Amendment No. 2 to Form SB-2
Table of Contents

As filed with the Securities and Exchange Commission on March 19, 2004

Registration Number 333-111096


UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549


AMENDMENT NO. 2 TO

FORM SB-2

REGISTRATION STATEMENT

Under

THE SECURITIES ACT OF 1933


Marchex, Inc.

(Name of small business issuer in its charter)


Delaware   7389   35-2194038

(State or other jurisdiction of

incorporation or organization)

 

(Primary standard industrial

classification code number)

 

(I.R.S. employer

identification number)

 

Marchex, Inc.

2101 Fourth Avenue

Suite 1980

Seattle, Washington 98121

(206) 774-5000

 

Russell C. Horowitz

Chairman and Chief Executive Officer

Marchex, Inc.

2101 Fourth Avenue

Suite 1980

Seattle, Washington 98121

(206) 774-5000

(Address and telephone number of principal executive offices and principal place of business)   (Name, address and telephone number of agent for service)

Copies to:

Francis J. Feeney, Jr., Esq.

Nixon Peabody LLP

100 Summer Street

Boston, MA 02110

(617) 345-1000

 

Michael Jay Brown, Esq.

Dorsey & Whitney LLP

1420 Fifth Avenue

Suite 3400

Seattle, WA 98101

(206) 903-8800

 

Approximate date of commencement of proposed sale to the public:

As soon as practicable after the effective date hereof.


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 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 under the Securities Act, please check the following box:  x

 

The Registrant hereby amends this Registration Statement on such date or dates as may be necessary to delay its effective date until the Registrant shall file a further amendment which specifically states that this Registration Statement shall thereafter become effective in accordance with section 8(a) of the Securities Act of 1933, as amended, or until the Registration Statement shall become effective on such date as the Securities and Exchange Commission, acting pursuant to said section 8(a), may determine.

 



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The information in this preliminary prospectus is not complete and may be changed. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell these securities, and it is not soliciting offers to buy these securities in any state where the offer or sale is not permitted.

 

PROSPECTUS (Subject to Completion)

Dated March 19, 2004

 

4,000,000 shares

 

LOGO

 

Marchex, Inc.

Class B Common Stock

 

This is our initial public offering of shares of our Class B common stock. No public market currently exists for any shares of our capital stock. We anticipate the initial public offering price of our Class B common stock will be from $6.00 to $7.00 per share. This price may not reflect the market price of our Class B common stock after our offering.

 

We have two classes of authorized common stock:  Class A common stock and Class B common stock. All of our outstanding Class A common stock is beneficially owned by our founding officers. Holders of our Class B common stock are entitled to one vote per share, while holders of our Class A common stock are entitled to twenty-five votes per share, on all matters submitted to a vote of our stockholders.

 

We have applied to list our Class B common stock on the NASDAQ National Market and have reserved the trading symbol “MCHX.”

 

This offering involves a high degree of risk. Before buying any shares you should read the discussion of material risks of investing in our Class B common stock in “ Risk Factors” beginning on page 7.

 

     Per Share(1)

     Total(1)

Public offering price

   $ 6.50        $ 26,000,000

Underwriting discounts and commissions

   $ 0.325      $ 1,300,000

Proceeds, before expenses, to us(2)

   $ 6.175      $ 24,700,000

(1) Based on the middle of the filing range on the date of this prospectus.
(2) We estimate the expenses of this offering will be approximately $1,400,000.

 

As additional compensation to the underwriters, we have granted the representatives of the underwriters warrants, exercisable over a period commencing one year after the offering date and ending five years from the offering date, to purchase 120,000 shares of our Class B common stock at an exercise price equal to 130% of the initial public offering price.

 

We granted the underwriters a 30-day option to purchase up to 600,000 shares of Class B common stock at the initial public offering price, less the underwriting discounts and commissions, to cover over-allotments, if any. If the underwriters exercise the option in full, the total underwriting discounts and commissions will be $1,495,000 and our total proceeds, before expenses, will be $28,405,000 (in each case assuming an initial public offering price of $6.50, which represents the middle of the filing range as of the date of this prospectus).

 

The underwriters are offering the Class B common stock on a firm commitment basis, such that the underwriters will purchase all offered shares if any of such shares are not purchased. The representatives, on behalf of the underwriters, expect to deliver the shares on or about                     , 2004.

 

Our directors, officers and employees will purchase up to 600,000 shares at the initial public offering price. At our request, the underwriters have reserved shares at the initial public offering price for this purpose. Any reserved shares which are not purchased will be offered by the underwriters to the general public on the same basis as the other shares offered by this prospectus.

 

Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or passed upon the adequacy or accuracy of this prospectus. Any representation to the contrary is a criminal offense.

 

Sanders Morris Harris   National Securities Corporation

 

The date of this prospectus is March     , 2004.

 


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You should rely only on the information contained in this prospectus. We have not authorized anyone to provide information different from that contained in this prospectus. We are offering to sell, and seeking offers to buy, shares of Class B common stock only in jurisdictions where offers and sales are permitted. The information contained in this prospectus is accurate only as of the date of this prospectus, regardless of the time of delivery of this prospectus or of any sale of our Class B common stock.

 

TABLE OF CONTENTS

 

     Page

Prospectus Summary    1
Summary Consolidated Financial Data    5
Risk Factors    7
Special Note Regarding Forward-Looking Statements    21
Use of Proceeds    22
Determination of Offering Price    23
Capitalization    24
Dilution    26
Dividend Policy    27
Management’s Discussion and Analysis of Financial Condition and Results of Operations    28
Business    51
Management    62
Executive Compensation    66
Security Ownership of Certain Beneficial Owners and Management    70
Certain Relationships and Related Transactions    72
Description of Capital Stock    74
Market for Common Equity and Related Stockholder Matters    79
Underwriting    82
Legal Matters    85
Experts    85
Disclosure of Commission Position on Indemnification for Securities Act Liabilities    85
Where You Can Find More Information    85
Financial Statements    F-1

 

Until            , 2004, 25 days after the date of this offering, all dealers that effect transactions in our Class B common stock, whether or not participating in this offering, may be required to deliver a prospectus. This is in addition to the dealers’ obligation to deliver a prospectus while acting as underwriters and with respect to their unsold allotments or subscriptions.


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PROSPECTUS SUMMARY

 

This summary highlights selected information contained elsewhere in this prospectus. This summary may not contain all of the information that you should consider before investing in our Class B common stock. You should carefully read the entire prospectus, including “Risk Factors” and the financial statements, before making an investment decision. Unless otherwise specified or the context otherwise requires, references in this prospectus to “we,” “our” and “us” refer to Marchex, Inc. and its wholly-owned subsidiaries, including Enhance Interactive, Inc. (f/k/a ah-ha.com, Inc.), and TrafficLeader, Inc. (f/k/a Sitewise Marketing, Inc.), on a consolidated basis.

 

Our Company

 

We provide technology-based services to merchants engaged in online transactions. Our objective is to be a leader in terms of growth, profitability, technological innovation, and business model innovation. We anticipate achieving our objectives through a combination of consolidation opportunities, growing those businesses we acquire, internal development initiatives and strategic relationships.

 

We believe there is a significant, long-term opportunity to capture market share of online transactions, and services that support online transactions, by building a profitable, diversified global company that provides a wide range of technology-based services to merchants, including: Web site infrastructure and development services; online payment and commerce infrastructure; promotional tools to market and sell products and services; and automated tools to manage and track online transactions. We intend to leverage the experience of our senior management to capture this opportunity, as they have substantial operational and strategic experience, including experience in building and managing public companies, executing acquisitions and forming strategic relationships.

 

Our current operating businesses are in the performance-based advertising and search marketing industries, primarily focused on helping merchants market and sell their products and services via the Internet. We currently provide our merchant customers with the following technology-based services:

 

  Performance-Based Advertising primarily includes pay-per-click and paid inclusion services.

 

  Pay-Per-Click Services. With pay-per-click services, merchant advertisers purchase keywords based on an amount they choose for a targeted placement, usually within search engine results.

 

  Paid Inclusion Services. With paid inclusion services, merchant advertisers pay for their Web pages and product databases to be crawled, or searched, and indexed and included primarily within search engine and shopping engine results. Generally, the paid inclusion results are presented separately from the pay-per-click results.

 

  Search Marketing is designed for merchant advertisers who are focused on acquiring customers through search-based marketing methods, such as pay-per-click management (“advertising campaign management”), enhancing the performance of their campaigns through tracking and analyzing historical results (“conversion tracking and analysis”), and refining their Web sites for increased relevance in algorithmic search engine indexes (“search engine optimization”).

 

In support of our partners and merchants, we devote resources to developing and building proprietary technology-based products and services that we believe are innovative and provide a high degree of utility. Additionally, we continually evaluate opportunities to evolve existing technologies and business models, and we regularly consider possible acquisitions and strategic relationships.

 

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Our Industry

 

Internet-based transactions between consumers and merchants have grown rapidly in recent years. This growth is the result of decreasing price points of Internet access devices coupled with corresponding performance gains of such devices; a large installed base of personal computers in the workplace and home; penetration of broadband technologies and increased Internet usage; and the emergence of compelling commerce opportunities and a growing awareness among consumers of the convenience and other benefits of online shopping. We believe that today’s consumers are becoming increasingly confident that they can find comprehensive product information and securely transact online. Additionally, we believe merchants’ abilities to more efficiently and effectively acquire and monetize customers have also led to a steady increase in merchants coming online and therefore in the number of online transactions.

 

We believe there is a significant, long-term opportunity to capture market share of online transactions and services that support online transactions, by building a profitable, diversified global company that provides a wide range of technology-based services to merchants, including: Web site infrastructure and development services; online payment and commerce infrastructure; promotional tools to market and sell products and services; and automated tools to manage and track online transactions. On an ongoing basis, we intend to evaluate points in the merchant transactions value chain that will provide the greatest opportunity for us to build and acquire offerings with the following characteristics: growth, scalability, profitability and defensibility.

