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+RISK FACTORS BEFORE MAKING AN INVESTMENT DECISION, YOU SHOULD CAREFULLY CONSIDER THE FOLLOWING RISKS. THE RISKS DESCRIBED BELOW ARE NOT THE ONLY ONES THAT WE FACE. ANY OF THE FOLLOWING RISKS COULD HAVE A MATERIAL ADVERSE EFFECT ON OUR BUSINESS, FINANCIAL CONDITION AND OPERATING RESULTS. ADDITIONAL RISKS AND UNCERTAINTIES OF WHICH WE ARE UNAWARE OR CURRENTLY BELIEVE ARE IMMATERIAL MAY ALSO IMPAIR OUR BUSINESS OPERATIONS. THE TRADING PRICE OF OUR COMMON STOCK COULD DECLINE DUE TO ANY OF THESE RISKS, AND YOU COULD LOSE ALL OR PART OF YOUR INVESTMENT IN OUR COMMON STOCK. BEFORE MAKING AN INVESTMENT DECISION, YOU SHOULD ALSO READ THE OTHER INFORMATION INCLUDED IN THIS PROSPECTUS, INCLUDING OUR FINANCIAL STATEMENTS AND THE RELATED NOTES. RISKS RELATED TO GENERAL BUSINESS OPERATIONS TEN CLIENTS WERE RESPONSIBLE FOR 63% OF OUR CONSOLIDATED REVENUE LAST YEAR, AND THE LOSS OF ANY OF THESE CLIENTS COULD CAUSE A SIGNIFICANT DROP IN OUR REVENUE. We depend on a limited number of large clients for a significant portion of our consolidated revenue. Our 10 largest clients were responsible for approximately 63% of our consolidated revenue during the year ended December 31, 2000, with The Limited and its retail affiliates representing approximately 25% of our 2000 consolidated revenue. A decrease in revenue from any of our significant clients for any reason, including a decrease in pricing or activity, or a decision to either utilize another service provider or to no longer outsource some or all of the services we provide, could have a material adverse effect on our consolidated revenue. TRANSACTION SERVICES. Our 10 largest clients in this segment were responsible for approximately 71% of our Transaction Services revenue in 2000. The Limited and its retail affiliates were the largest Transaction Services client in 2000, representing approximately 28% of this segment's 2000 revenue, and Brylane, our second largest Transaction Services client, was responsible for approximately 10% of this segment's 2000 revenue. Equiva Services, LLC was responsible for approximately 8% of this segment's 2000 revenue. Our contracts with The Limited and its retail affiliates and Brylane expire in 2006, and our contract with Equiva expires in December 2001. We provide transaction processing services to Equiva which is the service provider to Shell-branded locations in the United States. Equiva is one of our 10 largest clients both in the Transaction Services segment and on a consolidated basis. We have been informed by Equiva that it would like to discontinue a portion of the services we currently provide effective upon termination of the existing contract in December 2001. As a result of this termination, our revenue and profitability attributable to Equiva for periods beyond 2001 will decrease. We are now in the process of negotiating with Equiva regarding the other services we currently provide. We can give no assurance that we will successfully reach an agreement with Equiva on similar terms to those currently existing, or at all. If our negotiations with Equiva result in a decrease in pricing or in the number and types of the transaction services we provide to Equiva, our revenue and profitability from Equiva would be further adversely affected. CREDIT SERVICES. Our two largest clients in this segment were responsible for approximately 80% of our Credit Services revenue in 2000. The Limited and its retail affiliates were responsible for approximately 59%, and Brylane was responsible for approximately 21%, of our Credit Services revenue in 2000. Our contracts with these clients expire in 2006. The Limited is currently planning a restructuring involving some of its retail affiliates. The proposed restructuring would involve a sale of Lane Bryant and the integration of Structure into the Express brand name as Express Men's. While we have a contract with Lane Bryant through 2006, we cannot assure you that an acquirer of Lane Bryant would assume the credit card processing agreement that we currently have with Lane Bryant or that the acquirer would continue Lane Bryant's marketing strategy of utilizing private label credit cards. The integration of Structure into Express could lead to the closing of stores and the name change could adversely impact credit sales causing lower revenues for our Credit Services segment. MARKETING SERVICES. Our 10 largest clients in this segment were responsible for approximately 61% of our Marketing Services revenue in 2000. Bank of Montreal, Canada Safeway and The Limited and its retail affiliates were the three largest Marketing Services clients in 2000. The Bank of Montreal represented approximately 27%, Canada Safeway represented approximately 10% and The Limited and its retail affiliates represented approximately 7% of this segment's 2000 revenue. Our contracts with The Bank of Montreal and Canada Safeway expire in March 2002 and December 2002, respectively, and our contract with The Limited expires in September 2003. OUR LARGEST CLIENT, THE LIMITED, IS A SIGNIFICANT STOCKHOLDER, AND AS A RESULT IT HAS THE ABILITY TO INFLUENCE OUR CORPORATE AFFAIRS IN A MANNER THAT COULD BE INCONSISTENT WITH THE BEST INTERESTS OF OUR OTHER STOCKHOLDERS. Eight of our clients are retail affiliates of Limited Commerce Corp., our second largest stockholder and a wholly owned subsidiary of The Limited. The Limited, together with its retail affiliates, is our largest client. Limited Commerce Corp. beneficially owned approximately 25.3% of our common stock as of April 30, 2001 and, through a stockholders agreement, has the right to designate up to two members of our board of directors. As a significant stockholder with board representation, The Limited, unlike our other clients, is able to exercise significant influence over matters requiring stockholder approval, including the election of directors and the approval of significant corporate transactions. The interests of The Limited may not be aligned with the interests of our company or other stockholders. The Limited could use its influence as a major client and large stockholder to negotiate contracts with us that have terms that are more favorable to The Limited than could be obtained by unaffiliated retailers. In addition, The Limited could use its influence and could act to hinder our ability to enter into contracts with its competitors. COMPETITION IN OUR INDUSTRY IS INTENSE AND WE EXPECT IT TO INTENSIFY. The markets for our products and services are highly competitive, and we expect competition to intensify in each of those markets. Many of our current competitors have longer operating histories, stronger brand names and greater financial, technical, marketing and other resources than we do. We cannot assure you that we will be able to compete successfully against our current and potential competitors nor can we be sure that we will be able to successfully market our services at our current levels of profitability. THE MARKETS FOR THE SERVICES THAT WE OFFER MAY FAIL TO EXPAND OR MAY CONTRACT AND THIS COULD NEGATIVELY IMPACT OUR GROWTH AND PROFITABILITY. Our growth and continued profitability rely on acceptance of the services that we offer. If demand for transaction, credit or marketing services decreases, the price of our common stock could fall and you could lose value in your investment. Loyalty and database marketing strategies are relatively new to retailers, and we cannot guarantee that merchants will continue to use these types of marketing strategies. Changes in technology may enable merchants and retail companies to directly process transactions in a cost-efficient manner without the use of our services. Additionally, downturns in the economy or the performance of retailers may result in a decrease in the demand for our marketing strategies. Any decrease in the demand for our services for the reasons discussed above or other reasons could have a material adverse effect on our growth and revenue. WE CANNOT ASSURE YOU THAT WE WILL EFFECTIVELY INTEGRATE FUTURE ACQUISITIONS, REALIZE THEIR FULL BENEFITS OR SUCCESSFULLY MANAGE OUR COMBINED COMPANY, AND FUTURE ACQUISITIONS MAY RESULT IN DILUTIVE EQUITY ISSUANCES OR INCREASES IN DEBT. If we are unable to successfully integrate any future acquisition, we may incur substantial costs and delays or other operational, technical or financial problems, any of which could harm our business and impact the trading price of our common stock. In addition, the failure to successfully integrate any future acquisition may divert management's attention from our core operations, which could harm our ability to timely meet the needs of our customers and could damage our relationships with key clients. To finance future acquisitions, we may need to raise funds either by issuing equity securities or incurring debt. If we issue additional equity securities, such sales could reduce the current value of our stock by diluting the ownership interest of our stockholders. If we incur additional debt, the related interest expense may significantly reduce our profitability. Additionally, we are likely to use purchase accounting for future acquisitions and the related amortization expense associated with goodwill and purchased intangibles may significantly reduce our profitability. WE MAY FACE DAMAGES AS A RESULT OF LITIGATION IN CONNECTION WITH THE BANKRUPTCY PROCEEDINGS OF ONE OF OUR FORMER CUSTOMERS, SERVICE MERCHANDISE, AND A CLASS ACTION SUIT FILED ON BEHALF OF A GROUP OF WORLD FINANCIAL CARDHOLDERS. World Financial, our wholly owned subsidiary, is a party to a lawsuit filed by Service Merchandise, Inc. in U.S. Bankruptcy Court for the Middle District of Tennessee. Service Merchandise, which is in voluntary Chapter 11 bankruptcy, alleges that World Financial breached certain contractual provisions of an agreement regarding a private label credit card program by, among other things, unilaterally revising the credit standards applicable to existing cardholders and withholding monthly program payments owed to Service Merchandise. In addition, Service Merchandise alleges that certain actions taken by World Financial violated the automatic stay provisions of the U.S. Bankruptcy Code. Service Merchandise has not specified the amount of damages that it is seeking and has asked that the amount of any such damages be determined at trial. In a separate action, a group of World Financial cardholders recently filed a putative class action complaint against World Financial in U.S. District Court for the Southern District of Florida, Miami Division, alleging that World Financial's billing practices are false, misleading and deceptive, and therefore in breach of state and federal laws and cardholder contracts. The plaintiff group of cardholders has not specified the amount of damages that it is seeking. The amount of such damages, if any, would be determined at trial. See "Business--Legal Proceedings." Due to the uncertainty inherent in litigation, we cannot provide assurance that an ultimate result against World Financial in either of these actions would not have a material adverse effect on us. FAILURE TO SAFEGUARD OUR DATABASES AND CONSUMER PRIVACY COULD AFFECT OUR REPUTATION AMONG OUR CLIENTS AND THEIR CUSTOMERS AND MAY EXPOSE US TO LEGAL CLAIMS FROM CONSUMERS. An important feature of our marketing and credit services is our ability to develop and maintain individual consumer profiles. As part of our Air Miles reward miles program, database marketing program and private label program, we maintain marketing databases containing information on consumers' account transactions. Although we have extensive security procedures, our databases may be subject to unauthorized access. If we experience a security breach, the integrity of our marketing databases could be affected. Security and privacy concerns may cause consumers to resist providing the personal data necessary to support our profiling capability. The use of our loyalty, database marketing or private label programs could decline if any well-publicized compromise of security occurred. Any public perception that we released consumer information without authorization could subject us to legal claims from consumers and adversely affect our client relationships. LOSS OF DATA CENTER CAPACITY OR INTERRUPTION OF TELECOMMUNICATION LINKS COULD AFFECT OUR ABILITY TO TIMELY MEET THE NEEDS OF OUR CLIENTS AND THEIR CUSTOMERS. Our ability to protect our data centers against damage from fire, power loss, telecommunications failure and other disasters is critical. In order to provide many of our services, we must be able to store, retrieve, process and manage large databases and periodically expand and upgrade our capabilities. Any damage to our data centers or any failure of our telecommunication links that interrupts our operations could adversely affect our ability to meet our clients' needs and their confidence in utilizing us for future services. AS A RESULT OF OUR SIGNIFICANT CANADIAN OPERATIONS, OUR REPORTED RESULTS WILL BE AFFECTED BY FLUCTUATIONS IN THE EXCHANGE RATE BETWEEN THE U.S. AND CANADIAN DOLLARS. A significant portion of our Marketing Services revenue is derived from our Loyalty Group operations in Canada, which transacts business in Canadian dollars. Therefore, our reported results from quarter-to-quarter will be affected by changes in the exchange rate between the U.S. and Canadian dollars over the relevant periods. OUR HEDGING ACTIVITY SUBJECTS US TO OFF-BALANCE SHEET RISKS RELATING TO THE CREDITWORTHINESS OF THE COMMERCIAL BANKS WITH WHOM WE CONTRACT IN OUR HEDGING TRANSACTIONS. IF ONE OF THESE BANKS CANNOT HONOR ITS OBLIGATIONS, WE MAY SUFFER A LOSS. The interest rate swap and treasury lock agreements we use to reduce our exposure to fluctuations in interest rates subject us to off-balance sheet risk. These off-balance sheet financial instruments involve elements of credit and interest rate risk in excess of the amount recognized on our balance sheet. Our hedging policy subjects us to risks relating to the creditworthiness of the commercial banks with whom we contract in our hedging transactions. If one of these banks cannot honor its obligations, we may suffer a loss. While our hedging policy reduces our exposure to losses resulting from unfavorable changes in interest rates, it also reduces or eliminates our ability to profit from favorable changes in interest rates. OUR FAILURE TO PROTECT OUR INTELLECTUAL PROPERTY RIGHTS MAY HARM OUR COMPETITIVE POSITION, AND LITIGATION TO PROTECT OUR INTELLECTUAL PROPERTY RIGHTS OR DEFEND AGAINST THIRD-PARTY ALLEGATIONS OF INFRINGEMENT MAY BE COSTLY. Third parties may infringe or misappropriate our trademarks or other intellectual property rights, which could have a material adverse effect on our business, financial condition or operating results. The actions we take to protect our trademarks and other proprietary rights may not be adequate. Litigation may be necessary to enforce our intellectual property rights, protect our trade secrets or determine the validity and scope of the proprietary rights of others. We cannot assure you that we will be able to prevent infringement of our intellectual property rights or misappropriation of our proprietary information. Any infringement or misappropriation could harm any competitive advantage we currently derive or may derive from our proprietary rights. Third parties may assert infringement claims against us. Any claims and any resulting litigation could subject us to significant liability for damages. An adverse determination in any litigation of this type could require us to design around a third party's patent or to license alternative technology from another party. In addition, litigation is time-consuming and expensive to defend and could result in the diversion of our time and resources. Any claims from third parties may also result in limitations on our ability to use the intellectual property subject to these claims. RISKS PARTICULAR TO TRANSACTION SERVICES AN INABILITY TO FULLY AND EFFECTIVELY INTEGRATE THE RECENT ACQUISITIONS OF SPS AND UTILIPRO IN OUR TRANSACTION SERVICES SEGMENT COULD RESULT IN INCREASED COSTS WHILE DIVERTING MANAGEMENT'S ATTENTION FROM OUR CORE OPERATIONS, HARM OUR ABILITY TO TIMELY MEET THE NEEDS OF OUR CLIENTS AND DAMAGE OUR RELATIONSHIPS WITH THOSE CLIENTS. We are currently in the process of integrating the network transaction processing business of SPS Payment Systems, Inc. we acquired in July 1999, and are beginning to integrate the Utilipro operating assets we acquired in February 2001. We expect the SPS integration process to continue through the second quarter of 2001 and the Utilipro integration process to continue through the third quarter of 2001. Although the majority of the integration process of migrating the SPS systems to an in-house processing environment has proceeded as planned, there were a number of service disruptions that occurred in the first quarter of 2001 which resulted in an inefficient routing of transactions and a backlog of authorizations. We cannot assure you that we will be able to fully or successfully integrate SPS or Utilipro in a timely manner or at all. If we are unable to successfully integrate the Utilipro operations or successfully complete the SPS integration, we may incur substantial costs and delays or other operational, technical or financial problems, any of which could harm our business and adversely affect the trading price of our common stock. In addition, management's attention may be diverted from core operations which could harm our ability to timely meet the needs of our clients and their customers and damage our relationships with those clients. WE ARE DEPENDENT UPON TRANSACTION NETWORK SERVICES, INC., FORMERLY KNOWN AS PSINET TRANSACTION SOLUTIONS, FOR DATA TRANSMISSION SERVICES AND POINT-OF-SALE DIAL-UP TRANSMISSION SERVICES, AND ANY FAILURE OF TRANSACTION NETWORK SERVICES TO PROVIDE THESE SERVICES COULD SIGNIFICANTLY DISRUPT OUR NETWORK SERVICES OR INCREASE OUR COSTS BY REQUIRING US TO OBTAIN DATA TRANSMISSION SERVICES FROM ANOTHER SUPPLIER. We are dependent on Transaction Network Services, Inc., or TNS, for data transmission services and point-of-sale dial-up transmission services for our network services business. On April 3, 2001, an investor group led by GTCR Golder Rauner, LLC purchased TNS from PSINet, Inc. PSINet has been experiencing significant liquidity and cash flow shortfalls that require the addition of substantial capital, the availability of which is uncertain. If PSINet were to declare bankruptcy, it is possible that parties to the bankruptcy proceeding could attempt to undo the sale of TNS to Golder Rauner and seek to reject our contract with TNS. In the event the sale is undone and our contract with TNS rejected, we would be forced to utilize our backup supplier or another vendor for the contracted services. In the first half of 2001, we intend to complete the migration of a large percentage of our data and point-of-sale dial-up transmission needs for our network services business, representing a quarter of the transactions we processed in 2000, to TNS. Given our dependence on TNS, if it were to fail to perform its obligations or its services were otherwise interrupted, for financial or other reasons, we would have to transition the services to our current backup supplier or to another supplier. If this were to occur, any new contract we might enter into for the long-term provision of those services may be at a price and on terms substantially less favorable to us than the terms of our current arrangement. IF A CARDHOLDER HAS A DISPUTE WITH A MERCHANT OR IF A CARDHOLDER IS A VICTIM OF A FRAUDULENT TRANSACTION WITH A MERCHANT, WE MAY BE LIABLE FOR THE AMOUNT OF ANY CHARGES RELATED TO SUCH DISPUTE OR TRANSACTION IN THE EVENT WE ARE NOT REIMBURSED FOR SUCH CHARGES BY THE MERCHANT. In our merchant bankcard services business, when a billing dispute between a cardholder and a merchant is resolved in favor of the cardholder, or when a card issuer detects fraudulent transactions submitted by a merchant, we "charge back" to the merchant the amount we originally credited to the merchant. We then credit the amount of the transaction back to the cardholder's account. These billing disputes or chargebacks typically relate to, among others: - the cardholder's nonreceipt of merchandise or services; - unauthorized use of a credit card; or - general disputes between a cardholder and a merchant as to the quality of the goods purchased or the services rendered by the merchant. If we are unable to collect amounts charged back to a merchant's account, and if the merchant refuses or is unable to reimburse us for the chargeback, we incur a loss equal to the amount of the chargeback. We cannot assure you that we will not experience significant losses from chargebacks in the future. Such significant losses could arise from merchant bankruptcies or other reasons which reduce the likelihood that we will be reimbursed for chargebacks. Any significant chargeback losses in a period would have a material adverse effect on our profitability. IF WE ARE REQUIRED TO PAY STATE TAXES ON TRANSACTIONS PROCESSING, IT COULD NEGATIVELY IMPACT OUR PROFITABILITY. Transaction processing companies may be subject to state taxation of certain portions of their fees charged to merchants for their services. If we are required to pay such taxes and are unable to pass this tax expense through to our merchant clients, these taxes would negatively impact our profitability. RISKS PARTICULAR TO CREDIT SERVICES IF WE ARE UNABLE TO SECURITIZE OUR CREDIT CARD RECEIVABLES DUE TO CHANGES IN THE MARKET, THE UNAVAILABILITY OF CREDIT ENHANCEMENTS, AN EARLY AMORTIZATION EVENT OR FOR OTHER REASONS, WE WOULD NOT BE ABLE TO FUND NEW CREDIT CARD RECEIVABLES, WHICH WOULD HAVE A NEGATIVE IMPACT ON OUR OPERATIONS AND EARNINGS. Since January 1996, we have sold substantially all of the credit card receivables owned by our credit card bank, World Financial, to World Financial Network Credit Card Master Trust as part of our securitization program. This securitization program is the primary vehicle through which World Financial finances our private label credit card receivables. If World Financial were not able to regularly securitize the receivables it originates, our ability to grow or even maintain our credit services business would be materially impaired. World Financial's ability to effect securitization transactions is impacted by the following factors, some of which are beyond our control: - conditions in the securities markets in general and the asset-backed securitization market in particular; - conformity in the quality of credit card receivables to rating agency requirements and changes in those requirements; and - our ability to fund required overcollateralizations or credit enhancements, which we routinely utilize in order to achieve better credit ratings to lower our borrowing costs. Once World Financial securitizes receivables, the agreement governing the transaction contains covenants that address the receivables' performance and the continued solvency of the retailer where the underlying sales were generated. In the event one of those or other similar covenants is breached, an early amortization event could be declared, in which case the trustee for the securitization trust would retain World Financial's interest in the related receivables, along with the excess interest income that would normally be paid to World Financial, until such time as the securization investors are fully repaid. The occurrence of an early amortization event would significantly limit, or even negate, our ability to securitize additional receivables. INCREASES IN NET CHARGE-OFFS BEYOND OUR EXPECTATIONS COULD HAVE A NEGATIVE IMPACT ON OUR OPERATING INCOME AND PROFITABILITY; AS THE AVERAGE AGE OF OUR SECURITIZED LOAN PORTFOLIO INCREASES, WE WILL LIKELY EXPERIENCE INCREASING LEVELS OF DELINQUENCY AND LOAN LOSSES. The primary risk associated with unsecured consumer lending is the risk of default or bankruptcy of the borrower, resulting in the borrower's balance being charged-off as uncollectible. We rely principally on the customer's creditworthiness for repayment of the loan and therefore have no other recourse for collection. We may not be able to successfully identify and evaluate the creditworthiness of cardholders to minimize delinquencies and losses. An increase in defaults or net charge-offs beyond historical levels will reduce the net spread available to us from the securitization master trust and could result in a reduction in finance charge income or a write-down of the interest only strip. General economic factors, such as the rate of inflation, unemployment levels and interest rates, may result in greater delinquencies that lead to greater credit losses among consumers. In addition to being affected by general economic conditions and the success of our collection and recovery efforts, our delinquency and net credit card receivable charge-off rates are affected by the credit risk of credit card receivables and the average age of our various credit card account portfolios. The average age of credit card receivables affects the stability of delinquency and loss rates of the portfolio because delinquency and loss rates typically increase as the average age of accounts in a credit card portfolio increases. At March 31, 2001, 19.2% of our securitized accounts and 38.6% of our securitized loans were less than 24 months old. We believe that our credit card loan portfolio will experience increasing levels of delinquency and loan losses as the average age of our accounts increases. For the three months ended March 31, 2001, our securitized net charge-off ratio was 7.9% compared to 7.6% for the three months ended March 31, 2000. Our securitized net charge-off ratio was 7.6% for 2000 compared to 7.2% for 1999 and 7.8% for 1998. We believe that this ratio will continue to fluctuate but generally rise over time as the average age of our accounts increases. Also, we cannot assure you that our risk-based pricing strategy can offset the negative impact on profitability caused by increases in delinquencies and losses. Any material increases in delinquencies and losses beyond our expectations could have a material adverse impact on us and the value of our net retained interests in loans that we sell though securitizations. CHANGES IN THE AMOUNT OF PREPAYMENTS AND DEFAULTS BY CARDHOLDERS ON CREDIT CARD BALANCES MAY CAUSE A DECREASE IN THE ESTIMATED VALUE OF INTEREST ONLY STRIPS. The estimated fair value of interest only strips depends upon the anticipated cash flows of the related credit card receivables. A significant factor affecting the anticipated cash flows is the rate at which the underlying principal of the securitized credit card receivables is reduced. Prepayments represent principal reductions in excess of the contractually scheduled reductions. Other assumptions used in estimating the value of the interest only strips include estimated future credit losses and a discount rate commensurate with the risks involved. The rate of cardholder prepayments or defaults on credit card balances may be affected by a variety of economic factors, including interest rates and the availability of alternative financing, most of which are not within our control. A decrease in interest rates could cause cardholder prepayments to increase, thereby requiring a write down of the interest only strips. If prepayments from cardholders or defaults by cardholders exceed our estimates, we may be required to decrease the estimated value of the interest only strips through a charge against earnings. INTEREST RATE FLUCTUATIONS COULD SIGNIFICANTLY REDUCE THE AMOUNT WE REALIZE FROM THE SPREAD BETWEEN THE YIELD ON OUR ASSETS AND OUR COST OF FUNDING. An increase or decrease in market interest rates could have a negative impact on the amount we realize from the spread between the yield on our assets and our cost of funding. A rise in market interest rates may indirectly impact the payment performance of consumers or the value of, or amount we could realize from the sale of, interest only strips. At March 31, 2001, approximately 9.2% of our outstanding debt was subject to fixed rates with a weighted average interest rate of 8.3%. An additional 55.3% of our outstanding debt at March 31, 2001 was locked at an effective interest rate of 6.7% through interest rate swap agreements and treasury locks with notional amounts totaling $1.5 billion. Assuming we do not take any counteractive measures, a 1.0% increase in interest rates would result in a decrease to pretax income of approximately $8.6 million. Conversely, a corresponding decrease in interest rates would result in a comparable improvement to pretax income. The foregoing sensitivity analysis is limited to the potential impact of an interest rate swing of 1.0% on cash flows and fair values, and does not address default or credit risk. WE EXPECT GROWTH IN OUR CREDIT SERVICES SEGMENT TO RESULT FROM NEW AND ACQUIRED PRIVATE LABEL CARD PROGRAMS, WHOSE CREDIT CARD RECEIVABLE PERFORMANCE COULD RESULT IN INCREASED PORTFOLIO LOSSES AND NEGATIVELY IMPACT OUR NET RETAINED INTERESTS IN LOANS SECURITIZED. We expect an important source of growth in our private label card operations to come from the acquisition of existing private label programs and initiating private label programs with retailers who do not currently offer a private label card. Although we believe our pricing and models for determining credit risk are designed to evaluate the credit risk of existing programs and the credit risk we are willing to assume for acquired and start-up programs, we cannot assure you that the loss experience on acquired and start-up programs will be consistent with our more established programs. The failure to successfully underwrite these private label programs may result in defaults greater than our expectations and could have a material adverse impact on us and the value of our net retained interests in loans securitized. CURRENT AND PROPOSED REGULATION AND LEGISLATION RELATING TO OUR CREDIT SERVICES COULD LIMIT OUR BUSINESS ACTIVITIES, PRODUCT OFFERINGS AND FEES CHARGED. Various Federal and state laws and regulations significantly limit the credit services activities in which we are permitted to engage. Such laws and regulations, among other things, limit the fees and other charges that we can impose on customers, limit or prescribe certain other terms of our products and services, require specified disclosures to consumers, or require that we maintain certain licenses, qualifications and minimum capital levels. In some cases, the precise application of these statutes and regulations is not clear. In addition, numerous legislative and regulatory proposals are advanced each year which, if adopted, could have a material adverse effect on our profitability or further restrict the manner in which we conduct our activities. The failure to comply with, or adverse changes in, the laws or regulations to which our business is subject, or adverse changes in their interpretation, could have a material adverse effect on our ability to collect our receivables and generate fees on the receivables, thereby adversely affecting our profitability. IF OUR BANK SUBSIDIARY FAILS TO MEET CREDIT CARD BANK CRITERIA, WE MAY BECOME SUBJECT TO REGULATION UNDER THE BANK HOLDING COMPANY ACT, WHICH WOULD FORCE US TO CEASE ALL OF OUR NON-BANKING BUSINESS ACTIVITIES AND THUS CAUSE A DRASTIC REDUCTION IN OUR PROFITS AND REVENUE. Our bank subsidiary, World Financial, is a limited purpose credit card bank. The Bank Insurance Fund, which is administered by the Federal Deposit Insurance Corporation, insures the deposits of World Financial. World Financial is not a "bank" as defined under the Bank Holding Company Act because it is in compliance with the following requirements: - it engages only in credit card operations; - it does not accept demand deposits or deposits that the depositor may withdraw by check or similar means for payment to third parties; - it does not accept any savings or time deposits of less than $100,000, except for deposits pledged as collateral for extensions of credit; - it maintains only one office that accepts deposits; and - it does not engage in the business of making commercial loans. If World Financial failed to meet the credit card bank criteria described above, World Financial would be a "bank" as defined by the Bank Holding Company Act, subjecting us to regulation under the Bank Holding Company Act. Being deemed a bank holding company could significantly harm us, as we could be required to either divest any activities deemed to be non-banking activities or cease any activities not permissible for a bank holding company and its affiliates. While the consequences of being subject to regulation under the Bank Holding Company Act would be severe, we believe that the risk of becoming subject to such regulation is minimal as a result of the precautions we have taken in structuring our business. RISKS PARTICULAR TO MARKETING SERVICES BECAUSE WE ARE DEPENDENT UPON AIR CANADA, THE DOMINANT DOMESTIC AIR CARRIER IN CANADA, AS A SUPPLIER OF AIRLINE TICKETS FOR OUR AIR MILES REWARD MILES PROGRAM, WE MAY NOT BE ABLE TO MEET THE NEEDS OF OUR COLLECTORS IF THE CAPACITY MADE AVAILABLE TO US BY AIR CANADA IS INADEQUATE TO MEET OUR COLLECTORS' DEMANDS. Air Canada completed its acquisition of Canadian Airlines in July 2000 and thereby solidified its position as the dominant Canadian domestic airline. Air Canada has merged the operations of Canadian Airlines and consolidated routes resulting in the reduction of routes, flights and seats offered by the merged airline. As a result of the acquisition, we entered into a new supply agreement with Air Canada that runs through 2004, superseding our prior agreement with Canadian Airlines. Notwithstanding our agreement with Air Canada, we cannot predict what impact route consolidation or elimination or changes in the merged airline's operations will have on our ability to satisfy and retain active collectors and sponsors of the Air Miles reward miles program. The new supply agreement with Air Canada contains reductions in the guarantee related to the number of tickets available at contractual rates on certain routes after December 31, 2002. Once these capacity guarantees on certain routes are reduced in 2003, we may be required to meet the demands of collectors by purchasing tickets from other carriers. These tickets could be more expensive than a comparable ticket under the Air Canada agreement, and the routes offered by the other airlines may be inconvenient or undesirable to the redeeming collectors. As a result, we may experience higher air travel redemption costs in 2003 and 2004 than we are currently experiencing, while at the same time collector satisfaction with the Air Miles reward miles program may be adversely affected by requiring travel on other carriers on certain routes. IF ACTUAL REDEMPTIONS BY COLLECTORS OF AIR MILES REWARD MILES ARE GREATER THAN EXPECTED, OUR REVENUES AND PROFITABILITY COULD BE ADVERSELY AFFECTED. A portion of our revenue is based on our estimate of the number of Air Miles reward miles that will go unused by the collector base. The percentage of unredeemed reward miles is known as "breakage" in the loyalty industry. While our Air Miles reward miles currently do not expire, reward miles are not redeemed by collectors for a number of reasons, including: - loss of interest in the program or sponsors; - collectors moving out of the program area; and - death of a collector. If actual redemptions are greater than our estimates, our revenues and profitability could be adversely affected. THE LOSS OF OUR MOST ACTIVE AIR MILES REWARD MILES COLLECTORS COULD NEGATIVELY IMPACT OUR GROWTH AND PROFITABILITY. Our most active Air Miles reward miles collectors represent a disproportionately large percentage of our Air Miles reward program revenue. Over the past year, we estimate that over half of the Air Miles reward program revenues came from our most active Air Miles reward miles collectors. The loss of a significant portion of these collectors, for any reason, could impact our ability to generate significant revenue from sponsors and loyalty partners. The continued attractiveness of our loyalty and rewards programs will depend in large part on our ability to remain affiliated with sponsors that are desirable to consumers and to offer rewards that are both attainable and attractive. LEGISLATION RELATING TO CONSUMER PRIVACY MAY AFFECT OUR ABILITY TO COLLECT DATA THAT WE USE IN PROVIDING OUR MARKETING SERVICES, WHICH COULD NEGATIVELY AFFECT OUR ABILITY TO SATISFY OUR CLIENTS' NEEDS. The enactment of legislation or industry regulations arising from public concern over consumer privacy issues could have a material adverse impact on our marketing services. Any such legislation or industry regulations could place restrictions upon the collection and use of information that is currently legally available, which could materially increase our cost of collecting some data. Legislation or industry regulation could also prohibit us from collecting or disseminating certain types of data, which could adversely affect our ability to meet our clients' requirements. The Gramm-Leach-Bliley Act, which became law in November 1999, makes it more difficult to collect and use information that has been legally available and may increase our costs of collecting some data. New regulations under this act that take effect in July 2001 will give cardholders the ability to "opt out" of having information generated by their credit card purchases shared with other parties or the public. Our ability to gather and utilize this data will be adversely affected if a significant percentage of the consumers whose purchasing behavior we track elect to "opt out," thereby precluding us from using their data. Once the regulations take effect, we will need to refrain from using data generated by our existing cardholders and new cardholders until such cardholders are given the opportunity to opt out. Similarly, the Personal Information Protection and Electronic Documents Act enacted in Canada requires organizations to obtain a consumer's consent to collect, use or disclose personal information. Under this act, which took effect on January 1, 2001, the nature of the required consent depends on the sensitivity of the personal information, and the act permits personal information to be used only for the purposes for which it was collected. The Loyalty Group allows its customers to voluntarily "opt out" from either promotional mail or electronic mail. Heightened consumer awareness of, and concern about, privacy may encourage more customers to "opt out" at higher rates than they have historically. This would mean that a reduced number of customers would receive bonus mile offers and therefore would collect fewer Air Miles reward miles. RISKS RELATED TO OUR COMPANY SOME OF OUR STOCKHOLDERS CURRENTLY OWN, AND AFTER THE OFFERING WILL CONTINUE TO OWN, A SIGNIFICANT AMOUNT OF OUR COMMON STOCK. THESE STOCKHOLDERS MAY HAVE INTERESTS THAT CONFLICT WITH YOURS AND WOULD BE ABLE TO CONTROL THE ELECTION OF DIRECTORS AND THE APPROVAL OF SIGNIFICANT CORPORATE TRANSACTIONS, INCLUDING A CHANGE IN CONTROL. As of April 30, 2001, Limited Commerce Corp. and the affiliated entities of Welsh, Carson, Anderson & Stowe in the aggregate beneficially owned approximately 99.6% of our outstanding common stock and would have owned approximately 81.4% of our common stock as of that date after giving pro forma effect to this offering. Through a stockholders agreement, Limited Commerce Corp. has the right to designate up to two members of our board of directors and Welsh Carson has the ability to designate up to three members of our board of directors. As a result, these stockholders are able to exercise significant influence over, and in most cases control, matters requiring stockholder approval, including the election of directors, changes to our charter documents and significant corporate transactions. This concentration of ownership makes it unlikely that any other holder or group of holders of common stock will be able to affect the way we are managed or the direction of our business. Limited Commerce Corp. and Welsh Carson may have interests that conflict with the interests of our company or other stockholders. Their continued concentrated ownership after the offering will make it impossible for another company to acquire us and for you to receive any related takeover premium for your shares unless they approve the acquisition. DELAWARE LAW AND OUR CHARTER DOCUMENTS COULD PREVENT A CHANGE OF CONTROL THAT MIGHT BE BENEFICIAL TO YOU. Delaware law, as well as provisions of our certificate of incorporation and bylaws, could discourage unsolicited proposals to acquire us, even though such proposals may be beneficial to you. These provisions include: - a board of directors classified into three classes of directors with the directors of each class having staggered, three-year terms; - our board's authority to issue shares of preferred stock without stockholder approval; and - provisions of Delaware law that restrict many business combinations and provide that directors serving on staggered boards of directors, such as ours, may be removed only for cause. These provisions of our certificate of incorporation, bylaws and Delaware law could discourage tender offers or other transactions that might otherwise result in our stockholders receiving a premium over the market price for our common stock. RISKS RELATED TO THIS OFFERING IF THE PRICE OF OUR COMMON STOCK FLUCTUATES SIGNIFICANTLY, YOUR INVESTMENT COULD LOSE VALUE. Prior to this offering, there has been no public market for our common stock. Although our common stock has been approved for listing, subject to official notice of issuance, on the New York Stock Exchange, we cannot assure you that an active public market will develop for our common stock or that our common stock will trade in the public market subsequent to this offering at or above the initial public offering price. If an active public market for our common stock does not develop, the trading price and liquidity of our common stock will be materially and adversely affected. Negotiations between us and the underwriters will determine the initial offering price, which may not be indicative of the trading price for our common stock after this offering. In addition, the stock market is subject to significant price and volume fluctuations, and the price of our common stock could fluctuate widely in response to several factors, including: - our quarterly operating results; - changes in our earnings estimates; - additions or departures of key personnel; - changes in the business, earnings estimates or market perceptions of our competitors; - changes in general market or economic conditions; and - announcements of legislative or regulatory change. The stock market has experienced extreme price and volume fluctuations in recent years that have significantly affected the quoted prices of the securities of many companies, including companies in our industry. The changes often appear to occur without regard to specific operating performance. The price of our common stock could fluctuate based upon factors that have little or nothing to do with our company and these fluctuations could materially reduce our stock price. FUTURE SALES OF OUR COMMON STOCK MAY ADVERSELY AFFECT OUR COMMON STOCK PRICE. If a large number of shares of our common stock are sold in the open market after this offering, the trading price of our common stock could decrease. In addition, the sale of these shares could impair our ability to raise capital through the sale of additional common stock. After this offering, we will have an aggregate of 118,810,864 shares of our common stock authorized but unissued and not reserved for specific purposes. In general, we may issue all of these shares without any action or approval by our stockholders. We may pursue acquisitions of competitors and related businesses and may issue shares of our common stock in connection with these acquisitions. Upon consummation of the offering, we will have 70,936,136 shares of our common stock outstanding. Of these shares, all shares sold in the offering, other than shares, if any, purchased by our affiliates, will be freely tradable. Of the remaining 57,936,136 shares, 72,013 shares will be freely transferable and 57,864,123 shares will be "restricted securities" as that term is defined in Rule 144 under the Securities Act. We have reserved 1,500,000 shares of common stock for issuance under our employee stock purchase plan. We have also reserved 8,753,000 shares of our common stock for issuance under our stock option and restricted stock plan, of which 4,351,105 shares are issuable upon exercise of options granted as of April 30, 2001, including options to purchase 1,731,787 shares exercisable as of April 30, 2001 or that will become exercisable within 60 days after April 30, 2001. The sale of shares issued upon the exercise of currently outstanding stock options could further dilute your investment in our common stock and adversely affect our stock price.

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+RISK FACTORS Before you invest in our common stock, you should be aware of the significant risks described below. You should carefully consider these risks, together with all of the other information included in this prospectus, before you decide whether to purchase shares of our common stock. RISKS RELATING TO OUR INDUSTRY OUR BUSINESS IS SUBJECT TO SUBSTANTIAL GOVERNMENTAL REGULATION AND PERMITTING REQUIREMENTS AND MAY BE ADVERSELY AFFECTED BY ANY FUTURE INABILITY TO COMPLY WITH EXISTING OR FUTURE REGULATIONS OR REQUIREMENTS. IN GENERAL. Our business is subject to extensive energy, environmental and other laws and regulations of federal, state and local authorities. We generally are required to obtain and comply with a wide variety of licenses, permits and other approvals in order to operate our facilities. We may incur significant additional costs because of our compliance with these requirements. If we fail to comply with these requirements, we could be subject to civil or criminal liability and the imposition of liens or fines. In addition, existing regulations may be revised or reinterpreted, new laws and regulations may be adopted or become applicable to us or our facilities, and future changes in laws and regulation may have a detrimental effect on our business. Furthermore, with the continuing trends toward stricter standards, greater regulation, more extensive permitting requirements and an increase in the assets we operate, we expect our environmental expenditures to be substantial in the future. ENERGY REGULATION. The Public Utility Holding Company Act of 1935, or PUHCA, and the Federal Power Act regulate public utility holding companies and their subsidiaries and place certain constraints on the conduct of their business. The Energy Policy Act of 1992 provides relief from regulation under PUHCA to exempt wholesale generators. Maintaining the status of our facilities as exempt wholesale generators is conditioned on their continuing to meet statutory criteria and could be jeopardized, for example, by the making of retail sales by an exempt wholesale generator in violation of the requirements of the Energy Policy Act. We are continually in the process of obtaining or renewing federal, state and local approvals required to operate our facilities. Additional regulatory approvals may be required in the future due to a change in laws or regulations, or interpretations of existing laws and regulations, a change in our customers or other reasons. We may not always be able to obtain all required regulatory approvals, and we may not be able to obtain any necessary modifications to existing regulatory approvals or maintain all required regulatory approvals. If there is a delay in obtaining any required regulatory approvals or if we fail to obtain and comply with any required regulatory approvals, the operation of our facilities or the sale of electricity to third parties could be prevented or subject to additional costs. ENVIRONMENTAL REGULATION. In July 1999, the United States Environmental Protection Agency finalized rules designed to protect and improve visibility impairment resulting from air emissions. Among other things, the regulations required states to identify sources of emissions (including specified coal-fired generating units built between 1962 and 1977) by 2004 that would be subject to "best available retrofit technology," or BART. These sources will be required to implement BART within five years after the EPA approves state plans adopted to combat visibility impairment (the submission of these plans is due between 2004 and 2008). In January 2001, the EPA proposed guidance to assist states in determining which sources should be subject to the BART requirement, but the proposed guidance has not been published pending a review by the newly appointed administrator of the EPA. Currently, the best available technology consists of "scrubbers," which are devices that trap pollutants in power-plant stacks. While we have installed scrubbers in our Wyodak and Neil Simpson II plants, we have not done so at the remainder of our coal-fired plants. If the proposed guidance is adopted in its current form, management believes that the only existing plant where additional capital investment may be required in order to comply with Clean Air Act requirements is our Neil Simpson I plant. Any capital expenditures associated with bringing the plant into compliance are not expected to have a material adverse effect on our financial condition or results of operations. In acquiring some of our facilities, we assumed on-site liabilities associated with the environmental condition of those facilities, regardless of when such liabilities arose and whether known or unknown, and in some cases agreed to indemnify the former owners of those facilities for on-site environmental liabilities. We strive at all times to be in compliance with all applicable environmental laws and regulations. However, steps to bring our facilities into compliance could be expensive, and thus could adversely affect our financial condition. Environmental and other governmental laws have also increased the costs to plan, design, drill, install, operate and abandon oil and natural gas wells and related facilities. Moreover, environmental laws and regulations can change. See "Business--Regulation." WE FACE ONGOING CHANGES IN THE UNITED STATES UTILITY INDUSTRY THAT COULD AFFECT OUR COMPETITIVENESS. The United States electric utility industry is currently experiencing increasing competitive pressures, primarily in wholesale markets, as a result of consumer demands, technological advances, deregulation, greater availability of natural gas-fired generation and other factors. The Federal Energy Regulatory Commission, or FERC, has implemented and continues to propose regulatory changes to increase access to the nationwide transmission grid by utility and non-utility purchasers and sellers of electricity. In addition, a number of states have implemented or are considering or currently implementing methods to introduce and promote retail competition. Industry deregulation in some states has led to the disaggregation of some vertically integrated utilities into separate generation, transmission and distribution businesses and deregulation initiatives in a number of states may encourage further disaggregation. As a result, significant additional competitors could become active in the generation, transmission and distribution segments of our industry. Proposals have been introduced in Congress to repeal PUHCA, and FERC has publicly indicated support for the PUHCA repeal effort. To the extent competitive pressures increase and the pricing and sale of electricity assumes more characteristics of a commodity business, the economics of domestic independent power generation projects may come under increasing pressure. In addition, the independent system operators who oversee most of the wholesale power markets have in the past imposed, and may in the future continue to impose, price limitations and other mechanisms to address some of the volatility in these markets. These types of price limitations and other mechanisms may adversely affect the profitability of our generation facilities that sell energy into the wholesale power markets. Given the extreme volatility and lack of meaningful long-term price history in some of these markets and the imposition of price limitations by independent system operators, we can offer no assurance that we will be able to operate profitably in all wholesale power markets. WE HAVE SOME EXPOSURE TO MARKET DISRUPTIONS IN CALIFORNIA. In 1996, California enacted legislation restructuring the state's investor-owned utilities. The legislation instituted a freeze on retail rates that investor-owned utilities could charge their customers for the duration of a transition period established by the legislation. The legislation did not make any provision for a California utility to recover costs of purchased electricity that exceeded the rates that could be charged under the rate freeze. Due to inadequate supplies of power and an unanticipated surge in demand, the California market has experienced rapid increases in electric power and natural gas prices. As a result, the state's two largest investor-owned utilities, Pacific Gas & Electric Company ("PG&E") and Southern California Edison ("SCE"), have incurred costs of procuring power significantly in excess of their ability to recover those costs through authorized retail rates and have indicated that, unless the rate freeze is eliminated or other proposed relief is provided, they are, or shortly will become, insolvent. In April 2001, PG&E filed a voluntary petition for Chapter 11 bankruptcy protection. We may experience losses related to the potential insolvency of the California utilities in the event that a utility defaults on its obligations: - under its agreements with us; - to the California Independent System Operator, or CAISO, which administers the real-time markets for energy and ancillary services, resulting in non-payment to us under our capacity sales agreement with the CAISO; or - to other energy companies, causing those energy companies to default on their obligations to us. We have two agreements with SCE involving our California independent power plants. - In 1999, we entered into a settlement agreement with SCE involving the Harbor Cogeneration plant located in Wilmington, California, in which we own a 31.8% interest. The settlement agreement provides for the termination of a 30-year power purchase agreement, in exchange for which we are entitled to receive payments of approximately $4 million per year through October 2008 for our interest in the plant. - The cogeneration plant located in Ontario, California is entitled to receive energy and capacity payments from SCE of approximately $1.7 million per year, under a long-term contract expiring in 2010. As of March 1, 2001, SCE owed us past due payments of approximately $1.5 million, with delinquencies ranging from 15 to 75 days in duration. We have no other material contractual relationships with SCE and no material agreements with PG&E. The Harbor Cogeneration plant has sold the peaking capacity from its expansion to the CAISO for the peak summer periods of 2001 through 2003 under an agreement that provides for payments to us of $1 million per year for each of 2001, 2002 and 2003. We have no other agreements with the CAISO and do not otherwise sell capacity and energy directly into the California market either through long-term contracts or on a merchant basis. All other merchant sales are made to power marketers who in turn sell into the California market. In addition, our fuel production and fuel marketing exposure to the California market is primarily indirect through sales to creditworthy counterparties, including neighboring utilities and gas and power marketing firms. In recent months, the Governor of the State of California, representatives of the state legislature and numerous industry participants have undertaken several initiatives designed to address market disruptions in California. In April 2001, SCE, its parent, Edison International, and the California Department of Water Resources signed a "Memorandum of Understanding" under which the state would pay $2.76 billion to purchase SCE's high voltage transmission system and SCE would withdraw a federal lawsuit in which it has sought authority to bill its customers for past unrecovered costs. Prior to its implementation, this agreement must be approved by the California state legislature, the California Public Utilities Commission and FERC. There is no assurance that any legislation will be enacted or that, if enacted, the sale of transmission assets will provide SCE with sufficient funds to pay any current or future obligations to us. In addition, there is no assurance that any current or future defaults by California utilities on obligations owed to others will not result in defaults by our counterparties. However, we believe that our direct exposure to potential defaults in the California market is largely limited to the agreements with SCE and the CAISO described above and that our indirect exposure is minimal. RISKS RELATED TO OUR BUSINESS COMPETITION IS INCREASING IN ALL OF OUR BUSINESSES. In particular, the independent power industry is characterized by numerous strong and capable competitors, some of which have more extensive experience in the operation, acquisition and development of power generation facilities, larger staffs or greater financial resources than we do. Many of our competitors are also seeking favorable power generation opportunities. This competition may adversely affect our ability to make investments or acquisitions on attractive terms. There also exists strong competition in all aspects of the oil and gas industry, including exploration, production and fuel marketing. We must compete with a substantial number of other energy companies, many of which have substantially greater financial, managerial, technical and other resources than we possess. OUR BROADBAND COMMUNICATIONS BUSINESS IS SUBJECT TO SIGNIFICANT COMPETITION FOR ITS SERVICES AND TO RAPID TECHNOLOGICAL CHANGE. Although our communications unit has achieved rapid penetration of our existing market, Black Hills FiberCom faces strong competition for its services from the incumbent local exchange carrier, which has dominated the local communications markets, as well as from long distance providers, Internet service providers, the incumbent cable television provider and others. The area's incumbent local exchange carrier has responded to our presence by offering an extended area service plan matching our market area. Internet service provider competition is currently limited primarily to dial-up services. Broadband services competing with our cable modem service are not widely available in our market, except for the small number of digital subscriber lines provided by the area's incumbent local exchange carrier. The incumbent cable television provider has upgraded its system, but not to the extent necessary to provide bundled services through its own facilities, and it must resell telephony services to compete with our bundled products. However, the incumbent cable television provider may respond with more competitive services as our market penetration increases. The communications industry is subject to rapid and significant changes in technology. There can be no assurance that future technological developments will not have a material adverse effect on Black Hills FiberCom's competitive position. We do, however, expect that future technological developments will be based on fiber optic technology, and that we will be in an advantageous position to be the first in our market to deploy those technological advancements on a cost-effective basis. Our ability to recover our capital investment and achieve operating profits is dependent on our ability to attract additional customers and is subject to the risk that technological advances may render our network obsolete. No assurance can be given that we will be successful in meeting our goals. If we determine that we will be unable to recover our investment, we would be required to take a non-cash charge to earnings in an amount that could be material in order to write down a portion of our investment in Black Hills FiberCom. OUR RATE FREEZE AGREEMENT WITH THE SOUTH DAKOTA PUBLIC UTILITIES COMMISSION PREVENTS US FROM PASSING ON TO OUR SOUTH DAKOTA RETAIL UTILITY CUSTOMERS COST INCREASES THAT MAY BE INCURRED DURING THE RATE FREEZE PERIOD, ABSENT EXTRAORDINARY CIRCUMSTANCES. Our utility's rate freeze agreement with the South Dakota Public Utilities Commission provides that, during the period ending January 1, 2005, Black Hills Power may not apply to the Commission for any increase in rates, except upon the occurrence of certain extraordinary events. Although most of our utility's costs are fixed under long-term fuel and power supply agreements, our utility's historically stable returns could be threatened by plant outages, machinery failure, increases in purchased power costs over which our utility has no control, acts of nature or other unexpected events that could cause operating costs to increase. Since, however, we own or control generating capacity in excess of our historical peak demands, we do not anticipate that our utility will be required to purchase replacement power in wholesale power markets, except in the event of unexpected plant outages. BECAUSE WHOLESALE POWER, FUEL PRICES AND OTHER COSTS ARE SUBJECT TO VOLATILITY, OUR REVENUES MAY FLUCTUATE. A substantial portion of our growth in net income in recent years is attributable to increasing wholesale sales by our utility and our independent energy unit into a robust wholesale market. The prices of energy products in the wholesale power markets are influenced by many factors outside our control, including fuel prices, transmission constraints, supply and demand, weather, economic conditions, and the rules, regulations and actions of the system operators in those markets. Moreover, unlike most other commodities, electricity cannot be stored and therefore must be produced concurrently with its use. As a result, wholesale power markets are subject to significant price fluctuations over relatively short periods of time and can be unpredictable. The success of our oil and gas operations will depend substantially upon the prevailing market prices of oil and natural gas. Historically, oil and natural gas prices and markets have also been volatile, and they are likely to continue to be volatile in the future. A decrease in oil or natural gas prices will not only reduce revenues and profits, but will also reduce the quantities of reserves that are commercially recoverable and may result in charges to earnings for impairment of the value of these assets. Oil and natural gas prices are subject to wide fluctuations in response to relatively minor changes in the supply of and demand for oil and natural gas, market uncertainty and a variety of additional factors that are beyond our control. A decline in fuel price volatility could also affect our revenues and returns from oil and gas marketing, which tend to increase when markets are volatile. ESTIMATES OF OUR PROVED RESERVES MAY MATERIALLY CHANGE DUE TO NUMEROUS UNCERTAINTIES INHERENT IN ESTIMATING OIL AND NATURAL GAS RESERVES. There are many uncertainties inherent in estimating quantities of proved reserves and their values. The process of estimating oil and natural gas reserves requires interpretations of available technical data and various assumptions, including assumptions relating to economic factors. Any significant inaccuracies in these interpretations or assumptions could materially affect the estimated quantities and present value of our reserves. The accuracy of any reserve estimate is a function of the quality of available data, engineering and geological interpretations and judgment, and the assumptions used regarding quantities of recoverable oil and natural gas reserves and prices for oil and natural gas. Actual prices, production, development expenditures, operating expenses, and quantities of recoverable oil and natural gas reserves will vary from those assumed in our estimates, and these variances may be significant. Any significant variance from the assumptions used could result in the actual quantity of our reserves and future net cash flow being materially different from the estimates in our reported reserves. In addition, results of drilling, testing and production and changes in oil and natural gas prices after the date of the estimate may result in substantial upward or downward revisions. WE HAVE A LIMITED HISTORY OF SELLING AND MARKETING PRODUCTS IN THE WHOLESALE POWER MARKETS AND MAY NOT BE ABLE TO SUCCESSFULLY MANAGE THE RISKS ASSOCIATED WITH THIS ASPECT OF OUR BUSINESS. We sell our energy, capacity and other energy products that are not otherwise committed under long-term contracts into wholesale power markets, either directly or through power marketers. We operate within strict limits, typically selling only our available capacity and not engaging in power marketing for others or in any speculative activity by selling in excess of what we reasonably believe our facilities are capable of producing or will produce. The overall objective of our power marketing activities is to optimize the utilization of our facilities to achieve an appropriate rate of return on our generation asset portfolio and our utility's off-system sales without taking any undue risks. Nevertheless, we have been managing risks associated with price volatility in this manner for only a limited amount of time. We and any power marketing company we hire may not be able to effectively manage this price volatility, and may not be able to successfully manage the other risks associated with trading in energy markets, including the risk that counterparties may not perform, especially if the current disruptions in the western markets worsen. WE HAVE SUBSTANTIAL INDEBTEDNESS AND WILL REQUIRE SIGNIFICANT ADDITIONAL AMOUNTS OF DEBT AND EQUITY CAPITAL TO GROW OUR BUSINESSES. OUR FUTURE ACCESS TO SUCH FUNDS IS NOT CERTAIN. As of December 31, 2000, we had short-term debt of $226 million, long-term recourse debt of $159 million and long-term non-recourse debt of $148 million. Our substantial debt presents the risk that we might not generate sufficient cash to maintain our credit facilities or service our indebtedness. In addition, our leveraged capital structure could limit our ability to finance the acquisition and development of additional projects, to compete effectively, to operate successfully under adverse economic conditions and to fully implement our strategy. The terms of our debt may also restrict our flexibility in operating our projects. In order to access capital on a substantially non-recourse basis in the future, we may have to make larger equity investments in, or provide more financial support for, our project subsidiaries. We also may not be successful in structuring future financing for our projects on a substantially non-recourse basis. The South Dakota Constitution requires shareholder approval of corporate indebtedness and prohibits South Dakota corporations, such as us, from incurring recourse debt in excess of levels previously approved by shareholders. At our next annual shareholders meeting in May 2001, we intend to ask our shareholders to approve an increase in the level of authorized borrowings from $500 million to $2 billion in order to support the future growth of our independent energy business. No assurance can be given, however, that our shareholders will approve this additional borrowing authority. Any failure to obtain additional borrowing authority could inhibit our ability to pursue our growth plan. We estimate that our communications unit will require approximately $25 million of additional financing to substantially complete the construction of its network in 2001. To date, we have generated capital for our independent energy investments and our communications network principally through internally-generated cash flow and through borrowings. We cannot assure you that we will continue to generate sufficient cash flow or that we will be able to raise additional debt or equity capital from others in the future. OUR POWER PROJECT DEVELOPMENT, EXPANSION AND ACQUISITION ACTIVITIES, OUR OIL AND GAS EXPLORATION AND PRODUCTION ACTIVITIES AND THE CONSTRUCTION OF OUR COMMUNICATIONS NETWORK MAY NOT BE SUCCESSFUL, WHICH WOULD IMPAIR OUR ABILITY TO EXECUTE OUR GROWTH STRATEGY. The growth of our independent power business through development, expansion and acquisition activities is critical to our future growth. While we are currently developing new facilities and expanding existing projects, with a significant development backlog, we may not be able to continue to develop attractive opportunities or to complete acquisitions or development projects that we undertake. Factors that could cause our activities to be unsuccessful include competition, our inability to obtain required governmental permits and approvals, and our inability to negotiate acceptable acquisition, construction, fuel supply or other material agreements. Similarly, we expect to continue to evaluate and pursue oil and gas acquisition opportunities on terms which management considers favorable. Our operations may be materially curtailed, delayed or canceled as a result of numerous factors, including accidents, title problems, weather conditions, shortages or delays in delivery of equipment or compliance with governmental requirements. There are relatively few manufacturers of the hybrid fiber coaxial cable equipment we are using to build our broadband communications network. Although construction is approximately 75% complete, any difficulties we experience in identifying satisfactory suppliers or alternative sources of equipment could delay the completion of our network, impede our ability to connect new customers and cause our communications unit to experience operating losses for a longer period than currently expected. CONSTRUCTION, EXPANSION, REFURBISHMENT AND OPERATION OF POWER GENERATION FACILITIES INVOLVE SIGNIFICANT RISKS THAT CANNOT ALWAYS BE COVERED BY INSURANCE OR CONTRACTUAL PROTECTIONS. The construction, expansion and refurbishment of power generation and transmission and resource recovery facilities involve many risks, including: - inability to obtain required governmental permits and approvals; - unavailability of equipment; - supply interruptions; - work stoppages; - labor disputes; - social unrest; - weather interferences; - unforeseen engineering, environmental and geological problems; and - unanticipated cost overruns. The ongoing operation of our facilities involves all of the risks described above, in addition to risks relating to the breakdown or failure of equipment or processes and performance below expected levels of output or efficiency. New plants may employ recently developed and technologically complex equipment, especially in the case of newer environmental emission control technology. While we maintain insurance, obtain warranties from vendors and obligate contractors to meet certain performance levels, the proceeds of such insurance, warranties or performance guarantees may not be adequate to cover lost revenues, increased expenses or liquidated damages payments. Any of these risks could cause us to operate below expected capacity levels, which in turn could result in lost revenues, increased expenses, higher maintenance costs and penalties. As a result, a project may operate at a loss or be unable to fund principal and interest payments under its project financing agreements, which may result in a default under that project's indebtedness. RISKS RELATING TO OUR CORPORATE STRUCTURE PROVISIONS OF SOUTH DAKOTA LAW AND OUR ARTICLES OF INCORPORATION AND BYLAWS, AND SEVERAL OTHER FACTORS, COULD LIMIT ANOTHER PARTY'S ABILITY TO ACQUIRE US AND COULD DEPRIVE YOU OF THE OPPORTUNITY TO OBTAIN A TAKEOVER PREMIUM FOR YOUR SHARES OF COMMON STOCK. A number of provisions under South Dakota law and that are contained in our articles of incorporation and bylaws could make it more difficult for another company to acquire us and for you to receive any related takeover premium for your shares. These provisions, among other things: - provide for a classified board of directors, which allows only one-third of our directors to be elected each year; - restrict the ability of shareholders to take action by written consent and to call a special meeting; - authorize the board of directors to designate the terms of and issue new series of preferred stock; and - impose restrictions on business combinations with certain interested parties. In addition, the South Dakota Public Utility Commission may assert jurisdiction to review and authorize certain business combinations or other acquisitions of our capital stock. Any attempt to obtain control of us by means of a tender offer, merger or otherwise could be discouraged, delayed or prevented if the South Dakota Public Utility Commission determined that it has the authority or the obligation to review the transaction. LIQUIDITY RISKS WE CANNOT ASSURE YOU THAT A HIGHLY ACTIVE TRADING MARKET FOR OUR COMMON STOCK WILL DEVELOP. We have not offered common stock in the public market since 1993 and our common stock currently lacks the level of liquidity or high trading volume enjoyed by some of our competitors. The continued absence of a highly active trading market for our common stock could cause our stock price to fluctuate significantly.

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+RISK FACTORS An investment in our common stock involves various risks, including those described in the risk factors below. You should carefully consider these risk factors, together with all of the other information included in this prospectus, before you decide to invest in our common stock. If any of the following risks, or other risks not presently known to us or that we currently believe not to be material, develop into actual events, then our business, financial condition, results of operations, or prospects could be materially adversely affected, the market price of our common stock could decline and you could lose all or part of your investment. WE WILL DEPEND ON ADDITIONAL CAPITAL Our ability to implement our strategy and expand our operations largely depends on our access to capital. We expect to make expenditures to continue integrating the acquired floral businesses with our existing businesses. To implement our long-term strategy, we plan to acquire additional floral businesses, which will require ongoing capital expenditures. To date, we have financed capital expenditures and acquisitions primarily through private equity, a public offering and our revolving bank credit facility. We have a $36 million revolving credit facility and a $7 million working capital facility under which we have aggregate outstanding borrowings of approximately $37.8 million on January 18, 2001. The working capital facility expires on February 28, 2001, and the revolving capital facility expires on June 30, 2002. Further, mandatory prepayments are required upon sales of certain assets and issuances of debt and equity. Asset sales through January 18, 2001 have reduced the commitment under the working capital facility to $6.1 million. As a result, we have limited options for raising capital without the consent of our existing lenders. In addition, to execute our growth strategy and meet our capital needs, we may issue additional equity securities as part of the purchase price of future acquisitions and we may issue additional debt or equity securities for cash in public or private offerings. Any of these transactions may have a dilutive effect on the interests of our stockholders. Further, our recent delisting from the Nasdaq National Market may make it more difficult to raise capital in the public markets, and, otherwise, additional capital may not be available on terms acceptable to us. Our failure to obtain sufficient additional capital could continue to curtail or alter our growth strategy or further delay needed capital expenditures. WE NEED TO IMPROVE OUR INFORMATION SYSTEMS To implement our long-term strategy, we need to improve existing information systems and install and integrate uniform information systems. We estimate that it would cost between $4 million and $6 million to install common point-of-sale systems in our existing stores, and we believe this installation is an important step in implementing our long-term strategy. We may experience delays, disruptions and unanticipated expenses in improving, installing and integrating our information systems. Failure to improve existing information systems and install and integrate uniform information systems could have a material adverse effect on our business, financial condition, results of operations and growth prospects. WE MAY HAVE DIFFICULTIES INTEGRATING ACQUIRED BUSINESSES WITH OUR COMPANY Until we complete and install our information systems, we will use and depend upon the information and operating systems of our acquired entities. We may not be able to efficiently combine our operations with those of the businesses we have acquired without encountering difficulties. These difficulties could result from having different and potentially incompatible operating practices, computers or other information systems. By consolidating personnel with different business backgrounds and corporate cultures into one company, we may experience additional difficulties. As a result, we may not achieve anticipated cost savings and operating efficiencies and we may have difficulties managing, operating and integrating our businesses. As part of our long-term strategy, we intend to convert our retail stores, nearly all of which we have acquired, using a retail store concept that we have designed. We also intend to open new stores using our retail store concept, and we intend to convert any subsequently acquired stores to this concept. We do not PROSPECTUS SUMMARY This summary highlights information contained elsewhere in this prospectus. It is not complete and may not contain all of the information that you should consider before investing in the common stock. You should read this entire prospectus carefully, including the "Risk Factors" section and the financial statements and the notes to those statements. We are an integrated retailer and marketer of flowers, plants, and complementary gifts and decorative accessories. We currently operate the largest company-owned network of floral specialty retail stores in the United States, with over 300 retail locations across the country. We believe we are transforming the retail floral industry by integrating our operations throughout the floral supply chain, from product sourcing to delivery, and by managing every interaction with the customer, from order generation to order fulfillment. We ultimately intend to provide all of our retail customers with a unique and enhanced shopping experience. We believe our execution of this integrated operating model will make our stores synonymous with superior service, quality and value. Our order generation division permits us, through multiple marketing channels, including the Internet, dial-up numbers and direct mail, to serve customers who do not visit or phone our retail stores. This division includes National Flora, the largest yellow page advertiser of floral products; Calyx & Corolla, the largest direct marketer of flowers; The Flower Club, a leading corporate affinity marketer; and three primary websites. To ensure superior customer service and efficient order processing, we operate three call centers. To distribute orders in markets where we do not have our own stores, we use several floral wire services, including our own Florafax floral wire service, which has approximately 6,000 member florists covering all 50 states. We operate a leading floral importer and wholesaler, AGA Flowers, which has long-term supply agreements and other relationships to purchase cut flowers with many of the finest growers in the United States, Central America and South America. These supply arrangements help us to eliminate several steps in the floral distribution chain and ensure a reliable source of high-quality products at favorable prices. Gerald Stevens was incorporated in Delaware in 1970, and reincorporated in Florida in 2000. Our principal executive offices are located at 1800 Eller Drive, Fort Lauderdale, Florida 33316, and our telephone number is (954) 627-1000. RECENT DEVELOPMENTS On December 4, 2000, our common stock was delisted from the Nasdaq National Market because we did not meet the listing requirements. Our common stock initiated quotation on the NASD OTC Bulletin Board on that date. currently have sufficient capital available to implement this strategy. To the extent that we are able to secure sufficient capital to convert some or all of our retail sales, the conversion of these stores and opening of new stores may not have the positive effect on our business that we expect. The conversion of stores may cause us to lose customers that were loyal to the former store brand, and customers may not respond positively to the concept store. In the store conversion and new store opening processes, we may incur other unanticipated difficulties, including delays in project completion, unexpected or excessive costs, and zoning or other regulatory problems. OUR POTENTIAL INABILITY TO IMPLEMENT OUR GROWTH STRATEGY Our near-term business strategy will focus on growing our revenue and operations internally by improving our existing retail operations and expanding sales through order-generation businesses, including our websites. In the long-term, we seek to open or acquire additional retail locations. The success of our growth strategy will depend on a number of factors including our ability to: - obtain financing to support this growth; - successfully integrate acquired businesses and new retail locations with existing operations; - retain experienced management and other key personnel; - expand our customer base; - market our products and services effectively through traditional media and over the Internet; - assess the value, strengths and weaknesses of acquisition candidates and new store locations; - evaluate the costs and projected returns of expanding our operations; and - lease desirable store locations on suitable terms and complete construction on a timely basis. We may expand our operations not only within our current lines of business, but also into other related and complementary businesses. Our entry into any new lines of business may not be successful, as we may lack the understanding and experience to operate profitably in new lines of business. DEMANDS ON OUR RESOURCES Our operations could place significant demands on our management and our operational, financial and marketing resources. These demands are primarily due to our plans to: - expand the scope of our operating and financial systems; - increase the complexity of our operations; - increase the level of responsibility of management personnel; - continue to train and manage our employee base; - acquire and integrate numerous floral and gift retailers; - open new locations; - increase the number of our employees; and - broaden the geographic area of our operations. Our management and resources, now and in the future, may not be adequate to meet the demands resulting from our plans. CONTINUED NET LOSSES COULD HINDER OUR STRATEGY We have experienced losses during our most recent fiscal year. Our net loss for fiscal 2000 was $42.6 million, which included a charge of $28.6 million for the impairment of long-lived assets. Our net loss for the first quarter of fiscal 2001 was $5.2 million. If we continue to incur net losses in future periods, we may not be able to implement our business strategy in accordance with our present plans. OUR FINANCIAL RESULTS MAY NOT BE INDICATIVE OF FUTURE RESULTS The financial statements in this report cover periods when Gerald Stevens and some of our acquired businesses were not under common control or management. These financial statements may not be indicative of our future financial condition, operating results, growth trends or prospects. We acquired our initial retail operations in our April 1999 merger with Gerald Stevens Retail, Inc. Gerald Stevens Retail was established in May 1998 and commenced operations in October 1998 upon completion of its acquisition of ten floral businesses. For the period from its inception to September 30, 1998, Gerald Stevens Retail was a development stage company with no revenue and generated a net loss of $2.1 million. You should evaluate our prospects in light of the risks, expenses and difficulties frequently encountered by companies in the early stages of a new growth strategy. Our strategy of building a national floral and gift retailer and marketer may not lead to growth or profitability. WE MAY INCUR UNEXPECTED LIABILITIES WHEN WE ACQUIRE BUSINESSES During the acquisition process, we may not discover some of the liabilities of businesses we acquire. These liabilities may result from a prior owner's non-compliance with applicable federal, state or local laws. For example, we may be liable after an acquisition of a business for the prior owner's failure to pay taxes or comply with environmental regulations. Environmental liabilities could arise regardless of whether we own or lease our properties. While we will try to minimize our potential exposure by conducting thorough investigations during the acquisition process, we will not be able to identify all existing or potential liabilities. We also generally will require each seller of an acquired business to indemnify us against undisclosed liabilities. In most cases, this indemnification obligation will be supported by deferring payment of a portion of the purchase price or other appropriate security. However, this indemnification may not be adequate to fully offset any undisclosed liabilities associated with the acquired business. DEBT COVENANTS MAY RESTRICT OUR GROWTH AND IMPLEMENTATION OF OUR BUSINESS STRATEGY Restrictive covenants contained in our credit facility may limit our ability to make capital expenditures, finance acquisitions, build new locations and finance other expansion of our operations. These covenants also require us to achieve specific financial ratios. Credit facilities obtained in the future likely will contain similar covenants. In particular, consolidated earnings before interest, taxes, depreciation and amortization must equal or exceed $7.2 million in the fiscal quarter ending February 28, 2001; $14 million in the six-month fiscal period ending May 31, 2001; $13.2 million in the nine-month fiscal period ending August 31, 2001; and $13.75 million in any four-quarter fiscal period on or after November 30, 2001. Further, our aggregate capital expenditures may not exceed $500,000 in any fiscal quarter, except that we may also spend up to $3.8 million for a standardized point-of-sale and management information system. Any of these covenants could become more restrictive over time. Our ability to respond to changing business and economic conditions and to secure additional financing for operating and capital needs may be significantly restricted by these covenants. Furthermore, we may be prevented from engaging in acquisitions that are important to our long-term growth strategy. Any breach of these covenants could cause a default under our debt obligations and result in our debt becoming immediately due and payable. We are not certain whether we would have, or would be able to obtain, sufficient funds to make these accelerated payments. OUR QUARTERLY OPERATING RESULTS WILL FLUCTUATE DUE TO SEASONALITY The floral industry has historically been seasonal, with higher revenue generated during holidays such as Christmas, Valentine's Day, Easter and Mother's Day. Given the importance of holidays to the floral industry, a change in the date (in the case of a "floating" holiday such as Easter) or day of the week on which a holiday falls may also have a substantial impact on our business. During the summer and fall months, floral retailers tend to experience a decline in revenue. As a result, we currently expect the period from June through November (encompassing our fourth and first fiscal quarters) to be a period of lower revenue and unprofitable operations. In addition, the floral industry is affected by economic conditions and other factors, including, but not limited to, competition and weather conditions that impact other retail businesses. We intend to plan our operating expenditures based on revenue forecasts. Any revenue shortfall below these forecasts in any quarter would likely decrease our operating results for that quarter. PROBLEMS WITH ORDER TRANSMISSION NETWORKS AND THE COMPATIBILITY OF OUR SYSTEMS A large percentage of floral industry revenue is dependent upon the ability of the party taking an order from a customer to transmit the order to a delivering florist outside the immediate geographic market. Over the past several years, this process has increasingly relied on electronic communications and computers to create networks that serve as the transmission medium for orders. We believe that a substantial number of floral industry participants use one or more of these networks, particularly FTD's Mercury network. In the event that one or more of these networks were to become disabled, or our systems were unable to communicate with the network or any other transmission medium, we may not be able to use our normal computer-based methods for communicating orders. In this event, we would either need to route orders via alternative wire services, requiring reconfiguration of the existing wire interfaces and programming logic, or be required to make individual telephone calls or send faxes to florists. Conducting business primarily through telephone and fax orders would cause us to operate in a slower and more costly manner. Any of these situations could have a negative impact on our business, financial condition, results of operations or prospects. RELATIONSHIPS WITH FLORAL WIRE SERVICE BUSINESSES MAY DETERIORATE The retail floral industry has traditionally relied upon floral wire services, including FTD, Teleflora, AFS and our Florafax wire service business, to act as intermediaries to effectively manage, among other things, the financial settlement among florists and serve as a clearinghouse for orders. To our knowledge, these intermediaries do not currently operate retail stores but do engage in other marketing and floral order generating activities. One or more of these wire services may seek to prohibit our order generation business or our retail operations from settling orders through their wire services or using their technology to transmit orders. These actions may have a short-term material adverse impact on our business, financial condition, results of operations or prospects. Wire service intermediaries also provide financial rebates or incentives to those florists, order generators and other parties that transmit and/or financially settle a large number of orders through their system. These rebates and incentives provide a significant portion of our operating profit. Any change in the industry's rebate or incentive structure may have a short-term material impact on our business, financial condition, results of operations or prospects. CUSTOMERS MAY REDUCE DISCRETIONARY PURCHASES OF FLOWERS AND GIFTS We believe that the floral and gift industry is influenced by general economic conditions, particularly by the level of personal discretionary spending by customers. As a result, the floral and gift industry could experience periods of decline and recession during economic downturns. The industry may experience sustained periods of decline in sales in the future. Any material decline in personal discretionary spending could have a negative effect on our business, financial condition, results of operations or prospects. UNCERTAINTY OF INTERNET USE AND ITS IMPACT ON OUR BUSINESS We believe that the Internet and electronic commerce will play an increasingly important role in floral and gift-related merchandising and order taking over the coming years. As such, we intend to devote significant financial resources to our Internet operations. However, the use of the Internet and e-commerce by customers to purchase flowers and gifts may not increase as rapidly as we expect, and other purchasing mediums may replace the Internet. Additionally, unlike building traditional retail stores, where there is a limited amount of prime retail real estate and significant capital requirements, there are few barriers to entry on the Internet. Our competitors may be better funded or have other proprietary technologies or approaches to e-commerce that may make it difficult for us to compete on the Internet. In any of these instances, our business, financial condition, results of operation or prospects may be materially adversely impacted. In addition, if the use of the Internet for direct-from-grower sales does rapidly increase and such sales replace locally delivered floral arrangements, then the revenue we plan to generate by owning and operating numerous retail stores may be adversely affected. Also, as e-commerce becomes more prevalent and the use of Internet phone directories increases, the value we receive from advertisements in traditional phone books may decrease. COMPETITION MAY ADVERSELY IMPACT OUR PERFORMANCE The floral and gift industry is highly competitive. Competition exists in each segment of the industry. We expect competition from: - flower growers, importers, wholesalers and bouquet companies, including Dole Food Company, Inc. and USA Floral Products Inc.; - floral wire services, including FTD, Teleflora and AFS; - retailers including traditional floral and gift shops, supermarkets, mass merchandisers and garden centers; and - traditional and online order generators of floral and gift products, including 1-800-FLOWERS. In many of our markets, our competitors have larger and greater financial resources than we do. The Gerald Stevens(SM) brand is new, and may not be marketed effectively by us. We may not be able to compete successfully against our existing competitors and any future competitors. GOODWILL RESULTING FROM ACQUISITIONS MAY ADVERSELY AFFECT OUR RESULTS Goodwill resulting from our acquisitions of retail floral businesses, and the amortization of this goodwill and other intangible assets, could adversely affect our financial condition and results of operations. We have considered various factors, including projected future cash flows, in determining the purchase prices of our acquired retail floral and order generation businesses. Except to the extent we recorded impairment charges in our 2000 fiscal fourth quarter, we do not believe that any material portion of the goodwill related to any of these acquisitions will dissipate over a period shorter than the expected useful life. However, our earnings in future years could be materially adversely affected if management later determines either that the remaining balance of goodwill is impaired or that a shorter amortization period is applicable. WE MAY INCUR ANTI-DUMPING LIABILITY The majority of flowers sold in the United States are grown in other countries. Flower-importing companies are subject to anti-dumping duties. Generally, if the United States Department of Commerce determines that a foreign grower sold flowers to an importer in the United States for a price less than the home market price or constructed value of the flowers, then the Commerce Department may impose an anti-dumping duty upon the importer. The precise amount of duty is calculated after a review of sales over a twelve-month period and a comparison of the prices of the United States sales with the prices of home market sales or constructed value. POLITICAL AND ECONOMIC EVENTS IN FOREIGN COUNTRIES MAY LIMIT SUPPLY OF FLOWERS Flowers are imported principally from countries in South America and Central America. The political and economic climate in several of these countries from time to time has been volatile. In some of these countries, this volatility has from time to time adversely affected many aspects of the countries' economies, including flower production. At times, this volatility has also impacted trade relations with the United States. As a result, future political and economic events in these flower-growing countries may reduce the production or export of flowers. Any adverse changes in the production or export of flowers from flower-producing countries could have a material impact on our business, financial condition, results of operations or prospects. POTENTIAL ADVERSE EFFECTS OF BAD WEATHER IN FLOWER-GROWING REGIONS The supply of perishable floral products depends significantly on weather conditions where the products are grown. Severe weather, including unexpected cold weather, may have an adverse effect on the available supply of flowers, especially at times of peak demand. For example, in order for a sufficient supply of roses to be available for sale on Valentine's Day, rose growing regions must not suffer a freeze or other harsh conditions in the weeks leading up to the holiday. Any shortages or disruptions in the supply of fresh flowers, or any inability on our part to procure our flower supply from alternate sources at acceptable prices in a timely manner, could lead to the inability to fulfill orders during periods of high demand, and the loss of customers. WE MAY HAVE DIFFICULTIES TRANSPORTING FLOWERS The perishable nature of flowers requires the floral industry to have a transportation network that can move products quickly from the farm to the retailer. Flowers grown in South America and Central America are typically transported via charter flights to the United States, principally to Miami. After flowers arrive in Miami or other ports of entry, they are distributed throughout the United States primarily via refrigerated trucks. There may be disruptions in service at ports of entry, fuel shortages, work stoppages in the air charter or trucking industries or other problems encountered in transporting flowers. RELATIONSHIPS WITH MEMBER FLORISTS OF OUR WIRE SERVICE BUSINESS MAY DETERIORATE Some of the member florists of our Florafax wire service business may not want to continue as members if they perceive that we are in competition with them through our retail stores. This risk may be heightened when we acquire or open retail operations in markets where our member florists are located. Loss of member florists could have a negative impact on our business, financial condition, results of operations or prospects. WE MAY FACE INCREASED GOVERNMENT REGULATIONS OF THE INTERNET There are an increasing number of federal, state, local and foreign laws and regulations pertaining to the Internet. In addition, a number of federal, state, local and foreign legislative and regulatory proposals are under consideration. Laws or regulations may be adopted with respect to the Internet relating to liability for information retrieved from or transmitted over the Internet, online content, user privacy and quality of services. Changes in tax laws relating to electronic commerce could adversely affect our business. The applicability to the Internet of existing laws covering issues such as intellectual property, libel, personal privacy and other areas is uncertain and developing. New legislation or regulations could decrease growth in the use of the Internet, impose additional burdens on e-commerce or alter how we do business. This could decrease demand for our online product offerings, increase our cost of doing business, increase the costs of products sold on the Internet or otherwise have an adverse effect on our business, financial condition, results of operations and prospects. OUR DIRECTORS AND EXECUTIVE OFFICERS HAVE LIMITED INDUSTRY EXPERIENCE Many of our directors and executive officers have no significant experience in the floral and gift industry. Accordingly, our management may not ultimately be successful in the floral and gift industry. In addition, we believe that our success will depend to a significant extent upon the efforts and abilities of the management of companies that we have acquired. WE DEPEND HEAVILY ON OUR SENIOR MANAGEMENT We believe that our success will depend to a significant extent upon the efforts and abilities of our executive officers and the senior management of the companies that we acquire. While we have entered into employment agreements with our executive officers and the senior management of some companies we have acquired, these individuals may not remain with us throughout the term of the agreements or thereafter. We do not have "key person" life insurance policies covering any of our employees. If we lose the services of one or more of these key employees before we are able to attract qualified replacement personnel, our business could be adversely affected. OUR SIGNIFICANT STOCKHOLDERS WILL BE IN A POSITION TO INFLUENCE CORPORATE ACTION As a result of its stock ownership and board representation, New River Capital Partners will be in a position to influence our corporate actions such as mergers or takeover attempts in a manner that could conflict with the interests of our other stockholders. New River Capital Partners owns approximately 1.48 million shares, or approximately 15.0% of our outstanding common stock. In addition, our Chairman of the Board controls the managing general partner of New River Capital Partners. Our directors and executive officers are deemed to beneficially own approximately 2.82 million shares, or approximately 28.3%, of our outstanding common stock (which include the shares owned by New River Capital Partners). Although there are no agreements or understandings between New River Capital Partners and our executive officers as to voting, if these parties voted in concert they would exert significant influence over us. Under the November 6, 2000 amendment to our credit agreement, we issued three-year warrants to purchase up to 10% of our diluted common stock to the bank and three members of management who were required to participate in the credit facility. We also provided the bank with the right to appoint a director on our board of directors. These provisions, as well as other covenants and restrictions in the credit agreement, may provide the bank with the ability to exert significant influence over us. OUR STOCK PRICE IS VOLATILE The market price for our common stock has been volatile and may be affected by a number of factors, including the announcement of acquisitions or other developments by us or our competitors, quarterly variations in our or other industry participants' results of operations, changes in earnings estimates or recommendations by securities analysts, developments in the floral and gift industry, sales of a substantial number of shares of our common stock in the public market, general market conditions, general economic conditions and other factors. Some of these factors may be beyond our control or may be unrelated to our results of operations or financial condition. Such factors may lead to further volatility in the market price of our common stock. PENNY STOCK RULES MAY DECREASE THE LIQUIDITY OF OUR COMMON STOCK Our delisting from the Nasdaq National Market and subsequent quotation on the OTC Bulletin Board brings our common stock within the definition of a "penny stock." As a result, our common stock is subject to the penny stock rules and regulations that require additional disclosure by broker-dealers in connection with any trades involving a penny stock. The additional burdens imposed on broker-dealers may restrict the ability of broker-dealers to sell our common stock and may affect your ability to resell our common stock. POSSIBLE DEPRESSING EFFECT OF SHARES ELIGIBLE FOR FUTURE SALE We have issued a substantial number of shares of our common stock in connection with past acquisitions. The shares of common stock issued pursuant to these acquisitions generally have been registered with the Commission after the acquisition, making them available for resale. We have issued to our employees, officers and directors options to purchase shares of our common stock. The shares issuable upon exercise of the options have been registered with the Commission. We have also issued a significant number of warrants to purchase shares of our common stock to our primary lender and three members of management pursuant to an amendment to our credit agreement in November 2000. Any actual sales or any perception that sales of a substantial number of shares may occur could adversely affect the market price of our common stock and could impair our ability to raise capital through an offering of equity securities. POSSIBLE DILUTION IN VALUE OF COMMON STOCK AND VOTING POWER If we issue additional shares of common stock, purchasers of common stock may experience dilution in the net tangible book values per share of the common stock. In addition, because our stockholders do not have any preemptive right to purchase additional shares in the future, their voting power will be diluted by any issuance of shares.

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+RISK FACTORS YOU SHOULD CONSIDER CAREFULLY THE RISKS DESCRIBED BELOW BEFORE YOU DECIDE TO BUY OUR CLASS A COMMON STOCK. IF ANY OF THE FOLLOWING RISKS ACTUALLY OCCURS, OUR BUSINESS, FINANCIAL CONDITION OR RESULTS OF OPERATIONS WOULD LIKELY SUFFER. IN THAT CASE THE TRADING PRICE OF OUR CLASS A COMMON STOCK COULD FALL, AND YOU MIGHT LOSE ALL OR PART OF THE MONEY THAT YOU HAVE PAID TO BUY OUR CLASS A COMMON STOCK. RISKS RELATED TO OUR BUSINESS FREQUENCY CONTROL DEVICES ACCOUNT FOR NEARLY ALL OF OUR SALES; CONSEQUENTLY, CONTINUED MARKET ACCEPTANCE OF OUR FREQUENCY CONTROL DEVICES IS CRITICAL TO OUR SUCCESS. Virtually all of our net sales come from sales of our frequency control devices, which consist of packaged quartz crystals and oscillator modules. We expect that this product line will continue to account for substantially all of our net sales for the foreseeable future. Continued market acceptance of this product line is critical to our success. Any decline in demand for this product line or failure to achieve continued market acceptance of our frequency control devices may harm our business. IF WE ARE UNABLE TO DEVELOP OR ACQUIRE SUCCESSFUL NEW PRODUCTS AND TECHNOLOGIES IN A TIMELY MANNER, OUR ABILITY TO GROW OUR BUSINESS MAY BE HARMED. Frequency control devices are subject to technological changes, particularly in devices that control higher frequencies. We believe that our future success will depend in part upon our ability to continue to enhance our existing product line and to develop or acquire successful new products in a timely manner. In particular, we need to enhance our ability to produce products that operate at higher frequencies and have longer product lives than our current products. We cannot assure you that our product development or acquisition efforts will be successful or that we will be able to respond effectively to technological change. If we are unsuccessful, our business may be negatively impacted. IF WE ARE UNABLE TO INCREASE OUR MANUFACTURING CAPACITY, WE MAY BE UNABLE TO GROW OUR BUSINESS. We are currently producing our products at or near full capacity. Our ability to increase our manufacturing capacity is dependent upon our ability to obtain equipment, hire additional employees, reduce manufacturing cycle times and increase our utilization of our contract manufacturers. If we are unable to successfully increase our manufacturing capacity, including that of our contract manufacturers, we may be unable to grow our business. WE RELY UPON TWO CONTRACT MANUFACTURERS FOR A SIGNIFICANT PORTION OF OUR FINISHED PRODUCTS, AND A DISRUPTION IN OUR RELATIONSHIPS WITH EITHER OF THESE CONTRACT MANUFACTURERS COULD HAVE A NEGATIVE IMPACT ON OUR SALES. In the first nine months of 2000, approximately 39% of our net sales were attributable to finished products that were manufactured by two independent contract manufacturers located in Korea and China. We expect that sales of products manufactured by our contract manufacturers will represent a material portion of our sales for the next several years. Although we believe that we maintain good relations with these contract manufacturers, we do not have written long term supply contracts with them and our relationships with them could deteriorate in the future. If either of our contract manufacturers becomes unable to provide products in the volumes needed, or at acceptable prices, we would have to identify and qualify acceptable replacement manufacturers or manufacture the products internally. Due to industry-wide capacity shortfalls, we could encounter difficulties in locating, qualifying and entering into arrangements with replacement manufacturers. As a result, a reduction in the production capability or financial viability of either of our independent contract manufacturers, or a termination of, or significant interruption in, our relationships with either of them, may harm our business. OUR DEPENDENCE ON A FEW SIGNIFICANT CUSTOMERS EXPOSES US TO A RISK OF LOSS OF BUSINESS, AND WE MAY NOT BE ABLE TO OBTAIN ORDERS FROM NEW CUSTOMERS. Sales to our ten largest customers accounted for approximately 60% of our net sales in the first nine months of 2000 and in 1999, 1998, and 1997. As of September 30, 2000, our net sales to Newbridge Networks, a subsidiary of Alcatel, accounted for approximately 10.0% of our net sales for 2000. In 1999, our net sales to Newbridge Networks accounted for approximately 12.4% of our net sales. No other customer accounted for greater than 10% of our net sales in 1999 or in the first three quarters of 2000. No customer accounted for greater than 10% of our net sales in 1998 or 1997. If a significant customer reduces or delays orders for any reason, our business may be negatively affected. In addition, our ability to increase our sales will depend in part upon our ability to obtain orders from new customers for whom there is intense competition. OUR DEPENDENCE ON SUPPLIERS TO DELIVER KEY COMPONENTS MAY AFFECT OUR ABILITY TO DELIVER PRODUCTS TO OUR CUSTOMERS IN A TIMELY MANNER, WHICH MAY RESULT IN LOST SALES. We rely on outside suppliers that in some instances are single or limited sources for key components used in our products, and for some components we have made the strategic choice to purchase from only one supplier. If we have to replace one or more of these sources, we could be delayed in, or even prevented from, delivering our products to our customers. If supply delays and shortages of key components persist, we may experience an interruption in production until we locate alternative sources of supply or we may even be forced to adjust our product designs and production schedules. Because of a worldwide demand for and shortage of some components, we have experienced lengthening lead times and delivery times for some of the components, including some types of integrated circuits and the packages within which our frequency control devices are assembled, that we purchase. If we are not able to obtain sufficient allocations of these components, our production and shipment of product may be delayed, we may lose customers and our business may be adversely affected. OUR DEPENDENCE UPON INTERNATIONAL CUSTOMERS AND SUPPLIERS MAY REDUCE OUR NET SALES OR IMPEDE OUR ABILITY TO SUPPLY PRODUCTS. Our international sales represented approximately 46% of our net sales in the first nine months of 2000. This consisted of approximately 20% from customers in Canada, 12% from customers in Asia, 5% from customers in Western Europe, 4% from customers in Mexico and 5% from other international customers. We expect that the percentage of sales to international customers will increase in the future. Furthermore, we sell our products to manufacturers of communications equipment for incorporation into their own products, many of which we believe are sold by those manufacturers to international customers. In manufacturing our products, we rely on contract manufacturers and component suppliers in various countries. As a result, our sales and our ability to manufacture our products are subject to the risks associated with international commerce. International sales and our relationships with suppliers may be harmed by many factors, including: - changes in law or policy resulting in burdensome government controls, tariffs, restrictions, embargoes or export or import license requirements; and - political or economic instability in international markets. If our international sales or our relationships with our international suppliers are adversely affected by any of these factors, our business may be harmed. SEVERAL KEY MANAGEMENT EMPLOYEES, INCLUDING ROBERT R. ZYLSTRA, OUR PRESIDENT AND CHIEF EXECUTIVE OFFICER, HAVE ONLY RECENTLY JOINED US, AND WE CANNOT BE CERTAIN THAT OUR MANAGEMENT TEAM WILL WORK TOGETHER EFFECTIVELY IN THE FUTURE. Several key members of our management team have joined us within the last one to two years, including Robert R. Zylstra, our President and Chief Executive Officer, John R. Kerg, Jr., our Vice President of Sales and Marketing, and Gregory T. Rogers, our Vice President of Engineering. We have little basis on which to judge their individual performance or whether they will work together effectively in the future. If they do not perform well individually or together, our ability to execute our business strategy may be impaired and our business may suffer. We do not have employment agreements with any officers or employees, other than Mr. Zylstra. PART OF OUR GROWTH STRATEGY IS TO MAKE ACQUISITIONS. IF WE ARE UNABLE TO DO SO, OUR FUTURE RATE OF GROWTH MAY BE LIMITED. An element of our growth strategy is to acquire businesses, technologies or products that expand and complement our current products. We may not be able to execute our acquisition strategy if we: - are unable to identify suitable and available businesses, technologies or products to acquire; - do not have access to required capital at the necessary time; or - are unwilling or unable to outbid larger companies with more resources. OUR ACQUISITION STRATEGY INVOLVES FINANCIAL AND MANAGEMENT RISKS WHICH MAY ADVERSELY AFFECT OUR INCOME IN THE FUTURE. If we acquire additional businesses, technologies or products, we may face additional risks, including the following: - future acquisitions could divert management's attention from daily operations or otherwise require additional management, operational and financial resources; - we might not be able to integrate future acquisitions into our business successfully or operate acquired businesses profitably; - we may realize substantial acquisition related expenses, including the amortization of goodwill, which would reduce our net income in future years; - we may lose key employees and customers as a result of changes in management; and - our investigation of potential acquisition candidates may not reveal problems and liabilities of or associated with the businesses, technologies or products that we acquire. If events such as those described above occur, our net income might be adversely affected. If we issue shares of our common stock or other rights to purchase our common stock in connection with any future acquisitions, we could dilute our existing stockholders' interests and our net income per share may decrease. If we issue debt in connection with any future acquisitions, lenders may impose covenants upon us which could, among other things, restrict our ability to increase capital expenditures or acquire additional businesses. OUR SALES AND OPERATING RESULTS COULD FLUCTUATE SIGNIFICANTLY FROM PERIOD TO PERIOD, THEREBY POTENTIALLY ADVERSELY AFFECTING THE MARKET PRICE OF OUR COMMON STOCK. Our quarterly and annual results could be affected by a wide variety of factors that could adversely affect or lead to significant variability in our net sales or operating results. In addition, because a significant portion of our net sales in any particular quarter has historically come from the sale of products to a relatively small number of customers, the loss or delay of sales to one or a few of our customers could have a significant negative impact. A variety of other factors could also cause, and in the past have caused, this variability, including the following: - decreases in capital spending by providers of communications services; - competitive pricing pressures; - component shortages resulting in manufacturing delays; - a downturn in general economic conditions; and - a loss of, or decrease in sales to, one of our significant customers. During periods in which there is a downturn in general economic conditions, or in which there is a decrease in the rate of capital spending by communications service providers, our rate of growth may slow significantly, or even decline, resulting in lower net income or net losses. We have experienced two such periods during the last five years, most recently during 1998, when our rate of growth for the year was essentially zero. We believe that, in 1998, rates of capital spending by providers of communications services remained flat as a result of the Asian currency crisis that existed at that time. Our rate of growth also slowed significantly in 1996, when we lost a large customer. Competitive pricing pressures are a factor in all periods. We generally respond to such pressures by requiring our vendors to supply products and components to us at prices that allow us to remain competitive, but there can be no assurance that we will be able to do so at any time in the future. While we have occasionally experienced component shortages that have had a material impact on our ability to manufacture our products, such shortages have occurred infrequently and only during times of very rapid growth industry-wide. During such shortages, manufacturing lead times for our products, and for those produced within our industry generally, are extended. We cannot predict the impact of these and other factors on our sales and operating results in any future period. Results of operations in any period, therefore, should not be considered indicative of the results to be expected for any future period. Because of this difficulty in predicting future performance, our operating results may fall below expectations of securities analysts or investors in some future quarter or quarters. Our failure to meet these expectations would likely adversely affect the market price of our Class A common stock. OUR BUSINESS COULD BE NEGATIVELY IMPACTED IF WE ARE UNABLE TO PUT IN PLACE THE APPROPRIATE CONTROLS TO MANAGE OUR GROWTH EFFECTIVELY. We have recently experienced substantial growth in our operations, the number of our employees, our product offerings and the geographic area in which we do business, and we will seek to continue to grow in the future. Our growth places a significant strain on our management, operations and financial systems. Our future operating results will depend upon our ability to continue to implement and improve our operating and financial controls and management information systems. Failure to manage our growth effectively may negatively impact our business. RISKS RELATED TO OUR INDUSTRY OUR PRINCIPAL MARKET IS THE COMMUNICATIONS EQUIPMENT INDUSTRY; CONSEQUENTLY, OUR FUTURE RATE OF GROWTH IS HIGHLY DEPENDENT ON THE DEVELOPMENT AND GROWTH OF THE MARKET FOR COMMUNICATIONS EQUIPMENT. Our business depends heavily upon capital expenditures by the providers of communications services. In 1999 and the first nine months of 2000, the majority of our net sales were to manufacturers of communications infrastructure equipment, including indirect sales through distributors and contract manufacturers, and we intend to increase our sales to communications infrastructure equipment manufacturers in the future. Communications service providers have experienced periods of capacity shortage and periods of excess capacity. In periods of excess capacity, communications network operators cut purchases of capital equipment, including equipment utilizing our products. A slowdown in the manufacture and purchase of communications infrastructure equipment could substantially reduce our net sales and operating results and hurt our financial condition. In this regard, for the nine months ended September 30, 2000 and the three months ended December 31, 2000 we received new orders, net of permitted cancellations, of approximately $4.0 million per month and $3.0 million per month, respectively. If new orders continue at the recent reduced rate, we will be unable to sustain our growth. COMMUNICATIONS EQUIPMENT MANUFACTURERS ARE SOMETIMES LOYAL TO A SPECIFIC FREQUENCY CONTROL DEVICE SUPPLIER; WE MAY BE UNABLE TO SELL OUR PRODUCTS TO THESE POTENTIAL CUSTOMERS, AND OUR ABILITY TO GROW MAY SUFFER AS A RESULT. We believe that once a communications equipment manufacturer has selected one supplier's frequency control component for a specific piece of equipment, the manufacturer generally continues to rely upon that component and, to the extent possible, subsequent generations of the same vendor's component. Once a communications equipment manufacturers' production line has been configured for use and installation of a particular vendor's component, that manufacturer must often make substantial technical modifications to its production line and may experience production-line downtime, in order to switch to another vendor's component. Accordingly, unless our products offer performance, delivery or cost advantages that outweigh a customer's expense of switching to them, it may be difficult for us to acquire orders from such a customer. SOME COMMUNICATIONS EQUIPMENT MANUFACTURERS ARE INCREASINGLY RELYING UPON CONTRACT MANUFACTURERS, THEREBY DIMINISHING OUR ABILITY TO SELL OUR PRODUCTS DIRECTLY TO THOSE EQUIPMENT MANUFACTURERS AT FAVORABLE PRICES. There is a growing trend among communications equipment manufacturers to outsource the manufacturing of their equipment or components. As a result, our ability to persuade these original equipment manufacturers to specify our products has been reduced and, in the absence of a manufacturer's specification of our products, the prices that we can charge for them may be subject to greater competition which in turn may harm our profitability and our business. OUR MARKET IS HIGHLY COMPETITIVE AND WE MAY LOSE BUSINESS TO LARGER AND BETTER-FINANCED COMPETITORS. The frequency control device market is highly competitive. Many domestic and foreign companies participate in the market for our products. Some of our present competitors, as well as other potential competitors, have substantially greater financial resources and more extensive engineering, manufacturing, marketing, and customer support capabilities than we have. Unless we are able to invest significant financial resources in acquiring or developing products and enhancing customer support worldwide, and are able to gain customer acceptance of our products, our ability to compete with other manufacturers and distributors of frequency control devices may be limited. PUBLIC CONCERN OVER HEALTH RISKS POSED BY WIRELESS DEVICES MAY DECREASE DEMAND FOR SUCH PRODUCTS. Claims have been made that handheld cellular telephones and related infrastructure equipment may pose health risks. If wireless communications equipment or other devices that incorporate our products were determined or perceived to create a significant health risk, the market for communications infrastructure products could be significantly impacted and our business could be harmed. RISKS RELATED TO OUR RELATIONSHIP WITH LYNCH WE ARE EFFECTIVELY CONTROLLED BY LYNCH, OUR PRINCIPAL STOCKHOLDER, WHICH MAY LIMIT YOUR ABILITY TO INFLUENCE STOCKHOLDER MATTERS OR TO RECEIVE A PREMIUM FOR YOUR SHARES THROUGH A CHANGE IN CONTROL. Upon completion of this offering, our principal stockholder, Lynch, will own 6,500,000 shares of our Class B common stock. Because each share of Class B common stock is entitled to cast five votes per share on all matters requiring stockholder approval, our principal stockholder will have the right to cast 97% of the total votes that can be cast on any matter requiring stockholder approval. As long as Lynch owns a majority of the voting power of our outstanding common stock, Lynch will continue to be able to elect our entire board of directors and to remove any director, with or without cause, without calling a special meeting, and investors in this offering will not be able to affect the outcome of any stockholder vote. As a result, Lynch will control all matters affecting us, including: - the composition of our board of directors and, through it, any determination with respect to our business direction and policies, including the appointment and removal of officers; - any determinations with respect to acquisitions, mergers or other business combinations; - our financing; and - administration of, or changes to, the agreements providing for our separation from Lynch. Conflicts of interest may arise between Lynch and us in a number of areas, including those listed above. Lynch is not obligated to distribute its shares of Class B common stock to its own stockholders and is not prohibited from selling a controlling interest in us to a third party. Moreover, if Lynch were to distribute its shares of Class B common stock to its own stockholders, such shares would be converted into shares of Class A common stock five years after the date of distribution, or sooner if Lynch, in its discretion, accelerated the conversion date, and a single stockholder of Lynch, Mario J. Gabelli (including a charitable foundation and a partnership controlled by Mr. Gabelli), might be deemed to be the beneficial owner of approximately 28.5% of our Class A common stock, assuming full exercise of all subscription rights, including by Mr. Gabelli. The interests of Mr. Gabelli might conflict with those of other stockholders. Moreover, Mr. Gabelli's ownership of a substantial portion of our common stock could delay, defer or prevent a change in our control, and some transactions might be more difficult or impossible to accomplish without his support. Mr. Gabelli has not advised us whether he intends to exercise any of his subscription rights. WE MAY HAVE LIABILITIES ARISING FROM OUR STATUS AS A MEMBER OF LYNCH'S CONSOLIDATED TAX GROUP. Even if the rights offering is fully subscribed, we will continue as a member of Lynch's consolidated tax group under federal income tax law until the M-tron securities held by Lynch do not constitute either 80% of the voting power or the market value of our outstanding stock. Each member of a consolidated group for federal income tax purposes is severally liable for the federal income tax liability of each other member of the consolidated group. Similar rules may apply under state income tax laws. If Lynch or members of its consolidated tax group fail to pay tax liabilities arising prior to the time that we are no longer a member of Lynch's consolidated tax group, we could be required to make payments in respect of these tax liabilities. Such payments, if required, could materially adversely affect our financial condition. OUR STOCK PRICE AND BUSINESS MAY SUFFER SO LONG AS LYNCH OR ANOTHER ENTITY CONTINUES TO OWN A SUBSTANTIAL PORTION OF OUR COMMON STOCK. The liquidity of our common stock in the market will be constrained unless and until Lynch elects to sell or distribute some significant portion of its shares of our Class B common stock to unaffiliated persons. The potential sale of our shares by Lynch could adversely affect market prices. In addition, because of the relatively limited liquidity of the market for our Class A common stock, relatively small trades of our common stock may have a disproportionate effect on our Class A common stock price. Also, so long as Lynch or another entity owns a controlling interest in us, we may face significant difficulty hiring and retaining key personnel, many of whom might be attracted by the potential of operating our business as a fully independent entity. A DISTRIBUTION OR DISPOSITION OF THE SHARES OF OUR CLASS B COMMON STOCK BY LYNCH COULD DEPRESS OUR STOCK PRICE. If Lynch were to distribute its shares of its Class B common stock to its stockholders, such Class B shares would convert into an equal number of shares of Class A common stock five years after the date of such distribution unless Lynch, in its sole discretion, accelerated the date of such conversion. Any shares of Class B common stock that were transferred by Lynch to an unaffiliated person or entity would convert into an equal number of shares of Class A common stock immediately upon the transfer of such shares. We are unable to predict whether significant amounts of our common stock will be sold in the open market in anticipation of, or following, a distribution or disposition of our stock by Lynch, but sales of substantial amounts of our stock in the public market, or the perception that these sales may occur, could adversely affect the market price of our stock. WE DERIVE INTANGIBLE BENEFITS FROM LYNCH'S OWNERSHIP OF US. IF WE CEASED TO BE A SUBSIDIARY OF LYNCH, WE WOULD NO LONGER BE PROVIDED THESE BENEFITS. Although we have operated in all material respects as a free-standing subsidiary, we have historically derived intangible benefits from being a subsidiary of Lynch, including management advisory and oversight services that have been provided to us by Lynch. These benefits would be lost to us if Lynch ceased to own a majority of the voting power of our common stock. The loss of these benefits might adversely affect our business. RISKS RELATED TO THE PURCHASE OF OUR SHARES IN THE OFFERING THERE HAS BEEN NO PRIOR PUBLIC MARKET FOR OUR COMMON STOCK, AND THERE MAY BE NO MEANINGFUL PUBLIC MARKET FOR OUR COMMON STOCK AFTER THIS OFFERING; OUR STOCK PRICE MAY DECLINE BELOW THE SUBSCRIPTION PRICE AND COULD BE HIGHLY VOLATILE. There has been no public market for our common stock and an active public market may not develop. If an active public market for our common stock does not develop, you may be unable to sell any shares that you may purchase in this offering, and the price of our common stock may decrease below the subscription price. There can be no assurance that any shares of our Class A common stock will be sold in this offering. The stock market in general, and the stock prices of technology and communications companies in particular, have experienced extreme price and volume fluctuations. This volatility is often unrelated or disproportionate to the operating performance of these companies. Because we serve the communications industry, we expect our stock to be similarly volatile. Broad market and industry factors may reduce our stock price, regardless of our operating performance. Many of the additional factors that might cause volatility in our stock price are beyond our control. Some of these factors include: - changes in financial estimates by securities analysts; - changes in the economic performance or market valuations of communications companies; - actions by institutional stockholders or by Lynch; - announcements by us or our competitors of significant acquisitions, strategic partnerships, joint ventures or capital commitments or the market's response to any such announcements; and - potential litigation. In the past, following periods of volatility in the market price of a company's securities, securities class action litigation has often been instituted against that company. The institution of securities class action litigation against us could result in substantial costs to us and a diversion of our management's attention and resources. IT MAY BE DIFFICULT FOR INVESTORS TO SELL OUR COMMON STOCK IF OUR COMMON STOCK IS NOT LISTED ON A SECURITIES EXCHANGE. We intend to file an application to the American Stock Exchange for quotation of our Class A common stock immediately after consummation of this offering. If we meet the listing criteria and our application is approved, our Class A common stock will be traded on the American Stock Exchange. The listing and continued trading of our Class A common stock on the American Stock Exchange will be conditioned upon our meeting certain criteria. The American Stock Exchange requires that, in order for our securities to be listed for quotation, we must have a public float with a market value of at least $3,000,000 at a price of at least $3.00 per share. In addition, we will have to meet the following distribution criteria: - a public float of at least 500,000 shares and at least 800 public stockholders; or - a public float of at least 1,000,000 shares and at least 400 public stockholders; or - a public float of at least 500,000 shares, at least 400 public stockholders and an average daily volume of at least 2,000. Lynch has advised us that it believes it currently has approximately 1,800 public stockholders. In order to meet the American Stock Exchange listing requirements, we will be required to sell at least 600,000 shares of our Class A common stock (assuming a market value of $5.00 per share) to at least 800 public stockholders, excluding officers, directors and controlling shareholders and excluding other affiliated persons holding 10% or more of our outstanding stock. There can be no assurance that we will meet these criteria, particularly since approximately 29% of the rights in this offering will be distributed to persons who, if they exercised such rights, would not be deemed to be "public shareholders" for purposes of satisfying the American Stock Exchange's listing requirements. If we fail to meet any of these criteria, we may not be able to list our Class A common stock on the American Stock Exchange. If we are unable to list our Class A common stock on the American Stock Exchange, we will try to qualify for listing on another securities exchange, however there can be no assurance that we will be able to do so. If we cannot do so, it may be difficult for investors to sell their Class A common stock. WE MAY BE OBLIGATED TO PAY TWO OF OUR OFFICERS SUBSTANTIAL ADDITIONAL COMPENSATION ON A ONE TIME BASIS IF LYNCH SELLS A MAJORITY OF ITS HOLDINGS OF OUR STOCK. In the event that, at any time before 2009, Lynch sells a majority of its stock interest in us in one or a series of transactions, we will be obligated to pay two of our officers, if they are still employed by us as of the last of such sales, a total of 4% of the excess of the value of Lynch's interest in us determined on the basis of the weighted-average per share price paid to Lynch over our book value immediately prior to the consummation of this offering. Thus, by way of illustration, if Lynch were to sell a majority of its stock interest in us in 2001 at a per share price of $7.50 per share, we would be obligated to pay such officers if they were then employed by us a total of approximately $1,719,000 of additional compensation in 2001, thereby resulting in a one-time after-tax reduction in net income for that year of $1,134,000 (using our book value as of September 30, 2000 and assuming an effective tax rate of 34%). DELAWARE LAW AND PROVISIONS OF OUR CHARTER MAY DELAY OR PREVENT US FROM BEING ACQUIRED, WHICH COULD AFFECT THE VALUE OF OUR STOCK. As a Delaware corporation, we are subject to the Delaware General Corporation Law, including Section 203. Generally, Section 203 may prevent a person or entity owning 15% or more of our outstanding voting stock from engaging in a merger or business combination with us. Our board of directors has resolved that Section 203 shall not apply to a person or entity acquiring 15% or more of our voting stock directly from Lynch. Otherwise, however, as a result of the application of Section 203, potential acquirers might be discouraged from attempting to acquire us, even if we were no longer affiliated with Lynch. We are authorized to issue up to 1,000,000 shares of preferred stock and to determine the price, privileges, voting rights and other terms of the shares. The issuance of any preferred stock with superior rights to our common stock could reduce the value of our common stock. Moreover, specific rights we may grant to future holders of our preferred stock could be used to restrict our ability to merge with or sell our assets to a third party, preserving control of us by our then existing stockholders and management and preventing you from realizing a premium on your shares.

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+RISK FACTORS You should carefully consider the following factors in addition to the other information set forth in this prospectus in evaluating an investment in the notes. Our High Level of Debt May Adversely Affect Our Ability To Repay the Notes As a result of our acquisitions, we have a substantial amount of debt. As of December 31, 2000, we had total debt of $289.4 million (excluding unused commitments) and total stockholder's equity of $53.2 million, giving us total debt representing 84% of total capitalization. In addition, subject to restrictions in the senior secured credit agreement and in the indenture, we may borrow more money for working capital, capital expenditures, acquisitions or other purposes. Our high level of debt could have important consequences for you, including the following: o we will need to use a large portion of the cash earned by our subsidiaries to pay principal and interest on the senior secured credit agreement, the notes and other debt, which will reduce the amount of cash available to us to finance our operations, to invest in additional plant and equipment, to make improvements to existing plant and equipment and to improve our technology capabilities; o our debt level makes us more vulnerable to economic downturns and adverse developments in our business; o we may have a much higher level of debt than certain of our competitors, which may put us at a competitive disadvantage; o we may have difficulty borrowing money in the future for working capital, capital expenditures, acquisitions or other purposes; and o some of our debt has a variable rate of interest, which exposes us to the risk of increased interest rates. To Service Our Indebtedness, We Will Require a Significant Amount of Cash. Our Ability to Generate Cash Depends on Many Factors Beyond Our Control We expect to obtain the cash to pay our expenses and to pay the principal and interest on the notes, the senior secured credit agreement and other debt from the operations of our subsidiaries. Availability under the revolving credit facility will be important for us to maintain liquidity to pay obligations as they become due. Our ability to meet our expenses and debt service obligations depends on the future performance of our subsidiaries, which will be affected by financial, business, economic and other factors. We will not be able to control many of these factors, such as economic conditions and pressure from competitors. We cannot be certain that the cash earned by our subsidiaries will be sufficient to allow us to pay principal and interest on our debt (including the notes) and meet our other obligations. If we do not have enough cash, we may be required to refinance all or part of our existing debt, including the notes, sell assets, borrow more money or raise equity. We cannot guarantee that we will be able to refinance our debt, sell assets, borrow more money or raise equity on terms acceptable to us, or at all. For example, neither J.P. Morgan Partners, LLC ("JPMP LLC") nor D. George Harris & Associates, LLC ("DGHA") is obligated to make any additional equity investments in USS Holdings, Inc., our parent. In addition, the terms of existing or future debt agreements, including the senior secured credit agreement and the indenture, may restrict us from adopting any of these alternatives. The indenture contains certain limitations on our operating flexibility. See "Description of the Notes--Certain Covenants." In addition, the senior secured credit agreement contains many similar and more stringent limitations and will prohibit us from prepaying certain of our other debt (including the notes) while debt under the senior secured credit agreement is outstanding. In addition, under the senior secured credit agreement, we must also comply with certain specified financial ratios. On February 22, 2001, the lenders under our senior secured credit agreement approved an amendment effective December 31, 2000 that revised the required leverage ratio and interest coverage ratio covenants under the senior secured credit agreement for the period of December 31, 2000 through December 31, 2001. As a result of this amendment, we were in compliance with these financial ratio covenants, as revised, as of December 31, 2000. If we do not comply with these or other covenants and restrictions contained in the senior secured credit agreement, we could default under the senior secured credit agreement. Upon the occurrence of an event of default under the senior secured credit agreement, the lenders could declare all amounts outstanding under the senior secured credit agreement, together with accrued interest, to be immediately due and payable, which could cause all or a portion of our other debt, including the notes, to become immediately due and payable. If we were unable to repay those amounts, the lenders could proceed against the collateral granted to them to secure that debt. If the lenders under the senior secured credit agreement accelerate the payment of the debt, we cannot assure you that our assets would be sufficient to repay in full that debt and our other debt, including the notes. Furthermore, our ability to comply with the provisions of the senior secured credit agreement may be affected by events beyond our control. See "Description of the Senior Secured Credit Agreement." Demand for Our Products Is Affected by External Factors Demand in the markets served by the industrial minerals and aggregates industries is affected by many external factors, including the following: o the general and regional economic conditions in the states in which we produce and sell our products; o demand for automobiles and other vehicles; o the substitution of plastic or other materials for glass; o levels of government spending on road and other infrastructure construction; and o demand for residential and commercial construction. General or localized economic downturns or other external factors adversely affecting demand in the areas where we sell our products could result in a decrease in sales and operating income and, therefore, could have a material adverse effect on us. For example, because our aggregates business is more geographically concentrated than the businesses of some of our competitors, we may be more vulnerable to local economic conditions in Pennsylvania and New Jersey. Demand for Our Aggregates May Be Affected by Weather Poor weather during the peak season of our aggregates business from April through November could result in lower sales of aggregates by reducing or delaying road construction and maintenance, other infrastructure projects and residential and commercial construction. In the past, significant changes in weather conditions during this period have caused variations in demand for aggregates. In addition, because we are not as geographically diverse as some of our aggregates competitors, we may be more vulnerable than these competitors to poor weather conditions in the geographic areas in which we operate. Our Business Is Subject to Operating Risks, Including Fluctuations in Oil and Energy Prices All of our revenue is and will be derived from our industrial minerals and aggregates businesses. The mining, processing and related infrastructure facilities of these businesses are subject to risks normally encountered in the industrial minerals and aggregates industries. These risks include environmental hazards, industrial accidents, technical difficulties or failures, late delivery of supplies, the price and availability of power, the price and availability of transportation, unusual or unexpected geological formations or pressures, cave-ins, pit wall failures, rock falls, unanticipated ground, grade or water conditions, flooding and periodic or extended interruptions due to the unavailability of materials and equipment, inclement or hazardous weather conditions, fires, explosions or other accidents or acts of force majeure. Any of these risks could result in damage to, or destruction of, our mining properties or production facilities, personal injury, environmental damage, delays in mining or processing, losses or possible legal liability. Any prolonged downtime or shutdowns at our mining properties or production facilities could have a material adverse effect on us. In addition, the price or availability of oil, a raw material of hot mixed asphalt, could adversely affect operating costs, which could in turn adversely affect our operating results if we cannot pass these increased costs through to our customers or if customers use less asphalt due to higher prices. Furthermore, increased energy prices, particularly relating to natural gas, propane, diesel fuel and other petroleum-based products, could adversely affect operating costs and, therefore, operating results. We Rely Heavily on Third Party Transportation We rely heavily on railroads and trucking companies to ship our industrial minerals and aggregates products to our customers. Because freight costs represent a significant portion of the total cost to the customer, fluctuations in freight rates can change the relative competitive position of our production facilities. Rail and trucking operations are subject to various hazards, including extreme weather conditions, work stoppages and operating hazards. If we are unable to ship our products as a result of the railroads or trucking companies failing to operate or if there are material changes in the cost or availability of railroad or trucking services, we may not be able to arrange alternative and timely means to ship our products, which could lead to interruptions or slowdowns in our businesses and, therefore, have a material adverse effect on us. Our Future Performance Will Depend on Our Ability To Succeed in Competitive Markets We compete in highly competitive industries. Transportation costs are a significant portion of the total cost of industrial minerals and aggregates to customers, typically representing up to 50% of that cost. As a result, the industrial minerals and aggregates markets are typically local, and competition from beyond the local area is limited. The industrial silica industry is a competitive market that is characterized by a small number of large, national producers and a larger number of small, regional producers. We are the second leading producer of industrial silica in the United States, accounting for approximately 24% of industry volume in 2000. We compete with, among others, Unimin Corporation, Fairmount Minerals, Inc., Oglebay Norton Industrial Sands, Inc. and Badger Mining Corporation. Competition in the industrial minerals industry is based on price, consistency and quality of product, site location, distribution capability, customer service, reliability of supply, breadth of product offering and technical support. In addition, there is significant unutilized capacity in the industrial minerals industry that could adversely affect the pricing of our industrial minerals products. In recent years, the aggregates industry has seen increasing consolidation, although competition remains primarily local. Competition in the aggregates industry is based primarily on price, quality of product, site location, distribution capability and customer service. Due to the high cost of transportation relative to the value of the product, competition within the aggregates industry favors producers with aggregates production facilities in close proximity to transportation modes and customers. Accordingly, in Pennsylvania and New Jersey, we compete primarily with local or regional operations. In addition, in western Pennsylvania, slag, a residue from steel processing, also competes with our aggregates products. Many of our competitors are large companies that have greater financial resources than we do, may develop technology superior to ours and have production facilities that are located closer to key customers. We cannot guarantee that we will be able to compete successfully against our competitors in the future or that competition will not have a material adverse effect on us. Silica Health Issues and Litigation Could Have a Material Adverse Effect on Our Business The exposure of persons to silica and the accompanying health risks have been, and will continue to be, a significant issue confronting the industrial minerals industry. Concerns over silicosis and other potential adverse health effects, as well as concerns regarding potential liability from the use of silica, may have the effect of discouraging our customers' use of our silica products. The actual or perceived health risks of mining, processing and handling silica could materially and adversely affect silica producers, including us, through reduced use of silica products, the threat of product liability or employee lawsuits, increased levels of scrutiny by federal and state regulatory authorities of us and our customers (see "--Our Business Is Subject to Extensive Environmental, Health and Safety Regulations") or reduced financing sources available to the silica industry. The inhalation of respirable crystalline silica is associated with silicosis. There is recent evidence of an association between crystalline silica exposure or silicosis and lung cancer and a possible association with other diseases, such as immune system disorders like scleroderma. Since 1975, U.S. Silica Company, one of our subsidiaries, has been named as a defendant in numerous products liability lawsuits brought by alleged employees or former employees of our customers alleging damages caused by silica exposure. As of March 1, 2001, there were an estimated 1,472 silica-related products liability claims pending in which U.S. Silica is a defendant. Almost all of the claims pending against U.S. Silica arise out of the alleged use of U.S. Silica products in foundries or as an abrasive blast media and have been filed in the states of Texas and Mississippi. We currently have certain limited sources of recovery for silica-related products liability claims, including an indemnity for those claims (including litigation expenses) from ITT Industries, Inc., successor to the former owner of U.S. Silica, and insurance coverage. The ITT Industries indemnity expires in 2005, only covers alleged exposure to U.S. Silica products for the period prior to September 12, 1985 and contains other limitations. Existing and potential insurance coverage only applies to occurrences of alleged silica exposure prior to certain dates in 1985 and 1986, respectively. We have no insurance or indemnity for claims relating to silica exposure after these dates. The silica-related litigation brought against us to date has not resulted in material liability to us. However, it is likely that we will continue to have silica-related products liability claims filed against us, including claims that allege silica exposure for periods after 1986. Any such claims or inadequacies of the ITT Industries indemnity or insurance coverage could have a material adverse effect on us. See "Business--Product Liability." Our Business Is Subject to Extensive Environmental, Health and Safety Regulations Environmental and Silica Exposure Regulations. We are subject to a variety of governmental regulatory requirements relating to the environment, including those relating to our handling of hazardous materials and air and wastewater emissions. Some environmental laws impose substantial penalties for noncompliance, and others, such as the federal Comprehensive Environmental Response, Compensation, and Liability Act, impose strict, retroactive and joint and several liability upon persons responsible for releases of hazardous substances. If we fail to comply with present and future environmental laws and regulations, we could be subject to liabilities or our operations could be interrupted. In addition, future environmental laws and regulations could restrict our ability to expand our facilities or extract our mineral deposits or could require us to acquire costly equipment or to incur other significant expenses in connection with our business. Although we believe we have made sufficient capital expenditures to achieve substantial compliance with existing environmental laws and regulations, future events, including changes in any environmental requirements and the costs associated with complying with such requirements, could have a material adverse effect on us. See "Business--Government Regulation--Environmental Matters." In addition to environmental regulation, we are also subject to laws relating to human exposure to crystalline silica. We believe that we materially comply with governmental requirements for crystalline silica exposure and emissions and other regulations relating to silica and plan to continue to comply with these regulations. Several federal and state regulatory authorities, including the Occupational Safety and Health Administration and the Mining Safety and Health Administration, have indicated that they will propose changes in their regulations regarding workplace exposure to crystalline silica. We cannot guarantee that we will be able to comply with any new standards that are adopted or that these new standards will not have a material adverse effect on us by requiring us to modify our operations or equipment or shut down some of our plants. Additionally, we cannot guarantee that our customers will be able to comply with any new standards or that any such new standards will not have a material adverse effect on our customers by requiring them to shut down old plants or to relocate plants to locations with less stringent regulations that are further away from us. Accordingly, we cannot at this time reasonably estimate our costs of compliance or the timing of any costs associated with any new standards, or any material adverse effects that any new standards will have on our customers and, consequently, on us. See "Business--Government Regulation--Regulation of Silica." Other Regulations Affecting Mining Activity. In addition to the regulatory matters described above, the industrial minerals and aggregates industries are subject to extensive governmental regulation on matters such as permitting and licensing requirements, plant and wildlife protection, wetlands protection, reclamation and restoration of mining properties after mining is completed, the discharge of materials into the environment, surface subsidence from underground mining and the effects that mining has on groundwater quality and availability. Our future success depends upon the quantity of our industrial minerals and aggregates deposits and our ability to extract these deposits profitably. It is difficult for us to estimate quantities of recoverable deposits, in part due to future permitting and licensing requirements. We believe we have obtained all material permits and licenses required to conduct our present mining operations. However, we will need additional permits and renewals of permits in the future. We may be required to prepare and present to governmental authorities data pertaining to the impact that any proposed exploration or production activities may have upon the environment. New site approval procedures may require the preparation of archaeological surveys, endangered species studies and other studies to assess the environmental impact of new sites. Compliance with these regulatory requirements is expensive, requires an investment of funds well before the potential producer knows if its operation will be economically successful and significantly lengthens the time needed to develop a new site. Furthermore, obtaining or renewing required permits is sometimes delayed or prevented due to community opposition and other factors beyond our control. New legal requirements, including those related to the protection of the environment, could be adopted that could materially adversely affect our mining operations (including the ability to extract mineral deposits), our cost structure or our customers' ability to use our industrial minerals or aggregates products. Finally, we could be adversely affected if our current provisions for mine reclamation and closure costs were later determined to be insufficient, or if future costs associated with reclamation are significantly greater than our current estimates. Accordingly, there can be no assurance that current or future mining regulation will not have a material adverse effect on our business or that we will be able to obtain or renew permits in the future. The Notes and Note Guarantees Are Contractually Subordinated to Senior Debt The notes are contractually subordinated in right of payment to all senior debt of the issuer and the note guarantees are contractually subordinated in right of payment to all senior debt of the applicable note guarantor. As of December 31, 2000, the issuer had approximately $138.1 million of senior debt (excluding unused commitments under the senior secured credit agreement), all of which was secured debt, and the note guarantors had approximately $1.35 million of senior debt (excluding their guarantees of the issuer's debt under the senior secured credit agreement). The indenture permits us to borrow certain additional debt, which may be senior debt, subject to certain restrictions. The issuer or the applicable note guarantor may not pay principal, premium (if any), interest or other amounts on account of the notes or a note guarantee in the event of a payment default or certain other defaults in respect of certain senior debt (including debt under the senior secured credit agreement) unless that senior debt has been paid in full or the default has been cured or waived. In addition, in the event of certain other defaults with respect to that senior debt, the issuer or the applicable note guarantor may not be permitted to pay any amount on account of the notes or the note guarantees for a designated period of time. If the issuer or a note guarantor is declared bankrupt or insolvent, or if there is a payment default under, or an acceleration of, any senior debt, the assets of the issuer or the applicable note guarantor, as the case may be, will be available to pay obligations on the notes or that note guarantor's note guarantee, as applicable, only after the senior debt of the issuer or the note guarantor has been paid in full. In such a case, there can be no assurance that there will be sufficient assets remaining to pay amounts due on all or any of the notes or any note guarantee. Further, the senior secured credit agreement prohibits us, and our future senior debt may prohibit us, from purchasing any notes prior to maturity, even though the indenture requires the issuer to offer to purchase notes in certain circumstances. If the issuer or a note guarantor makes certain asset sales or if a change of control occurs when we are prohibited from purchasing notes, the issuer could ask the lenders under the senior secured credit agreement (or such future senior debt) for permission to purchase the notes or the issuer could attempt to refinance the borrowings that contain those prohibitions. If the issuer does not obtain such a consent to repay those borrowings or is unable to refinance those borrowings, it would be unable to purchase the notes. The failure to purchase tendered notes at a time when their purchase is required by the indenture would constitute an event of default under the indenture, which, in turn, would constitute a default under the senior secured credit agreement and may constitute an event of default under our future senior debt. In those circumstances, the subordination provisions in the indenture restrict payments to you. Our Holding Company Structure Causes Us To Rely on Funds from Our Subsidiaries The issuer is a holding company and as such it conducts substantially all its operations through its subsidiaries. As a holding company, the issuer is dependent upon dividends or other intercompany transfers of funds from its subsidiaries to meet its debt service and other obligations. Generally, creditors of a subsidiary will have a superior claim to the assets and earnings of that subsidiary than the claims of creditors of its parent company, except to the extent the claims of the parent's creditors are guaranteed by the subsidiary. Although the note guarantees provide the holders of the notes with a direct claim against the assets of the note guarantors, enforcement of the note guarantees against any note guarantor may be subject to legal challenge in a bankruptcy or reorganization case or a lawsuit by or on behalf of creditors of that note guarantor, and would be subject to certain defenses available to guarantors generally. See "--The Notes and the Note Guarantees Are Subject to Fraudulent Conveyance and Preferential Transfer Laws." To the extent that a note guarantee is not enforceable, the notes would be effectively subordinated to all liabilities (including trade payables) and preferred stock of the relevant note guarantor. In any event, the notes will be effectively subordinated to all liabilities (including trade payables) and preferred stock of the issuer's Canadian subsidiary, which will not be a guarantor of the notes unless it guarantees any indebtedness (other than indebtedness of a Restricted Subsidiary that is not a note guarantor) in the future. This Canadian subsidiary has an immaterial amount of assets and liabilities. As of December 31, 2000, the note guarantors had total liabilities of $482.7 million (excluding the note guarantees and liabilities owed to the issuer). In addition, the payment of dividends and other payments to the issuer by its subsidiaries may be restricted by, among other things, applicable corporate and other laws and regulations and agreements of the subsidiaries. Although the indenture will limit the ability of those subsidiaries to enter into consensual restrictions on their ability to pay dividends and make other payments, those limitations are subject to a number of significant qualifications and exceptions. See "Description of the Notes--Certain Covenants--Limitations on Restrictions on Distributions from Restricted Subsidiaries." The Notes Are Unsecured Obligations, While the Senior Secured Credit Agreement Is Secured In addition to being contractually subordinated to all existing and future senior debt, the issuer's obligations under the notes are unsecured while our obligations under the senior secured credit agreement are secured by a security interest in substantially all the tangible and intangible assets of BMAC Holdings, Inc., our direct parent, the issuer and each existing and subsequently acquired or organized domestic subsidiary of the issuer, including a pledge of (a) all the capital stock of the issuer, and (b) all the capital stock held by BMAC Holdings, the issuer and any domestic subsidiary of the issuer in each of the issuer's existing or subsequently acquired or organized domestic subsidiaries and 65% of the capital stock held by those entities in each of the issuer's existing or subsequently acquired or organized foreign subsidiaries. If we are declared bankrupt or insolvent or if we default under the senior secured credit agreement, the lenders could declare all of the funds borrowed thereunder, together with accrued interest, immediately due and payable. If we were unable to repay that debt, the lenders could foreclose on the pledged stock of our subsidiaries and on the assets in which they have been granted a security interest, in each case to your exclusion, even if an event of default exists under the indenture at that time. Furthermore, under the note guarantees, if all shares of any note guarantor are sold to persons pursuant to an enforcement of the pledge of shares in that note guarantor for the benefit of the lenders under the senior secured credit agreement, then the applicable note guarantor will be released from its note guarantee automatically and immediately upon such sale. See "Description of the Senior Secured Credit Agreement." Our Aggregates Business Depends Heavily on Government Funding of Highways Many of our aggregates customers depend substantially on government funding of highway construction and maintenance and other infrastructure projects. Although TEA-21 provides for increased federal funding for highways and related infrastructure improvements through 2003, there can be no assurance that any successor program adopted by Congress, if one is adopted at all, will provide for equivalent or increased government funding. Furthermore, although TEA-21 provides for federal funding through 2003, state and municipal governmental entities need to provide for matching funds in order to obtain federal funding under TEA-21, and state and municipal governmental entities have separate approval processes relating to the matching of any federal funding for highways that have not been completed. Accordingly, a decrease in federal funding of highways and related infrastructure improvements after the expiration of TEA-21, or a failure of states or municipalities to match the federal funding to be provided by TEA-21, could adversely affect our revenue and profits in our aggregates business. In addition, unlike some of our competitors, we currently sell our aggregates products almost entirely in only two states, Pennsylvania and New Jersey. As a result, we are more vulnerable than our more geographically diverse competitors to decreases in state government highway spending in those states. We Depend on Good Labor Relations As of March 1, 2001, we had approximately 1,053 employees, of which approximately 538 were represented by 12 local unions under 12 union contracts. These union contracts have remaining durations ranging from one to five years. Over the last 10 years, we have been involved in numerous labor negotiations, only two of which have resulted in a work disruption at two of our 26 facilities. During these disruptions, the operations of the facilities and the ability to serve our customers were not materially affected. Although we consider our current relations with our employees to be good, if we do not maintain these good relations, or if a work disruption were to occur, we could suffer a material adverse effect. Future Acquisitions May Adversely Affect Our Operations We intend to actively pursue acquisition opportunities, some of which could be material. We may finance future acquisitions through internally generated funds, bank borrowings, public offerings or private placements of equity or debt securities, or a combination of these sources. We might not be able to make acquisitions on terms that are favorable to us, or at all. If we do complete any future acquisitions, we will face many risks, including the possible inability to integrate an acquired business into our operations, diversion of our management's attention, failure to retain key acquired personnel and unanticipated problems or liabilities, some or all of which could have a material adverse effect on us. Acquisitions could place a significant strain on management, operating, financial and other resources and increased demands on our systems and controls. Control of USS Holdings; Stockholders Agreement The holders of all of the capital stock of USS Holdings are party to a stockholders agreement. Subject to certain exceptions, the stockholders agreement provides that the holders of USS Holdings' capital stock have to vote their shares of USS Holdings to elect to the board of directors two directors designated by D. George Harris, a principal of DGHA, one director designated by Anthony J. Petrocelli, a principal of DGHA, and three directors designated by an affiliate of JPMP LLC. In addition, upon the occurrence of certain "trigger events" described in the stockholders agreement, the JPMP LLC affiliates will collectively have the right to appoint two additional directors to the board of USS Holdings, thus giving them the right to appoint a majority of directors of USS Holdings. The interests of these stockholders may conflict with your interests as a holder of the notes. See "Security Ownership of Certain Beneficial Owners and Management--The Stockholders Agreement."

