. If our manufacturers increase our costs, our margins would be adversely affected if we cannot pass along these increased costs to our customers. Should we experience significant unanticipated demand, we will be required to expand our access to manufacturing, both from current and new manufacturing sources. If such additional manufacturing capacity is not available or is not available on terms as favorable as those obtained from current sources, then our revenues or margins, or both, will suffer. (1)Based on dollar volumes sold in the U.S. market as of April 18, 2004, except Clear eyes (July 27, 2003) and Murine (March 21, 2004). (2)December 31, 2003 for Prestige International and Spic and Span and March 31, 2004 for Medtech and Denorex. (3)Based on unit volume rather than dollar volume. We have grown our company by acquiring strong and well-recognized brands from larger consumer products and pharmaceutical companies. We believe that these brands were considered non-core under previous ownership and, in most cases, did not benefit from the focus of senior level management or strong brand support. Our management has taken advantage of this opportunity by providing each acquired brand with the marketing support and senior level attention necessary to enhance the brand's market position, expand its distribution and successfully launch line extensions and new products. Our core competencies are marketing, sales, customer service and product development. We outsource manufacturing, warehousing, distribution and logistics to experienced, low-cost third-party providers. This outsourcing model enables us to: continue to focus on building and maintaining significant brand equities; benefit from the economies of scale of our third-party providers; maintain a highly variable cost structure, minimal capital expenditures, low working capital and strong free cash flow; and Furthermore, we do not have long-term contracts with many of our manufacturers. The fact that we do not have long-term contracts with our manufacturers means that they could cease manufacturing these products for us at any time and for any reason. Finally, two of our products are produced and imported directly from China. If these products become difficult or impossible to bring into the United States due to tariffs, embargoes or other reasons and if we cannot obtain such merchandise from other sources at similar costs, then our sales and margins would decline. Moreover, in the event that commercial transportation is curtailed or substantially delayed, we may not be able to maintain adequate inventory levels of these products on a consistent basis, which would negatively impact our sales and potentially erode the confidence of our customer base, leading to further loss of sales and an adverse impact on our results of operations. Failure to maintain our relationships with our main product distributors or disruption in our main distribution centers could adversely affect our business. We manage our product distribution in the continental United States through a main distribution center in St. Louis, Missouri, and outsource the shipping and distribution of our products to customers to a single logistics company. We cannot assure you that this company will continue to ship and distribute our products on current pricing or terms. If there is any disruption in this company's ability to deliver our products, we may lose customers and our sales will be adversely affected. Further, should this company decide to terminate its contract with us, we may not be able to find an adequate replacement within a reasonable period of time and at a reasonable cost to us. To the extent that this company increases its prices, we are unable to find a replacement or are required to hire a replacement at additional cost, our financial performance could be materially adversely affected. In addition, a serious disruption, such as a flood or fire, to our main distribution centers could damage our inventory and could materially impair our ability to distribute our products to customers in a timely manner or at a reasonable cost. We could incur significantly higher costs and longer lead times associated with distributing our products to our customers during the time that it takes for us to reopen or replace a distribution center. As a result, any such disruption could have a material adverse effect on our business, results of operations and financial condition. Difficulty in integrating the Prestige International business may adversely affect our operations. In connection with the Prestige Acquisition completed on April 6, 2004, we acquired five additional brands. We are currently integrating the operations of this company and brands into our existing portfolio. The integration may proceed more slowly or be more difficult than we currently contemplate and, as a result, our financial position and results of operations may be adversely affected. Furthermore, we may encounter unanticipated difficulties with integrating Prestige International and its brands, including problems that may arise as we integrate our respective information technology systems, and the measures that we have taken to date or plan to take in the future may not adequately resolve these issues. Integration difficulties may adversely affect our future financial position and results of operations. We may not realize all of the anticipated operating synergies and cost savings from the Acquisitions, which may adversely affect our financial performance. We cannot assure you that we will realize all of the anticipated operating synergies and cost savings from the Acquisitions, which we discuss under "Summary Unaudited Pro Forma Financial Data," "Management's Discussion and Analysis of Financial Condition and Results of Operations" and elsewhere in this prospectus. These are forward-looking estimates and involve known and unknown risks, uncertainties and other factors that may cause the actual cost savings or cash generated to be materially different from our estimates or result in these savings not being realized in the time frame expected, or at all. In addition to the general factors discussed above, such estimates are based on a variety of other factors and were derived utilizing numerous important assumptions, including: maintaining the historical sales levels of Medtech, Prestige International, Denorex and Spic and Span; integrating information technology systems without undue cost, delay or interruption; eliminating certain components of corporate and fixed overhead without adversely affecting our ability to manage our operations; terminating certain leases for real property in order to eliminate direct and indirect costs associated with maintaining redundant facilities; and achieving the expected cost savings set forth elsewhere in this prospectus. Furthermore, there can be no assurance that, as a combined company, we will continue to maintain all of the manufacturer and customer relationships that the acquired companies enjoyed as separate companies. As a combined company, we may encounter difficulties managing relationships with our manufacturers due to our increased size and scope and to the increased number of relationships we will have with manufacturers. We depend on a limited number of customers for a large portion of our gross sales and the loss of one or more of these customers could reduce our gross sales. Our core customer relationships include Wal-Mart, Walgreens, Target, CVS and Albertson's. For the year ended March 31, 2004, our top five and ten customers accounted for approximately 42.1% and 57.1% of our gross sales, respectively, and Wal-Mart itself accounted for approximately 23.0% of our gross sales. We expect that for the year ended March 31, 2005 and future periods our top five and ten customers, including Wal-Mart, will, in the aggregate, continue to account for a large portion of our gross sales. The loss of one or more of our top customers that account for a significant portion of our gross sales, any significant decrease in sales to these customers, or any significant decrease in our retail display space in any of these customers' stores, could reduce our gross sales and therefore could have a material adverse effect on our business, financial condition and results of operations. In addition, our business is based primarily upon individual sales orders, and we typically do not enter into long-term contracts with our customers. Accordingly, our customers could cease buying our products from us at any time and for any reason. The fact that we do not have long-term contracts with our customers means that we have no recourse in the event a customer no longer wants to purchase products from us. If a significant number of our customers elect not to purchase products from us, our business, prospects, financial condition and results of operations could be adversely affected. Regulatory matters governing our industry could have a significant negative effect on our business. In both our U.S. and foreign markets, we are affected by extensive laws, governmental regulations, administrative determinations, court decisions and similar constraints. Such laws, regulations and other constraints may exist at the federal, state or local levels in the United States and at all levels of government in foreign jurisdictions. The formulation, manufacturing, packaging, labeling, distribution, importation, sale and storage of our products are subject to extensive regulation by various federal agencies, including the Food and Drug Administration ("FDA"), the Federal Trade Commission (the "FTC"), the Consumer Product Safety Commission, the Environmental Protection Agency (the "EPA") and by various agencies of the states, localities and foreign countries in which our products are manufactured, distributed and sold. Failure by us or our manufacturers to comply with those regulations could lead to the imposition of significant penalties or claims and could materially adversely affect our business. In addition, the adoption of new regulations or changes in the interpretations of existing regulations may result in significant compliance costs or discontinuation of product sales and may adversely affect the marketing of our products, resulting in significant loss of sales revenues. All of our over-the-counter drug products are regulated pursuant to the FDA's monograph system. The monographs, both tentative and final, set out the active ingredients and labeling indications that are permitted for certain broad categories of over-the-counter drug products. Where the FDA has finalized a particular monograph, it has concluded that a properly labeled product formulation is generally recognized as safe and effective and not misbranded. A tentative final monograph indicates that the FDA has not made a final determination about products in a category to establish safety and efficacy for a product and its uses. However, unless there is a serious safety or efficacy issue, the FDA will typically exercise enforcement discretion and permit companies to sell products conforming to a tentative final monograph until the final monograph is published. Products that comply with either final or tentative final monograph standards do not require pre-market approval from the FDA. In accordance with the Federal Food, Drug and Cosmetic Act, or "FDC Act," and FDA regulations, the manufacturing processes of our third party manufacturers must also comply with the FDA's current Good Manufacturing Practice, or "cGMPs." The FDA inspects our facilities and those of our third party manufacturers periodically to determine if we and our third party manufacturers are complying with cGMPs. A history of past compliance is not a guarantee that future cGMPs will not mandate other compliance steps and associated expense. If we or our third party manufacturers fail to comply with federal, state or foreign regulations, we could be required to: suspend manufacturing operations; change product formulations; suspend the sale of products with non-complying specifications; initiate product recalls; or change product labeling, packaging or advertising or take other corrective action. Any of these actions could materially and adversely affect our financial results. In addition, our failure to comply with FTC or state regulations, or with regulations in foreign markets that cover our product claims and advertising, including direct claims and advertising by us, may result in enforcement actions and imposition of penalties or otherwise materially and adversely affect the distribution and sale of our products. Furthermore, we also are subject to a variety of other regulations in various foreign markets, including regulations pertaining to import/export regulations and antitrust issues. Our failure to comply, or assertions that we fail to comply, with these regulations could have a material adverse effect on our business in a particular market or in general. To the extent we decide to commence or expand operations in additional countries, government regulations in those countries may prevent or delay entry into or expansion of operations in those markets. In addition, our ability to sustain satisfactory levels of sales in our markets is dependent in significant part on our ability to introduce additional products into the markets. However, government regulations in both our domestic and international markets can delay or prevent the introduction, or require the reformulation or withdrawal, of some of our products. Product liability claims could hurt our business. We may be required to pay for losses or injuries purportedly caused by our products. We have been and may again be subjected to various product liability claims. Claims could be based on allegations that, among other things, our products contain contaminants, include inadequate instructions regarding their use or inadequate warnings concerning side effects and interactions with other substances. For example, Denorex products contain coal tar which the State of California has determined causes cancer and our packaging contains a warning to this effect. In addition, any product liability claims may result in negative publicity that may adversely affect our net sales. Also, if one of our products is found to be defective we may be required to recall it, which may result in substantial expense and adverse publicity and adversely affect our net sales. Although we maintain, and require our material suppliers and manufacturers to maintain, product liability insurance coverage, potential product liability claims may exceed the amount of insurance coverage or potential product liability claims may be excluded under the terms of the policy, which could hurt our financial condition. In addition, we may also become required to pay higher premiums and accept higher deductibles in order to secure adequate insurance coverage in the future. If we are unable to protect our intellectual property rights our ability to compete could be negatively impacted. The market for our products depends to a significant extent upon the goodwill associated with our trademark and trade names. We own the material trademark and trade name rights used in connection with the packaging, marketing and sale of our products. Therefore, trademark and trade name protection is critical to our business. Although most of our trademarks are registered in the United States and in certain foreign countries, we may not be successful in asserting trademark or trade name protection. We could also incur substantial costs to defend legal actions relating to the use of our intellectual property, which could have a material adverse effect on our business, results of operations or financial condition. Other parties may infringe on our intellectual property rights and may thereby dilute our brands in the marketplace. Any such infringement of our intellectual property rights would also likely result in a commitment of our time and resources to protect these rights through litigation or otherwise. In addition, we cannot assure you that third parties will not assert claims against any such intellectual property or that we will be able to successfully resolve all such claims. We are dependent on third parties for intellectual property relating to some of the products we sell. We have licenses or manufacturing agreements with third parties that own intellectual property (e.g., formulae, copyrights, trade dress, patents and other technology) used in the manufacture and sale of some of our products. In the event that any such license or manufacturing agreement is terminated, we may lose the right to use or have reduced rights to use the intellectual property covered by such agreement and may have either to develop or to obtain rights to use other intellectual property. In such event, we might not be able to develop or obtain replacement intellectual property in a timely manner and the products modified as a result of this development may not be well-received by customers. The consequences of losing the right to use or having reduced rights to such intellectual property could negatively impact the results of operations through the cost of developing or obtaining different intellectual property and possible reduction in sales of the affected products. We depend on our key personnel and the loss of the services provided by any of our executive officers or other key employees could harm our business and results of operations. Our success depends to a significant degree upon the continued contributions of our senior management, many of whom would be difficult to replace. These employees may voluntarily terminate OPERATING EXPENSES: General and administrative 4,776 4,286 3,646 Advertising and promotion 4,506 3,810 2,286 Depreciation 109 63 26 Amortization of goodwill Net income $ 1,778 Add back: goodwill amortization their employment with us at any time. We may not be able to successfully retain existing personnel or identify, hire and integrate new personnel. While we believe we have developed depth and experience among our key personnel, there can be no assurance that our business would not be adversely affected if one or more of these key individuals left. We do not maintain any key-man or similar insurance policies covering any of our senior management or key personnel. In connection with the Medtech Acquisition, Peter C. Mann and Peter J. Anderson became our president and chief executive officer, and chief financial officer, respectively. Although each of these individuals has significant experience in the business of marketing and distributing consumer products, there can be no assurance that this management transition will not adversely affect our business, financial condition and operating results. Our amended and restated certificate of incorporation and bylaws and several other factors could limit another party's ability to acquire us and deprive our investors of the opportunity to obtain a takeover premium for their securities. A number of provisions in our amended and restated certificate of incorporation and bylaws make it difficult for another company to acquire us and for you to receive any related takeover premium for your securities. For example, our amended and restated certificate of incorporation provides that stockholders generally may not act by written consent or call a special meeting of stockholders. Our amended and restated certificate of incorporation will authorize the issuance of preferred stock without stockholder approval and upon such terms as the board of directors may determine. The rights of the holders of shares of our common stock will be subject to, and may be adversely affected by, the rights of holders of any class or series of preferred stock that may be issued in the future.
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+RISK FACTORS This offering involves a high degree of risk. You should carefully consider the risks described below, in conjunction with other information and our consolidated financial statements and related notes included elsewhere in this prospectus, before making an investment decision. You should pay particular attention to the fact that we conduct our operations in China and are governed by a legal and regulatory environment that in some respects differs significantly from the environment that may prevail in other countries that you may be familiar with. Our business, financial condition or results of operations could be affected materially and adversely by any or all of these risks. The trading price of our ADSs could decline due to any or all of these risks, and you may lose all or part of your investment. Risks Related to Our Business Because we face significant competition, including intense competition in several of our markets, we may lose market share and our results of operations may be materially and adversely affected. We face significant competition in our Career Post Weekly and www.51job.com businesses as well as in our executive search and other human resource businesses. Career Post Weekly currently faces intense competition in many of our largest markets. Competitors of Career Post Weekly primarily consist of local newspaper publishers and specialized recruitment advertising publications. In addition, Career Post Weekly faces competition from online job-search websites and other online businesses seeking to expand into print recruitment advertising. Our online recruitment services face competition from other dedicated job search websites such as ChinaHR.com, Cjol.com and Zhaopin.com, as well as increasing levels of competition from national Internet portals in China such as NetEase.com, sina.com, sohu.com and tom.com which provide online recruitment services. In addition, many executive search firms and other competitors currently engaged in print advertising have started to internally develop or acquire online capabilities. Our executive search and other human resource related businesses face significant competition from a variety of Chinese and foreign firms in all of our markets, including certain firms that compete with us in the market for online recruitment advertising. Many of our competitors or potential competitors have long operating histories, may have greater financial, management, technological development, sales, marketing and other resources than we do, and may be able to adopt our business model. As a result of competition, we may experience reduced margins, loss of market share or less use of our services by job seekers and businesses. We cannot assure you that existing or future competitors will not develop or offer services and products which provide significant performance, price, creative or other advantages over our services. If we are unable to compete effectively with current or future competitors as a result of these or other factors, our market share and our results of operations may be materially and adversely affected. New competitors face low entry barriers to our industries, and successful entry by new competitors may cause us to lose market share and materially and adversely affect our results of operations. In the future, we may face competition from new entrants in the recruitment advertising industry and other human resource industries in which we operate. We may face greater competition from Internet portals, newspapers, dedicated recruitment advertising websites and publications, and other human resource service providers who may enter the market for any or all of our services. Our businesses are characterized by relatively low start-up and fixed costs, modest capital requirements, short start-up lead times and an absence of significant proprietary technology that would prevent or significantly inhibit the entry of competitors. As a result, potential market entrants, both in China and from abroad, face relatively low barriers to entry to all of our businesses and in all of our markets. In addition, we believe that there are relatively low existing penetration rates in our markets, and that competitors could acquire significant numbers of clients and establish significant market share within a relatively short period. Furthermore, the newspaper and print media industry in China is highly regulated at present which may have the effect of limiting competition and keeping Table of Contents prices, including print advertising prices, at higher levels. Any deregulation of this industry may result in increased competition and a material decrease in advertising rates, including prices we charge for our print advertising services. Increased competition could result in loss of market share and revenues, and have a material adverse effect on our business, financial condition and results of operations. If we are unable to achieve or maintain economies of scale with respect to our recruitment advertising businesses, our results of operations from these businesses may be materially and adversely affected. We incur fixed costs such as printing, distribution, direct marketing, advertising, management, staff, office, infrastructure and utilities in each of our geographic markets in connection with operating our print advertising business. In addition, we incur fixed costs relating to website maintenance, design and operation in our online businesses. Our ability to realize our desired margins in our recruitment advertising businesses depends largely on our success in posting a high volume of print and online recruitment advertisements to generate sufficient revenues to offset associated fixed costs. Further, we need to reach and maintain a critical mass of recruitment advertisements in order for Career Post Weekly and www.51job.com to build and maintain acceptance among employers and job seekers as attractive vehicles for posting and seeking jobs. In some of our markets, Career Post Weekly has not achieved the necessary economies of scale and these operations have not achieved profitability despite our having operated in these markets for a significant period of time. We believe that this is due primarily to significant competition from rival print advertising publications. We may be unable to achieve and maintain sufficient economies of scale in any or all of our geographic markets in connection with our recruitment advertising businesses. Any failure to do so could materially and adversely affect our results of operations from these businesses. A slowdown or other adverse developments in the PRC economy may materially and adversely affect our customers, demand for our services and our business. Substantially all of our operations are conducted in China and substantially all of our revenues are generated from providing recruitment advertising and search services for PRC businesses or divisions of firms operating in China. Although the PRC economy has grown significantly in recent years, we cannot assure you that such growth will continue. Print advertising, online recruitment services, executive search and our other human resource related businesses are all relatively new industries in China, and we do not know how sensitive we are to a slowdown in economic growth or other adverse changes in the PRC economy. In response to adverse economic developments, employers might hire fewer permanent employees, engage in hiring freezes, lay off employees, or reduce spending on print advertising, online recruitment services and executive search services. Employers may decide to rely more heavily on traditional recruitment methods such as referrals and job fairs, and utilize more in-house resources to conduct training and perform other human resource functions, or otherwise modify their behavior in ways that may have a significant negative impact on our business. As a result, a slowdown in overall economic growth, an economic downturn or recession or other adverse economic developments in China may materially reduce the demand for our services and materially and adversely affect our business. If the use of advertising to conduct recruitment does not achieve broader acceptance in China, we may be unable to expand our recruitment advertising businesses. The use of advertising services to recruit employees is relatively new in China. Due to significant control and regulation by the national and local governments, the private sector recruiting process in China continues to be largely characterized by the use of personal referrals and large job fairs. We believe that the use of advertising by employers and job seekers remains relatively low. As a result, we face considerable challenges in promoting greater use of advertising, which involves, among other things, significant changes in the way that employers disseminate information about jobs, the way that prospective employees search and apply for jobs, and the way in which hiring decisions are made. We cannot assure you that recruitment advertising will achieve broader acceptance in China. Any significant failure of advertising to gain acceptance among employers and job seekers may substantially limit our ability to expand our recruitment advertising businesses. (1) Estimated solely for the purpose of computing the amount of the registration fee in accordance with Rule 457(a) and Rule 457(c) under the Securities Act of 1933, as amended. (2) Includes common shares that may be purchased by the underwriters pursuant to over-allotment options. Also includes common shares initially offered and sold outside the United States that may be resold from time to time in the United States either as part of the distribution or within 40 days after the later of the effective date of this registration statement and the date the securities are first bona fide offered to the public. These common shares are not being registered for the purpose of sales outside the United States. (3) American depositary shares issuable upon deposit of the common shares registered hereby will be registered under a separate registration statement on Form F-6 filed with the Commission. Each American depositary share represents two common shares. (4) Previously paid. Table of Contents If the Internet, and online advertising in particular, does not achieve broad acceptance in China as a medium for recruitment, our online recruitment services business may be adversely affected. We generate a significant portion of our revenues from online recruitment services, which are targeted toward employers and job seekers who use the Internet. As part of our online recruitment services, we offer general online advertising on our website, which is an important element in our ability to sell online recruitment advertisements to employers and which generates a material portion of our revenues. China has only recently begun to develop the Internet as a commercial medium and has a relatively low Internet penetration rate compared to most developed countries. Our future results of operations from online recruitment services will depend substantially upon an increase in Internet penetration and an increase in acceptance and use of the Internet for the distribution of services and for the facilitation of commerce in China. In addition, unless they are resolved, telecommunication capacity constraints may impede further development of the Internet to the extent that users experience delays, transmission errors and other difficulties. Any negative perceptions as to the effectiveness of online recruitment services, or online advertising generally, or any significant failure of the Internet to gain acceptance as a medium for recruitment may adversely affect our online recruitment services business and our ability to further integrate our online and print recruitment advertising businesses. The markets for executive search services and business process outsourcing are still in the development stage in China and we may be unable to expand these businesses. Many employers in China are not familiar with the executive search model or may not accept the value of a targeted, professional search. Many employers may be unwilling to pay a commission of up to 35% of a candidate s annual compensation. Similarly, the market for the third party outsourcing of business processes is also still developing in China. Companies may not be willing to use third parties for significant administrative functions and may instead choose to continue to perform such operations in-house. If these services do not gain wider acceptance in China, we may be unable to expand these businesses. We are dependent on local newspaper contractors in each of our geographic markets to publish and distribute Career Post Weekly. In the PRC, entities engaged in publishing activities are required by the government to have a publishing license. We do not have any publishing licenses and we are, and will continue to be, dependent on contractual arrangements with local newspapers in each of our geographic markets in order to publish and distribute Career Post Weekly. Our arrangements with our local newspaper contractors require them to print, publish and distribute Career Post Weekly as an insert in their newspaper, and in some cases to contribute marketing support. The successful execution of our business plan is highly dependent on establishing and maintaining relationships with newspapers in all of the new markets in which we intend to offer recruitment advertising services. The term of our agreements with local newspaper contractors is generally two years, and six of these agreements will expire in the next six months. In addition, certain of these agreements are subject to early termination by either party on various grounds. We cannot assure you that our local newspaper contractors will conduct their activities in full compliance with applicable laws and regulations governing the publishing, distribution and sale of newspapers. In addition, we cannot assure you that: our local newspaper contractors will fulfill their obligations under our agreements; the agreements will be renewed; our current contractors will not, upon termination of our agreements, seek to compete directly against us or establish relationships with one or more of our competitors; or in the event that we wish to do so or it is necessary to do so, we will be able to locate and enter into an agreement with a suitable alternative local newspaper on a timely basis or at all. Deemed dividends to holders of Series A Preference Shares 13 (1,233,659 ) Amount allocated to participating preference shareholders The Registrant hereby amends this Registration Statement on such date or dates as may be necessary to delay its effective date until the Registrant shall file a further amendment which specifically states that this Registration Statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933 or until the Registration Statement shall become effective on such date as the Securities and Exchange Commission, acting pursuant to said Section 8(a), may determine. Table of Contents In addition, we may experience lower levels of readership and circulation if we lose the marketing support of a local newspaper contractor. Any adverse developments involving our local newspaper contractors could significantly disrupt or impair the publication, promotion and distribution of Career Post Weekly, which in turn could damage our Career Post Weekly brand name and materially and adversely affect our recruitment advertising business and our results of operations. We are dependent on our Internet service provider, and we are vulnerable to failures of the Internet, fixed line telecommunications networks in China and our technology platform. Our online businesses are heavily dependent on the performance and reliability of China s Internet infrastructure, the continual accessibility of bandwidth and servers to our service providers networks, and the continuing performance, reliability and availability of our technology platform. We rely on affiliates of China Telecommunications Corporation, or China Telecom, to provide us with bandwidth and server custody service for our services. We are unlikely to have any access to alternative networks or services in the event of disruptions, failures or other problems with China s Internet infrastructure or China Telecom s fixed telecommunications networks, or if China Telecom or its affiliates otherwise fail to provide such services. In addition, we have no control over the costs of the services provided by China Telecom or its affiliates. If China Telecom or its affiliates fail to provide these services, we would be required to seek other providers, and there is no assurance that we will be able to find alternative providers willing or able to provide high quality services and there is no assurance that such providers will not charge us higher prices for their services. If the prices that we are required to pay for Internet services rise significantly, our results of operations could be adversely affected. If we are unable to protect or promote our brand names and reputation, our business may be materially and adversely affected. If we fail to generate a high volume of recruitment advertisements, maintain our relationships with local newspaper contractors, successfully promote and develop the perception of www.51job.com as a destination site, undertake effective marketing and promotional activities, and generally provide high quality services, we may not be successful in protecting or promoting our brand names and reputation in a cost-effective manner or at all. We may dedicate significantly greater resources in the future to advertising, marketing and other promotional efforts aimed at building awareness of our brands. Any significant damage to our reputation, the perceived quality or awareness of our brand names or services, or any significant failure on our part to promote and protect our brand names and reputation could make it more difficult for us to successfully attract job seekers, compete for customers or retain qualified personnel, which may have a material adverse effect on our business. If we are unable to prevent others from using our intellectual property, our business may be materially and adversely affected. Our intellectual property has been, and will continue to be, subject to various forms of theft and misappropriation. Competitors copy and distribute content from our www.51job.com website, from Career Post Weekly and from the training materials that we use, and utilize misleadingly similar Internet domain names and URLs in an effort to divert Internet traffic away from our website. We are also susceptible to others copying our business model and methods. The legal protection of trademarks, trade names, copyrighted material, domain names, trade secrets, know-how and other forms of intellectual property in the PRC is significantly more limited than in the United States and many other countries and may afford us little or no effective protection. Preventing unauthorized use of our intellectual property is difficult, time consuming and expensive, and may divert significant management and staff resources from our business operations, and yield limited and uncertain results. Misappropriation of our content, trademarks and other intellectual property could divert significant business to our competitors, damage our brand name and reputation, and require us to initiate litigation that could be expensive and require us to divert management resources from the operation of our businesses. Table of Contents We rely heavily on our senior management team and key personnel, and the loss of any of their services could severely disrupt our business. Our future success is highly dependent on the ongoing efforts of the members of our senior management and key personnel, in particular on Rick Yan, our chief executive officer. We rely heavily on his management skills, his expertise in consumer products, marketing and technology, and his relationships with many of our clients and local contractors. We do not maintain key man life insurance on any of our senior management or key personnel, other than Mr. Yan and Kathleen Chien, our chief financial officer. The loss of the services of one or more of our senior executives or key personnel, Mr. Yan in particular, may have a material adverse effect on our business, financial condition and results of operations. Competition for senior management and key personnel is intense, and the pool of suitable candidates is very limited, and we may not be able to retain the services of our senior executives or key personnel, or attract and retain senior executives or key personnel in the future. In addition, if Mr. Yan, any other members of our senior management or any of our other key personnel joins a competitor or forms a competing company, we may not be able to replace them easily and we may lose customers, business partners, key professionals and staff members. Each of our senior executives and key personnel has entered into an employment agreement with us, which contains confidentiality and non-competition provisions. In the event of a dispute between any of our senior executives or key personnel and us, we cannot assure you as to the extent, if any, that these provisions may be enforceable in the PRC due to uncertainties involving the PRC legal system. Our business may suffer if we do not successfully manage our current and potential future growth. We have experienced rapid expansion since we commenced operations in 1998 and we intend to continue to expand in size and increase the number of services we provide. We have established 12 new offices from the beginning of 2002 to June 30, 2004. Our anticipated future growth will place significant demands on our management and operations. Our success in managing this growth will depend to a significant degree on the ability of our executive officers and other members of senior management to operate effectively both independently and as a group, and on our ability to improve and develop our financial and management information systems, controls and procedures. In addition, we will have to successfully adapt our existing systems and introduce new systems, expand, train and manage our workforce, and improve and expand our sales and marketing capabilities. Mismanagement of any of our services in our new or existing markets or the deterioration of the quality of our services could significantly damage our brand name and reputation, adversely affecting our ability to expand our client base. As a one-stop human resource provider, we will be required to provide high quality executive search and other human resource related services. As we are currently in the process of developing many of these businesses, we may encounter initial difficulties in ensuring the high quality of our services. In particular, we may be unable to provide our eSearch clients with acceptable candidates, we may provide clients with candidates whom they subsequently perceive as poor performers, and/or we may provide clients with candidates whom they subsequently fail to retain. With respect to our business process outsourcing service, we may be unable to establish a substantial nationwide capability, accurately monitor ongoing changes in PRC laws and regulations, acquire, develop and use up-to-date business and management technology and software, including sophisticated computer and technology systems that could require significant capital expenditures, and maintain the integrity and security of our systems. If we are unable to provide high quality services, if material mistakes occur, or if we are unable to price these services properly, our brand name and reputation could be damaged and we could incur legal liability to our clients and their employees. The management of our business involves the collection by our employees and agents of cash payments from our customers, which constitute a significant portion of our total revenues. As a result, we are exposed to theft, embezzlement and other criminal and fraudulent activity by our employees, our agents and third parties. If we are unable to successfully detect and prevent such activity, our results of operations and financial condition may be materially and adversely affected. Table of Contents Our limited operating history may not serve as an adequate basis to judge our future prospects and results of operations. We began operations in 1998. Our limited operating history may not provide a meaningful basis on which to evaluate our business. Although our revenues have grown rapidly since inception, we incurred net losses prior to 2002. We cannot assure you that we will maintain our profitability or that we will not incur net losses in the future. We expect that our operating expenses will increase as we expand. Any significant failure to realize anticipated revenue growth could result in significant operating losses. We will continue to encounter risks and difficulties frequently experienced by companies at a similar stage of development, including our potential failure to: implement our business model and strategy and adapt and modify them as needed; increase awareness of our brands, protect our reputation and develop customer loyalty; manage our expanding operations and service offerings, including the integration of any future acquisitions; maintain adequate control of our expenses; adequately and efficiently operate, maintain, upgrade and develop our website and the other systems and equipment we utilize in providing our services; attract, retain and motivate qualified personnel; maintain our current, and develop new, partnerships with local newspapers and other important operational relationships; and anticipate and adapt to changing conditions in the print, online and other markets in which we operate as well as the impact of any changes in government regulation, mergers and acquisitions involving our competitors, technological developments and other significant competitive and market dynamics. If we are not successful in addressing any or all of these risks, our business may be materially and adversely affected. We rely on our print advertising business to provide a significant majority of our revenues and any adverse development in this business could materially and adversely affect our overall results of operations. We generate a significant majority of our revenues from Career Post Weekly, which generated approximately 70.7% of our revenues in 2002 and 62.3% of our revenues in 2003. While we have experienced significant growth in our Career Post Weekly business in recent years, online advertisement may cause print media such as Career Post Weekly to become less desirable as a form of advertising. To the extent this occurs and if we are not able to generate sufficient revenues from our online recruitment services to offset any loss of revenues from our print advertisement business, our overall results of operations could be materially and adversely affected. We may not be able to successfully execute future acquisitions or efficiently manage any acquired business. We may decide to expand, in part, by acquiring certain complementary businesses. The success of any material acquisition will depend upon several factors, including: our ability to identify and acquire businesses on a cost-effective basis; our ability to integrate acquired personnel, operations, products and technologies into our organization effectively; and our ability to retain and motivate key personnel and to retain the clients of acquired firms. Table of Contents Any such acquisition may require a significant commitment of management time, capital investment and other management resources. There is a possibility that we will not be successful in identifying and negotiating acquisitions on terms favorable to us. In addition, we cannot be certain that any acquisition, if completed, will be successfully integrated into our existing operations. If we are unable to effectively integrate an acquired business, our business, financial condition and results of operations may be materially and adversely affected. In addition, if we use our equity securities as consideration for acquisitions, we may dilute the value of your common shares or ADSs. We have not engaged in any material acquisitions. In addition, we presently have no specific plans to make any acquisition and we are not currently engaged in any discussions or negotiations with respect to any such transaction. If we are unable to attract and retain qualified personnel, our executive search, training and business process outsourcing businesses may be materially and adversely affected. The success of our executive search, training and business process outsourcing services depends heavily on our ability to attract and retain skilled personnel. Successful expansion of our executive search business depends on a dedicated team of consultants with expertise and relationships in the geographic markets and industries in which our clients seek candidates. Likewise, the success of our training business depends on personnel with the necessary skills to conduct and support our training seminars and our other activities and services in this business. Our business of outsourcing traditional human resource department functions such as payroll, benefits and compliance management and related services depends on personnel with expertise in local and national PRC government employment regulations, payroll management and other human resource department functions. If we are unable to attract and retain critical skilled personnel, our executive search, training and business process outsourcing businesses may be materially and adversely affected. We may be subject to liability for placing advertisements with content that is deemed inappropriate. PRC laws and regulations prohibit advertising companies from producing, distributing or publishing any advertisement that contains any content that violates laws and regulations, impairs the national dignity of the PRC, involves designs of the national flag, national emblem or national anthem or the music of the national anthem of the PRC, is reactionary, obscene, superstitious or absurd, is fraudulent, or disparages similar products. If we are deemed to be in violation of such regulations, we may be subject to penalties including confiscation of the illegal revenues, levying of fines and suspension or revocation of our business license or advertising license, any of which may materially and adversely affect our business. We are subject to potential legal liability from both employers and job seekers with respect to our executive search businesses and other human resource related services. We are exposed to potential claims associated with the recruitment process, including claims by clients seeking to hold us liable for recommending a candidate who subsequently proves to be unsuitable for the position filled, claims by current or previous employers of our candidates alleging interference with employment contracts, claims by candidates against us alleging our failure to maintain the confidentiality of their employment search or alleging discrimination or other violations of employment law or other laws or regulations by our clients, and claims by either employers or candidates alleging the failure of our business process outsourcing services to comply with laws or regulations relating to employment, employee s insurance or benefits, individual income taxes or other matters. Any such claims, regardless of merit, may force us to participate in time-consuming, costly litigation or investigation, divert significant management and staff attention, and damage our reputation and brand names. We do not maintain insurance coverage for liabilities arising from claims by employers, candidates or third parties. We may be exposed to infringement or misappropriation claims by third parties, which, if successful, could cause us to pay significant damage awards. Third parties may bring claims against us alleging infringement of patents, trademarks or copyrights, or misappropriation of their creative ideas or formats, or other infringement of their proprietary intellectual property rights. Any such claims, regardless of merit, may involve us in time-consuming, costly litigation or 51job, Inc. is offering 5,250,000 American depositary shares, or ADSs. Each ADS represents two common shares. This is our initial public offering and no public market exists for our ADSs or our common shares. We anticipate that the initial public offering price will be between US$11 and US$13 per ADS. Table of Contents investigation, divert significant management and staff resources, require us to enter into expensive royalty or licensing arrangements, prevent us from using important technologies, business methods, content or other intellectual property, result in monetary liability, or otherwise disrupt our operations. We expect that the likelihood of such claims may increase, particularly in our online businesses, as the number of competitors in our markets grows and as related patents and trademarks are registered or copyrights are obtained by such competitors. We rely heavily on our information systems, and if our access to technology supporting our information systems is impaired or interrupted, or if we fail to further develop our technology, our operations may be seriously disrupted. Our success depends in large part upon our ability to store, retrieve, process and manage substantial amounts of information, including our client and candidate databases. To achieve our strategic objectives and to remain competitive, we must continue to develop and enhance our information systems. This may require the acquisition of equipment and software and the development, either internally or through independent consultants, of new proprietary software. Our inability to design, develop, implement and utilize, in a cost-effective manner, information systems that provide the capabilities necessary for us to compete effectively, or any interruption or loss of our information processing capabilities, for any reason, could materially disrupt our operations. If we are not able to respond successfully to technological or industry developments, our business may be materially and adversely affected. The market for online products and services is characterized by rapid technological developments, frequent launches of new product and services, the introduction of new business models, changes in customer needs and behavior, and evolving industry standards. These developments may make our existing online recruitment services obsolete or less competitive. In order to respond to such developments, we may be required to undertake substantial efforts and incur significant costs. In the event that we do not successfully respond to such developments in a timely and cost-effective manner, our business may be materially and adversely affected. Computer viruses and hacking may cause delays or interruptions on our systems and may reduce use of our services and damage our reputation and brand names. Computer viruses and hacking may cause delays or other service interruptions on our systems. Hacking involves efforts to gain unauthorized access to information or systems or to cause intentional malfunctions, loss or corruption of data, software, hardware or other computer equipment. In addition, the inadvertent transmission of computer viruses could expose us to a material risk of loss or litigation and possible liability. Hacking and computer viruses could result in significant damage to our hardware and software systems and databases, disruptions to our business activities, including to our e-mail and other communications systems, breaches of security and the inadvertent disclosure of confidential or sensitive information, interruptions in access to our website through the use of denial of service or similar attacks, and other material adverse effects on our operations. We may incur significant costs to protect our systems and equipment against the threat of, and to repair any damage caused by, computer viruses and hacking. Moreover, if a computer virus or hacking affects our systems and is highly publicized, our reputation and brand names could be materially damaged and usage of our services may decrease. Our business could be adversely affected if our software contains bugs. Our online systems, including the www.51job.com website, and our other software applications, products and systems could contain undetected errors or bugs that could adversely affect their performance. Additionally, we regularly update and enhance our website and our other online systems and introduce new versions of our software products and applications. The occurrence of errors in any of these may cause us to lose market share, injure our reputation and brand names, and materially and adversely affect our business. We have applied to have the ADSs listed on the Nasdaq National Market under the symbol JOBS. Selected Operating Data: Estimated number of print advertising pages(4) 2,469 3,176 4,635 4,256 Estimated unique employers using online recruitment services(4) 7,584 16,497 25,880 26,591 Number of cities where Career Post Weekly was published(5) 8 13 16 Table of Contents We are controlled by a small number of our existing shareholders and our board of directors has the power to discourage a change of control. Immediately following this offering, our five largest shareholders will beneficially own approximately 76.0% of our outstanding common shares on a fully diluted basis, or approximately 73.9% if the underwriters exercise their over-allotment option in full. These shareholders are: Rick Yan, our chief executive officer and a director, who will beneficially own approximately 30.6% of our outstanding common shares on a fully diluted basis immediately following the offering; entities affiliated with Doll Capital Management, or DCM, which will own approximately 24.7%, and which is affiliated with David K. Chao, one of our directors; Michael Lei Feng, one of our executive officers, who will own approximately 10.5%; Norman Lui, one of our executive officers, who will own approximately 6.5%; and Kathleen Chien, one of our executive officers, who will own approximately 3.7%. While these shareholders have advised us that they do not consider themselves to be a group as defined under the U.S. Securities Exchange Act of 1934, as amended, or the Exchange Act, individually these shareholders could have significant influence in determining the outcome of any corporate transaction or other matter submitted to the shareholders for approval, including mergers, consolidations and the sale of all or substantially all of our assets, election of directors and other significant corporate actions. In cases where their interests are aligned and they vote together, these shareholders will also have the power to prevent or cause a change in control. Without the consent of some or all of these shareholders, we may be prevented from entering into transactions that could be beneficial to us. In addition, these persons could violate their non-competition or employment agreements with us or otherwise violate their fiduciary duties by diverting business opportunities from us to themselves or others. The interests of our largest shareholders may differ from the interests of our other shareholders. In addition, our board of directors will have the authority, without further action by our shareholders, to issue common and preferred shares of up to 20% by par value of all issued shares and to fix the powers and rights of these shares, including dividend rights, conversion rights, voting rights, terms of redemption and liquidation preferences, any or all of which may be greater than the rights associated with our common shares. These provisions could have the effect of depriving you of an opportunity to sell your ADSs at a premium over prevailing market prices by discouraging third parties from seeking to obtain control of us in a tender offer or similar transaction. See Description of Share Capital Directors Power to Issue Shares. The preferential tax treatment of a number of the AdCo Subsidiaries will expire from 2004 to 2006, which will result in higher tax rates for these entities and could adversely affect our overall results of operations. Newly organized PRC entities conducting advertising businesses are entitled to elect to receive a tax exemption for their first two years of operation in lieu of carrying forward tax losses accumulated in those years. Entities making such an election may carry forward tax losses incurred after the expiration of this two-year period. A number of our AdCo Subsidiaries have elected to receive these two-year tax exemptions. These exemptions will expire from 2004 to 2006. As of June 30, 2004, the tax exemptions with respect to the AdCo Subsidiaries that generate a substantial majority of our taxable income had expired. In the six-month period ended June 30, 2004, 95% of our total taxable income, excluding the impact of tax losses generated by our subsidiaries during the period, was related to subsidiaries whose tax exemptions expired during that period or that did not receive tax exemptions. Upon the expiration of these tax exemptions, these AdCo Subsidiaries will be taxed at the full statutory tax rate, currently 33%. As these tax exemptions expire, the effective tax rate of our PRC subsidiaries and our consolidated effective tax rate will increase, which will adversely affect our net income. Primarily as a result of the expiration of our tax exemptions in 2003 and in the six months ended June 30, 2004, we recognized income tax expense of RMB3.2 million (US$0.4 million) in 2003 and an Estimated number of print advertising pages(1) 2,469 3,176 4,635 4,256 Estimated number of cities where Career Post Weekly was published(2) 8 13 16 Investing in the ADSs involves risks. See Risk Factors beginning on page 11. Table of Contents income tax expense of RMB15.4 million (US$1.9 million) in the six months ended June 30, 2004, as compared to an income tax benefit of RMB1.3 million in 2002. We have no business insurance coverage. Other than insurance for some of our properties, we do not maintain any insurance. Insurance companies in China offer limited business insurance products and do not, to our knowledge, offer business liability insurance. We do not have any business liability insurance coverage for our operations. Any business disruption, litigation or natural disaster might result in substantial costs and diversion of resources. We are vulnerable to natural disasters and other calamities. All of our servers are currently hosted in Shanghai. We have backup systems, but we cannot assure you that such backup systems will be adequate if there are problems, or that they will adequately protect us from the effects of fire, floods, typhoons, earthquakes, power loss, telecommunications failures, break-ins, war, terrorist acts or similar events. Any of the foregoing events may give rise to server interruptions, breakdowns, system failures, technology platform failures and Internet failures, which could cause the loss or corruption of data or malfunctions of software or hardware. Any such event could adversely affect our ability to provide our services to users. See Our Business Technology. We may become a passive foreign investment company, which could result in adverse U.S. tax consequences to U.S. investors. We may be a passive foreign investment company for U.S. federal income tax purposes for any year. Such classification could result in adverse U.S. tax consequences to U.S. investors. For example, if we are a passive foreign investment company for any year, our U.S. investors may be subject to increased tax liabilities under U.S. tax laws and regulations and may be subject to additional reporting requirements. The determination of whether we are a passive foreign investment company will be made on an annual basis and will depend on the composition of our income and assets, including goodwill. The calculation of goodwill will be based, in part, on the market value of our ADSs from time to time, which may be volatile. In addition, the composition of our income and assets will be affected by how we spend the cash we raise in this offering. In general, we will be classified as a passive foreign investment company for any taxable year in which either (1) at least 75% of our gross income is passive income or (2) at least 50% of the value (determined on the basis of a quarterly average) of our assets is attributable to assets that produce or are held for the production of passive income. For purposes of these tests, cash, including working capital, and investments are considered assets that produce or are held for the production of passive income. If we were to retain or to invest the cash that we raise in this offering, and the retained cash or investments and any other passive assets comprised at least 50% of the value of our assets, we could be a passive foreign investment company. Our determination of whether we are a passive foreign investment company is not binding on the Internal Revenue Service. We cannot assure you that we will not be a passive foreign investment company for the current or any future taxable year. If we are a passive foreign investment company in any year that a U.S. investor holds shares or ADSs, we generally will continue to be treated as a passive foreign investment company for that investor in all succeeding years. We urge U.S. investors to consult their own tax advisors concerning the availability and making of a mark-to-market election. See Taxation United States Federal Income Taxation Passive foreign investment company rules. Our subsidiaries face limitations on paying dividends or making other distributions to us. We are a holding company and do not have any assets or conduct any business operations other than our holding of the equity interests in, directly and indirectly: Qian Cheng Wu You Network Information Technology (Beijing) Co., Ltd., or WFOE, a wholly foreign owned enterprise in China; Qianjin Network Information Technology (Shanghai) Co., Ltd., or Tech JV; and PRICE US$ AN ADS Table of Contents Shanghai Qianjin Culture Communication Co., Ltd., or AdCo, and its subsidiaries. As a result of our holding company structure, we rely entirely on dividends, royalty payments and license fees paid under trademark license agreements and certain other contractual arrangements paid to us by our subsidiaries and affiliated entities in the PRC to finance our operations and to pay dividends to our shareholders. These royalty payments and license fees paid under trademark license agreements and certain other contractual arrangements do not require governmental or other third party approval. However, the payment of dividends in China is subject to certain restrictions. PRC regulations currently permit payment of dividends only out of accumulated profits as determined in accordance with PRC accounting standards and regulations. Our subsidiaries and affiliated entities in the PRC are also required to set aside a portion of their after-tax profits according to PRC accounting standards and regulations to fund certain reserve funds that are not distributable as cash dividends. The PRC government also imposes controls on the convertibility of Renminbi into foreign currencies and, in certain cases, the remittance of currency out of the PRC. We may also experience difficulties in completing the administrative procedures necessary to obtain and remit foreign currency. See Regulation Regulation of Foreign Currency Exchange and Dividend Distribution. If we or any of our subsidiaries are unable to receive all of the revenues from our operations through these contractual or dividend arrangements, we may be unable to effectively finance our operations or pay dividends on our common shares. Risks Related to Our Corporate Structure If the PRC authorities determine that our past ownership structure was inconsistent with the requirements for operating certain of our businesses, we could be subject to sanctions. The PRC government regulates foreign ownership in entities providing advertising and human resource related services. Prior to March 2004, PRC laws and regulations prohibited foreign persons from owning a controlling interest in advertising entities. This foreign ownership restriction has subsequently been relaxed to 70%. In addition, until November 2003, there were no PRC laws or regulations explicitly prohibiting or limiting foreign ownership in entities providing human resource related services. Since November 2003, foreign ownership in entities providing human resource related services has been limited to 49%. Prior to our restructuring, 51net, our BVI subsidiary and a foreign entity, owned 99% of Tech JV, which in turn owned, and continues to own, 80% of AdCo. AdCo owned, and continues to own, 90% of the principal AdCo Subsidiaries. During this period, Tech JV, AdCo and the AdCo Subsidiaries conducted a portion of our advertising and human resource services businesses. We have been advised by Jun He Law Offices, our PRC counsel, that the foreign ownership percentage of Tech JV, AdCo and the AdCo Subsidiaries prior to our restructuring was above the maximum foreign ownership permitted for an entity conducting advertising operations. In addition, we have been advised by our PRC counsel that, prior to our restructuring, the foreign ownership percentage of Tech JV was above the maximum foreign ownership permitted for an entity conducting human resource operations. In May 2004, we restructured our operations to comply with the foregoing PRC laws and regulations governing foreign ownership in entities conducting advertising and human resource related services. In connection with our restructuring, we informed relevant PRC governmental authorities that, historically, our foreign ownership percentage of Tech JV, AdCo and the AdCo Subsidiaries was not in compliance with limitations on foreign ownership of entities conducting advertising and human resources operations. However, we have not received any waiver from the PRC government with respect to our past non-compliance with foreign ownership laws limitations. There remains uncertainty regarding whether foreign owned PRC entities, such as AdCo, are required to obtain special governmental approval in order to establish subsidiaries in the PRC or otherwise invest in PRC entities. Following the formation of the AdCo Subsidiaries, in connection with our restructuring we made inquiries with relevant PRC governmental authorities as to whether AdCo was required to obtain such approval before establishing the AdCo Subsidiaries. We have been unable to obtain any governmental ruling or advice on this matter. As a result, it is uncertain whether special governmental approval, which we did not obtain, was necessary for the establishment by AdCo of the AdCo Subsidiaries. Underwriting Price to Discounts and Proceeds to Public Commissions 51job, Inc. Table of Contents The PRC government may determine that our ownership structure is or was inconsistent with or insufficient for the proper operation of our businesses, or that our business licenses or other approvals are or were not properly issued or not sufficient. For a discussion of the limitations on foreign ownership governing our businesses, see Regulation Limitations on Foreign Ownership of Our Businesses. If we or any of our subsidiaries or affiliated entities were found to be or to have been in violation of PRC laws or regulations governing foreign ownership of advertising or human resource services businesses, the relevant regulatory authorities would likely have broad discretion in dealing with such violation, including but not limited to: levying fines; revoking business licenses; restricting or prohibiting our use of the proceeds from this offering to finance our business and operations in China; requiring us to restructure the ownership structure or operations of our subsidiaries or affiliated entities; and/or requiring us to discontinue all or a portion of our business. Any of these or similar actions could cause significant disruption to our business operations or render us unable to conduct a substantial portion of our business operations and may materially and adversely affect our business, financial condition and results of operations. We rely on our agreements with an affiliated entity to provide human resource related services and to act as an Internet content provider, and we rely on agreements with an affiliated entity and its shareholders to receive all of the beneficial interest of this entity. Current PRC laws and regulations limit foreign investment in entities providing human resource related services and in entities operating as Internet content providers. We currently provide technical, consulting and human resource related services in conjunction with our affiliated entity, RAL, which is wholly owned by Michael Lei Feng and Tao Wang, two of our executive officers. RAL holds a license to provide human resource related services and we rely on RAL to provide human resource related services to our clients under a contractual arrangement between RAL and our majority owned subsidiary Tech JV. Similarly, RAL holds a license to operate as an Internet content provider. While we provide all of our online recruitment services through Tech JV, we rely on RAL to provide certain Internet content provider services to support Tech JV s online recruitment services through a contractual arrangement with RAL. We have entered into agreements with RAL s shareholders which enable us to effectively control RAL. Tech JV, AdCo and the AdCo Subsidiaries recognize substantially all of our revenues. The minority interests in Tech JV, AdCo and the AdCo Subsidiaries, which are direct or indirect subsidiaries of Tech JV, are held by Qian Cheng, which is wholly owned by Michael Lei Feng and Tao Wang. Through agreements with Qian Cheng and its shareholders, we have the substantial ability to control, bear all the economic risks of, and receive all the economic rewards from, Qian Cheng. As a result, we consolidate all of its interests for U.S. GAAP reporting purposes. As we rely on these agreements with RAL and Qian Cheng to enable us to provide certain critical services to our clients as well as to receive all the economic benefits of Qian Cheng, a significant disruption in these contractual relationships as a result of governmental sanction or otherwise could result in our being required to restructure our operations which could result in a significant expenditure of resources. If we are unable to restructure our operations to provide those services through a different entity, we may experience significant disruptions in our ability to provide online recruitment services or human resource related services to our customers. In addition, if we are unable to consolidate the minority interests in Tech JV, AdCo and the AdCo Subsidiaries, our results of operations would reflect Qian Cheng s minority interest in these entities which, if not otherwise consolidated, would result in a significant reduction in our reported net income. For a description of our contractual arrangements with these entities, see Corporate Structure. Table of Contents If our affiliated entity RAL is found to be operating in jurisdictions outside of Shanghai without a business license, we could be subject to sanctions and our revenues could be adversely affected. RAL s existing human resource services license is limited to Shanghai. In 2003, revenues from human resource related services provided to customers outside Shanghai accounted for approximately 5% of our total revenues. It is possible that government authorities in jurisdictions outside Shanghai where certain of RAL s customers are located may assert that RAL is providing human resource related services in such jurisdictions without a necessary license and is required to obtain a human resource services license in such jurisdictions. As a result, RAL could be required to cease providing human resource services to customers in such locations which could result in a reduction in human resource