 

Our Strategy

 

We intend to leverage our senior management’s experience, our financial and human resources, and our existing operating businesses to provide technology-based services for merchants engaged in online transactions. Key elements of our strategy include the following initiatives:

 

  provide quality services in support of merchants and distribution partners;

 

  increase the number of merchants served;

 

  continue to innovate and develop proprietary technologies and intellectual property;

 

  pursue selective acquisition and consolidation opportunities;

 

  drive increased profitability through revenue growth and operating leverage; and

 

  develop new markets.

 

Our Relationship with Our Founding Officers

 

In connection with our formation in January 2003, Russell C. Horowitz, Ethan A. Caldwell, Peter Christothoulou, John Keister and Victor Oquendo, our founding officers, provided our initial capital investment. As of December 31, 2003, these founding officers beneficially owned 71% of our capital stock, which represented 98% of the combined voting power of all of our outstanding stock. Upon completion of this offering, these founding officers will own 59% of all of our outstanding common stock, excluding any amounts that may be purchased by them in this offering, which will represent 97% of the combined voting power of all of our outstanding stock.

 

Company Information

 

We were incorporated in Delaware on January 17, 2003. On February 28, 2003, we acquired eFamily.com, Inc., together with its direct wholly-owned subsidiary Enhance Interactive. eFamily was incorporated in Utah on November 29, 1999, under the name FocusFilter.com, Inc. On October 24, 2003, we acquired TrafficLeader, which was incorporated in Oregon on January 24, 2000, under the name Sitewise Marketing, Inc.

 

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From January 17, 2003 (inception) through February 28, 2003, we were involved in business and product development, as well as financing and acquisition initiatives. During this period we had no revenues.

 

Our principal executive offices are located at 2101 Fourth Avenue, Suite 1980, Seattle, Washington 98121, and our telephone number is (206) 774-5000. Our corporate Web site address is www.marchex.com. Our subsidiaries have Web sites located at www.enhance.com and www.trafficleader.com. The information on our Web sites is not incorporated by reference into and does not form a part of this prospectus.

 

The Offering

 

Class B common stock offered

 

4,000,000 shares

Common stock to be outstanding after the offering:

   

Class A common stock (twenty-five votes per share)

 

11,987,500 shares

Class B common stock (one vote per share)

 

12,291,563 shares

Total

  24,279,063 shares

Proposed NASDAQ National Market symbol *

 

MCHX

Use of proceeds

 

We expect to use the net proceeds of the offering for:

 

•      product and business development;

 

•      acquisitions and strategic relationships;

 

•      capital expenditures;

 

•      personnel;

 

•      facilities;

 

•      our earn-out payment obligations (related to our acquisitions); and

 

•      working capital and other general corporate purposes.

 

Pending such use, we plan to invest the net proceeds in short-term, investment grade, interest-bearing securities. See “Use of Proceeds.”


* We have applied to list our Class B common stock on the NASDAQ National Market and have reserved the trading symbol “MCHX.” 

 

Unless we indicate otherwise, in preparing this prospectus:

 

  we have given effect to the conversion of all outstanding shares of our preferred stock into 6,724,063 shares of our Class B common stock upon the closing of this offering;

 

  we have not given effect to the exercise by the underwriters of the over-allotment option granted to them to purchase an additional 600,000 shares of Class B common stock in the offering;

 

  we have not given effect to the exercise by the representatives of the warrants to be issued as compensation under the underwriting agreement; and

 

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  we have assumed the filing of our amended and restated certificate of incorporation concurrently with the completion of this offering.

 

The number of shares of common stock to be outstanding after this offering is based on 20,279,063 shares outstanding as of February 16, 2004. This number of shares:

 

  includes 6,724,063 shares of Class B common stock issuable upon the automatic conversion of all outstanding shares of our Series A convertible preferred stock upon the completion of this offering;

 

  excludes 5,013,953 shares of Class B common stock that we have reserved for issuance under our 2003 stock incentive plan and 300,000 shares of Class B common stock that we have reserved for issuance under our 2004 employee stock purchase plan. As of February 16, 2004, 3,196,600 shares were subject to outstanding options, of which 2,421,500 options have a weighted average exercise price of $1.67 per share and 775,100 options will have an exercise price equal to the initial public offering price; and

 

  excludes 262,500 shares of Class A common stock that are held in treasury.

 

The numbers of shares beneficially owned by our officers and directors and included in this prospectus do not include any shares of Class B common stock that any officer or director may purchase in the offering. In cases where we have calculated ownership percentages following the offering, these calculations assume that no additional shares of Class B common stock were purchased by the officers and directors in the offering. Our officers and directors may individually decide to purchase shares of the Class B common stock in the offering.

 

You should rely only on the information contained in this prospectus. This prospectus is not an offer to sell or a solicitation of an offer to buy shares in any jurisdiction where such offer or any sales of shares would be unlawful. The information in this prospectus is complete and accurate only as of the date on the front cover regardless of the time of delivery of this prospectus or of any sale of shares.

 

See “Risk Factors” and other information included in this prospectus for a discussion of factors you should consider before investing in shares of our Class B common stock.

 

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Summary Consolidated Financial Data

 

The following tables summarize historical consolidated financial data regarding our business and should be read together with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and the related notes included elsewhere in this prospectus. The summary information as of December 31, 2003 and for the year ended December 31, 2002, the period from January 1, 2003 to February 28, 2003 and the period from January 17, 2003 (inception) to December 31, 2003 has been derived from our audited consolidated financial statements included elsewhere in this prospectus. The results of operations for Enhance Interactive have been presented as the “Predecessor” for the year ended December 31, 2002 and for the period from January 1, 2003 to February 28, 2003. See subsection “Presentation of Financial Reporting Periods” on page 29 for a further description of the basis of presentation of the 2003 period and of other financial reporting periods.

 

     Predecessor Periods

   Successor
Period


 
     Year ended
December 31,
2002


    Period from
January 1 to
February 28,
2003


   Period from
January 17
(inception) to
December 31,
2003


 

Consolidated Statement of Operations Data:

                   

Revenue

   $ 10,070,507     3,071,055    19,892,158  

Income (loss) from operations

     (238,150 )   555,072    (3,327,723 )

Net income (loss)

     (89,783 )   332,519    (2,169,352 )

Accretion to redemption value of redeemable convertible preferred stock

     —       —      1,318,885  
    


 
  

Net income (loss) applicable to common stockholders

   $ (89,783 )   332,519    (3,488,237 )
    


 
  

Consolidated Statement of Cash Flows Data:

                   

Cash flows from operating activities

   $ 1,539,808     353,053    2,907,053  

Other Financial Data:

                   

Operating income before amortization (OIBA) (1)

   $ 126,543     594,053    1,820,795  
     December 31, 2003

 
     Actual

    Pro forma (2)

   Pro forma as
Adjusted (2)


 

Consolidated Balance Sheet Data:

                   

Cash and cash equivalents

   $ 6,019,119     6,019,119    29,348,996  

Total current assets

     8,343,151     8,343,151    31,673,028  

Total assets

     33,702,612     33,702,612    56,656,139  

Total current liabilities

     8,501,674     8,501,674    8,155,201  

Series A redeemable convertible preferred stock

     21,440,402     —      —    

Total stockholders’ equity

   $ 1,834,332     23,274,734    46,574,734  

 

(1)

We report operating income before amortization (OIBA) that is a supplemental measure to GAAP. OIBA represents income (loss) from operations before (1) stock-based compensation expense and (2) amortization of intangible assets. This measure, among other things, is one of the primary metrics by which we evaluate the performance of our business. Additionally, management uses adjusted OIBA which excludes acquisition-related retention consideration as we view this as part of the earn-out consideration from the transaction. Adjusted OIBA is the basis on which our internal budgets are based and by which management is currently evaluated. Management believes that investors should have access to, and we are obligated to provide, the same set of tools that we use in analyzing our results. This non-GAAP measure should be considered in addition to results prepared in accordance with GAAP, and should not be considered in

 

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isolation, as a substitute for or superior to GAAP results. We believe this measure is useful to investors because it represents our consolidated operating results, taking into account depreciation, which we believe is an ongoing cost of doing business, but excluding the effects of certain other non-cash expenses. OIBA has certain limitations in that it does not take into account the impact to our statement of operations of certain expenses, including non-cash stock-based compensation associated with our employees and acquisition-related accounting. We endeavor to compensate for the limitations of the non-GAAP measure presented by providing the comparable GAAP measure with equal or greater prominence, GAAP financial statements and detailed descriptions of the reconciling items and adjustments, including quantifying such items, to derive the non-GAAP measure. The following is a reconciliation of Income (loss) from operations and Net income (loss) applicable to common stockholders to the non-GAAP measure of Operating income before amortization:

 

     Predecessor Periods

    Successor
Period


 
     Year ended
December 31,
2002


    Period from
January 1 to
February 28,
2003


    Period from
January 17
(inception to
December 31,
2003


 

Operating income before amortization (OIBA)

   $ 126,543     594,053     1,820,795  

Stock-based compensation

     (364,693 )   (38,981 )   (2,125,110 )

Amortization of intangible assets

     —       —       (3,023,408 )
    


 

 

Income (loss) from operations

     (238,150 )   555,072     (3,327,723 )

Other income:

                    

Interest income

     5,491     1,529     45,874  

Adjustment to fair value of redemption obligation

     —       —       25,500  

Other

     —       —       2,685  
    


 

 

Total other income

     5,491     1,529     74,059  
    


 

 

Income (loss) before provision for income taxes

     (232,659 )   556,601     (3,253,664 )

Income tax expense (benefit)

     (142,876 )   224,082     (1,084,312 )
    


 

 

Net income (loss)

     (89,783 )   332,519     2,169,352 )

Accretion to redemption value of redeemable convertible preferred stock

     —       —       1,318,885  
    


 

 

Net income (loss) applicable to common stockholders

   $ (89,783 )   332,519     (3,488,237 )
    


 

 

 

(2) Pro forma amounts give effect to the automatic conversion of all outstanding shares of our Series A redeemable convertible preferred stock into 6,724,063 shares of Class B common stock upon the closing of this offering. Pro forma as adjusted amounts also give effect to the issuance and sale of 4,000,000 shares of our Class B common stock at an assumed initial public offering price of $6.50 per share, which represents the middle of the filing range as of the date of this prospectus (after deducting $2.7 million in underwriting discounts and commissions and estimated expenses of the offering). As of December 31, 2003, the estimated expenses of the offering included approximately $376,000 in other assets as deferred offering costs, of which approximately $30,000 were paid and approximately $346,000 are reflected as current liabilities.