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+RISK FACTORS You should carefully consider the following factors, in addition to the other information in this prospectus, before investing in our common stock. Risks Related to an Investment in our Common Stock We are highly leveraged. Our substantial indebtedness will severely limit cash flow available for our operations and could adversely affect our ability to service debt or obtain additional financing if necessary. After giving effect to the Refinancing, we had, as of June 30, 2001 $3.7 billion of outstanding indebtedness (including current maturities but excluding letters of credit) and stockholders' equity of $567.6 million. We also have additional borrowing capacity under our new revolving credit facility of $500.0 million. Our debt obligations will continue to adversely affect our operations in a number of ways and our cash flow is insufficient to service our debt, which may require us to borrow additional funds for that purpose, restructure or otherwise refinance that debt. Our earnings were insufficient to cover our fixed charges for fiscal 2001 by $1.2 billion. After giving effect to the Refinancing on a pro forma basis, we estimate that our earnings would have been insufficient to cover our fixed charges for fiscal 2001. Our high level of indebtedness will continue to restrict our operations. Among other things, our indebtedness will: o limit our ability to obtain additional financing; o limit our flexibility in planning for, or reacting to, changes in the markets in which we compete; o place us at a competitive disadvantage relative to our competitors with less indebtedness; o render us more vulnerable to general adverse economic and industry conditions; and o require us to dedicate substantially all of our cash flow to service our debt. In fiscal 2000 we experienced operational and financial difficulties, resulting in disputes with suppliers and vendors. These disputes were based primarily on our level of indebtedness and led to more restrictive vendor contract terms. Although we believe that our prior disputes with suppliers and vendors have been largely resolved, any future material deterioration in our operational or our financial situation could again impact vendors' and suppliers' willingness to do business with us. Our ability to make payments on our debt, depends upon our ability to substantially improve our future operating performance, which is subject to general economic and competitive conditions and to financial, business and other factors, many of which we cannot control. If our cash flow from our operating activities is insufficient, we may take certain actions, including delaying or reducing capital or other expenditures, attempting to restructure or refinance our debt, selling assets or operations or seeking additional equity capital. We may be unable to take any of these actions on satisfactory terms or in a timely manner. Further, any of these actions may not be sufficient to allow us to service our debt obligations or may have an adverse impact on our business. Our existing debt agreements, limit our ability to take certain of these actions. Our failure to earn enough to pay our debts or to successfully undertake any of these actions could have a material adverse effect on us. Some of our debt, including borrowings under our new credit facility, is based upon variable rates of interest, which could result in higher interest expense in the event of increases in interest rates. Approximately $378.0 million of our outstanding indebtedness as of June 30, 2001, following the Refinancing, bears an interest rate that varies depending upon LIBOR and is not covered by interest rate swap contracts that expire in 2002. If we borrow additional amounts under our senior secured facility, the interest rate on those borrowings will vary depending upon LIBOR. If LIBOR rises, the interest rates on this outstanding debt will also increase. Therefore an increase in LIBOR would increase our interest payment obligations under these outstanding loans and have a negative effect on our cash flow and financial condition. We are a holding company with no direct operations. We are a holding company with no direct operations. Our principal assets are the equity interests that we hold in our operating subsidiaries. As a result, we are dependent upon dividends and other payments from our subsidiaries to generate the funds necessary to meet our financial obligations, including the payment of principal of and interest on our outstanding debt. Our subsidiaries are legally distinct from us and have no obligation to pay amounts due with respect to our debt or to make funds available to us for such payment or for any other reason. As of June 30, 2001, after giving effect to the Refinancing, our subsidiaries had approximately $3.7 billion of indebtedness and liabilities. The covenants in our outstanding indebtedness impose restrictions that may limit our operating and financial flexibility. The covenants in the instruments governing our outstanding indebtedness, including our new credit facility and the instruments governing our new 11.25% notes and 12.5% notes, restrict our ability to incur liens and debt, pay dividends, make redemptions and repurchases of capital stock, make loans, investments and capital expenditures, prepay, redeem or repurchase debt, engage in mergers, consolidations, asset dispositions, sale-leaseback transactions and affiliate transactions, change our business, amend certain debt and other material agreements, issue and sell capital stock of subsidiaries, restrict distributions from subsidiaries and grant negative pledges to other creditors. Moreover, if we are unable to meet the terms of the financial covenants or if we breach any of these covenants, a default could result under one or more of these agreements. A default, if not waived by our lenders, could result in the acceleration of our outstanding indebtedness and cause our debt to become immediately due and payable. If acceleration occurs, we would not be able to repay our debt and it is unlikely that we would be able to borrow sufficient additional funds to refinance such debt. Even if new financing is made available to us, it may not be available on terms acceptable to us. If we were required to obtain waivers of defaults, we may incur significant fees and transaction costs. In fiscal 2000, we were required to obtain waivers of compliance with, and modifications to, certain of the covenants contained in our senior credit and loan agreements and public indentures. In connection with obtaining certain of such waivers and modifications, we paid significant fees and transaction costs. Risks Related to our Operations Major lawsuits have been brought against us and certain of our subsidiaries, and there are currently pending both civil and criminal investigations by the U.S. Securities and Exchange Commission, the United States Attorney and an investigation by the United States Department of Labor. In addition to any fines or damages that we might have to pay, any criminal conviction against us may result in the loss of licenses and contracts that are material to the conduct of our business, which would have a negative effect on our results of operations, financial condition and cash flows. There are several major ongoing lawsuits and investigations in which we are involved. These include, in addition to the investigations described below, several class action lawsuits. While some of these lawsuits have been settled, pending court approval, we are unable to predict the outcome of any of these matters at this time. If any of these cases result in a substantial monetary judgment against us or is settled on unfavorable terms, our results of operations, financial condition and cash flows could be materially adversely affected. There are currently pending both civil and criminal governmental investigations by the SEC and the United States Attorney concerning our financial reporting and other matters. In addition, an investigation has also been commenced by the U.S. Department of Labor concerning our employee benefit plans, including our principal 401(k) plan, which permitted employees to purchase our common stock. Purchases of our common stock under the plan were suspended in October 1999. In January 2001, we appointed an independent trustee to represent the interests of these plans in relation to the company and to investigate possible claims the plans may have against us. Both the independent trustee and the Department of Labor have asserted that the plans may have claims against us. These investigations are ongoing and we cannot predict their outcomes. If we were convicted of any crime, certain licenses and government contracts, such as Medicaid plan reimbursement agreements, that are material to our operations may be revoked, which would have a material adverse effect on our results of operations and financial condition. In addition, substantial penalties, damages, or other monetary remedies assessed against us could also have a material adverse effect on our results of operations, financial condition and cash flows. Given the size and nature of our business, we are subject from time to time to various lawsuits which, depending on their outcome, may have a negative impact on our results of operations, financial condition and cash flows. We are substantially dependent on a single supplier of pharmaceutical products to sell products to us on satisfactory terms. A disruption in this relationship would have a negative effect on our results of operations, financial condition and cash flows. We obtain approximately 93% of our pharmaceutical supplies from a single supplier, McKesson HBOC, Inc., pursuant to a long-term contract. Pharmacy sales represented approximately 59.5% of our total revenues during fiscal 2001, and, therefore, our relationship with McKesson HBOC is important to us. Any significant disruptions in our relationship with McKesson HBOC would make it difficult for us to continue to operate our business, and would have a material adverse effect on our results of operations, financial condition and cash flows. Our auditors have identified numerous "reportable conditions", which relate to our internal accounting systems and controls, which systems and controls may be insufficient. Improvements to our internal accounting systems and controls could require substantial resources. An audit of our financial statements for fiscal 1998 and fiscal 1999, following a previous restatement, concluded in July 2000 and resulted in an additional restatement of fiscal 1998 and fiscal 1999. Following its review of our books and records, our management concluded that further steps were needed to establish and maintain the adequacy of our internal accounting systems and controls. In connection with the above audits of our financial statements, Deloitte & Touche LLP advised us that it believed there were numerous "reportable conditions" under the standards established by the American Institute of Certified Public Accountants which relate to our accounting systems and controls that could adversely affect our ability to record, process, summarize and report financial data consistent with the assertions of management in the financial statements. In order to address the reportable conditions identified by Deloitte & Touche LLP, we are developing and implementing comprehensive, adequate and reliable accounting systems and controls. If, however, we determine that our internal accounting systems and controls require additional improvements beyond those identified, or if the changes we are implementing are inadequate, we may need to commit additional substantial resources, including time from our management team, to implement new systems and controls, which could affect the timeliness of our financial or management reporting. We need to continue to improve our operations in order to improve our financial condition, but our operations will not improve if we cannot continue to effectively implement our business strategy or if they are negatively affected by general economic conditions. Our operations during fiscal 2000 were adversely affected by a number of factors, including our financial difficulties, inventory shortages, allegations of violations of the law, including drug pricing issues, disputes with suppliers and uncertainties regarding our ability to produce audited financial statements. To improve operations, new management developed and in fiscal 2001 began implementing and continues to implement, a business strategy to improve our stores and enhance our relationships with our customers by improving the pricing of products, providing more consistent advertising through weekly circulars, eliminating inventory shortages and out-dated inventory, resolving issues and disputes with our vendors, and developing programs intended to provide better customer service and purchasing prescription files and other means. If we are not successful in implementing our business strategy, or if our business strategy is not effective, we may not be able to continue to improve our operations. In addition, any adverse change in general economic conditions can adversely affect consumer buying practices and reduce our sales of front-end products, which are our higher margin products, and cause a proportionately greater decrease in our profitability. Failure to continue to improve operations or a decline in general economic conditions would adversely affect our results of operations, financial condition and cash flows and our ability to make principal or interest payments on our debt. We cannot assure you that management will be able to successfully manage our business or successfully implement our strategic plan. This could have a material adverse effect on our business and the results of our operations, financial condition and cash flows. In December 1999, we hired a new management team to address our business, operational financial and accounting challenges. Our management team has considerable experience in the retail industry. Nonetheless, we cannot assure you that our management will be able successfully to manage our business or successfully implement our strategic business plan. This could have a material adverse effect on our results of operations, financial condition and cash flows. We are dependent on our management team, and the loss of their services could have a material adverse effect on our business and the results of our operations or financial condition. The success of our business is materially dependent upon the continued services of our chairman and chief executive officer, Robert G. Miller, and the other members of our management team. The loss of Mr. Miller or other key personnel could have a material adverse effect on the results of our operations, financial condition and cash flows. Additionally, we cannot assure you that we will be able to attract or retain other skilled personnel in the future. Risks Related to our Industry The markets in which we operate are very competitive and further increases in competition could adversely affect us. We face intense competition with local, regional and national companies, including other drugstore chains, independently owned drugstores, supermarkets, mass merchandisers, discount stores and mail order pharmacies. We may not be able to effectively compete against them because our existing or potential competitors may have financial and other resources that are superior to ours. In addition, we may be at a competitive disadvantage because we are more highly leveraged than our competitors. Because many of our stores are new, their ability to achieve profitability depends on their ability to achieve a critical mass of customers. While customer growth is often achieved through purchases of prescription files from existing pharmacies, our ability to achieve this critical mass through purchases of prescription files could be confined by liquidity constraints. Although in the recent past, our competitiveness has been adversely affected by problems with inventory shortages, uncompetitive pricing and customer service, we have taken steps to address these issues. We believe that the continued consolidation of the drugstore industry will further increase competitive pressures in the industry. As competition increases, a significant increase in general pricing pressures could occur which would require us to increase our sales volume and to sell higher margin products and services in order to remain competitive. We cannot assure you that we will be able to continue effectively to compete in our markets or increase our sales volume in response to further increased competition. Changes in third-party reimbursement levels for prescription drugs could reduce our margins and have a material adverse effect on our business. Sales of prescription drugs, as a percentage of revenues, and the percentage of prescription sales reimbursed by third parties, have been increasing and we expect them to continue to increase. In fiscal 2001, sales of prescription drugs represented 59.5% of our revenues and we were reimbursed by third-party payors for approximately 90.3% of all of the prescription drugs that we sold. In the first quarter of fiscal 2002, sales of prescription drugs represented 61.6% of our revenues and we were reimbursed by third-party payors for approximately 91.7% of all of the prescription drugs that we sold. During fiscal 2001, the top five third-party payors accounted for approximately 26.4% of our total revenues. Any significant loss of third-party provider business could have a material adverse effect on our business and results of operations. Also, these third-party payors could reduce the levels at which they will reimburse us for the prescription drugs that we provide to their members. Furthermore, if Medicare is reformed to include prescription benefits, we may be reimbursed for some prescription drugs at prices lower than our current retail prices. If third-party payors reduce their reimbursement levels or if Medicare covers prescription drugs at reimbursement levels lower than our current retail prices, our margins on these sales would be reduced, and the profitability of our business and our results of operations, financial condition and cash flows could be adversely affected. We are subject to governmental regulations, procedures and requirements; our noncompliance or a significant regulatory change could adversely affect our business, the results of our operations or our financial condition. Our pharmacy business is subject to federal, state, and local regulation. These include local registrations of pharmacies in the states where our pharmacies are located, applicable Medicare and Medicaid regulations, and prohibitions against paid referrals of patients. Failure to properly adhere to these and other applicable regulations could result in the imposition of civil and criminal penalties and could adversely affect the continued operation of our business. Furthermore, our pharmacies could be affected by federal and state reform programs, such as healthcare reform initiatives which could, in turn, negatively affect our business. The passing of these initiatives or any new federal or state programs could adversely affect our results of operations, financial condition and cash flows. Certain risks are inherent in the provision of pharmacy services; our insurance may not be adequate to cover any claims against us. Pharmacies are exposed to risks inherent in the packaging and distribution of pharmaceuticals and other healthcare products, such as with respect to improper filling of prescriptions, labeling of prescriptions and adequacy of warnings. Although we maintain professional liability and errors and omissions liability insurance from time to time, claims result in the payment of significant amounts, some portions of which are not funded by insurance. We cannot assure you that the coverage limits under our insurance programs will be adequate to protect us against future claims, or that we will maintain this insurance on acceptable terms in the future. Our results of operations, financial condition or cash flows may be adversely affected if in the future our insurance coverage proves to be inadequate or unavailable or there is an increase in liability for which we self insure or we suffer reputational harm as a result of an error or omission. We will not be able to compete effectively if we are unable to attract, hire and retain qualified pharmacists. There is a nationwide shortage of qualified pharmacists. In response, we have implemented improved benefits and training programs in order to attract, hire and retain qualified pharmacists. However, we may not be able to attract, hire and retain enough qualified pharmacists. This could adversely affect our operations. Risks Related to our Common Stock You may not be able to sell the common stock when you want to and, if you do, you may not be able to receive the price that you want. Although our common stock has been actively traded on the New York Stock Exchange and the Pacific Exchange, we do not know if an active trading market for the common stock will continue or, if it does, at what prices the common stock may trade. The shares of our common stock offered by this prospectus will significantly increase the number of shares of our common stock registered for sale to the public, and could result in a decline in the market price of our common stock. Therefore, you may not be able to sell the common stock when you want and, if you do, you may not receive the price you want. Additionally, in connection with the settlement of a class action suit brought against us, we may be required to issue 20 million shares of common stock. If the value of our shares of common stock is less than $7.75 per share in February 2002, we may deliver a greater number of shares. We will also issue additional shares of common stock pursuant to outstanding options granted pursuant to our various stock option plans. In addition, as described below, the refinancing of our indebtedness may include additional issuances of equity securities. We cannot predict the extent to which this dilution, the availability of a large amount of shares for sale, and the possibility of additional issuances and sales of our common stock will negatively affect the trading price of our common stock or the liquidity of our common stock. Our debt restructuring efforts may be dilutive to your shares. We may undertake additional transactions to simplify and restructure our capital structure, which may include, as part of these efforts, additional issuances of equity securities in exchange for our indebtedness. The issuance of additional shares of common stock may be dilutive to the holders of our common stock, including holders who purchase shares of common stock in this offering.

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+RISK FACTORS You should read carefully the following risk factors and the other sections of this prospectus before purchasing any Senior Unsecured Notes. Risk Factors Relating to the Senior Unsecured Notes We do not expect there to be any significant secondary market for the Senior Unsecured Notes and consequently your ability to sell the Senior Unsecured Notes if you wish to do so before they mature may be limited. There is no present trading market for the Senior Unsecured Notes. We do not intend to create or encourage a trading market for the Senior Unsecured Notes, and it is highly unlikely that any secondary trading market will develop. We do not intend to apply for a listing of the Senior Unsecured Notes on any securities exchange or to include them in any automated quotation system. Any secondary market which might develop for, and the market value of, the Senior Unsecured Notes will be affected by a number of factors which are independent of our creditworthiness. These factors include the level and direction of interest rates, the remaining period to maturity of the Senior Unsecured Notes, our right to redeem the Senior Unsecured Notes, our right to issue Senior Unsecured Notes at interest rates higher than the rates for the Senior Unsecured Notes previously issued, the aggregate principal amount of the Senior Unsecured Notes outstanding and the terms and availability of comparable investments. In addition, the market value of the Senior Unsecured Notes may be affected by numerous other interrelated factors, including factors that affect the U.S. corporate debt market generally, and Southern States specifically. You should rely solely on our ability to repay at maturity the principal of the offered Senior Unsecured Notes as the source for liquidity for this investment. See "Description of the Senior Unsecured Notes--Interest Rates," "--Redemption at the Option of Holders" and "--Redemption at the Option of Southern States." We are not offering the Senior Unsecured Notes through an underwriter, which means that no independent third party has evaluated our ability to meet our payment obligations under the Senior Unsecured Notes. This is not an underwritten offering of securities. No underwriter, such as an investment bank, has undertaken a review of our corporate records, evaluated our financial condition or evaluated the terms of the Senior Unsecured Notes and this offering, including our ability to meet our payment obligations to purchasers of the Senior Unsecured Notes. Thus, there are no assurances that we will be able to meet our payment obligations under the Senior Unsecured Notes when due. Except in limited circumstances, holders of the Senior Unsecured Notes who ask to have their Senior Unsecured Notes redeemed prior to their maturity will be penalized by the deduction from the redemption price of an amount equal to up to six months' interest. You may submit your Senior Unsecured Notes for redemption prior to maturity if you wish to do so. However, we will impose an interest penalty for redemptions made at your request prior to maturity for reasons other than death or mandatory IRA withdrawals. We will permit early redemption without any interest penalty in the case of death of a holder of Senior Unsecured Notes or if the holder is holding a Senior Unsecured Note in an individual retirement account established under section 408 of the Internal Revenue Code and the redemption is necessary to satisfy mandatory withdrawal requirements. In the case of six month and one year Senior Unsecured Notes, the penalty will be equal to three months' interest. In the case of Senior Unsecured Notes with a maturity date of more than one year, the interest penalty will be equal to six months' interest. The penalty could exceed the amount of interest paid or accrued on the Senior Unsecured Note to the redemption date, and result in a redemption price that is less than the principal amount of the Senior Unsecured Note being redeemed. The effect of the interest penalty is more fully described under "Description of the Senior Unsecured Notes--Redemption at the Option of Holders." Depending on your investment objective, the imposition of interest penalties may make these Senior Unsecured Notes an unsuitable investment for you. The Senior Unsecured Notes are not collateralized obligations, and will be effectively subordinated to all of our collateralized indebtedness, which means that in the event of a bankruptcy or liquidation the holders of our collateralized indebtedness would likely receive payment before holders of our Senior Unsecured Notes. Historically, Southern States has relied on commercial bank loans in significant part to finance its working capital needs throughout its annual operating cycle. Our new credit facility, effective September 18, 2001, consists of a $200 million term loan and a $270 million revolving line of credit. The revolving line of credit and the term loan are collateralized by substantially all of Southern States' assets. Thus, our indebtedness under our new credit facility, and under any other collateralized borrowings, will effectively rank senior in liquidation to the Senior Unsecured Notes offered by this prospectus. This means that there are no specific assets that you can look to for repayment of the Senior Unsecured Notes. If our assets are distributed as a result of bankruptcy, liquidation or reorganization, the holders of all of our collateralized indebtedness would likely receive payment before you receive any payment. As a result, we might not have enough assets after paying off our collateralized indebtedness to pay you the amounts owed to you under the Senior Unsecured Notes. As of September 30, 2001, our collateralized indebtedness aggregated approximately $423 million. The Indenture under which the Senior Unsecured Notes will be issued does not limit our ability to incur additional debt that ranks senior or equal to the Senior Unsecured Notes, which may increase the risk that we might not be able to meet our interest and principal obligations on the Senior Unsecured Notes or our other senior debt. The Indenture under which the Senior Unsecured Notes will be issued does not limit our ability to incur additional debt that ranks senior or equal to the Senior Unsecured Notes. As a result, we potentially could incur significant additional indebtedness through the issuance of senior notes or other senior indebtedness, including collateralized indebtedness which would effectively be senior to the Senior Unsecured Notes. The issuance of such additional indebtedness could entail financial risks to Southern States and the holders of Senior Unsecured Notes because of the increased payments of interest and repayments of principal that accompany higher levels of indebtedness, and the consequent increased risk that Southern States might not be able to meet its required payments to you or its other lenders. Holders of any senior or collateralized indebtedness incurred after the issuance of the Senior Unsecured Notes would also effectively be senior to the Senior Unsecured Notes in right of payment. If holders of a large amount of Senior Unsecured Notes submit their Senior Unsecured Notes for early redemption, it is possible Southern States may have to seek other sources of funds in order to satisfy those redemption requests. Southern States does not intend to maintain back-up lines of credit from commercial banks or other lenders sufficient to cover the early redemption of all or any substantial portion of the Senior Unsecured Notes. If circumstances should cause holders of a substantial amount of the Senior Unsecured Notes to submit their Senior Unsecured Notes for early redemption in close proximity to each other, Southern States may not have readily available bank lines of credit or other funds to satisfy all such early redemption requests. In such an event, Southern States would have to seek other sources of funding and, if such funding is not available, Southern States might have to seek some accommodation with the holders of Senior Unsecured Notes in order to permit an orderly plan of payment of the Senior Unsecured Notes. Risk Factors Relating to Southern States Our earnings for the year ended June 30, 2001, were insufficient to cover our fixed charges by $36.8 million. As detailed in Note 3 to the Selected Historical Consolidated Financial Information table on page 14 of this prospectus, our earnings were insufficient to cover our fixed charges by $36.8 million for the fiscal year ended June 30, 2001. A continued inability of our earnings to cover our fixed charges would have a negative impact on our ability to meet our payment obligations under the Senior Unsecured Notes. A violation of financial covenants in our credit facilities and other borrowing agreements could cause an acceleration of payment on a substantial portion of our debt obligations and could affect our ability to pay interest and principal on the Senior Unsecured Notes. If we experience an event of default under one of our loan agreements, it may cause a default under other loan agreements. Our bank credit facilities, our tax-exempt bond financings, and some of our other borrowing agreements relating to our senior debt contain various financial covenants. If we violate any of these covenants and do not cure the violation within the time permitted under such agreements, the violation could constitute an event of default under one or more of these agreements. In some cases, an event of default might permit the lender to accelerate the payment of our indebtedness under a particular agreement. Virtually all of our bank credit agreements, tax-exempt bond financing agreements, capital leases and other financing agreements contain some form of cross-default provision, which could permit our lenders to accelerate the payment of at least a substantial portion of our total indebtedness if a default occurs under any one of these agreements. Such an event could cause an acceleration of payment under our various loan agreements and prevent us from borrowing under our credit facilities if we needed to do so in order to make payments of principal or interest on the Senior Unsecured Notes. The Indenture under which the Senior Unsecured Notes will be issued does not contain any provision that would make an event of default under any of Southern States' other loan agreements a default with respect to the Senior Unsecured Notes. Effective September 18, 2001, we executed a new $470 million credit facility with our lenders. And at September 30, 2001, we were in compliance with all of the financial covenants in the new credit facility. As a cooperative, we are restricted in our ability to raise equity in the capital markets and, consequently, our ability to finance our current operations and future growth is more limited than is the case for other types of business organizations. As a cooperative, we raise equity primarily through the retention of a portion of our patronage refunds and through retention of net savings (net earnings) generated by transactions with non-members. Under applicable law governing cooperatives, the only persons eligible to own our membership common stock are our members, and consequently we are restricted in our ability to raise equity capital in the public capital markets. Thus, we are more limited in our ability to finance our current operations and our future growth than other types of business organizations. In the past we have relied primarily on bank borrowings and other types of debt financings to finance a significant portion of our business. Through the offering of the Senior Unsecured Notes, we plan to reduce to some extent our reliance on bank financings to support our business operations. A decline in commodity prices could result in lower than anticipated revenues and reduced net savings in future years. Historically, our operating results have been adversely affected by significant declines in a wide range of agricultural commodity prices. In the normal course of our operations, we have exposure to market risk from price fluctuations associated with commodities such as petroleum products, grains and fertilizer. These price fluctuations impact commodity inventories, product gross margins, and anticipated transactions in our Crops, Feed, Petroleum and Marketing divisions. We manage the risk of market price fluctuations of some of these commodities by entering into commodities futures contracts. However, because the commodities markets are very volatile, our future gains or losses on these contracts might not fully offset the corresponding change in the prices of the underlying commodity, which could result in lower revenues or reduced net savings in future years. The cyclical and often unpredictable nature of the agriculture business can reduce our revenues and our ability to meet our payment obligations under the Senior Unsecured Notes. Agriculture is generally cyclical in nature. Agricultural commodities experience wide fluctuations in price, based largely on the supply of farm commodities and demand for raw or processed products. The cyclical nature of the agriculture business is something over which we have no control; at times it negatively affects our revenues and operating results. In recent years, the agriculture industry has experienced periods of depressed prices for a wide variety of commodities. This has affected our operating results in terms of lower sales, lower net savings and increased credit risk among some of our customers. In addition, a portion of our business is dependent on the demand of farmers for particular products, which is influenced by the general farm economy and the success of particular crops. The cyclical nature of our operations related to various commodities can result in significant variations from year to year and over a period of years in sales volume, cost of goods and cost of raw materials. These variations could negatively affect our net income and reduce our ability to meet our payment obligations with respect to the Senior Unsecured Notes. See "Management's Discussion and Analysis of Financial Condition and Results of Operations." Weather conditions can materially impact the demand for our products and services. Historically, weather conditions have had a significant impact on the farm economy and, consequently, our operating results. Weather conditions affect the demand for, and in some cases the supply of, products, which in turn has an impact on our prices. For example, weather patterns such as flood, drought or frost can cause crop failures that in turn affect the supply of feed and seed and the marketing of grain products, as well as the demand for fertilizer, crop protectants, seeds and other agronomic supplies. In recent years, we have experienced unusually severe weather conditions, including ice storms, floods and wind damage, and a summer dearth of water and pasture in some states. Weather conditions also directly affect the demand for petroleum products, particularly during the winter heating season. Adverse weather conditions can also impact the financial position of agricultural producers who do business with us. This, in turn, may adversely affect the ability of the producers to repay their obligations to us in a timely manner. Accordingly, the weather can have a material effect on our business, financial condition, and results of operations. Competition in the agribusiness industry could materially adversely affect our business and operating results. We compete against large national and regional manufacturers and suppliers as well as small independent businesses operating in our territory for sales of feed, fertilizer, seed, grain, petroleum and farm supplies. Competition with other suppliers is based primarily on price and service. Agriculture, and the entire food industry, is consolidating rapidly. The potential inability to compete successfully would result in a loss of customers, which could have a material adverse effect on our business, financial condition, and results of operations. For example, some of our competitors may offer supplies or services on more favorable terms, and some may have capital resources, research and development staffs, facilities or name recognition that may be greater than ours. See "Business of Southern States--Other Factors Affecting the Business of Southern States--Competition." Exposure to environmental liabilities could materially adversely affect our business. The use and handling of fertilizer, crop protectants and petroleum products sometimes result in environmental contamination. We are governed by stringent and changing federal, state and local environmental laws and regulations, including those governing the labeling, use, storage, discharge and disposal of hazardous materials. These laws and regulations impose liability for the cleanup of environmental contamination. Because we use and handle hazardous substances in our business, changes in environmental requirements or an unanticipated significant adverse environmental event could have a material adverse effect on our business, financial condition and results of operations. See "Business of Southern States--Other Factors Affecting the Business of Southern States-- Matters Involving the Environment."

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+RISK FACTORS Investing in the trust preferred securities involves a number of risks. Please read all of the information contained in this prospectus. In addition, please consider carefully the following factors in evaluating an investment in the trust before you purchase the trust preferred securities. Because the trust will rely on the payments it receives on the junior subordinated debentures to fund all payments on the trust preferred securities, and because the trust may distribute the junior subordinated debentures in exchange for the trust preferred securities, purchasers of the trust preferred securities are making an investment decision that relates to the junior subordinated debentures being issued by NCF as well as the trust preferred securities. Purchasers should carefully review the information in this prospectus about the trust preferred securities, the junior subordinated debentures and the Guarantee. Risks Related to an Investment in National Commerce Financial Corporation If Economic or Political Conditions in General or in NCF's Primary Market Areas in Particular Deteriorate, NCF's Results of Operations and Financial Condition, as well as NCF's Ability to Timely Pay Interest and Principal on the Junior Subordinated Debentures, Could Be Adversely Impacted. NCF's financial results may be adversely affected by changes in prevailing economic conditions, including declines in real estate values, changes in interest rates, adverse employment conditions, the monetary and fiscal policies of the federal government and other significant external events. United States economists have declared that the United States economy is currently in recession. The recession has adversely affected employment and other significant elements of the economy that drive productivity and the financial strength of businesses. These current conditions could have a material adverse affect on loan and deposit growth, loan loss reserves and, as a result, NCF's financial condition and results of operations in future periods. The events of September 11, 2001, in New York and Washington, D.C., as well as the United States' war on terrorism, may have an unpredictable effect on economic conditions in general and in NCF's primary market areas. NCF's results of operations, financial condition and ability to timely pay the principal of or interest on the junior subordinated debentures could be adversely impacted if those events and other related events cause a further decline in the economy in general or in NCF's primary market areas in particular. NCF's Financial Performance May Suffer as a Result of NCF's Merger with CCB and its Purchase and Integration of 37 Former First Union and Wachovia Branches. There are many risks associated with completing a merger-of-equals transaction like the one NCF completed on July 5, 2000 with CCB. The respective businesses of NCF and CCB may not be successfully integrated within the time frame envisioned prior to the merger. The synergies anticipated from this business combination may fail to be achieved within the expected time frame, or at all. Additionally, NCF has announced that it has signed a definitive agreement to acquire 37 branches from First Union and Wachovia, which it expects to close in the first quarter of 2002. NCF may lose deposits or be unable to attract new deposits to these branches. Moreover, NCF may lose key employees in these branches who control key customer relationships. Integration may also divert management's attention from operational matters, which could adversely affect results of operations. These risks may hinder NCF's ability to attain the level of financial performance it has historically achieved. NCF Is Subject to Significant Government Regulation Over Which It Has No Control. Unforeseen Changes in Regulations Applicable to NCF's Business Could Affect Its Financial Condition. The banking industry is heavily regulated under both federal and state law. These regulations are primarily intended to protect customers and the federal deposit insurance funds, not creditors or shareholders. Regulations affecting banks and financial services companies are continuously changing, and NCF cannot predict the ultimate effect of such changes, which could have a material adverse effect on NCF's profitability or financial condition. Regulations and laws may be modified at any time, and new legislation may be enacted that adversely affects NCF and its subsidiaries. In the fourth quarter of 1999, then-President Clinton signed into law the Gramm-Leach-Bliley Act, or the "GLBA," which permits qualifying bank holding companies to become financial holding companies. The GLBA authorized financial holding companies, national banks and their financial subsidiaries to engage in activities that are financial in nature. The GLBA also permits insurance companies and securities companies that meet certain criteria to become financial holding companies and thereby acquire banks and bank holding companies, possibly increasing competition. See "Information about National Commerce Financial Corporation--Government Regulation and Supervision" for further discussion of these matters. NCF Must Act as a Source of Financial and Managerial Strength to Each of its Subsidiary Banks. Under Federal Reserve policy, NCF, as a bank holding company, is expected to maintain resources adequate to support each subsidiary bank. This support may be required at times when NCF may not have the resources to provide it. In addition, Section 55 of the National Bank Act, as amended, permits the Office of the Comptroller of the Currency, or "OCC," to order the pro rata assessment of shareholders of a national bank whose capital has become impaired. If a shareholder fails within three months to pay such an assessment, the OCC can order the sale of the shareholder's stock to cover the deficiency. NCF, as the sole shareholder of its subsidiary banks, is subject to such provisions. Such an assessment could have a material adverse effect on NCF's financial condition and its ability to timely pay the principal of or interest on the junior subordinated debentures. There Are Restrictions on the Ability of NCF's Banking Subsidiaries to Pay Dividends. NCF relies on dividends from its subsidiary banks as its principal source for the payment of interest and principal on its debt. Federal and state banking regulations restrict the ability of the banking subsidiaries to pay dividends. Although NCF expects to continue receiving dividends from its subsidiary banks sufficient to meet its current and anticipated cash needs, a decline in the profitability of those subsidiaries could result in restrictions on the payment of such dividends in the future. Also, there can be no assurance that additional federal or state regulations will not further restrict the ability of banking subsidiaries to pay dividends. Restrictions on the ability of NCF's banking subsidiaries to pay dividends could have a material adverse effect on NCF's ability to pay interest and principal on the junior subordinated debentures and the trust's ability to pay distributions on the trust preferred securities. See "Management's Discussion and Analysis of Financial Condition and Results of Operations--Liquidity and Interest- Sensitivity" and "Information about National Commerce Financial Corporation-- Government Regulation and Supervision." Competition With Other Financial Institutions Could Adversely Affect NCF's Profitability. Vigorous competition for loans and deposits exists in all major geographic and product areas where NCF is presently engaged in business. Its subsidiary banks compete not only with other commercial banks but also with diversified financial institutions such as thrift institutions, money market and other mutual funds, securities firms, mortgage companies, leasing companies, finance companies, insurance companies and a variety of financial services and advisory companies. Moreover, competition is not limited to NCF's immediate geographic markets, as an increased variety of financial services is being offered on the Internet. Larger competing financial institutions may be able to offer services and products that are not cost-efficient for NCF's subsidiary banks to offer. In addition, larger competing financial institutions have access to greater financial resources than NCF's subsidiary banks. NCF's non-banking subsidiaries face competition from other commercial banks, securities firms, transaction processing companies, trust companies, investment advisers and other firms engaged in retirement plan consulting/ administration. Several of these competitors are larger and have more experience, ability to provide broader services and greater financial resources than the NCF subsidiaries. NCF's long- term success will depend on its ability to compete successfully in its markets. If NCF's Allowance for Loan Losses Is Not Sufficient to Cover Actual Loan Losses, NCF's Net Income Could Decrease. NCF's loan customers may not repay their loans according to the terms of these loans, and the collateral securing the payment of these loans may be insufficient to assure repayment. Such loan losses could have a material adverse effect on the company's operating results. NCF makes various assumptions and judgments about the collectibility of its loan portfolio, including the creditworthiness of its borrowers and the value of the real estate and other assets serving as collateral for the repayment of many of its loans. In determining the size of the allowance for loan losses, NCF relies on its experience and its evaluation of economic conditions. If NCF's assumptions prove to be incorrect, its current allowance for loan losses may not be sufficient to cover losses inherent in its loan portfolio and adjustments may be necessary to allow for different economic conditions or adverse developments in its loan portfolio. The current economic downturn could have a material adverse effect on corporate profits, household incomes, real estate values and values of other types of collateral, all of which could result in a larger amount of loan losses than NCF has estimated. Material additions to NCF's allowance for loan losses could materially decrease its net income. In addition, federal and state regulators periodically review NCF's allowance for loan losses and may require NCF to increase its provision for loan losses or recognize additional loan charge-offs. Any increase in NCF's allowance for loan losses or loan charge-offs as required by these regulatory agencies could have a material adverse effect on NCF's results of operations and financial condition. See "Management's Discussion and Analysis of Financial Condition and Results of Operations--Asset Quality" for a more complete discussion of NCF's method of estimating loan losses and its loan loss experience over the last five fiscal years and related interim periods. Fluctuations in Interest Rates Could Reduce NCF's Profitability. A major element of NCF's net income is its net interest income, which consists largely of the difference between interest earned on loans and investments and the interest paid on deposits and borrowings. NCF expects to periodically experience "gaps" in the interest rate sensitivities of its assets and liabilities, meaning that either its interest-bearing liabilities will be more sensitive to changes in market interest rates than its interest-earning assets, or vice versa. In either event, if market interest rates should move contrary to NCF's position, NCF's net interest margin and, consequently, its net income may be negatively affected. See "Management's Discussion and Analysis of Financial Condition and Results of Operations of NCF--Liquidity and Interest Sensitivity" for a more complete discussion of NCF's exposure to and management of its interest rate risk. NCF cannot predict fluctuations of market interest rates, which are affected by, among other factors, changes in the following: . inflation rates; . levels of business activity; . unemployment levels; . monetary and fiscal policies of the United States and its agencies, particularly the Federal Reserve; . money supply; and . domestic and foreign financial markets. Decreased Growth Rates in Traditional Deposits May Result in the Need to Fund Loan Growth With Higher-Cost Sources. NCF's loan growth has been more rapid than its growth in lower-cost deposits. Substantially all deposits originate within the subsidiary banks' market areas. As with the rest of the financial institutions industry, NCF has seen decreased growth rates in traditional deposits as consumers elect other savings and investment opportunities. Continued slow growth in traditional deposits may result in the need to fund loan growth in part with higher-cost funding sources, which may contribute to decreases in NCF's net interest margin. This in turn may negatively affect NCF's net income. There is no assurance that NCF will be able to achieve growth in or retain existing deposits in the future. NCF Relies Heavily on Its Management Team, and the Unexpected Loss of Key Managers May Adversely Affect NCF's Operations. NCF's success to date has been influenced strongly by its ability to attract and to retain senior management experienced in banking and financial services. NCF's ability to retain executive officers and the current management teams of each of NCF's lines of business will continue to be important to successful implementation of the company's strategies and integration of its acquisitions. The unexpected loss of services of any key management personnel, or the inability to recruit and retain qualified personnel in the future, could have an adverse effect on NCF's business and financial results. Risks Related to an Investment in the Trust Preferred Securities If NCF Does Not Make Interest Payments Under the Junior Subordinated Debentures, the Trust Will be Unable to Pay Distributions and Liquidation Amounts on the Trust Preferred Securities. The trust will depend solely on NCF's payments on the junior subordinated debentures to pay amounts due to you on the trust preferred securities. If NCF defaults on its obligation to pay the principal or interest on the junior subordinated debentures, the trust will not have sufficient funds to pay distributions or the liquidation amount on the trust preferred securities. In that case, you will not be able to rely on the Guarantee for payment of these amounts because the Guarantee only applies if the trust has sufficient funds to make distributions on or to pay the liquidation amount of the trust preferred securities. Instead, you or the property trustee will have to institute a direct action against NCF to enforce the property trustee's rights under the Indenture relating to the junior subordinated debentures. NCF's Status as a Holding Company. NCF is a holding company and substantially all of its assets are held by its subsidiaries. NCF's ability to make payments on the junior subordinated debentures when due will depend primarily on dividends from its subsidiaries. Dividend payments or extensions of credit from NCF's banking subsidiaries are subject to regulatory limitations that are generally based on capital levels and current and retained earnings. The ability of each banking subsidiary to pay dividends is also subject to its profitability, financial condition, capital expenditures and other cash flow requirements. NCF cannot assure you that its subsidiaries will be able to pay dividends in the future. In addition, NCF's right to participate in any distribution of assets from any subsidiary, upon the subsidiary's liquidation or otherwise, is subject to the prior claims of creditors of that subsidiary, except to the extent that NCF is recognized as a creditor of that subsidiary. As a result, the junior subordinated debentures and the Guarantee will be effectively subordinated to all existing and future liabilities of NCF's subsidiaries. You should look only to the assets of NCF as the source of payment for the junior subordinated debentures and the Guarantee. As of September 30, 2001, NCF's subsidiaries had approximately $15.3 billion of total liabilities (including trade payables), of which deposits comprised $11.9 billion. NCF could also be precluded from making interest payments on the junior subordinated debentures by regulators if in the future they were to perceive deficiencies in liquidity or regulatory capital levels. If this were to occur, NCF may be required to obtain the consent of its regulators prior to paying interest on the junior subordinated debentures. If consent were to be required and NCF's regulators were to withhold their consent, NCF would likely exercise its right to defer interest payments on the junior subordinated debentures, and the trust would not have funds available to make distributions on the trust preferred securities during such period. The Junior Subordinated Debentures and the Guarantee Rank Junior in Right of Payment to Most of NCF's Other Indebtedness, and NCF's Holding Company Structure Effectively Subordinates any Claims Against NCF to Those of Its Subsidiaries' Creditors. NCF's obligations under the junior subordinated debentures and the Guarantee are unsecured and rank junior in right of payment to all of NCF's existing and future Senior Debt. This means that NCF cannot make any payments on the junior subordinated debentures or under the Guarantee if NCF is in default in the payment of principal, premium, interest or any other payment due on any Senior Debt following any grace period, or in the event that the maturity of any Senior Debt has been accelerated because of a default. In addition, in the event of the bankruptcy, insolvency or liquidation of NCF, the company's assets must be used to pay off its Senior Debt in full before any payments may be made on the junior subordinated debentures or under the Guarantee. Substantially all of NCF's existing debt, other than the junior subordinated debentures, is Senior Debt except for the 1997 Debentures held by National Commerce Capital Trust I, which we call the "1997 Trust" in this prospectus. The 1997 Trust purchased the 1997 Debentures with the proceeds from the sale of the 1997 Trust Preferred Securities. The junior subordinated debentures will rank pari passu with the 1997 Debentures and NCF's guarantee of the 1997 Trust Preferred Securities. Consequently, the 1997 Trust and holders of the 1997 Trust Preferred Securities will have an equal claim with the trust and holders of the trust preferred securities to payments from NCF's assets. These equal and competing claims could reduce the amount available to holders of the trust preferred securities. As of September 30, 2001, NCF had $39 million in aggregate principal amount of Senior Debt and $43 million in aggregate principal amount of pari passu debt consisting of the 1997 Debentures and NCF's guarantee of the 1997 Trust Preferred Securities. The Indenture, the Guarantee and the Trust Agreement do not limit NCF's ability to incur additional secured or unsecured debt, including Senior Debt. See "Description of the Guarantee--Status of the Guarantee" and "Description of the Junior Subordinated Debentures--Subordination." NCF Has the Option to Defer Interest Payments on the Junior Subordinated Debentures for Substantial Periods. NCF may, at one or more times, defer interest payments on the junior subordinated debentures for up to 20 consecutive quarters. If NCF defers interest payments on the junior subordinated debentures, the trust will defer distributions on the trust preferred securities. During a deferral period, you will be required to recognize as income for federal income tax purposes the amount approximately equal to the interest that accrues on your proportionate share of the junior subordinated debentures held by the trust in the tax year in which that interest accrues, even though you will not receive these amounts until a later date. You will also not receive the cash related to any accrued and unpaid distributions from the trust if you sell the trust preferred securities before the end of any deferral period. During a deferral period, accrued but unpaid distributions will increase your tax basis in the trust preferred securities. If you sell the trust preferred securities during a deferral period, your adjusted tax basis will decrease the amount of any capital gain or increase the amount of any capital loss that you may have otherwise realized on the sale. For United States federal tax purposes, a capital loss, except in certain limited circumstances, cannot be applied to offset ordinary income. As a result, deferral of distributions could result in ordinary income, and a related tax liability for the holder, and a capital loss that may only be used to offset a capital gain. NCF does not currently intend to exercise its right to defer interest payments on the junior subordinated debentures. However, if NCF exercises its right in the future, the market price of the trust preferred securities would likely be adversely affected. The trust preferred securities may trade at a price that does not fully reflect the value of accrued but unpaid interest on the junior subordinated debentures. If you sell the trust preferred securities during a deferral period, you may not receive the same return on investment as someone who continues to hold the trust preferred securities. Due to NCF's right to defer interest payments, the market price of the trust preferred securities may be more volatile than the market prices of other securities without the deferral feature. NCF May Redeem the Junior Subordinated Debentures. Under the following circumstances, NCF may redeem the junior subordinated debentures before their stated maturity: . NCF may redeem the junior subordinated debentures, in whole or in part, at any time on or after . . NCF may redeem the junior subordinated debentures in whole, but not in part, within 90 days after certain occurrences at any time during the life of the trust. These occurrences include adverse tax or bank regulatory developments. See "Description of the Junior Subordinated Debentures--Conditional Right to Redeem Upon a Tax Event or Capital Treatment Event." You should assume that an early redemption may be attractive to NCF if it is able to obtain capital at a lower cost than it must pay on the junior subordinated debentures or if it is otherwise in its interest to redeem the junior subordinated debentures. If the junior subordinated debentures are redeemed, the trust must redeem trust preferred securities having an aggregate liquidation amount equal to the aggregate principal amount of junior subordinated debentures redeemed. The Trust Can Distribute the Junior Subordinated Debentures to You, Which May Have Adverse Tax Consequences for You and Which May Adversely Affect the Market Price of the Trust Preferred Securities. NCF may dissolve the trust at any time before maturity of the junior subordinated debentures on . As a result, and subject to the terms of the Trust Agreement, the trustees may distribute junior subordinated debentures to you. NCF cannot predict the market prices for the junior subordinated debentures that may be distributed in exchange for trust preferred securities upon liquidation of the trust or whether a trading market will develop. The trust preferred securities, or the junior subordinated debentures that you may receive if the trust is liquidated, may trade at a discount to the price that you paid to purchase the trust preferred securities. Because you may receive junior subordinated debentures, your investment decision with regard to the trust preferred securities will also be an investment decision with regard to the junior subordinated debentures. You should carefully review all of the information contained in this prospectus regarding the junior subordinated debentures. Under current interpretations of United States federal income tax laws supporting classification of the trust as a grantor trust for tax purposes, a distribution of the junior subordinated debentures to you upon the dissolution of the trust would not be a taxable event to you. Nevertheless, if the trust is classified for United States federal income tax purposes as an association taxable as a corporation at the time it is dissolved, the distribution of the junior subordinated debentures would be a taxable event to you. In addition, if there is a change in law, a distribution of junior subordinated debentures upon the dissolution of the trust could be a taxable event to you. There is No Current Public Market for the Trust Preferred Securities and Their Market Price May Be Subject to Significant Fluctuations. There is currently no public market for the trust preferred securities. The trust preferred securities have been approved for listing on the New York Stock Exchange, and trading is expected to commence on or prior to delivery of the trust preferred securities. The underwriters of this offering have advised NCF that they intend to make a market in the trust preferred securities prior to the date the trust preferred securities begin trading on the New York Stock Exchange. However, the underwriters may discontinue market making at any time. There is no guarantee that an active or liquid trading market will develop for the trust preferred securities or that the quotation of the trust preferred securities will continue on the New York Stock Exchange. If an active trading market does not develop, or even if such a market does develop, there is no guarantee that the market price for the trust preferred securities will equal or exceed the price you pay for the trust preferred securities. Future trading prices of the trust preferred securities may be subject to significant fluctuations in response to prevailing interest rates, NCF's future operating results and financial condition, the market for similar securities and general economic and market conditions. The initial public offering price of the trust preferred securities has been set at the liquidation amount of the trust preferred securities, but the market price following the offering may be less than the offering price. The market price for the trust preferred securities, or the junior subordinated debentures that you may receive in a distribution, is also likely to decline during any period that NCF is deferring interest payments on the junior subordinated debentures. You Must Rely on the Property Trustee to Enforce Your Rights if There is an Event of Default Under the Indenture. You may not be able to directly enforce your rights against NCF if an event of default under the Indenture occurs. If an event of default under the Indenture occurs and is continuing, this event will also be an event of default under the Trust Agreement. In that case, you must rely on the enforcement by the property trustee, as holder of the junior subordinated debentures, of its rights against NCF. The holders of a majority in liquidation amount of the outstanding trust preferred securities will have the right to direct the property trustee to enforce its rights. If the property trustee does not enforce its rights following an event of default and a request by the record holders to do so, any record holder may, to the extent permitted by applicable law, take action directly against NCF to enforce the property trustee's rights. If an event of default occurs under the Trust Agreement that is attributable to NCF's failure to pay interest or principal on the junior subordinated debentures, or if NCF defaults under the Guarantee, you may proceed directly against NCF. You will not be able to exercise directly any other remedies available to the holders of the junior subordinated debentures unless the property trustee fails to do so. As a Holder of Trust Preferred Securities, You Have Limited Voting Rights. Holders of the trust preferred securities have limited voting rights. Your voting rights pertain primarily to amendments to the Trust Agreement. In general, only NCF, as holder of the trust common securities, can replace or remove any of the trustees. However, if a debenture event of default occurs and is continuing, the holders of at least a majority in aggregate liquidation amount of the outstanding trust preferred securities may replace the property trustee and the Delaware trustee. The holders of the trust preferred securities do not have the right to appoint, remove or replace the administrative trustees. See "Description of the Trust Preferred Securities--Voting Rights; Amendment of the Trust Agreement" and "--Removal of Trustees."

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+RISK FACTORS This offering involves a high degree of risk and uncertainty. You should carefully consider the risks and uncertainties described below and the other information in this prospectus before deciding to invest in shares of our common stock. If any of the following risks actually occur, our business, operating results and financial condition could be materially adversely affected. This could cause the trading price of our common stock to decline, and you may lose part or all of your investment. OUR PROFITABILITY DEPENDS IN LARGE PART ON OUR ABILITY TO ACCURATELY PREDICT AND EFFECTIVELY MANAGE RISING HEALTHCARE COSTS AND TO IMPLEMENT INCREASES IN PREMIUM RATES. Our operating results for the first half of 2001 were adversely impacted by industry-wide and historically high medical inflation. Healthcare costs have increased over the last few years for several reasons. The aging of the population and other demographic characteristics, increasing use of medical services and advances in medical technology contributed to rising healthcare costs. The increased use and costs of pharmaceutical products and services, which increased faster than the costs of other medical products and services, also continued to contribute significantly to rising healthcare costs. Government-imposed limitations on Medicare and Medicaid reimbursements have caused the private sector to bear a greater share of increasing healthcare costs. These factors, which are beyond our control, could adversely affect our ability to accurately predict and effectively manage healthcare costs, resulting in a material adverse effect on our business, financial condition and results of operations. In addition to the challenge of managing healthcare costs, we face pressure to contain premium prices. Our policyholders may select our more restricted benefit packages to lower their premium costs. Alternatively, our customers may move to a competitor to obtain more favorable premiums. Furthermore, our ability to raise our premiums is subject to regulatory constraints. Limitations on our ability to increase or maintain our premium levels could adversely affect our business, financial condition and results of operations. OUR PROFITABILITY DEPENDS ON OUR ABILITY TO ACCURATELY PREDICT CLAIMS LIABILITIES WHEN PRICING OUR PRODUCTS, MAKING ACQUISITIONS AND ESTABLISHING OUR LIABILITIES FOR FUTURE POLICY BENEFITS AND CLAIMS. If actual claims experience is less favorable than our underlying assumptions used in setting the prices for our products and establishing our liabilities, the required change in our claims reserves could have a material adverse effect on our business, financial condition and results of operations. Reserves are only actuarial estimates and it is possible that our claims experience may be worse than anticipated. When we acquire blocks of insurance policies or insurers owning blocks of policies, our assessment of the adequacy of transferred policy liabilities is subject to similar uncertainties and risks. United Benefit Life had a shortfall in reserves of approximately $19.4 million that we subsequently discovered in connection with our August 1, 1998 reinsurance agreement. We foreclosed on the stock of United Benefit Life on July 21, 1999. As of December 31, 1999, we had recovered approximately $17.8 million of this shortfall, including $4.6 million from real and personal property, $5.3 million from commissions due Insurance Advisors of America, Inc., United Benefit Life's agents, and $7.9 million from our reinsurance agreement. Of the portion not recovered, we recorded an expense of $0.7 million in 1998 and $0.9 million in 1999. With acquired and existing businesses, we may, from time to time, need to increase our loss projections for claims reserves significantly in excess of our original estimates. In addition, we review on a regular basis the loss ratios of our business segments and record a premium deficiency reserve, if necessary. Any increase in claims reserves could have a material adverse effect on our business, financial condition and results of operations. In addition, in connection with the sale of our insurance policies, we defer and amortize a portion of the policy acquisition costs over the related premium paying periods of the life of the policy. Deferred acquisition costs are affected by unanticipated termination of policies because, upon such termination, we expense fully the unamortized deferred acquisition costs associated with the terminated policies. For example, in connection with the termination or replacement of the United Benefit Life and Provident American Life policies, we expensed $5.9 million in the first quarter of 2001 relating to the unamortized deferred acquisition costs associated with those policies. In addition, when we determine that a specific block of our business is unprofitable and therefore the deferred acquisition costs are not recoverable, we expense fully the unamortized deferred acquisition costs associated with that business. For example, in the third quarter of 2001, we expensed $4.9 million of unamortized deferred acquisition costs relating to Central Reserve's business in two states due to the continuing unprofitability of the business in those states. Therefore, the unanticipated termination of a significant number of policies or the determination that deferred acquisition costs are unrecoverable could have a material adverse effect on our financial condition and results of operations. Increased policy termination by our policyholders, or lapsation, will also result in reduced premium collection and a greater percentage of higher-risk insureds. Increased claims in future periods and unfavorable loss ratios are usually associated with blocks of business which have greater percentages of higher-risk insureds, and, therefore, lapsation may also adversely impact our future earnings. CHANGES IN GOVERNMENT REGULATION MAY AFFECT OUR PROFITABILITY AND INCREASE OUR COSTS TO MAINTAIN COMPLIANCE. We are subject to extensive federal and state regulation and compliance with future laws and regulations could increase our operating costs. Our insurance subsidiaries are subject to regulation and supervision in each of the states in which they are admitted. This supervision and regulation is largely for the benefit and protection of policyholders and not stockholders. Supervision and regulation by the insurance departments extends, among other things, to: - the declaration and payment of dividends; - the setting of rates to be charged for our products; - the granting and revocation of licenses to conduct business; - the approval of forms; - the establishment of reserve requirements; - the timely payment of claims; - the regulation of maximum commissions payable; and - the form and content of financial statements required by statute. In addition, federal and state legislative proposals relating to healthcare reform contain features that would severely limit or eliminate our ability to vary our pricing terms or apply medical underwriting standards with respect to individuals. These proposals, if enacted, may have the effect of increasing our loss ratios and decreasing our profitability. A failure to comply with legal or regulatory restrictions may subject us to a loss or suspension of a right to engage in certain businesses or business practices, criminal or civil fines, an obligation to make restitution or pay refunds or other sanctions, which could have a material adverse effect on our business, financial condition or results of operations. For example, recently enacted Texas statutes require insurance companies, with insureds in the state, to pay at least 85% of "clean claims" as defined in the statutes within 45 days of receipt. Failure to comply with the prompt payment laws and clean claims rules may require the insurer to pay restitution, such as the full amount of the billed charges or the contracted penalty rate, and/or an administrative penalty that may not exceed $1,000 for each day each claim remained unpaid. The Texas Department of Insurance recently requested information from health maintenance organizations and insurers operating in the state, including Central Reserve, Provident American Life and Continental General, with respect to their respective claims payment practices. We are in the process of evaluating our compliance with these laws and at this time, we cannot predict the impact, if any, on us of compliance with these laws. In addition, many states, including states in which we do business, have enacted, or are considering, various healthcare reform statutes. We have decided, and may continue to decide in the future, to discontinue selling certain products in states where, due to these healthcare reform measures, we cannot function profitably. Some of the new federal and state regulations promulgated under the Health Insurance Portability and Accountability Act of 1996 (HIPAA) are currently unsettled, making certainty of compliance impossible at this time. Due to this uncertainty, we cannot be sure that the systems and programs that we plan to implement will comply with the regulations that are ultimately approved. Implementation of additional systems and programs may be required, the cost of which is unknown to us at this time. Further, compliance with these regulations could require changes to many of the procedures we currently use to conduct our business, which may lead to additional costs that we have not yet identified. In addition, in December 2000, the Department of Health and Human Services (HHS) promulgated regulations under HIPAA related to privacy of individually identifiable health information. These regulations establish significant criminal penalties and civil sanctions for noncompliance. In addition, the regulations could expose us to additional liability for, among other things, violations by our business associates. We must comply with the new privacy regulations by April 14, 2003. We have not quantified the costs required to comply with these regulations, but they may be material. Statutory and regulatory changes may significantly alter our ability to manage pharmaceutical costs through restricted formularies of products available to our members. In addition, Congress and various states are considering some form of a "Patients' Bill of Rights." Although this legislation was originally conceived to regulate HMOs, it will affect all facets of the nation's healthcare delivery system, including medical providers, PPOs, exclusive provider organizations (EPOs), community-based healthcare organizations, and indemnity insurance plans. These changes are expected to result in higher total medical costs, that could encourage more partnerships and associations between medical providers and insurers to control costs, more community-based health organizations, and greater use of higher deductibles to lower insurance costs and reduce administrative expenses of smaller claims. We cannot predict what federal reforms, if any, may be enacted or how these federal reforms would affect our business. Additional regulatory initiatives may be undertaken in the future, either at the federal or state level, to engage in structural reform of the insurance or healthcare industry in order to reduce the escalation of insurance or healthcare costs or to make insurance or healthcare more accessible. These future regulatory initiatives and any form of the Patients' Bill of Rights could have a material adverse effect on our business, financial condition and results of operations. In addition, as we continue to implement our e-business initiatives, uncertainty surrounding the regulatory authority and requirements in this area may make it difficult to ensure compliance. OUR COMMON STOCK HAS HAD LOW TRADING VOLUME AND ITS PRICE MAY CONTINUE TO BE SUBJECT TO SIGNIFICANT FLUCTUATIONS. Our common stock has had low trading volume prior to this offering. The average daily trading volume of our common stock for the first nine months of 2001 was 11,112 shares per day. This low trading volume may have had a significant effect on the market price of our common stock and, accordingly, historical prices of our common stock may not necessarily be indicative of market prices in a more liquid market. The trading volume in our common stock may not increase after the offering even though we are selling a significant number of shares in this offering. Investors in this offering may be unable to resell their shares at prices equal to or greater than the offering price. The market price of our common stock could be subject to significant fluctuations due to a limited trading volume, variations in our quarterly financial results and other factors, such as changes in earnings estimates by analysts or our ability to meet these estimates, conditions in the overall economy and the financial markets and other developments affecting us and our competitors. SHARES ELIGIBLE FOR SALE IN THE FUTURE COULD AFFECT THE MARKET PRICES FOR OUR COMMON STOCK. No prediction can be made as to the effect, if any, future sales of shares, or the availability of shares for future sales, will have on the market price of our common stock prevailing from time to time. Our directors, officers and certain of our other stockholders have agreed not to offer, sell, contract to sell or otherwise dispose of their equity securities (or any securities exercisable for or convertible into such equity securities) until 180 days after the date of this prospectus without the prior written consent of the representatives of the underwriters. After that date, all of these shares may be sold subject to the limitations of Rule 144 under the Securities Act. Upon the closing of this offering, we will have 31,757,895 shares of our common stock outstanding, of which 13,166,353 are "restricted shares" within the meaning of Rule 144. In addition, we have warrants and options outstanding to purchase 7,507,636 shares of our common stock, 5,715,034 of which were exercisable at December 12, 2001. We have entered into a registration rights agreement with some of our stockholders granting them rights to have their restricted shares registered under the Securities Act. The agreement provides "demand" and "piggyback" registration rights for 13,186,766 of the outstanding shares of our common stock and 5,486,857 shares of our common stock issuable upon the exercise of warrants and options that were exercisable at December 12, 2001. We anticipate that each of these holders will waive his, her or its rights under the registration rights agreement in connection with this offering. Sales of substantial amounts of common stock in the public market, or the perception that such sales could occur, could adversely affect prevailing market prices for our common stock, as well as our ability to raise additional capital through an offering of our securities. OUR PROFITABILITY MAY BE ADVERSELY AFFECTED IF WE ARE UNABLE TO MAINTAIN OUR CURRENT PREFERRED PROVIDER ORGANIZATION (PPO) ARRANGEMENTS AND TO ENTER INTO OTHER APPROPRIATE ARRANGEMENTS. Our profitability is dependent upon our ability to reach favorable arrangements with PPO networks that contract with hospitals, physicians and other health benefits providers. The failure to maintain our largest network arrangements or to secure new cost-effective PPO network contracts may result in a loss of policyholders or higher medical costs that could adversely affect our business. As of September 30, 2001, our largest network, First Health Group Corporation, accounted for 29.3% of our PPO certificates and policies in force. A REDUCTION IN NEW SALES OR THE LOSS OF POLICYHOLDERS COULD HAVE AN ADVERSE EFFECT ON OUR FINANCIAL CONDITION AND RESULTS OF OPERATIONS. A reduction in new sales or in the number of our policyholders could reduce our fee income. Fees are charged for services such as medical care coordination programs, claims processing, administration for direct billing, reinsurance management and management services for associations. Fees received from our non-regulated subsidiaries are used by Ceres to meet our debt obligations. For more information on our debt obligations, see "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources." A reduction in our fee income could cause us to default on our debt obligations which could have a material adverse effect on our financial condition and results of operations. OUR SUCCESS DEPENDS ON OUR ABILITY TO DEVELOP NEW PRODUCTS THAT RESPOND TO CHANGES IN THE INSURANCE INDUSTRY. Our success depends, in part, on our ability to develop and provide new products that meet consumers' changing health insurance needs and changes in government requirements. During recent years, the health insurance industry has experienced substantial changes, primarily caused by healthcare legislation. The introduction of managed care organizations has also affected the health insurance industry. In addition, over the past several years, the rapid growth of HMOs and PPOs and the organization of healthcare providers in new ways, such as physician hospital organizations, have dramatically changed health insurance sales. Our future success will depend, in part, on our ability to effectively enhance our current products and claims processing capabilities and to develop new products in the changing healthcare environment on a timely and cost-effective basis. In addition, our products must be approved by the various states in which those products are offered. We could be adversely affected if we are unable to obtain approval for the products that we plan to offer. FAILURE BY OUR REINSURERS TO TIMELY AND FULLY MEET THEIR OBLIGATIONS UNDER OUR REINSURANCE AGREEMENTS COULD HAVE AN ADVERSE EFFECT ON OUR PROFITABILITY AND FINANCIAL CONDITION. We have been able to write insurance risks beyond the level that the capital and surplus of our insurance subsidiaries would support by transferring substantial portions of these risks to other, larger insurers through reinsurance contracts. We reinsure portions of the health and life insurance policies we write and portions of policies we reinsure from other companies. Reinsurance does not discharge us from our primary liability to our insureds. Our growth may be dependent on our ability to obtain reinsurance in the future. We may be unable to obtain reinsurance in the future, if necessary, at competitive rates or at all. Failure by reinsurers to continue to pay in full and in a timely manner the claims made against them in accordance with the terms of our reinsurance agreements could expose our insurance subsidiaries to liabilities in excess of their reserves and surplus and could subject each of them to insolvency proceedings. For the nine months ended September 30, 2001, 24.6% of our total premiums were ceded to our reinsurers, of which approximately 94% was ceded to a single reinsurance company, Hannover Life Reassurance Company of America. The inability of Hannover and other reinsurers to satisfy their obligations could have a material adverse effect on our business, financial condition and results of operations. For more information on our reinsurance arrangements, see "Business -- Reinsurance." OUR INSURANCE SUBSIDIARIES ARE SUBJECT TO RISK-BASED OR STATUTORY CAPITAL REQUIREMENTS. OUR FAILURE TO MEET THESE STANDARDS COULD SUBJECT US TO REGULATORY ACTIONS. Our insurance subsidiaries are subject to risk-based capital (RBC) standards imposed by their states of domicile. These laws, based on the RBC Model Act adopted by the National Association of Insurance Commissioners (NAIC), require our regulated subsidiaries to report their results of risk-based capital calculations to the departments of insurance and the NAIC. Prior to the third quarter of 1998, we experienced ten consecutive quarters of net losses. In 1996 and 1997, Central Reserve Life Insurance Company, our then-principal subsidiary, experienced substantial losses. At December 31, 1996, Central Reserve's statutory capital levels fell to an amount that subjected it to mandatory examination by the State of Ohio Department of Insurance and possible corrective action. In addition, the auditors' report for the periods ended December 31, 1996 and 1997 expressed substantial doubt about our ability to continue as a going concern. However, beginning in 1997 and continuing with the change of control in 1998, we affected a series of transactions that increased statutory capital levels. In the first quarter of 2001 and for the nine months ended September 30, 2001, we again experienced net losses. These losses have affected our statutory capital levels at our insurance subsidiaries. Without additional capital or reinsurance, the statutory capital levels at Central Reserve may be below "company action level" at December 31, 2001. At this level, we must submit a comprehensive plan to the Ohio Department of Insurance which discusses proposed corrective actions to improve Central Reserve's capital position. Failure to meet minimum risk-based capital requirements or statutory capital requirements could subject our insurance subsidiaries to further examination or corrective action, including state supervision or liquidation, which could have a material adverse effect on our business, financial condition and results of operations. For more information, see "Management's Discussion and Analysis of Financial Condition and Results of Operations." INSURANCE COMPANIES ARE FREQUENTLY THE TARGETS OF LITIGATION, INCLUDING CLASS ACTION LITIGATION, THAT COULD RESULT IN SUBSTANTIAL JUDGMENTS. We are and may become a party to a variety of legal actions that affect our business, such as employment and employment discrimination-related suits, employee benefit claims, breach of contract actions, tort claims and intellectual property related litigation. In addition, because we are in the health insurance business, we are subject to a variety of legal actions relating to our business operations, including claims relating to the denial of healthcare benefits. A number of civil jury verdicts have been returned against insurers in the jurisdictions in which we do business involving the insurers' sales practices, alleged agent misconduct, discrimination and other matters. Increasingly these lawsuits have resulted in the award of substantial judgments against the insurer that are disproportionate to the actual damages, including material amounts of punitive damages. In some states, juries have substantial discretion in awarding punitive and non-economic compensatory damages which creates the potential for unpredictable material adverse judgments in any given lawsuit. In addition, in some class actions and other lawsuits involving insurers' sales practices, insurers have made material settlement payments. We, in the ordinary course of business, are involved in such litigation or alternatively, in arbitration. We cannot predict the outcome of any such litigation or arbitration. We have recently been sued for compensatory damages and, in some cases, unspecified punitive damages in a number of actions pertaining to the insureds of United Benefit Life arising from claims payment issues. We cannot predict the outcome of these lawsuits, including the award of punitive damages and, therefore, we cannot predict the financial impact on us of these actions. OUR PERFORMANCE WILL BE SUBSTANTIALLY DEPENDENT ON THE CONTINUED SERVICES AND PERFORMANCE OF OUR SENIOR MANAGEMENT AND OTHER KEY PERSONNEL. Our performance depends on our ability to retain and motivate our officers and key employees. The loss of the services of any of our executive officers or other key employees could have a material adverse effect on our business, financial condition and results of operations. We have existing employment agreements with each of our executive officers, most of which expire on June 30, 2003. We do not maintain "key person" life insurance policies on any key personnel. Our future success also will depend on our ability to identify, attract, hire, train, retain and motivate other highly skilled technical, managerial, marketing and customer service personnel. Competition for these employees is intense and we may not be able to successfully attract, integrate or retain sufficiently qualified personnel. Our future success also depends on our ability to attract, retain and motivate our agents. Our failure to attract and retain the necessary personnel and agents could have a material adverse effect on our business, financial condition and results of operations. For more information, see "Management." A GROUP OF OUR EXISTING STOCKHOLDERS HAS THE ABILITY TO APPROVE ALL MATTERS REQUIRING THE VOTE OF OUR STOCKHOLDERS INCLUDING THE ELECTION OF OUR BOARD OF DIRECTORS. A group of our stockholders has entered into a voting agreement. Prior to this offering, these stockholders owned approximately 73.3% of our outstanding common stock, assuming exercise of their warrants and options and no others. Upon completion of this offering, the parties to the voting agreement will own approximately 41.8% of the outstanding common stock, assuming exercise of their warrants and options and no others, or 39.5% if the underwriters elect to purchase an additional 2,100,000 shares. These stockholders, acting together, will continue to be able to elect all of our directors and to determine the outcome of all corporate actions requiring stockholder approval, including approving or preventing a change of control of the company, a business combination involving the company, the incurrence of indebtedness, the issuance of equity securities and the payment of dividends on our common stock. The voting agreement provides that the stockholders that are parties to the agreement will cause our board of directors to consist of nine directors, some or all of whom are designated by a few of these stockholders. For more information, see "Principal Stockholders -- Voting Agreement." International Managed Care, LLC, formerly Insurance Partners, L.P., and International Managed Care (Bermuda), L.P., formerly Insurance Partners Offshore (Bermuda), L.P., together owned 39.0% of our outstanding common stock prior to this offering, assuming the exercise of their warrants and no others. Upon completion of this offering, the International Managed Care funds together will own 22.9% of our outstanding common stock, assuming the exercise of their warrants and no others, or 21.6% if the underwriters elect to purchase an additional 2,100,000 shares. Peter W. Nauert, our Chairman of the Board, President and Chief Executive Officer, owned 16.4% of our outstanding common stock prior to this offering, assuming the exercise of his warrants and options and no others. Upon completion of this offering, Mr. Nauert will own 9.5% of our outstanding common stock, assuming the exercise of his warrants and options and no others, or 8.9% if the underwriters elect to purchase an additional 2,100,000 shares. The concentration of ownership and control by these stockholders could delay or prevent a change of control of the company or have a depressive effect on the trading market for our common stock. APPLICABLE LAWS RESTRICT THE ACQUISITION OF MORE THAN 10% OF OUR OUTSTANDING VOTING SECURITIES. Ceres is regulated as an insurance holding company by the jurisdictions in which our insurance company subsidiaries are domiciled. These laws require prior approval by the state insurance regulators of changes in control of an insurer. Generally, these laws require notice to the insurer and prior written approval by the state insurance regulator of the jurisdiction in which the insurance company is domiciled. Under these laws, anyone acquiring a specified percentage of our outstanding voting securities would be presumed to have acquired control of Ceres, unless such presumption is rebutted. The specified percentage is 10% under the insurance laws of the relevant jurisdictions. WE MAY HAVE DIFFICULTY MANAGING OUR EXPANDING OPERATIONS AND WE MAY NOT BE SUCCESSFUL IN ACQUIRING NEW BUSINESSES. Since July 1998, we significantly expanded our operations through several acquisitions, including Pyramid Life, Continental General, Provident American Life and United Benefit Life, and several blocks of business, including Central Benefits Mutual Insurance Company and American Chambers Life Insurance Company. We are experiencing and may continue to experience significant growth. Our rapid growth in size and complexity of our operations has placed, and will continue to place, significant demands on our management, operations, systems, accounting, internal controls and financial resources. To the extent that we continue to grow rapidly, we will be faced with risks, including risks associated with identifying, hiring and assimilating new personnel, marketing new products or continuing new and existing products, and our ability to obtain additional debt or equity financing on favorable terms, or at all, to facilitate growth. Our ability to manage any future growth depends on our ability to continue to implement and improve our operational, financial and management information systems on a timely basis and to expand, train, motivate and manage our work force and, when appropriate, to cost-effectively outsource certain administrative and claims functions. Our ability to compete effectively will depend, in part, upon our ability to overcome these growth-related risks and to revise, improve and effectively use our operational, management, marketing and technical systems. Any failure by us to effectively manage our growth and to respond to changes in our business could have a material adverse effect on our business, financial condition and results of operations. Although we are not actively seeking new acquisitions, we remain open to strategic acquisition opportunities. Future acquisitions may require significant amounts of cash, potentially dilutive issuances of our common stock or other equity securities or the incurrence of debt or amortization expenses related to goodwill and other intangible assets. Any of these events could have a material adverse effect on our business, financial condition and results of operations. Acquisitions also involve numerous risks, some of which we have experienced with our prior acquisitions, including: - difficulties in assimilating the operations, technologies, products and personnel of the acquired company, including accounting and internal control systems; - diversion of financial and management resources from existing operations; - risks of entering markets in which we have no or limited prior experience; - potential increase in policy lapses; - potential losses from unanticipated litigation; - potential loss of key employees of the acquired company; and - inability to generate sufficient revenues to offset acquisition costs. We may be unable to identify suitable acquisition candidates, obtain financing necessary to complete acquisitions, acquire businesses on satisfactory terms or enter into any definitive acquisition agreements. If entered into, future acquisitions may not be profitable. OUR FINANCIAL PERFORMANCE IS SUBJECT TO THE CYCLICAL PATTERNS OF THE HEALTH INSURANCE INDUSTRY. The availability of health insurance is determined principally by the insurance industry's level of capitalization, historical underwriting results, returns on investments and perceived premium rate adequacy. Historically, the cycles of the health insurance industry have tended to fluctuate in patterns characterized by periods of greater competition in pricing and underwriting terms and conditions followed by periods of capital shortage and lesser competition. During periods of greater competition, premium rates may be below profitable levels. These industry-related conditions could have a material adverse effect on our business, financial condition and results of operations. A SIGNIFICANT PORTION OF OUR DIRECT AND ASSUMED PREMIUMS AND ANNUITY CONSIDERATIONS ARE RECEIVED FROM THREE STATES. The states of Ohio, Texas and Florida accounted for a total of $205.8 million, or 30.6%, of our total direct and assumed premiums, before reinsurance ceded, and annuity considerations received for the first nine months of 2001. The states of Ohio, Florida and Texas accounted for a total of $249.0 million, or 31.1%, of our total direct and assumed premiums, before reinsurance ceded, and annuity considerations received for the year ended December 31, 2000. Any changes in the managed care or health insurance laws or regulations of these states, a general decline in the economy of these states, the occurrence of a natural disaster, such as an earthquake, or the occurrence of a major terrorist attack in these states could have a material adverse effect on our business, financial condition and results of operations. EAGLE ASSOCIATION ACCOUNTS FOR A SIGNIFICANT PORTION OF ALL OF OUR CERTIFICATES AND INDIVIDUAL POLICIES IN FORCE. Eagle Association, an association that was formed for the purpose of offering discounts on certain goods, services and information, including pharmaceuticals, vision products, hearing aids, vitamins, restaurants, travel and health insurance, to individuals who pay dues to be members, accounted for 11.8% of all of our certificates and individual policies in force as of September 30, 2001. Eagle Association is not contractually obligated to do business with us. We face the risk of termination of our relationship with Eagle or the promotion by Eagle of competing products. If any of these risks materialize, we will need to develop alternative methods of marketing and until we did, our sales may decline. A significant lapse in part or all of the business from Eagle Association or its members could have a material adverse effect on our business, financial condition and results of operations. A DECLINE IN OUR FINANCIAL AGENCY RATINGS COULD ADVERSELY AFFECT OUR OPERATIONS. Our ratings assigned by A.M. Best Company, Inc. and other nationally recognized rating agencies are important in evaluating our competitive position. Best ratings reflect their opinions of our insurance subsidiaries' financial strength, operating performance, strategic position and ability to meet our obligations to our policyholders, and are not evaluations directed to investors. Our ratings are subject to periodic review by Best and the continued retention of those ratings cannot be assured. In August 2001, the Best ratings of each of our insurance subsidiaries were downgraded, all with negative outlooks, due primarily to the losses at United Benefit Life and our need to raise capital. Central Reserve's rating was downgraded from a B+(very good) to a B(fair) rating. Continental General's and Pyramid Life's ratings were downgraded from A-(excellent) to B+(very good) ratings. Provident American Life's and United Benefit Life's ratings were affirmed NR-3(rating procedure inapplicable). This rating is defined by Best to mean that normal rating procedures do not apply due to unique or unusual business features. Provident American Life and United Benefit Life fall into this category because, due to reinsurance, they both retain only a small portion of their gross premiums. Also, in August 2001, Fitch downgraded Continental General's rating from A-(high credit quality) to BBB(good credit quality) with "rating watch evolving" and downgraded Central Reserve's rating from BBB+(good credit quality) to BB(speculative credit quality) with a negative outlook. In addition, Standard & Poor's recently downgraded the ratings of Provident American Life, Continental General and Pyramid Life. Any further downgrading of any of our ratings by Best or other rating companies could materially affect our business, financial condition and results of operations. While most of the considered factors relate to the rated company, some of the factors relate to general economic conditions and circumstances outside the control of the rated company. For the past several years, rating downgrades in the industry have exceeded upgrades. WE ARE DEPENDENT ON OUTSIDE COMPANIES FOR ADMINISTRATIVE AND OPERATIONS SERVICES. We outsource our information and telephone systems at our Cleveland, Ohio headquarters to Antares Management Solutions, a division of Medical Mutual Services, which is a subsidiary of Medical Mutual of Ohio. We also outsource claims processing for our Central Reserve Ohio insureds to Antares. HealthPlan Services Corporation provides claims processing and other administrative services for our Provident American Life and United Benefit Life subsidiaries. Our operating history with Antares and HealthPlan Services is limited, and these companies may be unable to provide these same services in the future in a manner that meets our quality standards or that is cost-effective. Because we could have difficulty in finding another third party vendor, in hiring qualified internal personnel to perform the same functions or in acquiring appropriate information systems, any discontinuance of this outsourcing, failure by our outsourcing partners to meet our quality standards or financial reporting standards or cost increases could have a material adverse effect on our business, financial condition and results of operations. OUR FAILURE OR THE FAILURE OF OUR THIRD PARTY VENDORS TO EFFECTIVELY MAINTAIN AND MODERNIZE OUR OPERATIONS COULD ADVERSELY AFFECT OUR BUSINESS. Our business depends significantly on effective information systems, including the use of our third party vendors' systems, for our various businesses. Our many disparate information systems require an ongoing commitment of significant resources to maintain and enhance existing systems and develop new systems or relationships with third party vendors in order to keep pace with continuing changes in information processing technology, evolving industry and regulatory standards, and changing customer preferences. A significant portion of our systems is obtained from third party vendors, which makes us vulnerable to such party's failure to perform adequately. Our failure to maintain or obtain effective and efficient information systems, or our failure to efficiently and effectively consolidate our information systems, could have a material adverse effect on our business, financial condition and results of operations. CERES IS AN INSURANCE HOLDING COMPANY AND, THEREFORE, MAY NOT BE ABLE TO RECEIVE DIVIDENDS FROM ITS SUBSIDIARIES IN AMOUNTS NEEDED TO MEET ITS OBLIGATIONS. Ceres' principal assets are the shares of capital stock of its subsidiaries. We rely on funds and dividends from our subsidiaries to meet our obligations on our outstanding debt obligations, dividends to stockholders and corporate expenses. The payment of dividends by our non-regulated subsidiaries is not restricted by state insurance regulatory restrictions but the payment of dividends by our insurance subsidiaries is subject to regulatory restrictions and will depend on the surplus and future earnings of these subsidiaries, as well as these regulatory restrictions. As of September 30, 2001, none of our insurance subsidiaries could pay a dividend to Ceres without prior approval of their respective state regulators as a result of their respective statutory deficits in unassigned surplus. As a result, we may be unable to receive dividends from these insurance subsidiaries at times and in amounts necessary to meet our obligations. Funds to meet our debt obligations are generated from fee income from non-regulated subsidiaries and from dividends by our insurance subsidiaries, if available. Ceres' ability to make scheduled payments of the principal of, or interest on, its indebtedness, including our credit agreement with The Chase Manhattan Bank, depends on its future performance and the future performance of its non-regulated subsidiaries, which are subject to economic, financial, competitive and other factors beyond their control. If our non- regulated subsidiaries do not generate sufficient fee income to service all of our debt obligations, there may be a material adverse effect on our business, financial condition and results of operations, and a significant adverse effect on the market value of our common stock. CERES HAS PLEDGED THE STOCK OF ITS INSURANCE SUBSIDIARIES IN CONNECTION WITH ITS CREDIT AGREEMENT WITH CHASE. If Ceres fails to make the required payments, does not meet the financial covenants or otherwise defaults in the terms of its credit agreement, the stock of its insurance subsidiaries and several other non-regulated subsidiaries could be transferred to its lenders pursuant to the pledge agreement with respect to the credit agreement. Any such transfer would have a material adverse effect on our business, financial condition and results of operations, and would have a significant adverse effect on the market value of our common stock. Some of our competitors may operate on a less leveraged basis, which gives them greater operating and financing flexibility. For more information on our credit agreement and debt obligations, see "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources."

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+RISK FACTORS An investment in the Warrants or Common Stock involves a high degree of risk. The following risk factors should be considered carefully in addition to the other information in this Prospectus before purchasing the Warrants or Common Stock. RISK FACTORS RELATING TO THE WARRANTS AND COMMON STOCK THE WARRANTS ARE NOT LISTED ON A SECURITIES EXCHANGE NOR IS THERE ANY ASSURANCE THAT THE WARRANTS WILL BE LISTED, SO YOU MAY BE UNABLE TO SELL YOUR WARRANTS AT THE PRICE YOU DESIRE OR AT ALL. We cannot assure you that a liquid trading market will develop for the Warrants, or the underlying Common Stock, that you will be able to sell the Warrants or the underlying Common Stock at a particular time, if at all, or that the prices that you receive when you sell the Warrants or the underlying Common Stock will be favorable. There is currently no public market for the Warrants. In addition, such market-making activity will be subject to limits imposed by the Securities Act of 1933 and other regulations. We do not intend to apply (and are not obligated to apply) for listing of the Warrants on any securities exchange or any automated quotation system. THE WARRANTS ARE A SPECULATIVE INVESTMENT. The Warrants do not confer any rights of Common Stock ownership on their holders, such as voting rights or the right to receive dividends, but rather merely represent the right to acquire shares of Common Stock at a fixed price for a limited period of time. Specifically, holders of the Warrants may exercise their right to acquire Common Stock and pay an exercise price of $1.16875 per share, subject to adjustment upon the occurrence of certain dilutive events, until November 1, 2007, after which any unexercised Warrants will expire and have no further value. We give no assurance that the market price of the Common Stock will ever equal or exceed the exercise price of the Warrants and, consequently, whether it will ever be profitable for holders of the Warrants to exercise the Warrants. In addition, although our Common Stock is listed on the New York Stock Exchange, trading is limited and sporadic. PROVISIONS OF OUR ARTICLES OF INCORPORATION AND BY-LAWS AND LOUISIANA LAW MAY DISCOURAGE TAKEOVERS. Our charter documents contain provisions that may have the effect of discouraging a proposal for a takeover of the Company. The provisions, among other things, authorize the issuance of "blank check" preferred stock and divide our Board of Directors into three classes with staggered terms. We have also adopted a Rights Agreement pursuant to which each share of Common Stock has an associated preferred stock purchase right that, if triggered by the acquisition of 15% or more of the outstanding Common Stock, would have the effect of significantly increasing the cost to a potential acquiror of a takeover of the Company. In addition, we are subject to certain provisions of Louisiana law that limit, in some cases, our ability to engage in certain business combinations with significant shareholders. Such provisions, either alone, or in combination with each other and our Rights Agreement, may give our current directors and executive officers a substantial ability to influence the outcome of a proposed takeover. See "Description of Capital Stock -- Certain Provision of our Articles of Incorporation and By-laws." WE HAVE NO CURRENT INTENTION TO PAY DIVIDENDS. We presently do not pay dividends to holders of our Common Stock and do not plan to pay dividends for the foreseeable future. In addition, the Indenture, the Term Loan Credit Facility and the Senior Credit Facility limit our ability to pay dividends on our Common Stock. See "Market Price of and Dividends on Common Stock." RISK FACTORS RELATING TO OUR BUSINESS OUR SUBSTANTIAL LEVERAGE AND DEBT SERVICE OBLIGATIONS COULD IMPEDE OUR OPERATIONS AND FLEXIBILITY. We have a substantial amount of debt. - Our total senior debt outstanding under the Notes and the Term Loan Credit Facility is $81 million, and we have the ability to incur up to an additional $25 million of debt under the Senior Credit Facility. - Our ratio of Total debt-to-Total capitalization would have been 51.0% if the Original Offerings and the borrowings under the Term Loan Credit Facility had been completed at September 30, 2000. - Our ratio of Total debt-to-EBITDA would have been 2.9x if the Original Offerings and the borrowings under the Term Loan Credit Facility had been completed at September 30, 2000. - If the Original Offerings and the borrowings under the Term Loan Credit Facility had been completed on October 1, 1999, our EBITDA-to-Interest expense would have been 2.9x for the twelve months ended September 30, 2000. We may, subject to certain restrictions in the Indenture, the Term Loan Credit Facility and the Senior Credit Facility, be able to incur substantial additional indebtedness in the future. Our high level of debt could have important consequences to you, including the following: - limiting our ability to obtain additional financing for working capital, capital expenditures, acquisitions and general corporate purposes; - increasing our vulnerability to downturns in our business or the economy generally; - limiting our ability to withstand competitive pressures from our less leveraged competitors; and - having a material adverse effect on us if we fail to comply with the covenants in the Indenture, the Term Loan Credit Facility or our Senior Credit Facility, because a failure could result in an event of default that, if not cured or waived, could result in all of our indebtedness becoming immediately due and payable. Economic, financial, competitive, legislative, regulatory, and other factors beyond our control could affect our ability to generate cash flow from operations to make payments on or refinance the Notes and our other indebtedness and to fund necessary working capital. A significant reduction in operating cash flow would likely increase the need for alternative sources of liquidity. If we are unable to generate sufficient cash flow to make payments on the Notes or our other debt, we will have to pursue one or more alternatives, such as reducing or delaying capital expenditures, refinancing the Notes or other debt, selling assets or raising equity. We cannot assure you that any of these alternatives could be accomplished on satisfactory terms or that they would yield sufficient funds to retire the Notes and our other debt. We urge you to consider the information under "Capitalization," "Summary -- Summary Pro Forma Financial and Operating Data" and "Description of Indebtedness" for more information on these matters. THE INDENTURE, THE TERM LOAN CREDIT FACILITY AND OUR SENIOR CREDIT FACILITY IMPOSE RESTRICTIONS ON US THAT MAY RESTRICT OUR ABILITY TO OPERATE OUR BUSINESS. Our Senior Credit Facility will require us to maintain specified financial ratios, including fixed charge coverage and total leverage ratios. In addition, the Indenture, the Term Loan Credit Facility and our Senior Credit Facility contain covenants that restrict, among other things, our ability to incur additional indebtedness and dispose of assets, incur or guarantee obligations, repay indebtedness or amend debt instruments, pay dividends, create liens on assets, make investments, make acquisitions, engage in mergers or consolidations, make capital expenditures and engage in certain transactions with subsidiaries or affiliates. Our ability to comply with these covenants may be affected by events beyond our control and we cannot assure you that we will satisfy those requirements. A failure to comply with any of these provisions contained in the Indenture, the Term Loan Credit Facility or our Senior Credit Facility could lead to an event of default under the Indenture, the Term Loan Credit Facility or our Senior Credit Facility which could result in all amounts outstanding under any of them to be declared immediately due and payable. We may also be prevented from taking advantage of available business opportunities if we fail to meet certain financial ratios or because of the limitations imposed on us by the restrictive covenants under the Indenture, the Term Loan Credit Facility and our Senior Credit Facility. See "Description of Indebtedness." We urge you to consider the information under "Capitalization," "Summary -- Summary Pro Forma Financial and Operating Data" and "Description of Indebtedness" for more information on these matters. OUR SALES-BUILDING AND COST-SAVINGS INITIATIVES MAY NOT BE SUCCESSFUL. We have recently implemented several sales-building initiatives designed to increase customer traffic at our cafeterias and to reverse recent same-store sales declines. We have also implemented several cost-savings initiatives designed to reduce operating expenses. All of these initiatives are in their early stages and there can be no assurance that the initiatives will achieve the results expected within the time periods discussed in this Prospectus or at all. WE FACE THE RISK OF INCREASING LABOR COSTS THAT COULD ADVERSELY AFFECT OUR CONTINUED PROFITABILITY. We are dependent upon an available labor pool of unskilled and semi-skilled employees, many of whom are hourly employees whose wages are based on the federal or state minimum wage. Numerous proposals have been made on state and federal levels to increase minimum wage levels. Because a significant number of our employees are paid at rates tied to the federal minimum wage, an increase in the minimum wage would increase our labor costs. A shortage in the labor pool or other general inflationary pressures or changes could also increase labor costs. An increase in labor costs could have a material adverse effect on our income from operations, and decrease our profitability and cash available to service our debt obligations if we are unable to recover these increases by raising the prices we charge our customers. WE ARE VULNERABLE TO FLUCTUATIONS IN THE COST, AVAILABILITY, AND QUALITY OF OUR INGREDIENTS. The cost, availability, and quality of the ingredients we use to prepare our food are subject to a range of factors, many of which are beyond our control. Fluctuations in economic conditions, weather and demand could adversely affect the cost of our ingredients. We require fresh produce, dairy products and meat, and are therefore subject to the risk that shortages or interruptions in supply of these food products could develop. All of these factors could adversely affect our financial results. Although we believe that we could find alternative suppliers for these ingredients, we have no control over fluctuations in the price of commodities and no assurance can be given that we will be able to pass through any cost increases to our customers. WE RELY PRIMARILY ON ONE WHOLESALE DISTRIBUTOR AND REPLACING IT COULD DISRUPT THE FLOW OF OUR FOOD PRODUCTS AND SUPPLIES. We currently obtain approximately two-thirds of all of our food orders through one distributor located in Baton Rouge, Louisiana and may increase our shipments through this distributor in the future. The remaining food items are purchased from local suppliers and delivered directly to our cafeterias. Our arrangement with this distributor is on competitive terms but is terminable at-will by either of us. Although we are dependent upon this distributor for most of our food ingredients, we believe that there are other distributors who would be able to service our needs. However, there can be no assurance that we will be able to replace our distributor with others on comparable terms or without disruption to the flow of food products and other supplies to our cafeterias. WE FACE INTENSE COMPETITION. All aspects of the restaurant business are highly competitive. Price, restaurant location, food quality, service and attractiveness of facilities are important aspects of competition, and the competitive environment is often affected by factors beyond a particular restaurant management's control, including changes in the public's taste and eating habits, population and traffic patterns and economic conditions. Our cafeterias compete with a large number of other restaurants, including national and regional restaurant chains and franchised restaurant operations, as well as locally-owned, independent restaurants. Many of our competitors have greater financial resources than we have. There can be no assurance that we will be able to compete successfully against our competitors in the future or that competition will not have a material adverse effect on our operations. WE FACE RISKS BECAUSE OF THE NUMBER OF CAFETERIAS THAT WE LEASE. Our success depends in part on our ability to secure leases in desired locations at rental rates we believe to be reasonable. We currently lease 142 of our cafeterias located in strip shopping centers and malls and we lease the land for 62 of our free-standing cafeterias. 100 of our leases have terms expiring during the next five years. Each lease agreement also provides that the lessor may terminate the lease for a number of reasons, including if we default in any payment of rent or taxes or if we breach any covenants or agreements in the lease. Termination of any of our leases could harm our results of operations. Although we believe that we will be able to renew our existing leases, we can offer no assurances that we will succeed in obtaining such leases in the future at rental rates that we believe to be reasonable or at all. Moreover, if certain locations should prove to be unprofitable, we would remain obligated for lease payments if we decided to withdraw from such locations. See "Business -- Properties."

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+QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS
+
+FOREIGN CURRENCY RISK
+
+The Company's functional and reporting currency is the United States dollar.
+Transactions at the Company's subsidiaries may be denominated in the currency of
+the country in which the subsidiary operates. The Company may also hold assets
+and liabilities denominated in a foreign currency. As a global enterprise, we
+face exposure to adverse movements in foreign currency exchange rates. Our
+foreign currency exposures may change over time as the level of activity in
+foreign markets grows and could have a material adverse impact upon our
+financial results. No changes have occurred since March 31, 2001 that would
+materially impact our exposure to foreign currency risk.
+
+ 23
+
+INTEREST RATE RISK
+
+We have incurred interest bearing liabilities to finance our operations and for
+the purchase of capital equipment. All of these agreements currently are based
+on fixed interest rates. However, future borrowings may be at higher rates or on
+variable rates. A sharp rise in interest rates could have a material adverse
+impact upon our interest expense. No changes have occurred since March 31, 2001
+that would materially impact our exposure to interest rate risk.
+
+ OUR BUSINESS
+OVERVIEW
+
+We are a facilities-based international telecommunications company focused
+primarily on the international long distance telecommunications market. We
+provide competitively priced long distance telecommunication services to other
+telecommunications carriers. We provide international long distance service to a
+number of foreign countries through a flexible network comprised of various
+foreign termination relationships, international gateway switches, leased
+transmission facilities and resale arrangements with other long distance
+providers.
+
+CDX was incorporated in June, 1978. The original business was to engage in the
+manufacture and sale of computerized pulmonary diagnostic equipment used in the
+medical profession.
+
+On November 18, 2000, Tampa Bay Financial, Inc., a Florida corporation ("TBF"),
+acquired control of the Company.
+
+TBF changed the Company's business plan from the manufacture and sale of
+computerized pulmonary diagnostic equipment to international communications and
+began doing business as (d/b/a) DataStream Global Communications.
+
+On January 12, 2001, CDX entered in an Agreement and Plan of Merger with Pensat
+International Communications, Inc. a Delaware corporation ("Pensat"). Pursuant
+to this Agreement, Pensat merged with and into Pensat Inc., a newly formed
+subsidiary of CDX, such that Pensat Inc. is the surviving corporation. The
+merger was accounted for as a reverse merger under generally accepted accounting
+principles. Pensat stockholders effectively acquired control and retain majority
+interest in CDX. The merger became effective on February 9, 2001. In the merger,
+Pensat ceased to exist as a Delaware corporation. To date, the Company has been
+unable to file the Certificate of Merger formally terminating Pensat's existence
+in Delaware because of a dispute between Pensat and the State of Delaware over
+the computation and payment of franchise tax. The Company and the State of
+Delaware have agreed upon the amount due, and upon completion of negotiation of
+acceptable payment terms, the Company will file the Certificate of Merger.In
+connection with the merger, CDX announced the appointment of Mr. Philip Verruto
+as its new CEO and the redirection of its business from that of a medical
+technology supplier to a new business plan that refocuses the Company's efforts
+and resources on the opportunities rapidly emerging as a result of deregulation
+across the international communications markets.
+
+Current Financial Situation
+
+We are currently in arrears on approximately $37,000,000 of our liabilities,
+including approximately $27,000,000 of promissory notes and capital leases. A
+significant amount of our past due liabilities is owed to certain vendors who
+are critical to our on-going operations and to our ability to provide
+revenue-generating services to our customers. In addition, we have certain
+unpaid tax liabilities. In order to maximize the utilization of available cash
+resources, we have curtailed certain operations that were not generating
+positive cash flow and may curtail other operations in the future. Further,
+certain vendors have declined to provide further credit to the Company and
+certain vendors have withheld services. While we have been able to continue to
+operate despite these restrictions, there is no assurance we will be able to
+continue to do so in the future.
+
+We are currently in discussions with the note holders and vendors regarding
+possible restructuring or deferral of these liabilities and while we have made
+progress along these lines, there is no assurance that these discussions will be
+successful. Failure to restructure or defer these overdue liabilities will have
+a material adverse effect on the business and the financial condition of the
+Company. Further, the Company is currently incurring operating losses and has
+done so since inception. Accordingly, the Company will need additional financing
+to fund ongoing operations and that funding may be dilutive or on terms that are
+unreasonable or unacceptable to the Company. There is no assurance that the
+Company will be able to obtain such funding in adequate amounts or on a timely
+basis. Failure to acquire adequate funds on a timely basis will require the
+Company to further reduce its headcount, reduce the scope of operations, sell
+assets to acquire additional cash, seek protection for our US or overseas
+operations from creditors under applicable bankruptcy codes, and/or a complete
+cessation of operations by the Company and some or all of its subsidiaries.
+
+The Company continues to restructure its business and financial status with a
+focus on achieving profitability in its operations and making the Company more
+financable. In its move toward profitability, the Company has taken steps to cut
+expenses and costs. Reductions in the work force have been implemented as well
+as the elimination of certain business units that were not strategically
+
+ 24
+
+important to the Company's central business plan and were not generating
+profits. The Company plans to focus on its core business units and direct its
+efforts on building revenues and profits from these operations.
+
+The consolidated financial statements contained in this prospectus have been
+prepared assuming that we will continue as a going concern. However our
+independent public accountants have determined that due to recurring operating
+losses, our working capital deficiency, significant short-term cash commitments
+and a lack of firm financial commitments raise substantial doubt about our
+ability to continue as a going concern.
+
+THE BUSINESS
+
+Following the merger with Pensat, CDX.Com Incorporated (the "Company", "CDX")
+has implemented a new business plan that refocuses the Company's efforts and
+resources on the opportunities rapidly emerging as a result of deregulation
+across the international communications markets. CDX.Com Incorporated, d/b/a
+DataStream Global Communications is a cross-border, Integrated Communications
+Provider (ICP), facilities based and headquartered in Washington, DC, USA with
+international operations in North America, South America, Europe and the Middle
+East. The Company's business model is built around a strategy designed to link
+operations in local markets in the Latin American and Middle Eastern regions in
+a common global backbone anchored in the USA giving each local operation an
+advantage over local competitors. The company currently has four subsidiaries
+operating as licensed in-country telephone companies in the USA, Spain and
+Brazil, and under special agreements in Syria and Argentina. The company
+operates a hybrid international network comprised of traditional voice equipment
+as well as state-of-the art technologies such as ATM and VoIP. Suppliers include
+Lucent Technologies, Cisco and ECI.
+
+The Company has established its first subsidiary in the acquisition of Pensat
+International Communications, Inc. ("Pensat"), an ICP with existing operations
+in the USA, Spain, Brazil and Syria. As a result of the merger, the Company has
+new management, which consists of key members of the former Pensat management
+team, all of whom have extensive experience in telecommunications, public
+finance, international and domestic marketing.
+
+Pensat's business began in 1995 when the founders (now part of the Company's
+management), applied for and received certification from the FCC to operate as a
+facilities based international telecommunications company. Pensat is a Global
+Integrated Communications Provider (ICP) with licensed operations in the US,
+Spain, Brazil and Syria and has established international operating agreements
+and fiber optic or satellite interconnectivity with telecommunications providers
+in several countries, principally in Latin America and the USA. Many of these
+are incumbent monopoly carriers in markets expected to deregulate in the future.
+See the consolidated financial statements, which are included in this
+prospectus, for detailed segment data.
+
+Pensat's strategic plan is to provide service from proprietary in-country
+Company operations wherever possible. In markets where there are high barriers
+to establishing in-country Company operations, such as government regulations or
+high cost to build out and implement a facilities based presence, Pensat
+establishes strategic partnerships or joint ventures with existing
+communications service providers, generally incumbent monopoly entities. These
+carrier partners represent a gateway into their respective markets, giving
+Pensat access to their customer base without having to establish proprietary
+operations in that country or market. In turn, Pensat provides the strategic
+partner access to global services otherwise unavailable to its customers. See
+the consolidated financial statements, which are included in this prospectus,
+for significant customer data.
+
+Where our customer base has developed sufficient traffic, we have leased fiber
+optic cable transmission capacity to connect our various switches. We currently
+lease lines on a monthly or longer-term basis at a fixed cost. As our volumes
+increase, we increase the capacity of the circuits we lease and eventually may
+acquire economic interests in transmission capacity through minimum assignable
+ownership units and Indefeasible Rights of Use, or IRU to international traffic
+destinations.
+
+We have invested in switching infrastructure. We made such purchases under the
+belief that the investment in switches would provide the network with a
+relatively low network cost base by reducing the need for transmission capacity
+between points on the network. Our network consists of six high capacity,
+carrier-grade Lucent 5ESS and Excel switches and five Coral switches. Of these,
+nine are located in our international offices and two are located within the
+U.S. Additionally, we utilize equipment such as routers, access concentrators
+and various types of compression technology to enhance the performance of our
+network and to provide the necessary infrastructure to handle data related
+services such as Internet virtual private networks and data transmissions. Such
+mainstream vendors as Lucent, Cisco and ECI provide this assortment of hardware
+and software.
+
+ 25
+
+We offer international long distance telecommunications services to countries
+around the world. We seek to retain flexibility and maximize our termination
+opportunities by utilizing a continuously changing mix of routing alternatives,
+including alternative termination agreements, operating agreements and resale
+arrangements. Our strategy is based first on our ability to utilize our own
+subsidiaries operating in foreign countries to terminate calls on their networks
+and after that to enter into and maintain: (1) where possible and economically
+feasible for us, operating agreements directly with post, telegraph and
+telephone operators, or PTTs, in countries that have yet to become liberalized
+so that we would then be permitted to terminate traffic in, and receive return
+traffic from, that country, (2) where possible and economically feasible for us,
+operating agreements directly with PTTs and emerging carriers in foreign
+countries whose telecommunications markets have been liberalized so we can
+terminate traffic in such countries, (3) resale agreements and transit and
+refile agreements with PTT's and other international carriers to terminate our
+traffic in countries with which we do not have operating agreements so as to
+provide us with multiple options for routing traffic and (4) interconnection
+agreements with the PTT in each of the countries where we plan to have operating
+facilities so that we can terminate traffic in those countries.
+
+SERVICES
+
+Pensat operates a domestic and international facilities-based backbone for both
+voice and data on a wholesale basis to other carriers for U.S. and foreign
+termination. In addition to more fully utilizing its networks as it builds
+direct subscriber traffic, the wholesale business provides unique partnering
+opportunities for the Company with foreign carriers in need of U.S. termination.
+
+The Company uses its own facilities and its relationships with other carriers in
+Latin America and the Middle East to provide high quality, cost-competitive
+services. Furthermore, the Company believes its relationships will increase the
+volume of inbound calling traffic to the US due to its ability to direct traffic
+from its interconnection points with foreign carriers to its domestic network.
+
+In the USA, Pensat currently provides international transport and termination
+services to other carriers. The company also provides carriers with value added
+services ("VAS"), including international prepaid and post paid calling cards
+that its VAS carrier customers market as a branded product to their end-user
+clients. Pensat acts as an application service bureau, managing the back-office
+requirements including customer service and operator services of this offering,
+and is the underlying carrier as well, completing all calls made by users of
+these calling cards from 90 countries around the world.
+
+In Spain, the Company's Iberian Networks subsidiary is a telecommunications
+carrier headquartered in Madrid. Iberian operates under a class "A" license
+awarded by CMT, the Comision del Mercado de las Telecomunicaciones. This license
+permits the company to provide any type of voice services in the country.
+Iberian maintains offices and network facilities in Barcelona and Madrid.
+Iberian provides national and international long distance services to business
+customers and to other carriers in Spain. Iberian has recently launched its
+prepaid calling card product offering in Spain and markets to distributors who
+place the calling cards into the retail channels.
+
+The Company's Brazil based subsidiary, Pensat do Brazil, Ltda., is headquartered
+in Sao Paulo and is a certified carrier in Brazil licensed to operate a closed
+user group network under a license awarded in August 2000 by Anatel, the
+Brazilian regulatory body governing the telecommunications industry there.
+
+In the Middle East, the Company has an existing presence in Syria providing
+international pre-paid calling card services under an exclusive multi-year
+agreement with the Syrian Telecommunications Entity, the government owned and
+operated incumbent monopoly telecommunications carrier. This is the only such
+service offered in the country.
+
+OUR MARKETS
+
+Pensat's business direction is aimed at the global ethnic-based communications
+market, with initial focus on the Hispanic and Arabic markets.
+
+Over the past twenty years, industrialized nations have deregulated their
+telecommunications industries to allow for an increase in the number of
+competitors in their countries. With privatization, deregulation, and market
+liberalization, the rules and regulations governing telecommunications in Latin
+America have become much more transparent over the past several years. The
+biggest recent step toward transparency was the establishment of an independent
+regulatory body in Brazil, and regulatory clarity has also improved in Mexico
+over the past year, especially regarding tariffs. New and transparent regulatory
+schemes have emerged in Argentina and Peru to address telecom market
+liberalization. Chile and Mexico have already opened their markets to local
+
+ 26
+
+competition, while limited local competition started in 2000 in Brazil and
+Argentina. The growth of the Latin American market is being driven by two main
+factors, deregulation and pent up demand.
+
+According to Morgan Stanley's 1999 "Global Telecommunications Primer", in Latin
+America, the average wire line penetration rate in Latin America is still very
+low, averaging only some 11% in the six largest economies (Brazil, Mexico,
+Argentina, Chile, Peru, and Venezuela). In some countries, consumers still have
+to wait years to get telephones, and the waiting list in Brazil is estimated at
+some 10 million lines. The low penetration rate is partially explained by the
+lack of investment in the sector over the years. Until the early 1990s, the
+region's governments controlled most of the telephone companies, and they could
+not afford the heavy investment needed to develop the telecom infrastructure.
+Only recently has privatization brought new capital and acceleration in growth.
+Even in more "mature" Latin American countries, line growth is still expected to
+average some 5-10% per year over the next five years. For Brazil, average growth
+over this five-year time span should be in the 15-25% ranges. The Internet and
+IP/data telecommunications market is growing very rapidly in Latin America.
+
+Spain, like Latin America, began formal deregulation of its communications
+services market in 1998. In 2000 the market became completely deregulated, and
+companies are be allowed to openly compete with the incumbent carrier. Spain
+represents a $13 billion (US) market opportunity for communications services to
+Pensat, as well as a gateway to the European market. The Company is a fully
+licensed common carrier in Spain and has facilities-based operations established
+in Madrid and Barcelona.
+
+The Arabic market is in an earlier stage of deregulation than the Latin American
+markets. Pensat has obtained an exclusive right to offer pre-paid international
+calling card services within Syria under and agreement with the Syrian
+Telecommunications Entity.
+
+COMPETITION
+
+The international telecommunications industry is intensely competitive and
+subject to rapid change. Our competitors in the international wholesale switched
+long distance market include large, facilities-based multinational corporations
+and PTTs, smaller facilities-based providers in the U.S. and overseas that have
+emerged as a result of telecommunications deregulation, switched-based resellers
+of international long distance services and international joint ventures and
+alliances among such companies. International wholesale-switched long distance
+providers compete on the basis of price, customer service, transmission quality,
+breadth of service offerings and value-added services. We also compete abroad
+with a number of dominant telecommunications operators that are incumbent
+monopolies in their countries. Additionally, the telecommunications industry is
+in a period of rapid technological evolution, marked by the introduction of
+competitive new product and service offerings, such as the utilization of the
+Internet for international voice and data communications. Furthermore, the World
+Trade Organization agreement, under which the United States and the other 75
+countries have committed to open their telecommunications markets to
+competition, foreign ownership and adopt measures to protect against
+anticompetitive behavior, competition is likely to increase, creating downward
+pressure on prices which could adversely affect our gross margins if cost
+reductions commensurate with these price reductions cannot be achieved by the
+Company.
+
+AT&T, MCI WorldCom and Sprint currently generate a majority of the U.S. based
+international telecommunications services revenue. We also compete with other
+U.S. based and foreign long distance providers, including regional Bell
+operating companies, which currently have Federal Communications Commission
+authority to resell and terminate international telecommunication services. Many
+of these companies have considerably greater financial and other resources and
+more extensive domestic and international communications networks than we do.
+Future consolidation in the telecommunications industry will continue to create
+even larger competitors with greater financial and other resources, and could
+adversely affect us.
+
+The telecommunications market in Spain began its deregulation in December 1998
+when the first competitive carrier was admitted. In 1999, the market was opened
+to additional competitors including Iberian. There are several competitors in
+Spain, two of which are owned in part by major telecommunications companies,
+Lince, owned in part by France Telecom, and Retevision, owned by Telecom Italia.
+Other startup companies have also been aggressively developing their network and
+market positions. Notable among these is Jazztel.
+
+The Brazilian telecommunications market is in the early stages of deregulation,
+and Pensat has received one of the early licenses awarded to provide services
+in-country. As is the case in any newly deregulated market, the most prominent
+
+ 27
+
+competition comes from the incumbent carriers. In the case of Brazil, these
+companies were auctioned off in privatization programs to large
+telecommunications entities around the world, including MCI WorldCom,
+Telefonica, Telecom Italia and others. Competition from newly certified
+companies operating on limited licenses similar to Pensat's comes primarily from
+Global One, Global Link and World Access, who are all a part of US companies.
+
+SALES & MARKETING
+
+In North America we market our services on a wholesale basis to other
+telecommunications companies through our direct sales force and
+marketing/account management. We reach our customers primarily through domestic
+and international trade shows and through relationships gained from years of
+experience in the telecommunications industry. The sales made to the wholesale
+trade customers are primarily focused on those routes where we have the most
+advantageous terminating positions. These are generally destinations that are
+served by our operating subsidiary in Spain and the carriers to which it is
+interconnected. The Spain network hub serves to create an extended reach for us
+through these interconnections to carriers that are often not accessible to
+companies located strictly in the United States. Additionally, our direct
+agreements with PTTs in certain countries in Latin America provide a cost basis
+that supports wholesale traffic sales.
+
+In Spain we have an operating company headquartered in Madrid, Spain responsible
+for sales to wholesale customers throughout Spain. This operation includes
+sales, marketing, technical and administrative staff. We market our services to
+small- and medium-sized enterprises and small and medium sized carriers through
+our direct sales team.
+
+Our Brazilian company sells its services through direct sales and through third
+party agents. The customer base is made up primarily of businesses that utilize
+extensive international long distance. The product offerings in Brazil currently
+are international call back and international calling cards.
+
+Our subsidiary operating in Syria sells prepaid international calling cards to
+the public in three major cities in Syria: Damascus, Aleppo and Lattakia. These
+cards are sold under exclusive agreement with the Syrian Telecommunications
+Entity, the country's government operated PTT. We market through a network of
+distributors who in turn sell to retailers who market directly to end user
+consumers through their retail outlets. Teledensity (the measure of the
+percentage of the population that has telephone service) is in the single digits
+and the majority of the population does not have telephone service. Our prepaid
+calling card, which is usable from any touch tone telephone, is used by
+consumers who may make their calls from any public or private telephone that may
+be available to them.
+
+LICENSES AND GOVERNMENT REGULATION
+
+Pensat has licenses to operate as a telecommunications provider in Spain and
+Brazil. Pensat is an FCC certified, 214 facilities-based carrier in the US and
+is licensed to provide intrastate services in several states. Pensat also has an
+exclusive agreement with the Syrian telecommunications Entity to provide prepaid
+calling card services in Syria.
+
+Our U.S. interstate and international telecommunications service offerings
+generally are subject to the regulatory jurisdiction of the Federal
+Communications Commission. Intrastate telecommunication services offered by us
+in the U.S. may also be subject to the jurisdiction of state regulatory
+authorities, commonly known as public utility commissions, or PUCs. Our
+telecommunications service offerings outside the U.S. are also generally subject
+to regulation by national regulatory authorities. In addition, U.S. and foreign
+regulatory authorities may affect our international service offerings as a
+result of the termination or transit arrangements associated therewith. U.S. or
+foreign regulatory authorities may take actions or adopt regulatory requirements
+that could adversely affect us.
+
+U.S. REGULATION
+
+Our business is subject to various U.S. laws, regulations, agency actions and
+court decisions. Our U.S. international telecommunications service offerings are
+subject to regulation by the Federal Communications Commission. The Federal
+Communications Commission requires international carriers to obtain
+authorization under Section 214 of the Communications Act of 1934 prior to
+providing international service to the public. Prior Federal Communications
+Commission approval is also required to transfer control of a certificated
+carrier. We are also subject to Federal Communications Commission policies and
+rules that regulate the manner in which international telecommunication services
+may be provided, including, for instance, the circumstances under which a
+carrier may provide international switched services using international private
+line facilities and under which it may route traffic through third countries to
+or from its final destination.
+
+ 28
+
+The Communications Act and the Federal Communications Commission's rules and
+policies also impose certain other obligations on carriers providing
+international telecommunication services. These include the obligations to (1)
+file at the Federal Communications Commission and to maintain tariffs containing
+the rates, terms, and conditions applicable to their services, (2) file certain
+reports regarding international traffic and facilities, (3) file certain
+contracts with correspondent carriers, (4) disclose affiliations with foreign
+carriers and significant foreign ownership interests, and (5) pay certain
+regulatory fees based upon, among other things, the carrier's revenues and
+ownership of international transmission capacity. The Federal Communications
+Commission is considering requiring international carriers to cancel their
+tariffs, which action may decrease our ability to price our services.
+
+International Services: Federal Communications Commission rules require us to
+obtain prior Federal Communications Commission authorization to provide
+international services. We hold both facilities-based and resale international
+authorizations, including a global authorization that provides broad authority
+to offer switched and private line international services. We have filed tariffs
+for international services with the Federal Communications Commission, although
+we may in the future be required to cancel these tariffs. In recent years, the
+Federal Communications Commission rulemaking orders and other actions have
+lowered the entry barriers for new facilities-based and resale international
+carriers by streamlining the processing of new applications. In addition, the
+Federal Communications Commission's rules implementing the WTO agreement presume
+that competition will be advanced by the U.S. entry of facilities-based and
+resale carriers from WTO member countries, thus further increasing the number of
+potential competitors in the U.S. market and the number of carriers which may
+also offer end-to-end services.
+
+Federal Communications Commission International Private Line Resale Policy The
+Federal Communications Commission's international private line resale policy
+limits the conditions under which a carrier may connect international private
+lines to the public switched telephone network at one or both ends to provide
+switched services, commonly known as international simple resale. U.S. carriers
+are allowed to engage in international simple resale on any route where the U.S.
+carrier exchanges switched traffic with a foreign carrier that lacks market
+power. In addition, U.S. carriers are permitted to engage in international
+simple resale with any foreign carrier, regardless of market power, on any route
+for which the Federal Communications Commission has authorized the provision of
+international simple resale. The Federal Communications Commission will allow
+international simple resale between the U.S. and a WTO member country for which
+it has not previously authorized service upon a demonstration that (1)
+settlement rates for at least 50% of the settled U.S.-billed traffic between the
+U.S. and the proposed destination country are at or below the benchmark
+settlement rate adopted by the Federal Communications Commission, or (2) where
+such destination country affords resale opportunities equivalent to those
+available under U.S. law. Settled traffic refers to traffic subject to an
+accounting rate agreement between the U.S. and foreign carriers. An accounting
+rate is a per minute wholesale charge negotiated by international carriers for
+terminating traffic in either direction. Each carrier is paid a settlement rate
+for terminating traffic on its own network which ordinarily is one half of the
+accounting rate. The Federal Communications Commission will allow international
+simple resale between the U.S. and a non-WTO member country not previously
+authorized to provide service if both conditions summarized above are satisfied.
+As of February 9, 2001, the Federal Communications Commission has authorized
+international simple resale to the following countries: Argentina, Australia,
+Austria, Belgium, Brunei, Canada, Czech Republic, Denmark, Dominican Republic,
+Finland, France, Germany, Greece, Hong Kong, Hungary, Iceland, Ireland, Israel,
+Italy, Japan, Luxembourg, The Netherlands, Netherlands Antilles, Macau, New
+Zealand, Norway, Philippines, Poland, Singapore, Spain, Sweden, Switzerland,
+Trinidad & Tobago, United Arab Emirates, the United Kingdom, and Uruguay. The
+Federal Communications Commission is currently reviewing U.S. carrier
+applications to engage in international simple resale on other routes, and upon
+grant of any application to a given country, the Federal Communications
+Commission's rules also would permit us to provide international simple resale
+service to that country.
+
+If international simple resale is not permitted on a route, absent prior Federal
+Communications Commission consent, U.S. facilities based international carriers
+must terminate switched telephone traffic in accordance with the international
+settlement policy which is primarily intended to deter foreign carriers with
+market power from discriminating amongst competing U.S. carriers by, for
+example, favoring the foreign carrier's U.S. affiliate. The international
+settlement policy requires that all U.S. carriers terminate traffic with a
+foreign carrier on equivalent terms and receive inbound traffic only in
+proportion to the volume of U.S. outbound traffic which they generate.
+
+If the Federal Communications Commission were to determine, by its own actions
+or in response to the filing of a third party, that any of our international
+simple resale arrangements violate its rules and regulations or our
+authorizations, the Federal Communications Commission could order us to
+terminate any non-conforming arrangements. In addition, we could be subject to a
+monetary forfeiture and to other penalties, including the revocation of our
+Federal Communications Commission authorizations to operate as an international
+carrier. Any such Federal Communications Commission action could have a material
+adverse effect upon our business, operating results and financial condition.
+
+ 29
+
+Federal Communications Commission International Settlement Policy: The Federal
+Communications Commission's international settlement policy places limits on the
+arrangements which U.S. international carriers may enter into with dominant
+foreign carriers for exchanging public switched telecommunications traffic,
+which the Federal Communications Commission terms international message
+telephone service. The policy does not apply to international simple resale
+services and does not apply to U.S. carrier agreements with non-dominant foreign
+carriers. The international settlement policy is primarily intended to deter
+dominant foreign carriers from discriminating among competing U.S. carriers by,
+for example, favoring the foreign carrier's U.S. affiliate. Absent Federal
+Communications Commission consent, the international settlement policy requires
+that the accounting rate applicable to a particular call be divided equally
+between the U.S. carrier and the corresponding foreign carrier such that the
+settlement rate for the call is identical for both the U.S. and the foreign
+carrier, and that U.S. carriers receive inbound traffic in proportion to the
+volume of U.S. outbound traffic which they generate. The international
+settlement policy does not apply to certain low cost routes where 50% or more of
+the U.S. billed traffic is settled at rates which are 25% or more below a
+Federal Communications Commission benchmark rate. Federal Communications
+Commission policies also prohibit a U.S. carrier from offering or accepting a
+special concession from a foreign carrier where the foreign carrier possesses
+sufficient market power on the foreign end of the route to affect competition
+adversely in the U.S. market. A special concession is defined by the Federal
+Communications Commission as an exclusive arrangement involving services,
+facilities or functions on the foreign end of a U.S. international route which
+are necessary for providing basic telecommunications, and which are not offered
+to similarly situated U.S. carriers authorized to serve that route. It is
+possible that the Federal Communications Commission could find that certain of
+our arrangements with foreign operators were or are inconsistent with the
+international settlement policy and that we have not requested prior Federal
+Communications Commission authority therefore. If the Federal Communications
+Commission were to determine by its own actions or in response to the filing of
+a third party that we have violated the international settlement policy, the
+Federal Communications Commission could order us to terminate any non-conforming
+arrangement. In addition, we could be subject to a monetary forfeiture and to
+other penalties, including revocation of our Federal Communications Commission
+authorizations to operate as an international carrier. Any such Federal
+Communications Commission action could have a material adverse effect upon our
+business, operating results and financial condition.
+
+The Federal Communications Commission's policies also require U.S. international
+carriers providing international message telephone service to negotiate and
+adopt settlement rates with foreign correspondents for international message
+telephone service which are at or below certain benchmark rates. We currently
+have international message telephone service operating agreements with certain
+foreign correspondents which provide for settlement rates above the Federal
+Communications Commission's prescribed benchmarks. We will negotiate in good
+faith to establish international message telephone service settlement rates with
+our foreign correspondents which satisfy the Federal Communications Commission's
+benchmarks but there can be no assurance that such negotiations will succeed. If
+we are unable to negotiate benchmark settlement rates with certain foreign
+correspondents, the Federal Communications Commission may intervene on its own
+action or in response to a filing by a third party. We are unable to predict the
+form which such intervention may take but it could disrupt our arrangement for
+transmitting traffic to certain countries or require us to suspend direct
+service to certain countries or require us to make alternative termination
+arrangements with certain countries, all of which could have a material adverse
+effect on our business, operating results and financial condition.
+
+Federal Communications Commission Policies On Transit And Refile: International
+switched telecommunication traffic is frequently routed indirectly via one or
+more third countries to its final destination. When such arrangements are
+mutually agreed upon, they are commonly based on a transit agreement under which
+settlement payments are made to all parties. In other cases, traffic may be sent
+to a third country and then forwarded or refiled for delivery to its final
+destination without the knowledge or consent of the destination carrier. We use
+both transit and refile arrangements to terminate our international traffic. The
+Federal Communications Commission routinely approves transit arrangements by
+U.S. international carriers. The Federal Communications Commission's rules also
+permit carriers to use international simple resale facilities in many cases to
+route traffic via a third country for refile through the public switched
+network. Notwithstanding the Federal Communications Commission's past rules,
+policies and statements regarding the scope of permissible transit and refile
+arrangements, the Federal Communications Commission could find by its own
+actions or in response to the filing of a third party, that certain of our
+transit or refile arrangements violate the international settlement policy or
+other Federal Communications Commission policies. In that event, the Federal
+Communications Commission could order us to terminate any non-conforming transit
+or refile arrangements. In addition, we could be subject to a monetary
+forfeiture and to other penalties, including revocation of our Federal
+Communications Commission authorizations to operate as an international carrier.
+Any such Federal Communications Commission action could have a material adverse
+effect on our business, operating results and financial condition.
+
+ 30
+
+Reporting Requirements: International telecommunication carriers also are
+required by the Federal Communications Commission's rules to file timely certain
+reports regarding international traffic and revenues, the ownership and use of
+international facilities, and their affiliates with foreign carriers. The
+Federal Communications Commission considers a U.S. carrier to be affiliated with
+a foreign carrier if one of them, or an entity that controls one of them,
+directly or indirectly owns more than 25% of the capital stock of, or controls,
+the other one. Capital stock includes all forms of equity ownership, including
+partnership interests. The Federal Communications Commission requires these
+reports so that, among other things, it may monitor the development of industry
+competition and the potential for a dominant foreign carrier to discriminate
+amongst U.S. carriers. The Federal Communications Commission's rules require
+international telecommunication carriers to file at the Federal Communications
+Commission copies of their contracts with other carriers, including operating
+agreements, within 30 days of execution. The Federal Communications Commission
+by its own action or in response to the filing of a third party could determine
+that we have failed to meet certain of the foregoing filing and reporting
+requirements or that certain filings are deficient. In that event, we could be
+directed to remedy any asserted non-compliance; we could also be subject to a
+monetary forfeiture and to other penalties, and, although we believe that it
+would be largely unprecedented in such circumstances, and hence unlikely, the
+Federal Communications Commission could revoke our authorizations to operate as
+an international carrier. Any such Federal Communications Commission action
+could have a material adverse effect on our business, operating results and
+financial condition.
+
+Regulatory Fees: The Communications Act, and Federal Communications Commission
+rules and policies, impose certain fees upon carriers providing interstate and
+international telecommunication services. These fees are levied, among other
+things, to defray the Federal Communications Commission's operating expenses, to
+underwrite universal telecommunication service provided as a subsidy to schools
+and libraries for certain services, such as Internet access, and by other
+telecommunications users in areas of the U.S. where service costs are
+significantly above average, to fund the telecommunications relay service, which
+provides special options for hearing-impaired users, and to support the
+administration of telephone numbering plans.
+
+Carriers that provide domestic interstate and international services must pay an
+annual regulatory fee based on their interstate revenues; for the 2000 filing
+year, the fee was 0.12% of net revenue. International carriers that own
+international transmission capacity must also pay a fee for each international
+64 kilobit per second equivalent circuit they operate; for the 2000 filing year,
+the fee was $7 per circuit. Carriers that provide, or that have an affiliate
+which provides, domestic interstate services to end users must pay a universal
+telecommunications service fee each month based upon the total estimated demand
+for U.S. universal service funding. If applicable, each carrier's share is
+approximately 5% of the carrier's annual end user revenues, including both
+domestic and international end user revenue, unless less than 8% of the
+carrier's end-user revenues comes from domestic interstate services, in which
+case only domestic revenues are counted. We generally offer our services only to
+other carriers that in turn provide services to end-users. Such
+carrier-to-carrier revenues are not subject to universal service fees, and thus
+we generally are not liable to pay universal service fees. U.S. interstate and
+international carriers must pay a percentage of their total revenue each year to
+support the North American Numbering Plan Administrator. The contribution rate
+is approximately 0.006% of net telecommunications revenue. U.S. carriers must
+pay a certain percentage of their domestic interstate revenues to support the
+Telecommunications Relay Services Fund. The contribution rate is approximately
+0.04% of gross revenues. U.S. carriers must pay a percentage of their end-user
+revenue to support local number portability; that rate varies depending on the
+cost of the supported services and overall revenue for all carriers in different
+regions of the United States. Our local number portability payments would
+typically be minimal because most of our revenue comes from other carriers
+rather than end users. The foregoing regulatory fees typically change annually.
+We cannot predict the future regulatory fees for which we may be liable. Said
+fees could rise significantly for us and amount to 5% or more of our gross
+international and interstate revenues if we are no longer exempt from paying
+universal service in the event we provide service directly to end-users, or
+because amendments to the Communications Act repeal the universal service fee
+exemption for revenues from connecting carriers. Because the international
+telecommunication services business is highly competitive, an increase in the
+regulatory fees that we must pay could impair our market position and have a
+material adverse effect on our business, operating results and financial
+condition.
+
+State Regulation: Our intrastate long distance telecommunications operations and
+those of our subsidiaries are subject to various state laws and regulations,
+including prior certification, notification, registration and/or tariff
+requirements. In certain states, prior regulatory approval is required for
+changes in control of telecommunications services and for certain types of
+financial transactions. The vast majority of states require us and our
+subsidiaries to apply for certification to provide intrastate telecommunications
+services, or at a minimum to register or to be found to be exempt from
+regulation, prior to commencing sale of intrastate services. Additionally, the
+vast majority of states require us or our subsidiaries to file and maintain
+detailed tariffs setting forth rates charged by us to our end-users for
+intrastate services. Many states also impose various reporting requirements
+and/or require prior approval for transfers of control of certificated carriers
+
+ 31
+
+and assignments of carrier assets, including customer bases, carrier stock
+offerings, and incurrence by carriers of significant debt. Certificates of
+authority can generally be conditioned, modified, canceled, terminated or
+revoked by state regulatory authorities for failure to comply with state laws
+and/or rules, regulations and policies of the state regulatory authorities.
+Fines and other penalties, including, for example, the return of all monies
+received for intrastate traffic from residents of a state in which a violation
+has occurred, may be imposed. In addition, some states have intrastate universal
+service fees which apply to intrastate revenues.
+
+We, along with our regulated subsidiaries, believe we have made the filings and
+taken the actions we believe are necessary to provide the intrastate services we
+currently provide to end-users. We and/or our subsidiaries are qualified to do
+business as foreign corporations, and have received certification to provide
+intrastate telecommunications services in the states where we provide such
+service and where certification is required.
+
+FOREIGN REGULATION
+
+Spain: In Spain, telecommunications services offered by us through our
+subsidiary, Iberian Networks, are subject to regulation principally by CMT, the
+Comision del Mercado de las Telecomunicaciones, the principal Spanish regulatory
+agency. Spain generally permits competition in all sectors of the
+telecommunications market, subject to licensing requirements and license
+conditions. We have been granted a Class B (?) license to provide local,
+domestic and international long distance and data services. This license is
+subject to a number of restrictions. Implementation of these licenses has
+permitted us to engage in cost-effective routing of traffic between the U.S. and
+Spain and other countries using interconnections in Spain. We cannot assure that
+future changes in the regulation of the services provided by us or our
+competitors in Spain will not have a material adverse effect on our business
+operating results and financial condition.
+
+Brazil: The Brazilian market has not yet fully deregulated. Pensat do Brasil
+Ltda holds Anatel Licenses, granted on the 22nd of March 2000, to explore
+Specialized Network Services and Specialized Circuit Services, under the title
+of Limited Specialized Services, for the benefit of individual groups of persons
+and corporate clients. The granting of the licenses depends upon the ability of
+the Company making the request to fulfill the requirements demanded by Anatel,
+such as technical capacity, positive financial results, competent administration
+and marketing organizations, and the presentation of an acceptable
+communications network.
+
+Middle East: In the Middle East, we currently operate in Syria under the
+auspices of a special agreement with the Syrian Telecommunications Entity (STE)
+the government owned and operated incumbent monopoly PTT there.
+
+EMPLOYEES
+
+As of June 30, 2001, we employed approximately 72 full-time employees with 32 of
+those in the U.S. and 40 in international locations. We are not subject to any
+collective bargaining agreements.
+
+PROPERTIES
+
+Our corporate headquarters are located in the Bethesda, Maryland in a rented
+facility consisting of approximately 3,500 square feet. We also lease a facility
+at 8712 West Dodge Road, Omaha, Nebraska, consisting of approximately 4,000
+square feet. We have overseas facilities in Madrid and Barcelona, Spain and Sao
+Paulo, Brazil. The Spain facility houses a Lucent 5E Switch and other smaller
+switches.
+
+LEGAL PROCEEDINGS
+
+From time to time, we become subject to litigation which is incidental to and arises
+in the ordinary course of business. There are no material pending legal proceedings
+involving us.
+
+ MANAGEMENT
+
+EXECUTIVE OFFICERS AND DIRECTORS
+
+ 32
+
+Shown below are the names of all our directors and executive officers as of
+August 8, 2001, all positions and offices held by each such person, the period
+during which each person has served as such, and the principal occupations and
+employment of each such person during the last five years:
+
+ 
+ Name Age Position
+ 
+ Philip A. Verruto 61 Chairman of the Board and Chief Executive Officer
+ Georges Hneich 48 Pensat, Inc. President & Chief Operating Officer
+ Alex Matini 43 Pensat, Inc. Executive Vice President
+ Bruce G. Burton 48 Pensat, Inc. Chief Technical and Information Officer
+ Robert Miller 48 Secretary
+
+Philip A. Verruto has been CEO and Chairman of the Board of CDX since its merger
+with Pensat on February 9, 2001. Mr. Verruto has also served as CEO and Chairman
+of the Board of Pensat from 1996 until the present. Mr. Verruto is a co-founder
+of Pensat International Communications Inc. Prior to joining Pensat, Mr. Verruto
+was President of the telecommunications services division of ICT Response from
+1981 to 1996. This division provided contract telephone marketing services and
+facilities management services to major telecommunications companies. Before ICT
+Response, Mr. Verruto was Vice-President of Marketing and Sales with Audio
+Information Sciences from 1987 to 1991.
+
+Georges Hneich has been President & Chief Operating Officer of Pensat Inc. since
+CDX's merger with Pensat International Communications, Inc on February 8, 2001.
+Mr. Hneich became President and Chief Operating Officer of Pensat International
+in 1999 and served as President of Pensat's international operations since 1995.
+Mr. Hneich is a co-founder of Pensat International Communications, Inc. Prior to
+joining Pensat, Mr. Hneich was co-founder and President of Escort Telecom
+International, Ltd., a distributor of telecommunications and computer products
+worldwide, from 1994 to 1998. From 1978 to 1994 Mr. Hneich was President and
+Chief Operating Officer of Eagle Corporation C.A. & Sunnytron Import Export
+S.A., a representative and distributor of electronic products in Venezuela.
+
+Alex Matini has been Executive Vice President of Pensat Inc. since CDX's merger
+with Pensat International Communications Inc. ("Pensat International") on
+February 9, 2001. Mr. Matini was Pensat International's Executive Vice President
+from 1997 to 2001. Prior to joining Pensat International, Mr. Matini was
+President of COMCOR, a commercial real estate and executive office suite
+company, from 1988 to 1997. Prior to COMCOR, Mr. Matini was a Vice President of
+Dean Witter Reynolds, a Wall Street brokerage firm from 1983 to 1988.
+
+Bruce G. Burton has been Chief Technical and Information Officer of Pensat Inc.
+since CDX's merger with Pensat International Communications, Inc. on February 9,
+2001. Mr. Burton was Chief Technical Officer for Pensat International
+Communication, Inc. from 1998 to 2001. Prior to 1998, Mr. Burton was president
+of Burton & Associates, a computer and communications systems consulting
+company, from 1997 to 1998. From 1991 to 1997 Mr. Burton was President and Chief
+Operating Officer of Telenational Communications, Ltd., an international
+telecommunications company.
+
+Robert Miller has been General Counsel for CDX and Pensat Inc. since CDX's
+merger with Pensat International Communications, Inc. on February 9, 2001. Mr.
+Miller joined Pensat International as General Counsel for Pensat International
+in 1999. Prior to Pensat, Mr. Miller was a partner in the Florida law firm of
+Stanley, Miller, Dehlinger & Rascher from 1985 to 1999.
+
+BOARD COMPENSATION
+
+Each officer is elected by and serves at the discretion of our board. Each of
+our officers and directors, devotes substantially full time to our affairs. Our
+sole current member of the Board of Directors is an employee of the Company and
+does not receive additional compensation for serving on the board.
+
+ EXECUTIVE COMPENSATION
+
+The following table sets forth the compensation earned by our chief executive
+officer and four (4) other executive officers who earned, or would have earned,
+salary and bonus in excess of $100,000 for services rendered in all capacities
+to us and our subsidiaries for each of the three-year period ended December 31,
+2000. We refer to these individuals collectively as the CDX Named Officers. The
+historical information provided herein is of Pensat as all of CDX's pre-merger
+
+ 33
+
+executives and officers are no longer with the Company and as all of CDX's
+former operating activities were divested and they are not indicative of the
+ongoing operations of the merged companies.
+
+SUMMARY COMPENSATION TABLE
+
+ Long Term
+ Annual Compensation Compensation
+ Securities
+ Calendar Underlying All Other
+Name And Principal Position Years Salary ($) Bonus ($) Options (#) Compensation ($)
+
+Philip A. Verruto, 2000 100,000 100,000 94,024 -
+Chairman and CEO, 1999 100,000 25,035 940,244 -
+CDX.Com Incorporated & Pensat Inc. (1) 1998 - - - -
+
+Georges Hneich 2000 111,047 100,000 94,024 -
+President, Pensat Inc. (2) 1999 80,000 25,000 940,244 -
+ 1998 - - - -
+
+Alex Matini 2000 100,000 100,000 94,024 -
+Executive Vice President, Pensat Inc. (3) 1999 66,667 25,000 940,244 -
+ 1998 - - - -
+
+Bassam Haje 2000 91,663 91,666 94,024 -
+President, Pensat Middle East (4) 1999 - - 940,244 -
+ 1998 - - - -
+
+Craig Thompson 2000 142,077 42,500 94,024 -
+Chief Financial Officer, CDX.Com Incorporated (5) 1999 33,173 - 940,244 -
+ 1998 - - - -
+
+(1) Prior to January 1999, Mr. Verruto served without direct compensation from Pensat.
+(2) Mr. Hneich joined Pensat Inc. in May 1999.
+(3) Mr. Matini joined Pensat Inc. in May 1999.
+(4) Mr. Haje joined Pensat Inc. in December 1999.
+(5) Mr. Thompson joined Pensat Inc. in October 1999. He served as CDX's Chief Financial
+ Officer from February 9, 2001 until June 11, 2001.
+
+OPTION/WARRANT/SAR GRANTS IN LAST FISCAL PERIOD
+
+The following table sets forth the information concerning individual grants of
+stock options, warrants, and stock appreciation rights ("SARs") (together
+"Incentive Awards") during the last fiscal year to each of the CDX Named
+Executive Officers during such period. All such Incentive Awards were issued to
+the Named Officers by Pensat International Communications, Inc. prior to its
+merger with CDX. All of the options and warrants granted in the year ended June
+30, 2001 to the Named Officers have terms of five (5) years. A total of
+15,452,698 options and warrants were granted to our employees and directors in
+the 12-month period ended June 30, 2001.
+
+ 34
+
+ Number of Potential realizable value of
+ securities Percent of options at assumed annual rates
+ underlying total options / of stock price appreciation for
+ options / SARS / granted to Exercise price option term (1)
+ warrants granted employees in per share
+ Name (#) fiscal year (%) ($/sh) Expiration date 5% ($) (2) 10%($) (2)
+
+Philip Verruto 3,760,979 24.3% $0.10 January 31, 2006 - -
+Georges Hneich 1,880,489 12.2% $0.10 January 31, 2006 - -
+Alex Matini 1,880,489 12.2% $0.10 January 31, 2006 - -
+Basam Haje 1,006,062 6.5% $0.10 January 31, 2006 - -
+Craig Thompson 2,820,734 18.3% $0.10 January 31, 2006 - -
+
+(1) The 5% and 10% assumed annual rates of compounded stock price appreciation
+are mandated by the rules of the Securities and Exchange Commission. There can
+be no assurance provided to any CDX named officer or any other holder of our
+securities that the actual stock price appreciation over the option term will be
+at the assumed 5% and 10% levels or at any other defined level.
+
+(2) No value will be realized from the option grants made to the named officers
+at these assumed rates of 5% and 10%. Unless the market price of our common
+stock appreciates in excess of 27% per year over the option term, no value will
+be realized from the option grants made to the named officers.
+
+AGGREGATED OPTION/SAR EXERCISES IN LAST FISCAL PERIOD AND FISCAL PERIOD-END OPTION/SAR VALUES
+
+The following table sets forth information concerning each exercise of stock
+options and warrants during the last fiscal period by each of the Named
+Executive Officers during such fiscal period and the fiscal period end value of
+unexercised options.
+
+ Aggregate option exercises in last fiscal year
+ And fiscal year-end option values
+ 
+ Shares acquired Value realized Unexercised options & In-the-money options at
+Name on exercise (#) warrants at fiscal year-end(#) fy-end ($)
+
+ Exercisable / Unexercisable Exercisable / Unexercisable
+
+Philip Verruto - $ - 9,752,264 / 360,443 - / -
+Georges Hneich - $ - 2,554,314 / 360,443 - / -
+Alex Matini - $ - 2,969,647 / 360,443 - / -
+Basam Haje - $ - 2,261,901 / 360,443 - / -
+Craig Thompson - $ - 3,494,559 / 360,443 - / -
+
+No stock appreciation rights were exercised during 2001 nor were any outstanding
+at the end of that year.
+
+ 35
+
+EMPLOYMENT AGREEMENTS AND CHANGE OF CONTROL ARRANGEMENTS
+
+The Company currently has no employment agreements with its officers or key employees.
+
+ SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
+
+SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE
+
+The following table sets forth the number and percentage of shares of our common
+stock owned beneficially, as of June 30, 2001 by each director and executive
+officer of CDX, each beneficial owner of more than 5% of our voting securities
+and by all directors and executive officers of CDX as a group.
+
+ 36
+
+Information as to beneficial ownership is based upon the Company's records
+and/or statements furnished to us by such persons. Unless otherwise indicated,
+the address of each of the named individuals is c/o CDX.com Incorporated 7920
+Norfolk Avenue, 11th Floor, Bethesda, Maryland 20817
+
+ - BEN - each stockholder known by us to own beneficially more than 5% of our voting common stock;
+ - DIR - each of our directors;
+ - NEO - the Named Executive Officers for the year ended June 30, 2001;
+ - ALL - all of our directors and executive officers as a group.
+
+ Name (1) Type Number of shares owned beneficially
+
+ Number (2) Percent (3)
+
+Alpina Business International, Inc. BEN 28,466,234 18.2%
+Jean-Marc Emden BEN 14,286,174 9.1%
+Arthur Verbin BEN 10,005,803 6.4%
+HH Development, Inc. (8) BEN 9,429,527 6.0%
+Bocage Finance Corp. BEN 8,318,440 5.3%
+Albert Boyajian BEN 8,123,305 5.2%
+Philip A. Verruto (4) NEO 12,567,571 7.7%
+L. Craig Thompson (5) NEO 3,494,559 2.2%
+Basam Haje (6) NEO 2,261,901 1.4%
+Alex Matini (7) NEO 3,931,732 2.5%
+Georges Hneich (8) NEO 11,983,841 7.5%
+All executive officers and directors as
+a group (9) ALL 34,239,604 19.6%
+
++ Represents beneficial ownership of less than 1% of the outstanding shares of our common stock.
+
+(1) To our knowledge, except as indicated in the footnotes to this table and
+pursuant to applicable community property laws, the persons named in the table
+have sole voting and investment power with respect to all shares of our common
+stock.
+
+(2) In accordance with Rule 13d-3 under the Exchange Act, a person is deemed to
+be a "beneficial owner" of a security if he or she has or shares the power to
+vote or direct the voting of such security or the power to dispose or direct the
+disposition of such security. A person is also deemed to be a beneficial owner
+of any securities of which that person has the right to acquire beneficial
+ownership within 60 days from June 30, 2001. More than one person may be deemed
+to be a beneficial owner of the same securities. All persons shown in the table
+above have sole voting and investment power, except as otherwise indicated. This
+table includes shares of common stock subject to outstanding options granted
+pursuant to our option plans.
+
+(3) For the purpose of computing the percentage ownership of each beneficial
+owner, any securities which were not outstanding but which were subject to
+options, warrants, rights or conversion privileges held by such beneficial owner
+exercisable within 60 days were deemed to be outstanding in determining the
+percentage owned by such person, but were deemed not to be outstanding in
+determining the percentage owned by any other person.
+
+(4) Consists of 5,317,460 shares of common stock, 3,760,979 shares of common
+stock issuable upon the exercise of warrants exercisable within 60 days of June
+30, 2001 and of 673,825 shares of our common stock issuable upon the exercise of
+options exercisable within 60 days of June 30, 2001. Mr. Verruto disclaims
+beneficial ownership of 2,303,334 shares held or issuable pursuant to a warrant
+held by Mr. Ralph Pisani, his uncle and of 511,973 shares held or issuable
+pursuant to a warrant by Mr. Michael Verruto his son.
+
+(5) Consists of 2,820,734 shares of common stock issuable upon the exercise of
+warrants exercisable within 60 days of June 30, 2001 and of 673,825 shares of
+our common stock issuable upon the exercise of options exercisable within 60
+days of June 30, 200.
+
+(6) Consists of 515,348 shares of common stock, 1,072,728 shares of common stock
+issuable upon the exercise of warrants exercisable within 60 days of June 30,
+2001 and of 673,825 shares of our common stock issuable upon the exercise of
+options exercisable within 60 days of June 30, 2001.
+
+ 37
+
+(7) Consists of 2,295,822 shares of common stock issuable upon the exercise of
+warrants exercisable within 60 days of June 30, 2001 and of 673,825 shares of
+our common stock issuable upon the exercise of options exercisable within 60
+days of June 30, 2001. Mr. Matini disclaims beneficial ownership of 1,128,293
+shares held by 836,845 shares issuable pursuant to a warrant held by Nasser
+Matini, his father and 125,240 shares held by Khosrow Matini, his uncle.
+
+(8) Consists of 1,880,489 shares of common stock issuable upon the exercise of
+warrants exercisable within 60 days of June 30, 2001 and of 673,825 shares of
+our common stock issuable upon the exercise of options exercisable within 60
+days of June 30, 200. Mr. Hneich disclaims beneficial ownership of 9,429,527
+shares held by HH Development Corp. for which he holds a power of attorney.
+
+(9) All directors and executive officers in office on June 30, 2001. Consists of
+15,683,939 shares of our common stock and 18,555,665 shares of our common stock
+issuable upon the exercise of warrants and/or stock options exercisable within
+60 days of June 30, 2001.
+
+ CERTAIN RELATIONS AND RELATED-PARTY TRANSACTIONS
+
+TRANSACTIONS WITH OUTSIDE DIRECTORS
+
+On November 21, 2000, the Company executed a contract with Cyberdiagnostics,
+Inc. ("CDI") for the sale of substantially all of the Company's assets used in
+connection with the sale of computerized pulmonary diagnostic equipment and
+bio-hazard control products. The transferred assets included all furniture,
+fixtures, equipment, inventory, plans, permits, licenses, approvals and trade
+names (including "CDX", "CDX Spiro 850", "CDX 50", "CDX Biosponse", and "CDX
+Biopail") in addition to the Company's books, records signage and goodwill,
+associated with that line of business. In consideration for the sale, CDI
+expressly assumed all of the Company's liabilities and agreed to indemnify the
+Company against all costs, expenses, claims, judgments or damages arising out of
+CDI's assumption of liabilities.
+
+Since January 2001 Tampa Bay Financial, Inc. ("TBF") a corporation controlled by
+a Carl Smith, a former Board Member of the Company, has purchased 2,039,473
+shares of common stock of the Company. The issuance described herein was exempt
+from registration under the Securities Act pursuant to Section 4(2) of the
+Securities Act or Regulation D.
+
+TRANSACTIONS WITH MANAGEMENT AND OTHERS
+
+Subsequent to the merger with Pensat, Mr. Alex Matini loaned CDX $69,000 in
+exchange for a demand promissory note from CDX.
+
+TRANSACTIONS WITH STOCKHOLDERS OWNING MORE THAN 5% OF OUR COMMON STOCK
+
+Effective in March 2000, the Pensat entered into a marketing services agreement
+with another company, which is under common control with a holder of more than
+5% of our common stock. This agreement required a fixed fee of $14,000 per
+month. The fixed monthly payment was increased to $25,000 effective in October
+2000. Subsequent to the merger with CDX, Pensat has incurred $100,000 of
+marketing expenses under this agreement of which $62,500 has been paid.
+
+This Agreement was terminated on June 30, 2001.
+
+Subsequent to the merger a company holding more than 5% of our common stock has
+purchased 328,947 shares of common stock of the Company. The issuance described
+herein was exempt from registration under the Securities Act pursuant to Section
+4(2) of the Securities Act or Regulation D.
+
+ DESCRIPTION OF SECURITIES
+
+The following summary description of our capital stock is not a complete
+description and is subject to the provisions of our Restated Certificate of
+Incorporation, as amended (the "Restated Charter"), and our Amended and Restated
+Bylaws, as amended (the "Bylaws"), which are included as exhibits to the
+Registration Statement of which this prospectus forms a part, and the provisions
+of applicable law.
+
+COMMON STOCK
+
+ 38
+
+Voting Rights. Each holder of shares of common stock is entitled to attend all
+special and annual meetings of our stockholders and, together with the holders
+of all other classes of stock entitled to attend such meetings and to vote
+(except any class or series of stock having special voting rights), to cast one
+vote for each outstanding share of common stock upon any matter (including,
+without limitation, the election of directors) acted upon by the stockholders.
+The shares of common stock do not have cumulative voting rights in the election
+of directors.
+
+Holders of a majority of the common stock represented at a meeting may approve
+most actions submitted to the stockholders. Certain matters require different
+approvals: election of directors requires the approval of a plurality of the
+votes cast, certain corporate actions such as mergers, sale of all or
+substantially all of our assets and charter amendments require the approval of
+holders of a majority of the total number of shares of common stock outstanding.
+
+Liquidation Rights. Upon our dissolution, liquidation, or winding up, the
+holders of the common stock, and holders of any class or series of stock
+entitled to participate in the distribution of assets in such event, will be
+entitled to participate in the distribution of any assets remaining after we
+have paid all of our debts and liabilities and after we have paid the holders of
+classes of stock having preference over the common stock the full preferential
+amounts to which they are entitled.
+
+Dividends. Dividends may be paid on the common stock and on any class or series
+of stock entitled to participate therewith as to dividends but only when and as
+declared by the Board of Directors.
+
+Miscellaneous. Holders of common stock have no preemptive (right to buy a pro
+rata share of new stock issuances), subscription, redemption or conversion
+rights. All outstanding shares of common stock, including the shares offered in
+this prospectus, are, or upon issuance will be, fully paid and nonassessable.
+
+As of June 30, 2001, our authorized capital stock consisted of 500,000,000
+shares of common stock, $.01 par value per share. As of June 30, 2001, there
+were 156,243,503 shares of common stock issued held of record by approximately
+1,120 stockholders, options to purchase an aggregate of 11,209,049 shares of
+common stock and warrants to purchase an aggregate of 71,219,391 shares of
+common stock. The issued shares amount above includes 27,500,000 shares of
+common stock issued, but held for release to Pensat shareholders pending
+completion of a provision of the merger agreement.
+
+ 39
+
+ SELLING STOCKHOLDERS
+
+This prospectus relates to the possible offer and sale from time to time of up
+to 3,177,716 shares of our common stock by various selling stockholders. Certain
+selling stockholders have agreed not to directly or indirectly offer, sell,
+offer to sell, contract to sell, or otherwise dispose of any shares of common
+stock in excess of ten percent of their initial holding in any thirty day
+period.
+
+This prospectus relates to the possible offer and sale of 3,177,716 shares of
+common stock. All 3,177,716 shares are subject to contractual restrictions on
+the number of shares that can be offered and sold each month.
+
+The selling stockholders, each of whom acquired securities from us in the manner
+discussed below, and none of whom, at the time of such acquisition, had any
+agreements or understandings, directly or indirectly, with any person to
+distribute the securities, include:
+
+- Global Crossing Bandwidth, Inc., former creditor of Pensat which received
+ shares of our common stock in connection with the settlement of certain
+ claims against Pensat and the conversion of certain debt to equity.
+
+- Valentine Braver and Robert H. Jaffe, Esq., Braver's attorney, agreed to
+ accept common stock in connection with the cancellation of certain warrants held
+ by Braver and in connection with a deferral of payments on overdue obligations
+ of Pensat to Braver.
+
+- Hozik and Charin, former creditor of Pensat who agreed to accept common stock
+ in lieu of payment.
+
+We are registering the shares under the Securities Act of 1933 in accordance
+with registration rights we granted to the selling stockholders when we
+conducted these transactions. Our registration of the shares does not
+necessarily mean that any selling stockholder will sell all or any of his
+shares.
+
+The following table sets forth certain information with respect to the selling shareholders.
+
+ Shares beneficially owned Shares to be sold (included) Shares beneficially owned
+ before offering in the offering after offering (assuming
+ Name all shares are sold)
+ 
+ Number Percent Number Percent Number Percent
+
+Global Crossing Bandwidth, Inc 3,066,666 2.0 3,066,666 96.5 - -
+
+Valentine Braver 60,000 + 60,000 1.9 - -
+
+Robert H. Jaffe Esq. 15,000 + 15,000 + - -
+
+Hozik and Charin 36,050 + 36,050 1.1 - -
+
++ Less than one percent.
+
+ 40
+
+ PLAN OF DISTRIBUTION
+
+The shares registered hereunder are being registered in connection with the resale
+by the selling stockholders of shares issued by us in connection with agreements
+to convert certain debt of Pensat into common stock of CDX. As used herein, "selling
+stockholders" may include donees and pledgees selling shares received from the named
+selling stockholders after the date of this prospectus.
+
+The selling stockholders may sell or distribute the shares being registered
+hereunder directly to purchasers as principals or through one or more
+underwriters, brokers, dealers or agents from time to time in one or more
+transactions.
+
+The shares may be sold or distributed from time to time by the selling
+stockholders named in this prospectus, by their donees, pledgees, transferees or
+other successors in interest. The selling stockholders may sell their shares at
+market prices prevailing at the time of sale, at prices related to such
+prevailing market prices, at negotiated prices, or at fixed prices, which may be
+changed. Each selling stockholder reserves the right to accept or reject, in
+whole or in part, any proposed purchase of shares, whether the purchase is to be
+made directly or through agents.
+
+The selling stockholders may offer their shares at various times in one or more
+of the following transactions, which may include block transactions:
+
+ 41
+
+ o in ordinary brokers' transactions and transactions in which the broker
+ solicits purchasers;
+
+ o in transactions involving cross or block trades or otherwise such
+ market on which the common stock may from time to time be trading
+ (including transactions in which brokers or dealers may attempt to
+ sell the shares as agent but may position and resell a portion of
+ the block as principal to facilitate the transaction);
+
+ o in transactions in which brokers, dealers or underwriters purchase
+ the shares as principal and resell the shares for their own accounts
+ pursuant to this prospectus;
+
+ o in transactions "at the market" to or through market makers in our
+ common stock or into an existing market for the common stock;
+
+ o in other ways not involving market makers or established trading
+ markets, including direct sales of the shares to purchasers or sales
+ of the shares effected through agents;
+
+ o through transactions in options, swaps or other derivatives which
+ may or may not be listed on an exchange;
+
+ o in privately negotiated transactions;
+
+ o in short sales or transactions to cover short sales; or
+
+ o in a combination of any of the foregoing transactions.
+
+ The sale price to the public may be:
+
+ o the market price prevailing at the time of sale;
+
+ o a price related to such prevailing market price;
+
+ o at negotiated prices; or
+
+ o such other price as the selling stockholders determine from time to time.
+
+The selling stockholders shall have the sole and absolute discretion not to
+accept any purchase offer or make any sale of shares if they deem the purchase
+price to be unsatisfactory at any particular time.
+
+The selling stockholders also may sell their shares in accordance with Rule 144
+under the Securities Act, rather than pursuant to this prospectus.
+
+From time to time, one or more of the selling stockholders may pledge or grant a
+security interest in some or all of the shares owned by them. If the selling
+stockholders default in performance of the secured obligations, the pledgees or
+secured parties may offer and sell the shares from time to time. The selling
+stockholders also may transfer and donate shares in other circumstances. The
+number of shares beneficially owned by selling stockholders who transfer,
+donate, pledge or grant a security interest in their shares will decrease as and
+when the selling stockholders take these actions. The plan of distribution for
+the shares offered and sold under this prospectus will otherwise remain
+unchanged, except that the transferees, donees or other successors in interest
+
+ 42
+
+will be selling stockholders for purposes of this prospectus.
+
+A selling stockholder may sell short our common stock. The selling stockholder
+may deliver this prospectus in connection with such short sales and use the
+shares offered by this prospectus to cover such short sales.
+
+A selling stockholder or its pledgee, donee, transferee or other successor in
+interest may enter into hedging transactions with broker-dealers. The
+broker-dealers may engage in short sales of our common stock in the course of
+hedging the positions they assume with the selling stockholders, including
+positions assumed in connection with distributions of the shares by such
+broker-dealers. A selling stockholder or its pledgee, donee, transferee or other
+successor in interest also may enter into option or other transactions with
+broker-dealers that involve the delivery of the shares to the broker-dealers,
+who may then resell or otherwise transfer such shares. In addition, a selling
+stockholder may loan or pledge shares to a broker-dealer, which may sell the
+loaned shares or, upon a default by the selling stockholder of the secured
+obligation, may sell or otherwise transfer the pledged shares.
+
+A selling stockholder or its pledgee, donee, transferee or other successor in
+interest may also sell the shares directly to market makers acting as principals
+and/or broker-dealers acting as agents for themselves or their customers or use
+brokers, dealers, underwriters or agents to sell their shares. The
+broker-dealers acting as agents may receive compensation in the form of
+commissions, discounts or concessions. The selling stockholders or the
+purchasers of the shares for whom such persons may act as agent, or to whom they
+may sell as principal, or both may pay this compensation. The compensation as to
+a particular person may be less than or in excess of customary commissions. The
+selling stockholders and any agents or broker-dealers that participate with the
+selling stockholders in the offer and sale of the shares may be deemed to be
+"underwriters" within the meaning of the Securities Act. Any commissions they
+receive and any profit they realize on the resale of the shares by them may be
+deemed to be underwriting discounts and commissions under the Securities Act.
+Neither we nor any selling stockholders can presently estimate the amount of
+such compensation.
+
+The selling stockholders, alternatively, may sell all or any part of the shares
+offered in this prospectus through an underwriter. No selling stockholder has
+entered into any agreement with a prospective underwriter and there is no
+assurance that any such agreement will be entered into. If a selling stockholder
+enters into such an agreement or agreements, the relevant details will be set
+forth in a supplement or revisions to this prospectus.
+
+We have advised the selling stockholders that during such time as they may be
+engaged in a distribution of the shares, they are required to comply with
+Regulation M under the Exchange Act. With certain exceptions, Regulation M
+prohibits any selling stockholder, any affiliated purchasers and any
+broker-dealer or other person who participates in such distribution from bidding
+for or purchasing, or attempting to induce any person to bid for or purchase,
+any security which is the subject of the distribution until the entire
+distribution is complete. Regulation M also prohibits any bids or purchases made
+in order to stabilize the price of a security in connection with the
+distribution of that security. The foregoing restrictions may affect the
+marketability of the shares.
+
+Under our agreements with the selling stockholders, we are
+required to bear the expenses relating to this offering, excluding any
+underwriting discounts or commissions, stock transfer taxes and fees of legal
+counsel to the selling stockholders. We estimate these expenses will total
+approximately $15,500.
+
+We have agreed to indemnify the selling stockholders and any underwriters,
+brokers, dealers or agents and their respective controlling persons against
+certain liabilities, including certain liabilities under the Securities Act.
+
+It is possible that a significant number of shares could be sold at the same
+time. Such sales, or the perception that such sales could occur, may adversely
+affect prevailing market prices for our common stock.
+
+This offering by any selling stockholder will terminate on the date specified in
+the selling stockholder's agreement with CDX or, if earlier, on the date on which
+the selling stockholder has sold all of his shares.
+
+ LEGAL MATTERS
+
+Thomas P. McNamara, P.A. of Tampa Florida will issue an opinion about certain legal
+matters with respect to the common stock on behalf of CDX.
+
+ 43
+
+EXPERTS
+
+The financial statements for the fiscal years ended December 31, 1997 and 1998 have
+been audited by Ernst and Young, LLP. The financial statements included in this
+registration statement for the fiscal years ended December 31, 1999 and June 30,
+2000 have been audited by Aronson Fetridge & Weigle, independent public accountants,
+as indicated in their reports, and are included herein in reliance upon the authority
+of said firm as experts in giving said report
+
+ WHERE YOU CAN FIND MORE INFORMATION ABOUT US
+
+We file annual, quarterly and special reports, proxy statements and