related revenues. In addition, RAL may be subject to sanctions in the form of forfeiture of profits, fines, or both. Our contractual arrangements with RAL and Qian Cheng may not be as effective in providing operational control as direct ownership of these businesses. Because the percentage of foreign ownership in human resource and Internet content businesses in China is limited under PRC laws and regulations, we depend substantially on RAL, in which we have no direct ownership interest, and its contractual arrangements with us to provide those services. Similarly, we rely on our contractual arrangements with Qian Cheng, in which we have no direct ownership interest, to realize all of the economic rewards from Qian Cheng s minority interests in Tech JV, AdCo and the AdCo Subsidiaries. Our contractual arrangements with RAL, Qian Cheng and their respective shareholders may not be as effective as direct ownership in providing control over their operations. RAL may fail to perform its contractual obligations required for us to operate our business, such as keeping in good standing under its business licenses. Qian Cheng and its shareholders may refuse to make payments or otherwise refuse to perform their contractual obligations necessary for us to realize the economic rewards relating to Qian Cheng s minority interests in Tech JV, AdCo and the AdCo Subsidiaries. In addition, the contractual arrangements which provide us with the substantial ability to control these entities may be unenforceable and the shareholders of these entities may refuse to renew these contractual arrangements. In any such event, we will have to rely on the PRC legal system to enforce our rights. In many cases, the laws and regulations governing the enforcement and performance of contractual arrangements are significantly more limited than in the United States and many other countries and may afford us little or no effective protection. If we are unable to enforce our rights, we may be unable to operate our human resource and Internet content businesses through RAL or receive all of the economic rewards from Qian Cheng. As a result, we may be required to restructure our operations which would likely entail a significant expenditure of resources. We cannot assure you that any such restructuring would be effective or would not result in similar or other difficulties. For a description of these contractual arrangements, see Corporate Structure. If we or any of our subsidiaries or affiliated entities were found to be in violation of PRC laws or regulations, the relevant regulatory authorities would likely have broad discretion in dealing with such violation, including but not limited to: levying fines; revoking business licenses; restricting or prohibiting our use of the proceeds from this offering to finance our business and operations in China; requiring us to restructure the ownership structure or operations of our subsidiaries or affiliated entities; and/or requiring us to discontinue all or a portion of our business. Any of these or similar actions could cause significant disruption to our business operations or render us unable to conduct a substantial portion of our business operations and may materially and adversely affect our business, financial condition and results of operations. Table of Contents The PRC laws and regulations governing our current business operations and contractual arrangements are uncertain, and if we are found to be in violation, we could be subject to sanctions. In addition, any changes in such PRC laws and regulations may have a material and adverse effect on our business. There are substantial uncertainties regarding the interpretation and application of PRC laws and regulations, including but not limited to the laws and regulations governing our business, or the enforcement and performance of our contractual arrangements in the event of the imposition of statutory liens, death, bankruptcy and criminal proceedings. We and our subsidiaries are considered foreign persons or foreign funded enterprises under PRC laws, and, as a result, we are required to comply with PRC laws and regulations, including those governing foreign ownership in the advertising, human resource services and Internet content industries. These laws and regulations are relatively new and may be subject to future changes, and their official interpretation and enforcement may involve substantial uncertainty. The effectiveness of newly enacted laws, regulations or amendments may be delayed, resulting in detrimental reliance by foreign investors. New laws and regulations that affect existing and proposed future businesses may also be applied retroactively. In addition, the PRC authorities retain broad discretion in dealing with violations of laws and regulations, including levying fines, revoking business licenses and requiring actions necessary for compliance. In particular, licenses, permits and beneficial treatments issued or granted to us by relevant governmental bodies may be revoked at a later time under contrary findings of higher regulatory bodies. We cannot predict what effect the interpretation of existing or new PRC laws or regulations may have on our businesses. We cannot assure you that any such restructuring would be effective or would not result in similar or other difficulties. We may be subject to sanctions, including fines, and could be required to restructure our operations. As a result of these substantial uncertainties, we cannot assure you that we will not be found in violation of any current or future PRC laws or regulations. If we or any of our subsidiaries or affiliated entities or any of our contractual arrangements are found to be or to have been in violation of any existing or future PRC laws or regulations, the relevant regulatory authorities would likely have broad discretion in dealing with such violation, including but not limited to: levying fines; revoking business licenses; restricting or prohibiting our use of the proceeds from this offering to finance our business and operations in China; requiring us to restructure the ownership structure or operations of our subsidiaries or affiliated entities; and/or requiring us to discontinue all or a portion our business. Any of these or similar actions could cause significant disruption to our business operations or render us unable to conduct a substantial portion of our business operations and may materially and adversely affect our business, financial condition and results of operations. We are unable to quantify the likelihood that any sanctions would be imposed or the magnitude of the effect of any such sanctions on our business, financial condition or results of operations. Risks Related to the People s Republic of China Our business could be affected by changes in China s economic, political or social conditions or government policies. The PRC economy differs from the economies of most developed countries in many respects, including with respect to the: amount of government involvement; level of development; growth rate; Per ADS US$ US$ US$ Total US$ US$ US$ The Securities and Exchange Commission and state securities regulators have not approved or disapproved these securities or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense. 51job, Inc. has granted the underwriters the right to purchase up to an additional 787,500 ADSs to cover over-allotments. The underwriters expect to deliver the ADSs to purchasers on or about , 2004. Table of Contents control of foreign exchange; and allocation of resources. While the PRC economy has experienced significant growth in the past 20 years, growth has been uneven, both geographically and among various sectors of the economy. The PRC government has implemented various measures to encourage economic growth and guide the allocation of resources. Some of these measures benefit the overall PRC economy, but may also have a negative effect on us. For example, our financial condition and results of operations may be adversely affected by government control over capital investments or changes in tax regulations that are applicable to us. The PRC economy has been transitioning from a planned economy to a more market-oriented economy. Although in recent years the PRC government has implemented measures emphasizing the utilization of market forces for economic reform, the reduction of state ownership of productive assets and the establishment of sound corporate governance in business enterprises, a substantial portion of the productive assets in China is still owned by the PRC government. The continued control of these assets and other aspects of the national economy by the PRC government could materially and adversely affect our business. For example, the PRC government could determine to limit the extent to which government controlled entities may use private sector businesses such as ours to service their human resource requirements. The PRC government could also determine to develop and support government owned or controlled human resource enterprises in direct competition with us. In addition, the PRC government continues to play a significant role in regulating industry development by imposing industrial policies. It also exercises significant control over PRC economic growth through the allocation of resources, controlling payment of foreign currency-denominated obligations, setting monetary policy and providing preferential treatment to particular industries or companies. Efforts by the PRC government to slow the pace of growth in the Chinese economy could result in reduced job growth and recruitment activity, which in turn could reduce demand for our recruitment advertising services. In addition, the PRC government could determine to more closely regulate the advertising, Internet content delivery or human resource industries, which could impose additional regulatory costs and burdens on us. PRC laws and regulations governing operators of Internet websites are unclear and the regulation of the telecommunications and Internet industries may become more burdensome, and if we are found to be in violation of PRC laws and regulations, we could be subject to sanctions. The interpretation and application of existing PRC laws and regulations, the stated positions of the main governing authority, the PRC Ministry of Information Industry, and the possibility of new laws or regulations being adopted, have created significant uncertainty regarding the legality of existing and future foreign investments in, and the businesses and activities of, companies with Internet operations, including those of our company. In particular, the PRC Ministry of Information Industry has stated that the activities of Internet content providers, or entities providing delivery of Internet content, are subject to regulation by various PRC government authorities, depending on the specific activities conducted by the Internet content provider. We cannot be certain that the commercial Internet content provider license issued by the local Shanghai Municipal Telecommunications Bureau and held by RAL will satisfy these requirements. For example, we may be required to obtain an inter-provincial Internet content provider license in order to operate online businesses in multiple provinces, autonomous regions and centrally administered municipalities. In addition, PRC government regulation of the telecommunications and Internet industries is burdensome and may become even more so. New regulations could increase our costs of doing business and prevent us from efficiently delivering our services. We have been informed that the PRC Ministry of Information Industry is in the process of preparing a draft of a national telecommunications law to provide a uniform regulatory framework for the telecommunications industry. We do not know the nature or scope of these new laws and regulations and we cannot predict whether they will have a positive or negative effect on any or all aspects of our business. Our failure to comply with applicable PRC Internet regulations could subject us to severe sanctions. Table of Contents The continued growth of the Chinese Internet market depends on the establishment of an adequate telecommunications infrastructure. Although private sector Internet service providers currently exist in China, almost all access to the Internet is maintained through ChinaNet, which is owned by China Telecom under the administrative control and regulatory supervision of the PRC Ministry of Information Industry. In addition, the national networks in China connect to the Internet through a government-controlled international gateway. This international gateway is the only channel through which a domestic user can connect to the international Internet network. We rely on this infrastructure and China Telecom to provide data communications capacity, primarily through local telecommunications lines. We cannot assure you that this infrastructure will be developed. We have no access to alternative networks or services, on a timely basis if at all, in the event of disruptions, failures or other problems with China s Internet infrastructure or telecommunications networks. The Internet infrastructure in China may not support the demands associated with continued growth in Internet usage. The PRC legal system has inherent uncertainties that could materially and adversely affect us. The PRC legal system is based upon written statutes. Prior court decisions may be cited for reference but are not binding on subsequent cases and have limited value as precedents. Since 1979, the PRC legislative bodies have promulgated laws and regulations dealing with economic matters such as foreign investment, corporate organization and governance, commerce, taxation and trade. However, the PRC has not developed a fully integrated legal system and the array of new laws and regulations may not be sufficient to cover all aspects of economic activities in the PRC. In particular, because these laws and regulations are relatively new, and because of the limited volume of published decisions and their non-binding nature, the interpretation and enforcement of these laws and regulations involve uncertainties. In addition, published government policies and internal rules may have retroactive effects and, in some cases, the policies and rules are not published at all. As a result, we may be unaware of our violation of these policies and rules until some time later. Our contractual arrangements with our affiliated entities are governed by the laws of the PRC. The enforcement of these contracts and the interpretation of the laws governing these relationships is subject to uncertainty. See Risks Related to Our Corporate Structure The PRC laws governing our current business operations and contractual arrangements are uncertain, and if we are found to be in violation of PRC law, we could be subject to sanctions. You may experience difficulties in effecting service of legal process, enforcing foreign judgments or bringing original actions in China based on United States or other foreign laws against us, our management or the experts named in the prospectus. We conduct substantially all of our operations in China and substantially all of our assets are located in China. In addition, the majority of our directors and executive officers and some of the experts named in the prospectus reside within China. As a result, it may not be possible to effect service of process within the United States or elsewhere outside China upon these directors or executive officers or some of the experts named in the prospectus, including with respect to matters arising under U.S. federal securities laws or applicable state securities laws. Moreover, our PRC counsel has advised us that the PRC does not have treaties with the United States or many other countries providing for the reciprocal recognition and enforcement of judgment of courts. Governmental control of currency conversion may affect the value of your investment. The PRC government imposes controls on the convertibility of Renminbi into foreign currencies and, in certain cases, the remittance of currency out of China. We receive substantially all of our revenues in Renminbi, which is currently not a freely convertible currency. Under our current structure, our income will be primarily derived from dividend payments from our PRC subsidiaries and other payments such as royalty and licensing fees. Shortages in the availability of foreign currency may restrict the ability of our PRC subsidiaries and our affiliated entities to remit sufficient foreign currency to pay dividends, royalty payments or other fees to us, or otherwise satisfy their foreign currency dominated obligations. Under existing PRC foreign exchange regulations, payments of current account items, including profit distributions, interest payments and Table of Contents Table of Contents expenditures from the transaction, can be made in foreign currencies without prior approval from the PRC State Administration of Foreign Exchange by complying with certain procedural requirements. However, approval from appropriate governmental authorities is required where Renminbi is to be converted into foreign currency and remitted out of China to pay capital expenses such as the repayment of bank loans denominated in foreign currencies. The PRC government may also at its discretion restrict access in the future to foreign currencies for current account transactions. If the foreign exchange control system prevents us from obtaining sufficient foreign currency to satisfy our currency demands, we may not be able to pay dividends in foreign currencies to our shareholders, including holders of our ADSs. The fluctuation of the Renminbi may materially and adversely affect your investment. The value of the Renminbi against the U.S. dollar and other currencies may fluctuate and is affected by, among other things, changes in the PRC s political and economic conditions. As we rely entirely on dividends, royalty payments and other fees paid to us by our subsidiaries and affiliated entities in the PRC, any significant revaluation of the Renminbi may materially and adversely affect our cash flows, revenues and financial condition, and the value of, and any dividends payable on, our ADSs in foreign currency terms. For example, to the extent that we need to convert U.S. dollars we receive from this offering into Renminbi for our operations, appreciation of the Renminbi against the U.S. dollar could have a material adverse effect on our business, financial condition and results of operations. Conversely, if we decide to convert our Renminbi into U.S. dollars for the purpose of making payments for dividends on our common shares or for other business purposes and the U.S. dollar appreciates against the Renminbi, the U.S. dollar equivalent of the Renminbi we convert would be reduced. In addition, the depreciation of significant U.S. dollar denominated assets could result in a charge to our income statement and a reduction in the value of these assets. For further information on our foreign exchange risks and certain exchange rates, see Exchange Rate Information and Management s Discussion and Analysis of Financial Condition and Results of Operations Quantitative and Qualitative Disclosures about Market Risk Foreign exchange risk. We face risks related to health epidemics and other outbreaks. Our business could be adversely affected by the effects of Severe Acute Respiratory Syndrome, or SARS, or another epidemic or outbreak on the economic and business climate. China reported a number of cases of SARS in April 2004. Restrictions on travel resulting from a reoccurrence of SARS or another epidemic or outbreak could adversely affect our ability to market and service new and existing customers throughout China. Our business operations could be disrupted if one of our employees is suspected of having SARS, which would require that a certain number of our employees be quarantined and/or our offices be disinfected. In addition, our results of operations could be adversely affected to the extent that SARS or another outbreak harms the Chinese economy in general. Risks Related to Our ADSs and This Offering There has been no public market for our shares or ADSs prior to this offering. Prior to this initial public offering, there has been no public market for our common shares or ADSs. We cannot predict the extent to which a trading market for our ADSs will develop or how liquid that market may become. The initial public offering price for our ADSs will be determined by negotiations between us and the underwriters and may bear no relationship to the market price for our ADSs after the initial public offering. We cannot be certain that an active trading market will develop. The market price for our ADSs may be volatile. The market prices of the securities of companies with Internet related and online businesses have been extremely volatile and may be subject to wide fluctuations in response to factors including the following: actual or anticipated fluctuations in our quarterly operating results; announcements of new services by us or our competitors; TABLE OF CONTENTS Page Table of Contents changes in financial estimates by securities analysts; conditions in our industry, which is the market for recruitment advertising services and other human resource related services in China; announcements by us or our competitors of significant acquisitions, strategic partnerships, joint ventures or capital commitments; additions or departures of key personnel; release of lock-up or other transfer restrictions on our outstanding ADSs or sales of additional common shares or ADSs; and potential litigation or regulatory investigations. In addition, recently a number of PRC companies and companies with substantial operations in the PRC that offered and sold securities in the United States have experienced significant volatility in their share prices after their initial public offerings due to market fluctuations and other issues. Furthermore, the securities market has from time to time experienced significant price and volume fluctuations that are not related to the operating performance of particular companies. These market fluctuations may also materially and adversely affect the market price of our ADSs. We cannot assure you that the market price of our ADSs will not decline below the initial public offering price. As a result, you may not be able to resell your shares above the initial public offering price and you may suffer a loss on your investment. The future sales, or perceived future sales, by our existing shareholders of a substantial number of our ADSs in the public market could adversely affect the price of our ADSs. If our shareholders sell, or are perceived as intending to sell, substantial amounts of our common shares or ADSs, including those issued upon the exercise of outstanding options, in the public market following this offering, the market price of our ADSs could fall. Such sales, or perceived potential sales, also might make it more difficult for us to sell equity or equity related securities in the future at a time and price that we deem appropriate. The 10,500,000 common shares represented by 5,250,000 ADSs offered in this offering (other than those held by our affiliates) will be eligible for immediate resale in the public market without restrictions. Common shares held by our existing shareholders and any ADSs held by our affiliates may also be sold in the public market in the future under, and subject to the restrictions contained in, Rule 144 under the U.S. Securities Act of 1933, as amended, or the Securities Act, and applicable lock-up agreements. In addition, see Management Stock-Based Compensation Plans for a description of outstanding options to purchase our common shares. Substantially all of our common shares outstanding immediately after this offering, excluding common shares represented by ADSs sold in this offering, will be subject to lock-up agreements. See Shares Eligible for Future Sale and Underwriters for additional information regarding resale restrictions. In addition, after this offering, the holders of 43,099,329 common shares will be entitled to certain registration rights. For a description of the registration rights that we have granted, see Description of Share Capital Registration Rights. Your right to participate in any future rights offerings may be limited, which may cause dilution of your holdings. We may from time to time distribute rights to our shareholders, including rights to acquire our securities. Under the deposit agreement, the depositary bank will not offer you those rights unless the distribution to ADS holders of both the rights and any related securities is either registered under the Securities Act, or exempt from registration under the Securities Act. We are under no obligation to file a registration statement with respect to any such rights or securities or to endeavor to cause such a registration statement to be declared effective. Moreover, we may not be able to establish an exemption from registration under the Securities Act. Accordingly, you may be unable to participate in our rights offerings and may experience dilution in your holdings. Table of Contents You will experience immediate and substantial dilution in the book value of ADSs purchased. The public offering price per ADS will be substantially higher than the net tangible book value per ADS prior to this offering. Therefore, when you purchase ADSs in the offering at the initial public offering price, you will incur an immediate dilution of US$9.12 per ADS. See Dilution. If we issue additional ADSs, you may experience further dilution. In addition, you may experience further dilution to the extent that common shares are issued upon the exercise of stock options. Substantially all of the common shares issuable upon the exercise of currently outstanding stock options will be issued at a purchase price on a per ADS basis that is less than the initial public offering price per ADS in this offering. You may not be able to exercise your right to vote. As a holder of ADSs, you may only exercise the voting rights with respect to the underlying common shares in accordance with the provisions of the deposit agreement. Under the deposit agreement, you must vote by giving voting instructions to the depositary. Upon receipt of your voting instructions, the depositary will vote the underlying common shares in accordance with these instructions. Otherwise, you will not be able to exercise your right to vote unless you withdraw the shares. Under our fifth amended and restated memorandum and articles of association, the minimum notice period required for convening either an annual meeting or a general meeting called to vote on matters requiring the approval of two thirds of the voting shares is 20 days. The minimum notice period for other general meetings is 14 days. When a general meeting is convened, you may not receive sufficient advance notice to withdraw the shares to allow you to vote with respect to any specific matter. If we ask for your instructions, the depositary will notify you of the upcoming vote and will arrange to deliver our voting materials to you. We cannot assure you that you will receive the voting materials in time to ensure that you can instruct the depositary to vote your shares. In addition, the depositary and its agents are not responsible for failing to carry out voting instructions or for the manner of carrying out voting instructions. This means that you may not be able to exercise your right to vote and there may be nothing you can do if the shares underlying your ADSs are not voted as you requested. You may not receive distributions on common shares or any value for them if it is illegal or impractical to make them available to you. The depositary of our ADSs has agreed to pay to you the cash dividends or other distributions it or the custodian receives on common shares or other deposited securities after deducting its fees and expenses. You will receive these distributions in proportion to the number of common shares your ADSs represent. However, the depositary is not responsible if it decides that it is inequitable or impractical to make a distribution available to any holders of ADSs. For example, the depositary may determine that it is not feasible to distribute certain property through the mail. Additionally, the value of certain distributions may be less than the cost of mailing them. In these cases, the depositary may determine not to distribute such property. We have no obligation to register under U.S. securities laws any ADSs, common shares, rights or other securities received through such distributions. We also have no obligation to take any other action to permit the distribution of ADSs, common shares, rights or anything else to holders of ADSs. This means that you may not receive the distribution we make on our common shares or any value for them if it is illegal or impractical for us to make them available to you. These restrictions may have a material adverse effect on the value of your ADSs. You may be subject to limitations on transfer of your ADSs. Your ADSs represented by the ADRs are transferable on the books of the depositary. However, the depositary may close its transfer books at any time or from time to time when it deems expedient in connection with the performance of its duties. In addition, the depositary may refuse to deliver, transfer or register transfers of ADSs generally when our books or the books of the depositary are closed, or at any time if we or the depositary thinks it advisable to do so because of any requirement of law or of any government or governmental body, or under any provision of the deposit agreement, or for any other reason. Table of Contents You may face difficulties in protecting your interests, and your ability to protect your rights through the U.S. federal courts may be limited, because we are incorporated under Cayman Islands law. We are a company incorporated under the laws of the Cayman Islands, and substantially all of our assets are located outside the United States. In addition, a majority of our directors and executive officers are nationals or residents of jurisdictions other than the United States and all or a substantial portion of their assets are located outside the United States. As a result, it may be difficult for investors to effect service of process within the United States upon our directors or executive officers, or enforce judgments obtained in the United States courts against our directors or executive officers. Our corporate affairs are governed by our memorandum and articles of association, the Cayman Islands Companies Law (2004 Revision) and the common law of the Cayman Islands. The rights of shareholders to take action against the directors, actions by minority shareholders and the fiduciary responsibilities of our directors to us under Cayman Islands law are to a large extent governed by the common law of the Cayman Islands. The common law of the Cayman Islands is derived in part from comparatively limited judicial precedent in the Cayman Islands as well as from English common law, the decisions of whose courts are of persuasive authority, but are not binding on a court in the Cayman Islands. The rights of our shareholders and the fiduciary responsibilities of our directors under Cayman Islands law are not as clearly established as they would be under statutes or judicial precedent in some jurisdictions in the United States. In particular, the Cayman Islands has a less developed body of securities laws as compared to the United States, and some states, such as Delaware, have more fully developed and judicially interpreted bodies of corporate law. In addition, Cayman Islands companies may not have standing to initiate a shareholder derivative action in a federal court of the United States. The Cayman Islands courts are also unlikely: to recognize or enforce against us judgments of courts of the United States based on certain civil liability provisions of U.S. securities laws; and to impose liabilities against us, in original actions brought in the Cayman Islands, based on certain civil liability provisions of U.S. securities laws that are penal in nature. There is no statutory recognition in the Cayman Islands of judgments obtained in the United States, although the courts of the Cayman Islands will in certain circumstances recognize and enforce a non-penal judgment of a foreign court of competent jurisdiction without retrial on the merits. As a result of all of the above, public shareholders may have more difficulty in protecting their interests in the face of actions taken by management, members of the board of directors or controlling shareholders than they would as public shareholders of a U.S. company. For a discussion of significant differences between the provisions of the Companies Law of the Cayman Islands and the laws applicable to companies incorporated in the United States and their shareholders, see Description of Share Capital Differences in Corporate Law. We will have broad discretion over the use of the proceeds from this offering. We will have broad discretion to use the net proceeds from this offering. See Use of Proceeds. You will be relying on the judgment of our board of directors and management regarding the application of these proceeds. The net proceeds may be used for corporate purposes that do not improve our efforts to maintain profitability or increase our share price. The net proceeds from this offering may be placed in investments that do not produce income or that lose value. Table of Contents
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+RISK FACTORS Any investment in our common stock involves a high degree of risk. You should consider carefully the risks and uncertainties described below, and all other information included or incorporated by reference in this prospectus, before you decide whether to purchase our common stock. The risks described below are the material risks that we face. The occurrence of any of the following risks could cause our business, prospects, financial condition and results of operations to suffer. The trading price of our common stock could decline due to any of these risks and uncertainties, and you may lose part or all of your investment in our common stock. Risks Relating to Our Business Risks Relating to Our Limited Operating History and Financial Results Our limited operating history makes it difficult to evaluate our business and prospects and to accurately forecast revenues and appropriately plan our expenses. We were incorporated in February 2000 and launched our website in September 2000. You must consider our business and prospects in light of the risks and difficulties we face as an early stage company with a limited operating history. These risks and difficulties include challenges in accurate financial planning as a result of limited historical data and the uncertainties resulting from having had a relatively limited time period in which to implement and evaluate our business strategies as compared to more established companies with longer operating histories. In addition, we base our expense levels and merchandise purchases on our estimates of future revenues. Our future revenues will depend on the volume and timing of customer purchases on our website, which are uncertain. Because approximately 20% of our expenses are fixed, we may be unable to adjust our spending in a timely manner to compensate for any unexpected shortfall in revenues. This inability could cause our net loss to be higher than expected or our net income, if any, to be lower than expected, in any given quarter. Our failure to address these risks and difficulties successfully would seriously harm our business. We have a history of significant losses. If we do not achieve or sustain profitability, our financial condition and stock price could suffer. We have a history of losses and we may continue to incur operating and net losses for the foreseeable future. We incurred net losses of $13.8 million, $10.7 million and $1.4 million for fiscal years 2001, 2002 and 2003, respectively, and $1.7 million for the quarter ended May 1, 2004. As of May 1, 2004, our accumulated deficit was $90.3 million. We have not achieved profitability on an annual basis. We will need to generate significant revenues to achieve profitability, and we may not be able to do so. If our revenues grow more slowly than we anticipate, or if our operating expenses exceed our expectations, we may not be able to achieve profitability in the near future or at all. Even if we do achieve profitability, we may not be able to sustain or increase profitability on a quarterly or annual basis. If we are unable to achieve profitability in the near future, or at all, or if we are unable to sustain or increase profitability, our financial condition and stock price could be adversely affected. We will continue to incur significant operating expenses and capital expenditures as we: expand the number and breadth of our product offerings; increase our general and administrative functions to support our operations; increase our sales and marketing activities; enhance our warehouse and order fulfillment capabilities; expand our customer service capabilities; further improve our order processing systems and capabilities; and develop enhanced technologies and features. Copies to: Jay E. Bothwick, Esq. David A. Westenberg, Esq. Wilmer Cutler Pickering Hale and Dorr LLP 60 State Street Boston, Massachusetts 02109 Telephone: (617) 526-6000 Telecopy: (617) 526-5000 Alan L. Jakimo, Esq. Sidley Austin Brown Wood LLP 787 Seventh Avenue New York, New York 10019 Telephone: (212) 839-5300 Telecopy: (212) 839-5599 Table of Contents We will incur many of these expenses before we receive any revenues from our efforts. Therefore, any significant shortfall in revenues would likely harm our business, operating results and financial condition. In addition, we may find that these efforts are more expensive than we currently anticipate, which would further increase our losses. Our quarterly operating results are volatile and may adversely affect our stock price. Our future revenues and operating results are likely to vary significantly from quarter to quarter due to a number of factors, many of which are outside our control, and any of which could harm our business. As a result, we believe that quarterly comparisons of our operating results are not necessarily meaningful and that you should not rely on the results of one quarter as an indication of our future performance. In addition to the other risk factors described in this prospectus, factors that could cause our quarterly operating results to fluctuate include: our ability to retain existing customers and encourage repeat purchases; our ability to attract visitors to our website and convert those visitors into customers; the extent to which our future marketing initiatives are successful; advertising and other marketing costs; the extent to which seasonal fluctuations in customer purchasing activity impact our revenues; our ability to manage our product mix and inventory; our, or our competitors , pricing and marketing strategies; our ability to purchase from suppliers the products that our customers want to buy; our ability to manage fulfillment operations and provide adequate levels of customer service; the amount and timing of operating costs and capital expenditures relating to the expansion of our business; general economic conditions; and conditions or trends in the Internet and e-commerce industry. As a result, our operating results in future quarters may be below the expectations of investors, and the price of our common stock may decline. As a result of seasonal fluctuations in our revenues, our quarterly results may fluctuate and could be below expectations. We have experienced and expect to continue to experience fluctuations in our operating results because of seasonal fluctuations in traditional retail patterns. In particular, a disproportionate amount of our revenues has been realized during the fourth quarter as a result of the December holiday season, and we expect this seasonality to continue in the future. Approximately 66.1%, 44.6% and 36.7% of our revenues for the fiscal years 2001, 2002 and 2003, respectively, were generated during the year s fourth quarter. In anticipation of increased sales activity during the fourth quarter, we incur significant costs for increased inventories. If we were to experience lower than expected revenues during any future fourth quarter, it would have a disproportionately large impact on our operating results and financial condition for that year. In the future, our seasonal sales patterns could become more pronounced, strain our personnel and fulfillment activities and cause a shortfall in revenues, which would substantially harm our business and results of operations. We have grown quickly and our business will suffer if we fail to manage our growth. We have rapidly and significantly expanded our operations and anticipate that further significant expansion will be required for potential growth. This expansion has placed strain, and is expected to continue to place strain, on our management, operational and financial resources. To manage the expected Approximate date of commencement of proposed sale to the public: As soon as practicable after the effective date of this Registration Statement. If any of the securities being registered on this Form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act, check the following box. If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. If delivery of the prospectus is expected to be made pursuant to Rule 434, check the following box. The registrant hereby amends this registration statement on such date or dates as may be necessary to delay its effective date until the registrant shall file a further amendment which specifically states that this registration statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933 or until the registration statement shall become effective on such date as the Commission, acting pursuant to said Section 8(a), may determine. Table of Contents growth of our operations and personnel, we will be required to improve existing and implement new transaction-processing, fulfillment, operational and financial systems, procedures and controls, and to expand, train and manage our employee base. If we are unable to manage growth effectively, our business, prospects, financial condition and results of operations will be harmed. If we fail to maintain an effective system of internal controls, we may not be able to accurately report our financial results or detect fraud. Consequently, investors could lose confidence in our financial reporting, and this would harm the trading price of our stock. We must maintain effective internal controls to provide reliable financial reports and detect fraud. We have been assessing our internal controls to identify areas that need improvement. In addition, our independent registered public accountants have advised us that we should implement a purchase order system for non-inventory related items and better segregate tasks performed by our accounting department so that account reconciliations are not performed by employees who have regular access to the related assets or who enter transactions on the accounts being reconciled. Our accountants have also recommended that we formalize the documentation of our accounting policies, our quarter-end and year-end closing procedures and our bank reconciliation reviews. They have identified these matters as significant deficiencies, as recently defined by the Public Company Accounting Oversight Board. We are in the process of implementing the changes recommended by our accountants to address these significant deficiencies, but have not yet completed implementing these changes. Failure to implement these changes to our internal controls or any others that we identify as necessary to maintain an effective system of internal controls could harm our operating results and cause investors to lose confidence in our reported financial information. Any such loss of confidence would have a negative effect on the trading price of our stock. Risks Relating to Our Outsourced Operations We outsource our warehouse and fulfillment operations to a third party. If these operations are interrupted for any significant period of time, or we experience other problems at our warehouse facility, our business and results of operations would be substantially harmed. We outsource our warehouse and fulfillment operations, including our inventory management, packaging, shipping and product return processes to a third party, UPS Supply Chain Solutions, a subsidiary of UPS. In January 2004, we entered into a five-year agreement with UPS Supply Chain Solutions that can be terminated by either party after three years, beginning January 27, 2007. We moved our warehouse and fulfillment operations to UPS Supply Chain Solutions in April 2004. UPS Supply Chain Solutions may not continue to perform these operations to our satisfaction or on commercially reasonable terms. Our outsourced warehouse and fulfillment operations are located in a single facility in Hebron, Kentucky. This facility is susceptible to damage or interruption from human error, fire, flood, power loss, telecommunications failure, terrorist attacks, acts of war, break-ins, earthquake and similar events. We do not presently have a formal disaster recovery plan and our business interruption insurance may be insufficient to compensate us for losses that may occur in the event operations at our fulfillment center are interrupted. We experienced delayed product shipments in May 2004 as we transitioned to the new UPS operations. Future interruptions in our fulfillment center operations for any significant period of time, including interruptions resulting from the expansion of our existing facility or the transfer of operations to a new facility, could damage our reputation and brand and substantially harm our business and results of operations. If we experience other problems with our warehouse and fulfillment center operations, including inventory damage and theft, our business will also suffer. We must manage customer returns and the shrinkage resulting from theft, loss and misrecording of inventory. If we are unsuccessful in any of these areas, our results of operations could be harmed. Table of Contents We outsource our customer service center to a third party. If these operations are interrupted for any significant period of time or we experience other problems at our customer service center, our business and results of operations would be substantially harmed. We outsource our customer service center to a third party, Market Central. We depend on Market Central s representatives to handle customer inquiries, answer their merchandise questions and place orders on behalf of customers who prefer to order by telephone. Our agreement with Market Central initially expires on May 1, 2005 and renews on a yearly basis. Any renewal period may be terminated by either party upon 90 days written notice. Market Central may not continue to perform these services to our satisfaction or on commercially reasonable terms, or at all. Our existing customers could become dissatisfied and cancel their orders or decline to make future purchases if they believe they are not receiving satisfactory customer service. Likewise, prospective customers may choose not to purchase from us if they perceive that we do not offer high quality customer service. If our customers or prospective customers become dissatisfied with the services provided by Market Central, our reputation could suffer, which could harm our revenues, business, prospects, financial condition and results of operations. Any interruptions in our customer service operations for any significant period of time, including interruptions resulting from telecommunications failure or from the transfer of operations to a different service provider, could damage our reputation and brand and substantially harm our business and results of operations. We depend on third parties to serve pages to visitors to our website and to process links from our advertisements to our website. Any interruption in these services could severely harm our revenues, business, prospects, financial condition and results of operations. We utilize the services of Akamai Technologies to serve pages to visitors to our website. If a significant portion of Akamai s global systems are interrupted for any reason, our customers would be unable to access our website, which could seriously harm our revenues, business, prospects, financial condition and results of operations. In May 2004, due to an Akamai system failure, customers were unable to access our website for approximately 80 minutes. In addition, we utilize the services of Commission Junction, a division of ValueClick, to process links from affiliate, portal and Bargain Alert advertisements to our website. Approximately half of our revenues are generated from customers who access our website through these advertisements. If Commission Junction s computer systems were interrupted for any reason, customers would not be able to access our website through these advertisements, which could seriously harm our revenues, business, prospects, financial condition and results of operations. Interruptions in the service provided by these companies have occurred in the past and may occur in the future. We depend on a third party to host our computer and communications hardware. Any interruption in these services could severely harm our revenues, business prospects, financial condition and results of operations. Substantially all of our computer and communications hardware is hosted by a third party, SAVVIS Communications, at its facility in Waltham, Massachusetts. Our systems and operations are vulnerable to damage or interruption from fire, flood, power loss, telecommunications failure, terrorist attacks, acts of war, break-ins, earthquake and similar events. We do not have back-up systems in other locations or a formal disaster recovery plan, and our business interruption insurance may be insufficient to compensate us for losses that may occur. Our servers are vulnerable to computer viruses, physical or electronic break-ins and similar disruptions, which could lead to interruptions, delays, loss of critical data or the inability to accept and fulfill customer orders. If it became necessary to transition to another facility or systems operator due to disruptions in service or for any reason, we may need to suspend the operation of our website during the transition. The occurrence of any of the foregoing risks could harm our revenues, business, prospects, financial condition and results of operations. Table of Contents Risks Relating to Managing Our Operations If our advertising and marketing efforts prove ineffective, or we are unable to attract customers on cost-effective terms, our operating results could be harmed. Our success depends on our ability to attract customers on cost-effective terms, which depends on our ability to advertise and market our products effectively through our website and our other advertising and marketing efforts. We have relationships with affiliates, portals and search engines to provide content, advertising and other links that direct consumers to our website. We rely on these relationships, as well as direct marketing, as significant sources of traffic to our website and to generate new customers. Increases in the cost of advertising and marketing, including costs and fees associated with banner and Internet advertising and affiliate marketing programs, may limit our ability to advertise and market our business without increasing our expenses. We expect to increase spending on advertising and marketing in the future, and if our advertising and marketing efforts prove ineffective or do not produce a sufficient level of sales to cover their costs, our operating results would be harmed. Conversely, if we decrease our advertising or marketing activities due to increased costs or for any other reason, our future operating results could be significantly harmed. We are dependent on several marketing relationships for a significant portion of our revenues. If these relationships are not continued or are substantially curtailed, our business could be severely harmed. We have marketing agreements with America Online, which holds approximately 10% of our common stock, and Microsoft Corporation s MSN. Our agreements with AOL allow us to advertise on the AOL Shop@ section of AOL s website and on other sections of AOL s websites and to feature our merchandise on a SmartBargains website, branded AOL Outlets and located at www.aoloutlets.com, that we developed and maintain. Aggregate revenues derived through these sources accounted for 17.5% of total revenues in the quarter ended May 1, 2004 and 19.3% in fiscal 2003. The agreement to advertise on AOL Shop@ runs through September 14, 2004. The agreement to advertise on other AOL websites expires on March 31, 2005. The agreement to operate AOL Outlets runs through March 8, 2005. Our agreement with MSN allows us to advertise on MSN s websites and runs through July 2, 2004. Revenues derived from advertising with MSN accounted for 7.7% of total revenues in the quarter ended May 1, 2004 and 11.3% in fiscal 2003. If our agreements with AOL or MSN are terminated or are not renewed on commercially reasonable terms, our business would be harmed. If we were unable to advertise or were restricted from advertising on AOL or MSN for any reason, our business could be severely harmed. We may not succeed in continuing to establish or promote the SmartBargains brand, which would prevent us from acquiring customers and increasing our revenues. Due to the competitive nature of the online retail market, if we do not continue to establish or promote our brand, we may fail to attract the customers required to substantially increase our revenues. Promoting and positioning our brand will depend largely on the success of our marketing and merchandising efforts and our ability to provide a consistent, high quality customer experience. We may not be able to compete successfully against existing or future competitors. The online retail market for excess merchandise is new, rapidly evolving and intensely competitive. Barriers to entry are minimal, and current and new competitors can launch new websites at a relatively low cost. We currently compete with: Internet based off-price retailers such as Bluefly and Overstock.com; off-price retail chains such as Ross Stores, TJX Companies and Tuesday Morning; auction websites such as eBay; outlet malls; and discount retailers and wholesale clubs such as Wal-Mart and Costco Wholesale. Table of Contents The information in this prospectus is not complete and may be changed. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell these securities and it is not soliciting an offer to buy these securities in any state where the offer or sale is not permitted. Subject to Completion Preliminary Prospectus dated August 27, 2004 PROSPECTUS Shares Common Stock Table of Contents We expect the retail market for excess merchandise to become even more competitive as Internet and other retailers continue to develop services that compete with our services. In addition, manufacturers and retailers may decide to create their own websites to sell their own excess inventory and the excess inventory of third parties. Competitive pressures could severely harm our revenues, business, prospects, financial condition and results of operations. Many of our current and potential competitors have longer operating histories, larger customer bases, greater brand recognition and significantly greater financial, marketing and other resources than we do. Retail chains offer consumers the ability to physically handle and examine products in a manner that is not possible over the Internet, as well as a more convenient means of returning and exchanging purchased products. In addition, Internet based retailers may be acquired by, receive investments from or enter into other commercial relationships with larger, well-established and well-financed companies. Some of our competitors may be able to secure merchandise from suppliers on more favorable terms, devote greater resources to marketing and promotional campaigns, adopt more aggressive pricing or inventory availability policies and devote substantially more resources to website and systems development than we are able to do. Increased competition may result in reduced operating margins, loss of market share and impairment of the SmartBargains brand. We may not be able to compete successfully against current and future competitors. If we do not manage our inventory levels successfully, our operating results will be adversely affected. To manage our inventory successfully, we need to maintain sufficient inventory to meet the demands of our customers and sell our inventory rapidly enough to avoid inventory markdowns for unpopular or obsolete items. Seasonality and rapidly changing trends in consumer tastes expose us to significant inventory risks. Consumer preferences can change between the time we order a product and the time it is available for sale. In the event that one or more products do not achieve consumer acceptance, we may be required to take significant inventory markdowns for unpopular or obsolete inventory, which could reduce our revenues and gross margins. In addition, to the extent that our sales increase over time, we may be forced to increase inventory levels. Any such increase would require the use of additional working capital and subject us to additional inventory risks. Our operating results depend on our website, network infrastructure and transaction-processing systems. Capacity constraints or system failures would harm our revenues, business, prospects, results of operations and financial condition. We use internally developed systems for our website and certain aspects of transaction processing, including order verifications. Our systems must be able to communicate with the systems of our outsourced warehouse and fulfillment center, outsourced customer service center, drop-ship suppliers and other third parties. If our systems were unable to communicate with these third party systems due to interruptions or failures in network infrastructure, technical incompatibility or otherwise, it could cause deterioration in these third party relationships, system disruptions, slower response times, degradation in levels of customer service, impaired quality and speed of order fulfillment or delays in reporting accurate financial information. We have experienced systems interruptions due to server failure, which we believe may continue to occur from time to time. Any interruptions or failures of our current systems to communicate with third party systems could seriously harm our revenues, business, prospects, financial condition and results of operations. If we are unable to expand and upgrade our systems in the future to increase capacity, our revenues, business, prospects, financial condition and results of operations would be harmed. We have experienced and may continue to experience temporary capacity constraints due to sharply increased traffic during sales or other promotions and during the December holiday shopping season. If the volume of traffic on our website or the number of purchases made by customers substantially increases, we will need to further expand and upgrade our technology, transaction processing systems and network infrastructure. We may be unable to project accurately the rate or timing of traffic increases or successfully upgrade our systems and infrastructure to accommodate future traffic levels on our website. This is SmartBargains, Inc. s initial public offering. We are selling shares and the selling stockholders are selling shares. We will not receive any proceeds from the sale of shares by the selling stockholders. We expect the public offering price to be between $ and $ per share. Currently, no public market exists for the shares. After pricing of the offering, we expect that the shares will be quoted on the Nasdaq National Market under the symbol SBAR. Investing in the common stock involves risks that are described in the Risk Factors section beginning on page 6 of this prospectus. Table of Contents The loss of key personnel or any inability to attract and retain additional personnel could affect our ability to successfully grow our business. Our performance is substantially dependent on the continued services and on the performance of our executive officers. All of our employees, including our executive officers, are employees-at-will and we do not maintain key person life insurance policies. Our future success also depends on our ability to identify, attract, hire, train, retain and motivate other highly-skilled technical, managerial, merchandising and marketing personnel. Competition for such personnel is intense, and we may not be able to successfully attract, assimilate or retain sufficiently qualified personnel. Our failure to attract and retain the necessary personnel could harm our revenues, business, prospects, financial condition and results of operations. Risks Relating to Our Merchandise Inadvertent sale or advertisement by us of gray market or counterfeit goods may harm our business. A significant portion of the products that we sell are branded. As a result, we have received in the past, and we anticipate we will receive in the future, claims asserted by third parties alleging that certain items that we offer for sale on our website infringe third party copyrights, trademarks and trade names or other intellectual property rights. Resolving litigation or claims regarding trademark infringement related to the sale of genuine goods not properly authorized for sale in the United States, commonly known as gray market goods, or counterfeit goods, whether meritorious or not, can be costly and time-consuming, cause service delays, divert our management from our business operations, require expensive or unwanted changes in our methods of doing business or require us to enter into costly royalty or licensing agreements, if available. As a result, these claims could harm our business. A significant increase in merchandise returns and the failure to accurately predict those returns could substantially harm our revenues, business, prospects, financial condition and results of operations. We allow customers to return most items to us within 30 days after receiving their order for a 100% refund of the merchandise price, not including shipping fees. We make allowances for product returns in our financial statements based on historical return rates. Actual merchandise returns are difficult to predict and may significantly exceed our allowances. Any significant increase in merchandise returns would substantially harm our revenues, business, prospects, financial condition and results of operations. Any policies intended to reduce the number of product returns may result in customer dissatisfaction and fewer repeat customers. If we implement a more restrictive return policy, our revenues, business, prospects, financial condition and results of operations could be harmed. The success of our business may depend on our ability to successfully expand our product offerings. Our ability to significantly increase our revenues and achieve and maintain profitability may depend on our ability to successfully expand our product departments beyond our current offerings. If we offer a new product department that is not accepted by consumers, the SmartBargains brand and reputation could be adversely affected, our revenues may fall short of expectations and we may incur substantial expenses that are not offset by increased revenues. Expansion of our product departments may also strain our management and operational resources. If the products that we offer on our website do not reflect the tastes and preferences of our target customers at a price they are willing to pay, our revenues and profit margins would decrease. Consumers tastes are subject to frequent, significant and sometimes unpredictable changes. Because the products that we sell typically consist of manufacturers and retailers excess inventory, we have limited control over the specific products that we are able to offer for sale. If our merchandise fails to satisfy the tastes of our target customers, or respond to changes in their preferences, our sales could suffer and we could Per Share Total Table of Contents be required to mark down unsold inventory, which would depress our profit margins. In addition, unless we offer products at prices that our target customers are willing to pay, our revenues will decline. If we fail to maintain our relationships with manufacturers, retailers and other suppliers on acceptable terms, our sales could suffer. We typically do not enter into contracts or arrangements with suppliers that guarantee the long-term availability of merchandise, but instead purchase merchandise pursuant to individual purchase orders. Our current suppliers may discontinue selling their excess inventory to us, and we may not be able to establish new supply relationships. In most cases, our suppliers are free to sell their excess inventory to other retailers, which could in turn limit the selection of products that we are able to offer for sale on our website. If we are unable to maintain relationships with suppliers that allow us to obtain sufficient quantities of merchandise on acceptable terms, our revenues, business, prospects, financial condition and results of operations could be harmed. We may be subject to product liability claims that could be costly and time consuming. We sell products manufactured by third parties, some of which may be defective. If any product that we sell were to cause physical injury or injury to property, the injured party or parties could bring claims against us as the retailer of the product. Our insurance coverage may not be adequate to cover every claim that could be asserted. If a successful claim were brought against us in excess of our insurance coverage, it could adversely affect our business. Even unsuccessful claims could result in the expenditure of funds and management time and could have a negative impact on our business. Risks Relating to Intellectual Property We may not be able to maintain or obtain trademark protection for our marks, which could impede our efforts to build brand identity. We regard our intellectual property, particularly our service marks and domain names, as critical to our success. As a result, we rely on a combination of contractual restrictions, copyrights and trade secrets to protect our proprietary rights, know-how, information and technology. Despite these precautions, it may be possible for a third party to copy or otherwise obtain and use our intellectual property without authorization or independently develop similar intellectual property. We have registered smartbargains and smartbargains.com as service marks in the United States, and use The Bargain Alert as an unregistered service mark. We have also registered SmartBargains in certain other countries. Our competitors may adopt service names similar to ours, thereby impeding our ability to build brand identity and possibly leading to customer confusion. In addition, there could be potential trade name or trademark infringement claims brought by owners of other registered trademarks or trademarks that incorporate variations of the term smartbargains or our other service marks. Any claims or customer confusion related to our service marks could damage our reputation and brand and substantially harm our business and results of operations. We currently hold the smartbargains.com Internet domain name and various other related domain names. If competitors adopt website Internet domain names similar to ours, it could impede our ability to build brand identity and lead to customer confusion. While our business is focused on customers within the United States, an Internet domain name overseas that causes confusion with smartbargains.com could also harm our business. Domain names generally are regulated by Internet regulatory bodies and are subject to change. Regulatory bodies could establish additional top-level domains, appoint additional domain name registrars or modify the requirements for holding domain names. As a result, we may not be able to acquire or maintain the domain names that utilize the name SmartBargains in all of the countries in which we currently or intend to conduct business, or where doing so would preserve the SmartBargains brand. Net cash provided by (used in) investing activities (491 ) (1,778 ) (1,247 ) 29 (443 ) Cash flows from financing activities: Repayments of capital lease obligations (83 ) (370 ) (33 ) (67 ) Short term borrowings 2,488 Proceeds from issuance of mandatorily redeemable convertible preferred stock and warrants, net of issuance costs 11,000 18,710 4,942 Repurchase of Class B nonvoting common stock (41 ) (21 ) (20 ) Proceeds from issuance of Class A common stock 17 23 178 18 Table of Contents Assertions by third parties of infringement by us of their intellectual property rights could result in significant costs and substantially harm our business and results of operations. Other parties may assert that we have infringed their technology or other intellectual property rights. We use internally developed systems and licensed technology to operate our website. Third parties could assert intellectual property infringement claims against us for our internally developed systems or against parties from whom we license technology. We cannot predict whether any such assertions or claims arising from such assertions will substantially harm our business and results of operations. If we are forced to defend against any infringement claims, whether they are with or without merit or are determined in our favor, we may face costly litigation, diversion of technical and management personnel or product shipment delays. Furthermore, the outcome of a dispute may be that we would need to change technology, develop non-infringing technology or enter into royalty or licensing agreements. A switch to different technology could cause interruptions in our business. Royalty or licensing agreements, if required, may be unavailable on terms acceptable to us, or at all. Risks Relating to the Internet Industry Our success is tied to the continued use of the Internet and the reliability and adequacy of the Internet infrastructure. If consumers are unwilling to use the Internet to purchase goods for any reason, our revenues, business, prospects, financial condition and results of operations would be harmed. Our business is substantially dependent upon the continued use of the Internet as an effective medium of business and communication by our target customers. Internet use may not continue to develop at historical rates and consumers may not continue to use the Internet and other online services as a medium for commerce. Even if the total market for the sale of goods and services from businesses to consumers through the Internet continues to grow, some segments of this market may grow at a slower pace than of the total market or not at all. If the market for the sale of excess inventory through the Internet grows slowly or not all, our revenues, business, prospects, financial conditions and results of operations could be harmed. The demand for and acceptance of products sold over the Internet are highly uncertain, and most e-commerce businesses have limited operating histories. Failures by some online retailers to meet consumer demands could result in consumer reluctance to adopt the Internet as a means for commerce, and thereby damage our reputation and substantially harm our business and results of operations. Our success will depend, in large part, upon third parties maintaining the Internet infrastructure to provide a reliable network backbone with the speed, data capacity, security and hardware necessary for reliable Internet access and services. Our business, which relies on a contextually rich website that requires the transmission of substantial data, is also significantly dependent upon the availability and adoption of high speed Internet access. Credit card fraud could adversely affect our business. We do not carry insurance against the risk of credit card fraud, so the failure to adequately control fraudulent credit card transactions could reduce our operating income. We experienced a $320,000 loss from credit card fraud in the first quarter of fiscal year 2002 and we may suffer further losses in the future as a result of credit card fraud. Under current credit card practices, we may be liable for fraudulent credit card transactions because we do not obtain a cardholder s signature. If we are unable to detect or control credit card fraud, our liability for these transactions could harm our business, results of operations or financial condition. Public offering price $ $ Underwriting discount $ $ Proceeds, before expenses, to SmartBargains, Inc. $ $ Proceeds, before expenses, to the selling stockholders $ $ The underwriters may also purchase up to an additional shares from SmartBargains, and up to an additional shares from the selling stockholders, at the public offering price, less the underwriting discount, within 30 days from the date of this prospectus to cover overallotments. Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense. The shares will be ready for delivery on or about , 2004. Income (loss) before income taxes (13,802 ) (10,688 ) (1,374 ) (1,549 ) (1,667 ) Income taxes 29 Table of Contents Our failure to protect confidential information of our customers and our network against security breaches could damage our reputation, expose us to liability and harm our business and results of operations. If third parties are able to penetrate our network security or otherwise misappropriate our customers personal information or credit card information, or if we give third parties improper access to our customers personal information or credit card information, it could damage our reputation, expose us to liability and harm our business and results of operations. This liability could include claims for unauthorized purchases with credit card information, impersonation or other similar fraud claims. This liability could also include claims for other misuses of personal information, including unauthorized marketing purposes. These claims could result in litigation. Liability for misappropriation of this information could adversely affect our business. We rely on encryption and authentication technology licensed from third parties to provide the security and authentication necessary to effect secure transmission of confidential information such as customer credit card numbers. If any compromise of our security were to occur, it could harm our reputation, business, prospects, financial condition and results of operations. A party who is able to circumvent our security measures could misappropriate proprietary information or cause interruptions in our operations. We may be required to expend significant capital and other resources to protect against such security breaches or to alleviate problems caused by such breaches. If our security measures do not prevent security breaches, our revenues, business, prospects, financial condition and results of operations could be harmed. Existing or future government regulation impacting the use of the Internet could harm our business. We are subject to the same federal, state and local laws as other companies conducting business on the Internet. There are relatively few laws specifically directed towards conducting business on the Internet. However, due to the increasing popularity and use of the Internet, many laws and regulations relating to the Internet are being debated at the state and federal levels. These laws and regulations could cover issues such as user privacy, freedom of expression, pricing, fraud, quality of products and services, taxation, advertising, intellectual property rights and information security. Applicability to the Internet of existing laws governing issues such as property ownership, copyrights and other intellectual property issues, taxation, libel, obscenity and personal privacy could also harm our business. United States and foreign laws regulate our ability to use customer information and to develop, buy and sell mailing lists. The vast majority of these laws were adopted prior to the advent of the Internet, and do not contemplate or address the unique issues raised thereby. Those laws that do reference the Internet, such as the Digital Millennium Copyright Act and the CAN-SPAM Act of 2003, are only beginning to be interpreted by the courts and their applicability and reach are therefore uncertain. These current and future laws and regulations could harm our business, results of operations and financial condition. If one or more states successfully assert that we should collect sales or other taxes on the sale of our merchandise or the merchandise of third parties that we offer for sale on our website, our business could be harmed. We do not currently collect sales or other similar taxes for physical shipments of goods into states other than Kentucky, Massachusetts and North Carolina, states in which we have a presence either directly or indirectly through outsourced operations. One or more local or state jurisdictions may seek to impose sales tax collection obligations on us and other out-of-state companies that engage in online commerce. Our business could be adversely affected if one or more states successfully asserts that we should collect sales or other taxes on the sale of our merchandise. In October 1998, the United States adopted The Internet Tax Freedom Act. This law imposed a three-year moratorium on the imposition of new, special, and discriminatory taxes on Internet access and transactions, but exempted through a grandfather clause the Internet access taxes that were then in effect in eight states (Connecticut, Iowa, New Mexico, North Dakota, Ohio, South Dakota, Tennessee and Income (loss) before income taxes (13,158 ) (13,802 ) (10,688 ) (1,374 ) (1,549 ) (1,667 ) Income taxes 29 Income (loss) before income taxes (2,679 ) (3,573 ) (3,403 ) (1,033 ) (1,549 ) (1,332 ) 146 1,361 (1,667 ) Income taxes 29 Loss before income taxes (13,802 ) (10,688 ) (1,374 ) (1,549 ) (1,667 ) Provision for income tax 29 Merrill Lynch Co. SG Cowen Co. Pacific Crest Securities Table of Contents Wisconsin). In November 2001, the moratorium and grandfather clause were extended through November 1, 2003. In September 2003, the United States House of Representatives adopted a bill which, if enacted into law, would make the moratorium permanent and end the grandfather clause. In April 2004, the United States Senate passed a bill which, if enacted into law, would extend the moratorium and grandfather clause to November 1, 2007. The differences between the House and Senate bills must be reconciled before a new moratorium, whether permanent or temporary, can be enacted into law. The moratorium, in the form that expired in November 2003 and the form proposed for extension by the Senate, prohibits three types of taxes relating to the Internet: (1) taxes on Internet access; (2) double-taxation (for example, by two or more states) of a product or service bought over the Internet; and (3) discriminatory taxes that treat Internet purchases differently from other types of sales. While the moratorium, in both its expired and proposed form, does not expressly prohibit states from collecting sales taxes on Internet purchases, the prohibitions on double-taxation and discriminatory taxation make it difficult to adopt such taxes. Moreover, the United States Supreme Court has ruled that vendors whose only connection with customers in a state seeking to impose sales taxes is by common carrier or the United States mail are free from state imposed duties to collect sales and use taxes. This rule is generally regarded as being applicable to sales ordered through the Internet. If the moratorium under consideration by the United States Congress is not extended or made permanent, or the existing case law exemption from sales and use taxes for common carrier and mail order sales is ruled to be inapplicable to sales through the Internet or otherwise changed by federal legislation, our sales could be adversely affected. Laws or regulations relating to online commerce, including with respect to privacy and data protection, may adversely affect the growth of our Internet business or our marketing efforts. We are subject to increasing regulation at the federal and state levels relating to privacy and the use of personal user information. The Federal Trade Commission has adopted regulations regarding the collection and use of personal identifying information obtained from children under the age of 13. Bills proposed in Congress would extend online privacy protections to adults. Moreover, current and proposed laws require companies to establish procedures to notify users of privacy and security policies, obtain consent from users for collection and use of personal information, and/or provide users with the ability to access, correct and delete personal information stored by us. These data protection regulations and enforcement efforts may restrict our ability to collect demographic and personal information from users, which could be costly or harm our marketing efforts. Several states have proposed legislation that would limit the uses of personal user information gathered online or require online services to establish privacy policies. Some states have also recently adopted legislation that limits the gathering of Internet-user data and the display of pop-up advertisements, such as Utah s Spyware Control Act. Such legislation could adversely impact online commerce by limiting the ability of retailers to use customer analytics and certain forms of online advertising. In addition, we may face liability for violations of such legislation. We are the subject of a lawsuit in Utah which alleges that we violated the Utah Spyware Control Act, engaged in unfair competition and improperly interfered with the plaintiff s current and potential customers. This lawsuit, or other similar lawsuits in the future, could damage our reputation and brand and substantially harm our business and results of operations. Online retailers are also subject to regulations that apply to retailers generally, including those of the Federal Trade Commission with respect to truthful advertising and pricing comparisons. Some Internet retailers have recently come under scrutiny for their failure to comply with truth in advertising regulations. Any failure by us to comply with such regulations, or other regulations that apply to retailers generally, could harm our business, results of operations and financial condition. Changes in accounting standards or our accounting policy relating to stock-based compensation may negatively affect our reported results of operations. We currently are not required to record stock-based compensation charges if the employee s stock option exercise price equals or exceeds the deemed fair value of our common stock at the date of grant. However, several companies recently have elected to change their accounting policies and begun to record Expected tax (4,693 ) 34.0 % (3,634 ) 34.0 % (467 ) 34.0 % Effect of change in valuation allowance 5,472 (39.6 ) 4,293 (40.2 ) 545 (39.7 ) State taxes, net (850 ) 6.2 (667 ) 6.2 (65 ) 4.7 Other 71 (0.5 ) 8 (0.1 ) The date of this prospectus is , 2004. Table of Contents the fair value of stock options as an expense. Although the standards have not been finalized and the timing of a final statement has not been established, the Financial Accounting Standards Board, or FASB, has issued an exposure draft that included a requirement for companies to record the fair value of stock options granted as an expense. We account for stock-based employee compensation arrangements under the recognition and measurement provisions of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees , and related interpretations. Under APB 25, compensation expense is recognized for the difference between the fair value of our stock on the date of grant and the exercise price. We have elected to apply the disclosure-only provisions of Statement of Financial Accounting Standards No. 123, Accounting for Stock Based Compensation . Had compensation cost for the Company s stock options been determined based on the fair value of the options at the date of grant under SFAS No. 123, our pro forma net income (loss) would have been as set forth in Note 2 to our consolidated financial statements included elsewhere in this prospectus. Risks Relating to This Offering No public market for our common stock currently exists and an active trading market may not be developed or sustained after this offering. Before this offering, there was no public trading market for our common stock. We cannot be certain that an active trading market for our common stock will develop or be sustained following this offering. Further, we cannot be certain that the market price of our common stock will not decline below the initial public offering price. The initial public offering price was determined by negotiation among us and the underwriters based upon several factors and may not be indicative of future market prices for our common stock. The price of our common stock may be volatile. The trading price of our common stock following this offering may fluctuate substantially. The price of the common stock that will prevail in the market after this offering may be higher or lower than the price you pay, depending on many factors, some of which are beyond our control and may not be related to our operating performance. The fluctuations could cause you to lose part or all of your investment in our shares of common stock. Those factors that could cause fluctuations in the trading price of our common stock include, but are not limited to, the following: actual or anticipated changes in our earnings or fluctuations in our operating results or in the expectations of securities analysts; departures of key personnel; sales of large blocks of our stock; significant volatility in the market price and trading volume of companies in our market; price and volume fluctuations in the overall stock market from time to time; general economic conditions and trends; or major catastrophic events. In addition, the market prices of technology and e-commerce companies generally have been volatile and have experienced sharp share price and trading volume changes in the first days and weeks after the securities were released for public trading. In the past, following periods of volatility in the market price of a company s securities, securities class action litigation has often been brought against that company. Due to the potential volatility of our stock price, we may therefore be the target of securities litigation in the future. Securities litigation could result in substantial costs and divert management s attention and resources from our business. Table of Contents Table of Contents Securities analysts may not initiate coverage or continue to cover our common stock and this may have a negative impact on our common stock s market price. The trading market for our common stock will depend on the research and reports that securities analysts publish about us or our business. We do not have any control over these analysts. As an early stage company with no significant corporate history and no existing public market for our common stock, securities analysts may not cover our common stock after the completion of this offering. If securities analysts do not cover our common stock after the completion of this offering, the lack of research coverage may adversely affect our common stock s market price. If one or more of these analysts cease coverage of our company or fail to regularly publish reports on us, we could lose visibility in the financial markets, which could cause our stock price or trading volume to decline. If a substantial number of shares of our common stock become available for sale and are sold in a short period of time, the market price of our common stock could decline significantly. If our existing stockholders sell substantial amounts of our common stock in the public market following this offering, the market price of our common stock could decrease significantly. The perception in the public market that our existing stockholders might sell shares of common stock could also depress the market price of our common stock. Upon completion of this offering we will have shares of common stock outstanding, assuming no exercise of the underwriters overallotment option. All but of the shares of our common stock that are not being sold in this offering will be eligible for sale in the public market 180 days after the date of this prospectus under Rules 144, 144(k) and 701, subject in some cases to volume and other limitations. In addition, of the shares issuable upon exercise of options to purchase our common stock outstanding as of , 2004, approximately shares will be vested and eligible for sale upon exercise 180 days after the date of this prospectus, as will shares of common stock issuable upon exercise of outstanding warrants. For a further description of the eligibility of shares for sale into the public market following this offering see Shares Eligible for Future Sale. A number of our current stockholders hold registration rights relating to our common stock. If we propose to register any of our securities under the Securities Act either for our own account or for the accounts of other security holders after this offering, subject to certain conditions and limitations, the holders of registration rights will be entitled to include their shares of common stock in the registered offering. In addition, holders of registration rights may require us at any time after March 16, 2005 to file a registration statement under the Securities Act with respect to their shares of common stock. Further, the holders of registration rights may require us to register their shares on Form S-3 if and when we become eligible to use that form. In the future, we may also issue additional shares to our employees, directors or consultants, in connection with corporate alliances or acquisitions and in follow-on offerings to raise additional capital. As such, sales of a substantial number of shares of our common stock in the public market could occur at any time. These sales could reduce the market price of our common stock. If you purchase shares of common stock sold in this offering, you will experience immediate dilution. If you purchase shares of common stock in this offering, you will experience immediate dilution of $ per share assuming an offering price of per share, because the price that you pay will be substantially greater than the net tangible book value per share of common stock that you acquire. As a result, you will pay a price per share that substantially exceeds the per share book value of our net assets. In addition, purchasers of common stock in this offering will have contributed % of the aggregate price paid by all purchasers of our stock but will own only % of our common stock outstanding after this offering. You will experience additional dilution upon the exercise of stock options to purchase common stock and the issuance of restricted stock to our employees under our equity incentive plans. TABLE OF CONTENTS Page Table of Contents We have broad discretion in the use of the proceeds of this offering. The net proceeds from this offering will be used, as determined by management in its sole discretion, for working capital and general corporate purposes. Our management will have broad discretion over the use and investment of the net proceeds of this offering, and, accordingly, investors in this offering will need to rely upon the judgment of our management with respect to the use of proceeds. We do not intend to pay dividends on our common stock and, consequently, your only opportunity to achieve a return on your investment is if the price of our stock appreciates. We do not plan to declare dividends on shares of our common stock in the foreseeable future. Consequently, your only opportunity to achieve a return on your investment in us will be if the market price of our common stock appreciates and you sell your shares at a profit. There is no guarantee that the price of our common stock that will prevail in the market after this offering will ever exceed the price that you pay. Insiders will continue to have substantial control over us after this offering and could limit your ability to influence the outcome of key transactions, including a change of control. Our principal stockholders, directors and executive officers, and entities affiliated with them, will own approximately % of the outstanding shares of our common stock after this offering. As a result, these stockholders, if acting together, would be able to influence or control matters requiring approval by our stockholders, including the election of directors and the approval of mergers, acquisitions or other extraordinary transactions. They may also have interests that differ from yours and may vote in a way with which you disagree and which may be adverse to your interests. The concentration of ownership may have the effect of delaying, preventing or deterring a change of control of our company, could deprive our stockholders of an opportunity to receive a premium for their common stock as part of a sale of our company and might ultimately affect the market price of our common stock. Some provisions in our certificate of incorporation and bylaws may deter third parties from acquiring us. Our certificate of incorporation and our bylaws filed on the closing of this offering will contain provisions that may make the acquisition of our company more difficult without the approval of our board of directors, including the following: our board of directors is classified into three classes, each of which will serve for staggered three year terms; only our board of directors, the chairman of our board of directors or our president may call special meetings of our stockholders; our stockholders may take action only at a meeting of our stockholders and not by written consent; we have authorized undesignated preferred stock, the terms of which may be established and shares of which may be issued without stockholder approval; our stockholders have only limited rights to amend our bylaws; and we require advance notice requirements for stockholder proposals. These anti-takeover defenses could discourage, delay or prevent a transaction involving a change in control of our company. These provisions could also discourage proxy contests and make it more difficult for you and other stockholders to elect directors of your choosing and cause us to take other corporate actions you desire. Table of Contents Section 203 of the Delaware General Corporation Law may delay, defer or prevent a change in control that our stockholders might consider to be in their best interest. We are subject to Section 203 of the Delaware General Corporation Law which, subject to certain exceptions, prohibits business combinations between a publicly-held Delaware corporation and an interested stockholder, which is generally defined as a stockholder who becomes a beneficial owner of 15% or more of a Delaware corporation s voting stock, for a three-year period following the date that such stockholder became an interested stockholder. Section 203 could have the effect of delaying, deferring or preventing a change in control of our company that our stockholders might consider to be in their best interests. Table of Contents
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+Table of Contents Following the subsequent issuance of notes with OID (or any issuance of notes thereafter) and resulting exchange, we (and our agents) will report any OID on the subsequently issued notes ratably among all holders of notes and IDSs, and each holder of notes or IDSs will, by purchasing notes or IDSs, agree to report OID in a manner consistent with this approach. However, the IRS may assert that any OID should be reported only to the persons that initially acquired such subsequently issued notes (and their transferees) and thus may challenge the holders reporting of OID on their tax returns. Such a challenge by the IRS could create significant uncertainties in the pricing of IDSs and notes and could adversely affect the market for IDSs and notes. For a discussion of these tax related risks, see Material U.S. Federal Income Tax Consequences. Holders of subsequently issued notes may not be able to collect their full stated principal amount prior to maturity. Under New York and federal bankruptcy law, holders of subsequently issued notes having OID (including the recipients of such notes pursuant to the automatic exchange under the indenture) may not be able to collect the portion of their principal amount that represents unaccrued OID in the event of an acceleration of the notes or our bankruptcy prior to the maturity date of the notes. As a result, an automatic exchange that results in a holder receiving an interest in notes with OID in exchange for notes that do not have OID could have the effect of ultimately reducing the amount such holder can recover from us in the event of an acceleration or bankruptcy to an amount that is less than the amount paid for the notes in this offering. If the IDSs separate, the limited liquidity of the market for the notes and Class A common stock may adversely affect your ability to sell the notes and Class A common stock. We do not intend to list the notes represented by the IDSs on any exchange or quotation system. Our shares of Class A common stock will be listed on the Toronto Stock Exchange, but holders of shares of Class A common stock will not be able to trade such shares on the Toronto Stock Exchange until the applicable requirements for separate trading are satisfied, including that a sufficient number of shares are held separately, not represented by IDSs, by a sufficient number of holders. Our Class A common stock will not initially be listed on any other exchange or quotation system, including the New York Stock Exchange. We will not apply to list our shares of Class A common stock for separate trading on the New York Stock Exchange or on any other exchange or quotation system on which the IDSs are then listed until a sufficient number of shares is held separately, not represented by IDSs, by a sufficient number of holders to satisfy applicable requirements for separate trading on such exchange or quotation system for 30 consecutive trading days. The Class A common stock may not be approved for listing at such time. Upon separation of the IDSs, no sizable market for the notes and the Class A common stock may ever develop and the liquidity of any trading market for the notes or the Class A common stock that does develop may be limited. As a result, your ability to sell your notes or Class A common stock, and the market price you can obtain, could be adversely affected. The limited liquidity of the trading market for the notes sold separately (not represented by IDSs) may adversely affect the trading price of the separate notes. We are separately selling $45.3 million aggregate principal amount of notes (not represented by IDSs), representing approximately 10.0% of the total outstanding notes (assuming the exchange of all outstanding Class B common stock for IDSs). While the notes sold separately (not represented by IDSs) are part of the same series of notes as, and identical to, the notes represented by IDSs at the time of the issuance of the separate notes, the notes represented by the IDSs will not be separable for at least 45 days and will not be separately tradeable until separated. As a result, the initial trading market for the notes sold separately (not represented by IDSs) will be very limited. Even after holders of the IDSs are permitted to separate their IDSs, a sufficient number of holders of IDSs may not separate their IDSs into shares of our Class A common stock and notes to create a sizable and more liquid trading market for the notes not represented by IDSs. Therefore, a liquid market for the separate notes may not develop, which may adversely affect the ability of the holders of the separate notes to sell any of their separate notes and the price at which these holders would be able to sell any of the notes sold separately. Table of Contents Required payments with respect to our indebtedness and payments pursuant to our dividend policy will reduce the amount of funds available for other corporate purposes, which could harm our competitiveness and/or limit opportunities to grow our business. Upon completion of this offering, we expect that the cash generated by our business in excess of operating needs, reserves for contingencies and capital expenditures (including an amount sufficient to maintain our operations, properties and other assets and a limited amount to finance growth opportunities) will be dedicated to the payment of the principal of and interest on our indebtedness and dividends on our common stock, thereby reducing funds available for other purposes, including research and development, additional capital expenditures and acquisitions. Accordingly, such interest and dividend payments may mean: we will have less funds available to devote to research and development, which could reduce our ability to develop new and innovative technologies and products and ultimately affect our ability to remain competitive; we will have less funds available for capital expenditures, which could inhibit our ability to invest in new or upgraded production equipment and other capabilities, thereby restricting efforts to improve our manufacturing processes, reduce our operating costs, expand product offerings and conduct business in new markets; and we will have reduced flexibility to finance growth opportunities such as acquisitions, which could limit or cause us to forego future opportunities to grow our business. We may be able to incur substantially more debt, which would increase the risks described above associated with our substantial leverage. We may be able to incur substantial additional indebtedness in the future. Specifically, the indenture governing the notes will permit us to incur additional debt, including issuances of additional notes under the indenture, unless our total leverage ratio exceeds 5.55:1. The indenture governing the notes will also permit us to incur other amounts of additional debt without regard to such total leverage ratio, including certain capitalized lease obligations, refinancing indebtedness, hedging obligations and issuances of additional notes in connection with the exercise of the underwriters over-allotment option or upon exchange of the shares of Class B common stock outstanding immediately following the completion of this offering. The new credit facility provides up to $100 million of borrowing from undrawn commitments under our revolving credit facility and for the incurrence of $20,000,000 of additional indebtedness with respect to capital leases and purchase money obligations, $15,000,000 of general additional indebtedness and certain other additional indebtedness. As of June 30, 2004, on a pro forma basis after giving effect to this offering and the related transactions contemplated by this prospectus, based on the covenants in the indenture governing the notes and our new credit facility, we would have had the ability to incur an additional $109.2 million aggregate principal amount of indebtedness, all of which could be senior indebtedness. Shortly following the completion of this offering, we expect to borrow approximately $40 million under our revolving credit facility to fund the legal reorganization of a portion of our international operations. For details regarding the circumstances under which we would be able to incur additional indebtedness, see Description of Certain Indebtedness New Credit Facility Covenants, Description of Notes Additional Notes and Description of Notes Certain Covenants Limitations on Incurrence of Indebtedness and Issuance of Disqualified Stock and Preferred Stock. Any additional indebtedness incurred by us could increase the risks associated with our substantial leverage. Table of Contents You may not receive any dividends. Dividend payments are not guaranteed and are within the absolute discretion of our board of directors. You may not receive any dividends as a result of any of the following factors: nothing requires us to pay dividends; while the dividend policy to be adopted by our board of directors upon the closing of this offering contemplates the distribution of our excess cash, up to the intended dividend rate set forth in Dividend Policy and Restrictions, our board of directors could modify or revoke the policy at any time and for any reason. The policy to distribute our excess cash is based upon our current assessment of the cash needs of our business and the environment in which it operates. That assessment could change due to, among other things, changes in our results of operations, cash requirements, financial condition, contractual restrictions, growth opportunities, competitive or technological developments, provisions of applicable law and other factors that our board of directors may deem relevant; even if the dividend policy is not modified or revoked, our board of directors could decide to reduce dividends or not to pay any dividends at all, at any time and for any reason; the amount of dividends distributed is subject to debt covenant restrictions under the indenture governing the notes and our new credit facility. In particular, we will be prohibited from paying dividends during any interest deferral period under the indenture or while any deferred interest (including interest on deferred interest) from a prior interest deferral period remains unpaid or if certain interest coverage and leverage ratios are not met; the amount of dividends distributed is subject to state law restrictions; our stockholders have no contractual or other legal right to dividends; and we may not have enough cash to pay dividends due to changes to our operating earnings, working capital requirements and anticipated cash needs. See Dividend Policy and Restrictions. The reduction or elimination of dividends may negatively affect the market price of the IDSs. The amount we expect to pay in dividends on our shares of Class A common stock in respect of the first year following the offering represents approximately 46% of the total distributions we expect to make to IDS holders in respect of the first year following the offering, including dividends on our shares of Class A common stock represented thereby and interest on our notes represented thereby. We may be required to make payments to our senior officers under our Long Term Incentive Plan even if we make no dividend payments, as the requirement to make payments under the Long Term Incentive Plan is tied to our financial performance and not to the level of dividend payments to holders of IDSs. See Management Long Term Incentive Plan. We may need to borrow funds to make our anticipated dividend payments, which could adversely affect our financial condition and/or reduce our ability to pay interest or dividends in the future. If we do not generate enough cash from our operations to pay dividends at the anticipated level, we may borrow funds to do so. Because our new credit facility and the indenture governing our notes each restrict the amount of indebtedness we are permitted to have outstanding, such borrowings would reduce the amount of money we would be able to borrow for other purposes, which could negatively impact our financial condition, our results of operations and our ability to maintain or expand our business. In addition, because any such borrowings would increase our debt and interest expense, our the leverage ratios would increase and our interest coverage ratios would decrease. An increase in the leverage ratios above the levels set forth in our new credit facility or a decrease in the interest coverage ratios below the levels set forth in the new credit facility or the indenture governing the notes would cause us to be prohibited from paying interest on the notes or dividends on our Class A common stock. If the offering and the related transactions had been completed on July 1, 2003 and we had wanted to pay dividends at the level anticipated after the offering, we would have needed to borrow approximately $15.3 million in the twelve month period ended June 30, 2004, given the actual levels of capital expenditures during such periods. Table of Contents We are subject to restrictive debt covenants that limit our business flexibility by imposing operating and financial restrictions on our operations. Although credit facilities of similarly situated borrowers customarily prohibit payments of dividends, our new credit facility will permit us, subject to certain restrictions, to pay dividends. Because the payment of dividends will decrease the amount of cash available to service our senior debt, the new credit facility will impose significant operating and financial restrictions on our operations that may be more restrictive than customary for credit facilities of similarly situated borrowers that prohibit or substantially limit payments of dividends. These restrictions imposed by our new credit facility, as described in detail under Description of Certain Indebtedness New Credit Facility, will prohibit or limit, among other things: the incurrence of additional indebtedness and the issuance of preferred stock and certain redeemable capital stock; investments and acquisitions; disposition of assets in subsidiary interests; transactions with affiliates; the creation of liens on our assets; consolidations, mergers and transfers of all or substantially all of our assets; and our ability to change the nature of our business. The terms of the new credit facility will include other restrictive covenants and prohibit us from prepaying our other indebtedness, including the notes, while indebtedness under the new credit facility is outstanding. These restrictions could limit our ability to obtain future financing, make acquisitions or needed capital expenditures, withstand downturns in our business or take advantage of business opportunities. Furthermore, the new credit facility also requires us to maintain specified financial ratios and satisfy financial condition tests, including a maximum senior leverage ratio, maximum total leverage ratio and minimum senior interest coverage ratio. Our ability to comply with the ratios or tests may be affected by events beyond our control, including prevailing economic, financial and industry conditions. A breach of any of these covenants, ratios or tests could result in a default under the new credit facility and/or the indenture. Upon the occurrence of an event of default under the new credit facility, the lenders could elect to declare all amounts outstanding under the new credit facility to be immediately due and payable. If the lenders accelerate the payment of the indebtedness under the new credit facility, our assets may not be sufficient to repay in full this indebtedness and our other indebtedness, including the notes. We are subject to significant restrictions on our ability to pay interest and dividends, and expect to continue to be subject to such restrictions. Our new credit facility will contain significant restrictions on our ability to pay interest on the notes and dividends on our common stock based on meeting a maximum senior leverage ratio, maximum total leverage ratio and minimum senior interest coverage ratio and compliance with other conditions (including timely delivery of applicable financial statements), as described in detail under Description of Certain Indebtedness New Credit Facility Restricted Payments. As a result of general economic conditions, conditions in the lending markets, the results of our business or for any other reason, we may elect or be required to amend or refinance our new credit facility, at or prior to maturity, or enter into additional agreements for senior indebtedness. Regardless of any protection you have in the indenture governing the notes, any such amendment, refinancing or additional agreement may contain covenants which could limit in a significant manner our ability to pay interest on the notes and/or dividends on our common stock. Table of Contents Our ability to pay dividends may reduce the amount of funds available to make payments on our debt. Both our new credit facility and the indenture governing our notes will permit us, subject to certain restrictions, to pay a significant portion of our cash flow to stockholders in the form of dividends on our common stock, including the Class A common stock represented by IDSs. Specifically, the indenture governing our notes permits us to pay dividends of up to 100% of our excess cash, as defined in the indenture, plus $45 million, subject to compliance with an interest coverage test, as more fully described under Description of Notes Certain Covenants. Our new credit facility permits us to use up to 100% of excess cash, as defined in the new credit facility with the same meaning as set forth in the indenture, plus $45 million, subject to compliance with senior interest coverage, senior leverage and total leverage tests to fund dividends on our shares of common stock, as more fully described under Description of Certain Indebtedness New Credit Facility Restricted Payments. Following completion of the offering, we intend to pay quarterly dividends. Holders of notes held separately from the IDSs may be adversely affected by such provisions because any amounts paid by us in the form of dividends will not be available in the future to satisfy our obligations under the notes. We may not be able to refinance our new credit facility at maturity on favorable terms or at all. The new credit facility will have a 4.5 year maturity except for that portion of the new term loan facility allocated to Canadian borrowers, which will have a 5 year maturity. We may not be able to renew or refinance the new credit facility, or if renewed or refinanced, the renewal or refinancing may occur on less favorable terms. In particular, our ability to defer interest on our notes is limited and such limitations may be viewed as favorable to the senior lenders, and at the time we seek to renew or refinance our new credit facility we may not have the same ability to defer interest on our notes that we will have immediately following completion of this offering. If we are unable to refinance or renew our new credit facility, our failure to repay all amounts due on the maturity date would cause a default under the new credit facility. In addition, our interest expense may increase significantly if we refinance our new credit facility on terms that are less favorable to us than the terms of our new credit facility, which could reduce the amount of funds available to make interest payments on the notes and pay dividends on our common stock, including the Class A common stock represented by IDSs. We will require a significant amount of cash, which may not be available to us, to service our debt, including the notes, and to fund our liquidity needs. Our ability to make payments on, refinance or repay our debt, including the notes, to fund planned capital expenditures or expand our business will depend largely upon our future operating performance. Our future operating performance is dependent upon our ability to execute our business strategy successfully. Such performance is also subject to general economic, financial and competitive factors, as well as other factors that are beyond our control. Assuming the transactions contemplated by this offering are completed on November 12, 2004, interest payments on our notes are scheduled to be approximately $58.1 million in 2005, interest payments on term loan borrowings under our new credit facility are scheduled to be approximately $3.7 million in 2004 and $26.4 million in 2005 and interest payments on revolver borrowings under our new credit facility are scheduled to be approximately $0.4 million in 2004 and $1.0 million in 2005, including approximately $0.3 million in 2004 and $0.7 million in 2005 associated with temporary borrowings to finance a planned legal reorganization of a portion of our international operations. See Dividend Policy and Restrictions Minimum Adjusted EBITDA. In addition, we estimate that interest payments under lines of credit in foreign countries that are used to facilitate short-term operating needs will be $0.2 million in 2004 and $1.2 million in 2005. If we are unable to generate sufficient cash to service our debt requirements, we will be required to refinance our new credit facility. If we are unable to refinance our debt or obtain new financing, we would have to consider other options, including: sales of assets to meet our debt service requirements; sales of equity; negotiations with our lenders to restructure the applicable debt; and Marketable equities 72 % 71 % Fixed income securities 28 Table of Contents and sole bookrunner. In this prospectus, we refer to this credit facility as the new credit facility. The new credit facility will consist of a revolving credit facility in an aggregate principal amount of up to $100 million (to be reduced to $50 million after the first anniversary of the closing date) and a $435 million term loan facility. While the new credit facility will permit us to pay interest and dividends to our security holders, including IDS holders, it will contain significant restrictions on our ability to make such interest and dividend payments. The new credit facility will have a 4.5 year maturity, except the portion of the term loan allocated to Canadian borrowers, which will have a 5 year maturity. See Description of Certain Indebtedness New Credit Facility. Our Existing Equity Investors We are an indirect, wholly-owned subsidiary of Xerium S.A. prior to this offering. Apax Europe IV GP, L.P., which, together with its affiliates, we refer to as Apax in this prospectus, is manager, directly or indirectly, of investment funds holding the majority of the outstanding common stock of Xerium S.A. Affiliates of CIBC World Markets Corp., the lead managing underwriter for this offering, own approximately 5.6% of the common stock of Xerium S.A. prior to this offering. We refer to CIBC World Markets Corp. as CIBC in this prospectus. Our senior management and certain other investors also own equity interests in Xerium S.A. We refer to Apax, CIBC and these other investors in Xerium S.A. as our existing equity investors in this prospectus. Xerium 3 S.A. is our direct parent company and, prior to our recapitalization and the offering, owns 100% of our capital stock. The Recapitalization and the Offering This offering consists of an offering by us of 28,125,000 IDSs, representing 28,125,000 shares of Class A common stock and $201.1 million aggregate principal amount of % senior subordinated notes due 2019, and an offering by us of $45.3 million aggregate principal amount of % senior subordinated notes due 2019 sold separately (not represented by IDSs). We refer to the % senior subordinated notes due 2019 (whether or not represented by IDSs) as the notes in this prospectus. The completion of the offering of the IDSs and the offering of the separate notes are conditioned on each other. Prior to the closing of this offering, our existing common stock, all of which is held by Xerium 3 S.A., will be reclassified as Class A common stock. In connection with the reclassification, the directors and members of our senior management who own equity interests in Xerium S.A. will exchange such interests for shares of our Class A common stock. The other existing equity investors will, through their ownership interests in Xerium S.A., continue to own all economic rights of the shares of Class A common stock held by Xerium 3 S.A. After the reclassification, and in connection with the offering, we will undergo a recapitalization in which all of the shares of Class A common stock held (directly or indirectly) by the existing equity investors will be exchanged for cash, IDSs and shares of Class B common stock, as described in the following table: Prior to the Offering Table of Contents seeking protection under the U.S. federal bankruptcy code or other applicable bankruptcy, insolvency or other applicable laws dealing with creditors rights generally. If we are forced to pursue any of the above options under distressed conditions, our business and/or the value of your investment in our IDSs and notes would be adversely affected. We are a holding company and rely on dividends, interest and other payments, advances and transfers of funds from our subsidiaries to meet our debt service and other obligations. We are a holding company and conduct all of our operations through our subsidiaries and currently have no significant assets other than the capital stock of our subsidiaries. As a result, we will rely on dividends, interest and other payments or distributions from our subsidiaries to meet our debt service obligations and enable us to pay interest and dividends. The ability of our subsidiaries to pay dividends or interest or make other payments or distributions to us will depend substantially on their respective operating results and will be subject to restrictions under, among other things, the laws of their jurisdiction of organization (which may limit the amount of funds available for the payment of dividends), agreements of those subsidiaries, the terms of the new credit facility and the covenants of any future outstanding indebtedness we or our subsidiaries incur. Interest on the notes may not be deductible by us for U.S. federal and applicable state income tax purposes, which could adversely affect our financial condition, significantly reduce our future cash flow and impact our ability to make interest and dividend payments. Our position that the notes should be treated as debt for U.S. federal income tax purposes may not be sustained if challenged by the IRS. If the notes were treated as equity rather than debt for U.S. federal and applicable state income tax purposes, then the stated interest on the notes could be treated as a dividend, and interest on the notes would not be deductible by us for U.S. federal and applicable state income tax purposes. Our inability to deduct interest on the notes on an on-going basis could materially increase our taxable income and, thus, our U.S. federal and applicable state income tax liability. In addition, to the extent any portion of our interest expense from prior years is determined not to be deductible, we could be required to pay a significant amount of additional income tax for such years, together with interest and possible penalties. Any increase in tax liabilities for prior or future periods as a result of a determination that interest on the notes is not deductible would materially and adversely affect our financial condition and our after-tax cash flow, which in turn would materially and adversely affect our ability to meet our obligations on the notes and to pay dividends. We do not expect to maintain any reserve in our financial statements for the possibility of there being a determination that interest on the notes would not be deductible for U.S. federal and applicable state income tax purposes. In addition, if a challenge to the deductibility of interest on the notes were to prevail, the amount, timing and character of any income, gain, or loss that you recognize in respect of your IDSs could be adversely affected. In the case of foreign holders, treatment of the notes as equity for U.S. federal income tax purposes would subject payments to such holders in respect of the notes to withholding or estate taxes in the same manner as payments made with regard to Class A common stock and could subject us to liability for withholding taxes that were not collected on payments of interest. Payments to foreign holders would not be grossed-up for any such taxes. For a discussion of these tax related risks, see Material U.S. Federal Income Tax Consequences. We may have to establish a reserve for contingent tax liabilities in the future, which could adversely affect our ability to make interest and dividend payments on the IDSs. Even if the IRS does not challenge the tax treatment of the notes, it is possible that as a result of a change in law relied upon at the time of issuance of the notes, we will in the future need to change our anticipated accounting treatment and establish a reserve for contingent tax liabilities associated with a disallowance of all or part of the interest deductions on the notes. If we were required to maintain such a reserve, our ability to make interest and dividend payments could be materially impaired and the market for the IDSs, Class A common stock and notes could be adversely affected. In addition, any resulting restatement of our financial statements could lead to defaults under our new credit facility. Table of Contents You will be immediately diluted by $16.65 per share of Class A common stock if you purchase IDSs in this offering. If you purchase IDSs in this offering, based on the book value of the assets and liabilities reflected on our balance sheet at June 30, 2004, you will experience an immediate dilution of $16.65 per share of Class A common stock represented by the IDSs (assuming all Class B common stock has been exchanged), which exceeds the entire price allocated to each share of Class A common stock represented by the IDSs in this offering because there will be a net tangible book deficit for each share of Class A common stock outstanding immediately after this offering. Our net tangible book deficit as of June 30, 2004, after giving effect to this offering, would have been approximately $444.2 million, or $7.80 per share of Class A common stock represented by IDSs (assuming all Class B common stock has been exchanged). Subject to certain limitations, we may defer interest on the notes at any time at our option if we reasonably believe it is necessary to avoid a default under our senior indebtedness. If we defer interest, we will not be permitted to make any payment of dividends so long as any deferred interest or interest on deferred interest remains outstanding. Prior to , 2009, we may, subject to certain limitations set forth in the indenture governing the notes, defer interest payments on the notes on one or more occasions for eight quarters in the aggregate if we reasonably believe such deferral is necessary to avoid a default under our senior indebtedness. After , 2009, we may, subject to certain limitations set forth in the indenture governing the notes, defer interest payment on up to four occasions for up to two quarters per occasion if we reasonably believe such deferral is necessary to avoid a default under our senior indebtedness provided that we may not defer additional interest until all previously deferred interest has been paid in full. After the end of any interest deferral period occurring before , 2009, deferred interest, together with any accrued interest thereon, will be required to be repaid on , 2009. Consequently, you may be owed a substantial amount of deferred interest that will not be due and payable until such date. All interest deferred after , 2009, together with any accrued interest thereon, must be repaid on or before maturity. Consequently, you may be owed a substantial amount of deferred interest that will not be due and payable until such date. During any interest deferral period and so long as any deferred interest or interest on deferred interest remains outstanding, we will not be permitted to make any payment of dividends with respect to shares of common stock. Deferral of interest payments would have adverse tax consequences for you by causing you to recognize interest income and pay taxes before you receive any cash payment of such interest, and may adversely affect the trading price of the IDSs or the separately held notes. If interest payments on the notes are deferred, the notes will be treated as issued with OID at the time of such occurrence. As a result, you will be required to recognize interest income for U.S. federal income tax purposes in respect of the notes represented by the IDSs or the separately held notes, as the case may be, held by you before you receive any cash payment of this interest. See Material U.S. Federal Income Tax Consequences Consequences to U.S. Holders Notes Deferral of Interest. In addition, you will not receive any cash payment with respect to the accrued interest if you sell the IDSs or the notes, as the case may be, before the record date relating to interest payments that are to be paid. If interest is deferred, the IDSs or separately held notes may trade at a price that does not fully reflect the value of accrued but unpaid interest on the notes. In addition, the existence of the right to defer payments of interest on the notes under certain circumstances may mean that the market price for the IDSs or separately held notes may be more volatile than other securities that do not have such provisions. The realizable value of our assets upon liquidation may be insufficient to satisfy claims. At June 30, 2004, our assets included intangible assets in the amount of approximately $332 million, representing approximately 34% of our total consolidated assets and consisting primarily of goodwill (the excess of the Table of Contents The Recapitalization and the Offering Table of Contents acquisition cost over the fair market value of the net assets acquired in purchase transactions). The value of these intangible assets will continue to depend significantly upon the success of our business as a going concern and the growth in cash flows. As a result, in the event of a default under our new credit facility or on our notes or any bankruptcy or dissolution of our Company, the realizable value of these assets may be substantially lower and may be insufficient to satisfy the claims of our creditors, including holders of notes. Claims of holders of the notes and the guarantees will be structurally subordinated to claims of creditors of our non-guarantor subsidiaries. We are a holding company and conduct all of our operations through our subsidiaries. Certain of our subsidiaries will not be guarantors of the notes. As a result, no payments are required to be made to us from the assets of these subsidiaries. Claims of holders of the notes and the guarantees will be structurally subordinated to the indebtedness and other liabilities and commitments of our non-guarantor subsidiaries. The ability of our creditors, including the holders of the notes, to participate in the assets of any of our non-guarantor subsidiaries upon any bankruptcy, liquidation or reorganization or similar proceeding of any such entity will be subject to the prior claims of that entity s creditors, including trade creditors, and any prior or equal claim of any other equity holder. In addition, the ability of our creditors, including the holders of our notes, to participate in distributions of assets of our non-guarantor subsidiaries will be limited to the extent that the outstanding shares of any of our subsidiaries are either pledged to secure other creditors (including lenders under our new credit facility) or are not owned by us. Our non-guarantor subsidiaries accounted for approximately 53% of our net sales in 2003 and, as of December 31, 2003, they held approximately 53% of our total consolidated assets. For the six months ended June 30, 2004, such non-guarantor subsidiaries accounted for approximately 52% of our net sales and, as of June 30, 2004, they held approximately 53% of our total consolidated assets. See Note 17 of the audited consolidated financial statements included elsewhere in this prospectus and Note 13 of the accompanying unaudited consolidated financial statements included elsewhere in this prospectus. Your right to receive payments on the notes and the guarantees is junior to all of our senior debt and the senior debt of our subsidiaries. The notes and the related guarantees will be unsecured senior subordinated obligations, junior in right of payment to all of our senior debt and the senior debt of each subsidiary guarantor, respectively. As a result of the subordinated nature of our notes and the related guarantees, upon any distribution to our creditors or the creditors of the subsidiary guarantors in bankruptcy, liquidation or reorganization or similar proceedings relating to us or the subsidiary guarantors or our or their property or assets, the holders of such entities senior indebtedness will be entitled to be paid in full in cash before any payment may be made with respect to the notes or the subsidiary guarantees (and before any distribution may be made by our subsidiaries to us). In the event of a bankruptcy, liquidation or reorganization or similar proceeding relating to us or the subsidiary guarantors, the subordinated noteholders would participate in available distributions with other holders of unsecured senior subordinated indebtedness after the payment in full of all senior indebtedness. In any of these cases, we and our subsidiary guarantors may not have sufficient funds to pay all of our creditors and the holders of the notes may receive less, ratably than the holders of our senior indebtedness or the senior indebtedness of our subsidiary guarantors. Furthermore, because of the existence of subordination provisions, including the obligation to turn over distributions to holders of our senior indebtedness or the senior indebtedness of our subsidiary guarantors, the holders of notes may receive less, ratably, than holders of trade payables and other general unsecured indebtedness. In such event we and the guarantors would not be able to make all principal payments on the notes. The subordination provisions of the indenture will also provide that payments to you under the notes will be prohibited while a payment default exists under designated senior indebtedness or if such designated senior indebtedness has been accelerated. In addition, these payments to you may be blocked for up to 179 days by holders of designated senior indebtedness if a default other than a payment default exists under such senior IDSs to be issued to the existing equity investors in connection with the recapitalization and the offering 23,934,267 (1) Shares of Class B common stock to be issued to the existing equity investors in connection with the recapitalization and the offering 4,912,500 shares Cash to be paid to the existing equity investors in connection with the recapitalization and the offering $ 62,613,390 Voting power held by the existing equity investors after the recapitalization and the offering (includes Class A common stock represented by IDSs and Class B common stock and assumes no exercise of the underwriters over-allotment option to purchase additional IDSs) 50.6 % Table of Contents indebtedness. During any period in which payments to you are prohibited or blocked in this manner, any amounts received by you with respect to the notes or guarantees, including as a result of any legal action to enforce the notes or guarantees, would be required to be turned over to the holders of senior indebtedness. As of June 30, 2004, on a pro forma basis after giving effect to the transactions contemplated by this prospectus: Xerium Technologies, Inc. would have had $302.6 million aggregate principal amount of senior indebtedness outstanding, all of which would have been senior secured indebtedness to which the notes would be junior in right of payment; Xerium Technologies, Inc. would have had an additional $417.5 million aggregate principal amount of indebtedness outstanding, consisting exclusively of the notes; our subsidiary guarantors would have had $69.4 million aggregate principal amount of senior indebtedness outstanding, all of which would have been senior secured indebtedness to which the guarantees of the notes would be junior in right of payment; our subsidiary guarantors would have had $72.8 million aggregate principal amount of other indebtedness outstanding, including trade payables, all of which would have ranked pari passu with the guarantees, except as discussed in Risk Factors Risks Related to Capital Structure and Description of Notes Ranking ; and our non-guarantor subsidiaries would have had $172.1 million aggregate principal amount of indebtedness outstanding, including trade payables, to which the notes and the guarantees would be structurally subordinated. In addition, as of June 30, 2004, on a pro forma basis after giving effect to the transactions contemplated by this prospectus, based on the covenants in the indenture and our new credit facility, we would have had the ability to incur an additional $109.2 million aggregate principal amount of indebtedness, all of which could be senior in right of payment to the notes. Shortly after the completion of this offering we expect to borrow approximately $40 million under our revolving credit facility to fund the legal reorganization of a portion of our international operations. The validity and enforceability of the notes and the guarantees of the notes by our subsidiaries may be limited by fraudulent conveyance laws and foreign laws restricting guarantees. Our obligations under the notes will be guaranteed by certain of our subsidiaries, including our domestic subsidiaries organized under Delaware law and our foreign subsidiaries organized under the laws of Australia, Canada, Japan, Mexico and the United Kingdom. These guarantees provide the holders of the notes with a direct claim against the assets of the subsidiary guarantors. The offering of the notes and the guarantees of the notes by certain of our subsidiaries may be subject to legal challenge and review based on various laws and defenses relating to fraudulent conveyance or transfer, voidable preferences, financial assistance, corporate purpose, capital maintenance, the payment of legally sufficient consideration and other laws and defenses affecting the rights of creditors generally. The laws of various foreign jurisdictions, including the jurisdictions in which the subsidiary guarantors are organized and those in which the subsidiary guarantors own assets or otherwise conduct business, may be applicable to the notes and the guarantees. Accordingly, we cannot assure you that a third party creditor or bankruptcy trustee would not challenge the notes or one or more of these subsidiary guarantees in court and prevail in whole or in part. Although laws differ among various jurisdictions, in general, under fraudulent conveyance or transfer laws, a court could void or subordinate the notes or the guarantees issued by our subsidiaries if it found that: we or the subsidiary guarantors intended to hinder, delay or defraud our creditors; we or the subsidiary guarantors knew or should have known that the transactions were to the detriment of our creditors; Table of Contents the transactions had the effect of giving a preference to one creditor or class of creditors over another; or we or the subsidiary guarantors did not receive fair consideration and reasonably equivalent value for incurring such indebtedness or guarantee obligations and we or the subsidiary guarantors (i) were insolvent or rendered insolvent by reason of the incurrence of such indebtedness or obligations, (ii) were engaged or about to engage in a business or transaction for which our or the subsidiary guarantors remaining assets constituted unreasonably insufficient capital or (iii) intended to incur, or believed that we or the subsidiary guarantors would incur, debts beyond our or their ability to pay as they mature. The measure of insolvency for purposes of fraudulent transfer laws varies depending on the law applied. Generally, however, an entity would be considered insolvent if: the sum of its debts, including contingent liabilities, was greater than the fair saleable value of all of its assets; the present fair saleable value of its assets was less than the amount that would be required to pay its existing debts and liabilities, including contingent liabilities, as they become absolute and mature; or it could not or would not pay its debts as they become due. We cannot assure you that a court would reach the conclusion that, upon the issuance of the notes and the subsidiary guarantees, we and each of the subsidiary guarantors will be solvent, will have sufficient capital to carry on our business and will be able to pay our debts as they mature. If a court were to find that the issuance of the notes or a subsidiary guarantee was a fraudulent conveyance or transfer or constituted an illegal preference, the court could void the payment obligations under the notes or the guarantee, further subordinate the notes or the subsidiary guarantee to presently existing and future indebtedness of ours or the subsidiary guarantor, or require the holders of the notes to repay any amounts received with respect to the notes or guarantee. The guarantees issued by certain of our foreign subsidiaries will contain language limiting the amount of debt guaranteed so that applicable local law restrictions will not be violated, although there can be no assurance that such limitation is enforceable. As a result, a subsidiary s liability under its guarantee could be materially reduced or eliminated depending on the amount of its other obligations and the effect of applicable laws. In particular, in certain jurisdictions, a guarantee that is not in the guarantor s corporate interest or the burden of which exceeds the benefit to the guarantor may not be valid and enforceable. It is possible that a creditor of a subsidiary guarantor, or a bankruptcy trustee in the case of a bankruptcy of a subsidiary guarantor, may contest the validity or enforceability of the subsidiary s guarantee of the notes and that a court may determine that the guarantee should be limited or voided. To the extent that any subsidiary guarantee is determined to be void or unenforceable, or the agreed limitations on the guaranteed obligations become applicable, the notes would not have a claim under the guarantee and would accordingly be effectively subordinated to all other liabilities of the applicable subsidiary. Although the insolvency laws of the jurisdiction of incorporation of the respective subsidiaries would most likely apply to the insolvency of the relevant subsidiary, a subsidiary could conceivably enter into an insolvency procedure in another jurisdiction. Therefore, the validity and enforceability of the subsidiary guarantees may be affected by the insolvency, administration and other laws of various foreign jurisdictions, including the jurisdictions in which the subsidiary guarantors are organized and those in which the subsidiary guarantors own assets or otherwise conduct business. The laws of these jurisdictions are in many cases materially different from, and conflict with each other and with the laws of the United States, including in the areas of bankruptcy, creditors rights, fraudulent transfers, priority of governmental and other creditors, ability to obtain post petition interest, duration of proceeding and preference periods. For example, in the United Kingdom an administrator or liquidator of a company may apply to the court for an order to recover preferred payments made to creditors within certain periods prior to a company s insolvency only in circumstances where it can be shown that the insolvent entity was, among other factors, motivated by a desire to put the creditor in a better position than it would have been in an insolvency proceeding. However, in a U.S. bankruptcy proceeding, a debtor or its trustee in bankruptcy may recover sums paid to creditors within a 90 day period prior to bankruptcy irrespective of the Table of Contents motivation for such payments. The application of these and other similar laws, and any conflict between laws of various jurisdictions, could call into question whether, and to what extent, the laws of any particular jurisdiction should apply, which may adversely affect your ability to enforce your rights under the guarantees of the notes by our subsidiaries in these jurisdictions or limit any amounts that you may receive. You may have difficulty effecting service of process upon our foreign subsidiary guarantors and/or our directors and executive officers who reside outside of the United States. Several of the subsidiary guarantors are organized under laws outside of the United States and certain of our directors and officers reside outside of the United States. In addition, a substantial portion of the assets of such guarantors and our directors and officers are located outside of the United States. As a result, it may be difficult for holders of our securities to effect service of process upon the guarantors or such directors or officers within the United States or to enforce against them the United States judgments of courts of the United States predicated upon the civil liability provisions of the United States federal securities laws or other laws of the United States. In addition, we have been advised by legal counsel in certain foreign jurisdictions that there is doubt as to the enforcement in such jurisdictions of liabilities predicated upon United States federal securities laws against our guarantors and our directors and executive officers who are not residents of the United States, in original actions or in actions for enforcements of judgments of U.S. courts. In the event of bankruptcy or insolvency, the notes and guarantees could be adversely affected by principles of equitable subordination or recharacterization, which may eliminate your ability to recover any amounts owed on the notes or require you to return any prior payments you received on the notes. In the event of bankruptcy or insolvency, a party in interest may seek to subordinate the notes or the guarantees under principles of equitable subordination or to recharacterize the notes as equity. There can be no assurance as to the outcome of such proceedings. In the event a court subordinates the notes or the guarantees, or recharacterizes the notes as equity, we cannot assure you that you would recover any amounts owed on the notes or the guarantees and you may be required to return any payments made to you on account of the notes or guarantees within six years before the bankruptcy. In addition, should the court equitably subordinate the notes or the guarantees, or recharacterize the notes as equity, you may not be able to enforce the notes or the guarantees. While generally speaking, equitable subordination would require a showing of inequitable conduct on the part of the lender, under certain circumstances, courts have recognized the potential for so-called no-fault equitable subordination; that is, equitable subordination without the necessity to show inequitable conduct. This doctrine has mainly been employed to subordinate tax and penalties claims, punitive damage claims and claims relating to stock redemption/repurchase obligations. As such, even absent a finding of inequitable conduct, it is possible that a court could conclude that the debt represented by the notes represented by IDSs should be equitably subordinated to the extent such notes were originally issued in exchange for equity. The notes represented by IDSs to be issued to our existing equity investors in connection with the recapitalization and the offering, as described in The Transactions The Recapitalization and the Offering and Related Party Transactions Proceeds from the Recapitalization and the Offering, will be issued in exchange for equity. To the extent that particular notes can be traced to notes represented by IDSs that were issued to our existing equity investors in connection with the recapitalization and the offering, such notes could be subject to a no-fault equitable subordination claim. The allocation of the purchase price of the IDSs may not be respected. The purchase price of each IDS must be allocated among the underlying shares of Class A common stock and notes in proportion to their respective fair market values at the time of purchase. We expect to report the initial fair market value of each share of Class A common stock as $8.85 and the initial fair market value of each of our notes represented by IDSs as $7.15, assuming an initial public offering price of $16.00 per IDS, which represents the mid-point of the range set forth on the cover page of this prospectus. By purchasing IDSs, you will agree to Table of Contents be bound by such allocation. If our allocation is not respected, it is possible that the notes will be treated as having been issued with OID (if the allocation to the notes is determined to be too high) or amortizable bond premium (if the allocation to the notes is determined to be too low). You generally would have to include OID in income in advance of the receipt of cash attributable to that income and would be able to elect to amortize bond premium over the term of the notes. Because of the deferral of interest provisions, the notes may be treated as issued with original issue discount. Under applicable Treasury regulations, a remote contingency that stated interest will not be timely paid will be ignored in determining whether a debt instrument is issued with OID. Although there is no authority directly on point, based on our financial forecasts and the fact that we have no present plan or intention to exercise our right to defer interest after , 2009, we believe that the likelihood of deferral of interest payments on the notes is remote within the meaning of the Treasury regulations. Based on the foregoing, although the matter is not free from doubt because of the lack of direct authority, we believe the notes will not be considered issued with OID at the time of their original issuance. If deferral of any payment of interest were determined not to be remote, or if the interest payment deferral actually occurred, the notes would be treated as issued with OID at the time of issuance or at the time of such occurrence, as the case may be. In that case, all stated interest on the notes would thereafter be treated as OID, and all holders, regardless of their method of tax accounting, would be required to include stated interest in income on a constant accrual basis. If we subsequently issue notes with significant original issue discount, we may not be able to deduct all of the interest on those notes. It is possible that notes we issue in a subsequent issuance will be issued at a discount to their face value and, accordingly, may have significant original issue discount and thus be classified as applicable high yield discount obligations, or AHYDOs. If any such notes were so treated, a portion of the OID on such notes could be nondeductible by us and the remainder would be deductible only when paid. This treatment would have the effect of increasing our taxable income and may adversely affect our cash flow available for interest payments and distributions to our equityholders. Subsequent issuances of notes pursuant to an offering by us or in connection with an exchange of Class B common stock may cause you to recognize original issue discount. The indenture governing our notes and agreements with DTC will provide that, in the event there