 

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RISK FACTORS

 

Any investment in our Class B common stock involves a high degree of risk. You should carefully consider the following information about these risks, together with the other information contained in this prospectus, before you decide whether to purchase our Class B common stock. Additional risks and uncertainties not currently known to us or that we currently do not deem material may also become important factors that may harm our business. If any of the following risks occur, our business, financial condition and results of operations could be materially adversely affected. In such case, the trading price of our Class B common stock could decline, and you may lose all or part of your investment.

 

Risks Relating to Our Company

 

Our limited operating history makes evaluation of our business difficult.

 

We were formally incorporated in January 2003. We acquired Enhance Interactive in February 2003 and TrafficLeader in October 2003. As a result, we have limited historical financial data upon which to base planned operating expenses or forecast accurately our future operating results. Further, our limited operating history will make it difficult for investors and securities analysts to evaluate our business and prospects. You must consider our prospects in light of the risks, expenses and difficulties we face as an early stage company with a limited operating history.

 

We may need additional funding to support our operations and capital expenditures, which may not be available to us and which lack of availability could adversely affect our business.

 

We have no committed sources of additional capital. For the foreseeable future, we intend to fund our operations and capital expenditures from limited cash flow from operations, our cash on hand and the net proceeds of the offering. If our capital resources are insufficient, we will have to raise additional funds. We may need additional funds to continue our operations, pursue business opportunities (such as expansion, acquisitions of complementary businesses or the development of new products or services), to react to unforeseen difficulties or to respond to competitive pressures. There can be no assurance that any financing arrangements will be available in amounts or on terms acceptable to us, if at all. Furthermore, the sale of additional equity or convertible debt securities may result in additional dilution to existing stockholders. If adequate additional funds are not available, we may be required to delay, reduce the scope of or eliminate material parts of the implementation of our business strategy, including the possibility of additional acquisitions or internally developed businesses.

 

We may need additional funding to make payments to the former shareholders of Enhance Interactive and TrafficLeader, which may not be available to us and which lack of availability could adversely affect our financial condition.

 

We are obligated to make earnings-based performance payments to the original shareholders and certain employees of eFamily which we acquired in February 2003, together with its direct wholly-owned subsidiary, Enhance Interactive. These payment obligations are calculated based on a percentage of Enhance Interactive’s earnings before taxes excluding stock-based compensation and amortization of intangibles relating to the acquisition for the calendar years 2003 and 2004, according to the terms of the merger agreement, with a maximum aggregate obligation of $13.5 million. For the 2003 calendar year, the total Enhance Interactive earnings-based payment obligation was approximately $3.5 million. We may also be obligated to make revenue-based performance payments to the original shareholders of TrafficLeader, which we acquired in October 2003. If TrafficLeader has revenues in excess of $15 million for 2004, we will be obligated to pay an amount equal to 10% of each dollar in revenue above the $15 million threshold, with a maximum obligation of $1 million. If we are unable to raise sufficient funds in this offering or any subsequent offerings, we may not be able to meet our payment obligations under our acquisition agreements for Enhance Interactive and TrafficLeader, which could have a material adverse effect upon our financial condition.

 

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Further, in the event that we have not completed a firm commitment initial public offering with gross proceeds of at least $20 million prior to October 24, 2005, the original shareholders of TrafficLeader can require us to redeem 425,000 shares of our Class B common stock for $8 per share (for an aggregate redemption amount of $3.4 million) upon the affirmative vote of the holders of 75% of such shares. Our failure to meet this potential payment obligation could have a material adverse effect upon our financial condition.

 

We have incurred losses since our inception, and we expect our losses to continue for the foreseeable future, which will adversely affect our ability to achieve profitability.

 

To date, we have incurred net losses and had an accumulated deficit of $3.5 million for the period from January 17, 2003 (inception) through December 31, 2003 and as of December 31, 2003.

 

Our net losses are likely to continue for the foreseeable future. Also, our net losses may increase to the extent we increase our sales and marketing activities and acquire additional businesses. These efforts may prove to be more expensive than we currently anticipate, which could further increase our net losses. We cannot predict when, or if, we will become profitable in the future. Even if we achieve profitability, we may not be able to sustain it.

 

We may make acquisitions, which could divert management’s attention, cause ownership dilution to our stockholders and be difficult to integrate.

 

Our business strategy depends heavily upon our ability to identify, structure and integrate acquisitions. Acquisitions, strategic relationships and investments in the technology and Internet sectors involve a high degree of risk. We may also be unable to find a sufficient number of attractive opportunities, if any, to meet our objectives. Although many technology and Internet companies have grown in terms of revenue, few companies are profitable or have competitive market share. Our potential strategic acquisition, strategic relationship or investment targets and partners may have histories of net losses and may expect net losses for the foreseeable future.

 

Acquisition transactions are accompanied by a number of risks that could harm us and our business, operating results and financial condition:

 

  we could experience a substantial strain on our resources, including time and money, and we may not be successful;

 

  our management’s attention may be diverted from our ongoing business concerns;

 

  while integrating new companies, we may lose key executives or other employees of these companies;

 

  we could experience customer dissatisfaction or performance problems with an acquired company or technology;

 

  we may become subject to unknown or underestimated liabilities of an acquired entity or incur unexpected expenses or losses from such acquisitions; and

 

  we may incur possible impairment charges related to goodwill or other intangible assets or other unanticipated events or circumstances, any of which could harm our business.

 

Consequently, we might not be successful in integrating any acquired businesses, products or technologies, and might not achieve anticipated revenue and cost benefits.

 

The loss of our senior management, including our founding officers, could harm our current and future operations and prospects.

 

We are heavily dependent upon the continued services of Russell C. Horowitz and John Keister and the other members of our senior management team. We do not have long-term employment agreements with any of the members of our senior management team. Each of these individuals may voluntarily terminate his employment

 

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with Marchex at any time upon short notice. Following any termination of employment, each of these employees would only be subject to a twelve-month period of non-competition under our standard confidentiality agreement.

 

Further, as of December 31, 2003, our founding officers together controlled ninety-eight percent (98%) of the combined voting power of our issued and outstanding capital stock and after the offering will control ninety-seven percent (97%) of such combined voting power. Their collective voting control is not tied to their continued employment with Marchex. The loss of the services of any member of our senior management, including our founding officers, for any reason, or any conflict among our founding officers, could harm our current and future operations and prospects.

 

We may have difficulty attracting and retaining qualified, experienced, highly skilled personnel, which could adversely affect the implementation of our business plan.

 

In order to fully implement our business plan, we will need to attract and retain additional qualified personnel. Thus, our success will in significant part depend upon the efforts of personnel not yet identified and upon our ability to attract and retain highly skilled managerial, engineering, sales and marketing personnel. We are also dependent on managerial and technical personnel to the extent they may have knowledge or information about our businesses and technical systems that may not be known by other personnel in our Company. There can be no assurance that we will be able to attract and retain necessary personnel. The failure to hire and retain such personnel could adversely affect the implementation of our business plan.

 

Our use of variable plan accounting for some stock options will result in stock-based compensation charges and reduce our reported net income.

 

We use variable plan accounting to account for certain non-qualified stock options (for the purchase of an aggregate of 125,000 shares) issued under our 2003 stock incentive plan and, accordingly, we may be required to record a compensation charge on a quarterly basis, which will lower our earnings. These options were issued in connection with the acquisition of Enhance Interactive and are conditioned upon employment. These options are potentially subject to forfeiture if certain indemnification obligations under the acquisition agreement are not met. Under variable plan accounting, compensation expense is measured quarterly as the amount by which the fair value of the shares of our Class B common stock exceeds the exercise price for these options and is recognized over the vesting period of the options. Increases or decreases in the fair value of our Class B common stock between the date of grant and the date of the exercise of these options could result in a corresponding increase or decrease in the measure of compensation expense and thus could cause fluctuations in our earnings from period to period.

 

New rules, including those contained in and issued under the Sarbanes-Oxley Act of 2002, may make it difficult for us to retain or attract qualified officers and directors, which could adversely affect the management of our business and our ability to obtain or retain listing of our Class B common stock on NASDAQ.

 

We may be unable to attract and retain qualified officers, directors and members of board committees required to provide for our effective management as a result of the recent and currently proposed changes in the rules and regulations which govern publicly-held companies, including, but not limited to, certifications from executive officers and requirements for financial experts on the board of directors. The perceived increased personal risk associated with these recent changes may deter qualified individuals from accepting these roles. The enactment of the Sarbanes-Oxley Act of 2002 has resulted in the issuance of a series of new rules and regulations and the strengthening of existing rules and regulations by the Securities and Exchange Commission, as well as the adoption of new and more stringent rules by the NASDAQ National Market.

 

Further, certain of these recent and proposed changes heighten the requirements for board or committee membership, particularly with respect to an individual’s independence from the corporation and level of

 

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experience in finance and accounting matters. We may have difficulty attracting and retaining directors with the requisite qualifications. If we are unable to attract and retain qualified officers and directors, the management of our business and our ability to maintain the NASDAQ National Market System listing of our shares of Class B Common Stock (assuming we are successful in obtaining such listing) could be adversely affected.

 

If we are unable to obtain adequate insurance, our financial condition could be adversely affected in the event of uninsured or inadequately insured loss or damage. Our ability to effectively recruit and retain qualified officers and directors could also be adversely affected if we experience difficulty in obtaining adequate directors’ and officers’ liability insurance.