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@@ -0,0 +1 @@
+RISK FACTORS You should carefully consider each of the risks described below, together with all of the other information contained in this prospectus, before deciding to invest in shares of our common stock. If any of the following risks develop into actual events, our business, results of operations and financial condition could be materially adversely affected, the value of our common stock could decline and you may lose all or part of your investment. Lack of a Public Market for the Common Stock -- There will be no trading market for these shares of common stock for the foreseeable future. As a result of the recapitalization, no trading market for our common stock exists. No public market for our common stock will develop unless we or one of our stockholders undertakes a significant underwritten public offering. We do not expect this to happen in the foreseeable future. Should a market develop, it may not be active and our common stock could trade at prices lower than the price at which you purchased your shares. Moreover, while we currently report our financial results publicly due to the existence of the publicly traded 4 1/2% convertible subordinated debentures and due to the number of holders of our common stock, we cannot assure you that we will continue to be so obligated. The lack of publicly available financial results could further adversely affect the market for, and value of, your shares. Should a market develop, its liquidity will be affected by a number of factors, including general economic conditions and changes or volatility in the financial markets, announcements or significant developments with respect to the automotive industry or labor relations, actual or anticipated variations in our quarterly or annual financial results, the introduction of new products or technologies by us or our competitors, changes in other conditions or trends in our industry or in the markets of any of our significant customers, changes in governmental regulation or changes in securities analysts' estimates of our future performance or that of our competitors or our industry. Recently, the stock market has experienced extreme price and volume volatility. These fluctuations may be unrelated to the operating performance of particular companies whose shares are traded. Leverage; Ability to Service Debt -- We may not be able to manage our business as we might otherwise do so due to our high degree of leverage. We incurred indebtedness in connection with the recapitalization and the Simpson acquisition that is substantial in relation to our stockholders' equity. As of December 31, 2000, we had approximately $1.5 billion of outstanding debt and approximately $252.9 million of stockholders' equity. We expect our acquisition activities to be financed with further indebtedness. The degree to which we are leveraged will have important consequences, including the following: o our ability to obtain additional financing in the future for working capital, capital expenditures, acquisitions, business development efforts or general corporate purposes may be impaired; o a substantial portion of our cash flow from operations will be dedicated to the payment of interest and principal on our indebtedness, thereby reducing the funds available to us for other purposes; o our operations are restricted by our debt instruments, which contain material financial and operating covenants, and those restrictions will limit, among other things, our ability to borrow money in the future for working capital, capital expenditures, acquisitions or other purposes; o indebtedness under our credit facility is at variable rates of interest, which makes us vulnerable to increases in interest rates; o our leverage may place us at a competitive disadvantage as compared with our less leveraged competitors; o our substantial degree of leverage will make us more vulnerable in the event of a downturn in general economic conditions or in any of our businesses; and o our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate may be limited. Our ability to service our debt and other obligations will depend on our future operating performance, which will be affected by prevailing economic conditions and financial, business and other factors, many of which are beyond our control. See "Description of Our Indebtedness" and "Management's Discussion and Analysis of Financial Condition and Results of Operations--Liquidity and Capital Resources." Liquidity and Capital Resources -- If we are unable to raise junior capital, our liquidity and business strategies will be adversely impacted. Our principal sources of liquidity are our $300 million revolving credit facility and $225 million accounts receivable financing, but there are significant limitations on our use of these facilities by reason of the near-term maturity of our outstanding $305 million of convertible subordinated debentures. Our credit facility contains provisions that are designed to ensure that we have the necessary liquidity to repay the convertible subordinated debentures. Under the credit facility, we must maintain restricted cash either in escrow from the proceeds of other subordinated debt financing or equity financing or in the form of availability under our revolving credit facility and accounts receivable financing in increasing amounts at specified dates until the maturity of the convertible subordinated debentures, in an amount which grows to $205 million by the maturity date of the convertible subordinated debentures. To address the balance of the amount due on the convertible subordinated debentures, we have secured a commitment from Masco Corporation, one of our shareholders, to purchase up to $100 million of a new issue of Metaldyne subordinated debt from us, subject to limited conditions, on or prior to October 31, 2003. We are obligated by our credit facility to utilize our subordinated loan commitment from Masco to satisfy our obligations in respect of the convertible subordinated debentures, upon maturity, conversion or otherwise, to the extent that we have not raised other subordinated debt or equity. Should Masco default in its obligations, we will be materially and adversely affected, will be in default under our credit facility and certain other obligations and may have difficulty in securing the necessary financing to meet our obligations, including in respect of the convertible subordinated debentures. Moreover, if we are not otherwise in compliance with the terms of our credit agreement we may not be able to satisfy such obligation. By reason of the foregoing, we do not expect to be able to utilize our full revolving credit commitments, absent being able to raise additional junior financing. In the event that we are unsuccessful in raising additional junior financing, our acquisition activities will also be materially impaired and we may have difficulty with respect to our liquidity should we encounter difficult business conditions. Challenges of Acquisition Strategy -- We may not be able to identify attractive acquisition candidates, successfully integrate our acquired operations or realize the intended benefits of our acquisitions. One of the primary purposes of our recapitalization was to enable us to pursue acquisition opportunities to become a full-service provider of engineered metal products for our customers. We continually evaluate potential acquisitions and engage in discussions with acquisition candidates for our Metal Forming Group, as well as for our Diversified Industrial Product Group. We intend to actively pursue acquisition opportunities, some of which could be material. We have entered into a strategic relationship with GMTI, which is owned by our largest shareholder, Heartland. We intend to continue to explore possible strategic relationships with GMTI, including marketing programs and a merger of GMTI into our company. We cannot assure you that we will pur- sue or be able to finance an acquisition of GMTI. There can be no assurance that other suitable acquisition candidates will be identified and acquired in the future, that the financing for any such acquisitions will be available on satisfactory terms or that we will be able to accomplish our strategic objectives as a result of any such acquisition. Nor can we assure you that our full metal services strategies will be successfully received by customers or achieve their intended benefits. Often acquisitions are undertaken to improve the operating results of either or both of the acquiror and the acquired company and we cannot assure you that we will be successful in this regard. We will encounter various risks in acquiring other companies, including the possible inability to integrate an acquired business into our operations, increased goodwill amortization, diversion of management's attention and unanticipated problems or liabilities, some or all of which could materially and adversely affect us. Substantial Capital Expenditure Requirements -- If we are unable to meet future capital requirements, our business will be adversely affected. We operate in a capital intensive industry. We have made an aggregate of $655 million in capital investments (including Simpson) from 1996 through 2000 to, among other things, maintain and upgrade our facilities and enhance our production processes. This level of capital expenditures was needed to: o increase production capacity; o improve productivity; o satisfy customer requirements; and o upgrade selected facilities to meet competitive requirements. We have planned capital expenditures of up to approximately $133 million in 2001. We believe that we will be able to fund these expenditures through cash flow from operations, borrowings under our existing credit agreement and sales of receivables under our receivables facility. We cannot assure you that we will have adequate funds to make all required maintenance capital expenditures or that the amount of future capital expenditures will not be materially in excess of our anticipated expenditures. If we are unable to make necessary capital expenditures, our business will be adversely affected. Substantial Restrictions and Covenants -- Restrictions in our credit facility limit our ability to take certain actions. Our credit facility contains covenants that restrict our ability to: o pay dividends or redeem or repurchase capital stock; o incur additional indebtedness and grant liens; o make acquisitions and joint venture investments; o sell assets; and o make capital expenditures. Our credit facility also requires us to comply with financial covenants relating to interest coverage and leverage. In addition, our accounts receivable facility contains covenants and requirements regarding the purchase and sale of receivables. There can be no assurance that we will be able to satisfy these covenants in the future or that we will be able to pursue our new business strategies within the constraints of these covenants. If we cannot comply, the value of our common stock may be materially and adversely affected. In addition, our accounts receivable facility contains concentration limits with respect to the percentage of receivables we can sell from a particular customer. The concentration limits are based on the credit ratings of such particular customer. If one or more of our customers were to have its credit ratings downgraded and consequently the amount of receivables of such customer that we could sell were decreased, our business could be materially adversely affected. Our ability to comply with our covenants may be affected by events beyond our control, including prevailing economic, financial and industry conditions. The breach of our covenants could result in an event of default under our credit facility, which could cause an event of default under our accounts receivable facility and our equipment lease financing. Such breach would permit the lenders to declare all amounts borrowed thereunder to be due and payable, together with accrued interest, and the commitments of the lenders to make further extensions of credit under our credit facility could be terminated. In addition, such breach may cause a termination of our accounts receivable facility and our equipment lease financing. If we were unable to secure a waiver or repay such indebtedness, our secured lenders could proceed against their collateral. We do not presently expect that alternative sources of financing will be available to us under these circumstances or available on attractive terms. Dependence on Automotive Industry and Industry Cyclicality -- The industries in which we operate are dependent upon the economy and are cyclical. Our sales for use in the OEM segments of the automotive industry accounted for approximately one-half of our pro forma 2000 net sales. While we may engage in acquisitions for our Diversified Industrial Product Group that reduce this percentage, it is more likely that the effect of acquisitions for our Metal Forming Group will be to increase this percentage. The automotive industry is highly cyclical, is dependent on consumer spending, interest rates and consumer confidence and is subject to, among other things, general economic conditions and the impact of international trade. In addition, the automotive industry is significantly unionized and subject to work slowdowns and stoppages resulting from labor disputes. We also sell products to customers in other industries that experience cyclicality in demand for products, such as the construction, industrial equipment, truck and electrical equipment industries. There are signs of increasing weakness in the economy generally. A general recession would have a material adverse effect on us and on our customers. Recently reported results from North American automotive manufacturers reflect weakness in demand for their products which may continue throughout 2001 and beyond. A downturn in the North American automotive industry could have a material adverse effect on us. In addition, a portion of our net sales result from products we manufacture for SUVs and light trucks, which, until recently, have experienced positive sales trends for several years. There can be no assurance that sales of these vehicles will not continue to decline. A decrease in consumer demand for the models that generate most of our sales, our failure to obtain sales orders for new or redesigned models or pricing pressure from our customers or competitors could have a material adverse effect on us. For example, a major customer has announced a requirement that suppliers reduce, by 5%, their prices, effective January 1, 2001. While our ten largest customers accounted for less than one half of our pro forma 2000 net sales and represent a range of industries, certain of our individual operating businesses have a larger concentration of sales to particular automotive or other customers. Although we consider our relations with our customers to be good, the loss of certain automotive or other customers could have a material adverse effect on us. Dependence on Third-Party Suppliers and Manufacturers -- The loss of a substantial number of our suppliers could affect our financial health. Generally, our raw materials requirements are obtainable from various sources and in quantities desired. While we currently maintain alternative sources for raw materials, our businesses are subject to the risk of price fluctuations and periodic delays in the delivery of certain raw materials, component parts and specialty fasteners. Under long term supply contracts for special bar quality steel, we have established the prices at which we will purchase most of our steel requirements. We may not be able to renegotiate future prices under those contracts at prices favorable to us, depending on industry conditions. The domestic steel industry has experienced substantial financial instability due to numerous factors, including energy costs and the effect of foreign competition. Adverse developments in the steel industry, including bankrupticies, could materially adversely affect us. In addition, failure by suppliers to continue to supply us with certain raw materials or component parts on commercially reasonable terms, or at all, would have a material adverse effect on us. Our Industries Are Highly Competitive -- Recent trends among our customers will increase competitive pressures in our businesses. The markets for our products are highly competitive. Our competitors include driveline component manufacturing facilities of existing OEMs, as well as independent domestic and international suppliers. Certain of our competitors are large companies that have greater financial resources than us. We believe that the principal competitive factors are product quality and conformity to customer specifications, design and engineering capabilities, product development, timeliness of delivery and price. The rapidly evolving nature of the markets in which we compete may attract new entrants as they perceive opportunities, and our competitors may foresee the course of market development more accurately than we may. In addition, our competitors may develop products that are superior to our products or may adapt more quickly than us to new technologies or evolving customer requirements. In our fastener segment, we compete with domestic full-line industrial fastener distributors and other domestic distributors that offer fasteners in addition to other products, as well as a number of fastener manufacturers who, in certain circumstances, may sell directly to OEMs. Recent trends by OEMs to limit their number of outside vendors and moderate growth in the industrial fastener industry have resulted in increased competition as many manufacturers and distributors have reduced prices to compete more effectively. Management expects competitive pressures in our markets to remain strong. Such pressures arise from existing competitors, other companies that may enter our existing or future markets and, in certain cases, our customers, which may decide to move production in-house of certain items sold by us. In addition, some of our competitors and customers solicit bids for and obtain business via the Internet. Because e-commerce is a relatively recent development, we cannot predict the impact, if any, that this medium will have on us. There can be no assurance that we will be able to compete successfully with our existing competitors or with new competitors. Failure to compete successfully could have a material adverse effect on us. Dependence on Key Personnel and Relationships -- We depend on the services of other key individuals and relationships, the loss of which would materially harm us. Our success will depend, in part, on the efforts of our executive officers and other key employees. In addition, our future success will depend on, among other factors, our ability to attract and retain other qualified personnel. The loss of the services of any of our key employees or the failure to attract or retain employees could have a material adverse effect on us. Our controlling stockholder, Heartland Industrial Partners, provides us with valuable strategic, operational and financial guidance and our former controlling stockholder, Masco Corporation, provides us with valuable transitional corporate services which transitional services are not required to be provided after calendar year 2002. Masco has provided corporate services to us since 1984. To the extent that we cannot provide either internally or through third parties the services provided to us by Masco at a comparable cost, our business and financial results could be materially adversely affected. Labor Relations -- A portion of our workforce is unionized. As of December 31, 2000, approximately 27% of our work force is unionized, principally through the United Auto Workers union. We experienced a labor strike at our Fraser, Michigan plant which lasted from July 1997 to June 1998 and involved approximately 140 employees. If our unionized workers were to engage in a strike, work stoppage or other slowdown in the future, we could experience a significant disruption of our operations, which could have a material adverse effect on us. In addition, if a greater percentage of our work force becomes unionized, our business and financial results could be materially adversely affected. Labor Stoppages Affecting OEMs -- Slowdowns, strikes or similar actions could have a material adverse effect on our results of operations. Many OEMs and their suppliers have unionized work forces. Work stoppages or slowdowns experienced by OEMs or their suppliers could result in slowdowns or closures of assembly plants where our products are included in assembled vehicles. For example, over the past four years, there have been labor strikes against General Motors that have resulted in work stoppages at General Motors. Furthermore, organizations responsible for shipping our customers' products may be impacted by occasional strikes staged by the Teamsters Union. Any interruption in the delivery of our customers' products would reduce demand for our products and could have a material adverse effect on us. International Sales -- A growing portion of our revenue may be derived from international sources, which presents separate uncertainty for us. A portion of our revenue, 13% for the year ended December 31, 2000, is derived from sales outside of the United States. As part of our business strategy, we intend to expand our international operations through internal growth and acquisitions. Sales outside of the United States, particularly sales to emerging markets, are subject to other various risks which are not present in sales within U.S. markets, including currency fluctuations, governmental embargoes or foreign trade restrictions such as antidumping duties, changes in U.S. and foreign governmental regulations, tariffs, fuel duties, other trade barriers, the potential for nationalization of enterprises, economic downturns, inflation, environmental regulations, political, economic and social instability, foreign exchange risk, difficulties in receivable collections and dependence on foreign personnel and foreign unions. In addition, there are tax inefficiencies in repatriating cash flow from non-U.S. subsidiaries. To the extent such repatriation is necessary for us to meet our debt service or other obligations, this will adversely affect us. The occurrence of or increase in any adverse international economic conditions could have a material adverse effect on us. Product Liability -- Our businesses expose us to product liability risks that could materially and adversely impact us. Our businesses expose us to potential product liability risks that are inherent in the design, manufacture and sale of our products and products of third-party vendors that we use or resell. While we currently maintain what management believes to be suitable and adequate product liability insurance, there can be no assurance that we will be able to maintain such insurance on acceptable terms or that any such insurance will provide adequate protection against potential liabilities. In the event of a claim against us, a lack of sufficient insurance coverage could have a material adverse effect on us. Environmental Matters -- We have been and may be subject in the future to potential exposure to environmental liabilities. Our operations are subject to federal, state, local and foreign laws and regulations pertaining to pollution and protection of the environment governing, among other things, emissions to air, discharge to waters and the generation, handling, storage, treatment and disposal of waste and other materials, and remediation of contaminated sites. Our subsidiaries were named as potentially responsible parties in several sites requiring cleanup related to disposal of wastes we generated. We have entered into consent decrees relating to two sites in California along with the many other co-defendants in these matters. We have incurred expenses for all these sites over a number of years, a portion of which has been covered by insurance. In addition to the foregoing, our businesses have incurred expenses to clean up company-owned or leased property. We believe that our business, operations and facilities are being operated in compliance in all material respects with applicable environmental and health and safety laws and regulations, many of which provide for substantial fines and criminal sanctions for violations. The operation of manufacturing plants entails risks in these areas, however, and there can be no assurance that we will not incur material costs or liabilities in the future. In addition, potentially significant expenditures could be required in order to comply with evolving environmental and health and safety laws, regulations or requirements that may be adopted or imposed in the future. Government Regulation -- Fastener Quality Act. The Fastener Quality Act of 1990 regulates the manufacture, importation and distribution of certain high-grade industrial fasteners in the United States. The Fastener Act, which was amended in June 1999, requires some testing, certification, quality control and recordkeeping by the manufacturers, importers and distributors of such fasteners. As a result, we, along with other fastener suppliers, are required to maintain records and product tracking systems. We have tracking and traceability systems, which, to date, have not materially increased expenses. However, there can be no assurance that future regulations will not result in materially increased costs for us. Control by Principal Stockholder -- We are controlled by Heartland, whose interests in our business may be different than yours. As a result of the recapitalization, Heartland Industrial Partners and its affiliates are able to control our affairs in all cases, except for certain actions specified in a shareholders agreement among Heartland, Credit Suisse First Boston Equity Partners, L.P., Masco Corporation, Richard Manoogian and their various affiliates and certain other investors. Under the shareholders agreement, holders of approximately 90% of our shares of common stock have agreed to vote their shares for directors representing a majority of our board that have been designated by Heartland. You should consider that the interests of Heartland, as well as our other owners, will likely differ from yours in material respects. See "Related Party Transactions" and "Security Ownership of Certain Beneficial Owners and Management."

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+RISK FACTORS INVESTING IN OUR COMMON STOCK INVOLVES A HIGH DEGREE OF RISK. YOU SHOULD CAREFULLY CONSIDER THE FOLLOWING RISK FACTORS AND ALL OTHER INFORMATION CONTAINED IN THIS PROSPECTUS BEFORE PURCHASING OUR COMMON STOCK. THE RISK AND UNCERTAINTIES DESCRIBED BELOW ARE NOT THE ONLY ONES FACING US. ADDITIONAL RISKS AND UNCERTAINTIES THAT WE ARE UNAWARE OF, OR THAT WE CURRENTLY DEEM IMMATERIAL, ALSO MAY BECOME IMPORTANT FACTORS THAT AFFECT US. IF ANY OF THE FOLLOWING RISKS OCCUR, OUR BUSINESS, FINANCIAL CONDITION OR RESULTS OF OPERATIONS COULD BE MATERIALLY AND ADVERSELY AFFECTED. IN THAT CASE, THE TRADING PRICE OF OUR COMMON STOCK COULD DECLINE, AND YOU MAY LOSE SOME OR ALL OF YOUR INVESTMENT. RISKS RELATED TO OUR INDUSTRY COMPETITIVE PRESSURES MAY ADVERSELY AFFECT OUR OPERATING REVENUES. We have numerous competitors in the remote sensing services (airborne hyperspectral services) and natural resource development industries. Competition in the remote sensing industry comes from several primary sources. Our principal competitors in the natural resource development industry include traditional exploration companies using a variety of other technologies. Some of our competitors in both remote sensing and natural resource development have substantially greater financial and other resources than we do. Competitive pressures in either industry may materially adversely affect our operating revenues and in turn, our business and financial condition. FACTORS THAT HAVE AN ADVERSE IMPACT ON THE NATURAL RESOURCES OR ENERGY INDUSTRY MAY ADVERSELY AFFECT OUR RESULTS OF OPERATIONS. A substantial percentage of our gross profit and operating income is derived from our airborne hyperspectral services business segment. Our airborne hyperspectral operations are focused, in part, on discovering potential deposits of hydrocarbons and minerals. Therefore, our business is directly affected by economic factors and other trends that affect our customers in the energy and natural commodities industries, including a possible decrease in the cost of energy or projected market growth that may not materialize or be sustainable. When these economic and other factors depress the price of energy, they tend to reduce the overall customer demand for natural resources development services, which could decrease our operating income. Economic and other factors that might affect the energy industry may have an adverse impact on our results of operations. WE MAY NEED TO EXPEND SIGNIFICANT CAPITAL TO KEEP PACE WITH TECHNOLOGICAL DEVELOPMENTS IN OUR INDUSTRY. The remote sensing industry (as well as the computing industry instrumental in processing the raw data) is constantly undergoing development and change and it is likely that new technology, whether embodied in new equipment or techniques, will be introduced in the future. In order to keep pace with any new developments, we may need to expend significant capital to develop or purchase new equipment or to train our employees in the new techniques. We are pursuing financing to develop additional remote sensing instruments; however, we may not be able to raise sufficient funds and if we do so, there is no guaranty that the new instruments will out perform instruments used by our competitors. WE MAY INCUR SIGNIFICANT EXPENSES TO COMPLY WITH NEW OR MORE STRINGENT GOVERNMENTAL REGULATION. The sale of our imagery is regulated by the Department of Commerce. Although we (through our acquisition of STDC) have acquired a Department of Commerce Remote Sensing License that permits us to market globally hyperspectral and panchromatic imagery, there is no guarantee that the government will not impose restrictions on sales if the quality of our imagery increases with new technology that, for example, allows increased resolution. Because our license was the first issued Department of Commerce Remote Sensing License, we cannot anticipate how the Department of Commerce specifically will treat our license or how the airborne remote sensing industry will be regulated in the future. RISKS RELATED TO OUR BUSINESS THE LOSS OF OUR KEY CUSTOMERS COULD HAVE A MATERIAL ADVERSE EFFECT ON OUR OPERATING RESULTS. For the twelve months ended March 31, 2001, a significant survey in South American accounted for approximately 32% of our total revenue. We are pursuing contracts that produce revenues from the application of hyperspectral remote sensing technology. In the future, however, we may not receive significant contracts and our results of operations may be materially adversely affected. WE MAY NOT REALIZE OUR ANTICIPATED RETURN ON CAPITAL COMMITMENTS MADE TO EXPAND OUR CAPABILITIES. We purchased an aircraft, additional satellite and airborne hyperspectral instruments as well as oil and gas property rights. The aircraft and airborne hyperspectral instruments were purchased to increase our capacity to conduct airborne surveys. If we do not experience continued demand for our remote sensing services, we may incur significant expense without generating corresponding revenues. The oil and gas property rights were acquired in order to exploit suspected natural resources located within certain properties. If these properties do not contain sufficient natural resources to warrant exploitation, we may incur significant expenses without generating corresponding revenues. In addition, from time to time, we expect to make significant capital expenditures to implement new processes and to increase both efficiency and capacity. Some of these projects may require additional training for our employees and not all projects may be implemented as anticipated. If any of these projects do not achieve the anticipated increase in efficiency or capacity, our returns on these capital expenditures may not be as expected. WE MAY NEED ADDITIONAL FINANCING FOR ACQUISITIONS AND CAPITAL EXPENDITURES AND SUCH FINANCING MAY NOT BE AVAILABLE ON TERMS ACCEPTABLE TO US. A key element of our strategy has been, and continues to be, internal growth and growth through the acquisition of other companies engaged in commercial hyperspectral remote sensing. In order to grow internally, we may need to make significant capital expenditures and may need to obtain additional capital to do so. Our ability to grow is dependent upon, and may be limited by, among other things, our capital structure, the price of our stock and our existing financing arrangements. If additional funding sources are needed, we may not be able to obtain the additional capital necessary to pursue our internal growth and acquisition strategy or, if we can obtain additional financing, the additional financing may not be on financial terms that are satisfactory to us. THE NEMO PROJECT MAY NOT BE SUCCESSFUL. The NEMO project, our satellite-based hyperspectral instrument, is the cornerstone of STDC's strategic plan. The satellite is not yet in orbit. In the third quarter of 2000, we retained the investment-banking firm of Houlihan Lokey Howard & Zukin to raise funds to expand our hyperspectral services market and to satisfy our financial commitment to the NEMO project to enable completion and successful launch of the satellite. We cannot guarantee that sufficient financing will be raised. If sufficient funding is raised, we cannot guarantee that the satellite will be properly completed, launched and set into orbit. Although the satellite has an expected lifetime of five years, we cannot guarantee that the satellite will not be rendered inoperable sooner. OUR FUTURE OWNERSHIP OF THE NEMO PROJECT MAY BE DILUTED TO A MINORITY INTEREST. We currently own 100% of STDC, our subsidiary responsible for developing and launching the NEMO satellite. We formed our subsidiary Earthmap, Inc. to raise capital to fund the completion and launch of the NEMO sensor and satellite. Currently, we own 100% of Earthmap. As Earthmap raises capital, we will contribute assets, primarily our shares in STDC, to Earthmap. In order to raise the funds necessary to complete and launch the NEMO satellite, our interest in Earthmap may be diluted to a minority interest. OUR DATABASE OF SPECTRAL INFORMATION MAY NOT BE MARKETABLE OR MAY NOT GARNER A PRICE WHICH MAKES PROCESSING OR ANALYZING THE DATA ECONOMICALLY REASONABLE. We have a substantial archive of Probe 1 hyperspectral imagery that was not gathered under contract with a client. We continue to gather hyperspectral imagery without having sold the rights to that data. The collection process requires variable as well as fixed expenditures that must be recouped though marketing the collected data. Although we do not carry the value of our existing Phase 1 hyperspectral archives as an asset on our balance sheet, our future success depends to some extent upon our ability to market this archived data. CANCELLATIONS, REDUCTIONS OR DELAYS IN CUSTOMER ORDERS MAY ADVERSELY AFFECT OUR RESULTS OF OPERATIONS. Our overall operating results are affected by many factors, including the timing of survey contracts from large clients and the timing of capital expenditures to increase our capacity for gathering data in anticipation of future sales of products and services. A portion of our operating expenses are relatively fixed; however, a significant portion of our expenses relating to airborne surveys are variable. Because several of our operating divisions and subsidiaries are new businesses and have not obtained long-term commitments from our clients, we must anticipate the future demand for our services based upon our discussions with clients. Cancellations, reductions or delays in orders by a client or group of clients could have a material adverse effect on our business, financial condition and results of operations. OUR ACQUISITION STRATEGY EXPOSES US TO RISKS, INCLUDING THE RISK THAT WE MAY NOT BE ABLE TO SUCCESSFULLY INTEGRATE ACQUIRED BUSINESSES. We view the STDC acquisition (and the NEMO project) as a means to achieving our stated goal of becoming a vertically integrated remote sensing services provider. The NEMO project may not be successfully integrated as an affiliate. Our ability to grow by acquisition is dependent upon, among other things, the availability of suitable acquisition candidates. Growth by acquisition involves risks that could adversely affect our operating results, including difficulties in integrating the operations and personnel of acquired companies, the potential amortization of acquired intangible assets and the potential loss of key employees of acquired companies. We may not be able to consummate acquisitions on satisfactory terms or, if any acquisitions are consummated, satisfactorily integrate these acquired businesses. THE UNAVAILABILITY OF SKILLED PERSONNEL MAY HAVE AN ADVERSE EFFECT ON OUR OPERATIONS. From time to time, we or some of our operating divisions and subsidiaries may experience difficulties in attracting and retaining skilled personnel to process and interpret the substantial volume of imagery data that is already collected or is expected to be collected in the future. Our ability to operate successfully could be jeopardized if we are unable to attract and retain a sufficient number of skilled personnel to conduct our business. RISKS RELATED TO THIS OFFERING OUR CHARTER DOCUMENTS MAY INHIBIT A TAKEOVER THAT SHAREHOLDERS MAY CONSIDER FAVORABLE. Our certificate of incorporation and bylaws contain cumulative voting provisions that could prevent or delay a change in control or change in management that would provide shareholders with a premium to the market price of their common stock. Cumulative voting could have the effect of discouraging unsolicited acquisition proposals or make it more difficult for a third party to gain control of us, or otherwise could adversely affect the market price of our common stock. BECAUSE OUR STOCK PRICE MAY BE VOLATILE, OUR STOCK PRICE COULD EXPERIENCE SUBSTANTIAL DECLINES. The market price of our common stock has historically experienced and may continue to experience volatility. This volatility may cause wide fluctuations in the price of our common stock on the NASD Over-the-Counter Bulletin Board Service. The market price is likely to be affected by: o changes in general conditions in the economy of the financial market; o variations in our quarterly operating results; o changes in financial estimates by securities analysts; o other developments affecting us, our industry, customers or competitors; o the operating and stock price performance of companies that investors deem comparable to us; and o the number of shares available for resale in the public market under applicable securities laws. The entire stock market has experienced significant volatility in recent months. This volatility has affected the market prices of securities issued by many companies for reasons unrelated to their operating performance. Therefore, we cannot predict the market price for our common stock after this offering. WE DO NOT ANTICIPATE PAYING DIVIDENDS IN THE FORESEEABLE FUTURE. We have not paid any dividends on our common stock and do not intend to pay dividends in the foreseeable future. In the event that we and/or certain of our subsidiaries enter into future financings, the terms of such financings may include dividend restrictions. IF THE PRICE OF OUR COMMON STOCK BECOMES LOWER, THE SALE OF OUR COMMON STOCK TO ALPHA MAY DILUTE THE INTERESTS OF OTHER SECURITY HOLDERS AND DEPRESS THE PRICE OF OUR COMMON STOCK. As of August 31, 2001, we had 154,201,609 outstanding shares of common stock. As of August 31, 2001, there were 200,000 shares of convertible preferred stock outstanding that are currently convertible into 1,000,000 shares of common stock. Additional shares of common stock that may be sold by means of this prospectus, are issuable under the Purchase Agreement and upon exercise of the "A" and "B" Warrants held by Alpha. We may also issue additional shares for various reasons and may grant additional stock options to our employees, officers, directors and third parties. Accordingly, the issuance of shares under the Purchase Agreement, in connection with any other financing, and upon exercise of warrants, options or the conversion of preferred stock will have a dilutive impact on other shareholders and could have a negative effect on the market price of the common stock. In addition, the shares issuable to Alpha will be issued at a discount to the daily volume weighted average prices of our common stock. As we sell shares of our common stock to Alpha under the Purchase Agreement, and Alpha sells the common stock to third parties, the price of the common stock may decrease due to the additional shares in the market. If we decide to draw down on the Purchase Agreement as the price of our common stock decreases, we will be required to issue more shares of our common stock for any given dollar amount invested by Alpha. The more shares that are issued to Alpha, the more the then outstanding shares will be diluted and the more our common stock price may decrease. Any decline in the price of the common stock may encourage short sales that could place further downward pressure on the price of our common stock. The following table illustrates how the number of shares of common stock required to be sold to draw down the full $10,000,000 under the Purchase Agreement would increase or decrease if the market price (as defined in the Purchase Agreement) of our common stock were to increase or decrease. For illustrative purposes, the market prices shown below are based on the trading price of our common stock as of September 4, 2001 ($.15), the 52-week high of our common stock ($.72) and the 52-week low of our common stock ($.125). Also included are market prices representing an increase of 50% from the current trading price ($.225) and a decrease of 50% from the current trading price ($.075). <TABLE><CAPTION> ------------------------ ------------ ------------ ------------ ------------- ------------- <S> <C> <C> <C> <C> <C> Market Price $.72 $.225 $.15 $.125 $.075 ------------------------ ------------ ------------ ------------ ------------- ------------- Purchase Price $.6336 $.198 $.132 $.11 $.066 ------------------------ ------------ ------------ ------------ ------------- ------------- Number of Shares of Common Stock Required to Draw Down $10,000,000 15,782,828 50,505,050 75,757,575 90,909,090 151,515,151 ------------------------ ------------ ------------ ------------ ------------- ------------- Percentage of Shares of Common Stock Outstanding as of August 31, 2001 upon Issuance 9.28% 24.67% 32.94% 37.09% 49.56% ------------------------ ------------ ------------ ------------ ------------- ------------- </TABLE> The market price is based on the average of the five (5) lowest reported daily volume weighted average market prices of the common stock for the ten (10) days preceding the date of the draw down request. The purchase price reflects an 88% discount from the market price pursuant to the Purchase Agreement. This chart is for illustrative purposes only and the amount we will actually be able to draw down is subject to certain minimums, maximums and other conditions. We are under no obligation to draw down any amount under the Purchase Agreement. OUR COMMON STOCK IS A "PENNY STOCK" AND ITS LIQUIDITY MAY BE AFFECTED BY CERTAIN SEC REGULATIONS. Trading of our common stock is now being conducted over-the-counter through the NASD Electronic Bulletin Board and covered by Rule 15g-9 under the Securities Exchange Act of 1934. Under this rule, broker/dealers who recommend these securities to persons other than established customers and accredited investors must make a special written suitability determination for the purchaser and receive the purchaser's written agreement to a transaction prior to sale. Securities are exempt from this rule if the market price is at least $5.00 per share. The Securities and Exchange Commission adopted regulations that generally define a "penny stock" as any equity security that has a market price of less than $5.00 per share. Additionally, if the equity security is not registered or authorized on a national securities exchange or the Nasdaq and the issuer has net tangible assets under $2,000,000, the equity security also would constitute a "penny stock." Our common stock falls within the definition of penny stock. These regulations require the delivery, prior to any transaction involving our common stock, of a disclosure schedule explaining the penny stock market and the risks associated with it. Furthermore, the ability of broker/dealers to sell our common stock and the ability of stockholders to sell our common stock in the secondary market would be limited. As a result, the market liquidity for our common stock would be severely and adversely affected. We can provide no assurance that trading in our common stock will not be subject to these or other regulations in the future, which would negatively affect the market for our common stock. Forward-Looking Statements -------------------------- This prospectus contains statements about future events and expectations that constitute forward-looking statements. Forward-looking statements are based on management's beliefs, assumptions and expectations of our future economic performance, taking into account the information currently available to management. These statements are not statements of historical fact. Forward-looking statements involve risk and uncertainties that may cause our actual results, performance or financial condition to differ materially from the expectations of future results, performance or financial conditions we express or imply in any forward-looking statements. Factors that could contribute to these differences include those discussed in "Risk Factors" and in other sections of this prospectus. The words "believe," "may," "will," "should," "anticipate," "estimate," "expect," "intend," "objective," "seek," or similar words, or the negatives of these words, identify forward-looking statements. We qualify any forward-looking statements entirely by these cautionary factors.

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+RISK FACTORS You should carefully consider the following factors and other information contained in this prospectus before deciding to invest in our common stock. Government Contracts Present Risks of Termination for Convenience, Adjustment of Payments Received, Restrictions on Ability to Compete for Government Work and Funding Constraints In 2000, we derived approximately 63 percent of our total revenues from contracts with federal, state, local and foreign government agencies. In addition, we own equity interests in joint ventures with revenues attributable primarily or entirely to contracts with governmental clients. The following risks are inherent in government contracts: Because federal law and some state and foreign laws permit government agencies to terminate a contract for convenience, our government clients may terminate or decide not to renew our contracts with little or no prior notice. Federal government clients may audit contract payments we receive for several years after these payments are made. Based on these audits, the clients may adjust or demand repayment of payments we previously received. Audits have been completed on our federal contracts through December 31, 1997 and are continuing for subsequent periods. None of the audits performed to date on our federal contracts have resulted in any significant adjustments to our financial statements. We believe, on the basis of the information that we currently have about the ongoing audits, that they will not result in material adjustments to our financial statements. However, we cannot be sure that an audit in the future will not result in a material adjustment to our financial statements. Federal government contract regulations provide that any company convicted of a crime or indicted on a violation of statutes related to federal contracting may lose its right to receive future contract awards or extensions. Our ability to earn revenues from our existing and future government projects will depend upon the availability of funding from various federal, state, local and foreign government agencies. We cannot control whether those clients will fund or continue funding our outstanding projects. Our ability to secure new government contracts and our revenues from existing government contracts could be adversely affected by any one or a combination of the factors listed above. We Could Sustain Losses on Our Contracts If Our Costs Exceed the Fixed Price or the Not to Exceed Pricing Provisions Under fixed price contracts, we agree to deliver the project for a definite, predetermined price regardless of our actual costs incurred over the life of the project. Under time-and-materials contracts with not to exceed provisions, we are compensated for the labor hours expended at agreed-upon hourly rates plus cost of materials used; however, there is a stated maximum compensation for the services to be provided under the contract. Many fixed price and not to exceed contracts involve large industrial facilities and public infrastructure projects and present the risk that our costs to complete a project may exceed the fixed price or not to exceed price agreed upon with the client. The fixed or maximum fees negotiated for such projects may not cover our actual costs and desired profit margins. If our actual costs for a fixed or not to exceed price project are higher than we expect, our profit margins on the project will be reduced or we could suffer a loss. A Reduction in the Scope of Environmental Regulations or Changes in Government Policies Could Adversely Affect Our Revenues A substantial portion of our business is generated either directly or indirectly as a result of federal, state, local and foreign laws and regulations related to environmental matters. Changes in environmental regulations could affect our business more significantly than they would affect some other engineering firms. Accordingly, a reduction in the number or scope of these laws and regulations, or changes in government policies regarding the Amendment No. 2 on Form S-1 to Registration Statement on Form S-3 UNDER THE SECURITIES ACT OF 1933 Table of Contents funding, implementation or enforcement of such laws and regulations, could significantly reduce the size of one of our most important markets and limit our opportunities for growth or reduce our revenues below their current levels. In addition, any significant effort by government agencies to reduce the role of private contractors in regulatory programs, including environmental compliance projects, could have the same adverse effects. Our Environmental Remediation Work May Expose Us to Environmental Liability We could become subject to liabilities or fines as a result of our environmental remediation activities. The assessment, analysis, remediation, handling, management, and disposal of hazardous substances represent a significant portion of our business and involve significant risks, including the possibility of property damages, personal injuries, fines and penalties and other regulatory sanctions. Civil and criminal liabilities and liabilities to clients and third parties for environmental violations and damages can be very large. Although we have never been subject to any significant fines relating to environmental matters, it is possible that we could be subject to such fines or liabilities in the future. The fines and penalties could reduce our net income, cause a loss, or could adversely affect our ability to compete for new business. Unpredictable Economic Cycles and Uncertain Demand for Our Engineering Capabilities and Related Services Could Cause Our Revenues to Fluctuate Demand for our engineering and other services is affected by the general level of economic activity in the markets in which we operate, both in the United States and abroad. Our customers, particularly our private sector customers, and the markets in which we compete to provide services, are likely to experience periods of economic decline from time to time. Adverse economic conditions may decrease our customers willingness to make capital expenditures or otherwise reduce their spending to purchase our services, which could result in diminished revenues and margins for our business. In addition, adverse economic conditions could alter the overall mix of services that our customers seek to purchase, and increased competition during a period of economic decline could force us to accept contract terms that are less favorable to us than we might be able to negotiate under other circumstances. Changes in our mix of services or a less favorable contracting environment may cause our revenues and margins to decline. Our Projects May Result in Liability for Faulty Engineering Services Because our projects are often large and can affect many people, our failure to make judgments and recommendations in accordance with applicable professional standards could result in large damages and, perhaps, punitive damages. Our engineering practice involves professional judgments regarding the planning, design, development, construction, operation and management of industrial facilities and public infrastructure projects. Although we have adopted a range of insurance, risk management and risk avoidance programs designed to reduce potential liabilities, there can be no assurance that such programs will protect us fully from all risks and liabilities. Our Inability to Attract and Retain Professional Personnel Could Adversely Affect our Business Our ability to attract, retain and expand our staff of qualified engineers and technical professionals will be an important factor in determining our future success and growth. A shortage of qualified technical professionals currently exists in the engineering and design industry. The market for these professionals is competitive in the United States and internationally. We cannot assure you that we will continue to be successful in attracting and retaining such professionals. Since we derive a significant part of our revenues from services performed by our professional staff, our failure to retain and attract professional staff could adversely affect our business by impacting our ability to complete our projects and secure new contracts. Absence of a Public Market May Prevent You from Selling Your Stock and Cause You to Lose All or Part of Your Investment There is no public market for our common stock. While we intend the internal market to provide liquidity to shareholders, there can be no assurance that there will be enough orders to purchase shares to permit CH2M HILL Companies, Ltd. (Exact name of registrant as specified in its charter) Oregon 8711 93-0549963 (State or other jurisdiction of incorporation or organization) (Primary Standard Industrial Classification Code Number) (I.R.S. Employer Identification Number) 6060 South Willow Drive, Greenwood Village, CO 80111-5142 (303) 771-0900 (Address, including zip code, and telephone number, including area code, of registrant s principal executive offices) Table of Contents shareholders to resell their shares on the internal market, or that a regular trading market will develop or be sustained in the future. The price in effect on any trade date may not be attractive enough to both buyers and sellers to result in a balanced market because the price will be fixed in advance by the Board of Directors, using their judgment of the fair market value of the common stock, and not by actual market trading activity. Moreover, although CH2M HILL may enter the internal market as a buyer of common stock if there are more sell orders than buy orders, we have no obligation to engage in internal market transactions and will not guarantee market liquidity. Consequently, insufficient buyer demand could cause sell orders to be prorated, or could prevent the internal market from opening on any particular trade date. Insufficient buyer demand could cause shareholders to suffer a total loss of investment or substantial delay in their ability to sell their common stock. No assurance can be given that shareholders desiring to sell all or a portion of their shares of common stock will be able to do so. Accordingly, the investment in CH2M HILL common stock is suitable for you only if you have limited need for liquidity in your investment. Transfer Restrictions on the Common Stock Could Prevent You from Selling Your Stock and Cause You to Lose All or Part of Your Investment Since all of the shares of common stock will be subject to transfer restrictions, you will generally only be able to sell your stock through the internal market on the trade dates in each year. Unlike shares that are actively traded in the public markets, you may not be able to sell at a particular time even though you would like to do so. The stock price could decline between the time you want to sell and the time you become able to sell. The Offering Price Is Determined by the Board of Directors Judgment of Fair Market Value and Not by Market Trading Activity The offering price is, and subsequent offering prices at each trade date will be, established by the Board of Directors approximately 30 days before the trade date. In establishing the price, the Board will take into consideration the factors which are described in the section of this prospectus called Internal Market Information. However, since the Board of Directors will set the offering price in advance of the trade date, market trading activity on any given trade date can not affect the price on that trade date. This is a risk to you because our stock price will not change to reflect supply of and demand for shares on a given trade date as it would in a public market. You may not be able to sell shares or you may have to sell your shares at a price that is lower than the price that would prevail if the internal market price could change on a given trade date to reflect supply and demand. Our Board of Directors intends to use the common stock valuation methods that result in offering prices that represent fair market value. The valuation method for common stock is subject to change at the discretion of the Board of Directors. The Limited Market and Transfer Restrictions on the Common Stock Will Likely Have Anti-Takeover Effects Only CH2M HILL employees, directors, consultants and employee benefit plans may own CH2M HILL common stock and participate in the internal market. In addition, we have imposed significant restrictions on the transfer of our common stock other than through sales on the internal market. These limitations make it extremely difficult for a potential acquirer who does not have the prior consent of our Board of Directors to acquire control of our company, regardless of the price per share the acquirer were willing to pay and whether or not shareholders were willing to sell at that price. Actual Results May Differ From Results Discussed in Forward-Looking Statements This prospectus contains forward-looking statements that involve risks and uncertainties. Our actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such differences include, but are not limited to: the continuance of and funding for certain governmental regulation and enforcement programs which create demand for our services our ability to attract, finance and perform large, longer-term projects Samuel H. Iapalucci CH2M HILL Companies, Ltd. 6060 South Willow Drive Greenwood Village, CO 80111-5142 (303) 771-0900 (Name, address, including zip code, and telephone number, including area code, of agent for service) Retirement and Tax-Deferred Savings Plan (401(k) Plan) 1999 Stock Option Plan Payroll Deduction Stock Purchase Plan Pre-Tax and After-Tax Deferred Compensation Plans Deferred Compensation Plan (DCP) Internal Market Program CH2M Hill has established the internal market for its common stock as a benefit to CH2M HILL employees, whom may purchase or sell common stock directly on the internal market or through separate employee benefit plans. This offering of common stock is not intended primarily to raise capital for CH2M HILL. CH2M HILL will offer common stock to its employees through bonuses, various employee benefit plans and, at CH2M HILL s discretion, in case of an over-subscribed market, as described in the section called Internal Market Information. Officers and directors may sell up to an aggregate of 1,502,524 shares of common stock through the internal market. Other employees of CH2M HILL may sell up to an aggregate of 16,026,059 shares of common stock on the internal market. We do not know whether these officers and other employees will offer or sell some, none or all of such shares. The shares offered by officers and other employees may include shares they hold directly and also shares they hold indirectly through the employee benefit plans. The officers and directors will not be treated more favorably than other shareholders participating on the internal market. Pursuant to our Restated Bylaws, all shares of common stock are subject to CH2M HILL s repurchase right, right of first refusal, and other restrictions on transferability. INTERNAL MARKET INFORMATION This section contains a summary of the material provisions of our internal market. For additional information, we encourage you to read the internal market rules, which are included as an exhibit to our registration statement filed in 1999 with the Securities and Exchange Commission. Information about the internal market is also available on the internal Employee Ownership Web site at https://webapps.ch2m.com/oicp. The internal market permits shareholders, certain employees, directors, consultants and the benefit plans to buy and sell shares of common stock up to four times each year on predetermined trade dates. 1 20% 0% 2 40% 20% 3 60% 40% 4 80% 60% 5 100% 80% Copy to: Mashenka Lundberg, Esq. Holme Roberts Owen LLP 1700 Lincoln Street, Suite 4100 Denver, CO 80203 (303) 861-7000 Employees, directors and consultants of CH2M HILL Trustees of the benefit plans Administrator of the Payroll Deduction Stock Purchase Plan CH2M HILL may impose limitations on the number of shares that an individual may purchase when there are more buy orders than sell orders for a particular trade date. After the Board of Directors determines the stock price for use on the next trade date, which is approximately 30 days prior to such trade date, we will advise all shareholders, employees, directors, and eligible consultants as to the new stock price and the next trade date. Broker. Our internal market is managed through an independent broker, currently Buck Investment Services, Inc., which acts upon instructions from the buyers and sellers. Buck Investment Services, Inc. is not affiliated with CH2M HILL. Individual stock ownership account records are maintained by the broker. CH2M HILL May Purchase Shares if Market is Under-Subscribed. CH2M HILL may, but is not obligated to, purchase shares of common stock on the internal market on any trade date at the price in effect on that trade date, but only to the extent that the number of shares offered for sale by shareholders exceeds the number of shares sought to be purchased by authorized buyers. The decision as to whether or not CH2M HILL will purchase shares in the internal market if the internal market is under-subscribed is solely within CH2M HILL s discretion and CH2M HILL will not notify investors whether or not it will participate prior to the trade date. Investors should understand that there can be no assurance that they will be able to sell their CH2M HILL stock without substantial delay or that their stock will be able to be sold at all on the internal market. CH2M HILL will consider a variety of factors including CH2M HILL s cash position, financial performance and number of shares outstanding in making the determination of whether to participate in an under-subscribed market. The terms of CH2M HILL s revolving line of credit do not play a role in the decision whether to buy or sell shares in the internal market. To date, no other factors have been considered by CH2M HILL in its decisions as to whether or not to participate in the under-subscribed market. If the aggregate number of shares offered for sale on the internal market on any trade date is greater than the number of shares sought to be purchased, shareholder offers to sell will be accepted as follows: If enough orders to buy are received to purchase all the shares offered by each seller selling fewer than 500 shares and at least 500 shares from each other seller, then all sell orders will be accepted up to the first 500 shares and the portion of any sell orders exceeding 500 shares will be accepted on a pro-rata basis. If not enough orders to buy are received to purchase all the shares offered by each seller selling fewer than 500 shares and at least 500 shares from each other seller, then the purchase orders will be allocated equally to each seller. CH2M HILL May Sell Shares if Market is Over-Subscribed. To the extent that the aggregate number of shares sought to be purchased exceeds the aggregate number of shares offered for sale, CH2M HILL may, but is not obligated to, sell authorized but unissued shares of common stock on the internal market at the price in effect on that trade date to satisfy purchase demands. The decision as to whether or not CH2M HILL will sell shares in the internal market if the internal market is over-subscribed is solely within CH2M HILL s discretion and CH2M HILL will not notify investors whether or not it will participate prior to the trade date. Investors should understand that there can be no assurance that they will be able to buy as many shares as they would like on a given trade date. CH2M HILL will consider a variety of factors including CH2M HILL s cash position, financial performance and number of shares outstanding in making the determination of whether to participate in an over-subscribed market. The terms of CH2M HILL s revolving line of credit do not play a role in the Approximate date of commencement of proposed sale to the public: August 9, 2001 or as soon as practicable after this Registration Statement becomes effective and from time to time thereafter. If any of the securities being registered on this form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, check the following box. If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, please check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering: If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. If delivery of the prospectus is expected to be made pursuant to Rule 434, please check the following box: The Registrant hereby amends this Registration Statement on such date or dates as may be necessary to delay its effective date until the Registrant shall file a further amendment which specifically states that this Registration Statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933 or until this Registration Statement shall become effective on such date as the Commission, acting pursuant to said Section 8(a), may determine. Table of Contents decision whether to buy or sell shares in the internal market. To date, no other factors have been considered by CH2M HILL in its decisions as to whether or not to participate in the over-subscribed market. If the aggregate purchase orders exceed the number of shares available for sale, the following prospective purchasers will have priority to purchase shares, in the order listed: Administrator of the Payroll Deduction Stock Purchase Plan Trustees of the 401(k) Plan Individual employees, directors and consultants on a pro-rata basis which includes participants purchasing through the pre-tax and after-tax deferred compensation plans Sellers Pay Sales Commission. All sellers on the internal market, other than CH2M HILL and the trustees of the 401(k) Plan, will pay the broker, currently Buck Investment Services, Inc., a commission equal to two percent of the proceeds from such sales. Employees who sell their common stock upon retirement from CH2M HILL will have the option to sell the common stock they own on the internal market and pay a commission on the sale or to sell to CH2M HILL without paying a commission. In the case of the latter, the employee will sell their common stock to CH2M HILL at the price in effect on the date of their termination in exchange for a four-year note at a market interest rate determined bi-annually. No commission is paid by buyers on the internal market. Stock Price Determined by Board of Directors. The Board of Directors will determine the price, which is intended to be the fair market value, of the shares of common stock to be used for buys and sells on each trade date pursuant to the valuation methodology described below. The price per share of common stock generally is set as follows: Share Price = [(7.8 M P) + (SE)] / CS In order to determine the fair market value of the stock in the absence of a public trading market, the Board of Directors felt it appropriate to develop a formula to use as a tool to determine a price that would be a valid approximation of the fair market value. In determining the fair market value stock price, the Board believes that the use of a going concern component (i.e., net income, which we call profit after tax, as adjusted by the market factor) and a book value component (i.e., total shareholders equity) is important. The Board of Directors believes that the process CH2M HILL has developed reflects modern equity valuation techniques and is based on those factors that are generally used in the valuation of equity securities. Market Factor ( M ). M is the market factor, which is subjectively determined in the sole discretion of the Board of Directors. In determining the market factor, the Board of Directors will take into account factors the directors consider to be relevant in determining the fair market value of the common stock, including: the market for publicly traded equity securities of companies comparable to CH2M HILL the merger and acquisition market for companies comparable to CH2M HILL the prospects for CH2M HILL s future performance general economic conditions general capital market conditions other factors the Board of Directors deems appropriate. As part of the total mix of information that the Board considers in determining the M factor, the Board also may take into account company appraisal information prepared by The Environmental Financial Consulting Group, Inc. ( EFCG ), an independent appraiser engaged by the trustees of CH2M HILL s benefit plans. In setting the stock price, the Board compares the sum total of the going concern and book value components used in the valuation methodology to the company enterprise appraisal provided by EFCG. If, after such comparison, the Board concludes that its initial determination of the M factor should be re-examined, the Board may review, and if appropriate adjust, the M factor. Since the inception of the program in January 2000 the sum PURSUANT TO RULE 429 UNDER THE SECURITIES ACT OF 1933, THE PROSPECTUS CONTAINED HEREIN WILL BE USED IN CONNECTION WITH THE SECURITIES COVERED BY THIS REGISTRATION STATEMENT AND REGISTRATION STATEMENT NOS. 333-74427, 333-36822 AND 333-56370. Table of Contents total of the going concern and book value components used by the Board in setting the price for CH2M HILL stock has always been within the company appraisal range developed by EFCG. The existence of an over-subscribed or under-subscribed market on any given trade date will not affect the stock price on that trade date. However, the Board of Directors, when determining the stock price for a future trade date, may take into account the fact that there have been under-subscribed or over-subscribed markets on prior trade dates. The Board has not assigned predetermined weights to the various factors it may consider in determining the market factor. A market factor greater than 1.0 would increase the price per share and a market factor less than 1.0 would decrease the price per share. In its discretion, the Board of Directors may change, from time to time, the market factor used in the valuation process. The Board of Directors could change the market factor, for example, following a change in general market conditions that either increased or decreased stock market equity values for companies comparable to CH2M HILL, if the Board of Directors felt that the market change were applicable to CH2M HILL s common stock as well. The Board of Directors will not make any other changes in the method of determining the price per share of common stock unless in the good faith exercise of its fiduciary duties and, if appropriate, after consultation with its professional advisors, the Board of Directors determines that the method for determining the price per share of common stock no longer results in a stock price that reasonably reflects the fair market value of CH2M HILL on a per share basis. Since the inception of the program on January 1, 2000, the M factor has not deviated from 1.0. In deciding that the M factor should remain unchanged during the last 18 months, the Board has considered CH2M HILL s performance (which has been very favorable as evidenced by 90% increase in profit after tax during this period), the performance of the engineering and construction industry as a whole and CH2M HILL s perception of its future prospects. CH2M HILL s Board believes that its industry, on the average, has out-performed the market over the last 18 months. We believe that one reason for the favorable performance of this industry segment is that the revenues and earnings of the engineering and construction industry have faired better in the recent economic slowdown than those of many other industries, especially industries connected with technology and the Internet. There can be no assurance that this industry or CH2M HILL will continue to have such favorable results in the future. Profit After Tax ( P ). P is profit after tax, otherwise referred to as net income, for the four fiscal quarters immediately preceding the trade date. Nonrecurring or unusual transactions could be excluded from the P calculation at the discretion of the Board of Directors. Nonrecurring or unusual transactions are unforeseen developments that the market would not generally take into account in valuing an equity security. A change in accounting rules, for example, could increase or decrease net income without changing the fair market value of the common stock. Similarly, such a change could fail to have an immediate impact on the value of the common stock, but still have an impact on the value of the common stock over time. As a result, the Board of Directors feels that in order to determine the fair market value of the common stock, it needs the ability to review unusual events that affect net income. Total Shareholder s Equity ( SE ). SE is total shareholders equity, which includes intangible items, as set forth on CH2M HILL s most recently available quarterly or annual financial statements. Nonrecurring or unusual transactions could be excluded from the calculation at the discretion of the Board of Directors. Common Stock Outstanding ( CS ). CS is the weighted average number of shares of common stock outstanding during the four fiscal quarters immediately preceding the trade date, calculated on a fully diluted basis. By fully diluted we mean that the calculations are made as if all outstanding options to purchase common stock had been exercised and other dilutive securities were converted into shares of common stock. In addition, an estimate of the number of shares that CH2M HILL reasonably anticipates will be issued in the next twelve months under CH2M HILL s stock based compensation programs and employee benefit plans is included in this calculation. The CS calculation is done on a fully-diluted basis since CH2M HILL believes that taking into account the issuance of all securities which will affect the per share value is a better representation of the share value February 18, 2000 32,066 29,737 May 11, 2000 32,625 30,200 August 4, 2000 32,968 30,023 November 10, 2000 32,974 30,022 February 16, 2001 33,354 30,033 May 10, 2001 33,666 30,601 Constant 7.8. In the course of developing this valuation methodology, it became apparent to the Board that a multiple would be required in order for the stock price derived by this methodology to approximate CH2M HILL s historical, pre-internal market stock price. Another objective of the Board when developing the valuation methodology was to establish the fair market value of CH2M HILL common stock using a market factor of 1.0. CH2M HILL believes that it was important to begin the internal market program with an M factor equal to 1.0 in order to make it easier for shareholders to understand future changes, if any, to the market factor. Therefore, the constant 7.8 was introduced into the formula. The constant 7.8 is the multiple that the Board determined is necessary (i) for the new stock price to approximate CH2M HILL s historical stock price derived using the pre-internal market formula as well as (ii) to allow the use of the market factor of 1.0 at the beginning of the internal market program. Under the new valuation methodology, and as demonstrated by the following calculation, the price per share of common stock would have been $4.30 per share based on a market factor of 1.0 as of January 1, 1999. At that time, cumulative profit after tax (P) was $5,812,000, total shareholders equity was $75,132,000 and the weighted average number of shares of common stock outstanding during the immediately preceding four fiscal quarters was 28,025,490. [(7.8 x 1.0 x $5,812,000) + ($75,132,000) _________________________________________________________________ = $4.30 28,025,490 Under the old valuation formula, the price for the common stock for 1999 was $4.31, as determined by our Board of Directors based on 1998 year-end financial results. The stock price is reviewed by the Board of Directors up to four times each year. This review is made in conjunction with Board of Directors meetings, currently scheduled for February, May, August and November. The Board of Directors believes that the process described above will result in a stock price that will reasonably reflect the fair market value of CH2M HILL on a per share basis. February 18, 2000 1.0 $ 13,626 $ 97,092 32,066 $ 6.34 May 11, 2000 1.0 16,932 98,233 32,625 7.06 11.4 % August 4, 2000 1.0 18,286 109,290 32,968 7.64 8.2 % November 10, 2000 1.0 20,113 120,090 32,974 8.40 9.9 % February 16, 2001 1.0 24,532 133,992 33,354 9.75 16.1 % May 10, 2001 1.0 25,442 141,692 33,666 10.10 3.6 % Table of Contents Information in this prospectus is not complete and will be amended and completed. A registration statement relating to the common stock has been filed with the Securities and Exchange Commission and neither we nor the selling shareholders may sell such securities until the registration statement becomes effective. The prospectus is not an offer to sell these securities and it is not soliciting an offer to buy these securities in any jurisdiction where the offer or sale is not permitted. Subject to completion, dated August 3, 2001 PROSPECTUS 33,228,583 Shares of Common Stock Table of Contents Since the inception of the internal market program on January 1, 2000, CH2M HILL has enjoyed very favorable financial performance. During that time, CH2M HILL has reported significant revenue growth a 44.1% increase in 2000 as compared to 1999 and a 32.1% increase in the first quarter of 2001 compared to the same period of 2000. CH2M HILL has also experienced positive growth in other key financial metrics during 2000. Net income, which CH2M HILL calls profit after tax, was up 80%, and net worth, which CH2M HILL calls total shareholders equity, was up 38%, all as compared to 1999. In the first quarter of 2001, net income was up $0.9 million, or 18% compared to the same period of 2000 and net worth as of March 31, 2001 compared to December 31, 2000 was up $7.7 million or 6%. See SELECTED FINANCIAL DATA on page 13 of this prospectus. This strong financial performance has been the basis for CH2M HILL s appreciating stock price over the last 18 months. However, past performance is not indicative of future results and there can be no assurance that CH2M HILL s strong financial performance will continue or that its stock price will continue to increase. CH2M HILL Companies, Ltd. and its shareholders are offering up to 33,228,583 shares of common stock, including: Up to 1,000,000 shares that CH2M HILL may offer through its internal market Up to 14,700,000 shares that CH2M HILL may offer to its employees through its employee benefit plans or that our employee benefit plans may offer through the internal market Up to 1,502,524 shares that officers and directors may offer through the internal market Up to 16,026,059 shares that other shareholders may offer through the internal market This offering of common stock is designed to allow trading of the common stock among CH2M HILL employees, directors, consultants and employee benefit plans up to four times each year on CH2M HILL s internal market. No exchange lists the common stock. For more details on how the internal market functions, see Internal Market Information beginning on page 6. All of the shares being offered for sale by this prospectus will be sold through the internal market at the price set by the Board of Directors from time to time. On , the Board of Directors established the price for the common stock at $ per share. Table of Contents USE OF PROCEEDS The shares of common stock which may be offered by CH2M HILL are principally being offered to permit the acquisition of shares by the employee benefit plans as described herein and to permit CH2M HILL to offer shares of common stock on the internal market, at CH2M HILL s discretion, because there are more buy orders than sell orders on a trade date. We do not intend or expect this offering to raise significant capital. Any net proceeds received by CH2M HILL from the sale of the common stock offered, after paying expenses of the offering, will be added to our general funds and used for working capital and general corporate purposes. It is anticipated that the majority of the sales of common stock on the internal market will be made by shareholders and the employee benefit plans. All shareholders selling common stock through the internal market, other than CH2M HILL and the trustees of the 401(k) Plan, will pay a commission equal to 2 percent of the proceeds of the sale. The commission will be used by the broker to defray the costs of establishing and maintaining the internal market. DIVIDEND POLICY We do not currently anticipate paying any cash dividends on the common stock and intend to retain any future earnings to finance the growth and development of our business. Investing in the common stock involves risks. See Risk Factors beginning on page 3. (dollars in thousands except per share data) (unaudited) (unaudited) Statement of Operations Data: Revenues $ 491,726 $ 372,221 $ 1,706,738 $ 1,184,528 $ 935,030 $ 917,578 $ 937,198 Operating income 10,048 10,140 47,138 25,987 14,802 13,946 13,444 Net income 6,096 5,185 24,531 13,626 5,812 4,716 4,709 Net income per common share Basic 0.21 0.18 0.83 0.46 0.21 0.17 0.17 Diluted 0.20 0.17 0.82 0.46 0.21 0.17 0.17 Balance Sheet Data: Total assets 503,911 326,167 515,415 360,229 298,325 311,117 309,364 Long-term debt including current maturities 13,637 36,197 14,467 21,296 27,388 34,414 39,987 Total shareholders equity 141,692 79,195 133,992 97,092 75,132 62,303 58,130 Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense. Table of Contents BUSINESS Overview CH2M HILL is an engineering and project delivery firm founded in 1946. We provide engineering, consulting, design, construction, procurement, operations and maintenance, and program and project management services to clients in the private and public sector in the United States and abroad. We are an employee-owned Oregon corporation with approximately 11,000 employees working in 87 offices throughout the United States and 32 offices abroad. Business Strategy Our business strategy is to grow domestically and internationally through increasing market share in each of our operating segments. The key elements of this strategy are: Increasing the number and the dollar value of our contracts Expanding and diversifying our client base by attracting new private and public sector clients and developing a diversified mix of projects Increasing the number of large, longer-term projects with the potential for higher profit margins Allowing ownership in our common stock across a greater proportion of our workforce Operating Segments We provide services to our clients through three operating segments: Environmental, Energy and Infrastructure Water Industrial Environmental, Energy and Infrastructure Our Environmental, Energy and Infrastructure ( EE I ) operating segment consists of two businesses: Environmental, Nuclear, Energy Systems ( ENE S ) and Transportation. These two businesses are described below. EE I s business strategy is to grow by increasing market share in each of its two businesses, expanding its client base and obtaining large, longer-term projects with the potential for higher profit margins. While maintaining its focus on its traditional services, EE I is expanding its expertise into related industries such as telecommunications, and into related business concepts such as sustainable development. Sustainable development is a design approach used, for example, in power plant design. Sustainable development addresses environmental issues throughout the life of a project, from design and construction to decommissioning. Sustainable development seeks to minimize total environmental impact of a project. ENE S. ENE S provides integrated environmental and waste management consulting and engineering services, and performs design and build, remediation, construction and implementation of infrastructure and telecommunications systems for a variety of public and private clients. 1. Environmental. Our Environmental group provides environmental consulting for remedial construction projects, ecological and natural resource damage assessments, strategic environmental management and permitting services, environmental liability management services, site investigations, remedial design, implementation and construction services, treatment systems for hazardous, toxic and radioactive waste contaminated Table of Contents properties, and sustainable development planning, design and construction services. Representative Environmental projects include: Environmental consulting, engineering and remedial activities for the U.S. Air Force Center for Environmental Excellence Remediation of contaminated sites on Naval and Marine Corps installations in 26 domestic states and several foreign countries Program management and remedial design of a refinery for a large oil company Environmental impact studies for a number of proposed industrial projects and municipal programs on behalf of the Beijing city government in China 2. Nuclear. Our Nuclear group provides program management, integration, engineering, construction and operations and maintenance services for the U.S. Department of Energy and commercial nuclear power plants. We manage decommissioning and closure of weapons production facilities and design nuclear waste treatment and handling facilities in the United States, Western, Central and Eastern Europe and the former Soviet Union. Representative Nuclear projects include: Management and integration of decontamination, decommissioning, and closure of the nuclear weapons production facility at Rocky Flats in Golden, Colorado, on behalf of the U.S. Department of Energy Engineering, design and technical services to support decontamination, decommissioning and remedial activities at the U.S. Department of Energy s Hanford River Protection project in Richland, Washington Decontamination and decommission planning and engineering for a university research center in Atlanta, Georgia 3. Energy. Our Energy group provides full lifecycle energy services for power projects around the world. The Energy group s services range from design to decommissioning, including consulting, engineering, design, construction, operations and maintenance services. Representative Energy projects include: Expert consulting on utility deregulation Consulting and design for photovoltaic manufacturing process The design and construction of energy efficiency upgrades Development of generation services in renewable energy Carbon and other greenhouse gasses management projects 4. Systems. For the communications industry, our Systems group provides program management, planning, design, and construction management of local and regional fiber optic and hybrid fiber/ coaxial systems for voice, video and data communications. In other markets, our Systems group develops and implements environmental management information systems, total energy management and information technology systems and industrial process design/ build. It provides military base operation services for government agencies, and other outsourcing services for industrial and government clients. Representative Systems projects include: Program management, design and construction management of voice, video and data networks for a large telecommunications company in Europe Design, construction and installation of an industrial process system for metal plating facility Program management for the upgrade of a hybrid fiber/coaxial network for voice, video and high-speed data services in several U.S. cities TABLE OF CONTENTS PROSPECTUS SUMMARY RISK FACTORS

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+RISK FACTORS The shares of our common stock offered by this prospectus are speculative and involve a high degree of risk of loss. Before making an investment, you should carefully read this entire prospectus and consider the following risks and speculative factors: RISKS RELATED TO OUR COMPANY IF WE DO NOT DEVELOP AND INTRODUCE NEW PRODUCTS IN A TIMELY MANNER, WE MAY NOT BE ABLE TO MEET THE NEEDS OF OUR CUSTOMERS AND OUR NET SALES MAY DECLINE. Our success depends upon our ability to develop and introduce new sensor products, sensor-based consumer products, and product line extensions. If we are unable to develop or acquire new products in a timely manner, our net sales will suffer. The development of our new products involves highly complex processes, and at times we have experienced delays in the introduction of new products. Since many of our sensor products are designed for specific applications, we must frequently develop new products jointly with our customers. We are dependent on the ability of our customers to successfully develop, manufacture, and market products that include our sensors. Successful product development and introduction of new products depends on a number of factors, including the following: o accurate product specification; o timely completion of design; o achievement of manufacturing yields; o timely and cost-effective production; and o effective marketing. WE HAVE SUBSTANTIAL NET SALES AND OPERATIONS OUTSIDE OF THE UNITED STATES, INCLUDING SIGNIFICANT OPERATIONS IN CHINA, THAT EXPOSE US TO INTERNATIONAL RISKS. Our international operations accounted for approximately 35.1% of our net sales in the fiscal year ended March 31, 2001 and 28.4% of our net sales in the fiscal year ended March, 31, 2000. At March 31, 2001, we had total liabilities of approximately $4.4 million in Hong Kong, which represented approximately 7.2% of our total liabilities, total assets of approximately $12.6 million in China, which represented approximately 14.6% of our total assets, and total assets of $8.4 million in the United Kingdom, which represented approximately 9.7% of our total assets. We anticipate that international operations will continue to account for a significant percentage of our net sales. We manufacture or source nearly all of our sensor-based consumer products and the majority of our sensors in China. Our China subsidiary is subject to certain government regulations, including currency exchange controls, which limit the subsidiary's ability to pay cash dividends or lend funds to us. Pursuant to current Chinese tax policies, our China operations qualify for a special state corporate tax rate of 15.0%, or 10.0% provided that we export a minimum of 70% of production. Because our China subsidiary has agreed to operate in China for a minimum of ten years, it has been taxed at a reduced rate, most recently 7.5%. This tax rate reduction lapsed on March 31, 2001. Expiration of this tax benefit, and any increase in effective tax rates, will reduce our profitability. During the recent months, political relations between the United States and China have become increasingly strained. If these relations further deteriorate, it may be more difficult for United States companies to transact business in China. As a result, we may be unable to continue operating in China or may be subject to the imposition of new regulations, restrictions, taxes, or tariffs affecting our operations in China. The inability to operate in China or the imposition of significant restrictions, taxes, or tariffs on our operations in China would impair our ability to manufacture products in a cost-effective manner and could signifcantly reduce our profitability. Risks specific to our international operations include: o political conflict and instability in the relationships among Hong Kong, Taiwan, China, and the United States, and in our target international markets; o political instability and economic turbulence in Asian markets; o changes in United States and foreign regulatory requirements resulting in burdensome controls, tariffs, and import and export restrictions; o difficulties in staffing and managing international operations; o changes in foreign currency exchange rates, which could make our products more expensive as stated in local currency, as compared to competitive products priced in the local currency; o enforceability of contracts and other rights or collectability of accounts receivable in foreign countries due to distance and different legal systems; and o delays or cancellation of production and delivery of our products due to the logistics of international shipping, which could damage our relationships with our customers. COMPETITION IN THE MARKETS WE SERVE IS INTENSE AND COULD REDUCE OUR NET SALES AND HARM OUR BUSINESS. Both our Sensor business and Consumer Products business are characterized by highly fragmented markets and high levels of competition. Competitors in our Consumer Products business include some customers for whom we manufacture products. We cannot assure you that our original equipment manufacturer customers, who are also competitors, will not develop their own production capability or locate alternative sources of supply, and discontinue purchasing products from us. Some of our competitors and potential competitors may have a number of significant advantages over us, including: o greater financial, technical, marketing, and manufacturing resources; o preferred vendor status with our existing and potential customer base; o more extensive distribution channels and a broader geographic scope; o larger customer bases; and o a faster response time to new or emerging technologies and changes in customer requirements. A SUBSTANTIAL PORTION OF OUR NET SALES IS GENERATED BY A SMALL NUMBER OF LARGE CUSTOMERS. IF ANY OF THESE CUSTOMERS REDUCES OR POSTPONES ORDERS, OUR NET SALES AND EARNINGS WILL SUFFER. Historically, a relatively small number of customers have accounted for a significant portion of our net sales. For the fiscal year ended March 31, 2001, the five largest customers of our Consumer Products business represented 55.6% of net sales for that business and 29.2% of net sales, and the five largest customers of our Sensor business represented 16.3% of net sales for that business and 7.8% of net sales. Because we have no long-term volume purchase commitments from any of our significant customers, we cannot be certain that our current order volume can be sustained or increased. Based upon recent acquisitions, customer concentration in our Sensor business may increase. The loss of or decrease in orders from any major customer could significantly reduce our net sales and profitability. ONE OF OUR LARGEST CONSUMER PRODUCTS CUSTOMERS, SUNBEAM, HAS FILED FOR BANKRUPTCY PROTECTION. THE LOSS OF OR DECREASE IN ORDERS FROM THIS CUSTOMER COULD SIGNIFICANTLY REDUCE OUR NET SALES AND PROFITABILITY. Recently, Sunbeam, one of the largest customers of our Consumer Products business, filed for bankruptcy protection. Sales to Sunbeam represented 13.0% of net sales for the Consumer Products business and less than 10% of net sales for the fiscal year ended March 31, 2001, and 27.1% of net sales for the Consumer Products business and 19.9% of net sales for the fiscal year ended March 31, 2000. We cannot assure you that Sunbeam will continue to purchase at the same levels as in the past, or at all. ONE OF OUR LARGEST CONSUMER PRODUCTS CUSTOMERS, KORONA, HAS BEEN ACQUIRED BY BONSO ELECTRONICS INTERNATIONAL, INC., ONE OF OUR COMPETITORS. THE LOSS OF OR DECREASE IN ORDERS FROM THIS CUSTOMER COULD SIGNIFICANTLY REDUCE OUR NET SALES AND PROFITABILITY. Recently, Korona, one of the largest customers of our Consumer Products business, was acquired by Bonso Electronics International, Inc., a competitor of ours. Sales to Korona accounted for 14.0% of net sales for the Consumer Products business and less than 10% of net sales for the fiscal year ended March 31, 2001, and accounted for 18.8% of net sales for the Consumer Products business and 13.9% of net sales for the fiscal year ended March 31, 2000. We cannot assure you that Korona will continue to purchase at the same levels as in the past, or at all. WE DEPEND ON A LIMITED NUMBER OF SUPPLIERS TO DELIVER KEY COMPONENTS AND FINISHED PRODUCTS WHICH MAY AFFECT OUR ABILITY TO MEET THE NEEDS OF OUR CUSTOMERS, RESULTING IN THE LOSS OF SALES AND CUSTOMERS. We rely on contract manufacturers for a significant portion of our consumer finished products. Our principal supplier is located in China and assembles the majority of our consumer products, using proprietary subassemblies provided by us and other components purchased from third parties. We procure components and finished products as needed, through purchase orders. We do not have a guaranteed level of production capacity or any long-term contracts with any of our suppliers, who could choose to allocate production capacity toward their other customers. If delivery delays or supply shortages of certain key components develop, we may experience an interruption in production or we may be forced to adjust our product designs and production schedules until we locate alternative sources of supply. If we lose one or more of our sources of supply and/or assembly, and we are not able to replace that source in a timely manner, we may be unable to meet the needs of our customers, resulting in a loss of net sales and jeopardizing our customer relationships. WE INVEST HEAVILY IN RESEARCH AND DEVELOPMENT EFFORTS AND OUR CONTINUED GROWTH DEPENDS UPON THE SUCCESS OF THESE EFFORTS. We have spent, and expect to continue to spend, a significant amount of time and resources developing new products, refining existing products, and expanding product lines. Our ability to compete successfully in a rapidly changing marketplace is largely dependent on the success of these efforts. In light of the long product development cycles inherent in our industry, expenditures for research and development will be made well in advance of the prospect of deriving revenue from the sale of new products. Our ability to introduce and market new products successfully is subject to a wide variety of challenges during this development cycle, such as design defects that could delay introduction of new products. In addition, since our customers are not obligated by long-term contracts to purchase our products, our anticipated product orders may not materialize, or orders that do materialize may be cancelled. As a result, if we do not achieve market acceptance of new products, we may not be able to realize sufficient sales needed to recoup our research and development expenditures. If too many of our development projects do not lead to successful products, our business will suffer. OUR EXCLUSIVE ARRANGEMENTS WITH SOME CUSTOMERS MAY RESTRICT OUR ABILITY TO PURSUE MARKET OPPORTUNITIES AND MAY RESULT IN LOSS OF NET SALES. We have granted some of our customers exclusivity on specific products, which precludes us from selling those products to other potential customers. We expect that in some cases our existing customers and new customers may require us to give them exclusivity on certain products, which may force us to forego opportunities to supply these products to other prospective customers. In addition, if we enter into exclusive relationships with customers who are unsuccessful, our net sales will be negatively affected. WE DEPEND ON SALES REPRESENTATIVES FOR A SIGNIFICANT PORTION OF OUR NET SALES. ANY LOSS OF SALES REPRESENTATIVES MAY REDUCE OUR NET SALES. A significant portion of our net sales were made through independent, third party sales representatives. We generally do not have long-term arrangements with these sales representatives. While there are restrictions on the ability of some of our sales representatives to sell competing products during the period that they sell our products, we cannot assure you that a sales representative would not stop selling our products and begin selling those of a competitor. The loss of one or more significant sales representatives without successfully replacing them would reduce our net sales and damage our customer relationships. OUR ABILITY TO SUCCESSFULLY IDENTIFY AND INTEGRATE ACQUISITIONS MAY AFFECT PROFITABILITY. Part of our continuing business strategy is to acquire companies, products, and technologies that complement our current products, enhance our market coverage, technical capabilities or production capacity, or offer other growth opportunities. Our ability to successfully complete acquisitions, including our proposed acquisition of Terraillon (see "Recent Developments"), requires that we identify suitable target companies, agree on acceptable terms, and obtain acquisition financing on acceptable terms. In connection with these acquisitions, we could incur debt, amortization expenses relating to goodwill, or merger related charges, or could issue stock that would dilute our current shareholders' percentage of ownership. If we are unable to make acquisitions on acceptable terms, our future rate of growth may be limited. The success of any acquisitions will depend upon our ability to integrate acquired operations, retain and motivate acquired personnel, and increase the customer base of the combined businesses. We cannot assure you that we will be able to accomplish all of these goals. Any future acquisitions would involve certain additional risks, including: o difficulty integrating the purchased operations, technologies, or products; o unanticipated costs; o diversion of management's attention from our core business; o entrance into markets in which we have limited or no prior experience; and o potential loss of key employees, particularly those of the acquired business. OUR ABILITY TO MANAGE GROWTH WILL AFFECT OUR PROFITABILITY AND RESULTS OF OPERATIONS. We have been experiencing a period of growth and expansion, especially due to our recent acquisitions. This growth and expansion is placing significant demands on our management, manufacturing facilities, engineering resources, and operating systems. In addition, to support possible future growth, we will need to continue to attract and retain additional management, research and development, and manufacturing personnel. To manage our growth, we may also need to spend significant amounts of cash to meet working capital requirements and respond to unanticipated developments or competitive pressures. If we do not have enough cash generated from our operations or available under our credit facilities to meet these cash requirements, we will need to seek alternative sources of financing to sustain our growth and operating strategies. We may not be able to raise needed cash on terms acceptable to us, or at all. Financing may be on terms that are potentially dilutive to our shareholders. If alternative sources of financing are required but are insufficient or unavailable, we will be required to modify our growth and operating plans. IF WE ARE NOT ABLE TO INCREASE OUR MANUFACTURING CAPACITY, WE MAY NOT BE ABLE TO MEET THE DEMANDS OF OUR CUSTOMERS, WHICH COULD RESULT IN THE LOSS OF SALES AND OUR CUSTOMER BASE. Our long-term competitive position will depend to a significant extent on our ability to increase our manufacturing capacity. We will need to invest in additional plant and equipment to expand capacity in our current facilities or obtain additional capacity through acquisitions. Either of these alternatives will require substantial additional capital, which we may not be able to obtain on favorable terms, or at all. Further, we may not be able to acquire sufficient capacity or successfully integrate and manage additional facilities. The failure to obtain capacity when needed or to successfully integrate and manage additional manufacturing facilities could adversely impact our relationships with our customers and materially harm our business and results of operations. OUR EXECUTIVE OFFICERS AND OTHER KEY PERSONNEL ARE CRITICAL TO OUR BUSINESS AND OUR FUTURE SUCCESS DEPENDS ON OUR ABILITY TO RETAIN THEM. Our success will depend to a significant extent on the continued service of our executive officers and other key employees, including key sales, technical, and marketing personnel. If we lose the services of one or more of our executives or key employees, our business and ability to implement our business objectives successfully could be harmed, particularly if one or more of our executives or key employees decided to join a competitor or otherwise compete directly or indirectly with us. We do not have key person life insurance on, or non-compete agreements with, any of our executives. FOREIGN EXCHANGE FLUCTUATIONS COULD LOWER OUR RESULTS OF OPERATIONS. The majority of our net sales are priced in United States dollars. Our costs and expenses are priced in United States dollars, Chinese renminbi, Hong Kong dollars, and British pounds. A strengthening in the United States dollar relative to the currencies of those countries where we do business would increase the prices of our products as stated in those currencies and hurt our sales in those countries. If we lower our prices to reflect a change in exchange rates, our profitability in those markets will decrease. We have not historically tried to reduce our exposure to exchange rate fluctuations by using hedging transactions. However, we may choose to do so in the future. We may not be able to do so successfully. Accordingly, we may experience economic loss and a negative impact on our earnings as a result of foreign currency exchange rate fluctuations. These factors will similarly apply following our planned acquisition of Terraillon which derives a significant portion of its net sales in French francs. OUR TRANSFER PRICING PROCEDURES MAY BE CHALLENGED, WHICH MAY SUBJECT US TO HIGHER TAXES AND ADVERSELY AFFECT OUR EARNINGS. Transfer pricing refers to the prices that one member of a group of related corporations charges to another member of the group for goods, services, or the use of intellectual property. If two or more affiliated corporations are located in different countries, the laws or regulations of each country generally will require that transfer prices be the same as those charged by unrelated corporations dealing with each other at arm's length. If one or more of the countries in which our affiliated corporations are located believes that transfer prices were manipulated by our affiliate corporations in a way that distorts the true taxable income of the corporations, the laws of countries where our affiliated corporations are located could require us to redetermine transfer prices and thereby reallocate the income of our affiliate corporations in order to reflect these transfer prices. Any reallocation of income from one of our corporations in a lower tax jurisdiction to an affiliated corporation in a higher tax jurisdiction would result in a higher overall tax liability to us. Moreover, if the country from which the income is being reallocated does not agree to the reallocation, the same income could be subject to taxation by both countries. We have adopted transfer pricing agreements with our subsidiaries located in the United States, Hong Kong, China, and the United Kingdom to regulate intercompany transfers. A transfer pricing agreement is a contract for the transfer of goods, services, or intellectual property from one corporation to a related corporation that sets forth the prices that the related parties believe are arm's length. We have entered into these types of agreements due to the fact that some of our assets, such as intellectual property developed in the United States, are transferred among our affiliated companies. In such agreements, we have determined transfer prices that we believe are the same as the prices that would be charged by unrelated parties dealing with each other at arm's length. If the United States Internal Revenue Service or the taxing authorities of any other jurisdiction were to successfully challenge these agreements or require changes to our transfer pricing practices, we could become subject to higher taxes and our earnings would be adversely affected. We believe that we operate in compliance with all applicable transfer pricing laws in these jurisdictions. However, there can be no assurance that we will continue to be found to be operating in compliance with transfer pricing laws, or that such laws will not be modified, which, as a result, may require changes to our transfer pricing practices or operating procedures. Any determination of income reallocation or modification of transfer pricing laws can result in an income tax assessment of the portion of income deemed to be derived from the United States or other taxing jurisdiction. DEFECTS IN OUR PRODUCTS COULD IMPAIR OUR ABILITY TO SELL OUR PRODUCTS OR COULD RESULT IN LITIGATION AND OTHER SIGNIFICANT COSTS. Detection of any significant defects in our products may result in, among other things, delay in time-to-market, loss of market acceptance and sales of our products, diversion of development resources, injury to our reputation, or increased warranty costs. Because our products are complex, they may contain defects that cannot be detected prior to shipment. These defects could harm our reputation, which could result in significant costs to us and could impair our ability to sell our products. The costs we may incur in correcting any product defects may be substantial and could decrease our profit margins. Since our products are used in applications that are integral to our customers' businesses, errors, defects, or other performance problems could result in financial or other damages to our customers. Product liability litigation, even if it were unsuccessful, would be time consuming and costly to defend. Our product liability insurance may not be adequate to cover claims. RISKS RELATED TO OUR INDUSTRY WE TYPICALLY HAVE FIXED-PRICE CONTRACTS WITH OUR CUSTOMERS AND ANY COST OVERRUNS WILL ADVERSELY AFFECT PROFITABILITY. Our customers set demanding specifications for product performance, reliability, and cost. Most of our customer contracts include a predetermined fixed price for the products we make, regardless of the costs we incur. We may make pricing commitments to our customers based on our expectation that we will achieve more cost effective product designs and automate more of our manufacturing operations. The manufacture of our products requires a complex integration of demanding processes involving unique technical skill sets. We face risks of cost overruns or order cancellations if we fail to achieve forecasted product design and manufacturing efficiencies or if products cost more to produce than expected. The expense of producing products can rise due to increased cost of materials, components, labor, capital equipment, or other factors. We may have cost overruns or problems with the performance or reliability of our products in the future. OUR SALES THROUGH RETAIL MERCHANTS RESULT IN SEASONALITY AND SUSCEPTIBILITY TO A DOWNTURN IN THE RETAIL ECONOMY. Historically, a significant portion of our net sales have been sales of consumer products to retail merchants such as Sears, Sam's Club, and Bed Bath & Beyond. In addition, many of our other customers, such as Sunbeam, sell to retail merchants. Accordingly, these portions of our customer base are susceptible to a downturn in the retail economy. Our sales of consumer products are seasonal, with highest sales during the second and third fiscal quarters. A significant portion of our sales are attributable to the promotional programs of our retail industry customers. These promotional programs result in significant orders by customers who do not carry our products on a regular basis. Promotional programs often involve special pricing terms or require us to spend funds to have our products promoted. We cannot assure you that promotional purchases by our retail industry customers will be repeated regularly, or at all. Our promotional sales could cause our quarterly results to vary significantly. Occasionally, our sales to retail merchants are made with a provision allowing them to return unsold or returned products. Although we record an estimate of the impact of the expected returns at the time of sale, substantial returns in excess of estimated amounts from these customers could harm our sales and results of operations. CUSTOMER ORDER ESTIMATES MAY NOT BE INDICATIVE OF ACTUAL FUTURE SALES. Some of our customers have provided us with forecasts of their requirements for our products over a period of time. We make many management decisions based on these customer estimates, including purchasing materials, hiring personnel, and other matters that may increase our production capacity and costs. If a customer reduces its orders from prior estimates after we have increased our production capabilities and costs, this reduction may decrease our net sales and we may not be able to reduce our costs to account for this reduction in customer orders. Many customers do not provide us with forecasts of their requirements for our products. If those customers place significant orders, we may not be able to increase our production quickly enough to fulfill the customers' orders. The inability to fulfill customer orders could damage our relationships with customers and reduce our net sales. PRESSURE BY OUR CUSTOMERS TO REDUCE PRICES AND AGREE TO LONG-TERM SUPPLY ARRANGEMENTS MAY CAUSE OUR NET SALES OR PROFIT MARGINS TO DECLINE. Our customers are under pressure to reduce prices of their products. Therefore, we expect to experience pressure from our customers to reduce the prices of our products. Our customers frequently negotiate supply arrangements with us well in advance of delivery dates, thereby requiring us to commit to price reductions before we can determine if we can achieve the assumed cost reductions. We believe we must reduce our manufacturing costs and obtain higher volume orders to offset declining average sales prices. If we are unable to offset declining average sales prices, our gross profit margins will decline. RAPID TECHNOLOGICAL CHANGE MAY MAKE OUR PRODUCTS OBSOLETE, RESULTING IN LOSS OF SALES. Technology changes rapidly in the markets we serve. Our success depends on our ability to anticipate these changes, enhance our existing products, and develop new products to meet customer requirements and achieve market acceptance. We may not be able to respond correctly or soon enough. If we fail in these efforts, our products will become obsolete, which will reduce our net sales. We may also be required to write off inventory, tooling, or other assets associated with obsolete products. OUR INTELLECTUAL PROPERTY MAY NOT BE ADEQUATE TO PROTECT OUR BUSINESS. We rely on our patent and trade secret rights to protect our proprietary technology. Our patents may not provide us with meaningful protection from competitors, including those who may pursue patents which may block our use of our proprietary technology. In addition, we rely upon unpatented trade secrets and seek to protect them, in part, through confidentiality agreements with employees, consultants, customers, and potential customers. If these agreements are breached, or if our trade secrets become known to or are independently developed by competitors, we may not have adequate remedies. If a competitor's products infringe upon our patents, we may sue to enforce our rights in an infringement action. These suits may be costly and could divert funds, management, and technical resources from our operations. Currently, a significant portion of our net sales is derived from sales in foreign countries. The laws of some foreign countries do not protect our proprietary rights to as great an extent as do the laws of the United States. Many United States companies have encountered substantial problems in protecting their proprietary rights against infringement in foreign countries, including some countries in which we sell products. Our means of protecting our proprietary rights may not be adequate in these countries. For example, our competitors in these countries may independently develop similar technology or duplicate our systems. If we fail to protect our intellectual property adequately in these countries, it would be easier for our competitors to sell competing products in these countries. SUCCESSFUL INFRINGEMENT CLAIMS BY THIRD PARTIES COULD RESULT IN SUBSTANTIAL DAMAGES, LOST PRODUCT SALES, AND THE LOSS OF IMPORTANT PROPRIETARY RIGHTS. There has been substantial litigation regarding patent and other intellectual property in various high technology industries. In the future, we may be notified of allegations that we may be infringing on intellectual property rights possessed by others. Even if we are ultimately successful in our defense, any litigation of this type could result in substantial costs and diversion of time and effort by our management team. Other risks of infringement claims include: o loss of certain proprietary rights; o significant liabilities, including treble damages in some instances; o the need to seek licenses from third parties, which may not be available on reasonable terms, if at all; and o barriers to product manufacturing. Any of these outcomes could materially harm our business. OUR RESULTS OF OPERATIONS AND REPUTATION COULD BE HARMED BY ENVIRONMENTAL REGULATION AND ASSOCIATED COSTS. We are required to comply with foreign, federal, state, and local laws and regulations regarding health and safety and the protection of the environment, including those governing the storage, use, handling, discharge, and disposal of hazardous substances in the ordinary course of our manufacturing processes. We are required to obtain and comply with various permits under current environmental laws and regulations, and new laws and regulations may require us to obtain and comply with additional permits. We may be unable to obtain or comply with, and could be subject to revocation of, permits necessary to conduct our business. Environmental laws and regulations may be enacted or interpreted to impose environmental liability on us with respect to our facilities or operations. Under various foreign, federal, state, and local laws and regulations relating to the protection of the environment, an owner or operator of real property may be held liable for the costs of investigation or remediation of certain substances located at, or emanating from, the property. These laws often impose liability without regard to fault for the presence of such substances. The costs of investigation or remediation of such substances may be substantial, and the presence of such substances may adversely affect the ability to sell or lease the property or borrow using such property as collateral. The presence of such substances may also expose the owner or operator to liability resulting from any release of or exposure to such substances, including toxic tort claims. Persons who arrange for the disposal or treatment of certain substances may also be liable for the costs of investigation and remediation of such substances at the disposal facility, whether or not such facility is owned or operated by such person. Third parties may also seek recovery from owners or operators of real properties for personal injury associated with the release of certain substances. In connection with our ownership and operation of our current and former facilities, we may be liable for other investigation or remediation costs, as well as certain related costs, including fines and penalties and injuries to persons and property. Further, we cannot assure you that additional environmental matters will not arise in the future at our sites where no problem is currently known to us or at sites that we may acquire in the future. More stringent environmental laws as well as more vigorous enforcement policies or discovery of previously unknown conditions requiring remediation could have a material adverse effect on our business, financial condition, and results of operations. RISKS RELATED TO THIS OFFERING FUTURE SALES OF OUR STOCK COULD CAUSE THE PRICE OF OUR STOCK TO DECLINE. Sales of a substantial number of shares of our common stock in the public market after this offering could cause the market price of our common stock to decline. In addition, the sale of these shares could impair our ability to raise capital through the sale of additional equity securities. Upon the completion of this offering, we will have approximately 10,647,594 shares of common stock outstanding, and approximately 10,977,594 shares if the underwriters' over-allotment option is exercised in full, based on shares outstanding as of July 10, 2001. OUR MANAGEMENT TEAM HAS DISCRETION AS TO THE USE OF THE MAJORITY OF THE PROCEEDS OF THIS OFFERING. While our term loan agreement requires that one-third of the net proceeds from this offering must be used to repay indebtedness, our management has broad discretion as to how to spend the remaining proceeds. We plan to use the remaining proceeds from this offering to pay the cash portion of the purchase price to acquire Terraillon, repay outstanding indebtedness under our credit facility, for working capital, or for other general corporate purposes. We may also use some of the proceeds to acquire other companies, technologies, or assets that complement our business. You will be relying on the judgment of our management team, which cannot assure you that investment of the proceeds will yield a favorable return. OUR CHARTER DOCUMENTS AND NEW JERSEY LAW MAY INHIBIT A TAKEOVER OR CHANGE IN OUR CONTROL THAT SHAREHOLDERS MAY CONSIDER BENEFICIAL. Provisions in our certificate of incorporation and New Jersey law may have the effect of delaying or preventing a merger or acquisition of us, or making a merger or acquisition less desirable to a potential acquirer, even when the shareholders may consider the acquisition or merger favorable. Our certificate of incorporation provides for a staggered board of directors, which will make it more difficult for a group of shareholders to elect a board member of their choice. We are authorized to issue up to 978,244 shares of "blank check" preferred stock, and to determine the price, privileges, and other terms of these shares. The issuance of any preferred stock with superior rights to the common stock could reduce the value of our common stock. In particular, specific rights we may grant to future holders of preferred stock could be used to restrict our ability to merge with or sell our assets to a third party, preserving control of us by present owners and management and preventing you from realizing a premium on your shares. In addition, provisions of the New Jersey Shareholders Protection Act prohibit certain business combination transactions with anyone owning more than 10% of our voting stock. These provisions may also delay, prevent, or discourage someone from merging with or acquiring us. WE DO NOT PLAN TO PAY DIVIDENDS IN THE FORESEEABLE FUTURE. We do not anticipate paying cash dividends to the holders of our common stock in the foreseeable future. Additionally, we are currently restricted from paying any non-stock dividends under our credit facility. Accordingly, investors must rely on sales of their common stock after price appreciation, which may never occur, as the only way to realize a return on their investment. Investors seeking cash dividends should not purchase our common stock. RISKS RELATED TO TERRAILLON ACQUISITION OUR EFFORT TO ACQUIRE TERRAILLON MAY NOT BE SUCCESSFUL. On June 7, 2001, we signed an agreement, which was amended on July 11, 2001, to acquire all of the outstanding shares of Terraillon. The Terraillon acquisition is contingent on a number of factors including completing this offering or finding another acceptable financing source and satisfying applicable governmental conditions and regulatory issues. In addition, either party may terminate the transaction if the closing has not occurred by the close of business in Ireland on August 30, 2001 or such other date as shall be mutually agreed upon. As we cannot assure you that these contingencies will be met in a timely fashion or at all, our effort to acquire Terraillon may not be successful. In addition, whether or not the acquisition of Terraillon is consummated, we will likely incur substantial expenses. If the acquisition of Terraillon is consummated, we also expect that we will incur significant consolidation and integration expenses that we cannot accurately estimate at this time. IF WE ACQUIRE TERRAILLON, WE MAY NOT BE ABLE TO SUCCESSFULLY INTEGRATE TERRAILLON AND ACHIEVE THE BENEFITS EXPECTED TO RESULT FROM THE ACQUISITION. We expect that the proposed acquisition of Terraillon will result in mutual benefits including, among other things, benefits relating to expanded and complementary product offerings, expanded distribution channels and markets, enhanced sales, and new consumer product technology. Achieving the benefits of the acquisition will depend in part on the integration of our technologies, operations, and personnel in a timely and efficient manner so as to minimize the risk that the acquisition will result in the loss of market opportunity or key employees or the diversion of the attention of management. In addition, Terraillon's principal offices are located in Chatou, France, and our principal offices are located in Fairfield, New Jersey. We do not have significant experience conducting business in France. We must successfully integrate Terraillon's operations and personnel with our operations and personnel for the acquisition to be successful. We cannot assure you that we will successfully integrate or profitably manage Terraillon's businesses. In addition, we cannot assure you that, following the acquisition, our businesses will achieve efficiencies or synergies that justify the acquisition. Furthermore and in general, most of the other risk factors described above similarly apply to Terraillon. SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS This prospectus contains forward-looking statements including statements concerning the future of the industry, product development, business strategy, including the possibility of future acquisitions, continued acceptance and growth of our products, and dependence on significant customers. These statements can be identified by the use of forward-looking terminology such as "may," "will," "expect," "anticipate," "estimate," "continue," or other similar words. These statements discuss future expectations, contain projections of results of operations or of financial condition, or state other forward-looking information. When considering forward-looking statements, you should keep in mind the risk factors and other cautionary statements in this prospectus. The risk factors noted above and other factors noted throughout this prospectus could cause our actual results to differ significantly from those contained in any forward-looking statement. In this prospectus, we rely on and refer to information and statistics regarding the markets in which we compete. We obtained this information and these statistics from various third party sources, discussions with our customers, and our own internal estimates. We believe that these sources and estimates are reliable, but we have not independently verified them and we cannot guarantee that they are accurate.

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+RISK FACTORS Before you invest in our common stock, you should be aware that there are risks, including those set forth below. You should carefully consider these risk factors, together with all the other information included in this prospectus, before you decide to purchase shares of our common stock. The trading price of our common stock could decline due to any of these risks, and, as a result, you may lose all or part of your investment. COMPANY RISKS WE HAVE A LIMITED OPERATING HISTORY ON WHICH TO BASE AN INVESTMENT DECISION. We began operations in January 1999 with the acquisition of an Internet-based health care management system and the subsequent acquisition of e-Net Technology Ltd., a company based in the United Kingdom, in March 1999. Because we have been in operation for a little more than two years, it is difficult to evaluate our business model and our prospects. Our Internet solutions business is unproven and has not gained wide acceptance in the market. Most of our revenue has been generated from our pharmacy management services and our sales and servicing of computer hardware and software though our UK subsidiary, e-Net Technology Ltd. We have only recently begun to realize sales from our other services. We are unable to predict whether or the extent to which our Internet-based solutions will be accepted or the amount and timing of revenues we might realize from them. Our historical financial information is of limited value in projecting our future operating results because of our limited operating history as a combined organization and the emerging nature of our markets. WE HAVE A HISTORY OF LOSSES AND WE EXPECT TO INCUR OPERATING LOSSES AND TO OPERATE ON A NEGATIVE CASH FLOW BASIS FOR THE FORSEEABLE FUTURE. We began operations in January 1999 and have incurred net losses from operations in each fiscal period since then. During this period we also have utilized our available cash more quickly than we have generated cash from operations, and have made significant cash investments for acquisitions, infrastructure developments and product introductions and development. As of December 31, 2000, we had accumulated losses of approximately $40.6 million. Since March 31, 2000, our available cash decreased from $59.9 million to approximately $15.1 million as of December 31, 2000. Contributing to our negative cash flow has been the aging of our accounts receivable and the buildup of inventory. As of December 31, 2000, approximately $8.0 million of our total accounts receivable of $25.9 million were past due 90 days or more of which $5.8 million was owed by affiliates. For the foreseeable future, we expect to incur significant expenses and to utilize cash for the following: - funding operating losses; - developing additional infrastructure; - bringing products and services to market - settlement of past due payables - repayment and servicing debt We cannot be certain that we can achieve sufficient revenues in relation to our expenses to become profitable or to become cash flow positive. Our ability to become profitable is dependent upon acceptance of electronic data exchange by the healthcare industry generally, and our specific Internet based solutions to a greater extent than they have been to date. In addition, we will be affected by economic, political, and regulatory developments in the healthcare industry that are favorable to the acceptance of our Internet-based solutions, and continued growth in our non-Internet-based solutions businesses. Our ability to fund our capital and liquidity needs and our business plan for the next 12 months is dependent upon our ability to achieve a combination of the following: - Bringing our unaffiliated accounts receivable current and reducing our investment in pharmacy inventories - Receipt of funds previously committed to us by one of our strategic partners and affiliates including: - Payment of all invoices as of December 31, 2000 for services rendered by us to our partner and its subsidiaries and affiliates over 7 months ended July 31, 2001, - Payment of all invoices generated subsequent to December 31, 2000 in accordance with the terms of existing agreements, - Provision of equity or debt financing in accordance with the terms of existing agreements, - Provision of additional funding either in the form of equity or debt financing to support our cash requirements through March 31, 2001, - Provision of capital required, if any, for defaults under our VidiMedix settlement agreement. We are actively pursuing opportunities to obtain an additional asset-based line of credit for the pharmacy division as well as obtaining additional equity funding. As of March 12, 2001 we have secured approximately $2.6 million in net funds from an asset-based line of credit. On February 20, 2001, we entered into an equity line facility for up to $50 million of our common stock. However, our ability to draw on this facility will be subject to prior registration of the shares and various other conditions, which may not be met. We may be unable to raise any additional amounts on reasonable terms, or at all, when needed. If we are not successful in obtaining funding from our affiliate or resolve the matters referred to above, and we do not obtain other sources of funding to replace these commitments, we may not be able to fund our operations or support our capital needs and business plan beyond April 30, 2001. In addition, if we do not obtain the funding required to continue operations over the next 12 months, our auditors may conclude that a report modification for going concern relating to the auditor's report on our March 31, 2001 financial statements may be appropriate. OUR RELATIONSHIP WITH THE PRINCIPAL STOCKHOLDERS OF PRIMERX.COM HAS BEEN TROUBLED Since April 2000, we have consolidated the results of operations of PrimeRx.com with ours. Among other factors, this consolidation is based upon a 30 year exclusive management contract with PrimeRx and our ownership of approximately 29% of PrimeRx. Our ownership interest was obtained effective as of April 12, 2000, pursuant to the exercise of an option to exchange shares of our common stock for shares of PrimeRx common stock held by the principal stockholders of PrimeRx, consisting of Dr. Prem Reddy and a related trust. Notwithstanding the principal stockholders' exercise and delivery of their option to acquire our stock in exchange for PrimeRx stock, their participation in a prior registration of a portion of those shares, and other actions consistent with the arrangement, following a significant decline in the price of our common stock they claimed, among other allegations, that they were misled as to the tax consequences of their exercise of the options. They made this claim although they admit at the time they were represented by separate and qualified tax counsel. We believe their allegations are without merit, have denied them, and over several months have attempted to address their issues. On December 13, 2000, the principal stockholders filed a complaint against us and other parties in connection with the stock option agreement and exchange of shares for fraud, negligent representation, breach of oral contract, promissory estoppel, declaratory relief and breach of fiduciary duty in the Superior Court of the State of California for the County of Los Angeles (Central District), entitled Prime A Investments, LLC and Dr. Prem Reddy vs. E-MedSoft.com, et. al (Case No. BC241745). This complaint was dismissed without prejudice on December 15, 2000. In the event these PrimeRx stockholders refile their complaint or otherwise pursue their claims against us, we plan to vigorously defend our position. We recently filed a claim against Dr. Reddy and others alleging fraud, breach of contract, breach of fiduciary duty and other business torts relating to the management agreement with PrimeRx. We are seeking damages in excess of $12 million and a permanent injunction against Dr. Reddy precluding him from interfering with the consolidated operations of PrimeRx. On March 5, 2001, the Superior Court of California for the County of Los Angeles issued a Temporary Restraining Order and Order to Show Cause against Dr. Reddy precluding him from entering upon the premises of PrimeRx, bringing weapons on to the premises, threatening the murder of any employees, shareholders, directors, contractors, and others, or destroying or altering any of our property, files, records or those of PrimeRx. As of this date, defendants have not answered the complaint or asserted any cross-claims. We and other shareholders of PrimeRx believe that our ownership interest in PrimeRx was legally and validly acquired and we are the owners of the shares we purport to own in PrimeRx. However, if the principal stockholders' file the above or a similar complaint against us, and if a court ultimately finds in their favor, we could experience adverse consequences if we were to deconsolidate PrimeRx from our financial statements, including a write-off of goodwill recorded at the time of our acquisition of our ownership interest in PrimeRx, which was $33.9 million at December 31, 2000, a possible charge to earnings for the establishment of a reserve against amounts we have advanced to PrimeRx under our management agreement, which amounted to $13.1 million as of December 31, 2000, and a reduction in our revenues attributable to our pharmacy services, which amounted to $53.7 million for the nine month period ended December 31, 2000 or additional monetary damages. OUR INVESTMENT IN QUANTUM DIGITAL SOLUTIONS IS SUBJECT TO A RISK OF WRITEDOWN In March 2000, we entered into an acquisition and joint venture agreement with Quantum Digital Solutions Corporation and acquired an exclusive 10-year license for application of their security encryption and data scrambling technology. We intend to embed the security technology into all of our application services and, subject to obtaining sufficient financing and other conditions, will seek to develop a separate subsidiary, Securus, that will focus on selling security solutions to the health care industry. In return for the license, Quantum Digital will receive 25 percent of Securus' profits, plus warrants to purchase up to 25 percent of Securus' equity at $0.01 per share in the event of a sale of any Securus equity securities. Pursuant to the agreement, we issued to Quantum approximately 1.4 million shares of our common stock for the right to purchase up to 15 percent of the outstanding common stock of Quantum for an aggregate cash purchase price of $15 million, either in a single transaction or in tranches over a period of up to five years. As of December 31, 2000, we have exercised two options to purchase 1.5 percent of Quantum common stock for $1,500,000. We have not exercised the options that vested on September 30, 2000 or December 31, 2000. In accordance with the agreement, if we do not exercise the options on a timely basis, we will lose the right to exercise the remaining options. We are currently negotiating with Quantum an amendment to the agreement that will extend the timing of exercising the options and the method of payment. At December 31, 2000, we have reflected approximately $29.8 million on the balance sheet which represents $25 million for the value of the shares issued to obtain the option to acquire equity in Quantum, $1,500,000 paid upon partial exercise of the option to acquire equity interest and approximately $3.3 million in present value of other commitments made by us for the acquisition of the option. We made a preliminary analysis of the relative values of the acquired assets and allocated $2.8 million to the value of the technology license and software and $27 million to the value of the equity option. If we fail to reach agreement on the amendment, we will lose our right to exercise future options to increase our holdings in Quantum to 15%. This limitation may impair the equity option currently recorded on the balance sheet as an asset and require us to write down such value based on the projected realization of our investment in Quantum Digital. In addition, Quantum is a development stage company operating in the internet/technology industry which is subject to numerous risks such as evolving standards, customer acceptance and development of markets, rapidly changing technology and other risks. The realization of the investment in Quantum is subject to the successful execution of its business plan. WE FACE RISKS ASSOCIATED WITH OUR OFFSHORE OPERATIONS. We currently derive a significant portion of our revenues from e-Net Technology Ltd., our U.K. subsidiary. In addition, we now control a significant interest in an Australian company which will distribute certain of our products in Australia and Asia. We are subject to the risks inherent to operations in such countries including economic, political and regulatory considerations that may differ from those under which we operate in the United States. In addition, our investments in foreign subsidiaries could be affected by fluctuations in the foreign operations' currencies. Further, if problems develop in an offshore subsidiary, which local management is unable to resolve, it will be difficult for our management to react in a timely manner due to the geographical separation and time differences. This inability to react quickly and sufficiently could have material adverse consequences on our operations and financial results. WE RELY ON OUR STRATEGIC RELATIONSHIPS. To be successful, we believe that we must establish and maintain strategic relationships with leaders in a number of health care industry segments. This is critical because we are relying on these relationships to: - extend the reach of our applications and services to the various participants in the health care industry; - obtain specialized health care expertise; - bring to market new products and services; - further enhance the e-MedSoft brand; and - generate revenue. Entering into strategic relationships is complex because some of our current and future partners may compete with us. In addition, we may not be able to establish relationships with key participants in the health care industry if we have established relationships with their competitors. Consequently, it is important that we are perceived as independent of any particular customer or partner. Once we have established strategic relationships, we work with our partners to generate increased acceptance and use of products and services. For example, we are depending upon NCFE to recommend to its clients that they use our software system. If fewer NCFE clients sign up to transact their accounts receivable financing over our Web portal than we anticipate, we may not be able to grow according to our plans. As with most service businesses, the loss of one or more material contracts could have a material adverse effect on our business. We cannot assure you that we will not lose any of our short or long-term contracts or that we will be able to fully realize the value assigned to certain intangible assets related to our contract with NCFE. IF WE FAIL TO ENHANCE OUR MANAGEMENT AND OTHER RESOURCES OUR BUSINESS COULD SUFFER. We have expanded our operations through acquisitions and other ventures. We acquired e-Net in March 1999 and recently acquired three multimedia companies (VirTx, VidiMedix and Illumea), entered into three major agreements to be the exclusive provider of electronic data exchange (NCFE, University Affiliates and PrimeRX), entered into a major management agreement with PrimeRX, and entered into a joint licensing arrangement with Quantum Digital. We also plan to expand our domestic and international operations. On February 22, 2001, we had over 600 full-time employees (including approximately 350 PrimeRx employees) compared to 75 on March 31, 1999. This growth has placed, and is expected to continue to place, a significant strain on our managerial, operational, financial, and other resources. Certain of our acquisitions and other ventures have resulted in disputes, which have required management's time and attention, additional legal expenses, the issuance of additional shares of our common stock, and other obligations. We must enhance our management, financial and accounting systems, controls, reporting systems and procedures, integrate new personnel, and more effectively manage our expanded operations. In connection with these enhancements, we will be required to attract and retain qualified personnel in managerial positions. Any failure to do so could negatively affect the quality of our products and services, our ability to respond to our clients, retain key personnel, and our business in general. WE FACE RISKS ASSOCIATED WITH ACQUISITIONS. We have expanded and plan to expand our business by making acquisitions of other companies in the health care information services industry. There are a number of risks associated with financing these acquisitions and integrating them into our business, including the following: - our profitability could be adversely affected by depletion of cash, servicing any additional debt and amortizing the expenses related to goodwill and intangible assets; - the issuance of additional equity would dilute the interests of our current stockholders; - it could be difficult to assimilate the acquired companies' employees, equipment, and operations; - the acquisition could divert management's attention from other business concerns; - the acquired companies could operate in markets with which we have little or no familiarity; - there could be undisclosed or unforeseen liabilities associated with the acquired companies; and - we could lose key employees or customers of the acquired companies. WE RELY ON THE PERFORMANCE AND SECURITY OF OUR SYSTEMS. Our customer satisfaction and our business could be harmed if our customers experience any system delays, failures, or loss of data. The occurrence of a major catastrophic event or other system failure at our facilities could interrupt data processing or result in the loss of stored data. In addition, we depend on the efficient operation of Internet connections from customers to our systems. These connections, in turn, depend on the efficient operation of Web browsers, Internet service providers, and Internet backbone service providers, all of which could have periodic operational problems or outages. Any disruption to Internet access provided by third parties could have a material adverse effect on our business, financial condition, and results of operations. Furthermore, we are dependent on hardware suppliers for prompt delivery, installation, and services equipment used to deliver our services. A material security breach could damage our reputation or result in liability to our company. We retain confidential customer and patient information in our processing centers. Therefore, it is critical that our facilities and infrastructure remain secure and that they are perceived by the marketplace to be secure. Despite the implementation of security measures, our infrastructure may be vulnerable to physical break-ins, computer viruses, programming errors, attacks by third parties, or similar disruptions. WE FACE INTENSE COMPETITION, WHICH COULD HARM OUR BUSINESS. The market for health care information services is intensely competitive, rapidly evolving, and subject to rapid technological change. Many of our competitors have greater financial, technical, product development, marketing, and other resources than we do. These organizations may be better known and have more customers than we do. Certain competitors have announced or introduced Internet strategies that will compete with our applications and services, including - application services providers, such as US Internetworking, Inc., Exodus Communications, Inc., and Trizetto; - healthcare e-commerce and portal companies, such as Healtheon/WebMD and CareInsite, Inc.; - healthcare electronic data interchange companies, including ENVOY Corporation and National Data Corporation; - large information technology consulting service providers, including Accenture, International Business Machines Corporation, and Electronic Data Systems Corporation; and - smaller regional organizations. In addition, we expect that major software information systems companies and others specializing in the health care industry will offer competitive applications or services. Some of our large customers may also compete with us. We may be unable to compete successfully against current and future competitors, and competitive pressures may seriously harm our business. WE MAY BE ADVERSELY AFFECTED BY PRODUCT-RELATED LIABILITIES. Although we and our customers test our applications, they may contain defects or result in system failures. In addition, our platform may experience problems in security, availability, scalability, or other critical features. These defects or problems could result in: - loss of or delay in generating revenue; - loss of market share; - failure to achieve market acceptance; - diversion of development resources; - injury to our reputation; - increased insurance costs; and - loss of clients. Our services agreements involve providing critical information technology services to clients' businesses. If we fail to meet our clients' expectations, our reputation could suffer and we could be liable for damages. In addition, patient care could suffer, and we could be liable if systems fail to deliver correct information in a timely manner. Finally, we could become liable if confidential information is disclosed inappropriately. Our insurance may not protect us from these risks. In addition, our insurance may not be sufficient to cover large claims, or the insurer could disclaim coverage on claims. WE MAY FACE INTELLECTUAL PROPERTY INFRINGEMENT CLAIMS FROM THIRD PARTIES. We could be subject to intellectual property infringement claims as the number of competitors grows and the functionality of our applications overlaps with competitive offerings. These claims, even if not meritorious, could be expensive to resolve and divert management's attention from operating the business. If we become liable to a third party for infringing its intellectual property rights, we could be required to pay a substantial damage award. Such a judgment would have a material adverse effect on our business, financial condition, and results of operations. In addition, we may be unable to develop noninfringing technology or obtain a license on commercially reasonable terms. WE MAY NOT BE ABLE TO PROTECT OUR PROPRIETARY RIGHTS. Our future success and ability to compete in the health care information services business may be dependent in part upon our proprietary rights to products and services that we develop. We expect to rely on a combination of patent, copyrights, trademark, and trade secret laws and contractual restrictions to protect our proprietary technology and to rely on similar proprietary rights of any of our content and technology providers. We intend to file patent applications to protect certain of our proprietary technology. We cannot assure you that such applications will be approved or, if approved, will be effective in protecting our proprietary technology. We enter into confidentiality agreements with our employees, as well as with our clients and potential clients seeking proprietary information, and limit access to and distribution of our software, documentation, and other proprietary information. We cannot assure you that the steps we take or the steps such providers take would be adequate to prevent misappropriation of our proprietary rights. THE LOSS OF KEY PERSONNEL OR THE INABILITY TO HIRE OR RETAIN QUALIFIED PERSONNEL COULD ADVERSELY AFFECT OUR BUSINESS. Our operations are dependent on the continued efforts of the executive officers and management, and in particular, John F. Andrews, our Chief Executive Officer. If any one of these persons becomes unable or unwilling to continue in his or her role with us, or if we are unable to attract and retain other qualified employees, our business and prospects could be adversely affected. Our success is also dependent to a significant degree on our ability to attract, motivate, and retain highly skilled sales, marketing, and technical personnel, including software programmers and systems architects skilled in the computer language with which our products operate. Competition for such personnel in the software and information services industries is intense. The loss of key personnel or the inability to hire or retain qualified personnel could have a material adverse effect on our business. INVESTMENT RISKS WE MAY BE REQUIRED TO SELL ADDITIONAL EQUITY SECURITIES WHICH COULD DILUTE EXISTING SHAREHOLDERS We may be required to sell additional equity or debt securities with equity features in order to provide us with additional funds to finance our continued operations, develop our infrastructure, introduce new products and services and acquire additional companies or businesses. We cannot assure that we will be able to sell such securities or the price and other terms that will be required by investors in such securities. Based upon current market prices, it is likely that the price at which any securities can be sold under the equity line, will result in financial and ownership dilution of existing stockholders. FUTURE SALES OF A LARGE NUMBER OF SHARES OF OUR COMMON STOCK COULD DEPRESS OUR STOCK PRICE. The market price of our common stock could decline as a result of sales of a large number of shares of common stock in the market, or the perception that such sales could occur. In particular, if Hoskin International sells all of the shares we are offering through this prospectus, the market price of our common stock may decline. Such sales also might make it more difficult for us to sell equity or equity related securities in the future at a time and price that we deem appropriate. Hoskin International could purchase and resell up to approximately 16.8% of our common stock outstanding at March 7, 2001 during the 36 months following effectiveness of this Registration Statement. Furthermore, to the extent the price of our common stock decreases, we will be required to issue more shares of common stock to Hoskin International for any given dollar amount that we draw from the equity drawdown facility. Sales of a substantial number of shares of our common stock could cause our stock price to decline. Based on shares outstanding as of March 7, 2001, upon issuance of all of the shares included in this offering, we will have outstanding 94,396,284 shares of common stock. In addition, we have a large number of shares of common stock outstanding and available for resale beginning at various points in time in the future. These sales also might make it more difficult for us to sell equity securities in the future at a time and at a price that we deem appropriate. As of December 31, 2000, we have outstanding 78,148,172 shares of common stock. Of these shares, 65,036,891 shares are restricted securities and will become eligible for sale without registration pursuant to Rule 144 under the Securities Act, subject to certain conditions of Rule 144. Certain holders of our common stock have demand and piggyback registration rights enabling them to register up to 9,113,721 of their shares for sale under the Securities Act pursuant to this prospectus. If holders sell a large number of shares in the public market, our stock price could fall materially. THE SALE OF SHARES OF COMMON STOCK COVERED IN THIS PROSPECTUS COULD INFLUENCE THE CONTROL OF EMEDSOFT We have registered 16,248,112 shares of our common stock for sale by the selling stockholders under the registration statement of which this prospectus forms a part. Under the terms of our common stock purchase agreement with Hoskin International, we may not issue shares of our common stock to Hoskin International which would result in ownership by Hoskin International of more than 9.9% of our issued and outstanding common stock. However, if all of the shares being registered are issued under the terms of the common stock purchase agreement and resold by Hoskin International and the other selling stockholders, third party investors could acquire 20.8% of our common stock outstanding as of March 7, 2001. The acquisition by third party investors of a significant percentage of our common stock could enable such investors to influence or direct the policies, decisions and composition of our Board of Directors and management. A potential change of control could involve a number of risks, including the diversion of management attention and resources, the loss of key employees, and changes in our business plan and operations. Any such events could have a material adverse effect on our business and results of operations. WE MAY BE UNABLE TO ACCESS ALL OR PART OF OUR EQUITY LINE FACILITY If our stock price and trading volume are at certain levels, then we will not be able to drawdown all $50 million pursuant to the proposed equity line facility with Hoskin International. In addition, business and economic conditions may not make it feasible to drawdown pursuant to this facility. Furthermore, if we are unable to keep a registration statement effective for those shares of common stock subject to the equity line, or if our common stock is delisted from the American Stock Exchange, or if we experience a material adverse change to our business that is not cured within 60 days, the common stock purchase agreement may terminate, or we may not be able to drawdown any funds. THE ISSUANCE OF SHARES TO HOSKIN INTERNATIONAL UNDER THE COMMON STOCK PURCHASE AGREEMENT MAY CAUSE SIGNIFICANT DILUTION TO OUR STOCKHOLDERS The shares of our common stock issuable to Hoskin International under the equity line facility will be issued at a maximum 7.5% discount, and minimum 5.5%, to the volume-weighted average daily price of our common stock during the applicable drawdown period. The issuance of shares to Hoskin International will therefore dilute the equity interest of existing stockholders and could have an adverse effect on the market price of our common stock. Depending on the extent to which we draw on the equity line facility, we may be required to register additional shares for resale, which could have a further dilutive effect. The perceived risk of dilution may cause the selling stockholders as well as other stockholders of ours to sell their shares, which would contribute to a downward movement in the stock price of our common stock. Moreover, the perceived risk of dilution and the resulting downward pressure on our stock price could encourage investors to engage in short sales of our common stock. By increasing the number of shares offered for sale, material amounts of short selling could further contribute to progressive price declines in our common stock. HOLDERS OF OPTIONS AND WARRANTS AND OTHER PARTIES HAVE THE RIGHT TO ACQUIRE A LARGE NUMBER OF SHARES OF OUR COMMON STOCK. We have reserved a total of 8,802,500 shares of our common stock for issuance upon exercise of options granted or which may be granted under our existing stock option plans. As of December 31, 2000, stock options to acquire 2,256,826 shares at a weighted average exercise price of $4.911 were outstanding. In addition, as of December 31, 2000, warrants to acquire 5,129,000 shares of our common stock at a weighted average exercise price of $5.11 were outstanding. The holders of these options and warrants will have the opportunity to profit from an increase in the market price of our common stock. These options and warrants may make it more difficult for us to obtain additional equity financing in the future. The holders of these options and warrants can be expected to exercise the options and warrants at a time when we, in all likelihood, would be able to sell equity securities on terms more favorable to us than those provided in the options and warrants. In addition to holders of options and warrants, we have issued or agreed to issue a large number of shares of our common stock to certain parties who were involved in disputes with us. In November 2000 the Company settled a legal dispute with certain of the prior shareholders of VidiMedix. This agreement was amended in February 2001. Under this amended settlement agreement, the Company will issue $3,350,000 in shares of its common stock to satisfy the earn out provisions in the VidiMedix purchase agreement. The number of shares required to be issued is the higher of 1,302,354 or the product of $3,350,000 divided by weighted average closing price calculated using the first six days of the nine days prior to whichever of several reference dates would result in the greatest number of shares to be issued. For example, based on a closing date of January 5, 2001, the shares required to be issued under the average closing price calculation would be 5,687,607 shares. This issuance of additional shares have been accounted for in the third quarter of 2001 as an addition to goodwill. If registration of these shares is not effective by April 30, 2001, we will be required at the option of the prior VidiMedix shareholders to pay these VidiMedix shareholders the greater of (i) $4,000,000 or (ii) the product of (A) the number of shares to be delivered times (B) the weighted average closing price for the first six of the nine trading days preceeding April 30, 2001, or other applicable reference date. In February 2001 the Company settled a dispute with those VidiMedix shareholders who were not parties to the November settlement agreement. Under this agreement the Company is obligated to issue 136,113 shares of common stock. WE MAY BE REQUIRED TO PLEDGE OUR OWNERSHIP INTERESTS IN OUR OPERATING SUBSIDIARIES TO SECURE FINANCING In connection with future debt financings, we may be required, among other conditions, to pledge our entire ownership interest in certain of our material operating subsidiaries as collateral for such debt financings. Any such pledge will limit our flexibility to deal with such subsidiaries and will place such subsidiaries, their assets and results of operations at risk of loss to us, which, if lost, could adversely affect our financial condition and results of operations. THE PRICE OF OUR COMMON STOCK MAY BE VOLATILE The market price of our common stock has been, and in the future could be, significantly affected by factors such as: - actual or anticipated fluctuations in operating results; - announcements of technical innovations; - new products or new contracts; - competitors or their customers; - governmental regulatory action; - developments with respect to patents or proprietary rights; - changes in financial estimates by securities analysts; and - general market conditions. WE DO NOT INTEND TO PAY DIVIDENDS We currently intend to retain earnings to provide funds for the operation and expansion of our business. We have not paid cash dividends on our common stock and do not anticipate that we will do so in the foreseeable future. Any declaration and payment of dividends would be subject to the discretion of our board of directors. Any future determination to pay dividends will depend upon our results of operations, financial condition, capital requirements, contractual restrictions, and other factors deemed relevant at the time by the board of directors. INDUSTRY RISKS THE HEALTH CARE INDUSTRY MAY NOT ACCEPT ELECTRONIC INFORMATION EXCHANGE. Our business could suffer dramatically if Internet solutions are not widely accepted or not perceived to be effective. Growth in demand for our applications and services depends on the adoption of Internet solutions by health care participants, which requires the acceptance of a new way of conducting business and exchanging information. To maximize the benefits of our platform, health care participants must be willing to allow sensitive information to be stored in our proprietary databases in order to process transactions for them. The benefits of our connectivity and information management solutions are, however, limited under these circumstances. Customers using legacy and client-server systems may nonetheless refuse to adopt new systems when they have made extensive investments in hardware, software, and training for older systems. THE HEALTH CARE INDUSTRY MAY NOT ACCEPT OUR SOLUTION. To be successful, we must attract a significant number of United States customers throughout the health care industry. We believe that complexities in the nature of the transactions that must be processed have hindered the development and acceptance of information technology solutions by the health care industry. Conversion from traditional methods to electronic information exchange may not occur as rapidly as we expect that it will. Even then, health care industry participants may use applications and services offered by others. We believe that we must gain significant market share before our competitors introduce alternative products, applications, or services with features similar to our current or proposed offerings. Our business model is based on our belief that the value and market appeal of our solution will grow as the number of participants and the scope of the services available on our platform increase. We may not achieve the critical mass of users we believe is necessary to become successful. In addition, we expect to generate a significant portion of our revenue from service offerings. Consequently, any significant shortfall in the number of users would adversely affect our financial results. CHANGES IN THE HEALTH CARE INDUSTRY COULD ADVERSELY AFFECT OUR BUSINESS. The health care industry is subject to changing political, economic, and regulatory influences. These factors affect the purchasing practices and operations of health care organizations. Changes in current health care financing and reimbursement systems could cause us to make unplanned enhancements of applications or services, or result in delays or cancellations of orders, or in the revocation of endorsement of our applications and services by health care participants. Federal and state legislatures have periodically considered programs to reform or amend the U.S. health care system at both the federal and state level. Such programs may increase governmental involvement in health care, lower reimbursement rates, or otherwise change the environment in which health care industry participants operate. Health care industry participants may respond by reducing their investments or postponing investment decisions, including investments in our applications and services. Many health care industry participants are consolidating to create integrated health care delivery systems with greater market power. As the health care industry consolidates, competition to provide products and services to industry participants will become even more intense, as will the importance of establishing a relationship with each industry participant. These industry participants may try to use their market power to negotiate price reductions for our products and services. If we were forced to reduce our prices, our operating results could suffer as a result if we cannot achieve corresponding reductions in our expenses. GOVERNMENT REGULATION OF THE HEALTH CARE INDUSTRY COULD ADVERSELY AFFECT OUR BUSINESS. Our business is subject to U.S. and international government regulation. Existing as well as new laws and regulations could adversely affect our business. Laws and regulations may be adopted with respect to the Internet or other online services covering issues such as user privacy, pricing, content, copyrights, distribution, and characteristics and quality of products and services. Moreover, the applicability to the Internet of existing laws in various jurisdictions governing issues such as property ownership, sales and other taxes, libel and personal privacy is uncertain and may take years to resolve. Demand for our applications and services may be affected by additional regulation of the Internet. We are subject to extensive regulation relating to the confidentiality and release of patient records. Additional legislation governing the distribution of medical records has been proposed at both the state and federal level. It may be expensive to implement security or other measures designed to comply with new legislation. Moreover, we may be restricted or prevented from delivering patient records electronically. For example, until recently, the Health Care Financing Administration guidelines prohibited transmission of Medicare eligibility information over the Internet. Legislation currently being considered at the federal level could affect our business. For example, the Health Insurance Portability and Accountability Act of 1996 mandates the use of standard transactions, standard identifiers, security, and other provisions. Regulations setting these standards are now being released. We are designing our platform and applications to comply with these proposed regulations; however, until these regulations are fully understood and become final, they could cause us to use additional resources and lead to delays as we revise our platform and applications. In addition, our success depends on other health care participants complying with these regulations. OUR GROWTH MIGHT BE LIMITED IF WE BECOME SUBJECT TO SALES OR OTHER TAXES. The tax treatment of the Internet and e-commerce is currently unsettled. A number of proposals have been made at the federal, state, and local level and by certain foreign governments that could impose taxes on the sales of goods and services and certain other Internet activity. A recently enacted law places a temporary moratorium on certain types of taxation on Internet commerce. We cannot predict the effect of current attempts at taxing or regulating commerce on the Internet. Any legislation that substantially impairs the growth of e-commerce could have a material adverse effect on our business, financial condition, and results of operations. CAUTIONARY NOTE ON FORWARD-LOOKING STATEMENTS Some of the matters discussed under the captions "Prospectus Summary," "Risk Factors" "Management's Discussion and Analysis of Financial Condition and Results of Operations, "Business" and elsewhere in this prospectus include forward-looking statements. We have based these forward-looking statements in our current expectations and projections about future events, including: - implementing our business strategy; - integrating the operations of companies we have acquired; - establishing and maintaining our strategic relationships; - competition in our markets; - healthcare industry trends; and - selling our services and systems In some cases you can identify forward looking statements by terminology such as "may," "will," "should," "potential," "continue," "expects," "anticipates," "intends," "plans," "believes," "estimates," and similar expressions. These statements are based on our current beliefs, expectations and assumptions and are subject to a number of risks and uncertainties. A description of some risks that could cause our results to vary appears under the caption "Risk Factors" and elsewhere in this prospectus. In light of these assumptions, risks and uncertainties, the forward-looking events discussed in this prospectus might not occur. DILUTION The issuance of further shares and the eligibility of issued shares for resale will dilute our common stock and may lower the price of our common stock. If you invest in our common stock, your interest will be diluted to the extent the price per share you pay for the common stock is greater than the pro forma as adjusted net tangible book value per share of our common stock at the time of sale. We calculate net tangible book value per share by calculating the total assets less intangible assets and total liabilities, and dividing it by the number of outstanding shares of common stock. The net tangible book value of our common stock as of December 31, 2000 was $47,873,370, or approximately $0.613 per share. Assuming that-- o we issued on December 31, 2000 a total of 12,490,361 shares to Hoskin International under the common stock purchase agreement at $0.925 per share, which is 92.5% of the closing price of our common stock on March 7, 2001, and reflects Hoskin International's maximum 7.5% discount; o on December 31, 2000, all warrants held by Hoskin International following the drawdowns described above were exercised by Hoskin International for cash at the exercise price stated in the warrants, assuming the market price of our common stock remained constant at 1.00 per share and; o on December 31, 2000, you purchased shares under this prospectus for $1.00 per share, which is the closing price of our common stock on March 7, 2001; our pro forma net tangible book value as of December 31, 2000 would have been $59,924,793 or $0.657 per share. This would represent an increase of $0.044 per share to existing shareholders on March 7, 2001 and would represent an immediate dilution to you of approximately $0.343 per share. The actual dilution may be greater or less than in this example depending on actual price you pay for the shares, the actual prices at which we issue shares to Hoskin International under the common stock purchase agreement and how many of the warrants have been exercised under the common stock purchase agreement. Furthermore, approximately 10,517,285 stock options and warrants will vest within the next 10 years, we may issue additional shares options and warrants, and we may grant additional stock options to our employees, officers, directors and consultants under our stock option plans, all of which may further dilute our net tangible book value.