is a subsequent issuance of notes with OID, and upon each subsequent issuance of notes thereafter, each holder of notes or IDSs, as the case may be, agrees that a portion of such holder s notes will be automatically exchanged for a portion of the notes acquired by the holders of such subsequently issued notes. Consequently, immediately following each such subsequent issuance and exchange, each holder of notes, held either as part of IDSs or separately, as the case may be, will own an inseparable unit composed of notes of each separate issuance in the same proportion as each other holder. However, the aggregate stated principal amount of notes owned by each holder will not change as a result of such subsequent issuance and exchange. We are not able to predict the likelihood that an automatic exchange would occur because we are unable to predict the selling price of any subsequent issuance of notes, and therefore whether the notes would be issued with OID. It is unclear whether the exchange of notes for subsequently issued notes will result in a taxable exchange for U.S. federal income tax purposes, and it is possible that the IRS might successfully assert that such an exchange should be treated as a taxable exchange. Regardless of whether the exchange is treated as a taxable event, such exchange may result in holders having to include OID in taxable income prior to the receipt of cash as described below, and may result in other potentially adverse tax consequences to holders. See Material U.S. Federal Income Tax Consequences Consequences to U.S. Holders Notes Additional Issuances. In addition, the potential amount of OID that would be required to be included in taxable income by holders as a result of an automatic exchange is indefinite and may be a significant amount, in part due to our ability to engage in numerous subsequent issuances. Table of Contents Following the subsequent issuance of notes with OID (or any issuance of notes thereafter) and resulting exchange, we (and our agents) will report any OID on the subsequently issued notes ratably among all holders of notes and IDSs, and each holder of notes or IDSs will, by purchasing notes or IDSs, agree to report OID in a manner consistent with this approach. However, the IRS may assert that any OID should be reported only to the persons that initially acquired such subsequently issued notes (and their transferees) and thus may challenge the holders reporting of OID on their tax returns. Such a challenge by the IRS could create significant uncertainties in the pricing of IDSs and notes and could adversely affect the market for IDSs and notes. For a discussion of these tax related risks, see Material U.S. Federal Income Tax Consequences. Holders of subsequently issued notes may not be able to collect their full stated principal amount prior to maturity. Under New York and federal bankruptcy law, holders of subsequently issued notes having OID (including the recipients of such notes pursuant to the automatic exchange under the indenture) may not be able to collect the portion of their principal amount that represents unaccrued OID in the event of an acceleration of the notes or our bankruptcy prior to the maturity date of the notes. As a result, an automatic exchange that results in a holder receiving an interest in notes with OID in exchange for notes that do not have OID could have the effect of ultimately reducing the amount such holder can recover from us in the event of an acceleration or bankruptcy to an amount that is less than the amount paid for the notes in this offering. If the IDSs separate, the limited liquidity of the market for the notes and Class A common stock may adversely affect your ability to sell the notes and Class A common stock. We do not intend to list the notes represented by the IDSs on any exchange or quotation system. Our shares of Class A common stock will be listed on the Toronto Stock Exchange, but holders of shares of Class A common stock will not be able to trade such shares on the Toronto Stock Exchange until the applicable requirements for separate trading are satisfied, including that a sufficient number of shares are held separately, not represented by IDSs, by a sufficient number of holders. Our Class A common stock will not initially be listed on any other exchange or quotation system, including the New York Stock Exchange. We will not apply to list our shares of Class A common stock for separate trading on the New York Stock Exchange or on any other exchange or quotation system on which the IDSs are then listed until a sufficient number of shares is held separately, not represented by IDSs, by a sufficient number of holders to satisfy applicable requirements for separate trading on such exchange or quotation system for 30 consecutive trading days. The Class A common stock may not be approved for listing at such time. Upon separation of the IDSs, no sizable market for the notes and the Class A common stock may ever develop and the liquidity of any trading market for the notes or the Class A common stock that does develop may be limited. As a result, your ability to sell your notes or Class A common stock, and the market price you can obtain, could be adversely affected. The limited liquidity of the trading market for the notes sold separately (not represented by IDSs) may adversely affect the trading price of the separate notes. We are separately selling $45.3 million aggregate principal amount of notes (not represented by IDSs), representing approximately 10.0% of the total outstanding notes (assuming the exchange of all outstanding Class B common stock for IDSs). While the notes sold separately (not represented by IDSs) are part of the same series of notes as, and identical to, the notes represented by IDSs at the time of the issuance of the separate notes, the notes represented by the IDSs will not be separable for at least 45 days and will not be separately tradeable until separated. As a result, the initial trading market for the notes sold separately (not represented by IDSs) will be very limited. Even after holders of the IDSs are permitted to separate their IDSs, a sufficient number of holders of IDSs may not separate their IDSs into shares of our Class A common stock and notes to create a sizable and more liquid trading market for the notes not represented by IDSs. Therefore, a liquid market for the separate notes may not develop, which may adversely affect the ability of the holders of the separate notes to sell any of their separate notes and the price at which these holders would be able to sell any of the notes sold separately. Table of Contents Prior to the completion of this offering, there was no public market for our IDSs, shares of our Class A common stock or notes which may cause the price of the IDSs or notes to fluctuate substantially and negatively affect the value of your investment. Our IDSs, the shares of our Class A common stock and the notes have no public market history in the United States or in Canada. In addition, there has not been an active market for securities similar to the IDSs. An active trading market for the IDSs or notes might not develop in the future, which may cause the price of the IDSs or notes to fluctuate substantially, and we currently do not expect that an active trading market for the shares of our Class A common stock will develop until the notes mature. If the notes represented by your IDSs mature or are redeemed pursuant to the terms of the indenture, the IDSs will be automatically separated and you will then hold the shares of our Class A common stock. If interest rates rise, the trading value of our IDSs and notes may decline. Should interest rates rise or should the threat of rising interest rates develop, debt markets may be adversely affected. As a result, the trading value of our IDSs and notes may decline. Future sales or the possibility of future sales of a substantial amount of IDSs, shares of our Class A common stock or our notes may depress the price of the IDSs, the shares of our Class A common stock and our notes. Future sales or the availability for sale of substantial amounts of IDSs or shares of our Class A common stock or a significant principal amount of our notes in the public market could adversely affect the prevailing market price of the IDSs, the shares of our Class A common stock and our notes and could impair our ability to raise capital through future sales of our securities. The holders of the 23,934,267 IDS and the 4,912,500 shares of Class B common stock exchangeable into IDSs that will be issued to our existing equity investors in the recapitalization in connection with this offering will have three demand and unlimited piggyback registration rights, which, if exercised, will allow them to sell their IDSs to the public. The registration rights may not be exercised during the lock-up period. See Underwriting. In addition, we may issue shares of our Class A common stock and notes, which may be represented by IDSs, or other securities from time to time as consideration for future acquisitions and investments. In the event any such acquisition or investment is significant, the number of shares of our Class A common stock and the aggregate principal amount of notes, which may be represented by IDSs, or the number or aggregate principal amount, as the case may be, of other securities that we may issue may in turn be significant. In addition, we may also grant registration rights covering those IDSs, shares of our Class A common stock, notes or other securities in connection with any such acquisitions and investments. Our organizational documents, Delaware laws and/or our indenture could limit another party s ability to acquire us and deprive our investors of the opportunity to obtain a takeover premium for their securities. A number of provisions in our amended and restated certificate of incorporation and amended and restated by- laws will make it difficult for another company to acquire us and for you to receive any related takeover premium for your securities. For example, our organizational documents provide that stockholders may not act by written consent and do not provide our stockholders with the power to call or to request that our board of directors call a special meeting. Our organizational documents authorize the issuance of preferred stock without stockholder approval and upon such terms as the board of directors may determine. The rights of the holders of shares of our Class A common stock will be subject to, and may be adversely affected by, the rights of holders of any class or series of preferred stock that may be issued in the future. We are also subject to Section 203 of the Delaware General Corporation Law, which restricts the ability of a publicly held Delaware corporation to engage Table of Contents in a business combination such as a merger or sale of assets with any stockholder who, together with affiliates, owns 15% or more of the corporation s voting stock. The restrictions imposed by Section 203 could prohibit or delay the accomplishment of an acquisition transaction, or discourage attempts to acquire us. In addition, the indenture governing the notes provides that the notes are not redeemable at our option until the seventh anniversary of the offering, and are redeemable thereafter at our option subject to the payment of certain premiums prior to , 2016. These provisions will effectively increase the cost to acquire us, especially prior to the seventh anniversary of the offering, because we or the acquiror would need to conduct a tender offer for the notes that would likely require payment of a significant premium. For additional details, see Description of Capital Stock Anti-Takeover Effects of Various Provisions of Delaware Law and Our Restated Certificate of Incorporation and Amended and Restated By-Laws, as well as provisions in our indenture. We may not be able to repurchase the notes upon a change of control. Upon the occurrence of certain change of control events, we will be required to offer to repurchase the outstanding notes at 101% of their principal amount at the date of repurchase unless such notes have been previously called for redemption. We may not have sufficient financial resources to purchase all of the notes that are tendered upon a change of control offer. Furthermore, our new credit facility, with certain limited exceptions, will prohibit the repurchase or redemption of the notes before their stated maturity. Consequently, lenders thereunder may have the right to prohibit any such purchase or redemption, in which event we will seek to obtain waivers from the required lenders. We may not be able to obtain such waivers or refinance our indebtedness on terms acceptable to us, or at all. Finally, the occurrence of a change of control could also constitute an event of default under our new credit facility, which could result in the acceleration of all amounts due thereunder. See Description of Notes Change of Control. Furthermore, we may enter into transactions which do not constitute a change of control as defined in the indenture governing the notes and which are otherwise permitted under the indenture governing the notes. Any such transactions would not give note holders the right to demand redemption of their notes and may have the effect of increasing the amount of indebtedness outstanding or otherwise affect our capital structure, credit ratings or the note holders. Our existing equity investors will retain an aggregate of approximately 50.6% of the voting power in us, and their interests may differ from your interests. Upon the completion of the transactions contemplated by this offering, Apax and our other existing equity investors, through their ownership of IDSs and Class B common stock, will collectively, own approximately 50.6% of the voting power in us, or approximately 43.2% of the voting power if the over-allotment option is exercised in full. If the over-allotment option is not exercised, our existing equity investors could, if they act together as a group, control our business, policies and affairs and will be able to elect our entire board of directors, determine, without consent of the holders of IDSs or Class A common stock, the outcome of any corporate transaction or other matter submitted to our stockholders for approval, including mergers, consolidations and sales of substantially all of our assets. They will also, if they act together, be able to prevent or cause a change of control of our company and/or an amendment to our certificate of incorporation and by-laws. We cannot assure you that the interests of Apax and our other existing equity investors will be consistent with the interests of other holders of IDSs, Class A common stock or notes. Even if the over-allotment option is not exercised or our existing equity investors do not act together as a group, this concentration of ownership could have the effect of delaying, deferring or preventing a change in control, merger or tender offer, which would deprive you of an opportunity to receive a premium for your IDSs and may negatively affect the market price of the IDSs. Moreover, Apax either alone or with other existing owners could effectively receive a premium for transferring ownership to third parties that would not inure to your benefit. Severance $ 70 $ 3,583 $ $ (1,885 ) $ 1,768 Facility costs 295 2,619 (1,356 ) (1,519 ) Table of Contents Furthermore, we expect that Apax will own approximately 37.7% of the voting power in us, or 31.8% if the over-allotment option is exercised, and will be our largest stockholder after the offering. As a result, Apax and its affiliates will have a strong ability to influence our business, policies and affairs. One representative of Apax will serve on our seven-member board of directors immediately after the offering, although Apax will have no contractual rights to nominate any directors. We cannot assure you that the interests of Apax will be consistent with the interests of other holders of IDSs, Class A common stock or notes. Risks Relating to our Business and the Industry Our industry is competitive and our future success will depend on our ability to effectively develop and market competitive products. The paper-making consumables industry is highly competitive. Some of our competitors are larger than us, have greater financial and other resources and are well-established as suppliers to the markets we serve. In addition, some of our competitors also manufacture paper-making machines and have the ability to initially package sales of their clothing and roll cover products with the sale of their machines and/or to tie the warranties on their machines to the use of their clothing and roll cover products. Our products may not be able to compete successfully with the products of our competitors, which could result in a loss of customers and, as a result, decreased revenues and profitability. We compete primarily based on the technology and performance of our products, including the ability of our products to help reduce our customers production costs and increase the quality of the paper they produce. Our competitors could develop new technology or products that lead to a reduced demand for our products. In addition, our business depends on our customers regularly needing to replace the clothing and roll covers used on their paper-making machines. Either we or our competitors could develop new technologies that increase the useful life of clothing or roll covers, which could reduce the frequency with which our customers would need to replace their clothing and refurbish or replace their roll covers, and consequently lead to fewer sales. Increased price competition in our industry could adversely affect our gross margins and revenues. We and our competitors have been able to sell clothing and roll covers products and services at favorable prices that reflect the value they deliver to customers. This favorable pricing has been particularly available for our more technically advanced products, such as forming fabrics, press felts and roll covers. If our competitors reduce the prices of such products, we may be required to decrease our prices to compete successfully, which could adversely affect our gross margins and revenues. Fluctuations in currency exchange rates could adversely affect our revenues and profitability. Our foreign operations expose us to fluctuations in currency exchange rates and currency devaluations. We report our financial results in US Dollars, but a substantial portion of our sales are denominated in Euros and other currencies. As a result, changes in the relative values of US Dollars, Euros and these other currencies will affect our levels of revenues and profitability. In particular, if the value of the US Dollar increases relative to the value of the Euro and these other currencies, our levels of revenue and profitability will decline since the translation of a certain number of Euros or units of such other currencies into US Dollars for financial reporting purposes will represent fewer US Dollars. In addition, in certain locations, our sales are denominated in US Dollars or Euros but a substantial portion of our associated costs are denominated in a different currency. As a result, changes in the relative values of US Dollars, Euros and any such different currency will affect our profitability. Fluctuations in currency exchange rates may cause volatility in our results of operations. Although in certain circumstances we attempt to hedge our exposure to fluctuations in currency exchange rates, our hedging strategies may not be effective. Interest and dividend payments on our IDSs and interest payments on our notes sold separately are to be paid in US Dollars. We do not expect to generate sufficient cash flows denominated in US Dollars to make such Table of Contents payments and will therefore rely, in part, on the conversion to US Dollars of cash flows generated in other currencies. After the completion of this offering, we will estimate the extent to which we will need to rely on cash flows denominated in foreign currencies in order to make interest payments on our notes and to pay dividends on our Class A common stock for the first year following this offering in accordance with the initial dividend policy adopted by our board of directors upon the closing of this offering, and we believe that we will be able to enter into fixed-rate currency contracts that will effectively fix the exchange rate applicable to such cash flows at the then current rate. There can be no assurance that these hedging transactions will be sufficient to enable us to pay interest on the notes and dividends on our Class A common stock in accordance with such initial dividend policy, in part because our actual results of operations and liquidity may differ from the estimates relied upon at the time we enter into the fixed rate currency contracts. In addition, our new credit facility contains requirements that we defer paying cash interest on the notes based upon certain financial tests and our new credit facility and the indenture governing our notes contain restrictions on our ability to pay dividends on our Class A common stock based upon certain financial tests. These financial tests depend in part upon our reported financial results, which as indicated above are directly affected by currency fluctuations. Except to the extent that the hedging transactions discussed above result in gains for financial reporting purposes that directly and fully offset any reductions in reported profitability attributable to currency fluctuations, we may be required by our new credit facility to defer the payment of cash interest on the notes or may be prohibited by the indenture governing our notes or the new credit facility from paying dividends on our Class A common stock. This result may be obtained even if our results of operations meet our expectations when viewed in local currencies. See Description of Certain Indebtedness New Credit Facility Restricted Payments, Description of Notes Certain Covenants and Dividend Policy and Restrictions. A sustained downturn in the paper industry could reduce our sales and adversely affect our revenues and profitability. Our ability to sell our products depends primarily on the volume of paper produced on a worldwide basis. The profitability of paper producers has historically been highly cyclical due to wide swings in the price of paper, and the paper industry is currently experiencing a period of lower prices that began in 2001. A sustained downturn in the paper industry could cause paper manufacturers to reduce production or cease operations, which could reduce our sales and adversely affect our revenues and profitability. A paradigm shift in the paper manufacturing industry or the demand for paper could adversely affect our revenues and profitability. Because our products are used on paper-making machines, a paradigm shift in the paper manufacturing industry or the demand for paper could materially reduce the demand for our products. For example, if someone were to develop a new paper production process that did not require clothing or roll covers, the demand for our products could decline or cease. In addition, many people have predicted a decrease in the global demand for paper due to the emergence of the so-called electronic office in which documents are stored electronically rather than in paper format. We cannot assure you that the demand for paper will continue to grow, or that the increased reliance on computers and the electronic storage of documents will not cause the demand for paper to decline. Any material decline in the worldwide demand for paper could cause a reduced demand for our products and ultimately adversely affect our revenues and profitability. We must continue to innovate and improve our products to maintain our competitive advantage and our use of cash to service our debt and pay dividends may limit our ability to do so. Our ability to maintain our customers and increase our business depends on our ability to continually develop new, technologically superior products. We cannot assure you that our investments in technological development will be sufficient, that we will be able to create and market new products or that we will be successful in competing against new technologies developed by competitors. In addition, after the offering, a substantial Table of Contents portion of our cash flow will be required to service our debt and we currently intend to pay quarterly dividends, which may use a significant portion of any remaining cash flow. If there is a sustained downturn in our business, our new capital structure following this offering may have the effect of reducing the amount of money available for investment in new technologies, products and manufacturing processes, which could ultimately affect our ability to remain competitive. Furthermore, members of our senior management may have an incentive to limit certain expenditures, including expenditures that may be necessary for us to remain competitive or to grow our business, because payments to them under our Long Term Incentive Plan are tied to the amount by which our EBITDA less capital expenditures, interest expense and cash income taxes, plus or minus certain working capital and other adjustments exceeds a target determined by our board of directors. See Management Long Term Incentive Plan. The loss of our major customers could have a material adverse effect on our sales and profitability. Our top ten customers generated 28% of our net sales during 2003. The loss of one or more of our major customers, or a substantial decrease in such customers purchases from us, could have a material adverse effect on our sales and profitability. Because we do not generally have binding long term purchasing agreements with our customers, there can be no assurance that our existing customers will continue to purchase products from us. Because we have substantial operations outside the United States, we are subject to the economic and political conditions of foreign nations. We have manufacturing facilities in 15 countries. In 2003, we sold products in approximately 61 countries other than the United States, which represented approximately 71% of our net sales. Our foreign operations are subject to a number of risks and uncertainties, including risks that: foreign governments may impose limitations on our ability to repatriate funds; foreign governments may impose withholding or other taxes on remittances and other payments to us, or the amount of any such taxes may increase; an outbreak or escalation of any insurrection or armed conflict may occur; or foreign governments may impose or increase investment barriers or other restrictions affecting our business. The occurrence of any of these conditions could disrupt our business in particular countries or regions of the world, or prevent us from conducting business in particular countries or regions, which could reduce our sales and affect our net sales and profitability. In addition, we will rely on dividends and other payments or distributions from our subsidiaries to meet our debt obligations and enable us to pay interest and dividends on the IDSs. If foreign governments impose limitations on our ability to repatriate funds or impose or increase taxes on remittances or other payments to us, the amount of dividends and other distributions we receive from our subsidiaries could be reduced, which could reduce the amount of cash available to us to meet our debt obligations and pay dividends. We may fail to adequately protect our proprietary technology, which would allow competitors or others to take advantage of our research and development efforts. We rely upon trade secrets, proprietary know-how, and continuing technological innovation to develop new products and remain competitive. If our competitors learn of our proprietary technology, they may use this information to produce products that are equivalent or superior to our products, which could reduce the sales of our products. Our employees, consultants, and corporate collaborators may breach their obligations not to reveal our confidential information, and any remedies available to us may be insufficient to compensate our damages. Even in the absence of such breaches, our trade secrets and proprietary know-how may otherwise become known to our competitors, or be independently discovered by our competitors, which could reduce our competitive position. We may be liable for product defects or other claims relating to our products. Our products could be defective, fail to perform as designed or otherwise cause harm to our customers, their equipment or their products. If our customers believe that they have suffered harm caused by our products, they 2001: Net sales $ 312,944 $ 186,902 $ $ $ 499,846 Depreciation and amortization (1) 35,842 33,423 362 69,627 Segment Earnings (Loss) 95,925 70,139 (13,732 ) Total assets 522,114 401,695 320,456 (355,272 ) 888,993 Capital expenditures 23,683 8,843 132 32,658 2002: Net sales $ 321,864 $ 193,081 $ 514,945 Depreciation and amortization (1) 31,617 15,584 378 47,579 Segment Earnings 103,062 69,503 449 Total assets 545,588 419,084 336,687 (376,083 ) 925,276 Capital expenditures 18,957 9,103 235 28,295 2003: Net sales $ 361,966 $ 198,702 $ 560,668 Depreciation and amortization (1) 32,387 15,627 221 48,235 Segment Earnings (Loss) 118,505 66,490 (10,471 ) Total assets 595,620 443,384 342,550 (394,748 ) 986,806 Capital expenditures 34,579 9,802 Table of Contents could bring claims against us that could result in significant liability. A failure of our products could cause substantial damage to a paper-making machine. Any claims brought against us by customers may result in: diversion of management s time and attention; expenditure of large amounts of cash on legal fees, expenses, and payment of damages; decreased demand for our products and services; and injury to our reputation. Our insurance may not sufficiently cover a large judgment against us or settlement payment, and is subject to customary deductibles, limits and exclusions. We could incur substantial costs as a result of violations of or liabilities under laws protecting the environment and human health. Our operations and facilities are subject to a number of national, state and local laws and regulations protecting the environment and human health in the United States and foreign countries that govern, among other things, the handling, storage and disposal of hazardous materials, discharges of pollutants into the air and water and workplace safety. We cannot assure you that we have been or will be at all times in complete compliance with such laws and regulations. We could incur substantial costs, including clean-up costs, fines and sanctions and third party property damage or personal injury claims, as a result of violations of or liabilities under environmental laws, relevant common law or the environmental permits required for our operations. We have been named as a defendant in lawsuits in the United States filed by persons alleging injuries caused by asbestos contained in clothing produced by other manufacturers. We may be required to spend a significant amount of money to defend against such claims. Adverse labor relations could harm our operations and reduce our profitability. We currently have approximately 4,000 employees, approximately 48% of whom are subject to protection of various collective bargaining agreements and approximately 22% of whom are subject to protection as members of trade unions, employee associations or workers councils. Approximately 64% of the employees subject to collective bargaining agreements (or approximately 31% of our total employees) are covered by collective bargaining agreements that expire prior to June 30, 2005. We cannot assure you that we will be able to renew such collective bargaining agreements, or enter into new collective bargaining agreements on the same or more favorable terms or at all and without production interruptions, including labor stoppages. In addition, approximately 41% of the employees subject to protection as members of trade unions, employer associations or workers councils (or approximately 9% of our total employees) are subject to arrangements that expire prior to June 30, 2005. We cannot assure you that the terms of employment applicable to such employees will remain the same or become more favorable. We cannot assure you that we will not experience disruptions in our operations as a result of labor disputes or experience other labor relations issues. If we are unable to maintain good relations with our employees, our ability to produce our products and provide services to our customers could be reduced and/or our production costs could increase, either of which could disrupt our business and reduce our profitability. If we are unable to successfully complete our current plant closure and cost reduction program, our revenues and profitability could decline. We are in the process of closing a significant clothing plant located in Virginia and transferring production to our other facilities. If we are unable to successfully transition our customers and production from this facility to our other facilities, we may not be able to retain these customers, or we may experience a loss of sales to such customers, which could adversely affect our revenues and profitability. Table of Contents
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+RISK FACTORS You should carefully consider the risks described below, together with the other information in this prospectus, before deciding whether to invest in the notes. If any of the events described in the risk factors below actually occur, our business, financial condition, operating results and prospects could be materially adversely affected, which in turn could adversely affect our ability to repay the notes. In such case, you may lose all or part of your original investment. Risks Related To Our Leverage Our substantial leverage could harm our business by limiting our available cash and our access to additional capital. As a result of the Transactions and the senior discount notes offering, we are highly leveraged. As of June 30, 2004, our total consolidated indebtedness was $3,634.0 million and we had $250.0 million of borrowing capacity available under our revolving credit facility (excluding $34.7 million of outstanding standby letters of credit). The following chart shows our level of indebtedness and certain other information as of June 30, 2004. As of June 30, 2004 (dollars in millions) Revolving credit facility of Nalco Company $ — Term loan A facility of Nalco Company(1) 224.0 Term loan B facility of Nalco Company 1,186.0 Senior notes of Nalco Company(2) 908.2 Senior subordinated notes of Nalco Company(2) 708.2 Senior discount notes 467.6 Receivables facility of Nalco Company 92.0 Other debt(3) 48.0 Total indebtedness $ 3,634.0 (1) Includes the U.S. dollar equivalent of 64.2 million term loan A borrowings. (2) Includes the U.S. dollar equivalent of 200 million of senior notes and 200 million of senior subordinated notes. (3) Includes $27.8 million aggregate principal amount of Nalco Company's 6¼% notes due 2008, $4.3 million of indebtedness of certain non-U.S. subsidiaries and $15.9 million of short-term bank overdrafts. Our high degree of leverage could have important consequences for you, including the following: It may limit our and our subsidiaries' ability to obtain additional financing for working capital, capital expenditures, product development, debt service requirements, acquisitions and general corporate or other purposes on favorable terms or at all; A substantial portion of our subsidiaries' cash flows from operations must be dedicated to the payment of principal and interest on their and our indebtedness and thus will not be available for other purposes, including operations, capital expenditures and future business opportunities; The debt service requirements of our subsidiaries' other indebtedness could make it more difficult for us and them to make payments on the notes and their existing indebtedness; It may limit our ability to adjust to changing market conditions and place us at a competitive disadvantage compared to those of our competitors that are less highly-leveraged; It may restrict our ability to make strategic acquisitions or cause us to make non-strategic divestitures; and We may be more vulnerable than a less leveraged company to a downturn in general economic conditions or in our business, or we may be unable to carry out capital spending that is important to our growth. Our pro forma cash interest expense for the year ended December 31, 2003 was $199.2 million. At June 30, 2004, we had $1,516.4 million of variable rate debt. A 1% increase in the average interest rate would increase future interest expense by approximately $15.2 million per year. Our and our subsidiaries' debt agreements contain restrictions that limit our flexibility in operating our business. Nalco Company's senior credit agreement, the indentures governing Nalco Company's senior notes and senior subordinated notes and the indenture under which the notes will be issued, and other financing arrangements contain a number of significant covenants that, among other things, restrict our or our subsidiaries' ability to: incur additional indebtedness; pay dividends on or make other distributions or repurchase certain capital stock; make certain investments; enter into certain types of transactions with our affiliates; limit dividends or other payments by restricted subsidiaries; use assets as security in other transactions; and sell certain assets or merge with or into other companies. In addition, under the senior credit agreement, Nalco Holdings is required to satisfy and maintain specified financial ratios and tests. Events beyond our control may affect its ability to comply with those provisions and Nalco Holdings may not be able to meet those ratios and tests. The breach of any of these covenants would result in a default under the senior credit agreement and the lenders could elect to declare all amounts borrowed under the senior credit agreement, together with accrued interest, to be due and payable and could proceed against the collateral securing that indebtedness. Borrowings under the senior credit facilities are effectively senior in right of payment to the notes to the extent of the value of the collateral securing the senior credit facilities and are senior in right of payment to the notes. If any of our or our subsidiaries' indebtedness were to be accelerated, our and our subsidiaries' assets may not be sufficient to repay in full that indebtedness and the notes. Our variable rate indebtedness subjects us to interest rate risk, which could cause our debt service obligations to increase significantly. Certain of Nalco Company's borrowings, primarily borrowings under the senior credit facilities, are at variable rates of interest and expose us to interest rate risk. If interest rates increase, its debt service obligations on the variable rate indebtedness would increase even though the amount borrowed remained the same, and net income and cash available for servicing our and its indebtedness, including the notes, would decrease. Our pro forma cash interest expense for the year ended December 31, 2003 was $199.2 million. At June 30, 2004, we had $1,516.4 million of variable rate debt. A 1% increase in the average interest rate would increase future interest expense by approximately $15.2 million per year. Risks Related to Our Business If we are unable to respond to the changing needs of a particular industry and to anticipate, respond to or utilize changing technologies and develop new offerings , it could become more difficult for us to respond to our customers' needs and cause us to be less competitive. We have historically been able to maintain our market positions and margins through continuous innovation of products and development of new offerings to create value for our customers. Recent innovations and development that we have relied on include our 3D TRASAR system for controlling and monitoring chemical feed and our recent relationship with US Filter, which permits us to sell equipment solutions as part of a bundled offering to our water treatment customers. We may not be successful in continuing to make similar innovations in the future. Our future operating results will depend to a significant extent on our ability to continue to introduce new products and applications and to develop new offerings that offer distinct value for our customers. Many of our products may be affected by rapid technological change and new product introductions and enhancements. We expect to continue to enhance our existing products and identify, develop and manufacture new products with improved capabilities and make improvements in our productivity in order to maintain our competitive position. We intend to devote sizeable resources to the development of new technologically advanced products and systems and to continue to devote a substantial amount of expenditures to the research and development functions of our business. However, we cannot assure you that: we will be successful in developing new products or systems or bringing them to market in a timely manner; products or technologies developed by others will not render our offerings obsolete or non-competitive; the market will accept our innovations; our competitors will not be able to produce our core non-patented products at a lower cost; we will have sufficient resources to research and develop all promising new technologies and products; or significant research and development efforts and expenditures for products will ultimately prove successful. Our ability to anticipate, respond to and utilize changing technologies is crucial because we compete with many companies in each of the markets in which we operate. For example, we compete with hundreds of companies in the water treatment chemicals market, including our primary global competitor, GE Water Technologies. Other companies, including Ecolab, Inc. are expected to enter or increase their presence in our markets. Our ability to compete effectively is based on a number of considerations, such as product and service innovation, product and service quality, distribution capability and price. Moreover, water treatment for industrial customers depends on the particular needs of the industry. For example, the paper industry requires a specific water quality for bleaching paper; certain industrial boilers require demineralized water; the pharmaceuticals industry requires ultra pure water for processing; and, in the case of municipal services, water treatment includes clarification for re-use, sludge dewatering and membrane ultra filtration. We may not have sufficient financial resources to respond to the changing needs of a particular industry and to continue to make investments in our business, which could cause us to become less competitive. Our significant non-U.S. operations expose us to global economic and political changes that could impact our profitability. We have significant operations outside the United States, including joint ventures and other alliances. We conduct business in 130 countries and in 2003, approximately 52% of our net sales originated outside the United States. There are inherent risks in our international operations, including: exchange controls and currency restrictions; currency fluctuations and devaluations, such as the recent currency crisis in Argentina; tariffs and trade barriers; export duties and quotas; changes in local economic conditions, such as the economic decline in Venezuela; changes in laws and regulations; difficulties in managing international operations and the burden of complying with foreign laws; exposure to possible expropriation or other government actions; restrictions on our ability to repatriate dividends from our subsidiaries; and unsettled political conditions, such as those found in Nigeria, and possible terrorist attacks against American interests. Our international operations also expose us to different local political and business risks and challenges. For example, in certain countries we are faced with periodic political issues which could result in currency risks or the risk that we are required to include local ownership or management in our businesses. We are also periodically faced with the risk of economic uncertainty, such as recent strikes and currency exchange controls in Venezuela, which has impacted our business in these countries. Other risks in international business also include difficulties in staffing and managing local operations, including our obligations to design local solutions to manage credit risk to local customers and distributors. Our overall success as a global business depends, in part, upon our ability to succeed in differing economic, social and political conditions. We may not continue to succeed in developing and implementing policies and strategies that are effective in each location where we do business, which could negatively affect our profitability. Environmental, safety and production and product regulations or concerns could subject us to liability for fines or damages, require us to modify our operations and increase our manufacturing and delivery costs. We are subject to the requirements of environmental and occupational safety and health laws and regulations in the United States and other countries. These include obligations to investigate and clean up environmental contamination on or from properties or at off-site locations where we are identified as a responsible party. For example, we are currently identified as a potentially responsible party at certain waste management sites. Additionally, the U.S. Environmental Protection Agency is conducting a civil and criminal investigation of environmental practices at our Louisiana manufacturing facility. No claims or charges have been issued and we are unable to predict the results of such investigation. We have also been named as a defendant in a series of multi-party and individual lawsuits based on claims of exposure to hazardous materials. We cannot predict with certainty the outcome of any such tort claims or the involvement we might have in such matters in the future and there can be no assurance that the discovery of previously unknown conditions will not require significant expenditures. In each of these chemical exposure cases, our insurance carriers have accepted the claims on our behalf and our financial exposure is limited to the amount of our deductible (not exceeding $1 million per occurrence); however, we cannot predict the number of claims that we may have to defend in the future and we may not be able to continue to maintain such insurance. We have made and will continue to make capital and other expenditures to comply with environmental requirements. Although we believe we are in material compliance with environmental law requirements, we may not have been and will not at all times be in complete compliance with all of these requirements, and may incur material costs, including fines or damages, or liabilities in connection with these requirements in excess of amounts we have reserved. In addition, these requirements are complex, change frequently and have tended to become more stringent over time. In the future, we may discover previously unknown contamination that could subject us to additional expense and liability. In addition, future requirements could be more onerous than current requirements. For more information about our environmental compliance and potential environmental liabilities, see "Business—Environmental Matters." The activities and plants at our production facilities are subject to a variety of federal, state, local and foreign laws and regulations ("production regulations"). Similarly, the solid, air and liquid waste streams produced from our production facilities are subject to a variety of regulations ("waste regulations") and many of our products and the handling of our products are governmentally regulated or registered ("product regulations"). Each of the production, waste and product regulations is subject to expansion or enhancement. Any new or tightened regulations could lead to increases in the direct and indirect costs we incur in manufacturing and delivering products to our customers. For example, the European Commission is currently considering imposing new chemical registration requirements on the manufacturers and users of all chemicals, not just those which are considered to be harmful or hazardous. Should such regulations, referred to as REACH, be imposed, all chemical companies will be faced with additional costs to conduct their businesses in European Commission countries. Similarly, certain of our products are used to assist in the generation of tax credits for our customers, and the termination or expiration of such tax credits could impact the sale of these products. In addition to an increase in costs in manufacturing and delivering products, a change in production regulations or product regulations could result in interruptions to our business and potentially cause economic or consequential losses should we be unable to meet the demands of our customers for products. We may not be able to achieve all of our expected cost savings. We initiated a comprehensive cost reduction plan immediately upon consummation of the Acquisition. However, a variety of risks could cause us not to achieve the benefits of the expected cost savings, including, among others, the following: higher than expected severance costs related to staff reductions; higher than expected retention costs for employees that will be retained; delays in the anticipated timing of activities related to our cost-saving plan, including the reduction of inefficiencies in our administrative and overhead functions; and other unexpected costs associated with operating the business. We have experienced, and may continue to experience, difficulties in securing the supply of certain raw materials we and our competitors need to manufacture some of our products. During 2004, certain of the raw materials used by us and other chemical companies have faced supply limitation. In some cases because of unexpectedly large demand and in other instances because of plant and equipment problems, certain of our raw material vendors have placed us and their other customers "on allocation," proportionately reducing the amounts of raw materials supplied to us as against our past requirements. If these limitations continue or become more severe, we risk shortfalls in our sales and the potential of claims from our customers if we are unable to fully meet contractual requirements. Our pension plans are currently underfunded and we may have to make significant cash payments to the plans, reducing the cash available for our business. We sponsor various pension plans worldwide that are underfunded and require significant cash payments. For example, in 2003, we contributed $31.2 million to our pension plans and in 2002, we contributed $100.9 million to our pension plans, including a $90.0 million voluntary contribution to our U.S. pension plan. We contributed $4.1 million to our U.S. pension plan in 2004 and do not currently plan to make additional contributions to that plan this year. We are required to contribute at least $21.0 million to the U.S. pension plan in 2005. We may also opt to make additional voluntary contributions to various pension plans worldwide in 2004 and 2005. Additionally, if the performance of the assets in our pension plans does not meet our expectations, or if other actuarial assumptions are modified, our contributions for those years could be even higher than we expect. For example, our U.S. pension assets had a fair value of $210.1 million as of December 31, 2003. We expect to earn an 8.5% investment return on our U.S. pension assets. In the event actual investment returns are 1% lower than expected for one year, we expect our long-term cash requirements to increase by $2.1 million. If our cash flow from operations is insufficient to fund our worldwide pension liability, we may be forced to reduce or delay capital expenditures, seek additional capital or seek to restructure or refinance our indebtedness, including the notes. As of December 31, 2003, our worldwide pension plans were underfunded by $359.6 million (based on the actuarial assumptions used for FAS 87 purposes). Our U.S. pension plans are subject to the Employee Retirement Income Security Act of 1974, or ERISA. Under ERISA, the Pension Benefit Guaranty Corporation, or PBGC, has the authority to terminate an underfunded pension plan under limited circumstances. In the event our U.S. pension plans are terminated for any reason while the plans are underfunded, we will incur a liability to the PBGC that may be equal to the entire amount of the underfunding. Prior to the closing of the Acquisition, the PBGC requested and received information from us regarding our business, the Transactions and our pension plans. The PBGC took no further action with respect to their inquiry. We have recorded a significant amount of goodwill and other identifiable intangible assets, and we may never realize the full value of our intangible assets. In connection with the Acquisition, we have recorded a significant amount of goodwill and other identifiable intangible assets, including customer relationships, trademarks and developed technologies. Goodwill and other net identifiable intangible assets were approximately $3.7 billion as of June 30, 2004, or 63% of our total assets. Goodwill, which represents the excess of cost over the fair value of the net assets of the businesses acquired, was approximately $2.3 billion as of June 30, 2004, or 39% of our total assets. Goodwill and net identifiable intangible assets are recorded at fair value on the date of acquisition and, in accordance with Financial Accounting Standards Board Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible Assets, will be reviewed at least annually for impairment. Impairment may result from, among other things, deterioration in our performance, adverse market conditions, adverse changes in applicable laws or regulations, including changes that restrict the activities of or affect the products and services sold by our business, and a variety of other factors. The amount of any quantified impairment must be expensed immediately as a charge to results of operations. Depending on future circumstances, it is possible that we may never realize the full value of our intangible assets. Any future determination of impairment of a significant portion of goodwill or other identifiable intangible assets would have an adverse effect on our financial condition and results of operations. Our future success will depend in part on our ability to protect our intellectual property rights, and our inability to enforce these rights could permit others to offer products competitive with ours, which could reduce our ability to maintain our market position and maintain our margins. We rely on the patent, trademark, copyright and trade secret laws of the United States and other countries to protect our intellectual property rights. However, we may be unable to prevent third parties from using our intellectual property without authorization. The use of our intellectual property by others could reduce any competitive advantage we have developed or otherwise harm our business. If we had to litigate to protect these rights, any proceedings could be costly, and we may not prevail. We have obtained and applied for several U.S. and foreign trademark registrations, and will continue to evaluate the registration of additional service marks and trademarks, as appropriate. Our pending applications may not be approved by the applicable governmental authorities and, even if the applications are approved, third parties may seek to oppose or otherwise challenge these registrations. A failure to obtain trademark registrations in the United States and in other countries could limit our ability to protect our trademarks and impede our marketing efforts in those jurisdictions. Our Sponsors control us and may have conflicts of interest with us or you in the future. Our Sponsors beneficially own approximately 97% of the equity interests of Nalco LLC, the ultimate parent company of the issuers. As a result, our Sponsors have control over our decisions to enter into any corporate transaction and have the ability to prevent any transaction that requires the approval of our boards of directors or the equityholders regardless of whether or not other members of our boards of directors or equityholders or noteholders believe that any such transactions are in their own best interests. For example, our Sponsors could cause us to sell revenue-generating assets, which could impair our ability to make payments under the notes. Additionally, our Sponsors are in the business of making investments in companies and may from time to time acquire and hold interests in businesses that compete directly or indirectly with us. Our Sponsors may also pursue acquisition opportunities that may be complementary to our business, and as a result, those acquisition opportunities may not be available to us. So long as our Sponsors continue to own a significant amount of the equity of our ultimate parent, Nalco LLC, even if less than 50%, they will continue to be able to significantly influence or effectively control our decisions. See "Certain Relationships and Related Party Transactions." Risks Related To The Notes The issuers are the sole obligors of the notes and their subsidiaries do not guarantee the issuers' obligations under the notes and do not have any obligation with respect to the notes; the notes will be structurally subordinated to all of the debt and liabilities of the issuers' subsidiaries and effectively subordinated to any of the issuers' secured debt. The issuers have no operations of their own and derive all of their revenues and cash flow from their subsidiaries. The issuers' subsidiaries are separate and distinct legal entities and have no obligation, contingent or otherwise, to pay amounts due under the notes or to make any funds available to pay those amounts, whether by dividend, distribution, loan or other payments. The notes will be structurally subordinated to all debt and liabilities of the issuers' subsidiaries, including Nalco Holdings LLC and Nalco Company. In the event of a bankruptcy, liquidation or reorganization or similar proceeding relating to the issuers' subsidiaries, you will participate with all other holders of the issuers' indebtedness in the assets remaining after the issuers' subsidiaries have paid all of their debt and liabilities. In any of these cases, the issuers' subsidiaries may not have sufficient funds to make payments to the issuers, and you may receive less, ratably, than the holders of debt of the issuers' subsidiaries and other liabilities. As of June 30, 2004, the aggregate amount of liabilities of the issuers' subsidiaries was approximately $4,929.9 million. In addition, as of that date, the issuers' subsidiaries had $250.0 million of borrowing capacity under the revolving credit facility (excluding $34.7 million of outstanding standby letters of credit). In addition, holders of their secured debt will have claims that are prior to your claims as holders of the notes to the extent of the value of the assets securing that other debt. Notably, the senior credit facility is secured by certain of the assets of the issuers' subsidiaries. Additionally, the indentures governing the notes and the indebtedness of our subsidiaries and the senior credit facility permit us and/or our subsidiaries to incur additional indebtedness, including secured indebtedness, under certain circumstances. Our subsidiaries may not be able to generate sufficient cash to service all of their and our indebtedness, including the notes, and may be forced to take other actions to satisfy their and our obligations under their and our indebtedness, which may not be successful. Our subsidiaries' ability to make scheduled payments or to refinance their and our debt obligations depends on our subsidiaries' financial and operating performance, which is subject to prevailing economic and competitive conditions and to certain financial, business and other factors beyond their and our control. Our subsidiaries may not be able to maintain a level of cash flows from operating activities sufficient to permit them and us to pay the principal, premium, if any, and interest on their and our indebtedness. See "Management's Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources." If our subsidiaries' cash flows and capital resources are insufficient to fund their and our debt service obligations, we and our subsidiaries may be forced to reduce or delay capital expenditures, seek additional capital or seek to restructure or refinance our and their indebtedness, including the notes. These alternative measures may not be successful and may not permit us and our subsidiaries to meet our and their scheduled debt service obligations. In the absence of such operating results and resources, we and they could face substantial liquidity problems and might be required to sell material assets or operations to attempt to meet our and their debt service and other obligations. The senior credit facilities, the indentures governing Nalco Company's existing senior notes and senior subordinated notes restrict, and the indenture under which the notes will be issued restrict our subsidiaries' ability to use the proceeds from asset sales. Our subsidiaries may not be able to consummate those asset sales to raise capital or sell assets at prices that they believe are fair and proceeds that they do receive may not be adequate to meet any debt service obligations then due. See "Description of Other Indebtedness—Senior Credit Facilities" and "Description of Notes." Despite our current leverage, we may still be able to incur substantially more debt. This could further exacerbate the risks related to significant leverage that we and our subsidiaries face. We and our subsidiaries may be able to incur substantial additional indebtedness in the future. The terms of the indenture governing the notes and the indentures governing Nalco Company's senior notes and senior subordinated notes do not fully prohibit us or our subsidiaries from doing so. Nalco Company's revolving credit facility provides borrowing capacity of up to $250.0 million. As of June 30, 2004, there were no outstanding borrowings under the revolving credit facility (excluding $34.7 million of outstanding standby letters of credit). All of those borrowings would be secured, and as a result, would be effectively senior to the notes and further, because they represent debt of one of our subsidiaries, the borrowings would be structurally senior to the notes. If we incur any additional indebtedness that ranks equally with the notes, the holders of that debt will be entitled to share ratably with the holders of the notes in any proceeds distributed in connection with any insolvency, liquidation, reorganization, dissolution or other winding-up of us. This may have the effect of reducing the amount of proceeds paid to you. If new debt is added to our current debt levels, the related risks that we and our subsidiaries now face could intensify. You should not expect Nalco Finance Holdings Inc. to participate in making payments on the notes. Nalco Finance Holdings Inc. is a wholly-owned subsidiary of Nalco Finance Holdings LLC that was incorporated to accommodate the issuance of the notes by Nalco Finance Holdings LLC. Nalco Finance Holdings Inc. will not have any operations or assets of any kind and will not have any revenue other than as may be incidental to its activities as a co-issuer of the notes. You should not expect Nalco Finance Holdings Inc. to participate in servicing any of the obligations on the notes. The terms of Nalco Company's senior credit agreement fully prohibit Nalco Holdings and its subsidiaries from paying dividends or otherwise transferring their assets to the issuers, and agreements governing other indebtedness of Nalco Company also contain restrictions on our subsidiaries' ability to pay us dividends or transfer assets to us. Nalco Finance Holdings LLC's operations are conducted through its subsidiaries and its ability to make payments on the notes is dependent on the earnings and the distribution of funds from its subsidiaries. However, the terms of Nalco Company's senior credit agreement fully prohibit Nalco Holdings and its subsidiaries from paying dividends or otherwise transferring their assets to the issuers. Accordingly, on August 1, 2009 when the issuers are obligated to pay interest in cash on the notes, such payments may still be prohibited by the terms of the senior credit agreement. Further, the terms of the indentures governing the 7¾% Dollar Senior Notes due 2011, 7¾% Euro Senior Notes due 2011, 8 7/8% Dollar Senior Subordinated Notes due 2013 and 9% Euro Senior Subordinated Notes due 2013 of Nalco Company significantly restrict Nalco Holdings and the issuers' other subsidiaries from paying dividends and otherwise transferring assets to the issuers. For example, the ability of Nalco Holdings to make such payments is governed by a formula based on 50% of its consolidated net income (which, as defined in such indentures, excludes impairment charges, amortization charges from purchase accounting and any after-tax extraordinary or nonrecurring gains and losses). In addition, as a condition to making such payments to the issuers based on such formula, Nalco Holdings must have an Adjusted EBITDA to interest expense ratio of at least 2.0 to 1 after giving effect to any such payments. Notwithstanding such restrictions, such indentures permit an aggregate of $50.0 million of such payments to be made whether or not there is availability under the formula or the conditions to its use are met. The issuers' subsidiaries will be permitted under the terms of the senior credit facilities and other indebtedness to incur additional indebtedness that may severely restrict or prohibit the making of distributions, the payment of dividends or the making of loans by such subsidiaries to the issuers. We cannot assure you that the agreements governing the current and future indebtedness of the issuers' subsidiaries will permit the issuers' subsidiaries to provide the issuers with sufficient dividends, distributions or loans to fund scheduled interest and principal payments on these notes when due. See "Description of Other Indebtedness." All of our assets are owned, and all of our net sales are earned, by our direct and indirect subsidiaries. Our ability to repay the notes depends upon the performance of these subsidiaries and their ability to make distributions. All of our operations are conducted by our subsidiaries and, therefore, our cash flows and our ability to service indebtedness, including our ability to pay the interest on and principal of the notes when due, will be dependent upon cash dividends and distributions or other transfers from our subsidiaries. Payments to us by our subsidiaries will be contingent upon our subsidiaries' earnings. Our subsidiaries are separate and distinct legal entities and they will have no obligation, contingent or otherwise, to pay amounts due under the notes or to make any funds available to pay those amounts, whether by dividend, distribution, loan or other payments. If we or our subsidiaries default on our or their obligations to pay our or their other indebtedness, we may not be able to make payments on the notes. Any default under the agreements governing our or our subsidiaries' indebtedness, including a default under Nalco Company's senior credit facilities that is not waived by the required lenders, and the remedies sought by the holders of such indebtedness could make the issuers unable to pay principal, premium, if any, and interest on the notes and substantially decrease the market value of the notes. If we or they are unable to generate sufficient cash flow and are otherwise unable to obtain funds necessary to meet required payments of principal, premium, if any, and interest on our or their indebtedness, or if we or they otherwise fail to comply with the various covenants, including financial and operating covenants, in the instruments governing our or their indebtedness (including the senior credit facilities), we or they could be in default under the terms of the agreements governing such indebtedness. In the event of such default, the holders of such indebtedness could elect to declare all the funds borrowed thereunder to be due and payable, together with accrued and unpaid interest, the lenders under the revolving credit facility could elect to terminate their commitments, cease making further loans and institute foreclosure proceedings against our assets, and we could be forced into bankruptcy or liquidation. If our or their operating performance declines, Nalco Company may in the future need to seek to obtain waivers from the required lenders under the senior credit facilities to avoid being in default. If Nalco Company breaches its covenants under the senior credit facilities and seeks a waiver, it may not be able to obtain a waiver from the required lenders. If this occurs, Nalco Company would be in default under the senior credit facilities, the lenders could exercise their rights as described above, and we could be forced into bankruptcy or liquidation. See "Description of Other Indebtedness—Senior Credit Facilities," and "Description of Notes." Although the issuers will be required to offer to repurchase the notes upon a change of control, they may not have sufficient financial resources to purchase all notes that are tendered. Upon the occurrence of specific kinds of change of control events, including the sale, lease or transfer of "all or substantially" all the assets of Nalco Finance Holdings LLC and its subsidiaries taken as a whole, the issuers will be required to offer to repurchase all outstanding notes at 101% of their principal amount, plus accrued and unpaid interest, unless such notes have been previously called for redemption. However, the issuers may not have sufficient financial resources to purchase all of the notes that are tendered upon a change of control offer. Any such failure to repurchase the notes could constitute a default under the indenture governing the notes. As mentioned above, under the indenture governing the notes, the sale, lease or transfer of "all or substantially all" the assets of Nalco Finance Holdings LLC and its subsidiaries taken as a whole constitutes a change of control that will require the issuers to offer to repurchase the notes. Although there is a developing body of case law interpreting the phrase "substantially all," there is no precise established definition of the phrase under applicable law. Accordingly, the ability of a holder of notes to require the issuers to repurchase such notes as a result of a sale, lease or transfer of less than all of the assets of Nalco Finance Holdings LLC and its subsidiaries taken as a whole to another person or group may be uncertain. See "Description of Notes—Change of Control." In addition, it is possible that we could, in the future, enter into certain transactions, including acquisitions, refinancings or other recapitalizations or highly leveraged transactions, that would not constitute a change of control under the indenture, but that could increase the amount of indebtedness outstanding at such time or otherwise affect our capital structure or credit ratings or otherwise adversely affect holders of the notes. Furthermore, because of the potential restrictions on a change of control, we could be prevented from completing a transaction which might otherwise benefit the noteholders. The occurrence of a change of control could also constitute an event of default under Nalco Company's senior credit facilities. The bank lenders may have the right to prohibit any such purchase or redemption, in which event we will seek to obtain waivers from the required lenders under the senior credit facilities, but may not be able to do so. Federal and state fraudulent transfer laws may permit a court to void the notes, and, if that occurs, you may not receive any payments on the notes. The issuance of the notes may be subject to review under federal and state fraudulent transfer and conveyance statutes. While the relevant laws may vary from state to state, under such laws the payment of consideration will be a fraudulent conveyance if (1) the issuers paid the consideration with the intent of hindering, delaying or defrauding creditors or (2) the issuers received less than reasonably equivalent value or fair consideration in return for issuing the notes and, in the case of (2) only, one of the following is also true: the issuers were insolvent or rendered insolvent by reason of the incurrence of the indebtedness; or payment of the consideration left the issuers with an unreasonably small amount of capital to carry on the business; or the issuers intended to, or believed that they would, incur debts beyond their ability to pay as they mature. If a court were to find that the issuance of the notes was a fraudulent conveyance, the court could void the payment obligations under the notes or further subordinate the notes to presently existing and future indebtedness of the issuers, or require the holders of the notes to repay any amounts received with respect to the notes. In the event of a finding that a fraudulent conveyance occurred, you may not receive any repayment on the notes. Further, the voidance of the notes could result in an event of default with respect to our and our subsidiaries' other debt that could result in acceleration of such debt. Generally, an entity would be considered insolvent if, at the time it incurred indebtedness: the sum of its debts, including contingent liabilities, was greater than the fair salable value of all its assets; or the present fair salable value of its assets was less than the amount that would be required to pay its probable liability on its existing debts and liabilities, including contingent liabilities, as they become absolute and mature; or it could not pay its debts as they become due. We cannot be certain as to the standards a court would use to determine whether or not the issuers were solvent at the relevant time, or regardless of the standard that a court uses, that the issuance of the notes would not be further subordinated to our or any of our subsidiaries' other debt. Your ability to transfer the notes may be limited by the absence of an active trading market, and there is no assurance that any active trading market will develop for the notes. The notes are new issues of securities for which there is no established public market. Goldman, Sachs & Co. has advised us that it intends to make a market in the notes as permitted by applicable laws and regulations; however, Goldman, Sachs & Co. is not obligated to make a market in the notes, and it may discontinue its market-making activities at any time without notice. Therefore, we cannot assure you that an active market for the notes will develop or, if developed, that it will continue. Historically, the market for noninvestment grade debt has been subject to disruptions that have caused substantial volatility in the prices of securities similar to the notes. The market, if any, for the notes may experience similar disruptions and any such disruptions may adversely affect the prices at which you may sell your notes. In addition, subsequent to their initial issuance, the notes may trade at discounts from their initial offering price, depending upon prevailing interest rates, the market for similar notes, our financial and operating performance and other factors.