 

We may not be able to obtain insurance policies on terms affordable to us that would adequately insure our business and property against damage, loss or claims by third parties. To the extent our business or property suffers any damages, losses or claims by third parties, which are not covered or adequately covered by insurance, the financial condition of our Company may be materially adversely affected.

 

We currently have directors’ and officers’ liability insurance, but we may be unable to maintain sufficient insurance as a public company to cover liability claims made against our officers and directors. If we are unable to adequately insure our officers and directors, we may not be able to retain or recruit qualified officers and directors to manage our Company.

 

Risks Relating to Our Business

 

We are dependent on our distribution partners for a significant portion of our total revenue. A loss of distribution partners or decrease in revenue from distribution partners could adversely affect our operating results.

 

We rely primarily on distribution partners to provide us with access to users and consumers. This sector has experienced, and will likely continue to experience, consolidation among the larger distribution partners. This consolidation has reduced the number of partners that control the online advertising outlets with the most user traffic. For example, Yahoo! owns or controls multiple distribution networks and destinations. According to U.S. Bancorp Piper Jaffray in a March 2003 report, Yahoo! Search accounts for twenty-one percent (21%) of the online searches in the United States and Google accounts for thirty-four percent (34%). Certain Yahoo! subsidiaries are among our current distribution partners, and we purchase advertising on Google.

 

As a result, the larger distribution partners have greater control over determining the market terms of distribution, including placement of merchant advertisements and cost of placement. Our agreements with large distribution partners contain short-term termination clauses in their favor. We cannot be assured that we will maintain our current agreements with any of these distribution partners. In addition, we cannot be assured that any of these distribution partners will continue to generate current levels of revenue for us. A loss of any of these distribution partners or a decrease in revenue from any one of these distribution partners could have an adverse effect on our revenue and profitability, and the loss of any one large distribution partner could have a material adverse effect on our operating results.

 

If we do not maintain and grow a critical mass of merchant advertisers and distribution partners, the value of our services could be adversely affected.

 

Our success depends, in part, on the maintenance and growth of a critical mass of merchant advertisers and distribution partners and a continued interest in our performance-based advertising and search marketing services. If our business is unable to achieve a growing base of merchant advertisers, our current distribution partners may be discouraged from continuing to work with us, and this may create obstacles for us to enter into agreements with new distribution partners. Similarly, if our distribution network does not grow and improve over time, current and prospective merchant advertisers may reduce or terminate their business with us. In particular, we may not successfully develop or market technologies, products or services that are competitive or accepted by

 

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merchant advertisers. Any decline in the number of merchant advertisers and distribution partners could adversely affect the value of our services generally.

 

We are dependent upon our distribution partners to continue to provide us traffic that our merchant advertisers deem to be of value, and if they do not, it could have a material adverse effect on the value of our services.

 

We are dependent upon our distribution partners to provide us traffic that our merchant advertisers deem to be of value. We monitor the traffic of our distribution partners in an attempt to optimize the quality of traffic we deliver to our merchant advertisers, which may include terminating certain distribution partners. We review factors such as non-human processes, including robots, spiders, scripts (or other software), mechanical automation of clicking and other sources and causes of low-quality traffic, including, but not limited to, other non-human clicking agents. Even with such monitoring in place, there is a risk that a certain amount of low-quality traffic will be provided to our merchant advertisers, which, if not contained, may be detrimental to those relationships. Low-quality traffic (or traffic that is deemed to be less valuable by our merchant advertisers) that is provided by our distribution partners may prevent us from growing our base of merchant advertisers and cause us to lose relationships with existing merchant advertisers.

 

We may be subject to intellectual property claims, which could adversely affect our financial condition and ability to use certain critical technologies, divert our resources and management attention from our business operations and create uncertainty about ownership of technology essential to our business.

 

Our success depends, in part, on our ability to protect our intellectual property and to operate without infringing on the intellectual property rights of others in the process. There can be no guarantee that any of our intellectual property will be adequately safeguarded, or that it will not be challenged by third parties. We may be subject to patent infringement claims or other intellectual property infringement claims that would be costly to defend and could limit our ability to use certain critical technologies.

 

For example, Overture Services, a subsidiary of Yahoo!, which operates in certain competitive areas with us, owns a patent (U.S. Patent No. 6,269,361), which purports to give Overture rights to certain bid-for-placement products and pay-per-performance search technologies. Overture is currently involved in litigation with two companies relating to this patent (FindWhat and Google). These companies are vigorously contesting Overture’s patent. If we were to acquire or develop a related product or business model that Overture construes as infringing upon the above-referenced patent, then we could be asked to license, re-engineer our product(s) or revise our business model according to terms that may be extremely expensive and/or unreasonable. Additionally, if Overture construes any of our current products or business models as infringing upon the above-referenced patent, then we could be asked to license, re-engineer our product(s) or revise our business model according to terms that could be extremely expensive and/or unreasonable.

 

Any patent litigation could negatively impact our business by diverting resources and management attention from other aspects of the business and adding uncertainty as to the ownership of technology and services that we view as proprietary and essential to our business. In addition, a successful claim of patent infringement against us and our failure or inability to license the infringed or similar technology on reasonable terms, or at all, could have a material adverse effect on our business.

 

We currently have a reliance on certain distribution partners, including Yahoo! and its subsidiaries, to distribute our services. The termination of any of these distribution relationships could have a material adverse effect on our operating results.

 

We currently have certain distribution partners that deliver a significant percentage of traffic to our merchant listings, in terms of click-throughs. However, for the period of January 17, 2003 (inception) through December 31, 2003, none of these partners represented more than 10% of our total revenue. Given the

 

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consolidation trend in distribution and ownership of traffic, we anticipate that one or more distribution partners could individually represent more than 10% of our total revenue in future periods. For example, Yahoo!, through its subsidiaries, such as Inktomi and Overture, is an important distribution partner of our paid inclusion services, and they represent less than 10% of our total revenue for the period from January 17, 2003 (inception) to December 31, 2003. Existing agreements with certain Yahoo! subsidiaries contain mutual termination clauses and are primarily structured on a variable-payment basis, under which we make payments based on a specified percentage of revenue or based on the number of paid click-throughs. We intend to continue devoting resources in support of our Yahoo! relationship, although there are no guarantees that this relationship will remain in place over the short- or long-term.

 

Currently, many participants in the performance-based advertising and search marketing industries own significant portions of the traffic that they deliver to advertisers. We do not believe, for example, that Yahoo! and Google are as reliant as we are on a distribution network to deliver their services. This gives these companies a significant advantage in delivering their services, and with a lesser degree of risk. If the existing relationships with our distribution partners were terminated, our operating results could suffer.

 

We have grown quickly and if we fail to manage our growth, our business could suffer.

 

We have rapidly expanded our operations and anticipate that further significant expansion, including the possible acquisition of third-party assets, technologies or businesses, will be required to address potential growth in our customer base and market opportunities. This expansion has placed, and is expected to continue to place, a significant strain on our management, operational and financial resources. If we are unable to manage our growth effectively or if we are unable to successfully integrate any assets, technologies or businesses that we may acquire, our business could be affected adversely.

 

Risks Relating to Our Industry

 

If we are unable to compete in the highly competitive performance-based advertising and search marketing industries, we may experience reduced demand for our products and services.

 

We operate in a highly competitive environment. We principally compete with other companies in five main areas:

 

  sales to merchant advertisers of performance-based advertising;

 

  sales to merchant advertisers of paid inclusion services;

 

  aggregation or optimization of advertising inventory for distribution through search engines, product shopping engines, directories, Web sites or other outlets;

 

  delivery of products and services to end users or customers of merchants at destination Web sites or other distribution outlets; and

 

  services that allow merchants to manage their advertising campaigns across multiple networks and track the success of these campaigns.

 

Although we currently pursue a strategy that allows us to potentially partner with all relevant companies in the industry, there are certain companies in the industry that may not wish to partner with us. Despite the fact that we currently work with several of our potential competitors, there are no guarantees that these companies will continue to work with us in the future.

 

We currently or potentially compete with a variety of companies, including Decide Interactive, DoubleClick, FindWhat, Google, LookSmart, Microsoft, ValueClick and Yahoo!. We currently have some form of relationship with a majority of these companies. Going forward, however, these relationships could be terminated by either party. Furthermore, our competitors may be able to secure agreements with more favorable terms, which could

 

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reduce the usage of our services, increase the amount payable to our distribution partners and reduce our total revenue. Increased competition is likely to result in a loss of market share.

 

We expect competition to intensify in the future because current and new competitors can enter our market with little difficulty. The barriers to entering our market are relatively low. In fact, many current Internet and media companies presently have the technical capabilities and advertiser bases to enter the search marketing services industry. Further, if the consolidation trend continues among the larger media and search engine companies with greater brand recognition, the share of the market remaining for us and other smaller search marketing services providers could decrease, even through the number of smaller providers could continue to increase. These factors could adversely affect our competitive position in the search marketing services industry.

 

Some of our competitors, as well as potential entrants into our market, may be better positioned to succeed in this market. They may have:

 

  longer operating histories;

 

  more management experience;

 

  an employee base with more extensive experience;

 

  a better ability to service customers in multiple cities in the United States and internationally by virtue of the location of sales offices;

 

  larger customer bases;

 

  greater brand recognition; and

 

  significantly greater financial, marketing and other resources.

 

In addition, many current and potential competitors can devote substantially greater resources than we can to promotion, Web site development and systems development. Furthermore, currently and in the future to the extent the use of the Internet and other online services increases, there will likely be larger, more well-established and well-financed entities that acquire companies and/or invest in or form joint ventures in categories or countries of interest to us, all of which could adversely impact our business. Any of these trends could increase competition and reduce the demand for any of our services.

 

If we are not able to respond to the rapid technological change characteristic of our industry, our products and services may not be competitive.