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+RISK FACTORS AN INVESTMENT IN OUR COMMON STOCK INVOLVES SIGNIFICANT RISKS. YOU SHOULD CAREFULLY CONSIDER THE FOLLOWING RISKS DESCRIBED BELOW AND THE OTHER INFORMATION IN THIS PROSPECTUS INCLUDING OUR FINANCIAL STATEMENTS AND RELATED NOTES BEFORE YOU DECIDE TO BUY OUR COMMON STOCK. THE TRADING PRICE OF OUR COMMON STOCK COULD DECLINE DUE TO ANY OF THESE RISKS, AND YOU COULD LOSE ALL OR PART OF YOUR INVESTMENT. RISKS RELATED TO OUR INDEBTEDNESS OUR SUBSTANTIAL INDEBTEDNESS COULD RESTRICT OUR OPERATIONS AND MAKE US MORE VULNERABLE TO ADVERSE ECONOMIC CONDITIONS. We are a highly leveraged company and our liabilities exceed our assets by a substantial amount. As of June 13, 2001, we had $769.2 million of outstanding debt, excluding letters of credit and guarantees. Of our total debt, $491.0 million consisted of borrowings under our credit facility, $260.0 million consisted of our 10 3/8% senior subordinated notes due 2011, and $18.2 million consisted of equipment debt and capitalized lease obligations. In connection with the KKR acquisition, we incurred $726.0 million of indebtedness of which $466.0 million was provided under our credit facility and $260.0 million was provided by a senior subordinated bridge loan from KKR. We used the $260.0 million of net proceeds from the offering of our 10 3/8% senior subordinated notes to repay the subordinated bridge loan from KKR. Accordingly, of the $726.0 million of debt we incurred in connection with the KKR acquisition, $466.0 million remains outstanding. We intend to use the $137.0 million of estimated net proceeds from this offering to reduce the amount outstanding under our credit facility. Our substantial indebtedness could have important consequences for our stockholders. For example, it could: - require us to dedicate a substantial portion of our cash flow from operations to payments on our indebtedness, thereby reducing the availability of our cash flow to fund working capital, capital expenditures and acquisitions and for other general corporate purposes; - increase our vulnerability to economic downturns and competitive pressures in our industry; - increase our vulnerability to interest rate fluctuations because a substantial amount of our debt is at variable interest rates; as of June 13, 2001, $491.0 million of our debt was at variable interest rates; - place us at a competitive disadvantage compared to our competitors that have less debt in relation to cash flow; and - limit our flexibility in planning for, or reacting to, changes in our business and our industry. DESPITE CURRENT INDEBTEDNESS LEVELS, WE AND OUR SUBSIDIARIES MAY STILL BE ABLE TO INCUR SUBSTANTIALLY MORE INDEBTEDNESS WHICH COULD INCREASE THE RISKS DESCRIBED ABOVE. We and our subsidiaries may be able to incur substantial additional indebtedness in the future. The terms of the indenture that govern our 10 3/8% senior subordinated notes due 2011 permit us or our subsidiaries to incur additional indebtedness, subject to certain restrictions. In addition, as of June 13, 2001, our revolving credit facility permitted additional borrowings of up to approximately $125 million subject to the covenants contained in the credit facility. If new debt is added to our and our subsidiaries' current debt levels, the risks discussed above could intensify. IF WE ARE UNABLE TO GENERATE OR BORROW SUFFICIENT CASH TO MAKE PAYMENTS ON OUR INDEBTEDNESS OR TO REFINANCE OUR INDEBTEDNESS ON ACCEPTABLE TERMS, OUR FINANCIAL CONDITION WOULD BE MATERIALLY HARMED, OUR BUSINESS MAY FAIL AND YOU MAY LOSE ALL OF YOUR INVESTMENT. Our ability to make payments on our indebtedness will depend on our ability to generate cash flow in the future which, to a certain extent, is subject to general economic, financial, competitive, legislative, regulatory and other factors that are beyond our control. In addition, future borrowings may not be available to us under our credit facility in an amount sufficient to enable us to pay our indebtedness or to fund our other cash needs. We may need to refinance all or a portion of our indebtedness on or before maturity. We may not be able to refinance any of our indebtedness, including our credit facility and our 10 3/8% senior subordinated notes due 2011, on commercially reasonable terms or at all. Any refinancing of our debt could be at higher interest rates and may require us to comply with more onerous covenants which could further restrict our business operations. If we are not able to refinance our debt, we could become subject to bankruptcy proceedings, and you may lose all of your investment because the claims of our creditors on our assets are prior to the claims of our stockholders. WE MAY NOT BE ABLE TO FINANCE FUTURE NEEDS OR ADAPT OUR BUSINESS PLAN TO CHANGES BECAUSE OF RESTRICTIONS PLACED ON US BY OUR CREDIT FACILITY, THE INDENTURE GOVERNING OUR 10 3/8% SENIOR SUBORDINATED NOTES DUE 2011 AND INSTRUMENTS GOVERNING OUR OTHER INDEBTEDNESS. The indenture for our 10 3/8% senior subordinated notes due 2011 and our credit facility contain affirmative and negative covenants which restrict, among other things, our ability to: - incur additional debt; - sell assets; - create liens or other encumbrances; - make certain payments and dividends; or - merge or consolidate. All of these restrictions could affect our ability to operate our business and may limit our ability to take advantage of potential business opportunities as they arise. A failure to comply with these covenants and restrictions would permit the relevant creditors to declare all amounts borrowed under the relevant facility, together with accrued interest and fees, to be immediately due and payable. If the indebtedness under the credit facility or our 10 3/8% senior subordinated notes due 2011 is accelerated, we may not have sufficient assets to repay amounts due under the credit facility, the notes or on other indebtedness then outstanding. If we are not able to refinance our debt, we could become subject to bankruptcy proceedings, and you may lose all or a portion of your investment because the claims of our creditors on our assets are prior to the claims of our stockholders. RISKS RELATED TO GOVERNMENT REGULATION OF OUR BUSINESS COMPLYING WITH FEDERAL AND STATE REGULATIONS IS AN EXPENSIVE AND TIME-CONSUMING PROCESS, AND ANY FAILURE TO COMPLY COULD RESULT IN SUBSTANTIAL PENALTIES. We are directly or indirectly through our clients subject to extensive regulation by both the federal government and the states in which we conduct our business. If our operations are found to be in violation of any of the laws and regulations to which we or our clients are subject, we may be subject to the applicable penalty associated with the violation, including civil and criminal penalties, damages, fines and the curtailment of our operations. Any penalties, damages, fines or curtailment of our operations, individually or in the aggregate, could adversely affect our ability to operate our business and our financial results. The risk of our being found in violation of these laws and regulations is increased by the fact that many of them have not been fully interpreted by the regulatory authorities or the courts, and their provisions are open to a variety of interpretations. Any action against us for violation of these laws or regulations, even if we successfully defend against it, could cause us to incur significant legal expenses and divert our management's attention from the operation of our business. For a more detailed discussion of the various state and federal regulations to which we are subject see "Business--Regulation." AN UNEXPECTED ADVERSE OUTCOME FROM ANY OF OUR ONGOING ADMINISTRATIVE AUDITS AND PROCEEDING COULD RESULT IN DAMAGES, FINES OR THE CURTAILMENT OF OUR OPERATIONS. We currently have the following administrative proceedings pending: - a review by the National Heritage Insurance Company, our Medicare Part B contractor, of our Medicare billing claims in Massachusetts; and - an action by MassPRO stemming from an audit of Medicaid claims submitted by one of our wholly-owned subsidiaries. Each of the proceedings listed above is described in greater detail in "Business--Legal and Administrative Proceedings." We have accrued $4,350,000 for probable settlement of these proceedings. While actual results could vary from this estimate, we believe that the resolution of any deficient billing process will not have a material adverse effect on our business. If this assessment is incorrect, however, then additional amounts required to settle these issues may have an adverse effect on our financial condition and our operations. HEALTHCARE REFORM LEGISLATION COULD LIMIT THE PRICES WE CAN CHARGE FOR OUR SERVICES, WHICH WOULD REDUCE OUR REVENUES AND HARM OUR OPERATING RESULTS. In addition to extensive existing government healthcare regulation, there are numerous initiatives at the federal and state levels for comprehensive reforms affecting the payment for and availability of healthcare services, including a number of proposals that would significantly limit reimbursement under the Medicare and Medicaid Programs. Limitations on reimbursement amounts and other cost containment pressures have in the past resulted in a decrease in the revenue we receive for each scan we perform. It is not clear at this time what proposals, if any, will be adopted or, if adopted, what effect these proposals would have on our business. Aspects of certain of these healthcare proposals, such as reductions in the Medicare and Medicaid Programs, containment of healthcare costs on an interim basis by means that could include a short-term freeze on prices charged by healthcare providers, and permitting greater state flexibility in the administration of Medicaid, could limit the demand for our services or affect the revenue per procedure that we can collect which would harm our business and results of operations. THE APPLICATION OR REPEAL OF STATE CERTIFICATE OF NEED REGULATIONS COULD HARM OUR BUSINESS AND FINANCIAL RESULTS. Some states require a certificate of need or similar regulatory approval prior to the acquisition of high-cost capital items including diagnostic imaging systems or provision of diagnostic imaging services by us or our clients. Seventeen of the 43 states in which we operate require a certificate of need and more states may adopt similar licensure frameworks in the future. In many cases, a limited number of these certificates are available in a given state. If we are unable to obtain the applicable certificate or approval or additional certificates or approvals necessary to expand our operations, these regulations may limit or preclude our operations in the relevant jurisdictions. Conversely, states in which we have obtained a certificate of need may repeal existing certificate of need regulations or liberalize exemptions from the regulations. For example, Pennsylvania, Nebraska, New York, Ohio and Tennessee have liberalized exemptions from certificate of need programs. The repeal of certificate of need regulations in states in which we have obtained a certificate of need or a certificate of need exemption would lower barriers to entry for competition in those states and could adversely affect our business. IF WE FAIL TO COMPLY WITH VARIOUS LICENSURE, CERTIFICATION AND ACCREDITATION STANDARDS WE MAY BE SUBJECT TO LOSS OF LICENSURE, CERTIFICATION OR ACCREDITATION WHICH WOULD ADVERSELY AFFECT OUR OPERATIONS. All of the states in which we operate require that the imaging technologists that operate our computed tomography, single photon emission computed tomography, and positron emission tomography systems be licensed or certified. Also, each of our retail sites must continue to meet various requirements in order to receive payments from the Medicare Program. In addition, we are currently accredited by the Joint Commission on Accreditation of Healthcare Organizations, an independent, non-profit organization that accredits various types of healthcare providers such as hospitals, nursing homes and providers of diagnostic imaging services. In the healthcare industry, various types of organizations are accredited to meet certain Medicare certification requirements, expedite third-party payment, and fulfill state licensure requirements. Some managed care providers prefer to contract with accredited organizations. Any lapse in our licenses, certifications or accreditations, or those of our technologists, or the failure of any of our retail sites to satisfy the necessary requirements under Medicare could adversely affect our operations and financial results. RISKS RELATED TO OUR BUSINESS CHANGES IN THE RATES OR METHODS OF THIRD-PARTY REIMBURSEMENTS FOR DIAGNOSTIC IMAGING AND THERAPEUTIC SERVICES COULD RESULT IN REDUCED DEMAND FOR OUR SERVICES OR CREATE DOWNWARD PRICING PRESSURE, WHICH WOULD RESULT IN A DECLINE IN OUR REVENUES AND HARM TO OUR FINANCIAL POSITION. We derive a small portion of our revenues from direct billings to patients and third-party payors such as Medicare, Medicaid or private health insurance companies, and changes in the rates or methods of reimbursement for the services we provide could have a significant negative impact on those revenues. Moreover, our healthcare provider clients on whom we depend for the majority of our revenues generally rely on reimbursement from third-party payors. In the past, initiatives have been proposed which, if implemented, would have had the effect of substantially decreasing reimbursement rates for diagnostic imaging services. Similar initiatives enacted in the future may have an adverse impact on our financial condition and our operations. Any change in the rates of or conditions for reimbursement could substantially reduce the number of procedures for which we or these healthcare providers can obtain reimbursement or the amounts reimbursed to us or our clients for services provided by us. Because unfavorable reimbursement policies have constricted and may continue to constrict the profit margins of the hospitals and clinics we bill directly, we have and may continue to need to lower our fees to retain existing clients and attract new ones. These reductions could have a significant adverse effect on our revenues and financial results by decreasing demand for our services or creating downward pricing pressure. Recently promulgated federal regulations affect the ability of a Medicare provider, such as a hospital, to include a service or facility as provider-based, as opposed to treating the service as if it were offered offsite from the hospital, for purposes of Medicare reimbursement. Historically, provider-based status has allowed a provider to obtain more favorable Medicare reimbursement for services like the ones we provide. While the Medicare, Medicaid and SCHIP Benefits and Improvement Act of 2000 offers some relief for facilities recognized as provider-based on October 1, 2000, under these new regulations, some of our clients may have difficulty qualifying our services for provider-based status. If a client cannot obtain provider-based status for our services, then the provider might decide not to contract with us, which would result in a decline in our operating results. OUR REVENUES MAY FLUCTUATE OR BE UNPREDICTABLE AND THIS MAY HARM OUR FINANCIAL RESULTS. The amount and timing of revenues that we may derive from our business will fluctuate based on: - variations in the rate at which clients renew their contracts; - the extent to which our mobile shared-service clients become full-time clients; - changes in the number of days of service we can offer with respect to a given diagnostic imaging or therapeutic system due to equipment malfunctions or the seasonal factors discussed below; and - the mix of wholesale and retail billing for our services. In addition, we experience seasonality in the sale of our services. For example, our sales typically decline from our third fiscal quarter to our fourth fiscal quarter. First and fourth quarter revenues are typically lower than those from the second and third quarters. First quarter revenue is affected primarily by fewer calendar days and inclement weather, the results of which are fewer patient scans during the period. Fourth quarter revenue is affected primarily by holiday and client and patient vacation schedules and inclement weather, the results of which are fewer patient scans during the period. As a result, our revenues may significantly vary from quarter to quarter, and our quarterly results may be below market expectations. We may not be able to reduce our expenses, including our debt service obligations, quickly enough to respond to these declines in revenue, which would make our business difficult to operate and would harm our financial results. If this happens, the price of our common stock may decline. WE MAY EXPERIENCE COMPETITION FROM OTHER MEDICAL DIAGNOSTIC COMPANIES AND THIS COMPETITION COULD ADVERSELY AFFECT OUR REVENUES AND OUR BUSINESS. The market for diagnostic imaging services and systems is competitive. Our major competitors include InSight Health Services Corp., Medical Resources, Inc., Shared Medical Services, Kings Medical Company Inc., Otter Tail Power Company, U.S. Diagnostic Inc., and Syncor International Corporation. In addition to direct competition from other mobile providers, we compete with independent imaging centers and healthcare providers that have their own diagnostic imaging systems as well as with equipment manufacturers that sell or lease imaging systems to healthcare providers for full-time installation. Some of our direct competitors which provide diagnostic imaging services may now or in the future have access to greater financial resources than we do and may have access to newer, more advanced equipment. In addition, some clients have in the past elected to provide imaging services to their patients directly rather than renewing their contacts with us. Finally, we face competition from providers of competing technologies such as ultrasound and may face competition from providers of new technologies in the future. If we are unable to successfully compete, our client base would decline and our business and financial condition would be harmed. MANAGED CARE ORGANIZATIONS MAY PREVENT HEALTHCARE PROVIDERS FROM USING OUR SERVICES WHICH WOULD CAUSE US TO LOSE CURRENT AND PROSPECTIVE CLIENTS. Healthcare providers participating as providers under managed care plans may be required to refer diagnostic imaging tests to specific imaging service providers depending on the plan in which each covered patient is enrolled. These requirements currently inhibit healthcare providers from using our diagnostic imaging services in some cases. The proliferation of managed care may prevent an increasing number of healthcare providers from using our services in the future which would cause our revenues to decline. TECHNOLOGICAL CHANGE IN OUR INDUSTRY COULD REDUCE THE DEMAND FOR OUR SERVICES AND REQUIRE US TO INCUR SIGNIFICANT COSTS TO UPGRADE OUR EQUIPMENT. Technological change in the MRI industry has been gradual since the last major technological advancements were made in 1994. However, technological changes in the MRI industry may accelerate in the future. The effect of technological change could significantly impact our business. The development of new scanning technology or new diagnostic applications for existing technology may require us to adapt our existing technology or acquire new or technologically improved systems in order to successfully compete. In the future, however, we may not have the financial resources to do so, particularly given our indebtedness. In addition, advancing technology may enable hospitals, physicians or other diagnostic service providers to perform tests without the assistance of diagnostic service providers such as ourselves. The development of new technologies or refinements of existing ones might make our existing systems technologically or economically obsolete, or cause a reduction in the value of, or reduce the need for, our systems. WE MAY BE UNABLE TO EFFECTIVELY MAINTAIN OUR IMAGING AND THERAPEUTIC SYSTEMS OR GENERATE REVENUE WHEN OUR SYSTEMS ARE NOT WORKING. Timely, effective service is essential to maintaining our reputation and high utilization rates on our imaging systems. Repairs to one of our systems can take up to two weeks and result in a loss of revenue. Our warranties and maintenance contracts do not fully compensate us for loss of revenue when our systems are not working. The principal components of our operating costs include depreciation, salaries paid to technologists and drivers, annual system maintenance costs, insurance and transportation costs. Because the majority of these expenses is fixed, a reduction in the number of scans performed due to out-of-service equipment will result in lower revenues and margins. Repairs of our equipment are performed for us by the equipment manufacturers. These manufacturers may not be able to perform repairs or supply needed parts in a timely manner. Thus, if we experience greater than anticipated system malfunctions or if we are unable to promptly obtain the service necessary to keep our systems functioning effectively, our revenues could decline and our ability to provide services would be harmed. WE MAY BE UNABLE TO RENEW OR MAINTAIN OUR CLIENT CONTRACTS WHICH WOULD HARM OUR BUSINESS AND FINANCIAL RESULTS. Upon expiration of our clients' contracts, we are subject to the risk that clients will cease using our imaging services and purchase or lease their own imaging systems or use our competitors' imaging systems. Thirty-three percent of our MRI contracts will expire in 2001 and an additional twenty-four percent will expire in 2002. If these contracts are not renewed, it could result in a significant negative impact on our business. In particular, renewal rates for contracts inherited from our acquired companies have historically been lower than those for our own contracts. For example, in 2000, the retention rate on contracts originated by us was approximately 87% compared with an average retention rate of approximately 83% for contracts originated by companies we acquired in the last three years. Our overall contract renewal rate for the first quarter of 2001 was 81%. It is not always possible to immediately obtain replacement clients, and historically many replacement clients have been smaller facilities which have a lower number of scans than lost clients. WE MAY BE SUBJECT TO PROFESSIONAL LIABILITY RISKS WHICH COULD BE COSTLY AND NEGATIVELY IMPACT OUR BUSINESS AND FINANCIAL RESULTS. We may be subject to professional liability claims. Although there currently are no known hazards associated with MRI or our other scanning technologies when used properly, hazards may be discovered in the future. Furthermore, there is a risk of harm to a patient during an MRI if the patient has certain types of metal implants or cardiac pacemakers within his or her body. Patients are carefully screened to safeguard against this risk, but screening may nevertheless fail to identify the hazard. To protect against possible professional liability, we maintain professional liability insurance. However, if we are unable to maintain insurance in the future at an acceptable cost or at all or if our insurance does not fully cover us, and a successful claim was made against us, we could be exposed. Any claim made against us not fully covered by insurance could be costly to defend against, result in a substantial damage award against us and divert the attention of our management from our operations, which could have an adverse effect on our financial performance. LOSS OF KEY EXECUTIVES AND FAILURE TO ATTRACT QUALIFIED MANAGERS, TECHNOLOGISTS AND SALES PERSONS COULD LIMIT OUR GROWTH AND NEGATIVELY IMPACT OUR OPERATIONS. We depend upon our management team to a substantial extent. In 2000, we added 216 employees. As we grow, we will increasingly require field managers and sales persons with experience in our industry and skilled technologists to operate our diagnostic equipment. It is impossible to predict the availability of qualified field managers, sales persons and technologists or the compensation levels that will be required to hire them. In particular, there is a very high demand for qualified technologists who are necessary to operate our systems. We may not be able to hire and retain a sufficient number of technologists, and we may be required to pay bonuses and higher salaries to our technologists, which would increase our expenses. The loss of the services of any member of our senior management or our inability to hire qualified field managers, sales persons and skilled technologists at economically reasonable compensation levels could adversely affect our ability to operate and grow our business. In addition, our inability to retain employees who have received options under our 1999 Equity Plan could have a material adverse effect on our net income in a future period. On June 20, 2001, our compensation committee authorized us to enter into the amended option agreements to reduce the performance targets that trigger the acceleration of the vesting of performance-based options granted under the plan. As discussed in "Management's Discussion and Analysis of Financial Condition and Results of Operations," if we achieve the new reduced performance vesting targets specified in the amended option agreements but do not achieve the original performance vesting targets, and an option holder terminates employment prior to the eighth anniversary of the option grant date, we would be required to record a non-cash compensation charge equal to the amount by which the actual value of the shares subject to the performance vesting option on the date of the amendment exceeded the option's exercise price. We note that the executive officers listed in "Management--Executive Officers and Directors" in the aggregate hold approximately 81% of the outstanding options under the 1999 Equity Plan. If a substantial number of senior managers were to leave in future periods under these circumstances, the non-cash compensation charges that we would be required to record would have a material adverse effect on our net income in those periods. OUR POSITRON EMISSION TOMOGRAPHY, OR PET, SERVICE AND SOME OF OUR OTHER IMAGING SERVICES REQUIRE THE USE OF RADIOACTIVE MATERIALS, WHICH COULD SUBJECT US TO REGULATION, RELATED COSTS AND DELAYS AND POTENTIAL LIABILITIES FOR INJURIES OR VIOLATIONS OF ENVIRONMENTAL, HEALTH AND SAFETY LAWS. Our PET service and some of our other imaging and therapeutic services require radioactive materials. While this radioactive material has a short half-life, meaning it quickly breaks down into inert, or non-radioactive substances, storage, use and disposal of these materials presents the risk of accidental environmental contamination and physical injury. We are subject to federal, state and local regulations governing storage, handling and disposal of these materials and waste products. Although we believe that our safety procedures for storing, handling and disposing of these hazardous materials comply with the standards prescribed by law and regulation, we cannot completely eliminate the risk of accidental contamination or injury from those hazardous materials. In the event of an accident, we could be held liable for any damages that result, and any liability could exceed the limits or fall outside the coverage of our insurance. We may not be able to maintain insurance on acceptable terms, or at all. We could incur significant costs and the diversion of our management's attention in order to comply with current or future environmental, health and safety laws and regulations. WE MAY NOT BE ABLE TO ACHIEVE THE EXPECTED BENEFITS FROM ANY PAST OR FUTURE ACQUISITIONS WHICH WOULD ADVERSELY AFFECT OUR FINANCIAL CONDITION AND RESULTS. We have historically relied on acquisitions as a method of expanding our business. In the past five years we have, directly or indirectly through our subsidiaries, completed seven significant acquisitions. In addition, although we have not presently identified any potential future acquisition candidates, we will consider future acquisitions as opportunities arise. If we do not successfully integrate acquisitions, we may not realize anticipated operating advantages and cost savings. The integration of companies that have previously operated separately involves a number of risks, including: - demands on management related to the increase in our size after an acquisition; - the diversion of our management's attention from the management of daily operations to the integration of operations; - difficulties in the assimilation and retention of employees; - potential adverse effects on operating results; and - challenges in retaining clients. With regard to the last item noted above, our client contract renewal rates for contracts inherited from our acquired companies have historically been lower than those for our own contracts. We may not be able to maintain the levels of operating efficiency acquired companies will have achieved or might achieve separately. Successful integration of each of their operations will depend upon our ability to manage those operations and to eliminate redundant and excess costs. Because of difficulties in combining operations, we may not be able to achieve the cost savings and other size related benefits that we hoped to achieve after these acquisitions which would harm our financial condition and results. RISKS RELATED TO THIS OFFERING INVESTORS WILL BE SUBJECT TO MARKET RISKS TYPICALLY ASSOCIATED WITH INITIAL PUBLIC OFFERINGS WHICH COULD CAUSE OUR STOCK PRICE TO DECLINE. Prior to this offering there has not been a public market for our common stock. We cannot predict the extent to which a trading market will develop or how liquid that market might become. If you purchase shares of common stock in this offering, you will pay a price that was not established in the public trading markets. The initial public offering price will be determined by negotiations between the underwriters and us. You may not be able to resell your shares at or above the initial public offering price and may suffer a loss on your investment. The market price of our common stock is likely to be highly volatile, in part as a result of factors which are beyond our control. These factors may cause the market price of our common stock to decline, regardless of our operating performance. If our future quarterly operating results are below the expectations of securities analysts or investors, the price of our common stock would likely decline. Stock price fluctuations may be exaggerated if the trading volume of our common stock is low. Securities class action litigation is often brought against a company after a period of volatility in the market price of its stock. Any securities litigation claims brought against us could result in substantial expense and divert management's attention from our core business. THIS OFFERING WILL HAVE SUBSTANTIAL BENEFITS TO THE INDIVIDUALS AND ENTITIES THAT PARTICIPATED IN THE KKR ACQUISITION. KKR, our other stockholders and our named executive officers will realize substantial benefits from the offering. As discussed in this prospectus under "KKR acquisition," assuming an initial public offering price of $16.00 per share, the value of KKR's investment in Alliance would increase by approximately $365.6 million, the value of Apollo's investment would increase by $28.3 million, the value of the investment by the affiliate of Deutsche Banc Alex. Brown Inc. would increase by $1.3 million, and the value of the options held by our named executive officers would increase by approximately $48.4 million. We also note that the management agreement we have with KKR which is described under "Certain Transactions" will remain in effect after the offering. In addition to the increase in value of our stockholders' investments, this offering will create a liquid market for our common stock. Although our named executive officers have generally agreed not to transfer sell or otherwise dispose of shares prior to the fifth anniversary of the grant of the related options, the existence of substantial unrealized gains and a liquid market for our shares could present an opportunity for KKR and our other stockholders to realize their gain. The lock-up agreements and other transfer restrictions are described elsewhere in this prospectus under "Shares Eligible for Future Sale" and the registration rights of KKR and Apollo are described elsewhere in this prospectus under "Description of Capital Stock--Registration Rights." A sale of a substantial number of shares of our stock by KKR or Apollo could cause our stock price to decline. WE ARE CONTROLLED BY A SINGLE STOCKHOLDER WHICH WILL BE ABLE TO EXERT SIGNIFICANT INFLUENCE OVER MATTERS REQUIRING STOCKHOLDER APPROVAL, INCLUDING CHANGE OF CONTROL TRANSACTIONS. As a result of the KKR acquisition, Viewer Holdings L.L.C., which is an affiliate of KKR owns approximately 78% of our common equity after giving effect to outstanding stock options. Following this offering, Viewer will own approximately 65% of our common equity, after giving effect to outstanding options. Accordingly, the KKR affiliate will control us and have the power to elect all of our directors, appoint new management and approve any action requiring the approval of the holders of shares of our common stock, including adopting amendments to our certificate of incorporation and approving mergers, consolidations or sales of all or substantially all of our assets. This concentration of ownership may also delay or prevent a change of control of our company or reduce the price investors might be willing to pay for our common stock. The interests of KKR may conflict with the interests of other holders of our common stock. FUTURE SALES BY OUR CURRENT SHAREHOLDERS MAY ADVERSELY AFFECT THE MARKET PRICE OF OUR COMMON STOCK. The market price of our common stock could decline as a result of sales of a large number of shares in the market after this offering or the perception that these sales could occur. These factors also could make it more difficult for us to raise funds through future offerings of our common stock. For a discussion of the shares of our common stock available for future sale, see "Shares Eligible for Future Sale." YOU WILL SUFFER IMMEDIATE AND SUBSTANTIAL DILUTION. The initial public offering price per share significantly exceeds our net tangible book value per share immediately after the offering. If you purchase common stock in this offering, you will incur dilution of $22.26 per share from the price per share you paid based on our adjusted net book value at March 31, 2001. See "Dilution."

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+RISK FACTORS The value of an investment in VCA will be subject to significant risks inherent in our business. You should carefully consider the risks and uncertainties described below and other information included in this prospectus before purchasing our common stock. If any of the events described below occur, our business and financial results could be adversely affected in a material way. This could cause the trading price of our common stock to decline, perhaps significantly. Risks Related to Our Business We may be unable to successfully execute our growth strategy and, as a result, our business may be harmed. Our success depends in part on our ability to build on our position as a leading animal health care services company through a balanced program of internal growth initiatives and selective acquisitions of established animal hospitals and laboratories. If we cannot implement or are not successful in executing these initiatives, our results of operations will be adversely affected. Our internal growth rate may decline and could become negative. Our laboratory internal revenue growth has fluctuated between 9.1% and 12.6% for each fiscal year since 1998. Similarly, our animal hospital same-facility revenue growth has fluctuated between 2.6% and 7.0% over the same periods. Even if we are successful implementing our growth strategy, we may not achieve the economies of scale that we have experienced in the past or that we anticipate. Our internal growth may continue to fluctuate and may be below our historical rates. Any reductions in the rate of our internal growth may cause our revenue and margins to decrease. Our internal growth calculations involve a number of assumptions, and our internal growth may not be calculated in the same manner as that of comparable companies. Our historical growth rates and margins are not necessarily indicative of future results. Our business and results of operations may be adversely affected if we are unable to manage our growth effectively. Since January 1, 1996, we have experienced rapid growth and expansion. Our failure to manage our growth effectively may increase our costs of operations and hinder our ability to execute our business strategy. Our rapid growth has placed, and will continue to place, a significant strain on our management and operational systems and resources. If our business grows, we will need to improve and enhance our overall financial and managerial controls, reporting systems and procedures, and expand, train and manage our workforce. We will also need to increase the capacity of our current systems to meet additional demands. Difficulties with the integration of new acquisitions may impose substantial costs and delays and cause other problems for us. Acquisitions involve a number of risks relating to our ability to integrate an acquired business into our existing operations. The process of integrating the operations of an acquired business, including its personnel, could cause interruptions to our business. Some of the risks we face include: . negative effects on our operating results; . impairments of goodwill and other intangible assets; . dependence on retention, hiring and training of key personnel, including specialists; . amortization of intangible assets; and . contingent and latent risks associated with the past operations of, and other unanticipated problems arising in, an acquired business. The process of integration may require a disproportionate amount of the time and attention of our management, which may distract management's attention from its day-to-day responsibilities. In addition, any interruption or deterioration in service resulting from an acquisition may result in a customer's decision to stop using us. For these reasons, we may not realize the anticipated benefits of an acquisition, either at all or in a timely manner. If that happens and we incur significant costs, it could have a material adverse impact on our business. A prolonged economic downturn could materially adversely affect our business. Our business may be materially adversely affected by prolonged, negative trends in the general economy that reduce consumer spending. Our business depends on the ability and willingness of animal owners to pay for our services. This dependence could make us more vulnerable to any reduction in consumer confidence or disposable income than companies in other industries that are less reliant on consumer spending, such as the human health care industry, in which a large portion of payments are made by insurance programs. Our substantial amount of debt could adversely affect our ability to run our business. We have, and will continue to have, a substantial amount of debt. At September 30, 2001, our debt, excluding unamortized discount, consisted primarily of: . $246.5 million of outstanding borrowings under our credit facility; . $136.6 million of outstanding senior notes and senior subordinated notes; and . $1.5 million of other debt. Our substantial amount of debt, including senior and secured debt, as well as the guarantees of our subsidiaries and the security interests in our assets, could impair our ability to operate our business effectively and may limit our ability to take advantage of business opportunities. For example, our indentures and credit facility: . limit our ability to borrow additional funds or to obtain other financing in the future for working capital, capital expenditures, acquisitions, investments and general corporate purposes; . require us to dedicate a substantial portion of our cash flow from operations to pay down our indebtedness, thereby reducing the funds available to use for working capital, capital expenditures, acquisitions and general corporate purposes; . limit our ability to dispose of our assets, create liens on our assets or to extend credit; . make us more vulnerable to economic downturns and reduce our flexibility in responding to changing business and economic conditions; . limit our flexibility in planning for, or reacting to, changes in our business or industry; . place us at a competitive disadvantage to our competitors with less debt; and . restrict our ability to pay dividends, repurchase or redeem our capital stock or debt, or merge or consolidate with another entity. The terms of our indentures and credit facility allow us, under specified conditions, to incur further indebtedness, which would heighten the foregoing risks. If compliance with our debt obligations materially hinders our ability to operate our business and adapt to changing industry conditions, we may lose market share, our revenue may decline and our operating results may suffer. We require a significant amount of cash to service our debt and expand our business as planned. Our ability to make payments on our debt, and to fund acquisitions, will depend on our ability to generate cash in the future. Insufficient cash flow could place us at risk of default under our debt agreements or could prevent us from expanding our business as planned. Our ability to generate cash is subject to general economic, financial, competitive, legislative, regulatory and other factors that are beyond our control. Our business may not generate sufficient cash flow from operations, our strategy to increase operating efficiencies may not be realized and future borrowings may not be available to us under our credit facility in an amount sufficient to enable us to service our debt or to fund our other liquidity needs. In order to meet our debt obligations, we may need to refinance all or a portion of our debt. We may not be able to refinance any of our debt, on commercially reasonable terms or at all. Our failure to satisfy covenants in our debt instruments will cause a default under those instruments. In addition to imposing restrictions on our business and operations, our debt instruments include a number of covenants relating to financial ratios and tests. Our ability to comply with these covenants may be affected by events beyond our control, including prevailing economic, financial and industry conditions. The breach of any of these covenants would result in a default under these instruments. An event of default would permit our lenders to declare all amounts borrowed from them to be due and payable, together with accrued and unpaid interest. Moreover, these lenders would have the option to terminate any obligation to make further extensions of credit under these instruments. If we are unable to repay debt to our senior lenders, these lenders could proceed against our assets. Due to the fixed cost nature of our business, fluctuations in our revenue could adversely affect our operating income. Approximately 56.5% of our expense, particularly rent and personnel costs, are fixed costs and are based in part on expectations of revenue. We may be unable to reduce spending in a timely manner to compensate for any significant fluctuations in our revenue. Accordingly, shortfalls in revenue may adversely affect our operating income. The significant competition in the animal health care services industry could cause us to reduce prices or lose market share. The animal health care services industry is highly competitive. To compete successfully, we may be required to reduce prices, increase our operating costs or take other measures that could have an adverse effect on our financial condition, results of operations, margins and cash flow. If we are unable to compete successfully, we may lose market share. There are many clinical laboratory companies that provide a broad range of laboratory testing services in the same markets we service. Our largest competitor for outsourced laboratory testing services is Idexx Laboratories, Inc. Also, Idexx and several other national companies provide on-site diagnostic equipment that allows veterinarians to perform their own laboratory tests. Our primary competitors for our animal hospitals in most markets are individual practitioners or small, regional, multi-clinic practices. Also, regional pet care companies and some national companies, including operators of super-stores, are developing multi-regional networks of animal hospitals in markets in which we operate. We may experience difficulties hiring skilled veterinarians due to periodic shortages which could disrupt our business. Skilled veterinarians are in shortage from time to time in particular regional markets in which we operate animal hospitals. During these shortages, we may be unable to hire enough qualified veterinarians to adequately staff our animal hospitals in these regions, in which event we may lose market share and our revenues and profitability may decline. If we fail to comply with governmental regulations applicable to our business, various governmental agencies may impose fines, institute litigation or preclude us from operating in certain states. The laws of many states prohibit business corporations from providing, or holding themselves out as providers of, veterinary medical care. These laws vary from state to state and are enforced by the courts and by regulatory authorities with broad discretion. We operate 53 animal hospitals in 11 states with these laws, including 21 in New York. We may experience difficulty in expanding our operations into other states with similar laws. Given varying and uncertain interpretations of the veterinary laws of each state, we may not be in compliance with restrictions on the corporate practice of veterinary medicine in all states. A determination that we are in violation of applicable restrictions on the practice of veterinary medicine in any state in which we operate could have a material adverse effect on us, particularly if we were unable to restructure our operations to comply with the requirements of that state. For example, we currently are a party to a lawsuit in the State of Ohio in which that State has alleged that our management of a veterinary medical group licensed to practice veterinary medicine in that state violates the Ohio statute prohibiting business corporations from providing or holding themselves out as providers of veterinary medical care. On March 20, 2001, the trial court in the case entered summary judgment in favor of the State of Ohio and issued an order enjoining us from operating in the State of Ohio in a manner that is in violation of the state statute. In response, we have restructured our operations in the State of Ohio in a manner that we believe conforms to the state law and the court's order. The Attorney General of the State of Ohio has informed us that it disagrees with our position that we are in compliance with the court's order. We are currently in discussions with the Attorney General's office in the State of Ohio in an attempt to resolve this matter. We may not be able to reach a settlement, in which case we would be required to discontinue our operations in the state. Our five animal hospitals in the State of Ohio have a book value of $6.1 million as of September 30, 2001. If we were required to discontinue our operations in the State of Ohio, we may not be able to dispose of the hospital assets for their book value. The animal hospitals located in the State of Ohio generated revenue, EBITDA and operating income of $2.2 million, $754,000 and $513,000, respectively, in the twelve months ended December 31, 2000 and $1.7 million, $575,000 and $376,000, respectively, in the nine months ended September 30, 2001. All of the states in which we operate impose various registration requirements. To fulfill these requirements, we have registered each of our facilities with appropriate governmental agencies and, where required, have appointed a licensed veterinarian to act on behalf of each facility. All veterinary doctors practicing in our clinics are required to maintain valid state licenses to practice. Any failure in our information technology systems could significantly increase testing turn-around time, reduce our production capacity and otherwise disrupt our operations. Our laboratory operations depend, in part, on the continued and uninterrupted performance of our information technology systems. Our growth has necessitated continued expansion and upgrade of our information technology infrastructure. Sustained system failures or interruption in one or more of our laboratory operations could disrupt our ability to process laboratory requisitions, perform testing, provide test results in a timely manner and/or bill the appropriate party. We could lose customers and revenue as a result of a system failure. Our computer systems are vulnerable to damage or interruption from a variety of sources, including telecommunications failures, electricity brownouts or blackouts, malicious human acts and natural disasters. Moreover, despite network security measures, some of our servers are potentially vulnerable to physical or electronic break-ins, computer viruses and similar disruptive problems. Despite the precautions we have taken, unanticipated problems affecting our systems could cause interruptions in our information technology systems. Our insurance policies may not adequately compensate us for any losses that may occur due to any failures in our systems. The loss of Mr. Robert L. Antin, our Chairman, President and Chief Executive Officer, could materially and adversely affect our business. We are dependent upon the management and leadership of our Chairman, President and Chief Executive Officer, Robert L. Antin. We have an employment contract with Mr. Antin which may be terminated at the option of Mr. Antin. We do not maintain any key man life insurance coverage for Mr. Antin. The loss of Mr. Antin could materially adversely affect our business. Risks Associated with this Offering Concentration of ownership among our existing executive officers, directors and principal stockholders may prevent new investors from influencing significant corporate decisions. Upon completion of this offering, our executive officers, directors and principal stockholders will beneficially own, in the aggregate, approximately 52.2% of our outstanding common stock. As a result, these stockholders will be able to exercise control over all matters requiring stockholder approval, including the election of directors, amendment of our certificate of incorporation and approval of significant corporate transactions and will have significant control over our management and policies. The directors elected by these stockholders will be able to make decisions affecting our capital structure, including decisions to issue additional capital stock, implement stock repurchase programs and incur indebtedness. This control may have the effect of deterring hostile takeovers, delaying or preventing changes in control or changes in management, or limiting the ability of our other stockholders to approve transactions that they may deem to be in their best interests. Future sales of shares of our common stock in the public market may depress our stock price and make it difficult for you to recover the full value of your investment in our shares. If our existing stockholders sell substantial amounts of our common stock in the public market following this offering or if there is a perception that these sales may occur, the market price of our common stock could decline. Based on shares outstanding as of September 30, 2001, upon completion of this offering we will have outstanding approximately 32,216,212 shares of common stock. Of these shares, only the shares of common stock sold in this offering will be freely tradable, without restriction, in the public market. After the lockup agreements pertaining to this offering expire 180 days from the date of this prospectus unless waived, an additional 18,216,212 shares will be eligible for sale in the public market at various times, subject to volume limitations under Rule 144 of the Securities Act of 1933. See "Shares Eligible for Future Sale" for more information regarding shares of our common stock that may be sold by existing stockholders after the closing of this offering. Because our common stock is not currently traded on a public market, the initial public offering price may not be indicative of the market price of our common stock after this offering. You may be unable to resell your shares at or above the initial public offering price. There is currently no public market for our common stock. An active public market may not develop for our common stock following this offering. If a market does develop, the market price of our common stock may be less than the public offering price. The public offering price will be determined by negotiations between us and the representatives of the underwriters and will not necessarily be indicative of the market price of the common stock after the offering. The prices at which the common stock will trade after the offering will be determined by the marketplace and may be influenced by many factors, including: . the information included in this prospectus and otherwise available to the representatives; . the history and the prospects of the industry in which we compete; . the ability of our management; . our past and present operations; . our prospects for future earnings; . the recent market prices of, and the demand for, publicly traded common stock of generally comparable companies; . market conditions for initial public offerings; and . the general condition of the securities markets at the time of this offering. The price of our common stock may be volatile. Following this offering, the price at which our common stock will trade may be volatile. The stock market has from time to time experienced significant price and volume fluctuations that have affected the market prices of securities. These fluctuations often have been unrelated or disproportionate to the operating performance of publicly traded companies. In the past, following periods of volatility in the market price of a particular company's securities, securities class-action litigation has often been brought against that company. We may become involved in this type of litigation in the future. Litigation of this type is often expensive to defend and may divert management's attention and resources from the operation of our business. Terrorism and the uncertainty of war may have a material adverse effect on our operating results. Terrorist attacks, such as the attacks that occurred in New York and Washington, D.C. on September 11, 2001, the response by the United States on October 7, 2001 and other acts of violence or war may affect the market on which our common stock will trade, the markets in which we operate, our operations and profitability and your investment. Further terrorist attacks against the United States or United States businesses may occur. The potential near-term and long-term effect these attacks may have for our customers, the market for our common stock, the markets for our services and the U.S. economy are uncertain. The consequences of any terrorist attacks, or any armed conflicts which may result, are unpredictable, and we may not be able to foresee events that could have an adverse effect on our markets, our business or your investment. Our stock price may be adversely affected because our results of operations may fluctuate significantly from quarter to quarter. Our operating results may fluctuate significantly in the future. If our quarterly revenue and operating results fall below the expectations of securities analysts and investors, the market price of our common stock could fall substantially. We believe that quarter to quarter or annual comparisons of our operating results are not a good indication of our future performance. Historically, when you eliminate the effect of acquisitions, we have experienced higher revenue in the second and third quarters than in the first and fourth quarters. The demand for our veterinary services is higher during warmer months because pets spend a greater amount of time outdoors, where they are more likely to be injured and are more susceptible to disease and parasites. Also, use of veterinary services may be affected by levels of infestation of fleas, heartworms and ticks, and the number of daylight hours. A substantial portion of our costs are fixed and do not vary with the level of demand for our services. Therefore, net income for the second and third quarters at individual animal hospitals and veterinary diagnostic laboratories generally is higher than in the first and fourth quarters. Operating results also may vary depending on a number of factors, many of which are outside our control, including: . demand for our tests; . changes in our pricing policies or those of our competitors; . the hiring and retention of key personnel; . wage and cost pressures; . changes in fuel prices or electrical rates; . costs related to acquisitions of technologies or businesses; and . seasonal and general economic factors. You will incur immediate and substantial dilution as a result of this offering. The initial public offering price is substantially higher than the book value per share of the common stock. As a result, purchasers in this offering will experience immediate and substantial dilution of $21.87 per share in the tangible book value of the common stock from the initial public offering price. Takeover defense provisions may adversely affect the market price of our common stock. Various provisions of Delaware corporation law and of our corporate governance documents may inhibit changes in control not approved by our board of directors and may have the effect of depriving you of an opportunity to receive a premium over the prevailing market price of our common stock in the event of an attempted hostile takeover. In addition, the existence of these provisions may adversely affect the market price of our common stock. These provisions include: . a classified board of directors; . a prohibition on stockholder action through written consents; . a requirement that special meetings of stockholders be called only by our the board of directors; . advance notice requirements for stockholder proposals and nominations; and . availability of "blank check" preferred stock.

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+RISK FACTORS An investment in our common stock involves a high degree of risk, including those risks discussed below. You should carefully consider these risk factors along with all of the other information contained in this prospectus before you decide to purchase shares of our common stock. If any of these risks actually occur, our business, financial condition and operating results could be adversely affected. If that happens, the trading price of our common stock could decline and you could lose part or all of your investment. The risks and uncertainties described below are not the only ones facing us. Additional risks and uncertainties not presently known to us, or that we currently see as immaterial, may also harm our business. RISKS ASSOCIATED WITH OUR BUSINESS AND OPERATIONS We are a start up company, have experienced historical operating losses and received a going concern opinion from our auditors. Substantially all of our historical revenues have been derived from providing Internet access services and digital and alpha paging services. We have no customers or revenues from our fiber optic and wireless broadband network that we are currently attempting to develop or our enterprise data storage facility that we are currently attempting to construct. Because our operating history is extremely limited, and we have not actually commenced operations on our fiber optic and wireless broadband network or our enterprise data storage facility, you may find it difficult to evaluate our business operations and prospects. We have experienced operating losses in each fiscal quarter since we were founded and will likely continue to experience such losses. As noted in our auditor's report dated September 18, 2000, our auditors have indicated that there was substantial doubt as to our ability to continue as a going concern. We have immediate needs for substantial additional capital. Our present operations do not provide sufficient cash flow to pay our debts as they become due. We had negative working capital of approximately $15,000,000 at September 30, 2000, and we expect we will need to obtain additional capital of approximately $150,000,000 to finance our operating and capital needs over the next twelve months. We are actively searching for sources of financing in order to fund our business operations and capital needs, but have no commitment to provide such financing as of the date of this Prospectus. See "Management's Discussion and Analysis of Financial Condition - Liquidity." If we fail to obtain additional capital our proposed operations will be substantially restricted and we may not be able to pursue our proposed business plan. We are currently in default in paying certain material obligations. In March 2000, we entered into an agreement with Qwest Communications to purchase 500 miles of fiber conduit from New Orleans to Mobile, Alabama and from Pensacola, Florida to Jacksonville, Florida. The total purchase price under this agreement was approximately $15,000,000. Payments totaling approximately $9,000,000 are currently due or past due under the agreement. We have not made any of the payments due under this agreement and we are not able to make the payments, but no default has been declared. Our obligations under this agreement are personally guaranteed by our president. See "Certain Relationships and Related Transactions." We have also entered into a contract with Thoroughbred Technology and Telecommunications to lay fiber conduit between Atlanta and Memphis, through Chattanooga, at a total cost of approximately $29,000,000, of which 10% was due on October 15, 2000. The Company has received a notice of default under this contract, as we have not made this payment and we are not currently able to make the payment. If we are not able to obtain financing or raise funds to satisfy these obligations, we may lose the ability to continue to lay fiber optic cable and be subject to claims for contract breach. This would impede our plans to develop and operate a fiber optic and wireless broadband network and enterprise data storage facility. We lease our facilities and the lessor has the right to terminate the lease. We lease our primary facility in Iuka, Mississippi from the Mississippi Department of Economic and Community Development. This facility is critical to our proposed business plan because it already contains many of the features necessary for us to establish an enterprise data storage facility. Under our current lease agreement the lessor has the right to terminate the lease on ninety days prior written notice, regardless of whether we have defaulted under the lease. Termination of the lease by the lessor, especially after we have invested considerable time and funds in developing the facility as an enterprise data storage facility, would cause material damage to us and to our proposed business plans. See "Business - Properties". We have certain outstanding obligations to pre-merger shareholders of Pierce International, Inc. As part of the share exchange transaction with Pierce International, Inc. effected in December 1999, we agreed that as soon as practicable after the closing of the share exchange transaction we would offer to those persons who were shareholders of Pierce International, Inc. immediately prior to the closing, by means of a registration statement filed with the Securities and Exchange Commission, the right to purchase 0.26 of a share for each share held by such person at a price of $0.25 per share at any time prior to the expiration of one year from the effective date of the registration statement. As of the date of this prospectus, we have determined that it is not yet practicable to make such an offer, principally due to the expense of state registration of the offer. There were approximately 7,515,705 shares outstanding held by Pierce shareholders immediately prior to closing the share exchange transaction, and we would need to issue approximately 1,954,083 additional shares of our common stock in the event all options to purchase such shares were exercised. A sudden increase in the number of shares of our common stock that is outstanding may cause the price of the stock to go down and also could affect our ability to raise equity capital. Our operating results are likely to fluctuate widely from one period to another. We expect that our operating results for the foreseeable future are likely to fluctuate widely from quarter to quarter and from year to year. This is especially true while we are building our fiber optic and wireless broadband network. Fluctuation of results may occur due to a variety of factors including, demand for and market acceptance of our products and services, reliability of service and network availability, the ability to increase bandwidth as necessary, customer retention, capacity utilization of our enterprise data storage facility, the timing of customer needs, the timing and magnitude of capital expenditures, changes in pricing policies or practices of competitors, and changes in governmental regulations. We will face significant competition in running our business. Our market is intensely competitive. We may not have the resources to compete successfully in the future. Current and potential competitors include national, foreign and regional internet service providers, global, regional and local telecommunications companies and the Regional Bell Operating Companies, providers of server hosting and data storage services, and other technology services and products companies. Most of these competitors will have substantially greater resources than us. See "Description of Business - Competition." We are entering a new market. The market for Internet system and network management solutions has only recently begun to develop, is evolving rapidly and is characterized by an increasing number of market entrants. This market may not prove to be viable or, if it becomes viable, may not continue to grow. We currently incur costs in excess of our revenues. If we cannot attract and retain a customer base, we will not be able to increase our sales and revenues nor create economies of scale to offset our fixed and operating costs. We will need to be able to manage growth. In order for us to accomplish our proposed business plan, we must experience rapid growth in building our enterprise data storage facilities and network infrastructure, expand our service offering, expand our geographical coverage, expand our customer base and increase the number of our employees. This growth is expected to place a significant strain on our financial, management, operational and other resources, including our ability to ensure customer satisfaction. This expansion will require significant time commitments from our senior management and involve the efficient management of multiple relationships with a growing number of third parties. Our ability to manage growth effectively will require us to continue to expand operating and financial procedures and controls, to upgrade operational, financial and management information systems and to attract, train, motivate and retain key employees. We will also need to be able to attract, hire and retain qualified employees in today's competitive employment market. If our executives are unable to manage growth effectively, our business could be materially adversely affected. If our systems fail, we could face significant costs. We must protect our network infrastructure and equipment against damage from human error, physical or electronic security breaches, power loss and other facility failures, fire, earthquake, flood, telecommunications failure, sabotage, vandalism and similar events. Despite precautions that we have taken, a natural disaster or other unanticipated problems at one of our facilities could result in interruptions in services or significant damage to customer equipment or data. Any damage to or failure of our systems or service providers could result in reductions in, or terminations of, services supplied to our customers, which could have a material adverse effect on our business. We will depend on network interconnections supplied by third parties. We will rely, in part, on a number of public and private network interconnections to allow our customers to connect to other networks. If the networks with which we interconnect were to discontinue their interconnections, our ability to exchange traffic would be significantly constrained. Furthermore, our business could be harmed if these networks do not add more bandwidth to accommodate increased traffic. Some of these networks will likely require the payment of fees for the right to maintain interconnections. There usually is nothing to prevent any networks from increasing fees or denying access. In such cases, our ability to pursue the proposed business plan could be materially adversely affected. A portion of our business may be subject to international risks. We are pursuing international business opportunities, especially with respect to the Country of Turkey. Risks inherent in international operations include unexpected changes in regulatory requirements, export restrictions, tariffs and other trade barriers; challenges in staffing and managing foreign operations; differences in technology standards; employment laws and practices in foreign countries; longer payment cycles and problems in collecting accounts receivable; political instability; changes in currency exchange rates and imposition of currency exchange controls and potentially adverse tax consequences. Our business is likely to become dependant upon one or a few major customers. Upon completion and commencement of operations of our planned fiber optic and wireless broadband network and enterprise data storage facility, we will likely experience periods during which we will be highly dependent on one or a limited number of customers. Being dependent on a single or a few customers will make it difficult to satisfactorily negotiate attractive prices for our services and will expose us to the risk of substantial losses if a single dominant customer stops conducting business with us. RISKS RELATED TO LEGAL REQUIREMENTS We will have to comply with telecommunications regulations. Most of our proposed business services and products are subject to regulation at the federal and state levels. These regulations are in some cases uncertain and are often undergoing change. If we fail to comply with these regulations our business could be materially adversely effected. See "Description of Business - Government Regulation." We will have to comply with environmental regulations. Our intended operations, especially the construction and operation of a fiber optic network, are subject to various federal, state and local laws and regulations relating to the protection of the environment. These environmental laws and regulations, which have become increasingly stringent, are implemented principally by the Environmental Protection Agency and comparable state agencies, and govern the management of hazardous wastes, the discharge of pollutants into the air and into surface and underground waters, and the manufacture and disposal of certain substances. There are no material environmental claims currently pending or, to our knowledge, threatened against us. In addition, we believe that our operations are in material compliance with current laws and regulations. We estimate that any expenses incurred in maintaining compliance with current laws and regulations will not have a material effect on our earnings or capital expenditures. However, current regulatory requirements may change, currently unforeseen environmental incidents may occur, or past non-compliance with environmental laws may be discovered on our properties. RISKS RELATED TO THE OFFERING We may issue additional shares of common stock or preferred stock without shareholder approval and may agree to register the resale of additional shares of common stock. Our Certificates of Incorporation authorizes the issuance of up to 150,000,000 shares of common stock and up to 10,000,000 shares of preferred stock with such rights and preferences as our board of directors may determine from time to time. Our board of directors may authorize us to issue additional shares of common stock or one or more series of preferred stock without shareholder approval. The existence or terms of these securities may adversely affect the rights of holders of the common stock. In addition, we may grant rights to other current or future holders of common stock to have their shares of common stock registered for resale under the Securities Act of 1933. A decision by any such shareholder to publicly sell a significant number of shares of the common stock will have the potential to cause a material decrease in the trading price of the common stock and may impair our future ability to raise capital at prices or on terms favorable to us. The market price of our common stock is extremely volatile. Trading volume and prices for our common stock have fluctuated widely since our share exchange transaction with Pierce International, Inc. During the period from January to September 2000 the bid price for our common stock has ranged from $0.95 per share to $9.13 per share. Our common stock trades only on the NASD's OTC Bulletin Board. As a result, selling our shares may be more difficult because smaller quantities of shares may be bought and sold, transactions may be delayed, and news media coverage of us is limited. Further, securities analysts do not cover our stock and institutional investors are unlikely to purchase our stock. See "Market for Registrant's Common Equity and Related Stockholder Matters." All of the shares registered for sale on behalf of the selling stockholders are "restricted securities" as that term is defined in Rule 144 under the Securities Act. We filed a Registration Statement of which this prospectus is a part to register these restricted shares for sale into the public market by the selling stockholders. The effect of this Registration Statement is to increase the number of unrestricted shares. A sudden increase in the amount of unrestricted shares may cause the price of the stock to go down and also could affect our ability to raise equity capital. Any outstanding shares not sold by the selling stockholders pursuant to this prospectus will remain "restricted shares" in the hands of the holder, except for those held by non-affiliates, for a period of one year, calculated pursuant to SEC Rule 144. "Penny Stock" regulations may impair the liquidity of our common stock. Because the bid price of our common stock is below $5.00 per share, shares of common stock may be subject to the SEC's Rule 15g-9 and other penny stock regulations under the Securities Exchange Act of 1934. Rule 15g-9 imposes sales practice requirements on broker-dealers that sell low-priced securities to persons other than established customers and institutional accredited investors. For transactions covered by this rule, a broker-dealer must make a special suitability determination for the prospective purchaser and have received the purchaser's written consent to the transaction before the sale. Consequently, this rule and other "penny stock" regulations may adversely affect the ability of broker-dealers to sell our shares and may adversely affect the ability of holders to sell their shares of common stock in the secondary market. A small number of persons control the Company. Robert R. Crawford, our President and sole director, controls approximately 45% of our outstanding shares of common stock. In addition, a trust for the benefit of certain adult members of Mr. Crawford's family controls approximately 18% of our outstanding shares of common stock, of which Mr. Crawford disclaims beneficial ownership. As a result, Mr. Crawford and his family are able to exercise a significant influence over all matters requiring shareholder or board of director approval, including the election of directors and approval of significant corporate transactions. Such concentration of ownership may also have the effect of delaying or preventing a change in control of the Company. We do not intend to pay, and expect to be unable to pay, dividends on our common stock. We have not paid dividends, and do not intend to pay any dividends in the foreseeable future, since earnings, if any, are expected to be retained for use in the development and expansion of our business. DISCLOSURE REGARDING FORWARD-LOOKING STATEMENTS This Prospectus contains forward-looking statements that involve substantial risks and uncertainties. You can identify these statements by forward-looking words such as "anticipate," "believe," "plan," "could," "would", "estimate," "expect," "intend," "may," "should," and "will" or similar words. For example, statements about the level of capital expenditures and working capital that we may need to fund our business plan and the miles of fiber optic plant that we expect to develop are forward-looking statements. You should read statements that contain these words carefully because they discuss our future expectations, contain projections or our future results of operations or of our financial position or state other "forward-looking" information. There will likely be events in the future that we are not able to accurately predict or control. The factors listed above in the section captioned "Risk Factors" as well as any cautionary language located elsewhere in this Prospectus, provide examples of some of the risks, uncertainties and events that may cause our actual results to differ materially from the expectations se describe in our forward-looking statements. Before you invest in our common stock, you should be aware that the occurrence of the events described in these risk factors and elsewhere in this Prospectus could have a material adverse effect on our business, results of operations and financial position.

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+RISK FACTORS INVESTING IN OUR COMMON STOCK WILL PROVIDE YOU WITH AN EQUITY OWNERSHIP IN MATADOR. AS ONE OF OUR SHAREHOLDERS, YOUR INVESTMENT WILL BE SUBJECT TO RISKS INHERENT IN OUR BUSINESS. THE TRADING PRICE OF YOUR SHARES WILL BE AFFECTED BY THE PERFORMANCE OF OUR BUSINESS RELATIVE TO, AMONG OTHER THINGS, COMPETITION, MARKET CONDITIONS AND GENERAL ECONOMIC AND INDUSTRY CONDITIONS. YOU SHOULD CAREFULLY CONSIDER THE FOLLOWING RISK FACTORS AS WELL AS OTHER INFORMATION CONTAINED IN THIS PROSPECTUS BEFORE DECIDING TO INVEST IN SHARES OF OUR COMMON STOCK. THE RISKS DESCRIBED BELOW ARE NOT THE ONLY ONES FACING MATADOR. ADDITIONAL RISKS AND UNCERTAINTIES NOT CURRENTLY KNOWN TO US OR THAT WE CURRENTLY CONSIDER IMMATERIAL MAY ALSO MATERIALLY AND ADVERSELY AFFECT OUR BUSINESS OPERATIONS. ANY OF THE FOLLOWING RISKS COULD MATERIALLY AND ADVERSELY AFFECT OUR BUSINESS, FINANCIAL CONDITION OR RESULTS OF OPERATIONS. IN THAT CASE, YOU MAY LOSE ALL OR PART OF YOUR ORIGINAL INVESTMENT. RISKS RELATING TO THE OIL AND NATURAL GAS INDUSTRY OUR PROFITABILITY IS HIGHLY DEPENDENT ON THE PRICES FOR OIL AND NATURAL GAS, WHICH ARE EXTREMELY VOLATILE. Our revenues, profitability and future growth substantially depend on prevailing prices for oil and natural gas. Prices for oil and natural gas are extremely volatile. Among the factors that can cause this volatility are: - the domestic and foreign supply of oil and natural gas; - the level of demand for oil and natural gas; - the availability, proximity and capacity of gathering systems of natural gas; - the price and availability of alternative fuels; - weather conditions; - political conditions in oil and natural gas producing regions; - the price of foreign imports; - overall economic conditions; and - domestic and foreign governmental regulations. Prices for oil and natural gas affect the amount of cash flow available to us for capital expenditures and our ability to borrow and raise additional capital. Our ability to maintain or increase our borrowing capacity and to obtain additional capital on attractive terms is also substantially dependent upon oil and natural gas prices. In addition, because we currently produce more natural gas than oil, we face more risk associated with fluctuations in the price of natural gas than oil. In the past, we have used hedging contracts to reduce our exposure to price changes, but we currently have no such contracts in place. IF WE ARE NOT ABLE TO REPLACE DEPLETED RESERVES, OUR FUTURE RESULTS OF OPERATIONS WILL BE ADVERSELY AFFECTED. The rate of production from oil and natural gas properties declines as reserves are depleted. Our proved reserves will decline as reserves are produced unless we acquire additional properties containing proved reserves, conduct successful exploration and development activities on new or currently leased properties or identify additional formations with primary or secondary reserve opportunities on our properties. If we are not successful in expanding our reserve base, our future oil and natural gas production, the primary source of our revenues, may decrease. The level of our future oil and natural gas production and our results of operations are therefore highly dependent on the level of our success in finding and acquiring additional reserves. Our ability to find and acquire additional reserves depends on our generating sufficient cash flow from operating activities and other sources of capital, including borrowings under our revolving credit facility. If we are unable to generate sufficient cash flow or obtain sufficient cash from other sources, we may not be able to expand our reserve base. EXPLORATION IS A HIGH-RISK ACTIVITY, AND THE 2-D AND 3-D SEISMIC DATA AND OTHER ADVANCED TECHNOLOGIES WE USE CANNOT ELIMINATE EXPLORATION RISK. Our future success will depend on the success of our exploratory drilling program. Exploration activities involve numerous risks, including the risk that no commercially productive oil or natural gas reservoirs will be discovered. In addition, we often are uncertain as to the future cost or timing of drilling, completing and producing wells. Furthermore, our drilling operations may be curtailed, delayed or canceled as a result of the additional exploration time and expense associated with a variety of factors, including: - unexpected adverse drilling conditions; - pressures or irregularities in formations; - equipment failures or accidents; - adverse weather conditions; - compliance with governmental requirements; and - shortages or delays in the availability of drilling rigs and the delivery of equipment. We employ visualization and 2-D and 3-D seismic images to assist us in exploration and drilling where applicable. Even when used and properly interpreted, these techniques only assist geoscientists in identifying subsurface structures and hydrocarbon indicators. They do not allow the interpreter to know conclusively if hydrocarbons are present or economically producible. We could incur losses by drilling unproductive wells based on these activities. Poor results from our exploration activities could limit our ability to replace reserves and materially and adversely affect our future cash flows and results of operations if we receive a limited return on our exploration investments. RESERVE ESTIMATES DEPEND ON MANY ASSUMPTIONS THAT MAY PROVE TO BE INACCURATE AND THAT MAY MATERIALLY AFFECT THE QUANTITIES AND PRESENT VALUE OF THE FUTURE NET CASH FLOWS OF OUR RESERVES. The process of estimating oil and natural gas reserves is complex. It requires interpretations of available technical data and various assumptions, including assumptions relating to economic factors. Any significant inaccuracies in these interpretations or assumptions could materially affect the estimated quantities and present value of reserves shown in this prospectus. Please read "Business and Properties--Oil and Natural Gas Reserves" for a discussion of our proved oil and natural gas reserves. In order to prepare these estimates of oil and natural gas reserves we must: - project production rates and timing of development expenditures; - analyze available geological, geophysical, production and engineering data; and - make economic assumptions about several factors, including, among others: - oil and natural gas prices; - drilling and operating expenses; - capital expenditures; - taxes; and - the availability of funds. Because the information used in our models varies in extent, quality and reliability, our estimates of oil and natural gas reserves are inherently imprecise. Actual future production, oil and natural gas prices, revenues, taxes, development expenditures, operating expenses and quantities of recoverable oil and natural gas reserves most likely will vary from our estimates. Any significant variance could materially affect the estimated quantities and present value of reserves shown in this prospectus. In addition, we may adjust estimates of proved reserves to reflect production histories, results of exploration and development, prevailing oil and natural gas prices and other factors, many of which are beyond our control. At April 30, 2001, 74% of our proved reserves were either proved producing or proved developed non-producing. Moreover, as of April 30, 2001, many of the producing wells included in our reserve report had produced for only a relatively short period. Because many of our reserve estimates are not based on a lengthy production history and many estimates are calculated using volumetric analysis, these estimates are less reliable than estimates based on a lengthy production history. You should not assume that the present value of future net cash flows from our proved reserves referred to in this prospectus is the current market value of our estimated oil and natural gas reserves. According to the requirements of the SEC, we generally base the estimated discounted future net cash flows from our proved reserves on prices and costs on the date of the estimate. Actual future prices and costs may differ materially from those used in the present value estimate. ANY FAILURE OF OUR ACTUAL RESULTS TO MEET OUR ESTIMATES OF PROVED RESERVES AND FUTURE NET REVENUES COULD AFFECT THE CARRYING VALUE OF OUR ASSETS, OUR INCOME AND OUR ABILITY TO BORROW FUNDS. There are numerous uncertainties inherent in estimating quantities of proved reserves and in projecting future rates of production and the timing of development expenditures, including many factors beyond our control. The reserve data included in this prospectus represent only estimates. In addition, the estimates of future net revenue from proved reserves and their present value are based on assumptions about future production levels, prices and costs that may not prove to be correct over time. In particular, estimates of oil and natural gas reserves, future net revenue from proved reserves and the present value of proved reserves for the oil and natural gas properties described in this prospectus are based on the assumption that future oil and natural gas prices remain the same as oil and natural gas prices at April 30, 2001. The prices as of April 30, 2001, used for purposes of our estimates, were $27.71 per Bbl of oil and $4.71 per Mcf of natural gas. These prices were derived from NYMEX prices of $28.29 per Bbl of oil and $4.87 per Mmbtu of natural gas. Any significant variance in actual results from these assumptions could also materially affect the estimated quantity and value of our reserves and impact our ability to borrow funds. WE MAY BE REQUIRED TO WRITE DOWN THE CARRYING VALUE OF OUR PROVED PROPERTIES UNDER ACCOUNTING RULES AND THESE WRITE-DOWNS COULD ADVERSELY AFFECT OUR FINANCIAL CONDITION. There is a risk that we will be required to write-down the carrying value of our oil and natural gas properties when oil and natural gas prices are low. In addition, write-downs may occur if we have: - downward adjustments to our estimated proved reserves; - increases in our estimates of development costs; or - deterioration in our exploration results. We periodically review the carrying value of our oil and natural gas properties under the full cost accounting rules of the SEC. Under these rules, the net capitalized costs of oil and natural gas properties may not exceed a ceiling limit that is based on the present value, based on flat prices at a single point in time, of estimated future net revenues from proved reserves, discounted at 10%. If net capitalized costs of oil and natural gas properties exceed the ceiling limit, we must charge the amount of this excess to earnings in the quarter in which the excess occurs. At December 31, 1998, we were required to write down the carrying value of our oil and natural gas properties by approximately $4.5 million. We may not reverse write-downs even if prices increase in subsequent periods. A write-down does not affect cash flow from operating activities, but it does reduce the book value of our net tangible assets and shareholders' equity and could lower the price of your shares and cause us to be in non-compliance with some of our debt covenants. THE UNAVAILABILITY OR HIGH COST OF ADDITIONAL DRILLING RIGS, EQUIPMENT, SUPPLIES AND PERSONNEL COULD ADVERSELY AFFECT OUR ABILITY TO EXECUTE OUR EXPLORATION AND DEVELOPMENT PLANS WITHIN BUDGET AND ON A TIMELY BASIS. Shortages or the high cost of drilling rigs, equipment, supplies or personnel could delay or adversely affect our development and exploration operations, which could have a material adverse effect on our financial condition and results of operations. Beginning in 2000, we experienced a significant escalation in the costs of products and services in our exploration and development activities. If drilling activity in the United States increases further, associated costs may also increase, including those costs related to drilling rigs, equipment, supplies and personnel and the services and products of other vendors to the industry. These costs may increase and necessary equipment and services may become unavailable to us at economical prices. Should this happen, we may delay our drilling activities, which may limit our ability to replace reserves, or we may incur these higher costs, which may negatively affect our results of operations. THE OIL AND NATURAL GAS BUSINESS INVOLVES MANY OPERATING RISKS THAT COULD CAUSE SUBSTANTIAL LOSSES. Drilling activities involve the risk that no commercially productive oil or natural gas reservoirs will be found or produced. We may drill or participate in new wells that are not productive. We may drill wells that are productive but that do not produce sufficient net revenues to return a profit after drilling, operating and other costs. Whether a well is productive and profitable depends on a number of factors, including the following, many of which are beyond our control: - general economic and industry conditions, including the prices received for oil and natural gas; - mechanical problems encountered in drilling wells or in production activities; - problems in title to our properties; - weather conditions that delay drilling activities or cause producing wells to be shut down; - compliance with governmental requirements; and - shortages in or delays in the delivery of equipment and services. If we do not drill productive and profitable wells in the future, our financial condition and results of operations could be materially and adversely affected due to decreased cash flow and net revenues. In addition to the substantial risk that we may not drill productive and profitable wells, the following hazards are inherent in oil and natural gas exploration, development, production and gathering, including: - unusual or unexpected geologic formations; - unanticipated pressures; - mechanical failures; - blowouts where oil or natural gas flows uncontrolled at a wellhead; - cratering or collapse of the formation; - explosions; - releases of hazardous substances or other waste materials that cause environmental damage; and - environmental accidents such as uncontrollable flows of oil, natural gas or well fluids into the environment, including groundwater contamination. We could suffer substantial losses from these hazards due to injury and loss of life, severe damage to and destruction of property and equipment, pollution and other environmental damage and suspension of operations. We carry insurance that we believe is consistent with customary industry practices for companies of our size. However, we do not fully insure against all risks associated with our business either because this insurance is not available or because we believe the cost is prohibitive. The occurrence of an event that is not covered, or not fully covered by insurance, could decrease cash flow and net revenues and negatively affect our financial condition if we incur cleanup costs or must settle claims related to these hazards. WE MAY PURCHASE OIL AND NATURAL GAS PROPERTIES WITH LIABILITIES OR RISKS WE DID NOT KNOW ABOUT OR THAT WE DID NOT CORRECTLY ASSESS, AND, AS A RESULT, WE COULD BE SUBJECT TO LIABILITIES THAT COULD ADVERSELY AFFECT OUR RESULTS OF OPERATIONS. Before acquiring oil and natural gas properties, we estimate the recoverable reserves, future oil and natural gas prices, operating costs, potential environmental liabilities and other factors relating to the properties. We believe our method of review is generally consistent with industry practices. However, our review involves many assumptions and estimates, and their accuracy is inherently uncertain. As a result, we may not discover all existing or potential problems associated with the properties we buy. We may not become sufficiently familiar with the properties to fully assess their deficiencies and capabilities. We do not generally perform inspections on every well, and we may not be able to observe mechanical and environmental problems even when we conduct an inspection. Even if we identify problems, the seller may not be willing or financially able to give us contractual protection against these problems, and we may decide to assume environmental and other liabilities in connection with properties we acquire. If we acquire properties with risks or liabilities we did not know about or that we did not correctly assess, our financial condition and results of operations could be adversely affected as we settle claims and incur cleanup costs related to these liabilities. WE MAY NOT ACCURATELY EVALUATE ACQUISITION OPPORTUNITIES AND AS A RESULT WE MAY PURCHASE ADDITIONAL OIL AND NATURAL GAS PROPERTIES AT PRICES GREATER THAN THEIR ACTUAL VALUE. We constantly evaluate acquisition opportunities and frequently engage in bidding and negotiating for acquisitions, many of which are substantial. However, we may not be successful in identifying or acquiring additional property interests, which could prevent us from replacing our reserves. If successful in this process, we may be required to alter or increase substantially our capitalization to finance these acquisitions through the use of cash on hand, the issuance of additional debt or equity securities, the sale of production payments, borrowing of additional funds or otherwise. Our existing credit facility includes covenants limiting our ability to incur additional debt. If we were to proceed with one or more acquisitions for stock, our stockholders would suffer dilution of their interests. While we intend to concentrate on acquiring producing properties with exploration and development potential located in our current areas of operation, we may decide to acquire properties located in other geographic regions. The acquisition of properties that are substantially different in operating or geologic characteristics or geographic locations from our existing properties, with which we have less experience, could change the nature of our operations and business. WE ARE SUBJECT TO GOVERNMENT REGULATION AND LIABILITY, INCLUDING COMPLEX ENVIRONMENTAL LAWS, THAT COULD REQUIRE SIGNIFICANT EXPENDITURES AND COULD MATERIALLY DECREASE OUR NET INCOME. The exploration, development, production and sale of oil and natural gas in the United States is subject to many federal, state and local laws and regulations, including complex environmental laws and regulations. Under these laws and regulations, we may be required to make large expenditures that could materially adversely affect our results of operations. These expenditures could include payments for: - personal injuries; - property damage; - containment and clean up of oil and other spills; - the management and disposal of hazardous materials; - remediation and clean-up costs; and - other environmental damages. While we maintain insurance coverage for our operations, we do not believe that full insurance coverage for all potential environmental damages is available at a reasonable cost. Failure to comply with these laws and regulations also may result in the suspension or termination of our operations and subject us to administrative, civil and criminal penalties. Laws and regulations protecting the environment have been changed frequently and the changes often imposed include increasingly stringent requirements. These laws and regulations may impose liability on us for environmental damage and disposal of hazardous materials even if we were not negligent or at fault. We may also be liable for the conduct of others or for acts that complied with applicable laws at the time we performed those acts. THE MARKETABILITY OF OUR PRODUCTION IS DEPENDENT UPON TRANSPORTATION FACILITIES OVER WHICH WE HAVE NO CONTROL. The unavailability of satisfactory oil and natural gas transportation arrangements may hinder our access to oil and natural gas markets or delay our production. The availability of a ready market for our oil and natural gas production depends on a number of factors, including the demand for, and supply of, oil and natural gas and the proximity of reserves to pipelines and terminal facilities. Our ability to market our production depends in substantial part on the availability and capacity of gathering systems, pipelines and processing facilities owned and operated by third parties. Our failure to obtain these services on acceptable terms could materially harm our business. We may be required to shut in wells for lack of a market or because of inadequacy or unavailability of natural gas pipeline or gathering system capacity. If that were to occur, we would be unable to realize revenue from those wells until production arrangements were made to deliver our production to market. RISKS RELATING TO MATADOR WE MAY HAVE DIFFICULTY FINANCING OUR PLANNED GROWTH AND CAPITAL EXPENDITURES. We have experienced and expect to continue to experience substantial capital expenditure and working capital needs as a result of our exploration, development and acquisition strategy. In the future, we may require financing, in addition to cash generated from our operations and this offering, to fund our planned growth and capital expenditures. If additional capital resources are unavailable, we will be unable to grow our business and we may curtail our drilling, development and other activities or be forced to sell some of our assets on an untimely or unfavorable basis. A SIGNIFICANT COMPONENT OF OUR GROWTH HAS BEEN THROUGH ACQUISITIONS, AND OUR FAILURE TO SUCCESSFULLY COMPLETE FUTURE ACQUISITIONS COULD REDUCE OUR EARNINGS AND SLOW OUR GROWTH. Our growth is due in part to strategic acquisitions, and we may not be able to continue to identify properties for acquisition or make acquisitions on terms that we consider economically acceptable. There is intense competition for acquisition opportunities in our industry. Competition for acquisitions may increase the cost of, or cause us to refrain from, completing acquisitions. Completion of acquisitions is dependent upon, among other things, our ability to obtain debt and equity financing and, in some cases, regulatory approvals. Our ability to pursue our growth strategy may be hindered if we are not able to obtain financing or regulatory approvals. Our ability to grow through acquisitions will require us to continue to invest in operations, financial and management information systems and to attract, retain, motivate and effectively manage our employees. The inability to manage the integration of acquisitions effectively could reduce our focus on subsequent acquisitions and current operations, and could negatively impact our earnings and growth. Our financial position and results of operations may fluctuate significantly from period to period, reflecting the completion of significant acquisitions during particular periods. Further, if we are not successful in identifying or acquiring any material property interests, our earnings could be reduced and our growth could be restricted. OUR ABILITY TO GENERATE SUFFICIENT CASH TO SERVICE OUR DEBT AND REPLACE OUR RESERVES DEPENDS ON MANY FACTORS BEYOND OUR CONTROL. We rely on cash from our operations to pay the principal and interest on our debt. In addition, our operations may not generate enough cash to pay the principal and interest on our debt. Our ability to generate cash from operations depends on: - the level of production from our properties; - general economic conditions, including the prices paid for oil and natural gas; - our success in exploration and development activities; and - legislative, regulatory, competitive and other factors beyond our control. OUR SUCCESS DEPENDS, TO A LARGE EXTENT, ON OUR CHIEF EXECUTIVE OFFICER, EXPERIENCED TECHNICAL PERSONNEL AND OTHER KEY PERSONNEL AND THE LOSS OF ANY COULD DISRUPT OUR BUSINESS OPERATIONS. We depend to a large extent on the efforts and continued employment of our chairman, president and chief executive officer, Joseph Wm. Foran, technical personnel and other key personnel. Competition for technical personnel and engineers is extremely intense. We currently do not have employment agreements with Mr. Foran or with any of our other key personnel. If Mr. Foran or any of these other key personnel resign or become unable to continue in their present role and if they are not adequately replaced, our business operations could be adversely affected. Please read "Management" for information regarding Mr. Foran and other members of our management team. IF WE ARE UNABLE TO COMPETE EFFECTIVELY AGAINST OTHER OIL AND NATURAL GAS COMPANIES, WE MAY BE UNABLE TO ACQUIRE NEW PROPERTIES AT ATTRACTIVE PRICES OR TO SUCCESSFULLY DEVELOP OUR PROPERTIES. We encounter strong competition from other oil and natural gas companies in acquiring properties and leases for the exploration and production of oil and natural gas. We also compete for the equipment and labor required to operate and develop these properties. Many of our competitors have financial resources, staffs and facilities substantially greater than ours. In addition, larger competitors may be able to absorb the burden of any changes in federal, state and local laws and regulations more easily than we can, which would adversely affect our competitive position. Our competitors may be able to pay more for desirable leases and to evaluate, bid for and purchase a greater number of properties or prospects than our financial or personnel resources will permit. As a result, we may not be able to buy properties or lease additional acreage at affordable prices or to successfully develop our properties. Our ability to explore, develop and exploit oil and natural gas reserves and to acquire additional properties in the future will depend on our ability to conduct operations, to evaluate and select suitable properties and to complete transactions in this highly competitive environment. OUR COMPETITORS MAY USE SUPERIOR TECHNOLOGY THAT WE MAY BE UNABLE TO AFFORD OR THAT WOULD REQUIRE A COSTLY INVESTMENT BY US IN ORDER TO COMPETE. Our industry is subject to rapid and significant advancements in technology, including the introduction of new products and services using new technologies. As our competitors use or develop new technologies, we may be placed at a competitive disadvantage, and competitive pressures may force us to implement new technologies at a substantial cost. In addition, our competitors may have greater financial, technical and personnel resources that allow them to enjoy technological advantages and may in the future allow them to implement new technologies before we can. We cannot be certain that we will be able to implement technologies on a timely basis or at a cost that is acceptable to us. One or more of the technologies that we currently use or that we may implement in the future may become obsolete, and we may be adversely affected. RELATIVELY FASTER INITIAL PRODUCTION DECLINES FOR EAST TEXAS GAS PROPERTIES SUBJECT US TO HIGHER RESERVE REPLACEMENT NEEDS. Producing oil and natural gas reservoirs generally are characterized by declining production rates that vary depending upon reservoir characteristics and other factors. High production decline rates generally result in recovery of a relatively higher percentage of reserves from properties during the initial few years of production as opposed to later years, and, as a result, our reserve replacement needs from properties with high production decline rates are relatively greater. Production from reserves in reservoirs in the East Texas Bossier trend generally decline initially more rapidly than reservoirs in our other producing regions. WE CANNOT CONTROL THE ACTIVITIES ON PROPERTIES WE DO NOT OPERATE. As of April 30, 2001, other companies operate properties constituting approximately 29% of our PV-10 value. As a result, our ability to exercise influence over the operations of these properties or their associated costs is limited. Our dependence on the operators and other working interest owners of these projects and our limited ability to influence operations and associated costs could materially and adversely affect the realization of our targeted returns on capital in drilling or acquisition activities. The success and timing of our drilling and development activities on properties operated by others therefore depends upon a number of factors outside of our control, including: - timing and amount of capital expenditures; - the operator's expertise and financial resources; - approval of other participants in drilling wells; and - selection of technology. OUR MAJOR SHAREHOLDERS, DIRECTORS AND OUR SENIOR MANAGEMENT OWN A SIGNIFICANT AMOUNT OF OUR COMMON STOCK, GIVING THEM SIGNIFICANT INFLUENCE IN CORPORATE TRANSACTIONS AND OTHER MATTERS, AND THE INTERESTS OF THESE SHAREHOLDERS, DIRECTORS AND OUR MANAGEMENT COULD DIFFER FROM YOURS. On completion of this offering, Unocal, The Travelers Insurance Company, The Lincoln National Life Insurance Company, our directors and our senior management will beneficially own approximately 47% of our outstanding shares of common stock, assuming no exercise of the underwriters' over-allotment option. As a result, these shareholders will be positioned to significantly influence or control the outcome of matters requiring a shareholder vote, including the election of directors, the adoption of any amendment to our articles of incorporation or bylaws and the approval of mergers and other significant corporate transactions. Their influence or control of Matador may have the effect of delaying or preventing a change of control of Matador and may adversely affect the voting and other rights of other shareholders. RISKS RELATING TO THE OFFERING THERE HAS NEVER BEEN A PUBLIC MARKET FOR OUR COMMON STOCK, AND OUR STOCK PRICE MAY FLUCTUATE SIGNIFICANTLY. Before this offering, no public market for our common stock existed, and an active trading market may not develop or be sustained in the future. The initial public offering price of our common stock was determined by negotiation between us and representatives of the underwriters and may bear no relationship to the market price of our common stock after this offering. The trading price of our common stock, and the price at which we may sell securities in the future, could be subject to significant fluctuations in response to government regulations, variations in quarterly operating results, the prices of oil and natural gas and other factors. SUBSTANTIALLY ALL OF OUR OUTSTANDING SHARES MAY BE SOLD INTO THE MARKET IN THE NEAR FUTURE. THIS COULD CAUSE THE MARKET PRICE OF OUR COMMON STOCK TO DROP SIGNIFICANTLY, EVEN IF OUR BUSINESS IS DOING WELL. The market price of our common stock could drop due to sales of a large number of shares of our common stock in the market after the offering or the perception that the sales could occur. This could make it more difficult to raise funds through future offerings of common stock. Please read "Shares Eligible for Future Sale." On completion of this offering, we will have outstanding 16,019,169 shares of our common stock. This number includes the 4,300,000 shares we and the selling shareholders are selling in this offering, which may be resold in the public market immediately. Additionally, shareholders who hold an aggregate of 1,474,146 shares of common stock may elect immediately to sell all or a portion of their existing shares under the safe harbor provided by Rule 144(k) of the Securities Act. Of the remaining 10,245,023 shares, 3,668,393 shares will become immediately available for resale in the public market after a period of 180 days from the date of this prospectus, under the safe harbor provided by Rule 144(k) of the Securities Act and 6,576,630 shares will be available for sale subject to the volume and manner of sale restrictions under Rule 144 of the Securities Act with some exceptions. All shares of our common stock outstanding prior to this offering could be sold following the 180-day period, either in transactions registered under the Securities Act or transactions exempt from registration. In addition, some of our current shareholders have rights that provide for the registration of their shares, at our expense, which would allow these shareholders to immediately resell their shares. Please read "Certain Relationships and Related Transactions" and "Description of Capital Stock--Registration Rights" for a description of these registration rights. As of July 31, 2001, options to purchase approximately 1.3 million shares of common stock were outstanding. Under our existing stock option plans, we can grant options to purchase approximately 1.1 million additional shares of common stock. After this offering, we intend to file a registration statement covering the sale of the common stock issuable upon exercise of these options. The shares received upon exercise of these options generally will be freely transferable. Please read "Management--Employee Stock Option Plans." PURCHASERS IN THIS OFFERING WILL SUFFER IMMEDIATE AND SUBSTANTIAL DILUTION. If you purchase common stock in this offering, you will experience immediate and substantial dilution of $9.80 per share, because the price you pay will be substantially greater than the as-adjusted net tangible book value per share of $7.20 for the shares you acquire. This dilution is due in large part to the fact that prior investors paid an average price of $2.91 per share when they purchased their shares of common stock, which is substantially less than the initial public offering price. PROVISIONS OF OUR ARTICLES OF INCORPORATION, BYLAWS AND TEXAS LAW AND SOME OF OUR AGREEMENTS AND OUTSTANDING SECURITIES MAY HAVE ANTI-TAKEOVER EFFECTS THAT COULD PREVENT A CHANGE IN CONTROL, WHICH MAY CAUSE OUR STOCK PRICE TO DECLINE. Provisions of our articles of incorporation and bylaws may discourage, delay or prevent a merger or acquisition that our shareholders may consider favorable. These provisions include: - authorization for our board of directors to issue preferred stock without shareholder approval; - a classified board of directors with staggered, three-year terms; - the prohibition of cumulative voting in the election of directors; - a limitation on the ability of shareholders to call special meetings to those owning at least 10% of our outstanding shares of common stock; and - advance notice requirements for nominations for election to the board of directors or for proposing matters that can be acted on by shareholders at shareholder meetings. Please read "Description of Capital Stock" for additional details concerning the provisions of our articles of incorporation and bylaws. Provisions of Texas law also may discourage, delay or prevent someone from acquiring or merging with us, which may cause the market price of our common stock to decline. See "Description of Capital Stock--Business Combinations Under Texas Law." In addition, our board of directors adopted a shareholder rights agreement, commonly known as a "poison pill," in May 2001. We also have a shareholders agreement among some of our shareholders and Unocal and option agreements with some of our employees that have change of control provisions, the effect of which may be to discourage, delay or prevent someone from acquiring or merging with us. For more information about the rights agreement and the shareholders agreement, see "Certain Relationships and Related Transactions--Shareholders Agreement" and "Description of Capital Stock--Common Stock Purchase Rights."

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+RISK FACTORS IN ADDITION TO THE OTHER INFORMATION IN THIS PROSPECTUS, YOU SHOULD CAREFULLY CONSIDER THE RISK FACTORS BELOW PRIOR TO MAKING AN INVESTMENT DECISION WITH RESPECT TO THE COMMON STOCK. THE FINANCIAL STATEMENTS AND NOTES TO FINANCIAL STATEMENTS CONTAIN MORE DETAILED DISCUSSIONS OF SOME OF THE MATTERS DISCUSSED BELOW. THESE RISK FACTORS ARE THE MATERIAL RISK FACTORS FACED BY SUNSHINE. WE HAVE EXPERIENCED OPERATING LOSSES FOR THE LAST TEN YEARS AND EXPECT OUR LOSSES TO CONTINUE Our earnings were directly related to the price of silver because almost all of our revenues came from the sale of silver mined from the Sunshine Mine, Kellogg, Idaho. Having recently closed the Sunshine Mine, we will have minimal or no revenues for the foreseeable future. Silver prices have been depressed since 1985. As a result, Sunshine's mining operations have not been profitable. Sunshine has experienced net losses for the past ten years. Recent losses for Sunshine and its subsidiaries on a consolidated basis are as follows: <Table> <S> <C> o 1995 - $15.5 million o 1998 - $64.8 million o 1996 - $25.9 million o 1999 - $10.8 million o 1997 - $19.3 million o 2000 - $20.9 million </Table> Our consolidated net losses for 2000 and 1998 reflect a $7.2 million and $50.4 million charge, respectively, to write down an investment in the Sunshine Mine. At June 30, 2001, Sunshine had a $536 thousand stockholders' deficit, working capital of $1.2 million and cash and cash investments of $285 thousand. At December 31, 2000, Sunshine reported a consolidated net loss of $20.9 million (which included a writedown of $7.2 million), had a $36.3 million stockholders' deficit, working capital of $2.8 million, and cash and cash investments of $291 thousand. At December 31, 1999, Sunshine had an $18.7 million stockholders' deficit, working capital of $839,000 and cash, cash investments and bullion of $4.7 million. We expect our operating losses and cash flow deficiencies to continue until we complete the development of the Pirquitas Mine in Argentina. Given current low silver prices and our lack of capital or earnings, we do not currently have the ability to access the financing to develop the Pirquitas Mine. FUTURE LOSSES MAY RESULT IN LIQUIDITY DEFICIENCIES AND AN INABILITY TO CONTINUE OPERATIONS Our historic net operating losses led to liquidity deficiencies which caused us to institute a bankruptcy proceeding in August 2000. Consolidated net operating losses have been primarily the result of depressed silver prices resulting in margins that are insufficient to cover our other expenses. Cash losses for the remainder of the 2001 fiscal year have been funded from the Amended Credit Facility. Remaining availability committed under the additional option at November 9, 2001 was approximately $1.3 million. When this facility is exhausted, currently anticipated by the third quarter of 2002, we have no other sources of financing at this time. To raise cash, we are currently negotiating the sale of certain of the Company's assets. Underground mining equipment which would be expected to deteriorate during a period of inactivity at the Sunshine Mine has been sold. The Company has recently sold an option to acquire its silver refinery, and/or its tailings impoundment, and/or its antimony plant, and may dispose of other real estate holdings at the Sunshine Mine. The Company will also consider a sale of the Sunshine Mine Complex in its entirety, but does not anticipate a separate sale of hoisting, mineral processing or other surface facilities necessary for the re-initiation of mining activity at the Complex. The terms of the option to acquire the refinery, tailings impoundment, and/or the antimony plant provide that, should the optionee acquire the tailings impoundment, upon any reopening of the Sunshine Mine, its then-operator will have the right to deposit waste from the Sunshine Mine into the tailings impoundment. The Company is also negotiating a sale of the Juanicipio concession in Mexico. If all these transactions are closed and the lenders make the optional amount available under the Amended Credit Facility, we expect to be able to fund operations until approximately the third quarter of 2002. THE ARGENTINA CALL OPTION The Elliott Group and the Stonehill Group (two large stockholders who control 89.99% of the Common Stock) hold the Argentina Call Option whereby, under certain circumstances, they would be able to obtain controlling interest in Sunshine Argentina, Inc., the owner of the Pirquitas Mine. According to the Argentina Call Option, if Sunshine's market capitalization falls below $15 million for fifteen consecutive days, or if there is a further event of bankruptcy, or if a registration statement is not filed or effective within a certain number of days after the Confirmation Date or such Registration Statement's effectiveness is not maintained or if shares of Common Stock are not traded on the OTC Bulletin Board or other acceptable market, the Elliott Group and the Stonehill Group will be able to purchase Sunshine Argentina, Inc. for common stock of Sunshine valued at $1 million. Once they have sold in excess of one-half of their shares in Sunshine, the amount of Sunshine Argentina, Inc. they will be able to acquire pursuant to the Argentina Call Option will begin to decline. Once all of their shares in Sunshine have been sold, the Argentina Call Option will expire. Sunshine Argentina, Inc. as the owner of the Pirquitas Mine, is the principal subsidiary of Sunshine at this time. Exercise of the Argentina Call Option by the Elliott Group and the Stonehill Group would likely have the effect of eliminating the viability of Sunshine. If the Call Option is exercised, the Elliott Group and the Stonehill Group will acquire the stock of Sunshine Argentina, Inc., and Sunshine will no longer control the Pirquitas Mine or its reserves. The Pirquitas Mine is the principal asset of Sunshine. The existence of the Argentina Call Option may adversely affect the availability of third-party financing. As the Elliott Group and the Stonehill Group together control approximately 90% of the Common Stock, their sales of Common Stock may lead to a reduction in the market capitalization such as would trigger the ability to exercise the Argentina Call Option. Further, as long as the Argentina Call Option remains outstanding (until 2010), the availability of financing involving the Pirquitas project and other corporate purposes may be limited. The existence of the Call Option may also negatively affect the market value of the stock. In addition, the Company's market capitalization in recent weeks has been below $15 million, the level that could trigger exercise of the Call Option. The Elliott Group and the Stonehill Group have waived any non-compliance with the Call Option until November 30, 2001 as part of a refinancing of the Credit Facility. THE PRICE OF SILVER IS VOLATILE AND AFFECTS THE COMMON STOCK PRICE Sunshine's earnings and the value of its assets have been (and will likely continue to be) directly related to the price of silver. Numerous factors beyond Sunshine's control, alone or in combination, may cause the price of silver to rise or fall. These factors include, among others: o Levels of silver production o The demand for silver as a component of manufactured goods o Inflation expectations o Speculative activities of market makers, arbitrageurs, traders and other participants in the commodities markets Silver prices have averaged approximately $5 per ounce for the past 13 years, and there is no assurance that the price of silver will improve. On November 9, 2001, the closing price of spot silver as reported on the COMEX was approximately $4.070 per ounce. WE ARE DEPENDENT ON THE SUCCESS OF OUR EXPLORATION AT THE SUNSHINE MINE AND THE DEVELOPMENT OF THE PIRQUITAS MINE Substantially all of our revenues have been derived from the Sunshine Mine (now closed), which has not generated sufficient cash at silver prices which prevailed in the last ten years to cover current cash requirements. In addition, silver prices which prevailed prior to its closure, the Sunshine Mine could not access sufficient reserves to justify maintaining production beyond 2001 without new discoveries and had limited funding for exploration. Therefore, future production at the Sunshine Mine is dependant on the success of future exploration and development projects at the Sunshine Mine. In addition, at current silver prices, future earnings are dependent upon the successful development of the Pirquitas Mine. Exploration success and successful development of a new mine involve a high degree of risk. Unknown factors such as the total extension and amount of ore-grade material and the cost of extraction of minerals measured against fluctuating metal prices increase the degree of risk. BECAUSE RESERVE ESTIMATES ARE IMPRECISE, WE DO NOT KNOW THE EXACT QUANTITY OF MATERIALS WE WILL RECOVER Our silver reserve estimates discussed in this Prospectus and other documents (129 million ounces of silver before metallurgical losses as of December 31, 2000) represent the judgment of our geologic personnel and are not guaranties that the indicated quantities will be recovered. Reserve estimates are expressions of judgment based largely on data from diamond drill holes and underground openings, such as drifts or raises, which expose the mineral on one, two, or three sides, sampling data, and similar examinations. Our reserve estimates may change as ore bodies are mined and we obtain additional data. Our reserve estimates at the Pirquitas Mine come from an independent study. Our estimates of mineralized material at the Sunshine Mine were prepared internally; however, the methodology used to prepare the Sunshine Mine reserve estimates has been reviewed and approved by an independent consultant. NO ASSURANCE CAN BE MADE THAT FINANCING CAN BE OBTAINED TO DEVELOP THE PIRQUITAS MINE It is estimated that approximately $140 million will be required to put the Pirquitas Mine into production, including working capital requirements. In order to develop the Pirquitas Mine, we will need to sell a significant amount of common stock or other securities in order to obtain bank project financing or enter into a joint venture, sell a royalty interest or take other similar action to raise the capital required in order to develop the Pirquitas Mine. Such sources of capital are likely not available to us given current low silver prices and our lack of capital or earnings. If such sources are not available, we will not be able to develop the Pirquitas Mine. WE MAY NOT BE ABLE TO FULLY INSURE AGAINST RISKS ASSOCIATED WITH OPERATING MINES, ESPECIALLY ENVIRONMENTAL RISKS Our operations may be affected by risks and hazards generally associated with the mining industry. These risks and hazards include fires, cave-ins, rock bursts, flooding, industrial accidents, mechanical or electrical failures, unusual or unexpected rock formations, and environmental pollution or other hazards resulting from the disposal of waste products occurring from production. Such risks could result in damage to, or destruction of, mineral properties or producing facilities, personal injury, environmental damage, delays in mining, monetary losses, and possible legal liability. We may not always be able to pay for this insurance, especially if there is an increase in the cost of premiums. Insurance for environmental risk is generally either not available or too costly for companies in our industry. THERE IS EXTENSIVE GOVERNMENT REGULATION OF OUR INDUSTRY AND SUCH REGULATION SOMETIMES RESULTS IN LAWSUITS Extensive federal, state and local laws and regulations control our mineral mining and exploration activities. These laws and regulations also govern the possible effects of these activities on the environment. We have been involved in lawsuits in which we have been accused of violating environmental laws in the past (now resolved in the bankruptcy proceeding) alleging natural resource damage and seeking payment of response or "clean-up" costs and may be subject to similar lawsuits in the future. These lawsuits have resulted in substantial expenses and diversions of our resources. See "LEGAL PROCEEDINGS." Any future lawsuits can be expected to result in similar expenses and unproductive diversion of our resources. In addition, new legislation and regulations could be adopted at any time that may result in additional operating expenses, expenditures or restrictions and delays in the mining, production or development of our properties. To the extent that we devote money and employee time responding to governmental regulations or lawsuit, these resources will not be devoted to further development of our income-producing operations. THE FINANCIAL CONDITION OF OUR ARGENTINA AND MEXICO OPERATIONS IS SUBJECT TO SOCIAL, POLITICAL AND ECONOMIC RISKS, INCLUDING CHANGES IN FOREIGN INVESTMENT AND TRADE POLICIES, AND OTHER RISKS ASSOCIATED WITH FOREIGN OPERATIONS We presently conduct operations in Argentina and Mexico and anticipate that we will continue to conduct significant international operations in the future. Because we conduct operations internationally, we are subject to the effects of local political and economical developments, exchange controls, currency fluctuations, royalty and tax increases, retroactive tax claims, expropriation, import and export regulations, and other foreign laws or policies governing operations of foreign-based companies, United States laws and policies affecting foreign trade, taxation and investment and civil unrest and union activity different from the United States. Changes in these items could restrict our ability to conduct operations, reduce the profitability of our operations, or reduce the value of our assets in Argentina and Mexico. Because we do business with foreign governments, our contracts with those governments are subject to renegotiation and our ability to enforce our rights against those governments by bringing a lawsuit may be subject to the doctrine of sovereign immunity, which prohibits or restricts lawsuits against government agencies. In addition, if we are sued in a foreign country or are forced to bring suit in a foreign country to enforce our rights against foreign parties, our ability to control the costs and manage the conduct of any foreign litigation will be difficult because of our unfamiliarity with foreign court systems and procedures, language barriers, and the expense and inconvenience of international travel and communications. SALES BY THE ELLIOTT GROUP AND THE STONEHILL GROUP MAY LOWER THE PRICE OF THE COMMON STOCK. Upon the Effective Date of the Plan, the Elliott Group and the Stonehill Group collectively acquired approximately 90% of our Common Stock. Pursuant to various arrangements, we have agreed with the Elliott Group and the Stonehill Group to register those shares for resale pursuant to a Registration Rights Agreement. Sales of Common Stock by the Elliott Group and the Stonehill Group could have the effect of depressing the market price of our stock. Depending upon the reaction of the market to such sales, the Elliott Group and the Stonehill Group may be put in a position to exercise the Argentina Call Option. Such exercise could result in the Elliott Group and the Stonehill Group obtaining all of the stock of Sunshine Argentina. See "PLAN OF REORGANIZATION - Argentina Transaction; Call Option Agreement." We will need to seek additional financing and could seek such financing in the equity markets to develop the Pirquitas Mine or fund its exploration and other activities. The sale of newly-issued shares of Common Stock could significantly dilute the current stockholders' ownership interests. Sale of shares of Common Stock previously registered or to be registered for resale could have a material adverse effect on the market price of the Common Stock. The issuance of shares of Common Stock that have been reserved for future issuance (7,799,265 Shares at November 9, 2001) could also have a material adverse effect on the market price of the Common Stock. FAILURE TO REGISTER STOCK HELD BY THE ELLIOTT GROUP AND THE STONEHILL GROUP The Registration Rights Agreement among the Company and the Elliott Group and the Stonehill Group provides for material penalties for failure by the Company to provide the Elliott Group and the Stonehill Group and other stockholders with an effective Registration Statement for the resale of their stock. These penalties include the ability to exercise the Argentina Call Option or alternatively, to sell all of the Elliott Group and Stonehill Group Common Stock to the Company at a price equal to 115% of the "Market Value" (as defined in the Registration Rights Agreement). Exercise of either of these alternatives would jeopardize the continued viability of the Company and may negatively impact the value of the Common Stock. TWO GROUPS OF STOCKHOLDERS ARE ABLE TO APPROVE ALL MATTERS SUBMITTED TO STOCKHOLDERS The Elliott Group and the Stonehill Group acquired 90% of our Common Stock on the Effective Date of the Plan. These holders have the ability to approve all matters which may be submitted to stockholders for approval, including the election of all directors. The stockholders who collectively hold the remaining 10% of the Common Stock are not able to cause the election of any directors or block any matter requiring stockholder approval. SUBSTANTIALLY ALL OF OUR ASSETS ARE PLEDGED TO SECURE DEBT Sunshine's only debt is the "Exit Financing Facility" in the maximum principal amount of $5 million to affiliates of our two largest stockholders. The facility is secured by substantially all of the assets of Sunshine and its subsidiaries, including the Pirquitas Mine. If Sunshine is unable to meet its requirements under the Exit Financing Facility, Sunshine faces the possible risk of foreclosure upon some or all of its assets. WE MAY NOT BE ABLE TO CONTINUE AS A GOING CONCERN The opinion of the Company's independent certified public accountants covering the 2000 year expresses substantial doubt about the Company's ability to continue as a going concern. The Company closed the Sunshine Mine in February 2001 and will have no revenues from operations for the foreseeable future. The recoverability of a major portion of assets listed in the financial statements is dependent upon the continued operations of the Company. The Company may sell some or all of its assets and will consider a merger or joint venture for the development of the Pirquitas Mine. If the Company is unable to sell a sufficient amount of assets for cash or find a partner to develop the Pirquitas Mine, it will ultimately cease to be a going concern. FOREIGN COUNTRY OPERATIONS The Company has not previously developed a mining project in a foreign country. Although the Company has endeavored to account for variations in costs, worker productivity, tax structures and other factors specific to the location in its feasibility study, there is a risk that the Company has not fully anticipated all potential impact on the project development schedule or economic projections for the Pirquitas Mine. BUSINESS ENVIRONMENT Due to the extended period of low silver prices, Sunshine and its North American peers have largely seen very significant reductions in their market capitalizations over the last several years. Gold mining companies have seen a similar trend in recent years, although not to the extent of the silver mining companies as the gold price has gone down only in the last three years, but the silver price has been at a level too low for North American companies (including Sunshine) to operate profitably for twelve years or more. Low metals prices generally have combined with the difficulty caused by low gold and silver prices to make access to capital difficult and expensive for the industry generally. Our present circumstances require a market capitalization above $15 million or the "Call Option" becomes exercisable. FOREIGN EXCHANGE RATES Sunshine's metal products are typically priced in dollars on world markets. Mining operations historically were conducted in the United States, and the costs of those operations are not subject to fluctuation due to foreign exchange rates. Sunshine has developed a feasibility study for the development of the Pirquitas Mine in Argentina. In recent years, Argentina has followed a policy of currency stabilization by maintaining parity of the local currency, the peso, with the dollar. This policy has succeeded in maintaining the value of one Argentine peso equal to one dollar. Should the policy change, a fluctuation in exchange rates could have an adverse impact on the economics of the project and reduce the availability of potential investors and lenders. Should the Argentine peso strengthen, the impact would be to increase capital and operating costs, making the economics less attractive.

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+RISK FACTORS......................................................... 10 FORWARD LOOKING STATEMENTS........................................... 16 USE OF PROCEEDS...................................................... 16 MARKET FOR COMMON STOCK.............................................. 17 MARKET FOR CONVERTIBLE PREFERRED SECURITIES.......................... 17 COMMONWEALTH BANKSHARES CAPITAL TRUST I.............................. 18 SELECTED FINANCIAL INFORMATION....................................... 19 CAPITALIZATION....................................................... 20 ACCOUNTING TREATMENT................................................. 21 REGULATORY TREATMENT................................................. 21 BUSINESS............................................................. 22 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS............................................... 36 MANAGEMENT........................................................... 44 SECURITY OWNERSHIP OF MANAGEMENT AND CERTAIN BENEFICIAL OWNERS....... 49 DESCRIPTION OF CONVERTIBLE PREFERRED SECURITIES...................... 50 DESCRIPTION OF JUNIOR SUBORDINATED DEBT SECURITIES................... 65 DESCRIPTION OF GUARANTEE............................................. 71 RELATIONSHIP AMONG THE CONVERTIBLE PREFERRED SECURITIES, THE JUNIOR SUBORDINATED DEBT SECURITIES AND THE GUARANTEE...................... 73 DESCRIPTION OF COMMONWEALTH BANKSHARES, INC. COMMON STOCK............ 74 UNITED STATES FEDERAL INCOME TAX CONSEQUENCES........................ 76 ERISA CONSIDERATIONS................................................. 79 PLAN OF DISTRIBUTION................................................. 80 VALIDITY OF SECURITIES............................................... 81 EXPERTS.............................................................. 82 WHERE YOU CAN FIND MORE INFORMATION.................................. 82 INDEX TO FINANCIAL STATEMENTS........................................ F-1 </TABLE> <PAGE> ------------------------------------------------------------------------------- ------------------------------------------------------------------------------- Up to 1,600,000 Convertible Preferred Securities COMMONWEALTH BANKSHARES CAPITAL TRUST I % Convertible Trust Preferred Securities (liquidation amount $5 per convertible preferred security) Guaranteed on a junior subordinated basis, as described in this prospectus, by [Bank of Commonwealth Logo] ------------------ PROSPECTUS , 2001 ------------------ Anderson & Strudwick Incorporated ------------------------------------------------------------------------------- We have not authorized any dealer, salesperson or other person to give you written information other than this prospectus or to make representations as to matters not stated in this prospectus. You must not rely on unauthorized information. This prospectus is not an offer to sell these securities or our solicitation of your offer to buy the securities in any jurisdiction where that would not be permitted or legal. Neither the delivery of this prospectus nor any sales made hereunder after the date of this prospectus shall create an implication that the information contained herein or the affairs of the company have not changed since the date hereof. ------------------------------------------------------------------------------- ------------------------------------------------------------------------------- <PAGE> PART II ================================================================================ INFORMATION NOT REQUIRED IN PROSPECTUS Item 13. Other Expenses of Issuance and Distribution Securities and Exchange Commission Registration Fee $ 2,125 National Association of Securities Dealers Examination Fee 1,500 Printing Expenses 15,000 Accounting Fees and Expenses 10,000 Legal Fees and Expenses 50,000 Blue Sky Fees and Expenses 1,000 Miscellaneous Expenses 20,375 Total $100,000 ======== Item 14. Indemnification of Directors and Officers Article 10 of Chapter 9 of Title 13.1 of the Code of Virginia, 1950, as amended (the "Code"), permits a Virginia corporation to indemnify any director or officer for reasonable expenses incurred in any legal proceeding in advance of final disposition of the proceeding, if the director or officer furnishes the corporation a written statement of his good faith belief that he has met the standard of conduct prescribed by the Code, and a determination is made by the board of directors that such standard has been met. In a proceeding by or in the right of the corporation, no indemnification shall be made in respect of any matter as to which an officer or director is adjudged to be liable to the corporation, unless the court in which the proceeding took place determines that, despite such liability, such person is reasonably entitled to indemnification in view of all the relevant circumstances. In any other proceeding, no indemnification shall be made if the director or officer is adjudged liable to the corporation on the basis that personal benefit was improperly received by him. Corporations are given the power to make any other or further indemnity, including advance of expenses, to any director or officer that may be authorized by the articles of incorporation or any bylaw made by the shareholders, or any resolution adopted, before or after the event, by the shareholders, except an indemnity against willful misconduct or a knowing violation of the criminal law. Unless limited by its articles of incorporation, indemnification of a director or officer is mandatory when he entirely prevails in the defense of any proceeding to which he is a party because he is or was a director or officer. The Articles of Incorporation of Commonwealth Bankshares contain provisions indemnifying the directors and officers of Commonwealth Bankshares against expenses and liabilities incurred in legal proceedings to the fullest extent permitted by Virginia law. Under the Declaration of Trust, Commonwealth Bankshares, as depositor of the Trust, has agreed (i) to indemnify and hold harmless each Administrative trustee and any employee or agent of the Trust or its Affiliates from and against any loss, damage, liability, tax, penalty, expense or claim of any kind or nature whatsoever incurred by such person by reason of the creation, operation or termination of the Trust or any act or omission performed or omitted by such person in good faith on behalf of the Trust and in a manner such person reasonably believes to be within the scope of authority conferred on such person by the Declaration, except that no person shall be entitled to be indemnified in respect of any loss, damage or claim incurred by such person by reason of negligence or willful misconduct with respect to such acts or omissions, and (ii) to advance expenses (including legal fees) incurred by such person in defending any claim, demand, action, suit or proceeding, from time to time, prior to the final disposition of such claim, demand, action, suit or proceeding. Item 15. Recent Sales of Unregistered Securities None. Item 16. Exhibits and Financial Statement Schedules (a) The following exhibits are filed on behalf of the Registrant as part of this Registration Statement: II-1 <PAGE> EXHIBIT NO. DESCRIPTION ----------- ----------- *1.1 Form of Underwriting Agreement for offering of Convertible Preferred Securities. 3.1 Articles of Incorporation of Commonwealth Bankshares, Inc. (incorporated herein by reference to Exhibit 3.1 to Commonwealth Bankshares, Inc.'s Registration Statement on Form S-4, filed with the Securities and Exchange Commission on June 15, 1988). 3.2 Bylaws of Commonwealth Bankshares, Inc. (incorporated herein by reference to Exhibit 3.2 to Commonwealth Bankshares, Inc.'s Registration Statement on Form S-4, filed with the Securities and Exchange Commission on June 15, 1988). 3.3 Amendment to Articles of Incorporation dated July 28, 1989 (incorporated herein by reference to Exhibit 3.3 to Commonwealth Bankshares, Inc.'s Form 10-K filed with the Securities and Exchange Commission on March 20, 1990). 3.4 Amendment to Articles of Incorporation dated November 2000 (incorporated herein by reference to Exhibit 3.4. to Commonwealth Bankshares, Inc.'s Registration Statement on Form S-1 filed with the Securities and Exchange Commission on November 20, 2000). 4.1 Certificate of Trust of Commonwealth Bankshares Capital Trust I. 4.2 Declaration of Trust between Commonwealth Bankshares, Inc. and Wilmington Trust Company. *4.3 Form of Amended and Restated Declaration of Trust for Commonwealth Bankshares Capital Trust I. *4.4 Form of Junior Subordinated Indenture between Commonwealth Bankshares, Inc. and Wilmington Trust Company, as trustee. 4.5 Form of Convertible Preferred Security (included in Exhibit 4.3 above). 4.6 Form of Junior Subordinated Debt Security (included in Exhibit 4.4 above). 4.7 Form of Guarantee Agreement with respect to Convertible Preferred Securities issued by Commonwealth Bankshares Capital Trust I. *4.8 Form of Escrow Agreement among Anderson & Strudwick Incorporated, Commonwealth Bankshares Capital Trust I, Commonwealth Bankshares, Inc. and Wilmington Trust Company. *5.1 Opinion of Kaufman & Canoles, P.C. *5.2 Opinion of Richards, Layton & Finger. *8.1 Opinion of Kaufman & Canoles, P.C. as to tax matters. *23.1 Consent of Poti, Walton & Associates, PC. 23.2 Consent of Kaufman & Canoles, P.C. (included in Exhibit 5.1 above). 23.3 Consent of Richards, Layton & Finger (included in Exhibit 5.2 above). 24.1 Powers of Attorney (included on signature page). 25.1 Statement of Eligibility under the Trust Indenture Act of 1939, as amended, of Wilmington Trust Company, as trustee under the Junior Subordinated Indenture. 25.2 Statement of Eligibility under the Trust Indenture Act of 1939, as amended, of Wilmington Trust Company, as Property trustee under the Declaration of Trust of Commonwealth Bankshares Capital Trust I. 25.3 Statement of Eligibility under the Trust Indenture Act of 1939, as amended, of Wilmington Trust Company, as Guarantee trustee under the Guarantee Agreement for the benefit of holders of Trust Securities of Commonwealth Bankshares Capital Trust I. ________________ II-2 <PAGE> * Filed herewith. (b) Financial Statement Schedules: All financial statement schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are either included in the financial information set forth in the Prospectus or are inapplicable and therefore have been omitted. Item 17. Undertakings Insofar as indemnification for liabilities arising under the Securities Act may be permitted to directors, officers and controlling persons of a Registrant pursuant to the foregoing provisions, or otherwise, each of the Registrants has been advised that in the opinion of the Commission such indemnification is against public policy as expressed in the Securities Act and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by a Registrant of expenses incurred or paid by a director, officer or controlling person of a Registrant in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, such Registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Securities Act and will be governed by the final adjudication of such issue. The undersigned registrant hereby undertakes to provide to the underwriter at the closing specified in the underwriting agreements certificates in such denominations and registered in such names as required by the underwriter to permit prompt delivery to each purchaser. Each of the undersigned Registrants hereby undertakes that, for purposes of determining any liability under the Securities Act, (i) the information omitted from the form of prospectus filed as part of this Registration Statement in reliance upon Rule 430A under the Securities Act and contained in a form of prospectus filed by the Company pursuant to Rule 424(b) under the Securities Act shall be deemed to be part of this Registration Statement as of the time it was declared effective and (ii) each post-effective amendment that contains a form of prospectus shall be deemed to be a new Registration Statement relating to the securities offered therein, and the offering of such securities at that time shall be deemed to be the initial bona fide offering thereof. II-3 <PAGE> SIGNATURES Pursuant to the requirements of the Securities Act of 1933, as amended, the registrant has duly caused this registration statement to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Norfolk, Commonwealth of Virginia, on July 6, 2001. COMMONWEALTH BANKSHARES, INC. By: /s/ Edward J. Woodard, Jr. -------------------------------------- Edward J. Woodard, Jr., CLBB President and Chief Executive Officer Pursuant to the requirements of the Securities Act of 1933, as amended, this registration statement has been signed by the following persons in the capacities and on the dates indicated. Signature Title Date /s/ Edward J. Woodard, Jr. President, Chief Executive July 6, 2001 ----------------------------------- Officer and Director Edward J. Woodard, Jr. (Principal Executive Officer) /s/ John H. Gayle Executive Vice President and July 6, 2001 ----------------------------------- Cashier (Principal Financial John H. Gayle Officer) * Director July 6, 2001 ----------------------------------- George H. Burton * Director July 6, 2001 ----------------------------------- Morton Goldmeier * Director July 6, 2001 ----------------------------------- William P. Kellam * Director July 6, 2001 ----------------------------------- Thomas W. Moss, Jr. * Director July 6, 2001 ----------------------------------- William D. Payne, M.D. * Director July 6, 2001 ----------------------------------- Herbert L. Perlin * Director July 6, 2001 ----------------------------------- Richard J. Tavss * Director July 6, 2001 ----------------------------------- Kenneth J. Young *Edward J. Woodard, Jr. by signing his name hereto signs this document on behalf of each of the persons indicated by an asterisk above pursuant to powers of attorney duly executed by such persons and previously filed with the Securities and Exchange Commission as part of the Registration Statement. II-4 <PAGE> Pursuant to the requirements of the Securities At of 1933, as amended, the registrant has duly caused this registration statement to be signed on its behalf by the undersigned, thereunto duly authorized, in the city of Norfolk, Commonwealth of Virginia, on July 6, 2001. COMMONWEALTH BANKSHARES CAPITAL TRUST I By: Commonwealth Bankshares, Inc., as Depositor By: /s/ Edward J. Woodard, Jr. ----------------------------------------- Edward J. Woodard, Jr., CLBB President and Chief Executive Officer II-5 </TEXT> </DOCUMENT>

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+RISK FACTORS An investment in the notes is subject to a number of risks. You should carefully consider the following factors, as well as the more detailed descriptions elsewhere in this prospectus before making an investment in the notes. RISKS RELATED TO OUR COMPANY WE ARE SUBSTANTIALLY LEVERAGED WHICH COULD AFFECT OUR ABILITY TO FULFILL OUR OBLIGATIONS UNDER THE NOTES. Our substantial outstanding debt has important consequences to you, including the risk that we may not generate sufficient cash flow from operations to pay principal and interest on our indebtedness, including the notes, or to invest in our businesses. While we believe, based upon our historical and anticipated performance, that we will be able to satisfy our obligations, including those under the notes, from our cash flow from operations and refinancings, we cannot assure you of this ability. While we can raise cash to satisfy our obligations through potential sales of assets or equity, our ability to raise funds by selling either assets or equity depends on our results of operations, market conditions, restrictions contained in the New Credit Agreement, the Existing Credit Agreement and the indentures governing our Senior Notes and other factors. If we are unable to refinance indebtedness or raise funds through sales of assets or equity or otherwise, we may be unable to pay principal of and interest on the notes. At December 31, 2000, we had total outstanding consolidated long-term debt of $680.6 million and a stockholders' deficit of $77.9 million. Our interest expense for the year ended December 31, 2000 was $53.5 million. Subject to covenants contained in the New Credit Agreement, the Existing Credit Agreement and the indentures governing our Senior Notes, we may incur additional indebtedness, including additional secured debt. Any additional indebtedness we may incur may rank equally or junior to the notes and will not by its terms rank senior to the notes, except for the obligations under the New Credit Agreement, the Existing Credit Agreement and the Other Indebtedness. YOU MAY NOT RECEIVE PAYMENT IN FULL BY FORECLOSING ON THE COLLATERAL IN THE EVENT OF A DEFAULT ON THE NOTES. Our obligations under our Senior Notes are secured by a second-priority lien on the Collateral. The Collateral, however, is subject to a first-priority lien in favor of the lenders under the New Credit Agreement, the Existing Credit Agreement and the Other Indebtedness. This ranking means that, if the first-priority lien holders were to sell or foreclose on the Collateral if an event of default occurs under those agreements, you would only be entitled to receive proceeds from the liquidation or sale of the Collateral in excess of the amounts owed by us to the first-priority lien holders. In addition, we may determine to refinance the New Credit Agreement, the Existing Credit Agreement and the Other Indebtedness with an unsecured credit facility, in which event, subject to certain limited exceptions, the Collateral would be released. Our obligations to the first-priority lien holders are significant. As of December 31, 2000, the notes were subordinated to approximately $119.3 million of obligations under the New Credit Agreement, the Existing Credit Agreement and the Other Indebtedness to the extent of the Collateral securing those obligations. There may not be sufficient proceeds from the Collateral available for payment in full to you once our obligations to our first-priority lien holders are discharged in full in which case you would be a general unsecured creditor. Moreover, as long as the New Credit Agreement, the Existing Credit Agreement and the Other Indebtedness are outstanding, the trustee under the indentures governing our Senior Notes will not have the authority to cause the collateral agent under the collateral agent agreement to foreclose on the Collateral. OUR PARENT CORPORATIONS ARE DEPENDENT UPON OUR CASH FLOWS TO MEET THEIR CASH REQUIREMENTS AND COULD CAUSE US TO MAKE DISTRIBUTIONS TO THEM WHICH WOULD REDUCE CASH FLOWS AVAILABLE TO US. Our parent corporations are essentially holding companies without independent businesses or operations and, as such, are presently dependent upon the earnings and cash flows of their subsidiaries, principally BMCA, in order to meet their cash requirements. If our parent corporations are unable to meet their cash requirements, they might take various actions that could reduce our cash flows. This reduction could adversely affect our ability to pay principal and interest on the notes. G-I Holdings Inc. and BMCA Holdings Corporation, our parent corporations, are principally dependent upon the cash flow of our company in order to satisfy their obligations and pay their operating expenses, including tax liabilities. In order to satisfy those obligations or pay those expenses, those corporations might take various actions, including: - causing us to make distributions to our stockholders by means of dividends or otherwise; - causing us to make loans to them; or - causing BMCA Holdings Corporation to sell our common stock. The only significant asset of our parent corporations is the stock of our company. Creditors of our parent corporations could seek to cause those corporations to sell our common stock or take similar action in order to satisfy liabilities owed to them that could cause a change of control. See the risk factor below regarding risks related to a change of control of BMCA. G-I Holdings has advised us that it expects to obtain funds to meet its cash requirements from, among other things, loans principally from us and from payments from us pursuant to a tax sharing agreement we entered into with it. OUR CONTROLLING STOCKHOLDER HAS THE ABILITY TO ELECT OUR ENTIRE BOARD OF DIRECTORS AND CAN CONTROL THE OUTCOME OF ANY MATTER SUBMITTED TO OUR STOCKHOLDERS. We are an indirect subsidiary of G-I Holdings which is approximately 99% beneficially owned (as defined in Rule 13d-3 under the Securities Exchange Act of 1934) by Samuel J. Heyman. Accordingly, Mr. Heyman has the ability to elect our entire Board of Directors and to determine the outcome of any other matter submitted to our stockholders for approval, including, subject to the terms of the indentures relating to the Senior Notes, mergers, consolidations and the sale of all, or substantially all, of our assets. See "Security Ownership of Certain Beneficial Owners and Management." OUR PARENT CORPORATIONS ARE DEPENDENT UPON OUR CASH FLOWS TO SATISFY THEIR OBLIGATIONS. IF G-I HOLDINGS IS UNSUCCESSFUL IN CHALLENGING ITS TAX DEFICIENCY NOTICE, IT COULD CAUSE US TO MAKE DISTRIBUTIONS WHICH WOULD REDUCE OUR CASH FLOW. On September 15, 1997, G-I Holdings received a tax deficiency notice for the 1990 fiscal year relating to Rhone-Poulenc Surfactants and Specialties, L.P., a partnership in which G-I Holdings held an interest. This notice could result in G-I Holdings incurring liabilities significantly in excess of the deferred tax liability recorded in 1990 in connection with this matter. G-I Holdings has advised us that it believes it will prevail in the surfactants partnership matter, although we cannot assure you of this result. See "Business -- Tax Claim Against G-I Holdings," "Certain Relationships -- Tax Sharing Agreement" and Note 7 to Consolidated Financial Statements. If G-I Holdings is unsuccessful in challenging its tax deficiency notice and is unable to satisfy its tax obligations, it might take various actions that could reduce our cash flows as described above in the risk factor regarding our parent corporations' dependence on our cash flows. This reduction could adversely affect our ability to pay principal and interest on the notes. As a member of the consolidated group for federal income tax purposes that has included G-I Holdings, we are severally liable for some federal income tax liabilities of the G-I Holdings consolidated tax group. We are indemnified under certain circumstances for those tax liabilities, principally by G-I Holdings. In light of G-I Holdings' recent bankruptcy filing, we cannot assure you that G-I Holdings will have sufficient assets to satisfy its indemnification obligation to us. See "Summary -- Recent Developments," the risk factors below regarding risks related to G-I Holdings' bankruptcy and Notes to Consolidated Financial Statements. RISKS RELATED TO G-I HOLDINGS' BANKRUPTCY IF G-I HOLDINGS IS FORCED TO SELL ITS INDIRECT HOLDINGS OF BMCA'S COMMON STOCK AND A CHANGE OF CONTROL OCCURS, WE MAY BE UNABLE TO REPURCHASE YOUR NOTES. THIS FAILURE WOULD CONSTITUTE AN EVENT OF DEFAULT UNDER THE INDENTURE RELATING TO THE NOTES AND OUR OTHER DEBT INSTRUMENTS. In January 2001, G-I Holdings filed a voluntary petition for reorganization under Chapter 11 of the U.S. Bankruptcy Code due to its Asbestos Claims. This proceeding is in a preliminary stage. Those persons with claims against G-I Holdings, which principally consist of persons with asbestos-related claims, might seek to satisfy their claims by asking the bankruptcy court to require the sale of G-I Holdings' assets, including G-I Holdings' indirect holdings of BMCA's common stock. If a change of control, as defined in the indenture relating to the notes, occurs, we cannot assure you that we will have available, or be able to obtain, sufficient funds, or will be permitted by our debt instruments, to repurchase your notes. The indenture relating to the notes provides that if a change of control occurs, you will have the right to require us to repurchase your notes at 101% of their principal amount, plus any accrued and unpaid interest to the repurchase date. The Existing Credit Agreement and the New Credit Agreement prohibit us from repurchasing any Senior Notes. Our failure to repurchase your notes would constitute an event of default under the indenture, which would in turn constitute a default under the Existing Credit Agreement, the New Credit Agreement and the indentures governing our Other Senior Notes. See "Description of the Notes -- Repurchase at Your Option." In addition, if a change of control as defined in the Existing Credit Agreement and the New Credit Agreement occurs, those facilities could be terminated and the outstanding loans accelerated. This event could cause our outstanding Senior Notes, including the notes, to be accelerated. If any of these events of default were to occur, we may be unable to pay the accelerated principal amount of and interest on the notes. WE MAY EXPERIENCE AN INCREASE IN ASBESTOS CLAIMS FILED AGAINST OUR COMPANY. Claimants in the G-I Holdings bankruptcy may seek to file Asbestos Claims against our company (with 2,147 Asbestos Claims having been filed against us as of December 31, 2000). We believe that we will not sustain any liability in connection with these or any other asbestos-related claims. On February 2, 2001, the United States Bankruptcy Court for the District of New Jersey issued a temporary restraining order enjoining any existing or future claimant from bringing Asbestos Claims against BMCA. The temporary restraining order expires on April 23, 2001. In addition, on February 7, 2001, G-I Holdings filed a defendant class action in the United States Bankruptcy Court for the District of New Jersey, seeking a declaratory judgment that BMCA has no successor liability for Asbestos Claims against G-I Holdings and that it is not the alter ego of G-I Holdings. If we are unsuccessful in obtaining the declaratory judgment and the temporary restraining order is not renewed, we could experience an increase in Asbestos Claims asserted against us. While we cannot predict whether any additional Asbestos Claims will be asserted against us, or the outcome of any litigation relating to those claims, we believe that we have meritorious defenses to any claim that we have asbestos-related liability. There can be no assurance, however, that we will be successful in those defenses. See "Business -- Legal Proceedings." In addition, G-I Holdings has indemnified us with respect to Asbestos Claims. See "-- G-I Holdings may be unable to satisfy its indemnification obligations owed to us," below. G-I HOLDINGS MAY BE UNABLE TO SATISFY ITS INDEMNIFICATION OBLIGATIONS OWED TO US. G-I Holdings has indemnified us with respect to Asbestos Claims, environmental claims and certain tax liabilities. See "Legal Proceedings." In light of G-I Holdings' recent bankruptcy filing, G-I Holdings may not have sufficient assets to satisfy these indemnification obligations to us. G-I Holdings' inability to satisfy these indemnification obligations could have a material adverse effect on our financial position and results of operations. THE BANKRUPTCY COURT MAY CONSOLIDATE G-I HOLDINGS AND BMCA. On February 8, 2001, the creditors committee formed in connection with G-I Holdings' bankruptcy case filed a motion requesting substantive consolidation of the assets and liabilities of BMCA with the assets and liabilities of G-I Holdings or, alternatively, an order directing G-I Holdings to cause us to file for bankruptcy protection. The committee asked the bankruptcy court to grant them relief on an interim basis pending a final determination. On March 21, 2001, the court refused to grant the requested interim relief. Under applicable bankruptcy law, a bankruptcy court could order substantive consolidation of the assets and liabilities of other entities with G-I Holdings if the court concludes that the requirements under the bankruptcy code have been satisfied. We believe we have meritorious defenses to the motion for substantive consolidation or alternate relief, and we intend to vigorously contest this motion. We cannot assure you, however, that substantive consolidation will not occur or that we will not be ordered to file for bankruptcy protection. If the bankruptcy court concludes that our assets should be consolidated with those of G-I Holdings, however, payments on indebtedness, including the notes, could be delayed and reduced. See "Business -- Legal Proceedings."