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+RISK FACTORS ANY INVESTMENT IN OUR SECURITIES INVOLVES A HIGH DEGREE OF RISK. YOU SHOULD CAREFULLY CONSIDER THE RISKS DESCRIBED BELOW, WHICH WE BELIEVE ARE ALL THE MATERIAL RISKS TO OUR BUSINESS, TOGETHER WITH THE INFORMATION CONTAINED ELSEWHERE IN THIS PROSPECTUS, BEFORE YOU MAKE A DECISION TO INVEST IN OUR COMPANY. RISKS RELATED TO THE COMPANY A FAILURE TO OBTAIN NECESSARY ADDITIONAL CAPITAL IN THE FUTURE COULD JEOPARDIZE OUR OPERATIONS. We will need additional capital in the future to fund our operations, finance investments in equipment and corporate infrastructure, expand our network, increase the range of services we offer and respond to competitive pressures and perceived opportunities. We have had a history of negative cash flows from operations. In the six months ended June 30, 2004 and the year ended December 31, 2003, our negative cash flow from operations was $2.4 million and $3.2 million, respectively. Cash flow from operations and cash on hand may not be sufficient to cover our operating expenses, working capital, interest on and repayment of our debt and capital investment needs. We may not be able to obtain additional financing on terms acceptable to us, if at all. If we raise additional funds by selling equity securities, the relative equity ownership of our existing investors could be diluted or the new investors could obtain terms more favorable than previous investors. A failure to obtain additional funding could prevent us from making expenditures that are needed to allow us to grow or maintain our operations. OUR FINANCIAL CONDITION, AND THE RESTRICTIVE COVENANTS CONTAINED IN OUR CREDIT FACILITY MAY LIMIT OUR ABILITY TO BORROW ADDITIONAL FUNDS OR RAISE ADDITIONAL EQUITY AS MAY BE REQUIRED TO FUND OUR FUTURE OPERATIONS. We incurred significant losses from continuing operations of $15.3 million, $10.9 million and $56.5 million for the six months ended June 30, 2004 and for the years ended December 31, 2003 and 2002, respectively. Our accumulated deficit and stockholders' deficit was approximately $427.5 million and $54.2 million, respectively, as of June 30, 2004. Moreover, the terms of our $15 million revolving credit facility and our new debt may limit our ability to, among other things: - incur additional debt; - retire or exchange outstanding debt; - pay cash dividends, redeem, retire or repurchase our stock or change our capital structure; - acquire assets or businesses or make investments in other entities; - enter into certain transactions with affiliates; - merge or consolidate with other entities; - sell or otherwise dispose of assets or use the proceeds from any asset sale or other disposition; - create additional liens on our assets; or - issue certain types of redeemable preferred stock. Our available cash, and the remaining borrowing capacity under our credit facility may not be sufficient to fund our operating and capital expenditure requirements in the foreseeable future. Our ability to borrow additional funds or raise additional equity is limited by the terms of our outstanding debt instruments and/or our financial condition. Additionally, events such as our inability to continue to reduce our loss from continuing operations, could adversely affect our liquidity and our ability to attract additional funding as required. WE MAY NOT BE ABLE TO PAY OUR DEBT AND OTHER OBLIGATIONS AND OUR ASSETS MAY BE SEIZED AS A RESULT. We may not generate the cash flow required to pay our liabilities as they become due. Following the completion of the Exchange Offer and refinancing of our Existing Senior Notes, our outstanding debt included approximately $0.9 million of the Existing Notes due in March 2005, $37.3 million of the New Subordinated Notes due in June 2009 and $29.0 million of New Secured Notes due in June 2007. We must pay interest on all of the Existing Notes, the New Subordinated Notes and the New Secured Notes twice a year. If our cash flow is inadequate to meet our obligations, we will default on the notes. Any default of the Existing Notes, the New Subordinated Notes or the New Secured Notes could allow our note holders to seize our assets or try to force us into bankruptcy. Additionally, as of June 30, 2004 we had an outstanding balance of $2.3 million on our line of credit totaling $15.0 million, and had approximately $1.6 million of outstanding letters of credit issued under these agreements. If we fail to pay our liabilities under these lines of credit, the bank may enforce all available remedies and seize our assets or receivables, to satisfy any amounts owed. WE MAY BE UNABLE TO REPAY OR REPURCHASE THE NEW SECURED NOTES, EXISTING NOTES OR NEW SUBORDINATED NOTES UPON A REPURCHASE EVENT AND BE FORCED INTO BANKRUPTCY. The holders of the New Secured Notes may require us to repurchase or prepay all of the outstanding New Secured Notes upon a "repurchase event." A repurchase event under the New Secured Notes includes a change of control under certain circumstances or a termination of listing of our common stock on a U.S. national securities exchange or trading on an established over-the-counter trading market in the U.S. In addition, upon the receipt of proceeds of certain asset sales by us that generate proceeds in excess of $10,000,000 (or if an event of default exists, regardless of the amount) that is not invested or used to reduce existing indebtedness and does not result in a change of control, we are required to use the proceeds from the asset sale to prepay or repurchase the New Secured Notes. We may not have sufficient cash reserves to repurchase the New Secured Notes at such time, which would cause an event of default under the New Secured Note Indenture and under our other debt obligations. The holders of the Existing Notes and New Subordinated Notes may require us to repurchase all or any portion of the outstanding Existing Notes or New Subordinated Notes upon a "repurchase event." A repurchase event under the Existing Notes and New Subordinated Notes includes a change in control under certain circumstances or a termination of listing of our common stock on a U.S. national securities exchange or trading on an established over-the-counter trading market in the U.S. We may not have sufficient cash reserves to repurchase the Existing Notes or New Subordinated Notes at such time, which would cause an event of default under the Existing Note Indenture or the New Subordinated Note Indenture and under our other debt obligations and may force us to declare bankruptcy. INVESTOR INTEREST IN THE COMMON STOCK MAY BE NEGATIVELY AFFECTED BY OUR CONTINUED TRADING ON THE OVER-THE-COUNTER BULLETIN BOARD. On November 13, 2002, we received a determination from the Nasdaq Stock Market that shares of the common stock would no longer trade on the Nasdaq National Market because we failed to meet certain minimum listing requirements. Our common stock began trading on the NASD-operated Over-the-Counter Bulletin Board on November 14, 2002. The Over-the-Counter Bulletin Board market is generally considered to be less efficient and not as liquid as the Nasdaq National Market. Trading in this market may decrease the market value and liquidity of our common stock, which could materially and adversely affect our ability to attract additional investment to finance our operations. PROVISIONS OF OUR GOVERNING DOCUMENTS AND DELAWARE LAW COULD ALSO DISCOURAGE ACQUISITION PROPOSALS OR DELAY A CHANGE IN CONTROL. Our certificate of incorporation and by-laws contain anti-takeover provisions, including those listed below, that could make it more difficult for a third party to acquire control of our company, even if that change in control would be beneficial to stockholders: - our board of directors has the authority to issue common stock and preferred stock, and to determine the price, rights and preferences of any new series of preferred stock, without stockholder approval; - our board of directors is divided into three classes, each serving three-year terms; - our stockholders need a supermajority of votes to amend key provisions of our certificate of incorporation and by-laws; - there are limitations on who can call special meetings of stockholders; - our stockholders may not take action by written consent; and - our stockholders must provide specified advance notice to nominate directors or submit stockholder proposals. In addition, provisions of Delaware law and our stock option plan may also discourage, delay or prevent a change of control of our company or unsolicited acquisition proposals. INTERNATIONAL GOVERNMENTAL REGULATION AND LEGAL UNCERTAINTIES AND OTHER LAWS COULD LIMIT OUR ABILITY TO PROVIDE OUR SERVICES, MAKE THEM MORE EXPENSIVE, OR SUBJECT US TO LEGAL OR CRIMINAL LIABILITY. A number of countries currently prohibit or limit competition in the provision of traditional voice telephony services. In some of those countries, licensed telephony carriers as well as government regulators have questioned our legal authority and/or the legal authority of our service partners or affiliated entities and employees to offer our services. We may face similar questions in additional countries. Our failure to qualify as a properly licensed service provider, or to comply with other foreign laws and regulations, could materially adversely affect our business, financial condition and results of operations, including subjecting us or our employees to taxes and criminal or other penalties and/or by precluding us from, or limiting us in, enforcing contracts in such jurisdictions. It is also possible that countries may apply to our activities laws otherwise relating to services provided over the Internet, including laws governing: - sales and other taxes, including payroll-withholding applications; - user privacy; - pricing controls and termination costs; - characteristics and quality of products and services; - qualification to do business; - consumer protection; - cross-border commerce, including laws that would impose tariffs, duties and other import restrictions; - copyright, trademark and patent infringement; and - claims based on the nature and content of Internet materials, including defamation, negligence and the failure to meet necessary obligations. If foreign governments or other bodies begin to impose related restrictions on Internet telephony or our other services or otherwise enforce criminal or other laws against us, our affiliates or employees, such activities could have a material adverse effect on our ability to attain and maintain profitability. THE TELECOMMUNICATIONS INDUSTRY IS SUBJECT TO DOMESTIC GOVERNMENTAL REGULATION AND LEGAL UNCERTAINTIES AND OTHER LAWS THAT COULD MATERIALLY INCREASE OUR COSTS AND PREVENT US FROM EXECUTING OUR BUSINESS PLAN. We are not licensed to offer traditional telecommunications services in any U.S. state and we have not filed tariffs for any service at the Federal Communications Commission (FCC) or at any state regulatory commission. Nonetheless, aspects of our operations may currently be, or become, subject to state or federal regulations governing licensing, universal service funding, access charges, advertising, disclosure of confidential communications or other information, excise taxes, transactions restricted by U.S. embargo and other reporting or compliance requirements. While the FCC to date has maintained an informal policy that information service providers, including Internet telephony providers, are not telecommunications carriers for regulatory purposes, various entities have challenged this idea, before the FCC and at various state government agencies. The FCC recently ruled against AT&T, finding that certain traffic AT&T carried in part utilizing an Internet protocol format was nonetheless regulated telecommunications for which terminating access charges were due. The FCC has also held hearings and announced a Notice of Proposed Rulemaking on IP-enabled services. Adverse rulings or rulemakings could subject us to licensing requirements and additional fees and subsidies. The IRS and the U.S. Department of Treasury have issued a notice of proposed rulemaking suggesting that VoIP calls may be subject to a 3% federal excise tax. We have offered our prepaid international calling card services on a wholesale basis to international carrier customers, and others, some of which provide these services to end-user customers, enabling them to call internationally over The iBasis Network from the U.S. We have also made arrangements to participate in the selling and marketing of such cards on a retail basis. Although the calling cards are not primarily marketed for domestic interstate or intrastate use, we have not blocked the ability to place such calls or required our wholesale customers or distributors to show evidence of their compliance with U.S. and state regulations. As a result, there may be incidental domestic use of the cards. Domestic calling may employ transport and switching that is not connected to the Internet and, therefore, may not enjoy the lighter regulation to which our Internet-based services are subject. Because we provide services that are primarily wholesale and/or international, we do not believe that we are subject to federal or state telecommunications regulation for the possible uses of these services described here and, accordingly, we have not obtained state licenses, filed state or federal tariffs, posted bonds, or undertaken other possible compliance steps. Under current standards or as-yet undetermined rules, the FCC and state regulatory authorities may not agree with our position. If they do not, we could become subject to regulation at the federal and state level for these services, and could become subject to licensing and bonding requirements, and federal and state fees and taxes, including universal service contributions and other subsidies, and other laws, all of which could materially affect our business. We are also subject to federal and state laws and regulations regarding consumer protection and disclosure regulations. These rules could substantially increase the cost of doing business domestically and in any particular state. Law enforcement authorities may utilize their powers under consumer protection laws against us in the event we do not meet legal requirements in that jurisdiction. The Telecommunications Act of 1996 requires that payphone service providers be compensated for all completed calls originating from payphones in the United States. When calling cards are used, the FCC's prior rules required the first switch-based carrier to compensate the payphone service provider, but newly adopted rules require the last switched-based carrier to do so, and further require that all carriers in the call chain implement a call-tracking system, utilize it to identify such calls, provide an independent audit of the adequacy of such system, and provide a report on these matters to the FCC and others in the call chain. We maintain that as an international Internet telephony provider, we sell an information service. We therefore are not a "carrier" for regulatory purposes and, in any case, our Internet-based systems do not rely on traditional long distance switches. Thus, there is a good faith legal basis for concluding that our services are not subject to payphone compensation requirements. Nonetheless, we have indirectly paid, and intend to continue paying, payphone service providers as part of our prepaid calling card business. To date, we have reimbursed certain of our toll-free access vendors - facilities-based long distance carriers from which we have received payphone calls that could be construed to be compensable under the payphone compensation rules - who have indeed paid payphone compensation for such calls. In the future, we intend to contract with a clearinghouse to remit funds directly to payphone service providers for calls originating from payphones utilizing our prepaid calling cards. For all other types of traffic related to our wholesale transport business, we believe that we are not responsible for payphone compensation, but rather that the carrier that precedes us is. In addition to specific telecommunications regulation, we are subject to other laws. As an example, the Office of Foreign Asset Control of the U.S. Department of the Treasury, or OFAC, administers the United States' sanctions against certain countries. OFAC rules restrict many business transactions with such countries and, in some cases, require that licenses be obtained for such transactions. We may currently, or in the future, transmit telecommunications between the U.S. and countries subject to U.S. sanctions regulations and undertake other transactions related to those services. We have undertaken such activities via our network or through various reciprocal traffic exchange agreements to which we are a party. We have received licenses from OFAC to send traffic to some countries and, if necessary, will remain in contact with OFAC with regard to other transactions. Failure to obtain proper authority could expose us to legal and criminal liability. RISKS RELATED TO OUR OPERATIONS WE MAY NEVER ACHIEVE SUSTAINED PROFITABILITY AND THE MARKET PRICE OF OUR COMMON STOCK AND CONVERTIBLE SECURITIES MAY FALL. Our revenue and results of operations have fluctuated and will continue to fluctuate significantly from quarter to quarter in the future due to a number of factors, some of which are not in our control, including, among others: - the amount of traffic we are able to sell to our customers, and their decisions on whether to route traffic over our network; - increased competitive pricing pressure in the international long distance market; - the percentage of traffic that we are able to carry over the Internet rather than over the more costly traditional public-switched telephone network; - loss of arbitrage opportunities resulting from declines in international settlement rates or tariffs; - our ability to negotiate lower termination fees charged by our local providers if our pricing deteriorates; - our continuing ability to negotiate competitive costs to interconnect our network with those of other carriers and Internet backbone providers; - capital expenditures required to expand or upgrade our network; - changes in call volume among the countries to which we complete calls; - the portion of our total traffic that we carry over more attractive routes could fall, independent of route-specific price, cost or volume changes; - technical difficulties or failures of our network systems or third party delays in expansion or provisioning system problems; - our ability to manage distribution arrangements and provision of retail offerings, including card printing, marketing, usage tracking, web-based offerings and customer service requirements, and resolution of associated disputes; - our ability to manage our traffic on a constant basis so that routes are profitable; - our ability to collect from our customers; and - currency fluctuations and restrictions in countries where we operate. Because of these factors, you should not rely on quarter-to-quarter comparisons of our results of operations as an indication of our future performance. It is possible that, in future periods, our results of operations will be significantly lower than the estimates of public market analysts, investors or our own estimates. Such a discrepancy could cause the price of our common stock and any securities exchangeable for or convertible into our common stock to decline significantly and prevent us from achieving profitability. WE MAY NEVER GENERATE SUFFICIENT REVENUE TO ATTAIN PROFITABILITY IF TELECOMMUNICATIONS CARRIERS AND OTHER COMMUNICATIONS SERVICE PROVIDERS OR OTHERS ARE RELUCTANT TO USE OUR SERVICES OR DO NOT USE OUR SERVICES, INCLUDING ANY NEW SERVICES, IN SUFFICIENT VOLUME. If the market for Internet telephony and new services does not develop as we expect, or develops more slowly than expected, our business, financial condition and results of operations will be materially and adversely affected. Our customers may be reluctant to use our Internet telephony services for a number of reasons, including: - perceptions that the quality of voice transmitted over the Internet is low; - perceptions that Internet telephony is unreliable; - our inability to deliver traffic over the Internet with significant cost advantages; - development of their own capacity on routes served by us; or - an increase in termination costs of international calls. The growth of our core business depends on carriers and other communications service providers generating an increased volume of international voice and fax traffic and selecting our network to carry at least some of this traffic. Similarly, the growth of any retail services we offer depends on these factors as well as acceptance in the market of the brands that we service, including their respective rates, terms and conditions. If the volume of international voice and fax traffic and associated or other retail services fail to increase, or decrease, and these parties or other customers do not employ our network or otherwise use our services, our ability to become profitable will be materially and adversely affected. WE MAY NOT BE ABLE TO COLLECT AMOUNTS DUE TO US FROM OUR CUSTOMERS AND WE MAY HAVE TO DISGORGE AMOUNTS ALREADY PAID. Some of our customers have closed their businesses or filed for bankruptcy owing us millions of dollars for services we have provided to them in the past. Despite our efforts to collect these overdue funds, we may never be paid. The bankruptcy court may require us to continue to provide services to these companies during their reorganizations. Other customers may discontinue their use of our services at any time and without notice, or delay payments that are owed to us. Additionally, we may have difficulty in collecting amounts from them. Although we have internal credit risk policies to identify companies with poor credit histories, we may not effectively manage these policies and provided services to companies that refuse to pay. The risk is even greater in foreign countries, where the legal and collection systems available may not be adequate or impartial for us to enforce the payment provisions of our contracts. Our cash reserves will be reduced and our results of operations will be materially adversely affected if we are unable to collect amounts from our customers. We have received claims including lawsuits from estates of bankrupt companies alleging that we received preferential payments prior to bankruptcy filing. We may be required to return amounts received from bankrupt estates. We intend to employ all available defenses in contesting such claims or, in the alternative settle such claims. The results of any suit or settlement may have a material adverse affect on our business. WE MAY INCREASE COSTS AND RISKS IN OUR BUSINESS BY RELYING ON THIRD PARTIES. VENDORS. We rely upon third-party vendors to provide us with the equipment, software, circuits, and other facilities that we use to provide our services. For example, we purchase a substantial portion of our Internet telephony equipment from Cisco Systems. We may be forced to try to renegotiate terms with vendors for products or services that have become obsolete. Some vendors may be unwilling to renegotiate such contracts, which could affect our ability to continue to provide services and consequently render us unable to generate sufficient revenues to become profitable. PARTIES THAT MAINTAIN PHONE AND DATA LINES AND OTHER TELECOMMUNICATIONS SERVICES. Our business model depends on the availability of the Internet and traditional telephone networks to transmit voice and fax calls. Third parties maintain and own these networks, other components that comprise the Internet, and business relationships that allow telephone calls to be terminated over the public switched telephone network. Some of these third parties are telephone companies. They may increase their charges for using these lines at any time and thereby decrease our profitability. They may also fail to maintain their lines properly, fail to maintain the ability to terminate calls, or otherwise disrupt our ability to provide service to our customers. Any such failure that leads to a material disruption of our ability to complete calls or provide other services could discourage our customers from using our network, which could have the effect of delaying or preventing our ability to become profitable. LOCAL COMMUNICATIONS SERVICE PROVIDERS. We maintain relationships with local communications service providers in many countries, some of whom own the equipment that translates calls from traditional voice networks to the Internet, and vice versa. We rely upon these third parties both to provide lines over which we complete calls and to increase their capacity when necessary as the volume of our traffic increases. There is a risk that these third parties may be slow, or fail, to provide lines, which would affect our ability to complete calls to those destinations. We may not be able to continue our relationships with these local service providers on acceptable terms, if at all. Because we rely upon entering into relationships with local service providers to expand into additional countries, we may not be able to increase the number of countries to which we provide service. Finally, any technical difficulties that these providers suffer, or difficulties in their relationships with companies that manage the public switched telephone network, could affect our ability to transmit calls to the countries that those providers help serve. STRATEGIC RELATIONSHIPS. We depend in part on our strategic relationships to expand our distribution channels and develop and market our services. In particular, we depend on our joint marketing and product development efforts with Cisco Systems to achieve market acceptance and brand recognition in certain markets. Strategic relationship partners may choose not to renew existing arrangements on commercially acceptable terms, if at all. In general, if we lose these key strategic relationships, or if we fail to maintain or develop new relationships in the future, our ability to expand the scope and capacity of our network and services provided, and to maintain state-of-the-art technology, would be materially adversely affected. DISTRIBUTORS OF PREPAID CALLING CARDS TO RETAIL OUTLETS. We make arrangements with distributors to market and sell prepaid calling cards to retail outlets. In some cases, we rely on these distributors to print cards, prepare marketing material, activate accounts, track usage and other data, and remit payments collected from retailers. There is a risk that distributors will not properly perform these responsibilities, comply with legal requirements, or pay us monies when due. We may not have adequate contractual or credit protections against these risks. There is also a risk that we will be ineffective in our efforts to implement new systems, customer care and disclosure policies, and certain technical and business processes. The result of any attendant difficulties may have a material impact on our business. WE MAY NOT BE ABLE TO SUCCEED IN THE INTENSELY COMPETITIVE MARKET FOR OUR VARIOUS SERVICES. We compete in our wholesale business principally on quality of service and price. In recent years, prices for long distance telephone services have been declining as a result of deregulation and increased competition. We face competition from major telecommunications carriers, such as AT&T, British Telecom, Deutsche Telekom, MCI WorldCom and Qwest Communications, as well as new emerging carriers. We also compete with Internet protocol and other Internet telephony service providers who route traffic to destinations worldwide. Also, Internet telephony service providers that presently focus on retail customers may in the future enter the wholesale market and compete with us. If we can not offer competitive prices and quality of service our business could be materially adversely affected. WE MAY NOT BE ABLE TO SUCCEED IN THE INTENSELY COMPETITIVE MARKET FOR PREPAID CALLING SERVICES. The market for prepaid calling services is extremely competitive. Hundreds of providers offer calling card products and services. We have just recently begun offering prepaid calling card services and have little prior experience in this business and no established distribution channel for these services. If we do not successfully establish a distribution channel and enter geographic markets in which our rates, fees, surcharges, country services, and our other products and service characteristics, can successfully compete, our business could be materially adversely affected. WE ARE SUBJECT TO DOWNWARD PRICING PRESSURES AND A CONTINUING NEED TO RENEGOTIATE OVERSEAS RATES, WHICH COULD DELAY OR PREVENT OUR PROFITABILITY. As a result of numerous factors, including increased competition and global deregulation of telecommunications services, prices for international long distance calls have been decreasing. This downward trend of prices to end-users has caused us to lower the prices we charge communications service providers and calling card distributors for call completion on our network. If this downward pricing pressure continues, we may not be able to offer Internet telephony services at costs lower than, or competitive with, the traditional voice network services with which we compete. Moreover, in order for us to lower our prices, we have to renegotiate rates with our overseas local service providers who complete calls for us. We may not be able to renegotiate these terms favorably enough, or fast enough, to allow us to continue to offer services in a particular country on a cost-effective basis. The continued downward pressure on prices and our failure to renegotiate favorable terms in a particular country could have a material adverse effect on our ability to operate our network and Internet telephony business profitably. A VARIETY OF RISKS ASSOCIATED WITH OUR INTERNATIONAL OPERATIONS COULD MATERIALLY ADVERSELY AFFECT OUR BUSINESS. Because we provide many of our services internationally, we are subject to additional risks related to operating in foreign countries. In particular, in order to provide services and operate facilities in some countries, we have established subsidiaries or other legal entities or have forged relationships with service partners or entities set up by our employees. Associated risks include: - unexpected changes in tariffs, trade barriers and regulatory requirements relating to Internet access or Internet telephony; - economic weakness, including inflation, or political instability in particular foreign economies and markets; - difficulty in collecting accounts receivable; - tax, consumer protection, telecommunications, and other laws; - compliance with tax, employment, securities, immigration, labor and other laws for employees living and traveling, or conducting business, abroad, which may subject them or us to criminal or civil penalties; - foreign taxes including withholding of payroll taxes; - foreign currency fluctuations, which could result in increased operating expenses and reduced revenues; - political or economic instability; - exposure to liability under the Foreign Corrupt Practices Act; - other obligations or restrictions, including, but not limited to, criminal penalties incident to doing business or operating a subsidiary or other entity in another country; - the personal safety of our employees and their families who at times have received threats of, or who may in any case be subject to, violence, and who may not be adequately protected by legal authorities or other means; and - inadequate insurance coverage to address these risks. These and other risks associated with our international operations may materially adversely affect our ability to attain or maintain profitable operations. IF WE ARE NOT ABLE TO KEEP UP WITH RAPID TECHNOLOGICAL CHANGE IN A COST-EFFECTIVE WAY, THE RELATIVE QUALITY OF OUR SERVICES COULD SUFFER. The technology upon which our services depends is changing rapidly. Significant technological changes could render the hardware and software that we use obsolete, and competitors may begin to offer new services that we are unable to offer. If we are unable to respond successfully to these developments or do not respond in a cost-effective way, we may not be able to offer competitive services. WE MAY NOT BE ABLE TO EXPAND AND UPGRADE OUR NETWORK ADEQUATELY AND COST-EFFECTIVELY TO ACCOMMODATE ANY FUTURE GROWTH. Our Internet telephony business requires that we handle a large number of international calls simultaneously. As we expand our operations, we expect to handle significantly more calls. If we do not expand and upgrade our hardware and software quickly enough, we will not have sufficient capacity to handle the increased traffic and growth in our operating performance would suffer as a result. Even with such expansion, we may be unable to manage new deployments or utilize them in a cost-effective manner. In addition to lost growth opportunities, any such failure could adversely affect customer confidence in The iBasis Network and could result in us losing business outright. WE DEPEND ON OUR CURRENT PERSONNEL AND MAY HAVE DIFFICULTY ATTRACTING AND RETAINING THE SKILLED EMPLOYEES WE NEED TO EXECUTE OUR BUSINESS PLAN. WE DEPEND HEAVILY ON OUR KEY MANAGEMENT. Our future success will depend, in large part, on the continued service of our key management and technical personnel, including Ofer Gneezy, our President and Chief Executive Officer, Gordon VanderBrug, our Executive Vice President, Richard Tennant, our Chief Financial Officer, Paul Floyd, our Senior Vice President of Research & Development, Engineering, and Operations, and Dan Powdermaker, our Senior Vice President of Worldwide Sales. If any of these individuals or others we employ are unable or unwilling to continue in their present positions, our business, financial condition and results of operations could suffer. We do not carry key person life insurance on our personnel. While each of the individuals named above has entered into an employment agreement with us, these agreements do not ensure their continued employment with us. WE WILL NEED TO RETAIN SKILLED PERSONNEL TO EXECUTE OUR PLANS. Our future success will also depend on our ability to attract, retain and motivate highly skilled employees, particularly engineering and technical personnel. Past workforce reductions have resulted in reallocations of employee duties that could result in employee and contractor uncertainty and dissatisfaction. Reductions in our workforce or restrictions on salary increases or payment of bonuses may make it difficult to motivate and retain employees and contractors, which could affect our ability to deliver our services in a timely fashion and otherwise negatively affect our business. IF WE ARE UNABLE TO PROTECT OUR INTELLECTUAL PROPERTY, OUR COMPETITIVE POSITION WOULD BE ADVERSELY AFFECTED. We rely on patent, trademark and copyright law, trade secret protection and confidentiality and/or license agreements with our employees, customers, partners and others to protect our intellectual property. Unauthorized third parties may copy our services or reverse engineer or obtain and use information that we regard as proprietary. End-user license provisions protecting against unauthorized use, copying, transfer and disclosure of any licensed program may be unenforceable under the laws of certain jurisdictions and foreign countries. We may seek to patent certain processes or equipment in the future. We do not know if any of our patent applications will be issued with the scope of the claims we seek, if at all. In addition, the laws of some foreign countries do not protect proprietary rights to the same extent as do the laws of the United States. Our means of protecting our proprietary rights in the United States or abroad may not be adequate and third parties may infringe or misappropriate our copyrights, trademarks and similar proprietary rights. If we fail to protect our intellectual property and proprietary rights, our business, financial condition and results of operations would suffer. We believe that we do not infringe upon the proprietary rights of any third party. It is possible, however, that such a claim might be asserted successfully against us in the future. Our ability to provide our services depends on our freedom to operate. That is, we must ensure that we do not infringe upon the proprietary rights of others or have licensed all such rights. A party making an infringement claim could secure a substantial monetary award or obtain injunctive relief that could effectively block our ability to provide services in the United States or abroad. We have received letters and other notices claiming that certain of our products and services may infringe patents or other intellectual property of other parties. To date, none of these has resulted in a material restriction on any use of our intellectual property or has had a material adverse impact on our business. We may be unaware of intellectual property rights of others that may, or may be claimed, to cover our technology. Current or future claims could result in costly litigation and divert the attention of management and key personnel from other business issues. The complexity of the technology involved and the uncertainty of intellectual property litigation increase these risks. Claims of intellectual property infringement also might require us to enter into costly royalty or license agreements to the extent necessary for the conduct of our business. However, we may be unable to obtain royalty or license agreements on terms acceptable to us or at all. We also may be subject to significant damages or an injunction against use of our proprietary or licenses systems. A successful claim of patent or other intellectual property infringement against us could materially adversely affect our business and profitability. WE RELY ON A VARIETY OF TECHNOLOGIES, PRIMARILY SOFTWARE, WHICH IS LICENSED FROM THIRD PARTIES. Continued use of this technology by us requires that we purchase new or additional licenses from third parties. We may not be able to obtain those third-party licenses needed for our business or that the third party technology licenses that we do have will continue to be available to us on commercially reasonable terms or at all. The loss or inability to maintain or obtain upgrades to any of these technology licenses could result in delays or breakdowns in our ability to continue developing and providing our services or to enhance and upgrade our services. WE MAY UNDERTAKE STRATEGIC ACQUISITIONS OR DISPOSITIONS THAT COULD DAMAGE OUR ABILITY TO ATTAIN OR MAINTAIN PROFITABILITY. We may acquire additional businesses and technologies that complement or augment our existing businesses, services and technologies. We may need to raise additional funds through public or private debt or equity financing to acquire any businesses, which may result in dilution for stockholders and the incurrence of indebtedness. We may not be able to operate acquired businesses profitably or otherwise implement our growth strategy successfully. We may need to sell existing assets or businesses in the future to generate cash or focus our efforts in making our core business, Internet telephony, profitable. As with many companies in the telecommunications sector that experienced rapid growth in recent years, we may need to reach profitability in one market before entering another. In the future, we may need to sell assets to cut costs or generate liquidity. RISKS RELATED TO THE INTERNET AND INTERNET TELEPHONY INDUSTRY IF THE INTERNET DOES NOT CONTINUE TO GROW AS A MEDIUM FOR VOICE AND FAX COMMUNICATIONS, OUR BUSINESS WILL SUFFER. Historically, the sound quality of calls placed over the Internet was poor. As the Internet telephony industry has grown, sound quality has improved, but the technology may require further refinement. Additionally, as a result of the Internet's capacity constraints, callers could experience delays, errors in transmissions or other interruptions in service. Transmitting telephone calls over the Internet, and other uses of the Internet, must also be accepted by customers as an alternative to traditional services. Because the Internet telephony market is evolving, predicting the size of these markets and their growth rate is difficult. If our market fails to continue to develop, then we will be unable to grow our customer base and our results of operations will be materially adversely affected. IF THE INTERNET INFRASTRUCTURE IS NOT ADEQUATELY MAINTAINED, WE MAY BE UNABLE TO MAINTAIN THE QUALITY OF OUR SERVICES AND PROVIDE THEM IN A TIMELY AND CONSISTENT MANNER. Our future success will depend upon the maintenance of the Internet infrastructure, including a reliable network backbone with the necessary speed, data capacity and security for providing reliability and timely Internet access and services. To the extent that the Internet continues to experience increased numbers of users, frequency of use or bandwidth requirements, the Internet may become congested and be unable to support the demands placed on it and its performance or reliability may decline thereby impairing our ability to complete calls and provide other services using the Internet at consistently high quality. The Internet has experienced a variety of outages and other delays as a result of failures of portions of its infrastructure or otherwise. Future outages or delays could adversely affect our ability to complete calls and provide other services. Moreover, critical issues concerning the commercial use of the Internet, including security, cost, ease of use and access, intellectual property ownership and other legal liability issues, remain unresolved and could materially and adversely affect both the growth of Internet usage generally and our business in particular. Finally, important opportunities to increase traffic on The iBasis Network will not be realized if the underlying infrastructure of the Internet does not continue to be expanded to more locations worldwide. OUR ABILITY TO PROVIDE OUR SERVICES USING THE INTERNET MAY BE ADVERSELY AFFECTED BY COMPUTER VANDALISM. If the overall performance of the Internet is seriously downgraded by website attacks or other acts of computer vandalism or virus infection, our ability to deliver our communication services over the Internet could be adversely impacted, which could cause us to have to increase the amount of traffic we have to carry over alternative networks, including the more costly public-switched telephone network. In addition, traditional business interruption insurance may not cover losses we could incur because of any such disruption of the Internet. While some insurers are beginning to offer products purporting to cover these losses, we do not have any of this insurance at this time. RISKS RELATED TO THIS OFFERING WE MAY BE UNABLE TO REPAY THE NEW SECURED NOTES. At maturity, the principal amount of the New Secured Notes then outstanding will become due and payable. The New Secured Notes do not have the benefit of a sinking fund or other requirement that we prepay principal. At maturity we may not have sufficient funds and may be unable to arrange for additional financing to pay the principal amount or repurchase price due on the New Secured Notes then outstanding. THE NEW SECURED NOTES ARE SUBORDINATE TO OUR SENIOR INDEBTEDNESS. The New Secured Notes are subordinated to the prior payment in full of all our existing and future senior indebtedness. As a result, we will not be able to make payments on the New Secured Notes until we have paid in full all of our senior indebtedness in the event of our insolvency, liquidation, reorganization or payment default on senior indebtedness. We may, therefore, not have sufficient cash to pay the amounts due on the New Secured Notes. Under the New Secured Note Indenture, we and our subsidiaries may only incur specified permitted indebtedness as more fully described in the New Secured Note Indenture. If we incur additional senior debt, our ability to pay amounts due on the New Secured Notes could be adversely affected. After the completion of the refinancing of our debt, we had $2.3 million in outstanding borrowings pursuant to a credit agreement with our bank and approximately $0.8 million in outstanding capital lease obligations. We may also incur additional senior debt in the future. The New Secured Notes are secured by a perfected, second priority security interest in substantially all of our tangible and intangible assets and certain of our subsidiaries have guaranteed the payment of amounts due on the New Secured Notes. WE MAY BE REQUIRED TO REPURCHASE THE NEW SECURED NOTES UPON A REPURCHASE EVENT. You may require us to repurchase all or any portion of your New Secured Notes upon a repurchase event. A repurchase event under the New Secured Notes includes a change of control or a termination of listing of our common stock on a U.S. national securities exchange or trading on an established over-the-counter trading market in the U.S. A "change of control" includes the acquisition by any person or group of more than 50% of the voting power of our outstanding securities entitled to generally vote for directors, stockholder approval of any plan or proposal for our liquidation, dissolution or winding up, any consolidation or merger or sale of substantially all assets and certain changes in the constitution in our board of directors. We may not have sufficient cash funds to repurchase the New Secured Notes upon a change of control. Under our senior indebtedness documents, including our bank revolving line of credit, the New Secured Notes may prevent us from paying the purchase price. If we are prohibited from repurchasing the New Secured Notes we could seek consent from our lenders to repurchase the New Secured Notes. If we are unable to obtain their consent, we could attempt to refinance the New Secured Notes. If we were unable to obtain a consent or refinance, we would be prohibited from repurchasing the New Secured Notes. If we were unable to repurchase the New Secured Notes upon a change of control, it would result in an event of default under the New Secured Note Indenture. An event of default under the New Secured Note Indenture could result in a further event of default under our other then-existing debt. In addition, the occurrence of a change of control may be an event of default under our other debt. As a result, we would be prohibited from paying amounts due on the New Secured Notes under the subordination provisions of the New Secured Note Indenture. WE MAY NOT BE ABLE TO PAY OUR DEBT AND OTHER OBLIGATIONS. There can be no assurance that we will be able to pay interest and other amounts due on the New Secured Notes as and when they become due and payable. If our cash flow from operations is inadequate to meet our obligations, we could face substantial liquidity problems. If we are unable to generate sufficient cash flow from operations or otherwise obtain funds necessary to make required payments on the New Secured Notes or our other obligations, we would be in default under their terms, which would permit the holders of the New Secured Notes to accelerate the maturity of the New Secured Notes and could also cause defaults under current indebtedness or future indebtedness we may incur. Any default could have a material adverse effect on our financial condition, results of operations and cash flows. In addition, there can be no assurance that we would be able to repay amounts due on the New Secured Notes if payment of the New Secured Notes were to be accelerated following the occurrence of an event of default as defined in the New Secured Note Indenture. THERE IS A LIMITED PUBLIC MARKET FOR THE EXISTING NOTES AND WE ANTICIPATE A LIMITED PUBLIC MARKET FOR THE NEW SECURED NOTES. The New Secured Notes were issued in a "private placement", and there is a limited trading market for the New Secured Notes. We do not intend to apply for listing of the New Secured Notes on any security exchange or other stock market, although we expect that they may be eligible for trading in the PORTAL Market of the National Association of Securities Dealers, Inc. ANY RATING OF THE NEW NOTES MAY CAUSE THEIR TRADING PRICE TO FALL. One or more rating agency may rate the New Secured Notes. If the rating agencies rate the New Secured Notes, they may assign a lower rating than expected by investors. Rating agencies may also lower ratings on the New Secured Notes in the future. If the rating agencies assign a lower than expected rating or reduce their ratings in the future, the trading price of the New Secured Notes could decline. THE MARKET PRICE OF OUR SHARES MAY EXPERIENCE EXTREME PRICE AND VOLUME FLUCTUATIONS FOR REASONS OVER WHICH WE HAVE LITTLE CONTROL. The trading price of our common stock has been, and is likely to continue to be, extremely volatile. Our stock price could be subject to wide fluctuations in response to a variety of factors, including, but not limited to, the following: - new products or services offered by us or our competitors; - failure to meet our publicly announced revenue projections; - actual or anticipated variations in quarterly operating results; - changes in financial estimates by securities analysts; - announcements of significant acquisitions, strategic partnerships, joint ventures or capital commitments by us or our competitors; - issuances of debt or equity securities; and - other events or factors, many of which are beyond our control. In addition, the stock market in general, and the OTC Bulletin Board market and companies in our industry, have experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of these companies. Broad market and industry factors may negatively affect the market price of our common stock, regardless of our actual operating performance. In the past, following periods of volatility in the market price of a company's securities, securities class action litigation has often been instituted against companies. This type of litigation, if instituted, could result in substantial costs and a diversion of management's attention and resources, which would harm our business. SHARES ELIGIBLE FOR SALE IN THE FUTURE COULD NEGATIVELY AFFECT OUR STOCK PRICE. The market price of our common stock could decline as a result of sales of a large number of shares of our common stock, including sales of shares as a result of this offering, or the perception that these sales could occur. This may also make it more difficult for us to raise funds through the issuance of debt or the sale of equity securities. As of June 30, 2004, we had outstanding 46,655,867 shares of common stock, of which 29,691,955 shares are freely tradable. The remaining 16,963,912 shares of common stock outstanding are not registered securities. These unregistered securities may be sold in the future pursuant to registration statements filed with the SEC or without registration under the Securities Act of 1933, as amended (the "Securities Act"), to the extent permitted by Rule 144 or other exemptions under the Securities Act. As of June 30, 2004, there were an aggregate of 14,782,168 shares of common stock issuable upon exercise of outstanding stock options and warrants, including 6,168,819 shares issuable upon exercise of options outstanding under our option plans and 8,613,349 shares of common stock issuable upon exercise of outstanding warrants. We may register additional shares in the future in connection with acquisitions, compensation or otherwise. We have not entered into any agreements or understanding regarding any future acquisitions and cannot ensure that we will be able to identify or complete any acquisition in the future. WE HAVE IMPLEMENTED ANTI-TAKEOVER PROVISIONS THAT COULD DISCOURAGE, PREVENT OR DELAY A TAKEOVER, EVEN IF THE ACQUISITION WOULD BE BENEFICIAL TO OUR STOCKHOLDERS. The existence of our stockholder rights plan and provisions of our amended and restated certificate of incorporation and bylaws, as well as provisions of Delaware law, could make it difficult for a third party to acquire us, even if doing so would benefit our stockholders. FORWARD-LOOKING STATEMENTS This prospectus contains "forward-looking statements" within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act. We intend the forward-looking statements to be covered by the safe harbor for forward-looking statements in these sections. These forward-looking statements include, without limitation, statements about our market opportunity, strategies, competition, expected activities, expected profitability and investments as we pursue our business plan, and the adequacy of our available cash resources. These forward-looking statements are usually accompanied by words such as "believe," "anticipate," "plan," "seek," "expect," "intend" and similar expressions. The forward-looking information is based on various factors and was derived using numerous assumptions. Forward-looking statements necessarily involve risks and uncertainties, and our actual results could differ materially from those anticipated in the forward-looking statements due to a number of factors, including those set forth below under "Risk Factors" and elsewhere in this prospectus. The factors set forth below under "Risk Factors" and other cautionary statements made in this prospectus should be read and understood as being applicable to all related forward-looking statements wherever they appear in this prospectus. The forward-looking statements contained in this prospectus represent our judgment as of the date of this prospectus. We caution readers not to place undue reliance on such statements. Except as required by law, we undertake no obligation to update publicly any forward-looking statements for any reason, even if new information becomes available or other events occur in the future.
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+RISK FACTORS In addition to the other information contained in this prospectus, the following factors should be considered carefully before investing in the IDSs (including the Class A common stock and senior subordinated notes represented thereby) or our senior subordinated notes. If any of the following risks actually occur, our business, results of operations or financial condition would likely suffer. Risks Relating to the IDSs, the Shares of Class A Common Stock and the Senior Subordinated Notes Represented by the IDSs, and the Senior Subordinated Notes Offered Separately Buffets Holdings is a holding company and relies on dividends, interest and other payments, advances and transfer of funds from its subsidiaries to meet its debt service and other obligations. Buffets Holdings has no direct operations and no significant assets other than ownership of 100% of the stock of Buffets, all of which will be pledged to the creditors under the Amended Credit Facility which Buffets Holdings guarantees. Because Buffets Holdings conducts its operations through its direct and indirect subsidiaries, Buffets Holdings depends on those entities for dividends and other payments to generate the funds necessary to meet its financial obligations, including payments of principal and interest on the senior subordinated notes, and to pay dividends with respect to the common stock. Legal and contractual restrictions in the Amended Credit Facility, the indenture governing Buffets Senior Notes and other agreements governing current and future indebtedness of Buffets Holdings subsidiaries, as well as the financial condition and operating requirements of Buffets Holdings subsidiaries, may limit Buffets Holdings ability to obtain cash from its subsidiaries. The earnings from, or other available assets of, Buffets Holdings subsidiaries may not be sufficient to pay dividends or make distributions or loans to enable Buffets Holdings to make payments in respect of the senior subordinated notes when such payments are due and to pay dividends on the common stock. Your rights as holders of the senior subordinated notes and guarantees thereof to receive payments will be contractually subordinated to those of holders of our senior indebtedness and may be otherwise adversely affected in the event of our bankruptcy. As a result of the subordinated nature of the senior subordinated notes and related guarantees, upon any distribution to our creditors or the creditors of the subsidiary guarantors in bankruptcy, liquidation or reorganization or similar proceeding relating to Buffets Holdings or the subsidiary guarantors or Buffets Holdings or their property, the holders of Buffets Holdings senior indebtedness and senior indebtedness of the subsidiary guarantors will be entitled to be paid in full in cash before any payment may be made with respect to the senior subordinated notes or the subsidiary guarantees. Holders of the senior subordinated notes would then participate with all other holders of unsecured senior subordinated indebtedness of Buffets Holdings or the subsidiary guarantors similarly subordinated in the assets remaining after Buffets Holdings and the subsidiary guarantors have paid all senior indebtedness. Buffets Holdings and the subsidiary guarantors may not have sufficient funds to pay all of our creditors, and holders of our senior subordinated notes may receive less, ratably, than the holders of senior indebtedness, and because of the obligation to turn over distributions to holders of senior indebtedness, the holders of the notes may receive less, ratably, than trade payables and other general unsecured indebtedness. Further, in the event of such bankruptcy proceedings, a party in interest may seek to subordinate the senior subordinated notes to all creditors under principles of equitable subordination or to recharacterize the senior subordinated notes as equity. If such a subordination or recharacterization did occur, you may not recover any amounts owing on the senior subordinated notes or the guarantees and you might be required to return any payments made to you on account of the senior subordinated notes up to six years prior to our bankruptcy. As of June 30, 2004, on a pro forma basis, the senior subordinated notes and the subsidiary guarantees would have ranked junior, on a consolidated basis, to approximately $ million of indebtedness, including borrowings under the Amended Credit Facility and Buffets Senior Notes. In addition, as of June 30, 2004, on a pro forma basis, we would have had the ability to borrow up to an 23 .3* Consent of Faegre Benson LLP (included in Exhibit 5.2 to this Registration Statement). 10 .13** Severance Protection Agreement, dated September 29, 2000, between Buffets, Inc. and Jean C. Rostollan (incorporated by reference to Exhibit 10.9.1 to Buffets, Inc. s Annual Report on Form 10-K filed with the Commission on September 30, 2003 (SEC file No. 033-00171)). 12 .1 Statement of Computation of Ratios of Earnings to Fixed Charges. 21 List of Subsidiaries of Buffets Holdings, Inc. 23 .1 Consent of Deloitte Touche LLP. 23 .2* Consent of Paul, Weiss, Rifkind, Wharton Garrison LLP (included in Exhibits 5.1 and 8.1 to this Registration Statement). 23 .3* Consent of Faegre Benson LLP (included in Exhibit 5.2 to this Registration Statement). Table of Contents BUFFETS HOLDINGS, INC. TABLE OF ADDITIONAL REGISTRANTS Primary Standard IRS Jurisdiction of Industrial Employer Incorporation or Classification Identification Name Organization Number Number Table of Contents additional amount of $ million under the Amended Credit Facility (less amounts reserved for letters of credit), which would have ranked senior in right of payment to the senior subordinated notes. Payments on the senior subordinated notes may be blocked if we default under senior indebtedness, including the Amended Credit Facility. If we default in the payment of any of our senior indebtedness, including the Amended Credit Facility and Buffets Senior Notes, we will not make any payments on the senior subordinated notes until the payment default has been cured or waived. In addition, even if we are making payments on our senior indebtedness on a timely basis, payments on the senior subordinated notes may be blocked for up to 180 days if we default on our senior indebtedness in some other manner. During any period in which payments on the senior subordinated notes are prohibited or blocked in this manner, we and the guarantors will be prohibited from making any payments in respect of the senior subordinated notes and the guarantees. Claims of noteholders will be structurally subordinated to claims of creditors of all of our existing and future unrestricted subsidiaries, all of which will not guarantee the senior subordinated notes. The senior subordinated notes will not be guaranteed by any of our current or future unrestricted subsidiaries. Our unrestricted subsidiaries are separate and distinct legal entities and have no obligation, contingent or otherwise, to pay any amounts due pursuant to the senior subordinated notes, or to make any funds available therefor, whether by dividends, loans, distributions or other payments. Any right that we or the guarantors have to receive any assets of any of the unrestricted subsidiaries upon the liquidation or reorganization of those subsidiaries, and the consequent rights of holders of senior subordinated notes to realize proceeds from the sale of any of those subsidiaries assets, will be structurally subordinated to the claims of that subsidiaries creditors, including trade creditors and holders of debt of those subsidiaries. Our substantial level of indebtedness could adversely affect our financial condition and prevent us from fulfilling our obligations under the senior subordinated notes. We have substantial indebtedness. As of June 30, 2004, on a pro forma basis, we would have had $ million of total indebtedness. Our ability to make distributions, pay dividends or make other payments will be subject to applicable law and contractual restrictions contained in the instruments governing any indebtedness of ours and our subsidiaries, including the Amended Credit Facility and Buffets Senior Notes. Our level of debt could have negative consequences to you and to us. For example, it could: make it more difficult for us to satisfy our obligations with respect to the senior subordinated notes; increase our vulnerability to general adverse economic and industry conditions, as well as increases in interest rates; limit our ability to fund future working capital, capital expenditures, debt service and general corporate requirements; require us to dedicate a substantial portion of our cash flow from operations to the payments on our indebtedness, thereby reducing the availability of our cash flow to fund working capital, capital expenditures and other general corporate purposes; place us at a competitive disadvantage compared to our competitors that have less debt; limit our ability to borrow additional funds; limit our ability to refinance our debt on terms acceptable to us or at all; make it more difficult to comply with the covenants in the indentures relating to our senior subordinated notes and Buffets Senior Notes and the amended credit agreement relating to the Table of Contents Amended Credit Facility, which could in turn result in an event of default under our indebtedness, which, if not cured or waived, could have a material adverse effect on us; and limit our flexibility in planning for, or reacting to, changes in our business and future business opportunities. Servicing our debt will require a significant amount of cash. Our subsidiaries ability to generate sufficient cash depends on numerous factors which are beyond our control and we may be unable to generate sufficient cash flow to service our debt obligations, including making payments on the senior subordinated notes, and to pay dividends on the common stock. Our ability to pay our expenses, principal and interest on the senior subordinated notes and other debt, and dividends on the common stock depends on our ability to generate positive cash flow in the future, which is subject to general economic, financial, competitive, legislative and regulatory factors and other factors that are beyond our control. Our subsidiaries operations may not generate sufficient cash flow from operations and future borrowings may not be available under the Amended Credit Facility in amounts sufficient to enable us or our subsidiaries to make payments in respect of the senior subordinated notes, to pay our other debt, to pay dividends on the common stock or to fund other liquidity needs. If our subsidiaries do not have sufficient cash flow from operations, Buffets Holdings or our subsidiaries may be required to incur additional indebtedness, refinance all or part of our existing debt or sell assets. If Buffets Holdings or our subsidiaries are required to refinance existing debt, or if Buffets Holdings or our subsidiaries are required to sell some of our assets, we may not be able to do so on terms that are acceptable to us or at all. In addition, the terms of existing or future debt agreements, including the indenture governing Buffets Senior Notes and the Amended Credit Facility, may restrict Buffets Holdings or our subsidiaries from effecting any of these alternatives or we may fail for other reasons. If we are required to pursue other alternatives, the value of the senior subordinated notes and the common stock, and our financial condition, could be significantly adversely affected. Despite our current leverage, we may still be able to incur substantially more debt. This could further exacerbate the risks that we and our subsidiaries face. We, including our subsidiaries, may be able to incur substantial additional indebtedness in the future. For example, the Amended Credit Facility will provide commitments of up to $ million, $ million of which would have been available for future borrowings as of June 30, 2004, on a pro forma basis, subject to the aggregate borrowing base availability and net of $ million in outstanding letters of credit. All of such indebtedness would have been secured and effectively senior to the senior subordinated notes. If we incur any additional indebtedness that ranks equally with the senior subordinated notes, the holders of that debt will be entitled to share ratably with the holders of the senior subordinated notes in any proceeds distributed in connection with any insolvency, liquidation, reorganization, dissolution or other winding-up of us. This may have the effect of reducing the amount of proceeds paid to you. If additional indebtedness is added to our or our subsidiaries current levels of indebtedness, the substantial risks described above would intensify. If we or our subsidiaries default on our or their obligations to pay our or their indebtedness, or fail to comply with other covenants thereunder, we may not be able to make payments on the senior subordinated notes and the common stock. If we or our subsidiaries are unable to generate sufficient cash flow and are otherwise unable to obtain funds necessary to meet required payments on our or their indebtedness, or if we or our subsidiaries otherwise fail to comply with the various covenants, including financial and operating covenants, in the instruments governing our or their indebtedness (including the Amended Credit Facility and our guarantee Table of Contents thereof and the indenture governing Buffets Senior Notes), we or they could be in default under the terms of the agreements governing such indebtedness. In the event of such default: the holders of such indebtedness could elect to declare all the funds borrowed thereunder to be due and payable, together with accrued and unpaid interest and liquidated damages, if any. The lenders under the Amended Credit Facility could elect to terminate their commitments, cease making further loans and institute foreclosure proceedings against our or our subsidiaries assets. We could directly or indirectly be prohibited from paying principal, premium, if any, and interest on the senior subordinated notes, and dividends with respect to the common stock, and we or our subsidiaries could be forced into bankruptcy or liquidation. We will be subject to restrictive covenants in our debt agreements that may limit our ability to pursue strategies that may otherwise improve our business. The indenture governing the senior subordinated notes, the indenture governing Buffets Senior Notes and the Amended Credit Facility will impose significant operating and financial restrictions on us. These restrictions will limit our ability, among other things, to: incur additional indebtedness; acquire the assets of, or merge or consolidate with, other companies; pay dividends or make other distributions on our capital stock or repurchase, repay or redeem the senior subordinated notes, subordinated debt and our capital stock; make certain investments; incur liens; make capital expenditures; enter into certain types of transactions with our stockholders and affiliates; limit dividends or other payments by our restricted subsidiaries to us; and transfer or sell certain or all or substantially all of our assets. These covenants in the indenture governing the senior subordinated notes, the indenture governing Buffets Senior Notes and the Amended Credit Facility may impair our ability to finance future operations or capital needs or to enter into acquisitions or joint ventures or engage in other favorable business activities. If we default under the indenture governing the senior subordinated notes, the indenture governing Buffets Senior Notes or the Amended Credit Facility or we fail to satisfy the financial covenants under the Amended Credit Facility, we could directly or indirectly be prohibited from making any payments with respect to the IDSs or our senior subordinated notes. In addition, the lenders under the Amended Credit Facility and the holders of Buffets Senior Notes could require immediate repayment of the entire principal that is outstanding under those facilities or those notes. If those lenders or holders require immediate repayment, our assets may not be sufficient to repay them and also repay the senior subordinated notes in full. Our dividend policy may negatively impact our ability to finance capital expenditure or operation. Upon completion of this offering, our board of directors will adopt a dividend policy under which cash generated by our business in excess of operating needs, interest and principal payments on indebtedness, and capital expenditures sufficient to maintain our properties would in general be distributed as regular quarterly dividends to the holders of our Class A common stock and Class B common stock rather than retained by us and used to finance growth opportunities. As a result, we may not retain a sufficient amount of cash to finance growth opportunities or unanticipated capital expenditure needs or to fund our Table of Contents operations in the event of a significant business downturn. We may have to forgo growth opportunities or capital expenditures that would otherwise be necessary or desirable if we do not find alternative sources or financing. If we do not have sufficient cash for these purposes or if the $ million in cash on hand available for capital expenditures is insufficient, our financial condition and our business will suffer. Federal and state laws permit a court to void the senior subordinated notes or the subsidiary guarantees under certain circumstances. The issuance of the senior subordinated notes and the guarantees may be subject to review under United States federal bankruptcy law and comparable provisions of state fraudulent conveyance laws if a bankruptcy or reorganization case or lawsuit is commenced by or on behalf of our or the guarantor s unpaid creditors. A court could void the obligations under the senior subordinated notes or the guarantees, further subordinate the senior subordinated notes or the guarantees or take other action detrimental to holders of the senior subordinated notes, if, among other things, at the time the indebtedness was incurred, Buffets Holdings or the guarantors: issued the senior subordinated notes or the guarantees to delay, hinder or defraud present or future creditors; or received less than reasonably equivalent value or fair consideration for issuing the senior subordinated notes or the guarantees at the time of issuance of the senior subordinated notes or the guarantees and: were insolvent or rendered insolvent by reason of issuing the senior subordinated notes or the guarantees; were engaged, or about to engage, in a business or transaction for which the remaining unencumbered assets constituted unreasonably small capital to carry on our or the guarantor s business; or intended to incur, or believed that we or the guarantor would incur, debts beyond our or the guarantor s ability to pay as they mature. The measures of insolvency for purposes of fraudulent transfer laws vary depending upon the law of the jurisdiction that is being applied in any proceeding to determine whether a fraudulent transfer had occurred. It is not clear what standard a court would use to determine whether or not we or a guarantor were solvent at the relevant time. Generally, however, a person would be considered insolvent if, at the time it incurred the debt: the sum of its debts, including contingent liabilities, was greater than the fair saleable value of all of its assets; the present fair saleable value of its assets was less than the amount that would be required to pay its probable liability on its existing debts, including contingent liabilities, as they become absolute and mature; or it could not pay its debts as they become due. The proceeds of the offering will be used to repurchase a portion of Buffets Holdings common stock from our existing stockholders and to repurchase all of our outstanding 13 7/8% Notes and Buffets 11 1/4% Notes, which may subject the holders of our senior subordinated notes in this offering to the claim that we did not receive fair consideration for the senior subordinated notes issued in this offering. In the event that we meet any of the financial condition fraudulent transfer tests described above at the time of or as a result of this offering, a court could integrate the issuance of our senior subordinated notes with the distribution to our shareholders and the repurchase of Buffets 11 1/4% Notes, and, therefore, conclude that we did not get fair value for the offering viewed as an integrated transaction. In such a case, a court could hold the debt owed to the holders of our senior subordinated notes void or unenforceable or may subordinate it to the claims of other creditors. BALANCE, July 2, 2003 69 (44 ) 34 (21 ) 317 (25 ) 420 (90 ) FY 2004 Activity: Amortization (12 ) (8 ) (20 ) Additions 28 Table of Contents The guarantee of our senior subordinated notes by any subsidiary guarantor could be subject to the claim that, since the guarantee was incurred for the benefit of Buffets Holdings, and only indirectly for the benefit of the subsidiary guarantor, the obligations of the subsidiary guarantor were incurred for less than fair consideration. If such a claim were successful and it was proven that the subsidiary guarantor was insolvent at the time the guarantee was issued, a court could void the obligations of the subsidiary guarantor under the guarantee or subordinate these obligations to the subsidiary guarantor s other debt or take action detrimental to the holders of the senior subordinated notes. If the guarantee of any subsidiary guarantor were voided, our notes would be effectively subordinated to the indebtedness of that subsidiary guarantor. If we defease the senior subordinated notes, such defeasance may be subject to preferential transfer laws. The indenture relating to the senior subordinated notes will provide that we may, after complying with certain conditions, defease the senior subordinated notes and be released from our obligations under many of the covenants contained in the indenture, or discharge all our obligations under the indenture within a year of the maturity date or a redemption date. One of the conditions to such defeasance or discharge is that we deposit sufficient funds with the trustee to pay the principal, interest and premium on the outstanding senior subordinated notes through maturity or an applicable redemption date. If a bankruptcy or reorganization proceeding is initiated within the applicable preference period, which generally varies from 90 days to one year, the deposit would likely be subject to review under federal bankruptcy law and comparable provisions of state law. In such an event, a court may void the deposit of funds with the trustee as a preferential transfer and recover such funds for the benefit of the bankruptcy estate and/or otherwise order that the funds be made available to satisfy claims of other creditors. In addition, under the fraudulent conveyance laws described above, a court could also void the deposit of funds or take other actions detrimental to you. The indenture will permit us to finance the defeasance deposit by issuing secured debt that we would not otherwise be permitted to incur under the indenture. In the event that the payments used to defease the senior subordinated notes are found to be a preferential transfer or a fraudulent conveyance, any claims arising out of or relating to the senior subordinated notes would be effectively subordinated in right of payment to any of our secured debt, including the secured debt incurred to finance the defeasance, to the extent of the value of the assets securing that debt. Your ability to recover on the senior subordinated notes after a defeasance or discharge may be reduced or eliminated as a result of these risks. You may not receive the level of dividends provided for in our dividend policy, which our board of directors is expected to adopt upon the closing of this offering, or any dividends at all. Our board of directors may, in its discretion, amend or repeal the dividend policy it is expected to adopt upon the closing of this offering. Our board of directors may decrease the level of dividends provided for in this dividend policy or entirely discontinue the payment of dividends. Future dividends with respect to shares of our capital stock, if any, will depend on, among other things, our results of operations, cash requirements, financial condition, contractual restrictions, business opportunities, provisions of applicable law and other factors that our board of directors may deem relevant. The Amended Credit Facility, the indenture governing Buffets Senior Notes and the indenture governing the senior subordinated notes will contain significant restrictions on our ability to make dividend payments. In addition, certain provisions of the Delaware General Corporation Law may limit our ability to pay dividends. The indenture governing the senior subordinated notes will permit us to pay a significant portion of our free cash flow to stockholders in the form of dividends. The indenture governing the senior subordinated notes, the indenture governing Buffets Senior Notes and the Amended Credit Facility will permit us to pay a significant portion of our free cash flow to holders of our common stock, including Class A common stock held as part of IDSs, and Class B common stock in the form of dividends. Holders of senior subordinated notes held separately from the IDSs may be Table of Contents The information in this prospectus is not complete and may be changed without notice. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell these securities and we are not soliciting offers to buy these securities in any jurisdiction where the offer or sale is not permitted. SUBJECT TO COMPLETION, DATED AUGUST 27, 2004 Prospectus Income Deposit Securities (IDSs) $ million % Senior Subordinated Notes due 2019 Buffets Holdings, Inc. Table of Contents adversely affected by such provisions because any amounts paid by us in the form of dividends will not be available in the future to satisfy our obligations under the senior subordinated notes. The realizable value of our assets upon liquidation may be insufficient to satisfy claims. As of June 30, 2004, on a pro forma basis, our total assets included intangible assets in the amount of $ million, representing approximately % of our total consolidated assets. The value of these intangible assets will continue to depend significantly upon the continued profitability of the respective brands. As a result, in the event of a default on our senior subordinated notes or any bankruptcy or dissolution of our company, the realizable value of these assets may be substantially lower and may be insufficient to satisfy the claims of our creditors. Subject to restrictions set forth in the indenture, we may defer the payment of interest to you for a significant period of time. Prior to , 2009, we may, subject to restrictions set forth in the indenture, defer interest payments on our senior subordinated notes on one or more occasions for up to an aggregate period of eight quarters. In addition, after , 2009, we may, subject to certain restrictions, defer interest payments on our senior subordinated notes on four occasions for up to two consecutive quarters per each occasion. At the end of any interest deferral period following , 2009, we may not further defer interest unless and until all deferred interest, including interest accrued on deferred interest, is paid in full. Deferred interest will bear interest at the same rate as the senior subordinated notes. For any interest deferred during the first five years, we are not obligated to pay any deferred interest until , 2009; so you may be owed a substantial amount of deferred interest that will not be due and payable until such time. For any interest deferred after , 2009, we are not obligated to pay all of the deferred interest until , 2019, so you may be owed a substantial amount of deferred interest that will not be due and payable until such time. During any interest deferral period and so long as any deferred interest or interest on deferred interest remains outstanding, we will not be permitted to make any payment of dividends on our capital stock. Deferral of interest payments would have adverse tax consequences for you and may adversely affect the trading price of the IDSs or the separately held senior subordinated notes. If interest payments on the senior subordinated notes are deferred, you will be required to recognize interest income for U.S. federal income tax purposes on an economic accrual basis in respect of interest payments on the senior subordinated notes represented by the IDSs or the separately held senior subordinated notes, as the case may be, held by you before you receive any cash payment of this interest. In addition, you will not receive the cash with respect to accrued interest if you sell the IDSs or the separately held senior subordinated notes, as the case may be, before the end of any deferral period or before the record date relating to interest payments that are to be paid. If interest is deferred, the IDSs or the separately held senior subordinated notes may trade at a price that does not fully reflect the value of accrued but unpaid interest on the senior subordinated notes. In addition, the fact that we may defer payments of interest on the senior subordinated notes under certain circumstances may mean that the market price for the IDSs or the separately held senior subordinated notes may be more volatile than other securities that do not have this term. See Material U.S. Federal Income Tax Consequences Consequences to U.S. Holders Senior Subordinated Notes Deferral of Interest. Interest on the notes may not be deductible by us for U.S. federal income tax purposes, which could significantly reduce our future cash flow and impact our ability to make interest and dividend payments. While we believe that the senior subordinated notes should be treated as debt for U.S. federal income tax purposes, this position may not be sustained if challenged by the Internal Revenue Service. If the senior subordinated notes were treated as equity rather than debt for U.S. federal income tax purposes, then the stated interest on the senior subordinated notes would be treated as a dividend (to the extent of our tax earnings and profits ), and interest on the senior subordinated notes would not be deductible by We are selling IDSs representing shares of our Class A common stock and $ million aggregate principal amount of our % senior subordinated notes due 2019. Each IDS initially represents: one share of our Class A common stock; and a % senior subordinated note with a $ principal amount. We are also selling $ million aggregate principal amount of our % senior subordinated notes separately (not represented by IDSs). The offering of IDSs and the offering of the separate senior subordinated notes are conditioned upon each other. This is the initial public offering of our IDSs, and the shares of our Class A common stock and senior subordinated notes represented thereby, and our separate senior subordinated notes. We anticipate that the public offering price of the IDSs will be between $ and $ per IDS and the public offering price of the senior subordinated notes sold separately will be % of their stated principal amount. We will apply to list our IDSs on the under the trading symbol . Holders of IDSs will have the right to separate the IDSs into the shares of our Class A common stock and senior subordinated notes represented thereby at any time after the earlier of 45 days from the closing of this offering or the occurrence of a change of control. Similarly, any holder of shares of our Class A common stock and senior subordinated notes may, at any time, unless the IDSs have automatically separated, combine the applicable number of shares of Class A common stock and principal amount of senior subordinated notes to form IDSs. Separation of all of the IDSs will occur automatically upon the continuance of a payment default on the senior subordinated notes for 90 days or upon the redemption, maturity or acceleration of the senior subordinated notes. Our senior subordinated notes mature on , 2019. We will be permitted to defer interest payments on our senior subordinated notes under certain circumstances and subject to the limitations described in Description of Senior Subordinated Notes Terms of the Notes Interest Deferral. Deferred interest on our senior subordinated notes will bear interest quarterly at a rate equal to the stated annual rate of interest on the senior subordinated notes divided by four. Upon a subsequent issuance by us of IDSs or senior subordinated notes of the same series, a portion of your senior subordinated notes may be automatically exchanged for an identical principal amount of the senior subordinated notes issued in such subsequent issuance, and in that event your IDSs will be replaced with new IDSs. In addition to the senior subordinated notes offered hereby, the registration statement of which this prospectus is a part also registers the senior subordinated notes and new IDSs to be issued upon any such subsequent issuance. We have granted the underwriters an option to purchase up to additional IDSs to cover over-allotments, if any. We will use all the proceeds from the sale of additional IDSs upon exercise of the underwriters over-allotment option to repurchase shares of our Class B common stock or other securities from certain of our existing stockholders. Investing in our IDSs, shares of our Class A common stock and senior subordinated notes involves risks. See Risk Factors beginning on page 24. Per IDS(1) Total Per Note(2) Total Table of Contents us for U.S. federal income tax purposes. Our inability to deduct interest on the senior subordinated notes could materially increase our taxable income and, thus, our U.S. federal and applicable state income tax liability. This would reduce our after-tax cash flow, which may result in a default under the Amended Credit Facility, and would materially and adversely impact our ability to make interest and dividend payments and may also affect our ability to continue as a going concern. In the case of foreign holders, treatment of the notes as equity for U.S. federal income tax purposes would subject payments to such holders in respect of the notes to withholding or estate taxes in the same manner as payments made with regard to Class A common stock and could subject us to liability for withholding taxes that were not collected on payments of interest. The allocation of the purchase price of the IDSs may not be respected. The purchase price of each IDS must be allocated for tax purposes between the share of Class A common stock and senior subordinated note represented thereby in proportion to their respective fair market values at the time of purchase. We expect to report the initial fair market value of each share of Class A common stock as $ and the initial fair market value of each of our senior subordinated notes represented by an IDS as $ and, by purchasing IDSs, you will agree to and be bound by such allocation, assuming an initial public offering price of $ per IDS, which represents the mid-point of the range set forth on the cover page of this prospectus. If this allocation is not respected, it is possible that the senior subordinated notes will be treated as having been issued with OID (if the allocation to the senior subordinated notes were determined to be too high) or amortizable bond premium (if the allocation to the senior subordinated notes were determined to be too low). You generally would have to include OID in income in advance of the receipt of cash attributable to that income and would be able to elect to amortize bond premium over the term of the senior subordinated notes. Subsequent issuances of senior subordinated notes may cause you to recognize OID and may be treated as a taxable exchange by you. The indenture governing the senior subordinated notes will provide that, in the event there is a subsequent issuance of senior subordinated notes but having terms that are otherwise identical (other than issuance date) to the senior subordinated notes, including any issuance of IDSs in exchange for shares of Class B common stock, but that are issued with OID, each holder of IDSs or separately held senior subordinated notes, as the case may be, agrees that, upon such issuance and any issuance of senior subordinated notes thereafter, a portion of such holder s senior subordinated notes will be automatically exchanged for a portion of the senior subordinated notes acquired by the holders of such subsequently issued senior subordinated notes. Consequently, immediately following such subsequent issuance and exchange, without any action by such holder, each holder of senior subordinated notes, held either as part of IDSs or separately, will own senior subordinated notes of each separate issuance in the same proportion as each other holder. Regardless of whether the exchange is treated as a taxable event, such exchange would result in holders having to include OID in taxable income prior to the receipt of cash as described below, and may result in other potentially adverse tax consequences to holders. See Material U.S. Federal Income Tax Consequences Consequences to U.S. Holders Senior Subordinated Notes Additional Issuances. In addition, the potential amount of OID that would be required to be included in taxable income by holders as a result of an automatic exchange (as described below) is indefinite and may be a significant amount, in part due to our ability to engage in numerous subsequent issuances. Following any subsequent issuance and exchange of senior subordinated notes with OID, we (and our agents) will report any OID on the subsequently issued senior subordinated notes ratably among all holders of IDSs and separately held senior subordinated notes, and each holder of IDSs and separately held senior subordinated notes will, by purchasing IDSs or separately held senior subordinated notes, agree to report OID in a manner consistent with this approach. However, the Internal Revenue Service may assert that any OID should be reported only to the persons that initially acquired such subsequently issued senior subordinated notes (and their transferees) and thus may challenge the holders reporting of OID on Table of Contents their tax returns. In such case, the Internal Revenue Service might further assert that, unless a holder can establish that it is not a person that initially acquired such subsequently issued senior subordinated notes (or a transferee thereof), all of the senior subordinated notes held by such holder would have OID. Any of these assertions by the Internal Revenue Service could create significant uncertainties in the pricing of IDSs and senior subordinated notes and could adversely affect the market for IDSs and senior subordinated notes. For a discussion of these tax related risks, see Material U.S. Federal Income Tax Consequences. The aggregate stated principal amount of the senior subordinated notes owned by each holder will not change as a result of such subsequent issuance and automatic exchange. However, under New York and federal bankruptcy law, holders of subsequently issued senior subordinated notes having OID may not be able to collect the portion of their principal face amount that represents unamortized OID at the acceleration or filing date in the event of an acceleration of the senior subordinated notes or our bankruptcy prior to the maturity date of the senior subordinated notes. As a result, an automatic exchange that results in a holder receiving a senior subordinated note with OID could have the effect of ultimately reducing the amount such holder can recover from us in the event of an acceleration or bankruptcy. We may have to establish a reserve for contingent tax liabilities in the future, which could adversely affect our ability to make dividend payments on the IDSs. Even if the IRS does not challenge the tax treatment of the senior subordinated notes, it is possible that as a result of an alteration of facts relied upon at the time of issuance of the notes, we will in the future need to change our anticipated accounting treatment and establish a reserve for contingent tax liabilities associated with the disallowance of all or part of the interest deductions on the notes. If we were required to maintain such a reserve, our ability to make dividend payments could be materially impaired and the market for the IDSs, Class A common stock and senior subordinated notes could be adversely affected. In addition, any resulting impact to our financial statements could lead to a default under the Amended Credit Facility. Before this offering, there has not been a public market for our IDSs, shares of our common stock or the senior subordinated notes, which may cause the price of the IDSs, shares of our common stock and separate senior subordinated notes to fluctuate substantially and negatively affect the value of your investment. None of the IDSs, the shares of our common stock or senior subordinated notes has a public market history. In addition, there has not been an active market in the United States for securities similar to the IDSs. An active trading market for the IDSs, shares of our common stock or the senior subordinated notes sold separately in this offering might not develop in the future, which may cause the price of the IDSs, shares of our common stock or the senior subordinated notes sold separately in this offering to fluctuate substantially, and we currently do not expect that an active trading market for the shares of our common stock will develop until the senior subordinated notes mature, if at all. If the senior subordinated notes represented by your IDSs are redeemed or mature, the IDSs will automatically separate and you will then hold the shares of our common stock. We do not intend to list our senior subordinated notes on any securities exchange. The initial public offering price of the IDSs and the senior subordinated notes sold separately in this offering will be determined by negotiations among us, our principal equity sponsor and the representatives of the underwriters and may not be indicative of the market price of the IDSs and the senior subordinated notes sold separately in this offering after the offering. Factors such as quarterly variations in our financial results and dividend payments, announcements by us or others, developments affecting us, our clients and our suppliers, general interest rate levels and general market volatility could cause the market price of the IDSs and the senior subordinated notes sold separately in this offering to fluctuate significantly. In addition, to the extent a market develops for our common stock or senior subordinated notes, or both, separate from the IDSs, the price of your IDSs may be affected. BALANCE, June 30, 2004 $ 3,185,672 $ Table of Contents The limited liquidity of the trading market for the senior subordinated notes sold separately may adversely affect the trading price of the separate senior subordinated notes. We are separately selling $ million aggregate principal amount of senior subordinated notes, representing approximately 10% of the total outstanding senior subordinated notes (including those senior subordinated notes represented by IDSs). While the senior subordinated notes sold separately are part of the same series of notes as, and are identical to, the senior subordinated notes represented by the IDSs, at the time of the issuance of the separate senior subordinated notes, the senior subordinated notes represented by the IDSs will not be separable for at least 45 days and will not be separately tradeable until separated. As a result, the initial trading market for the senior subordinated notes sold separately will be very limited. After the holders of the IDSs are permitted to separate their IDSs, a sufficient number of holders of IDSs may not separate their IDSs into shares of our common stock and senior subordinated notes so that a sizable and more liquid trading market for the senior subordinated notes not represented by IDSs may not develop or may not develop in a timely manner. Trading markets for debt securities have generally treated debt securities issued in larger aggregate principal amounts more favorably than similar securities issued in smaller aggregate principal amounts because of the increased liquidity created by potentially higher trading volumes associated with larger debt issuances. Because approximately 10% of the senior subordinated notes will initially be represented by the IDSs, it is likely that the senior subordinated notes sold separately will not trade at prices reflecting the aggregate principal amount of the combined issuance of senior subordinated notes included in the IDS offering and the separate senior subordinated notes offering. Therefore, a liquid market for the senior subordinated notes sold separately may not develop or may not develop in a timely manner, which may adversely affect the ability of the holders of the separate senior subordinated notes to sell any of their separate senior subordinated notes and the price at which these holders would be able to sell any of the senior subordinated notes sold separately. If interest rates rise, the trading value of our IDSs and the senior subordinated notes sold separately in this offering may decline. If interest rates rise or should the threat of rising interest rates develop, debt markets may be adversely affected. As a result, the trading value of our IDSs and senior subordinated notes may decline. Future sales or the possibility of future sales of a substantial amount of IDSs, shares of our common stock or the senior subordinated notes, together with the future conversion of our Class B common stock into IDSs, may depress the price of the IDSs, shares of our common stock and the senior subordinated notes. Future sales or the availability for sale of substantial amounts of IDSs or shares of our common stock or a significant principal amount of the senior subordinated notes in the public market could adversely affect the prevailing market price of the IDSs, shares of our common stock and the senior subordinated notes and could impair our ability to raise capital through future sales of our securities. After consummation of the Transactions, we anticipate that our existing stockholders will own IDSs and shares of our Class B common stock (or IDSs, if the underwriters over-allotment option is exercised in full). Subject to satisfaction of the Conversion Conditions, such shares of our Class B common stock will initially be convertible into IDSs. We may issue shares of our common stock and senior subordinated notes, which will be in the form of IDSs, or other securities from time to time as consideration for future acquisitions and investments. In the event any such acquisition or investment is significant, the number of shares of our common stock and the aggregate principal amount of senior subordinated notes, which may be in the form of IDSs, or the number or aggregate principal amount, as the case may be, of other securities that we may issue may in turn be significant. In addition, we may also grant registration rights covering those IDSs, shares of our common stock, senior subordinated notes or other securities in connection with any such acquisitions and investments. Table of Contents Our amended certificate of incorporation and by-laws and several other factors could limit another party s ability to acquire us and deprive our investors of the opportunity to obtain a takeover premium for their securities. Provisions contained in our amended and restated certificate of incorporation and by-laws could make it more difficult for a third party to acquire us, even if doing so might be beneficial to our stockholders. Provisions of our amended and restated certificate of incorporation and by-laws impose various procedural and other requirements that make it more difficult for stockholders to effect some corporate actions. For example, our amended and restated certificate of incorporation authorizes our board to determine the rights, preferences, privileges and restrictions of unissued series of preferred stock, without any vote or action by our stockholders. Thus, our board can authorize and issue shares of preferred stock with voting or conversion rights that could adversely affect the voting or other rights of holders of our common stock. These rights may have the effect of delaying or deterring a change of control of our company, and could limit the price that investors might be willing to pay in the future for shares of our common stock. In addition, a change of control of our company may be delayed or deferred as a result of our having three classes of directors. We are also subject to Section 203 of the Delaware General Corporation Law, which prohibits us from engaging in a business combination with an interested stockholder for a three-year period following the time that this stockholder becomes an interested stockholder, unless the business combination is approved in a prescribed manner. In addition, our amended and restated certificate of incorporation provides that for such time as Caxton-Iseman Capital together with its affiliates and related parties beneficially own at least 10% or 5% of our equity, it will be entitled to nominate two of our directors or one director, respectively. These provisions might make an unsolicited takeover more difficult or less likely to occur or might prevent such a takeover, even though such a takeover might offer our stockholders the opportunity to sell their stock at a price above the prevailing market price and might be favored by a majority of our stockholders. You will be immediately diluted by $ per share of common stock if you purchase IDSs in this offering. If you purchase IDSs in this offering, based on the book value of the assets and liabilities reflected on our balance sheet, you will experience an immediate dilution of $ per share of common stock represented by the IDSs, which exceeds the entire price allocated to each share of common stock represented by the IDSs in this offering, because there will be a net tangible book deficit for each share of common stock outstanding immediately after this offering. Our pro forma net tangible book deficiency as of June 30, 2004, after giving effect to this offering, was approximately $ million, or $ per share of Class A common stock. We may not be able to repurchase the senior subordinated notes upon a change of control. Upon the occurrence of specific kinds of change of control events, we will be required to offer to repurchase the outstanding senior subordinated notes at 101% of their principal amount at the date of repurchase unless such senior subordinated notes have been previously called for redemption. We may not have sufficient financial resources to purchase all of the senior subordinated notes that are tendered upon a change of control offer. Furthermore, the Amended Credit Facility, with certain limited exceptions, will prohibit the repurchase or redemption of the senior subordinated notes before their stated maturity. Consequently, lenders thereunder may have the right to prohibit any such purchase or redemption, in which event we will seek to obtain waivers from the required lenders. We may not be able to obtain such waivers or refinance our indebtedness on terms acceptable to us, or at all. Buffets Senior Notes will have similar terms restricting the repurchase of the senior subordinated notes while Buffets Senior Notes remain outstanding. Finally, the occurrence of a change of control could also constitute an event of default under the Amended Credit Facility, which could result in the acceleration of all amounts due thereunder. See Description of Senior Subordinated Notes Change of Control. Public offering price $ $ % $ Underwriting discount $ $ % $ Proceeds to Buffets Holdings, Inc. (before expenses)(3)(4) $ $ % $ (1) The price per IDS comprises $ allocated to each share of Class A common stock and $ allocated to each senior subordinated note. (2) Relates to the $ million aggregate principal amount of senior subordinated notes sold separately (not represented by IDSs). (3) Approximately $ million of these proceeds will be paid to our existing stockholders. (4) Assumes no exercise of the underwriters over-allotment option. The underwriters expect to deliver the IDSs and the senior subordinated notes in book-entry form only through the facilities of The Depository Trust Company to purchasers on or about , 2004. Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense. Table of Contents We may not be able to refinance the Amended Credit Facility or Buffets Senior Notes at maturity on favorable terms or at all. The amended and restated revolving credit facility and the senior secured term loan facility included in the Amended Credit Facility will mature in full in 2009 and 2011, respectively and Buffets Senior Notes will mature in 2014. We may not be able to renew or refinance the Amended Credit Facility or Buffets Senior Notes, or if renewed or refinanced, the renewal or refinancing may occur on less favorable terms. In particular, some of the terms of the senior subordinated notes that may be viewed as favorable to the senior lenders, such as our ability to defer interest and acceleration forbearance periods, become less favorable in 2009, which may materially adversely affect our ability to refinance or renew the Amended Credit Facility or Buffets Senior Notes beyond such date. If we are unable to refinance or renew the Amended Credit Facility or Buffets Senior Notes, our failure to repay all amounts due on the maturity date would cause a default under the Amended Credit Facility and Buffets Senior Notes. In addition, our interest expense may increase significantly if we refinance the Amended Credit Facility or Buffets Senior Notes on terms that are less favorable to us than the terms of the Amended Credit Facility or Buffets Senior Notes, respectively. Risks Relating to Our Business Our core buffet restaurants are a maturing restaurant concept and face intense competition. Our restaurants operate in a highly competitive industry comprising a large number of restaurants, including national and regional restaurant chains and franchised restaurant operations, as well as locally-owned, independent restaurants. Price, restaurant location, food quality, service and attractiveness of facilities are important aspects of competition, and the competitive environment is often affected by factors beyond a particular restaurant management s control, including changes in the public s taste and eating habits, population and traffic patterns and economic conditions. Many of our competitors have greater financial resources than we have and there are few non-economic barriers to entry. Therefore, new competitors may emerge at any time. We cannot assure you that we will be able to compete successfully against our competitors in the future or that competition will not have a material adverse effect on our operations or earnings. We have been operating our core buffet restaurant concept for 20 years, and our restaurant locations have a median age of approximately 10 years. As a result, we are exposed to vulnerabilities associated with being a mature concept. These include vulnerability to innovations by competitors and out-positioning in markets where the demographics or customer preferences have changed. Mature units require greater expenditures for repair, maintenance, refurbishments and re-concepting, and we will be required to continue making such expenditures in the future in order to preserve traffic at many of our restaurants. We cannot assure you, however, that these expenditures, particularly for remodeling and refurbishing, will be successful in preserving or building guest counts, as proved to be the case with a number of units recently upgraded as part of a two year re-imaging program. We are required to respond to changing consumer preferences and dining frequency. Our profits are dependent upon discretionary spending by consumers, which is markedly influenced by variations in the economy. Our average weekly sales declined 2.0% during fiscal 2003 due in large part to weak economic conditions. Furthermore, if our competitors in the casual dining, mid-scale and quick-service segments respond to economic changes through menu engineering or by adopting discount pricing strategies, it could have the effect of drawing customers away from companies such as ours that do not routinely engage in discount pricing, thereby reducing sales and pressuring margins. Because certain elements of our cost structure are fixed in nature, particularly over shorter time horizons, changes in marginal sales volume can have a more significant impact on our profitability than for a business possessing a more variable cost structure. We are dependent on attracting and retaining qualified employees while controlling labor costs. We operate in the service sector and are therefore extremely dependent upon the availability of qualified restaurant personnel. Availability of staff varies widely from location to location. If restaurant Joint Book-Running Managers Credit Suisse First Boston Banc of America Securities LLC CIBC World Markets Table of Contents management and staff turnover trends increase, we would suffer higher direct costs associated with recruiting and retaining replacement personnel. Moreover, we could suffer from significant indirect costs, including restaurant disruptions due to management changeover, increased above-store management staffing and potential delays in new store openings due to staff shortages. Competition for qualified employees exerts pressure on wages paid to attract qualified personnel, resulting in higher labor costs, together with greater expense to recruit and train them. Many of our employees are hourly workers whose wages may be impacted by an increase in the federal or state minimum wage. Proposals have been made at federal and state levels to increase minimum wage levels. An increase in the minimum wage may create pressure to increase the pay scale for our employees. A shortage in the labor pool or other general inflationary pressures or changes could also increase our labor costs. Furthermore, the operation of buffet-style restaurants is materially different from other restaurant concepts. Consequently, the retention of executive management familiar with our core buffet business is important to our continuing success. The departure of one or more key operations executives or the departure of multiple executives in a short time period could have an adverse impact on our business. Our former Executive Vice President of Purchasing separated from the company in 2004. We are currently considering the addition of one additional position to our executive management group. Our workers compensation and employee benefit expenses are disproportionately concentrated in states with adverse legislative climates. Our highest per-employee workers compensation insurance costs are in the State of California, where we retain a large employment presence. California also enacted legislation in October 2003 that would require large employers to provide health insurance or equivalent funding for workers who have traditionally not been covered by employer health plans. While this law is currently being challenged, other states have proposed similar legislation. Other state and federal mandates, such as compulsory paid absences, increases in overtime wages and unemployment tax rates, stricter citizenship requirements and revisions in the tax treatment of employee gratuities, could also adversely affect our business. Any increases in labor costs could have a material adverse effect on our results of operations and could decrease our profitability and cash available to service our debt obligations, if we were unable to compensate for such increased labor costs by raising the prices we charge our customers or realizing additional operational efficiencies. We are dependent on timely delivery of fresh ingredients by our suppliers. Our restaurant operations are dependent on timely deliveries of fresh ingredients, including fresh produce, dairy products and meat. The cost, availability and quality of the ingredients we use to prepare our food are subject to a range of factors, many of which are beyond our control. Fluctuations in weather, supply and demand and economic and political conditions could adversely affect the cost, availability and quality of our ingredients. Historically, when operating expenses increased due to inflation or increases in food costs, we recovered increased costs by increasing our menu prices. However, we may not be able to recover increased costs in the future because competition may limit or prohibit such future increases. If our food quality declines due to the lack of, or lower quality of, our ingredients or due to interruptions in the flow of fresh ingredients and similar factors, customer traffic may decline and negatively affect our restaurants results. We rely exclusively on third-party distributors and suppliers for such deliveries. The number of companies capable of servicing our distribution needs on a national basis has declined over time, reducing our bargaining leverage and increasing vulnerability to distributor interruptions. Our restaurant sales are subject to seasonality and major world events. Our restaurant sales volume fluctuates seasonally. Overall, restaurant sales are generally higher in the summer months and lower in the winter months. Positive or negative trends in weather conditions can have a strong influence on our business. This effect is heightened because many of our restaurants are in geographic areas that experience extremes in weather, including severe winter conditions and tropical storm patterns. Additionally, major world events may adversely affect our business. UBS Investment Bank Table of Contents We face risks associated with government regulations. In addition to wage and benefit regulatory risks, we are subject to other extensive government regulation at a federal, state and local level. These include, but are not limited to, regulations relating to the sale of food in all of our restaurants and of alcoholic beverages in our Tahoe Joe s Famous Steakhouse restaurants. We are required to obtain and maintain governmental licenses, permits and approvals. Difficulty or failure in obtaining or maintaining them in the future could result in delaying or canceling the opening of new restaurants or the closing of current ones. Local authorities may suspend or deny renewal of our governmental licenses if they determine that our operations do not meet the standards for initial grant or renewal. This risk would be even higher if there were a major change in the licensing requirements affecting our types of restaurants. The Federal Americans with Disabilities Act prohibits discrimination on the basis of disability in public accommodations and employment. Mandated modifications to our facilities in the future to make different accommodations for disabled persons could result in material, unanticipated expense. Application of state Dram Shop statutes, which generally provide a person injured by an intoxicated patron the right to recover damages from an establishment that wrongfully served alcoholic beverages to the intoxicated person, to our operations, or liabilities otherwise associated with liquor service in our Tahoe Joe s Famous Steakhouse restaurants, could negatively affect our financial condition if not otherwise insured under our general liability insurance policy. Negative publicity relating to one of our restaurants, including our franchised restaurants, could reduce sales at some or all of our other restaurants. We are, from time to time, faced with negative publicity relating to food quality, restaurant facilities, health inspection scores, employee relationships or other matters at one of our restaurants or those of our franchisees. Adverse publicity may negatively affect us, regardless of whether the allegations are valid or whether we are liable. In addition, the negative impact of adverse publicity relating to one restaurant may extend beyond the restaurant involved to affect some or all of our other restaurants. If a franchised restaurant fails to meet our franchise operating standards, our own restaurants could be adversely affected due to customer confusion or negative publicity. A similar risk exists with respect to totally unrelated food service businesses, if customers mistakenly associate such unrelated businesses with our own operations. Food-borne illness incidents could result in liability to us and could reduce our restaurant sales. We cannot guarantee that our internal controls and training will be fully effective in preventing all food-borne illnesses. Furthermore, our reliance on third-party food processors makes it difficult to monitor food safety compliance and increases the risk that food-borne illness would affect multiple locations rather than single restaurants. Some food-borne illness incidents could be caused by third-party food suppliers and transporters outside of our control. New illnesses resistant to our current precautions may develop in the future, or diseases with long incubation periods could arise, such as bovine spongiform encephalopathy ( BSE ), sometimes referred to as mad cow disease, that could give rise to claims or allegations on a retroactive basis. In addition, the levels of chemicals or other contaminants that are currently considered safe in certain foods may be regulated more restrictively in the future or become the subject of public concern. The reach of food-related public health concerns can be considerable given the attention given these matters by the media. Local public health developments could have a national adverse impact on our sales, whether or not specifically attributable to our restaurants or those of our franchisees or competitors. Any negative development relating to our self-service food service approach would have a material adverse impact on our primary business. Our buffet restaurants utilize a service format that is heavily dependent upon self-service by our customers. Food tampering by customers or other events affecting the self-service format could cause Co-Managers JPMorgan Piper Jaffray The date of this prospectus is , 2004. Table of Contents regulatory changes or changes in our business pattern or customer perception. Any development that would materially impede or prohibit our continued use of a self-service food service approach, or reduce the appeal of self-service to our guests, would have a material adverse impact on our primary business. We face risks associated with environmental laws. We are subject to federal, state and local laws, regulations and ordinances that govern activities or operations that may have adverse environmental effects, such as discharges to air and water, as well as handling and disposal practices for solid and hazardous wastes. These may impose liability for the costs of cleaning up, and damage resulting from, sites of past spills, disposals or other releases of hazardous materials, both from governmental and private claimants. We could incur such liabilities regardless of whether we lease or own the restaurants or land in question and regardless of whether such environmental conditions were created by us or by a prior owner or tenant. We cannot assure you that environmental conditions relating to our prior, existing or future restaurants or restaurant sites will not have a material adverse affect on us. We face risks because of the number of restaurants that we lease. Our success depends in part on our ability to secure leases in desired locations at rental rates we believe to be reasonable. We currently lease all of our restaurants located in shopping centers and malls, and we lease the land for all but one of our freestanding restaurants. By December 2007, approximately 85 of our current leases will have expiring base lease terms and be subject to renewal consideration. Each lease agreement provides that the lessor may terminate the lease for a number of reasons, including our default in any payment of rent or taxes or our breach of any covenant or agreement in the lease. Termination of any of our leases could harm our results of operations and, as with a default under any of our indebtedness, could have a material adverse impact on our liquidity. Although we believe that we will be able to renew the existing leases that we wish to extend, we cannot assure you that we will succeed in obtaining extensions in the future at rental rates that we believe to be reasonable or at all. Moreover, if some locations should prove to be unprofitable, we could remain obligated for lease payments even if we decided to withdraw from those locations. See Business Property. We will incur special charges relating to the closing of such restaurants, including lease termination costs. Impairment charges and other special charges will reduce our profits. We may not be able to protect our trademarks and other proprietary rights. We believe that our trademarks and other proprietary rights are important to our success and our competitive position. Accordingly, we devote substantial resources to the establishment and protection of our trademarks and proprietary rights. However, the actions taken by us may be inadequate to prevent imitation of our brands, proprietary rights and concepts by others, which may thereby dilute our brands in the marketplace or diminish the value of such proprietary rights, or to prevent others from claiming violations of their trademarks and proprietary rights by us. In addition, others may assert rights in our trademarks and other proprietary rights. Our exclusive rights to our trademarks are subject to the common law rights of any other person who began using the trademark (or a confusingly similar mark) prior to both the date of our registration and our first use of such trademarks in the relevant territory. For example, because of the common law rights of such a preexisting restaurant in portions of Colorado and Wyoming, our restaurants in those states use the name Country Buffet. We cannot assure you that third parties will not assert claims against our intellectual property or that we will be able to successfully resolve such claims. Future actions by third parties may diminish the strength of our restaurant concepts trademarks or other proprietary rights and decrease our competitive strength and performance. We could also incur substantial costs to defend or pursue legal actions relating to the use of our intellectual property, which could have a material adverse affect on our business, results of operation or financial condition. TABLE OF CONTENTS Page Table of Contents
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+RISK FACTORS An investment in our common stock involves a high degree of risk. We describe below the material risks and uncertainties that affect our market, business and the shares offered through this prospectus. Before making an investment decision, you should carefully consider all of these risks and all other information contained in this prospectus. If any of these risks were to happen, either by themselves or in some combination, the value of our common stock could decline significantly, and you could lose all or part of your investment. The order of these risk factors does not reflect their relative importance or likelihood of occurrence. Risk Factors Relating to our Market A deterioration in economic conditions and a slow down in growth generally, and a slowdown in gaming and tourism activities in particular, could adversely affect our business, financial condition, results of operations and prospects. Such a deterioration could result in a variety of adverse consequences to us, including a reduction in net income and the following: Loan delinquencies may increase, which would cause us to increase loan loss provisions; Problem assets and foreclosures may increase, which could result in higher operating expenses, as well as possible increases in our loan loss provisions; Demand for our products and services may decline including specifically, the demand for loans, which would cause our revenues, which include net interest income and noninterest income, to decline; and Collateral for loans made by us may decline in value, reducing a customer s borrowing power, and reducing the value of assets and collateral associated with our loans, which could cause decreases in net interest income and increasing loan loss provisions. The greater Las Vegas area economy has grown dramatically during the past several years. The failure of this economy to sustain such growth in the future could seriously affect our ability to grow and to be profitable. Our assets have enjoyed substantial growth with an annual compounded growth rate of 27.8% for the five year period ending December 31, 2003. In large part, our growth has been fueled by the significant growth in the greater Las Vegas area. Diminished growth of this market in the future could have a significant adverse impact on our continued growth and profitability. While the current economic forecasts prepared by CBER remain optimistic about the future growth of Las Vegas, albeit at lower growth rates than have recently been experienced, there are uncertainties in the economy, besides tourism and gaming discussed below, such as limitations on water, the continued measured availability of land from the Bureau of Land Management, infrastructure strains, increasing costs of housing, and tax and budgetary pressures, which may hamper future growth. Our market area is substantially dependent on gaming and tourism revenue, and a downturn in gaming or tourism could seriously hurt our business and our prospects. Our business is currently concentrated in the greater Las Vegas area which has an economy unique in the United States for its level of dependence on services and industries related to gaming and tourism. Any event that negatively impacts the tourism or gaming industry will adversely impact the Las Vegas economy. Gaming and tourism revenue (whether or not such tourism is directly related to gaming) is vulnerable to various factors. A prolonged downturn in the national economy could have a significant adverse effect Table of Contents on the economy of the Las Vegas area. Virtually any development or event that could dissuade travel or spending related to gaming and tourism, whether inside or outside of Las Vegas, could adversely affect the Las Vegas economy. In this regard, the Las Vegas economy is more susceptible than the economies of other cities to issues such as higher gasoline and other fuel prices, increased airfares, unemployment levels, recession, rising interest rates, and other economic conditions, whether domestic or foreign. Future growth of the greater Las Vegas area is dependent, among other things, on the availability of water, and any restrictions imposed by the government on water consumption could curtail future development, which has been a source of growth in our loan portfolio. Future development in the greater Las Vegas area is subject to the availability of water. According to the Rocky Mountain Institute, Las Vegas has one of the highest per-capita rates of water consumption in the nation. Based upon an August 2003 U.S. Geological Survey, inflows into Lake Mead and Lake Powell on the Colorado River have been below average since the start of a persistent drought in the western United States in 2000. In 2003, Lake Mead, the primary water supply for Las Vegas, dropped to its lowest level in more than three decades. We cannot assure that governmental officials will not impose building moratoriums, restrictive building requirements, water conservation measures, or other measures to address water shortages in the future. Such restrictions could curtail future development, which has been a source of growth in our loan portfolio, or make living conditions less desirable than current conditions, which could reduce the influx of new residents from current levels. The value of real estate in the greater Las Vegas area is influenced by the distribution policies of the federal Bureau of Land Management. A change in such distribution policies could affect the value of real estate, which, in turn, could negatively affect our real estate loan portfolio. Land values in Nevada are influenced by the amount of land sold by the federal Bureau of Land Management, which controls 67% of Nevada s land, according to the Nevada State Office of the Bureau of Land Management. Changes to the federal Bureau of Land Management distribution policies on Nevada land could adversely affect the value of Nevada real estate. We have a high concentration of loans secured by real estate and a downturn in the real estate market, for any reason, could hurt our business and our prospects. At September 30, 2004, 83% of our loan portfolio was comprised of loans secured by real estate. Raw land loans, which are included in the categories below, represent approximately 15% of our total loans secured by real estate. Of the loans secured by real estate, approximately: 47.4% are construction loans; 44.4% are commercial real estate loans; and 8.2% are residential real estate loans. These real estate-secured loans are concentrated in the greater Las Vegas area. A downturn in the local economy could have a material adverse effect on a borrower s ability to repay these loans due to either loss of borrower s employment or a reduction in borrower s business. Further, such reduction in the local economy could severely impair the value of the real property held as collateral. As a result, the value of real estate collateral securing our loans could be reduced. Our ability to recover on defaulted loans by foreclosing and selling the real estate collateral would then be diminished and we would be more likely to suffer losses on defaulted loans. Initial public offering price $ $ Underwriting discounts and commissions $ $ Proceeds, before expenses, to us $ $ Proceeds to selling shareholders $ $ We have granted an over-allotment option to the underwriters. Under this option, the underwriters may elect to purchase a maximum of 330,000 additional shares of our common stock from us at the initial offering price within 30 days following the date of this prospectus to cover over-allotment options, if any. Table of Contents A terrorist act, or the mere threat of a terrorist act, may adversely affect the Las Vegas economy and may cause substantial harm to our business. Gaming and tourism are also susceptible to certain political conditions or events, such as military hostilities and acts of terrorism, whether domestic or foreign. The effects of the terrorist attacks of September 11, 2001, on gaming and tourism in Las Vegas were substantial for a few months. Reduced civilian air traffic in large part caused a reduction in revenue and employee layoffs in many hotels and casinos. This resulted in a substantial loss of revenues for these businesses. Any direct attack on locations in Las Vegas would likely have an even greater adverse impact on our local economy. An expansion of permissible gaming activities in other states, particularly in California, may lead to a decline in gaming revenue in Las Vegas, which could hurt our business and our prospects. Las Vegas competes with other areas of the country for gaming revenue, and it is possible that the expansion of gaming operations in other states, as a result of changes in laws or otherwise, could significantly reduce gaming revenue in the greater Las Vegas area. This is particularly true of gaming operations in California, a state from which Nevada generally, and Las Vegas in particular, draw substantial year-round visitors. Agreements negotiated between the State of California and certain Indian tribes as well as other proposals currently under consideration in California may result in substantial additional casinos throughout the state. In addition, other California legislative proposals could permit an expansion of gaming activities allowed in card clubs, including the addition of slot machines. A dramatic growth in casino gaming in California or other states could have a substantial adverse effect on gaming revenue in Nevada, including the Las Vegas area, which would adversely affect the Las Vegas economy and our business. Risks Relating to our Business Our future success involves both our ability to grow and our ability to manage such growth. Additionally, we must continue to manage the risks inherent in the banking business. We may not be able to sustain our historical growth rates, be able to grow at all, or successfully manage any growth, whether or not the greater Las Vegas area economy continues to grow. This could result in a variety of adverse consequences to us, including the following: Inability to realize any benefit from our investment of resources made to support our future growth; Failure to attract or retain experienced commercial bankers or other key employees; Inability to maintain adequate controls and systems; and Failure to comply with applicable federal, state and local laws, rules and regulations. We may not be able to continue our growth at the rate we have in the past several years. We have grown from $183 million in total assets, $148 million in gross loans and $166 million in total deposits at December 31, 1999, to $536 million in total assets, $388 million in gross loans and $481 million in total deposits at September 30, 2004. Our business strategy calls for, among other things: continued growth of our assets, loans, deposits and customer base; expansion through acquisition or the establishment of new branches or banks in high growth markets, such as the greater Las Vegas area, or similar high growth markets in Arizona and California; Balance, December 31, 2001 4,582,040 9,820 12,310 206 22,336 Comprehensive income: Net income $ 4,725 4,725 4,725 Other comprehensive income: Unrealized holding gains on securities available for sale arising during the period, net of taxes of $106 207 207 207 Reclassification adjustment for realized losses, net of taxes of $6 11 11 NEITHER THE SECURITIES AND EXCHANGE COMMISSION NOR ANY STATE SECURITIES COMMISSION HAS APPROVED OR DISAPPROVED OF THE SECURITIES OR PASSED UPON THE ADEQUACY OR ACCURACY OF THIS PROSPECTUS. ANY REPRESENTATION TO THE CONTRARY IS A CRIMINAL OFFENSE. THE SECURITIES OFFERED HEREBY ARE NOT SAVINGS OR DEPOSIT ACCOUNTS OR OTHER OBLIGATIONS OF ANY BANK SUBSIDIARY OF COMMUNITY, AND THEY ARE NOT INSURED BY THE FEDERAL DEPOSIT INSURANCE CORPORATION OR ANY OTHER GOVERNMENTAL AGENCY. The underwriters expect that the shares of our common stock will be ready for delivery to purchasers on or about , 2004. Keefe, Bruyette Woods, Inc. D.A. Davidson Co. The date of this prospectus is , 2004. Table of Contents recruitment of experienced commercial bankers and other key employees; and effective leveraging of our capital. However, we may encounter unanticipated obstacles in implementing our strategy. If we are unable to expand our business, as we anticipate based on our strategic plan, we may not be able to maintain profitability, and there can be no assurance that we will be able to sustain our historical growth rates. A component of our business strategy is to expand into high growth markets by opening new branches or organizing new banks and/or acquisitions of other financial institutions. We may not be able to successfully implement this part of our business strategy, and therefore our market value and profitability may suffer. Growth through acquisitions of banks represents a component of our business strategy. At this time, we have no agreements or understandings to acquire any such bank or banks. Any future acquisitions will be, accompanied by the risks commonly encountered in acquisitions. These risks include, among other things: difficulty of integrating the operations and personnel of acquired banks and branches; potential disruption of our ongoing business; inability of our management to maximize our financial and strategic position by the successful implementation of uniform product offerings and the incorporation of uniform technology into our product offerings and control systems; and inability to maintain uniform standards, controls, procedures and policies and the impairment of relationships with employees and customers as a result of changes in management. We cannot assure you that we will be successful in overcoming these risks or any other problems encountered in connection with acquisitions. Our inability to improve the operating performance of acquired banks or to integrate successfully their operations could have a material adverse effect on our business, financial condition, results of operations and cash flows. In addition, we could incur substantial expenses, including the expenses of integrating the business of the acquired bank with our existing business. We expect that competition for appropriate candidates may be significant. We may compete with other banks or financial service companies with similar acquisition strategies, many of which may be larger or have greater financial and other resources than we have. The purchase price of banks that might be attractive acquisition candidates for us may significantly exceed the fair values of their net assets. As a result, material goodwill and other intangible assets would be required to be recorded. We cannot assure you that we will be able to successfully identify and acquire suitable banks on acceptable terms and conditions. Depending upon the structure of an acquisition and the consideration we may utilize, we may not seek your approval as a shareholder. Further, acquisitions may be structured to include cash consideration that may result in the depletion of a substantial portion of our available cash. Besides the acquisition of existing financial institutions, we may consider the organization of new banks in high growth areas, especially in markets outside of the greater Las Vegas area such as California or Arizona. To date we have not specifically identified any market area where we plan to organize a new bank. Any organization of a new bank carries with it numerous risks, including the following: The inability to obtain all required regulatory approvals; Significant costs and anticipated operating losses during the application and organizational phases, and the first years of operations of the new bank; LIABILITIES AND STOCKHOLDERS EQUITY Accrued interest payable and other liabilities $ 12 $ (Dollars in thousands) Cash Flows from Operating Activities: Net income $ 5,215 $ 4,725 Adjustments to reconcile net income to net cash (used in) operating activities: Equity in undistributed net loss (income) of Bank (5,670 ) (4,825 ) Provision for loan losses 33 Deferred taxes 26 (20 ) Tax benefit related to the exercise of stock options 30 Net amortization of investment premium and discount 43 (Increase) decrease in accrued interest receivable 3 (27 ) (Increase) decrease in other assets 14 (237 ) Increase in accrued interest payable and other liabilities Table of Contents Las Vegas, Nevada Table of Contents The inability to secure the services of qualified senior management; The local market may not accept the services of a new bank owned and managed by a bank holding company headquartered outside of the market area of the new bank; and The additional strain on management resources and internal systems and controls. Our growth could be hindered unless we are able to recruit additional, qualified employees. We may have difficulty attracting additional necessary personnel, which may divert resources and limit our ability to successfully expand our operations. The greater Las Vegas area is experiencing a period of rapid growth, placing a premium on highly qualified employees in a number of industries, including the financial services industry. Our business plan includes, and is dependent upon, our hiring and retaining highly qualified and motivated executives and employees at every level, including a chief credit officer, SBA management and support staff, experienced loan originators and branch managers. We expect to experience substantial competition in our endeavor to identify, hire and retain the top-quality employees. If we are unable to hire and retain qualified employees in the near term, we may be unable to successfully execute our business strategy and/or be unable to successfully manage our growth. We believe that we have built our management team and personnel, and established an infrastructure, to support our current size. Our future success will depend on the ability of our executives and employees to continue to implement and improve our operational, financial and management controls and processes, reporting systems and procedures, and to manage a growing number of client relationships. We may not be able to successfully implement improvements to our management information and control systems and control procedures and processes in an efficient or timely manner. In particular, our controls and procedures must be able to accommodate an increase in expected loan volume and the infrastructure that comes with new branches. We cannot assure you that our growth strategy will not place a strain on our administrative and operational infrastructure. If we are unable to locate additional personnel and to manage future expansion in our operations, we may experience compliance and operational issues, have to slow the pace of growth, or have to incur additional expenditures beyond current projections to support such growth, any one of which could adversely affect our business. Our business would be harmed if we lost the services of any of our senior management team. We believe that our success to date and our prospects for success in the future are substantially dependent on our senior management team, which includes our President and Chief Executive Officer, our Chief Operating Officer, our Chief Financial Officer, our Executive Vice President for Credit Administration and our Executive Vice President, Director of Operations. The loss of the services of any of these persons could have an adverse effect on our business. We recently entered into employment agreements with our President and Chief Executive Officer, our Chief Operating Officer and our Chief Financial Officer. In light of the relatively small pool of persons involved in the greater Las Vegas area banking industry, we could have difficulty replacing any of our senior management team or senior officers with equally competent persons who are also familiar with our market area. As the result of this offering, we will become a public reporting company subject to significant new laws and regulations that will increase our compliance costs and may strain our management resources. Upon completion of this offering, we will be a public company and, for the first time in our history, the reporting requirements of the Securities Exchange Act of 1934, as amended and the Sarbanes-Oxley Act of 2002, or SOX, and related regulations will be applicable to our operations. Despite our doing business in a highly regulated environment, these laws and regulations have vastly different requirements TABLE OF CONTENTS Page Table of Contents for compliance than we have previously experienced. Our expenses related to services rendered by our accountants, legal counsel and consultants will increase in order to ensure compliance with these laws and regulations that we will be subject to as a public company. In addition, it is possible that the sudden application of these requirements to our business will result in some cultural adjustments and strain our management resources. To date, we have not conducted a comprehensive review and confirmation of the adequacy of our existing systems and controls as will be required under Section 404 of SOX, and will not do so until after the completion of this offering. We may discover deficiencies in existing systems and controls. If that is the case, we intend to take the necessary steps to correct any deficiencies, and such steps may be costly and may strain our management resources. There is intense competition in our market area, and we cannot assure you that we will be able to successfully compete. Commercial banking in the greater Las Vegas area is a highly competitive business. Increased competition in our market may result in reduced loans and deposits. We compete for loans and deposits primarily with the local offices of major banks. We compete with other community banks in our market for customers as well. We also compete with credit unions, small loan companies, insurance companies, mortgage companies, finance companies, brokerage houses, other financial institutions and out-of-state financial intermediaries, some of which are not subject to the same degree of regulation and restriction as us and some of which have financial resources greater than us. Technological advances continue to contribute to greater competition in domestic and international products and services. Ultimately, we may not be able to compete successfully against current and future competitors. Our allowance for loan losses may not be adequate to cover actual losses particularly given our relatively large individual loan size. A significant source of risk arises from the possibility that losses could be sustained because borrowers, guarantors and related parties may fail to perform in accordance with the terms of their loans. The underwriting and credit monitoring policies that we have adopted to address this risk may not prevent unexpected losses that could have a material adverse affect on our business. Most of our loans, or approximately 83%, are secured by real estate. Community Bank of Nevada s legal lending limit is approximately $13 million. At September 30, 2004, we had 102 loans in excess of $1 million each, totaling $255 million. These loans comprise approximately 10.6% of our loan portfolio by number of loans and 65.7% by total loans outstanding. Our average loan size at September 30, 2004 was $368,000 (excluding credit card, overdraft and purchased participation loans). This relatively large average loan size, while an advantage from a cost generation standpoint, can adversely impact us if one or more of these larger loans becomes delinquent, unstable, impaired, uncollectible or inadequately collateralized. Like all financial institutions, we maintain an allowance for loan losses to provide for loan defaults and non-performance. Our allowance for loan losses may not be adequate to cover actual loan losses, and future provisions for loan losses could materially and adversely affect our business. Our allowance for loan losses is based on our prior experience and peer bank experience, as well as an evaluation of the known risks in the current portfolio, composition and growth of the loan portfolio and economic factors. The determination of the appropriate level of loan loss allowance is an inherently difficult process and is based on numerous assumptions. The amount of future losses is susceptible to changes in economic, operating and other conditions, including changes in interest rates, that may be beyond our control and these losses may exceed current estimates. We cannot assure you that we will not increase the allowance for loan losses further or that regulators will not require us to increase this allowance. Either of these occurrences could adversely affect our business and prospects. Table of Contents Risks Related to the Offering The shares of our common stock and the use of the proceeds from such sale provide certain unique risks to the investor, including: Our use of proceeds for corporate purposes that may not increase our market value or make us profitable; and Our common stock price, after the completion of this offering, may trade below the initial public offering price. Management will have broad discretion as to the use of the proceeds received by us from this offering, and we may not use the proceeds effectively. Although we plan to use the net proceeds from this offering for expansion purposes, including possible acquisitions or organizations of financial institutions, we have not designated the amount of net proceeds we will use for any particular purpose. Accordingly, our management will have broad discretion as to the application of the net proceeds and could use them for purposes other than those contemplated at the time of this offering. Our shareholders may not agree with the manner in which our management chooses to allocate and spend the net proceeds. Moreover, our management may use the net proceeds for corporate purposes that may not increase our market value or make us profitable. One of the intended use of proceeds of this offering is to implement our growth strategy, which includes expansion in the greater Las Vegas area and similar high growth markets in Arizona and California. We may not successfully implement our growth strategy and therefore, our intended use of proceeds from this offering may not result in an increase in our market value and profitability. One of the principal reasons for our raising the capital in this offering is to be able to create a source of funds to be used for establishing and/or acquiring other banks in the greater Las Vegas area or similar high growth markets in Arizona and California. If we are not successful in our strategy of opening new branches or organizing new banks and/or acquisitions of other financial institutions, our market value and profitability may suffer. There has been no prior active market for our common stock and our stock price may trade below the public offering price. Prior to this offering, there has been no public market for our common stock. The offering price for our common stock in this offering will be determined by negotiations between us and the underwriter. Among the factors to be considered in determining the offering price of our common stock, in addition to prevailing market conditions, will be our historical performance, estimates regarding our business potential and earnings prospects, an assessment of our management and the consideration of the above factors in relation to the market value of companies in our industry. The public offering price of our common stock may bear no relationship to the price at which our common stock will trade upon completion of this offering. You may not be able to resell your shares at or above the initial public offering price. You will experience substantial dilution in the book value of your shares immediately following this offering. Investors purchasing shares of our common stock in this offering will pay more for their shares than the amount paid by existing shareholders who acquired shares prior to this offering. If you purchase common stock in this offering, you will incur immediate dilution in pro forma net tangible book value of approximately $9.16 per share, assuming an initial public offering price of $19.00 per share (the midpoint of the range set forth on the cover page of this prospectus). If the holders of outstanding stock options exercise those options, you will incur further dilution. For more information, see Dilution. Table of Contents We cannot be sure that an active public trading market will develop or be maintained. We have applied to list our common stock for quotation on the Nasdaq National Market under the symbol CBON. However, there can be no assurance that an established and liquid market for our common stock will develop on Nasdaq, or that a market will continue if one does develop. Keefe, Bruyette Woods, Inc. and D.A. Davidson Co. have advised us that they intend to make a market in our common stock and assist us in obtaining additional market makers for our common stock. However, you should be aware that neither the underwriters nor any other market makers are obligated to make a market in such shares, and any such market making may be discontinued at any time in the sole discretion of each market maker making such market. In addition, we estimate that following this offering, approximately 20% of our outstanding common stock will be owned by our executive officers and directors. The substantial amount of common stock that is owned by our executive officers and directors may adversely affect the development of an active and liquid trading market. After an initial period of restriction, there will be a significant number of shares of our common stock available for future sale, which may depress our stock price. The market price of our common stock could decline as a result of sales of substantial amounts of our common stock in the public market after this offering, or even the perception that such sales could occur. We have agreed not to, and our directors, executive officers and principal shareholders have also agreed not to, offer or sell any of our shares of common stock for 180 days following the date of this prospectus. Notwithstanding these lock-up arrangements, our officers and directors and principal shareholders (greater than 5% owners) will own approximately 2,005,596 shares after completion of this offering, or 32.8% of our outstanding common stock if the underwriters exercises their over-allotment option in full. Sales of these shares or other shares owned by our affiliates may adversely affect the price of our common stock and the market for our common stock. While there are regulations regarding the sale of shares by insiders, we do not control their decisions to sell shares or the timing of their sales. See Shares Eligible For Future Sale. Provisions in our articles of incorporation and bylaws may limit the ability of another party to acquire us. Various provisions of our articles of incorporation and by-laws could delay or prevent a third-party from acquiring us, even if doing so might be beneficial to our shareholders. These provisions provide for, among other things, advance notice for nomination of directors and limitations on the ability of shareholders to call a special meeting of shareholders, which can make minority shareholder representation on the board of directors more difficult to establish. Risks Related to the Banking Industry Our business also presents other risks that are generally common to the banking industry. We are subject to extensive government regulation. These regulations could adversely affect our business, financial condition, results of operations or cash flows. We are subject to extensive regulation by federal, state and local governmental authorities and are subject to various laws and judicial and administrative decisions imposing requirements and restrictions on part or all of our operations. Because our business is highly regulated, the laws, rules and regulations applicable to us are subject to regular modification and change. There are currently proposed various laws, rules and regulations that, if adopted, would impact our operations. We cannot assure you that these proposed laws, rules and regulations or any other laws, rules or regulations will not be adopted in the future, which could adversely affect our business, financial condition, results of operations or cash flows. Table of Contents Fluctuating interest rates can adversely affect our profitability. Our profitability is dependent to a large extent upon net interest income, which is the difference, or spread, between the interest earned on loans, securities and other interest-earning assets and interest paid on deposits, borrowings and other interest-bearing liabilities. Because of the differences in maturities and repricing characteristics of our interest-earning assets and interest-bearing liabilities, changes in interest rates do not produce equivalent changes in interest income earned on interest-earning assets and interest paid on interest-earning liabilities. Accordingly, fluctuations in interest rates could adversely affect our interest rate spread and, in turn, our profitability. We cannot assure you that we can minimize our interest rate risk. In addition, interest rates also affect the amount of money we can lend. When interest rates rise, the cost of borrowing also increases. Therefore, changes in levels of market interest rates could materially and adversely affect our net interest spread, asset quality, loan origination volume, business and prospects. We are exposed to risk of environmental liabilities with respect to properties to which we take title. About 83% of our outstanding loan portfolio at September 30, 2004 was secured by real estate. In the course of our business, we may foreclose and take title to real estate, and could be subject to environmental liabilities with respect to these properties. We may be held liable to a governmental entity or to third parties for property damage, personal injury, investigation and clean-up costs incurred by these parties in connection with environmental contamination, or may be required to investigate or clean up hazardous or toxic substances, or chemical releases at a property. The costs associated with investigation or remediation activities could be substantial. In addition, if we are the owner or former owner of a contaminated site, we may be subject to common law claims by third parties based on damages and costs resulting from environmental contamination emanating from the property. These costs and claims could adversely affect our business and prospects. Table of Contents