 

The market for our products and services is characterized by rapid change in business models and technological infrastructure, and we will need to constantly adapt to changing markets and technologies to provide competitive products and services. We believe that our future success will depend, in part, upon our ability to develop our products and services for both our target market and for applications in new markets. We may not, however, be able to successfully do so, and our competitors may develop innovations that render our products and services obsolete or uncompetitive.

 

Our technical systems are vulnerable to interruption and damage that may be costly and time-consuming to resolve and may harm our business and reputation.

 

A disaster could interrupt our services for an indeterminate length of time and severely damage our business, prospects, financial condition and results of operations. Our systems and operations are vulnerable to damage or interruption from:

 

  fire;

 

  floods;

 

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  network failure;

 

  hardware failure;

 

  software failure;

 

  power loss;

 

  telecommunications failures;

 

  break-ins;

 

  terrorism, war or sabotage;

 

  computer viruses;

 

  denial of service attacks;

 

  penetration of our network by unauthorized computer users and “hackers” and other similar events;

 

  natural disaster; and

 

  other unanticipated problems.

 

We may not have developed or implemented adequate protections or safeguards to overcome any of these events. We also may not have anticipated or addressed many of the potential events that could threaten or undermine our technology network. Any of these occurrences could cause material interruptions or delays in our business, result in the loss of data or render us unable to provide services to our customers. In addition, if a person is able to circumvent our security measures, he or she could destroy or misappropriate valuable information or disrupt our operations. We have deployed firewall hardware intended to thwart hacker attacks. Although we maintain property insurance and business interruption insurance, our insurance may not be adequate to compensate us for all losses that may occur as a result of a catastrophic system failure or other loss, and our insurers may not be able or may decline to do so for a variety of reasons.

 

If we fail to address these issues in a timely manner, we may lose the confidence of our merchant advertisers and distribution partners, our revenue may decline and our business could suffer. In addition, as we expand our service offerings and enter into new business areas, we may be required to significantly modify and expand our software and technology platform. If we fail to accomplish these tasks in a timely manner, our business and reputation will likely suffer.

 

We rely on third party technology, server and hardware providers, and a failure of service by these providers could adversely affect our business and reputation.

 

We rely upon third party colocation providers to host our main servers. In the event that these providers experience any interruption in operations or cease operations for any reason or if we are unable to agree on satisfactory terms for continued hosting relationships, we would be forced to enter into a relationship with other service providers or assume hosting responsibilities ourselves. If we are forced to switch hosting facilities, we may not be successful in finding an alternative service provider on acceptable terms or in hosting the computer servers ourselves. We may also be limited in our remedies against these providers in the event of a failure of service. In the past, we have experienced short term outages in the service maintained by one of our current colocation providers. We also rely on third party providers for components of our technology platform, such as hardware and software providers, credit card processors and domain name registrars. A failure or limitation of service or available capacity by any of these third party providers could adversely affect our business and reputation.

 

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We may not be able to protect our intellectual property rights, which could result in our competitors marketing competing products and services utilizing our intellectual property and could adversely affect our competitive position.

 

Our success and ability to compete effectively are substantially dependent upon our internally developed and acquired technology and data resources, which we protect through a combination of copyright, trade secret, patent and trademark law. To date, we have filed two provisional patent applications with the United States Patent and Trademark Office and may in the future file additional patents with respect to internally developed or acquired technologies. Our industry is highly competitive and many individuals and companies have sought to patent processes in the industry. In addition, the patent process takes several years and involves considerable expense. Further, patent applications and patent positions in our industry are highly uncertain and involve complex legal and factual questions due in part to the number of competing technologies. As a result, we may not be able to successfully prosecute these patents, in whole or in part, or any additional patent filings that we may make in the future. We also depend on our trade name and domain names. We may not be able to adequately protect our technology and data resources. In addition, intellectual property laws vary from country to country, and it may be more difficult to protect our intellectual property in some foreign jurisdictions we may enter. If we fail to obtain and maintain patent or other intellectual property protection for our technology, our competitors could market competing products and services utilizing our technology which could have a material adverse effect on our competitive position.

 

Despite our efforts to protect our proprietary rights, unauthorized parties domestically and internationally may attempt to copy or otherwise obtain and use our services, technology and other intellectual property. We cannot be certain that the steps we have taken will prevent any misappropriation or confusion among consumers and merchant advertisers.

 

We may be involved in lawsuits to protect or enforce our patents, which could be expensive and time consuming.

 

We may initiate patent litigation against third parties to protect or enforce our patent rights, and we may be similarly sued by others. We may also become subject to interference proceedings conducted in the patent and trademark offices of various countries to determine the priority of inventions. The defense and prosecution, if necessary, of intellectual property suits, interference proceedings and related legal and administrative proceedings is costly and may divert our technical and management personnel from their normal responsibilities. We may not prevail in any of these suits. An adverse determination of any litigation or defense proceedings could put our patents at risk of being invalidated or interpreted narrowly and could put our patent applications at risk of not being issued.

 

Furthermore, because of the substantial amount of discovery required in connection with intellectual property litigation, there is a risk that some of our confidential information could be compromised by disclosure during this type of litigation. In addition, during the course of this kind of litigation, there could be public announcements of the results of hearings, motions or other interim proceedings or developments in the litigation. If securities analysts or investors perceive these results to be negative, it could have an adverse effect on the trading price of our Class B common stock.

 

Our quarterly results of operations might fluctuate due to seasonality, which could adversely affect our growth rate and in turn the market price of our Class B common stock.

 

Our quarterly results have fluctuated in the past and may fluctuate in the future due to seasonal fluctuations in the level of Internet usage. As is typical in our industry, the second and third quarters of the calendar year generally experience relatively lower usage than the first and fourth quarters. It is generally understood that during the spring and summer months of the year, Internet usage is lower than during other times of the year, especially in comparison to the fourth quarter of the calendar year. The extent to which usage may decrease during these off-peak periods is difficult to predict. Prolonged or severe decreases in usage during these periods may adversely affect our growth rate and in turn the market price of our Class B common stock.

 

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We are susceptible to general economic conditions, and a downturn in advertising and marketing spending by merchants could adversely affect our operating results.

 

Our operating results will be subject to fluctuations based on general economic conditions, in particular those conditions that impact merchant-consumer transactions. If there were to be a general economic downturn that affected consumer activity in particular, however slight, then we would expect that business entities, including our merchant advertisers and potential merchant advertisers, could substantially and immediately reduce their advertising and marketing budgets. We believe that during periods of lower consumer activity, merchant spending on advertising and marketing is more likely to be reduced, and more quickly, than many other types of business expenses. These factors could cause a material adverse effect on our operating results.

 

We depend on the growth of the Internet and Internet infrastructure for our future growth and any decrease or less than anticipated growth in Internet usage could adversely affect our business prospects.

 

Our future revenue and profits, if any, depend upon the continued widespread use of the Internet as an effective commercial and business medium. Factors which could reduce the widespread use of the Internet include:

 

  possible disruptions or other damage to the Internet or telecommunications infrastructure;

 

  failure of the individual networking infrastructures of our merchant advertisers and distribution partners to alleviate potential overloading and delayed response times;

 

  a decision by merchant advertisers to spend more of their marketing dollars in offline areas;

 

  increased governmental regulation and taxation; and

 

  actual or perceived lack of security or privacy protection.

 

In particular, concerns over the security of transactions conducted on the Internet and the privacy of users may inhibit the growth of the Internet and other online services, especially online commerce. In order for the online commerce market to develop successfully, we and other market participants must be able to transmit confidential information, including credit card information, securely over public networks. Any decrease or less than anticipated growth in Internet usage could have a material adverse effect on our business prospects.

 

We are exposed to risks associated with credit card fraud and credit payment, and we may continue to suffer losses as a result of fraudulent data or payment failure by merchant advertisers.

 

We have suffered losses and may continue to suffer losses as a result of payments made with fraudulent credit card data. Our failure to control fraudulent credit card transactions adequately could reduce any gross profit margin. In addition, under limited circumstances, we extend credit to merchant advertisers who may default on their accounts payable to us.

 

Government regulation of the Internet may adversely affect our business and operating results.

 

Companies engaging in online search, commerce and related businesses face uncertainty related to future government regulation of the Internet. Due to the rapid growth and widespread use of the Internet, legislatures at the federal and state levels are enacting and considering various laws and regulations relating to the Internet. Furthermore, the application of existing laws and regulations to Internet companies remains somewhat unclear. Our business and operating results may be negatively affected by new laws, and such existing or new regulations may expose us to substantial compliance costs and liabilities and may impede the growth in use of the Internet.

 

The application of these statutes and others to the Internet search industry is not entirely settled. Further, several existing and proposed federal laws could have an impact on our business:

 

  The Digital Millennium Copyright Act and its related safe harbors, are intended to reduce the liability of online service providers for listing or linking to third-party Web sites that include materials that infringe copyrights or other rights of others.

 

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  The Children’s Online Protection Act and the Children’s Online Privacy Protection Act are intended to restrict the distribution of certain materials deemed harmful to children, and they impose additional restrictions on the ability of online services to collect user information from minors.

 

  The Protection of Children from Sexual Predators Act of 1998 requires online service providers to report evidence of violations of federal child pornography laws under certain circumstances.

 

  The CAN-SPAM Act of 2003 and certain state laws are intended to regulate interstate commerce by imposing limitations and penalties on the transmission of unsolicited commercial electronic mail via the Internet.

 

With respect to the subject matter of each of these laws, courts may apply these laws in unintended and unexpected ways. As a company that provides services over the Internet, we may be subject to an action brought under any of these or future laws governing online services. Many of the services of the Internet are automated and companies, such as ours, may be unknowing conduits for illegal or prohibited materials. It is not known how courts will rule in many circumstances; for example, it is possible that some courts could find strict liability or impose “know your customer” standards of conduct in certain circumstances.