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+RISK FACTORS The shares of common stock being offered by this prospectus are highly speculative and involve a high degree of risk. You should carefully consider the risks described below and the other information in this prospectus before deciding to invest in these securities. Our failure to obtain the substantial financing we need for our operations on acceptable terms, or at all, would severely impact our ability to run our business, which could result in a loss in stockholder value and possibly termination of our operations. As of December 5, 2001, we had approximately $25,000 in cash and require an additional $90,000 prior to December 14, 2001, in order to meet our payroll obligations. We will need approximately an additional $135,000 to continue our operations through December 31, 2001. We are seeking to raise the necessary funds by means of a bridge financing or the exercise of outstanding warrants, but there can be no assurance that we will be able to obtain sufficient cash to continue our operations past December 14, or through the end of the year. In order to sustain our operations at current levels through December 31, 2002, and repay the $1.0 million note plus accrued interest to RMS Limited Partnership which is due May 13, 2002, we need to raise more than $9.0 million in additional funds. A portion of these funds may come from the exercise of the Series A and B warrants issued in the Series E preferred stock financing. If all of the warrants were to be exercised we would have proceeds of approximately $10.0 million of additional capital after payment of the debt owed to RMS Limited Partnership. If we cannot raise sufficient additional financing on acceptable terms, or at all, we would experience severe financial and operating difficulties, including the probable discontinuance of operations. If we discontinue operations our company will likely liquidate and our stock will become worthless. In order to raise additional working capital, we may need to issue additional shares of common stock or securities that are convertible into common stock. Our issuances of these securities could dilute the interests of stockholders. Additional financing may be unavailable to us or only available on terms unacceptable to us. We have, to date, had no success in raising this $9.0 million. Additionally, the terms of our Series E financing prohibit us from raising additional capital by selling equity securities that are discounted or that have a variable conversion price until 180 days after the effective date of the registration statement of which this prospectus forms a part. For more information on our liquidity and how we plan to meet our capital needs, see the section of the prospectus called "Management's Discussion and Analysis of Financial Condition and Operating Results -- Liquidity and Capital Resources." We have accumulated significant losses since we started doing business and may not be able to generate significant revenues or any net income in the future, which would negatively impact our ability to run our business, and potentially result in a loss of your investment. We may continue to accumulate losses. We have accumulated net losses of approximately $72.3 million on revenue of $12.1 million from our inception through September 30, 2001. We have continued to accumulate losses after September 30, 2001 to date and we may be unable to generate significant revenues or any net income in the future. We have funded our operations through issuances of debt and equity securities to investors and may not be able to generate a positive cash flow. For more information, see the section of the prospectus called "Management's Discussion and Analysis of Financial Condition and Operating Results." Our independent auditors have stated that there is doubt about our ability to continue as a going concern and in the event of a liquidation of our assets the value received may be less than the value of our assets as presented in our financial statements. As a result of our recurring losses from operations and our working capital deficit, our independent auditors, in their audit opinion covering our 2000 financial statements, stated there was substantial doubt about our ability to continue as a going concern. We are exploring options that would provide additional capital for our objectives and operating needs, such as: . the sale and issuance of additional stock; . the sale and issuance of debt; . the sale of certain assets; and . entering into an additional strategic relationship or relationships to obtain the needed funding or create what we believe would be a better opportunity to obtain such funds. Our failure to obtain additional capital could cause our company to cease or curtail operations and potentially result in a loss of your investment. The accompanying financial statements assume that we will be able to meet our obligations as they become due and that we will continue as a going concern. We may, in fact, not be able to meet our obligations or we may be forced to curtail or shut down our business. Our financial statements do not take into account any adjustments that might result from the outcome of this uncertainty, which means that if we had to liquidate, the funds received may be less than the value of our assets as presently recorded in our financial statements. An opinion by our independent auditors which expresses doubt about our ability to continue as a going concern may impact our dealings with third parties, including customers, suppliers and creditors, because of their concerns about our financial condition. Any such impact could harm our business and results of operation. You may be unable to sell your common stock if you are a resident of a state in which our common stock is not registered or if an exemption from registration is unavailable. Since sales of our common stock must be made pursuant to applicable state securities laws, you may be unable to sell your common stock if you live in a jurisdiciton in which the common stock is not registered or if an exemption from registration is unavailable. We are not currently registered and you may not qualify for an exemption in the State of New York. In certain states, you may be required to make a filing in order to take advantage of certain exemptions from registration. We cannot guarantee that we will be able to effect any required registration or qualification for exemption in such states. Our success depends on significant growth in the biometrics market and on broad acceptance of products in this market. Because almost all of our revenues will come from the sale of products that use biometric technologies, our success will depend largely on the expansion of markets for biometric products domestically and internationally. Even if use of biometric technology gains market acceptance, our products may not achieve sufficient market acceptance to ensure our viability. We cannot accurately predict the future growth rate of this industry or the ultimate size of the biometric technology market. Because they own approximately 55% of our company, a few stockholders will be able to significantly influence our affairs which may preclude other stockholders from being able to influence stockholder votes. Given that RMS Limited Partnership, Jotter Technologies, Inc., and Francis M. Santangelo own 54.6% of our currently outstanding common stock, they are able to significantly influence the vote on those corporate matters to be decided by our stockholders. RMS, Jotter and Mr. Santangelo, are parties to voting agreements which govern the parties' voting arrangements and further affect their influence over our corporate matters. In addition, the holders of the recently issued Series E preferred stock will be able to convert their shares into 5,714,309 shares of common stock, which would equal 55.6% of the then outstanding common stock. If the holders of the Series E preferred stock were to convert their preferred stock into common stock and exercise the Series A and Series B warrants held by them for an additional 6,353,685 shares, they would own 12,067,994 shares, or 72.6% of the then outstanding common stock. We may not be able to compete with our competitors with greater financial and technical resources and greater ability to respond to market changes, which would affect our ability to promote and sell our technology and services. We may not be able to compete successfully in our markets against our competitors. We will face intense competition in both the biometric software and Internet toolbar markets. Many of our competitors, such as BioNetrix, Inc., Digital Persona, Inc., Ankari, Inc., Precise Biometrics, A.B., Keyware, Inc., and I/O Software, Inc. have greater resources than we do. In addition, there are smaller competitors that may be able to respond more rapidly to changes in the market. Our competitors may also be able to adapt more quickly to new or emerging technologies and standards or changes in customer requirements or devote greater resources to the promotion and sale of their products. We may not be able to take advantage of sales opportunities in the future given the reduction in our workforce of sales and marketing personnel, which could cause our business to suffer. Given the reduced number of our sales and marketing personnel as a result of our recent restructuring, we may not be able to meet demand for our products and/or take advantage of sales opportunities, if this type of demand or these types of opportunities arise. If we cannot meet demand for our products, we may not be able to compete with our competitors and our business may suffer. We depend on attracting and retaining skilled employees, which may be difficult due to the competitive employment market. If we lose any of our key, highly skilled technical, managerial and marketing personnel due to the intense competition in the technology industry, our operations may suffer. The success of our company will depend largely upon our ability to hire and retain this type of personnel. If we are unable to raise capital it is likely that our employees will leave or be terminated. Certain key executive officers have not held their positions for very long and so we are dependent on their subordinates for some aspects of operating our business. Our future success depends to a significant degree on the skills, experience and efforts of our executive officers and management personnel. Our chief executive officer and chief financial officer, who were hired to replace our former chief executive and chief financial officers when they resigned, as well as certain other executive officers, have held their positions for less than a year. This means that our senior executives do not know the company as well as their predecessors, and are dependent, to some degree, on their subordinates, who, in turn, may not have the requisite skill and experience to advise our upper management. Our stock has been delisted from the Nasdaq SmallCap Market and there is a limited public market for our common stock. As a result, our stockholders may not be able to sell their common stock easily or may experience higher transaction costs resulting from pricing inefficiencies. Historically, there has been a limited public market for the shares of our common stock. On August 9, 2001, our stock was delisted from the Nasdaq SmallCap Market and there is no certainty that our stock will be permitted to trade again on Nasdaq or that there will be an active trading market for our common stock. Our common stock is currently quoted on both the Pink Sheets and the OTC Electronic Bulletin Board and investors may find it more difficult to obtain accurate price quotations of our common stock than they would if the stock were quoted on the Nasdaq SmallCap Market. This means that you may not be able to sell your SAFLINK stock readily and there may be inefficiencies in the pricing of our stock that could result in broader spreads between the bid and ask prices for our stock. Since our common stock is listed on the Pink Sheets and the OTC Electronic Bulletin Board, which can be volatile markets, you may realize a loss on the disposition of your shares. Our common stock is quoted on both the Pink Sheets and the OTC Electronic Bulletin Board, which are more limited trading markets than the Nasdaq SmallCap Market. Timely and accurate quotations of the price of our common stock may not always be available and trading volume in this market is relatively small. Consequently, the activity of trading only a few shares may affect the market and may result in wide swings in price and in volume. The price of our common stock may fall below the price at which an investor in this offering purchased shares, and an investor may receive less than the amount invested if the investor sells its shares. Our shares of common stock may be subject to sudden and large falls in value, and an investor could experience the loss of the investor's entire investment. Since our common stock is considered "penny stock," and additional rules apply to sales of penny stocks, broker-dealers may be less likely to trade our common stock which could cause investors to find it difficult to sell their shares. Since our stock has a market price of less than $5.00 per share, it is subject to rules regarding so-called "penny stocks" that may limit trading in the secondary market. These rules impose additional sales practice requirements on broker-dealers if they sell penny stock securities to ordinary investors. As a result, broker-dealers may be unable or unwilling to trade "penny stocks." This could result in investors finding it more difficult to sell their shares of our common stock. If the market price of our common stock continues to be volatile, the value of your stockholdings may decline. Like many other technology companies, the market price of our common stock has been, and may continue to be, volatile, which means the value of your SAFLINK stock may fluctuate. Factors that are difficult to predict such as . quarterly revenue, . statements and ratings by financial analysts, . overall market performance, and . announcements by our competitors concerning new product developments contribute to volatility and may have a significant impact on the market price of our common stock. If we are unable to raise additional capital our common stock may become worthless. The issuance of common stock reserved for our stock option plans and the exercise of warrants could dilute your investment and may create a negative public perception of the value of our stock. Our issuance of a large number of additional shares of our common stock upon the exercise of outstanding stock options or warrants could decrease the market price of our common stock. The market price of our common stock could decline as a result of sales of a large number of shares of our common stock in the market or the perception that these sales could occur. We have an aggregate of . 403,557 shares reserved for issuance upon exercise of options granted or that may be granted under our 1992 Stock Incentive Plan; . 2,142,858 shares reserved for issuance upon exercise of options granted or that may be granted under the 2000 Stock Incentive Plan; . 59,187 shares reserved for issuance upon the exercise of options granted outside the 1992 and 2000 Stock Incentive Plans; and . 6,897,396 shares of common stock reserved for issuance upon the exercise of outstanding warrants. If we issue our common stock to option and warrant holders, it will dilute your ownership interest. In addition, if a large number of option or warrant holders sell their shares of our common stock, it could create a negative public perception of the value of our stock. We are partly dependent on third parties for our product distribution and if these parties do not promote our products, it may limit our ability to generate revenue. We utilize third parties such as resellers, distributors and makers of complementary technology to complement our full-time sales staff in promoting sales of our products. If these third parties do not actively promote our products, our ability to generate revenue may be limited. We cannot control the amount and timing of resources that these third parties devote to marketing activities on our behalf. Some of these business relationships are formalized in agreements which can be terminated with little or no notice and may be subject to amendment. We also may not be able to negotiate acceptable distribution relationships in the future and cannot predict whether current or future distribution relationships will be successful. Since a large percentage of our historic revenues have been derived from a limited number of customers, our sales have experienced wide fluctuations. Four customers accounted for approximately 38%, 20%, 17% and 10% of our 2000 revenues. Two customers accounted for approximately 45% and 22% of our 1999 revenues. Approximately 80% of our 1998 revenue was from the sale of software licenses and related services to one customer. No other significant customer accounted for significant sales in 1998. As a result of this concentration of sales to a limited number of customers, our sales have experienced wide fluctuations. In order to succeed, we will have to keep up with rapid technological change in the software industry and various factors could impact our ability to keep pace with these changes. Software design and the biometric technology industry are characterized by rapid development and technological improvements. Because of these changes, our success will depend on our ability to keep pace with a changing marketplace and integrate new technology into our software and introduce new products and product enhancements to address the changing needs of the marketplace. Various technical problems and resource constraints may impede the development, production, distribution and marketing of our products and services. In addition, laws, rules, regulations or industry standards may be adopted in response to these technological changes which, in turn, could materially adversely affect how we do business. We are not experienced in doing business outside the United States and the application of Canadian laws or regulations not previously applicable to our business and which we have little experience in dealing with may have a negative effect on the business. We will have to become familiar with doing business in Canada which is a new corporate and legal environment for us, and we may experience difficulties in this regard. Prior to the asset purchase transaction with Jotter, we only had operations in the United States. Jotter, on the other hand, had a facility in Alberta, Canada, which now serves our company. Provisions in our certificate of incorporation and our Certificate of Designation, Preferences and Rights of the Series E preferred stock may prevent or impact the value of a takeover of our company even if a takeover is beneficial to stockholders. Our certificate of incorporation authorizes our board of directors to issue up to 1,000,000 shares of preferred stock, which may adversely affect our common stockholders. We may issue shares of preferred stock without stockholder approval and upon terms and conditions, and having those types of rights, privileges and preferences, as the board of directors determines. Specifically, the issuance of preferred stock may make it more difficult for a third party to acquire, or may discourage a third party from acquiring, voting control of our company even if the acquisition would benefit stockholders. In addition, the issuance of the Series E preferred stock may impact the value of a takeover to common stockholders because the holders of the Series E preferred stock are entitled to demand that we redeem their stock for cash equal to 125% of the price paid for this stock by the holders in connection with certain acquisitions in which more than 40% of our stock is issued. For a detailed description of the terms of our preferred stock, see "Description of Capital Stock."

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+RISK FACTORS You should carefully consider the following risk factors and all other information contained in this prospectus before subscribing. RISKS RELATED TO OUR BUSINESS DECLINING OPERATIONS; CAPITAL SHORTFALL Our inns have experienced a substantial decline in operating results over the past several years. Since 1996, our annual revenues have declined each year, from $97.4 million in 1996 to $91.5 million in 2000. Our operating profit has declined over the same period from a $17.3 million operating profit in 1996 to a $2.8 million operating loss in 2000. This trend has continued into the first and second quarters of 2001. Rooms revenues for the second quarter 2001 were down over $1.6 million or approximately 7% from the prior year quarter, and year-to-date, rooms revenues decreased by $2.6 million, or 6% from the same period in the prior year. Operating profit was down $94,000 from the prior year quarter. Year-to-date operating profit is up due to other revenues of $656,000 in the first quarter of 2001. The other revenues represent a reimbursement of funds previously paid by the partnership to On Command Video to provide for television equipment maintenance. On Command Video determined that the equipment maintenance was no longer necessary and the funds were subsequently reimbursed to the partnership during the first quarter of 2001. We do not expect that operations will improve during the remainder of the year and therefore believe that we will see declines in both revenue and operating profit. The decline in inn operations is primarily due to increased competition, over-supply of limited service hotels in the markets where our inns operate, the deferral of capital improvements needed to make our inns more competitive, and a slowdown in the economy resulting in a softness in the lodging industry as a whole. The current estimated debt service shortfall before ground rent deferrals is approximately $3 to $4 million for 2001. The shortfall has been funded from partnership cash, amounts in various debt service reserves and, as permitted under our ground lease agreements, deferral of a portion of the ground rent. Forecasts provided by our current manager indicate that our operating cash flow will be insufficient to cover debt service during the balance of 2001. We estimate that the total amount of ground rent that we will defer for 2001 is approximately $1.2 million. However, our ground lessors have agreed to cancel our obligation to pay the deferred ground rent for all of 2000 and 2001 effective on the closing of this offering. We believe there is sufficient cash to fund the debt service shortfall for 2001 by the deferral of ground rent and the use of partnership cash and amounts in certain debt service reserves. We currently estimate that the net decrease in partnership cash accounts and debt service reserves will be approximately $1 to $2 million in 2001. In light of the age of our inns, which range in age from 11 to 14 years, major capital expenditures will be required over the next several years to remain competitive in the markets where we operate and to satisfy brand standards. These capital expenditures include room refurbishments planned for 22 of our inns over the next several years and the replacement of roofs and facades. The capital expenditure needs for the next two years for our inns are estimated to total approximately $33 million. These expenditures will exceed our available funds. Based upon information provided by our current manager, the estimated capital shortfall in funds available for capital improvements is expected to be between $15 million to $20 million. We believe that the shortfall should be covered by the (a) proceeds from the sale of the notes, (b) cash flow savings from the reduction of ground rent described in "Business - "Ground Lease Modifications" and (c) funds drawn from our contribution of 7% of each inn's gross monthly revenues into an escrow account over the next 18 months described in "Business-New Franchise Agreements". However, there can be no assurance that the entire shortfall will be covered, if at all. If we need additional capital, there are no assurances that we can obtain capital on favorable terms to us, if at all. Moreover, we cannot ensure you that such additional funds will maintain or increase our revenues and operating results. For further discussion of our results of operations, shortfall of capital, and liquidity situation, as well as efforts being undertaken to address these problems, see "Management's Discussion and Analysis of Financial Condition and Results of Operations." WE ARE SUBJECT TO NUMEROUS CONDITIONS AFFECTING THE HOTEL INDUSTRY. Our revenues and the value of our inns are subject to conditions affecting the hotel industry. These include: o changes in the national, regional and local economic climate; o local conditions such as an oversupply of hotel properties or a reduction in demand for hotel properties; o the attractiveness of our inns to consumers and competition from comparable hotels; o changes in travel patterns; o changes in room rates and increases in operating costs due to inflation and other factors; and o the need periodically to repair and renovate our inns. Adverse changes in these conditions could adversely affect our financial performance and our ability to service the notes. In addition, the hotel industry is highly competitive. Our inns compete with other hotel properties in their geographical markets, and some of our competitors may have substantially greater marketing and financial resources than we do. OUR EXPENSES MAY REMAIN CONSTANT EVEN IF REVENUE DROPS. If our inns do not generate sufficient income to pay our expenses, service our debt and maintain our inns, we will be unable to make interest payments on the notes. The expenses of owning an inn are not necessarily reduced when circumstances, such as market factors and competition, cause a reduction in income from the inn. If an inn is mortgaged or leased and we are unable to meet the mortgage or lease payments, the lender could foreclose and take the inn or the landlord could terminate the lease on the inn. In addition, interest rate levels, the availability of financing, the cost of compliance with government regulation, including tax laws, and changes in laws and governmental regulations, including those governing usage, zoning and taxes, could adversely affect our financial condition and ability to service our debt, including the notes. WE MAY BE UNABLE TO SELL OUR INNS WHEN NECESSARY BECAUSE THEY ARE ILLIQUID. The sale of our inns is subject to a collateral substitution obligation in our mortgage debt and the inns generally cannot be sold quickly. However, upon the closing of this offering, we will obtain a waiver of this provision to allow proceeds from the sale of certain inns to reduce the outstanding mortgage debt. We may not be able to sell the inns promptly in response to economic or other conditions. Our inability to sell the inns could adversely affect our financial condition and ability to service our debt, including the notes. WE ARE DEPENDENT ON MARRIOTT INTERNATIONAL. Our inns will be franchised under the Fairfield Inn by Marriott brand and our potential desire, from time-to-time, to refinance or sell any of our inns may result in a need to obtain the consent of Marriott International. Any such consent may not be acceptable to Marriott International, and the lack of consent from Marriott International could adversely affect our ability to consummate such refinancing or sale. In addition, as a franchisee of Marriott International, we will be dependent on, among other things, its ability to continue to develop national brand loyalty and marketing programs that effectively market the Fairfield Inn by Marriott brand. THE HOTEL INDUSTRY IS SEASONAL IN NATURE. The hotel industry is seasonal in nature; however, the periods during which our inns experience higher hotel revenue vary from property to property and depend principally upon location. The seasonal nature of our industry affects our cash flow, and if we do not effectively manage our cash flow, it may affect our ability to service our debt. THE HOTEL BUSINESS IS CAPITAL INTENSIVE. In order for our inns to remain attractive and competitive, we have to spend money periodically to keep them well maintained, modernized and refurbished. This creates an ongoing need for cash and, to the extent expenditures cannot be funded from cash generated by our operations, we may be required to borrow or otherwise obtain these funds. Accordingly, our financial results may be sensitive to the cost and availability of funds. We may not be able to obtain additional capital, if necessary, to maintain our inns which could have materially adverse effects on our financial condition and operating results. WE MAY BE ADVERSELY AFFECTED BY THE LIMITATIONS IN OUR NEW FRANCHISE AGREEMENTS AND POSSIBLE ADDITIONAL CAPITAL EXPENDITURES ASSOCIATED WITH FRANCHISING. Our inns will be operated pursuant to new franchise agreements with Marriott International, a nationally recognized hotel brand. The franchise agreements contain specific standards for, and restrictions and limitations on, the operation and maintenance of an inn in order to maintain uniformity within the Marriott International system. Standards are often subject to change over time, and may restrict our ability to make improvements or modifications to an inn without the consent of Marriott International. In addition, compliance with standards could require us to incur significant expenses or capital expenditures. Loss of the franchise agreements without a replacement would likely have an adverse effect on our inn revenues. Moreover, the loss of a franchise could have a material adverse effect upon the operations or the underlying value of the inns covered by the franchise agreements because of the loss of associated name recognition, marketing support and centralized reservation systems provided by Marriott International. RISKS OF THE NOTES AND THIS OFFERING THE NOTES ARE SUBORDINATED TO THE MORTGAGE DEBT AND GROUND LEASES OF OUR PARTNERSHIP. The notes will be subordinated in right of payment to our mortgage indebtedness of approximately $151.3 million as of June 15, 2001, to our obligations to pay ground rent and to certain other obligations described below. Under the terms of the subordination agreement and loan agreement with our mortgage lender, so long as the mortgage debt is outstanding, until January 11, 2007, principal and interest on the notes may be paid from our funds after gross revenues have been applied as follows: o first, to fund a ground rent reserve account until the amount therein equals one month's anticipated ground rent; o second, to fund certain tax and insurance escrows; o third, to fund a debt service reserve account until the amount in the account equals three times the monthly debt service payment on our mortgage debt; o fourth, to fund a capital expenditure and FF&E reserve account until the amount therein equals 7% (or such greater percentage as may be required under the new management agreements) of gross revenues; o fifth, to pay all fees due under the franchise agreements; o sixth, to fund an operating reserve account used to pay anticipated operating expenses; o seventh, to pay ground rent; o eighth, to pay to the ground lessors quarterly option payments of $187,500 each; o ninth, to pay the monthly debt service and any other debt owed on our mortgage debt; and o tenth, to fund an earthquake restoration reserve account until the amount therein is a maximum of $300,000. As of September 20, 2001, all of the reserve and escrow accounts described above were funded in full. After January 11, 2007, our gross revenues are applied for the purposes set forth in items first through eighth above, and then: o ninth, to pay the cost of major repairs, alterations, improvements, renewals or replacements to our inns that are required by reason of any law, subject to certain limitations; o tenth, to remit to us the lesser of (x) the aggregate amount of payments for, or reserves created for the payment of, our administrative expenses not previously remitted to us and (y) $450,000 for the year ended December 31, 1997, increased by a cost of living index for each year thereafter; o eleventh, if an earthquake has occurred and the earthquake restoration cost of the applicable inn is less than 50% of the release price for the inn contained in the loan agreement, at our direction (i) to fund the earthquake restoration reserve account in the amount of such earthquake restoration cost (which we may be use to restore the applicable property) or (ii) to apply such amount in accordance with the provisions of the applicable mortgage with respect to casualty; o twelfth, to pay to the ground lessors quarterly payments of $187,500 for our option to purchase the land underlying certain of our inns; and o thirteenth, (i) first, to prepay the outstanding principal amount of the mortgage debt, and (ii) next, to pay all accrued and unpaid interest on the mortgage debt; provided, however, that the mortgage lender, in the exercise of its sole discretion, may elect to apply any funds payable to it to fund any shortfall in the earthquake restoration reserve account. Accordingly, after January 11, 2007, so long as the mortgage debt is outstanding, no gross revenues of our partnership can be used to pay amounts due on the notes. LEVERAGE AND DEBT SERVICE OBLIGATIONS MAY ADVERSELY AFFECT OUR CASH FLOW. Because of the mortgage debt outstanding, we may be unable to generate cash sufficient to pay the principal of and interest on the notes when due. Our substantial leverage could have significant negative consequences, including: o increasing our vulnerability to general adverse economic and industry conditions; o requiring the dedication of a substantial portion of our expected cash flow from operations to service our mortgage debt, thereby reducing the amount of our expected cash flow available for other purposes, including capital expenditures; and o limiting our flexibility in planning for, or reacting to, changes in our business and the industry in which we compete. WE MAY BE UNABLE TO REPAY THE NOTES. On the maturity date, the entire outstanding principal amount of the notes and accrued and unpaid interest will become due and payable. On the maturity date, we may not have sufficient funds or may be unable to arrange to refinance our mortgage debt to pay the principal and interest amount due. In such event, we will be unable to repay the notes. Furthermore, any future borrowing arrangements to which we become a party may contain restrictions on, or prohibitions against, our repayment of the notes. THE NOTES MAY CREATE CONFLICTS OF INTEREST BETWEEN OUR GENERAL PARTNER AND YOU. Since it is likely that an affiliate of our general partner will purchase notes, certain decisions concerning our operations or financial structure may present conflicts of interest between our general partner and you, other than in your capacity as purchasers of the notes. YOU MAY BE ALLOCATED ADDITIONAL TAXABLE INCOME BY OUR PARTNERSHIP IF YOU DO NOT PURCHASE NOTES. Upon the closing of this offering, if the notes are respected as indebtedness of our partnership for federal income tax purposes, it is likely that, over time, depreciation deductions (in a maximum aggregate amount equal to the principal amount of the notes) and deductions attributable to accrued and unpaid interest on the notes that would otherwise be allocable to all holders will be allocated solely to holders who subscribe for notes. Because our partnership's operating income will continue to be allocated to holders as provided under the partnership agreement, the decrease in depreciation and interest deductions allocated to holders who do not subscribe for notes would cause a corresponding increase in their taxable income from our partnership. It is impossible to predict with certainty when, or to what extent, this increase in taxable income will occur. As the notes are repaid, holders who purchase notes will be allocated income and gain by our partnership that will offset the depreciation and accrued interest deductions allocated to them in previous years on account of the notes (and, accordingly, the taxable income of holders who do not purchase notes will decrease at that time as a result of such allocations). YOU COULD SUFFER ADVERSE CONSEQUENCES IF THE NOTES ARE NOT RESPECTED AS INDEBTEDNESS FOR FEDERAL INCOME TAX PURPOSES. If the notes are not respected as indebtedness of our partnership for federal income tax purposes, then holders who do not subscribe for notes could suffer adverse tax consequences. The nature and extent of any such adverse tax consequences could depend to some extent upon the circumstances of the individual holder. Whether the notes will be respected as indebtedness for federal income tax purposes ultimately will depend on a number of factors, including a finding that our partnership has retained the burdens and benefits of ownership of the inns. No legal opinion will be provided to our partnership concerning this issue. YOUR TAX LIABILITY MAY EXCEED THE CASH PAYMENTS MADE TO YOU IN VARIOUS YEARS. Under federal income tax law, if you purchase notes, you generally will be required to report and pay tax on interest as accrued on the notes. If our partnership is unable to pay interest in full as accrued on the notes, or is unable to repay the notes at maturity, then you will likely be required to report interest income for the applicable year in excess of the cash payments actually made to you during the year. In that event, your resulting tax liability with respect to such interest income could exceed the cash payments made to you on the notes in such year(s) (although the amount of our partnership's taxable income allocable to you should be reduced by deductions for interest accruing on the notes). A TRADING MARKET FOR THE NOTES MAY NOT DEVELOP. The notes are a new issue of securities for which there is currently no active trading market. We do not intend to apply for listing of the notes on any securities exchange. If the notes are traded after their initial issuance, they may trade at a discount from their initial offering price, depending upon prevailing interest rates, the market for similar securities, the financial condition and the prospects of our partnership and other factors beyond our control, including general economic conditions. Since we do not intend to develop a trading market, such trading market is unlikely to develop and you may not be able to sell the notes. RISKS RELATED TO THE PARTNERSHIP WE WILL RELY ON OUR NEW MANAGER FOR THE OPERATION OF OUR INNS. Under the new management agreements, Sage will be given the exclusive authority to manage and operate the day to day operations of our inns. Also, it will be required to devote only such time as is reasonably needed to the operations of our inns. Therefore, our success will depend, in part, upon the ability of Sage, as manager, or the ability of any future manager, as well as upon the ability of our general partner to manage our partnership and our manager. IMPLEMENTATION OF THE RESTRUCTURING PLAN MAY NOT REVERSE OUR DECLINE IN OPERATING RESULTS. The restructuring plan is intended to address our continued decline in operating results which, among other things, has resulted in debt service and capital expenditure shortfalls. There can be no assurance, however, that the implementation of the actions contemplated by the restructuring plan will be successful in reversing the decline in our operating results or, if successful, will be sufficient to remedy our debt service and capital expenditure shortfalls. THE AGE OF OUR INNS SUGGEST THAT FURTHER CAPITAL WILL BE REQUIRED IN THE FUTURE. Significant capital expenditures are currently required in order for our inns to remain competitive and to satisfy brand standards that will be required by the new management agreements with Sage. The age and physical condition of our inns, which range in age from 11 to 14 years, make it likely that further and, perhaps more substantial, capital expenditures will be required in the future. There can be no assurance that the proceeds from the notes and, given current operating levels, cash from operations in the future will be sufficient to fund these expenditures.

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+RISK FACTORS This offering involves a high degree of risk. You should carefully consider the following information about these risks, as well as other information contained or incorporated by reference in this prospectus, or contained elsewhere in our reports, proxy statements and other available public information, as filed with the Commission, before you decide to buy any shares of our common stock. Any of the following risks could materially adversely affect our business, operating results and financial condition and could result in a complete loss of your investment. Only investors who can afford the loss of their entire investment should make an investment in these securities. WE HAVE A HISTORY OF OPERATING LOSSES THAT ARE LIKELY TO CONTINUE IN THE FUTURE Our auditors have included an explanatory paragraph in their report of Independent Public Accountants included in our audited financial statements, included elsewhere in this prospectus for the years ended December 31, 2000, 1999 as previously restated and 1998, respectively, to the effect that our losses from operations for the year ended December 31, 2000, and the working capital deficit and the retained deficit at December 31, 2000 raise substantial doubt about our ability to continue as a going concern. We have incurred significant losses in two of the last three years. We have historically financed our activities through working capital provided from operations, loans and the private placement of our debt and equity securities. As of March 31, 2001, our retained deficit was $42.9 million. In the first quarter of the year 2000, we implemented an operating plan to improve the financial results of the business, concentrating initially on major cost reductions. In doing so, we are also focusing on product margins, which have gradually eroded as the mix of products sold changes and the competition for retail shelf space erodes pricing. We expect to incur continuing losses because we plan to spend available resources on marketing new and existing products. We cannot assure you that we will market any products successfully, operate profitably in the future, or that we will not require significant additional financing in order to accomplish our business plan. WE WILL NEED RELIEF FROM OUR OBLIGATIONS TO PAY OUR SECURED CREDITOR IN THE NEAR TERM AND WE MAY NEED ADDITIONAL FINANCING TO MAINTAIN AND EXPAND OUR BUSINESS, AND SUCH FINANCING MAY NOT BE AVAILABLE ON FAVORABLE TERMS, IF AT ALL. We have historically financed our operations through working capital provided from operations, loans and the private placement of equity and debt securities. In 2000, we raised the gross amount of approximately $8.1 million through a private placement of our securities. The net proceeds of that financing, together with our existing financial resources and any revenues from our sales, distribution, licensing and manufacturing relationships, should be sufficient to meet our operating and capital requirements through July 15, 2001. On June 15, 2001, we entered into an amendment to our Secured Credit Agreement which, among other things extended the repayment date of the aggregate outstanding principal balance of the credit facility from June 15, 2001 to July 30, 2002. On July 20, 2001 our Secured Credit Agreement was amended so that, among other things, our permitted overadvance was increased by $200,000. On September 30, 2001, our permitted overadvance will revert to current levels. As of June 25, 2001 the borrowing under our Secured Credit Agreement was approximately $16.7 million. Under the terms of our amended Secured Credit Agreement we are required to make monthly interest payments on the 15th of each month that are presently approximating $130,000 per month. We may not have the resources to make these payments. We may not be able to pay the required interest payment on September 15, 2001 and we may need to seek relief from the lender from that payment and/or future payments. Our failure to receive such relief could have a material adverse effect on our financial condition and our ability to continue to operate. If we need additional financing, we cannot assure you that it will be available on favorable terms, if at all. If we need funds and cannot raise them on acceptable terms, we may not be able to - sustain our business operations; - execute our growth plan; - take advantage of future opportunities, including acquisitions, as feasible; - respond to customers and competition. THE ISSUANCE OF ADDITIONAL SHARES OF COMMON STOCK UPON CONVERSION OF PREFERRED STOCK MAY CAUSE SIGNIFICANT DILUTION OF EXISTING SHAREHOLDERS' INTERESTS. ITEM 16 EXHIBITS AND FINANCIAL STATEMENT SCHEDULES ITEM 16(A) EXHIBITS All other schedules have been omitted because they are not required, not applicable, or the information is otherwise set forth in the financial statements or notes thereto. EXHIBITS 2.01 Agreement and Plan of Merger dated April 10, 1996, by and between 4Health, Inc. and Surgical Technologies, Inc. as amended June 4, 1996. (1) 2.04 Amended and Restated Agreement and Plan of Merger dated December 24, 1997, signed January 7, 1998, by and between 4Health, Inc. and Irwin Naturals as amended April 2, 1998. (2) 2.05 Agreement to Purchase Asset of Inholtra Naturals Limited (3) 2.06 Agreement & Plan of Merger with Health & Vitamin Express Inc. ("HVE") (3) 3.01 Articles of Incorporation of Surgical Subsidiary, Inc., a Utah Corporation, now known as Surgical Technologies, Inc. Irwin Naturals/4Health, Inc. (4) 3.02 Articles of Merger and related Plan of Merger. (4) 3.03 Bylaws (4) 3.04 Articles of Merger and related Plan of Merger (1) 3.05 Form of Articles of Merger and related Plan of Merger (2) 3.06 Bylaws--Change to By-Laws Eliminating Executive Committee Approved by Shareholders in December 1999 to Proxy Statement. (5) 3.07 Form of Articles of Merger and related Plan of Merger Amendment to Articles Changing Name and Authorizing the Series A Preferred Stock. (6) 4.01 Form of Warrant Agreement between 4Health, Inc. and Zion's First National Bank with related form of Warrant (1) 4.02 Form of Sale Restriction Agreement respecting shareholders of both Surgical Technologies, Inc., and 4Health, Inc. (1) 4.03 Form of Consent, Approval, and Irrevocable Proxy respecting certain Surgical stockholders with related schedule (1) 4.04 Form of Consent, Approval, and Irrevocable Proxy respecting certain 4Health stockholders with related schedule (1) 4.05 Specimen Common Stock Certificate (1) 4.06 Specimen Warrant Certificate (1) 4.07 Warrant certificates between 4Health and Allen & Company Incorporated dated April 15, 1997 (7) 4.08 Warrant certificates between American Equities and Corporate Financial Enterprises (7) 4.09 Registration Rights Agreements with American Equities and Corporate Financial Enterprises. (1) 4.10 Lindsey Duncan Withdrawal Agreement. (1) 4.11 Voting Agreement Between Lindsey Duncan and Klee Irwin. (1) 5.01 Summary of Revolving Line of Credit Agreement between 4Health and Norwest Business Credit, Inc. (8) 5.1 Opinion of Luce, Forward, Hamilton & Scripps LLP (*) 10.01 1996 Long-Term Stock Incentive Plan Incorporated by Reference (1) 10.02 Form of Option granted to Rockwell D. Schutjer. (1) Significant dilution of existing shareholders' interests may occur if we issue additional shares of common stock underlying outstanding shares of our preferred stock or preferred stock. The number of shares of common stock issuable upon conversion of the preferred stock may constitute a significantly greater percentage of the total outstanding shares of common stock, as such conversion is based on a formula tied to the market price of the common stock. The exact number of shares of common stock into which currently outstanding preferred stock may ultimately be convertible will vary over time as the result of ongoing changes in the trading price of the common stock. Decreases in the trading price of the common stock will result in increases in the number of shares of common stock issuable upon conversion of the preferred stock. The conversion of the preferred stock would dilute the book value and earnings per share of common stock held by existing shareholders. The Securities Purchase Agreement, dated October 27, 2000, provides, in part, that to the extent that the number of shares required to be issued in connection with conversions of preferred stock exceeds 19.9% or approximately 6,520,700 shares of common stock outstanding at the closing, we are required to redeem the preferred stock representing such excess common shares at 140% of its face amount, plus accrued dividends. If this were to occur, we may not have adequate cash to redeem such excess and would then be in breach of the terms of the securities purchase stock agreements. OUR PRODUCTS RETURN POLICIES MAY HAVE A MATERIAL ADVERSE EFFECT UPON OUR OPERATIONS. Product returns are a recurring part of our business. Products may be returned for various reasons including expiration dates or lack of sufficient sales velocity. We accrue a reserve for returns based on historical experience. During 1999 and 2000, returns were far higher than in past years and, as such, our gross profit was negatively impacted in 1999 and 2000 for returns. Although we have increased our reserves and have generally been able to estimate the level of returns accurately, there is no guarantee that future returns will not exceed the high levels experienced in the year 2000 or will be in line with past return percentages. The risk of returns is amplified by the current industry trend, which shows negative growth. If this trend continues, retailers may decide to reduce inventory levels from their suppliers, by returning goods from their warehouse distribution centers. WE ARE RELIANT ON A LIMITED NUMBER OF PRODUCTS TO GENERATE REVENUES. We currently offer approximately 313 products and derive more than 31.8% of our total shipments during 2000 from the sale of Ultimate Cleanse and Inholtra products. As a result of the limited number of products from which we derive our revenue, the risks associated with our business increase since a decline in market demand for one or more products, for any reason, could have a significant adverse impact on the results of our operations. We may face costly product liability and other legal claims by consumers. The products we carry are particularly susceptible to product liability claims. Any claim of product liability by a consumer against us, regardless of merit, could be costly financially and could divert the attention of our management. It could also create negative publicity, which would harm our business. Although we maintain product liability insurance in the amount of $15 million, it may not be sufficient to cover a claim if one is made. Like other retailers, distributors and manufacturers of products that are ingested, we face an inherent risk of exposure to product liability claims in the event that the use of the products that we sell results in injury. We may be subjected to various product liability claims, including claims that the products we sell contain contaminants, are improperly labeled or include inadequate instructions as to use or inadequate warnings concerning side effects and interactions with other substances. We cannot predict whether product liability claims will be brought against us in the future or the effect of any resulting adverse publicity on our business. Moreover, we may not have adequate resources in the event of a successful claim against us. We do not have formal indemnification arrangements with the third-party vendors from which we source our products. If our insurance protection is inadequate and our third-party vendors do not indemnify us, the successful assertion of product liability claims against us could result in potentially significant monetary damages. 10.03 Form of Proprietary Information, Inventions, and Non-Competition Agreement between 4 Health and R. Lindsey Duncan. (1) 10.04 Form of Employment Agreement between the Surviving Corporation and Rockwell Schutjer. (1) 10.05 Deed of Trust Note and related Deed of Trust, Assignment of Rents, Security Agreement, and Fixture Filing, dated February 20, 1997, in the principal amount of $1,350,000 due Standard Insurance Company. (9) 10.06 Form of Non-Negotiable Promissory Note. (2) 10.07 Promissory Note issued to Inholtra Naturals Limited 10.10 Settlement Agreement; Indemnity Agreement with Lindsey Duncan; Lou Mancini Termination Agreement; Andrew Vollero, Jr. Stock Option Agreement. (10) 10.11 Indemnity Agreement with Klee Irwin dated April 19, 1999. (11) 10.12 Secured Credit Agreement by and among Irwin Naturals/4Health, Inc as Borrower, and First Source Financial LLP, as Agent and Lender dated as of June 10, 1999. (12) 10.13 Settlement Agreement dated October 8, 1999 between Omni Nutraceuticals, Inc, and Klee Irwin. (13) 10.14 Tax Indemnification and Allocation Agreement dated October 8, 1999 between Omni Nutraceuticals, Inc and Klee Irwin. (13) 10.15 Voting Agreement dated October 8, 1999 by and among Klee Irwin and Margareth Irwin and R. Lindsey Duncan. (13) 10.16 Escrow Agreement dated October 8, 1999 by and among Klee Irwin, Wells Fargo Bank as the Escrow Agent and Omni Nutraceuticals. (13) 10.17 Amendment No. 1 to Settlement Agreement dated October 8, 1999 between Omni Nutraceuticals, Inc. and Klee Irwin. (6) 10.18 Consulting Agreement by and between Omni Nutraceuticals, Inc. and corporate financial Enterprises, Inc dated as of January 24, 2000. (6) 10.19 Consulting Agreement by and between Omni Nutraceuticals, Inc. and Montfort Investments dated as of January 24, 2000. (6) 10.20 Lock up Agreement by Klee Irwin and R. Lindsey Duncan. (6) 10.21 Indemnity Agreement between Omni Nutraceuticals, Inc. and Reid Breitman. (6) 10.22 Agreement dated March 11, 20000 among the company, R. Lindsey Duncan and Cheryl Wheeler. (5) 10.23 Indemnity Agreement dated March 11, 20000 between the Company and R. Lindsey Duncan. (5) 10.24 Term Sheet dated March 11, 22000 between the Company and American Equities, LLC. (5) 10.25 Registration Rights Agreement dated March 11, 2000 among the Company, R. Lindsey Duncan and Cheryl Wheeler. (5) 10.26 Consulting Agreement between the Company and Liviakis Financial Communications, Inc. (5) 10.27 Termination Agreement between the company and Louis Mancini. (5) 10.28 Form of Stock Purchase Agreement by and between Omni Nutraceuticals, Inc. and the purchasers of 3,000 shares of Series A Convertible Preferred Stock, dated October 27, 2000. (14) 10.29 Form of Registration Rights Agreement by and between Omni Nutraceuticals, Inc. and the purchasers of 3,000 shares of Series A Convertible Preferred Stock, dated October 27, 2000. (14) 16.1 Letter re: Change in Certifying Accountant. (15) 20.1 Notice of change of transfer and warrant agent. (16) 22.1 List of subsidiaries of the Company 23.1 Consent of Singer, Lewak, Greenbaum & Goldstein LLP 23.2 Consent of Luce, Forward, Hamilton & Scripps LLP (included in Exhibit 5.1 hereto) 24.1 Power of Attorney (included on signature page) (*) To be filed by amendment. (1) Incorporate by reference from Surgical's registration statement on Form S-4 filed with the Commission, SEC file number 33-03243. (2) Proxy Statement of 4Health, Inc., dated June, 1998. (3) Incorporated by reference from the Company's report on Form 10-K/A, dated August 20, 1999, for the year ended December 31, 1998. (4) Incorporated by reference from Surgical's report on Form 10-K for the year ended March 31, 1994. (5) Incorporated by reference from the Company's report on Form 8-K filed on April 14, 2000. (6) Incorporated by reference from the Company's report on Form 8-K filed on January 31, 2000. (7) Incorporated by reference from Schedule 13D filed with the Commission by Allen & Company Incorporated on April 18, 1997. (8) Incorporated by reference from 4Health's report on Form 10-Q for the quarter ended September 30, 1997. (9) Incorporated by reference from 4Health's report on Form 10-K for the year ended December 31, 1996. (10) Incorporated by reference from the Company's report on Form 8-K dated August 25, 1999. (11) Incorporated by reference from the Company's report on Form 8-K filed on June 7, 1999. (12) Incorporated by reference from the Company's report on Form 8-K filed on July 22, 1999. (13) Incorporated by reference from the Company's report on Form 8-K filed on October 28, 1999. (14) Incorporated by reference from the Company's report on Form 8-K filed on November 3, 2000. (15) Incorporated by reference from the Company's report on Form 8-K dated April 20, 2000. (16) Incorporated by reference from 4Health's report on Form 10-Q for the quarter ended March 31, 1997. Although many of the ingredients in our products are vitamins, minerals, herbs and other substances for which there is a long history of human consumption, some of our products contain innovative ingredients or combinations of ingredients. There is little long-term experience with human consumption of some of these innovative product ingredients or combinations in concentrated form. In addition, interactions of these products with other similar products, prescription medicines and over-the-counter drugs have not been fully explored. Because we will be dealing with large numbers of end users, we will have a significant level of legal exposure due to this volume of customer relationships. The most serious area of exposure will be in relation to product advertising claims and the product quality. People may purchase products from us expecting certain physical results, unique to nutritional products. If they do not perceive the results to be in accordance with the claims made on the packaging or on our Web site, certain individuals or groups of individuals may seek monetary retribution. However, we have no assurance that our insurance company will comply with coverage in all instances or that such coverage will be adequate to cover all potential losses. OUR SUCCESS IS DEPENDENT UPON THE SUCCESSFUL INTRODUCTION OF OUR NEW PRODUCTS AND THE SUCCESS IN EXPANDING THE DEMAND FOR EXISTING BRANDS. We believe the growth of our net sales is substantially dependent upon our ability to introduce new products and to expand the demand for existing brands such as Nature's Secret, Irwin Naturals and others. At present, we have limited resources to spend on advertising and therefore we will be relying, to a large extent, on point of sale displays to generate interest in new products and existing brands. We introduced Inholtra Joint Pain, a new product, to the mass-market in May 2001. If we do not achieve velocity rates that our target mass-market customers demand, the Joint Pain product may be removed from our customers' shelves. Our ability to meet future debt obligations is dependent in large measure on the success of this product and the expansion of existing brands. We seek to introduce additional products each year. The success of new products is dependent upon a number of factors, including our ability to develop products that will appeal to consumers and respond to market trends in a timely manner. There can be no assurance that our efforts to develop new products will be successful or that consumers will accept our new products. In addition, products currently experiencing strong popularity and rapid growth may not maintain their sales volumes over time. WE DO NOT HAVE LONG-TERM CONTRACTS WITH MANUFACTURERS OR DISTRIBUTORS. We purchase all of our products from third-party manufacturers pursuant to purchase orders, but without any long term manufacturing agreements. In the event that a current manufacturer is unable to meet our manufacturing and delivery requirements at some time in the future, we may suffer short-term interruptions of delivery of certain products while we establish an alternative source. While alternative sources are in most cases readily available, we have also established relationships with two third-party manufacturers for all large volume products to further limit our exposure to this type of interruption, We also rely on third-party carriers for product shipments, including shipments to and from our distribution facilities. We are therefore subject to the risks, including employee strikes and inclement weather, associated with our carrier's ability to provide delivery services to meet our fulfillment and shipping needs. Failure to deliver products to our customers in a timely and accurate manner would harm our reputation and our business and results of operations. WE ARE DEPENDENT ON OUR BUSINESS RELATIONSHIPS WITH OUR LARGEST CUSTOMERS. During 2000, we had two customers who accounted for more than 10% of our business. Our top 10 customers account for approximately 60% of our business. The loss of any one of or a significant number of these customers would have a material adverse effect on our growth. We do not have long-term contracts with any of our customers. There is no assurance that our major customers will continue as major customers. The loss of a significant number of other major customers, or a significant reduction in purchase volume by or financial difficulty of such customers, for any reason, could have a material adverse effect on our business, financial condition and results of operations. INDUSTRY TRENDS INDICATE THAT OUR SALES IN OUR INDUSTRY ARE IN DECLINE. ITEM 16(B) FINANCIAL STATEMENT SCHEDULES No schedules have been included in this Registration Statement because they are not required, not applicable, or the information is otherwise set forth in the financial statements or notes thereto. ITEM 17. UNDERTAKINGS. The undersigned Registrant hereby undertakes: That, for purposes of determining any liability under the Securities Act of 1933, as amended (the "Securities Act"), each filing of the Registrant's annual report pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended (the "Exchange Act") (and, where applicable, each filing of an employee benefit plan's annual report pursuant to Section 15(d) of the Exchange Act) that is incorporated by reference in the registration statement shall be deemed to be a new registration statement relating to the securities offered therein, and the offering of such securities at that time shall be deemed to be the initial bona fide offering thereof. That, for purposes of determining any liability under the Securities Act, the information omitted from the form of prospectus filed as part of this registration statement in reliance upon Rule 430A and contained in a form of prospectus filed by the Registrant pursuant to Rule 424(b)(1) or (4) or 497(h) under the Securities Act shall be deemed to be part of this registration statement as of the time it was declared effective. That, for the purpose of determining any liability under the Securities Act, each post-effective amendment that contains a form of prospectus shall be deemed to be a new registration statement relating to the securities offered therein, and the offering of such securities at that time shall be deemed to be the initial bona fide offering thereof. (4) To file, during any period in which offers or sales are being made, a post-effective amendment to this registration statement: (i) To include any prospectus required by section 10(a) (3) of the Securities Act; (ii) To reflect in the prospectus any facts or events arising after the effective date of this registration statement (or the most recent post-effective amendment thereof) which, individually or in the aggregate, represent a fundamental change in the information set forth in this registration statement. Notwithstanding the foregoing, any increase or decrease in volume of securities offered (if the total dollar value of securities offered would not exceed that which was registered) and any deviation from the low or high end of the estimated maximum offering range may be reflected in the form of prospectus filed with the Commission pursuant to Rule 424(b) if, in the aggregate, the changes in volume and price represent no more than a 20% change in the maximum aggregate offering price set forth in the "Calculation of Registration Fee" table in the effective registration statement; (iii) To include any material information with respect to the plan of distribution not previously disclosed in this registration statement or any material change to such information in this registration statement; provided, however, that paragraphs (4) (i) and (4) (ii) do not apply if the information required to be included in a post-effective amendment by those paragraphs is contained in periodic reports filed by the Registrant pursuant to Section 13 or Section 15(d) of the Exchange Act that are incorporated by reference in this registration statement. (5) To remove from registration by means of a post-effective amendment any of the securities being registered which remain unsold at the termination of the offering. The total United States retail market for nutritional supplements, the vitamin, mineral and supplement market, or VMS is highly fragmented. Industry sources report that the VMS sector grew substantially during most of the 1990s, in many years at a double digit pace. However, there is evidence, that during the year 2000, the industry rate of growth became negative. Information Resources, Inc., or IRI, tracks sales data within the food, drug, and mass-market channels of distribution. In the twelve weeks ended February 4, 2001, vitamin and supplement sales in these channels of distribution fell 9.3% when compared to the same period a year earlier. Sales for the prior 52 weeks fell 4.0% when compared to the same 52-week period a year earlier. During the 12-week period, sales of herbal products fell 20.8% and in the 52-week period such sales fell 13.2%. In addition to the trends in our specific industry, the United States economy has experienced a significant downturn in recent months, which may contribute significantly to downward trends in our industry. There also can be no assurance that the industry growth rates of prior years can be regained. In addition, there can be no assurance that the industry growth rate will not continue to decline in future operating periods or that the growth rate of the U.S. economy may not be negative. Such a failure to achieve and sustain growth in the industry or in the U.S. economy as a whole may have a material adverse effect on our ability to return its results to its historic rates of growth and its results of operations. THE VMS INDUSTRY IS HIGHLY COMPETITIVE. Numerous companies, many of which have greater size and financial, personnel, distribution and other resources than us, compete with us in the development, manufacture and marketing of VMS supplements. Our principal competition in the health food store distribution channel comes from a limited number of large nationally known manufacturers and many smaller manufacturers of dietary supplements. In the mass-market distribution channel, our principal competition comes from broad line manufacturers, major private label manufacturers and other companies. In addition, large pharmaceutical companies have begun to compete with others and with us in the dietary supplement industry. Packaged food and beverage companies compete with us on a limited basis in the dietary supplement market. Increased competition from such companies could have a material adverse effect on us because such companies have greater financial and other resources available to them and possess manufacturing, distribution and marketing capabilities far greater than ours. We also face competition in both the health food store and mass market distribution channels from private label dietary supplements and multivitamins offered by health and natural food store chains, drugstore chains, mass merchandisers and supermarket chains. OUR BUSINESS MAY BE ADVERSELY AFFECTED BY UNFAVORABLE PUBLICITY. We believe that the VMS market is significantly affected by national media attention regarding the consumption of VMS supplements. Future scientific research or publicity may not be favorable to the VMS industry or to any particular product, and may not be consistent with earlier favorable research or publicity. Because of our dependence on consumers' perceptions, adverse publicity associated with illness or other adverse effects resulting from the consumption of our products or any similar products distributed by other companies and future reports of research that are perceived as less favorable or that question earlier research could have a material adverse effect on our business, financial condition and results of operations. We are highly dependent upon consumers' perceptions of the safety and quality of our products as well as dietary supplements distributed by other companies. Thus, the mere publication of reports asserting that such products may be harmful or questioning their efficacy could have a material adverse effect on our business, financial condition and results of operations, regardless of whether such reports are scientifically supported or whether the claimed harmful effects would be present at the dosages recommended for such products. THERE IS A SIGNIFICANT COST TO OUR RETAIL RELATIONSHIPS. Insofar as indemnification for liabilities arising under the Securities Act may be permitted to directors, officers and controlling persons of the Registrant pursuant to the foregoing provisions, or otherwise, the Registrant has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Securities Act and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the Registrant of expenses incurred or paid by a director, officer or controlling person of the Registrant in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, the Registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Securities Act and will be governed by the final adjudication of such issue. SIGNATURES Pursuant to the requirements of the Securities Act of 1933, the Registrant certifies that it has reasonable grounds to believe that it meets all of the requirements for filing on Form S-1 and has duly caused this Registration Statement to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Los Angeles, California on July 27, 2001. OMNI NUTRACEUTICALS, INC. By: /s/ KLEE IRWIN ----------------------------------------- Klee Irwin, President and Chief Executive Officer POWER OF ATTORNEY KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Klee Irwin, as his or her true and lawful attorney-in-fact and agent, each acting alone, with full power of substitution and resubstitution, for him or her and in his or her name, place and stead, in any and all capacities, to sign any and all amendments (including post-effective amendments) and supplements to this Registration Statement, and to file the same with the Securities and Exchange Commission, granting unto said attorney-in-fact and agent, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done in connection therewith, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorney-in-fact and agent, or any of them or their substitute or substitutes, may lawfully do or cause to be done by virtue hereof. Many large retailers demand various forms of incentive payments in order to conduct business with them. These payments include slotting fees, co-op advertising payments, rebate incentives, price off promotions and other forms of monetary and non-monetary support. We must continually evaluate specific demands to ascertain the profitability of potential business from the retailer making the demand. Because of such demands, we may, depending upon the demands being made, ascertain that we cannot profitably do business with certain retailers. This may cause us to stop doing business with existing customers or not allow us to enter into a business relationship with a potential new customer, each of which in turn could dampen future revenue growth. AN ABSENCE OF CONCLUSIVE CLINICAL STUDIES TO SHOW THAT THERE ARE NO HARMFUL SIDE EFFECTS TO OUR PRODUCTS COULD HAVE AN ADVERSE EFFECT ON OUR BUSINESS. Although many of the ingredients in our products are vitamins, minerals, herbs and other substances for which there is a long history of human consumption, some of our products contain ingredients for which no such history exists. In addition, although we believe all of our products are safe when taken as directed by us, there is little long-term experience with human consumption of a number of these product ingredients in concentrated form. Accordingly, there can be no assurance that our products, even when used as directed, will have the effects intended or will not have harmful side effects. Any such unintended effects may result in adverse publicity or product liability claims, which could have a material adverse effect on our business, financial condition and results of operations. WE RELY ON OUR INTELLECTUAL PROPERTY PROTECTION AS AN IMPORTANT ELEMENT OF COMPETITION. Our policy is to pursue registrations for all of the trademarks associated with its key products. We rely on common law trademark rights to protect our unregistered trademarks as well as our trade dress rights. Common law trademark rights generally are limited to the geographic area in which the trademark is actually used, while a United States federal registration of a trademark enables the registrant to stop the unauthorized use of the trademark by any third party anywhere in the United States. We intend to register our trademarks in certain foreign jurisdictions where our products are sold. However, the protection available, if any, in such jurisdictions may not be as extensive as the protection available to us in the United States. Currently, we have few patents on our products and no material business is derived from those items that are patented. To the extent we do not have patents on our products, another company may replicate one or more of our products. Although we seek to ensure that we do not infringe the intellectual property rights of others, there can be no assurance that third parties will not assert intellectual property infringement claims against us. WE ARE DEPENDENT ON KEY PERSONNEL. We depend on our executive officers and key personnel to implement our business strategy and could be harmed by the loss of their services. We believe that our growth and future success will depend in large part upon the skills of our management and technical team. The competition for qualified personnel in our industry is intense, and the loss of our key personnel or an inability to continue to attract, retain and motivate key personnel could adversely affect our business. We cannot assure you that we will be able to retain our existing key personnel or to attract additional qualified personnel. We do not have key-person life insurance on any of our employees. Our success depends in part upon the continued service and performance of Klee Irwin, President and Chief Executive Officer. DIFFICULTY OF STRICT COMPLIANCE WITH GOVERNMENT REGULATIONS The processing, formulation, packaging, labeling and advertising of our products are subject to governmental regulation. Congress has recognized the potential impact of dietary supplements in promoting the health of US citizens by enacting the DSHEA. Because of the broad language of certain sections of DSHEA and the regulations that implement it, it is difficult for any company manufacturing or making dietary supplements to remain in strict compliance. Pursuant to the requirements of the Securities Act of 1933, this Registration Statement has been signed by the following persons in the capacities and on the dates indicated. Signature Capacity in Which Signed Date /s/ ANDREW VOLLERO, JR. Chairman of the Board of Directors July 27, 2001 Andrew Vollero, Jr. /s/ KLEE KRWIN President, Chief Executive Officer Klee Irwin and Director July 27, 2001 /s/ THOMAS BAKER Vice President Finance (Principal Accounting Officer) July 27, 2001 Thomas Baker /s/ REBECCA PEARMAN Director Rebecca Pearman July 27, 2001 /s/ THOMAS AARTS Director Thomas Aarts July 27, 2001 OUR CHIEF EXECUTIVE OFFICER AND OUR CHAIRMAN OF THE BOARD VOTE A MAJORITY OF OUR SHARES, WHICH COULD DISCOURAGE AN ACQUISITION OF US OR MAKE REMOVAL OF INCUMBENT MANAGEMENT MORE DIFFICULT. Klee Irwin, our Chief Executive Officer, beneficially owns approximately 36.4% of our outstanding shares common stock as of June 25, 2001 and holds an irrevocable proxy to vote an aggregate of approximately 4.8% of the outstanding common stock on behalf of American Equities, LLC and Corporate Financial Enterprises, Inc. Andrew Vollero, Jr., Chairman of the Board of Directors currently holds an irrevocable proxy to vote an aggregate of approximately 14.4% of the outstanding common stock as of June 25, 2001. Together, they are able to control all matters requiring approval by our stockholders, including the election of directors and the approval of mergers or other business combination transactions. OUR ARTICLES OF INCORPORATION AND UTAH LAW CONTAIN PROVISIONS THAT COULD DELAY OR PREVENT AN ACQUISITION OF THE COMPANY. Our articles of incorporation and by-laws contain provisions that may discourage third parties from seeking to acquire us. These provisions include: - a classified board of directors; - a requirement that special meetings of shareholders be called only by our board of directors, chairman of the board, president or 10% of the stockholders of record of all shares entitled to vote; - limitations on the ability of shareholders to amend, alter or repeal our by-laws; and - the authority of the board of directors to issue, without shareholder approval, preferred stock with such terms as the board of directors may determine. We are also afforded the protections of the Utah Revised Business Corporation Act. This statute contains provisions that impose restrictions on shareholder action to acquire control of our company. The effect of the provisions of our articles of incorporation and by-laws and Utah law may discourage third parties from acquiring control of our company. THERE IS A RISK OF OWNING LOW PRICED STOCKS AND POSSIBLE DIFFICULTY IN LIQUIDATING SHARES OF SUCH STOCK. Our common stock is currently quoted on the NASD Bulletin Board, which is generally considered to be a less efficient market than markets such as NASDAQ or other national exchanges, and which may cause difficulty in conducting trades and difficulty in obtaining future financing. Further, our securities are subject to the "penny stock rules" adopted pursuant to Section 15(g) of the Securities Exchange Act of 1934, as amended, or the Exchange Act. The penny stock rules apply to non-NASDAQ companies whose common stock trades at less than $5.00 per share or which have tangible net worth less than $5,000,000 ($2,000,000 if the company had been operating for three or more years). Such rules require, among other things, that brokers who trade "penny stock" to persons other than "established customers" complete certain documentation, make suitability inquiries of investors and furnish quote information under certain circumstances. Many brokers have decided not to trade "penny stock" because of the requirements of the penny stock rules and, as a result, the number of broker-dealers willing to act as market makers in such securities is limited. In the event that we remain subject to the "penny stock rules" for any significant period, there may develop an adverse impact on the market, if any, for our securities. Because our securities are subject to the "penny stock rules," investors will find it more difficult to dispose of these securities. Further, for companies whose securities are quoted on the NASD Bulletin Board, it is more difficult: - to obtain accurate quotations, - to obtain coverage for significant news events because major wire services, such as the Dow Jones News Service, generally do not publish press releases about such companies, and - to obtain capital. EXHIBITS 10.07 PROMISSORY NOTE ISSUED TO INHOLTRA NATURALS LIMITED NON-RECOURSE PROMISSORY NOTE $10,000,000.00 March 10, 1999 FOR VALUE RECEIVED, the undersigned Irwin Naturals/4Health, Inc., a Utah corporation (the "Debtor"), with its principal place of business located at 10549 W. Jefferson Boulevard, Culver City, CA 90232, hereby promises to pay to Inholtra Natural, Ltd., a Maine corporation (the "Creditor"), at 21 Oceanview Road, Kennebunk, ME 04043, or at such other place as the Creditor shall designate to the Debtor in writing, the principal amount of Ten Million Dollars ($10,000,000.00) lawful money of the United States of America, with interest thereon at the rate of eight percent (8%) per annum calculated on the basis of 365-day year and the number of days elapsed. This Promissory Note evidences the obligation of the Debtor, subject to the terms and conditions set forth below, to pay a portion of the balance of the purchase price (the "Purchase Price") for certain assets purchase by it from the Creditor pursuant to that certain Asset Purchase Agreement between the Debtor, the Creditor and certain other parties dated as of March, 10, 1999 (the "Agreement"). 1. The principal amount hereof shall be payable on or before the close of business on June 10, 1999 (the "Maturity Date") and shall be repaid by Debtor as follows: (i) the principal amount of One Million Dollars ($1,000,000.00) shall be paid to the Indemnity Escrow Agent (as defined in Section 1.5 of the Agreement) to be held by its pursuant to the terms of the Indemnity Escrow Agreement (as also defined in Section 1.5 of the Agreement); and (ii) the remaining principal balance hereof, together with all accrued interest as herein provided shall be paid to Creditor. 2. In addition to its other rights hereunder and under the Agreement, Debtor shall have the right upon notice to Creditor specifying the reasonable detail the basis for a set-off hereunder, to set-off and apply against its obligations to Creditor hereunder any and all amounts to which it may be entitled from Creditor under the Agreement and the other documents executed in connection with the transactions contemplated thereby. The exercise of such right of set-off by Debtor in good faith shall not constitute default hereunder. 3. The principal amount of this Note may be prepaid, in whole or in part, along with accrued interest without premium or penalty. 4. Upon notice to the Debtor of the loss, theft, destruction or mutilation of this Note, and in the case of any such mutilation upon surrender and cancellation of the mutilated document, and in the case of such loss, theft or destruction, upon delivery by the Creditor of an indemnity agreement satisfactory to the Debtor, the Debtor will execute and deliver to the Creditor a new Note of like tenor in lieu of such lost, stolen, destroyed or mutilated Note. 5. Except as otherwise expressly provided herein, the terms of this Note may be amended only by a written instrument executed by the Debtor and the Creditor. No course of dealing with the Debtor and the Creditor nor any delay in executing any rights hereof shall operate as a waiver of any rights of the Creditor. 6. All notices, requests, demands and other communications which are required to be given hereunder shall be deemed to have been duly given only if in writing and delivered by first class mail, return receipt requested, to the other party at its address appearing on the first page hereof or to such other address as such party shall have specified by notice in writing to the other party. POTENTIAL FLUCTUATIONS IN OUR OPERATING RESULTS COULD LEAD TO FLUCTUATIONS IN THE MARKET PRICE FOR OUR COMMON STOCK. Our results of operations are expected to fluctuate significantly from quarter to quarter, depending upon numerous factors, including: - demand for our products; - changes in our pricing policies or those of our competitors; - increases in our manufacturing costs; - the number, timing and significance of product enhancements and new product announcements by ourselves and our competitors; - our ability to develop, introduce and market new and enhanced versions of our products on a timely basis considering, among other things, regulatory approval processes and the timing and results of - future clinical trials; and - product quality problems, personnel changes, and changes in our business strategy. THE MARKET PRICE FOR OUR COMMON STOCK COULD FLUCTUATE DUE TO VARIOUS FACTORS. THESE FACTORS INCLUDE: - acquisition-related announcements; - announcements by us or our competitors of new products; - changes in government regulations; - fluctuations in our quarterly and annual operating results; and - general market conditions. In addition, the stock markets have, in recent years, experienced significant price fluctuations. These fluctuations often have been unrelated to the operating performance of the specific companies whose stock is traded. Market fluctuations, as well as economic conditions, have adversely affected, and may continue to adversely affect, the market price of our common stock. Our ability to pay dividends on our common stock may be limited. We do not expect to pay any cash dividends in the foreseeable future. We intend to retain earnings, if any, to provide funds for the expansion of our business. LIMITATIONS ON DIRECTOR LIABILITY MAY DISCOURAGE STOCKHOLDERS FROM BRINGING SUIT AGAINST A DIRECTOR. Our articles of incorporation provide, as permitted by governing Utah law, that a director shall not be personally liable to us or our stockholders for monetary damages for breach of fiduciary duty as a director, with certain exceptions. These provisions may discourage stockholders from bringing suit against a director for breach of fiduciary duty and may reduce the likelihood of derivative litigation brought by stockholders on our behalf against a director. In addition, our articles of incorporation and bylaws provide for mandatory indemnification of directors and officers to the fullest extent permitted by Utah law. 7. The rights and obligations of the parties hereunder shall be construed and interpreted in accordance with the local laws of the State of New York without regard to the principles of conflicts of law thereof. 8. If (a) Debtor shall fail to pay any amount due under this Note when due; or (b) Debtor shall commit any other material breach or event of default under the Agreement which shall continue uncured for a period of ten (10) days after notice thereof to Debtor; or (c) Debtor shall be dissolved or become insolvent, or shall merge with or into another entity; or (d) there shall be an assignment for the benefit of creditors of Debtor or appointment of a receiver or similar official for Debtor to its assets, or Debtor shall apply for, or be the subject of any voluntary or involuntary application or petition for protection or relief under any Federal, state or foreign bankruptcy, insolvency, receivership or similar law; or (e) Debtor shall take any action for the purpose of effecting any of the foregoing; then and in any such event, all amounts of unpaid principal and all other amounts due to Creditor hereunder shall upon demand be due and payable in full. 9. Except as otherwise set forth herein, the Debtor hereby waives presentment, demand for payment, notice of dishonor, notice of protest and protest, and all other notices or demands in connection with the delivery, acceptance, performance, default, endorsement or guarantee of this instrument. 10. This is a nonrecourse note and, anything herein to the contrary notwithstanding, Creditor agrees for itself, its representatives, successor, endorsees, and assigns that (a) neither Debtor nor its representatives, successors or assignees shall be personally liable on this Note, it being intended that Debtor's obligation to pay the principal of this Note with interest thereon is included for the sole purpose of establishing the existence of the indebtedness represented hereby and (b) in the event of default, Creditor (and any such representative, successor, endorsee, or assign) shall look for payment solely to the Reassignments (as defined in the Agreement) and the rights and remedies set forth in the Security Escrow Agreement (as defined in the Agreement) and will not make any claim or institute any action or proceeding against Debtor (or any representative, successor or assign of Debtor) for payment of this Note (or for any deficiency remaining after application of the property which is the subject of the Reassignments); provided, however, that nothing herein contained shall be construed to release or impair the indebtedness evidence by this Note, or of the lien upon the property securing it, or preclude the application of said property to the payment hereof in accordance with the terms of the Security Escrow Agreement. 11. All disputes arising hereunder shall be resolved by binding arbitration in the City of New York, New York before a single arbitrator in accordance with the rules of the American Arbitration Association. IN WITNESS WHEREOF, this Note has been signed by the Debtor on the date first above written. IRWIN NATURALS/4HEALTH, INC. BY: /S/KLEE IRWIN -------------- KLEE IRWIN CHIEF EXECUTIVE OFFICER

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+Risk Factors You should carefully consider the risks described below before you decide to invest in our common stock. Our revenues are dependent on the continued research needs of companies in the pharmaceutical and biotechnology industries. We are highly dependent on research and development expenditures by the pharmaceutical and biotechnology industries. Accordingly, our operations could be materially and adversely affected by general economic downturns in these industries and other factors resulting in a decrease in research and development expenditures. Furthermore, we have benefited from the increasing trend among pharmaceutical and biotechnology companies to hire outside organizations like our company to conduct both small and large research projects. This "outsourcing" practice has grown substantially during the 1990's and we believe that because of our multiple biologically based capabilities, we are well positioned to continue to take advantage of this trend. If this trend in outsourcing were to change and companies in these industries reduced their tendency to outsource their projects, our operations and financial condition could be materially and adversely affected. We derive a substantial portion of our revenues from a limited number of customers. We have one customer who accounted for approximately 35% of our annual revenue for the year ended December 31, 2000, one customer who accounted for approximately 35% of our annual revenue for the fiscal year ended December 31, 1999 and two customers who accounted for approximately 10% of our annual revenues for the fiscal year ended December 31, 1998. The decrease or loss of business from these customers or any future customer of similar size could have a material adverse effect on our results of operations or financial condition. We generally provide our services on a fee-for-services basis and therefore bear the risk that our costs exceed what we charge our customers. Most of our contracts for the provision of our services are on a fee-for-service basis, providing for payments only after certain research milestones have been reached. We do not receive residual or royalty payments for future discoveries or uses involving the materials or services provided by us to our customers. For the year ended December 31, 2000 and 1999, these fee-for-service contracts accounted for 64% and 61% of our total annual revenues, respectively. Since our contracts are predominantly fee-for-service, we bear the risk if it costs us more to perform our services than what we charge our customers. Most of our contracts, including those with governmental agencies, may be terminated by the client immediately or upon notice for a variety of reasons. Although the contracts often require payment to us for our expenses to wind down the study and fees earned to date and, in some cases, a termination fee, the loss of one or more of our large contracts could have a material adverse effect on our business and operations. We may make substantial expenditures to fund Sentigen Corp.'s research efforts that may not result in the development of commercially viable products. We may use a substantial portion of our revenue to fund the research and development efforts of Sentigen Corp. Sentigen Corp. is in a development stage, having been incorporated in February 2000. Sentigen Corp. has not yet developed any products or generated any revenue and has no operating history on which to base an evaluation of its business or prospects. Sentigen Corp. may never develop any products and, if it does, those products may not be commercially viable, especially in light of the competition we will face in the industry in which Sentigen Corp. will compete. We may face potential liability for injuries resulting from our products. We may be exposed to product liability claims as a result of the sale of our products. Although we have obtained product liability insurance totaling $2.0 million, or $1.0 million per occurrence, and an umbrella policy that provides a $10.0 million coverage, in total or for each occurrence, this insurance may not fully cover us against any claims by our customers. If a successful suit were brought against us, unavailability or insufficiency of insurance coverage could have a material adverse effect on our operations. Moreover, any adverse publicity arising from claims made against us, even if the claims were unsubstantiated and unsuccessful, could adversely affect our reputation and sales. Our backlog may not be indicative of future results. Our backlog is based on anticipated net revenue from uncompleted projects that a customer has authorized. This backlog may not be indicative of our future results. Our backlog may be affected by a number of factors, including: o the variable size and duration of projects ranging from small, daily projects to large projects that take years to complete; o the loss or delay of projects; and o a change in the scope of work during the course of a project. Our charter documents and Delaware law may inhibit a takeover of our company. Provisions in our certificate of incorporation and bylaws may have the effect of delaying or preventing a change of control or changes in our management that a stockholder might consider favorable. These provisions include, among others: o the right of the board to elect a director to fill a space created by the expansion of the board; o the ability of the board to alter our bylaws; and o the ability of the board to issue series of preferred stock without stockholder approval.

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+RISK FACTORS An investment in our common stock involves significant risks. You should carefully consider the following risks described below and the other information in this prospectus including our financial statements and related notes before you decide to buy our common stock. The trading price of our common stock could decline due to any of these risks, and you could lose all or part of your investment. We have a history of losses and may experience losses in the future, which may result in the market price of our common stock declining Since our inception, we have incurred significant net losses, including net losses available to common stockholders of $1.6 million in 1998, $1.4 million in 1999, $1.1 million in 2000 and $1.5 million in the three months ended March 31, 2001. In addition, we had an accumulated deficit of $21.1 million as of March 31, 2001. We expect to continue to incur net losses in 2001. We anticipate that our expenses will increase substantially in the foreseeable future as we: . continue to invest in research and development to enhance our ALGO and CO-Stat products and develop new technologies; . develop additional applications for our current technology, such as the use of our CO-Stat breath analyzer for the detection of pregnancy induced hypertension; . increase our marketing and selling activities, particularly outside the United States; . continue to increase the size and number of locations of our customer support organization; and . develop additional infrastructure and hire additional management and other employees to keep pace with our growth. As a result of these increased expenses, we will need to generate significantly higher revenues to achieve profitability. We cannot be certain that we will achieve profitability in the future or, if we achieve profitability, sustain it. If we do not achieve and maintain profitability, the market price of our common stock is likely to decline, perhaps substantially. We have relied, and expect to continue to rely, on sales of our ALGO product family for substantially all of our revenues, and a decline in sales of these products could cause our revenues to fall Historically, we have derived substantially all of our revenues from sales of our ALGO products. Revenues from our ALGO products accounted for approximately 98% of our revenues in 1998, 1999, 2000 and the three months ended March 31, 2001. We expect that the revenues from the ALGO product family will continue to account for a substantial majority of our revenues for at least the next two years. To date, our MiniMuff product, which is disposable ear covers for newborns, has accounted for only a small percentage of our revenues. We have not derived any significant revenues from sales of our CO- Stat products. Any factors adversely affecting the pricing of our ALGO screening equipment and related disposables or demand for our ALGO products, including physician acceptance or the selection of competing products, could cause our revenues to decline and our business to suffer. As the ALGO and MiniMuff products were our only lines of commercially marketed products through 2000, if more physicians do not adopt our ALGO and MiniMuff products, we will not achieve future sales growth We acquired the ALGO product family in 1987, and we introduced our MiniMuff product in 1995. More neonatologists and pediatricians must adopt our products for us to increase our sales. We believe that physicians will not continue to use our ALGO products unless they determine, based on published peer-reviewed journal articles, long-term clinical data and experience, that the ALGO products provide an accurate and cost-effective alternative to other means of testing for hearing impairment. There are currently alternative hearing screening products, which are less expensive and may be quicker on a per test basis. Physicians are traditionally slow to adopt new products and testing practices, partly because of perceived liability risks and the uncertainty of third party reimbursement. If more neonatologists and pediatricians do not adopt our ALGO products, we may never have significant revenues or achieve and maintain profitability. Factors that may affect the medical community's acceptance of our ALGO products, some of which are beyond our control, include: . the changing governmental and physician group guidelines for screening of newborns, particularly with respect to full term babies; . the performance, quality, price and total cost of ownership of our screening products relative to other screening products for newborns; . our ability to maintain and enhance our existing relationships and to form new relationships with leading physician organizations, hospitals and third party payors; . changes in state and third party payor reimbursement policies for newborn hearing screening equipment; and . the adoption of state and foreign laws requiring universal newborn hearing screening. Our quarterly operating results may fluctuate, which could cause our stock price to decline Our revenues and operating results have varied significantly from quarter to quarter in the past and may continue to fluctuate in the future. The following are among the factors that could cause our operating results to fluctuate significantly from quarter to quarter: . the budgeting cycle of our customers; . the size and timing of specific sales, such as large purchases of screening equipment or disposables by government agencies or hospital systems; . product and price competition; . the timing and market acceptance of new product introductions and product enhancements by us and our competitors, such as the expected reduction in demand for our existing ALGO screener prior to the announced launch date of our next generation ALGO screener; . the length of our sales cycle; . the loss of key sales personnel or international distributors; and . changes caused by the rapidly evolving market for newborn screening products. In addition, if a majority of our customers were to implement enterprise- wide evaluation programs or purchase products for the entire organization at once, our sales cycle could lengthen and our revenues could be erratic from quarter to quarter. This could make our business difficult to manage. For example, in the fourth quarter of 1997, a local government agency in Belgium made a one time purchase of equipment for each of the hospitals in its jurisdiction and approximately one year's supply of disposables. This purchase resulted in an abnormally high level of sales during that period and the following quarter. We have limited historical experience selling our CO-Stat products and cannot determine how the sales cycle for the CO-Stat products will affect our revenues; however, the sales cycle could be protracted and could result in further unpredictability in our revenues from quarter to quarter. Many of these factors are beyond our control, and we believe that you should not rely on our results of operations for interim periods as any indication of our expected results in any future period. If our revenues vary significantly from quarter to quarter, our business could be difficult to manage and our quarterly results could be below expectations of investors and stock market analysts, which could cause our stock price to decline. Our operating results have been and may continue to be subject to seasonal fluctuations during the first fiscal quarter of each year We experience seasonality in the sale of our screening equipment. For example, our sales typically decline from our fourth fiscal quarter to our first fiscal quarter. We anticipate that we will continue to experience relatively lower sales in our first fiscal quarter due to patterns in the capital budgeting and purchasing cycles of our current and prospective customers, many of which are government agencies. We may also experience declining sales in the third fiscal quarter due to summer holiday and vacation schedules. These seasonal factors may lead to fluctuations in our quarterly operating results. It is difficult for us to evaluate the degree to which the summer slow down and capital budgeting and customer purchasing cycle variations may make our revenues unpredictable in the future. Our operating results may decline if we do not succeed in developing and marketing additional newborn testing products or improving our existing products We intend to develop additional testing products for the diagnosis and monitoring of common medical conditions in infants and pregnant women. Developing new products and improving our existing products to meet the needs of neonatologists and pediatricians requires significant investments in research and development. If we fail to successfully develop and market new products and update our existing products, our operating results may decline as our existing products reach the end of their commercial life cycles. Our future growth and profitability will depend on our ability to begin commercial, volume sales of our CO-Stat products We introduced our CO-Stat product family for clinical research uses in July 1999 and began commercially marketing it in January 2001. To date, CO-Stat products have accounted for only a limited portion of our revenues, which have been derived primarily from sales to participants in our clinical trials. We have limited experience marketing our CO-Stat product for commercial use. However, our future growth and profitability will depend on our ability to commercially sell our CO-Stat products and to sell our CO-Stat products in volume. We cannot be certain that our entry into the hemolysis monitoring segment of the newborn testing market with CO-Stat will be successful, that the hemolysis monitoring market will develop at all or that physicians, governments or other third party payors will accept and adopt these products. Physicians may not adopt our CO-Stat products if we cannot show that these products are cost-effective or if long-term clinical data does not support our early results, which would harm our operating results While one study has concluded that our CO-Stat product is more cost- effective than another test used for jaundice monitoring, we cannot be certain that additional clinical studies of the cost-effectiveness of our CO- Stat product compared to other tests used for jaundice monitoring will produce results that are favorable to our products. The commercial acceptance of our CO-Stat products depends in part upon favorable results from these studies if they are conducted. If our CO-Stat products are not shown to be cost-effective, we may not be able to persuade clinicians to adopt our products and our results of operations may suffer. If the studies do not produce satisfactory clinical data supported by the independent efforts of clinicians, our new products may not be accepted by physicians or government agencies as meeting the standards of care for universal newborn screening. Our safety, effectiveness, reliability, sensitivity and specificity data for the CO-Stat products is based in part on a study of over 1,300 children. We may find that data from longer-term follow-up studies or studies involving a larger number of children is inconsistent with our relatively short-term data. If longer-term studies or clinical experience indicate that the CO-Stat products do not provide sensitive, specific and reliable results, our products may not gain commercial acceptance and our revenues could decline. In addition, we could be subject to significant liability for screening that failed to detect hemolysis leading to jaundice or costs and emotional distress incurred by families whose children received results indicating elevated hemolysis when none existed. We could have similar problems with any other products we offer in the future. If the guidelines for recommended universal newborn screening do not continue to develop in the United States and foreign countries, and governments do not require testing of all newborns as we anticipate, our revenues may not grow because our products will not be needed for universal newborn screening The demand for our screening products depends, in part, on the state and foreign governments' adoption of universal screening requirements for the disorders for which our products screen. The guidelines for universal newborn screening for hearing impairment and jaundice monitoring have been adopted by some physician groups and governments only recently. We cannot predict the outcome or the impact that statutes and government regulations requiring universal newborn screening will have on our sales. The widespread adoption of these guidelines will depend on our ability to educate government agencies, neonatologists, pediatricians, third party payors and hospital administrators about the benefits of universal newborn hearing testing and the benefits of universal newborn hemolysis monitoring, as well as the use of our products to perform the screenings and monitoring. Our revenues may not grow if densely populated states and foreign countries do not adopt guidelines requiring universal newborn hearing screening or jaundice monitoring or if those guidelines have a long phase-in period If the governments in the most densely populated states and foreign countries do not require universal screening for the disorders for which our products test, our business would be harmed and our sales may not grow. As of March 31, 2001, 32 states have mandated universal newborn hearing screening, but the phase-in of these guidelines varies widely from six months to four years. To date, there has been only limited adoption of newborn hearing screening prior to hospital discharge by foreign governments. Our revenues may not grow if hospitals are slow to comply with these guidelines or the applicable government provides for a lengthy phase-in period for compliance. Our revenues may not grow if state and foreign governments do not mandate hemolysis monitoring as the standard of care for newborn jaundice screening To date, physician groups and federal, state and local governments have not mandated the screening methodology to be used for newborn jaundice management or established monitoring of hemolysis as the best practice. If these mandates or practice recommendations are not issued, a market may not develop for our CO-Stat products. Any failure in our efforts to educate clinician, government and other third party payors could significantly reduce our product sales It is critical to the success of our sales effort that we educate a sufficient number of clinicians, hospital administrators and government agencies about our products and the costs and benefits of universal newborn hearing testing and universal newborn jaundice management using hemolysis monitoring. We rely on physician, government agency and other third party payor confidence in the benefits of testing with our products as well as their comfort with the reliability, sensitivity and specificity of our products. The impact of our products will not be demonstrable unless highly sensitive and specific evaluations are performed on a substantial number of newborns, including those who do not have risk factors for hearing impairment or who do not display signs of jaundice. If we fail to demonstrate the effectiveness of our products and the potential long-term benefits to patients and third party payors of universal newborn screening, our products will not be adopted. If health care providers are not adequately reimbursed for the screening procedures or for screening equipment itself, we may never achieve significant revenues Physicians, hospitals and state agencies are unlikely to purchase our products if clinicians are not adequately reimbursed for the screening procedures conducted with our equipment or the disposable products needed to conduct the screenings. Unless a sufficient amount of positive, peer-reviewed clinical data about our products has been published, third party payors, including insurance companies and government agencies, may refuse to provide reimbursement for the cost of newborn hearing screening and hemolysis monitoring with our products. Furthermore, even if reimbursement is provided, it may not be adequate to fully compensate the clinicians or hospitals. Some third party payors may refuse adequate reimbursement for screening unless the infant has demonstrable risk factors. See "Business--Third Party Reimbursement" for a further discussion of reimbursement. If health care providers cannot obtain sufficient reimbursement from third party payors for our products or the screenings conducted with our products, it is unlikely that our products will ever achieve significant market acceptance. Acceptance of our products in international markets will be dependent upon the availability of adequate reimbursement or funding, as the case may be, within prevailing health care payment systems. Reimbursement, funding and health care payment systems vary significantly by country and include both government-sponsored health care and private insurance. Although we intend to seek international reimbursement or funding, as the case may be, approvals, we may not obtain these approvals in a timely manner or at all. Even if third party payors provide adequate reimbursement for some newborn hearing screening or hemolysis monitoring for jaundice management, adverse changes in reimbursement policies in general could harm our business We are unable to predict changes in the reimbursement methods used by third party health care payors. For example, some payors are moving toward a managed care system in which providers contract to provide comprehensive health care for a fixed cost per person. We cannot assure you that in a managed care system the cost of our products will be incorporated into the overall payment for childbirth and newborn care or that there will be adequate reimbursement for our screening equipment and disposable products separate from reimbursement for the procedure. Unless the cost of screening is reimbursed as a standard component of the newborn's care, universal screening is unlikely to occur and the number of infants likely to be screened with our products will be substantially reduced. We have very limited experience selling and marketing products other than our ALGO products, and our failure to build and manage our sales force or to market and distribute our CO-Stat products or other products effectively will hurt our revenues and quarterly results Since we only recently began to market our CO-Stat products, our sales force has little experience selling these products, and we cannot predict how successful they will be in selling these products. In order to successfully introduce and build market share for our CO-Stat products, we must sell our products to hospital administrators accustomed to the use of laboratory bench equipment rather than portable point of care screening devices for jaundice management. We market almost all of our newborn hearing screening products in the United States through a small direct sales force of 16 persons as of March 31, 2001. During the first quarter of 2001, we expanded our sales force by four persons in order to market our CO-Stat products along with our other products. There are significant risks involved in building and managing our sales force and marketing our products. We may be unable to hire a sufficient number of qualified sales people with the skills and training to sell our newborn hearing screening and jaundice management products effectively. Furthermore, we do not have any agreements with distributors for sales of our CO-Stat products. We may not be successful in generating revenues from our CO-Stat products because we may encounter difficulties in manufacturing our CO-Stat products in commercial quantities We do not have experience manufacturing our CO-Stat products in commercial quantities, and we may encounter difficulties in the manufacturing of these products. We must also increase our manufacturing personnel or increase the volume of products we purchase from contract manufacturers to produce the CO- Stat products for us. If we encounter any of these difficulties, we may not be successful in marketing our CO-Stat products, and our revenues and financial condition may be harmed. If we lose our relationship with any supplier of key product components or our relationship with a supplier deteriorates or key components are not available in sufficient quantities, our manufacturing could be delayed and our business could suffer We contract with third parties for the supply of some of the components used in our products and the production of our disposable products. Some of our suppliers are not obligated to continue to supply us. For certain of these materials and components, relatively few alternative sources of supply exist. In addition, the lead time involved in the manufacturing of some of these components can be lengthy. If these suppliers become unwilling or unable to supply us with our requirements, it might be difficult to establish additional or replacement suppliers in a timely manner or at all. This would cause our product sales to be disrupted and our revenues and operating results to suffer. Replacement or alternative sources might not be readily obtainable due to regulatory requirements and other factors applicable to our manufacturing operations. Incorporation of components from a new supplier into our products may require a new or supplemental filing with applicable regulatory authorities and clearance or approval of the filing before we could resume product sales. This process may take a substantial period of time, and we cannot assure you that we would be able to obtain the necessary regulatory clearance or approval. This could create supply disruptions that would harm our product sales and operating results. There is only one Natus approved supplier that provides hydrogel, the adhesive used in our disposable products. In addition, we have relied on a single supplier for the electrochemical sensors used in our CO-Stat analyzer and we have not qualified another vendor for this component. A disruption in the supply of the adhesive or electrochemical sensors could negatively affect our revenues. If we or our contract manufacturers were unable to locate another supplier, it could significantly impair our ability to sell our products. In addition, we may be required to make new or supplemental filings with applicable regulatory authorities prior to our marketing a product containing new materials or produced in a new facility. If we fail to obtain regulatory approval to use a new material, we may not be able to continue to sell the affected products. We rely on a continuous power supply to conduct our operations and California's current energy crisis could disrupt our operations and increase our expenses California is in the midst of an energy crisis that could disrupt our operations and increase our expenses. In the event of an acute power shortage, that is, when power reserves for the State of California fall below one and one-half percent, the State of California has on some occasions implemented, and may in the future continue to implement, rolling blackouts throughout the state. We currently do not have backup generators or alternate sources of power in the event of a blackout, and our current insurance does not provide coverage for any damages we or our customers may suffer as a result of any interruption in our power supply. If blackouts interrupt our ability to continue operations at our facilities, then our reputation could be damaged, our ability to retain existing customers could be harmed and we could fail to obtain new customers. These interruptions could also result in lost revenue, any of which could substantially harm our business and results of operations. Furthermore, the deregulation of the energy industry instituted in 1996 by the California state government has caused power prices to increase. Under deregulation, utilities were encouraged to sell their plants, which traditionally had produced most of California's power, to independent energy companies that were expected to compete aggressively on price. Instead, due in part to a shortage of supply, wholesale prices have skyrocketed over the past year. If wholesale prices continue to increase, our operating expenses will likely increase, as our primary North American facilities are located in California. Some of our component suppliers are also located in California. While our orders from our suppliers have not been affected by power failure to date, the continuance of blackouts may affect our suppliers' ability to manufacture our products and meet scheduled delivery needs. Our sales efforts through group purchasing organizations may reduce our average selling prices, which would reduce our revenues and gross profits from these sales In September 1999 and February 2000, we entered into two agreements to sell our products to members of group purchasing organizations, which negotiate volume purchase prices for medical devices and supplies for member hospitals, group practices and other clinics. While we still make sales directly to group purchasing organization members, the members of these group purchasing organizations now receive volume discounts off our normal selling price and other special pricing considerations from us. Sales to members of one group purchasing organization, Novation, LLC, accounted for approximately 22% of our total revenues in 2000, and approximately 79% of the customers who bought from us under the Novation agreement were also our customers prior to the time we entered into the Novation agreement. Other of our existing customers may be members of group purchasing organizations with which we do not have agreements. Our sales efforts through group purchasing organizations may conflict with our direct sales efforts to our existing customers. If we were to enter into agreements with other group purchasing organizations and our existing customers begin purchasing our products through those group purchasing organizations, our revenues and profit margin could decline. We rely on sales to existing customers for a majority of our revenues, and if our existing customers do not continue to purchase products from us, our revenues may decline We rely on sales of additional screening products to our existing customers for a majority of our revenues. Of our customers that purchased products from us in 1999, 90% also purchased products from us in 2000. If we fail to sell additional screening products to our existing customers directly or indirectly, we would experience a material decline in revenues. Because we rely on distributors to sell our products in some markets outside of the United States, our revenues could decline if our existing distributors do not continue to purchase products from us or if our relationship with any of these distributors is terminated We rely on our distributors for a majority of our sales outside the United States. These distributors also assist us with regulatory approvals and education of physicians and government agencies. Our revenues from sales through international distributors outside the United States represented approximately 10% of our revenues in 1999, approximately 14% of our revenues in 2000 and approximately 16% of our revenues in the three months ended March 31, 2001. We intend to continue our efforts to increase our sales in Europe, Japan and other countries with a relatively high level of health care spending on infants. If we fail to sell our products through our international distributors, we would experience a decline in revenues unless we begin to sell our products directly in those markets. We cannot be certain that we will be able to attract new international distributors that market our products effectively or provide timely and cost-effective customer support and service. Even if we are successful in selling our products through new distributors, the rate of growth of our revenues could be harmed if our existing distributors do not continue to sell a large dollar volume of our products. None of our existing distributors are obligated to continue selling our products. In the past, we have terminated our relationships with distributors for poor performance. We are also subject to foreign laws governing our relationships with our distributors. These laws may require us to make payments to our distributors even if we terminate our relationship for cause. Some countries require termination payments under common law or legislation that may supercede our contractual relationship with the distributor. These payments could be equal to a year or more of gross margin on sales of our products the distributor would have earned. Any required payments would adversely affect our operating results. Our plan to expand in international markets will result in increased costs and may not be successful, which could harm our business We must expand the number of distributors who sell our products or increase our direct international sales presence to significantly penetrate international markets. We have only recently begun to develop a direct sales force outside the United States. For example, we acquired our United Kingdom distributor in January 2001, and we assumed our Japanese distributor's sales and support activities effective July 1, 2001. As we continue to increase our direct international sales presence, we will incur higher personnel costs that may not result in additional revenues. A higher percentage of our sales to international distributors could also impair our revenues due to discounts available to these distributors. We may not realize corresponding growth in operating results from growth in international sales, due to the higher costs of sales outside of the United States. Even if we are able to successfully expand our direct and indirect international selling efforts, we cannot be certain that we will be able to create or increase demand for our products outside of the United States. Our operating results may suffer because of foreign currency exchange rate fluctuations or strengthening of the U.S. dollar relative to local currencies Although historically substantially all of our sales contracts provide for payment in United States dollars, we expect that we will incur expenses related to international sales denominated in the respective local currency. We established a Japanese subsidiary in July 2000 and a United Kingdom subsidiary in December 2000. These operations will incur expenses in the applicable local currency. We also expect to begin selling our products in local currencies as we expand our direct international sales. To date, we have not undertaken any foreign currency hedging transactions, and as a result, our future revenues and expense levels from international operations may be unpredictable due to exchange rate fluctuations. Furthermore, a strengthening of the dollar could make our products less competitive in foreign markets. We face other risks from foreign operations, which could reduce our operating results and harm our financial condition Our international operations are subject to other risks, which include: . contractual provisions governed by foreign law, such as common law rights to sales commissions by terminated distributors; . the dependence of demand for our products on health care spending by local governments; . greater difficulty in accounts receivable collection and longer collection periods; . difficulties of staffing and managing foreign operations; . reduced protection for intellectual property rights in some countries and potentially conflicting intellectual property rights of third parties under the laws of various foreign jurisdictions; and . difficulty in obtaining foreign regulatory approvals. Our failure to obtain necessary U.S. Food and Drug Administration clearances or approvals or to comply with Food and Drug Administration regulations could hurt our ability to commercially distribute and market our products in the United States, and this would harm our business and financial condition Unless an exemption applies, each medical device that we wish to market in the United States must first receive one of the following types of Food and Drug Administration premarket review authorizations: . 510(k) clearance via Section 510(k) of the federal Food, Drug, and Cosmetics Act of 1938, as amended; or . premarket approval via Section 515 of the Food, Drug, and Cosmetics Act if the Food and Drug Administration has determined that the medical device in question poses a greater risk of injury. The Food and Drug Administration's 510(k) clearance process usually takes from four to 12 months, but can take longer. The process of obtaining premarket approval is much more costly, lengthy and uncertain. Premarket approval generally takes from one to three years, but can take even longer. We cannot assure you that the Food and Drug Administration will ever grant either 510(k) clearance or premarket approval for any product we propose to market. Furthermore, if the Food and Drug Administration concludes that these future products using our technology do not meet the requirements to obtain 510(k) clearance, then we would have to seek premarket approval. We cannot assure you that the Food and Drug Administration will not impose the more burdensome premarket approval requirement on modifications to our existing products or future products, which in either case could be costly and cause us to divert our attention and resources from the development of new products or the enhancement of existing products. Our business may suffer if we are required to revise our labeling or promotional materials or the Food and Drug Administration takes an enforcement action against us for off-label uses We may not promote or advertise the ALGO, MiniMuff or CO-Stat products, or any future cleared or approved devices, for uses not within the scope of our clearances or approvals or make unsupported promotional claims about the benefits of our products. If the Food and Drug Administration determines that our claims are outside the scope of our clearances or are unsupported it could require us to revise our promotional claims or take enforcement action against us. If we were subject to such an action by the Food and Drug Administration, our sales could be delayed, our revenues could decline and our reputation among clinicians could be harmed. Our business would be harmed if the Food and Drug Administration determines that we have failed to comply with applicable regulations or we do not pass an inspection We are subject to inspection and market surveillance by the Food and Drug Administration concerning compliance with pertinent regulatory requirements. If the Food and Drug Administration finds that we have failed to comply with these requirements, the agency can institute a wide variety of enforcement actions, ranging from a public warning letter to more severe sanctions such as: . fines, injunctions and civil penalties; . the recall or seizure of our products; . the issuance of public notices or warnings; . the imposition of operating restrictions, partial suspension or total shutdown of production; . the refusal of our requests for 510(k) clearance or premarket approval of new products; . the withdrawal of 510(k) clearance or premarket approvals already granted; and . criminal prosecution. If we fail to obtain necessary foreign regulatory approvals in order to market and sell our products outside of the United States, we may not be able to sell our products in other countries Our products are regulated outside the United States as medical devices by foreign governmental agencies similar to the Food and Drug Administration and are subject to regulatory requirements similar to the Food and Drug Administration's in foreign countries. The time and cost required to obtain market authorization from other countries and the requirements for licensing a product in another country may differ significantly from the Food and Drug Administration requirements. We may not be able to obtain these approvals without incurring significant expenses or at all. If we or our suppliers fail to comply with applicable regulations, sales of our products could be delayed and our revenues could be harmed Every manufacturer of a finished medical device, including us and some of our contract manufacturers and suppliers, is required to demonstrate and maintain compliance with the Food and Drug Administration's quality system regulation and comparable regulations of states and other countries. The Food and Drug Administration enforces the quality system regulation through periodic inspections. Although we have passed inspections in the past, we cannot assure you that we or our contract manufacturers will pass any future quality system regulation inspections. If we or our contract manufacturers fail one of these inspections in the future, our operations could be disrupted and our manufacturing and sales delayed significantly until we can demonstrate adequate compliance. If we or our contract manufacturers fail to take adequate corrective action in a timely fashion in response to a quality system regulations inspection, the Food and Drug Administration could shut down our or our contract manufacturers' manufacturing operations and require us, among other things, to recall our products, either of which would harm our business. We may experience intense competition from other medical device companies, and this competition could adversely affect our revenues and our business Our most significant current and potential competitors for the ALGO products include companies that market hearing screening equipment. For the CO-Stat products, we anticipate that our competitors will be large medical device companies that market laboratory bench equipment used for blood-based antibody and bilirubin tests and companies that sell devices that analyze the amount of yellow in the skin to estimate the level of bilirubin. We believe that Bio-logic Systems Corp., Intelligent Hearing Systems and Sonamed Corp., each of which is also currently marketing enhanced auditory brainstem response and otoacoustic hearing screening equipment products, could introduce new, lower priced hearing screening equipment that may not require an audiologist or physician to interpret its results or review its recommendations, similar to our products. For example, Bio-logic recently announced its intention to seek FDA approval to sell its disposable products for use with our ALGO hearing screener. Similarly, we believe that Chromatics Color Sciences International, Inc., Minolta Co., Ltd. and SpectRx, Inc., each of which is currently marketing skin color analysis products for bilirubin monitoring, or Johnson & Johnson and F. Hoffman-La Roche Ltd., each of which is currently marketing equipment for blood-based bilirubin or antibody tests, could also introduce new, lower-priced options for the management of newborn jaundice. Some of our competitors may have greater financial resources and name recognition or larger, more established distribution channels than we do. We believe our future success depends on our ability to enhance existing products, develop and introduce new products, satisfy customer requirements and achieve market acceptance. We cannot be certain that we will successfully identify new product opportunities. We may not be able to develop and bring new products to market before our competitors or in a more cost-effective manner. Increased competition may negatively affect our business and future operating results by leading to price reductions, higher selling expenses or a reduction in our market share. Our business could be harmed if our competitors establish cooperative relationships with large medical testing equipment vendors or rapidly acquire market share through industry consolidation or by bundling other products with their hearing screening or jaundice monitoring products In addition, large medical testing equipment vendors, such as Johnson & Johnson or Roche, may also acquire or establish cooperative relationships with our current competitors. We expect that the medical testing equipment industry will continue to consolidate. New competitors or alliances among competitors may emerge and rapidly acquire significant market share, which would harm our business and financial prospects. Other medical device companies may decide to bundle their products with other newborn hearing screening or hemolysis monitoring products and sell the bundle at lower prices. If this happens, our business and future operating results could suffer if we were no longer able to offer commercially viable or competitive products. We may not be able to preserve the value of our products' intellectual property because we may not be able to protect access to our intellectual property or we may lose our intellectual property rights due to expiration of our licenses or patents If we fail to protect our intellectual property rights or if our intellectual property rights do not adequately cover the technology we employ, other medical device companies could sell hearing screening or hemolysis monitoring products with features similar to ours, and this could reduce demand for our products. We protect our intellectual property through a combination of patent, copyright, trade secret and trademark laws. We have eight issued United States patents, five patent applications pending before the United States Patent and Trademark Office and seven patent applications pending before foreign governmental bodies of which one European Patent Office application has been allowed and will be registered in nine European countries. We have one patent granted in Japan, six patent applications pending in Japan and one patent application pending in Hong Kong. We attempt to protect our intellectual property rights by filing patent applications for new features and products we develop. We enter into confidentiality or license agreements with our employees, consultants and corporate partners and seek to control access to our intellectual property and the distribution of our hearing screening or hemolysis monitoring products, documentation and other proprietary information. However, we believe that these measures afford only limited protection. Others may develop technologies that are similar or superior to our technology or design around the patents, copyrights and trade secrets we own. The original patent for an algorithm for analyzing auditory brainstem responses, which we licensed on a nonexclusive basis from a third party and upon which we developed our automated auditory brainstem response technology, expired in late 1999, and that subject matter is in the public domain. In addition, we cannot assure you that the patent applications we have filed to protect the features of our ALGO products that we have subsequently developed will be allowed, or will deter others from using the auditory brainstem response technology. Despite our efforts to protect our proprietary rights, others may attempt to copy or otherwise improperly obtain and use our products or technology. Policing unauthorized use of our technology is difficult and expensive, and we cannot be certain that the steps we have taken will prevent misappropriation, particularly in foreign countries where the laws may not protect our proprietary rights as fully. Our means of protecting our proprietary rights may be inadequate. Enforcing our intellectual property rights could be costly and time consuming and may divert our management's attention and resources. Enforcing our intellectual property rights could also result in the loss of our intellectual property rights. Our operating results would suffer if we were subject to a protracted infringement claim or a significant damage award Substantial intellectual property litigation and threats of litigation exist in our industry. We expect that medical screening equipment may become increasingly subject to third party infringement claims as the number of competitors in our industry segment grows and the functionality of products in different industry segments overlaps. Third parties such as individuals, educational institutions or other medical device companies may claim that we infringe their intellectual property rights. Any claims, with or without merit, could have any of the following negative consequences: . result in costly litigation and damage awards; . divert our management's attention and resources; . cause product shipment delays or suspensions; or . require us to seek to enter into royalty or licensing agreements, which may not be available on terms acceptable to us, if at all. A successful claim of infringement against us could result in a substantial damage award and materially harm our financial condition. Our failure or inability to license the infringed or similar technology could prevent us from selling our products and adversely affect our business and financial results. Product liability suits against us could result in expensive and time consuming litigation, payment of substantial damages and an increase in our insurance rates The sale and use of our medical testing products could lead to the filing of a product liability claim if someone were to be injured using one of our devices or if one of our devices fails to detect a disorder for which it was being used to screen. A product liability claim could result in substantial damages and be costly and time consuming to defend, either of which could materially harm our business or financial condition. We cannot assure you that our product liability insurance would protect our assets from the financial impact of defending a product liability claim. Any product liability claim brought against us, with or without merit, could increase our product liability insurance rates or prevent us from securing any coverage in the future. We may incur significant costs related to a class action lawsuit due to the likely volatility of the public market price of our stock When our common stock is publicly traded, our stock price may fluctuate for a number of reasons including: . quarterly fluctuations in our results of operations; . our ability to successfully commercialize our products; . announcements of technological or competitive developments by us or our competitors; . announcements regarding patent litigation or the issuance of patents to us or our competitors; . announcements regarding state screening mandates or third party payor reimbursement policies; . regulatory developments regarding us or our competitors; . acquisitions or strategic alliances by us or our competitors; . changes in estimates of our financial performance or changes in recommendations by securities analysts; and . general market conditions, particularly for companies with a relatively small number of shares available for sale in the public market. Securities class action litigation is often brought against a company after a period of volatility of the market price of its stock. If our future quarterly operating results are below the expectations of securities analysts or investors, the price of our common stock would likely decline. Stock price fluctuations may be exaggerated if the trading volume of our common stock is low. Any securities litigation claims brought against us could result in substantial expense and damage awards and divert our management's attention from running our business. We depend upon key employees in a competitive market for skilled personnel, and, without additional employees, we cannot grow or achieve and maintain profitability Our products and technologies are complex, and we depend substantially on the continued service of our senior management team including Tim C. Johnson, our chief executive officer, and William New, Jr., M.D., Ph.D., our chief technology officer, chairman and a founder. The loss of any of our key employees could adversely affect our business and slow our product development process. Although we maintain key person life insurance on Dr. New, we do not maintain key person life insurance on any of our other employees, and the amount of the policy on Dr. New may be inadequate to compensate us for his loss. Our future success also will depend in part on the continued service of our key management personnel, software engineers and other research and development employees and our ability to identify, hire, and retain additional personnel, including customer service, marketing and sales staff. Hiring sales, marketing and customer service personnel in our industry is very competitive due to the limited number of people available with the necessary technical skills and understanding of pediatric audiology and neonatal jaundice management. We may be unable to attract and retain personnel necessary for the development of our business. Moreover, our business is located in the San Francisco Bay area of California, where demand for personnel with the skills we seek is extremely high and is likely to remain high. For example, our former Vice President of Sales left our company in January 2000 to join an internet-related company. Because of this competition, our compensation costs may increase significantly. We could lose the ability to use net operating losses, which may adversely affect our financial results As of December 31, 2000, we had total net operating loss carryforwards of approximately $6.8 million for income tax purposes. These net operating loss carryforwards, if not utilized to offset taxable income in future periods, will expire in various amounts beginning in 2002 through 2020. If we continue to have net losses, we may not be able to utilize some or all of our net operating loss carryforwards before they expire. In addition, applicable United States income tax law imposes limitations on the ability of corporations to use net operating loss carryforwards if the corporation experiences a more than 50% change in ownership during any three- year period. We cannot assure you that we will not take actions, such as the issuance of additional stock, that would cause an ownership change to occur. Accordingly, we may be limited to the amount we can use in any given year, so even if we have substantial net income, we may not be able to use our net operating loss carryforwards before they expire. In addition, the net operating loss carryforwards are subject to examination by the Internal Revenue Service, or IRS, and are thus subject to adjustment or disallowance resulting from any such IRS examination. If we are unable to use our net operating loss carryforwards to offset our taxable income, our future tax payments will be higher and our financial results may suffer. We have broad discretion in how we use the net proceeds of this offering, and we may not use these proceeds effectively Our management could spend most of the net proceeds from this offering in ways that our stockholders may not desire or that do not yield a favorable return. You will not have the opportunity, as part of your investment in our common stock, to assess whether the net proceeds of this offering will be used appropriately. The failure of our management to apply the net proceeds of this offering effectively could have a material adverse effect on our business, financial condition and results of operations. Our executive officers, directors and their affiliates hold a substantial portion of our stock and could exercise significant influence over matters requiring stockholder approval, regardless of the wishes of other stockholders Our executive officers, directors and individuals or entities affiliated with them will beneficially own approximately 32% of our outstanding common stock as a group immediately after this offering. Acting together, these stockholders would be able to significantly influence all matters that our stockholders vote upon, including the election of directors and determination of significant corporate actions. This concentration of ownership could delay or prevent a change of control transaction that could otherwise be beneficial to our stockholders. We may need to raise additional capital in the future, which could result in dilution to our stockholders and adversely affect our operations While we believe the proceeds from this offering will provide us with adequate capital to fund operations for at least the next 18 months, we may need to raise additional funds prior to that time. We may seek to sell additional equity or debt securities or to obtain an additional credit facility, which we may not be able to do on favorable terms, or at all. The sale of additional equity or convertible debt securities could result in additional dilution to our stockholders. If additional funds are raised through the issuance of debt securities or preferred stock, these securities could have rights that are senior to holders of common stock and any debt securities could contain covenants that would restrict our operations. Our charter documents and Delaware law contain provisions that may inhibit potential acquisition bids, which may adversely affect the market price of our common stock, discourage merger offers and prevent changes in our management Section 203 of the Delaware General Corporation Law may inhibit potential acquisition bids for our company. Upon completion of this offering, we will be subject to Section 203, which regulates corporate acquisitions and limits the ability of a holder of 15% or more of our stock from acquiring the rest of our stock for three years. Under Delaware law, a corporation may opt out of the antitakeover provisions. We do not intend to opt out of the antitakeover provisions of Delaware Law. Upon the closing of this offering, our board of directors will have the authority to issue up to 10 million shares of preferred stock. Our board of directors can fix the price, rights, preferences and privileges of the preferred stock without any further vote or action by our stockholders. These rights, preferences and privileges may be senior to those of the holders of our common stock. We have no current plans to issue any shares of preferred stock. We have also adopted other provisions in our charter documents effective upon the closing of this offering that could delay or prevent a change in control. The consent of two-thirds of our stockholders is required to amend our certificate of incorporation, and our stockholders cannot act by written consent. Only stockholders entitled to vote at least 30% of the shares eligible to vote may call a special meeting. Each member of our board of directors will serve for a three year term and will only stand for election once every three years. These provisions could discourage potential acquisition proposals and could delay or prevent a change in control transaction. A large number of shares, 9,835,621, or 68.6% of our total outstanding common stock, may be sold into the market in the near future, which could cause the market price of our common stock to drop significantly Our current stockholders hold a substantial number of shares, which they will be able to sell in the public market in the near future. Sales of a substantial number of shares of our common stock could cause our stock price to fall. In addition, the sale of these shares could impair our ability to raise capital through the sale of additional stock. Immediately after the closing of this offering, we will have outstanding 14,335,621 shares of common stock. This includes 4,500,000 shares that we are selling in this offering, which may be resold immediately in the public market. The remaining 9,835,621 shares will become eligible for resale in the public market 180 days after the date of the final prospectus pursuant to agreements our stockholders have with us and the underwriters. However, Dain Rauscher Incorporated can waive this restriction and allow these stockholders to sell their shares at any time. Of these shares, 4,323,911 shares will be subject to volume limitations under the federal securities laws.

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+RISK FACTORS An investment in our common stock involves a high degree of risk. You should consider carefully the following information about these risks, as well as the other information included in this prospectus, before you decide to exercise the warrants. Furthermore, you should also note that there may be additional risks and uncertainties not presently known to us, or that we currently deem immaterial, which may also impair our business, results of operations and financial condition. We may experience operating losses if we cannot sustain our current sales volume. Prior to fiscal 2000, we had losses before extraordinary items for the previous four years. While we had net income of $2.3 million for the fiscal 2000, we cannot assure you that we will not have a loss for the current fiscal year which will end on December 31, 2001. Our prior years' losses were primarily caused by lower restaurant sales during these periods and these losses may occur again unless we are able to sustain our current level of sales. Our available cash is limited by our debt service obligations. At January 1, 2001, we had outstanding long term debt and capital lease obligations of approximately $40.5 million, pursuant to which we are required to make principal, interest and lease payments. During fiscal 2000, we paid $7.0 million in interest on our long term debt. Our debt service and capital lease obligations substantially limit our available cash flow. Our credit agreements contain financial covenants. We are subject to financial covenants contained in our credit facilities. For example, we must maintain a minimum level of earnings before interest, taxes, depreciation and amortization. If we are unable to make the required interest payments or to comply with the provisions of our debt covenants, our creditors may accelerate the due date of our debt and foreclose upon the operating assets we used to secure these obligations. Any such actions would adversely affect our operations and strain our cash flow. We may incur substantial liability arising from lawsuits to which we are a party. We are parties to the litigation described at page 21 in this prospectus. Although we cannot determine at this time the outcome of the lawsuits to which we are a party, if the result in one or more of the cases is adverse to us, the potential liability could be material. In addition, we believe that the costs of defending these actions could be significant. The litigation matters include disputes with our franchisees and include claims of fraud and violations of state franchise laws, a securities class action and a derivative action. There are many risks associated with the food services industry. The food service industry is affected by changes in consumer tastes, national, regional, and local economic conditions, demographic trends, traffic patterns and the type, number, and location of competing restaurants. Food service chains can also be adversely affected by publicity resulting from food quality, illness, injury or other health concerns (including food-borne illness claims) stemming from one store or a limited number of stores. Claims relating to foreign objects or food-borne illness are common in the food services industry and a number of such claims may exist at any given time. Dependence on frequent deliveries of produce and supplies also subjects food service businesses such as ours to the risk that shortages or interruptions in supply caused by adverse weather or other conditions could adversely affect the availability, quality, and cost of ingredients. In addition, material changes in, or our failure to comply with, applicable federal, state, and local government regulations, and factors such as inflation, increased food, labor, and employee benefits costs, regional weather conditions and the availability of an adequate number of experienced managers and hourly employees may also adversely affect the food service industry in general and our results of operations and financial condition in particular. The quick-service restaurant industry is intensely competitive and our operating results may be adversely affected by our need to adjust our operations to meet this competition. There is intense competition in the quick-service restaurant industry which has adversely affected us. We expect to continue to experience intense competition, especially from the major chains, which have substantially greater financial resources and longer operating histories then us, and dominate the quick-service restaurant industry. We compete primarily on the basis of food quality, price and speed of service. A significant change in pricing or other marketing strategies by one or more of our competitors could have a material adverse impact on our sales, earnings and growth. In order to compete with each other, all of the major quick-service chains have increasingly offered selected food items and combination meals at discounted prices. We anticipate that the major quick-service hamburger chains will continue to offer promotions of value priced, many specifically targeting the $.99 price point at which we sell many of our products. As a result, we cannot rely on low prices to give us a competitive advantage. Our growth strategy is dependent upon franchisees. As of March 26, 2001, approximately 207 of our restaurants were operated by us including three restaurants in which the Company is a joint venture partner, and approximately 638 were operated by franchisees. Our growth strategy will continue to be heavily dependent upon the opening of new stores owned by franchisees, and the manner in which they operate and develop their restaurants to promote and develop our concepts and our reputation for quality food and speed of service. The opening and success of stores is dependent on a number of factors, including the availability of suitable sites, the negotiation of acceptable lease or purchase terms for such sites, permitting and regulatory compliance, the ability to hire and train qualified personnel, the financial and other capabilities of our franchisees and area developers, and general economic and business conditions. Many of these factors are beyond our control or the control of our franchisees and area developers. We may be harmed by actions taken by our franchisees that are outside of our control. Franchisees are generally independent operators and are not our employees. We provide training and support to franchisees, but the quality of franchised store operations may be diminished by any number of factors beyond our control. Consequently, area developers and individual franchisees may not successfully operate stores in a manner consistent with our standards and requirements, or may not hire and train qualified managers and other store personnel. If they do not, our image and reputation may suffer, and systemwide sales could decline. We have experienced significant management turnover. Significant management changes were made during the second half of fiscal year 1999 and continuing through the first half of fiscal year 2000. During fiscal year 2000, our new management team began implementing significant operational and managerial changes designed to make us profitable. Any loss or turnover in the new management team could negatively impact our business plan and profitability. The ability to attract and retain highly qualified personnel is extremely important and our failure to do so could adversely affect us. We are heavily dependent upon the services of our officers and key management involved in restaurant operations, marketing, finance, purchasing, expansion, human resources and administration. The loss of any of these individuals could have a material adverse effect on our business and results of operations. Other than our CEO, we currently do not have employment agreements with any of our employees. Our success is also dependent upon our franchisee's ability to attract and maintain a sufficient number of qualified managers and other restaurant employees. Qualified individuals needed to fill these positions are in short supply in some geographic areas. The inability to recruit and retain such individuals may result in higher employee turnover in existing restaurants, which could have a material adverse effect on our business and results of operations. Our resources may be strained by implementing our business strategy. Our growth strategy may place a strain on our management, financial and other resources. To manage our growth effectively, we must maintain the level of quality and service at our existing and future restaurants. We must also continue to enhance our operations, financial and management systems and locate, hire, train and retain experienced and dedicated operating personnel, particularly restaurant managers. We may not be able to effectively manage any one or more of these aspects of our expansion. Failure to do so could have a material adverse effect on our business and results of operations. If we are not able to anticipate and react to our food and labor costs, our profitability could be adversely affected. Our stores' operating costs consist principally of food and labor costs. Our profitability is dependent in part on our ability to anticipate and react to changes in food and labor costs. Various factors beyond our control, including adverse weather conditions and governmental regulation, may affect our food costs. We may not be able to anticipate and react to changing food costs, whether through purchasing practices, menu composition or menu price adjustment in the future. In the event that food or labor price increases cause us to increase our menu prices, we face the risk that our customers will choose our competitors if their prices are lower. Failure to react to changing food costs, or retaining customers if we are forced to raise menu prices, could have a material adverse effect on our business and results of operations. Our ability to develop new franchised stores and to enforce contractual rights against franchisees may be adversely affected by franchise laws and regulations, which could cause our franchise revenues to decline and adversely affect our growth strategy. As a franchisor, we are subject to regulation by both the Federal Trade Commission and state laws regulating the offer and sale of franchises. Our failure to obtain or maintain approvals to sell franchises would cause us to lose franchise revenues. If we are unable to sell new franchises, we will not be able to accomplish our growth strategy. In addition, state laws that regulate substantive aspects of our relationships with franchisees may limit our ability to terminate or otherwise resolve conflicts with our franchisees. Because we plan to grow primarily through franchising, any impairment of our ability to develop new franchised stores will negatively affect us and our growth strategy more than if we planned to develop additional company stores. Our quarterly results may fluctuate and could fall below expectations of securities analysts and investors, resulting in a decline in our stock price. Our quarterly and yearly results have varied in the past, and we believe that our quarterly operating results will vary in the future. For this reason, you should not rely upon our quarterly operating results as indications of future performance. In some future periods, our operating results may fall below the expectations of securities analysts and investors. This could cause the trading price of our common stock to fall. Factors such as seasonality and unanticipated increases in labor, food, insurance or other operating costs may cause our quarterly results to fluctuate. You should not rely on our comparable store sales as an indication of our future results of operations because they may fluctuate significantly. A number of factors have historically affected, and will continue to affect, our comparable store sales results. Such factors include unusually strong sales performance by new stores (operated at least one year), competition, regional and national economic conditions, consumer trends, and our ability to execute our business strategy effectively. Significant fluctuations could result in lower than planned sales, adversely impacting our profitability goals and straining cash flow. Our costs may increase if our joint purchase agreement with CKE Restaurants, Inc. is terminated. We are currently party to a purchasing services agreement with CKE Restaurants, Inc. which allows us to enjoy pricing and other terms that are generally more favorable than we could independently obtain. This agreement will expire on August 5, 2001. As this agreement terminates, our product cost may increase. The warrant exercise price is not necessarily reflective of the value of our common stock. The warrant exercise price does not necessarily bear any relationship to the price at which our common stock is trading, the book value of our assets, past operations, cash flow, earnings, financial condition or any other established criteria for value. Accordingly, you should not consider the warrant exercise price as any indication of the underlying value of our common stock. Our common stock may not trade at or above the warrant exercise price. We cannot assure you that our common stock will trade at prices in excess of the warrant exercise price. Future sales of shares of our common stock could decrease its market price. As of June 15, 2001, we had 9,938,084 shares of our common stock outstanding and grants of options and warrants outstanding to purchase a total of 5,405,800 shares of our common stock. Possible or actual sales of any of these shares under Rule 144 or otherwise, may in the future decrease the price of shares of our common stock. Our largest stockholders may independently, by virtue of the size of their holdings, have a significant influence on matters put to a vote. The percentage interest held by our largest shareholders as of June 15, 2001 includes CKE Restaurants, Inc. which holds 904,357 shares of our common stock (approximately 9.1% of the outstanding shares) and beneficially owns warrants to acquire an additional 612,536 shares; Calm Waters Partnership which holds 892,000 shares of our common stock (approximately 9.0% of the outstanding shares); and Giant Group, Ltd. and its wholly owned subsidiary, KCC Delaware Company, which holds an aggregate of 757,283 shares of our common stock, and warrants to acquire an additional 237,416 shares. Therefore, we believe that CKE Restaurants, Inc., Calm Waters Partnership, Inc. and Giant Group, Ltd. may independently have a significant influence on elections of directors and other matters put to a vote of stockholders.

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+QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We are exposed to various market risks, including changes in interest rates and equity and market prices. Interest rate risk is generally associated with our outstanding indebtedness and securities issued under the Indenture. We also are subject to interest rate risk, as well as equity price risk, as a result of our nuclear decommissioning trust investments in debt and equity securities. Interest Rate Risk We use both fixed and variable rate debt as sources of financing. As of June 30, 2001, all of our outstanding long-term indebtedness accrued interest at fixed rates, except for two series of bonds with variable interest rates that are periodically re-priced which were issued to municipalities in connection with their issuance of tax-exempt bonds to finance the purchase of load management software and equipment and pollution control facilities. The following table illustrates financial instruments sensitive to interest rate changes that we held or were issued by us at June 30, 2001: Expected Maturity Value /(1)/ <TABLE> <CAPTION> Fair Liability 2001 2002 2003 2004 2005 Thereafter Total Value --------- ----- ----- ----- ----- ----- ---------- ------ ------ (in millions, except percentages) <S> <C> <C> <C> <C> <C> <C> <C> <C> Fixed rate taxable bonds...... $28.2 $28.2 $20.7 $20.6 $20.6 $367.0 $485.3 $503.5 Average interest rate....... 8.2% 8.2% 8.2% 8.2% 8.0% 8.0% Tax-exempt bonds............ $ 1.3 $10.7 $ 1.4 $ 1.5 $ 1.6 $ 48.7 $ 65.2 $ 66.3 Average interest rate....... 6.2% 6.2% 6.4% 6.4% 6.7% 6.7% Variable rate tax-exempt bonds $ 1.1 -- -- -- -- $ 6.7 $ 7.8 $ 7.8 Average interest rate....... 2.7% -- -- -- -- 2.9% -- -- </TABLE> (1)The maturities of the bonds reflect mandatory redemption obligations, if any. As of June 30, 2001, any impact on our earnings as a result of a change in interest rates on our variable rate tax exempt bonds due in 2001 and our short-term credit facilities would have been immaterial. If we borrowed amounts under our short-term credit lines (which are not included in the above table) to the extent permitted under the Existing Indenture, approximately $133 million after this offering, we estimate a 10% increase in market interest rates would increase our annual interest costs by less than $1 million. See "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS--Liquidity and Capital Resources." Equity Price Risk We are exposed to price fluctuations in equity markets with respect to some of our nuclear decommissioning investments. At June 30, 2001, these equity investments totaled approximately $36.6 million. We believe our exposure to fluctuations in equity prices will not have a material impact on our financial results. We accrue decommissioning costs over the expected service life of North Anna and make periodic deposits to a trust fund so that the fund balance will equal the estimated cost to decommission North Anna at the time of decommissioning. At June 30, 2001, these funds were invested primarily in equity securities and corporate obligations. These equity securities expose us to price fluctuations in equity markets. To minimize the risk of price fluctuations, we actively monitor our portfolio by measuring the performance of our investments against market indexes and by maintaining and reviewing established target allocation percentages of assets in our trust to various investment options. Unrealized gains and losses on investments in the trust are deferred as an adjustment to the reserve until realized. Market Price Risk Because our member distribution cooperatives' power requirements are greater than our owned or contractual power supply resources, we must secure additional energy resources by entering into forward, short-term and spot-purchase contracts to meet our total energy requirements. See "BACKGROUND" and "POWER SUPPLY RESOURCES--Other Power Supply Resources." These contracts are sensitive to changes in the prices of electricity, coal and natural gas. We currently are not party to any derivative commodity instruments. Through our relationship with APM, we expect to formulate policies and procedures to manage the risks associated with these price fluctuations and use various commodity instruments, such as hedges, futures and options, to reduce our risk exposure by creating offsetting market positions. We intend to use APM to assist us in managing our market price risks by: . designing a portfolio model that identifies our power producing resources (including fuel supply, our power purchase contract positions and our generating capacity) and analyzing the optimal use of these resources in light of costs and market risks associated with using these resources; . modeling our power obligations and assisting us with analyzing alternatives to meet our member distribution cooperatives' power requirements; . selling power as our agent and the agent of ODEC Power Trading, including excess power produced by the combustion turbine facilities; and . executing hedge trades to stabilize the cost of fuel requirements, primarily natural gas, used to operate the three combustion turbine facilities and to limit our exposure under power purchase contracts with variable rates based on natural gas prices. We continually review various options to acquire low cost power and are developing the combustion turbine facilities as a means of maintaining stable power costs. See "BACKGROUND."