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+COMPANY SPECIFIC RISK FACTORS We are highly dependent on the Charterers and their guarantors, Stena and Concordia All of our vessels are chartered to subsidiaries of Concordia and a subsidiary of Stena, which we refer to collectively as the Charterers. The Charterers' payments to us under the Charters are our sole source of revenue. We are highly dependent on the performance by the Charterers of their obligations under the Charters and by their guarantors, Stena and Concordia, of their obligations under their respective guarantees. Any failure by the Charterers or the guarantors to perform their obligations would materially and adversely affect our business and financial position. Our shareholders do not have any recourse against the Charterers or the guarantors. If we cannot refinance our loans, or in the event of a default under our secured credit facility, we may have to sell our vessels, which may leave no additional funds for distributions to shareholders Under the terms of our credit facility, we are only required to make interest payments during its five year term and are required to repay the principal amount outstanding at maturity in November 2009. Borrowings under our secured credit facility are guaranteed by each of our subsidiaries and are secured by mortgages over all of our vessels, assignments of earnings and insurances, pledges over the shares of our subsidiaries and assignments of our interests in the Charters and the ship management agreements. Whether or not the Charterers renew our charters, our credit facility will mature in November 2009 and we will be obligated to repay or refinance the principal amount of the loan at that time. There is no assurance that we will be able to repay or refinance this amount. In addition, even if the Charterers renew the Charters for one or more of our vessels, but we are unable to refinance our credit facility on acceptable terms, we may be forced to attempt to sell our vessels. In the event interest rates are higher than current rates at the time we seek to refinance our credit facility, such higher rates could prevent our ability to complete a refinancing or could adversely impact our future results, including the amount of cash available for future dividends. In such event, we may conclude that such a refinancing is not on acceptable terms. In addition, in the event of a default under our credit facility all of our vessels could be sold to satisfy amounts due to the lenders under our credit facility. Depending on the market value for our vessels at the time, it is possible that after payment of the amounts outstanding under our credit facility there would not be any funds to distribute to our shareholders. In addition, under our bye-laws, any sale of a vessel would require the approval of at least a majority of our shareholders voting at a meeting. Because we intend to distribute dividends to our shareholders in an amount substantially equal to our charterhire, less cash expenses and any reserves established by our board of directors, we do not believe we will be able to repay our credit facility at the end of five years without selling some or all of our vessels. As a result, we believe we will be required to refinance the borrowing under our credit facility at or prior to its maturity. Our Charters expire in 2009, unless extended at the option of the Charterers, and we may not be able to recharter our vessels profitably Each of our Charters expires approximately five years after the date of delivery of each vessel to us, November 2009, unless extended at the option of the applicable Charterer for up to three additional Risk Factors one-year periods. Each of the Charterers has the sole discretion to exercise that option. We cannot predict whether the Charterers will exercise any of their extension options under one or more of the Charters. The Charterers will not owe any fiduciary or other duty to us or our shareholders in deciding whether to exercise the extension option, and the Charterers' decision may be contrary to our interests or those of our shareholders. We cannot predict at this time any of the factors that the Charterers will consider in deciding whether to exercise any of their extension options under the Charters. It is likely, however, that the Charterers would consider a variety of factors, which may include the age and specifications of the particular vessel, whether a vessel is surplus or suitable to the Charterers' requirements and whether competitive charterhire rates are available to the Charterers in the open market at that time. If the Charterers decide not to extend our current Charters, we may not be able to re-charter our vessels with terms similar to the terms of our Charters. We may also employ the vessels on the spot charter market, which is subject to greater rate fluctuation than the time charter market. Under our ship management agreements, Northern Marine is responsible for all of the technical and operational management of our vessels for a fixed management fee, increasing 5% annually. Northern Marine has also agreed to indemnify us against specified off hire and reduced hire for our vessels. However, this indemnity only extends to the amount payable to us as Basic Hire and would not extend to any amounts that would otherwise be payable to us as Additional Hire if the vessels were not off hire. Our ship management agreements with Northern Marine may be terminated by either party if the relevant Charter is terminated or expires. If our ship management agreements with Northern Marine were to terminate, we may not be able to obtain similar fixed rate terms or indemnification for off hire and reduced hire periods from another ship manager. If we receive lower charter rates under replacement charters, are unable to recharter all of our vessels or we incur greater expenses under replacement management agreements, the amounts available, if any, to pay distributions to our shareholders may be significantly reduced or eliminated. Under our Charters, there is no obligation to pay Additional Hire during any period when the obligation to pay Basic Hire is suspended under the Charter if due to technical reasons the vessel is off hire, unless the vessel is off hire as a result of a class condition or recommendation determined by the vessel's classification society during the inspection of the vessel undertaken by us in connection with the purchase of the vessel and such condition or recommendation cannot be remedied or complied with during a regularly scheduled drydocking without increasing the duration of such drydocking. Because we are a newly formed company with no separate operating history, our historical financial and operating data may not be representative of our future results We are a newly incorporated company with no separate operating history. The vessels we will purchase from Concordia were delivered to Concordia in 2001 and the vessels we will purchase from Stena were delivered to Stena in the first four months of 2004. The historical predecessor combined carve-out financial statements included in this prospectus have been prepared on a carve-out basis and reflect the historical business activities of Stena and Concordia relating to our vessels. These predecessor financial statements do not reflect the results we would have obtained under our current fixed rate long term charters, ship management agreements and our financing arrangements and in any event are not a meaningful representation of our future results of operations. Our unaudited pro forma financial information has been prepared as if we had entered into our current charter contracts, ship management agreements and financing arrangements. Such information is provided for illustrative purposes only and does not represent what our results of operations, financial position or cash flows would actually have been if the transactions had in fact occurred on those dates and is not representative of our results of operations, financial position or cash flows for any future periods. There will likely be variations between our future operating results and our pro forma financial information and such variations may be material. Risk Factors Agreements between us, Stena, Concordia and their other affiliates may be less favorable than agreements that we could obtain from unaffiliated third parties The Charters, the ship management agreements and the other contractual agreements we have with Stena, Concordia and their affiliates were made in the context of an affiliated relationship and were negotiated in the overall context of the public offering of our shares, the purchase of our vessels and other related transactions. Stena and Concordia are affiliates. Stena is wholly-owned by members of the Sten A. Olsson family. Members of the Sten A. Olsson family also own, as of June 30, 2004, approximately 52% of the share capital of Concordia which represents approximately 73% of the voting rights in Concordia. Because we are currently a jointly owned subsidiary of Stena and Concordia, the negotiation of the Charters, the ship management agreements and our other contractual arrangements may have resulted in prices and other terms that are less favorable to us than terms we might have obtained in arm's length negotiations with unaffiliated third parties for similar services. Stena and Concordia's other business activities may create conflicts of interest Under the Charters, we are entitled to receive variable Additional Hire whether the vessel is subchartered by the applicable Charterer under a time charter or on the spot market. Additional Hire in the case of trading in the spot market is calculated with reference to average spot market rates on designated routes which are the routes traditionally served by our vessel types. Additional Hire in the case of time charters is calculated with reference to the amount received by the Charterer, net of specified expenses. Although the formula for calculating Additional Hire was designed to reduce potential conflicts of interest, because Stena and Concordia also own or manage other vessels in addition to our Fleet which are not included in the Additional Hire calculation, conflicts of interest may arise between us and Stena and Concordia in the allocation of chartering opportunities that could reduce our Additional Hire. Following the offering, Concordia and Stena will be able to influence the Company, including the outcome of shareholder votes Concordia and Stena are expected to directly and indirectly own together approximately 24.9% of our outstanding common shares following completion of this offering. As a result of their share ownership and for so long as either Concordia or Stena directly or indirectly owns a significant percentage of our outstanding common shares, Concordia and Stena will be able to influence the Company, including the outcome of any shareholder vote, such as the election of directors. We are leveraged and subject to restrictions in our financing agreements that impose constraints on our operating and financing flexibility We have a commitment letter for a secured credit facility under which we expect to borrow approximately $135 million to finance a portion of the cash purchase price for our vessels. We will be required to apply a substantial portion of our cash flow from operations to the payment of interest on borrowings under the facility. Our credit facility, which we expect will be secured by, among other things, mortgages on our vessels, pledges of our time charters and the shares of our vessel owning subsidiaries and assignments of earnings and insurances, requires that we comply with various operating covenants and maintain certain financial ratios including that the market value of our vessels exceeds 125% of the total facility amount outstanding and that the market value of our vessels exceeds 140% of our borrowings in order for us to pay dividends. The facility also requires that Northern Marine remain as technical manager for our vessels. We expect to have a floating rate of interest under our secured credit facility. We intend to use interest rate swaps to manage our interest rate exposure from our floating rate debt. However, by utilizing these interest rate swaps, we potentially forego benefits that might result from declines in interest rates. We are a holding company, and we depend on the ability of our subsidiaries to distribute funds to us in order to satisfy our financial and other obligations We are a holding company, and have no significant assets other than the equity interests in our subsidiaries. Our subsidiaries own all of our vessels, and payments under our Charters will be made to Risk Factors our subsidiaries. As a result, our ability to pay dividends depends on the performance of our subsidiaries and their ability to distribute funds to us. The ability of a subsidiary to make these distributions could be affected by a claim or other action by a third party, including a creditor, or by Bermuda law which regulates the payment of dividends by companies. If we are unable to obtain funds from our subsidiaries, we will not be able to pay dividends unless we obtain funds from other sources. We cannot assure you that we will be able to obtain funds from other sources. We cannot assure you that we will pay any dividends We intend to pay dividends on a quarterly basis commencing January 2005 in amounts determined by our board of directors. We believe our dividends will be substantially equal to the charterhire received by us under the Charters, less cash expenses and any reserves established by our board of directors. Such expenses will consist primarily of fees under our ship management agreements, directors' fees, salaries and benefits of our President and our Chief Financial Officer, payment of interest under our credit facility and other administrative and other expenses. There can be no assurance that we will not have other cash expenses, including extraordinary expenses, which could include the costs of claims and related litigation expenses. There can be no assurance that we will not have additional expenses or liabilities, that the amounts currently anticipated for the items set forth above will not increase, that we will not have to fund any required capital expenditures for our vessels or that our board of directors will not determine to establish additional reserves or change our dividend policy. Other than the fees under our ship management agreements, none of our fees or expenses are fixed. Based on the assumptions and other matters set forth below under "Dividend Policy," including that 15,500,000 common shares will be outstanding upon completion of this offering, the total amount of dividends per share we intend to pay with respect to each of the five twelve month periods following the completion of this offering is estimated to be $1.97, $1.95, $1.90, $1.79 and $1.79, respectively. The amount of future dividends set forth in the "Summary" and "Dividend Policy" represents only an estimate of future dividends based on our charter contracts, ship management agreements, an estimate of our other expenses and the other matters and assumptions set forth therein and assumes that other than our ship management expenses, none of our expenses increase during the periods presented in the table. The amount of future dividends, if any, could be affected by various factors, including the loss of a vessel, required capital expenditures, reserves established by our board of directors, increased or unanticipated expenses, a change in our dividend policy, increased borrowings or future issuances of securities, many of which will be beyond our control. As a result, the amount of dividends actually paid may vary from the amounts currently estimated and such variations may be material. Our credit facility also provides that we may not pay dividends if there is a default under the facility or if the market value of our vessels is less than 140% of our borrowings under the facility. The declaration of dividends is subject to our credit facility, compliance with Bermuda law and will be subject at all times to the discretion of our board of directors. There can be no assurance that dividends will be paid in the amounts anticipated as set forth herein or at all. U.S. tax authorities could treat us as a "passive foreign investment company," which could have adverse U.S. federal income tax consequences to U.S. holders A foreign corporation will be treated as a "passive foreign investment company," or PFIC, for U.S. federal income tax purposes if either (1) at least 75% of its gross income for any taxable year consists of certain types of "passive income" or (2) at least 50% of the average value of the corporation's assets produce or are held for the production of those types of "passive income." For purposes of these tests, "passive income" includes dividends, interest, and gains from the sale or exchange of investment property and rents and royalties other than rents and royalties which are received from unrelated parties in connection with the active conduct of a trade or business. For purposes of these tests, income derived from the performance of services does not constitute "passive income." U.S. shareholders of a PFIC are subject to a disadvantageous U.S. federal income tax regime with respect to the income derived by the PFIC, the distributions they receive from the PFIC and the gain, if any, they derive from the sale or other disposition of their shares in the PFIC. Risk Factors Based on our proposed method of operation, we do not believe that we will be a PFIC with respect to any taxable year. In this regard, we intend to treat the gross income we derive or are deemed to derive from our time chartering activities as services income, rather than rental income. Accordingly, we believe that our income from our time chartering activities does not constitute "passive income," and the assets that we own and operate in connection with the production of that income do not constitute passive assets. There is, however, no direct legal authority under the PFIC rules addressing our proposed method of operation. Accordingly, no assurance can be given that the U.S. Internal Revenue Service, or IRS, or a court of law will accept our position, and there is a risk that the IRS or a court of law could determine that we are a PFIC. Moreover, no assurance can be given that we would not constitute a PFIC for any future taxable year if there were to be changes in the nature and extent of our operations. If the IRS were to find that we are or have been a PFIC for any taxable year, our U.S. shareholders will face adverse U.S. tax consequences. Under the PFIC rules, unless those shareholders make an election available under the Internal Revenue Code of 1986, as amended, such shareholders would be liable to pay U.S. federal income tax at the then prevailing income tax rates on ordinary income plus interest upon excess distributions and upon any gain from the disposition of our common shares, as if the excess distribution or gain had been recognized ratably over the shareholder's holding period of our common shares. See "Tax Considerations—U.S. Federal Income Tax Consequences to Holders" for a more comprehensive discussion of the U.S. federal income tax consequences to U.S. shareholders if we are treated as a PFIC. Our operating income could fail to qualify for an exemption from U.S. federal income taxation, which will reduce our cash flow Unless exempt from U.S. federal income taxation, a foreign corporation is subject to U.S. federal income taxation at a rate of 4% on 50% of its shipping income that is attributable to transportation that begins or ends in the United States. Shipping income will be exempt from U.S. federal income taxation if, with respect to each specified category of shipping income, including time chartering income: (1) the foreign corporation generating the income is organized in a foreign country that grants an "equivalent exemption" to U.S. corporations and (2) either (A) our common shares are "primarily and regularly traded on an established securities market," as determined under complex applicable U.S. Treasury regulations, in that same foreign country, in the United States or in another country that grants an "equivalent exemption" to U.S. corporations, (B) more than 50% of the value of our shares is treated as owned, directly or indirectly, for at least half of the number of days in the taxable year by one or more "qualified shareholders," as defined under applicable U.S. Treasury regulations or (C) we are a controlled foreign corporation and other applicable conditions are met. See "Tax Considerations — Taxation of the Company" for a more comprehensive discussion of these rules and the U.S. federal income tax consequences to us if our time chartering income fails to qualify for the exemption from U.S. federal income taxation. Bermuda, our country of organization, is a foreign country that grants an "equivalent exemption" to U.S. corporations with respect to time chartering income. In addition, we anticipate that our common shares will be "primarily and regularly traded" on the New York Stock Exchange, which is an established securities market in the United States. Therefore, we expect our time chartering income to qualify for the exemption from U.S. federal income taxation immediately following the offering. Our qualification for the exemption, however, is based upon certain complex factual determinations that are not completely within our control and, therefore, there can be no assurance that we will qualify for the exemption either immediately after the closing of this offering or in the future. If we were not to qualify for the exemption, our cash available for distributions to shareholders would be correspondingly reduced. U.S. investors who own our common shares may have more difficulty in protecting their interests than U.S. investors who own shares of a Delaware corporation The Companies Act 1981 of Bermuda, which applies to us, differs in certain material respects from laws generally applicable to U.S. corporations and their shareholders. Set forth below is a summary of certain Risk Factors significant provisions of the Companies Act which differ in certain respects from provisions of Delaware corporate law. Because the following statements are summaries, they do not discuss all aspects of Bermuda law that may be relevant to us and our shareholders. Interested Directors. Bermuda law and our bye-laws provide that a transaction entered into by us in which a director has an interest will not be voidable by us and such director will not be liable to us for any profit realized pursuant to such transaction as a result of such interest, provided the nature of the interest is disclosed at the first opportunity at a meeting of directors, or in writing, to the directors. In addition, our Bye-laws allow a director to be taken into account in determining whether a quorum is present and to vote on a transaction in which that director has an interest following a declaration of the interest pursuant to the Companies Act, provided that the director is not disqualified from doing so by the chairman of the meeting. Under Delaware law such transaction would not be voidable if: the material facts as to such interested director's relationship or interests were disclosed or were known to the board of directors and the board had in good faith authorized the transaction by the affirmative vote of a majority of the disinterested directors; such material facts were disclosed or were known to the stockholders entitled to vote on such transaction and the transaction was specifically approved in good faith by vote of the majority of shares entitled to vote thereon; or the transaction was fair as to the corporation as of the time it was authorized, approved or ratified. Under Delaware law, the interested director could be held liable for a transaction in which the director derived an improper personal benefit. Shareholders' Suits. The rights of shareholders under Bermuda law are not as extensive as the rights of shareholders in many United States jurisdictions. Class actions and derivative actions are generally not available to shareholders under the laws of Bermuda. However, Bermuda courts ordinarily would be expected to follow English case law precedent which would permit a shareholder to commence an action in the name of the company to remedy a wrong done to the company where an act is alleged to be beyond the corporate power of the company, is illegal or would result in the violation of the company's memorandum of association or bye-laws. Consideration would also be given by the court to acts that are alleged to constitute a fraud against the minority shareholders or where an act requires the approval of a greater percentage of our shareholders than actually approved it. The winning party in such an action generally would be able to recover a portion of attorneys' fees incurred in connection with such action. Class actions and derivative actions generally are available to stockholders under Delaware law for, among other things, breach of fiduciary duty, corporate waste and actions not taken in accordance with applicable law. In such actions, the court has discretion to permit the winning party to recover attorneys' fees incurred in connection with such action. Indemnification of Directors. We may indemnify our directors or officers or any person appointed to any committee by the board acting in their capacity as such against all actions, costs, charges, losses, damages and expenses incurred or sustained by such person by reason of any act done, concurred in or omitted in or about in the conduct of our business, or in the discharge of his or her duties, provided that such indemnification shall not extend to any matter in which any of such persons has committed fraud or dishonesty. Under Delaware law, a corporation may indemnify a director or officer of the corporation against expenses (including attorneys' fees), judgments, fines and amounts paid in settlement actually and reasonably incurred in defense of an action, suit or proceeding by reason of such position if such director or officer acted in good faith and in a manner he or she reasonably believed to be in or not be opposed to the best interests of the corporation and, with respect to any criminal action or proceeding, such director or officer had no reasonable cause to believe his or her conduct was unlawful. Bermuda law and our bye-laws permit our board of directors to establish preference shares having terms which could reduce or eliminate dividends payable to our common shareholders Bermuda law and our bye-laws permit our board of directors to issue preference shares with dividend rates, relative voting rights, conversion or exchange rights, redemption rights, liquidation rights and Risk Factors other relative participation, optional or other special rights, qualifications, limitations or restrictions as may be determined by resolution of the board without shareholder approval. Such preference shares could have terms that provide for the payment of dividends prior to the payment of dividends in respect of the common shares. As a result, the issuance of these preference shares could reduce or eliminate dividends payable to common shareholders. Our bye-laws restrict shareholders from bringing certain legal action against our officers and directors Our bye-laws contain a broad waiver by our shareholders of any claim or right of action, both individually and on our behalf, against any of our officers or directors. The waiver applies to any action taken by an officer or director, or the failure of an officer or director to take any action, in the performance of his or her duties, except with respect to any matter involving any fraud or dishonesty on the part of the officer or director. This waiver limits the right of shareholders to assert claims against our officers and directors unless the act or failure to act involves fraud or dishonesty. We have anti-takeover provisions in our bye-laws that may discourage a change of control Our bye-laws contain provisions that could make it more difficult for a third party to acquire us without the consent of our board of directors. These provisions provide for: a classified board of directors with staggered three-year terms, elected without cumulative voting; directors only to be removed for cause and only with the affirmative vote of holders of at least 80% of the common shares issued and outstanding; advance notice for nominations of directors by shareholders and for shareholders to include matters to be considered at annual meetings; our board of directors to determine the powers, preferences and rights of our preference shares and to issue the preference shares without shareholder approval; a requirement that amalgamations, sales of assets and certain other transactions with persons owning 15% or more of our voting securities, which we refer to as interested shareholders, be approved by holders of at least 66% of our issued and outstanding voting shares not owned by the interested shareholder, subject to certain exceptions. These provisions could make it more difficult for a third party to acquire us, even if the third party's offer may be considered beneficial by many shareholders. As a result, shareholders may be limited in their ability to obtain a premium for their shares. INDUSTRY SPECIFIC RISK FACTORS The highly cyclical nature of the tanker industry may lead to volatile changes in charter rates and vessel values which may adversely affect our earnings If the tanker industry, which has been highly cyclical, is depressed in the future when our Charters expire or at a time when we may want to sell a vessel, our earnings and available cash flow may decrease. Our ability to recharter our vessels on the expiration or termination of the Charters and the charter rates payable under any renewal or replacement charters will depend upon, among other things, economic conditions in the tanker market at that time. Fluctuations in charter rates and vessel values result from changes in the supply and demand for tanker capacity and changes in the supply and demand for oil and oil products. Currently, we believe that charter rates and vessel values are at a high level. There can be no assurance that these rates and values will not decline from current levels. Our vessels will be operated under time charters with the Charterers. We will receive a fixed minimum daily base charter rate and may receive Additional Hire under the Charters. Additional Hire, if any, will be paid quarterly in arrears. The amount of Additional Hire is subject to variation depending on the charterhire received by the Charterers under time charters, spot charters and on general tanker market Risk Factors conditions. We cannot assure you that we will receive Additional Hire for any quarter other than in the case of the Charters for the V-MAX tankers which are currently time chartered to Sun International for approximately three additional years. Factors beyond our control may adversely affect the value of our vessels The factors affecting the supply and demand for tanker vessels are outside of our control, and the nature, timing and degree of changes in industry conditions are unpredictable and may adversely affect the value of our vessels. The factors that influence the demand for tanker capacity include: demand for oil and oil products, which affect the need for tanker capacity; global and regional economic and political conditions which among other things, could impact the supply of oil as well as trading patterns and the demand for various types of vessels; changes in the production of crude oil, particularly by OPEC and other key producers, which impact the need for tanker capacity; developments in international trade; changes in seaborne and other transportation patterns, including changes in the distances that cargoes are transported; environmental concerns and regulations; weather; and competition from alternative sources of energy. The factors that influence the supply of tanker capacity include: the number of newbuilding deliveries; the scrapping rate of older vessels; and the number of vessels that are out of service. An over supply of new vessels may adversely affect charter rates and vessel values If the number of new ships delivered exceeds the number of tankers being scrapped and lost, tanker capacity will increase. In addition, the newbuilding order book currently equals 34% of the existing fleet and we cannot assure you that the order book will not increase further in proportion to the existing fleet. If the supply of tanker capacity increases and the demand for tanker capacity does not increase correspondingly, charter rates could materially decline and the value of our vessels could be adversely affected. Terrorist attacks and international hostilities can affect the tanker industry, which could adversely affect our business Additional attacks like those of September 11, 2001 or longer-lasting war or international hostilities, including those currently underway in Iraq and the Middle East, could damage the world economy, adversely affect the availability of and demand for crude oil and petroleum products and adversely affect our ability to recharter our vessels on the expiration or termination of the Charters and the charter rates payable under any renewal or replacement charters. We conduct our operations outside of the United States, and our business, financial condition and results of operations may be adversely affected by changing economic, political and government conditions in the countries and regions where our vessels are employed. Moreover, we operate in a sector of the economy that is likely to be adversely impacted by the effects of political instability, terrorist or other attacks, war or international hostilities. The value of our vessels may fluctuate and adversely affect our liquidity and may result in breaches under our credit facility Tanker values have generally experienced high volatility. Investors can expect the fair market value of our tankers to fluctuate, depending on general economic and market conditions affecting the tanker industry Risk Factors and competition from other shipping companies, types and sizes of vessels and other modes of transportation. In addition, although our Panamax and Product tankers were built in 2004 and our V-MAX tankers were built in 2001, as vessels grow older, they generally decline in value. These factors will affect the value of our vessels at the termination of their Charters or earlier at the time of any sale, which during the term of the Charters will require the consent of the Charterer and the lenders under our credit facility. Our credit facility requires that in the event of the sale or loss of a vessel the facility must be repaid so that the amount outstanding does not exceed 60% of the value of our remaining vessels. Declining tanker values could adversely affect our ability to refinance our credit facility at its maturity in November 2009 and thereby adversely impact our business and operations and liquidity. Due to the cyclical nature of the tanker market, if for any reason we sell tankers at a time when tanker prices have fallen, the sale may be at less than the tanker's carrying amount on our financial statements, with the result that we would also incur a loss and a reduction in earnings. We operate in the highly competitive international tanker market which could affect our position if the Charterers do not renew our Charters The operation of tanker vessels and transportation of crude oil and petroleum products are extremely competitive. Competition arises primarily from other tanker owners, including major oil companies, as well as independent tanker companies, some of whom have substantially larger fleets and substantially greater resources than we do. Competition for the transportation of oil and oil products can be intense and depends on price, location, size, age, condition and the acceptability of the tanker and its operators to the charterers. During the term of our Charters with the Charterers we are not exposed to the risk associated with this competition. In the event that the Charterers do not renew the Charters in 2009, we will have to compete with other tanker owners, including major oil companies and independent tanker companies for charterers. Due in part to the fragmented tanker market, competitors with greater resources could enter and operate larger fleets through acquisitions or consolidations and may be able to offer better prices and fleets than us, which could result in our achieving lower revenues from our vessels. Compliance with environmental laws or regulations may adversely affect our business The shipping industry is affected by numerous regulations in the form of international conventions, national, state and local laws and national and international regulations in force in the jurisdictions in which such tankers operate, as well as in the country or countries in which such tankers are registered. These regulations include the U.S. Oil Pollution Act of 1990, or OPA, the International Convention on Civil Liability for Oil Pollution Damage of 1969, International Convention for the Prevention of Pollution from Ships, the IMO International Convention for the Safety of Life at Sea of 1974, or SOLAS, the International Convention on Load Lines of 1966 and the U.S. Marine Transportation Security Act of 2002. In addition, vessel classification societies also impose significant safety and other requirements on our vessels. We believe our tankers, four of which were built in 2004 and two of which were built in 2001, are maintained in compliance with present regulatory and class requirements relevant to areas in which they operate, and are operated in compliance with applicable safety/environmental laws and regulations. However, regulation of tankers, particularly in the areas of safety and environmental impact may change in the future and require significant capital expenditures be incurred on our vessels to keep them in compliance. Although the Charterers will be responsible for all capital expenditures required due to changes in law, classification society or regulatory requirements in an amount less than $100,000 per year per vessel, all other required capital expenditures during the charter period will be split between us and the applicable Charterer based on the remaining charter period and the remaining depreciation period of the vessel (calculated as 25 years from the year built). The shipping industry has inherent operational risks, which may not be adequately covered by insurance Our tankers and their cargoes are at risk of being damaged or lost because of events such as marine disasters, bad weather, mechanical failures, human error, war, terrorism, piracy and other circumstances or events. In addition, transporting crude oil across a wide variety of international jurisdictions creates a risk of business interruptions due to political circumstances in foreign countries, hostilities, labor strikes Risk Factors and boycotts, the potential for changes in tax rates or policies, and the potential for government expropriation of our vessels. Any of these events may result in loss of revenues, increased costs and decreased cash flows to the Charterer, which could impair its ability to make payments to us under our Charters. In the event of a casualty to a vessel or other catastrophic event, we will rely on our insurance to pay the insured value of the vessel or the damages incurred. Under the management agreements, Northern Marine is responsible for obtaining insurance for our Fleet against those risks that we believe the shipping industry commonly insures against. These insurances include marine hull and machinery insurance, protection and indemnity insurance, which includes pollution risks and crew insurances and war risk insurance. Northern Marine has also agreed to obtain off hire insurance in respect of each of our vessels. Currently, the amount of coverage for liability for pollution, spillage and leakage available to us on commercially reasonable terms through protection and indemnity associations and providers of excess coverage is $1 billion per vessel per occurrence. We cannot assure you that we will be adequately insured against all risks. Under the ship management agreements, Northern Marine has agreed to perform all technical management, including crewing and providing insurance for a fixed management fee. However, we may not be able to obtain adequate insurance coverage at reasonable rates for our Fleet in the future in the event our existing Charters are not renewed at the expiration of their terms. Additionally, our insurers may refuse to pay particular claims. Any significant loss or liability for which we are not insured could have a material adverse effect on our financial condition. In addition, the loss of a vessel would adversely affect our cash flows and results of operations. Maritime claimants could arrest our tankers, which could interrupt the Charterers' or our cash flow Crew members, suppliers of goods and services to a vessel, shippers of cargo and other parties may be entitled to a maritime lien against that vessel for unsatisfied debts, claims or damages. In many jurisdictions, a maritime lien holder may enforce its lien by arresting a vessel through foreclosure proceedings. The arrest or attachment of one or more of our vessels could interrupt the Charterers' or our cash flow and require us to pay a significant amount of money to have the arrest lifted. In addition, in some jurisdictions, such as South Africa, under the "sister ship" theory of liability, a claimant may arrest both the vessel which is subject to the claimant's maritime lien and any "associated" vessel, which is any vessel owned or controlled by the same owner. Claimants could try to assert "sister ship" liability against one vessel in our Fleet for claims relating to another vessel in our Fleet. Governments could requisition our vessels during a period of war or emergency without adequate compensation The government of the United Kingdom, the country under which our Bermuda flagged vessels would fall, could requisition or seize our vessels. Under requisition for title, a government takes control of a vessel and becomes its owner. Under requisition for hire, a government takes control of a vessel and effectively becomes its charterer at dictated charter rates. Generally, requisitions occur during periods of war or emergency. Although we would be entitled to compensation in the event of a requisition, the amount and timing of payment would be uncertain. OFFERING SPECIFIC RISK FACTORS If we cannot complete the purchase of any vessel after the closing of this offering, our future earnings would be adversely affected Although we have agreed to purchase six tankers with the proceeds from this offering, it is possible that the sellers could breach their agreements or otherwise be unable to deliver all or some of the vessels or that the conditions to our purchase will not be satisfied. We will not close the purchase of any of the vessels before the closing of this offering. If we cannot complete the purchase of any vessel for any reason (other than by reason of the Charterers' default), the related Charter will be terminated and the applicable Charterer will have no obligation to pay charterhire with respect to that vessel. In the event we Risk Factors do not complete the purchase of any vessel, we will repay a proportional amount of the borrowings under our credit facility and we will make a cash distribution to our shareholders in an amount equal to a proportional amount of the net proceeds we receive in the offering less a proportional amount of the expenses we incur in connection with the offering and the transactions contemplated hereby through the date of such distribution. The failure to complete the purchase of any vessel would adversely effect our future earnings and the amounts available, if any, to pay distributions to our shareholders may be significantly reduced. If due to a loss of a vessel or the failure of a vessel to satisfy a delivery condition we purchase less than six vessels, our earnings, cash flow and results of operations will be adversely affected While we fully expect to be able to complete the purchase of the six vessels in our Fleet simultaneously with the closing of this offering, if due to the loss of a vessel or otherwise, including the failure of a vessel to satisfy a delivery condition, we do not complete the purchase of all six vessels, our earnings, cash flow and results of operations will be adversely affected. In such event, we intend to return to shareholders the portion of the net proceeds of this offering related to the purchase price of that vessel pursuant to a special dividend. Under Bermuda law, such a dividend would require the approval by shareholders of a resolution reducing our share premium account by the amount of the special dividend and transferring that amount to our contributed surplus account. We do not expect to complete the inspections of all of our vessels prior to delivery We intend to inspect each of our vessels and its records in connection with the acquisition of our Fleet. However, we do not expect to complete all of these inspections prior to the closing of this offering and our purchase of the vessels. As a result, we may discover at or prior to the time of delivery that a vessel does not satisfy its delivery condition. In the event we become aware of damage to a vessel prior to closing as a result of an inspection or otherwise (except in the case of the existing condition with respect to the Stena Concord described below) we may determine not to complete the purchase of that vessel. In such event, our earnings, cash flow and estimated dividends would be adversely affected. In the case of inspections completed following delivery, we may discover following our purchase that one or more of the vessels in our Fleet must be repaired. One of our vessels, the Stena Concord, currently has conditions of class from DnV due to hull bottom structural damage in the two forward-most ballast tanks. The conditions of class require that the damage be repaired within three months from the date of the original DnV inspection, which took place on October 5, 2004, provided that such time period can be extended. DnV has required as a part of these conditions that the vessel's staff inspect this damage monthly and report their findings to DnV, as well as arranging for quarterly inspections by DnV. All of our vessels, including the Stena Concord, are currently in service. Under our ship management agreements, Northern Marine is responsible for repairing any damage or class condition on our vessels as part of the services it provides for its fixed daily fee. See "Business — Ship Management Agreements." Our ship management agreements also provide for indemnification for Basic Hire in the event a vessel is offhire for circumstances specified under the Charters for more than five days during any twelve month period (net of amounts received by us from offhire insurance). Our Charters provide for the payment of Additional Hire if the vessel is offhire as a result of a class condition or recommendation determined by a ship's classification society discovered by us prior to delivery or during the inspection undertaken by us in connection with the purchase of the vessel (so long as such inspection is completed within 90 days of purchase) and such condition or recommendation cannot be remedied or complied with during a regularly scheduled drydocking without increasing the duration of such drydocking. There may not be an active market for our common shares, which may cause our common shares to trade at a discount and make it difficult to sell the common shares you purchase Prior to this offering, there has been no public market for our common shares. We cannot assure you that an active trading market for our common shares will develop or be sustained after this offering. The initial public offering price for our common shares will be determined by negotiations between the underwriters and us. We cannot assure you that the initial public offering price will correspond to the price at which our common shares will trade in the public market subsequent to this offering or that the price of our shares in the public market will reflect actual financial performance. Risk Factors Future sales of our common shares could cause the market price of our common shares to decline The market price of our common shares could decline due to sales of a large number of shares in the market after this offering, including sales of shares by our large shareholders, or the perception that these sales could occur. These sales or the perception that these sales could occur could also make it more difficult or impossible for us to sell equity securities in the future at a time and price that we deem appropriate. We have agreed to issue concurrently with the closing of this offering approximately 4,050,000 common shares, representing approximately 26.1% of our common shares to be outstanding following the completion of this offering, to subsidiaries of Concordia and Stena and to two companies owned by Stena and Fram to pay a portion of the purchase price of our vessels. Concordia will indirectly receive common shares representing approximately 17.2% of our outstanding common shares, Stena will indirectly receive common shares representing approximately 7.7% of our outstanding common shares and Fram will indirectly receive common shares representing approximately 1.2% of our outstanding common shares. Concordia, Stena and Fram will not become eligible to sell their shares until their lock-up agreements expire 270 days after the date of this prospectus. We have entered into registration rights agreements with them that entitle them to have all or a portion of their remaining shares registered for sale in the public market following the expiration of a 270 day period after the date of this prospectus. In addition, all of these shares could be sold into the public market after one year pursuant to Rule 144 under the Securities Act subject to certain volume limitations. You should read the discussion under the heading entitled "Shares Eligible for Future Sale" for further information concerning potential sales of our shares after this offering. You will incur immediate and substantial dilution We expect the initial public offering price per share of our common shares to be substantially higher than the pro forma net tangible book value per share of our outstanding common shares, after adjustments for our acquisition of our vessels after the closing of this offering. As a result, investors purchasing common shares in this offering at an assumed initial public offering price of $17.50 per share, which represents the mid-point of initial public offering price range, will incur immediate and substantial dilution in the net tangible book value of their common shares of approximately $7.65 per share. To the extent we raise additional capital by issuing equity securities in the future, you and our other shareholders may experience dilution and future investors may be granted rights superior to those of our current shareholders.
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+RISK FACTORS Investing in our common stock involves a high degree of risk. You should carefully consider the following risk factors, as well as the other information in this prospectus, before deciding whether to invest in shares of our common stock. If any of the following risks actually occurs, our business, financial condition and results of operations would suffer. In this case, the trading price of our common stock would likely decline and you might lose all or part of your investment in our common stock. The risks described below are not the only ones we face. Additional risks that we currently do not know about or that we currently believe to be immaterial may also impair our business operations. Risks Related to Our Business and Industry We are an early-stage company in an emerging market with an unproven business model, a new and unproven enterprise technology model and a short operating history, which makes it difficult to evaluate our current business and future prospects and may increase the risk of your investment. We have only a limited operating history and our current business and future prospects are difficult to evaluate. We were founded in February 1999 and began offering our on-demand CRM application service in February 2000. You must consider our business and prospects in light of the risks and difficulties we encounter as an early-stage company in the new and rapidly evolving market of on-demand CRM application services. These risks and difficulties include the following: our new and unproven business and technology models; a limited number of service offerings and risks associated with developing new service offerings; and the difficulties we face in managing rapid growth in personnel and operations. We may not be able to successfully address any of these risks or others, including the other risks related to our business and industry described below. Failure to adequately do so could seriously harm our business and cause our operating results to suffer. We have incurred significant operating losses in the past and may incur significant operating losses in the future. We incurred significant losses in each fiscal quarter from our inception in February 1999 through fiscal 2003 and we may incur significant operating losses in the future. Our business does not have an established record of profitability and we may not continue to be profitable. In addition, we expect our operating expenses to increase in the future as we expand our operations. If our revenue does not grow to offset these expected increased expenses, we will not continue to be profitable. You should not consider recent quarterly revenue growth as indicative of our future performance. In fact, in future quarters we may not have any revenue growth, and our revenue could decline. Furthermore, if our operating expenses exceed our expectations, our financial performance will be adversely affected. If we experience significant fluctuations in our operating results and rate of growth and fail to meet revenue and earnings expectations, our stock price may fall rapidly and without advance notice. Due to our limited operating history, our evolving business model and the unpredictability of our emerging industry, we may not be able to accurately forecast our rate of growth. For example, in the last two fiscal years, we have recorded quarterly operating income of as much as $4.3 million and quarterly operating losses of as much as $4.9 million. We base our current and future expense levels and our investment plans on estimates of future revenue and future rate of growth. Our expenses and investments are, to a large extent, fixed and we Marc Benioff Chairman and Chief Executive Officer salesforce.com, inc. The Landmark @ One Market, Suite 300 San Francisco, California 94105 (415) 901-7000 (Name, address, including zip code, and telephone number, including area code, of agent for service) Table of Contents expect that these expenses will increase in the future. We may not be able to adjust our spending quickly enough if our revenue falls short of our expectations. As a result, we expect that our operating results may fluctuate significantly on a quarterly basis. Revenue growth may not be sustainable and may decrease in the future. We believe that period-to-period comparisons of our operating results may not be meaningful, and you should not rely upon them as an indication of future performance. Interruptions or delays in service from our third-party Web hosting facility could impair the delivery of our service and harm our business. We provide our service through computer hardware that is currently located in a third-party Web hosting facility in Sunnyvale, California operated by Qwest Communications International Inc. We do not control the operation of this facility, and it is subject to damage or interruption from earthquakes, floods, fires, power loss, telecommunications failures and similar events. It is also subject to break-ins, sabotage, intentional acts of vandalism and similar misconduct. Despite precautions taken at the facility, the occurrence of a natural disaster, a decision to close the facility without adequate notice or other unanticipated problems at the facility could result in lengthy interruptions in our service. In addition, the failure by the Qwest facility to provide our required data communications capacity could result in interruptions in our service. We have an agreement with SunGard Data Systems, a provider of availability services, to provide access to a geographically remote disaster recovery facility that would provide us access to hardware, software and Internet connectivity in the event the Qwest facility becomes unavailable. Even with this disaster recovery arrangement, however, our service would be interrupted during the transition. We are in the process of obtaining additional rapid recovery services. However, we do not expect to have these services in place before December 2004 at the earliest. Any damage to, or failure of, our systems could result in interruptions in our service. Interruptions in our service may reduce our revenue, cause us to issue credits or pay penalties, cause customers to terminate their subscriptions and adversely affect our renewal rates. Our business will be harmed if our customers and potential customers believe our service is unreliable. If our security measures are breached and unauthorized access is obtained to a customer s data, our service may be perceived as not being secure and customers may curtail or stop using our service. Our service involves the storage and transmission of customers proprietary information, and security breaches could expose us to a risk of loss of this information, litigation and possible liability. If our security measures are breached as a result of third-party action, employee error, malfeasance or otherwise, and, as a result, someone obtains unauthorized access to one of our customers data, our reputation will be damaged, our business may suffer and we could incur significant liability. Because techniques used to obtain unauthorized access or to sabotage systems change frequently and generally are not recognized until launched against a target, we may be unable to anticipate these techniques or to implement adequate preventative measures. If an actual or perceived breach of our security occurs, the market perception of the effectiveness of our security measures could be harmed and we could lose sales and customers. If our on-demand application service is not widely accepted, our operating results will be harmed. Historically, we have derived substantially all of our revenue from subscriptions to our on-demand application service, and we expect this will continue for the foreseeable future. As a result, widespread acceptance of our service is critical to our future success. Factors that may affect market acceptance of our service include: potential reluctance by enterprises to migrate to an on-demand application service; the price and performance of our service; Revenues by geography: Americas 91 % 86 % 82 % 85 % 81 % Europe 7 10 12 11 13 Asia Pacific 2 4 6 4 Copies to: Gregory M. Gallo, Esq. Peter M. Astiz, Esq. David A. Hubb, Esq. Gray Cary Ware & Freidenrich LLP 2000 University Avenue East Palo Alto, CA 94303-2248 (650) 833-2000 David Schellhase, Esq. Vice President and General Counsel salesforce.com, inc. The Landmark @ One Market, Suite 300 San Francisco, CA 94105 (415) 901-7000 Gordon K. Davidson, Esq. Jeffrey R. Vetter, Esq. Fenwick & West LLP Silicon Valley Center 801 California Street Mountain View, CA 94041 (650) 988-8500 Table of Contents the level of customization we can offer; the availability, performance and price of competing products and services; and potential reluctance by enterprises to trust third parties to store and manage their internal data. Many of these factors are beyond our control. The inability of our service to achieve widespread market acceptance would harm our business. The market for our technology delivery model and on-demand application services is immature and volatile, and if it does not develop or develops more slowly than we expect, our business will be harmed. The market for on-demand application services is new and unproven, and it is uncertain whether these services will achieve and sustain high levels of demand and market acceptance. Our success will depend to a substantial extent on the willingness of enterprises, large and small, to increase their use of on-demand application services in general, and for CRM in particular. Many enterprises have invested substantial personnel and financial resources to integrate traditional enterprise software into their businesses, and therefore may be reluctant or unwilling to migrate to on-demand application services. Furthermore, some enterprises may be reluctant or unwilling to use on-demand application services because they have concerns regarding the risks associated with security capabilities, among other things, of the technology delivery model associated with these services. If enterprises do not perceive the benefits of on-demand application services, then the market for these services may not develop at all, or it may develop more slowly than we expect, either of which would significantly adversely affect our operating results. In addition, as a new company in this unproven market, we have limited insight into trends that may develop and affect our business. We may make errors in predicting and reacting to relevant business trends, which could harm our business. Because we recognize revenue from subscriptions for our service over the term of the subscription, downturns or upturns in sales may not be immediately reflected in our operating results. We recognize revenue from customers monthly over the terms of their subscription agreements, which are typically 12 to 24 months, although terms can range from one to 60 months. As a result, much of the revenue we report in each quarter is deferred revenue from subscription agreements entered into during previous quarters. Consequently, a decline in new or renewed subscriptions in any one quarter will not necessarily be fully reflected in the revenue in that quarter and will negatively affect our revenue in future quarters. In addition, we may be unable to adjust our cost structure to reflect these reduced revenues. Accordingly, the effect of significant downturns in sales and market acceptance of our service may not be fully reflected in our results of operations until future periods. Our subscription model also makes it difficult for us to rapidly increase our revenue through additional sales in any period, as revenue from new customers must be recognized over the applicable subscription term. We do not have an adequate history with our subscription model to predict the rate of customer subscription renewals and the impact these renewals will have on our revenue or operating results. Our customers have no obligation to renew their subscriptions for our service after the expiration of their initial subscription period and in fact, some customers have elected not to do so. In addition, our customers may renew for a lower priced edition of our service or for fewer users. We have limited historical data with respect to rates of customer subscription renewals, so we cannot accurately predict customer renewal rates. Our customers renewal rates may decline or fluctuate as a result of a number of factors, including their dissatisfaction with our service and their ability to continue their operations and spending levels. If our customers do not renew their subscriptions for our service, our revenue may decline and our business will suffer. Our future success also depends in part on our ability to sell additional features or enhanced editions of our service to our current customers. This may require increasingly sophisticated and costly sales efforts that are targeted at senior management. If these efforts are not successful, our business may suffer. Approximate date of commencement of proposed sale to the public: As soon as practicable after the Registration Statement becomes effective. Table of Contents We derive a significant portion of our revenue from small businesses, which have a greater rate of attrition and non-renewal than medium-sized and large enterprise customers. Our small business customers, which we consider to be companies with fewer than 200 employees, typically have shorter initial subscription periods and, based on our limited experience to date, have had a higher rate of attrition and non-renewal as compared to our medium-sized and large enterprise customers. We estimate that sales to small businesses were approximately 40 percent of our total revenues during fiscal 2004. If we cannot replace our small business customers that do not renew their subscriptions for our service with new customers quickly enough, our revenue could decline. Our limited operating history may impede acceptance of our service by medium-sized and large customers. Our ability to increase revenue and maintain profitability depends, in large part, on widespread acceptance of our service by medium-sized and large businesses. Our efforts to sell to these customers may not continue to be successful. In particular, because we are a relatively new company with a limited operating history, these target customers may have concerns regarding our viability and may prefer to purchase critical CRM applications from one of our larger, more established competitors. Even if we are able to sell our service to these types of customers, they may insist on additional assurances from us that we will be able to provide adequate levels of service, which could harm our business. The market for our service may be limited if prospective customers, particularly large customers, require customized features or functions that we do not currently intend to provide in our service or that would be difficult for individual customers to customize within our service. Prospective customers, especially large enterprise customers, may require heavily customized features and functions unique to their business processes. If prospective customers require customized features or functions that we do not offer, and that would be difficult for them to implement themselves, then the market for our service will be more limited and our business could suffer. As more of our sales efforts are targeted at larger enterprise customers, our sales cycle may become more time-consuming and expensive, potentially diverting resources and harming our business. As we target more of our sales efforts at larger enterprise customers, we will face greater costs, longer sales cycles and less predictability in completing some of our sales. In this market segment, the customer s decision to use our service may be an enterprise-wide decision and, if so, these types of sales would require us to provide greater levels of education to prospective customers regarding the use and benefits of our service. In addition, larger customers may demand more customization, integration services and features. As a result of these factors, these sales opportunities may require us to devote greater sales support and professional services resources to individual sales, driving up costs and time required to complete sales and diverting sales and professional services resources to a smaller number of larger transactions. The market in which we participate is intensely competitive, and if we do not compete effectively, our operating results could be harmed. The market for CRM applications is intensely competitive and rapidly changing, barriers to entry are relatively low, many of our competitors are larger and have more resources than we do, and with the introduction of new technologies and market entrants, we expect competition to intensify in the future. If we fail to compete effectively, our operating results will be harmed. Some of our principal competitors offer their products at a lower price, which has resulted in pricing pressures. If we are unable to maintain our current pricing, our operating results could be negatively impacted. In addition, pricing pressures and increased competition generally could result in reduced sales, reduced margins or the failure of our service to achieve or maintain more widespread market acceptance, any of which could harm our business. Convertible preferred stock, $0.001 par value; 63,738,843 shares authorized, 58,024,345 shares issued and outstanding, actual; 5,000,000 shares authorized, none issued and outstanding, pro forma and pro forma as adjusted $ 61,137 $ $ Stockholders equity (deficit): Common stock, $0.001 par value; 200,000,000 shares authorized, 33,232,535 shares issued and outstanding, actual; 400,000,000 shares authorized, 91,256,880 issued and outstanding, pro forma; and 400,000,000 shares authorized, 101,256,880 shares issued and outstanding, pro forma as adjusted 33 91 101 Additional paid-in capital 36,624 97,703 182,043 Deferred stock-based compensation (7,526 ) (7,526 ) (7,526 ) Notes receivables from stockholders (1,698 ) (1,698 ) (1,698 ) Accumulated other comprehensive income 8 8 Balances at April 30, 2004 (unaudited) 58,024,345 $ 61,137 33,232,535 $ 33 $ 36,624 $ (7,526 ) $ (1,698 ) $ If any of the securities being registered on this Form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act, check the following box. If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement number for the same offering. If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. If delivery of the Prospectus is expected to be made pursuant to Rule 434, check the following box. Table of Contents Our current principal competitors include: enterprise software application vendors including Amdocs Limited, E.piphany, Inc., IBM Corporation, Microsoft Corporation, Oracle Corporation, PeopleSoft, Inc., SAP AG and Siebel Systems, Inc.; packaged CRM software vendors, some of whom offer hosted services, such as BMC Software Corporation, FrontRange Solutions, Inc., Onyx Software Corp., Pivotal Corporation, which has been acquired by CDC Software Corporation, a subsidiary of chinadotcom corporation, and Sage Group plc; on-demand CRM application service providers such as NetSuite, Inc., RightNow Technologies, Inc. and Salesnet, Inc.; and enterprise application service providers including British Telecom, Corio, Inc. and IBM. In addition, we face competition from businesses that develop their own CRM applications internally, as well as from enterprise software vendors and online service providers who may develop and/or bundle CRM products with their products in the future. We also face competition from some of our larger and more established competitors who historically have been packaged CRM software vendors, but who are developing directly competitive on-demand CRM application services offerings, such as Siebel Systems through Siebel CRM OnDemand and through its acquisition of Upshot Corporation. Our professional services organization competes with a broad range of large systems integrators, including Accenture Ltd., BearingPoint, Inc. and IBM, as well as smaller independent consulting firms specializing in CRM implementations. We have relationships with many of these consulting companies and frequently work cooperatively on projects with them, even as we compete for business in other customer engagements. Many of our potential competitors enjoy substantial competitive advantages, such as greater name recognition, longer operating histories and larger marketing budgets, as well as substantially greater financial, technical and other resources. In addition, many of our potential competitors have established marketing relationships and access to larger customer bases, and have major distribution agreements with consultants, system integrators and resellers. As a result, our competitors may be able to respond more quickly and effectively than we can to new or changing opportunities, technologies, standards or customer requirements. Furthermore, because of these advantages, even if our service is more effective than the products that our competitors offer, potential customers might accept competitive products and services in lieu of purchasing our service. For all of these reasons, we may not be able to compete successfully against our current and future competitors. We may not be able to develop enhancements and new features to our existing service or acceptable new services that keep pace with technological developments. If we are unable to develop enhancements to and new features for our existing service or acceptable new services that keep pace with rapid technological developments, our business will be harmed. The success of enhancements, new features and services depends on several factors, including the timely completion, introduction and market acceptance of the feature or edition. Failure in this regard may significantly impair our revenue growth. In addition, because our service is designed to operate on a variety of network hardware and software platforms using a standard browser, we will need to continuously modify and enhance our service to keep pace with changes in Internet-related hardware, software, communication, browser and database technologies. We may not be successful in either developing these modifications and enhancements or in timely bringing them to market. Furthermore, uncertainties about the timing and nature of new network platforms or technologies, or modifications to existing platforms or technologies, could increase our research and development expenses. Any failure of our service to operate effectively with future network platforms and technologies could reduce the demand for our service, result in customer dissatisfaction and harm our business. The Registrant hereby amends this Registration Statement on such date or dates as may be necessary to delay its effective date until the Registrant shall file a further amendment which specifically states that this Registration Statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933, as amended, or until the Registration Statement shall become effective on such date as the Commission, acting pursuant to said Section 8(a), may determine. Table of Contents Any efforts we may make in the future to expand our service beyond the CRM market may not succeed. To date, we have focused our business on providing on-demand application services for the CRM market, but we may in the future seek to expand into other markets. However, any efforts to expand beyond the CRM market may never result in significant revenue growth for us. In addition, efforts to expand our on-demand application service beyond the CRM market may divert management resources from existing operations and require us to commit significant financial resources to an unproven business, which may harm our business. If we fail to develop our brand cost-effectively, our business may suffer. We believe that developing and maintaining awareness of the salesforce.com brand in a cost-effective manner is critical to achieving widespread acceptance of our existing and future services and is an important element in attracting new customers. Furthermore, we believe that the importance of brand recognition will increase as competition in our market develops. Successful promotion of our brand will depend largely on the effectiveness of our marketing efforts and on our ability to provide reliable and useful services at competitive prices. In the past, our efforts to build our brand have involved significant expense. Brand promotion activities may not yield increased revenue, and even if they do, any increased revenue may not offset the expenses we incurred in building our brand. If we fail to successfully promote and maintain our brand, or incur substantial expenses in an unsuccessful attempt to promote and maintain our brand, we may fail to attract enough new customers or retain our existing customers to the extent necessary to realize a sufficient return on our brand-building efforts, and our business could suffer. Any failure to adequately expand our direct sales force will impede our growth. We expect to be substantially dependent on our direct sales force to obtain new customers, particularly large enterprise customers, and to manage our customer base. We believe that there is significant competition for direct sales personnel with the advanced sales skills and technical knowledge we need. Our ability to achieve significant growth in revenue in the future will depend, in large part, on our success in recruiting, training and retaining sufficient direct sales personnel. New hires require significant training and may, in some cases, take more than a year before they achieve full productivity. Our recent hires and planned hires may not become as productive as we would like, and we may be unable to hire sufficient numbers of qualified individuals in the future in the markets where we do business. If we are unable to hire and develop sufficient numbers of productive sales personnel, sales of our service will suffer. Sales to customers outside the United States expose us to risks inherent in international sales. Because we sell our service throughout the world, we are subject to risks and challenges that we would otherwise not face if we conducted our business only in the United States. For example, sales in Europe and Asia Pacific represented approximately 14 percent and 18 percent of our total revenues in fiscal 2003 and fiscal 2004, respectively, and 19 percent of our total revenues for the three months ended April 30, 2004, and we intend to expand our international sales efforts. The risks and challenges associated with sales to customers outside the United States include: localization of our service, including translation into foreign languages and associated expenses; laws and business practices favoring local competitors; compliance with multiple, conflicting and changing governmental laws and regulations, including employment, tax, privacy and data protection laws and regulations; foreign currency fluctuations; different pricing environments; difficulties in staffing and managing foreign operations; Net (decrease) increase in cash and cash equivalents (10,332 ) (3,310 ) 1,736 (3,778 ) (4,901 ) Effect of exchange rate changes on cash and cash equivalents (159 ) 310 18 Table of Contents longer accounts receivable payment cycles and other collection difficulties; and regional economic and political conditions. Some of our international subscription fees are currently denominated in U.S. dollars and paid in local currency. As a result, fluctuations in the value of the U.S. dollar and foreign currencies may make the service more expensive for international customers, which could harm our business. We do not currently engage in currency hedging activities to limit the risk of exchange rate fluctuation. Defects in our service could diminish demand for our service and subject us to substantial liability. Because our service is complex, it may have errors or defects that users identify after they begin using it, which could harm our reputation and our business. Internet-based services frequently contain undetected errors when first introduced or when new versions or enhancements are released. We have from time to time found defects in our service and new errors in our existing service may be detected in the future. Since our customers use our service for important aspects of their business, any errors, defects or other performance problems with our service could hurt our reputation and may damage our customers businesses. If that occurs, customers could elect not to renew, or delay or withhold payment to us, we could lose future sales or customers may make warranty claims against us, which could result in an increase in our provision for doubtful accounts, an increase in collection cycles for accounts receivable or the expense and risk of litigation. Any failure to protect our intellectual property rights could impair our ability to protect our proprietary technology and our brand. If we fail to protect our intellectual property rights adequately, our competitors might gain access to our technology, and our business might be harmed. In addition, defending our intellectual property rights might entail significant expense. Any of our trademarks or other intellectual property rights may be challenged by others or invalidated through administrative process or litigation. We currently have no issued patents and may be unable to obtain patent protection in the future. In addition, if any patents are issued in the future, they may not provide us with any competitive advantages, or may be challenged by third parties. Furthermore, legal standards relating to the validity, enforceability and scope of protection of intellectual property rights are uncertain. Effective patent, trademark, copyright and trade secret protection may not be available to us in every country in which our service is available. The laws of some foreign countries may not be as protective of intellectual property rights as those in the United States, and mechanisms for enforcement of intellectual property rights may be inadequate. Accordingly, despite our efforts, we may be unable to prevent third parties from infringing upon or misappropriating our intellectual property. We might be required to spend significant resources to monitor and protect our intellectual property rights. We may initiate claims or litigation against third parties for infringement of our proprietary rights or to establish the validity of our proprietary rights. Any litigation, whether or not it is resolved in our favor, could result in significant expense to us and divert the efforts of our technical and management personnel. We may be sued by third parties for alleged infringement of their proprietary rights. The software and Internet industries are characterized by the existence of a large number of patents, trademarks and copyrights and by frequent litigation based on allegations of infringement or other violations of intellectual property rights. As the number of entrants into our market increases, the possibility of an intellectual property claim against us grows. Our technologies may not be able to withstand any third-party claims or rights against their use. Any intellectual property claims, with or without merit, could be time-consuming and expensive to litigate or settle, and could divert management attention from executing our business plan. In addition, many of our subscription agreements require us to indemnify our customers for third-party intellectual property infringement claims, which would increase the cost to us of an adverse ruling in such a claim. An adverse determination could also prevent us from offering our service to others. Revenues: Subscription and support 96 % 93 % 89 % 89 % 89 % Professional services and other 4 7 11 11 (unaudited) Revenues: Subscription and support 94 % 95 % 91 % 94 % 89 % 91 % 88 % 89 % 89 % Professional services and other 6 5 9 6 11 9 12 11 Table of Contents The information in this prospectus is not complete and may be changed. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell these securities and we are not soliciting offers to buy these securities in any jurisdiction where the offer or sale is not permitted. PROSPECTUS (Subject to Completion) Issued June 22, 2004 10,000,000 Shares COMMON STOCK Table of Contents We rely on third-party hardware and software that may be difficult to replace or which could cause errors or failures of our service. We rely on hardware purchased or leased and software licensed from third parties in order to offer our service, including database software from Oracle Corporation. This hardware and software may not continue to be available on commercially reasonable terms, or at all. Any loss of the right to use any of this hardware or software could result in delays in the provisioning of our service until equivalent technology is either developed by us, or, if available, is identified, obtained and integrated, which could harm our business. Any errors or defects in third-party hardware or software could result in errors or a failure of our service which could harm our business. We may be required to purchase the interest in our Japanese joint venture held by our joint venture partner, under certain circumstances, on terms that may not be favorable to us. In some circumstances, we may be required to purchase the interest of our Japanese joint venture partner. If we default under the terms of our joint venture agreement with our joint venture partner, or if we and our partner disagree over a course of action proposed for the joint venture entity and the disagreement continues, then our partner may require that we purchase its interest in the joint venture. In the event we are required to purchase our partner s interest in the joint venture, we could be forced to make an unanticipated outlay of a significant amount of capital, which could harm our operating results. Although the timing and circumstances of any such purchase, were it to be required, are not predictable, if the joint venture were valued based on its most recent financing, which occurred in September 2003, the buyout price could be as much as approximately $13.0 million. If we acquire any companies or technologies in the future, they could prove difficult to integrate, disrupt our business, dilute stockholder value and adversely affect our operating results. We may acquire or make investments in complementary companies, services and technologies in the future. We have not made any acquisitions or investments to date, and therefore our ability as an organization to make acquisitions or investments is unproven. Acquisitions and investments involve numerous risks, including: difficulties in integrating operations, technologies, services and personnel; diversion of financial and managerial resources from existing operations; risk of entering new markets; potential write-offs of acquired assets; potential loss of key employees; inability to generate sufficient revenue to offset acquisition or investment costs; and delays in customer purchases due to uncertainty. In addition, if we finance acquisitions by issuing convertible debt or equity securities, our existing stockholders may be diluted which could affect the market price of our stock. As a result, if we fail to properly evaluate and execute acquisitions or investments, our business and prospects may be seriously harmed. Evolving regulation of the Internet may affect us adversely. As Internet commerce continues to evolve, increasing regulation by federal, state or foreign agencies becomes more likely. For example, we believe increased regulation is likely in the area of data privacy, and laws and regulations applying to the solicitation, collection, processing or use of personal or consumer information could affect our customers ability to use and share data, potentially reducing demand for CRM solutions and Cost of revenues: Subscription and support 17 14 8 8 6 Professional services and other 10 6 10 10 Cost of revenues: Subscription and support 16 12 17 12 8 8 8 7 6 Professional services and other 3 6 6 9 10 10 10 11 Salesforce.com, inc. is offering shares of its common stock. This is our initial public offering and no public market currently exists for our shares. We anticipate that the initial public offering price will be between $9 and $10 per share. Table of Contents restricting our ability to store, process and share data with our customers. In addition, taxation of services provided over the Internet or other charges imposed by government agencies or by private organizations for accessing the Internet may also be imposed. Any regulation imposing greater fees for Internet use or restricting information exchange over the Internet could result in a decline in the use of the Internet and the viability of Internet-based services, which could harm our business. The success of our business depends on the continued growth and acceptance of the Internet as a business tool. Expansion in the sales of our service depends on the continued acceptance of the Internet as a communications and commerce platform for enterprises. The Internet could lose its viability as a business tool due to delays in the development or adoption of new standards and protocols to handle increased demands of Internet activity, security, reliability, cost, ease-of-use, accessibility and quality-of-service. The performance of the Internet and its acceptance as a business tool has been harmed by viruses, worms and similar malicious programs, and the Internet has experienced a variety of outages and other delays as a result of damage to portions of its infrastructure. If for any reason the Internet does not remain a widespread communications medium and commercial platform, the demand for our service would be significantly reduced, which would harm our business. Our growth could strain our personnel and infrastructure resources, and if we are unable to implement appropriate controls and procedures to manage our growth, we may not be able to successfully implement our business plan. We are currently experiencing a period of rapid growth in our headcount and operations, which has placed, and will continue to place, a significant strain on our management, administrative, operational and financial infrastructure. We anticipate that further growth will be required to address increases in our customer base, as well as our expansion into new geographic areas. Our success will depend in part upon the ability of our senior management to manage this growth effectively. To do so, we must continue to hire, train and manage new employees as needed. If our new hires perform poorly, or if we are unsuccessful in hiring, training, managing and integrating these new employees, or if we are not successful in retaining our existing employees, our business may be harmed. To manage the expected growth of our operations and personnel, we will need to continue to improve our operational, financial and management controls and our reporting systems and procedures. The additional headcount and capital investments we are adding will increase our cost base, which will make it more difficult for us to offset any future revenue shortfalls by offsetting expense reductions in the short term. If we fail to successfully manage our growth, we will be unable to execute our business plan. We are dependent on our management team, and the loss of any key member of this team may prevent us from implementing our business plan in a timely manner. Our success depends largely upon the continued services of our executive officers and other key personnel, particularly Marc Benioff, our Chief Executive Officer and Chairman of the Board. We are also substantially dependent on the continued service of our existing development personnel because of the complexity of our service and technologies. We do not have employment agreements with any of our executive officers, key management or development personnel that require them to remain our employees and, therefore, they could terminate their employment with us at any time without penalty. We do not maintain key person life insurance policies on any of our employees. The loss of one or more of our key employees could seriously harm our business. Our common stock has been approved for listing on the New York Stock Exchange under the symbol CRM. Table of Contents Because competition for our target employees is intense, we may not be able to attract and retain the highly skilled employees we need to support our planned growth. To execute our growth plan, we must attract and retain highly qualified personnel. Competition for these personnel is intense, especially for engineers with high levels of experience in designing and developing software and Internet-related services and senior sales executives. We may not be successful in attracting and retaining qualified personnel. We have from time to time in the past experienced, and we expect to continue to experience in the future, difficulty in hiring and retaining highly skilled employees with appropriate qualifications. Many of the companies with which we compete for experienced personnel have greater resources than we have. In addition, in making employment decisions, particularly in the Internet and high-technology industries, job candidates often consider the value of the stock options they are to receive in connection with their employment. Significant volatility in the price of our stock after this offering may, therefore, adversely affect our ability to attract or retain key employees. Furthermore, proposed changes to accounting principles generally accepted in the United States relating to the expensing of stock options may discourage us from granting the size or type of stock options awards that job candidates require to join our company. If we fail to attract new personnel or fail to retain and motivate our current personnel, our business and future growth prospects could be severely harmed. We might require additional capital to support business growth, and this capital might not be available. We intend to continue to make investments to support our business growth and may require additional funds to respond to business challenges, including the need to develop new services or enhance our existing service, enhance our operating infrastructure and acquire complementary businesses and technologies. Accordingly, we may need to engage in equity or debt financings to secure additional funds. If we raise additional funds through further issuances of equity or convertible debt securities, our existing stockholders could suffer significant dilution, and any new equity securities we issue could have rights, preferences and privileges superior to those of holders of our common stock, including shares of common stock sold in this offering. Any debt financing secured by us in the future could involve restrictive covenants relating to our capital raising activities and other financial and operational matters, which may make it more difficult for us to obtain additional capital and to pursue business opportunities, including potential acquisitions. In addition, we may not be able to obtain additional financing on terms favorable to us, if at all. If we are unable to obtain adequate financing or financing on terms satisfactory to us, when we require it, our ability to continue to support our business growth and to respond to business challenges could be significantly limited. Our reported financial results may be adversely affected by changes in accounting principles generally accepted in the United States. Generally accepted accounting principles in the United States are subject to interpretation by the Financial Accounting Standards Board, or FASB, the American Institute of Certified Public Accountants, the Securities and Exchange Commission, or SEC, and various bodies formed to promulgate and interpret appropriate accounting principles. A change in these principles or interpretations could have a significant effect on our reported financial results, and could affect the reporting of transactions completed before the announcement of a change. For example, we currently are not required to record stock-based compensation charges if the employee s stock option exercise price is equal to or exceeds the deemed fair value of our common stock at the date of grant. However, several companies have recently elected to change their accounting policies and begun to record the fair value of stock options as an expense. Although the standards have not been finalized and the timing of a final statement has not been established, FASB has announced its support for recording expense for the fair value of stock options granted. If we were required to change our accounting policy in accordance with Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation and SFAS No. 148. Accounting for Stock-Based Compensation Transition and Disclosure, and retroactively restate prior periods as if we had adopted these standards for all periods presented, then our cost of revenues and operating expenses would have increased by approximately $1.7 million for fiscal 2003, $4.1 million for fiscal 2004 and $2.0 million for the three months ended April 30, 2004. Investing in our common stock involves risks. See Risk Factors beginning on page 5. Table of Contents Risks Related to this Offering If our involvement in a lengthy May 9th New York Times article about salesforce.com or any other publicity regarding salesforce.com or the offering during the waiting period were held to be gun jumping in violation of the Securities Act of 1933, we could be required to repurchase securities sold in this offering. You should only rely on statements made in this prospectus in determining whether to purchase our shares. In a New York Times article dated May 9, 2004 and entitled It s Not Google. It s That Other Big I.P.O., information regarding this offering and salesforce.com was published. The New York Times article included quotes from Marc Benioff, our Chairman of the Board and Chief Executive Officer, regarding the development of salesforce.com and its business strategy. In preparation of the article, the reporter was allowed to spend most of a full day with Mr. Benioff. As a result, it could have been expected that a lengthy article would be published. Portions of this New York Times article were subsequently reprinted by a number of news outlets. While some of the factual statements about salesforce.com in the article are disclosed in this prospectus, the article presented statements about our company in isolation and did not disclose many of the related risks and uncertainties described in this prospectus. In addition to the New York Times article, there has been substantial additional press coverage regarding us and this offering during the offering process. These articles also presented statements about our company in isolation and did not disclose many of the related risks and uncertainties described in this prospectus. You should carefully evaluate all the information in this prospectus, including the risks described in this section and throughout the prospectus. We have in the past received, and may continue to receive, a high degree of media coverage, including coverage that is not directly attributable to statements made by our officers and employees. You should only rely on the information contained in this prospectus in making your investment decision. In order to reduce the risk of investors possible reliance on the New York Times article and other news reports and articles, we stopped our offering on May 13, 2004. We then allowed a cooling off period to pass so that the effect of this article and other reports, articles and information would be dissipated. It is uncertain whether our involvement in the May 9th New York Times article or any of our other publicity related activities could be held to be a violation of Section 5 of the Securities Act of 1933. If our involvement or such activities were held by a court to be in violation of the Securities Act, we could be required to repurchase the shares sold to purchasers in this offering at the original purchase price for a period of one year following the date of the violation. We would contest vigorously any claim that a violation of the Securities Act occurred. The trading price of our common stock is likely to be volatile, and you might not be able to sell your shares at or above the initial public offering price. The trading prices of the securities of technology companies have been highly volatile. Accordingly, the trading price of our common stock is likely to be subject to wide fluctuations. Further, our common stock has no prior trading history. Factors affecting the trading price of our common stock will include: variations in our operating results; announcements of technological innovations, new services or service enhancements, strategic alliances or significant agreements by us or by our competitors; PRICE $ A SHARE Table of Contents recruitment or departure of key personnel; changes in the estimates of our operating results or changes in recommendations by any securities analysts that elect to follow our common stock; and market conditions in our industry, the industries of our customers and the economy as a whole. In addition, if the market for technology stocks or the stock market in general experiences continued or greater loss of investor confidence, the trading price of our common stock could decline for reasons unrelated to our business, operating results or financial condition. The trading price of our common stock might also decline in reaction to events that affect other companies in our industry even if these events do not directly affect us. If securities analysts do not publish research or reports about our business or if they downgrade our stock, the price of our stock could decline. The trading market for our common stock will rely in part on the research and reports that industry or financial analysts publish about us or our business. We do not control these analysts. There are many large, well- established publicly traded companies active in our industry and market, which may mean it will be less likely that we receive widespread analyst coverage. Furthermore, if one or more of the analysts who do cover us downgrade our stock, our stock price would likely decline rapidly. If one or more of these analysts cease coverage of our company, we could lose visibility in the market, which in turn could cause our stock price to decline. Future sales of shares by existing stockholders could cause our stock price to decline. If our existing stockholders sell, or indicate an intention to sell, substantial amounts of our common stock in the public market after the 180-day contractual lock-up and other legal restrictions on resale discussed in this prospectus lapse, the trading price of our common stock could decline below the initial public offering price. Based on shares outstanding as of April 30, 2004, upon completion of this offering, we will have outstanding 101,256,880 shares of common stock, assuming no exercise of the underwriters over-allotment option. Of these shares, only the 10,000,000 shares of common stock sold in this offering will be freely tradable, without restriction, in the public market. Morgan Stanley & Co. Incorporated may, in its sole discretion, permit our officers, directors, employees and current stockholders who are subject to the 180-day contractual lock-up to sell shares prior to the expiration of the lock-up agreements. After the lock-up agreements pertaining to this offering expire 180 days from the date of this prospectus, up to an additional 91,256,880 shares will be eligible for sale in the public market, 55,516,612 of which are held by directors, executive officers and other affiliates and will be subject to volume limitations under Rule 144 under the Securities Act and various vesting agreements. In addition, the 1,299,496 shares subject to outstanding warrants and the 23,115,865 shares that are either subject to outstanding options or reserved for future issuance under our 1999 Stock Option Plan, 2004 Equity Incentive Plan, 2004 Outside Directors Stock Plan and 2004 Employee Stock Purchase Plan will become eligible for sale in the public market to the extent permitted by the provisions of various vesting agreements, the lock-up agreements and Rules 144 and 701 under the Securities Act of 1933, as amended, or the Securities Act. If these additional shares are sold, or if it is perceived that they will be sold, in the public market, the trading price of our common stock could decline. The concentration of our capital stock ownership with insiders upon the completion of this offering will likely limit your ability to influence corporate matters. We anticipate that our executive officers, directors, current 5 percent or greater stockholders and affiliated entities will together beneficially own approximately 54.8 percent of our common stock outstanding after this offering. As a result, these stockholders, acting together, will have control over most matters that require approval by our stockholders, including the election of directors and approval of significant corporate (Loss) income before minority interest (5,452 ) (31,864 ) (29,034 ) (10,008 ) 3,698 352 454 Minority interest in consolidated joint venture 193 425 292 (184 ) (Loss) income before minority interest (29,034 ) (10,008 ) 3,698 352 454 Minority interest in consolidated joint venture 425 292 (184 ) (Loss) income before minority interest (1,605 ) (1,203 ) (4,896 ) (2,304 ) 352 127 3,902 (683 ) 454 Minority interest in consolidated joint venture 43 77 55 117 (Loss) income before minority interest (29,034 ) (10,008 ) 3,698 352 454 Minority interest in consolidated joint venture 425 292 (184 ) Price to Public Table of Contents transactions. Corporate action might be taken even if other stockholders, including those who purchase shares in this offering, oppose them. This concentration of ownership might also have the effect of delaying or preventing a change of control of our company that other stockholders may view as beneficial. Our management will have broad discretion over the use of the proceeds to us from this offering and might not apply the proceeds of this offering in ways that increase the value of your investment. Our management will have broad discretion to use the net proceeds from this offering, and you will be relying on the judgment of our management regarding the application of these proceeds. They might not apply the net proceeds of this offering in ways that increase the value of your investment. We expect to use the net proceeds from this offering for general corporate purposes, including working capital and capital expenditures, and for possible investments in, or acquisitions of, complementary services or technologies. We have not allocated these net proceeds for any specific purposes. Our management might not be able to yield a significant return, if any, on any investment of these net proceeds. You will experience immediate and substantial dilution in the net tangible book value of the shares you purchase in this offering. The initial public offering price of our common stock will be substantially higher than the book value per share of the outstanding common stock after this offering. Therefore, based on an assumed offering price of $9.50 per share, if you purchase our common stock in this offering, you will suffer immediate and substantial dilution of approximately $8.50 per share. If the underwriters exercise their over-allotment option, or if outstanding options and warrants to purchase our common stock are exercised, you will experience additional dilution. Provisions in our amended and restated certificate of incorporation and bylaws or Delaware law might discourage, delay or prevent a change of control of our company or changes in our management and, therefore, depress the trading price of our common stock. Our amended and restated certificate of incorporation and bylaws contain provisions that could depress the trading price of our common stock by acting to discourage, delay or prevent a change in control of our company or changes in our management that the stockholders of our company may deem advantageous. These provisions: establish a classified board of directors so that not all members of our board are elected at one time; provide that directors may only be removed for cause and only with the approval of 66 2/3 percent of our stockholders; require super-majority voting to amend some provisions in our amended and restated certificate of incorporation and bylaws; authorize the issuance of blank check preferred stock that our board could issue to increase the number of outstanding shares and to discourage a takeover attempt; limit the ability of our stockholders to call special meetings of stockholders; prohibit stockholder action by written consent, which requires all stockholder actions to be taken at a meeting of our stockholders; provide that the board of directors is expressly authorized to make, alter or repeal our bylaws; and establish advance notice requirements for nominations for election to our board or for proposing matters that can be acted upon by stockholders at stockholder meetings. In addition, Section 203 of the Delaware General Corporation Law may discourage, delay or prevent a change in control of our company. Underwriting Discounts and Commissions For investors outside the United States: Neither we nor any of the underwriters have done anything that would permit this offering or possession or distribution of this prospectus in any jurisdiction where action for that purpose is required, other than in the United States. You are required to inform yourselves about and to observe any restrictions relating to this offering and the distribution of this prospectus. Total cost of revenues 27 20 18 18 Total cost of revenues 19 18 23 21 18 18 18 18 Proceeds to salesforce.com Table of Contents USE OF PROCEEDS We estimate that our net proceeds from the sale of the shares in this offering will be approximately $84.4 million, after deducting estimated underwriting discounts and commissions and estimated offering expenses payable by us. If the underwriters exercise their over-allotment option in full, we estimate that our net proceeds will be approximately $97.6 million. The principal purposes of this offering are to obtain additional capital, to create a public market for our common stock and to facilitate our future access to the public equity markets. We anticipate that we will use the net proceeds for general corporate purposes, including working capital and capital expenditures, but we have not designated any specific uses. We may also use a portion of the net proceeds to fund possible investments in, or acquisitions of, complementary businesses, services or technologies. We have no current agreements or commitments with respect to any investment or acquisition, and we currently are not engaged in negotiations with respect to any investment or acquisition. In addition, the amount and timing of what we actually spend for these purposes may vary significantly and will depend on a number of factors, including our future revenue and cash generated by operations and the other factors described in Risk Factors. Accordingly, our management will have broad discretion in applying the net proceeds of this offering. Pending these uses, we intend to invest the net proceeds in high quality, investment grade, short-term fixed income instruments which include corporate, financial institution, federal agency or U.S. government obligations. DIVIDEND POLICY We have never paid any cash dividends on our common stock. Our board of directors currently intends to retain any future earnings to support operations and to finance the growth and development of our business and does not intend to pay cash dividends on our common stock for the foreseeable future. Any future determination related to our dividend policy will be made at the discretion of the board. Per Share $ $ $ Total $ $ $ We have granted the underwriters the right to purchase up to an additional 1,500,000 shares of common stock to cover over-allotments. The Securities and Exchange Commission and state securities regulators have not approved or disapproved these securities, or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense. Morgan Stanley & Co. Incorporated expects to deliver the shares to purchasers on , 2004. The number of shares shown as issued and outstanding in the table above excludes: 16,422,047 shares of common stock issuable upon the exercise of options outstanding as of April 30, 2004 with exercise prices ranging from $0.03 to $8.00 per share and a weighted average exercise price of $3.22 per share; 4,000,000 shares of common stock to be available for issuance under our 2004 Equity Incentive Plan, 1,000,000 shares of common stock to be available for issuance under our 2004 Outside Directors Stock Plan and 1,000,000 shares of common stock to be available for issuance under our 2004 Employee Stock Purchase Plan; however, the 2004 Employee Stock Purchase Plan will not be implemented unless and until our board of directors authorizes the commencement of one or more offerings under this plan; 1,299,496 shares of common stock issuable upon the exercise of warrants outstanding as of April 30, 2004 with exercise prices ranging from $1.10 to $3.89 per share and a weighted average exercise price of $2.43 per share; and 693,818 shares of common stock reserved for future grants under our 1999 Stock Option Plan as of April 30, 2004. Total operating expenses 5,564 35,613 45,887 51,128 75,032 15,541 28,115 (Loss) income from operations (5,564 ) (33,600 ) (29,525 ) (10,500 ) 3,718 17 361 Interest income 121 1,715 755 471 379 78 144 Interest expense (3 ) (42 ) (272 ) (77 ) (22 ) (9 ) (1 ) Other income (expense) (6 ) 63 8 98 164 315 Total operating expenses 45,887 51,128 75,032 15,541 28,115 (Loss) income from operations (29,525 ) (10,500 ) 3,718 17 361 Interest income 755 471 379 78 144 Interest expense (272 ) (77 ) (22 ) (9 ) (1 ) Other income 8 98 164 315 Total operating expenses 9,242 11,117 15,853 14,916 15,541 17,661 16,455 25,375 28,115 (Loss) income from operations (1,634 ) (1,386 ) (4,873 ) (2,607 ) 17 134 4,311 (744 ) 361 Interest income 114 142 129 86 78 91 89 121 144 Interest expense (25 ) (26 ) (15 ) (11 ) (9 ) (6 ) (5 ) (2 ) (1 ) Other income (expense) (60 ) 67 (137 ) 228 315 (70 ) (38 ) (43 ) Liabilities, convertible preferred stock, and stockholders (deficit) equity Current liabilities: Accounts payable $ 606 $ 2,035 $ 1,782 Accrued expenses and other current liabilities 8,487 17,682 18,648 Income taxes payable 534 560 Deferred revenue 19,171 49,677 52,340 Current portion of capital lease obligations 531 78 Total operating expenses 45,887 51,128 75,032 15,541 28,115 (Loss) income from operations (29,525 ) (10,500 ) 3,718 17 361 Interest income 755 471 379 78 144 Interest expense (272 ) (77 ) (22 ) (9 ) (1 ) Other income 8 98 164 315 MORGAN STANLEY DEUTSCHE BANK SECURITIES UBS INVESTMENT BANK WACHOVIA SECURITIES WILLIAM BLAIR & COMPANY , 2004 Table of Contents Table of Contents The number of shares to be outstanding immediately after the offering is based on 91,256,880 shares of common stock outstanding as of April 30, 2004, which assumes the conversion of all of our outstanding shares of convertible preferred stock into 58,024,345 shares of common stock, and excludes: 16,422,047 shares of common stock issuable upon the exercise of options outstanding as of April 30, 2004, with exercise prices ranging from $0.03 to $8.00 per share and a weighted average exercise price of $3.22 per share; 4,000,000 shares of common stock to be available for issuance under our 2004 Equity Incentive Plan, 1,000,000 shares of common stock to be available for issuance under our 2004 Outside Directors Stock Plan and 1,000,000 shares of common stock to be available for issuance under our 2004 Employee Stock Purchase Plan; however, the 2004 Employee Stock Purchase Plan will not be implemented unless and until our board of directors authorizes the commencement of one or more offerings under this plan; 1,299,496 shares of common stock issuable upon the exercise of warrants outstanding as of April 30, 2004, with exercise prices ranging from $1.10 to $3.89 per share and a weighted average exercise price of $2.43 per share; and 693,818 shares of common stock reserved for future grants under our 1999 Stock Option Plan as of April 30, 2004. Table of Contents TABLE OF CONTENTS Page Net (loss) income per share: Basic $ (0.55 ) $ (2.38 ) $ (1.36 ) $ (0.37 ) $ 0.12 $ 0.01 $ 0.01 Diluted (0.55 ) (2.38 ) (1.36 ) (0.37 ) 0.04 0.00 0.00 Weighted-average shares used in computing per share amounts: Basic (2) 10,000 13,314 21,039 26,375 29,605 28,660 31,688 Diluted (2) 10,000 13,314 21,039 26,375 95,409 91,618 100,398 (2) For information regarding the computation of per share amounts, refer to note 1 of the notes to our consolidated financial statements. Table of Contents MANAGEMENT S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes that appear in this prospectus. In addition to historical consolidated financial information, the following discussion contains forward-looking statements that reflect our plans, estimates and beliefs. Our actual results could differ materially from those discussed in the forward-looking statements. Factors that could cause or contribute to these differences include those discussed below and elsewhere in this prospectus, particularly in Risk Factors. Overview We are the leading provider, based on market share, of application services that allow organizations to easily share customer information on demand, according to a March 2004 report by Forrester Research, Inc. We provide a comprehensive CRM service to businesses of all sizes and industries worldwide. We were founded in February 1999 and began offering our on-demand CRM application service in February 2000. Our revenues have grown from $5.4 million in fiscal 2001 to $96.0 million in fiscal 2004. Our objective is to be the leading provider of on-demand application services for businesses worldwide. To address our market opportunity, our management team is focused on a number of short and long-term challenges, including strengthening and extending our service offerings, adding new customers and expanding our sales efforts into new territories, deepening our relationships with our existing customers and encouraging the development of third-party applications on our platform. In order to increase our revenues and take advantage of our market opportunity, we will need to add substantial numbers of paying subscriptions. We define paying subscriptions as unique user accounts, purchased by customers for use by their employees and other customer-authorized users, that have not been suspended for non-payment. The number of our paying subscribers increased from approximately 30,000 as of February 1, 2001 to over 147,000 as of April 30, 2004. We plan to re-invest our revenues for the foreseeable future in the following ways: hiring additional personnel, particularly in marketing and sales; expanding our domestic and international selling and marketing activities; increasing our research and development activities to upgrade and extend our service offerings and to develop new services and technologies; expanding the number of locations around the world where we conduct business; adding to our infrastructure to support our growth; and expanding our operational and financial systems to manage a growing business. We expect marketing and sales costs, which were 66 percent of our fiscal 2003 total revenues, 57 percent of our fiscal 2004 total revenues and 59 percent of our total revenues for the three months ended April 30, 2004, to continue to represent a substantial portion of total revenues in the future as we seek to add and manage more paying subscribers, build brand awareness and increase the number of marketing events that we sponsor. Fiscal Year Our fiscal year ends on January 31. References to fiscal 2004, for example, refer to the fiscal year ended January 31, 2004. Sources of Revenues We derive our revenues from two sources: (1) subscription revenues, which are comprised of subscription fees from customers accessing our on-demand application service, and from customers purchasing additional support beyond the standard support that is included in the basic subscription fee; and (2) related professional You should rely only on the information contained in this prospectus. We have not authorized anyone to provide you with information different from that contained in this prospectus. We are offering to sell, and seeking offers to buy, shares of our common stock only in jurisdictions where offers and sales are permitted. The information contained in this prospectus is accurate only as of the date of this prospectus, regardless of the time of delivery of this prospectus or any sale of our common stock. Until , 2004 (25 days after the commencement of this offering), all dealers that buy, sell or trade shares of our common stock, whether or not participating in this offering, may be required to deliver a prospectus. This delivery requirement is in addition to the obligation of dealers to deliver a prospectus when acting as underwriters and with respect to their unsold allotments or subscriptions. Table of Contents services and other revenues, consisting primarily of training fees. Subscription and support revenues accounted for more than 90 percent of our total revenues in fiscal 2002 and 2003, and 89 percent of our total revenues during fiscal 2004 and the three months ended April 30, 2004. Subscription revenues are driven primarily by the number of paying subscribers of our service and the subscription price of our service. None of our customers accounted for more than 5 percent of our revenues in any fiscal year. Subscription and support revenues are recognized on a monthly basis over the life of the contract. The typical subscription and support term is 12 to 24 months, although terms range from one to 60 months. Our subscription and support contracts are noncancelable, though customers typically have the right to terminate their contracts for cause if we fail to perform. We generally invoice our customers in annual or quarterly installments and typical payment terms provide that our customers pay us within 30 days of invoice. Amounts that have been invoiced are recorded in accounts receivable and in deferred revenue, or in revenue depending on whether the revenue recognition criteria have been met. In general, we collect our billings in advance of the subscription service period. We market our on-demand application service primarily through direct sales efforts and also indirectly through partners. We offer our customers three principal editions of our on-demand application service: Enterprise Edition, which is our most fully-featured offering and which is targeted at large companies that have several different divisions or departments; Professional Edition, which is targeted at medium-sized and large businesses that need a robust CRM solution but do not need some of the more advanced features and integration capabilities of Enterprise Edition; and Team Edition, which is targeted primarily at small businesses that seek a robust sales force automation solution without the more sophisticated features of our other editions. Professional services and other revenues consist of fees associated with consulting and implementation services and training. Our consulting and implementation engagements are typically billed on a time and materials basis. We also offer a number of classes on implementing, using and administering our service that are billed on a per person, per class basis. Our typical payment terms provide that our customers pay us within 30 days of invoice. Cost of Revenues and Operating Expenses Cost of Revenues. Cost of subscription and support revenues primarily consists of expenses related to hosting our service and providing support, depreciation expense associated with computer equipment, costs associated with website development activities, allocated overhead and amortization expense associated with capitalized software. To date, the expense associated with capitalized software has not been material to our cost of revenues. We allocate overhead such as rent and occupancy charges, employee benefit costs and depreciation expense to all departments based on headcount. As such, general overhead expenses are reflected in each cost of revenue and operating expense category. Cost of professional services and other revenues consists primarily of employee-related costs associated with these services and allocated overhead. The cost associated with providing professional services is significantly higher as a percentage of revenue than for our on-demand subscription service due to the labor costs associated with providing consulting services. To the extent that our customer base grows, we intend to continue to invest additional resources in our on-demand application service and in our consulting services. The timing of these additional expenses could affect our cost of revenues, both in terms of absolute dollars and as a percentage of revenues, in a particular quarterly period. For example, we plan to increase the number of employees who are fully dedicated to consulting services. We also plan to enter into an agreement with a third-party Web hosting provider during fiscal 2005 that will provide additional disaster recovery services in the event our primary data center becomes unavailable. We currently expect the annual cost of these services to be less than $2.0 million. Table of Contents Research and Development. Research and development expenses consist primarily of salaries and related expenses, and allocated overhead. We have historically focused our research and development efforts on increasing the functionality and enhancing the ease of use of our on-demand application service. Because of our proprietary, scalable and secure multi-tenant architecture, we are able to provide all of our customers with a service based on a single version of our application. As a result, we do not have to maintain multiple versions, which enables us to have relatively low research and development expenses as compared to traditional enterprise software business models. We expect that in the future, research and development expenses will increase in absolute dollars as we upgrade and extend our service offerings and develop new technologies. Marketing and Sales. Marketing and sales expenses are our largest cost, accounting for 66 percent of our fiscal 2003 total revenues, 57 percent of our fiscal 2004 total revenues and 59 percent of our total revenues for the three months ended April 30, 2004. Marketing and sales expenses consist primarily of salaries and related expenses for our sales and marketing staff, including commissions, payments to partners, marketing programs, which include advertising, events, corporate communications, and other brand building and product marketing expenses, and allocated overhead. As a result of the initial launch of our application service in February 2000, marketing costs, particularly advertising, accounted for 62 percent of fiscal 2001 and 47 percent of fiscal 2002 total marketing and sales expenses. Since the beginning of fiscal 2003, our sales costs as a percentage of total marketing and sales expenses have increased as a result of lower advertising expenditures. As our revenues increase, we plan to continue to invest heavily in marketing and sales by increasing the number of direct sales personnel in order to add new customers and increase penetration within our existing customer base, expanding our domestic and international selling and marketing activities, building brand awareness and sponsoring additional marketing events. We expect that in the future, marketing and sales expenses will increase in absolute dollars and continue to be our largest cost. General and Administrative. General and administrative expenses consist of salaries and related expenses for executive, finance and accounting, and management information systems personnel, professional fees, other corporate expenses and allocated overhead. We expect that in the future, general and administrative expenses will increase in absolute dollars as we add personnel and incur additional professional fees and insurance costs related to the growth of our business and to our operations as a public company. We expect that general and administrative expenses associated with executive compensation will increase in the future. In February 2004, we added a President of Technology, Marketing and Systems, Patricia Sueltz, to our executive team, and we may add other executives if our business continues to grow. Her annual base salary is $400,000 and she is eligible to receive a quarterly bonus of up to $50,000, based upon achievement of a mix of company and individual performance objectives. During the first twelve months of her employment, her bonus is guaranteed. In addition, we have paid our Chief Executive Officer one dollar per year in annual compensation, rising to ten dollars in fiscal 2005. At this time, it is not probable that there will be any increase in his compensation. However, if his compensation increases in the future or he leaves our employ and we need to recruit a new Chief Executive Officer, our executive compensation expenses will increase. Lease Abandonment and Recovery. In December 2001, we abandoned excess office space in San Francisco, California and recorded a $7.7 million charge in the fourth quarter of fiscal 2002 pertaining to the estimated future obligations under the non-cancelable lease. In August 2003, we entered into an agreement releasing us from future obligations for some of the abandoned space in connection with the landlord s lease of this space to another tenant. Accordingly, we recorded a $4.3 million credit in the third quarter of fiscal 2004 to reflect the reversal of the remaining accrued liability that was directly associated with this space. During the fourth quarter of fiscal 2004, we recorded an additional accrual of $900,000 related to the remaining 5,000 square feet of abandoned excess office space in San Francisco. This additional accrual resulted from a revision of our estimates of the timing and amount of projected subtenant income based on difficulties in subleasing the remaining space. Table of Contents Stock-Based Expenses. Our cost of revenues and operating expenses include stock-based expenses related to options and warrants issued to non-employees and option grants to employees in situations where the exercise price was less than the deemed fair value of our common stock at the date of grant. These charges have been significant and are reflected in the historical financial results. Joint Venture In December 2000, we established a Japanese joint venture, Kabushiki Kaisha salesforce.com, with SunBridge, Inc., a Japanese corporation, to assist us with our sales efforts in Japan. As of April 30, 2004, we owned a 64 percent interest in the joint venture. Because of this majority interest, we consolidate the venture s financial results, which are reflected in each revenue, cost of revenues and expense category in our consolidated statement of operations. We then record minority interest, which reflects the minority investors interest in the venture s results. Through April 30, 2004, the operating performance and liquidity requirements of the Japanese joint venture had not been significant. While we plan to expand our selling and marketing activities in Japan in order to add new customers, we believe the future operating performance and liquidity requirements of the Japanese joint venture will not be significant. Critical Accounting Policies Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States. The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, costs and expenses, and related disclosures. On an ongoing basis, we evaluate our estimates and assumptions. Our actual results may differ from these estimates under different assumptions or conditions. We believe that of our significant accounting policies, which are described in note 1 of the notes to our consolidated financial statements, the following accounting policies involve a greater degree of judgment and complexity. Accordingly, these are the policies we believe are the most critical to aid in fully understanding and evaluating our consolidated financial condition and results of operations. Revenue Recognition. We recognize revenue in accordance with SEC Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements, as amended by Staff Accounting Bulletin No. 104, Revenue Recognition. On August 1, 2003, we adopted Emerging Issues Task Force, or EITF, Issue No. 00-21, Revenue Arrangements with Multiple Deliverables. We recognize revenue when all of the following conditions are satisfied: (1) there is persuasive evidence of an arrangement; (2) the service has been provided to the customer; (3) the collection of our fees is probable; and (4) the amount of fees to be paid by the customer is fixed or determinable. We recognize revenues from subscription contracts each month over the lives of the contracts. Support revenues from customers who purchase our premium support offerings are recognized ratably over the term of the support contract. Consulting services and training revenues are accounted for separately from subscription and support revenues because these services have value to the customer on a standalone basis and there is objective and reliable evidence of their fair value of the undelivered elements. Our arrangements do not contain general rights of return. Consulting revenues are recognized upon completion of the contracts that are of short duration (generally less than 60 days) and as the services are rendered for contracts of longer duration. Training revenues are recognized after the services are performed. Table of Contents Accounting for Deferred Commissions. We defer commission payments to our direct sales force. The commissions are deferred and amortized to sales expense over the noncancelable terms of the related subscription contracts with our customers, which are typically 12 to 24 months. The commission payments, which are paid in full the month after the customer s service commences, are a direct and incremental cost of the revenue arrangements. The deferred commission amounts are recoverable through the future revenue streams under the noncancelable customer contracts. We believe this is the preferable method of accounting as the commission charges are so closely related to the revenue from the noncancelable customer contracts that they should be recorded as an asset and charged to expense over the same period that the subscription revenue is recognized. Fiscal years 2002, 2003 and 2004 and the three months ended April 30, 2004, have been prepared using the same basis of accounting for sales commissions. During fiscal 2002, we deferred $870,000 of commission expenditures and we amortized $241,000 to sales expense. During fiscal 2003, we deferred $5.7 million of commission expenditures and we amortized $2.9 million to sales expense. During fiscal 2004, we deferred $16.3 million of commission expenditures and we amortized $8.6 million to sales expense. During the three months ended April 30, 2004, we deferred $2.3 million of commission expenditures and we amortized $3.6 million to sales expense. Deferred commissions on our consolidated balance sheet totaled $11.2 million at January 31, 2004 and $9.9 million at April 30, 2004. Accounting for Stock-Based Awards. We record deferred stock-based compensation charges in the amount by which the exercise price of an option is less than the deemed fair value of our common stock at the date of grant. Because there has been no public market for our stock, our board of directors has determined the fair value of our common stock based upon several factors, including, but not limited to, our operating and financial performance, private sales of our common and preferred stock between third parties, issuances of convertible preferred stock and appraisals performed by an appraisal firm. We amortize the deferred compensation charges ratably over the four-year vesting period of the underlying option awards. As of January 31, 2004, we had an aggregate of $8.3 million of deferred stock-based compensation remaining to be amortized. We currently expect this deferred stock-based compensation balance to be amortized as follows: $3.2 million during fiscal 2005; $2.9 million during fiscal 2006; $1.9 million during fiscal 2007; and $300,000 during fiscal 2008. We have elected not to record stock-based compensation expense when employee stock options are awarded at exercise prices equal to the deemed fair value of our common stock at the date of grant. The impact of expensing employee stock awards using the Black-Scholes option-pricing model is further described in note 1 of the notes to our consolidated financial statements. In the past, we have awarded a limited number of stock options and warrants to non-employees. For these options and warrants, we recognize the stock-based compensation expense over the vesting periods of the underlying awards, based on an estimate of their fair value on the vesting dates using the Black-Scholes option-pricing model. As of April 30, 2004, we had recognized compensation expense on all options and warrants issued to non-employees except for options for 55,000 shares of our common stock, substantially all of which will fully vest by July 2007 and which have a weighted average exercise price of $2.50 per share. Table of Contents SUMMARY CONSOLIDATED FINANCIAL DATA The following tables provide summary consolidated financial data and should be read in conjunction with Management s Discussion and Analysis of Financial Condition and Results of Operations and our consolidated financial statements and related notes appearing elsewhere in this prospectus. Fiscal Year Ended January 31, (unaudited) (in thousands) Cash flow provided by (used in) operating activities $ (13,166 ) $ 5,213 $ 21,781 $ 4,761 $ 6,659 Three Months Ended April 30, Overview of Results of Operations for the Three Months Ended April 30, 2004 Revenues during the three months ended April 30, 2004 were $34.8 million, an increase of 84 percent over the comparable period a year ago. The total number of paying subscribers increased to approximately 147,000 as of April 30, 2004 from approximately 85,000 as of April 30, 2003. Our gross profit during the three months ended April 30, 2004 was $28.5 million, or 82 percent of revenues, and operating income was $400,000. Operating income included non-cash stock-based expense of $900,000. During the comparable period a year ago, we generated a gross profit of $15.6 million, or 82 percent of revenues, and operating income was $17,000. Operating income during the three months ended April 30, 2003 included $1.1 million of non-cash stock-based expense. During the three months ended April 30, 2004, we continued to incur substantial costs and operating expenses related to the expansion of our business. We added sales personnel to focus on adding new customers and increasing penetration within our existing customer base, professional services personnel to support our consulting services, and developers to broaden and enhance our on-demand service. During the three months ended April 30, 2004, we generated $6.7 million of cash from operating activities, as compared to $4.8 million during the comparable period a year ago. At April 30, 2004, we had cash, cash equivalents and short-term marketable securities of $43.7 million, as compared to $20.3 million at April 30, 2003, accounts receivable of $24.5 million, as compared to $12.1 million at April 30, 2003, and deferred revenue of $52.3 million, as compared to $24.3 million at April 30, 2003. Three Months Ended April 30, 2004 and 2003 Revenues. Total revenues were $34.8 million for the three months ended April 30, 2004, compared to $18.9 million during the same period a year ago, an increase of $15.9 million, or 84 percent. Subscription and support revenues were $31.1 million, or 89 percent of total revenues, for the three months ended April 30, 2004, compared to $16.9 million, or 89 percent of total revenues, during the same period a year ago. The increase in subscription and support revenues was due primarily to the increase in the number of paying subscribers to approximately 147,000 as of April 30, 2004 from approximately 85,000 as of April 30, 2003. Professional services and other revenues were $3.7 million, or 11 percent of total revenues, for the three months ended April 30, 2004, compared to $2.0 million, or 11 percent of total revenues, for the same period a year ago. The increase in professional services and other revenues was due primarily to the higher demand for services from an increased number of paying subscribers and customers. Table of Contents Revenues in Europe and Asia Pacific accounted for $6.5 million, or 19 percent of total revenues, during the three months ended April 30, 2004, compared to $2.9 million, or 15 percent of total revenues, during the same period a year ago, an increase of $3.6 million, or 124 percent. The increase in revenues outside of the Americas was the result of our efforts to expand the number of locations around the world where we conduct business and our international selling and marketing activities. Cost of Revenues. Cost of revenues was $6.4 million, or 18 percent of total revenues, during the three months ended April 30, 2004, compared to $3.4 million, or 18 percent of total revenues, during the same period a year ago, an increase of $3.0 million. The increase was primarily comprised of an increase of $2.3 million in employee-related costs, substantially all of which was due to the 66 percent increase in the headcount of our professional services organization, an increase of $300,000 in service delivery costs and an increase of $300,000 in allocated expenses. The cost of the additional professional services headcount resulted in cost of professional services and other revenues to be in excess of the related revenue during the three months ended April 30, 2004. We increased the professional services headcount in order to meet the anticipated demand for our consulting and training services as our customer base has expanded. Research and Development. Research and development expenses were $2.1 million, or 6 percent of total revenues, during the three months ended April 30, 2004, compared to $1.2 million, or 7 percent of total revenues, during the same period a year ago, an increase of $900,000. The increase was primarily comprised of an increase of $600,000 in employee-related costs. Our research and development headcount increased by 55 percent from the same period a year ago as we added personnel to upgrade and extend our service offerings. Marketing and Sales. Marketing and sales expenses were $20.4 million, or 59 percent of total revenues, during the three months ended April 30, 2004, compared to $10.7 million, or 56 percent of total revenues, during the same period a year ago, an increase of $9.7 million. The increase was primarily due to an increase of $8.1 million in employee-related costs, an increase of $600,000 in marketing spending related to new service offerings and an increase of $700,000 in allocated overhead. Of the $8.1 million increase in employee-related costs, $2.1 million was related to the increased amortization expense of deferred commissions. Our marketing and sales headcount increased by 65 percent from the same period a year ago as we hired additional sales personnel to focus on adding new customers and increasing penetration within our existing customer base. General and Administrative. General and administrative expenses were $5.6 million, or 16 percent of total revenues, during the three months ended April 30, 2004, compared to $3.6 million, or 19 percent of total revenues, during the same period a year ago, an increase of $2.0 million. The increase was primarily due to an increase of $700,000 in employee-related costs and an increase of $1.3 million in professional and outside service costs. Our general and administrative headcount increased by 31 percent from the same period a year ago as we added personnel to support our growth. Operating Income. Operating income during the three months ended April 30, 2004 was $400,000. During the same period a year ago, it was $17,000. The increase was primarily due to the increase in revenues, most of which was re-invested in an effort to expand our business. Loss from operations outside of the Americas was $100,000 during the three months ended April 30, 2004 and was $700,000 during the same period a year ago. The continued losses outside of the Americas were due to our efforts in expanding the number of locations where we conduct business and expanding our international selling and marketing activities. Interest Income. Interest income was $100,000 during the three months ended April 30, 2004 and 2003. Interest Expense. Interest expense consists of interest on our capital lease obligations. Operating expenses: Research and development 24 9 7 7 6 Marketing and sales 110 66 57 56 59 General and administrative 37 26 18 19 16 Lease abandonment (recovery) Table of Contents Other Income (Expense). Other income was $20,000 during the three months ended April 30, 2004, compared to other income of $300,000 during the same period a year ago. The decrease was due to the reduction in realized gains on foreign currency transactions. Provision for Income Taxes. We recorded a provision for income tax expense of $100,000 for the three months ended April 30, 2004. This provision for income taxes consists of amounts accrued for our estimated fiscal 2005 domestic federal and state income tax liability as well as an estimate of our foreign income tax expense. This provision is based upon our estimated fiscal 2005 income before the provision for income taxes and takes into consideration the utilization of our net operating loss carryforwards. To the extent our estimate of fiscal 2005 income before the provision for income taxes changes, our provision for income taxes will change as well and may take into consideration the utilization of our valuation allowance recorded against our deferred tax assets. With the exception of fiscal 2004, we have not recorded a provision for income tax expense because we had been generating net losses. Furthermore, we have not recorded an income tax benefit for fiscal 2002 and 2003 primarily due to continued substantial uncertainty regarding our ability to realize our deferred tax assets. Based upon available objective evidence, there has been sufficient uncertainty regarding the ability to realize our deferred tax assets, which warrants a full valuation allowance in our financial statements. Based on our estimates for fiscal 2005 and beyond, we believe the uncertainty regarding the ability to realize our deferred tax assets may diminish to the point where deferred tax assets may be realized. If we were to determine that we would be able to realize our deferred tax assets in the future in excess of our net recorded amount, an adjustment to the deferred tax asset would increase our income or reduce our loss and increase stockholders equity in the quarter when such determination is made. Minority Interest in Consolidated Joint Venture. The minority interest expense was $17,000 during the three months ended April 30, 2004 compared to minority interest income of $16,000 during the same period a year ago. Overview of Results of Operations for the Fiscal Year Ended January 31, 2004 Revenues during fiscal 2004 were $96.0 million, an increase of 88 percent over fiscal 2003. Gross profit during this period was $78.8 million, or 82 percent of total revenues, and operating income was $3.7 million. Operating income included non-cash income of $3.4 million related to the net reduction in accruals associated with office space that we had abandoned in fiscal 2002. Operating income also included non-cash stock-based expense of $4.4 million. During fiscal 2003, we generated gross profit of $40.6 million, or 80 percent of revenues, and incurred an operating loss of $10.5 million. The operating loss during fiscal 2003 included $4.8 million of non-cash stock-based expense. The increase in revenues was primarily due to increases in the number of subscription customers, international expansion and expansion of our consulting services and training offerings. During fiscal 2004, we continued to invest in our operations and increase revenues. We added sales personnel to focus on adding new customers and increasing penetration within our existing customer base, professional services personnel to support our consulting services and developers to broaden and enhance our on-demand service. With the increase in personnel and international expansion efforts, we also added office space under various operating leases. In addition, we incurred costs associated with corporate governance and regulatory compliance, such as required by the Sarbanes-Oxley Act of 2002. We intend to continue to invest heavily in marketing and sales in order to pursue new customers and expand relationships with existing customers. We also plan to expand our infrastructure, including additional geographically remote disaster recovery services provided by a third-party Web hosting service provider in fiscal 2005, and to continue to invest in research and development activities to upgrade and extend our service offerings. Table of Contents During fiscal 2004, we generated $21.8 million of cash from operating activities, as compared to $5.2 million of cash from operating activities during fiscal 2003. At January 31, 2004, we had cash, cash equivalents and short-term marketable securities of $35.8 million, accounts receivable of $26.5 million and deferred revenue of $49.7 million. Fiscal Years Ended January 31, 2004 and 2003 Revenues. Total revenues were $96.0 million for fiscal 2004, compared to $51.0 million during fiscal 2003, an increase of $45.0 million, or 88 percent. Subscription and support revenues were $85.8 million, or 89 percent of total revenues, for fiscal 2004, compared to $47.7 million, or 93 percent of total revenues, for fiscal 2003. The increase in subscription and support revenues was due primarily to the increase in the number of paying subscribers to approximately 127,000 as of January 31, 2004 from approximately 76,000 as of January 31, 2003. Professional services and other revenues were $10.2 million, or 11 percent of total revenues, for fiscal 2004, compared to $3.3 million, or 7 percent of total revenues, for fiscal 2003. The increase in professional service and other revenues was due primarily to the higher demand for services from an increasing number of paying subscribers and customers. Revenues in Europe and Asia Pacific accounted for $17.1 million, or 18 percent of total revenues, during fiscal 2004, compared to $7.1 million, or 14 percent of total revenues, during fiscal 2003, an increase of $10.0 million, or 141 percent. The increase in revenues outside of the Americas was the result of our efforts to expand the number of locations around the world where we conduct business and the expansion of our international selling and marketing activities. Cost of Revenues. Cost of revenues was $17.3 million, or 18 percent of total revenues, during fiscal 2004, compared to $10.4 million, or 20 percent of total revenues, during fiscal 2003, an increase of $6.9 million. The increase was primarily due to an increase of $5.4 million in employee-related costs, substantially all of which was due to the 53 percent increase in the headcount of our professional services organization, and an increase of $700,000 in service delivery costs. We increased the professional services headcount in order to meet the higher demand for our consulting and training services as our customer base has expanded. The increase in our gross margin was the result of our ability to leverage our existing infrastructure to serve new customers and paying subscribers. Research and Development. Research and development expenses were $7.0 million, or 7 percent of total revenues, during fiscal 2004, compared to $4.6 million, or 9 percent of total revenues, during fiscal 2003, an increase of $2.4 million. The increase was primarily due to an increase of $1.8 million in employee-related costs. Our research and development headcount increased by 57 percent from fiscal 2003 as we added personnel to upgrade and extend our service offerings. Marketing and Sales. Marketing and sales expenses were $54.6 million, or 57 percent of total revenues, during fiscal 2004, compared to $33.5 million, or 66 percent of total revenues, during fiscal 2003, an increase of $21.1 million. The increase was primarily due to an increase of $18.0 million in employee-related costs, $1.0 million in increased marketing event costs, $800,000 in payments to partners, and $700,000 in allocated overhead. Of the $18.0 million in increased employee-related costs, $6.6 million was related to sales commissions. Our marketing and sales headcount increased by 42 percent from fiscal 2003 as we hired additional sales personnel to focus on adding new customers and increasing penetration within our existing customer base. General and Administrative. General and administrative expenses were $16.9 million, or 18 percent of total revenues, during fiscal 2004, compared to $13.0 million, or 26 percent of total revenues, during fiscal 2003, an increase of $3.9 million. The increase was primarily due to an increase of $3.0 million in employee-related costs and an increase of $900,000 in professional and outside service costs. Our general and administrative headcount increased by 29 percent from fiscal 2003 as we added personnel to support our growth. Table of Contents Lease Recovery. In December 2001, we abandoned excess office space in San Francisco, California and recorded a $7.7 million charge in the fourth quarter of fiscal 2002 pertaining to the estimated future net obligations under the non-cancelable lease. Since the space was not leased to a subtenant, there were no immediate cash savings from the abandonment. In August 2003, we entered into an agreement, releasing us from future obligations for some of the space abandoned, in connection with the landlord s lease of this space to another tenant. Accordingly, we recorded a $4.3 million credit to reflect the reversal of the remaining accrued liability that was directly associated with this space. During the fourth quarter of fiscal 2004, we recorded an additional accrual of $900,000 related to the remaining 5,000 square feet of abandoned office space in San Francisco. This additional accrual resulted from a revision of our estimates of the timing and amount of projected subtenant income based on difficulties in subleasing the remaining space. Operating Income (Loss). Operating income during fiscal 2004 was $3.7 million and included the $3.4 million lease recovery described above. The operating loss during fiscal 2003 was $10.5 million. The increase in operating income was primarily due to a $45.0 million increase in revenues, most of which was re-invested in an effort to expand our business. Loss from operations outside of the Americas was $1.1 million during fiscal 2004 and was $3.8 million during fiscal 2003. The continued losses outside of the Americas were due to our efforts in expanding the number of locations where we conduct business and expanding our international selling and marketing activities. Interest Income. Interest income consists of investment income on cash and marketable securities balances and interest income on outstanding loans made to individuals who early exercised their stock options. Interest income was $400,000 during fiscal 2004, compared to $500,000 during fiscal 2003, a decrease of $100,000. The decrease was primarily due to declining interest rates and the mix of marketable securities investments, substantially offset by higher cash and marketable securities balances. Interest Expense. Interest expense consists of interest on our capital lease obligations. Other Income. Other income was $200,000 during fiscal 2004, compared to other income of $100,000 during fiscal 2003. The increase of $100,000 was due to realized gains on foreign currency transactions. Provision for Income Taxes. The provision for income taxes of $500,000 during fiscal 2004 represented federal alternative minimum taxes of $200,000, and various state income taxes and foreign withholding taxes of $300,000. Our deferred tax asset balance at January 31, 2004 was $19.7 million and was fully offset by a valuation allowance of the same amount due to uncertainties regarding realization of the deferred tax asset balance. While we have considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance, in the event we were to determine that we would be able to realize our deferred tax assets in the future in excess of our net recorded amount, an adjustment to the deferred tax asset would increase our net income or reduce our net loss and increase stockholders equity in the quarter when such determination is made. Minority Interest in Consolidated Joint Venture. The minority interest expense was $200,000 during fiscal 2004 compared to minority interest income of $300,000 during fiscal 2003. (unaudited) (in thousands, except per share data) Consolidated Statement of Operations Data: Revenues $ 22,409 $ 50,991 $ 96,023 $ 18,913 $ 34,839 (Loss) income from operations (1) (29,525 ) (10,500 ) 3,718 17 361 Net (loss) income (1) (28,609 ) (9,716 ) 3,514 368 437 Net (loss) income per share: Basic $ (1.36 ) $ (0.37 ) $ 0.12 $ 0.01 $ 0.01 Diluted (1.36 ) (0.37 ) 0.04 0.00 0.00 Weighted-average shares used in computing per share amounts: Basic (2) 21,039 26,375 29,605 28,660 31,688 Diluted (2) 21,039 26,375 95,409 91,618 100,398 Table of Contents Fiscal Years Ended January 31, 2003 and 2002 Revenues. Total revenues were $51.0 million in fiscal 2003 compared to $22.4 million in fiscal 2002, an increase of $28.6 million, or 128 percent. Subscription and support revenues were $47.7 million, or 93 percent of total revenues, in fiscal 2003, compared to $21.5 million, or 96 percent of total revenues, during fiscal 2002. The increase in subscription and support revenues was due primarily to the increase in the number of paying subscribers to approximately 76,000 as of January 31, 2003 from approximately 53,000 as of January 31, 2002. During fiscal 2003, we began offering consulting services. The growth in the number of paying subscribers and customers increased demand for our consulting, support and training services. Professional services and other revenues were $3.3 million, or 7 percent of total revenues in fiscal 2003, compared to $900,000, or 4 percent of total revenues, in fiscal 2002. Revenues in Europe and Asia Pacific accounted for $7.1 million, or 14 percent of total revenues, in fiscal 2003, compared to $2.1 million, or 9 percent of total revenues, in fiscal 2002, an increase of $5.0 million, or 238 percent. The increase in revenues outside of the Americas was the result of our efforts to expand the number of locations around the world where we conduct business and the expansion of our international selling and marketing activities. Cost of Revenues. Cost of revenues was $10.4 million, or 20 percent of total revenues, in fiscal 2003, compared to $6.0 million, or 27 percent of total revenues, in fiscal 2002, an increase of $4.4 million. The increase was primarily due to an increase of $2.2 million in employee-related costs, $1.9 million of which resulted from the hiring of employees for our consulting services, and increases of $1.2 million in service delivery costs, $400,000 in allocated overhead and $300,000 in depreciation and amortization expense. We increased the professional services headcount in order to provide the increased number of customers with consulting services and training that were complementary to their subscription service. Research and Development. Research and development expenses were $4.6 million, or 9 percent of total revenues, in fiscal 2003, compared to $5.3 million, or 24 percent of total revenues, in fiscal 2002, a decrease of $700,000. The decrease was primarily due to reductions of $200,000 in employee-related costs and $200,000 in allocated overhead because of a lower proportion of research and development headcount to our total headcount and an increase of $200,000 in the capitalization of development costs. Marketing and Sales. Marketing and sales expenses were $33.5 million, or 66 percent of total revenues, in fiscal 2003, compared to $24.6 million, or 110 percent of total revenues, in fiscal 2002, an increase of $8.9 million. The increase was primarily due to an increase of $10.3 million in employee-related costs and commission expense and an increase of $200,000 in allocated overhead, offset in part by $2.4 million of lower advertising spending. Our marketing and sales headcount increased by 160 percent from the same period a year ago as we hired additional sales personnel to focus on adding new customers and increasing the number of paying subscribers within our existing customer base. General and Administrative. General and administrative expenses were $13.0 million, or 26 percent of total revenues, in fiscal 2003, compared to $8.3 million, or 37 percent of total revenues, in fiscal 2002, an increase of $4.7 million. The increase was due primarily to an increase of $1.9 million in employee-related costs, $1.2 million in increased professional and outside service costs and $400,000 in depreciation expense. Our general and administrative headcount increased by 158 percent from the same period a year ago as we added personnel to support our growth. Operating Loss. The operating loss during fiscal 2003 was $10.5 million and the operating loss during fiscal 2002 was $29.5 million, of which $7.7 million was attributable to the abandonment of leased office space. The smaller operating loss during fiscal 2003 was primarily due to a $28.6 million increase in revenues, most of which was re-invested in an effort to expand our business. Loss from operations outside of the Americas was $3.8 million during fiscal 2003 and was $3.3 million during fiscal 2002. The continued losses outside of the Americas were due to expanding the number of locations where we conduct business and expanding our international selling and marketing activities. (1) Loss from operations and net loss for fiscal 2002 include a $7.7 million non-cash charge for office space that we abandoned in fiscal 2002. Income from operations and net income for fiscal 2004 include non-cash income of $3.4 million associated with the net reduction in accruals associated with the office space that we abandoned. (2) For information regarding the computation of per share amounts, refer to note 1 of the notes to our consolidated financial statements. As of April 30, 2004 Actual Revenues increased sequentially in each of the quarters presented, due to increases in the number of subscription customers, international expansion and the expansion of our consulting services and training offerings. The 106 percent increase in professional services and other revenues for the quarter ended October 31, 2002 over the preceding quarter reflected the formal introduction of our consulting services operation over the second and third quarters of fiscal 2003 and continued growth in the size of our customer base. Gross profit in absolute dollars also generally increased sequentially for the quarters presented due primarily to revenue growth. As a percentage of total revenues, gross profits remained constant at 82 percent during the five most recent quarters presented. The $800,000 increase in cost of subscription and support revenues for the quarter ended October 31, 2002 over the preceding quarter was primarily due to investments made to improve the delivery of our on-demand service. The $300,000 decrease in cost of subscription and support revenues for the quarter ended April 30, 2003 over the preceding quarter was primarily the result of our ability to leverage our infrastructure to serve new customers and paying subscribers. The $900,000 increase in cost of professional services and other for the quarter ended April 30, 2004 over the preceding quarter was primarily the result of hiring additional professional services personnel to support the anticipated demand for consulting services. Pro Forma Table of Contents Operating expenses in total have fluctuated between quarters due to the timing of employee-related spending, new on-demand application service offerings and marketing events. For example, marketing and sales expenses for the quarter ended October 31, 2002 increased by $2.6 million over the preceding quarter, primarily due to the hiring of additional sales personnel. General and administrative expenses for the quarter ended October 31, 2002 increased by $2.2 million over the preceding quarter primarily due to stock compensation expenses associated with warrants that we issued and the costs associated with hiring additional staff. Additionally, operating income for the quarter ended October 31, 2003 included non-cash income of $4.3 million related to the release of future obligations associated with office space that we abandoned in fiscal 2002. Our quarterly operating results are likely to fluctuate, and if we fail to meet or exceed the expectations of securities analysts or investors, the trading price of our common stock could decline. Some of the important factors that could cause our revenues and operating results to fluctuate from quarter to quarter include: our ability to retain and increase sales to existing customers, attract new customers and satisfy our customers requirements; the renewal rates for our service; changes in our pricing policies; the introduction of new features to our service; the rate of expansion and effectiveness of our sales force; the length of the sales cycle for our service; new product and service introductions by our competitors; seasonality in our markets; our success in selling our service to large enterprises; variations in the mix of editions of our service; technical difficulties or interruptions in our service; general economic conditions in our geographic markets; additional investment in our service or operations; and regulatory compliance costs. The occurrence of one or more of these factors might cause our operating results to vary widely. As such, we believe that quarter-to-quarter comparisons of our revenues and operating results may not be meaningful and should not be relied upon as an indication of future performance. Liquidity and Capital Resources At April 30, 2004, our principal sources of liquidity were cash, cash equivalents and short-term marketable securities totaling $43.7 million and accounts receivable of $24.5 million. From our inception in February 1999 through the end of fiscal 2002, we funded our operations primarily through issuances of convertible preferred stock, which provided us with aggregate net proceeds of $61.1 million. For the past several quarters, we have funded our operations through cash flow generated by the operating activities of our business. Net cash provided by operating activities was $5.2 million during fiscal 2003, $21.8 million during fiscal 2004 and $6.7 million during the three months ended April 30, 2004. These amounts compare favorably to the operating cash deficit of $13.2 million during fiscal 2002. The improvement in cash flow was due primarily to Pro Forma As Adjusted (in thousands) Capital lease obligations $ 80 $ 80 $ $ $ Operating lease obligations 38,715 8,192 12,170 8,343 10,010 Contractual commitments 1,450 1,450 Lease abandonment liabilities and other 2,307 477 804 481 545 Purchase orders are not included in the table above. Our purchase orders represent authorizations to purchase rather than binding agreements. The contractual commitment amounts in the table above are associated with agreements that are enforceable and legally binding and that specify all significant terms, including: fixed or minimum services to be used; fixed, minimum or variable price provisions; and the approximate timing of the transaction. Obligations under contracts that we can cancel without a significant penalty are not included in the table above. Table of Contents We believe our existing cash, cash equivalents and short-term marketable securities and cash provided by operating activities will be sufficient to meet our working capital and capital expenditure needs over the next 12 months. Our future capital requirements will depend on many factors, including our rate of revenue growth, the expansion of our marketing and sales activities, the timing and extent of spending to support product development efforts and expansion into new territories, the timing of introductions of new services and enhancements to existing services, and the continuing market acceptance of our services. To the extent that funds generated by this public offering, together with existing cash and securities and cash from operations, are insufficient to fund our future activities, we may need to raise additional funds through public or private equity or debt financing. Although we are currently not a party to any agreement or letter of intent with respect to potential investments in, or acquisitions of, complementary businesses, services or technologies, we may enter into these types of arrangements in the future, which could also require us to seek additional equity or debt financing. Additional funds may not be available on terms favorable to us or at all. Quantitative and Qualitative Disclosures about Market Risk Foreign currency exchange risk Our results of operations and cash flows are subject to fluctuations due to changes in foreign currency exchange rates, particularly changes in the Euro, British pound, Canadian dollar and Japanese yen. We have a risk management policy that allows us to utilize foreign currency forward and option contracts to manage currency exposures that exist as part of our ongoing business operations. To date, we have not entered into any hedging contracts since exchange rate fluctuations have had little impact on our operating results and cash flows. If we were to enter into hedging contracts, the contracts by policy would have maturities of less than three months and settle before the end of each quarterly period. Additionally, by policy we would not enter into any hedging contracts for trading or speculative purposes. Interest rate sensitivity We had unrestricted cash, cash equivalents and short-term marketable securities totaling $16.0 million at January 31, 2003, $35.8 million at January 31, 2004 and $43.7 million at April 30, 2004. These amounts were invested primarily in money market funds and high quality, investment grade, variable-rate municipal bonds. The unrestricted cash, cash equivalents and short-term marketable securities are held for working capital purposes. We do not enter into investments for trading or speculative purposes. Due to the short-term nature of these investments, we believe that we do not have any material exposure to changes in the fair value of our investment portfolio as a result of changes in interest rates. Declines in interest rates, however, will reduce future investment income. Prospectus Summary 1 Risk Factors 5
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