 

We may also be subject to costs and liabilities with respect to privacy issues. Several Internet companies have incurred costs and paid penalties for violating their privacy policies. Further, it is anticipated that new legislation will be adopted by federal and state governments with respect to user privacy. Additionally, foreign governments may pass laws which could negatively impact our business and/or may prosecute us for our products and services based upon existing laws. The restrictions imposed by, and costs of complying with, current and possible future laws and regulations related to our business could harm our business and operating results.

 

Future regulation of search engines may adversely affect the commercial utility of our search marketing services.

 

The Federal Trade Commission, or FTC, has recently reviewed the way in which search engines disclose paid placements or paid inclusion practices to Internet users. In 2002, the FTC issued guidance recommending that all search engine companies ensure that all paid search results are clearly distinguished from non-paid results, that the use of paid inclusion is clearly and conspicuously explained and disclosed and that other disclosures are made to avoid misleading users about the possible effects of paid placement or paid inclusion listings on search results. Such disclosures if ultimately mandated by the FTC or voluntarily made by us may reduce the desirability of our paid placement and paid inclusion services. We believe that some users may conclude that paid search results are not subject to the same relevancy requirements as non-paid search results, and will view paid search results less favorably. If such FTC disclosure reduces the desirability of our paid placement and paid inclusion services, and “click-throughs” of our paid search results decrease, the commercial utility of our search marketing services could be adversely affected.

 

State and local governments may in the future be permitted to levy additional taxes on Internet access and electronic commerce transactions, which could result in a decrease in the level of usage of our services.

 

In 1998, the federal government imposed a three-year moratorium on state and local governments’ imposition of new taxes on Internet access or electronic commerce transactions. This moratorium was extended until November 1, 2003, and has now expired. It is expected that Congress will enter into a several month extension of the moratorium, but such an extension may not be enacted. Unless the moratorium is extended, state and local governments may levy additional taxes on Internet access and electronic commerce transactions. An increase in applicable taxes may make electronic commerce transactions less attractive for merchants and businesses, which could result in a decrease in the level of usage of our services.

 

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We may incur liabilities for the activities of users of our service, which could adversely affect our service offerings.

 

The law relating to the liability of providers of online services for activities of their users and for the content of their merchant advertiser listings is currently unsettled and could damage our business, financial condition and operating results. Our insurance policies may not provide coverage for liability arising out of activities of our users or merchant advertisers for the content of our listings. Furthermore, we may not be able to obtain or maintain adequate insurance coverage to reduce or limit the liabilities associated with our businesses. We may not successfully avoid civil or criminal liability for unlawful activities carried out by consumers of our services or for the content of our listings. Our potential liability for unlawful activities of users of our services or for the content of our listings could require us to implement measures to reduce our exposure to such liability, which may require us, among other things, to spend substantial resources or to discontinue certain service offerings.

 

Risks Relating To This Offering

 

The market price of our Class B common stock is likely to be highly volatile, which could adversely impact the market price of our Class B common stock and cause investment losses for our stockholders and could result in shareholder litigation with substantial costs, economic loss and diversion of our resources.

 

The trading price of our Class B common stock is likely to be highly volatile and could be subject to wide fluctuations in price in response to various factors, many of which are beyond our control, including:

 

  developments concerning proprietary rights, including patents, by us or a competitor;

 

  announcements by us or our competitors of significant contracts, acquisitions, commercial relationships, joint ventures or capital commitments;

 

  actual or anticipated fluctuations in our operating results;

 

  developments concerning our various strategic collaborations;

 

  lawsuits initiated against us or lawsuits initiated by us;

 

  changes in the market valuations of similar companies; and

 

  changes in our industry and the overall economic environment.

 

In addition, the stock market in general, and the NASDAQ National Market and the market for online commerce companies in particular, have experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of the listed companies. These broad market and industry factors may seriously harm the market price of our Class B common stock, regardless of our operating performance. In the past, following periods of volatility in the market, securities class action litigation has often been instituted against these companies. Litigation against us, whether or not a judgment is entered against us, could result in substantial costs and potentially economic loss, and a diversion of our management’s attention and resources.

 

There may not be an active, liquid trading market for our Class B common stock, and the initial public offering price may not be indicative of prices that will prevail in the market.

 

Prior to this offering, there has been no public market for our Class B common stock. An active trading market for our Class B common stock may not develop or be sustained following this offering. The initial public offering price will be determined by negotiations between us and representatives of the underwriters based upon a number of factors. The initial public offering price may not be indicative of prices that will prevail in the trading market.

 

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Our founding officers will control the outcome of stockholder voting, and there may be an adverse effect on the price of our Class B common stock due to the disparate voting rights of our Class A common stock and our Class B common stock.

 

Upon the completion of this offering, our founding officers will beneficially own all of our outstanding shares of Class A common stock, representing 96% of the voting power of all issued and outstanding shares of our capital stock. With respect to their entire holdings, the founding officers will hold 97% of the combined voting power of all of our outstanding capital stock. The holders of our Class A common stock and Class B common stock have identical rights except that the holders of our Class B common stock are entitled to one vote per share, while holders of our Class A common stock are entitled to twenty-five votes per share on all matters to be voted on by stockholders. This concentration of control could be disadvantageous to our other stockholders with interests different from those of our founding officers. This difference in the voting rights of our Class A common stock and Class B common stock could adversely affect the price of our Class B common stock to the extent that investors or any potential future purchaser of our shares of Class B common stock give greater value to the superior voting rights of our Class A common stock.

 

Further, as long as our founding officers have a controlling interest, they will continue to be able to elect our entire board of directors and generally be able to determine the outcome of all corporate actions requiring stockholder approval. As a result, our founding officers will be in a position to continue to control all fundamental matters affecting the Company, including any merger involving, sale of substantially all of the assets of, or change in control of, the Company.

 

Our founding officers’ ability to control the Company may result in our Class B common stock trading at a price lower than the price at which it would trade if our founding officers did not have a controlling interest in us. This control may deter or prevent a third party from acquiring us which could adversely affect the market price of our Class B common stock.

 

Anti-takeover provisions may limit the ability of another party to acquire us, which could cause our stock price to decline.

 

Our certificate of incorporation, as amended, our by-laws and Delaware law contain provisions that could discourage, delay or prevent a third party from acquiring us, even if doing so may be beneficial to our stockholders. In addition, these provisions could limit the price investors would be willing to pay in the future for shares of our Class B common stock. The following are examples of such provisions in our certificate of incorporation, as amended or our by-laws:

 

  the authorized number of our directors can be changed only by a resolution of our board of directors;

 

  advance notice is required for proposals that can be acted upon at stockholder meetings;

 

  there are limitations on who may call stockholder meetings; and

 

  our board of directors is authorized, without prior stockholder approval, to create and issue “blank check” preferred stock.

 

We are also subject to Section 203 of the Delaware General Corporation Law, which provides, subject to enumerated exceptions, that if a person acquires 15% or more of our voting stock, the person is an “interested stockholder” and may not engage in “business combinations” with us for a period of three years from the time the person acquired 15% or more of our voting stock.

 

We anticipate that we will retain our future earnings, and as a result you are not likely to receive dividends as a holder of Class B common stock.

 

We anticipate that we will retain all of our future earnings, if any, for use in the operation and expansion of our business. Therefore, you are not likely to receive dividends in the foreseeable future. In addition, dividends, if and when paid, may be subject to income tax withholding.

 

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You will incur immediate and substantial dilution in the book value of the common stock you purchase, which could adversely affect the market price of our Class B common stock.

 

The initial public offering price is substantially higher than the price paid for our common stock in the past. This is referred to as dilution. The offering, therefore, will result in an immediate increase in net tangible book value of $0.97 per share to existing stockholders and an immediate dilution in net tangible book value of $5.58 per share to new investors purchasing shares of our common stock in this offering (based on the middle of the filing range as of the date of this prospectus). The exercise of outstanding options or warrants may result in further dilution. See “Dilution.”

 

Senior management will have broad discretion over the use of proceeds from this offering, which may be used for purposes that are not successful in increasing our operating results or market value.

 

The “Use of Proceeds” section reflects our current best estimate of the allocation of the net proceeds of this offering. The amounts actually expended by us for each purpose may vary significantly depending on a number of factors, such as the amount of cash used or generated by our operations and management’s assessment of our specific needs. Our senior management team will have considerable discretion in the application of the net proceeds, and you will not have the opportunity, as part of your investment decision, to assess whether the proceeds are being used appropriately. The net proceeds may be used for purposes that do not increase our operating results or market value. Until the net proceeds are used, they may be placed in investments that either do not produce income or lose value. See “Use of Proceeds.”

 

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SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

 

This prospectus includes forward-looking statements. All statements other than statements of historical facts contained in this prospectus, including statements regarding our future financial position, business strategy and plans and objectives of management for future operations, are forward-looking statements. The words “believe,” “may,” “estimate,” “continue,” “anticipate,” “intend,” “expect” and similar expressions, as they relate to us, are intended to identify forward-looking statements. We have based these forward-looking statements largely on our current expectations and projections about future events and financial trends that we believe may affect our financial condition, results of operations, business strategy and financial needs. These forward-looking statements are subject to a number of risks, uncertainties and assumptions described in “Risk Factors” and elsewhere in this prospectus, including, among other things:

 

  the anticipated benefits and risks associated with our business strategy;

 

  our future operating results and the future value of our Class B common stock;

 

  the anticipated sizes or trends of the markets in which we compete and the anticipated competition and consolidation in those markets;

 

  our ability to attract and maintain merchant advertisers and distribution partners in a cost-efficient manner and on beneficial commercial terms;

 

  potential intellectual property litigation;

 

  potential government regulation;

 

  our future capital requirements and our ability to satisfy our capital needs;

 

  the anticipated use of the proceeds realized from this offering;

 

  the potential for additional issuances of our securities; and

 

  the possibility of future acquisitions of businesses and technologies.

 

Market data and forecasts used in this prospectus, including for example, estimates of the size and growth rates of the performance-based advertising and search marketing industries and the Internet advertising and transaction markets generally, have been obtained from independent industry sources. Forecasts and other forward-looking information obtained from these sources are subject to the same qualifications and the additional uncertainties accompanying any estimates of future market size.