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+Our quarterly operating results have varied and we expect them to continue to vary. Our results of operations have been and can be expected to be subject to quarterly fluctuations. We may experience increased revenues in the first and fourth quarter of the year, depending upon the timing and severity of the cold and flu season and the related increased hospital census and movable medical equipment usage during that season. Because a significant portion of our expenses are relatively fixed over these periods, our operating income as a percentage of revenue tends to increase during the first and fourth quarter of each year. If the cold and flu season is delayed by as little as one month, or is less severe than in prior periods, our quarterly operating results for a current period can vary significantly from prior periods. Our quarterly results can also fluctuate as a result of other factors such as the timing of acquisitions, new AMPP agreements or new office openings. RISKS RELATED TO OUR INDUSTRY Changes in reimbursement rates and policies by third-party payors for medical equipment costs may reduce the rates that providers can pay for our services and adversely affect our operating results and financial condition. Our healthcare provider customers, who pay us directly for the services we provide to them, substantially rely on reimbursement from third party payors for their operating revenue. These third party payors include both governmental payors, such as Medicare and Medicaid, and private payors, such as insurance companies and managed care organizations. There are widespread efforts to control healthcare costs in the United States by all of these payor groups. These cost containment initiatives have resulted in reimbursement policies based on fixed rates for a particular patient treatment that are unrelated to the provider s actual costs or require healthcare providers to provide services on a discounted basis. Consequently, these reimbursement policies have a direct effect on healthcare providers ability to pay us for our services and an indirect effect on our level of charges. Ongoing concerns about rising healthcare costs may cause more restrictive reimbursement policies to be implemented in the future. Restrictions on the amounts or manner of reimbursements to healthcare providers may affect their willingness and ability to pay for the services we provide and may adversely affect our customers financial condition. Such restrictions could require us to reduce the rates we charge or could put at risk our ability to collect payments owed to us. Our operating results historically have been adversely affected in periods when significant healthcare reform initiatives were under consideration and uncertainty remained as to their likely outcome. We expect the uncertainty of future significant healthcare reform initiatives may have a similar, negative effect. Because the regulatory and political environment for healthcare significantly influences the capital equipment procurement decisions of healthcare providers, our operating results historically have been adversely affected in periods when significant healthcare reform initiatives were under consideration and uncertainty remained as to their likely outcome. To the extent general cost containment pressures on healthcare spending and reimbursement reform, or uncertainty as to possible reform, causes acute care hospitals and alternate site providers to defer the procurement of medical equipment, reduce their capital expenditures or change significantly their utilization of medical equipment, there could be a material adverse effect on our financial condition and results of operations. The Registrant hereby amends this Registration Statement on such date or dates as may be necessary to delay its effective date until the Registrant shall file a further amendment which specifically states that this Registration Statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933 or until the Registration Statement shall become effective on such date as the Commission, acting pursuant to said Section 8(a), may determine. Table of Contents The information in this prospectus is not complete and may be changed. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell these securities and we are not soliciting offers to buy these securities in any state where the offer or sale is not permitted. PRELIMINARY PROSPECTUS October 26, 2001 Subject to completion 5,000,000 Shares UNIVERSAL HOSPITAL SERVICES, INC. Common Stock This is our initial public offering of shares of our common stock. No public market currently exists for our common stock. We currently anticipate the initial public offering price to be between $14.00 and $15.00 per share. The Nasdaq National Market has approved our common shares for quotation under the symbol UHOS. Before buying any shares, you should read the discussion of material risks of investing in our common stock in Risk factors beginning on page 14. Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or determined if this prospectus is accurate or complete. Any representation to the contrary is a criminal offense. Per share Total Public offering price $ $ Underwriting discounts and commissions $ $ Proceeds, before expenses, to us $ $ The underwriters may also purchase up to 750,000 shares of common stock from certain of our shareholders identified under Principal and selling shareholders at the public offering price, less the underwriting discounts and commissions, to cover over-allotments, if any, within 30 days of the date of this prospectus. If the underwriters exercise the option in full, the total underwriting discounts and commissions will be $ . Except to the extent the shareholders referred to above sell shares to cover over-allotments, if any, all shares offered by this prospectus will be sold by us. We will not receive any proceeds from the sale of any common stock sold by the shareholders referred to above. The underwriters are offering the common stock as set forth under Underwriting. Delivery of the shares will be on or about October , 2001. Sole Book-Runner and Co-Lead Manager Co-Lead Manager UBS Warburg U.S. Bancorp Piper Jaffray CIBC World Markets Table of Contents TABLE OF CONTENTS Prospectus summary The offering Recent developments Summary financial data Risk factors Our 1998 recapitalization Forward-looking information Use of proceeds Dividend policy Capitalization Dilution Selected financial data Management s discussion and analysis of financial condition and results of operations Business Management Principal and selling shareholders Certain relationships and related transactions Description of indebtedness Description of capital stock Shares eligible for future sale Underwriting Legal matters Experts Where you can find more information INDEX TO FINANCIAL STATEMENTS Information not required in prospectus Signatures Exhibit index EX-10.18 2nd Amendment & Consent to Credit Agrmt EX-23.1 Consent of PricewaterhouseCoopers LLP Table of Contents No dealer, salesperson or any other person has been authorized to give any information or to represent anything not contained in this prospectus. You must not rely on any unauthorized information or representations. This prospectus is an offer to sell only the shares offered hereby but only under circumstances and in jurisdictions where it is lawful to do so. TABLE OF CONTENTS Income (loss) before income taxes and extraordinary charge (6,737 ) (5,976 ) (5,236 ) (167 ) (2,679 ) (1,662 ) (370 ) 284 Income taxes (1,097 ) (1,655 ) (158 ) 559 (92 ) 28 196 (in thousands, except per share amounts and other operating data) Income (loss) before income taxes and extraordinary charge 1,851 5,046 (6,737 ) (5,976 ) (5,236 ) (2,679 ) (1,662 ) Income taxes 919 2,347 (1,097 ) (1,655 ) (158 ) (92 ) (Loss) income before income taxes (1,662 ) 1,946 284 Provision (benefit) for income taxes: 28 (b) Table of Contents (This page intentionally left blank) Long term incentive plan Our Long Term Incentive Plan was terminated on February 25, 1998 in connection with our recapitalization. During 1998, two payouts were completed for this plan. The first was the normal plan payout and the second resulted from the early termination of the plan. The early termination payout amount for Mr. Dovenberg was $10,630. Pension plan The following table sets forth various estimated maximum annual pension benefits under our qualified non-contributory defined benefit pension plan on a straight life annuity basis, based upon Social Security benefits now available, and assuming retirement and specified remuneration and credited years of service. Amounts shown are subject to Social Security offset pursuant to the terms of our plan. Credited years of service Compensation 5 10 20 Cash flows from investing activities: Movable medical equipment purchases (23,112 ) (22,846 ) Property and office equipment purchases (1,341 ) (1,356 ) Proceeds from disposition of movable medical equipment 403 619 Other 203 Table of Contents The offering Common stock we are offering 5,000,000 shares Common stock to be outstanding after this offering 16,275,044 shares Nasdaq National Market symbol UHOS Use of proceeds Repayment of indebtedness, redemption of preferred stock and warrant and general corporate purposes. Risk factors Investing in our common stock involves significant risks. See Risk factors. Common stock to be outstanding after this offering is based on the number of shares outstanding as of June 30, 2001 adjusted only for the issuance of 5,000,000 shares in this offering. It does not include: o 2,276,545 shares issuable upon exercise of stock options outstanding as of June 30, 2001, with a weighted average exercise price of $2.38 per share; o 1,700,000 shares available for future grant or issuance under our 2001 stock option plan; and o 245,000 shares issuable upon exercise of a warrant that will be redeemed in connection with this offering. Table of Contents Recent developments RECENT FINANCIAL INFORMATION The following tables set forth unaudited summary statements of operation data for the three and nine months ended September 30, 2000 and September 30, 2001, unaudited summary balance sheet data as of September 30, 2001 and unaudited summary statements of cash flows for the three and nine months ended September 30, 2001. The financial data as of September 30, 2001 and for the three and nine months ended September 30, 2001 are derived from our unaudited internal financial records. The financial data for the three and nine months ended September 30, 2000 are derived from our unaudited financial statements not included elsewhere in this prospectus. Three months ended Nine months ended September 30, September 30, (in thousands, except per share amounts) Revenues: Equipment outsourcing $ 23,170 $ 26,937 $ 68,987 $ 81,668 Sales of supplies and equipment, and other 2,929 3,163 9,057 9,293 Loss before income taxes (2,233 ) (731 ) (4,911 ) (2,393 ) Income taxes (72 ) 14 (163 ) Total revenues 26,099 30,100 78,044 90,961 Cost of equipment outsourcing and sales: Cost of equipment outsourcing 6,418 8,267 18,902 23,844 Movable medical equipment depreciation 5,825 6,587 16,417 19,239 Cost of supplies and equipment sales 1,983 1,860 6,296 5,578 Total cost of equipment outsourcing and sales 14,226 16,714 41,615 48,661 Gross profit 11,873 13,386 36,429 42,300 Selling, general and administrative: Selling, general and administrative, excluding additional retirement benefits 8,932 9,323 25,944 28,242 Additional retirement benefits including $1.2 million of non-cash based compensation 1,553 Total selling, general and administrative 8,932 9,323 25,944 29,795 Operating income 2,941 4,063 10,485 12,505 Interest expense 5,174 4,794 15,396 14,898 Net loss (2,161 ) (745 ) (4,748 ) (2,435 ) Accrued dividends on preferred stock (230 ) (230 ) (689 ) (778 ) Income taxes received $ 26 $ Net loss applicable to common shareholders $ (2,391 ) $ (975 ) $ (5,437 ) $ (3,213 ) Table of Contents Unaudited balance sheet data: As of September 30, 2001 (in thousands, except share and per share amounts) Assets Current assets: Accounts receivable, less allowance for doubtful accounts of $1,850 at September 30, 2001 $ 28,029 Inventories 2,219 Deferred income taxes 1,720 Other current assets 1,261 Total current assets 33,229 Property and equipment, net: Movable medical equipment, net 104,325 Property and office equipment, net 5,369 Total property and equipment, net 109,694 Intangible assets: Goodwill, net 35,157 Other, primarily deferred financing costs, net 6,532 Total assets $ 184,612 Liabilities and Shareholders Deficiency Current liabilities: Current portion of long-term debt $ 302 Accounts payable 12,075 Accrued compensation and pension 5,876 Accrued interest 1,187 Other accrued expenses 1,518 Bank overdrafts 1,348 Total current liabilities 22,306 Long-term debt less current portion 198,659 Deferred compensation and pension 3,003 Deferred income taxes 1,720 Series B, 13% Cumulative Accruing Pay-in-Kind Preferred Stock, $0.01 par value; 25,000 shares authorized, 6,246 shares issued and outstanding at September 30, 2001, net of unamortized discounts, including accrued stock dividends 8,042 Common stock subject to put 3,909 Commitments and contingencies Shareholders deficiency: Common Stock, $0.01 par value; 35,000,000 shares authorized, 11,275,044 shares issued and outstanding at September 30, 2001 161 Additional paid-in capital 898 Accumulated deficit (53,029 ) Deferred compensation (1,057 ) Total shareholders deficiency (53,027 ) Total liabilities and shareholders deficiency $ 184,612 Table of Contents Nine months ended September 30, Net cash provided by operating activities 19,176 18,632 Net cash used in investing activities (23,847 ) (23,550 ) Net cash provided by financing activities 4,671 4,918 Net (loss) income (5,078 ) 4,352 (726 ) Accrued dividends on Series B 13% Cumulative Accruing Pay-In-Kind Stock (918 ) 918 Net change in cash and cash equivalents $ $ Supplemental cash flow information: Interest paid $ 18,033 $ 18,730 Movable medical equipment purchases in accounts payable $ 3,323 $ 5,639 Movable medical equipment additions $ 23,662 $ 25,510 Table of Contents The following table provides information on the percentages of certain items of financial data compared to total revenues and also indicates the percentage increase or decrease of this information over the prior comparable period. Percent of total revenues Percent increase (decrease) Three months ended Nine months ended Three months ended Nine months ended September 30, September 30, September 30, 2001 September 30, 2001 Revenues: Equipment outsourcing 88.8% 89.5% 88.4% 89.8% 16.3% 18.4% Sales of supplies and equipment, and other 11.2% 10.5% 11.6% 10.2% 8.0% 2.6% Total revenue 100.0% 100.0% 100.0% 100.0% 15.3% 16.6% Cost of equipment outsourcing and sales: Cost of equipment outsourcing 24.6% 27.4% 24.2% 26.2% 28.8% 26.1% Movable medical equipment depreciation 22.3% 21.9% 21.0% 21.2% 13.1% 17.2% Cost of supplies and equipment sales 7.6% 6.2% 8.1% 6.1% (6.2% ) (11.4% ) Total cost of equipment outsourcing and sales 54.5% 55.5% 53.3% 53.5% 17.5% 16.9% Gross profit 45.5% 44.5% 46.7% 46.5% 12.7% 16.1% Selling, general and administrative: Selling, general and administrative, excluding additional retirement benefits 34.2% 31.0% 33.3% 31.1% 4.4% 8.9% Additional retirement benefits 0.0% 0,0% 0.0% 1.7% NM NM (a) Reduction of interest expense related to the paydown on revolving credit facility $ (2,099 ) $ (2,477 ) $ (5,198 ) Bank commitment fee based on paydown and reduction of revolving credit facility $ 153 $ 168 $ Total selling, general and administrative 34.2% 31.0% 33.3% 32.8% 4.4% 14.8% Operating income 11.3% 13.5% 13.4% 13.7% 38.1% 19.3% Interest expense 19.9% 15.9% 19.7% 16.3% (7.3% ) (3.2% ) Loss before income taxes (8.6% ) (2.4% ) (6.3% ) (2.6% ) NM NM Income taxes (0.3% ) 0.1% (0.2% ) 0.1% NM NM Net loss (8.3% ) (2.5% ) (6.1% ) (2.7% ) NM NM Table of Contents Summary financial data The following table summarizes financial data regarding our business and should be read together with Management s discussion and analysis of financial condition and results of operations, our financial statements and the related notes included elsewhere in this prospectus. Year ended December 31, Six months ended June 30, (in thousands, except per share amounts and other operating data) Revenues: Equipment outsourcing $ 61,701 $ 79,345 $ 94,028 $ 94,028 $ 45,818 $ 54,731 $ 45,818 $ 54,731 Sales of supplies and equipment, and other 7,672 12,878 11,977 11,977 6,127 6,130 6,127 6,130 Total revenues 69,373 92,223 106,005 106,005 51,945 60,861 51,945 60,861 Cost of equipment outsourcing and sales: Cost of equipment outsourcing 16,312 22,398 26,092 26,092 12,483 15,577 12,483 15,577 Movable medical equipment depreciation 14,432 18,865 22,387 22,387 10,593 12,652 10,593 12,652 Cost of supplies and equipment sales 4,867 8,354 8,147 8,147 4,313 3,718 4,313 3,718 Loss on equipment disposal(1) 2,866 Total cost of equipment outsourcing and sales 38,477 49,617 56,626 56,626 27,389 31,947 27,389 31,947 Gross profit 30,896 42,606 49,379 49,379 24,556 28,914 24,556 28,914 Selling, general and administrative: Selling, general and administrative, excluding additional retirement benefits 21,300 30,570 33,868 33,868 17,013 18,919 17,013 18,919 Additional retirement benefits including $1.2 million of non-cash based compensation 1,553 1,553 Total selling, general and administrative 21,300 30,570 33,868 33,868 17,013 20,472 17,013 20,472 Recapitalization and transaction costs (2) 5,099 (Loss) income before income taxes (2,679 ) 2,309 (370 ) (Benefit) provision for income taxes: (92 ) 288 (b) Operating income 4,497 12,036 15,511 15,511 7,543 8,442 7,543 8,442 Interest expense 11,234 18,012 20,747 15,678 10,222 10,104 7,913 8,158 Net income (loss) per share applicable to common shareholders: basic $ (0.78 ) $ (0.53 ) $ (0.53 ) $ (0.05 ) $ (0.27 ) $ (0.20 ) $ (0.04 ) $ 0.02 diluted $ (0.78 ) $ (0.53 ) $ (0.53 ) $ (0.05 ) $ (0.27 ) $ (0.20 ) $ (0.04 ) $ 0.01 Table of Contents Year ended December 31, Six months ended June 30, Income (loss) before extraordinary charge (5,640 ) (4,321 ) (5,078 ) (726 ) (2,587 ) (1,690 ) (566 ) Net income (loss) $ (7,503 ) $ (5,133 ) $ (5,078 ) $ (726 ) $ (2,587 ) $ (1,690 ) $ (566 ) $ Net (loss) income available to common shareholders $ (2,238 ) $ 2,494 $ (in thousands, except per share amounts and other operating data) EBITDA(3) $ 22,145 $ 35,853 $ 43,173 $ 43,173 $ 20,839 $ 23,846 $ 20,839 $ 23,846 Adjusted EBITDA(4) 30,317 35,301 43,873 43,873 20,985 25,548 20,985 25,548 Net cash provided by (used in) operating activities 9,740 15,192 28,177 16,141 13,138 Net cash provided by (used in) investing activities (62,896 ) (49,441 ) (31,504 ) (14,707 ) (14,081 ) Net cash provided by (used in) financing activities 53,156 34,249 3,327 (1,434 ) 943 Movable medical equipment expenditures (including acquisitions) 42,588 41,587 31,158 13,700 14,447 Other operating data: Movable medical equipment (units at end of period) 76,000 93,000 101,000 97,000 107,000 Offices (at end of period) 50 56 60 56 61 Number of hospital customers (at end of period) 1,850 2,325 2,545 2,420 2,510 Number of total customers (at end of period) 4,450 4,860 5,275 5,125 5,210 Number of AMPP accounts (at end of period) 10 15 19 17 19 As of June 30, 2001 Pro forma Balance sheet data: Actual as adjusted(7) Working capital(5) $ 10,834 $ 10,834 Total assets 180,787 180,787 Total debt 194,000 140,114 Series B 13% Cumulative Pay-In-Kind Stock 7,811 Common stock subject to put 3,445 Shareholders equity (deficiency) (51,668 ) 13,474 Table of Contents Risk factors Before you invest in our common stock, you should be aware of various risks, including those described below. You should carefully consider these risk factors, together with all of the other information included in this prospectus, before you decide to purchase shares of our common stock. Additional risks not presently known to us or that we currently deem immaterial may also impair our business, operations or financial results. This could cause the trading price of our common shares to decline, and you may lose all or part of your investment. RISKS RELATED TO OUR BUSINESS We have a history of net losses and may not be profitable in the future. Primarily because of our debt service obligations, we have had a history of net losses. If we continue to incur net losses, our stock price could decline and adversely affect our ability to finance our business in the future. Our net losses of $7.5 million, $5.1 million, and $5.1 million for the years ended 1998, 1999 and 2000, respectively, and $1.7 million for the six months ended June 30, 2001, were primarily attributable to interest costs we must pay under the indenture related to our senior notes and our revolving credit facility. Although we intend to use part of the net proceeds from this offering to repay our outstanding indebtedness under our revolving credit facility, we anticipate that our debt service obligations will continue to be substantial and to affect our results of operations in future periods. Consequently, we anticipate we will report a net loss for the quarter ended September 30, 2001, and may do so in future periods. We will require substantial cash to operate and expand our business as planned, and failure to obtain needed financing from anticipated sources could impede our growth. We require substantial cash to operate our outsourcing programs and service our debt. Our outsourcing programs, particularly our AMPP total outsourcing program, require us to invest a significant amount of cash in movable medical equipment purchases. To the extent that such expenditures cannot be funded from our operating cash flow, borrowings under our revolving credit facility or other financing sources, we may not be able to conduct our business or to grow as currently planned. We currently expect that over the next 12 months we will be required to invest approximately $10 million to $12 million to replace existing equipment in our pool and approximately $25 million to $35 million to acquire new equipment to fuel anticipated growth. Upon entering into AMPP agreements, we generally are required to purchase all, or a significant portion, of a customer s movable medical equipment, requiring large portions of such capital expenditures to be made at the commencement of the program. In addition, a substantial portion of our cash flow from operations must be dedicated to servicing our existing debt and there are significant restrictions on our ability to incur additional indebtedness under our existing indenture and revolving credit facility. We have substantial debt, and we may be required to take action that would adversely affect our business in order to meet our debt service obligations. If we fail to meet those obligations, our secured lenders could take and sell our assets. We are highly leveraged and will continue to have significant debt following this offering. As of June 30, 2001, adjusted for repayment of debt from the proceeds of this offering, we would have had total long term debt of $140.1 million, or approximately 91.2% of our total capitalization. Our debt service requirements may adversely affect our ability to conduct our business as planned. Although we Table of Contents Risk factors intend to use a portion of the proceeds from this offering to repay a portion of the outstanding debt under our revolving credit facility, we may draw down from our revolving credit facility in the future or incur other debt. The degree to which we are leveraged may also have the following effects: o a substantial portion of our cash flow from operations must be dedicated to debt service and will not be available for other purposes; o a portion of our borrowings are at variable rates of interest, making us vulnerable to increases in interest rates; o we may not be able to obtain additional debt financing in the future for working capital, capital expenditures or acquisitions; o our flexibility to react to changes in the industry and economic conditions may be limited, and we may be more vulnerable to a downturn in our business or the economy generally; and o we may be at a competitive disadvantage to our competitors with less debt. Borrowings made as part of our February 1998 recapitalization and subsequent acquisitions resulted in a significant increase in our interest expense in 1998, 1999 and 2000 relative to prior periods, resulting in net losses for those years. Our ability to make cash payments with respect to our senior notes and to satisfy or refinance our other debt obligations will depend upon our future operating performance. If we are unable to generate sufficient cash flow from operations in order to service our debt, we will be forced to take actions such as reducing or delaying capital expenditures, selling assets, restructuring or refinancing our debt or seeking additional equity capital. If we are unable to repay our debt at maturity, we may have to obtain alternative financing, which may not be available to us. The debt under our revolving credit facility is secured by our working capital and our pool of movable medical equipment. If we default on our requirements under our revolving credit facility, our secured lenders could proceed against our working capital or our pool of movable medical equipment. Our debt agreements significantly restrict our ability to engage in certain activities. The indenture related to our senior notes and our revolving credit facility each restricts our ability to do the following: o pay cash dividends or make certain other payments; o incur liens; o enter into leases; o incur additional indebtedness; o use proceeds from sales of assets and subsidiary stock; and o enter into certain sale and leaseback transactions and transactions with affiliates. Additionally, our revolving credit facility requires us to maintain specified financial ratios and satisfy certain financial condition tests. We may be unable to meet those financial ratios and tests because of events beyond our control. A violation of any of these restrictions or a failure to meet the ratios and tests could result in a default under our revolving credit facility and the indenture. If an event of default should occur under our revolving credit facility, the lenders can accelerate repayment of the debt, plus accrued interest. Our working capital and pool of movable medical equipment are pledged as security under our revolving credit facility. If we fail to repay amounts due under our revolving credit facility, the lenders could proceed against the collateral granted to them to secure that debt and other of our debt which could substantially hinder our ability to conduct our business. Table of Contents Risk factors To achieve significant revenue growth, we must change the manner in which healthcare providers traditionally procure medical equipment. Our inability to effect such change could adversely affect our revenue growth. We believe that the strongest competition to our programs is the traditional purchase or lease alternative for obtaining movable medical equipment. Currently, many healthcare providers view outsourcing primarily as a means of meeting short-term or peak supplemental needs, rather than as a long-term alternative to purchase or lease. We may not be able to convince healthcare providers of the operational advantages and cost-effectiveness of outsourcing movable medical equipment needs on a long-term basis. As a result, many healthcare providers may continue to purchase or lease a substantial portion of their movable medical equipment. If we fail to change the manner in which healthcare providers procure their medical equipment, we may not be able to achieve significant growth. Our competitors providing outsourcing services may engage in significant price competition or liquidate significant amounts of surplus equipment, thereby decreasing the demand for outsourcing services. In a number of our geographic and product markets, we compete with one principal competitor and various smaller equipment outsourcing companies that may compete primarily on the basis of price. These competitors may offer certain customers lower prices depending on utilization levels and other factors. Our largest outsourcing competitor, MEDIQ/ PRN Life Support Services, Inc., a subsidiary of MEDIQ Incorporated, has recently emerged from bankruptcy and is currently under the control of its lenders. MEDIQ/ PRN may engage in competitive practices that may undercut our pricing. In addition, MEDIQ/ PRN may liquidate significant amounts of surplus equipment, thereby decreasing the demand for outsourcing services and possibly causing us to reduce the rates we may charge for our services. We have relationships with certain key suppliers, and adverse developments concerning these suppliers could adversely affect our business. We purchased our movable medical equipment from approximately 90 manufacturers and our disposable medical supplies from approximately 130 suppliers in 2000. Our ten largest suppliers of movable medical equipment, which supplied approximately 68% of our direct movable medical equipment purchases for 2000, are: Baxter Healthcare Corporation; Tyco International, Ltd. (Mallinckrodt Inc. and Kendall Healthcare Products Company); Respironics, Inc.; Siemens Business Services, Inc.; Drager Medical, Inc.; Abbott Laboratories; Smith Nephew, Inc.; Agilent Technologies; SIMS Deltec, Inc.; and Spacelabs Medical, Inc. Adverse developments concerning key suppliers or our relationships with them could force us to seek alternative sources for our movable medical equipment or to purchase such equipment on unfavorable terms. A delay in procuring equipment or an increase in the cost to purchase equipment could limit our ability to provide equipment to our customers on a timely and cost-effective basis. A substantial portion of our revenues come from customers with whom we do not have long term commitments, and cancellations by or disputes with customers could adversely affect our cash flows and results of operations. We derived approximately 80% of our revenues for the year ended December 31, 2000 and 78% of our revenues for the six months ended June 30, 2001 from customers with whom we do not have any formal long term commitment to use our programs. Our customers are generally not obligated to outsource our equipment under long-term commitments. In addition, many of our customers do not sign written agreements with us fixing the rights and obligations of the parties regarding matters such Table of Contents Risk factors as billing, liability, warranty or use. Therefore, we face risks such as fluctuations in usage, inaccurate or false reporting of usage by customers and disputes over liabilities related to equipment use. Some of our AMPP total outsourcing programs with customers, under which we own substantially all of the movable medical equipment that they use and provide substantial staffing resources, are not subject to a written contract and could be terminated by the healthcare provider without notice or payment of any termination fee. Any such termination would have an adverse effect on our revenues and operating results. We may lose existing customers if we are unable to renew our contracts with Group Purchasing Organizations. Our past revenue growth and our strategy for future growth depends, in part, on access to the new customers granted by our major contracts with group purchasing organizations, or GPOs, such as Premier, Novation and AmeriNet. Each of these contracts has a three year term expiring in late 2001 or 2002. In the past, we have been able to renew such contracts. If we are unable to renew or replace our current GPO contracts when they are up for renewal, we may lose the existing business with the customers who are members of such GPOs. If we were required to write off or accelerate the amortization of our goodwill, our operations and shareholders equity would be adversely affected. As a result of recent acquisitions, described in the notes to our financial statements included elsewhere in this prospectus, we have $37.2 million of goodwill recorded on our balance sheet as of December 31, 2000. Until January 1, 2002, we will be amortizing this goodwill on a straight-line basis over periods ranging from 15 to 40 years. Under new accounting rules, beginning January 1, 2002, we will no longer be able to amortize goodwill on a yearly basis. Instead, we will be required to periodically determine if our goodwill has become impaired, in which case we would be required to write off the impaired portion of goodwill. The amount of goodwill that we amortize or write off in any given year is treated as a charge against earnings under generally accepted accounting principles in the United States. If we were required to write off our goodwill, we could incur a one-time fixed charge against earnings, which would adversely affect our results of operations and shareholders equity. Although we do not manufacture any medical equipment, our business entails the risk of claims related to the medical equipment that we outsource and service. We may not have adequate insurance to cover a claim, and it may be more expensive or difficult for us to obtain adequate insurance in the future. We may be liable for claims related to the use of our movable medical equipment. Any such claims, if made, could have a material adverse effect on our business, financial condition or results of operations. We may be subject to claims exceeding our insurance coverage or we may not be able to continue to obtain liability insurance at acceptable levels of cost and coverage. In addition, litigation relating to a claim could adversely affect our existing and potential customer relationships, create adverse public relations and divert management s time and resources from the operation of the business. Table of Contents Risk factors Our growth strategy depends in part on our ability to successfully identify and manage our acquisitions and a failure to do so could impede our future growth and adversely affect our competitive position. As part of our growth strategy we intend to pursue acquisitions or other strategic relationships within our industry that we believe will enable us to generate revenue growth and enhance our competitive position. Since July 1998, we have acquired five new businesses. Future acquisitions may involve significant cash expenditures and operating losses that could have a material adverse effect on our financial condition and results of operations. In addition, our efforts to execute our acquisition strategy may be affected by our ability to identify suitable candidates and negotiate and close acquisitions. We may not be successful in acquiring other businesses, and the businesses we do acquire in the future may not ultimately produce returns that justify our related investment. Acquisitions may involve numerous risks, including: o difficulties assimilating acquired personnel and integrating distinct business cultures; o diversion of management s time and resources from existing operations; o potential loss of key employees or customers of acquired companies; and o exposure to unforeseen liabilities of acquired companies. If we are unable to continue to grow through acquisitions, our ability to generate revenue growth and enhance our competitive position would be impaired. We depend on key personnel, the loss of whom could have a material adverse effect on our business. We rely on a number of key personnel and losing any of these individuals could have a material adverse effect on our business, financial condition or results of operations. We believe that our future success will depend greatly on our continued ability to attract and retain additional highly skilled and qualified personnel. We have employment agreements with David E. Dovenberg expiring in July 2004 and John A. Gappa expiring in November 2002. We may be unable to renew these agreements prior to expiration, or Mr. Dovenberg or Mr. Gappa may choose to terminate the agreement prior to expiration. In such an event, a suitable replacement may be unavailable. Besides Mr. Dovenberg and Mr. Gappa, we also continue to need other qualified personnel. If we fail to attract or retain qualified personnel, we may be unable to execute our growth strategy. We depend on our sales representatives and service specialists, and may lose customers when any of our sales representatives and service specialists leave us. Our sales growth has been supported by hiring and developing new sales representatives and adding, through acquisitions, established sales representatives whose existing customers generally have become our customers. We have experienced and will continue to experience intense competition for managers and experienced sales representatives. As part of our strategy to grow our business by converting existing customers to our AMPP total outsourcing program, we have recently established a sales team which is specifically focused on and trained for AMPP sales. The success of our outsourcing programs, including AMPP, depends on the relationships developed between our sales representatives and our customers. If sales representatives or members of our AMPP team leave us we risk losing our AMPP customers and convincing other customers to convert to AMPP. Table of Contents Risk factors Our quarterly operating results have varied and we expect them to continue to vary. Our results of operations have been and can be expected to be subject to quarterly fluctuations. We may experience increased revenues in the first and fourth quarter of the year, depending upon the timing and severity of the cold and flu season and the related increased hospital census and movable medical equipment usage during that season. Because a significant portion of our expenses are relatively fixed over these periods, our operating income as a percentage of revenue tends to increase during the first and fourth quarter of each year. If the cold and flu season is delayed by as little as one month, or is less severe than in prior periods, our quarterly operating results for a current period can vary significantly from prior periods. Our quarterly results can also fluctuate as a result of other factors such as the timing of acquisitions, new AMPP agreements or new office openings. RISKS RELATED TO OUR INDUSTRY Changes in reimbursement rates and policies by third-party payors for medical equipment costs may reduce the rates that providers can pay for our services and adversely affect our operating results and financial condition. Our healthcare provider customers, who pay us directly for the services we provide to them, substantially rely on reimbursement from third party payors for their operating revenue. These third party payors include both governmental payors, such as Medicare and Medicaid, and private payors, such as insurance companies and managed care organizations. There are widespread efforts to control healthcare costs in the United States by all of these payor groups. These cost containment initiatives have resulted in reimbursement policies based on fixed rates for a particular patient treatment that are unrelated to the provider s actual costs or require healthcare providers to provide services on a discounted basis. Consequently, these reimbursement policies have a direct effect on healthcare providers ability to pay us for our services and an indirect effect on our level of charges. Ongoing concerns about rising healthcare costs may cause more restrictive reimbursement policies to be implemented in the future. Restrictions on the amounts or manner of reimbursements to healthcare providers may affect their willingness and ability to pay for the services we provide and may adversely affect our customers financial condition. Such restrictions could require us to reduce the rates we charge or could put at risk our ability to collect payments owed to us. Our operating results historically have been adversely affected in periods when significant healthcare reform initiatives were under consideration and uncertainty remained as to their likely outcome. We expect the uncertainty of future significant healthcare reform initiatives may have a similar, negative effect. Because the regulatory and political environment for healthcare significantly influences the capital equipment procurement decisions of healthcare providers, our operating results historically have been adversely affected in periods when significant healthcare reform initiatives were under consideration and uncertainty remained as to their likely outcome. To the extent general cost containment pressures on healthcare spending and reimbursement reform, or uncertainty as to possible reform, causes acute care hospitals and alternate site providers to defer the procurement of medical equipment, reduce their capital expenditures or change significantly their utilization of medical equipment, there could be a material adverse effect on our financial condition and results of operations. Table of Contents Risk factors We have recently increased the amount of business we do with home care providers and nursing homes, and these healthcare providers may pose additional credit risks. We may incur losses in the future due to the bankruptcy filings of our nursing home and home care customers. We derived approximately 20% of our revenues for the year ended December 31, 2000 and 18% of our revenues for the six months ended June 30, 2001 from alternate site providers such as home care providers and nursing homes. For the year ended December 31, 1997, we derived only 16% of our revenues from such providers. We expect that we will continue to increase the percentage of our revenues derived from alternative care providers. Such providers may pose additional credit risks, since such providers are generally less financially sound than hospitals. A significant number of nursing home companies in the United States have filed for Chapter 11 bankruptcy protection in the last two years. Consolidation in the healthcare industry may lead to a reduction in the outsourcing rates we charge. In recent years, many acute care hospitals and alternate site providers have consolidated to create larger healthcare organizations. We believe that this consolidation trend may continue. Any resulting consolidated healthcare organization may have greater bargaining power over us, which could lead to a reduction in the outsourcing rates that we are able to charge. A reduction in our outsourcing rates will decrease our revenues. Our customers operate in a highly regulated environment and the regulations affecting them could adversely affect our business. The healthcare industry is required to comply with extensive and complex laws and regulations at the federal, state and local government levels. While many of these regulations do not directly apply to us, there are some that do, including the Food, Drug and Cosmetics Act, or FDCA, and certain state pharmaceutical licensing requirements. Although we believe we are in compliance with the FDCA, if the FDA expands the reporting requirements under the FDCA, we may be required to comply with the expanded requirements and may incur substantial additional expenses in doing so. With respect to state pharmaceutical licensing requirements, we are currently licensed in four states and may be required to be licensed in up to 15 additional states. We are currently in the process of obtaining these. Our failure to possess such licenses in these states for our existing operations may subject us to certain additional expenses. Given that our industry is heavily regulated, we may be subject to additional regulatory requirements. If our operations are found to be in violation of any governmental regulations to which we or our clients are subject, we may be subject to the applicable penalty associated with the violation. Any penalties, damages, fines or curtailment of our operations would adversely affect our ability to operate our business and our financial results. Table of Contents Risk factors RISKS RELATED TO THE SHARES AND THIS OFFERING Some of our existing shareholders can exert control over us and may not make decisions that are in the best interests of all shareholders. Immediately after the closing of this offering our officers, directors and greater than 5% shareholders, together with their affiliates, will beneficially own an aggregate of 11,124,019 common shares (including shares issuable upon exercise of fully vested outstanding options). This number represents approximately 65% of our shares to be outstanding (including shares issuable upon exercise of outstanding options) immediately after the closing of this offering (assuming no exercise by the underwriters of their over-allotment option). In particular, J.W. Childs Equity Partners, L.P., and its affiliates will beneficially own shares representing approximately 53% of our common stock immediately after this offering. As a result, these shareholders will effectively control the outcome of our actions that require shareholder approval. Together, our officers, directors and J.W. Childs (or J.W. Childs alone) have the power to elect our board of directors, appoint new management and approve any action requiring a shareholder vote, including amendments to our Certificate of Incorporation and approving mergers or sales of substantially all of our assets. The directors they elect will have the authority to make decisions affecting our capital structure, including the issuance of additional indebtedness and the declaration of dividends. There can be no assurance that these shareholders will vote their shares in a manner that is consistent with your best interests. The concentration of ownership in J.W. Childs and its affiliates may also have the effect of delaying or preventing a change in control of us. See Principal and selling shareholders for additional information on the concentration of our common stock. As a new investor, you will experience immediate dilution of 112% in the value of your common stock, and may experience additional dilution as outstanding options and warrants are exercised. Prior investors paid a lower per share price than the price in this offering. The initial public offering price is substantially higher than the net book value per share of the outstanding common stock immediately after this offering. Accordingly, if you purchase common stock in this offering, you will incur immediate and substantial dilution of $16.24 per share. In addition, we have issued a significant number of options to acquire common stock at prices significantly below the initial public offering price. As of June 30, 2001, we had outstanding options to purchase 2,276,545 shares of common stock at a weighted average exercise price of $2.38 per share. To the extent these outstanding options are exercised, there will be further dilution to investors in this offering. There is a large number of shares that may be sold in the market following this offering, which may depress our stock price. Sales of a substantial number of shares of our common stock in the public market by our shareholders after this offering, or the perception that such sales are likely to occur, could depress the market price of our common stock and could impair our ability to raise capital through the sale of additional equity securities. Based on shares outstanding as of June 30, 2001, upon the completion of this offering we will have outstanding 16,275,044 shares of common stock. Of these shares, only the 5,750,000 shares of common stock sold in this offering, including the shares that may be sold in the over-allotment option, if any, will be freely tradable, without restriction, in the public market. After the lockup agreements pertaining to this offering expire 180 days from the date of this prospectus, an additional Table of Contents Risk factors 11,261,044 shares will be eligible for sale in the public market, subject to the volume limitations contained in Rule 144 under the Securities Act of 1933. In addition, 1,109,355 of the shares subject to outstanding options will be exercisable, and if exercised, available for sale 180 days after the date of this prospectus. There is no current trading market for our common stock, and an active public market for our common stock may not develop, which could impede your ability to sell your shares and depress our stock price. The market price of your shares may fall below the initial public offering price. Prior to our 1998 recapitalization our common stock was listed on the Nasdaq National Market. In connection with the recapitalization, we delisted our common stock from Nasdaq, and there is currently no public market for our common stock. Prior to the recapitalization, our stock was at times thinly traded and only a limited number of market makers and investment banking firms prepared research reports on us. An active public trading market for the common stock may not develop, and this could impede your ability to sell your shares or could depress our stock price. The initial price of our common stock to be sold in the offering will be determined through negotiations between us and the representatives of the underwriters and may not be indicative of prices that will prevail in the trading market. The price of our common shares may be volatile and this may adversely affect your investment. The market price for our common shares following this offering may be affected by a number of factors, including the following: o seasonal fluctuations in operating results; o failure to achieve operating results projected by securities analysts; o changes in earnings estimates or recommendations by securities analysts; o developments in our industry; o variations in our competitors results of operations; and o general market conditions and other factors, including factors unrelated to our operating performance or the operating performance of our competitors. In the past, securities class action litigation has often been brought against a company following periods of volatility in the market price of its securities. We may become the target of similar litigation. Securities litigation may result in substantial costs and divert management s attention and resources, which may harm our business and financial condition, as well as the market price of our common stock. Our board of directors may authorize and issue preferred stock without your approval. Such issuances could depress our stock price and adversely affect your voting rights. Our board of directors is authorized to establish various series of preferred stock from time to time and to determine the rights, preferences and privileges of any wholly unissued series, including, among other matters, any dividend rights, dividend rates, conversion rights, voting rights, terms of redemption, liquidation preferences, sinking fund terms, the number of shares, and the description of preferred stock, and to issue any shares of preferred stock. The creation and issuance of shares of an Table of Contents Risk factors additional class or series of preferred stock could adversely affect the market price and the voting power of the common stock. You are not likely to receive dividends in the foreseeable future. We have never paid cash dividends on our capital stock and do not anticipate paying any cash dividends in the foreseeable future. In addition, our revolving credit facility and the indenture for our outstanding senior notes contain certain restrictions on our ability to pay cash dividends on the stock. Provisions of our charter documents and Delaware law could delay or prevent an unsolicited takeover effort to acquire our company, which could inhibit your ability to receive an acquisition premium for your shares. Some provisions of our certificate of incorporation and bylaws may discourage, delay or prevent a merger or acquisition that you may consider favorable or the removal of our current management. These provisions may: o authorize the issuance of blank check preferred stock; o provide for a classified board of directors with staggered, three-year terms; o prohibit cumulative voting in the election of directors; o limit the persons who may call special meetings of stockholders; and o establish advance notice requirements for nominations for election to the board of directors or for proposing matters to be approved by stockholders at stockholder meetings. In addition, some provisions of Delaware law may also discourage, delay or prevent someone from acquiring or merging with us. See Description of capital stock. Table of Contents

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+RISK FACTORS You should carefully consider the following risk factors in addition to the other information in this prospectus before investing in our common stock. We have received reduced payments from governmental and other third-party payors for our services and have experienced other changes which have increased our administrative costs and reduced our revenues and profitability. Our revenues and profitability could suffer further if this trend continues. The healthcare industry has been undergoing significant changes as third-party payors, such as Medicare, Medicaid, managed care organizations and insurers, increase their efforts to control the cost of healthcare services, including clinical laboratory services. As a result of payors' cost-reduction efforts, the amounts we receive through reimbursements for our testing services have been reduced. In addition, payors have limited the number and types of tests that they will fully reimburse in particular medical circumstances. In 1998, 1999 and 2000, we derived approximately 25%-30% of our revenue from tests performed for beneficiaries of Medicare and Medicaid. Because the law generally requires clinical laboratories to accept Medicare and Medicaid reimbursement amounts as payment in full, when these payors unilaterally reduce the fees they are willing to pay for our services, we usually have no choice but to accept the reduced payments. Cost-reduction efforts by Medicare, Medicaid, managed care organizations and insurers have had and may continue to have a material adverse effect on our revenues and profitability. We expect additional efforts in the future by payors to reduce their healthcare costs, and if these efforts succeed, our revenues and profitability could suffer further. The continued importance of the managed care sector could have a negative impact on our profitability. We believe that California has among the highest enrollment rates in managed care plans of any state in the United States, with approximately 52% of the population covered at the end of 1999. We have historically experienced declines in average revenue per patient specimen processed as managed care organizations strengthened their presence in the California healthcare insurance market. The importance of the managed care sector presents challenges that could continue to have a material adverse effect on our financial condition, results of operations and cash flow. These challenges include: . Capitated Payment Contracts. Managed care organizations generally negotiate for capitated payment contracts for a substantial portion of their business. Under these contracts, clinical laboratories receive a fixed monthly fee per individual enrolled with the managed care organization for all laboratory tests performed during the month. Southern California is the most competitive market in the United States in terms of capitated reimbursement rates for laboratory services. In Southern California, capitated reimbursement rates, according to a 1999 survey, averaged approximately $0.65-$0.85 per member per month. In the same survey, areas in the northeastern United States reported rates as high as $1.50 per member per month. Capitated payment contracts shift the risk and cost of additional testing from the managed care organization to the clinical laboratory. Approximately 35%-40% of our testing volume and approximately 10%-15% of our revenue in 2000 were generated from capitated agreements with managed care organizations. . Pricing History. Clinical laboratory companies, including our company, historically have competitively priced their agreements with managed care organizations. Laboratory companies typically have had the opportunity, based upon patient and physician convenience, to perform not only the testing covered under the contract, but also higher priced fee-for-service testing relating to non-managed care patients of participating physicians. As the number of patients under managed care organizations increased, however, less fee-for-service business was available. Furthermore, physicians became increasingly affiliated with more than one managed care organization, and, therefore, a clinical laboratory might receive little, if any, additional fee-for-service testing from them. If physicians elect not to consolidate their managed care and fee-for-service laboratory testing with Unilab to the extent we anticipated when we entered into our managed care agreements, our revenues and profitability could be negatively affected. . Recent Bankruptcies. During 2000, a number of independent physicians associations in California went through bankruptcy. This trend may continue and may result in declines in the volume of tests that we perform for independent physician associations until patients are assigned to another health care provider. This development has reduced and, in the future, could reduce our revenues from independent physician associations. . Ongoing Value of Managed Care Agreements. As part of our strategy and ongoing sales efforts, we review our managed care agreements to better align pricing with the level of service we provide. To the extent we attempt to renegotiate these agreements, we may not be able to maintain our agreements with managed care providers, and, even if we do, we may be unable to renegotiate them in a way that is favorable to our company and to realize increased reimbursement rates. The clinical laboratory testing industry is subject to extensive, complex and frequently changing governmental regulations, which can have adverse effects upon us. The clinical laboratory testing industry is subject to extensive and complex governmental regulation, which is frequently changing. We are subject to extensive governmental regulation at both the federal and state levels in the following areas, among others: . level of reimbursement from government payors; . healthcare billing fraud and abuse; . relationships with our clients within the restrictions of kickback and self-referral laws; . licensing/certification requirements and quality assurance for clinical laboratories and personnel, with increasing scrutiny from California on licensure and training of personnel who draw patient specimens, known as phlebotomists; . anti-markup legislation; . environmental protection; and . occupational safety. We expect that in some of these areas governmental regulation, particularly at the California state level, will increase or become more burdensome. Generally, increased governmental regulation raises our costs and negatively impacts margins. Adverse consequences of our failure to meet governmental requirements in these areas include civil and criminal penalties, exclusion from participation in government healthcare programs such as Medicare and Medicaid and prohibitions or restrictions on the use of our laboratories. Existing or future governmental regulation could have a material adverse effect on our business, financial condition, results of operations and prospects. Some of our marketing and billing practices have been subject to federal and state investigations and related legal claims. This has resulted, and in the future may result, in our facing penalties and changes in the conduct of our business. We settled federal and California investigations of some of our past marketing and billing practices in 1993 and 1996 for an aggregate amount of $7.2 million. In connection with these government settlements, we voluntarily implemented a more formal and comprehensive compliance program to review our billing procedures and other compliance matters. In November 1999, without any admission of wrongdoing, we reached a settlement with a group of thirteen insurance companies in the amount of $0.6 million in connection with claims related to our settlement agreement with the federal government. In May 1999, we learned of a federal investigation under the False Claims Act relating to the billing of four types of medical tests we performed in the early to mid-1990s. In cooperation with the federal government, we have completed the process of gathering and submitting documentation to the Department of Justice regarding the tests with respect to which they requested information. We cannot at this time assess what the result of the investigation might be. Remedies available to the government include civil and criminal penalties and exclusion from participation in federal healthcare programs, such as Medicare and Medicaid. Application of these remedies could have a material adverse effect upon our business, financial condition, results of operations or prospects. On May 31, 2001, the Department of Justice orally offered to settle the claims subject to the federal investigation for a payment by us of approximately $2.8 million. We cannot assure you that this matter will be resolved pursuant to this offer. Although we dispute the claims that are the subject of the investigation and hope to negotiate a settlement with the Department of Justice for less than the government's initial settlement offer, we have recorded a legal charge, included in legal and other non-recurring charges in the statement of operations for the six months ended June 30, 2001, of $2.95 million, which reflects the verbal settlement offer plus certain legal expenses. We require a significant amount of cash to service our debt and expand our business as planned. Our ability to make payments on our debt, and to fund acquisitions, will depend on our ability to generate cash in the future. This, to some extent, is subject to general economic, financial, competitive, legislative, regulatory and other factors that are beyond our control. We cannot assure you that our business will generate sufficient cash flow from operations, that our strategy to increase operating efficiencies through cost savings and operating improvements will be realized or that future borrowings will be available to us under our credit facilities in an amount sufficient to enable us to service our debt or to fund our other liquidity needs. In order to pay the principal amount of our debt at maturity, we may need to refinance all or a portion of our debt, on or before maturity. We may not be able to refinance any of our debt, on commercially reasonable terms or at all. Insufficient cash flow could place us at risk of default under our debt agreements or could prevent us from expanding our business as planned. Our substantial leverage could adversely affect our ability to run our business. We have, and will continue to have, a significant amount of indebtedness. As of June 30, 2001, we had approximately $205.3 million of debt outstanding, after giving effect to the redemption on July 9, 2001 of $54.3 million of our senior subordinated notes. This indebtedness could have important consequences on our ability to operate our business effectively. For example, our indenture and credit facility: . limit our ability to borrow additional funds or to obtain other financing in the future for working capital, capital expenditures, acquisitions and general corporate purposes; . require us to dedicate a substantial portion of our cash flow from operations to pay down our indebtedness, thereby reducing the funds available to use for working capital, capital expenditures, acquisitions and general corporate purposes; . make us more vulnerable to economic downturns and reduce our flexibility in responding to changing business and economic conditions; . limit our flexibility in planning for, or reacting to, changes in our business or industry; . place us at a competitive disadvantage to our competitors with less debt; and . restrict our ability to pay dividends, repurchase or redeem our capital stock or debt, or merge or consolidate with another entity. The terms of our indenture and credit facility allow us to incur further indebtedness, which would heighten the foregoing risks. Under our credit facility, we are required to maintain specified financial ratios and meet financial tests. The ability to comply with these provisions may be affected by events beyond our control. The breach of any of these covenants will result in a default under our credit facility. The complexities of clinical laboratory billing may negatively affect our revenues and cash flow. Billing for clinical laboratory testing services is complicated. The industry practice of performing tests in advance of payment and without certainty as to the outcome of the billing process may negatively affect our revenues and our cash flow. Laboratories must bill various payors, such as patients, insurance companies, Medicare, Medicaid, doctors and employer groups, all of which have different billing requirements. In addition, the billing information requirements of the various payors have become increasingly stringent, typically conditioning reimbursement to us on the provision of proper medical necessity and diagnosis codes by the requisitioning client. This complexity may increase our bad debt expense, due primarily to several non-credit related issues such as missing or incorrect billing information on test requisitions. Among many other factors complicating our billing are: . disputes between payors as to which party is responsible for payment; . disparity in coverage among various payors; and . the difficulty of adherence to specific compliance requirements, diagnosis coding and procedures mandated by various payors. The complexity of clinical laboratory billing also tends to cause delays in our cash flow. Confirming incorrect or missing billing information generally slows down the billing process and increases the aging of accounts receivable. We assume the financial risk related to collection, including the potential uncollectibility of accounts and delays due to incorrect and missing information and the other complex factors identified above. Our growth strategy depends in part upon our ability to acquire other clinical laboratories. Therefore, our inability to make acquisitions that meet our criteria could impede our growth or harm our ability to maintain or improve our competitive position. As a part of our business strategy, we pursue selected acquisition opportunities that we believe will enable us to generate revenue growth, achieve additional operating efficiencies and solidify or enhance our competitive position. However, we cannot assure you that we will be able to acquire clinical laboratories that meet our target criteria on satisfactory terms, if at all. In addition, our acquisition program requires substantial capital resources, and the operations of our acquired clinical laboratories require ongoing capital expenditures. We may need to obtain additional capital or financing, from time to time, to fund these activities. We cannot assure you, however, that sufficient capital or financing will be available to us on satisfactory terms, if at all. If we are unable to continue to grow through acquisitions in a way that meets investor expectations, our share price may decline. Difficulties with the integration of any new acquisitions may impose substantial costs and delays and cause other problems for us. Acquisitions involve a number of risks relating to our ability to integrate an acquired business into our existing operations. These risks include possible difficulties relating to: . assimilation of acquired operations and personnel; . integration of acquired businesses' equipment, service offerings, networks and technologies and financial and information systems; . coordination of geographically separated facilities and workforces; . coordination of acquired businesses' sales, marketing and service development efforts; and . maintenance of common standards, controls, procedures and policies. The process of integrating operations of acquired businesses, including their personnel, could cause interruptions to our business, including that of the acquired businesses. Employees who may be key to the integration effort or our ongoing operations may choose not to continue to work for us following the closing of the acquisitions. Further, the process of integration may require a disproportionate amount of the time and attention of our management, which may distract management's attention from its day-to-day responsibilities. For the above reasons, it is possible that we may not realize all or any of the anticipated benefits of an acquisition, either at all or in a timely manner. If that happens and we incur significant costs, it could have a material adverse impact on our business. In addition, any interruption or deterioration in service resulting from an acquisition may result in a client's decision to stop using us for clinical laboratory testing. We perform most clinical laboratory testing under arrangements that are terminable at will or on short notice. We operate in an intensively competitive environment which could cause us to lower prices, resulting in reduced revenues and profit margins, or to lose market share. The independent clinical laboratory testing industry is highly competitive. Independent clinical laboratories fall into two categories. The first includes smaller, local laboratories that generally offer fewer tests and services and have less capital than the larger laboratories. These laboratories seek to differentiate themselves by maintaining a close working relationship with their physician clients, characterized by a high level of personal and localized services. The second category of independent clinical laboratories, which includes laboratories such as Unilab, consists of larger regional or national laboratories that provide a broader range of tests and services. These regional and national laboratories may have greater financial and other resources than us, which could place us at a competitive disadvantage. We also compete with hospital laboratories, which generally operate with low volumes and quick turnaround times. To compete successfully in California, we may be required to increase our operating costs, reduce prices and take other measures that could have an adverse effect on our financial condition, results of operations and cash flow. If we are unable to compete successfully, we may lose market share. Technology changes may lead to the development of cost-effective point-of-care testing that could negatively impact our testing volume and revenues. The clinical laboratory testing industry is characterized by changing technology and the ongoing development of new testing procedures. Technology changes may lead to the development of more cost-effective point-of-care testing equipment and procedures that can be operated and performed by physicians in their offices and hospital laboratories without requiring the services of clinical laboratories. Development of such technology and new procedures could negatively impact our testing volume and related revenues. We compete with some of our clients. If they reduce or discontinue purchases of our laboratory testing services, our revenues could decline. We compete with some of our clients, such as hospital laboratories and smaller independent laboratories, in the clinical laboratory testing market. These organizations often refer tests to us that they either cannot or elect not to perform themselves. These parties may no longer refer tests to us if they decide to develop and market tests similar to ours. If hospitals and independent laboratories decide to reduce or discontinue purchases of our tests, our revenue may be reduced. Our loss of key management personnel or our inability to hire and retain skilled employees at our clinical laboratories could adversely affect our business. Our success is dependent in part on the efforts of key members of our management team. The loss of their services could materially adversely affect our business, financial condition, results of operations or prospects. We do not currently maintain key person life insurance on any of our key employees. The success of our clinical laboratories also depends on employing and retaining qualified and experienced laboratory professionals who perform our clinical laboratory testing or billing services. The competition for skilled professionals is intense. The loss of healthcare professionals or the inability to recruit these individuals in our markets could adversely affect our ability to operate our business efficiently and profitably and could harm our ability to maintain our desired levels of client service. The tight labor market for qualified and experienced laboratory personnel has led to an increase in salaries and hourly wages. We may face further wage pressures if this trend continues, which could negatively impact our profitability. Our laboratories are all located in California, where the labor market for experienced technical and clerical personnel is very competitive. For example, the competition for qualified cytotechnologists, medical technologists and phlebotomists, as well as clerical personnel, has forced us to increase salaries and wages for these positions and spend more on recruitment efforts. This trend has and, in the future, could negatively affect our profitability. In addition, we are increasingly having to draw blood at our patient service centers as physicians do less of this work in their offices, requiring us to increase our phlebotomy personnel. This, combined with payor reimbursement limitations and California training and certification requirements, has increased and, in the future, will increase our costs. If we do not comply with laws and regulations governing the confidentiality of medical information, we could be subject to damages, fines or penalties. Federal and state initiatives in this area could require us to spend substantial sums on new information systems and could adversely affect our ability to transmit patient data. The confidentiality of patient medical information is subject to substantial regulation by state and the federal governments. Specific state and federal laws and regulations govern both the disclosure and use of confidential patient medical information, as well as access of patients to their own medical records. Similarly, many other federal laws also may protect such information, including the Electronic Communications Privacy Act of 1986 and federal laws relating to confidentiality of mental health records and substance abuse treatment. Congress passed the Health Insurance Portability and Accountability Act, known as HIPAA, in 1996. Among other things, HIPAA calls for the establishment of national standards to facilitate the electronic exchange of health information and to maintain the security of both the health information and the system that enables the exchange of this information. The Department of Health and Human Services, known as HHS, has promulgated several sets of proposed regulations pursuant to its authority under HIPAA. To date, the HIPAA regulations that have been finalized pertain to electronic transactions and the privacy of individually identifiable health information that is electronically transmitted and received or transmitted and maintained in any other form or medium. Pursuant to these final regulations, all medical records and other patient identifiable health information must be maintained in confidence, must not be used for non-health purposes and must be disclosed to the minimum extent required. In addition, patients must be given a clear notice of their rights and access to their records by laboratories (other than to the extent that access to their records is restricted by the Clinical Laboratory Services Improvement Act, as amended, commonly known, together with its implementing regulations, as CLIA, and by state law) and a patient's consent or authorization generally must be obtained before information is released. To ensure that these requirements are satisfied, covered entities must adopt appropriate policies and practices, designate a privacy officer, train employees and establish a grievance procedure. The privacy regulations recognize, however, that laboratories have little direct contact with patients, and therefore they allow healthcare providers with an indirect treatment relationship with the patient to use protected health information for purposes of treatment, without a separate consent. Nonetheless, laboratories will still have to directly address HIPAA regulations in other circumstances. In most circumstances, entities covered by HIPAA must be in compliance with the final HIPAA regulations within 24 months of the date the regulations become final (April 14, 2003 for the electronic privacy rules and October 16, 2002 for the electronic transaction rules). The Bush Administration has recently announced that it does not intend to further delay the implementation date of these regulations. If we are found to have violated any state or federal statute or regulation with regard to the confidentiality, dissemination or use of patient medical information, we could be liable for damages, or for civil or criminal fines or penalties. Because laboratory orders and reports fall within the scope of HIPAA, the costs of HIPAA compliance will impact us and others in the clinical laboratory industry. In 2000, we established a HIPAA Committee to evaluate the HIPAA requirements and to make recommendations to us regarding their implementation. Compliance with the HIPAA rules could require us to spend substantial sums, which could negatively impact our profitability. At this time, we cannot assess the total financial or other impact of the HIPAA regulations upon us.- We believe that our policies, procedures and systems are in material compliance with all applicable state and federal laws and regulations governing the confidentiality, dissemination and use of medical record information. However, differing interpretations of existing laws and regulations, or the adoption of new laws and regulations, could reduce or eliminate our ability to obtain or use patient information which, in turn, could limit our ability to use our information technology products for electronically transmitting patient data. Our net revenue will be diminished if payors do not authorize reimbursement for our services. There have been and will continue to be significant efforts by both federal and state agencies to reduce costs in government healthcare programs and otherwise implement government control of healthcare costs. In addition, emphasis on managed care in the United States may continue to pressure the pricing of healthcare services. Third party payors, including Medi-Cal and Medicare, are challenging the prices charged for medical products and services. In addition, government and other third party payors increasingly are limiting both coverage and the level of reimbursement for our tests. If government and other third party payors do not provide adequate coverage and reimbursement for our tests, our net revenue may decline. A purported class action has been filed against our company and our board of directors in connection with our November 1999 recapitalization. It is not possible to predict the likelihood of a favorable or unfavorable outcome. On November 4, 1999, a purported class action lawsuit was filed in the United States District Court for the Southern District of New York against us and our board of directors by two of our former stockholders, seeking compensatory damages, prejudgment interest, expenses on behalf of the class of shareholders and a preliminary injunction against the November 1999 recapitalization. The complaint alleges, among other things, that the proxy statement relating to our recapitalization contained material misrepresentations and omissions in violation of the federal proxy rules and that approval of the terms of the recapitalization amounted to a breach of the fiduciary duties owed to our stockholders by our directors. Plaintiffs and defendants negotiated a settlement in principle of the action, subject to completion of confirmatory discovery and definitive documentation relating to the settlement and court approval. However, on November 15, 2000, plaintiffs announced they would not agree to consummate the settlement. On September 26, 2001, plaintiffs filed a second amended complaint against us and our former board of directors. The second amended complaint adds as a defendant BT Alex. Brown, the investment banker that delivered a fairness opinion in connection with our recapitalization. The complaint asserts additional claims and allegations, including that the defendants brought the company private in order to obtain large profits for themselves and others, to the detriment of the public shareholders prior to the recapitalization. The complaint also seeks exemplary damages. We believe the plaintiffs' claims are without merit, but because this matter is in the early stages of litigation it is not possible to predict the likelihood of a favorable or unfavorable outcome. Professional liability litigation can be costly to defend, may harm our reputation and result in large damage awards, which our insurance may not adequately cover or which may make it more expensive or difficult for us to obtain insurance in the future. As a provider of clinical laboratory testing services, we are subject in the normal course of business to lawsuits involving alleged negligence in performing laboratory tests and other similar legal claims. These lawsuits can be costly to defend and involve claims for substantial damages. We maintain insurance which we believe to be adequate to cover our exposure to professional liability claims. However, our current insurance may not be adequate and we may not be able to obtain adequate insurance at an acceptable cost in the future. Professional liability lawsuits could also have an adverse effect on our client base by damaging our reputation. Any failure in our information technology systems could significantly increase testing turn-around time, reduce our production capacity and otherwise disrupt our operations. Any of these circumstances could reduce our customer base and result in lost revenue. Our laboratory operations depend, in part, on the continued and uninterrupted performance of our information technology systems. The significant growth we have experienced in California through our acquisitions has necessitated continued expansion and upgrading of our information technology infrastructure. Sustained system failures or interruption in one or more of our laboratory operations could disrupt our ability to process laboratory requisitions, perform testing, provide test results in a timely manner and/or bill the appropriate party. Our business, results of operations and financial condition could be adversely affected by a system failure. Our computer systems are vulnerable to damage or interruption from a variety of sources, including telecommunications failures, electricity brownouts or blackouts, malicious human acts and natural disasters. Moreover, despite network security measures, some of our servers are potentially vulnerable to physical or electronic break-ins, computer viruses and similar disruptive problems. Despite the precautions we have taken, unanticipated problems affecting our systems could cause interruptions in our information technology systems. Our insurance policies may not adequately compensate us for any losses that may occur due to any failures in our systems. If a catastrophe strikes our clinical laboratory facilities or if we experience sustained interruptions in electrical service, we may be unable to serve our clients in a timely manner, if at all. Our clinical and processing facilities may be affected by catastrophes such as earthquakes or by sustained interruptions in electrical service. Earthquakes are of particular significance to us because our clinical laboratory facilities are located in California, an earthquake-prone area. Interruptions in electrical service are also of particular concern to us since we operate in California, which is experiencing significant problems with its electricity systems. If our existing clinical laboratory facilities or equipment were affected by natural disasters or electrical brownouts or blackouts, we would be unable to process our clients' samples in a timely manner and unable to operate our business in a commercially competitive manner. We carry earthquake insurance with coverage in an amount of up to $10.0 million per year. Despite this precaution, there is no assurance that we could recover quickly from a serious earthquake or other disaster. Our principal stockholders, Kelso Investment Associates VI, L.P. and KEP VI, LLC, have significant control over us. This means that our principal stockholders could cause us to act, or refrain from acting, in a way that minority stockholders do not believe is in their best interest. Kelso Investment Associates VI, L.P. and KEP VI, LLC will beneficially own approximately 41.8% of the outstanding shares of our common stock upon the sale of their shares in connection with this offering. The Kelso affiliates and designees have significant influence in electing our directors, appointing new management and approving any action requiring the approval of our stockholders, including amendment of our certificate of incorporation and mergers or sales of substantially all of our assets. The directors elected by the Kelso affiliates and designees may be able to make decisions affecting our capital structure, including decisions to issue additional capital stock, implement stock repurchase programs and declare dividends. The interests of Kelso and its affiliates could conflict with your interests. Because of their large percentage of ownership, these Kelso affiliates have significant control over our management and policies. This may have the effect of deterring hostile takeovers, delaying or preventing changes in control or changes in management, or limiting the ability of our stockholders to approve transactions that they may deem to be in their best interests. Future sales of common stock may adversely affect the price of our common stock. The Kelso affiliates and our other current stockholders will be free to sell any and all of the shares they own after completion of this offering, except for the 90 day lock-up as described in this prospectus under the caption "Shares Eligible for Future Sale" and to the extent permitted by applicable law. We can make no prediction as to the effect, if any, that future sales of common stock, or the availability of common stock for future sale, will have on the market price of our common stock prevailing from time to time. Sales of substantial amounts of common stock, or the perception that sales may occur, could adversely affect prevailing market prices for our common stock. Our quarterly operating results have varied in the past and may vary in the future. If our quarterly net revenue and operating results fall below the expectations of securities analysts and investors, the market price of our common stock could fall substantially. Operating results vary depending on a number of factors, many of which are outside our control, including: . demand for our tests; . loss of a significant client contract; . new test introductions by competitors; . changes in our pricing policies or those of our competitors; . the hiring and retention of key personnel; . wage and cost pressures; . changes in fuel prices or electrical rates; . costs related to acquisitions of technologies or businesses; and . seasonal and general economic factors. The price of our common stock may be volatile and this may adversely affect our stockholders. Following this offering, the price at which our common stock will trade may be volatile. The stock market has from time to time experienced significant price and volume fluctuations that have affected the market prices of securities, particularly securities of clinical laboratory and other healthcare service companies. The prices at which the common stock will trade after the offering may be influenced by many factors, including: . our operating and financial performance; . the depth and liquidity of the market for the common stock; . future sales of common stock or the perception that sales could occur; . investor perception of our business and our prospects; . developments relating to litigation or governmental investigations; . developments in the regulation of the clinical laboratory testing industry; and . general economic and stock market conditions. In the past, following periods of volatility in the market price of a particular company's securities, securities class-action litigation has often been brought against that company. We may become involved in this type of litigation in the future. Litigation of this type is often expensive to defend and may divert our management's attention and resources from the operation of our business. This prospectus contains forward-looking statements. Some of the statements under "Prospectus Summary," "Risk Factors," "Management's Discussion and Analysis of Financial Condition and Results of Operations," "Business," and elsewhere in this prospectus are forward-looking statements within the meaning of Section 27A of the Securities Act and Section 21B of the Securities Exchange Act. We generally identify forward-looking statements in this prospectus using words like "believe," "intend," "expect," "estimate," "may," "should," "plan," "project," "contemplate," "anticipate," "predict," or similar expressions. These statements involve known and unknown risks, uncertainties, and other factors, including those described in this "Risk Factors" section, that may cause our or our industry's actual results, levels of activity, performance, or achievements to be materially different from any future results, levels of activity, performance, or achievements expressed or implied by these forward-looking statements. Except as required by applicable law, including the securities laws of the United States, and the rules and regulations of the SEC, we do not plan to publicly update or revise any forward-looking statements after we distribute this prospectus, whether as a result of any new information, future events or otherwise. We use market data and industry forecasts and projections throughout this prospectus, which we have obtained from internal surveys, market research, publicly available information and industry publications. Industry publications generally state that the information they provide has been obtained from sources believed to be reliable, but that the accuracy and completeness of such information are not guaranteed. The forecasts and projections are based on industry surveys and the preparers' experience in the industry and there is no assurance that any of the projected amounts will be achieved. Similarly, we believe that the surveys and market research we or others have performed are reliable, but we have not independently verified this information.

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+RISK FACTORS An investment in our common stock involves a number of risks. You should carefully read and consider the following factors in evaluating us and our business, in addition to the other information in this prospectus, before you purchase the common stock offered by this prospectus. OUR PROFITABILITY DEPENDS SIGNIFICANTLY ON LOCAL ECONOMIC CONDITIONS. Our success depends primarily on the general economic conditions of the northern Virginia area. Unlike larger banks that are more geographically diversified, we provide banking and financial services to customers primarily in the northern Virginia area. The local economic conditions in this area have a significant impact on our business, real estate and construction loans, the ability of the borrowers to repay these loans and the value of the collateral securing these loans. A significant decline in general economic conditions caused by inflation, recession, acts of terrorism, an outbreak of hostilities or other international or domestic calamities, unemployment or other factors beyond our control would impact these local economic conditions and could negatively affect the financial results of our banking operations. In recent years, there has been a proliferation of technology and communications companies in our market. The current recession in those industries has had a significant adverse impact on a number of those companies. While we do not have significant credit exposure to these companies, the recession in these industries could have a negative impact on local economic conditions and real estate collateral values generally, which could negatively affect our profitability. WE MAY NOT BE ABLE TO MAINTAIN OUR HISTORICAL GROWTH RATE, WHICH MAY ADVERSELY IMPACT OUR RESULTS OF OPERATIONS AND FINANCIAL CONDITION. To achieve our past levels of growth, we have initiated internal growth programs, completed several acquisitions and opened additional branches. We may not be able to sustain our historical rate of growth or may not even be able to grow at all. We may not be able to obtain the financing necessary to fund additional growth and may not be able to find suitable candidates for acquisition. Various factors, such as economic conditions and competition, may impede or prohibit our opening of new branch offices. Further, our inability to attract and retain experienced bankers may adversely affect our internal growth. A significant decrease in our historical rate of growth may adversely impact our results of operations and financial condition. WE MAY BE UNABLE TO COMPLETE ACQUISITIONS, AND ONCE COMPLETE, MAY NOT BE ABLE TO INTEGRATE OUR ACQUISITIONS SUCCESSFULLY. Our growth strategy includes our ability to acquire other financial institutions. We may not be able to complete any future acquisitions and, if completed, we may not be able to successfully integrate the operations, management, products and services of the entities we acquire. Following each acquisition, we must expend substantial managerial, operating, financial and other resources to integrate these entities. Our failure to successfully integrate the entities we acquire into our existing operations may adversely affect our results of operations and financial condition. OUR SMALL TO MEDIUM-SIZED BUSINESS TARGET MARKET MAY HAVE FEWER FINANCIAL RESOURCES TO WEATHER A DOWNTURN IN THE ECONOMY. We target our business development and marketing strategy primarily to serve the banking and financial services needs of small to medium-sized businesses. These small to medium-sized businesses generally have fewer financial resources in terms of capital or borrowing capacity than larger entities. If general economic conditions negatively impact this major economic sector in the northern Virginia area or the other markets in which we operate, our results of operations and financial condition may be adversely affected. FLUCTUATIONS IN INTEREST RATES COULD REDUCE OUR PROFITABILITY. WE REALIZE INCOME PRIMARILY FROM THE DIFFERENCE BETWEEN INTEREST EARNED ON LOANS AND INVESTMENTS AND THE INTEREST PAID ON DEPOSITS AND BORROWINGS. Our earnings are significantly dependent on our net interest income. We expect that we will periodically experience "gaps" in the interest rate sensitivities of our assets and liabilities, meaning that either our interest-bearing liabilities will be more sensitive to changes in market interest rates than our interest-earning assets, or vice versa. In either event, if market interest rates should move contrary to our position, this "gap" will work against us, and our earnings may be negatively affected. We are unable to predict fluctuations of market interest rates, which are affected by many factors, including the following: - inflation; - recession; - a rise in unemployment; - tightening money supply; and - domestic and international disorder and instability in domestic and foreign financial markets. For example, in the event of a sharp increase in interest rates, our market value of portfolio equity and net interest income will be negatively affected. Although our asset-liability management strategy is designed to control our risk from changes in market interest rates, we may not be able to prevent changes in interest rates from having a material adverse effect on our results of operations and financial condition. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Interest Rate Sensitivity and Market Risk" beginning on page 41. THE SUCCESS OF OUR PARTICIPATION IN SMALL BUSINESS ADMINISTRATION LOAN PROGRAMS DEPENDS ON RETENTION OF OUR PREFERRED AND CERTIFIED LENDER STATUS AND OUR COMPLIANCE WITH TECHNICAL CREDIT UNDERWRITING STANDARDS. Approximately 21% of our loan portfolio consists of loans made through various lending programs of the Small Business Administration. The federal government currently guarantees 75% to 90% of the principal amount of each qualifying loan. We have recently elected to hold the guaranteed portion of these loans in our loan portfolio rather than sell them into the secondary market. There can be no assurance that the federal government will maintain the SBA program, or if it does, that the guaranteed portion will remain at its current funding level. Furthermore, there can be no assurance that we will retain our Preferred and Certified Lender status, which generally enables us to approve and fund SBA loans without prior SBA approval. In the event of a default on an SBA loan, our pursuit of remedies against a borrower is subject to SBA approval. If the SBA establishes that its loss is attributable to deficiencies in the manner in which the loan application was prepared or submitted, the SBA may decline to honor its guarantee and we may suffer losses. LOSS OF OUR SENIOR EXECUTIVE OFFICERS OR OTHER KEY EMPLOYEES COULD IMPAIR OUR RELATIONSHIP WITH OUR CUSTOMERS AND ADVERSELY AFFECT OUR BUSINESS. Our success is dependent upon the continued service and skills of Georgia S. Derrico, R. Roderick Porter and other senior officers. The loss of services of any of these key personnel could have a negative impact on our business because of their skills, years of industry experience and the difficulty of promptly finding qualified replacement personnel. Although we currently have an employment agreement with Ms. Derrico, there can be no assurance that she will continue to be employed with us in the future. IF OUR ALLOWANCE FOR LOAN LOSSES IS NOT SUFFICIENT TO COVER ACTUAL LOAN LOSSES, OUR EARNINGS COULD DECREASE. Our loan customers may not repay their loans according to the terms of these loans and the collateral securing the payment of these loans may be insufficient to assure repayment. We may experience significant loan losses which could have a material adverse effect on our operating results. Management makes various assumptions and judgments about the collectibility of our loan portfolio, including the creditworthiness of our borrowers and the value of the real estate and other assets serving as collateral for the repayment of many of our loans. We maintain an allowance for loan losses in an attempt to cover any loan losses which may occur. In determining the size of the allowance, we rely on an analysis of our loan portfolio, our experience and our evaluation of general economic conditions. If our assumptions prove to be incorrect, our current allowance may not be sufficient to cover future loan losses and adjustments may be necessary to allow for different economic conditions or adverse developments in our loan portfolio. Material additions to our allowance would materially decrease our net income. In addition, federal and state regulators periodically review our allowance for loan losses and may require us to increase our provision for loan losses or recognize further loan charge-offs, based on judgments different than those of our management. Any increase in our loan allowance or loan charge-offs as required by these regulatory agencies could have a negative effect on our operating results. OUR BUSINESS IS DEPENDENT ON TECHNOLOGY AND AN INABILITY TO INVEST IN TECHNOLOGICAL IMPROVEMENTS MAY ADVERSELY AFFECT OUR RESULTS OF OPERATION AND FINANCIAL CONDITION. The financial services industry is undergoing rapid technological changes with frequent introductions of new technology-driven products and services. In addition to better serving customers, the effective use of technology increases efficiency and enables financial institutions to reduce costs. Our future success will depend in part upon our ability to address the needs of our customers by using technology to provide products and services that will satisfy customer demands for convenience as well as create additional efficiencies in our operations. Many of our competitors have substantially greater resources to invest in technological improvements. There can be no assurance that we will be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to our customers. ALTHOUGH PUBLICLY TRADED, OUR COMMON STOCK HAS SUBSTANTIALLY LESS LIQUIDITY THAN THE AVERAGE TRADING MARKET FOR A STOCK QUOTED ON THE NASDAQ NATIONAL MARKET SYSTEM. Although our common stock is listed for trading on the National Market System of the Nasdaq Stock Market, the trading market in our common stock has substantially less liquidity than the average trading market for companies quoted on the Nasdaq National Market System. A public trading market having the desired characteristics of depth, liquidity and orderliness depends on the presence in the market place of willing buyers and sellers of our common stock at any given time. This presence depends on the individual decisions of investors and general economic and market conditions over which we have no control. Although management believes that this offering will improve the liquidity of the market for our common stock, no assurance can be given that the offering will increase the volume of trading in our common stock. COMPETITION WITH OTHER FINANCIAL INSTITUTIONS COULD ADVERSELY AFFECT OUR PROFITABILITY. We face vigorous competition from banks and other financial institutions, including savings and loan associations, savings banks, finance companies and credit unions. A number of these banks and other financial institutions have substantially greater resources and lending limits, larger branch systems and a wider array of banking services. To a limited extent, we also compete with other providers of financial services, such as money market mutual funds, brokerage firms, consumer finance companies, insurance companies and governmental organizations which may offer more favorable financing than we can. Some of our nonbank competitors are not subject to the same extensive regulations that govern us. This competition may reduce or limit our margins on banking services, reduce our market share and adversely affect our results of operations and financial condition. WE OPERATE IN A HIGHLY REGULATED ENVIRONMENT AND MAY BE ADVERSELY AFFECTED BY CHANGES IN FEDERAL AND LOCAL LAWS AND REGULATIONS. We are subject to extensive regulation, supervision and examination by federal and state banking authorities. Any change in applicable regulations or federal or state legislation could have a substantial impact on us and our subsidiary bank, and their respective operations. Additional legislation and regulations may be enacted or adopted in the future that could significantly affect our powers, authority and operations or the powers, authority and operations of the bank, which could have a material adverse effect on our financial condition and results of operations. Further, regulators have significant discretion and power to prevent or remedy unsafe or unsound practices or violations of laws by banks and bank holding companies in the performance of their supervisory and enforcement duties. The exercise of this regulatory discretion and power may have a negative impact on us. SPECIAL CAUTIONARY NOTICE REGARDING FORWARD-LOOKING STATEMENTS Some information in this prospectus may contain forward-looking statements. The words "anticipate," "believe," "continue," "expect," "estimate," "intend," "may," "will," "should" and similar words identify forward-looking statements. These statements discuss future expectations, activities or events. Important factors that could cause actual results or developments to differ materially from estimates or projections contained in forward-looking statements include: - general business and economic conditions in the markets we serve may be less favorable than anticipated; - changes in market rates and prices may impact the value of securities, loans, deposits and other financial instruments; - legislative or regulatory developments including changes in laws concerning taxes, banking, securities, insurance and other aspects of the financial securities industry; - competitive factors including product and pricing pressures among financial services organizations may increase; - our ability to expand and grow our business and operations, including the acquisition of additional banks, and our ability to realize the cost savings and revenue enhancements we expect from such acquisitions; and - fiscal and governmental policies of the United States federal government. For other factors, risks and uncertainties that could cause actual results to differ materially from estimates and projections contained in forward-looking statements, please read the "Risk Factors" section of this prospectus. A forward-looking statement may include a statement of the assumptions or bases underlying the forward-looking statement. We believe we have chosen these assumptions or bases in good faith and that they are reasonable. However, we caution you that assumptions or bases almost always vary from actual results, and the differences between assumptions or bases and actual results can be material. When considering forward-looking statements, you should keep in mind the risk factors and other cautionary statements in this prospectus, any prospectus supplement and the documents we have incorporated by reference. We will not update these statements unless the securities laws require us to do so.

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+Risk Factors You should be aware that there are various risks relating to our business and common stock which you should consider carefully with all of the other information included in this prospectus before deciding to invest in our common stock. Business and Financial Risks 1. We are in default of the terms of our loan agreements and do not have sufficient financial resources to cure those defaults. We did not pay any of the quarterly principal installments of $514,000 due to FINOVA in January, 2001, and thereafter, and interest payments have been suspended since the interest payment covering the month of December 2000 was paid in January 2001. Although FINOVA has not made a demand for payment of the full balance outstanding, its right to do so has not been waived. We are also in default of the terms of a debenture issued to AMRO International, S.A. and these defaults result in violations of the terms of many other operating agreements. As a result, among other available remedies, our lenders could demand payment in full of all amounts due to them and our existing resources are insufficient to meet such a demand. In addition, several of our operating agreements could be terminated by our service providers as a result of the aforementioned defaults and our ability to service our customers could thereby be impaired. FINOVA has executed a forbearance agreement dated as of June 7, 2001 under which it has agreed not to make demand for payment as is its right due to our default under terms of our loan agreement with them. Although this agreement does not constitute a waiver of FINOVA's rights, it has provided a maturity date of December 31, 2001 for all amounts due, subject to specified covenants, which, if not met, could result in a demand for immediate payment. AMRO has executed a forbearance agreement under which it has agreed not to demand immediate payment of all outstanding amounts due or to convert its debenture into shares of Aquis common stock. The initial term of that forbearance was for a maximum period of 180 days from the April 18, 2001 date of that agreement, and has been extended through December 31, 2001. However, under certain circumstances specified in that agreement, such as the enforcement of any other party's rights against Aquis in the event of default under another material contract, and certain other circumstances, the termination date of that forbearance agreement may be accelerated. We are also negotiating with our lenders to restructure our debt and equity structure, but there is no assurance that these negotiations will be successful. In the event that we are unsuccessful, we will consider appropriate responses, including a voluntary petition for protection under the US Bankruptcy Code. Our ability to continue to operate is dependent on meeting short term financing requirements and long term profitability. 2. One of our creditors may effect a change in control of Aquis. Under the terms of the $2,000,000 11% convertible debenture held by AMRO International, S.A., AMRO may elect to convert the principal amount and related accrued interest, or any portion thereof, into Aquis common stock at a conversion price that is 90% of the market price as defined in that agreement. On April 2, 2001, AMRO provided written notice that it waived the provisions contained in the debenture that limited its right to acquire a number of Aquis shares that might cause its beneficial ownership of Aquis common stock to exceed 9.9%. This waiver was revoked by AMRO in their election dated May 30, 2001. However, AMRO has also executed a forbearance agreement under which it has agreed not to demand immediate payment of all outstanding amounts due or to convert its debenture into shares of Aquis common stock. The term of that forbearance was for a maximum period of 180 days from the April 18, 2001 date of that agreement and has been extended through December 31, 2001. However, under certain circumstances specified in that agreement, such as the enforcement of any other party's rights against Aquis in the event of default under another material contract, and certain other circumstances, the termination date of that forbearance agreement may be accelerated. To the extent that AMRO exercises its right to convert its debenture into common stock, a change in control of Aquis may be effected. However, as referenced in earlier filings, the Communications Act of 1934, as amended, contains restrictions on foreign ownership in FCC licensed commercial mobile radio services entities. Those restrictions were liberalized by the World Trade Organization Agreement on Basic Telecommunications Service, effective February 5, 1998. As a result of these liberalized ownership limitations in entities holding FCC licenses, AMRO may be able to control a larger percentage of our common stock without jeopardizing the licenses issued to us by the FCC. 3. We have a history of operating losses and we expect that trend to continue. We expect to report operating losses for the next several years. We purchased the paging operations of Bell Atlantic (now known as Verizon Communications) in December 1998. Paging Partners Corporation also merged with Aquis Communications, Inc. at the end of March 1999 to form Aquis Communications Group, Inc. We then purchased the Paging Assets of SourceOne Wireless, Inc. in January 2000 and those of Suburban Connect, L.P. ("Suburban Paging") in May 2000. A significant effect of the purchase accounting for these transactions was to record a substantial amount of intangible assets, which will result in substantial amortization charges to our consolidated income over the next ten years. As a result, we expect to incur operating losses for the next several years. Based on our current operating structure and loan agreement requirements, we currently anticipate that cash resources and cash generated from operations will be insufficient to meet our requirements for debt service, even assuming that our lenders do not demand immediate payment of amounts due to them. We also expect that cash resources will be insufficient to meet our working capital and capital expenditure needs. This will require us to raise additional capital to fund operating activities, to develop new and to enhance existing services to respond to competitive pressures, and to acquire complementary businesses or technologies. Therefore, we will need additional capital in the future. Additional financing may not be available as a result of our operating losses and defaults under our existing loan agreements. Further, our financial statements and the related audit opinion contain going concern qualifications due to our history of losses and working capital deficits. Our ability to continue operating is dependent on meeting short term financing requirements and long term profitability. 4. Our ability to raise capital is limited by expected and historical losses, our agreements with lenders, our equity line of credit, and our defaults under our loan agreements. Without additional capital, we may not be able to service our debt, maintain or grow our customer base, or maintain working capital at sufficient levels. Our history of losses and our ongoing expectations for continued losses impairs our ability to secure additional debt or equity funding. Our asset base already serves as collateral for our existing outstanding debt. Our placement agreement with Ladenburg Thalmann & Co., Inc. restricts us from raising investment capital during the term of a Common Stock Purchase Agreement we entered with Coxton, Limited in April 2000 except through the Coxton Common Stock Purchase Agreement. At the current time, it is not feasible to issue common stock under that agreement due to holding restrictions that limit Coxton's ownership to no more than 9.9% of our stock at any time and is further limited by the delisting of our shares from the NASDAQ SmallCap Market in October, 2000. If we need capital but are unable to draw down under the Common stock Purchase Agreement for the aforementioned or any other reasons, we will need to separately negotiate with Ladenburg Thalmann and Coxton to lift those restrictions so we can obtain the capital from other sources. Our common stock purchase agreement with Coxton also limits our ability to sell our securities for cash at a discount to the market price for 24 months from the effective date of a registration statement related to the shares of common stock that may be issued to Coxton. Our revenues and operating results may fluctuate, which could result in continued fluctuations in the price of our common stock and further limit our ability to secure additional funding from other sources as well. Therefore, we may not be able to obtain additional financing on terms favorable to us, if at all. If adequate funds are not available or are not available on terms favorable to us, we may not be able to effectively execute our business plan. 5. Existing indebtedness and related debt service requirements could adversely affect Aquis' business operations. A high amount of debt burdens our operations in several ways, including limiting our ability to borrow money and requiring us to use our cash flow to repay our borrowings. We have borrowed a large amount of money from our lenders, FINOVA Capital Corporation and AMRO International, S.A., and we expect to continue to be highly leveraged. Our high degree of debt may have adverse consequences for us. These include the following: o High amounts of debt may limit or eliminate our ability to obtain additional financing on acceptable terms, if at all, that may be necessary for acquisitions, working capital, capital expenditures or other purposes. o A substantial portion of our cash flow will be required to pay interest expenses; although we are not currently meeting debt service requirements, the terms of our forbearance agreements require such payments to be made on a cumulative basis on December 31, 2001; this will reduce or fully consume the funds which would otherwise be available to us for operations and future business opportunities. o Our credit agreements with our lenders contain financial and restrictive covenants; our failure to comply with these covenants have resulted in defaults which, if not cured or waived, could result in a demand for immediate payment of amounts due to either, or both, our senior and junior lenders. Resources currently available to us will be insufficient to meet such a demand. o We may be more highly leveraged than our competitors, which may place us at a competitive disadvantage. o Our high degree of debt will make us more vulnerable to a downturn in our business or the economy generally. 6. Our debt agreements impose operating and financial limitations that, if not met, could result in a demand for immediate repayment of outstanding debt that we would presently be unable to satisfy. Our loan agreements and related forbearance agreements limits or restricts, among other things, our ability to: o declare dividends or redeem or repurchase capital stock; o prepay or redeem debt; o incur liens and engage in sale/leaseback transactions; o make loans and investments; o incur indebtedness and contingent obligations; o amend or otherwise alter debt instruments and other material agreements; o engage in mergers, consolidations, acquisitions and asset sales; and o engage in transactions with affiliates. Our ability to comply with covenants contained in our loan or forbearance agreements may be affected by events beyond our control, including prevailing economic, market, and financial conditions. Upon the occurrence of an event of default, our lenders could elect to declare all amounts outstanding to be immediately due and payable, together with accrued and unpaid interest. We do not have sufficient liquid resources at present to enable repayment to be made to satisfy such a demand. Further, we are not able to provide any assurance that if the debt holders were to make such a demand, we would be able to further secure, pay or refinance this debt on sufficiently favorable terms. If our senior secured lender accelerated the repayment of such indebtedness, there can be no assurance that our assets would be sufficient to repay such indebtedness in full. If we were unable to repay any such amounts, our senior secured lender could proceed against the collateral securing our indebtedness. Further, although FINOVA has modified portions of our debt covenants in the past, and has modified certain financial covenant ratios most recently in connection with our forbearance agreement, we can provide no assurance that such modifications will be made in the future. Finally, our forbearance agreements with FINOVA and AMRO require us to pay all amounts due to them on December 31, 2001. Our existing asset base will not allow us to make such payments and we cannot provide any assurance that we will be able to obtain modifications to our loan agreements that will enable us to continue as a going concern. 7. Most of Aquis' assets are intangible assets. The value of such assets is determined by factors beyond our control. Aquis would be unable to satisfy its outstanding debt if demand for payment was made and liquidation of this collateral was required. Most of our assets are intangibles, consisting primarily of FCC licenses and certificates and also including subscriber lists. At December 31, 2000, we wrote down the carrying value of our licenses by $9,500,000 to their estimated realizable value. We also wrote off all previously-deferred financing costs in the approximate amount of $1,650,000 as the result of our defaults under our loan agreements. At December 31, 2000, Aquis' total assets were about $23 million with our net intangible assets making up about 31% of that total. If we were required to satisfy our debt requirements if, for example, demand for payment of our loans was made, we became insolvent or were otherwise required to liquidate, our lenders could proceed against our assets to satisfy our debts to them. The value of these assets might not be sufficient to satisfy those debts because, for example, changes in technology, regulation, competing services or lack of alternative financing could diminish the value of those assets. 8. Technological advancements could bring added competition to our service line. Future advancements in wireless communications services such as cellular and PCS could create new or lower cost services that would compete with our existing service offerings. Additional competition could result in reductions in Aquis' subscriber base, declining revenues and smaller operating margins. Narrowband PCS, providing advanced messaging capabilities, and broadband PCS, providing wireless phone service along with paging capabilities, could both affect our subscriber base as service becomes more prevalent and prices fall. We cannot provide any assurance that we will be able to introduce new and competitive services in a timely fashion, if at all, nor can we represent that our margins, inventory costs or cash flows will be unaffected by these developments. 9. Industry competitors and ongoing consolidation could impair our ability to maintain our subscriber base, resulting in lower earnings. The telecommunications industry is extremely competitive. Some of our competitors, which include local, regional and national paging companies, possess greater financial, technical and other resources than we do and may therefore be better able to complete strategic business acquisitions or to compete for subscribers in the one-way paging marketplace. Moreover, some of our competitors currently offer broader network coverage than that provided by our systems and some follow a low-price discounting strategy to expand their market shares. The paging industry has experienced, and will continue to experience, consolidation due to factors that favor larger, multi-market paging companies, including: o the ability to obtain additional radio spectrum; o greater access to capital markets and lower costs of capital; o broader geographic coverage of paging systems; o economies of scale in the purchase of capital equipment; o operating efficiencies due to scale; and o better access to executive personnel. One of the most notable recent business combinations was that of Arch Communications and Pagenet, giving the combined entity about 11 million units in service and a very broad and pervasive paging network. This consolidation trend may further intensify competition in our industry. We cannot assure investors that we will be able to overcome each of the challenges resulting from developments in our industry. 10. We may not be able to identify, finance or integrate suitable businesses to acquire. This would impair our ability to execute our business plan for growth and remain competitive. A key element of our longer term business strategy is to diversify our business and product lines through acquisitions of companies with businesses that will complement and enhance our own. A variety of wireless one-way and two-way communication technologies, including cellular telephone service, personal communications services, enhanced specialized mobile radio, low-speed data networks, mobile satellite services and advanced two-way paging services, are currently in use or under development. Although those technologies are generally higher-priced than one-way paging service or not yet commercially available, technological improvements are creating increased capacity and demand for wireless two-way communication. Accordingly, our business strategy contemplates targeted acquisitions of complementary communications businesses. However, we cannot assure investors that we will be able to successfully diversify our business or incorporate new technologies so as to keep our product and service offerings competitive. Because we do not have extensive cash resources or an acquisitions line of credit available to us, it may be difficult for us to respond to changes in technology because we cannot pay for or finance the purchase of new equipment or services. If we do not make acquisitions on economically acceptable terms and integrate acquired businesses successfully, our future growth and financial performance will be limited. In addition, the process of integrating acquired businesses may involve unforeseen difficulties and/or require a disproportionate amount of our time, attention and resources from time to time. We may not achieve some of the expected benefits of acquisitions that we may execute if the existing operations of such companies are not successfully integrated with our own in a timely manner. Even if integrated in a timely manner, there can be no assurance that our operating performance after acquisitions will be successful or will fulfill management's objectives. The integration of businesses we acquire will require, among other things, coordination of administrative, sales and marketing, distribution and accounting and finance functions and expansion of information and management systems. The integration process could cause the interruption of the activities of the two businesses or the diversion of attention and resources from the businesses' primary operational goals. The difficulties of such integration may initially be increased by the necessity of coordinating geographically separate organizations and integrating personnel with disparate business backgrounds and corporate cultures. We may not be able to retain key employees. The process of integrating newly acquired businesses may require a disproportionate amount of time and attention of our management and financial and other resources and may involve other, unforeseen difficulties. The success of our growth strategy will also depend on numerous other contingencies beyond our control, including national and regional economic conditions, interest rates, competition, changes in regulation or technology and our ability to attract and retain skilled employees. As a result, we cannot assure investors that our growth and business strategies will prove effective or that we will achieve our goals. 11. Government regulation may make our operations more difficult and costly. Our business is dependent on FCC licenses that may not be renewed, which would result in a significant reduction in our business. These licenses have varying terms of up to 10 years, at the end of which renewal applications must be made to and reviewed by the FCC. Renewals are typically granted by the FCC upon a demonstration of compliance with FCC regulations and of adequate service to the public. Although we are unaware of any circumstances which would prevent the grant of any pending or future renewal applications, we cannot assure investors that any of our renewal applications will be free of challenge. There may be competition for the radio spectrum associated with our FCC licenses at the time they expire, which could increase the chances of third party interventions in the renewal proceedings. We cannot assure investors that our applications for renewal of our FCC licenses will be granted. Future changes in regulatory environment may adversely affect our business, making it harder or more expensive to run our business. The wireless communications industry is subject to regulation by the FCC and various state regulatory agencies. From time to time, legislation and regulations which could potentially adversely affect us are proposed by federal and state legislators. We cannot assure investors that federal or state legislation or regulations will not be adopted that would adversely affect our business by making it harder or more expensive to conduct our operations. 12. We may not be able to attract or retain key personnel, which could impair our ability to compete within our industry. Our success will depend largely on our ability to attract, retain, train and motivate key employees. There is significant competition in the employment marketplace for qualified and motivated personnel and it is likely that our ability to attract additional qualified staff as and when required will remain limited for the foreseeable future. Many of our competitors are in a better financial position than Aquis to attract and reward such personnel sufficiently to ensure their ongoing employment. Risks Related to Our Common stock 13. We have anti-takeover defenses that could prevent, deter or delay any change in control of Aquis and impair the price of its common stock. Delaware corporation law, Aquis' certificate of incorporation and its bylaws could prevent, deter or delay a change in control of Aquis and adversely affect the price of our common stock. These defenses include: o An authorized class of 1,000,000 shares of "blank check" preferred stock which may be issued by the Board of Directors on such terms and with such rights, preferences and designations as the Board may determine o Certain "anti-takeover" provisions of the Delaware General Corporation Law that restrict the ability of certain "interested" stockholders to acquire control of our company. These "anti-takeover" provisions might discourage prospective acquirers from attempting to bid for our outstanding shares and therefore may be considered disadvantageous by certain investors. We have no control over, and therefore cannot predict, what effect these impediments to the ability of third parties to acquire control of us might have on the market price of our common stock o Our loan agreement with our senior lender includes provisions that may limit the staffing of Chief Operating Officer and President roles to parties acceptable to it in its sole discretion. 14. Aquis common stock is volatile and presents financial risk to an investor. The price at which our stock trades has been volatile since our inception and is expected to continue to experience significant fluctuations. The value of our common stock will contunue to be affected by numerous factors. These may include the affects of our own financial performance in relation to that of our competitors as well as that of other investment opportunities. These may also include other factors that are beyond our direct control, such as communications industry stock performance in general, technological advancements related to competing products and services, and the financial results and trading prices of shares of other publicly traded companies in our industry. Volatility is expected to increase an investor's financial risk and loss of investment capital may result. Increased volatility and decreased liquidity may result from the marketplace in which our shares trade. Stocks that trade on the Over the Counter Bulletin Board, such as ours, may experience lower trading volume than if traded in the NASDAQ SmallCap Market or one of the more well-known stock exchanges. Lower trading volume may create a supply/demand imbalance, making more difficult the effort to find willing buyers at favorable prices at a time when an investor might wish to sell his shares. Further, to the extent that our shares do experience lower trading volumes and decreased trading liquidity, our ability to raise additional capital through future sales of our shares into the investment markets may be hampered as potential investors are typically more attracted to stocks that exhibit greater levels of liquidity. This same liquidity issue may decrease our ability to use our common stock as payment of any portion of the purchase price in any future business combination, limiting our growth capabilities and pressuring our stock price. Decreased liquidity and increased volatility may also arise from the application of the "penny stock" rules to which our shares are now subject. The penny stock rules generally apply to a stock that is not listed on a national securities exchange or NASDAQ, is listed on the "pink sheets" or on the OTC Bulletin Board, trades at less the $5.00 per share and is issued by a company with net tangible assets of less than $5 million. The penny stock rules impose significant restrictions on broker-dealers that tend to lessen or limit their incentives to trade such shares. Some broker-dealers will not trade penny stocks except on an unsolicited basis. This may tend to decrease trading liquidity associated with our shares in relation to that of other companies whose shares are not subject to these same requirements. Negative effects on volume and volatility are also expected as the result of the restrictions applicable to our ability to pay dividends. We do not intend to pay dividends for the forseeable future, making our shares less attractive to investors seeking such a return on invested capital. Our credit agreement with FINOVA presently prohibits payment of dividends until our loans are paid off, and our business plans call for us to retain earnings, if any, for reinvestment in our business. We are additionally prohibited from paying dividends by the terms of our preferred stock indenture until amounts due to preferred stockholders are paid in full. Further, Delaware General Corporation Law requires that dividends be paid only from capital surplus or certain specified classes of retained earnings, of which we currently have none. We can offer no assurance that our Board of Directors will authorize any dividend payments if cash becomes available and if the other limitations on our ability to pay dividends are satisfied and removed. Finally, dilution caused by possible future issuances of our common stock may negatively influence any shareholder's interest in our net assets or earnings, if any, and may increase the volatility of our share price. Such issuances may result from conversion of AMRO's debenture, exercise of currently outstanding warrants, such as those included in this registration statement, or from any other future transactions involving our common stock into which we may enter. 15. Additional shares will be available for sale in the public market. This could cause the market price of our stock to drop further. We estimate that approximately 7.6 million shares of our common stock are currently eligible for resale under applicable securities laws. We expect to further facilitate the resale of an additional 10.6 million common shares, previously issued and outstanding but unregistered, by including them in this registration statement. We also expect to similarly facilitate the sale and re-sale of 4.2 million additional shares that may be issued upon AMRO's election to convert its debenture or upon the exercise of warrants previously granted. Sales of these shares would increase the number of shares eligible for public trading, could further depress the market price of our stock, and make it more difficult for us to sell stock under our equity line of credit or through any other future offering. Further, such sales could encourage short sales at such future date at which our shares may be eligible for such trading activity. Our convertible debenture with AMRO International and the equity line of credit we have with Coxton Limited could also have the effects noted above. The limits as to the number of shares issuable to AMRO upon conversion of the debenture was waived by AMRO in April 2001, then was subsequently revoked at their election. AMRO can again waive this limit and has the ability to either acquire substantial amounts of our stock in a single transaction or in several smaller transactions. The equity line with Coxton can similarly result in the acquisition of large numbers of shares by them. In the event that such shares are acquired and resold, the added volume of shares in the trading markets will exert downward pressure on our share value. Subsequent additional purchases of our shares by AMRO, through conversion of any remaining balance of the debenture, or by Coxton under the line of credit, will further depress the market price of our shares. 16. Significant dilution will result from the issuance of additional shares under terms of agreements with AMRO International, Coxton Limited, and from presently unexercised warrants and options. Our sale of shares upon conversion of the debenture due to AMRO International, at prices below the market price of our common stock, will have a dilutive impact on our stockholders. That convertible debenture permits AMRO to convert up to the full $2,000,000 original principal amount and accrued and unpaid interest into shares of our common stock at prices below the market price for our stock at the time of any conversion. This arrangement with AMRO may have a dilutive effect on our current and future stockholders. For example, o On the basis of the price at which AMRO could convert the debenture as of September 21, 2001, we would be required to issue to AMRO approximately 55,056,000 shares of our common stock (as calculated as set forth in footnote 2 below), representing 312% of our outstanding common stock as of September 21, 2001 and 76% of our common stock if all of that stock was issued to AMRO. o Because the number of shares that would be issued to AMRO if it converted the debenture to common stock changes as the price of our common stock changes, we cannot predict how many shares we will issue to AMRO. If our stock price declined by 25%, 50% and 75%, respectively, we would be required to issue AMRO more common stock: Shares issuable to Price (1) AMRO (2) --------- ------------- $0.045................... .......................... 55,056,000 $0.0338 (25% reduction)............................. 73,408,000 $0.0225 (50% reduction)............................. 110,112,000 $0.0113 (75% reduction)............................. 220,225,000 ----------- (1) Calculated as 90% of the average of the five lowest closing bid prices for our common stock during a period of 22 trading days prior to the conversion date, assumed to be September 24, 2001 for purposes of this illustration. (2) Calculated without giving effect to limitation in debenture that prohibits AMRO from converting portions of the principal of the debenture which, if converted, would result in AMRO holding more than 9.9% of our common stock. AMRO has the right to waive this limitation, and exercised that right in April 2001 then reversed that election about a month later. As a result of that such election, the number of shares that AMRO could acquire upon conversion of its debenture could result in a change in control of Aquis. o If AMRO was to resell many of the shares to the public after conversion of the debenture, the additional number of shares could cause our stock price to fall, which might ultimately increase the number of shares we would be required to issue to AMRO. We have also entered into an agreement with an investor, Coxton Limited, that may result in the issuance of our common stock to the investor at a discount to the then-prevailing market price of our common stock. Accordingly, the issuance of such shares will dilute, on a percentage basis, the ownership interests of stockholders as of the time of the issuance and may have dilutive impact on our stockholders on a per share basis. Discounted sales resulting from issuance to the investor could have an immediate adverse effect on the market price of the common stock. Also, to the extent that Coxton may sell the shares into the market, the price of our shares may decrease due to the additional shares in the market. If Coxton was to resell to the investing public some or all of the shares they might purchase from us, the additional number of shares could cause our stock price to fall, which might ultimately increase the number of shares we would be required to issue to Coxton with any subsequent drawdown. This agreement with Coxton currently excludes the Over The Counter market as a principal market. Accordingly, Coxton is presently under no obligation to purchase any of our shares, although it has not terminated the agreement with a written notification at this time. Finally, our agreement to purchase the assets of Suburban Connect, L.P. required us to issue approximately 645,000 additional shares in May 2001 in connection with the completion of that transaction, because the trading range for Aquis common stock did not exceed $1.66 through the specified measurement date of April 16, 2001. This issuance results in additional dilution of our tangible net worth and could impact future earnings per share, if any. The issuance of further shares and the eligibility of issued shares for resale will dilute our common stock and may lower the price of our common stock. If you invest in our common stock, your interest will be diluted to the extent of the difference between the price per share you pay for the common stock and the pro forma as adjusted net tangible book value per share of our common stock at the time of sale. We calculate net tangible book value per share by calculating the total assets less goodwill, deferred debt issuance costs and total liabilities, and dividing it by the number of outstanding shares of common stock.

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+RISK FACTORS An investment in our securities involves a high degree of risk. You should carefully consider the risks and uncertainties described below and the other information in this prospectus before deciding whether to invest in shares of our common stock. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also impair our business operations. If any of the following risks actually occur, our business, financial condition and operating results could be materially adversely affected. In such case, the trading price of our common stock could decline and you may lose part or all of your investment. RISKS RELATING TO OUR FINANCIAL CONDITION WE ARE EXPERIENCING LIQUIDITY PROBLEMS AND MAY HAVE INDICATIONS OF "GOING CONCERN" CONDITIONS. Our audited consolidated financial statements include a "going concern" explanatory paragraph (see Note 2 to our consolidated financial statements), which discuss certain conditions that could impact our ability to continue operations under the current business conditions given our recurring losses, negative cash flows and substantial difficulties in meeting our obligations. We cannot be sure that our cash and cash equivalents on hand and our cash availability will be sufficient to meet our anticipated working capital needs and capital expenditures. We have begun to address the "going concern" issue and the underlying liquidity problem through the Del Monte transaction and a fundamental change in our business strategy. To finance current and future expenditures, we are engaging in this rights offering. Also, we may have to issue additional equity securities and will need to incur additional debt or refinance existing debt. We may not be able to obtain additional required capital on satisfactory terms, if at all. WE MAY CONTINUE TO SUSTAIN LOSSES AND ACCUMULATED DEFICITS IN THE FUTURE. We have sustained net losses over the last four fiscal years and in the first three months of 2001. As of March 31, 2001 our accumulated deficit was $35.9 million. Our ability to achieve profitability in the future will depend on many factors, including our ability to produce and market commercially acceptable products into foreign countries while reducing operating costs. Because we were not profitable in the last four years there can be no assurance that we will achieve a profitable level of operations in fiscal 2001 or, if profitability is achieved that it can be sustained. WE ARE DEPENDENT UPON A LIMITED NUMBER OF CUSTOMERS. We have a limited number of customers. On August 31, 2000, we sold of our Sunfresh(R) brand to Del Monte and then entered into a long-term supply agreement to supply a minimum quantity of chilled and canned citrus products for distribution by Del Monte under the Sunfresh(R) brand into the United States retail and wholesale club markets. As such, more than half of our foreseeable future net sales will be dependent on Del Monte. We believe that our future success depends upon the future operating results of Del Monte with respect to the Sunfresh(R) brand and in their ability to broaden the customer base of the Sunfresh(R) brand products. Although the long-term supply agreement requires Del Monte to purchase minimum quantities of product, there can be no assurances that Del Monte will not reduce, delay or eliminate purchases from us, which could have a material adverse affect on our results of operations and financial condition. In addition, Del Monte has significant leverage and could attempt to change the terms, including pricing and volume, upon which we and Del Monte do business, thereby adversely affecting our results of operations and financial condition. WE ARE SUBJECT TO COMMODITY PRICE RISKS. We are subject to market price fluctuations for processed citrus juice. The world market price of frozen concentrate orange juice ("FCOJ") is established by the FCOJ futures market which is very sensitive to the projected annual size of crop harvest and weather conditions, primarily in Florida and Brazil. The Mexican crop size has very little influence, if any, on the quoted FCOJ future prices. We do not use the FCOJ futures market to hedge fruit and FCOJ inventory to reduce price risk. As a result, our selling prices for FCOJ are generally determined by reference to the commodity futures market price, over which we have no control. If the FCOJ futures market prices continue to remain at current depressed levels, our operations and financial condition could be materially adversely affected. WE ARE SUBJECT TO RISKS ASSOCIATED IN IMPLEMENTATION OF OUR BUSINESS STRATEGY. We are subject to our ability to implement our business strategy and improve our operating results, which will depend in part on our ability to realize significant cost savings associated with our supply agreement with Del Monte through operating efficiencies, achieve additional sales penetration for products sold into foreign markets and develop new products in our juice and oil business segment. No assurance can be given that we will be able to achieve such goals or that, in implementing cost saving measures, it will not impair our ability to respond rapidly or efficiently to changes in the competitive environment. In such circumstances, our results of operations and financial condition could be materially adversely affected. ADDITIONAL FINANCING MAY BE REQUIRED TO ACHIEVE OUR GROWTH. If we do not achieve or maintain significant revenues or profitability or have not accurately predicted our cash needs, or if we decide to change our business plans, we may need to raise additional funds in the future. There can be no assurance that we will be able to raise additional funds on favorable terms or at all, or that such funds, if raised, will be sufficient to permit us to manufacture and distribute our products. If we raise additional funds by issuing equity securities, shareholders may experience dilution in their ownership interest. If we raise additional funds by issuing debt securities, we may incur significant interest expense and become subject to covenants that could limit our ability to operate and fund our business. If additional funds are not available when required, we may be unable to effectively realize our current plans. RISKS RELATING TO OUR MEXICAN OPERATIONS WE ARE SUBJECT TO THE RISK OF FLUCTUATING FOREIGN CURRENCY EXCHANGE RATES AND INFLATION. We are subject to market risk associated with adverse changes in foreign currency exchange rates and inflation in our operations in Mexico. Our consolidated results of operations are affected by changes in the valuation of the Mexican peso to the extent that our Mexican subsidiaries have peso denominated net monetary assets or net monetary liabilities. In periods where the peso has been devalued in relation to the U.S. dollar, a gain will be recognized to the extent there are peso denominated net monetary liabilities while a loss will be recognized to the extent there are peso denominated net monetary assets. In periods where the peso has gained value, the converse would be recognized. Our consolidated results of operations are also subject to fluctuations in the value of the peso as they affect the translation to U.S. dollars of Mexican subsidiaries net deferred tax assets or net deferred tax liabilities. Since these assets and liabilities are peso denominated, a falling peso results in a translation loss to the extent there are net deferred tax assets or a translation gain to the extent there are net deferred tax liabilities. Pricing associated with the long-term supply agreement entered into with Del Monte is in U.S. dollars. Our exposure to foreign currency exchange rate risk is difficult to estimate due to factors such as balance sheet accounts, and the existing economic uncertainty and future economic conditions in the international marketplace. Significant fluctuations in the exchange rate of the Mexican peso compared to the U.S. dollar, as well as the Mexican inflation rate, could significantly impact our ability to fulfill our contractual obligations under the Del Monte supply agreement in a profitable manner, which could result in a material adverse effect upon results of operations and financial conditions. WE ARE DEPENDENT UPON FRUIT GROWING CONDITIONS, ACCESS TO WATER AND AVAILABILITY AND PRICE OF FRESH FRUIT. We grow oranges, grapefruit and pineapples used in our packaged fruit operations and grow Italian lemons pursuant to the terms of a long-term supply agreement (the "Lemon Project") with an affiliate of Coca-Cola. Severe weather conditions, lack of water and natural disasters, such as floods, droughts, frosts, earthquakes or pestilence, may affect the supply of one or more of our products and could significantly impact the development of the Lemon Project. A substantial amount of our growing operations are irrigated and a lack of water has not had a material adverse effect on our growing operations for many years. There can be no assurances that future weather conditions and lack of irrigation water will not have a material adverse effect on results of operations and financial conditions. In addition, we also source a substantial amount of our raw materials from third-party suppliers throughout various growing regions in Mexico and Texas. A crop reduction or failure in any of these fruit growing regions resulting from factors such as weather, pestilence, disease or other natural disasters, could increase the cost of our raw materials or otherwise adversely affect our operations. Competitors may be affected differently depending upon their ability to obtain adequate supplies from sources in other geographic areas. If we are unable to pass along the increased raw material costs, the financial condition and results of operations could be materially adversely affected. LABOR SHORTAGES AND UNION ACTIVITY CAN AFFECT OUR ABILITY TO HIRE AND WE ARE DEPENDENT ON THE MEXICAN LABOR MARKET. We are heavily dependent upon the availability of a large labor force to produce our products. The turnover rate among the labor force is high due to the strenuous work, long hours and relatively low pay. If it becomes necessary to pay more to attract labor to farm work, our labor costs will increase. The Mexican agricultural work force, whether seasonal or permanent, are generally affiliated with labor unions which are generally affiliated with a national confederation. If the unions attempt to disrupt production and are successful on a large scale, labor costs will likely increase and work stoppages may be encountered, which could be particularly damaging in our industry where the harvesting season for citrus crops occur at peak times and getting the fruit processed and packed on a timely basis is critical. WE ARE SUBJECT TO STATUTORY EMPLOYEE PROFIT SHARING IN MEXICO. All Mexican companies are required to pay their employees, in addition to their agreed compensation benefits, profit sharing in an aggregate amount equal to 10% of net income, calculated for employee profit sharing purposes, of the individual corporation employing such employees. All of our Mexican employees are employed by our Mexican subsidiaries, each of which pays profit sharing in accordance with its respective net income for profit sharing purposes. Statutory employee profit sharing expense is reflected in our cost of goods sold and selling, general and administrative expenses, depending upon the function of the employees to whom profit sharing payments are made. Our net income on a consolidated basis as shown in the consolidated financial statements is not a meaningful indication of net income of our subsidiaries for profit sharing purposes or of the amount of employee profit sharing. WE ARE SUBJECT TO VOLATILE INTEREST RATES IN MEXICO, WHICH COULD INCREASE OUR CAPITAL COSTS. We are subject to volatile interest rates in Mexico. Historically, interest rates in Mexico have been volatile, particularly in times of economic unrest and uncertainty. High interest rates restrict the availability and raise the cost of capital for our Mexican subsidiaries and for growers and other Mexican parties with whom we do business, both for borrowings denominated in pesos and for borrowings denominated in dollars. Costs of operations for our Mexican subsidiaries could be higher as a result. TRADE DISPUTES BETWEEN THE UNITED STATES, MEXICO AND EUROPE CAN RESULT IN TARIFFS, QUOTAS AND BANS ON IMPORTS, INCLUDING OUR PRODUCTS, WHICH CAN IMPAIR OUR FINANCIAL CONDITION. We are subject to trade agreements between Mexico, the United States and Europe. Despite the enactment of the North American Free Trade Agreement, Mexico and the United States from time to time are involved in trade disputes. The United States has, on occasion, imposed tariffs, quotas, and importation limitations on products produced in Mexico. Because all of our products are currently produced by our subsidiaries in Mexico, which we sell in the United States and Europe, such actions, if taken, could adversely affect our business. WE ARE SUBJECT TO GOVERNMENTAL LAWS THAT RELATE TO OWNERSHIP OF RURAL LANDS IN MEXICO. We own or lease, on a long-term basis, approximately 7,500 acres of rural land in Mexico, which is used for production of the Lemon Project. Historically, the ownership of rural land in Mexico has been subject to governmental regulations, which in some cases could lead to the owner being unable to sell his land to companies putting together significant land concentrations. Although we have not experienced any major legal disputes in obtaining the land for the Lemon Project, there can be no assurance that we will be able to obtain large blocks of land for future growing projects without incurring government resistance. GENERAL BUSINESS RISKS WE MAY BE SUBJECT TO PRODUCT LIABILITY AND PRODUCT RECALL. We produce a consumer product that is subject to product recall. The testing, marketing, distribution and sale of food and beverage products entail an inherent risk of product liability and product recall. There can be no assurance that product liability claims will not be asserted against us or that we will not be obligated to recall our products. Although we maintain product liability insurance coverage in the amount of $11,000,000 per occurrence, there can be no assurance that this level of coverage is adequate. A product recall or a partially or completely uninsured judgment against us could have a material adverse effect on results of operations and financial condition. WE ARE SUBJECT TO GOVERNMENTAL AND ENVIRONMENTAL REGULATIONS. We are subject to numerous domestic and foreign governmental and environmental laws and regulations as a result of our agricultural, food and juice processing activities. The Food and Drug Administration ("FDA"), the United States Department of Agriculture ("USDA"), the Environmental Protection Agency, and other federal and state regulatory agencies in the United States extensively regulate our activities in the United States. The manufacturing, processing, packing, storage, distribution and labeling of food and juice products are subject to extensive regulations enforced by, among others, the FDA and to inspection by the USDA and other federal, state, local agencies. Applicable statutes and regulations governing food products include "standards of identity" for the content of specific types of foods, nutritional labeling and serving size requirements and under "Good Manufacturing Practices" with respect to production processes. We believe that our products satisfy, and any new products will satisfy, all applicable regulations and that all of the ingredients used in our products are "Generally Recognized as Safe" by the FDA for the intended purposes for which they will be used. Failure to comply with applicable laws and regulations could subject us to civil remedies, including fines, injunctions, recalls or seizures, as well as potential criminal sanctions, which could have a material adverse effect on results of operations and financial condition. The Secretaria de Agricultura, Ganaderia y Desarrollo Rural, the Secretaria de Salud, and other federal and state regulatory agencies in Mexico extensively regulate our Mexican operations. Many of these laws and regulations are becoming increasingly stringent and compliance with them is becoming increasingly expensive. On a daily basis, we test our products in our internal laboratories and, periodically, submit samples of our products to independent laboratories for analysis. Failure to comply with applicable laws and regulations could subject us to civil remedies, including fines, injunctions, recalls or seizures, as well as potential criminal sanctions, which could have a material adverse effect on results of operations and financial condition. Although we believe that our facilities are currently in compliance with all applicable environmental laws, failure to comply with any such laws could have a material adverse effect on results of operations and financial condition. WE ARE DEPENDENT UPON OUR MANAGEMENT TEAM. We rely on the business, technical expertise and experience of our senior management and certain other key employees. The loss of the services of any of these individuals could have a material adverse effect on results of operations and financial condition. We believe that our future success is also dependent upon our ability to continue to attract and retain qualified personnel in all areas of our business. No senior members of our Mexican operations are bound by non-compete agreements, and if such members were to depart and subsequently compete with us, such competition could have a material adverse effect on results of operations and financial condition. WE HAVE A SEASONAL BUSINESS. We are a seasonal business and, as with any agribusiness, demand for our citrus and tropical fruit products is strongest during the fall, winter and spring when many seasonal fresh products are not readily available for sale in supermarkets in North America. In addition, a substantial portion of our exports to Japan are processed and shipped during the first and fourth quarter each year. Management believes our quarterly net sales will continue to be impacted by this pattern of seasonality. WE FACE STRONG COMPETITION. We operate in a highly competitive market. The food industry, including each of the markets in which we compete, is highly competitive with respect to price and quality, including taste, texture, healthfulness and nutritional value. We face direct competition from citrus processors with respect to our existing product lines and face potential competition from numerous, well established competitors possessing substantially greater financial, marketing, personnel and other resources than we do. Our fruit juice products compete broadly with all beverages available to consumers. In addition, the food industry is characterized by frequent introduction of new products, accompanied by substantial promotional campaigns. In recent years, numerous companies have introduced products positioned to capitalize on growing consumer preference for fresh fruit products. It can be expected that we will be subject to increasing competition from companies whose products or marketing strategies address these consumer preferences. Additionally, the level of price competition in the frozen concentrate orange juice ("FCOJ") industry is primarily driven by the United States and Brazil. These two countries dominate the world production of FCOJ by annual harvesting large quantities of oranges specifically for the juice processing industry. In other countries, such as Mexico and Spain, the fruit processing industry is a residual market. This implies that while prices for fresh fruit in both the United States and Brazil are driven by the FCOJ industry and the size of the annual crops, in Mexico the prices for FCOJ are driven by the fresh fruit market prices. WE ARE SUBJECT TO INTEREST RATE CHANGES. Our interest expense is most sensitive to changes in the general level of U.S. interest rates, Mexican interest rates and London Interbank Offered Rates ("LIBOR"). In this regard, changes in these interest rates affect the interest paid on our debt. At March 31, 2001, U.S. dollar denominated long-term debt amounted to $4.6 million as compared to Mexican peso denominated long-term debt of $5.6 million. RISKS RELATING TO OUR COMMON STOCK THE RECENT DELISTING FROM THE NASDAQ NATIONAL MARKET MAY REDUCE THE LIQUIDITY AND MARKETABILITY OF OUR STOCK AND MAY DEPRESS THE MARKET PRICE OF OUR STOCK. On March 15, 2001, Nasdaq delisted our common stock from The Nasdaq National Market and moved our stock to the Over-the Counter Electronic Bulletin Board ("OTC Bulletin Board") under the symbol "UNMG.OB". Although our securities are included on the OTC Bulletin Board, there can be no assurance that a regular trading market for the securities will be sustained in the future. The OTC Bulletin Board is an unorganized, inter-dealer, over-the-counter market which provides significantly less liquidity than The Nasdaq Stock Market, and quotes for stocks included on the OTC Bulletin Board are not listed in the financial sections of newspapers as are those for The Nasdaq Stock Market. Therefore, prices for securities traded solely on the OTC Bulletin Board may be difficult to obtain. The reduced liquidity of our stock and the reduced public access to quotations for our stock could depress the market price of our stock. "PENNY STOCK" REGULATIONS MAY IMPOSE RESTRICTIONS ON MARKETABILITY OF OUR STOCK. The Securities and Exchange Commission has adopted regulations which generally define "penny stock" to be any equity security that is not traded on a national securities exchange or Nasdaq and that has a market price of less than $5.00 per share or an exercise price of less than $5.00 per share, subject to certain exceptions. Since our securities that are currently included on the OTC Bulletin Board are trading at less than $5.00 per share at any time, our stock may become subject to rules that impose additional sales practice requirements on broker-dealers who sell such securities to persons other than established customers and accredited investors. Accredited investors generally include investors that have assets in excess of $1,000,000 or an individual annual income exceeding $200,000, or, together with the investor's spouse, a joint income of $300,000. For transactions covered by these rules, the broker-dealer must make a special suitability determination for the purchase of such securities and have received the purchaser's written consent to the transaction prior to the purchase. Additionally, for any transaction involving a penny stock, unless exempt, the rules require, among other things, the delivery, prior to the transaction, of a risk disclosure document mandated by the SEC relating to the penny stock market and the risks associated therewith. The broker-dealer must also disclose the commission payable to both the broker-dealer and the registered representative, current quotations for the securities and, if the broker-dealer is the sole market-maker, the broker-dealer must disclose this fact and the broker-dealer's presumed control over the market. Finally, monthly statements must be sent disclosing recent price information for the penny stock held in the account and information on the limited market in penny stocks. Consequently, the penny stock rules may restrict the ability of broker-dealers to sell our securities and may affect the ability of stockholders to sell our securities in the secondary market. OUR STOCK PRICE HAS BEEN AND MAY CONTINUE TO BE HIGHLY VOLATILE. The price of our common stock has been particularly volatile and will likely continue to fluctuate in the future. Announcements of chronological innovations, regulatory matters or new commercial products by us or our competitors, developments or disputes concerning patent or proprietary rights, publicity regarding actual or potential product results relating to products under development by us or our competitors, regulatory developments in both the United States and foreign countries, public concern as to the safety of pharmaceutical or dietary supplement products, and economic and other external factors, as well as period-to-period fluctuations in financial results, may have a significant impact on the market price of our common stock. In addition, from time to time, the stock market experiences significant price and volume fluctuations that may be unrelated to the operating performance of particular companies or industries. The market price of our common stock, like the stock prices of many publicly traded smaller companies, has been and may continue to be highly volatile. WE HAVE NEVER PAID A DIVIDEND. We have never paid cash dividends on our common stock or any other securities. We anticipate that we will retain any future earnings for use in the expansion and operation of our business, and do not anticipate paying cash dividends in the foreseeable future. Additionally, the terms of our debt agreements limit the ability to pay dividends to holders of our common stock. RISKS RELATED TO THE RIGHTS OFFERING IF YOU DO NOT EXERCISE ALL OF YOUR SUBSCRIPTION RIGHTS, YOU MAY SUFFER SIGNIFICANT DILUTION OF YOUR PERCENTAGE OWNERSHIP OF OUR COMMON STOCK. This rights offering is designed to enable UniMark to raise capital while allowing all shareholders on the record date to maintain their relative proportionate voting and economic interests. Our largest shareholder, M & M Nominee has indicated that it intends to exercise its basic subscription privileges and over-subscription privileges to purchase 6,849,315 shares of common stock. To the extent that you do not exercise your subscription rights and shares are purchased by other shareholders in the rights offering, your proportionate voting interest will be reduced, and the percentage that your original shares represent of our expanded equity after exercise of the subscription rights will be disproportionately diluted. If no shareholders other than M & M Nominee exercise their basic subscription privileges, M & M Nominee's ownership interest in UniMark will increase to approximately 63.26% from approximately 45.2% and the ownership interest of the remaining shareholders, who currently own in the aggregate 54.8% of our common stock, will decrease to approximately 36.74%. WE HAVE A SIGNIFICANT SHAREHOLDER THAT CAN OBTAIN COMPLETE CONTROL OF OUR MANAGEMENT AND OPERATIONS. We have a significant shareholder, M & M Nominee, that owns approximately 45.2% of our outstanding common stock. By virtue of such ownership, M & M Nominee is able to have significant influence over the election of members of the Board of Directors and over the affairs and direction of operations. If no shareholders other than M & M Nominee exercise their subscription privileges, M & M Nominee's ownership interest in UniMark will increase to approximately 63.26% from 45.2%. As such, M & M Nominee could become our majority shareholder and would have the requisite voting power to significantly affect virtually all decisions made by us and our shareholders, including the power to elect all of our directors and to block corporate actions such as amendments to our articles of incorporation. THE PRICE OF OUR COMMON STOCK MAY DECLINE BEFORE OR AFTER THE SUBSCRIPTION RIGHTS EXPIRE. We cannot assure you that the public trading market price of our common stock will not decline after you elect to exercise your subscription rights. If that occurs, you will have committed to buy shares of common stock at a price above the prevailing market price and you will have an immediate unrealized loss. Moreover, we cannot assure you that following the exercise of subscription rights you will be able to sell your shares of common stock at a price equal to or greater than the subscription price. Until shares are delivered upon expiration of the rights offering, you may not be able to sell the shares of our common stock that you purchase in the rights offering. Certificates representing shares of our common stock purchased will be delivered as soon as practicable after expiration of the rights offering. We will not pay you interest on funds delivered to the Subscription Agent pursuant to the exercise of rights. ONCE YOU EXERCISE YOUR SUBSCRIPTION RIGHTS, YOU MAY NOT REVOKE THE EXERCISE. Once you exercise your subscription rights, you may not revoke the exercise, even if less than all of the shares that we are offering are actually purchased. If we elect to withdraw or terminate the rights offering, neither we nor the Subscription Agent will have any obligation with respect to the subscription rights except to return, without interest, any subscription payments.

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+RISK FACTORS You should carefully consider the risks described below before making a decision to buy our shares. If any of the following risks actually occur, our business could be harmed. In that event, the trading price of our shares might decline, and you could lose all or part of your investment. You should also refer to the other information set forth in this prospectus, including our consolidated financial statements and related notes. Risks Relating to Our Business and Industry A downturn in the markets we serve would likely negatively affect our net sales. The communications, computing, data storage, industrial and medical equipment markets of the electronics manufacturing services industry are characterized by intense competition, relatively short product life-cycles and significant fluctuations in product demand. In addition, these markets are generally subject to rapid technological change and product obsolescence. Recently, a number of original equipment manufacturers in the markets we serve have publicly announced that they have experienced a reduction in demand for their products. As a result of these market conditions, there is uncertainty in the demand for our services, which could rapidly and significantly fluctuate. A recession or any other event leading to excess capacity or a continued or increased downturn in the markets we serve would likely negatively affect our net sales. If any of these factors or other factors reduce demand for specific products or components that we design or manufacture for our customers, our net sales would likely be negatively affected. Furthermore, these industries are subject to economic cycles and have in the past experienced, and are likely in the future to experience, recessionary periods. We depend on a small number of customers for a significant portion of our net sales and the loss of any of our major customers would harm us. We depend on a relatively small number of customers for a significant portion of our net sales. Our three largest customers in fiscal 2001 were IBM, Motorola and Efficient Networks, which represented approximately 23%, 16% and 11% of our total net sales. In addition, our ten largest customers in fiscal 2001 accounted for approximately 70% of our net sales. We expect to continue to depend upon a relatively small number of customers for a significant percentage of our net sales. Because our major customers represent such a large part of our business, the loss of any of our major customers could negatively impact our business. Our major customers may not continue to purchase products and services from us at current levels or at all. In the past, we have lost customers due to the acquisition of our customers, product discontinuation and customers' shifting production of products to internal facilities. We may lose customers in the future for similar reasons. We may not be able to expand our customer base to make up any sales shortfalls if we lose a major customer. Our attempts to diversify our customer base and reduce our reliance on particular customers may not be successful. Our business is not typified by long-term contracts, and cancellations, reductions or delays in customer orders would adversely affect our profitability. We do not typically obtain firm long-term purchase orders or commitments from our customers. We work closely with our customers to develop forecasts for future orders, but these forecasts are not binding. Customers may cancel their orders, change production quantities from forecast volumes or delay production for a number of reasons beyond our control. Any material delay, cancellation or reduction of orders from our largest customers could cause our net sales to decline significantly and could result in us holding excess inventories of components and materials. In addition, as many of our costs and operating expenses are relatively fixed, a reduction in customer demand can decrease our gross margins and adversely affect our business, financial condition and results of operations. Shortages or price fluctuations in component parts specified by our customers could delay product shipments and adversely affect our profitability. Many of the products we manufacture require one or more components that we order from sole-source suppliers. Supply shortages for a particular component can delay production of all products using that component or cause cost increases in the services we provide. In the past, some of the materials we use, such as capacitors and memory and logic devices, have been subject to industry-wide shortages. As a result, suppliers have been forced to allocate available quantities among their customers and we have not been able to obtain all of the materials desired. Our inability to obtain these needed materials could slow production or assembly, delay shipments to our customers, increase costs and reduce operating income. In certain circumstances, we may bear the risk of periodic component price increases. Accordingly, some component price increases could increase costs and reduce our operating income. In addition, if we fail to manage our inventory effectively, we may bear the risk of fluctuations in materials costs, scrap and excess inventory, all of which adversely affect our business, financial condition and results of operations. We are required to forecast our future inventory needs based upon the anticipated demand of our customers. Inaccuracies in making these forecasts or estimates could result in a shortage or an excess of materials. A shortage of materials could lengthen production schedules and increase costs. An excess of materials may increase the costs of maintaining inventory and may increase the risk of inventory obsolescence, both of which may increase expenses and decrease our profit margins and operating income. We have experienced significant growth in a short period of time and we may have trouble managing our expansion and integrating acquired businesses. We have grown rapidly in recent years due to acquisitions and internal growth. Since 1994, we have completed four acquisitions and began operations at eight new facilities. As a result, we have a limited history of owning and operating our acquired businesses on a consolidated basis. We cannot assure you that we will be able to meet performance expectations or successfully integrate our acquired businesses on a timely basis without disrupting the quality and reliability of service to our customers or diverting management resources. Our rapid growth has placed and will continue to place a significant strain on our management, financial resources and on our information, operations and financial systems. If we are unable to manage our growth effectively, it may have an adverse effect on our business, financial condition and results of operations. We cannot assure you that we will manage our growth effectively, and we expect that our annual growth rate of net sales will decrease in the future due to our increased size. We expect to continue to expand our operations through acquisitions and opening new facilities. These activities involve numerous risks, including: . Difficulty in integrating operations, technologies, systems, and products and services of these acquired companies; . Diversion of management's attention; . A disruption of operations; . Increases in expenses and working capital requirements; . Failure to enter markets effectively in which we have limited or no prior experience and where competitors in such markets have stronger market positions; and . Potential loss of key employees and customers of acquired companies. In addition, acquisitions may involve financial risks, such as: . Potential liabilities of the acquired businesses; . Dilutive effect of the issuance of additional equity securities; . Incurrence of additional debt; . Financial impact of transaction expenses; and . Amortization of goodwill and other intangible assets involved in any transactions that are accounted for using the purchase method of accounting, and possible adverse tax and accounting effects. Increased competition may result in decreased demand or prices for our services. The electronics manufacturing services industry is highly competitive and characterized by low margins. We compete against numerous U.S. and foreign service providers with global operations, as well as those who operate on a local or regional basis. In addition, current and prospective customers continually evaluate the merits of manufacturing products internally. Consolidation in the electronics manufacturing services industry results in a continually changing competitive landscape. The consolidation trend in the industry also results in larger and more geographically diverse competitors who have significant combined resources with which to compete against us. Some of our competitors have substantially greater managerial, manufacturing, engineering, technical, financial, systems, sales and marketing resources than we do. These competitors may: . Respond more quickly to new or emerging technologies; . Have greater name recognition, critical mass and geographic and market presence; . Be better able to take advantage of acquisition opportunities; . Adapt more quickly to changes in customer requirements; and . Devote greater resources to the development, promotion and sale of their services. We also may be operating at a cost disadvantage as compared to competitors who have greater direct buying power from component suppliers, distributors and raw material suppliers or who have lower cost structures. Increased competition from existing or potential competitors could result in price reductions, reduced margins or loss of market share. We anticipate that our net sales and operating results will fluctuate which could affect the price of our common stock. Our net sales and operating results have fluctuated and may continue to fluctuate significantly from quarter to quarter. A substantial portion of our net sales in any given quarter may depend on obtaining and fulfilling orders for assemblies to be manufactured and shipped in the same quarter in which those orders are received. Further, a significant portion of our net sales in a given quarter may depend on assemblies configured, completed, packaged and shipped in the final weeks of such quarter. Our operating results may fluctuate in the future as a result of many factors, including: . Variations in customer orders relative to our manufacturing capacity; . Variations in the timing of shipment of products to customers; . Our ability to recognize revenue with respect to products held for customers; . Introduction and market acceptance of our customers' new products; . Changes in competitive and economic conditions generally or in our customers' markets; . Effectiveness of our manufacturing processes, including controlling costs; . Changes in cost and availability of components or skilled labor; and . The timing and price we pay for acquisitions and related acquisition costs. Our operating expenses are based on anticipated revenue levels and a high percentage of our operating expenses are relatively fixed in the short term. As a result, any unanticipated shortfall in revenue in a quarter would likely adversely affect our operating results for that quarter. Also, changes in our product assembly mix may cause our margins to fluctuate which could negatively impact our results of operations for that period. Results in any period should not be considered indicative of the results to be expected in any future period. It is possible that in one or more future periods our results of operations will fail to meet the expectations of securities analysts or investors, and the price of our common stock could decline significantly. If we are unable to respond to rapidly changing technologies and process developments, we may not be able to compete effectively. The market for our products and services is characterized by rapidly changing technologies and continuing process developments. The future success of our business will depend in large part upon our ability to maintain and enhance our technological capabilities, to develop and market products and services that meet changing customer needs and to successfully anticipate or respond to technological changes on a cost-effective and timely basis. Our core technologies could in the future encounter competition from new or revised technologies that render existing technology less competitive or obsolete or that reduce the demand for our services. We cannot assure you that we will effectively respond to the technological requirements of the changing market. If we determine that new technologies and equipment are required to remain competitive, the development, acquisition and implementation of these technologies may require us to make significant capital investments. We cannot assure you that we will be able to obtain capital for these purposes in the future or that investments in new technologies will result in commercially viable technological processes. The loss of revenue and earnings to us from these changing technologies and process developments could adversely affect us. If we are unable to obtain additional financing, we may not be able to support our future growth. We expect to continue to make substantial capital expenditures to expand our operations and remain competitive in the rapidly changing electronics manufacturing services industry. Our future success depends on our ability to obtain additional financing and capital to support our future growth, if any. We may not be able to obtain additional capital when we want or need it, and capital may not be available on satisfactory terms. If we issue additional equity securities or convertible debt to raise capital, it may be dilutive to your ownership interest. In addition, any additional capital may have terms and conditions that adversely affect our business, such as financial or operating covenants. Operating in foreign countries exposes us to increased risks which could adversely affect our results of operations. We currently have foreign operations in Brazil, China, Ireland, Japan, Mexico, the Netherlands, Singapore and Thailand. We may in the future expand into other international regions. We have limited experience in managing geographically dispersed operations and in operating in foreign countries. We also purchase a significant number of components manufactured in foreign countries. Because of the scope of our international operations, we are subject to the following risks which could adversely impact our results of operations: . Economic or political instability; . Transportation delays and interruptions; . Foreign currency exchange rate fluctuations; . Increased employee turnover and labor unrest; . Longer payment cycles; . Greater difficulty in collecting accounts receivable; . Incompatibility of systems and equipment used in foreign operations; . Difficulties in staffing and managing foreign personnel and diverse cultures; and . Less developed infrastructures. In addition, changes in policies by the United States or foreign governments could negatively affect our operating results due to increased duties, increased regulatory requirements, higher taxation, currency conversion limitations, restrictions on the transfer of funds, the imposition of or increase in tariffs and limitations on imports or exports. Also, we could be negatively affected if our host countries revise their policies away from encouraging foreign investment or foreign trade, including tax holidays. Our acquisition strategy may not succeed. As part of our business strategy, we expect to continue to grow by pursuing acquisitions of other companies, assets or product lines that complement or expand our existing business. Competition for attractive companies in our industry is substantial. We cannot assure you that we will be able to identify suitable acquisition candidates or finance and complete transactions that we select. If we acquire a company, we may have difficulty integrating its personnel and operations into our operations. In addition, its key personnel may decide not to work for us. We may also have difficulty in integrating acquired businesses, products, services and technologies into our operations. These difficulties could disrupt our ongoing business, distract our management and workforce, increase our expenses and adversely affect our operating results. We may also incorrectly judge the value or worth of an acquired company or business. Furthermore, we may incur significant debt or be required to issue equity securities to pay for future acquisitions or investments. The issuance of equity securities could be dilutive to our shareholders. Failure to execute our acquisition strategy may adversely affect our business, financial condition and results of operations. We may be unable to protect our intellectual property, which would negatively affect our ability to compete. We rely on our proprietary technology, and we expect that future technological advances made by us will be critical to remain competitive. Therefore, we believe that the protection of our intellectual property rights is, and will continue to be, important to the success of our business. We rely on a combination of patent, trademark and trade secret laws and restrictions on disclosure to protect our intellectual property rights. Despite these protections, unauthorized parties may attempt to copy or otherwise obtain and use our proprietary technology. We cannot be certain that patents we have or that may be issued as a result of our pending patent applications will protect or benefit us or give us adequate protection from competing technologies. We also cannot be certain that others will not develop our unpatented proprietary technology or effective competing technologies on their own. We believe that our proprietary technology does not infringe on the proprietary rights of others. However, if others assert valid infringement claims against us with respect to our past, current or future designs or processes, we could be required to enter into expensive royalty arrangements, develop non-infringing technologies or engage in costly litigation, which could negatively affect our business, financial condition and results of operations. Our inability to expand our Web-based supply chain management system could negatively impact our future competitiveness. Our future success depends in part on our ability to rapidly respond to changing customer needs by scaling operations to meet customers' requirements, shift capacity in response to product demand fluctuations, procure materials at advantageous prices, manage inventory and effectively distribute products to our customers. In order to continue to meet these customer requirements, we have developed a Web-based supply chain management system that enables us to collaborate with our customers on product content and to process engineering changes. We are currently implementing an enhanced version of our existing system, which will include real-time communications between our customers across all of our facilities. Our inability to expand this Web-based system, or delays or defects in such expansion could negatively impact our ability to manage our supply chain in an efficient and timely manner to meet customer demands, which could adversely affect our competitive position and negatively affect our ability to be competitive in the electronics manufacturing services industry. Our business could suffer if we lose the services of, or fail to attract, key personnel. Our future success largely depends on the skills and efforts of our executive management and our engineering, manufacturing and sales employees. We do not have employment contracts or non-competition agreements with any of our executive management or other key employees. The loss of services of any of our executives or other key personnel could negatively affect our business. Our continued growth will also require us to attract, motivate, train and retain additional skilled and experienced managerial, engineering, manufacturing and sales personnel. We face intense competition for such personnel. We may not be able to attract, motivate and retain personnel with the skills and experience needed to successfully manage our business and operations. We are subject to a variety of environmental laws which expose us to potential financial liability. Our operations are regulated under a number of federal, state, provincial, local and foreign environmental laws and regulations, which govern, among other things, the discharge of hazardous materials into the air and water as well as the handling, storage and disposal of such materials. Compliance with these environmental laws is a significant consideration for us because we use metals and other hazardous materials in our manufacturing processes. We may be liable under environmental laws for the cost of cleaning up properties we own or operate if they are or become contaminated by the release of hazardous materials, regardless of whether we caused the release. In addition, we, along with any other person who arranges for the disposal of our wastes, may be liable for costs associated with an investigation and remediation of sites at which we have arranged for the disposal of hazardous wastes, if such sites become contaminated, even if we fully comply with applicable environmental laws. In the event of contamination or violation of environmental laws, we could be held liable for damages including fines, penalties and the costs of remedial actions and could also be subject to revocation of our discharge permits. Any such penalties or revocations could require us to cease or limit production at one or more of our facilities, thereby harming our business. Risks Relating to this Offering The market price of our common stock could fluctuate in response to quarterly operating results and other factors. The market price of our common stock could fluctuate significantly in response to quarterly operating results and other factors, including many over which we have no control and that may not be directly related to us. The stock market has from time to time experienced extreme price and volume fluctuations, which have often been unrelated or disproportionate to the operating performance of particular companies. Fluctuations or decreases in the trading price of our common stock may adversely affect your ability to trade your shares and you may lose all or part of your investment. In addition, these fluctuations could adversely affect our ability to raise capital through future equity financings. Future sales of our common stock could depress our stock price. Sales of a substantial number of shares of our common stock in the public market, or the perception that such sales are likely to occur, could depress the market price of our common stock. As of March 31, 2001, we had 28,294,347 shares outstanding. Of these shares, approximately 19,078,873 are available for sale in the public market. In connection with this offering, our executive officers, directors, our largest shareholder and the selling shareholders have agreed not to sell any shares owned by them for a period of 90 days following this offering. On the 91st day following this offering, at least an additional 9,215,474 shares will be eligible for sale in the public market. Provisions in our charter documents and Minnesota law may delay or prevent an unsolicited takeover effort to acquire our company, which could inhibit your ability to receive an acquisition premium for your shares. Provisions of our amended articles of incorporation and our amended and restated bylaws and provisions of Minnesota law may delay or prevent an unsolicited takeover effort to acquire our company on terms that you may consider to be favorable. These provisions include the following: . No cumulative voting by shareholders for directors; . A classified board of directors with three-year staggered terms; . The ability of our board to set the size of the board of directors, to create new directorships and to fill vacancies; . The ability of our board, without shareholder approval, to issue preferred stock, which may have rights and preferences that are superior to our common stock; . The ability of our board to amend the bylaws; . A shareholder rights plan, which discourages the unauthorized acquisition of 15% or more of our common stock or an unauthorized exchange or tender offer; . Restrictions under Minnesota law on mergers or other business combinations between us and any holder of 10% or more of our outstanding common stock; and . A requirement that at least two-thirds of our shareholders and at least two-thirds of our directors approve amendments of our articles of incorporation.