 

These risks are not exhaustive. Other sections of this prospectus include additional factors which could adversely impact our business and financial performance. Moreover, we operate in a very competitive and rapidly changing environment. New risk factors emerge from time to time and it is not possible for our management to predict all risk factors, nor can we assess the impact of all factors on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements.

 

You should not rely upon forward-looking statements as predictions of future events. We cannot assure you that the events and circumstances reflected in the forward-looking statements will be achieved or occur and actual results could differ materially from those projected in the forward-looking statements.

 

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USE OF PROCEEDS

 

We estimate that the net proceeds from the sale of the shares of our Class B common stock in this offering will be approximately $23.3 million, assuming an initial public offering price of $6.50, which represents the middle of the filing range as of the date of this prospectus, and after deducting the estimated underwriting discounts and commissions of approximately $1.3 million and estimated offering expenses of approximately $1.4 million. If the underwriters exercise the over-allotment option in full, we estimate that the net proceeds will be approximately $27.0 million.

 

The principal purposes of this offering are to:

 

  increase our working capital, capitalization and financial flexibility; and

 

  establish a public market for the Class B common stock, which will facilitate future access to public equity and debt markets, provide additional means to acquire potential businesses and technologies, and enhance our ability to use the Class B common stock as a means of attracting and retaining employees.

 

We expect to use the net proceeds from this offering approximately as follows:

 

    

Approximate
Dollar Amount


   Approximate
Percentage
of Net
Proceeds


 

Product and business development

   $  1.0 million    4 %

Acquisitions and strategic relationships

   12.0 million    52  

Capital expenditures

   1.0 million    4  

Personnel (recruiting, hiring, training and other associated costs)

   1.0 million    4  

Facilities (rent, capital improvements, moving expenses and deposits)

   1.0 million    4  

Earn-out payment obligations (related to our acquisitions)

   3.5 million    15  

Working capital and other general corporate purposes

   3.8 million    17  
    
  

     $23.3 million    100 %
    
  

 

The foregoing represents our current best estimate of the allocation of the net proceeds of this offering, based on the expected use of funds necessary to finance our existing activities in accordance with our senior management’s current objectives and market conditions. The amounts actually expended by us for each purpose may vary significantly depending on a number of factors, such as the amount of cash used or generated by our operations, opportunities for the acquisition of assets, technologies or businesses, changes in competitive conditions and our senior management’s assessments of our specific operational and strategic needs. For example, if the amount of cash used or generated by our operations were to be adversely affected in any way, our senior management could reallocate amounts in its discretion to meet any shortfall in cash flow from operations. At the time of any such reallocation, our senior management may make determinations to allocate less or more of the net proceeds to the remaining categories based on our specific priorities and needs at that time. In addition, the amounts of the allocations, which are not fixed obligations, may be proportionately reduced in the event the actual net proceeds are less than the estimated amount above. Our senior management may spend the proceeds from this offering in ways the stockholders may not deem desirable. See “Risk Factors—Senior management will have broad discretion over the use of proceeds from this offering . . . .”

 

Although we have no current agreements or commitments with respect to any acquisition, we may, if the opportunity arises, use a greater portion of the net proceeds to acquire or invest in products, technologies or companies. Any such acquisition could result in a reallocation of the estimated amounts set forth in the table above (which reallocation could be substantial).

 

In addition, we may be required to make additional payments for earn-out obligations relating to our acquisitions of Enhance Interactive and TrafficLeader.

 

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Until we use the net proceeds of this offering for the above purposes, we intend to invest the funds in short-term, investment grade, interest-bearing securities. We cannot predict whether the proceeds will yield a favorable return.

 

DETERMINATION OF OFFERING PRICE

 

Prior to this offering, there has been no public market for the shares of our Class B common stock. The initial public offering price for the shares of our Class B common stock will be determined by negotiation between the representatives of the underwriters and us. Among the factors considered in determining the proposed filing range of our initial public offering price were our record of operations, our financial position and prospects, the experience of our management, our revenue and other operating information, and the market prices of securities and financial and operating information of companies engaged in businesses similar to ours.

 

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CAPITALIZATION

 

The following table sets forth our capitalization as of December 31, 2003 on:

 

  an actual basis;

 

  a pro forma basis to give effect to the conversion of all outstanding shares of Series A redeemable convertible preferred stock into 6,724,063 shares of Class B common stock; and

 

  a pro forma as adjusted basis to also give effect to the sale of 4,000,000 shares of Class B common stock in this offering at an assumed initial public offering price of $6.50 per share, which represents the middle of the filing range as of the date of this prospectus, less $2.7 million in estimated underwriting discounts and commissions and estimated offering expenses. Of these estimated offering expenses, $376,000 are included in other assets as deferred offering costs of which approximately $30,000 were paid and approximately $346,000 are reflected as current liabilities.

 

You should read this table in conjunction with our consolidated financial statements and related notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” included elsewhere in this prospectus.

 

     As of December 31, 2003

 
     Actual

    Pro Forma

    Pro Forma
as Adjusted


 

Cash and cash equivalents

   $ 6,019,119     6,019,119     29,348,996  
    


 

 

Series A redeemable preferred stock, $0.01 par value: 8,500,000 shares authorized; 6,724,063 shares issued and outstanding actual; 8,500,000 shares authorized, none issued and outstanding pro forma; and 1,000,000 shares authorized, none issued and outstanding pro forma as adjusted

   $ 21,440,402     —       —    
    


 

 

Stockholders’ equity:

                    

Common stock, $0.01 par value: 46,500,000 shares authorized;

                    

Class A: 12,500,000 shares authorized; 12,250,000 shares issued and 11,987,500 shares outstanding actual, pro forma and pro forma as adjusted

     122,500     122,500     122,500  

Class B: 34,000,000 shares authorized; 1,567,500 shares issued and outstanding actual, including 137,500 shares of restricted stock; 8,291,563 shares issued and outstanding pro forma; 12,291,563 shares issued and outstanding pro forma as adjusted

     15,675     82,916     122,916  

Treasury stock: 262,500 shares of Class A common stock actual, pro forma and pro forma as adjusted

     —       —       —    

Additional paid-in capital

     6,716,734     28,089,895     51,349,895  

Deferred stock-based compensation

     (1,532,340 )   (1,532,340 )   (1,532,340 )

Accumulated deficit

     (3,488,237 )   (3,488,237 )   (3,488,237 )
    


 

 

Total stockholders’ equity

     1,834,332     23,274,734     46,574,734  
    


 

 

Total capitalization

   $ 23,274,734     23,274,734     46,574,734  
    


 

 

 

The above discussion and table exclude:

 

  4,000,000 shares of Class B common stock reserved for issuance under our stock incentive plan as of December 31, 2003, as well as an additional 1,013,953 shares reserved for issuance under the “evergreen provision” of the plan as of January 1, 2004.

 

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  600,000 shares of Class B common stock issuable upon the exercise of the over-allotment option by the underwriters.

 

  120,000 shares of Class B common stock issuable upon the exercise of the representatives’ warrants.

 

As of December 31, 2003, 3,089,600 shares were subject to outstanding options under the stock incentive plan, of which 2,421,500 options are at a weighted average exercise price of $1.67 per share and 668,100 options will have an exercise price equal to the initial public offering price. As of December 31, 2003, 325,000 options were exercisable with a weighted average exercise price of $0.98 per share.

 

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DILUTION

 

Purchasers of our Class B common stock in this offering will experience immediate and substantial dilution in the pro forma net tangible book value of the common stock from the initial public offering price. In our calculations, we have assumed an initial public offering price of $6.50 per share of Class B common stock, which represents the middle of the filing range as of the date of this prospectus.

 

Pro forma net tangible book value per common share is determined by dividing pro forma net tangible book value (total tangible assets less total liabilities) by the pro forma number of shares of common stock outstanding as of December 31, 2003. These pro forma amounts also assume the conversion of all outstanding shares of Series A convertible preferred stock into 6,724,063 shares of Class B common stock.

 

As of December 31, 2003, our pro forma net tangible book value of our common stock was approximately $(1.1) million, or approximately $(0.05) per share of our common stock.

 

As of December 31, 2003, after giving effect to the sale of 4,000,000 shares of Class B common stock offered by this prospectus (after deduction of the underwriting discounts of $1.3 million and estimated offering expenses of $1.4 million), our adjusted net tangible book value would have been approximately $22.3 million, or $0.92 per share of common stock.

 

The offering, therefore, will result in an immediate increase in net tangible book value of $0.97 per share to existing stockholders and an immediate dilution in net tangible book value of $5.58 per share to new investors purchasing shares of our Class B common stock in this offering.

 

The following table illustrates the per share dilution to the new investors:

 

Public offering price per share

           $ 6.50
            

Pro forma net tangible book value per share as of December 31, 2003

   $ (0.05 )      

Increase in net tangible book value per share attributable to this offering

   $ 0.97        
    


     

As adjusted pro forma net tangible book value per share after offering

           $ 0.92
            

Dilution per share to new investors in this offering

           $ 5.58
            

 

The following table summarizes, on a pro forma basis as of December 31, 2003, after giving effect to this offering, the differences between existing holders of common stock and the new investors with respect to the number of shares of common stock purchased from us, the total cash consideration paid and the average price per share paid by existing holders and investors in this offering, in each case before deducting underwriting discounts and commissions and estimated offering expenses.

 

     Shares Purchased

   

Total Cash
Consideration


   

Average
Price Per
Share


     Number

   Percent

   

Amount


   Percent

   

Existing stockholders

   20,279,063    83.5 %   $ 20,304,701    43.9 %   $ 1.00

New investors

   4,000,000    16.5       26,000,000    56.1     6.50
    
  

 

  

 

Total

   24,279,063    100.0 %   $ 46,304,701    100.0 %   $ 1.91
    
  

 

  

 

 

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The above discussion and table are based on pro forma shares outstanding as of December 31, 2003 and exclude:

 

  4,000,000 shares of Class B common stock reserved for issuance under our stock incentive plan as of December 31, 2003, as well as an additional 1,013,953 shares reserved for issuance under the “evergreen provision” of the plan as of January 1, 2004, and an additional 300,000 shares of Class B common stock reserved for issuance under our employee stock purchase plan as of February 16, 2004;

 

  600,000 shares of Class B common stock issuable upon the exercise of the over-allotment option by the underwriters; and

 

  120,000 shares of Class B common stock issuable upon the exercise of the representatives’ warrants.