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+RISK FACTORS An investment in the notes is subject to a number of risks. You should carefully consider the following factors, as well as the more detailed descriptions elsewhere in this prospectus before making an investment in the notes. RISKS RELATED TO OUR COMPANY WE ARE SUBSTANTIALLY LEVERAGED WHICH COULD AFFECT OUR ABILITY TO FULFILL OUR OBLIGATIONS UNDER THE NOTES. Our substantial outstanding debt has important consequences to you, including the risk that we may not generate sufficient cash flow from operations to pay principal and interest on our indebtedness, including the notes, or to invest in our businesses. While we believe, based upon our historical and anticipated performance, that we will be able to satisfy our obligations, including those under the notes, from our cash flow from operations and refinancings, we cannot assure you of this ability. While we can raise cash to satisfy our obligations through potential sales of assets or equity, our ability to raise funds by selling either assets or equity depends on our results of operations, market conditions, restrictions contained in the New Credit Agreement, the Existing Credit Agreement and the indentures governing our Senior Notes and other factors. If we are unable to refinance indebtedness or raise funds through sales of assets or equity or otherwise, we may be unable to pay principal of and interest on the notes. At December 31, 2000, we had total outstanding consolidated long-term debt of $680.6 million and a stockholders' deficit of $77.9 million. Our interest expense for the year ended December 31, 2000 was $53.5 million. Subject to covenants contained in the New Credit Agreement, the Existing Credit Agreement and the indentures governing our Senior Notes, we may incur additional indebtedness, including additional secured debt. Any additional indebtedness we may incur may rank equally or junior to the notes and will not by its terms rank senior to the notes, except for the obligations under the New Credit Agreement, the Existing Credit Agreement and the Other Indebtedness. YOU MAY NOT RECEIVE PAYMENT IN FULL BY FORECLOSING ON THE COLLATERAL IN THE EVENT OF A DEFAULT ON THE NOTES. Our obligations under our Senior Notes are secured by a second-priority lien on the Collateral. The Collateral, however, is subject to a first-priority lien in favor of the lenders under the New Credit Agreement, the Existing Credit Agreement and the Other Indebtedness. This ranking means that, if the first-priority lien holders were to sell or foreclose on the Collateral if an event of default occurs under those agreements, you would only be entitled to receive proceeds from the liquidation or sale of the Collateral in excess of the amounts owed by us to the first-priority lien holders. In addition, we may determine to refinance the New Credit Agreement, the Existing Credit Agreement and the Other Indebtedness with an unsecured credit facility, in which event, subject to certain limited exceptions, the Collateral would be released. Our obligations to the first-priority lien holders are significant. As of December 31, 2000, the notes were subordinated to approximately $119.3 million of obligations under the New Credit Agreement, the Existing Credit Agreement and the Other Indebtedness to the extent of the Collateral securing those obligations. There may not be sufficient proceeds from the Collateral available for payment in full to you once our obligations to our first-priority lien holders are discharged in full in which case you would be a general unsecured creditor. Moreover, as long as the New Credit Agreement, the Existing Credit Agreement and the Other Indebtedness are outstanding, the trustee under the indentures governing our Senior Notes will not have the authority to cause the collateral agent under the collateral agent agreement to foreclose on the Collateral. OUR PARENT CORPORATIONS ARE DEPENDENT UPON OUR CASH FLOWS TO MEET THEIR CASH REQUIREMENTS AND COULD CAUSE US TO MAKE DISTRIBUTIONS TO THEM WHICH WOULD REDUCE CASH FLOWS AVAILABLE TO US. Our parent corporations are essentially holding companies without independent businesses or operations and, as such, are presently dependent upon the earnings and cash flows of their subsidiaries, principally BMCA, in order to meet their cash requirements. If our parent corporations are unable to meet their cash requirements, they might take various actions that could reduce our cash flows. This reduction could adversely affect our ability to pay principal and interest on the notes. G-I Holdings Inc. and BMCA Holdings Corporation, our parent corporations, are principally dependent upon the cash flow of our company in order to satisfy their obligations and pay their operating expenses, including tax liabilities. In order to satisfy those obligations or pay those expenses, those corporations might take various actions, including: - causing us to make distributions to our stockholders by means of dividends or otherwise; - causing us to make loans to them; or - causing BMCA Holdings Corporation to sell our common stock. The only significant asset of our parent corporations is the stock of our company. Creditors of our parent corporations could seek to cause those corporations to sell our common stock or take similar action in order to satisfy liabilities owed to them that could cause a change of control. See the risk factor below regarding risks related to a change of control of BMCA. G-I Holdings has advised us that it expects to obtain funds to meet its cash requirements from, among other things, loans principally from us and from payments from us pursuant to a tax sharing agreement we entered into with it. OUR CONTROLLING STOCKHOLDER HAS THE ABILITY TO ELECT OUR ENTIRE BOARD OF DIRECTORS AND CAN CONTROL THE OUTCOME OF ANY MATTER SUBMITTED TO OUR STOCKHOLDERS. We are an indirect subsidiary of G-I Holdings which is approximately 99% beneficially owned (as defined in Rule 13d-3 under the Securities Exchange Act of 1934) by Samuel J. Heyman. Accordingly, Mr. Heyman has the ability to elect our entire Board of Directors and to determine the outcome of any other matter submitted to our stockholders for approval, including, subject to the terms of the indentures relating to the Senior Notes, mergers, consolidations and the sale of all, or substantially all, of our assets. See "Security Ownership of Certain Beneficial Owners and Management." OUR PARENT CORPORATIONS ARE DEPENDENT UPON OUR CASH FLOWS TO SATISFY THEIR OBLIGATIONS. IF G-I HOLDINGS IS UNSUCCESSFUL IN CHALLENGING ITS TAX DEFICIENCY NOTICE, IT COULD CAUSE US TO MAKE DISTRIBUTIONS WHICH WOULD REDUCE OUR CASH FLOW. On September 15, 1997, G-I Holdings received a tax deficiency notice for the 1990 fiscal year relating to Rhone-Poulenc Surfactants and Specialties, L.P., a partnership in which G-I Holdings held an interest. This notice could result in G-I Holdings incurring liabilities significantly in excess of the deferred tax liability recorded in 1990 in connection with this matter. G-I Holdings has advised us that it believes it will prevail in the surfactants partnership matter, although we cannot assure you of this result. See "Business -- Tax Claim Against G-I Holdings," "Certain Relationships -- Tax Sharing Agreement" and Note 7 to Consolidated Financial Statements. If G-I Holdings is unsuccessful in challenging its tax deficiency notice and is unable to satisfy its tax obligations, it might take various actions that could reduce our cash flows as described above in the risk factor regarding our parent corporations' dependence on our cash flows. This reduction could adversely affect our ability to pay principal and interest on the notes. As a member of the consolidated group for federal income tax purposes that has included G-I Holdings, we are severally liable for some federal income tax liabilities of the G-I Holdings consolidated tax group. We are indemnified under certain circumstances for those tax liabilities, principally by G-I Holdings. In light of G-I Holdings' recent bankruptcy filing, we cannot assure you that G-I Holdings will have sufficient assets to satisfy its indemnification obligation to us. See "Summary -- Recent Developments," the risk factors below regarding risks related to G-I Holdings' bankruptcy and Notes to Consolidated Financial Statements. RISKS RELATED TO G-I HOLDINGS' BANKRUPTCY IF G-I HOLDINGS IS FORCED TO SELL ITS INDIRECT HOLDINGS OF BMCA'S COMMON STOCK AND A CHANGE OF CONTROL OCCURS, WE MAY BE UNABLE TO REPURCHASE YOUR NOTES. THIS FAILURE WOULD CONSTITUTE AN EVENT OF DEFAULT UNDER THE INDENTURE RELATING TO THE NOTES AND OUR OTHER DEBT INSTRUMENTS. In January 2001, G-I Holdings filed a voluntary petition for reorganization under Chapter 11 of the U.S. Bankruptcy Code due to its Asbestos Claims. This proceeding is in a preliminary stage. Those persons with claims against G-I Holdings, which principally consist of persons with asbestos-related claims, might seek to satisfy their claims by asking the bankruptcy court to require the sale of G-I Holdings' assets, including G-I Holdings' indirect holdings of BMCA's common stock. If a change of control, as defined in the indenture relating to the notes, occurs, we cannot assure you that we will have available, or be able to obtain, sufficient funds, or will be permitted by our debt instruments, to repurchase your notes. The indenture relating to the notes provides that if a change of control occurs, you will have the right to require us to repurchase your notes at 101% of their principal amount, plus any accrued and unpaid interest to the repurchase date. The Existing Credit Agreement and the New Credit Agreement prohibit us from repurchasing any Senior Notes. Our failure to repurchase your notes would constitute an event of default under the indenture, which would in turn constitute a default under the Existing Credit Agreement, the New Credit Agreement and the indentures governing our Other Senior Notes. See "Description of the Notes -- Repurchase at Your Option." In addition, if a change of control as defined in the Existing Credit Agreement and the New Credit Agreement occurs, those facilities could be terminated and the outstanding loans accelerated. This event could cause our outstanding Senior Notes, including the notes, to be accelerated. If any of these events of default were to occur, we may be unable to pay the accelerated principal amount of and interest on the notes. WE MAY EXPERIENCE AN INCREASE IN ASBESTOS CLAIMS FILED AGAINST OUR COMPANY. Claimants in the G-I Holdings bankruptcy may seek to file Asbestos Claims against our company (with 2,147 Asbestos Claims having been filed against us as of December 31, 2000). We believe that we will not sustain any liability in connection with these or any other asbestos-related claims. On February 2, 2001, the United States Bankruptcy Court for the District of New Jersey issued a temporary restraining order enjoining any existing or future claimant from bringing Asbestos Claims against BMCA. The temporary restraining order expires on April 23, 2001. In addition, on February 7, 2001, G-I Holdings filed a defendant class action in the United States Bankruptcy Court for the District of New Jersey, seeking a declaratory judgment that BMCA has no successor liability for Asbestos Claims against G-I Holdings and that it is not the alter ego of G-I Holdings. If we are unsuccessful in obtaining the declaratory judgment and the temporary restraining order is not renewed, we could experience an increase in Asbestos Claims asserted against us. While we cannot predict whether any additional Asbestos Claims will be asserted against us, or the outcome of any litigation relating to those claims, we believe that we have meritorious defenses to any claim that we have asbestos-related liability. There can be no assurance, however, that we will be successful in those defenses. See "Business -- Legal Proceedings." In addition, G-I Holdings has indemnified us with respect to Asbestos Claims. See "-- G-I Holdings may be unable to satisfy its indemnification obligations owed to us," below. G-I HOLDINGS MAY BE UNABLE TO SATISFY ITS INDEMNIFICATION OBLIGATIONS OWED TO US. G-I Holdings has indemnified us with respect to Asbestos Claims, environmental claims and certain tax liabilities. See "Legal Proceedings." In light of G-I Holdings' recent bankruptcy filing, G-I Holdings may not have sufficient assets to satisfy these indemnification obligations to us. G-I Holdings' inability to satisfy these indemnification obligations could have a material adverse effect on our financial position and results of operations. THE BANKRUPTCY COURT MAY CONSOLIDATE G-I HOLDINGS AND BMCA. On February 8, 2001, the creditors committee formed in connection with G-I Holdings' bankruptcy case filed a motion requesting substantive consolidation of the assets and liabilities of BMCA with the assets and liabilities of G-I Holdings or, alternatively, an order directing G-I Holdings to cause us to file for bankruptcy protection. The committee asked the bankruptcy court to grant them relief on an interim basis pending a final determination. On March 21, 2001, the court refused to grant the requested interim relief. Under applicable bankruptcy law, a bankruptcy court could order substantive consolidation of the assets and liabilities of other entities with G-I Holdings if the court concludes that the requirements under the bankruptcy code have been satisfied. We believe we have meritorious defenses to the motion for substantive consolidation or alternate relief, and we intend to vigorously contest this motion. We cannot assure you, however, that substantive consolidation will not occur or that we will not be ordered to file for bankruptcy protection. If the bankruptcy court concludes that our assets should be consolidated with those of G-I Holdings, however, payments on indebtedness, including the notes, could be delayed and reduced. See "Business -- Legal Proceedings."

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+RISK FACTORS You should be aware that there are various risks to an investment in our common stock, including those described below. You should carefully consider these risk factors, together with all of the other information included in this prospectus, before you decide to invest in shares of our common stock. If any of the following risks, or other risks not known to us or that we currently believe to not be significant, develop into actual events, then our business, financial condition, results of operations or prospects could be materially adversely affected. If that happens, the market price of our common stock could decline, and you may lose all or part of your investment. If we do not raise significant additional capital, we will be unable to fund all of our research and development activities and will need to eliminate or curtail these programs. One of the most significant issues we face is adequate funding of our existing projects. As of March 31, 2001, we had cash and investments of $4,954,000. While we believe our existing financial resources are adequate to fund operations through September 30, 2001, which is the end of our fiscal year, we will need the capital raised in this offering and from other sales of our stock, or through collaborations with third parties, to support operations after fiscal 2001. Our financial requirements will depend upon the success of our research and development programs. In addition, our ability to enter into new collaborations that provide fees and research and development funding depends on the successful results of our research programs. If some or all of our programs show scientific progress, we will need significant additional funds to move therapies through the preclinical stages and into clinical trials. If we are unable to raise the amount of capital necessary to complete development and reach commercialization of any of our therapeutic products, we will need to delay or cease development of one or more of our products. We are not required to sell all of the common stock we are offering, and we may not raise enough capital from the sale of our common stock to adequately fund our planned research and development activities. There is no minimum amount of our common stock we must sell in this offering. Accordingly, investors will bear the risk that we will accept subscriptions for less than $10,000,000 worth of common stock and then be unable to successfully complete all of the anticipated uses of the proceeds of this offering. If less than $10,000,000 is raised, we might be unable to develop our programs as planned and our business, financial condition, and results of operations could be adversely affected. The placement agent, Petkevich & Partners, LLC, is not obligated to purchase any number or dollar amount of our shares at any time. While Petkevich & Partners has agreed to use its best efforts to identify prospective purchasers of the common stock offered, there can be no assurance that any or all of the shares offered will be sold. Our inability to obtain adequate financing may impede our research and development activities and thus negatively affect the return on your investment in our common stock. We will continue to incur substantial losses and we might never achieve a profit. As of March 31, 2001, we had an accumulated deficit of $93,685,000 from our research, development and other activities. We have not generated any revenues from product sales and do not expect to do so for at least several more years. In the past, most of our revenues have come from collaborators who reimbursed us for research and development activities. Our research and development programs are at an early stage and therefore might never result in viable products. Our programs to develop products are in the early stages of development, involve unproven technology, require significant further research and development and regulatory approvals, and are subject to the risks of failure inherent in the development of products or therapeutic procedures based on innovative technologies. These risks include the possibilities that any or all of these proposed products or procedures are found to be unsafe or ineffective, or otherwise fail to receive necessary regulatory approvals; that the proposed products or procedures are uneconomical to market or do not achieve broad market acceptance; that third parties hold proprietary rights that preclude us from marketing them; or that third parties market a superior or equivalent product. Further, the timeframes for commercialization of any products are long and uncertain, because of the extended testing and regulatory review process required before marketing approval can be obtained. As evidence of the difficulty in commercializing new products, in 1999, we terminated one product we were developing. We might have to terminate the development of current or future products and our results of operations could be adversely affected. We expect to remain dependent on collaborations with third parties for the development of new products. Our current business strategy is to enter into agreements with third parties both to license rights to our potential products and to develop and commercialize new products. We cannot assure that we will be able to enter into or maintain these agreements on terms favorable to us. We currently license from third parties, and do not own, rights under patents and certain related intellectual property for our current development programs. If any of these licenses were to expire, our business could be adversely affected. The development of OP2000 depends on our collaboration with Elan Corporation, plc, which is outside of our control. We are developing OP2000 through a collaboration with Elan. Incara Development, Ltd. is a company that we formed and jointly own with Elan to develop OP2000. We own 80.1% and Elan owns 19.9% of Incara Development. Despite our majority ownership of Incara Development, we have no control over the development activities regarding OP2000, because we control only 50% of the votes on the joint management committee of Incara Development. As a result, any revenue we earn on OP2000 will depend entirely on our ability to negotiate with Elan. Elan has the right to exchange the Series C convertible exchangeable preferred stock of Incara it owns for all of the preferred securities we own of Incara Development at any time until December 21, 2006, which would give Elan a 50% ownership interest in Incara Development. If Elan exercises this right, our ownership in Incara Development will be substantially diluted, which would reduce the return to which we would be entitled if OP2000 is successful. Our liver progenitor cell program and product depends on a constant, available source of livers from organ donors. We must maintain current or develop new sources of livers or liver tissues from which progenitor cells can be isolated. There are a limited number of suppliers and we face competition in obtaining livers from them. We have historically relied on several suppliers of liver tissues for research, but entering into the clinical trial stage of development will increase our needs. For clinical trials and ultimately for commercialization, we need to obtain, from traditional organ transplant donor programs, livers which are not suitable for full liver transplant. We might not be able to obtain these livers. If we are unable to maintain a supply of livers, our development of the liver progenitor cell program will be adversely affected. Our research and development programs rely on technology licensed from third parties, and termination of any of those licenses would result in loss of significant rights to develop and market our products, which would impair our business. We have exclusive worldwide rights to our antioxidant small molecule technology through a license agreement with Duke University. We also have the worldwide exclusive rights to patents licensed from Albert Einstein College of Medicine and patent applications and rights to license future technology arising out of research sponsored at the University of North Carolina at Chapel Hill (related to the liver progenitor cell program) and National Jewish Medical Center (related to antioxidant small molecules). Key financial and other terms, such as royalty payments, for the licensing of this future technology would still need to be negotiated with the research institutions, and it might not be possible to obtain any such license on terms that are satisfactory to us. Our licenses generally may be terminated by the licensor if we fail to perform our obligations, including obligations to develop the compounds and technologies under license. If terminated, we would lose the right to develop the products, which could adversely affect our business. The license agreements also generally require us to meet specified milestones or show reasonable diligence in development of the technology. If disputes arise over the definition of these requirements or whether we have satisfied the requirements in a timely manner, or if any other obligations in the license agreements are disputed by the other party, the other party could terminate the agreement and we could lose our rights to develop the licensed technology. We need to obtain collaborative arrangements for manufacturing and marketing of our potential products, or we will have to develop the expertise, obtain the additional capital and spend the resources to perform those functions. We do not have the staff or facilities to manufacture or market any products being developed in our programs. We need to enter into collaborative arrangements in the future to develop, commercialize, manufacture and market products emerging from our catalytic antioxidant program. We also might rely on a third party to manufacture the liver progenitor cell therapy being developed by us. We intend to seek a company to work with us on development of a liver assist device, and we intend to seek a company or companies to work with us on development of gene therapy and genomics applications of the liver progenitor cell program. Incara Development also will need third parties to manufacture and market OP2000, if it reaches commercialization. A large number of small biotechnology companies are seeking collaborators, some of whom compete in the same therapeutic areas as our programs, and obtaining and maintaining new collaborative arrangements will be difficult. We might not be successful in entering into third party arrangements on acceptable terms, if at all. If we are unable to obtain or retain third-party manufacturing or marketing on acceptable terms, we might be delayed in our ability to commercialize products. Substantial additional funds and personnel would be required if we needed to establish our own manufacturing or marketing operations. We might not be able to obtain adequate funding or establish such capabilities at all or in a cost-effective manner. Even if we do succeed in obtaining a collaborator for any of our programs, the product might not be commercialized profitably, if at all. The compensation owed to our manufacturers and marketers will reduce our profit margins and might delay or limit our ability to develop, deliver and sell products on a timely and competitive basis. Furthermore, one of these companies could pursue alternative technologies or develop alternative compounds either on its own or in collaboration with others, targeted at the same diseases as those involved in our programs. The manufacturers of any of our products, if they reach commercialization, must comply with applicable regulations. A manufacturer must conform to FDA and any applicable foreign regulations for the production and packaging of products. If any of our manufacturers cannot meet our needs or applicable regulatory standards with respect to the timing, quantity or quality of products, our development programs would be delayed. A failure to obtain or maintain patent and other intellectual property rights would allow others to develop and sell products similar to ours, which could impair our business. The success of our business depends, in part, on our ability to establish and maintain adequate protection for our intellectual property, whether owned by us or licensed from third parties. We rely primarily on patents in the United States and in other key markets to protect our intellectual property. If we do not have adequate patent protection, other companies could sell products that compete directly with ours, without incurring any liability to us. Patent prosecution, maintenance and enforcement on a global basis is expensive, and many of these costs must be incurred before we know whether a product covered by the claims can be successfully developed or marketed. Even if we expend considerable time and money on prosecution, a patent application might never issue as a patent. We can never be certain that we were the first to invent the particular technology or that we were the first to file a patent application for the technology, because a majority of U.S. patent applications are maintained in secrecy until a patent issues. Publications in the scientific or patent literature generally do not identify the date of an invention, so it is possible that a competitor could be pursuing the patenting of the same invention in the United States and have an earlier invention date. Outside the United States, priority of invention is determined by the earliest effective filing date, not the date of invention. Consequently, if another person or company pursues the same invention and has an earlier filing date, patent protection outside the United States would be unavailable to us. Also, outside the United States, an earlier date of invention cannot overcome a date of publication that precedes the earliest effective filing date. Accordingly, the patenting of our proposed products would be precluded outside the United States if a prior publication anticipates the claims of a pending application, even if the date of publication is within a year of the filing of the pending application. Even if patents issue, the claims allowed might not be sufficiently broad to offer adequate protection for our technology against competitive products. Patent protection differs from country to country, giving rise to increased competition from other products in countries where patent coverage is either unavailable, weak, or not adequately enforced, if at all. Once a patent issues, we still face the risk that others will try to design around our patent or will try to challenge the validity of the patent. If a patent were invalidated, we could be subject to unfettered competition from late comers. The cost of litigation can be substantial, even if we prevail and there can be no assurance for recovery of damages. If a third party were to bring an infringement claim against us, we would incur significant costs in our defense; if the claim were successful, we would need to develop non-infringing technology or obtain a license from the successful patent holder, if available. Our business also depends on our ability to develop and market products without infringing on the proprietary rights of others or being in breach of our license agreements. The pharmaceutical industry is subject to frequent and protracted litigation regarding patent and other intellectual property rights. Most companies have numerous patents that protect their intellectual property rights. These third parties might assert claims against us with respect to our product candidates and future products. If litigation were required to determine the validity of a third party's claims, we could spend significant resources and be distracted from our core business activities, regardless of the outcome. If we did not prevail in the litigation, we could be required to license a third party's technology, which might not be possible on satisfactory terms, or discontinue our own activities and develop non-infringing technology, any of which could prevent or delay pursuit of our development programs. Incara Development has rights under an exclusive license from Opocrin S.p.A., until 2013 in all countries other than Japan and Korea, to develop and market OP2000. This license is based on an issued patent held by Opocrin claiming a heparin derivative with a specified range of molecular weight. Incara Development also has rights to a non-exclusive license from Opocrin to practice certain related patents, to the extent required for our activities related to OP2000. We are aware of a recently issued patent claiming the use of specified fractions of heparin for the treatment of inflammatory bowel disease. We do not believe the development of OP2000 will require the licensing of this patent. If OP2000 were to be determined to fall within the scope of this patent and if the patent's claims were found to be valid, Incara Development would have to license this patent in order to commercialize OP2000. Incara Development might not be able to license this patent at a reasonable cost which would result in Incara Development not being able to market OP2000. Uncertainty regarding the scope or validity of this patent might deter Elan from continuing development of OP2000 or deter other companies from collaborating with Incara Development for the development and commercialization of OP2000. Protection of trade secret and confidential information is difficult, and loss of confidentiality could eliminate our competitive advantage. In addition to patent protection, we rely on trade secrets, proprietary know-how and confidential information to protect our technological advances. We use confidentiality agreements with our employees, consultants and collaborative partners to maintain the proprietary nature of this technology. However, confidentiality agreements can be breached by the other party, which would make our trade secrets and proprietary know-how available for use by others. There is generally no adequate remedy for breach of confidentiality obligations. In addition, the competitive advantage afforded by trade secrets is limited because a third party can independently discover or develop something identical to our own trade secrets or know-how, without liability to us. If our employees, consultants or collaborators were to use information improperly obtained from others (even if unintentional), disputes could arise as to ownership and rights in any resulting know-how or inventions. If we do not reach the market with our products before our competitors offer products for the same use, or if we do not compete effectively in marketing our products, the revenues from product sales, if any, will be reduced. We face intense competition in all of our development programs. The markets for therapeutic products that address liver disease, stroke, cancer and inflammatory bowel disease is large and competition is increasing. Our most significant competitors are fully integrated pharmaceutical companies and more established biotechnology companies, which have substantially greater financial, technical, sales and marketing, and human resources than us. These companies might succeed in obtaining regulatory approval for competitive products more rapidly than we can for our products. In addition, competitors might develop technologies and products that are cheaper, safer or more effective than those being developed by us or that would render our technology obsolete. The ownership interest of our stockholders will be substantially diluted by the common stock issued in this offering and by future issuances of stock, including new offerings, conversion of currently outstanding preferred stock, exercises of currently outstanding options and warrants and the exercise of warrants to be issued in this offering. As of July 31, 2001, Incara had 8,380,320 shares of common stock outstanding. We are offering up to $10,000,000 worth of shares of our common stock and warrants to purchase up to $3,000,000 worth of shares of common stock pursuant to this prospectus. This could result in up to 6,666,667 shares of our common stock, and warrants to purchase 1,600,000 shares of our common stock, assuming an exercise price of $1.875, being issued in this offering, based on the closing price of $1.50 of our common stock on July 31, 2001, which represents, assuming the exercise of the warrants, 49.7% of the total number of our shares of common stock which would then be outstanding, based on shares outstanding as of July 31, 2001. In addition, under our compensation arrangement with Petkevich & Partners, we will issue a warrant for up to 80,000 shares of our common stock, depending on the amount of our common stock sold in this offering, which would further dilute our stockholders. We may grant to our employees, directors and consultants options to purchase our common stock under the 1994 Stock Option Plan. As of July 31, 2001, options to purchase 2,141,148 shares at exercise prices ranging from $0.04 to $20.50, with a weighted average exercise price of $2.95 were outstanding and 1,141,565 shares were reserved for issuance under the 1994 Stock Option Plan. In addition, warrants to purchase 17,783 shares of common stock at an exercise price of $13.49 were outstanding, and we have reserved 36,208 shares of common stock for issuance pursuant to our Employee Stock Purchase Plan. In connection with a collaboration and financing transaction, we have issued preferred stock and warrants to purchase preferred stock to Elan. This preferred stock is convertible into common stock, as discussed below. In the event that the capital raised in this offering is insufficient to fund operations, we will need to sell additional shares of our common stock, preferred stock or other securities, or enter into collaborations with third parties during our next fiscal year to meet our capital requirements, including the issuance of shares of our stock to Elan and Torneaux Fund Ltd., as discussed below. We might not be able to complete these transactions when needed. If these sales of stock occur, these issuances of stock will dilute the ownership interests of our stockholders. The possibility of dilution posed by shares available for future sale could reduce the market price of our common stock and could make it more difficult for us to raise funds through equity offerings in the future. Stockholders might experience significant dilution from the conversion of outstanding preferred stock, warrants and a convertible promissory note held by Elan Corporation which are convertible into shares of our common stock. In January 2001, in connection with a collaboration and financing transaction, we sold to Elan 28,457 shares of our Series B convertible non- voting preferred stock, 12,015 shares of our Series C convertible exchangeable non-voting preferred stock and a warrant to purchase 22,191 shares of our Series B preferred stock. Each share of our Series B preferred stock is convertible into ten shares of our common stock. The Series C preferred stock has a face value of $1,000 per share and bears a 7% dividend payable in Series C preferred stock, which compounds annually, and is convertible by Elan into shares of Series B preferred stock at the rate of $64.90 per share. Accordingly, a total of 2,357,789 shares of our common stock could be issued to Elan, assuming the exercise of all warrants currently outstanding and the conversion into common stock of all shares of Series B and Series C preferred stock currently outstanding, but not including any dividends to be issued on the Series C preferred stock. This amount of shares represents 22.0% of the total shares of our common stock that would be outstanding after such conversion and exercise based on shares of common stock outstanding on July 31, 2001; however, pursuant to provisions in our Certificate of Incorporation, Elan may not own more than 9.9% of our common stock at any time. In addition, upon the later of the completion of enrollment of a Phase 2/3 clinical trial for OP2000 or December 21, 2001, Elan will purchase an additional $1,000,000 of our Series B preferred stock, at a per share price equal to ten times the greater of the average per share daily price of our common stock on the day before the purchase or a 25% premium to the average daily price per share of our common stock for the 60 trading day period immediately before the purchase. On that day, Elan also will receive a warrant to purchase an amount of Series B preferred stock equal to 20% of the shares of Series B preferred stock it purchases at that time. Accordingly, assuming the purchase price for the later purchased Series B preferred stock is the same as ten times the greater of the average per share daily price of our common stock on July 31, 2001 or a 25% premium to the average daily for the 60 trading day period prior to August 1, 2001, an additional 516,129 shares of our common stock could be issued to Elan. However, if the purchase price of the Series B preferred stock is less than $8.00 per share, the purchase of this stock will be limited to 150,000 shares of Series B preferred stock and will be at Elan's option. Further, we have issued to Elan a promissory note under which we can, subject to Elan's consent, borrow up to $4,806,000 for the development of OP2000. The note bears interest at 10%, compounded semi-annually on the amount outstanding under the note, and the principal and interest is convertible at Elan's option into shares of our Series B preferred stock at $43.27 per share. As of July 31, 2001, we had not borrowed any funds pursuant to this note. However, assuming the full amount is borrowed under the note, and assuming the conversion of the principal, but not any interest on the note, an additional 1,110,700 shares of our common stock could be issued to Elan. If Elan does not exchange its Series C preferred stock for either increased ownership of Incara Development or for Series B preferred stock by December 21, 2006, Incara will exchange the Series C preferred stock and accrued dividends, at its option, for either cash or shares of Series B preferred stock and warrants of Incara having a then fair market value of the amount due. Any issuance of equity securities or warrants to purchase equity securities in this situation would be dilutive to our common stockholders. If Elan does not exchange all or part of the note for either increased ownership of Incara Development or for Series B preferred stock by December 21, 2006, Incara will exchange the note and accrued interest, at its option, for either cash or shares of Series B preferred stock and warrants of Incara having a then fair market value of the amount due. Any issuance of equity securities or warrants to purchase equity securities in this situation would be dilutive to our common stockholders. The perceived risk of dilution by the convertible securities held by Elan might cause our stockholders to sell their shares, which would decrease the market price of our common stock. Further, any subsequent sale of our common stock by Elan would increase the number of our publicly traded shares, which could also lower the market price of our common stock. Stockholders might experience significant dilution from our issuance to Torneaux Fund Ltd. of up to 1,530,166 shares of common stock, or 15.4% of the total number of shares of our common stock which would then be outstanding, based on shares outstanding as of July 31, 2001. In August 2000, we entered into a financing arrangement with Torneaux Fund Ltd. under which we may sell our common stock to Torneaux and also issue to Torneaux warrants which are convertible into our common stock. As of July 31, 2001, we had not sold any shares or issued any warrants to Torneaux. The maximum number of shares that we could issue to Torneaux during the remaining term of the arrangement is 1,530,166 shares of our common stock (including shares covered by warrants). The issuance of shares to Torneaux under this financing arrangement will have a dilutive effect on our stockholders of as much as 15.4% of the total number of shares which would then be outstanding, based on the 8,380,320 shares of common stock outstanding on July 31, 2001. However, if the trading volume of our stock does not exceed an average of 200,000 shares per day during the purchase periods, the maximum number of shares that we could issue to Torneaux would be 1,040,111 shares and warrants, or 11.0% of the shares which would then be outstanding. The number of shares that we issue to Torneaux under the agreement is based upon a discount to the daily weighted average market price of our stock over a 20-day trading period. If we sell shares to Torneaux at a time when our stock price is low, our stockholders would be significantly diluted. In addition, the perceived risk of dilution might cause stockholders to sell their shares, which could further decrease the market price of our shares. Torneaux's resale of our common stock will increase the number of our publicly traded shares, which could also lower the market price of our common stock. A return on your investment in our common stock will be dependent on an increase in the price of our common stock. There is no set yield on our common stock. In addition, we do not currently anticipate paying cash dividends on our common stock because we have had no earnings to date and intend to retain all future earnings, if any, for the foreseeable future to fund our business operations. As a result, anyone investing in our common stock must look to an increase in its price to derive any value on their investment. Our common stock is not actively traded and the price of our common stock has fluctuated from $0.50 to $11.00 during the last two years. Our common stock is listed on the Nasdaq National Market System under the symbol "INCR." The public market for our common stock has been characterized by low and/or erratic trading volume, often resulting in price volatility. An active public market for our common stock might be limited because of the small number of shares outstanding, the limited number of investors and the small market capitalization (which is less than that authorized for investment by many institutional investors). All shares issued in this offering and all shares issued upon the exercise of warrants issued in this offering will be freely tradable. In addition, shares of our common stock that we might issue to Torneaux have been registered for resale with the SEC and will be freely tradable and we have agreed to register shares of common stock that might be issued to Elan, as well as the shares underlying a warrant to be issued to Petkevich & Partners. The sale of a significant amount of shares sold to Torneaux or shares issued in this offering or to Elan at any given time could cause the trading price of our common stock to decline and to be highly volatile. The market price of our common stock also is subject to wide fluctuations due to factors that we cannot control, including the results of preclinical and clinical testing of our products under development, decisions by collaborators regarding product development, regulatory developments, market conditions in the pharmaceutical and biotechnology industries, future announcements concerning our competitors, adverse developments concerning proprietary rights, public concern as to the safety or commercial value of any products, and general economic conditions. Furthermore, the stock market has experienced significant price and volume fluctuation unrelated to the operating performance of particular companies. These market fluctuations can adversely affect the market price and volatility of our common stock. If we fail to meet Nasdaq National Market listing requirements, our common stock will be delisted and become illiquid. Our common stock is currently listed on the Nasdaq National Market. Nasdaq has requirements that a company must meet in order to remain listed on the Nasdaq National Market. If we are unable to raise additional funds while we continue to experience losses from our operations, we might not be able to maintain the standards for continued quotation on the Nasdaq National Market, including a minimum bid price requirement of $1.00 per share and a minimum net tangible assets value of $4,000,000. In February 2001, Nasdaq notified us that our December 31, 2000 net tangible assets did not meet its listing requirements. Elan's investment in Incara in January 2001 satisfied this requirement and Nasdaq closed the matter. Nasdaq has proposed amendments to replace its minimum net tangible assets requirement with a stockholders' equity requirement that would require companies to have a minimum of $10,000,000 of stockholders' equity in order to remain listed on the Nasdaq National Market after October 31, 2002. At March 31, 2001, our stockholders' equity was $5,192,000, which was below the proposed requirement. If as a result of the application of these current or proposed listing requirements, our common stock were delisted from the Nasdaq National Market, our stock would become harder to buy and sell. Further, our stock could be subject to what are known as the "penny stock" rules. The penny stock rules place additional requirements on broker-dealers who sell or make a market in such securities. Consequently, if we were removed from the Nasdaq National Market, the ability or willingness of broker-dealers to sell or make a market in our common stock might decline. As a result, your ability to resell your shares of our common stock could be adversely affected. Our operating results are likely to fluctuate from quarter to quarter, which could cause the price of our common stock to decline. Our revenues and expenses have fluctuated in the past. This fluctuation has in turn caused our operating results to vary from quarter to quarter and year to year. We expect the fluctuations in our revenues and expenses to continue and thus our operating results should also continue to vary, possibly significantly. These fluctuations might be due to a variety of factors, including: . the timing and amount of sales of our products; . the timing and realization of milestone and other payments from any future collaborations with third parties; . the timing and amount of expenses relating to our research and development, product development, and collaborative activities; and . the extent and timing of costs related to our activities to obtain patents for our products and to extend, enforce and/or defend our rights to patents and other intellectual property. Because of these fluctuations, it is possible that our operating results for a particular quarter or quarters will not meet the expectations of public market analysts and investors, causing the market price of our common stock to decline. If we cannot retain or hire qualified personnel, our programs could be delayed. As of July 31, 2001, we had only 24 employees and we are highly dependent on the principal members of the management and scientific staff, including in particular Clayton I. Duncan, our Chairman, President and Chief Executive Officer. We also are highly dependent on the academic collaborators for each of our programs. The loss of key employees or academic collaborators could delay progress in our programs or result in termination of them in their entirety. We believe that our future success will depend in large part upon our ability to attract and retain highly skilled scientific and managerial personnel. We face intense competition for the kinds of personnel from other companies, research and academic institutions, government entities and other organizations. We might not be successful in hiring or retaining the personnel needed for success. If we do not obtain and maintain government authorizations to manufacture and market products, our business will be significantly harmed. Our research and development activities and the manufacturing and marketing of our products are subject to extensive regulation by governmental authorities in the United States and other countries. Clinical trials and the manufacturing and marketing of products are subject to the testing and approval processes of the FDA and foreign regulatory authorities. The process of obtaining required regulatory approvals for our products from the FDA and other regulatory authorities takes many years and is expensive. Data obtained from preclinical and clinical activities are susceptible to varying interpretations, and if regulatory authorities do not agree with our analyses of data, our product programs could be delayed or regulatory approval could be withheld. Additional government regulations might be promulgated which could delay or prevent regulatory approval of our products. Even if these approvals are obtained, post-marketing, adverse events or other monitoring of the products could result in suspension or limitation of the approvals. Product liability claims, if asserted against us in the future, could exceed our insurance coverage and use our cash resources. The pharmaceutical and biotechnology business exposes us to the risk of product liability claims alleging that use of our products caused an injury or harm. These claims can arise at any point in the development, testing, manufacture, marketing or sale of pharmaceutical products, and might be made directly by patients involved in clinical trials of our products, by consumers or healthcare providers or by organizations selling such products. Product liability claims can be expensive to defend even if the product did not actually cause the injury or harm. Insurance covering product liability claims becomes increasingly expensive as a product moves through the development pipeline to commercialization. Incara Pharmaceuticals has limited product liability insurance coverage for the clinical trials for OP2000. However, the available insurance coverage might not be sufficient to cover us against all potential losses due to liability, if any, or to the expenses associated with defending liability claims. A product liability claim successfully asserted against us could exceed our coverage and require us to use our own cash resources, which would then not be available for our own products. In addition, some of our licensing agreements with third parties require us to maintain product liability insurance. If we cannot maintain acceptable amounts of coverage on commercially reasonable terms, the corresponding agreements would be subject to termination. The costs of compliance with environmental, safety and similar laws could increase our cost of doing business or subject us to liability in the event of noncompliance. Our business is subject to regulation under state and federal laws regarding occupational safety, laboratory practices, environmental protection and the use, generation, manufacture, storage and disposal of hazardous substances. We might be required to incur significant costs in the future to comply with existing or future environmental and health and safety regulations. Our research activities involve the use of hazardous materials, chemicals and radioactive compounds. Although we believe that our procedures for handling such materials comply with applicable state and federal regulations, we cannot eliminate the risk of contamination or injury from these materials. In the event of contamination, we could be liable for any resulting damages. Provisions of our charter documents and Delaware law could lead to entrenchment of our management which could discourage or delay offers to acquire Incara, which might reduce the market price of our common stock and the voting rights of the holders of common stock. Provisions of our charter documents and Delaware law make it more difficult for our stockholders to change the directors of Incara or for a third party to acquire Incara, and might discourage a third party from offering to acquire Incara, even if a change in control or in management would be beneficial to our stockholders. These provisions also could limit the price that certain investors might be willing to pay in the future for shares of common stock. The Board of Directors of Incara has the authority to issue up to 3,000,000 shares of preferred stock in one or more series, and to determine the prices, rights, preferences, privileges and restrictions, including voting rights, of the shares within each series without any further vote or action by the stockholders. The rights of the holders of Incara common stock will be subject to, and may be adversely affected by, the rights of the holders of any preferred stock that may be issued in the future. The issuance of preferred stock with voting rights could make it more difficult for a third party to acquire a majority of the outstanding voting stock. Further, some provisions of Delaware law could delay or make more difficult a merger, tender offer or proxy contest involving Incara. Incara is subject to the antitakeover provisions of Section 203 of the Delaware General Corporation Law. In general, the statute prohibits a publicly held Delaware corporation from engaging in a business combination with an interested stockholder for a period of three years after the date of the transaction in which the person became an interested stockholder, unless the business combination is approved in a prescribed manner. While such provisions are intended to enable the Incara Board of Directors to maximize stockholder value, they might have the effect of discouraging takeovers that could be in the best interest of some stockholders. Such provisions could reduce the market value of Incara's common stock in the future. We remain contingently liable for IRL obligations. In connection with the sale of Incara Research Laboratories, or IRL, in December 1999 to a private pharmaceutical company, we agreed to remain contingently liable through May 2007 on debt and lease obligations assumed by the purchaser, including primarily the IRL facility lease in Cranbury, New Jersey. If the purchaser were to default, or the lender or landlord otherwise collect from us, our financial condition would be materially adversely affected. This contingent liability was approximately $7,000,000 in June 2001 and should decline on an approximately straight-line basis to zero in May 2007.

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+Risk Factors An investment in our securities involves a high degree of risk. You should consider carefully the risks described below together with the other information contained in this prospectus before making a decision to invest in our units. We are a development stage company with limited resources and managerial experience which could result in a material adverse effect on the development and growth of a target business We are a recently incorporated development stage company. We have not attempted to combine with another business. Because we do not have a meaningful operating history, you will have a limited basis upon which to evaluate our ability to achieve our business objective. We have limited resources and have not generated any revenues. In addition, we will not achieve any revenues (other than interest on the proceeds of this offering) until, and only if, we combine with another business. Even if we are able to effect a business combination, we may not be able to generate significant revenues or operate on a profitable basis and the combined business may not be successful. Our success in attaining our business objective of combining with a business with significant growth potential will largely be based on the abilities of our officers and directors in identifying, evaluating and selecting a prospective business and structuring and completing a business combination. Our officers and directors have limited operational and managerial experience. One of our officers has been a principal of four companies that have executed business plans similar to our business plan. These transactions represent substantially all of our management's experience in the identification, evaluation, selection and structuring of prospective business combinations. We cannot assure you that our assessment of the skills, qualifications or abilities of the management of a prospective target business will prove to be correct, especially in light of the possible inexperience of our officers and directors in evaluating many types of businesses. In addition, we cannot assure you that, despite a positive assessment by our management, the management of a prospective target business will have the necessary skills, qualifications or abilities to manage a public company intending to embark on a program of business development. If management of a target business is not qualified, it could result in a material adverse effect on the development and growth of the target business. See "Proposed Business--Effecting a Business Combination--Limited Ability to Evaluate the Target Business' Management." We may be unable to continue our existence if we are unable to raise funds in this offering Since we are a development state enterprise with no significant operating results to date and our ability to commence operations is contingent upon obtaining financing through a public offering of our securities, our auditors have raised substantial doubt as to our ability to continue as a going concern. You should carefully review and consider our financial statements in their entirety prior to investing in our common stock. We will need additional financing since we have funds to operate only until the early part of June 2001 We have sufficient funds to operate our business until approximately early June 2001; however, since this offering will likely not be completed by such time, we will need additional funds to pay the salaries of Mr. Richard Frost and Ms. Grout, our only two employees, and our rent and for general working capital purposes. We may receive loans from any of our existing stockholders, officers, or a bank or other financial institution. We intend to pay interest on the funds loaned. We will not issue any of our securities in connection with such loan or the raising of such funds. We cannot assure you that such financing would be available on acceptable terms, if at all. Such loan, together with all interest accrued thereon, may be repaid from the proceeds of this offering from funds not placed in trust, after the consummation of the business combination or upon other acceptable terms. You will not be entitled to protections, such as the return of your investment after 18 months upon failure to effect a business combination, normally afforded to investors of blank check companies Since the net proceeds of this offering are intended to be used to effect a business combination with a target business that has not been identified, we may be deemed to be a blank check company. However, we are exempt from rules promulgated by the SEC to protect investors of blank check companies since we will have net tangible assets in excess of $5,000,000 upon the successful completion of this offering. These rules, among other things, prevent a blank check company from holding investors' funds for more than 18 months from the investment date upon failure to effect a business combination as opposed to this offering in which we generally may hold investors' funds for up to 30 months. Accordingly, investors will not be afforded the benefits or protections of such rules. See "Proposed Business--Comparison to Rule 419." Our Chairman and President has been involved with four similar companies, three of which have had disappointing results Our Chairman and President, Richard Frost, has been a principal of companies that have completed four offerings similar to this offering and executed business plans similar to our business plan. All four of these companies acquired an operating business, but in two of the four cases, the companies filed for bankruptcy within 18 months after completing their acquisitions. In one of the other two cases, the entity into which the company was subsequently merged filed for bankruptcy four years after the initial business combination. Equity holders in a company that files for bankruptcy generally lose their entire investment. However, in two of such three cases, the price of the shares of such company's common stock at some point increased substantially beyond the initial public offering price offered to investors for such shares. The last of the companies of which Mr. Richard Frost has been involved merged with GBI Capital Management Corp. (currently Ladenburg Thalmann Financial Services Inc.), whose wholly-owned subsidiary is GBI Capital Partners, Inc., the representative of the underwriters of this offering. You will not acquire any interest in these companies by investing in our common stock. You should also not conclude that we will be able to complete a business combination within a time period comparable to these other four companies (or at all), or that we will complete a business combination with companies in similar lines of business. Moreover, you may lose your entire investment if we are unsuccessful in our business and are compelled to file for bankruptcy. Our Chairman and President was one of several principals in the four similar companies in which he was involved and is the sole principal in this company In the four completed offerings similar to this offering, Mr. Richard Frost was one of several principals. Such principals played a significant role in identifying and evaluating prospective businesses and structuring and completing the business combinations effected by the respective companies. Mr. Frost is the sole principal of this company. His primary experience with companies of this nature is comprised of his experience in the four offerings referred to above. We cannot assure you to what extent Mr. Frost as the sole principal in this offering will impact our ability to attain our business objectives. If we are deemed to be an investment company, we may be required to institute burdensome compliance requirements and our activities may be restricted, which may make it difficult for us to effect a business combination In the event we are deemed to be an investment company under the Investment Company Act of 1940, our activities may be restricted, including: - restrictions on the nature of our investments; and - restrictions on the issuance of securities, which may make it difficult for us to effect a business combination. In addition, we may have imposed upon us burdensome requirements, including: - registration as an investment company; - adoption of a specific form of corporate structure; and - reporting, record keeping, voting, proxy and disclosure requirements and other rules and regulations. Compliance with such additional regulatory burdens would require additional expense we have not allotted for such purposes. If we are forced to liquidate prior to a business combination, our public stockholders will receive less than $6.00 per share upon distribution of the trust fund and our remaining assets In the event we liquidate our assets upon our inability to effect a business combination, the per-share liquidation distribution will be less than $6.00 as a consequence of the expenses of this offering and our anticipated costs incurred in seeking a business combination. We intend to utilize the net proceeds not placed in trust to identify and evaluate prospective businesses for a business combination and to structure a business combination. We will be required to make these expenditures, which will likely be significant, whether or not we complete a business combination with the prospective businesses we consider. These proceeds will also be used to pay our general and administrative expenses, including office rent, salaries and accountable and non-accountable expenses. Furthermore, there will be no distribution from the trust fund with respect to our outstanding warrants and, accordingly, the warrants will expire worthless in the event we liquidate prior to the completion of a business combination. See "Proposed Business--Effecting a Business Combination--Liquidation If No Business Combination." We could have a claim by third parties which could reduce the proceeds held in trust Our placing of funds in trust will not protect such funds from third party claims against us and such funds could be subject to such claims which could take priority over the claims of the public stockholders. We cannot assure you that the per share liquidation price will not be less than $5.05 (or $.95 less than the per unit offering price of $6.00, which are the proceeds required to be deposited in the trust fund), plus interest, due to claims of creditors. If we liquidate prior to the consummation of a business combination, Mr. Richard Frost will be personally liable under certain circumstances to ensure that the proceeds in the trust fund are not reduced by any claims of our creditors. However, we cannot assure you that Mr. Frost could satisfy such obligations. See "Proposed Business--Effecting a Business Combination--Liquidation If No Business Combination." Since management is not required to allocate full time to our business, a conflict of interest may result in the allocation of their time, which could cause us a delay in or prevent us from effecting a business combination Our officers and directors are not required to commit their full time to our affairs, which may result in a conflict of interest in allocating management time between our operations and other businesses. Certain of these persons may in the future become affiliated with entities, including other "blank check" companies, engaged in business activities similar to those intended to be conducted by us. Such conflict may cause a delay in or prevent us from effecting a business combination and may not be in the best interest of our stockholders. See "Management--Conflicts of Interest." Since we have not as yet selected a particular industry or any target business with which to effect a business combination, we are unable to ascertain the merits or risks of the industry or business in which we may ultimately operate We have not selected any particular industry or any target business on which to concentrate our search for a business combination. Accordingly, there is no current basis for prospective investors to evaluate the possible merits or risks of the particular industry or the target business in which we may ultimately operate. We may be affected by numerous risks inherent in the business operations of any company with which we effect a business combination. Although our management will endeavor to evaluate the risks inherent in a particular industry or target business, we cannot assure you that we will properly ascertain or assess all such significant risk factors. We also cannot assure you that an investment in our units will not ultimately prove to be less favorable to investors in this offering than a direct investment, if such opportunity were available, in a target business. See "Proposed Business--Effecting a Business Combination--We Have Not Identified a Target Business or Target Industry." Our probable inability to effect more than one business combination may subject us to adverse economic, competitive and regulatory developments, including the inability to diversify our operations or benefit from the possible spreading of risks or offsetting of losses Our initial business combination must be with a business with a fair market value of at least 80% of our net assets at the time of such acquisition. Consequently, it is likely that we will have the ability to effect only a single business combination and be unable to diversify our operations or benefit from the possible spreading of risks or offsetting of losses. Our probable lack of diversification may subject us to numerous economic, competitive and regulatory developments, any or all of which may have a substantial adverse impact upon the particular industry in which we may operate subsequent to a business combination. Accordingly, our prospects for success will be entirely dependent upon the future performance of a single business or product. Therefore, we cannot assure you that the target business will prove to be commercially viable. See "Proposed Business--Effecting a Business Combination--Probable Lack of Business Diversification" and "--Competition." We may issue shares of our common stock and/or preferred stock to effect a business combination, which would reduce the equity interest of our stockholders Our Certificate of Incorporation authorizes the issuance of 100,000,000 shares of common stock, par value $.0001 per share. Upon completion of this offering, there will be 97,762,500 authorized but unissued shares of our common stock available for issuance (after appropriate reservation for the issuance of shares upon full exercise of the underwriters' option). Although we have no commitments as of the date of this offering to issue our securities, we will, in all likelihood, issue a substantial number of additional shares of our common stock or preferred stock, or a combination of common and preferred stock, to effect a business combination. The issuance of additional shares of our common stock or any number of shares of our preferred stock may: - significantly reduce the equity interest of our stockholders; - possibly cause a change in control if a substantial number of our shares of common stock are issued which may affect, among other things, our ability to utilize our net operating loss carry forwards, if any, and most likely also result in the resignation or removal of our present officers and directors; accordingly our investors will be relying on the abilities of the management and directors of the target business who are unidentifiable as of the date of this offering; - adversely affect prevailing market prices for our common stock; and - impair our ability to raise additional capital through the sale of our equity securities. Additionally, to the extent we issue shares of common stock to effect a business combination, the potential for the issuance of substantial numbers of additional shares upon exercise of our warrants could increase our cost of the target business in terms of number of shares required to be issued. We may be unable to obtain additional financing, if required, to effect a business combination or to fund the operations and growth of the target business, which could compel us to restructure the transaction or abandon a particular business combination We may seek additional financing to complete a business combination or to fund the operations and growth of a target business, which may include assuming or refinancing the indebtedness of the target business. We cannot assure you that such financing would be available on acceptable terms, if at all. To the extent that such additional financing proves to be unavailable when needed to complete a particular business combination, we would, in all likelihood, be compelled to restructure the transaction or abandon that particular business combination and seek an alternative candidate. In addition, our failure to secure additional financing could have a material adverse effect on the continued development or growth of the target business. We may incur certain risks if we seek debt financing The amount and nature of any borrowings by us will depend on numerous considerations, including our capital requirements, our perceived ability to meet debt service requirements and the prevailing conditions in the financial markets and general economic conditions. Debt financing may not be available to us on terms deemed to be commercially acceptable and in our best interests. Our inability to borrow funds required to effect or facilitate a business combination, or to provide funds for an additional infusion of capital into an acquired business, may have a material adverse effect on our financial condition and future prospects. Additionally, if debt financing is available, any borrowings may subject us to various risks traditionally associated with incurring of indebtedness. These risks include the risks of interest rate fluctuations and insufficiency of cash flow to pay principal and interest. We may assume similar risks to the extent that any business with which we combine has outstanding indebtedness. Certain states have enacted regulations restricting or prohibiting the sale of our securities Although for purposes of Rule 419, we are not a "blank check company," a number of states have enacted legislation regulating blank check company which will apply to us. In addition, many states, while not specifically prohibiting or restricting blank check companies, will not permit registration or qualification of our common stock for sale in their states. Because of such regulations and other restrictions, our selling efforts, and any secondary market which may develop, may only be conducted in certain states (or in those jurisdictions where an applicable exemption is available or a blue sky application has been filed and accepted). There can be no assurances that the SEC, the United States Congress, or state legislatures will not enact legislation or regulations which will prohibit or restrict the sale of our securities. You may only purchase our common stock if you reside within certain states We have applied to register, or have obtained or will seek to obtain an exemption from registration to offer our common stock, and intend to conduct our selling efforts in Delaware, the District of Columbia, Florida, Hawaii, Illinois, Maryland, New York and Rhode Island. You must be a resident of these jurisdictions to purchase our common stock. In order to prevent resale transactions in violation of states' securities laws, you may only engage in resale transactions in these states and such other jurisdictions in which an applicable exemption is available or a blue sky application has been filed and accepted. This restriction on resale may limit your ability to resell the common stock purchased in this offering. Several additional states may permit secondary market sales of the shares of common stock: (i) once or after certain financial and other information with respect to us is published in a recognized securities manual such as Standard & Poor's Corporation Records; (ii) after a certain period has elapsed from the date hereof; or (iii) pursuant to exemptions applicable to certain investors. However, because we are considered to be a "blank check" company for such purposes, we may not be able to be listed in any recognized securities manual until after the consummation of the first business combination. Our inability to be listed until a business combination may adversely impact the price of our common stock. You will experience immediate and substantial dilution The difference between the public offering price per share of our common stock and the pro forma net tangible book value per share of our common stock after this offering constitutes the dilution to you and the other investors in this offering. The fact that our existing stockholders acquired their shares of common stock at a nominal price (ranging from $.15 to $.89 per share after giving effect to a merger effective on April 4, 2001 where each issued and outstanding share of Frost Capital Group, Inc., a Florida corporation, was converted into approximately .6723 shares of our common stock) has significantly contributed to this dilution. Assuming the offering is completed, you and the other new investors will incur an immediate and substantial dilution of approximately $3.42 per share (the difference between the pro forma net tangible book value per share of $2.58, and the initial offering price of $6.00 per share) allocable to each share of common stock (in each case assuming no exercise of the option granted to any underwriters). Our common stock may become subject to the SEC's penny stock rules If at any time we have net tangible assets of $5,000,000 or less, transactions in our common stock may be subject to certain rules under the Securities Exchange Act of 1934. Under such rules, broker-dealers who recommend such securities to persons other than institutional accredited investors (generally institutions with assets in excess of $5,000,000): o must make a special written suitability determination for the purchaser; o receive the purchaser's written agreement to a transaction prior to sale; o provide the purchaser with risk disclosure documents which identify certain risks associated with investing in "penny stocks" and which describes the market for these "penny stocks" as well as a purchaser's legal remedies; and o obtain a signed and dated acknowledgment from the purchaser demonstrating that the purchaser has actually received the required risk disclosure document before a transaction in a "penny stock" can be consummated. For purposes of reducing the possible application of such rules, Mr. Richard Frost and Ms. Grout have agreed that their salaries or other expenses shall not accrue or be paid to them if it would reduce our tangible net worth below $5,000,000. If our common stock becomes subject to these rules, broker-dealers may find it difficult to effectuate customer transactions and trading activity in our common stock. As a result, the market price of our common stock may be depressed, and you may find it difficult to dispose of our common stock. Our loss of the services of Richard Frost would make it difficult to find a suitable company for a business combination, which makes it more likely that we will be forced to liquidate our trust fund and distribute to our stockholders something less than the amount paid for the securities purchased in this offering Our ability to successfully effect a business combination will be largely dependant upon the efforts of Mr. Richard Frost, our Chairman and President. We have not entered into an employment agreement with Mr. Frost or obtained any "key man" life insurance on his life. The loss of Mr. Frost's services could have a material adverse effect on our ability to successfully achieve our business objectives, including seeking a suitable target business to effect a business combination. Our directors may have a conflict of interest in determining whether a particular business is appropriate to effect a business combination, which may not be in the best interests of our stockholders Each of our directors owns stock in our company which will be held in escrow until after we effect a business combination. Consequently, management's discretion in determining the fair market value of a target business and the suitability of a proposed combination may result in a conflict of interest when determining whether a particular target business is appropriate to effect a business combination. Such conflict may not be in the best interests of our stockholders. See "Management--Conflicts of Interest." Our affiliates may potentially purchase our units in this offering and/or units, shares and warrants following this offering in the open market Our affiliates may purchase units in this offering and/or units, shares and warrants following this offering in the open market. Our affiliates may then have greater ownership of and greater control over us. We have an existing relationship with the representative of the underwriters of this offering GBI Capital Partners Inc. is the wholly-owned subsidiary of Ladenburg Thalmann Financial Services Inc., a publicly-traded corporation which was initially named Frost Hanna Capital Group, Inc., and was the most recent blind pool transaction that Richard Frost, our Chairman and President, engaged in as a principal. Mr. Frost is the nephew of Dr. Phillip Frost, who as of the date of this offering, beneficially owns approximately 25.2% of our issued and outstanding common stock and 3.4% of the issued and outstanding common stock of Ladenburg Thalmann Financial Services Inc. Additionally, Frost-Nevada Limited Partnership, of which Dr. Phillip Frost is the beneficial owner, loaned $10,000,000 to Ladenburg Thalmann Financial Services Inc. upon consummation by Ladenburg Thalmann Financial Services Inc. of a certain acquisition. Such proceeds were utilized by Ladenburg Thalmann Financial Services Inc. to fund the cash portion of the purchase price of such acquisition and Frost-Nevada Limited Partnership received a $10,000,000 senior convertible promissory note from Ladenburg Thalmann Financial Services Inc. As a result of this and certain related transactions, Frost-Nevada Limited Partnership has the right to acquire an additional number of the issued and outstanding common stock of Ladenburg Thalmann Financial Services Inc., so that Dr. Phillip Frost will beneficially own approximately 15.6% of such shares in the aggregate. Dr. Frost also serves as a director of Ladenburg Thalmann Financial Services Inc. See "Underwriting." Besides Dr. Frost, all of our existing officers and directors as well as a majority of our existing stockholders also own approximately 1.6% of the common stock of Ladenburg Thalmann Financial Services Inc. Dr. Frost is not and has never been an officer, director or principal of our company. We may reimburse our directors and officers for any reasonable business expenses with our board determining what may be deemed reasonable We will use the net offering proceeds not held in trust to pay, among other things, the salaries of Mr. Richard Frost and Ms. Grout, our only employees. There is no limit on the amount of reimbursable accountable expenses incurred in connection with seeking and consummating a business combination or performing other activities on our behalf. There will be no review of the reasonableness of such expenses by anyone other than our board of directors, one of the members of which is an officer. Notwithstanding the foregoing, to the extent that there are not sufficient funds to pay the salaries of Mr. Frost or Ms. Grout as described above and other expenses, we may accrue such amounts, which shall be paid from the trust account proceeds if a business combination is effectuated; provided, however that, the amounts paid or to be paid to such persons will not reduce our tangible net worth below $5,000,000 for purposes of the "penny stock" rules. See "Use of Proceeds -- Payment to Officers and Directors" and "Management -- Executive Compensation."

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+Risk Factors Exercising your rights delivered in this offering and purchasing our common stock involves a high degree of risk. You should carefully read and consider the information set forth under "Risk Factors" and the other information contained in this Prospectus. State and Date of Incorporation and Address We were incorporated in Delaware on March 30, 1994. Our principal executive offices are at 9189 Red Branch Road, Columbia, Maryland 21045. Our telephone number is (410) 772-3500. <PAGE> <TABLE> <S> <C> <C> <C> <C> <C> <C> Summary Consolidated Financial Data Six Months Ended Years Ended (in thousands, June 30, December 31, except per share data) 2001 2000 2000 1999 1998 1997 1996 Operating Data: Contract revenue $ 24,323 $ 28,424 $ 55,715 $ 66,699 $ 73,818 $ 79,711 $ 96,033 Gross profit 6,254 8,987 14,893 25,070 24,004 21,385 32,354 Operating expenses 5,999 9,264 19,548 24,326 22,113 30,812 27,509 Operating income (loss) 255 (277) (4,655) 744 1,891 (9,427) 4,845 Gain (loss) on sales of assets 3,273 - (990) - 550 - - Interest expense, net (452) (320) (687) (450) (350) (765) (387) Other income (expense), net 133 21 55 40 326 (1,228) 394 Provision (benefit) for income taxes 1,027 (210) 2,537 233 1,020 (2,717) 709 Net income (loss) $ 2,182 $ (366) (8,814) $ 101 $ 1,397 $ (8,703) $ 4,143 Per Share Data: Basic earnings (loss) per common share $ 0.42 $ 0.07 $(1.70) $ 0.02 $ 0.28 $(1.72) $ 0.82 Diluted earnings (loss) per common share $ 0.42 $ 0.07 $(1.70) $ 0.02 $ 0.27 $(1.72) $ 0.82 Common stock shares outstanding 5,194 5,193 5,182 5,066 5,066 5,066 5,066 As of June 30, As of December 31, Financial Condition Data: 2001 2000 2000 1999 1998 1997 1996 Working capital $ 3,855 $ 7,588 $ 5,522 $ 8,665 $ 4,058 $ 1,646 $ 13,867 Total assets 36,846 42,772 35,949 43,027 48,743 48,362 51,006 Long-term liablilities 11,154 9,737 12,390 9,083 3,350 2,369 2,580 Stockholders' equity 10,850 17,204 8,713 17,170 17,089 15,924 24,693 </TABLE> Our operating results in 2000 include $2.9 million contract revenues and related profit from the licensing of software to Avantium International B.V. in exchange for 251,501 shares of Avantium preferred stock and 352,102 shares of Avantium common stock. In addition, the following significant charges were incurred in 2000: a $710,000 provision to write-down Process Automation inventory, a $990,000 loss on the sale of our Belgium subsidiary, and a $4.3 million income tax charge to increase our deferred tax asset valuation allowance. Net income for the six months ended June 30, 2001 includes a $3.3 million pre-tax gain on the sale of our VirtualPlant business technology and assets to Avantium International B.V. <PAGE> Risk Factors Warning as to our use of forward-looking statements. This document contains certain forward-looking statements concerning GSE Systems. These forward-looking statements are based on the beliefs of our management, as well as on assumptions made by and information currently available to us at the time such statements are made. The discussion of our business strategy is not based on historical facts but is comprised of forward looking statements based upon numerous assumptions about future conditions, which may ultimately prove to be inaccurate. When we use words such as "anticipate," "believe," "estimate," "intend" and similar expressions in this Prospectus, we intend to identify forward-looking statements. Actual results could differ materially from those projected in the forward-looking statements as a result of the risk factors set forth below, the matters set forth or incorporated in this document generally and economic and business factors, some of which are beyond our control. In analyzing our company, you should carefully consider, along with other matters referred to in this document, the risk factors detailed in this Risk Factors section and throughout this document and future reports issued by our company. Risks related to this offering. Stock Market Risks. The subscription price in this rights offering represents a 10% premium to the market price of our common stock on June 15, 2001, which was the date selected by our board of directors for calculating the subscription price. On October 23, 2001, the last reported sale price for the common stock was $2.25 per share. We cannot assure you that the subscription price will be below any trading price for our common stock for all or part of the offering period or that its trading price will be above the subscription price at any time after the rights offering. We urge you to consider prevailing market conditions in deciding whether to exercise your subscription rights. The trading price of our common stock may be below the subscription price for all or a part of the offering period and following the offering period. Future prices of our stock may be affected positively or negatively by our future revenues and earnings, changes in estimates by analysts, our ability to meet analysts' estimates, speculation in the trade or business press about our company, and overall conditions affecting our businesses, economic trends and the securities markets. Although our common stock is listed on the American Stock Exchange, it is thinly traded. Our stock price may fluctuate more than the stock market as a whole. As a result of the thin trading market for our stock, its market price may fluctuate significantly more than the stock market as a whole or the stock prices of our peer companies. Of the 5,193,527 shares of our outstanding common stock, only about 1,713,864, or approximately 33%, are owned by persons other than our officers, directors and four largest stockholders. Without a larger float, our common stock will be less liquid than the stock of companies with broader public ownership, and, as a result, the trading prices for our common stock may be more volatile. Among other things, trading of a relatively small volume of our common stock may have a greater impact on the trading price for our stock than would be the case if our public float were larger. In addition, sales of a substantial amount of common stock in the public market, or the perception that these sales may occur, could adversely affect the market price of our common stock prevailing from time to time. Possible or actual sale of any of these shares, particularly by our officers, directors and large stockholders, may decrease the price of shares of our common stock. The subscription price is not necessarily an indication of the value of our company. We have established the subscription price at $2.53 per share, a 10% premium above the market price of the common stock as of June 15, 2001. The market price on that date also represented the average market price of the common stock for the preceding 30 days. On October 23, 2001, the last reported sale price for the common stock was $2.25 per share. We set the subscription price after considering a variety of factors, including our desire to encourage maximum stockholder participation in this rights offering, and thereby raise capital without diluting the interests of current stockholders. The subscription price does not necessarily bear any relationship to the book value of our assets, past operations, cash flows, losses, financial condition or any other established criteria for value. You should not consider the subscription price as an indication of our present or future value. We have neither sought nor obtained a valuation opinion from an outside financial consultant or investment banker. Once you send in your subscription forms and payment, you cannot revoke the exercise of your subscription rights. Once you send in your subscription forms and payment, you cannot revoke the exercise of your subscription rights, even if you later learn information about us that you consider to be unfavorable. You should not exercise your subscription rights unless you are certain that you wish to purchase additional shares of common stock at the subscription price. If we cancel the rights offering, we are obligated only to refund payments actually received, without interest. If you do not exercise your rights, your relative ownership interest may be diluted. If you choose not to exercise your subscription rights, your relative ownership interest may be diluted depending on the number of shares subscribed by other stockholders. In addition, because the prevailing market price of our common stock may be greater than the subscription price for part of the offering period, if you choose not to exercise your subscription rights you could experience dilution of your economic interest. There are significant restrictions on transfers of the rights. Generally, only our stockholders of record as of the record date may exercise the rights. You may not sell, give away, or otherwise transfer your subscription rights, except to your immediate family members, to entities wholly owned or controlled by you, or to other similar affiliates. For information on how your rights can be transferred, see "The Rights Offering - Transferability of Rights." Need to act promptly and follow subscription instructions. If you desire to purchase shares in the rights offering or to transfer or sell your rights, you must act promptly to ensure that all required forms and payments are actually received by the subscription agent, Continental Stock Transfer & Trust Company, prior to the expiration date. If you fail to complete and sign the required subscription forms, send an incorrect payment amount, or otherwise fail to follow the subscription procedures that apply to your desired transaction, the subscription agent may, depending on the circumstances, reject your subscription or accept it to the extent of the payment received. Neither GSE Systems nor the subscription agent undertakes to contact you concerning, or to attempt to correct, an incomplete or incorrect subscription form. GSE Systems has the sole discretion to determine whether a subscription exercise properly follows the subscription procedures. Personal checks may not clear in time for you to exercise your subscription right. Any personal check used to pay for shares must clear prior to the expiration date, and the clearing process may require five or more business days. You may be able to purchase shares of our common stock on the open market at a price that is lower than the exercise price of the rights in this offering. We have established the subscription price at $2.53 per share, a 10% premium above the market price of the common stock as of June 15, 2001. The market price on that date also represented the average market price of the common stock for the preceding 30 days. On October 23, 2001, the last reported sale price for the common stock was $2.25 per share. Since the market price of our common stock fluctuates, we urge you to consider prevailing market conditions in deciding whether to exercise your subscription rights. You may have committed to buy shares of common stock at a price above the prevailing market price and you may have an immediate unrealized loss. Moreover, we cannot assure you that following the exercise of subscription rights you will be able to sell your shares of common stock at a price equal to or greater than the subscription price. Until certificates are delivered upon expiration of the rights offering, you may not be able to sell the shares of our common stock that you purchase in the rights offering. Certificates representing shares of our common stock purchased will be delivered as soon as practicable after expiration of the rights offering. We will not pay you interest on funds delivered to the subscription agent pursuant to the exercise of rights. Risks related to our business. Our expense levels are based upon our expectations as to future revenues, so we may be unable to adjust spending to compensate for a revenue shortfall. Accordingly, any revenue shortfall would likely have a disproportionate adverse effect on our operating results. Our operating results have fluctuated in the past and may fluctuate in the future as a result of a variety of factors, including purchasing patterns, timing of new products and enhancements by us and our competitors and fluctuating foreign economic conditions. Since our expense levels are based in part on expectations as to future revenues, we may be unable to adjust spending in a timely manner to compensate for any revenue shortfall and such revenue shortfalls would likely have a disproportionate adverse effect on our operating results. We believe that these factors may cause the market price for our common stock to fluctuate, perhaps significantly. In addition, in recent years the stock market in general, and the shares of technology companies in particular, have experienced extreme price fluctuations. Risk of International Sales and Operations. Sales of products and the provision of services to end users outside the United States accounted for approximately 52% of our consolidated revenues in 2000. We anticipate that international sales and services will continue to account for a significant portion of our revenues in the foreseeable future. As a result, we may be subject to certain risks, including risks associated with the application and imposition of protective legislation and regulations relating to import or export (including export of high technology products) or otherwise resulting from trade or foreign policy and risks associated with exchange rate fluctuations. Additional risks include potential difficulties involving our strategic alliances and managing foreign sales agents or representatives and potential difficulties in accounts receivable collection. We currently sell products and provide services to customers in emerging market economies such as Russia, Ukraine, Bulgaria, and the Czech Republic. We have taken steps designed to reduce the additional risks associated with doing business in these countries, but we believe that such risks still exist and include, among others, general political and economic instability, as well as uncertainty with respect to the efficacy of applicable legal systems. We cannot be sure that these and other factors will not have a material adverse effect on our business, financial condition or results of operations. We rely for a substantial portion of our revenues on two customers. Loss of either of these customers would have a material adverse effect upon our revenues and results of operations. For the year ended December 31, 2000, one Power Simulation customer (Battelle's Pacific Northwest National Laboratory) accounted for approximately 22% of our consolidated revenues. The Pacific Northwest National Laboratory is the purchasing agent for the Department of Energy and the numerous projects we perform in Eastern and Central Europe. For the year ended December 31, 2000, one Process Automation customer (Westinghouse Savannah River Company) accounted for approximately 11% of our consolidated revenues. If we lost either of these customers, our revenue and results of operations would be materially and adversely affected. Our business is substantially dependent on sales to certain industries. Any disruption in these industries would have a material adverse effect upon our revenues. In 2000, 54.6% of our revenue was from customers in the nuclear power industry. We will continue to derive a significant portion of our revenues from customers in the nuclear power industry for the foreseeable future. Our ability to supply nuclear power plant simulators and related products and services is dependent on the continued operation of nuclear power plants and, to a lesser extent, on the construction of new nuclear power plants. A wide range of factors affects the continued operation and construction of nuclear power plants, including the political and regulatory environment, the availability and cost of alternative means of power generation, the occurrence of future nuclear incidents, and general economic conditions. In 2000, 26.1% of our revenue was from customers in the chemicals industry. Accordingly, our future performance is dependent to a certain extent upon the demand for our products by customers in the chemicals industry. Our revenues may be subject to period-to-period fluctuations as a consequence of industry cycles, as well as general domestic and foreign economic conditions and other factors affecting spending by companies in our target process industries. Our substantial indebtedness could adversely affect our financial condition. We have substantial indebtedness and will continue to have substantial indebtedness after the completion of the rights offering. In addition, we may increase our indebtedness in the future. The following are important statistics about us and our indebtedness: o On June 30, 2001, we had total long-term debt of $10.7 million, representing 49.7% of our total capitalization. o At June 30, 2001, our available borrowing base under our bank line of credit was approximately $6.4 million, of which we have borrowed approximately $5.3 million. Our level of indebtedness could have important consequences to our stockholders. For example, it could: o Make us more vulnerable to economic downturns. o Potentially limit our ability to withstand competitive pressures. o Impair our ability to obtain additional financing in the future for working capital, capital expenditures, acquisitions or general corporate purposes. o Make us more susceptible to the above risks because borrowings under our credit facility will bear interest at fluctuating rates. If we are unable to generate sufficient cash flow from operations in the future we may be unable to repay or refinance all or a portion of our then existing debt or to obtain additional financing. We cannot be sure that any such refinancing would be possible or that any additional financing could be obtained on terms that are acceptable to us. Our debt agreements impose significant operating and financial restrictions, which may prevent us from capitalizing on business opportunities. Our debt agreements impose significant operating and financial restrictions on us. These restrictions affect, and in certain cases limit, among other things, our ability to: o incur additional indebtedness and liens o make capital expenditures o make investments and acquisitions and sell assets o consolidate, merge or sell all or substantially all of our assets There can be no assurance that these restrictions will not adversely affect our ability to finance our future operations or capital needs or to engage in other business activities that may be in the interest of stockholders. Our business is dependent on product innovation and research and development, which costs are incurred prior to revenues for new products and improvements. We believe that our success will depend in large part on our ability to maintain and enhance our current product line, develop new products, maintain technological competitiveness and meet an expanding range of customer needs. Our product development activities are aimed at the development and expansion of our library of software modeling tools, the improvement of our display systems and process control technologies, the addition of applications aimed at increasing customer productivity, and expanding the capabilities of our products to take advantage of the Internet. The life cycles for software modeling tools, display system software, process control and simulation technologies are variable and are largely determined by competitive pressures. Consequently, we will need to continue to make significant investments in research and development to enhance and expand our capabilities in these areas and to maintain our competitive advantage. We rely upon our intellectual property rights for the success of our business; however, the steps we have taken to protect our intellectual property may be inadequate. Although we believe that factors such as the technological and creative skills of our personnel, new product developments, frequent product enhancements and reliable product maintenance are important to establishing and maintaining a technological leadership position, our business depends, in part, on our intellectual property rights in our proprietary technology and information. We rely upon a combination of trade secret, copyright, patent and trademark law, contractual arrangements and technical means to protect our intellectual property rights. We enter into confidentiality agreements with our employees, consultants, joint venture and alliance partners, customers and other third parties that are granted access to our proprietary information, and limit access to and distribution of our proprietary information. We cannot be sure, however, that we have protected or will be able to protect our proprietary technology and information adequately, that the unauthorized disclosure or use of our proprietary information will be prevented, that others have not or will not develop similar technology or information independently, or, to the extent we own patents, that others have not or will not be able to design around those patents. Furthermore, the laws of certain countries in which our products are sold do not protect our products and intellectual property rights to the same extent as the laws of the United States. The industries in which we operate are highly competitive. This competition may prevent us from raising prices at the same pace as our costs increase. Our businesses operate in highly competitive environments with both domestic and foreign competitors, many of whom have substantially greater financial, marketing and other resources than us. The principal factors affecting competition include price, technological proficiency, ease of system configuration, product reliability, applications expertise, engineering support, local presence and financial stability. We believe that competition in the simulation and process automation fields may further intensify in the future as a result of advances in technology, consolidations and/or strategic alliances among competitors, increased costs required to develop new technology and the increasing importance of software content in systems and products. Due to this level of competition, raising prices has been difficult over the past several years and will likely continue to be so in the near future. As our business has a significant international component, changes in the value of the dollar can adversely affect our ability to compete internationally. We will continue to pursue new acquisitions and joint ventures, and any of these transactions could adversely affect our operating results or result in increased costs or other problems. We intend to continue to pursue new acquisitions and joint ventures, a pursuit which will consume substantial time and resources. Identifying appropriate acquisition candidates and negotiating and consummating acquisitions can be a lengthy and costly process. We may also encounter substantial unanticipated costs or other problems associated with the acquired businesses. The risks inherent in our strategy could have an adverse impact on our results of operation or financial condition. The chemicals and nuclear power industries, two of our largest customer groups, are associated with a number of hazards which could create significant liabilities for us. Our business could expose us to third party claims with respect to product, environmental and other similar liabilities in the chemicals, nuclear power or other industries to which we market our products. Although we have sought to protect ourselves from these potential liabilities through a variety of legal and contractual provisions as well as through liability insurance, the effectiveness of such protections has not been fully tested. The failure or malfunction of one of our systems or devices could create potential liability for substantial monetary damages and environmental cleanup costs. Such damages or claims could exceed the applicable coverage of our insurance. Although we have no material liability claims against us to date, such potential future claims could have a material adverse effect on our business or financial condition. Certain of our products and services are used by the nuclear power industry primarily in operator training. Although our contracts for such products and services typically contain provisions designed to protect us from potential liabilities associated with such use, there can be no assurance that we would not be materially adversely affected by claims or actions which may potentially arise. We are controlled by our principal stockholders, whose interests may not be aligned with those of our other stockholders. As of June 30, 2001, ManTech, GP Strategies, our directors and our executive officers beneficially own approximately 49% of our outstanding common stock. In addition, we intend to issue 39,000 shares of Series A preferred stock to ManTech in full payment of our existing $3.9 million promissory note to ManTech. The Series A preferred stock converts into an aggregate of 1,474,480 shares of common stock. If fully converted by ManTech and if no shares are subscribed in this offering, ManTech will beneficially own approximately 35.8% of our outstanding common stock, and GP Strategies will beneficially own approximately 17.4% of our outstanding common stock. ManTech and GP Strategies disclaim beneficial ownership of all shares, including those subject to option, that are owned by affiliated individuals. ManTech has advised us that it intends to grant GP Strategies an option to acquire 19,500 shares of the Series A preferred stock from ManTech. If ManTech exercises its option to convert the Series A preferred stock to common stock, and GP Strategies exercises its option to acquire 50% of the Series A preferred stock held by ManTech and also converts those shares to common stock, and if no shares are subscribed in this offering, ManTech will beneficially own approximately 24.8%, and GP Strategies will beneficially own approximately 28.4%, of our outstanding common stock. If these stockholders vote together as a group, they will be able to control our business and affairs, including the election of individuals to our board of directors, and the outcome of actions that require stockholder approval including mergers, sales of assets, and to prevent, or to cause, a change of control of our company. <PAGE> The

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+RISK FACTORS Any investment in our common stock involves a high degree of risk. You should consider carefully the following information about risks, together with the other information contained in this prospectus, before you decide whether to buy our common stock. If any of the following risks actually occur, our business, results of operations and financial condition could suffer significantly. In any such case, the market price of our common stock could decline, and you may lose all or part of the money you paid to buy our common stock. RISKS RELATED TO OUR BUSINESS WE HAVE A HISTORY OF LOSSES AND WE HAVE ACCUMULATED A DEFICIT OF $35.7 MILLION AS OF MARCH 31, 2001. IF WE FAIL TO ACHIEVE AND TO MAINTAIN PROFITABILITY IN THE FUTURE, INVESTORS COULD LOSE CONFIDENCE IN THE VALUE OF OUR STOCK WHICH COULD CAUSE IT TO DECLINE. We have spent significant funds to date to develop and to refine our current technologies and services and to develop our sales and marketing resources. If we are unable to execute on our strategy to become profitable, our stock price could be negatively affected. We have incurred significant operating losses in the past and have not yet achieved profitability. As of March 31, 2001, we had an accumulated deficit of $35.7 million. In addition, we expect to continue to invest significantly in our next-generation research and development projects and to continue to hire additional people in all areas of our company to support our growing business. As a result of these factors, to achieve profitability we will need, among other matters, to increase our customer base and to increase the number of and amounts of products and services purchased by our customers. We cannot assure you that we will be able to increase our revenue or operating efficiencies in this manner or otherwise and achieve and maintain profitability. Because we expect to continue to increase our investment in new areas of our business, our investment could outpace growth in our revenue, thus preventing our ability to achieve and maintain profitability. If we are unable to achieve and maintain profitability, our stock price could be materially adversely affected. OUR RECENT ACQUISITIONS HAVE, AND FUTURE ACQUISITIONS COULD, REQUIRE SIGNIFICANT MANAGEMENT ATTENTION AND MIGHT FURTHER DISTRACT OUR MANAGEMENT AND DISRUPT OUR BUSINESS. We acquired Snaketech, S.A., a French societe anonyme, in March 2000 and Altius Solutions, Inc. in October 2000. If we fail to successfully integrate Snaketech, Altius, or any future acquisition into our company, the revenue and operating results of the combined company would decline. To realize the benefits of these recent acquisitions, we must successfully integrate both companies' research and development facilities into our existing operations despite differences in culture, language and legal environments, such as the mandated 35 hour work week in France, specific work rules covering the Altius Japan office, and different tax treatments related to the issuance of equity to employees. Such integration has required and will continue to require significant time and resources to manage; we may not be able to manage such integration successfully. If our customers are uncertain about our ability to operate on a combined basis, they could delay or cancel orders for our products. We intend to continue to make investments in complementary companies, products or technologies. If we buy a company or a division of a company, we could have difficulty in assimilating that company or division's personnel and operations which could negatively affect our operating results. In addition, the key personnel of the acquired company may decide not to work for us. Furthermore, we may have to incur debt or issue equity securities as we have in past acquisitions to pay for any future acquisition, the issuance of which would be dilutive to our existing stockholders. OUR INDUSTRIES ARE CHARACTERIZED BY RAPID TECHNOLOGICAL CHANGE. IF WE FAIL TO DESIGN NEW PRODUCTS THAT GAIN MARKET ACCEPTANCE, IT WILL RESULT IN REDUCED GROSS MARGINS AND LOSS OF MARKET SHARE. The semiconductor and design software industries are characterized by rapid technological change, frequent new product introductions and evolving industry standards. The introduction of products embodying new technologies and the emergence of new industry standards can render existing products obsolete and unmarketable. We devote a substantial amount of our resources to research and development to enable us to enhance current products and develop new technologies. If we fail to enhance our current products and develop and introduce new generations of technology and products on a timely basis, we will not be able to address the increasingly sophisticated needs of our customers and our results of operations will be harmed. In addition, if we develop new products that do not achieve market acceptance, we may not be able to recoup development and marketing expenses, which could lead to a loss of market share which could harm our results of operations. For example, we have been developing new physical design intellectual property which we expect to announce to the market in the second half of 2001. We cannot assure you that we will be successful in developing and marketing this new technology, future product enhancements or new products that respond to technological change, that we will not experience difficulties that could delay or prevent the successful development, introduction and marketing of these products, or that our new products and product enhancements will achieve market acceptance. If we are unable to develop, introduce and successfully market products and services in a timely manner in response to changing market conditions or customer requirements, our business, operating results and financial condition might be materially and adversely affected. IF CHIP DESIGNERS AND MANUFACTURERS DO NOT INTEGRATE OUR SOFTWARE INTO EXISTING SOFTWARE AND DESIGN FLOWS OR IF OTHER SOFTWARE COMPANIES DO NOT COOPERATE IN INTEGRATING OUR PRODUCTS WITH THEIR PRODUCTS, DEMAND FOR OUR PRODUCTS MAY DECREASE. To successfully implement our business strategy, we must provide products that can be integrated with the software of other design software companies. Execution of our business strategy is dependent upon our ability to develop superior products and cooperative relationships with competitors so that they work with us to integrate our software into a customers' design flow. Most of these bigger design software companies offer software intended to address a larger part of the market, including software which offers similar functionality as our software at highly discounted prices. Therefore, to market our products, we must both convince our customers of the technological superiority of our products and convince our competitors to cooperate in integrating our software with their products that provide different functionality. Currently, we have integrated our software with the existing software of Cadence, Mentor Graphics, Synopsys and other interoperability partners. If we are unable to convince customers to adopt our software solutions over those of competitors offering a broader set of products or if we are unable to convince other semiconductor companies to cooperate in integrating our software with theirs to meet the complete demands of chip designers and manufacturers, our business and operating results will suffer. IF OUR PRODUCTS DO NOT PERFORM AS EXPECTED, OUR REPUTATION COULD BE NEGATIVELY AFFECTED, WE COULD LOSE MARKET SHARE AND OUR GROWTH RATE COULD BE NEGATIVELY IMPACTED. If the software that we provide to our customers in the future performs poorly, contains errors or defects or is otherwise unreliable, our customers would likely be dissatisfied. Any failure or poor performance of our products could result in: - delayed or lost revenue; - hindered market acceptance of our products due to adverse customer reaction; - negative publicity or loss of reputation regarding us and our products and services; - diversion of research and development and management resources; and - claims for substantial damages against us. THE SALES CYCLE FOR OUR PRODUCTS AND SERVICES GENERALLY LASTS IN EXCESS OF THREE MONTHS AND IS UNPREDICTABLE. THIS LONG AND UNPREDICTABLE SALES CYCLE MAKES IT DIFFICULT TO PLAN OUR EXPENSES AND FORECAST OUR RESULTS OF OPERATIONS FOR ANY GIVEN PERIOD. OUR FAILURE TO ADEQUATELY MATCH OUR EXPENSES TO ANTICIPATED REVENUE IN ANY GIVEN PERIOD COULD CAUSE US NOT TO MEET MARKET EXPECTATIONS WHICH COULD HAVE A MATERIAL ADVERSE EFFECT ON OUR STOCK PRICE. The period between our initial contact with a potential customer and their purchase of our products and services is relatively long making it difficult to predict the quarter in which a particular sale will occur and to plan our expenditures accordingly. If we do not correctly predict the timing of our sales, the amount of revenue we recognize in that quarter could be negatively impacted, which could negatively effect our operating results. Our sales cycle is long due to several factors, including: - limited access to key decision-makers of potential customers to authorize the adoption of our products; - long periods of time for potential customers to perform technical evaluations of our products and validation of the integration flow of our products with their existing products; - the significant investment of resources required by a customer to purchase and integrate our products; - budget cycles of our customers which affect the timing of purchases; and - delay of purchases due to announcements or planned introductions of new products by us or our competitors. The delay or failure to complete large orders and sales in a particular quarter could significantly reduce revenue in that quarter, as well as subsequent quarters over which revenue for the sale would likely be recognized. If our sales cycle unexpectedly lengthens in general or for one or more large orders, it would adversely affect the timing of our revenue, could cause us not to meet research analysts expectations and cause our stock price to suffer. If we were to experience a delay on a large order, it could harm our ability to meet our forecasts for a given quarter. OUR MAINTENANCE OF OPERATIONS IN SEVERAL DIFFERENT COUNTRIES EXPOSES US TO RISKS INHERENT IN DOING BUSINESS ON AN INTERNATIONAL LEVEL THAT COULD NEGATIVELY IMPACT OUR RESULTS OF OPERATIONS. We currently operate Simplex Solutions, S.A. in France, Simplex Solutions K.K. in Japan, Simplex Solutions U.K. Limited in the United Kingdom and Simplex Solutions GmbH in Germany. Maintenance of these entities subjects us to risks of conducting business internationally which could harm our business, financial condition and results of operations. These risks include, among others: - proper maintenance of corporate formalities for our international entities; - the uncertainty of Japanese sales due to the typically lengthy Japanese sales cycle; - potential adverse tax consequences, including restrictions on repatriation of earnings and taxation of equity compensation for employees and consultants; - foreign currency exchange rate fluctuations; - greater difficulty in collecting accounts receivable; and - burdens of complying with foreign laws, particularly with respect to intellectual property. We generated 28% of our consolidated revenue from sales outside of North America for the six months ended March 31, 2000 and 50% of our consolidated revenue from sales outside North America for the six months ended March 31, 2001. On a fiscal year basis, we generated 23% of our consolidated revenue from sales outside of North America in fiscal 1999 and 34% of our consolidated revenue from sales outside North America in fiscal 2000. A significant proportion of our international sales to date have been denominated in U.S. dollars. As a result, an increase in the value of the U.S. dollar relative to foreign currencies could increase the relative costs of our overseas operations which could substantially reduce our operating margins. Any of the above could negatively affect our results of operations. IF WE FAIL TO MANAGE OUR RAPID GROWTH SUCCESSFULLY, OUR INFRASTRUCTURE, MANAGEMENT AND RESOURCES COULD BE STRAINED AND OUR ABILITY TO EFFECTIVELY MANAGE OUR BUSINESS COULD BE DIMINISHED AND OUR RESULTS OF OPERATIONS COULD SUFFER. We have grown rapidly since our inception and to be successful we need to grow quickly in the future. Any failure to manage this growth could strain our resources, which would impede our ability to increase revenue and achieve profitability. For example, the number of our employees increased from 69 at September 1999 to 186 at March 2001. This increase in personnel was accompanied by increased resources and management time focused on infrastructure, training and integration. We expect this growth in personnel to continue and require us to relocate to larger and more expensive corporate offices within a year. Further, future expansion could be expensive and strain our infrastructure, management and other resources. To manage growth effectively, we must: - maintain a high level of customer service and support; - improve our management, financial and information systems and controls; - manage and expand our sales operations, which are in several locations; and - hire, train, manage and integrate new personnel. There will be additional demands on our customer service support, research and development, sales and marketing and administrative resources as we try to increase our product and service offerings and expand our target markets. The strains imposed by these demands are magnified by our relatively limited operating history. If we cannot manage our growth effectively, our business and results of operations could be adversely affected. BECAUSE 10 CUSTOMERS REPRESENTED 65% OF OUR TOTAL REVENUE FOR THE SIX MONTHS ENDED MARCH 31, 2001, THE LOSS OF ANY OF THESE CUSTOMERS COULD SUBSTANTIALLY ADVERSELY IMPACT OUR REVENUE. We currently derive, and we expect to continue to derive, a large percentage of our total revenue from a relatively small number of customers. If any of these customers terminates or substantially diminishes its relationship with us, our revenue could decline significantly. Revenue concentration among our largest customers is as follows: - our 10 largest customers accounted for approximately 62% of our revenue for the six months ended March 31, 2000 and approximately 65% of our revenue for the six months ended March 31, 2001; - our 10 largest customers accounted for approximately 53% of our revenue in both fiscal 1999 and fiscal 2000; - our largest single customer in fiscal 2000, Toshiba, accounted for approximately 22% of our revenue for the six months ended March 31, 2000, approximately 6% of our revenue for the six months ended March 31, 2001, approximately 5% of our revenue in fiscal 1999 and approximately 18% of our revenue in fiscal 2000; and - on a consolidated basis revenue from Sony Semiconductor accounted for approximately 25% of our revenue for the six months ended March 31, 2001 and approximately 14% of our pro forma revenue for the 12 months ended December 31, 2000, after giving effect to our acquisition of Altius Solutions, Inc. See "Selected Pro Forma Consolidated Financial Data" beginning on page 23. The loss of significant revenue from any of our major customers could negatively impact our results of operations, or limit our ability to execute our strategy. We expect that we will continue to be dependent upon a limited number of customers for a significant portion of our revenue in future periods. BECAUSE MANY OF OUR CURRENT COMPETITORS HAVE MORE MARKET SHARE THAN WE DO AND PRE-EXISTING RELATIONSHIPS WITH OUR POTENTIAL CUSTOMERS, WE MIGHT NOT BE ABLE TO ACHIEVE SUFFICIENT MARKET PENETRATION TO ACHIEVE OR SUSTAIN PROFITABILITY OR BE ABLE TO GAIN ADDITIONAL MARKET SHARE. Many of our competitors have substantially greater financial, customer support, technical and marketing resources, larger customer bases, longer operating histories, greater name recognition and more established relationships in the industry than we do. We cannot be sure that we will have the resources or expertise to compete successfully in the future. If we are unable to gain additional market share due to their pre-existing relationships with our potential customers, our operating results could be harmed. The design software industry is comprised of companies that offer software products that are used to facilitate the chip design process. Our products are used to facilitate complex deep submicron chip designs. Our competitors who offer products that are used for other segments of the chip design process often bundle their products together to offer discounts on products competitive with those we offer, making it extremely attractive for our customers or potential customers to use alternative products to ours. In addition, these competitors may not support our effort to integrate our products into their existing software. These competitors include such companies as Avant!, Cadence, Mentor Graphics and Synopsys. Since these competitors offer a more comprehensive range of products than we do, they are often able to respond more quickly or price more effectively to take advantage of new or changing opportunities and respond to new technologies and customer requirements. If we lose such opportunities to our competitors, our results of operations could be harmed. AS THE DEEP SUBMICRON MARKET CONTINUES TO GROW, COMPETITORS WILL LIKELY INCREASE THEIR FOCUS ON THIS MARKET AND APPLY SUBSTANTIALLY GREATER RESOURCES TO THE DEVELOPMENT AND DISTRIBUTION OF DESIGN SOFTWARE DIRECTLY COMPETITIVE WITH OUR SOFTWARE. We currently encounter direct competition from competitors such as Avant!, Cadence, Mentor Graphics and Synopsys for design software at deep submicron geometries. If the market for design software at 0.18 micron geometries and below continues to grow, some of our competitors may increase their focus on offering design software directly competitive with ours, whether by internal development, external development or acquisition. If competition for software competitive with ours increases, our competitors may attempt to keep us from integrating our software with theirs, making it more difficult for our customers to adopt our software in their design flows. If such increased competition were to result in resistance to integration of our software with those of our competitors, our business would be harmed. IF WE CANNOT CONTINUALLY ATTRACT AND RETAIN SUFFICIENT SALES, MARKETING AND TECHNICAL PERSONNEL, OUR RESULTS OF OPERATIONS WILL BE HARMED. Our future success depends on our continuing ability to attract and retain highly qualified technical personnel, particularly engineers, and qualified sales and marketing personnel. If we cannot attract and retain the necessary individuals we may not be able to continue our innovation and sell our products which could negatively affect our operating results. For instance, during fiscal 1999 and fiscal 2000, we experienced significant difficulty in hiring and retaining engineers qualified to support our current products and develop next generation technologies. We partially addressed our hiring needs through the acquisitions of Altius and Snaketech. Appropriate acquisition targets may not be available in the future and we might not otherwise be able to find adequate personnel. In addition, we have previously experienced significant turnover in our sales force. Any future turnover might adversely impact our revenue. If we are unable to hire and retain qualified personnel in the future, which is particularly difficult in Silicon Valley, our business could be seriously harmed and our operating results could suffer. IF WE LOSE ANY OF OUR KEY PERSONNEL, OUR ABILITY TO MANAGE OUR BUSINESS AND CONTINUE OUR GROWTH WOULD BE NEGATIVELY IMPACTED. Our future success depends upon the continued service of our executive officers and other key personnel, and their ability to work together. Of particular importance to our continued operation are: - Penelope A. Herscher, Chairman and Chief Executive Officer; - Aki Fujimura, President and Chief Operating Officer; - Aurangzeb Khan, Executive Vice President and General Manager; - Luis P. Buhler, Chief Financial Officer; - Steven L. Teig, Chief Technical Officer; and - James D. Behrens, Executive Vice President of Worldwide Field Operations. Searching for replacements for our key management could divert management's time and result in increased operating expenses. Most of our executive officers or key employees are not bound by an employment agreement for any specific term and we do not maintain any key person life insurance policies. If we lose the services of one or more of our executive officers or key employees, or if one or more of them decide to join a competitor or otherwise compete directly or indirectly with us, our business could be seriously harmed. ANY INABILITY TO PROTECT OUR INTELLECTUAL PROPERTY ADEQUATELY COULD IMPAIR OUR COMPETITIVE ADVANTAGE, DIVERT MANAGEMENT ATTENTION, REQUIRE ADDITIONAL INTELLECTUAL PROPERTY TO BE DEVELOPED AND/OR CAUSE US TO INCUR EXPENSES TO ENFORCE OUR RIGHTS. Because our products are based on the technology in our software, our success depends on our ability to protect our intellectual property. If we are not able to successfully protect our technology domestically and abroad, our results of operations could suffer. We rely on a combination of patent, copyright, trademark and trade secrets to establish and protect our intellectual property rights. In addition, we seek to avoid disclosure of our trade secrets through a number of means, including requiring those with access to our intellectual property to execute nondisclosure agreements with us and restricting access to our technology. We currently have one issued U.S. patent and we have several patent applications pending relating to our technology. We cannot provide any assurance that these applications will be granted. In addition, we cannot assure that, even if granted, third parties have not or will not develop competitive technologies or products without infringing our current patent or any future patents, or that such patents would be held valid and enforceable by a court having jurisdiction over a dispute involving such patents. If such patents are not held valid our use of technology under such patents could result in a claim of infringement and we may be unable to license the patented technology on commercially reasonable terms, or at all. If we are unable to obtain licenses to technology embedded in our software our business would be materially harmed. Despite our efforts to protect our intellectual property, unauthorized parties, including employees may attempt to copy our software or obtain and use information we regard as proprietary. Policing unauthorized use of software is difficult, especially internationally. The laws of some foreign countries in which we do business do not protect our intellectual property to as great an extent as do the laws of the United States. Patent infringement and trade secret misappropriation litigation is highly visible and increasing in our industry. As a result of all these factors, our means of protecting our intellectual property may not be adequate and our competitors may independently develop similar technology, duplicate our products or design around our intellectual property. IF WE ARE UNABLE TO CONTINUE TO LICENSE KEY THIRD-PARTY TECHNOLOGY, OUR BUSINESS WOULD BE SIGNIFICANTLY HARMED. We currently license certain third-party technologies that are critical to our software products. For instance, we currently have license agreements with Computational Applications and System Integration, Inc., Digital Semiconductor (a business unit of Digital Equipment Corporation which has been acquired by Compaq Computer Corporation) and Chris Terman (an independent contractor who was formerly engaged by us) that are important to our current software products. These and other third-party licenses are generally perpetual but may be terminated upon a material breach, including failure to protect the underlying intellectual property. Some of these technologies would be difficult or impossible to replace in the short term. The loss of the use of these technologies would prevent us from selling a significant portion of our software products, which would materially reduce our revenue and significantly harm our business. IF THIRD PARTIES ASSERT, REGARDLESS OF MERIT, THAT OUR TECHNOLOGIES INFRINGE THEIR INTELLECTUAL PROPERTY RIGHTS, OUR REPUTATION AND ABILITY TO LICENSE OR SELL OUR PRODUCTS COULD BE HARMED. We expect that, like other software developers, we may increasingly be subject to infringement claims for our verification software and proprietary technologies. These claims could injure our reputation and decrease or inhibit our ability to license or sell our products. On November 1, 2000 we received a written notice of alleged infringement from Sequence Design, Inc., and on March 15, 2001 we received further written notice that legal action is imminent. Based on a review of the relevant intellectual property, we believe this infringement allegation by Sequence to be without merit. If this allegation results in a lawsuit we intend to defend ourselves vigorously. However, because of the uncertainties of litigation, if this matter proceeds to litigation we cannot assure you that we would ultimately prevail. A final judgment rendered against us in litigation on this matter will have a significant negative impact on our revenue and will have a material adverse effect on our business. Further, claims of infringement relating to our intellectual property, or technology we license from third parties, regardless of merit, might be costly and time-consuming to defend against, could divert management's attention from the day to day operations of our company and could seriously harm our ability to develop and market our products and manage our daily operations. Our customer contracts generally require us to indemnify customers for losses resulting from third party infringement claims resulting from the use of our products. Thus, in addition to any claims brought directly against us, we could be responsible to indemnify customers for claims brought against them. The competitive nature of the semiconductor industry and the importance of our software products to our customers' design flows and competitors' businesses may contribute to a higher likelihood of being subject to third party claims of infringement. IF WE NEED TO RAISE ADDITIONAL FUNDS IN THE FORESEEABLE FUTURE TO FUND OUR OPERATIONS OR FUTURE ACQUISITIONS, THEY MIGHT NOT BE AVAILABLE TO US, ON FAVORABLE TERMS OR AT ALL, AND IF UNAVAILABLE, COULD IMPAIR OUR ABILITY TO RUN OUR BUSINESS. We anticipate that our cash resources will be sufficient to meet our currently predicted working capital and capital expenditure requirements for at least the next 18 months. We might, however, need to raise additional funds through public or private financings, strategic relationships or other arrangements to do any of the following: - develop next-generation technologies or enhance current products; - fund additional sales and marketing programs; - acquire complementary businesses or technologies; - hire additional personnel; - expand our operations faster than currently anticipated; or - respond to competitive pressures in our industry. If we are unable to fund such potential business requirements, our results of operations could be harmed. POWER OUTAGES IN CALIFORNIA MAY ADVERSELY AFFECT US. We conduct most of our operations in the state of California and rely on a continuous power supply to conduct operations. California's current energy crisis could substantially disrupt our operations and increase our expenses. California has recently implemented, and may in the future continue to implement, rolling blackouts throughout the state. If blackouts interrupt our power supply, we may be temporarily unable to continue operations at our facilities. Any extended interruption in our ability to continue operations at our facilities could delay the development of our products and disrupt communications with our customers, suppliers or manufacturing operations. Future interruptions could damage our reputation and could result in lost revenue, either of which could substantially harm our business and results of operations. Furthermore, shortages in wholesale electricity supplies have caused power prices to increase. If wholesale prices continue to increase, our operating expenses will likely increase which will have a negative effect on our operating results. FUTURE CHANGES IN ACCOUNTING POLICIES OR STANDARDS, SPECIFICALLY CHANGES AFFECTING METHODS OF REVENUE RECOGNITION, COULD CAUSE ADVERSE UNEXPECTED REVENUE FLUCTUATIONS. Future changes in accounting policies including those affecting revenue recognition, could require the company to change its methods of revenue recognition. Such changes could cause deferment of revenue recognized in current periods to subsequent periods or accelerated recognition of deferred revenue to current periods, each of which could cause shortfalls in meeting securities analysts and investors' expectations. Any such shortfalls could have an adverse impact on our stock price. RISKS RELATED TO OUR INDUSTRY IF THE INDUSTRIES INTO WHICH WE SELL OUR PRODUCTS EXPERIENCE RECESSION OR OTHER CYCLICAL EFFECTS IMPACTING OUR CUSTOMERS' RESEARCH AND DEVELOPMENT BUDGETS, OUR OPERATING RESULTS COULD BE NEGATIVELY IMPACTED. The primary customers for our products are semiconductor design and manufacturing companies. Any significant downturn in our customers' markets, in particular, or in general economic conditions which result in the cut back of research and development budgets or the delay of software purchases would likely result in a reduction in demand for our products and services and could harm our business. In addition, the markets for semiconductor products are cyclical. For example, in recent years certain Asian countries have experienced significant economic difficulties, including currency devaluation and instability, business failures and a depressed business environment. These difficulties triggered a significant downturn in the semiconductor market, resulting in reduced budgets for chip design tools which, in turn, negatively impacted us. Our business is harmed when research and development budgets of our customers are curtailed or when software purchases by our customers are delayed. In addition, the electronics industry has historically been subject to seasonal and cyclical fluctuations in demand for its products, and this trend may continue in the future. Such industry downturns have been, and may continue to be, characterized by diminished product demand, excess manufacturing capacity and subsequent erosion of average selling prices. IF WE ARE UNABLE TO EFFECTIVELY MANAGE OUR RESOURCES IN ANTICIPATION OF THE EXPECTED SEASONALITY OF OUR REVENUE, OUR QUARTERLY OPERATING RESULTS MAY SUFFER AND OUR STOCK PRICE MAY DECLINE. We expect to experience significant seasonal variations in our revenue due to sales incentives that result in increased sales efforts at the end of the fiscal year. These seasonal trends materially affect our quarter to quarter operating results, which, if not effectively managed, could negatively impact our stock price. Based on our limited operating history, we expect that our revenue in the first quarter each year will typically be lower than revenue in other quarters. If we are unable to effectively manage our resources in anticipation of the seasonality of our revenue and the costs we expect to incur during periods of lower revenue, our operating results might be lower than anticipated by investors. This would likely cause the trading price of our stock to fall. IF WE FAIL TO MAINTAIN COMPETITIVE STOCK OPTION PACKAGES FOR OUR EMPLOYEES, OR IF OUR STOCK DECLINES MATERIALLY FOR A PROTRACTED PERIOD OF TIME, WE MIGHT HAVE DIFFICULTY RETAINING OUR EMPLOYEES, PARTICULARLY IN THE SILICON VALLEY, AND OUR BUSINESS MAY BE HARMED. In today's competitive technology industry, employment decisions of highly skilled personnel are influenced by stock option packages, which offer incentives above traditional compensation only where there is a consistent, long-term upward trend over time of a company's stock price. If our stock price declines due to market conditions, investors' perceptions of the technology industry or managerial or performance problems we have, our stock option incentives may lose value to key employees and we may lose such employees or be forced to grant additional options to retain such employees, which could result in the following material adverse consequences to us: - loss of employees due to negative impact on our option packages; - immediate and substantial dilution to investors resulting from the grant of additional options necessary to retain employees; and - potential compensation charges against the company which could negatively impact our operating results. WE MIGHT BECOME SUBJECT TO LITIGATION BY COMPETITORS OR PRIOR EMPLOYEES, WHICH COULD BE COSTLY TO DEFEND AND COULD DIVERT MANAGEMENT'S ATTENTION FROM FOCUSING ON OUR BUSINESS AND OPERATIONS. We may be subject to claims by competitors for infringement of their intellectual property or prior employees for human resources-related claims. Our insurance is limited to specific amounts per claim depending on the type of claim involved. A successful liability claim brought against us in excess of corresponding insurance coverage could be costly, which would harm our business, financial condition and results of operations. RISKS RELATED TO THIS OFFERING YOU WILL BE RELYING ON OUR MANAGEMENT'S JUDGMENT, WITH WHICH YOU MAY DISAGREE, REGARDING THE USE OF PROCEEDS FROM THIS OFFERING. We do not have a definitive quantified plan with respect to the use of the net proceeds of this offering and have not committed the substantial majority of these proceeds to any particular purpose, as more fully described in "Use of Proceeds." Accordingly, our management will have broad discretion with respect to the use of the net proceeds from this offering and investors will be relying on the judgment of our management regarding the application of these proceeds. These investments may not yield a favorable return. We have only made preliminary determinations as to the amount of net proceeds to be used based upon our current expectations regarding our financial performance and business needs over the foreseeable future. These expectations may prove to be inaccurate, as our financial performance may differ from our current expectations or our business needs may change as our business and the industry we address evolve. As a result, the proceeds we receive in this offering may be used in a manner significantly different from our current allocation plans. NEW INVESTORS WILL SUFFER IMMEDIATE AND SUBSTANTIAL DILUTION OF APPROXIMATELY $7.74 PER SHARE, ASSUMING AN INITIAL OFFERING PRICE OF $11.00 PER SHARE. We expect the initial public offering price to be substantially higher than the net tangible book value per share of our common stock. The pro forma net tangible book value of a share of common stock purchased at an assumed initial public offering price of $11.00 per share will be only $3.26. Additional dilution may be incurred if holders of stock options, whether currently outstanding or subsequently granted, exercise their options or if warrantholders exercise their warrants to purchase common stock. See "Dilution" for a more complete description. THE LARGE NUMBER OF SHARES ELIGIBLE FOR PUBLIC SALE AFTER THIS OFFERING COULD DEPRESS OUR STOCK PRICE. Upon completion of this offering, based upon shares outstanding as of March 31, 2001, and an assumed offering price of $11.00 per share, we will have 14,419,462 shares of our common stock outstanding, of which: - all of the 4,000,000 shares we are selling in this offering may be resold in the public market immediately other than shares purchased by affiliates; - another 10,419,462 shares are subject to the lock-up agreements described in "Underwriting" and will become available for resale in the public market beginning 180 days after the date of this prospectus; Beginning 180 days after the date of this prospectus, approximately 1,836,315 additional shares subject to vested options will become available for sale in the public market. Further, shares issued in a merger, if any, will be subject to similar lock-up agreements as those described in "Underwriting" and will become available for resale in the public market beginning 180 days after the date of this prospectus; and In addition, some of our current stockholders have "demand" and/or "piggyback" registration rights in connection with future offerings of our common stock. "Demand" rights enable the holders to demand that their shares be registered and may require us to file a registration statement under the Securities Act at our expense. "Piggyback" rights provide for notice to the relevant holders of our stock if we propose to register any of our securities under the Securities Act, and grant such holders the right to include their shares in the registration statement. All holders of registrable securities have agreed not to exercise their registration rights until 180 days following the date of this prospectus without the consent of Credit Suisse First Boston Corporation. As restrictions on resale end, our stock price could drop significantly if the holders of these restricted shares sell them or are perceived by the market as intending to sell them. These sales also might make it more difficult for us to sell equity securities in the future at a time and at a price that we deem appropriate. OUR PRINCIPAL STOCKHOLDERS CAN EXERCISE A CONTROLLING INFLUENCE OVER OUR BUSINESS AFFAIRS AND THEY MAY MAKE BUSINESS DECISIONS WITH WHICH YOU DISAGREE THAT WILL AFFECT THE VALUE OF YOUR INVESTMENT. Our executive officers, directors and entities affiliated with them will, in the aggregate, beneficially own approximately 30% of our common stock following this offering. If they were to act together, these stockholders would be able to exercise control over most matters requiring approval by our stockholders, including the election of directors and approval of significant corporate transactions. This concentration of ownership may also have the effect of delaying or preventing a change in control of our company, which could cause our stock price to drop. These actions may be taken even if they are opposed by the other investors, including those who purchase shares in this offering. OUR CHARTER DOCUMENTS AND DELAWARE LAW COULD MAKE IT MORE DIFFICULT FOR A THIRD PARTY TO ACQUIRE US, AND DISCOURAGE A TAKEOVER. Provisions of our certificate of incorporation, bylaws, and Delaware law could make it more difficult for a third party to acquire us, even if doing so would benefit our stockholders. See "Description of Capital Stock-Anti-Takeover Effects of Provisions of the Certificate of Incorporation, and Bylaws and of Delaware Law" for a more complete description of these provisions. NEGOTIATIONS BETWEEN THE UNDERWRITERS AND US WILL DETERMINE THE INITIAL PUBLIC OFFERING PRICE OF OUR COMMON STOCK, BUT THE MARKET PRICE FOR OUR COMMON STOCK MAY BE VOLATILE, AND YOU MAY NOT BE ABLE TO RESELL YOUR SHARES AT OR ABOVE THE INITIAL PUBLIC OFFERING PRICE. The initial public offering price of our common stock may vary from the market price of our common stock following this offering. The market price of our common stock may fluctuate in response to various factors, some of which are beyond our control. Such factors include: - changes in market valuations of our competitors or other technology companies; - actual or anticipated fluctuations in our operating results; - technological advances in our industry either by us or our competitors; - loss of key personnel; - sale of significant amounts of our common stock or other securities in the open market; and - volume fluctuations, which are common for technology companies. General economic conditions, such as recession or interest rate or currency rate fluctuations in the United States or abroad, could negatively affect the market price of our common stock. Please see "Underwriting." In addition, there has not been a public market for our common stock. We cannot predict the extent to which investor interest in our company will lead to the development of an active, liquid trading market. MARKET PRICES OF TECHNOLOGY COMPANIES HAVE BEEN HIGHLY VOLATILE AND THE MARKET FOR OUR STOCK MAY BE VOLATILE AS WELL. The stock market has experienced significant price and trading volume fluctuations, and the market prices of technology companies generally have been extremely volatile and have recently experienced sharp declines. Recent initial public offerings by technology companies have been accompanied by exceptional share price and trading volume changes in the first days and weeks after the securities were released for public trading. Investors may not be able to resell their shares at or above the initial public offering price. In the past, following periods of volatility in the market price of a public company's securities, securities class action litigation has often been instituted against that company. Such litigation could result in substantial costs and a diversion of management's attention and resources.

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+Risk factors INVESTING IN OUR COMMON SHARES INVOLVES RISKS. YOU SHOULD CAREFULLY CONSIDER EACH OF THE FOLLOWING RISK FACTORS BELOW AND ALL OTHER INFORMATION SET FORTH IN THIS PROSPECTUS BEFORE MAKING A DECISION TO INVEST IN OUR COMMON SHARES. THE RISKS AND UNCERTAINTIES DESCRIBED BELOW ARE NOT THE ONLY ONES FACING US. ADDITIONAL RISKS NOT PRESENTLY KNOWN TO US OR THAT WE CURRENTLY DEEM IMMATERIAL MAY ALSO IMPAIR OUR BUSINESS, OPERATIONS, OR FINANCIAL RESULTS. THIS COULD CAUSE THE TRADING PRICE OF OUR COMMON SHARES TO DECLINE, AND YOU MAY LOSE ALL OR PART OF YOUR INVESTMENT. RISKS RELATED TO OUR BUSINESS We are subject to extensive, complex and changing government regulation. The clinical laboratory testing industry is subject to significant governmental regulations at the federal, state or provincial, and local levels in the United States and Canada, including regulations with respect to: - billing matters including prohibitions on fraud and abuse, kickbacks, rebates and fee splitting; - licensing and certification requirements; - handling, transportation and disposal of medical specimens and hazardous waste; - quality assurance for clinical laboratories; and - occupational safety. A large number of laboratories have been forced by the U.S. federal and state governments, as well as by private payors, to enter into substantial settlements under laws prohibiting fraudulent billing and providing for the recoupment of non-fraudulent overpayments. Government investigations of clinical laboratories have been ongoing for a number of years and are expected to continue in the future. Existing U.S. federal laws governing Medicare and Medicaid and other similar state laws impose a variety of broadly described restrictions on financial relationships among healthcare providers, including clinical laboratories. These laws include federal anti-kickback laws which prohibit clinical laboratories from, among other things, making payments or furnishing other benefits intended to induce the referral of patients for tests billed to Medicare, Medicaid or other federally funded programs. They also include self-referral prohibitions which prevent us from accepting referrals from physicians who have non-exempt ownership or compensation relationships with us as well as anti-markup and direct billing rules that may apply to our relationships with customers. Many states have similar laws. Furthermore, many state laws prohibit physicians from sharing professional fees with non-physicians and prohibit non-physician entities, such as us, from practicing medicine and from employing physicians to practice medicine. The operations of our clinical laboratories in the United States are subject to a stringent level of regulation under the U.S. Clinical Laboratory Improvement Act of 1988 and subsequent amendments, or CLIA. For certification under CLIA, laboratories, such as ours in the United States and Canada, must meet various requirements, including requirements relating to quality assurance and personnel standards. Our laboratories are also subject to strict regulation by various states. Most of our clinical laboratories in the United States and Canada are accredited by the College of American Pathologists and are therefore subject to the College's requirements and evaluation. Compliance with such standards is verified by periodic inspections and requires participation in proficiency testing programs. -------------------------------------------------------------------------------- Risk factors -------------------------------------------------------------------------------- Our facilities may not pass all future inspections conducted to ensure compliance with federal or any other applicable licensing or certification laws. Some of these statutes and regulations, principally in the area of billing, have not been interpreted by the courts and may be interpreted or applied in a manner that might adversely affect us. Substantial time and expense are required on an ongoing basis to ensure that we comply with existing regulations. Although we believe that we are in compliance with the applicable fraud and abuse laws and regulations, we may become the subject of a regulatory or other investigation or proceeding. Furthermore, changes in existing regulations or new regulations could have a material adverse effect on our profitability and financial condition. Healthcare providers in Canada are subject to significant governmental regulation and licensing requirements, primarily at the provincial level but also at the federal and municipal levels. Laboratory licenses authorize clinical diagnostic laboratories to perform specific tests. The licensing and regulatory requirements relate to, among other matters, the conduct of testing and reporting of results, the handling and disposal of medical specimens and infectious and hazardous waste and other materials, the safety and health of laboratory employees and the proficiency of staff. The clinical laboratory testing industry in Canada is subject to periodic inspections by regulatory agencies. Any failure to comply with licensing requirements or violation of other statutes and regulations may result in civil or criminal sanctions, and/or may also include: - the revocation of licenses, certifications and authorizations; - the denial of the right to conduct business; - exclusion from participation in government healthcare programs such as Medicare and Medicaid; - significant fines; and - criminal penalties. The imposition of any of these sanctions could have a material adverse effect on our profitability and financial condition. See "Business--Regulation" for additional information regarding government regulations to which we are subject. The complexities of billing for laboratory services in the United States may adversely affect our revenues, profitability and cash flows. Billing for laboratory services in the United States is a complex process. Laboratories (including our laboratories) generally bill many different payors, including physicians, patients, insurance companies, Medicare, Medicaid and others. All of these payors have different billing requirements. In order to bill and receive payment for laboratory services, the physician and the patient must provide appropriate billing information, including medical necessity and diagnosis codes. Following up on incorrect or missing information generally slows down the billing process and increases the aging of accounts receivable. We assume the financial risk related to collection, including the potential uncollectibility of accounts from delays due to incorrect and missing information. Failure to meet the billing requirements of the different payors or to manage these collection risks could have a material adverse impact on our revenues, profitability, cash flows and financial condition. "Business--Billing--United States" discusses this topic in greater detail. -------------------------------------------------------------------------------- Risk factors -------------------------------------------------------------------------------- Our growth strategy depends upon our ability to acquire clinical laboratories and enter into new joint venture partnerships. However, we may not be able to make acquisitions or enter into new joint venture partnerships that meet our target criteria. A key element of our growth strategy is expansion through the acquisition of clinical laboratories and the creation of joint venture partnerships in new markets. We may not be able to acquire clinical laboratories or enter into joint venture partnerships that meet our target criteria on satisfactory terms, if at all. Our acquisition program requires substantial capital resources, and the operation of our clinical laboratories requires ongoing capital expenditures. We may need to obtain additional capital or financing, from time to time, to fund these activities. Sufficient capital or financing may not be available to us on satisfactory terms, if at all. If we are unable to continue to grow through acquisitions and new joint venture partnerships, our growth may not meet investor expectations, and our share price may decline. We may not be able to integrate acquired operations and joint venture partnerships successfully. This would adversely affect our profitability and financial condition. Since the beginning of 1999, we made 18 acquisitions and entered into two new joint venture partnerships. Our growth strategy contemplates further acquisitions and joint venture partnerships. See "Business--Acquisitions and Joint Venture Partnerships" for additional details. Continued rapid growth may impair our ability to provide our laboratory services effectively and to manage our employees adequately. While we are taking steps to manage rapid growth, future profitability could be materially adversely affected if we are unable to do so effectively. The successful integration and management of acquired businesses involves numerous risks that could adversely affect our growth and profitability, including the risks that: - our management may not be able to manage the acquired operations successfully and the integration may place significant demands on our management, diverting attention from our existing operations; - our operational, financial and management systems may be incompatible with or inadequate to effectively integrate and manage acquired systems. For example, during 1999, we installed three new billing systems and upgraded three existing systems. As a result, the billing workflow was interrupted, causing an increase in our "days sales outstanding," a common measurement of the aging of accounts receivable. Further, any steps taken to implement changes in our systems may not be sufficient and may result in substantial costs, delays or other operational or financial problems; - acquisitions may require substantial financial resources that otherwise could be used in the development of other aspects of our business; - acquisitions may result in liabilities and contingencies, which could be significant to our operations; and - personnel from our acquisitions and our existing businesses may not be able to work together successfully, which would adversely affect the operation of our businesses. We may not be able to successfully integrate our acquisitions. Our failure to do so could adversely affect our business, profitability and financial condition. -------------------------------------------------------------------------------- Risk factors -------------------------------------------------------------------------------- We have received and may continue to receive reduced payments for our services in the United States due to efforts by governmental payors, other third-party payors and managed care plans to control their costs. We expect to continue to be subject to pricing pressures. We may lose business and we may be compelled to lower our prices due to increased pricing pressures. This may reduce our revenues and, since a significant portion of our costs are fixed, this could have a material adverse impact on our profitability. Third party payors, including Medicare, Medicaid and health insurers, have increased their efforts to control the cost of providing healthcare services. As a result of these cost-control efforts, the reimbursement amounts we receive for testing services have been reduced from time to time. For the six months ended June 30, 2001, approximately 18% of our U.S. revenues (14% of our total revenues) were from services provided under the Medicare and Medicaid programs. Legislative and regulatory changes continue to be introduced with an objective of reducing amounts paid for laboratory services under the Medicare and Medicaid programs. Examples of measures already adopted include: - federal legislation that reduced ceilings on Medicare reimbursement to the clinical laboratory testing industry; - reductions in the number of tests which may be concurrently ordered and billed for; and - limits on our ability to bill for tests unless they are considered to be medically necessary and properly documented by a physician. Due to these legislative and regulatory changes, we may not be reimbursed for a portion of our Medicare- and Medicaid-related testing. Further, in those cases where we are unable to bill Medicare or Medicaid, we might be able to bill patients directly. In these cases, however, we must rely on the patients to properly complete and sign forms approving the billing. The law generally requires clinical laboratories to accept Medicare and Medicaid reimbursement amounts as payment in full. Therefore, when these payors unilaterally reduce the fees they are willing to pay, we must accept the reduced payments. Future reductions in payments could have a material adverse effect on our revenues, profitability and financial condition. Due to their size, many third party payors and certain clients in the United States are able to negotiate favorable fee arrangements with healthcare providers. Approximately 45%-50% of our revenues in the United States for the six months ended June 30, 2001 were generated from third party payors and clients, excluding Medicare/Medicaid and long-term hospital contracts. A substantial portion of our Canadian revenues is subject to Canadian regulatory limits that can prevent us from being paid for all of the testing services we are required to provide. Future reductions in provincial government payments or in our share of those payments, or the implementation of other measures, would reduce our revenues and profitability. Our laboratory operations in Ontario are subject to an agreement with the Ontario government pursuant to which each laboratory service provider has been allocated a fixed share (referred to as a corporate funding cap) of an overall industry funding cap for government reimbursed services. For the six months ended June 30, 2001, approximately 73% of our Canadian revenues (20% of our total revenues) were for services that are subject to the corporate funding cap. Under the agreement, we do -------------------------------------------------------------------------------- Risk factors -------------------------------------------------------------------------------- not receive government payments in excess of our annual corporate funding cap, even when we are required to provide testing services that would otherwise have a value in excess of the cap. Having to provide testing services in excess of our annual corporate funding cap could have a material adverse impact on our profitability and financial condition. Should a laboratory service provider perform testing valued below its corporate funding cap in any year, its funding would be reduced to the value of testing actually completed and the amount of the shortfall would be permanently reallocated to other laboratory service providers as an increase to their share of the corporate funding cap. Although we have continued to provide testing services in excess of our annual corporate funding cap, we cannot assure you that we will continue to process adequate test volumes to maintain our existing corporate funding cap in the future. Through our joint venture partnership in Alberta, we have entered into a long-term agreement with the Capital Health Authority in Alberta to provide services in the Edmonton region. In addition, we have entered into agreements with several other regional health authorities in Northern Alberta. In the aggregate, these agreements accounted for approximately 17% of our Canadian revenues for the six months ended June 30, 2001 (approximately 5% of our total revenues). The loss or non-renewal of one or more of these contracts could have a material adverse impact on us. Healthcare providers in Canada are subject to pricing pressures as the provincial governments attempt to control costs. In general, provincial governments in Canada continue to examine funding methods and laboratory delivery systems, with a longer-term view to improving the efficiency and cost effectiveness of laboratory services provided by both independent and hospital laboratories. Future changes which may be implemented by provincial governments in Canada may have a material adverse effect on the funding received by us. As a result of the use of partially capitated payment contracts, the profitability of our long-term hospital contracts in the United States may be adversely affected by a number of factors beyond our control. Six of our long-term hospital contracts generally provide for a fixed price per admission adjusted on a monthly basis for the hospital's acuity factor, regardless of the number or cost of tests performed during the month (excluding certain tests, such as esoteric tests and anatomic pathology services). Acuity commonly refers to the degree of severity of ailment and the complexity of treatment required. If the utilization per patient under these contracts increases, the contracts will be more costly for us to perform. The utilization per patient may not be directly related to acuity and may be affected by certain factors out of our control, including changes in physician test ordering patterns and other factors which affect test volume and mix of tests. Although the acuity adjustment is an indirect means of adjusting for changes in volumes and mix of tests, there is no direct adjustment for all factors affecting test utilization. An increase in test utilization and/or a change in the mix of tests per patient without a corresponding increase in acuity could lead to decreased profitability of these contracts which could have a material adverse effect on our profitability and cash flows. The U.S. clinical laboratory testing market is intensely competitive. In the United States, where we have a relatively limited operating history, the clinical laboratory testing market is largely dominated by two large national laboratory companies. We may not have the necessary resources to compete effectively in that market. The U.S. clinical laboratory testing business is highly competitive and we expect this high level of competition to continue. In the United States, the clinical laboratory testing market is dominated by two large independent clinical laboratories, each of which has nationwide operations and greater -------------------------------------------------------------------------------- Risk factors -------------------------------------------------------------------------------- financial and purchasing power than we do and is considerably larger than we are. Accordingly, these competitors may: - be able to respond more effectively to changes in the clinical laboratory testing and general financial markets; - benefit from greater economies of scale; - offer more aggressive pricing; - devote greater resources to the promotion of their services; and/or - have greater ability to contract with managed care and group purchasing organizations. In addition to competing with the two largest national laboratories, we also compete with many smaller niche, independent regional laboratories and hospital laboratories that provide community services in each of the local markets we serve. We may not be able to compete effectively in the U.S. market or to successfully implement our growth strategy in the United States. See "Business-- Competition" for additional information. We are dependent upon a small number of hospital contracts for a significant portion of our revenues in the United States. The primary way we provide services to hospitals is through long-term contracts pursuant to which we provide all of the hospital's laboratory testing. These contracts accounted for an aggregate of approximately 20% of our revenues in the United States (14% of our total revenues) for the six months ended June 30, 2001. One of these contracts is with an affiliate of Swedish Medical Center in Seattle, Washington. This contract expires in February 2005 and accounted for approximately 6% of our U.S. revenues (4% of our total revenues) for the six months ended June 30, 2001. Our hospital contracts may be terminated without our consent for our non-performance or in the event that changes in laws or regulations make the arrangements unlawful. The loss or non-renewal of one or more of these hospital contracts (the Swedish Medical contract in particular) could have a material adverse impact on our profitability and financial condition. Our contract with Memorial Hermann in Houston, Texas, which expired on September 30, 2000, was not renewed by the hospital. See "Business-- Acquisitions and Joint Venture Partnerships" for additional details. Our substantial leverage could adversely affect our ability to run our business. We have, and will continue to have, a significant amount of indebtedness. As of June 30, 2001, we had $207.5 million of long-term debt obligations outstanding. This indebtedness could have important consequences on our ability to operate our business effectively. For example, it could: - limit our ability to borrow additional funds or to obtain other financing in the future for working capital, capital expenditures, acquisitions and general corporate purposes; - require us to dedicate a substantial portion of our cash flow from operations to pay down our indebtedness, thereby reducing the funds available for working capital, capital expenditures, acquisitions and general corporate purposes; - make us more vulnerable to economic downturns and reduce our flexibility in responding to changing business and economic conditions; - limit our flexibility in planning for, or reacting to, changes in our business or industry; -------------------------------------------------------------------------------- Risk factors -------------------------------------------------------------------------------- - place us at a competitive disadvantage to our competitors with less debt; and - restrict our ability to pay dividends, repurchase or redeem our capital stock or debt, merge or consolidate with another entity or issue capital stock of our subsidiaries. Our substantial leverage could adversely affect our ability to finance future operations or other capital needs or to engage in other business activities that may be in the best interests of our shareholders. Any failure in our information technology systems could significantly increase testing turn-around time, reduce our production capacity and otherwise disrupt our operations. Any of these circumstances could reduce our customer base and result in lost revenue and adversely affect our profitability. Our laboratory operations depend, in part, on the continued and uninterrupted performance of our information technology systems. The significant growth we have experienced in the United States through our acquisitions and joint venture partnerships has necessitated continued expansion and upgrading of our information technology infrastructure. Sustained system failures or interruption of our systems in one or more of our laboratory operations could disrupt our ability to process laboratory requisitions, perform testing, provide test results in a timely manner and/or bill the appropriate party. Our computer systems are vulnerable to damage from a variety of sources, including telecommunications failures, malicious human acts and natural disasters. Moreover, despite network security measures, some of our servers are potentially vulnerable to physical or electronic break-ins, computer viruses and similar disruptive problems. Despite the precautions we have taken, unanticipated problems affecting our systems could cause interruptions in our information technology systems. Our insurance policies may not adequately compensate us for any losses that may occur due to any failures in our systems. Our business, profitability and financial condition could be adversely affected by a system failure. See "Business--Information Technology" for additional information about our information technology. Any failure by us to consolidate certain of our laboratory operations and implement cost management initiatives successfully could have a material adverse impact on our profitability. An important component of our strategy is to enhance the profitability of our existing regional operations by consolidating certain of our laboratory operations and implementing cost-management initiatives. We have commenced the consolidation of certain of our operations in our Southwest Region and have undertaken various measures to reduce our cost of materials. Our failure to successfully implement these initiatives could adversely affect our profitability and financial condition. -------------------------------------------------------------------------------- Risk factors -------------------------------------------------------------------------------- Claims brought against us could have an adverse impact on us. We may not have adequate insurance, and it may be more expensive or difficult for us to obtain adequate insurance in the future. As a provider of healthcare services we are exposed to the risk of litigation. Plaintiffs have brought claims against clinical laboratories and other healthcare providers, alleging a variety of complaints, including malpractice. These actions may involve large claims and significant defense costs. We maintain professional malpractice liability insurance and general liability insurance in amounts that we believe are sufficient to cover claims arising out of our operations. Some claims, however, could exceed the scope of our coverage, or the coverage of particular claims could be denied. Our existing insurance may not continue to be sufficient or, in the future, policies for adequate levels of insurance may not be available to us at acceptable costs or at all. In addition, such litigation could adversely affect our existing and potential customer relationships, create adverse public relations and divert management's time and resources from the operation of the business. See "Business--Insurance" and "--Legal Proceedings" for additional details. We depend significantly on key personnel. The loss of one or more of our key senior management personnel or a significant portion of our local management personnel would weaken our management team and our ability to deliver laboratory services efficiently and profitably. Our success largely depends on the skills, experience and effort of our senior management. Our operations are also dependent on the efforts, ability and experience of key members of our local management staff. The loss of services of one or more members of our key senior management personnel or of a significant portion of any of our local management personnel could significantly weaken our management expertise and our ability to deliver laboratory services efficiently and profitably. See "Management" for more information. Our performance depends on our ability to recruit and retain experienced and qualified personnel at our clinical laboratories. Shortages of qualified and experienced laboratory personnel in our markets could negatively impact our ability to operate our business efficiently and profitability. The success of our laboratory operations depends on employing qualified and experienced laboratory professionals who perform our clinical laboratory testing or billing services. The healthcare industry is currently experiencing a shortage of qualified personnel. Hiring and retaining healthcare professionals in this tight labor market will be difficult due to intense competition for their services, which has caused increased salary and wage rates. The loss of healthcare professionals, the inability to recruit these individuals in our markets or overall salary and wage rate increases could adversely affect our ability to operate our business efficiently. Any failure by us to comply with laws and regulations governing the confidentiality of medical information could adversely affect our ability to do business. The disclosure and the use of confidential patient medical information are subject to substantial regulation by state, provincial and federal governments. Most states and provinces have laws that govern the use and disclosure of patient medical information and the right to privacy. Similarly, many federal laws also may apply to protect such information, including the Electronic Communications -------------------------------------------------------------------------------- Risk factors -------------------------------------------------------------------------------- Privacy Act of 1986, and federal laws relating to confidentiality of mental health records and substance abuse treatment. Legislation governing the dissemination and use of medical information is continually being proposed at both the state and federal levels. For example, the Health Insurance Portability and Accountability Act of 1996, also known as HIPAA, requires us to comply with standards for the exchange of health information within our company and with third parties, such as payors, business associates and patients. These include standards for common healthcare transactions (such as claims information, plan eligibility, payment information and the use of electronic signatures); unique identifiers for providers, employers, health plans and individuals; security; privacy and enforcement. To date, the Department of Health and Human Services has released two standards, one governing healthcare transactions and the second relating to the privacy of individually identifiable health information (rules governing the security of health information have been proposed but not finalized). We have until October 2002 to comply with the transactions standards, and until February 2003 to comply with the privacy standards. In addition, many of these federal provisions do not preempt more stringent state laws and regulations. Future legislation may affect the dissemination of medical information that is not individually identifiable. Physicians and other persons providing patient information to us are also required to comply with these laws and regulations. If a patient's privacy is violated, or if we are found to have violated any state or federal statute or regulation with regard to the confidentiality, dissemination or use of patient medical information, we could be liable for damages or for civil or criminal fines or penalties. The period of amortization for licenses and goodwill may be overestimated and therefore the value of our intangible assets may be less than that reflected in our financial statements. Goodwill arises when an acquiror pays more for a business than the fair value of the tangible assets and the measurable intangible assets acquired. Canadian generally accepted accounting principles require that goodwill and other unmeasurable intangible assets, such as our Ontario clinical laboratory licenses, be amortized over a period which corresponds with the useful life of such assets. We have estimated that the amortization period for the majority of our goodwill and licenses is 40 years. However, if some of the goodwill or licenses proves to have a useful life shorter than 40 years, earnings reported in the periods following an acquisition would have been overstated. In June 2001, the Financial Accounting Standards Board issued Statements of Financial Accounting Standards No. 141-Business Combinations (FASB 141), and No. 142-Goodwill and Other Intangible Assets (FASB 142), effective for fiscal years beginning after December 15, 2001. Similarly, in August 2001, the Canadian Institute of Chartered Accountants (CICA) issued handbook sections 1581-Business Combinations and 3062-Goodwill and Other Intangible Assets effective for fiscal years beginning January 1, 2002. Under the new U.S. and Canadian accounting rules, goodwill and intangible assets deemed to have an indefinite life will no longer be amortized but will be subject to annual impairment tests. We may incur impairment charges for licenses and goodwill in the future, which would adversely impact our profitability and financial condition. We may not be able to recover the value of our licenses and goodwill which make up approximately half of our consolidated assets. As of December 31, 2000 and June 30, 2001, $166.7 million (approximately 48%) of our total consolidated assets of $349.0 million and $172.8 million (approximately 48%) of our total consolidated assets of $359.4 million, respectively, consisted of our Ontario clinical laboratory licenses -------------------------------------------------------------------------------- Risk factors -------------------------------------------------------------------------------- and goodwill. Laboratory licenses are required to operate clinical laboratories and to receive reimbursement in Ontario. In 1997, we recorded a $79.4 million impairment charge against licenses and goodwill. The recently issued FASB 141 and 142 as well as CICA handbook sections 1581 and 3062 require the valuation of our licenses and goodwill on an annual basis and it is possible we may incur an additional impairment charge for licenses and goodwill in the future. Although the licenses and goodwill are included in our total consolidated assets in accordance with Canadian generally accepted accounting principles, we might not receive the amount so included in the event of a sale, liquidation or bankruptcy of any of the related businesses. For more information regarding our licenses and goodwill you should read note 4 to our consolidated financial statements. Changes in technology could adversely impact our testing volumes and revenues. The clinical laboratory testing industry is faced with changing technology and new product introductions. As an example, changes in technology may lead to the development of more cost effective point-of-care testing equipment that can be operated by physicians or other healthcare providers in their offices or by patients themselves without requiring the services of clinical laboratories. This could adversely impact our testing volumes, revenues and profitability. Our operations may be adversely impacted by a catastrophic event, which could prevent us from operating our business in the affected region. A catastrophic event such as an earthquake or flood could adversely impact one or more central laboratory facilities and could prevent us from operating our business in the affected regions. Although we have property and business interruption insurance, there is no assurance that these policies would adequately compensate us for the losses that may occur. The occurrence of any catastrophic event could impair our ability to operate our business. On September 11, 2001, the United States was the target of terrorist attacks of unprecedented scope. We were not significantly impacted because our regional structure limits our reliance on air transportation of specimens and because we do not have operations in the New York City and Washington D.C. markets. However, those terrorist attacks and the U.S. government's response may lead to further acts of terrorism, bio-terrorism and financial, economic and political instability. While the precise effects of such instability on our industry and our business are difficult to determine, it may have an adverse effect on our business, profitability and financial condition. Our quarterly operating results have varied and we expect them to continue to vary. Our results of operations have been and can be expected to continue to be subject to quarterly fluctuations. We experience lower testing volumes during the holiday and vacation seasons and, to a lesser extent, inclement weather. As a result, because a significant portion of our expenses are relatively fixed over the short term, our operating income as a percentage of revenue tends to decrease during the third quarter due to the summer vacation period and the fourth quarter due to the various holidays in that quarter. Our quarterly results can also fluctuate as a result of a number of other factors including the timing and transition of new acquisitions or joint venture partnerships and the loss, non-renewal or commencement of significant hospital contracts. As a result of these fluctuations, we may experience losses. We believe that quarterly comparisons of our financial results should not be relied upon as an indication of future performance. See "Management's discussion and analysis of financial condition and results of operations--Overview" for additional details. -------------------------------------------------------------------------------- Risk factors -------------------------------------------------------------------------------- As a result of our significant Canadian operations, our reported results may be affected by fluctuations in the exchange rate between the U.S. and Canadian dollars. A significant portion of our revenues and expenses is derived from our operations in Canada, which transacts business in Canadian dollars. Therefore, our reported financial results from quarter-to-quarter may be adversely affected by changes in the exchange rate between U.S. and Canadian dollars over the relevant periods. RISKS RELATED TO THIS OFFERING Some of our existing shareholders can exert control over us and may not make decisions that are in the best interests of all shareholders. Immediately after the closing of this offering our officers, directors and greater than 5% shareholders will beneficially own an aggregate of 10,527,773 common shares. This number represents approximately 48% of our shares to be outstanding (including shares issuable upon exercise of outstanding options) immediately after the closing of this offering (assuming no exercise by the underwriters of their over-allotment option). As a result, these shareholders will effectively control the outcome of our actions that require shareholder approval. For example, these shareholders may be able to elect all of our directors, delay or prevent a transaction in which shareholders might receive a premium over the prevailing market price for their shares, delay or prevent the approval of any merger or consolidation involving us and prevent changes in control or management. These significant shareholders may have interests that differ from those of other shareholders. See "Principal and selling shareholders" for further information about our existing shareholders. The price of our common shares may be volatile and this may adversely affect our shareholders. The market price for our common shares following this offering may be affected by a number of factors, including the following: - seasonal fluctuations in operating results; - failure to achieve operating results projected by securities analysts; - changes in earnings estimates or recommendations by securities analysts; - developments in our industry; - variations in our or our competitors' operating results; and - general market conditions and other factors, including factors unrelated to our operating performance or the operating performance of our competitors. In the past, following periods of volatility in the market price of a particular company's securities, securities class action litigation has often been brought against that company. We may become involved in this type of litigation in the future. Litigation of this type is often expensive and diverts management's attention and resources. -------------------------------------------------------------------------------- Risk factors -------------------------------------------------------------------------------- Existing shareholders may sell their common shares after this offering. This could cause the market price of our common shares to decline significantly and cause your shareholding to be diluted. Upon completion of this offering, we will have outstanding 19,628,937 common shares, and options to acquire 2,176,774 additional common shares. Of our outstanding shares, 10,418,023 shares will be freely tradable, and 9,210,914 shares will be "restricted securities," as the term is defined in Rule 144 under the Securities Act and for purposes of Canadian securities laws. Restricted securities may be sold in the public market only if they are registered or if they qualify for an exemption from registration under Rules 144 or 701 of the Securities Act or are sold under a prospectus or a prospectus exemption in Canada. See "Shares eligible for future sale" for a more detailed discussion of these shares. Of the 16,928,937 common shares outstanding prior to completion of this offering, 11,510,914 shares, pursuant to lock-up agreements with our directors and officers and the selling shareholders (and their affiliates), may not be sold or otherwise disposed of for a period of 90 days after the date of this prospectus without the prior written consent of UBS Warburg LLC, other than 2,300,000 common shares held by the selling shareholders which are being sold pursuant to this offering. As of June 30, 2001, we have options outstanding to acquire 2,176,774 of our common shares which were issued in the past at prices significantly below the offering price per share in this offering. If and when these options are exercised there will be further dilution to investors in all common shares. See "Dilution" for additional information. In addition, some of our current shareholders have "demand" and/or "piggyback" registration rights in connection with future offerings of our common shares. Pursuant to these rights, it is contemplated that our selling shareholders will sell 2,300,000 common shares in this offering. "Demand" rights generally permit the holders to require us to register their shares under the Securities Act at our expense. "Piggyback" rights provide for notice to the relevant holders of our shares if we propose to register any of our securities under the Securities Act and grant such holders the right to include their shares in the registration statement. See "Principal and selling shareholders--Registration Rights Agreement" for a more detailed discussion of these registration rights. We will have broad discretion as to the use of proceeds of this offering and may fail to use them effectively. We expect to use a portion of the net proceeds of this offering to fund future growth through acquisitions and joint venture partnerships. While we engage in discussions on a regular basis regarding possible acquisitions and joint venture partnerships, at present we have no current agreements for any material acquisitions or joint venture partnerships. However, our management will have broad discretion in utilizing the proceeds and may use them in ways with which you and our other shareholders may disagree. We may not be able to invest these funds effectively, which would adversely affect our profitability and financial condition. -------------------------------------------------------------------------------- --------------------------------------------------------------------------------

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+RISK FACTORS You should carefully consider the following risk factors and all other information contained in this prospectus before exercising your rights. Investing in our common stock involves a high degree of risk. Any of the following risks could materially harm our business, operating results and financial condition and could result in a complete loss of your investment. RISKS RELATED TO OUR SEPARATION FROM WESTERN RESOURCES We have no operating history as an independent company. Prior to the rights offering, we operated as a subsidiary in the broader corporate organization of Western Resources rather than as a stand-alone company. Western Resources assisted us by providing administrative functions through shared services arrangements and other support. Because we have never been operated as an independent company, we cannot assure you that we will be able to implement successfully the changes necessary to operate independently or that we will not incur additional costs operating independently that will result in losses. Our historical financial information may not be representative of our results as a separate company and, therefore, may not be reliable as an indicator of our historical or future results. The historical financial information we have included in this registration statement may not reflect what our results of operations, financial position and cash flows would have been had we been a stand-alone company during the periods presented or what our results of operations, financial position and cash flows will be in the future. This is because our consolidated financial statements reflect allocations for services, primarily with respect to corporate overhead, which may not reflect the costs we will incur for similar services as a stand-alone company. The information also does not reflect changes we expect to occur in the future as a result of our separation from Western Resources, including changes in how we fund our operations, taxes and employee matters. The KCC has initiated an investigation of the actions of Western Resources and us related to the rights offering and our separation from Western Resources' electric public utility business and related matters which could materially adversely affect our business and our financial condition. On May 8, 2001, the KCC, a regulatory agency with jurisdiction over the electric public utility business of Western Resources, initiated an investigation of Western Resources' and our actions with respect to the rights offering and our separation from Western Resources, including the terms of related agreements and other related matters. The order initiating the investigation requires that Western Resources and we explain why each of the "actions, events or relations" described in the order concerning the separation and related matters will not adversely affect Western Resources' ability to provide statutorily required electric public utility service at reasonable rates. In the order, the KCC stated that the investigation shall include, but not be limited to: . The basis for and the effect of the amended allocation agreement discussed below on Western Resources' ability to meet its obligations to provide sufficient and efficient service at just and reasonable rates. . The basis for and the effect of the intercompany receivable on Western Resources' ability to meet its obligations to provide sufficient and efficient service at just and reasonable rates. . The split-off of our stock and other aspects of our separation from Western Resources. . The effect of business difficulties faced by our operations, including whether the utility business of Western Resources should continue to be affiliated with us and, if so, under what conditions. . Whether the present and prospective capital structures of Western Resources are appropriate given the public utility responsibilities of Western Resources and its wholly owned electric utility subsidiary, Kansas Gas and Electric Company. . Whether Western Resources and Kansas Gas and Electric Company are taking the actions necessary to assure that electric service to Kansas customers is economical and efficient. The Staff of the KCC is required by the order to report to the KCC no later than October 8, 2001, unless the date is extended. The KCC has invited others to submit requests for additional matters which might be considered. By letter written to the Securities and Exchange Commission, or the SEC, on May 11, 2001, the KCC informed the SEC of its investigation and the "possibility of subsequent regulatory actions" indicating that "it is the [KCC's] position that any or all of the rights offering, Split-off or Merger are subject to its regulatory jurisdiction and may be modified or prohibited by the order of the Commission". The KCC stated that the purpose of the investigation is "to determine, among other things, whether or not the consummation of the rights offering, the Merger and the Split-off would leave the Western Resources portion of the resulting utility company which would be merged into PNM with negative equity (that is, more debt on its balance sheet than it has in assets). This would immediately impair the resulting utility's ability to raise capital for necessary construction projects (e.g., build power plants) and might even cause short-term financial hardship for the utility." We are unable to predict what the nature and findings of the KCC Staff report may be and what action the KCC may take. No assurance can be given that the KCC will not take action which would result in modifications of the terms of the rights offering, the split-off, the composition of our assets (including our ONEOK and Western Resources holdings and the receivable from Western Resources), the composition of our liabilities, the terms of our agreements (or Protection One's agreements) and relations with Western Resources, including terms of the allocation agreement, the shared services agreement, borrowing arrangements, our option agreement to acquire Western Resources' interest in an electric power plant and the tax disaffiliation agreement. We have not operated as a stand-alone company and our business, financial condition and prospects as described in this prospectus are based upon the premise that we will be able to implement the changes necessary to do so within the framework we describe in this prospectus which is provided by our present assets, liabilities, contracts and relationships with Western Resources. We can give no assurance that actions taken by the KCC as a result of the investigation will not impact our assets, liabilities or these agreements and relationships in a manner which would materially adversely affect our financial position, results of operations, liquidity, business or prospects and, thus, our shareholders and the value of our common stock. For further information, we refer you to the KCC order which is an exhibit to the Registration Statement of which this prospectus is a part. We will need to find sources of capital. We have historically relied on Western Resources for our capital needs for strategic transactions. Our needs for operating funds historically have not been significant because we operated as a subsidiary of Western Resources. After the rights offering, we do not expect Western Resources to finance our operations. We expect to have adequate cash flow to meet our existing operating requirements following the rights offering from existing cash balances, the operating cash flow of Protection One and Protection One Europe, dividends from ONEOK and our other investments, amounts repaid on the receivable owed to us by Western Resources, proceeds of asset sales and, following the closing of the PNM merger and the split-off, dividends from PNM Holdings. However, we can give no assurance as to whether our cash flow will be adequate in the future. In any event, we will need to find other sources of capital or financing to make any strategic acquisition or investment. We cannot assure you that capital or financing would be available to us on acceptable terms or at all. See the following risk factor for a discussion of restrictions on the use of cash from the sale of certain assets and the risk factor above for information on a KCC investigation which might materially adversely impact our liquidity. The receivable owed to us by Western Resources will be converted into certain securities. Our assets currently include a receivable due from Western Resources in the amount of approximately $116.6 million at April 30, 2001. The receivable will be increased or decreased by additional advances or payments between us and Western Resources, including the advance of all the net proceeds of the rights offering. Prior to the effective time of the PNM merger, pursuant to the allocation agreement, we will convert any amounts then outstanding under the receivable into (1) our common stock owned by Western Resources at a price based on the average market prices for the 20 trading days preceding conversion, but not less than the subscription price, (2) Western Resources common stock at a price based on the average market prices for the 20 trading days preceding conversion, or (3) Western Resources convertible preference stock. On February 28, 2001, we converted $350 million of the then outstanding balance of the receivable into approximately 14.4 million shares of Western Resources common stock, representing approximately 17% of Western Resources outstanding common stock. At the effective time of the PNM merger, any Western Resources common stock we own will be converted into PNM Holdings common stock based on the merger exchange ratio, and any Western Resources convertible preference stock we own will be converted into PNM Holdings convertible preferred stock. In addition, we will receive shares of our common stock as part of the split-off transaction and these shares will be retired. In addition, under an amendment to the allocation agreement we have agreed to use the net cash proceeds of any sales of our ONEOK or Western Resources shares or the net cash proceeds of any borrowings by us secured by our interest in ONEOK or Western Resources, to purchase the securities described above or to advance such proceeds to Western Resources which will increase the amount of the receivable owed to us. This agreement will terminate upon the earlier of the closing of the PNM merger or the secured debt of Western Resources related to its electric utility operations receiving an investment grade rating from Moody's and Standard & Poor's. The allocation agreement and amendment to this agreement is described further under "Certain Relationships and Related Transactions--Our Transactions Involving Western Resources--Asset Allocation and Separation Agreement." You should refer to that description for information about termination of the amendment, actions required should the PNM merger not be completed and other important information concerning the allocation agreement. See also "Risk Factors--Risks Related To Our Separation From Western Resources" for information with respect to the KCC investigation which may materially adversely impact the agreement and the receivable due to us from Western Resources. We are a holding company and are dependent on our subsidiaries and ONEOK to meet our payment obligations and requirements for liquidity. We are a holding company with ownership interests in our subsidiaries, Western Resources, ONEOK and, following the closing of the PNM merger and the split-off, PNM Holdings. We conduct all of our business through our subsidiaries. The ability of our subsidiaries to pay dividends or to make loans, advances or other payments to us will depend on the subsidiaries' results of operations, provisions of applicable laws and contractual restrictions in existing and future instruments governing indebtedness. Dividends on our ONEOK stock provide a significant portion of our cash flow from operations. A decrease or interruption in the dividends paid by ONEOK would adversely affect our liquidity and ability to continue our operations. There can be no assurance ONEOK will continue to pay dividends at the current rate or at all in the future. ONEOK's failure to pay dividends in certain amounts would result in the termination of a shareholder agreement with ONEOK unless we agreed otherwise, and we would then be free of certain restrictions contained in the shareholder agreement. Debt agreements pursuant to which ONEOK's outstanding long-term and short-term debt has been issued limit dividends and other distributions on its common stock. Please refer to ONEOK's financial statements attached hereto as Exhibit A and Exhibit B and ONEOK's Form 10-K for 2000 and Form 10-Q for March 31, 2001 and other documents it files with the Securities and Exchange Commission, or SEC, for further information concerning ONEOK. Such reports and documents are available at the SEC's public reference rooms and from the SEC's website. See "Available Information." Dividends on PNM Holdings common stock will provide significant additional cash flow after the closing of the PNM merger and the split-off. A decrease or interruption in the dividends paid by PNM Holdings would adversely affect our liquidity and ability to continue our operations. There can be no assurance PNM Holdings will pay dividends at the expected rate or at all following the closing of the PNM merger. PNM Holdings' failure to pay dividends in certain amounts would result in the termination of a shareholder agreement with PNM Holdings unless we agreed otherwise, and we would then be free of certain restrictions, including restrictions on our sale of our PNM Holdings stock, contained in the shareholder agreement. PNM Holdings may incur indebtedness subject to agreements which restrict its ability to pay dividends and make other distributions on its common stock. Dividends on Western Resources common stock are currently reinvested under Western Resources' direct stock purchase plan. These dividends constitute a significant portion of our income and if not reinvested would constitute a significant portion of our cash flow. A decrease or interruption in the dividends paid by Western Resources would adversely affect our operations and could adversely affect our liquidity. Western Resources' articles of incorporation and certain agreements relating to its indebtedness restrict its ability to pay dividends and make other distributions on its common stock in various circumstances. Protection One has never paid any cash dividends on its common stock (other than a special dividend in connection with our acquisition of Protection One in 1997) and does not intend to pay any cash dividends in the foreseeable future. The ability of Monitoring, the principal operating subsidiary of Protection One, to pay dividends or make other distributions to Protection One is restricted by the agreements relating to certain of its indebtedness. Consequently, we do not have access to the cash flow of Protection One for the payment of dividends on our capital stock or for our other purposes. See "Risks Factors--Risks Related To Our Separation From Western Resources" relating to the KCC investigation. We must maintain our exemption from registration under the Investment Company Act. Upon consummation of the rights offering, we will rely on a temporary one- year exemption from registration under the Investment Company Act. Registration would otherwise be required because of the value and nature of our ownership interests in ONEOK, our subsidiaries, our common stock interest in Western Resources, the receivable from Western Resources and, following the closing of the PNM merger and the split-off, an ownership interest in PNM Holdings. Registration under the Investment Company Act would impose significant restrictions on our operations and adversely affect shareholder value. We have submitted an application to the SEC requesting a permanent exemption from registration under the Investment Company Act, but no assurance can be given that we will receive a permanent exemption following the expiration of the temporary one-year exemption from registration under the Investment Company Act. Without a permanent exemption, we would need to take action to avoid registration. Possible action could include selling a portion of our ownership interests in ONEOK and PNM Holdings or exercising our option to purchase an electric generating facility near Joplin, Missouri from Western Resources and registering as a holding company under the Public Utility Holding Company Act of 1935, or PUHCA. Legislation has been proposed to repeal PUHCA which could eliminate this alternative. Our ability to transfer our ownership interests in ONEOK and PNM Holdings is restricted under the terms of shareholder agreements. Therefore, if we wished to dispose of all or a portion of our ONEOK or PNM Holdings interests in order to avoid registration under the Investment Company Act, such transactions could be required to be effected in a manner which could adversely affect the amount of proceeds we receive upon consummation. We have deferred tax assets we may not utilize. Western Resources makes payments to Protection One for current tax benefits utilized by Western Resources in its consolidated tax return pursuant to a tax sharing arrangement. If Western Resources completes its proposed transaction with PNM Holdings, including the split-off, we would no longer be able to file taxes on a consolidated basis with Western Resources. As a result, our deferred tax assets of $80.1 million at March 31, 2001 would not be realizable and we would not be in a position to record a tax benefit for losses incurred. We would be required to record a non-cash charge against income for the portion of our deferred tax assets we determine not to be realizable. This charge could be material and could have a material adverse effect on our business, financial condition and results of operations. If we register under the Public Utility Holding Company Act, we would have additional restrictions imposed on our business. If we are unable to obtain a permanent exemption from registration under the Investment Company Act, we may decide to register as a holding company under PUHCA. Being subject to regulation under PUHCA would impose a number of restrictions on our operations. These restrictions include a requirement that the SEC approve, in advance, securities issuances, sales and acquisitions of utility assets or of securities of utility companies and acquisitions of interests in other businesses. PUHCA also limits the ability of registered holding companies to engage in non-utility ventures and regulates transactions between various affiliates within the holding company system, including the provision of services by holding company affiliates to the system's utilities. Legislation has been proposed to repeal PUHCA which could eliminate this exemption. Our ability to grow may be affected by certain occurrences. Our operations and ability to grow may be affected by numerous factors, including changes in customer requirements, new laws, technological advances, entry of new competitors and changes in our access to capital. We cannot predict which, if any, of these or other factors might have a significant impact in the future, nor can we predict what impact, if any, the occurrence of these or other events might have on our operations. The split-off may not be completed. Western Resources will distribute any shares of our common stock held by it at the time of the PNM merger to its shareholders immediately before the closing of the PNM merger. However, we can give no assurances whether or when the closing of the PNM merger or the split-off will occur since the closing is subject to the satisfaction of various closing conditions, including regulatory and shareholder approvals. In addition, in the event the split-off does not occur Western Resources may be required to take actions, including the sale of our common stock or our assets, to raise funds to reduce its debt. For a discussion of the actions Western Resources may be required to take, see "Certain Relationships and Related Transactions--Asset Allocation and Separation Agreement." The failure of Western Resources to complete the split- off could have a material adverse effect on the liquidity and trading price of our common stock. The investigation by the KCC discussed under "Risk Factors-- Risks Related To Our Separation From Western Resources" may also impact the split-off. RISKS PARTICULAR TO THE MONITORED SECURITY BUSINESS Protection One has experienced net losses which are likely to continue. Protection One has a history of significant net losses which are expected to continue. Protection One incurred net losses of $8.5 million in the first quarter of 2001 (a net loss of $26.8 million excluding extraordinary gains of $18.3 million, net of tax), $57.2 million in 2000 (a net loss of $106.4 million excluding extraordinary gains of $49.3 million, net of tax), $80.7 million in 1999 (a net loss of $91.9 million excluding the effect of a one time gain, net of tax), $17.8 million in 1998, and $42.3 million in 1997. These losses increased in 1999 and 2000 primarily due to accelerated amortization of customer accounts and a shorter period for amortizing goodwill. Losses may be higher in the future as a result of declining revenues and higher borrowing costs under Protection One's senior credit facility. Protection One is not expected to attain profitable operations in the foreseeable future. The impact of recently proposed accounting changes relating to goodwill could be significant. The Financial Accounting Standards Board (FASB) issued an exposure draft on February 14, 2001 which, if adopted as proposed, would establish a new accounting standard for the treatment of goodwill in a business combination. The new standard would continue to require recognition of goodwill as an asset in a business combination but would not permit amortization as currently required by Accounting Principles Board ("APB") Opinion No. 17, "Intangible Assets." The new standard would require that goodwill be separately tested for impairment using a fair-value based approach as opposed to the undiscounted cash flow approach used under current accounting standards. If goodwill is found to be impaired, we would be required to record a non-cash charge against income. The impairment charge would be equal to the amount by which the carrying amount of goodwill exceeds the fair value. Goodwill would no longer be amortized on a current basis as is required under current accounting standards. The exposure draft contemplates this standard to become effective on July 1, 2001, although this effective date is not certain. New information from the FASB indicates the new rule is now expected to become effective on January 1, 2002, although this effective date is not certain. Furthermore, the proposed standard could be modified prior to its adoption. If the new standard is adopted as proposed, any subsequent impairment test on the customer accounts would be performed on the customer accounts alone rather in conjunction with goodwill utilizing an undiscounted cash flow test pursuant to Statement of Financial Accounting Standards ("SFAS") No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of." At March 31, 2001, we had $959.6 million in goodwill attributable to acquisitions of businesses and $971.0 million in customer accounts. Together these intangible assets represented 58.3% of the book value of our total assets. We recorded $14.5 million and $61.3 million in goodwill amortization expense in the first quarter of 2001 and the year ended December 31, 2000, respectively. If the new standard becomes effective as proposed, it is probable that we would be required to record a non-cash impairment charge. We are unable to determine the amount at this time, but we believe the amount would be material and could be a substantial portion of our intangible assets. This impairment charge would have a material adverse effect on our results of operations and could have a material adverse effect on our business and financial condition. The impact of Protection One class action litigation may be material. We, Protection One, certain of Protection One's officers and directors and Western Resources are defendants in a purported class action litigation pending in the U.S. District Court for the Central District of California brought on behalf of shareholders of Protection One. The plaintiffs are seeking unspecified compensatory damages based on allegations that various statements concerning Protection One's financial results and operations for 1997, 1998, 1999 and the first three quarters of 2000 were false and misleading. See "Business--Legal Proceedings" for a description of this litigation and other investigations, proceedings and arbitrations pending against Protection One or us. There can be no assurance that these proceedings will not have a material adverse impact on Protection One or us. Protection One and Protection One Europe lose customers over time. Protection One and Protection One Europe experience the loss of accounts, referred to as attrition, as a result of, among other factors, relocation of customers, adverse financial and economic conditions, competition from other alarm service companies, and customer service and operational difficulties with the integration of acquired customers. The effects of the gross number of lost customers have historically been offset by a combination of factors that has resulted in an overall increase in the number of customers and revenue, including adding new accounts from customers who move into premises previously occupied by prior customers in which security alarm systems are installed, adding accounts for which Protection One obtains a guarantee from the seller that allows Protection One to "put" back to the seller cancelled accounts, and revenues from price increases and the sale of enhanced services. In 2000 and 2001, Protection One's customer acquisition strategies did not replace accounts lost as a result of attrition. This is due primarily to a move from reliance on a dealer program to generate customer accounts to reliance on a mix of marketing strategies. If Protection One's new marketing strategies do not increase the number of new accounts, or if Protection One is unable to reduce the level of attrition, there could be a material adverse effect on its business, financial condition and results of operation. Protection One has a substantial amount of debt which could constrain its growth or otherwise adversely affect our investment. Protection One has, and will likely continue to have, a large amount of consolidated indebtedness. As of March 31, 2001, Protection One had outstanding total indebtedness of approximately $644.1 million. A large amount of indebtedness could have a negative impact on, among other things, Protection One's ability to obtain additional financing in the future for working capital, acquisitions of customer accounts, capital expenditures and general corporate purposes, Protection One's ability to withstand a downturn in its business or the economy generally, and Protection One's ability to compete against other less leveraged companies. The indentures governing Protection One's long-term indebtedness require Protection One to satisfy certain financial conditions in order to borrow additional funds. The most restrictive of these covenants require total debt to annualized EBITDA for the most recent quarter to be less than 6.0, annualized EBITDA for the most recent quarter to interest expense to be greater than 2.25, and senior debt to annualized EBITDA to be less than 4 to 1. Protection One was in compliance with these covenants at March 31, 2001. Protection One's ability to comply with these ratios and the tests will be affected by events outside its control and there can be no assurance that Protection One will meet those tests. The indentures governing this indebtedness contain other covenants that impose operational restrictions on Protection One. A breach of any of the covenants could result in an event of default which would allow the lenders to declare all amounts outstanding immediately due and payable. Protection One may not be able to replace its credit facility on current terms. We provide a portion of Protection One's liquidity needs through an intercompany $155 million senior credit facility which matures on January 2, 2002. As of April 30, 2001, Protection One had borrowed $130 million under this facility. We have advised Protection One that we desire that Protection One replace the facility with other financing. Protection One has announced that it is considering new sources of financing, including new credit facilities with third parties and sales of assets. Protection One was unsuccessful in refinancing the facility with an unaffiliated lender on satisfactory terms in 2000. There is no assurance Protection One will be able to obtain new financing from third parties on similar terms with no disruption to its operations or liquidity, or at all. The investigation by the KCC discussed under "Risk Factors--Risks Related To Our Separation From Western Resources" may also impact our ability to provide Protection One credit. The credit facility requires that Protection One comply with certain financial covenants, including a leverage ratio of 5.50 to 1.0 and an interest coverage ratio of 2.25 to 1.0. At March 31, 2001, these ratios were approximately 4.9 to 1.0 and 2.4 to 1.0, respectively. The failure to satisfy these covenants could result in an event of default which would allow us to declare all amounts outstanding immediately due and payable. Protection One does not expect to be in compliance with the interest coverage ratio covenant because of expenses related to the consolidation of certain operations in 2001. We will waive compliance with this covenant or enter into an amendment of the senior credit facility to address this issue. RISKS PARTICULAR TO OUR INTERESTS IN ONEOK AND PNM HOLDINGS A shareholder agreement with ONEOK restricts our right to transfer and vote our ONEOK stock We own approximately 45% of the capital stock of ONEOK. As of April 30, 2001, our interest consisted of approximately 2.2 million shares of the outstanding common stock of ONEOK and 19.9 million shares of convertible preferred stock. The terms of a shareholder agreement with ONEOK restrict our right to transfer and vote our ONEOK shares. Before we can transfer shares representing more than 5% of ONEOK's voting securities to another person (other than by way of a public offering), ONEOK must be given the opportunity to purchase those shares at a cash purchase price equal to 98.5% of the then current market price for ONEOK's common stock. During the term of the shareholder agreement, we have agreed to vote our shares, including for the election of directors, in an agreed upon manner rather than at our sole discretion. These restrictions may prevent us from realizing the full benefits of ownership normally associated with owning a substantial stake in another entity. There can be no assurance as to what effect, if any, these restrictions may have on the value of our ownership stake in ONEOK. In addition, on November 26, 2012 and each subsequent annual anniversary, each of us and ONEOK, on behalf of its shareholders, has the right to buy from or sell to the other all outstanding shares of ONEOK capital stock beneficially owned by the selling party (which, in the case of ONEOK, means its shareholders other than us and our affiliates). ONEOK may exercise its buy/sell rights immediately upon our registering as a holding company under PUHCA if ONEOK believes that our regulatory status would place an unreasonable restriction on the implementation of ONEOK's strategic business plans. A stockholder agreement with PNM Holdings will restrict our right to transfer and vote any PNM Holdings stock we acquire in the PNM merger. Prior to the closing of the PNM merger, any remaining balance of the receivable owed to us by Western Resources will be converted into Western Resources common stock and convertible preference stock or shares of our common stock and subsequently all Western Resources shares we own will be converted into PNM Holdings common stock and convertible preferred stock in the PNM merger. The terms of a stockholder agreement with PNM Holdings will restrict our right to transfer and vote our PNM Holdings shares. Before we can transfer shares representing more than 5% of PNM Holdings' voting securities to another person (other than by way of a public offering), PNM Holdings must be given the opportunity to purchase those shares at the cash price proposed by us. During the term of the agreement, we have agreed to vote our shares, including for the election of directors, in an agreed upon manner rather than at our sole discretion. These restrictions may prevent us from realizing the full benefits of ownership normally associated with owning a substantial stake in another entity. There can be no assurance as to what effect, if any, these restrictions may have on the value of our ownership stake in PNM Holdings. See "Certain Relationships and Related Transactions--Our Transaction Involving PNM Holdings--Stockholder Agreement." See "Risk Factors--Risks Related To Our Separation From Western Resources" for information with respect to the KCC investigation which may have an impact on our ownership of ONEOK and PNM Holdings. RISKS PARTICULAR TO THIS OFFERING There has been no prior public market for our common stock, so the trading price may be less than the subscription price. There has been no public market for our common stock, and we cannot assure you that an active public market will develop. The subscription price of $10 per share is not necessarily indicative of the market price of our common stock after the rights offering, which price may fall below the subscription price. We cannot assure you that if a trading market develops in our common stock, the stock will trade at prices in excess of the subscription price at any time after the date of this prospectus. We set the subscription price based upon factors we deemed relevant. In making our determination, we did not obtain an independent valuation of our company, our assets or our common stock. Accordingly, the actual value or resale value of our common stock may be significantly higher or lower than the subscription price for the rights. See "The Rights Offering--How The Exercise Price Was Arrived At." It is difficult to predict whether an active market for our stock will develop and be sustained, and the market price of our stock may be volatile. Prior to the closing of the rights offering you could not purchase our common stock publicly. We cannot assure you that investors will develop an interest in our common stock so that a trading market develops or, if a trading market does develop, how active that trading market will be or whether it will be sustained. Specific factors that may affect the price and liquidity of our securities include: . actual or anticipated fluctuations in our quarterly operating results; . operating results that vary from investors' expectations as to our future financial performance or changes in financial estimates; . announcements of technological innovations or new services by us or our competitors; . announcements by third parties of significant claims or proceedings against us; . whether and how any distributions or other dispositions of our common stock owned by Western Resources will be made; . whether our stock will continue to qualify for listing on the NYSE or The Nasdaq National Market; . the operating and stock price performance of other comparable companies; and . when and whether the PNM merger and our split-off from Western Resources would occur. Western Resources' voting control after this offering and prior to the closing of the PNM merger and the split-off could prevent a change of control. Upon closing of the rights offering and prior to the closing of the PNM merger and the split-off, Western Resources will have effective voting control over us since Western Resources will own approximately 85.7% of the outstanding shares of our common stock, assuming all rights are exercised. As a result, Western Resources will be able to control the outcome of substantially all matters submitted to our stockholders for approval, including the election of directors and any proposed merger, liquidation, transfer or encumbrance of a substantial portion of our assets, or amendment to our charter to change our authorized capitalization or otherwise. This concentration of voting power may also have the effect of delaying or preventing a change of control even if it would be beneficial to our minority stockholders. Anti-Takeover Effects of Charter Provisions and Kansas Law. Certain provisions of Kansas law and our Amended and Restated Articles of Incorporation and By-laws could delay, impede or make more difficult a merger, tender offer or proxy contest involving us, even if such events could be beneficial to the interests of our stockholders. A shareholders rights plan we have may also have such affect. Such provisions could limit the price that certain investors might be willing to pay in the future for shares of our common stock. See "Description of Westar Industries Capital Stock--Certain Anti-Takeover Provisions and Statutes." The presence of interlocking directors and officers between Western Resources and us will create potential conflicts of interest. Some of our directors also are directors, officers or employees of Western Resources and, in most cases, own either shares or rights to equity securities of Western Resources. As a result, these individuals have inherent conflicts of interest when making decisions related to transactions between us and Western Resources. Western Resources' ability to control us prior to the separation, together with the potential conflicts of interest of its directors and executive officers who also serve as our directors, could adversely affect the trading price and liquidity of our common stock. These factors could limit the price that investors might be willing to pay for our common stock in the future. Personnel serving both Western Resources and us may suffer competing claims on their time which may place demands on our resources. Initially, through the shared services agreement with Western Resources, we will rely on the services of personnel of Western Resources who will devote their business time and efforts to both Western Resources and us. The competing claims upon each person's time and energies could divert his or her attention from our affairs, placing additional demands on our resources. The efforts of all or any of these individuals may be insufficient to meet both our needs and those of Western Resources. If we lose access to such services altogether, our business, prospects, results of operations and financial condition could be materially adversely affected. As previously stated, we and our subsidiaries will be split off from Western Resources' electric utilities concurrently with the closing of the PNM merger. We will have the right to continue receiving administrative services pursuant to the shared services agreement for at least two years following the closing of the PNM merger. As we increase our infrastructure and hire additional staff, we expect Western Resources to allocate less of its resources to administrative services for us. We do not know what the cost for such services will be to us or the potential impact on our operations. See "Risk Factors--Risks Related To Our Separation From Western Resources," which may have a material adverse impact on the shared services agreement. We rely on intercompany agreements. We have entered, or will enter, into intercompany agreements with Western Resources, including the shared services agreement. Pursuant to the shared services agreement, Western Resources will provide us with administrative services we request including financial reporting, accounting, auditing, tax, office services, payroll and human resources. We will pay Western Resources for these services at various hourly charges and negotiated fees. The agreement may be terminated upon one year's notice by either party but such notice may not be given earlier than the first anniversary of the closing of the PNM merger. A loss of services provided under the shared services agreement would cause us to seek such services from other sources and no assurance can be given that we will be able to obtain such services on terms at least comparable to the intercompany agreements with Western Resources. The terms of these intercompany agreements with Western Resources were negotiated in the context of a parent- subsidiary relationship. We cannot assure you that the terms of these agreements, or the related transactions, will be effected on terms at least as favorable to us as could have been obtained from unaffiliated third parties. See "Risk Factors--Risks Related To Our Separation From Western Resources," which may have a material adverse impact on the intercompany agreements. See also "Certain Relationships and Related Transactions." A substantial amount of our common stock will be eligible for future sale or distribution. Upon the closing of the rights offering, excluding shares owned by Western Resources, there will be issued and outstanding approximately 12.25 million shares of our common stock, assuming all rights are exercised. All such shares will be freely tradeable without restriction, except for any shares purchased by our "affiliates" as defined in Rule 144 under the Securities Act. The approximately 73.2 million shares owned by Western Resources will be "restricted securities" as that term is defined in Rule 144. Such restricted securities will be available for public sale only if registered under the Securities Act, sold in accordance with Rule 144 or sold or transferred in transactions otherwise exempt from registration requirements under the Securities Act. Under Rule 144, a person who is not our affiliate and who has held restricted securities for a period of one year may sell a limited number of shares to the public in ordinary brokerage transactions and, after holding the securities for two years, may freely trade them. Under Rule 144, affiliates of ours holding restricted securities may only sell all of them after holding them for one year and only within the parameters of Rule 144 governing the timing, manner and volume of sales of such shares. Our officers and directors and those of Western Resources may be considered to be affiliates for these purposes. Following consummation of the rights offering and assuming all of the rights are exercised, Western Resources will hold approximately 73.2 million shares of our common stock which may not be sold to the public without registration under the Securities Act or transferred in transactions otherwise exempt from registration requirements under the Securities Act. We may enter into a registration rights agreement with Western Resources which would grant to Western Resources registration rights with respect to shares of our common stock that it holds. These registration rights would effectively allow Western Resources to sell all of its shares of common stock either on demand or upon the occurrence of certain events and to participate as a selling shareholder in future public offerings by us. Although Western Resources currently intends to distribute, on a pro rata basis, the remaining shares of our common stock it holds to its common stockholders immediately prior to the consummation of the PNM merger, it may sell additional shares of our common stock in one or more public or private transactions prior to the proposed split-off. The shares of our common stock distributed by Western Resources would be freely transferable upon such distribution, other than shares distributed to our affiliates. In addition, 12.5 million shares of our common stock are reserved for issuance under our 2001 Long Term Incentive Compensation and Share Award Plan, and our Employee Stock Purchase Plan. Following the consummation of the rights offering, we intend to file registration statements on Form S-8 under the Securities Act covering the shares reserved for issuance under some or all of these plans. However, there is no present intention to issue any shares pursuant to such plans prior to completion of the split-off. Any such registration statement will automatically become effective upon filing. We may also issue large amounts of additional common stock in connection with raising additional capital and in connection with possible acquisitions. These shares would become available for resale at various dates in the future. Sales under Rule 144 may have a depressive effect on the market price of our common stock due to the potential increased number of publicly held securities. The timing and amount of sales of common stock made pursuant to other filed registration statements could also have a negative impact on the market price of our common stock. Any stock options we issue are likely to be exercised, if at all, at a time when we otherwise could obtain a price for the sale of our common stock that is higher than the exercise price per share of such options or warrants. Any such exercise or the possibility of such exercise may impede our efforts to obtain additional financing through the sale of additional securities or make such financing more costly. We cannot predict the effect, if any, that sales of our common stock, or the availability of shares for sale, or the distribution of our common stock in the future, will have on the market price prevailing from time to time. Nevertheless, sales of significant amounts of our common stock in the public or private market, or the perception that such sales may occur, or the expectation that additional shares will be distributed in the future, could adversely affect prevailing market prices. See "Certain Relationships and Related Transactions--Asset Allocation and Separation Agreement" for a discussion of the obligation of Western Resources to continue to own at least 80% of our common stock.

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+RISK FACTORS Our Company is subject to various risks which may materially harm our business, financial condition and results of operations. YOU SHOULD CAREFULLY CONSIDER THE RISKS AND UNCERTAINTIES DESCRIBED BELOW AND THE OTHER INFORMATION IN THIS FILING BEFORE DECIDING TO PURCHASE OUR COMMON STOCK. THESE ARE NOT THE ONLY RISKS AND UNCERTAINTIES THAT WE FACE. IF ANY OF THESE RISKS OR UNCERTAINTIES ACTUALLY OCCUR, OUR BUSINESS, FINANCIAL CONDITION OR OPERATING RESULTS COULD BE MATERIALLY HARMED. IN THAT CASE, THE TRADING PRICE OF OUR COMMON STOCK COULD DECLINE AND YOU COULD LOSE ALL OR PART OF YOUR INVESTMENT. RISKS RELATED TO OUR BUSINESS WE HAVE HISTORICALLY LOST MONEY AND LOSSES MAY CONTINUE IN THE FUTURE We have historically lost money. For the year ended December 31, 2000 and the year ended December 31, 1999, we sustained losses of $2.9 million and $0.1 million, respectively. Future losses are likely to occur. Our independent auditors have noted that our Company may not have significant cash or other material assets to cover its operating costs and to allow it to continue as a going concern. Our ability to obtain additional funding will determine our ability to continue as a going concern. Accordingly, we may experience significant liquidity and cash flow problems if we are not able to raise additional capital as needed and on acceptable terms. No assurances can be given that we will be successful in reaching or maintaining profitable operations. WE NEED TO RAISE ADDITIONAL CAPITAL TO FINANCE OPERATIONS We have relied on significant external financing to fund our operations. Such financing has historically come from a combination of borrowings from and sale of common stock to third parties and funds provided by certain officers and directors. We may need to raise additional capital to fund our anticipated operating expenses and future expansion. We cannot assure you that financing whether from external sources or related parties will be available if needed or on favorable terms. The sale of our common stock to raise capital may cause dilution to our existing shareholders. Our inability to obtain adequate financing will result in the need to curtail business operations. Any of these events would be materially harmful to our business and may result in a lower stock price. WE HAVE BEEN THE SUBJECT OF A GOING CONCERN OPINION FROM OUR INDEPENDENT AUDITORS Our independent auditors have added an explanatory paragraph to their audit opinions issued in connection with the 2000 and 1999 financial statements which states that our Company may not have significant cash or other material assets to cover its operating costs and to allow it to continue as a going concern. Our ability to obtain additional funding will determine our ability to continue as a going concern. Our financial statements do not include any adjustments that might result from the outcome of this uncertainty. WE HAVE BEEN AND CONTINUE TO BE SUBJECT TO A WORKING CAPITAL DEFICIT AND ACCUMULATED DEFICIT We had a working capital deficit of $0.6 million and $0.2 million at December 31, 2000 and 1999, respectively. We had an accumulated deficit of $3.2 million and $0.3 million at December 31, 2000 and 1999, respectively. Our ability to obtain additional funding will determine our ability to continue as a going concern. Accordingly, we may experience significant liquidity and cash flow problems if we are not able to raise additional capital as needed and on acceptable terms. No assurances can be given that we will be successful in reaching or maintaining profitable operations. OUR COMMON STOCK MAY BE AFFECTED BY LIMITED TRADING VOLUME AND MAY FLUCTUATE SIGNIFICANTLY There has been a limited public market for our common stock and there can be no assurance that an active trading market for our common stock will develop. As a result, this could adversely affect our shareholders' ability to sell our common stock in short time periods, or possibly at all. Our common stock has experienced, and is likely to experience in the future, significant price and volume fluctuations, which could adversely affect the market price of our common stock without regard to our operating performance. In addition, we believe that factors such as quarterly fluctuations in our financial results, announcements by our competitors and changes in the overall economy or the condition of the financial markets could cause the price of our common stock to fluctuate substantially. WE HAVE BEEN IN BUSINESS FOR A SHORT PERIOD OF TIME Because we have been in business for a short period of time, there is limited information upon which investors can evaluate our business. We were incorporated on December 4, 1994 but did not begin significant operations until the third quarter of 1999. You should consider the likelihood of our future success to be highly speculative in view of our limited operating history, as well as the complications frequently encountered by other companies in the early stages of development, particularly companies in the highly competitive technology industry. WE HAVE HAD A HISTORY OF A LIMITED CUSTOMER BASE AND THIS MAY CONTINUE At present, our customer base consists primarily of Internet service providers, telephone companies, and value-added resellers. Our ability to operate depends on increasing our customer base and achieving sufficient gross profit margins. We cannot assure you that we will be able to increase our customer base or to operate profitably. If any of our major customers stop or delay their purchases of our products, our revenue and profitability would be adversely affected. We anticipate that sales of our products to relatively few customers will continue to account for a significant portion of our revenue. In 1999, sales to three customers accounted for 60% of our revenue, while in 2000, sales to 10 customers accounted for 53% of our revenue. If these customers cancel or delay their purchase orders, our revenue may decline and the price of our common stock may fall. We cannot assure you that our current customers will continue to place orders with us, that orders by existing customers will continue at the levels of previous periods or that we will be able to obtain orders from new customers. Although our financial performance depends on large orders from a few key customers and resellers, we do not have binding commitments from any of them. WE MAY BE HARMED BY IMPORT RESTRICTIONS Our imported materials are subject to certain quota restrictions and U.S. customs duties, which are a material part of our cost of goods. A decrease in quota restrictions or an increase in customs duties could harm our business by making needed materials scarce or by increasing the cost of such materials. WE MAY BE EXPOSED TO INTERNATIONAL BUSINESS AND CURRENCY FLUCTUATIONS Although we are not dependent on international sales for a substantial amount of our revenue (10% of total revenue in 1999 and in 2000), we still face the risks of international business and associated currency fluctuations, which might adversely affect our operating results. These risks include potential regulation of our technology by foreign governments, general geopolitical risks associated with political and economic instability, changes in diplomatic and trade relationships, and foreign laws affecting the Internet generally. Our risks of doing business abroad also include our ability to develop and maintain distribution relationships on favorable terms. To the extent we are unable to favorably renew our distribution agreements or make alternative arrangements, revenue may decrease from our international operations. In addition, delays in deliveries from our component suppliers could cause our revenue to decline and adversely affect our results of operations. OUR COMMON STOCK MAY BE DEEMED TO BE "PENNY STOCK" Our common stock may be deemed to be "penny stock" as that term is defined in Rule 3a51-1 promulgated under the Securities Exchange Act of 1934. Penny stocks are stock: o With a price of less than $5.00 per share; o That are not traded on a "recognized" national exchange; o Whose prices are not quoted on the Nasdaq automated quotation system (Nasdaq listed stock must still have a price of not less than $5.00 per share); or o In issuers with net tangible assets less than $2.0 million (if the issuer has been in continuous operation for at least three years) or $5.0 million (if in continuous operation for less than three years), or with average revenues of less than $6.0 million for the last three years. Broker/dealers dealing in penny stocks are required to provide potential investors with a document disclosing the risks of penny stocks. Moreover, broker/dealers are required to determine whether an investment in a penny stock is a suitable investment for a prospective investor. These requirements may reduce the potential market for our common stock by reducing the number of potential investors. This may make it more difficult for investors in our common stock to resell shares to third parties or to otherwise dispose of them. This could cause our stock price to decline. OUR STOCK PRICE COULD DECLINE DUE TO FLUCTUATIONS IN THE DEMAND FOR OUR PRODUCTS AND GENERAL ECONOMIC CONDITIONS Fluctuations in consumer demand and the timing and amount of orders from key customers contribute to the variability of our operating results. In addition, any general economic downturn, whether real or perceived, could change consumer spending habits and decrease demand for our products. As a result of these and other factors, our operating results may fall below market analysts' expectations in some future quarters, and our stock price may decline. We are subject to all of the substantial risks inherent in an Internet related business, any one of which may harm our ability to operate successfully. These include, but are not limited to: o Our inability to attract or retain customers; o Our failure to anticipate and adapt to a developing market; o Our inability to upgrade and develop competitive products; and o Technical difficulties with product development. In addition, we believe that many potential customers in our target markets are not fully aware of the need for Internet security products and services. Historically, only enterprises with substantial resources have developed or purchased Internet security solutions. Also, there is a perception that Internet security is costly and difficult to implement. Therefore, we will not succeed unless we can educate our target markets about the need for Internet security and convince potential customers of our ability to provide this security in a cost-effective and easy-to-use manner. Although we have spent, and will continue to spend, considerable resources educating potential customers about the need for Internet security and the benefits of our products and services, our efforts may be unsuccessful. WE HAVE A SUBSTANTIAL AMOUNT OF STOCK THAT WILL BECOME AVAILABLE FOR RESALE UNDER RULE 144, WHICH MAY HAVE AN ADVERSE EFFECT ON THE MARKET AND OUR ABILITY TO OBTAIN EQUITY FINANCING As of July 2, 2001, we have issued and outstanding 36,153,385 shares of common stock of which 32,804,652 shares are "restricted securities" as that term is defined under Rule 144 promulgated under the Securities Act. Future sales of the restricted shares may be made under Rule 144. Such sales may have an adverse effect on the then prevailing market price of the common stock, adversely affect our ability to obtain future financing in the capital markets, and may create a potential market overhang. OUR ARTICLES OF INCORPORATION ALLOW AUTHORIZATION AND DISCRETIONARY ISSUANCE OF BLANK CHECK PREFERRED STOCK WHICH COULD DELAY, DETER, OR PREVENT A TAKEOVER, MERGER OR CHANGE OF CONTROL AND MAY PREVENT YOU FROM REALIZING A PREMIUM RETURN Our Articles of Incorporation authorize the issuance of "blank check," preferred stock. The Board of Directors is empowered, without shareholder approval, to designate and issue additional series of preferred stock with dividend, liquidation, conversion, voting or other rights, including the right to issue convertible securities with no limitations on conversion. These designations and issuances, could: o Adversely affect the voting power or other rights of the holders of our common stock. o Substantially dilute the common shareholder's interest. o Depress the price of our common stock. o Delay, deter, or prevent a merger, takeover or change in control without any action by the shareholders. OUR BUSINESS PLAN CONTEMPLATES FUTURE INTERNATIONAL OPERATIONS BUT THERE ARE NUMEROUS RISKS AND UNCERTAINTIES IN OFFERING PRODUCTS OUTSIDE OF THE UNITED STATES We intend to expand into international markets. We currently have a technology sharing business relationship with Nexland France, which precludes us from marketing in Europe. We cannot be sure that we will be able to successfully sell our products or adequately maintain operations outside North or South America. In addition, there are certain risks inherent in operating a business internationally. These include: o Unexpected changes in regulatory requirements; o Ability to secure and maintain the necessary physical and telecommunications infrastructure; o Challenges in staffing and managing foreign operations; and o Employment laws and practices in foreign countries. Any of these could adversely affect our proposed international operations. Furthermore, some foreign governments have enforced laws and regulations on content distributed over the Internet that are more restrictive than those currently in place in the United States. In addition, companies located in Taiwan perform our manufacturing. The current political tension between Taiwan and Mainland China may impair our ability to import product from our manufacturers. Anyone or more of these factors could adversely affect our contemplated future international operations, and consequently, our business. WE MAY BE UNABLE TO PROTECT OUR INTELLECTUAL PROPERTY RIGHTS OR TO CONTINUE USING INTELLECTUAL PROPERTY THAT WE LICENSE FROM OTHERS; WE MAY ALSO BE THE SUBJECT OF INTELLECTUAL PROPERTY INFRINGEMENT CLAIMS We rely and intend to rely on a combination of pending patents, copyright, trademark, service mark, and trade secret laws and contractual restrictions to establish and protect certain of our proprietary rights. We have a patent pending for certain technology, which is included in our family of Internet sharing products. There can be no assurance that we will be able to obtain such protection. Despite our efforts to protect our proprietary rights, we cannot assure you that unauthorized parties will not copy or otherwise obtain and use our data or technology or will not independently develop similar or competing technology. We cannot assure you that these precautions will prevent misappropriation or infringement of our intellectual property. Monitoring unauthorized use of our products is difficult, and we cannot assure you that the steps we have taken will prevent misappropriation of our technology or intellectual property, particularly in foreign countries where the laws may not protect our proprietary rights as fully as in the United States. Our industry is characterized by the existence of a large number of patents and frequent claims and related litigation regarding patent and other intellectual property rights. In particular, leading companies in the data communications and networking markets have extensive patent portfolios with respect to modem and networking technology. From time to time, third parties, including these leading companies, have asserted and may assert exclusive patent, copyright, trademark and other intellectual property rights to technologies and related standards that are important to us. We expect that we may increasingly be subject to infringement claims as the numbers of products and competitors in the office market for shared Internet access solutions grow and the functionality of products overlaps. As of the date of this filing, we have not been the recipient of any such claims. We may in the future initiate claims or litigation against third parties for infringement of our proprietary rights to determine the scope and validity of our proprietary rights. Any such claims, with or without merit, could be time consuming, result in costly litigation and diversion of technical and management personnel, or require us to develop non-infringing technology or enter into royalty or licensing agreements. Such royalty or licensing agreements, if required, may not be available on acceptable terms, if at all. In the event of a successful claim of infringement and our failure or inability to develop non-infringing technology or license the proprietary rights on a timely basis, our business would be harmed. BECAUSE OF THE UNCERTAINTY ASSOCIATED WITH UNPROVEN BUSINESS MODELS, WE MAY BE UNABLE TO ACHIEVE WIDESPREAD MARKET ACCEPTANCE Since our business model is relatively new and unproven, we may not be able to anticipate or adapt to a developing market. In addition, our success will depend upon the widespread commercial acceptance of shared Internet access products in the office and home markets. Businesses have only recently begun to deploy shared Internet access products, and the market for these products is not fully developed. If single Internet access devices currently utilized by many offices are deemed sufficient even though they do not enable shared access, then the market acceptance of our products may be slower than expected. Potential users of our products may have concerns regarding the security, reliability, cost, ease of use and capability of our products. We cannot accurately predict the future growth rate or the ultimate size of the office or home markets. WE CANNOT BE CERTAIN THAT WE WILL BE ABLE TO COMPETE WITH SIGNIFICANT PRICING PRESSURE BY OUR COMPETITORS As a result of increased competition in our industry, we expect to encounter significant pricing pressure. We cannot be certain that we will be able to offset the effects of any price reductions we may be forced to give to our customers or that we will have the resources to compete successfully. OUR BUSINESS WILL BE ADVERSELY AFFECTED IF WE LOSE MARKET SHARE We compete in a new, rapidly evolving and highly competitive market. We expect competition to persist and intensify in the future. Our current and potential competitors offer a variety of competitive products, including shared Internet access products offered by RAMP Networks, Flowpoint, Intel, Netopia, Watchguard, Netscreen, Nortel, Cisco, Sonicwall, Linksys, Cayman Systems and others, and high-end networking equipment offered by companies such as 3Com and Nortel. Many of our competitors are substantially larger than we are and have significantly greater financial, sales, marketing, technical, manufacturing and other resources and more established distribution channels. These competitors may be able to respond more quickly to new or emerging technologies and changes in customer requirements or devote greater resources to the development, promotion and sale of their products than we can. Furthermore, some of our competitors may make strategic acquisitions or establish cooperative relationships to increase their ability to rapidly gain market share by addressing the needs of our prospective customers. These competitors may enter our existing or future markets with solutions that may be less expensive, provide higher performance or additional features or be introduced earlier than our solutions. Given the market opportunity in the shared Internet access market, we also expect that other companies may enter our market with better products and technologies. If any technology is more reliable, faster, and less expensive or has other advantages over our technology, then the demand for our products and services would decrease, which would seriously harm our business. We expect our competitors to continue to improve the performance of their current products and introduce new products and technologies as industry standards and customer requirements evolve. These new products and technologies could supplant or provide lower cost alternatives to our products. To be competitive, we must continue to invest significant resources in research and development, sales and marketing, and customer support. Increased competition is likely to result in price reductions, reduced gross margins, longer sales cycles, and loss of market share, any of which would seriously harm our business and results of operations. The market for shared Internet access solutions is characterized by rapidly changing technologies and short product life cycles. Our future success will depend in large part upon our ability to: o Identify and respond to emerging technological trends in the market; o Develop and maintain competitive products; o Enhance our products by adding innovative features that differentiate our products from those of our competitors; o Bring products to market on a timely basis and at competitive prices; o Respond effectively to new technological changes or new product announcements by others; and o Respond to emerging broadband access technologies. The technical innovations required for us to remain competitive are inherently complex, require long development cycles, and are dependent, in some cases, on sole source suppliers. We will be required to continue to invest in research and development in order to attempt to maintain and enhance our existing technologies and products, but we may not have the funds available to do so. Even if we have sufficient funds, these investments may not serve the needs of customers or be compatible with changing technological requirements or standards. Most development expenses are incurred before the technical feasibility or commercial viability of new or enhanced products can be ascertained. Revenue from future products or product enhancements may not be sufficient to recover the associated development costs. WE HAVE LIMITED MARKETING AND SALES CAPABILITY Because of our limited working capital in the past, we have not had the resources to fully implement our marketing and sales strategy. In order to increase our revenues, we intend to implement a marketing and sales force with technical expertise and marketing capability. There can be no assurance that we will be able to: o Establish and develop such a sales force; o Gain market acceptance for our products; o Obtain and retain qualified sales personnel on acceptable terms; and o Meet our proposed marketing schedules or plans. To the extent that we arrange with third parties to market our products, the success of such products may depend on the efforts of such third parties. OUR EXECUTIVE OFFICERS, DIRECTORS AND PRINCIPAL SHAREHOLDERS, TOGETHER, MAY BE ABLE TO EFFECTIVELY EXERCISE CONTROL OVER ALL MATTERS SUBMITTED TO A VOTE OF SHAREHOLDERS Our executive officers, directors, and principal shareholders beneficially own, in the aggregate, approximately 81% of our outstanding shares of common stock. These shareholders, if acting together, will be able to effectively control most matters requiring approval by our shareholders. These shareholders can designate the members of our Board of Directors and can decide our operations and business strategy. You may disagree with these shareholders' decisions. Even if you do not like the members of our Board of Directors, you will not be able to remove them from office. Additionally, these members of our Board of Directors would be able to significantly influence a proposed amendment to our charter, a merger proposal, a proposed sale of assets or other major corporate transaction or a non-negotiated takeover attempt. Their influence may not be beneficial to you. If they prevent or delay a merger or takeover, you may not realize the premium return that shareholders may realize in conjunction with corporate takeovers. Moreover, there are no preemptive rights in connection with our common stock. Finally, cumulative voting in the election of our Directors is not provided for. Accordingly, the holders of a majority of the shares of common stock, present in person or by proxy, will be able to elect all of our Directors. WE HAVE NOT PAID NOR DO WE EXPECT TO PAY DIVIDENDS IN THE NEAR FUTURE It is not anticipated that we will pay any dividends on our common stock in the future. The Board of Directors intends to follow a policy of retaining earnings, if any, for use in our business operations. As a result, the return on your investment in us will depend upon any appreciation in the market price of the common stock. THE INSIDE SHAREHOLDERS RECEIVED SHARES FOR LESS CONSIDERATION THAN YOU ARE ASKED TO PAY The number of shares of common stock issued to our present shareholders for cash, property and consulting services was arbitrarily determined and was not the product of arm's length transactions. The inside shareholders received shares of our common stock from $0.0104 to $0.1223 per share, which is substantially less than you might pay. THE OFFICERS AND DIRECTORS MAY BE ENTITLED TO INDEMNIFICATION FOR SECURITIES LIABILITIES BY OUR COMPANY RESULTING IN SUBSTANTIAL EXPENDITURES FOR US AND PREVENTING ANY RECOVERY FROM OFFICERS AND DIRECTORS Our Articles of Incorporation provide that we may indemnify any Director, officer, agent, and/or employee as to those liabilities and on those terms and conditions as are specified in the Delaware Business Corporation Act. Further, we may purchase and maintain insurance on behalf of any such persons whether or not the corporation would have the power to indemnify such person against the liability insured against. The foregoing could result in substantial expenditures by us and prevent any recovery from our Directors, officers, agents, and employees for losses incurred by us as a result of their actions. Further, we have been advised that in the opinion of the Securities and Exchange Commission, indemnification is against public policy as expressed in the Securities Act of 1933, as amended, and is, therefore, unenforceable. WE HAVE EXPERIENCED NEGATIVE CASH FLOW WHICH COULD RESULT IN OUR INABILITY TO FUND PROGRAMS AND CREATE A NEED FOR ADDITIONAL FINANCING Since inception, we have experienced negative cash flow from operations and we expect to continue to experience negative cash flow from operations for the foreseeable future. Therefore, we have relied solely on limited revenues, shareholder loans and the issuances of equity securities to fund our operations. In particular, we may need to raise additional funds, especially if our estimates of revenue, working capital and/or capital expenditure requirements change or prove inaccurate or in order for us to respond to technological or marketing hurdles or to take advantage of unanticipated opportunities. We cannot be certain that additional financing, through the issuance of equity securities or otherwise, will be available to us on favorable terms when required, or at all. If adequate funds are not available, or are not available on acceptable terms, we may not be able to take advantage of market opportunities, develop new products or otherwise respond to competitive pressures which could adversely affect our ability to achieve and sustain positive cash flow and profitability in the future. WE DEPEND ON CONTRACT MANUFACTURERS FOR SUBSTANTIALLY ALL OF OUR MANUFACTURING REQUIREMENTS; THE INABILITY OF OUR CONTRACT MANUFACTURERS TO PROVIDE US WITH ADEQUATE SUPPLIES OF HIGH QUALITY PRODUCTS OR THE LOSS OF ANY OF OUR CONTRACT MANUFACTURERS WOULD CAUSE A DELAY IN OUR ABILITY TO FULFILL ORDERS WHILE WE OBTAIN A REPLACEMENT MANUFACTURER We have developed an outsourced contract manufacturing capability for the production of our products. Our primary relationship with our contract manufacturers has been accomplished through Smerwick, Ltd., our Hong Kong affiliate located in Taiwan. We rely on contract manufacturers to procure components, assemble, test and package our products. We rely primarily on one contract manufacturer for all of our product manufacturing and assembly, and if we cannot obtain its services, we may not be able to ship products. We outsource all of our hardware manufacturing and assembly primarily to one manufacturer and assembly house. We employ Smerwick, Ltd. to coordinate all manufacturing and packaging with this manufacturer. We do not have a long term manufacturing contract with this manufacturer. To date, this manufacturer has produced products with acceptable quality, quantity and cost, but there can be no assurance it will be able or willing to meet our future demands. Our operations could be disrupted if we have to switch to a replacement vendor or if our hardware supply is interrupted for an extended period. While we believe there are alternative manufacturing companies available at competitive prices, any interruption in the operations of one or more of these contract manufacturers or delays in their shipment of products would adversely affect our ability to meet scheduled product deliveries to our customers and could result in a loss in customer orders and revenue. We intend to introduce new products and product enhancements that will require us to rapidly achieve volume production by coordinating our efforts with those of our suppliers and contract manufacturers. The inability of our contract manufacturers to provide us with adequate supplies of high quality products or the loss of any of our contract manufacturers would cause a delay in our ability to fulfill orders while we obtain a replacement manufacturer. In addition, our inability to accurately forecast the actual demand for our products could result in supply, manufacturing or testing capacity constraints. These constraints could result in delays in the delivery of our products or the loss of existing or potential customers. Although we perform random spot testing on manufactured products, we rely on our contract manufacturers for assembly and primary testing of our products. Any product shortages or quality assurance problems could increase the costs of manufacturing, assembling or testing our products. IF WE FAIL TO DEVELOP AND EXPAND OUR DISTRIBUTION CHANNELS OUR BUSINESS WILL SUFFER Our product distribution strategy focuses primarily on continuing to develop and expand our distribution channels through Internet service providers, value-added resellers, and telephone companies. If we fail to develop and cultivate relationships with these customers, or if they are not successful in their sales efforts, our product sales may decrease and our operating results may suffer. Many of our resellers also sell products that compete with our products. We cannot assure you that our customers will market our products effectively or continue to devote the resources necessary to provide us with effective sales, marketing and technical support. OUR FINANCIAL RESULTS MAY PERIODICALLY VARY DUE TO FACTORS WHICH MAY AFFECT OUR STOCK Our operating results may vary due to factors unrelated to the progress of our business and beyond our control. These factors include: o Continued market acceptance of our products; o Fluctuations in demand for our products and services; o Variations in the timing of orders and shipments of our products; o Timing of new product and service introductions by us or our competitors; o Our ability to obtain sufficient supplies of sole or limited source components for our products; o Unfavorable changes in the prices of the components we purchase; o Our ability to attain and maintain production volumes and quality levels for our products; and o Our ability to integrate new technologies we develop or acquire into our products. The amount and timing of our operating expenses generally will vary from quarter to quarter depending on the level of actual and anticipated business activities. Research and development expenses will vary as we develop new products. General and administrative expense fluctuations in past periods have been due primarily to the level of sales and marketing expenses associated with new product introductions. In the past, we have experienced fluctuations in operating results. WE ARE SUBJECT TO VARIOUS RISKS PERTAINING TO THE INTERNET INDUSTRY Our revenue growth is dependent on the continued growth of broadband access services, which are currently in early stages of development, and if such services are not widely adopted or we are unable to address the issues associated with the development of such services, our sales will be adversely affected. Sales of our products depend on the increased use and widespread adoption of broadband access services, such as cable, digital subscriber lines, integrated services digital networks, frame relay and point-to-point digital circuits. These broadband access services typically are more expensive with respect to the required equipment and ongoing access charges than is the case with Internet dial-up access providers. Our business, prospects, results of operations and financial condition would be materially adversely affected if the use of broadband access services does not increase as anticipated or if our customers' access to broadband services is limited. Critical issues concerning the use of broadband access services are unresolved and will likely affect the use of broadband access services. These issues include: o Security; o Reliability; o Capacity; o Congestion; o Cost; o Ease of access; and o Quality of service. If the market for products that provide broadband access to the Internet fails to develop, or if it develops at a slower pace than we anticipate, our business, prospects, results of operations and financial condition would be materially adversely affected. The broadband access service market is new and is characterized by rapid technological change, frequent enhancements to existing products, new product introductions, changes in customer requirements and evolving industry standards. We may be unable to respond quickly or effectively to these developments. The introduction of new products by competitors, market acceptance of products based on new or alternative technologies, or the emergence of new industry standards, could render our existing or future products obsolete, which would materially adversely affect our business, prospects, results of operations and financial condition. The emergence of new industry standards might require us to redesign our products. If our products fail to comply with widely adopted industry standards, our customers and potential customers may not purchase our products. This would have a material adverse effect on our business, prospects, results of operations and financial condition. Governmental regulations affecting Internet security could affect our revenue. Any additional governmental regulation of imports/exports or the failure to obtain required export approval of our encryption technologies could adversely affect our international and domestic sales. The United States and various foreign governments have imposed controls, export license requirements and restrictions on the import and export of certain technologies, including encryption technology. In addition, from time to time governmental agencies have proposed additional regulations on encryption technology, such as requiring the escrow and governmental recovery of private encryption keys. Additional regulation of encryption technology could delay or prevent the acceptance and use of encryption products and public networks for secure communications. This, in turn, could decrease demand for our products. In addition, some foreign competitors are subject to less stringent controls on exporting their encryption technologies. As a result, they may be able to compete more effectively than we can in the United States and internationally. THE PURCHASE OF SHARES IN OUR COMPANY WILL BE SUBJECT TO VARIOUS INVESTMENT RISKS Because our officers, directors, principal shareholders and their affiliates beneficially own approximately 81% of our stock ownership, they will be able to elect the Board of Directors and control all matters requiring shareholder approval. The price of our common stock has been volatile and may continue to experience volatility. The trading price of our common stock may fluctuate widely as a result of a number of factors, most of which are outside our control. Some of these factors include: o Quarterly variations in our operating results; o Announcements by our Company about the performance of our products and our competitors' announcements about performance of their products; and o Changes in earnings estimates by analysts, or the failure to meet the expectations of analysts. In addition, the stock market has experienced extreme price and volume fluctuations, which have particularly affected the market prices of many technology and computer software companies and which have in some cases, been unrelated to the operating performance of these companies. CHARTER AND BYLAW PROVISIONS OF OUR COMPANY LIMIT THE AUTHORITY OF OUR SHAREHOLDERS, AND THEREFORE MINORITY SHAREHOLDERS MAY NOT BE ABLE TO SIGNIFICANTLY INFLUENCE THE COMPANY'S GOVERNANCE OR AFFAIRS Our Board of Directors has the authority to issue shares of preferred stock and to determine the price, rights, preferences, privileges and restrictions, including voting rights, of those shares without any further vote or action by shareholders. The rights of the holders of common stock will be subject to, and may be adversely affected by, the rights of the holders of any preferred stock that may be issued in the future. The issuance of preferred stock, while providing flexibility in connection with possible acquisitions and other corporate purposes, could have the effect of making it more difficult for a third party to acquire a majority of our outstanding voting stock. Substantial future sales of our common stock in the public market could cause our stock price to fall. If our shareholders sell substantial amounts of our common stock in the public market, including shares sold pursuant to the Equity Line of Credit, from the conversion of debentures or issued upon the exercise of outstanding options, the trading price of our common stock could fall. Such sales also might make it more difficult for us to raise capital in the future at a time and price that we deem appropriate. WE COULD FAIL TO ATTRACT OR RETAIN KEY PERSONNEL Our success largely depends on the efforts and abilities of key executives and consultants, including Gregory S. Levine, our President and a Director of our Company, and Martin Dell'Oca, our Chief Financial Officer and a Director of our Company. The loss of the services of any of these people could materially harm our business because of the cost and time necessary to replace and train such personnel. Such a loss would also divert management attention away from operational issues. We have entered into employment agreements with Mr. Levine and Mr. Dell'Oca, respectively. We do not maintain key-man life insurance policies on any of these people. WE MAY BE UNABLE TO MANAGE GROWTH Successful implementation of our business strategy requires us to manage our growth. Growth could place an increasing strain on our management and financial resources. To manage growth effectively, we will need to: o Implement changes in certain aspects of our business; o Enhance our information systems and operations to respond to increased demand; o Attract and retain qualified personnel; and o Develop, train and manage an increasing number of management-level and other employees. If we fail to manage our growth effectively, our business, financial condition or operating results could be materially harmed, and our stock price may decline. RISKS RELATED TO THIS OFFERING FUTURE SALES BY OUR STOCKHOLDERS MAY ADVERSELY AFFECT OUR STOCK PRICE AND OUR ABILITY TO RAISE FUNDS IN NEW STOCK OFFERINGS Sales of our common stock in the public market following this offering could lower the market price of our common stock. Sales may also make it more difficult for us to sell equity securities or equity-related securities in the future at a time and price that our management deems acceptable or at all. Of the 36,153,385 shares of common stock outstanding as of July 2, 2001 (assuming no exercise of options), 3,348,733 shares are, or will be, freely tradable without restriction, unless held by our "affiliates." The remaining 32,804,652 shares of common stock held by existing stockholders are "restricted securities" and may be resold in the public market only if registered or pursuant to an exemption from registration. Some of these shares may be resold under Rule 144. Immediately following the effective date of this prospectus, including the shares to be issued to Cornell Capital Partners, L.P., and upon conversion of debentures, 13,673,814 shares of common stock will be freely tradeable without restriction, unless held by our "affiliates." Upon completion of this offering, and assuming all shares registered in this offering are resold in the public market, there will be an additional 13,673,814 shares of common stock outstanding. All of these shares of common stock may be immediately resold in the public market upon effectiveness of the accompanying registration statement and the sale to the investor under the terms of the Equity Line of Credit agreement. In addition, we have issued options to purchase a total of 4,399,179 shares of our common stock at exercise prices ranging from $0.120 to $0.0927 per share. We have also issued warrants to purchase a total of 3,089,184 shares of our common stock at exercise prices of $2.50 per share and $5.00 per share, respectively. All of the warrants expire on August 15, 2001 if unexercised. EXISTING SHAREHOLDERS MAY EXPERIENCE SIGNIFICANT DILUTION FROM OUR SALE OF SHARES UNDER THE LINE OF CREDIT The sale of shares pursuant to the Equity Line of Credit and from conversion of debentures will have a dilutive impact on our stockholders. As a result, our net income per share could decrease in future periods, and the market price of our common stock could decline. In addition, the lower our stock price is the more shares of common stock we will have to issue under the Equity Line of Credit to draw down the full amount. If our stock price is lower, then our existing stockholders would experience greater dilution. THE INVESTOR UNDER THE LINE OF CREDIT WILL PAY LESS THAN THE THEN-PREVAILING MARKET PRICE OF OUR COMMON STOCK The common stock to be issued under the Equity Line of Credit will be issued at a 20% discount to the lowest closing bid price for the 10 days immediately following the notice date. These discounted sales could cause the price of our common stock to decline. THE SELLING STOCKHOLDERS INTEND TO SELL THEIR SHARES OF COMMON STOCK IN THE MARKET, WHICH SALES MAY CAUSE OUR STOCK PRICE TO DECLINE The selling stockholders intend to sell in the public market the shares of common stock being registered in this offering. That means that up to 13,673,814 shares of common stock, the number of shares being registered in this offering, may be sold. Such sales may cause our stock price to decline. OUR COMMON STOCK HAS BEEN RELATIVELY THINLY TRADED AND WE CANNOT PREDICT THE EXTENT TO WHICH A TRADING MARKET WILL DEVELOP Before this offering, our common stock has traded on the Over-the-Counter Bulletin Board. Our common stock is thinly traded compared to larger more widely known companies in our industry. Thinly traded common stock can be more volatile than common stock trading in an active public market. We cannot predict the extent to which an active public market for the common stock will develop or be sustained after this offering. THE PRICE YOU PAY IN THIS OFFERING WILL FLUCTUATE The price in this offering will fluctuate based on the prevailing market price of the common stock on the Over-the-Counter Bulletin Board. Accordingly, the price you pay in this offering may be higher or lower than the prices paid by other people participating in this offering. WE MAY NOT BE ABLE TO ACCESS SUFFICIENT FUNDS UNDER THE EQUITY LINE OF CREDIT WHEN NEEDED We are dependent on external financing to fund our operations. Our financing needs are expected, in part, to be provided from the Equity Line of Credit. No assurances can be given that such financing will be available in sufficient amounts or at all when needed, in part, because the amount of financing available will fluctuate with the price and volume of our common stock. As the price and volume decline, then the amount of financing available under the Equity Line of Credit will decline.

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+RISK FACTORS The notes entail a high degree of risk, including the following risks. If any of the events described in the following risks actually occur, our business, operating results, financial condition, or ability to pay principal or interest on the notes could be materially adversely affected. In that event, you may lose all or part of your investment. You should carefully consider the following factors and other information in this prospectus before deciding to purchase the notes. Risks related to our financial history, condition, and requirements. Our limited operating history makes an evaluation of our prospects difficult and the notes a highly speculative investment. We have a limited operating history from which you can evaluate our business and prospects. Our company is in a development stage. As a young company, we face risks and uncertainties relating to our ability to successfully implement our business plan. You should consider the significant risks, expenses, and difficulties encountered by companies like us in their early stages of development in a highly regulated, high technology industry. Specifically, we must successfully deploy our satellite and introduce new services and products on a commercial basis in an industry that is still evolving. If we do not successfully address these risks and uncertainties, our business, operating results, and financial condition will be materially adversely affected. Since commencing operations on March 31, 1995, we have invested in research and development and incurred substantial operating costs, as well as selling and general and administrative expenses. Four days after launching our first satellite, EarlyBird 1, in December 1997, we lost contact with it, resulting in a total loss of that satellite. Our second satellite, QuickBird 1, was lost on launch on November 20, 2000, due to a failure to achieve orbit. As a result, we have not generated significant revenue from the sale of licenses for the use of imagery products. Given our limited operating history, you have only limited operating and financial data on which to evaluate our performance. Also, our historical financial results are not representative of what we expect to achieve after our launch of QuickBird 2. Our business plan depends upon: . the timely construction and deployment of QuickBird 2 and the development of related ground systems; . our ability to develop a customer base and distribution channels for our imagery products and services; and . demand for commercially available satellite imagery we plan to offer. We have a history of losses, we expect to incur additional losses in the near future, and we may not achieve or sustain profitability. We have not achieved profitability and, since inception, we have generated no significant revenues from our proposed satellite imaging business. We had accumulated net losses of approximately $69.3 million at June 30, 2001. Our business strategy requires substantial capital and operating expenditures before we can begin to realize any significant revenues. We expect to incur significant operating losses as we continue to develop our satellite and imaging network and as we begin to market our products. We expect to continue to incur negative cash flow and substantial operating losses at least through the third quarter of 2002. Our ability to become profitable and to generate positive cash flow will depend on our ability to sell imagery to existing markets for geographic imagery and develop new markets for geographic imagery. In addition, our revenues and operating results could vary significantly from period to period. We expect to experience a delay in generating revenue for some time after the QuickBird 2 satellite is launched. We will need several months to test the system prior to serving our customers. In addition, we anticipate that many customers will wait to commit to enter into contracts until after QuickBird 2 is successfully launched and fully operational. We also expect that many customers will wait until satellite operations are assured before investing in new and upgraded ground stations. Although construction time varies, it usually ranges from six months for an upgrade to two years for a new facility. Until such customers upgrade or construct their own ground stations, they will need to receive delivery of our imagery through our ground stations and distribution systems. We experienced significant delays in launching QuickBird 1 and EarlyBird 1, a predecessor satellite to QuickBird 1, and incurred greater than anticipated costs in designing, building and launching those satellites. In addition, we have experienced delays in building QuickBird 2 and have incurred greater than anticipated costs for its design and construction. If we experience any additional delays or a failure in the launch of QuickBird 2, we could incur losses for a longer period and may require significant additional financing. If we experience a delay or cannot obtain additional financing, we may not be able to continue our operations. We may need additional financing. Based on our current operating plan, we believe that existing capital resources will meet our anticipated cash needs through fiscal 2002. However, we cannot assure you that we will have sufficient funds to service the notes or our other indebtedness or to fund our other liquidity needs, including our anticipated capital expenditures, or that these expenditures will fall within our estimates. If we face any launch delays, if the system takes longer to become operational, if technical or regulatory developments require that we modify the design of the EarthWatch system, if we are unable to achieve our revenue targets, or if we incur other additional unforeseen costs, we will likely require additional capital. In addition, a significant delay in the launch of QuickBird 2 would require us to modify our operating plan and to defer substantial amounts of planned capital expenditures. This, in turn, would delay deployment of the complete EarthWatch system and may prevent us from continuing as a going concern. We may also need to raise additional capital to support the construction and deployment of our next generation satellites. We do not have a revolving credit facility or other source of readily available capital. Therefore, any shortfall in funds available for our operations or to service our debt would cause us serious liquidity problems. In such case, we would need to seek additional financing which we may not be able to obtain on commercially reasonable terms or at all. Failure to obtain such additional financing may result in a material adverse effect on our business and could prevent us from continuing as a going concern. Our substantial indebtedness could adversely affect our financial condition and prevent us from fulfilling our payment obligations under the notes. We currently have a significant amount of indebtedness. As of June 30, 2001, we had approximately $68.8 million of debt. This amount includes $63.1 million in accreted value of notes, which will have a fully accreted value of $71.7 million on July 15, 2002. The notes will begin to accrue cash interest on July 15, 2002, which interest will be payable semiannually in cash on January 15 and July 15 of each year, beginning on January 15, 2003. In addition, we have obtained $9.0 million of vendor financing which we intend to use to fund the completion of QuickBird 2, under which we had borrowed approximately $5.7 million as of June 30, 2001. This vendor financing facility will accrue interest at an annual rate of 11%, which will become payable seven months following the launch of QuickBird 2. Beginning with the eighth month and ending with the eighteenth month following the launch of QuickBird 2, principal, in equal monthly amounts, and interest are payable in cash each month. We may also raise additional financing in the future. The amount of our indebtedness could have important consequences to you. For example, it could: . make it more difficult for us to satisfy our obligations with respect to payments on the notes; . require us to dedicate a substantial portion of our cash flow from operations, if any, to repaying indebtedness, thereby reducing the availability of cash flow to fund operating expenses, working capital, capital expenditures, and other general corporate purposes; . limit our flexibility in planning for or reacting to changes in our business and the satellite imaging industry, placing us at a competitive disadvantage; . limit our ability to borrow additional funds for working capital, capital expenditures, debt service requirements, or other purposes; and . limit our ability to react to changing market conditions, changes in our industry, or economic downturns. We will require a significant amount of cash to service our indebtedness. Our ability to make scheduled payments of principal and interest on our indebtedness and to fund planned capital expenditures, development expenses, and operating costs will depend on our ability to generate cash in the future through sales of imagery products and services. Our ability to generate cash will depend on our successful deployment of high-resolution satellites, implementation of our marketing and distribution strategy, customer demand for our imagery products and services, and, to a certain extent, general economic, financial, competitive, regulatory, and other factors beyond our control. If we are unable to generate sufficient cash from our operations, we will be required to identify and secure additional financing. However, we cannot assure you that additional financing will be available to us on acceptable terms or at all. Consequently, we could be required to significantly reduce or suspend our operations, seek a merger partner, sell the business, or seek additional financing. We must make significant additional capital expenditures. We expect to incur significant capital expenditures to construct and launch the QuickBird 2 satellite and to upgrade both our ground stations and other operating systems. The QuickBird 2 satellite is now in final assembly and testing. We expect to spend approximately $34.6 million to complete, launch, and insure QuickBird 2 and its related systems, in addition to the approximately $104.8 million that has been spent through June 30, 2001. The QuickBird 2 satellite is scheduled for launch in 2001 and has a designed useful life of five years. We have begun to develop plans for the next-generation satellites that will replace QuickBird 2. The first replacement satellite is planned for launch by 2005. We expect to incur in excess of $400 million of research and development costs and capital expenditures to develop our next-generation satellites. However, we cannot assure you that such funds will be available to us on acceptable terms or at all. Consequently, we could be required to significantly reduce or suspend our operations, seek a merger partner, sell the business, or seek additional financing. Our cost to insure future launches may increase. Due to the launch failure of QuickBird 1 and the failure of EarlyBird 1 on orbit, we have made claims on the insurance policies covering both of these satellites. Although we did obtain insurance for QuickBird 2, these claims may hinder or prevent us from obtaining insurance for future launches on commercially reasonable terms or at all. The cost of launch insurance for a particular satellite is based on many factors, including failure rates of similar launch vehicles or satellite components. An adverse change in insurance market conditions, or the failure of a satellite using similar components or a similar launch vehicle, could significantly increase the cost of insurance on future launches. Recently, there have been several commercial satellite launch failures. Additionally, there have been numerous government launch failures which were not insured. Consequently, the launch insurance industry is assessing the impact of failed launches and examining the resulting claims. These factors could cause the market terms of future insurance policies to be significantly less favorable than those currently available, may result in limits on amounts of coverage that we can obtain, or may prevent us from obtaining insurance at all. We cannot assure you that launch insurance for our next generation satellites will be available on acceptable terms, or at all. Our current revenues depend on a limited number of customers. NASA accounted for approximately 39%, and NIMA accounted for approximately 54%, of our revenue during the fiscal year ended December 31, 2000. Any termination of our relationships with NASA and NIMA would have a material adverse effect on our current operating results and financial condition. NASA and NIMA retain our services on a case-by-case basis and may choose at any time to use another firm to provide the services that we perform. Therefore, any shift in either NASA's or NIMA's decisions to continue to use our services could also result in substantially reduced revenues for us. Our use of net operating losses to offset taxes may be limited. Under the Internal Revenue Code as currently in effect, utilization of our net operating loss carryforwards against future taxable income could be limited if we are treated as having experienced an ownership change, as defined in the Code. We believe that we may have experienced an ownership change as a result of certain prior transactions. Future events also may result in an ownership change that could result in limitations on our ability to utilize our net operating loss carryforwards. In addition, the Internal Revenue Code restricts our ability to utilize net operating losses to a limited period of time after they are incurred. Risks relating to our planned satellite launch and operations. A delay in launching the QuickBird 2 satellite will adversely affect us. Prior to launch, we must fully construct, test, and transport our satellite to the launch site and install the satellite on the launch vehicle. We also must coordinate the launch campaign, the shipment of equipment and materials, and the setup of such equipment and materials at the launch site. These steps are complex and entail numerous risks. Also, many of these activities are entirely outside of our control. Difficulties in any aspect of this process or a delay in launching the QuickBird 2 satellite will adversely affect our business, operating results, financial condition, and ability to pay interest and principal on the notes. We have already lost the QuickBird 1 satellite and cannot afford a delay in our scheduled launch date for QuickBird 2 in October 2001. One of our competitors, Space Imaging, successfully launched a satellite in September 1999 and has been distributing imagery to its customers since that time. Also, ImageSat successfully launched its high-resolution EROS A1 satellite in December 2000 and began receiving high-resolution imagery shortly thereafter. Any further delay may put us at a significant competitive disadvantage by allowing our competitors more time to launch a satellite before us and to establish themselves in the market. A launch failure would adversely affect our ability to deliver imagery products and services. Satellite launches are subject to significant risks, including disabling damage to or loss of the satellite. We cannot assure you that our planned satellite launches will be successful. The interruption of our business that would result from a launch failure would materially adversely affect our business, operating results, financial condition, and ability to repay the notes, particularly if the launch failure is not wholly covered by insurance. We cannot assure you that our satellite will operate as designed. We have limited experience in producing our products, contracting for such production, and providing services. To date, we are still in the process of developing our products and services and have yet to fully establish our processes and facilities. Problems may occur in the future with respect to product or service quality, performance, and reliability. If such problems occur, we could experience increased costs, delays in, or cancellations of orders, loss of customers, and product returns, any one of which would materially adversely affect our business, operating results, financial condition, and our ability to pay interest and principal on the notes. See "Business--Products and services." We cannot assure you that QuickBird 2 will operate successfully or that it will continue to operate throughout its expected design life. Even if this satellite is launched and operated properly, minor technical flaws in its sensors, power supply, data recorder, communications systems, or other components could significantly degrade its performance, which could materially affect our ability to collect and market imagery products. For example, our EarlyBird 1 satellite was successfully launched, but we lost contact with it four days later. After we were unable to reestablish communications, we determined that the satellite was a total loss. Our QuickBird 2 satellite will employ advanced technology that will be subject to severe environmental stresses during launch and in space that could adversely affect its performance. Hardware component problems in space could require premature satellite replacement, with attendant costs and revenue losses. In addition, human operators may make mistakes in issuing commands, negatively impacting our satellite's performance. If QuickBird 2 were to fail prematurely, we could experience significant delays while we replace the satellite. During this period, our revenue would decline significantly, as we would have no images to sell from the failed satellite. This could also adversely affect market acceptance of our imagery products and our competitive position if other companies are able to launch and successfully operate similar satellites. Even if any such loss of satellite capacity were covered by insurance, we cannot assure you that we would have on hand, or be able to obtain in a timely manner, the necessary funds to cover the costs of a replacement satellite. Our satellites have limited design lives and are expensive to replace. Satellites have limited useful lives. We determine a satellite's useful life, or design life, using a complex calculation involving the probabilities of failure of the satellite's components from design or manufacturing defects, environmental stresses, or other causes. The designed useful life of a QuickBird satellite is five years. We expect the performance of the QuickBird 2 satellite to decline near the end of its design life. However, we cannot assure you that each satellite will function properly for its expected design life. We anticipate using funds primarily generated from operations to develop next generation high-resolution satellites. We expect the cost of the next generation satellites to be significant. If we do not generate sufficient funds from operations or are unable to obtain financing from outside sources, we will not be able to develop next generation satellites to replace the QuickBird 2 satellite at the end of its design life. This would materially and adversely affect our business, operating results, financial condition, and ability to pay principal and interest on the notes and our other indebtedness. Our business depends on component and software suppliers. We are highly dependent on other companies for the development and manufacture of various components critical to our operation. These components include software and products for our satellite systems, ground stations, DigitalGlobe archive, data distribution network, and the launch of our satellite. Many of the sources for these components are our primary source of supply, including Ball Aerospace, Eastman Kodak Company, Fokker Space B.V., Datron/Transco Inc., InfoFusion, LLC, ITT Industries, Inc., Kongsberg Spacetec A.S., L3 Communications Storm Control Systems, Inc., and MacDonald Dettwiler & Associates, Ltd. The EarthWatch system will be delayed if these or other companies and subcontractors fail to complete development or produce these components on a timely basis. Additionally, the failure of any such components to function as required will adversely affect our business. Our business depends on the continued functioning of our data centers. We must protect our data centers against damage from fire, earthquake, power loss, telecommunications failure, and similar events. We plan to take precautions to protect ourselves from events that could interrupt our operations, including the implementation of redundant systems, offsite storage of back-up data, and sprinkler systems in the data centers. Our master international distributors will maintain separate archives of portions of our imagery data and we plan to enter into arrangements with other high volume customers for alternative data back-up storage. We cannot assure you that such precautions will be adequate, and our operations may still be interrupted, possibly for extended periods. Although we have insurance to cover damage to our data centers, and we also carry business interruption insurance to cover the loss of revenue that would result if one of our data centers was damaged or destroyed, the insurance proceeds might not sufficiently compensate us for interruptions of our operations. Risks related to government regulation of our industry. We are subject to extensive government regulation. Our business is subject to extensive regulation in the United States and in foreign jurisdictions in which we may operate or in which our products may be sold. Regulatory changes could significantly impact our operations by: . restricting our development efforts and those of our customers; . restricting the amount and type of data that we can collect; . making current products obsolete; . restricting sales or distribution of our products; or . increasing competition. We might need to modify our products or operations to comply with such regulations. Such modifications could be expensive and time-consuming. Foreign governments may attempt to limit or prohibit sales of images into their country or other countries. The United States government imposes restrictions on our ability to collect and sell imagery covering Israel and could elect to limit or proscribe sales of imagery covering other countries or regions. Additionally, the United States government may limit our ability to distribute images in order to protect the safety and security of the United States or allied military forces. We could in the future be subjected to new laws, policies, or regulations, or changes in the interpretation or application of existing laws, policies, and regulations that modify the present regulatory environment in the United States or abroad. U.S. regulators could decide to impose limitations on U.S. companies that are currently applicable only to other countries or other regulatory limitations that affect satellite remote imaging operations. Any limitations of this kind could materially adversely affect our business. National Oceanic and Atmospheric Administration Licenses. We are required to hold, and have obtained, licenses from the National Oceanic and Atmospheric Administration of the United States Department of Commerce for the operation of our commercial remote sensing satellite system. These licenses regulate our activities in several areas. For example, the collection and distribution of data and the percentage of foreign ownership of our company may be controlled for purposes of national security or foreign policy in certain circumstances. Federal Communications Commission Licenses. We are required to hold, and have obtained, licenses from the Federal Communications Commission for the operation of radio frequency devices on board our satellite and at United States ground stations. Any future regulatory changes could materially adversely affect our business, operating results, financial condition, and our ability to pay interest and principal on the notes and our other indebtedness. In addition, the terms of the FCC license require that we meet certain construction and launch deadlines. Currently, our FCC license, as amended, requires launch of QuickBird 2 to be completed by December 2001. If we are unable to meet this deadline and are unable to obtain an additional amendment to the FCC license, our business, operating results, financial condition, and our ability to pay interest and principal on the notes and our other indebtedness could be materially adversely affected. Risks related to the market for our products and services. Our business will suffer if we do not compete successfully in the collection and distribution of digital geographic and image data. We expect to encounter substantial competition in the market for digital geographic and image data. We expect to face competition from traditional sources of image-based information, including aerial photography, and from high-resolution satellite systems developed and operated by other commercial enterprises or foreign governments. Industry analysts generally expect that aerial photography will remain the dominant source of imagery because it offers superior spatial resolution as compared to imagery produced by commercial satellites. Aerial photography offers high-resolution imagery, is efficient and competitively priced, and currently enjoys a majority share of the overhead imagery market. We expect that aerial photography firms will continue to offer products that are competitive with ours in many applications. We also face competition from high-resolution commercial satellite ventures, including Space Imaging, Orbimage, and ImageSat. Space Imaging, a joint venture including Lockheed Martin, E-Systems, and Mitsubishi, has developed a high-resolution imaging system. Space Imaging successfully launched a high-resolution satellite in September 1999 and has begun serving the commercial market. Space Imaging also has the right to distribute imagery for Landsat 4 and 5 and for the Indian Remote Sensing System. It also has access to significant technological and capital resources. Orbimage, a wholly-owned subsidiary of Orbital Sciences Corporation, is developing two high-resolution imaging systems, which are scheduled for launch during the third and fourth quarters of 2001, as publicly announced. In addition, ImageSat successfully launched a 1.8-meter resolution satellite in December 2000 and has announced plans to launch a 1-meter high- resolution satellite for commercial use during the third quarter of 2001. We also will face competition from new and emerging technologies, possibly including satellites with higher resolution and radar. We cannot assure you that we will be able to compete successfully against current and future competitors, or that competitive pressures faced by us will not materially adversely affect our business, operating results, financial condition, or our ability to pay principal and interest on the notes and our other indebtedness. Our business may become subject to intense price competition. As more of our competitors successfully launch earth-observing imaging satellites, our business will become increasingly competitive. The cost to enter our business is very high, while operating costs, on a day-to-day basis, are lower. Therefore, one of our competitors may substantially reduce prices in an effort to gain market share and eliminate other market participants, and still be able to carry on business and finance operations. A reduction in prices by one of our competitors would force us to reduce our prices in order to maintain market share. Any significant price reduction in the market could have a material adverse effect on our revenues, operating results, financial condition, and our ability to pay principal and interest on the notes and our other indebtedness. Our dependence on third party distributors, sales agents, and value-added resellers could result in marketing and distribution delays. We plan to market and license our products using a network of distributors covering major world regions and, on a regional basis, through local distributors retained by the major distributors. We currently have agreements with certain of our strategic partners to serve as master international distributors, with exclusive distribution rights for at least four years to certain of our products in Europe, Asia, and Australia. We are currently engaged in discussions with other potential distributors, sales agents, and value-added resellers. Our ability to terminate a distributor who is not performing satisfactorily may be limited. Inadequate performance by a master international distributor would adversely affect our ability to develop markets in the regions for which the master international distributor is responsible and could result in substantially greater expenditures by us in order to develop such markets. Our operating results will be highly dependent upon: . our ability to maintain our existing master international distributor arrangements; . our ability to establish and maintain coverage of major geographic areas and establish access to customers and markets; and . the ability of our distributors, sales agents, and value-added resellers to successfully market our products. Market acceptance of our products and services is uncertain. We intend to address the needs of existing imagery markets and to develop new markets. Our success will depend on demand for satellite imagery with a resolution of one meter or less, which to date has not been widely available commercially. Consequently, it is difficult to predict the ultimate size of the market and the demand for products and services based on this type of imagery. Our strategy to target certain markets for our satellite imagery is based on a number of assumptions, some or all of which may prove to be incorrect. Our description of potential markets for our products and services, and estimates of the addressable markets that we discuss in this prospectus, represent our view as of the date of this prospectus. Actual markets could vary materially from these estimates. As is typical in many emerging markets, demand and market acceptance for a new product or service is subject to many uncertainties. We cannot assure you that our products will achieve market acceptance in existing imagery markets or that new markets will develop. Even if markets for our imagery develop, we may capture a smaller share of these markets than we currently anticipate. We have entered into contracts to supply imagery, which provide for agreed upon minimum and maximum purchases by our customers of imagery and value-added products and services. We cannot assure you that our customers will purchase any such data in excess of minimum contractual obligations. Lack of significant market acceptance of our products and services, delays in acceptance, or failure of certain markets to develop would have a material adverse effect on our business, operating results, and financial condition, and would negatively affect our ability to pay interest and principal on the notes and our other indebtedness. Our business will suffer if we are not able to expand into international markets or compete effectively in those markets. We expect to derive a significant portion of our revenues from international markets. We have limited experience internationally and may not be able to compete effectively in international markets. International operations are subject to certain risks, such as: . increases in tariffs, taxes, and other trade barriers; . difficulties in collecting accounts receivable and longer collection periods ; . fluctuations in currency exchange rates; . changes in political and economic stability; . potentially adverse tax consequences; . government regulations; and . reduced protection for intellectual property rights in certain countries. Any of these factors could materially adversely affect our international revenues and, consequently, our business, operating results, and financial condition. We face technological risks. The EarthWatch system is exposed to the risks inherent in a complex satellite system employing advanced technologies. The technology used in the EarthWatch system has never been used in an integrated commercial system and has been or must be adapted to meet our specific needs. The operation of the EarthWatch system will require the design and integration of advanced digital technologies throughout our satellite, ground station, and data gathering and distribution networks. The failure to develop, produce, and implement the EarthWatch system or any of its elements could delay the operation of the EarthWatch system or render it unable to perform to the quality standards required for success. We believe that, based upon presently available information, our QuickBird 2 satellite will, at the time of launch, be technologically competitive with other high-resolution satellites. However, because of substantial and continual technological change, we may be unable to maintain our competitive position, and our business, results of operations, and financial condition may be adversely affected. Therefore, we may be unable to pay interest and principal on the notes and our other indebtedness. Risks relating to our personnel and intellectual property. Our business will suffer if we do not attract and retain additional highly-skilled personnel or manage our growth effectively. Our future success depends on our ability to identify, attract, hire, and train highly-skilled technical, managerial, sales, and marketing personnel. Competition for skilled technical personnel is intense. Some of our competitors have significantly greater financial resources than us and may be able to more easily attract such skilled personnel. Moreover, competition for technical talent in the Denver metropolitan area is particularly intense. Failure to attract and retain the necessary technical, managerial, sales, and marketing personnel could materially adversely affect our business, operating results, and financial condition. We may experience periods of rapid growth. If we fail to manage our growth, this could materially adversely affect our business, operating results, and financial condition. We must effectively manage our operational, financial, and accounting systems, procedures, and controls to manage this future growth. We may not be able to successfully operate our business if we lose key personnel. We believe that our success will depend on the continued services of our senior management team and other key personnel, including Herbert F. Satterlee III, our Chief Executive Officer and President, Dr. Walter S. Scott, our Chief Technical Officer and Executive Vice President, and Henry Dubois, our Chief Operating Officer, Chief Financial Officer, and Executive Vice President. The loss of the services of any of our senior management team or other key employees could materially adversely affect our business, operating results, and financial condition. We generally have not entered into written employment contracts with any members of management. Furthermore, we do not maintain key person life insurance on our management personnel. Our limited ability to protect our intellectual property and proprietary information may adversely affect our competitive position. Trade secrets, copyright laws, nondisclosure agreements, and other proprietary rights are important to our success and competitive position. Our efforts to protect our proprietary rights may be inadequate and may not prevent others from using our proprietary rights. Existing trade secret and copyright laws offer only limited protection. Further, effective trade secret and copyright protection may not be available in every country in which our services or products are made available, and policing unauthorized use of our proprietary information is difficult. The unauthorized misappropriation of our proprietary rights could have a material adverse effect on our business, operating results, and financial condition. Our expected use of the Internet as a means of distribution for our images may exacerbate the risks, as it places our imagery data in the hands of our customers in a form readily duplicated and transferable to other persons without our consent. If we resort to legal proceedings to enforce our proprietary rights, the proceedings could be burdensome and expensive, and the outcome could be uncertain. Claims of intellectual property infringement expose us to costs and potential losses. Because we have contracted for a significant portion of our infrastructure, suppliers often grant us licenses to use their intellectual property embodied in the hardware and software supplied, and indemnification for any infringement of intellectual property rights in connection with such use. Despite this indemnification, we may be subject to claims alleging infringement by us of third party proprietary rights. If any of our products or services infringes third party rights, we may not be able to obtain permission to use such intellectual property on commercially reasonable terms. This could require us to expend significant resources to make our products and services noninfringing or to discontinue the use of such products and services. Any claim of infringement also could cause us to incur substantial costs defending against the claim, even if the claim is without merit. Finally, a party making such a claim could secure a judgment that requires us to pay substantial damages or that prevents us from using or selling our products and services. Any of these events could have a material adverse effect on our business, operating results, financial condition, and our ability to pay principal and interest on the notes and our other indebtedness. Claims of invasion of privacy or misappropriation of trade secrets could be expensive and cause substantial losses. Because our QuickBird 2 satellite will be capable of obtaining imagery in finer detail than has been possible to date by other commercial systems, we may be subject to claims of invasion of privacy, misappropriation of trade secrets, or other novel claims by persons or companies that may object to our collection of satellite imagery of their property. Such claims could cause us to incur substantial costs defending against such claims, even if the claim is without merit. Finally, a party making such a claim could secure a judgment that requires us to pay substantial damages or that prevents us from collecting or using imagery. Any of these events could have a material adverse effect on our business, operating results, financial condition, and our ability to pay principal and interest on the notes and our other indebtedness. Risks relating to the notes. Any launch insurance coverage may not provide adequate protection against satellite loss or impairment. We have been advised that holders of the notes will have an indirect security interest in proceeds from one or more insurance policies covering the launch and first year of operations of QuickBird 2. Holders' interests in these policies are shared on an equal basis with Ball, as the lender in our vendor financing, through a collateral pledge and security agreement. We believe the security interest granted in favor of holders of the notes will be perfected to the extent feasible under the governing laws of Colorado, Delaware and New York. However, there is ambiguity in the governing law of these jurisdictions with respect to perfecting a security interest in proceeds of an insurance policy. As a result, we cannot assure you that the rights of holders of the notes to receive payments on the notes from such insurance proceeds will not be superseded by another creditor or class of creditors. Moreover, a default by any of our insurers in their obligations to pay upon a loss would reduce the proceeds available to holders of the notes. Any launch insurance policies will contain customary exclusions, such as war, insurrection, or willful act, the occurrence of any of which would result in a lack of insurance coverage, which could have a material adverse effect on our business, operating results, and financial condition. We cannot assure you that an active trading market will develop for the notes. Morgan Stanley Dean Witter has advised us that it may make a market in the notes. Morgan Stanley Dean Witter is not obligated to do so and such market-making activities, if any, may be discontinued at any time without notice, in its sole discretion. We have not and do not intend to apply for listing of the notes on any securities exchange or through the Nasdaq National Market. The notes may trade at a discount, depending upon prevailing interest rates, the market for similar securities, our performance, and other factors. We cannot be certain, therefore, that an active market for the notes will develop, or if such a market does develop, that it will continue. See "Plan of distribution." As of the date hereof, we have notes outstanding with an aggregate principal amount at maturity of $71.7 million. We may not have the ability to raise the funds necessary to finance the change of control offer required by the notes. Upon the occurrence of certain change of control events, we will be required to offer to repurchase the notes at a price equal to 101% of their accreted value, plus accrued interest. It is possible that we will not have sufficient funds at the time of the change of control to make the required repurchases. If we are unable to make the required repurchases, we would be in default under the notes. Purchasers of the notes will be required to include amounts in gross income for federal income tax purposes in advance of receipt of cash payments. The notes have been issued with original issue discount for United States federal income tax purposes. As a result, U.S. holders (as defined in "United States federal income tax consequences") will be required to include amounts in income in respect of the notes on a constant yield to maturity basis in advance of the receipt of the cash to which such income is attributable. See "United States federal income tax consequences--Original issue discount." We may not be able to deduct a portion of the original issue discount that accrues on the notes. The notes are applicable high-yield discount obligations, as defined in the Internal Revenue Code, and the following rules will apply if the yield to maturity of the notes exceeds the "applicable federal rate" in effect at the time of their issuance, plus five percentage points. Under these rules, if the yield to maturity of the notes exceeds the applicable federal rate plus five percentage points, we will not be able to deduct a portion of the original issue discount that accrues on the notes, and the remaining original issue discount on the notes will not be deductible by us until we pay the original issue discount in cash. See "United States federal income tax consequences--Applicable high-yield discount obligations."

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+RISK FACTORS INVESTMENT IN OUR COMMON STOCK INVOLVES A HIGH DEGREE OF RISK. PROSPECTIVE INVESTORS SHOULD CAREFULLY CONSIDER THE FOLLOWING RISK FACTORS BEFORE PURCHASING OUR COMMON STOCK. BECAUSE WE HAVE EARNED INSIGNIFICANT REVENUE OF ONLY $222,361 FROM INCEPTION TO JUNE 30, 2001, WE FACE A SERIOUS RISK OF INSOLVENCY. We have never earned significant operating revenue. We have been dependent on equity financing to pay operating costs and to cover operating losses. We have sufficient cash to pay ongoing operating expenses, at their current level, to approximately October 31, 2001. To continue operation beyond that we will have to generate operating revenue or raise additional capital. If we are unable to do so, we face a risk of insolvency. The auditors report on our December 31, 2000 consolidated financial statements includes an additional paragraph that identifies conditions which raise substantial doubt about our ability to continue as a going concern. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. BECAUSE WE HAVE NO SIGNIFICANT SALES HISTORY AND ARE SUBSTANTIALLY DEPENDENT ON OUR ALLIANCE WITH ABB TO GENERATE FUTURE SALES, OUR FUTURE IS UNCERTAIN IF OUR ALLIANCE WITH ABB FAILS. We plan to market our machine vision systems and also our Internet based support and service system through our alliance with ABB. We believe our alliance with ABB is our best prospect for generating sales revenue. We have no other established distribution channels or marketing arrangements, and if we are unable to generate sales through ABB, our prospects for generating revenue are highly speculative. BECAUSE OUR ALLIANCE WITH ABB IS NEW, WE ARE UNCERTAIN WE WILL SUCCESSFULLY DEVELOP OUR RELATIONSHIP WITH ABB. We made our alliance agreement with ABB in March 2000 and have completed three projects with ABB to date. We intend to develop our relationship with ABB to try and make additional sales through that relationship. However, our relationship with ABB does not yet have a proven track record. Our prospects for generating sales under the ABB alliance are uncertain. BECAUSE OUR INTERNET BASED SERVICE AND SUPPORT SYSTEM IS IN THE DEVELOPMENT STAGE, WE HAVE NO ASSURANCE THAT WE WILL COMPLETE DEVELOPMENT SUCCESSFULLY. We commenced development of our Internet based service and support system during the fall of 2000. That system is still in the development stage. We have no assurance that we will be able to complete development of the system, or that any market will exist for the system when it is completed. BECAUSE OF OUR LIMITED OPERATING AND SALES HISTORY, WE CANNOT MAKE RELIABLE PROJECTIONS OF OUR FUTURE OPERATING COSTS. If we are able to generate sales, we may have to hire additional personnel to service our customers and to continue development of our technology. We may also have to incur additional marketing and overhead expenses. As a result of our lack of historical sales, we cannot make reliable projections of the number of additional personnel we will require, the cost of employing those personnel, or the level of marketing and overhead expenses we will incur. We thus have no assurance that any revenue we earn will be sufficient to cover the cost of earning that revenue, or to generate operating profits. BECAUSE WE DEVELOP AND INSTALL CUSTOMIZED VISION SYSTEMS FOR SPECIFIC CUSTOMER NEEDS, WE MAY NOT BE ABLE TO CREATE A REPEAT CUSTOMER BASE. Most machine vision systems are designed for the specific needs of a particular customer, and represent isolated purchases by the customers in question. As a result, we have no assurance that we will be able to obtain additional contracts to supply machine vision systems, or that any customers we secure will become repeat customers. BECAUSE OUR WORK FORCE IS SMALL, WITH ONLY 25 PEOPLE EMPLOYED EITHER AS OFFICERS, EMPLOYEES OR CONTRACTORS, WE ARE VULNERABLE TO THE LOSS OF KEY PEOPLE OR TO RAPID EXPANSION. We employ only 25 people either as officers, employees or contractors. We try to employ people with skill sets that match the specific fields important to our business. As a result, the departure of a single person or a small number of people could materially adversely affect our business. We do not have key man insurance on any of the people we employ. Qualified technical personnel are in great demand in all high technology industries. Accordingly, it may be difficult for us to replace people who depart, or to hire additional people we may require if we are able to generate substantial sales. BECAUSE WE DO NOT HAVE PATENT PROTECTION FOR ANY OF OUR PRODUCTS, OUR INTELLECTUAL PROPERTY MAY BE COPIED OR MISAPPROPRIATED. We have not applied for patent protection for any of our products. Accordingly, we have no legal means to prevent other companies from developing products that perform similar functions in a similar way. We believe that software code that we have written for eVisionFactory, the BrainTron processor, and the Odysee Development Studio is protected by copyright law. However, copyright law does not prevent other companies from developing their own software to perform the same functions as our products. BECAUSE THE MARKET PRICE OF OUR COMMON STOCK HAS BEEN PARTICULARLY VOLATILE, PURCHASERS OF OUR COMMON STOCK FACE A HIGH DEGREE OF MARKET RISK. The market price of our common stock has experienced extreme fluctuations. Since January 1, 2000 the market price of our common stock has varied between $0.10 and $6.12. As we have not announced any material changes to our earnings, we believe that the fluctuations in our stock price have resulted primarily from market perceptions of the speculative value of our business opportunities. The susceptibility of our stock price to fluctuation exposes purchasers of our stock to a high degree of risk. BECAUSE WE HAVE GENERATED REVENUE OF ONLY $222,361 FROM INCEPTION TO JUNE 30, 2001, AND OUR BUSINESS HAS NOT BEEN PROFITABLE WITH ACCUMULATED LOSSES OF $9,040,968 FROM INCEPTION TO JUNE 30, 2001, WE MAY NOT BE ABLE TO RAISE ADDITIONAL CAPITAL WE NEED. We will likely require additional capital to continue the development of our products, to pay the costs of marketing those products, or to cover operating losses until we are able to become profitable. As we have never generated operating profits or significant sales revenue, we may not be able to raise the amount of capital we require. Several other factors may also hinder our efforts to raise capital. They include the following: - Our share price has been highly volatile during 2000 and the first half of 2001. The volatility of our share price may deter potential investors. - Subsequent to the first quarter of 2000, many technology companies have experienced financial difficulties and rapidly declining share prices. As a result, potential investors may be less willing to invest in technology companies generally. - Subsequent to the first quarter of 2000, capital markets have become tighter generally, with less financing available for technology companies generally. BECAUSE WE MAY HAVE TO RAISE ADDITIONAL CAPITAL, THE INTERESTS OF SHAREHOLDERS MAY BE DILUTED. To raise additional capital we may have to issue additional shares, which may dilute the interests of existing shareholders substantially. Alternatively, we may have to borrow large sums, and assume obligations to make substantial interest and capital payments. We may also have to sell significant interests in some or all of our products. If we are able to raise additional capital, we cannot assure that it will be on terms that enhance the value of our common shares. BECAUSE THIS OFFERING WILL QUALIFY OVER 16 MILLION SHARES FOR RESALE, THERE IS A RISK THAT THE SALE OF THIS AMOUNT OF SHARES IN THE MARKET MAY PUT DOWNWARD PRESSURE ON OUR STOCK PRICE. Subsequent to January 1, 2000, we have issued over 16 million shares, including shares issuable under share purchase warrants, and in private placements and other exempt transactions. The purpose of this prospectus is to qualify these shares for resale by the owners. The market price of our stock could drop significantly if the owners of these shares sell all or a large portion of the shares, or are perceived as intending to sell them. BECAUSE OUR STOCK MAY BE SUBJECT TO "LOW PRICE STOCK" RULES, THE MARKET FOR OUR STOCK MAY BE LIMITED. The Securities and Exchange Commission has adopted regulations which generally define a "penny stock" to be any equity security that has a market price less than $5.00. Our stock is presently covered by those rules, and may continue to be so. The penny stock rules require broker-dealers to make a special suitability determination before selling our stock to investors who are not either regular customers or accredited investors. As a result, the potential market for our stock may be limited. SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS This prospectus, and the other reports we file from time to time with the Securities and Exchange Commission, contain forward-looking statements within the meaning of Section 27A of the Securities Act and Section 21E of the Securities Exchange Act. Forward-looking statements deal with our current plans, intentions, beliefs and expectations and are statements of future economic performance. Statements containing terms like "believes," "does not believe," "plans," "expects," "intends," "estimates," "anticipates," and other phrases of similar meaning are considered to imply uncertainty and are forward-looking statements. Forward-looking statements involve known and unknown risks and uncertainties that may cause our actual results in future periods to differ materially from what is currently anticipated. We make cautionary statements throughout this prospectus and the documents we have incorporated by reference, including those stated under the heading "Risk Factors." You should read these cautionary statements as being applicable to all related forward- looking statements wherever they appear in this prospectus, the materials referred to in this prospectus, and the materials incorporated by reference into this prospectus. We cannot guarantee our future results, levels of activity, performance or achievements. Neither we nor any other person assumes responsibility for the accuracy and completeness of these statements. We are under no duty to update any of the forward-looking statements after the date of this prospectus.

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+RISK FACTORS You should carefully consider the following risks before investing in our common stock. If any of the following risks come to fruition, our business, results of operations or financial condition could be materially adversely affected. In that case, the trading price of our common stock could decline, and you may lose all or part of your investment. You should also refer to the other information set forth in this prospectus, including our financial statements and the accompanying notes. If we are unable to manage our growth and the related expansion in our operations effectively, our business may be harmed through a decreased ability to monitor and control effectively our operations, and a decrease in the quality of work and innovation of our employees. Our ability to successfully offer products and services and implement our business plan in a rapidly evolving market requires effective planning and management. Not only are we growing in size, but we are also continuing to transition towards greater reliance on our video-on-demand products for an increased portion of our revenue. Our growth has placed, and our anticipated future operations will continue to place, a significant strain on our management, administrative, operational and other resources. To manage future growth effectively, we must continue to improve our management and operational controls, enhance our reporting systems and procedures, integrate new personnel and manage expanded operations. A failure to manage our growth may harm our business through a decreased ability to monitor and control effectively our operations, and a decrease in the quality of work and innovation of our employees upon which our business is dependent. We may not be able to hire and retain highly skilled employees, particularly managerial, engineering, selling and marketing, finance and manufacturing personnel, which could affect our ability to compete effectively because our business is technology-based and there is a shortage of these employees within the New England area. Our success depends to a significant degree upon the continued contributions of our key management, engineering, selling and marketing and manufacturing personnel, many of whom would be difficult to replace given the shortage within the New England area of qualified persons for these positions. We do not have employment contracts with our key personnel. We believe that our future success will also depend in large part upon our ability to attract and retain highly skilled managerial, engineering, selling and marketing, finance and manufacturing personnel, as our business is technology-based. Because competition for these personnel is intense, we may not be able to attract and retain qualified personnel in the future. The loss of the services of any of the key personnel, the inability to attract or retain qualified personnel in the future or delays in hiring required personnel, particularly software engineers and sales personnel, could have a material adverse effect on our business, financial condition and results of operations because our business is technology-based. Cancellation or deferral of purchases of our products could cause our operating results to be below the expectations of the public market stock analysts who cover our stock, resulting in a decrease in the market price of our common stock. Any significant cancellation or deferral of purchases of our products could have a material adverse effect on our business, financial condition and results of operations in any particular quarter due to the resulting decrease in revenue and our relatively fixed costs. In addition, to the extent significant sales occur earlier than expected, operating results for subsequent quarters may be adversely affected because our expense levels are based, in part, on our expectations as to our future revenues, and we may be unable to adjust spending in a timely manner to compensate for any revenue shortfall. Because of these factors, in some future quarter our operating results may be below the expectations of public market analysts and investors which may adversely affect the market price of our common stock. Seasonal trends may cause our quarterly operating results to fluctuate, making period-to-period comparisons of our operating results meaningless. We have experienced significant variations in the revenue, expenses and operating results from quarter to quarter and these variations are likely to continue. We believe that fluctuations in the number of orders being placed from quarter to quarter are principally attributable to the buying patterns and budgeting cycles of television operators and broadcast companies, the primary buyers of the digital advertising systems and broadcast systems, respectively. We expect that there will continue to be fluctuations in the number and value of orders received. As a result, our results of operations have in the past and likely will, at least in the near future, fluctuate in accordance with this purchasing activity making period-to-period comparisons of our operating results meaningless. In addition, because these factors are difficult for us to forecast, our business, financial condition and results of operations for one quarter or a series of quarters may be adversely affected and below the expectations of public market analysts and investors, resulting in a decrease in the market price of our common stock. Due to the lengthy sales cycle involved in the sale of our products, our quarterly results may vary and should not be relied on as an indication of future performance. Digital video, movie and broadcast products are relatively complex and their purchase generally involves a significant commitment of capital, with attendant delays frequently associated with large capital expenditures and implementation procedures within an organization. Moreover, the purchase of these products typically requires coordination and agreement among a potential customer's corporate headquarters and its regional and local operations. For these and other reasons, the sales cycle associated with the purchase of our digital video, movie and broadcast products are typically lengthy and subject to a number of significant risks, including customer's budgetary constraints and internal acceptance reviews, over which we have little or no control. Based upon all of the foregoing, we believe that our quarterly revenues, expenses and operating results are likely to vary significantly in the future, that period- to-period comparisons of our results of operations are not necessarily meaningful and that, in any event, these comparisons should not be relied upon as indications of future performance. If we are unable to successfully compete in our marketplace, our financial condition and operating results may be adversely affected. We currently compete against suppliers of both analog tape-based and digital systems in the digital advertisement insertion market and against both computer companies offering video server platforms and more traditional movie application providers in the movie system market. In the television broadcast market, we compete against various computer companies offering video server platforms and television equipment manufacturers. Due to the rapidly evolving markets in which we compete, additional competitors with significant market presence and financial resources, including computer hardware and software companies and television equipment manufacturers, may enter those markets, thereby further intensifying competition. Increased competition could result in price reductions and loss of market share which would adversely affect our business, financial condition and results of operations. Many of our current and potential competitors have greater financial, selling and marketing, technical and other resources than we do. Moreover, our competitors may also foresee the course of market developments more accurately than us. Although we believe that we have certain technological and other advantages over our competitors, realizing and maintaining these advantages will require a continued high level of investment by us in research and product development, marketing and customer service and support. In the future we may not have sufficient resources to continue to make these investments or to make the technological advances necessary to compete successfully with our existing competitors or with new competitors. If we are unable to compete effectively, our business, prospects, financial condition and operating results would be materially adversely affected because of the difference in our operating results from the assumptions on which our business model is based. If the emerging digital video market does not gain commercial acceptance, our business, financial condition and results of operations would be negatively affected because the market for our products would be more limited than we currently believe and have communicated to the financial markets. Cable television operators and television broadcasters have historically relied on traditional analog technology for video management, storage and distribution. Digital video technology is still a relatively new technology and requires a significant initial investment of capital. Our future growth will depend on the rate at which television operators convert to digital video systems. In addition, to date our products have been purchased primarily by cable television operators and telecommunications companies. An inability to penetrate new markets would have a material adverse effect on our business, financial condition and results of operations because the market for our products would be more limited than we currently believe and have communicated to the financial markets. If there were a decline in sales of our SPOT System, our revenues could be materially affected because we currently derive a large percentage of our revenues from this product. Sales of our SPOT System have historically accounted for a large percentage of our revenues, and this product and related enhancements are expected to continue to account for a significant portion of our revenues in the remainder of fiscal year 2000 and in fiscal year 2001. Our success depends in part on continued sales of our SPOT System product. Accordingly, a decline in demand or average selling prices for our SPOT System product line, whether as a result of new product introductions by others, price competition, technological change, inability to enhance the products in a timely fashion, or otherwise, would have a material adverse effect on our business, financial condition and results of operations. If we fail to respond to rapidly changing technologies related to digital video, our business, financial condition and results of operations would be materially adversely affected because the competitive advantage of our products relative to those of our competitors would decrease. The markets for our products are characterized by rapidly changing technology, evolving industry standards and frequent new product introductions and enhancements. Future technological advances in the television and video industries may result in the availability of new products or services that could compete with the solutions provided by us or reduce the cost of existing products or services, any of which could enable our existing or potential customers to fulfill their video needs better and more cost efficiently than with our products. Our future success will depend on our ability to enhance our existing digital video products, including the development of new applications for our technology, and to develop and introduce new products to meet and adapt to changing customer requirements and emerging technologies. In the future, we may not be successful in enhancing our digital video products or developing, manufacturing and marketing new products which satisfy customer needs or achieve market acceptance. In addition, there may be services, products or technologies developed by others that render our products or technologies uncompetitive, unmarketable or obsolete, or announcements of currently planned or other new product offerings either by us or our competitors that cause customers to defer or fail to purchase our existing solutions. If we are unable to successfully introduce to our marketplace new products or enhancements to existing products, our financial condition and operating results may be adversely effected by a decrease in purchases of our products. Because our business plan is based on technological development in the form of both development of new products and enhancements to our existing products, our future success is dependent on our successful introduction to the marketplace of these products and enhancements. In the future we may experience difficulties that could delay or prevent the successful development, introduction and marketing of these and other new products and enhancements, or find that our new products and enhancements do not adequately meet the requirements of the marketplace or achieve market acceptance. Announcements of currently planned or other new product offerings may cause customers to defer purchasing our existing products. Moreover, despite testing by us, and by current and potential customers, errors or failures may be found in our products, or, if discovered, successfully corrected in a timely manner. These errors or failures could cause delays in product introductions and shipments, or require design modifications that could adversely affect our competitive position. Our inability to develop on a timely basis new products, enhancements to existing products or error corrections, or the failure of these new products or enhancements to achieve market acceptance could have a material adverse effect on our business, financial condition and results of operations. Because our customer base is highly concentrated among a limited number of large customers, the loss of or reduced demand of these customers could have a material adverse effect on our business, financial condition and results of operations. Our customer base is highly concentrated among a limited number of large customers, and, therefore, a limited number of customers account for a significant percentage of our revenues in any year. In the years ended December 31, 1998 and 1999, the one month ended January 31, 2000, and the year ended January 31, 2001, revenues from our five largest customers represented approximately 55%, 47%, 47% and 44%, respectively, of our total revenues. In the years ended December 31, 1998 and 1999, the one month ended January 31, 2000, and the year ended January 31, 2001, two customers each accounted for more than 10% of our revenues. We generally do not have written continuing purchase agreements with our customers and do not generally have written agreements that require customers to purchase fixed minimum quantities of our products. Our sales to specific customers tend to vary significantly from year to year depending upon these customers' budgets for capital expenditures and new product introductions. In addition, we derive a substantial portion of our revenues from products that have a selling price in excess of $200,000. We believe that revenue derived from current and future large customers will continue to represent a significant proportion of our total revenues. The loss of, or reduced demand for products or related services from, any of our major customers could have a material adverse effect on our business, financial condition and results of operations. Because we purchase certain of the components used in manufacturing our product from a sole supplier and we use a limited number of third party manufacturers to manufacture our product, our business, financial condition and results of operation could be materially adversely affected by a failure of this supplier or these manufacturers. Certain key components of our products are currently purchased from a sole supplier, including a computer chassis manufactured by Trimm Technologic Inc., a different computer chassis manufactured by JMR Electronics, Inc., a switch chassis manufactured by Ego Systems, a decoder card manufactured by Vela Research, Inc. for MPEG-2, the industry standard for digital video and audio compression, and an MPEG-2 encoder manufactured by Optibase, Inc. We have in the past experienced quality control problems, where products did not meet specifications or were damaged in shipping, and delays in the receipt of these components. These problems were generally of short duration and did not have a material adverse effect on us. However, we may in the future experience similar types of problems which could be more severe or more prolonged. The inability to obtain sufficient key components as required, or to develop alternative sources if and as required in the future, could result in delays or reductions in product shipments which, in turn, could have a material adverse effect on our business, financial condition and results of operations. In addition, we rely on a limited number of third parties who manufacture certain components used in our products. While to date there has been suitable third party manufacturing capacity readily available at acceptable quality levels, in the future there may not be manufacturers that are able to meet our future volume or quality requirements at a price that is favorable to us. Any financial, operational, production or quality assurance difficulties experienced by these third party manufacturers that result in a reduction or interruption in supply to us could have a material adverse effect on our business, financial condition and results of operations. The success of our business model depends on both the response of the market to the current regulatory structure and the continued deregulation of the telecommunications and television industries. The telecommunications and television industries are subject to extensive regulation which may limit the growth of our business, both in the United States and other countries. Although recent legislation has lowered the legal barriers to entry for telecommunications companies into the United States multichannel television market, telecommunications companies may either choose not to enter or be unable to successfully enter this or related markets. Moreover, the growth of our business internationally in the manner and to the extent currently contemplated by our business model is dependent in part on similar deregulation of the telecommunications industry abroad, the timing and magnitude of which is uncertain. Television operators are also subject to extensive government regulation by the Federal Communications Commission and other federal and state regulatory agencies. These regulations could have the effect of limiting capital expenditures by television operators and thus could have a material adverse effect on our business, financial condition and results of operations. The enactment by federal, state or international governments of new laws or regulations, changes in the interpretation of existing regulations or a reversal of the trend toward deregulation in these industries could adversely affect our customers, and thereby materially adversely affect our business, financial condition and results of operations. If we are unable to protect our intellectual property we may lose valuable assets on which our business is based or incur costly litigation to protect our rights. Our success and ability to compete depends upon our intellectual property, including our proprietary technology and confidential information, as the broadband and broadcast systems that we develop, market, license and sell are dependent on this technology and information. We rely on patent, trademark, trade secret and copyright laws to protect our intellectual property. Despite our efforts to protect our intellectual property, a third party could copy or otherwise obtain our proprietary information without authorization. Our means of protecting our proprietary rights may not be adequate and our competitors may independently develop similar technology, or duplicate our products or our other intellectual property. We may have to resort to litigation to enforce our intellectual property rights, to protect our trade secrets or know-how or to determine their scope, validity or enforceability. Enforcing or defending our proprietary technology is expensive, could cause the diversion of our resources, and may not prove successful. Our protective measures may prove inadequate to protect our proprietary rights, and any failure to enforce or protect our rights could cause us to lose a valuable asset. Future acquisitions may be difficult to integrate, disrupt our business, dilute stockholder value or divert management attention. As part of our business strategy, we may seek to acquire or invest in businesses, products or technologies that we believe could complement or expand our business, augment our market coverage, enhance our technical capabilities or otherwise offer growth opportunities. Acquisitions could create risks for us, including: . difficulties in assimilation of acquired personnel, operations, technologies or products which may affect our ability to develop new products and services and compete in our rapidly changing marketplace due to a resulting decrease in the quality of work and innovation of our employees upon which our business is dependent; and . adverse effects on our existing business relationships with suppliers and customers, which may be of particular importance to our business because our customer base is highly concentrated among a limited number of large customers and we purchase certain of the components used in manufacturing our product from a sole supplier and we use a limited number of third party manufacturers to manufacture our product. In addition, if we consummate acquisitions through an exchange of our securities, our existing stockholders could suffer significant dilution. Any future acquisitions, even if successfully completed, may not generate any additional revenue or provide any benefit to our business. Because our business is susceptible to risks associated with international operations, we may not be able to maintain or increase international sales of our products. International sales accounted for approximately 13%, 23%, 18% and 20% of our revenues in the years ended December 31, 1998 and 1999, the one month ended January 31, 2000 and the year ended January 31, 2001, respectively. We expect that international sales will account for a significant portion of our business in the future. However, in the future we may be unable to maintain or increase international sales of our products. International sales are subject to a variety of risks, including: . difficulties in establishing and managing international distribution channels; . difficulties in selling, servicing and supporting overseas products and in translating products into foreign languages; . the uncertainty of laws and enforcement in certain countries relating to the protection of intellectual property; . multiple and possibly overlapping tax structures; . currency and exchange rate fluctuations; and . economic or political changes in international markets. Our executive officers, directors and major stockholders possess significant control over us which may lead to conflicts with other stockholders over corporate governance matters. Our officers, directors and their affiliated entities, and other holders of 5% or more of our outstanding capital stock, together beneficially owned approximately 27.49% of the outstanding shares of our common stock as of June 8, 2001. As a result, these persons will strongly influence the composition of our board of directors and the outcome of corporate actions requiring stockholder approval, irrespective of how other of our stockholders may vote. This concentration of ownership may have the effect of delaying or preventing a change in control of us which may be favored by a majority of the remaining stockholders, or cause a change of control not favored by our other stockholders.

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+RISK FACTORS BEFORE YOU INVEST IN OUR COMMON STOCK, YOU SHOULD BE AWARE THAT THERE ARE VARIOUS RISKS, INCLUDING THOSE DESCRIBED BELOW. YOU SHOULD CONSIDER CAREFULLY THESE RISK FACTORS TOGETHER WITH ALL OF THE OTHER INFORMATION INCLUDED IN THIS PROSPECTUS BEFORE YOU DECIDE TO PURCHASE SHARES OF OUR COMMON STOCK. WE MAY NOT BE ABLE TO MANAGE OUR GROWTH Our business has grown rapidly in recent periods. As an example, we completed 39 mergers or acquisitions accounted for as poolings of interests and 61 acquisitions accounted for as purchases from January 1, 1998 through March 31, 2001. This growth of our business has placed a significant strain on our management and operations. Our expansion has resulted, and is expected in the future to result, in substantial growth in the number of our employees. In addition, this growth is expected to result in increased responsibility for both existing and new management personnel and incremental strain on our existing operations, financial and management information systems. Our success depends to a significant extent on the ability of our executive officers and other members of senior management to operate effectively both independently and as a group. If we are not able to manage existing or anticipated growth, our business, financial condition and operating results will be materially adversely affected. OUR SUCCESS DEPENDS ON THE VALUE OF OUR BRANDS, PARTICULARLY MONSTER-REGISTERED TRADEMARK-.COM Our success depends on our brands and their value. Our business would be adversely affected if we were unable to adequately protect our brand names, particularly Monster.com. We are also susceptible to others imitating our products, particularly Monster.com, and infringing our intellectual property rights. We may not be able to successfully protect our intellectual property rights, upon which we are materially dependent. In addition, the laws of many foreign countries do not protect intellectual property rights to the same extent as the laws of the United States. Imitation of our products, particularly Monster.com, or infringement of our intellectual property rights could diminish the value of our brands or otherwise adversely affect our revenues. TRADITIONAL MEDIA IS IMPORTANT TO US A substantial portion of our total commissions and fees comes from designing and placing recruitment advertisements in traditional media such as newspapers and trade publications. This business constituted approximately 13.3%, 15.0% and 20.2% of our total commissions and fees for the three months ended March 31, 2001 and the years ended December 31, 2000 and 1999, respectively. We also receive a substantial portion of our commissions and fees from placing advertising in yellow page directories. This business constituted approximately 6.1%, 7.6% and 11.1% of total commissions and fees for the three months ended March 31, 2001 and the years ended December 31, 2000 and 1999, respectively. We cannot assure you that the total commissions and fees we receive in the future will equal the total commissions and fees which we have received in the past. In addition, new media, like the Internet, may cause yellow page directories and other forms of traditional media to become less desirable forms of advertising media. If we are not able to generate Internet advertising fees to offset any decrease in commissions from traditional media, our business, financial condition and operating results will be materially adversely affected. WE FACE RISKS RELATING TO DEVELOPING TECHNOLOGY, INCLUDING THE INTERNET The market for Internet products and services is characterized by rapid technological developments, frequent new product introductions and evolving industry standards. The emerging character of these products and services and their rapid evolution will require our continuous improvement in performance, features and reliability of our Internet content, particularly in response to competitive offerings. We cannot assure that we will be successful in responding quickly, cost effectively and sufficiently to these developments. In addition, the widespread adoption of new Internet technologies or standards could require us to make substantial expenditures to modify or adapt our Web sites and services. This could affect our business, financial condition and operating results. New Internet services or enhancements which we have offered or may offer in the future may contain design flaws or other defects that could require expensive modifications or result in a loss of client confidence. Any disruption in Internet access or in the Internet generally could have a material adverse effect on our business, financial condition and operating results. WE ARE VULNERABLE TO INTELLECTUAL PROPERTY INFRINGEMENT CLAIMS BROUGHT AGAINST US BY OTHERS Successful intellectual property infringement claims against us could result in monetary liability or a material disruption in the conduct of our business. We cannot be certain that our products, content and brand names do not or will not infringe valid patents, copyrights or other intellectual property rights held by third parties. We expect that infringement claims in our markets will increase in number as more participants enter the markets. We may be subject to legal proceedings and claims from time to time relating to the intellectual property of others in the ordinary course of our business. We may incur substantial expenses in defending against these third party infringement claims, regardless of their merit. COMPUTER VIRUSES MAY CAUSE OUR SYSTEMS TO INCUR DELAYS OR INTERRUPTIONS Computer viruses may cause our systems to incur delays or other service interruptions and could damage our reputation and have a material adverse effect on our business, financial condition and operating results. The inadvertent transmission of computer viruses could expose us to a material risk of loss or litigation and possible liability. Moreover, if a computer virus affecting our system is highly publicized, our reputation could be materially damaged and our visitor traffic may decrease. Internet users can freely navigate and instantly switch among a large number of websites, many of which offer original content. It is difficult for us to distinguish our content and attract users. In addition, many other websites offer very specific, highly targeted content. These sites could have greater appeal than our sites to particular groups within our target audience. WE FACE RISKS ASSOCIATED WITH OUR ACQUISITION STRATEGY We expect our growth to continue, in part, by acquiring businesses. The success of this strategy depends upon several factors, including: - the continued availability of financing; - our ability to identify and acquire businesses on a cost-effective basis; - our ability to integrate acquired personnel, operations, products and technologies into our organization effectively; and - our ability to retain and motivate key personnel and to retain the clients of acquired firms. We cannot assure you that financing for acquisitions will be available on terms we find acceptable, or that we will be able to identify or consummate new acquisitions, or manage and integrate our recent or future expansions successfully. Any inability to do so would materially adversely affect our business, financial condition and operating results. We also cannot assure you that we will be able to sustain the rates of growth that we have experienced in the past. OUR MARKETS ARE HIGHLY COMPETITIVE The markets for our services are highly competitive. They are characterized by pressures to: - reduce prices; - incorporate new capabilities and technologies; and - accelerate job completion schedules. Furthermore, we face competition from a number of sources. These sources include: - national and regional advertising agencies; - Internet portals; - specialized and integrated marketing communication firms; - traditional media companies; - executive search firms; and - search and selection firms. In addition, many advertising agencies and publications have started either to internally develop or acquire new media capabilities, including Internet. We are also competing with established companies that provide integrated specialized services like website advertising services or website design, and are technologically proficient. Many of our competitors or potential competitors have long operating histories, and some may have greater financial, management, technological development, sales, marketing and other resources than we do. In addition, our ability to maintain our existing clients and attract new clients depends to a large degree on the quality of our services and our reputation among our clients and potential clients. We have no significant proprietary technology that would preclude or inhibit competitors from entering the online advertising, executive search, recruitment advertising, or yellow page advertising markets. We cannot assure you that existing or future competitors will not develop or offer services and products which provide significant performance, price, creative or other advantages over our services. This could have a material adverse effect on our business, financial condition and operating results. OUR OPERATING RESULTS FLUCTUATE FROM QUARTER TO QUARTER Our quarterly operating results have fluctuated in the past and may fluctuate in the future. These fluctuations are a result of a variety of factors, including: - the timing of acquisitions; - the timing of yellow page directory closings, the largest number of which currently occur in the third quarter; and - the receipt of additional commissions from yellow page publishers for achieving a specified volume of advertising, which are typically reported in the fourth quarter. Generally our quarterly commissions and fees earned from recruitment advertising tend to be highest in the first quarter and lowest in the fourth quarter. Additionally, recruitment advertising commissions and fees tend to be more cyclical than yellow page commissions and fees. To the extent that a significant percentage of our commissions and fees are derived from recruitment advertising, our operating results may be subject to increased cyclicality. EFFECT OF GLOBAL ECONOMIC FLUCTUATIONS Demand for our services is significantly affected by the general level of economic activity in the regions and industries in which we operate. When economic activity slows, many companies hire fewer permanent employees. Therefore, a significant economic downturn, especially in regions or industries where our operations are heavily concentrated, could have a material adverse effect on our business, financial condition and operating results. Further, we may face increased pricing pressures during such periods. There can be no assurance that during these periods our results of operations will not be adversely affected. WE DEPEND ON OUR CONSULTANTS The success of our executive search business depends upon our ability to attract and retain consultants who possess the skills and experience necessary to fulfill our clients' executive search needs. Competition for qualified consultants is intense. We believe that we have been able to attract and retain highly qualified, effective consultants as a result of our reputation and our performance-based compensation system. Consultants have the potential to earn substantial bonuses based on the amount of revenue they generate by: - obtaining executive search assignments; - executing search assignments; and - assisting other consultants to obtain or complete executive search assignments. Bonuses represent a significant proportion of consultants' total compensation. Any diminution of our reputation could impair our ability to retain existing or attract additional qualified consultants. Our inability to attract and retain qualified consultants could have a material adverse effect on our executive search business, financial condition and operating results. OUR CONSULTANTS MAY DEPART WITH EXISTING EXECUTIVE SEARCH CLIENTS The success of our executive search business depends upon the ability of our consultants to develop and maintain strong, long-term relationships with clients. Usually, one or two consultants have primary responsibility for a client relationship. When a consultant leaves an executive search firm and joins another, clients that have established relationships with the departing consultant may move their business to the consultant's new employer. The loss of one or more clients is more likely to occur if the departing consultant enjoys widespread name recognition or has developed a reputation as a specialist in executing searches in a specific industry or management function. Historically, we have not experienced significant problems in this area. However, a failure to retain our most effective consultants or maintain the quality of service to which our clients are accustomed could have a material adverse effect on our business, financial condition and operating results. Also, the ability of a departing consultant to move business to his or her new employer could have a material adverse effect on our business, financial condition and operating results. WE FACE RISKS MAINTAINING OUR PROFESSIONAL REPUTATION AND BRAND NAME Our ability to secure new executive search engagements and hire qualified professionals is highly dependent upon our overall reputation and brand name recognition as well as the individual reputations of our professionals. We obtain a majority of our new engagements from existing clients or from referrals by existing clients. Therefore, the dissatisfaction of any client could have a disproportionate, adverse impact on our ability to secure new engagements. Any factor that diminishes our reputation or the reputation of any of our personnel could make it more difficult for us to compete successfully for both new engagements and qualified consultants. This could have an adverse effect on our executive search business, financial condition and operating results. WE FACE RESTRICTIONS IMPOSED BY BLOCKING ARRANGEMENTS Either by agreement with clients or for marketing or client relationship purposes, executive search firms frequently refrain, for a specified period of time, from recruiting certain employees of a client, and possibly other entities affiliated with such client, when conducting executive searches on behalf of other clients. This is known as a "blocking" or "off-limits" arrangement. Blocking arrangements generally remain in effect for one or two years following completion of an assignment. The actual duration and scope of any blocking arrangement, including whether it covers all operations of a client and its affiliates or only certain divisions of a client, generally depends on such factors as: - the length of the client relationship; - the frequency with which the executive search firm has been engaged to perform executive searches for the client; and - the number of assignments the executive search firm has generated or expects to generate from the client. Some of our executive search clients are recognized as industry leaders and/or employ a significant number of qualified executives who are potential candidates for other companies in that client's industry. Blocking arrangements with a client of this nature, or the awareness by a client's competitors of such an arrangement, may make it difficult for us to obtain executive search assignments from, or to fulfill executive search assignments for, competitors while employees of that client may not be solicited. As our client base grows, particularly in our targeted business sectors, blocking arrangements increasingly may impede our growth or ability to attract and serve new clients. This could have an adverse effect on our executive search business, results of operations and financial condition. WE FACE RISKS RELATING TO OUR FOREIGN OPERATIONS We conduct operations in various foreign countries, including Australia, Belgium, Brazil, Canada, China, France, Germany, India, Ireland, Italy, Japan, Luxembourg, the Netherlands, New Zealand, Singapore, Spain and the United Kingdom. For the three months ended March 31, 2001 and the years ended December 31, 2000 and 1999, approximately 40%, 40% and 45%, respectively, of our total commissions and fees were earned outside of the United States. Such amounts are collected in the local currency. In addition, we generally pay operating expenses in the corresponding local currency. Therefore, we are at risk for exchange rate fluctuations between such local currencies and the dollar. We do not conduct any significant hedging activities. We are also subject to taxation in foreign jurisdictions. In addition, transactions between us and our foreign subsidiaries may be subject to United States and foreign withholding taxes. Applicable tax rates in foreign jurisdictions differ from those of the United States, and change periodically. The extent, if any, to which we will receive credit in the United States for taxes we pay in foreign jurisdictions will depend upon the application of limitations set forth in the Internal Revenue Code of 1986, as well as the provisions of any tax treaties which may exist between the United States and such foreign jurisdictions. Other risks inherent in transacting foreign operations include changes in applicable laws and regulatory requirements, tariffs and other trade barriers and political instability. WE DEPEND ON OUR KEY PERSONNEL Our continued success will depend to a significant extent on our senior management, including Andrew J. McKelvey, our Chairman of the Board and CEO. The loss of the services of Mr. McKelvey or of one or more key employees could have a material adverse effect on our business, financial condition and operating results. In addition, if one or more key employees join a competitor or form a competing company, the resulting loss of existing or potential clients could have a material adverse effect on our business, financial condition and operating results. If we were to lose a key employee, we cannot assure you that we would be able to prevent the unauthorized disclosure or use of our procedures, practices, new product development or client lists. WE ARE INFLUENCED BY A PRINCIPAL STOCKHOLDER Andrew J. McKelvey beneficially owns all of our outstanding Class B common stock and a large number of shares of our common stock, which together with his Class B common stock ownership represents approximately 45% of the combined voting power of all classes of our voting stock. Mr. McKelvey can strongly influence the election of all of the members of our board. He can also exercise significant influence over our business and affairs. This includes any determinations with respect to mergers or other business combinations, the acquisition or disposition of our assets, whether or not we incur indebtedness, the issuance of any additional common stock or other equity securities and the payment of dividends with respect to common stock. EFFECTS OF ANTI-TAKEOVER PROVISIONS COULD INHIBIT OUR ACQUISITION Some of the provisions of our certificate of incorporation, bylaws and Delaware law could, together or separately: - discourage potential acquisition proposals; - delay or prevent a change in control; and - limit the price that investors might be willing to pay in the future for shares of our common stock. In particular, our board of directors may issue up to 800,000 shares of preferred stock with rights and privileges that might be senior to our common stock, without the consent of the holders of the common stock. Our certificate of incorporation and bylaws provide, among other things, for advance notice of stockholder proposals and director nominations. THERE MAY BE VOLATILITY IN OUR STOCK PRICE The market for our common stock has, from time to time, experienced extreme price and volume fluctuations. Factors such as announcements of variations in our quarterly financial results and fluctuations in advertising commissions and fees, including the percentage of our commissions and fees derived from Internet-based services and products could cause the market price of our common stock to fluctuate significantly. Further, due to the volatility of the stock market generally, the price of our common stock could fluctuate for reasons unrelated to our operating performance. The market price of our common stock is based in large part on professional securities analysts' expectations that our business will continue to grow and that we will achieve certain levels of net income. If our financial performance in a particular quarter does not meet the expectations of securities analysts, this may adversely affect the views of those securities analysts concerning our growth potential and future financial performance. If the securities analysts who regularly follow our common stock lower their ratings of our common stock or lower their projections for our future growth and financial performance, the market price of our common stock is likely to drop significantly. WE FACE RISKS ASSOCIATED WITH GOVERNMENT REGULATION As an advertising agency which creates and places print and Internet advertisements, we are subject to Sections 5 and 12 of the FTC Act. These sections regulate advertising in all media, including the Internet, and require advertisers and advertising agencies to have substantiation for advertising claims before disseminating advertisements. The FTC Act prohibits the dissemination of false, deceptive, misleading, and unfair advertising, and grants the FTC enforcement powers to impose and seek civil penalties, consumer redress, injunctive relief and other remedies upon advertisers and advertising agencies which disseminate prohibited advertisements. Advertising agencies like us are subject to liability under the FTC Act if the agency actively participated in creating the advertisement, and knew or had reason to know that the advertising was false or deceptive. In the event that any advertising that we have created is found to be false, deceptive or misleading, the FTC Act could potentially subject us to liability. The fact that the FTC has recently brought several actions charging deceptive advertising via the Internet, and is actively seeking new cases involving advertising via the Internet, indicates that the FTC Act could pose a somewhat higher risk of liability to the advertising distributed via the Internet. The FTC has never brought any actions against us. In addition, we cannot assure you that other current or new government laws and regulations, or the application of existing laws and regulations will not: - subject us to significant liabilities; - significantly dampen growth in Internet usage; - prevent us from offering certain Internet content or services; or - otherwise have a material adverse effect on our business, financial condition and operating results. WE HAVE NEVER PAID DIVIDENDS We currently intend to retain earnings, if any, to support our growth strategy. We do not anticipate paying dividends on our stock in the foreseeable future. In addition, payment of dividends on our stock is restricted by our financing agreement.