 

The total cash consideration in the table above excludes the value ascribed to the issuance of 425,000 shares of Class B common stock issued in connection with the acquisition of TrafficLeader valued at $6.75 per share, subject to a redemption right, and the issuance of 137,500 shares of restricted Class B common stock to employees valued at $6.75 per share. The 137,500 shares of restricted Class B common stock vest over a period of three years.

 

To the extent that any of these shares of Class B common stock are issued, your investment may be further diluted. As of December 31, 2003, 3,089,600 shares were subject to outstanding options under the stock incentive plan of which 2,421,500 options are at a weighted average exercise price of $1.67 per share and 668,100 options will have an exercise price equal to the initial public offering price. As of December 31, 2003, 325,000 options were exercisable at a weighted average exercise price of $0.98 per share. We may also grant more options or warrants in the future.

 

DIVIDEND POLICY

 

We have never declared or paid any cash dividends on shares of our Class B common stock. We currently intend to retain our earnings for future growth and do not anticipate paying any cash dividends in the foreseeable future. Any future determination to pay dividends will be at the discretion of our board of directors and will depend on a number of factors, such as our results of operations, capital requirements, financial conditions, future prospects and other factors that the board of directors deems relevant.

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

You should read the following discussion and analysis of our financial condition and results of operations together with our financial statements and related notes appearing elsewhere in this prospectus. This discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of many factors, including, but not limited to, those set forth under “Risk Factors” and elsewhere in this prospectus.

 

Overview

 

We are an early stage company focused on providing technology-based services to merchants engaged in online transactions. Our current operating businesses are in the performance-based advertising and search marketing industries, primarily focused on helping merchants market and sell their products and services via the Internet.

 

We currently provide our merchant advertisers with the following technology-based services through our wholly-owned operating subsidiaries Enhance Interactive and TrafficLeader:

 

  Performance-Based Advertising primarily includes pay-per-click and paid inclusion services.

 

  Pay-Per-Click Services. With pay-per-click services, merchant advertisers purchase keywords based on an amount they choose for a targeted placement, usually within search engine results.

 

  Paid Inclusion Services. With paid inclusion services, merchant advertisers pay for their Web pages and product databases to be crawled, or searched, and indexed and included primarily within search engine and shopping engine results.

 

  Search Marketing is designed for merchant advertisers who are focused on advertising campaign management, conversion tracking and analysis, and search engine optimization.

 

Enhance Interactive provides performance-based advertising services to merchant advertisers, including pay-per-click listings. Through Enhance Interactive, merchant advertisers market their products and services to millions of consumers and businesses through targeted pay-per-click listings that are primarily found in search engine or directory results when users search for information, products or services.

 

TrafficLeader provides performance-based advertising and search marketing services to merchant advertisers, including paid inclusion, advertising campaign management, conversion tracking and analysis, and search engine optimization. Through TrafficLeader’s primary service, paid inclusion, TrafficLeader manages advertising campaigns and services for merchant advertisers that have hundreds or even thousands of products or content pages. TrafficLeader’s paid inclusion service helps merchant advertisers reach prospective advertisers by placing their products or information, as well as associated detail and pricing, into many of the Internet’s most-visited search engines, product shopping engines, and directories.

 

We were incorporated in Delaware on January 17, 2003. On February 28, 2003, we acquired eFamily, together with its direct wholly-owned subsidiary Enhance Interactive. eFamily was incorporated in Utah on November 29, 1999, under the name FocusFilter.com, Inc. On October 24, 2003, we acquired TrafficLeader, which was incorporated in Oregon on January 24, 2000, under the name Sitewise Marketing, Inc.

 

From January 17, 2003 (inception) through February 28, 2003, we were involved in business and product development, as well as financing and acquisition initiatives. During this period we had no revenues.

 

We currently have offices in Seattle, Washington; Provo, Utah; and Eugene, Oregon.

 

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Acquisitions

 

Enhance Interactive.    In February 2003, we acquired eFamily together with its wholly-owned subsidiary Enhance Interactive, a Provo, Utah-based company, for the following consideration:

 

  $13.3 million in net cash and acquisition costs; plus

 

  additional consideration in the form of a contingent earnings-based cash payment of up to $13.5 million payable over two years.

 

The additional consideration consists of two components: (i) a contingent earnings-based payment to the original stockholders (“earn-out consideration”) and (ii) a contingent earnings-based payment to certain employees (“retention consideration”). These amounts are payable by us with respect to the years 2003 and 2004. We shall have no obligation with respect to a calendar year in the event that Enhance Interactive’s earnings before taxes, excluding stock-based compensation and amortization of intangibles relating to the acquisition (“earnings before taxes”) do not exceed $3.5 million for that calendar year. The threshold determination is calculated separately for each of the calendar years 2003 and 2004. For the 2003 calendar year, the total Enhance Interactive earnings-based payment obligation was approximately $3.5 million.

 

The contingent payment of earn-out consideration, payable to the original stockholders of Enhance Interactive, is calculated based on the formula of 69.44% of earnings before taxes for each of the calendar years 2003 and 2004, up to a maximum payout cap of $12.5 million in aggregate. This payment obligation for each calendar year is conditioned on Enhance Interactive meeting the earnings threshold described above. To the extent we make any payments under this obligation, we have and will account for such amounts as additional goodwill. For the 2003 calendar year, the earn-out consideration was approximately $3.2 million.

 

The contingent payment of retention consideration, payable to certain employees of Enhance Interactive, is calculated based on the formula of 5.56% of Enhance Interactive’s earnings before taxes for each of the calendar years 2003 and 2004, up to a maximum payout cap of $1 million in aggregate. This payment obligation for each calendar year is also conditioned on Enhance Interactive meeting the earnings threshold described above. To the extent we make any payments under this obligation, we have and will account for such amounts as compensation. For the 2003 calendar year, the retention consideration was approximately $283,000.

 

In connection with this acquisition, we also issued nonqualified stock options to certain employees of Enhance Interactive, subject to their continued employment, to purchase up to an aggregate of 1,250,000 shares of our Class B common stock with an exercise price per share of $0.75.

 

The Enhance Interactive operations were consolidated in our results from the acquisition date of February 28, 2003 and have had a substantial impact on our results.

 

TrafficLeader.    In October 2003, we acquired TrafficLeader, a Eugene, Oregon-based company, for the following consideration:

 

  $3.2 million in net cash and acquisition costs; plus

 

  425,000 shares of Class B common stock with a redemption right that requires us to buy back the 425,000 shares for $8 per share, but only at the election of the holders of 75% of such shares in the event we have not completed a firm commitment initial public offering with gross proceeds of at least $20 million prior to October 24, 2005; plus

 

  137,500 shares of restricted Class B common stock which will vest over a three-year period in installments of 16.67% after each six month period during that term; plus

 

  additional consideration in the form of a contingent revenue-based cash incentive payment of up to $1 million.

 

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With respect to the second and third components of the acquisition consideration, the fair value of the shares and the redemption right were recorded at $3.9 million.

 

Of the 137,500 restricted shares, 108,432 were issued to employees of TrafficLeader and valued at $732,000, which amount will be recorded as compensation expense over the associated employment period during which these shares vest.

 

The contingent, revenue-based payment is conditioned on TrafficLeader having revenue in excess of $15 million for calendar 2004. To the extent we make any payment under this obligation, we will account for such amount as additional goodwill. In the event that TrafficLeader meets the minimum revenue threshold, we will be obligated to pay an amount equal to 10% of each dollar in revenue above the $15 million revenue threshold, up to a maximum payout of $1 million.

 

In the event on or prior to December 31, 2004, there is a change of control of TrafficLeader or of us, or both TrafficLeader’s CEO and CTO either resign for good reason or are terminated without cause, or we take any action prior to the end of December 31, 2004, which makes it impractical to calculate or reconstruct the earn-out obligation, we will be obligated to pay the full amount of the $1 million contingent payment obligation.

 

Consolidated Statements of Operations

 

Our consolidated statements of operations, stockholders’ equity, and cash flows have been presented for the period of January 17, 2003 (inception) through December 31, 2003. Business planning and other activities related to our business began in late 2002. We were organized and incorporated in Delaware in January 2003. Included in the results of operations subsequent to our incorporation in January 2003 are reimbursements to certain founding officers for approximately $86,000 in general and administrative pre-incorporation costs. Included in property and equipment are purchases from certain of our founding officers of approximately $62,000 for the carrying value of the assets.

 

The assets, liabilities and operations of Enhance Interactive and TrafficLeader are included in our consolidated financial statements since the date of their respective acquisitions in February and October 2003. All significant inter-company transactions and balances have been eliminated in consolidation. Our purchase accounting resulted in all assets and liabilities from our acquisitions of Enhance Interactive and TrafficLeader being recorded at their estimated fair values. For the period of February 28 through December 31, 2003 and October 24, 2003 through December 31, 2003, all goodwill, intangible assets and liabilities resulting from the respective Enhance Interactive and TrafficLeader acquisitions have been recorded in our financial statements. Accordingly, our consolidated financial results for periods subsequent to the acquisitions of Enhance Interactive and TrafficLeader are not comparable to the financial statements of Enhance Interactive and TrafficLeader presented for prior periods. The consolidated statements of operations, stockholders’ equity, and cash flows reflecting Enhance Interactive’s historical results have been presented for the year ended December 31, 2002 and the period from January 1, 2003 through February 28, 2003.

 

eFamily and its wholly-owned subsidiary Enhance Interactive are described as Enhance Interactive in the accompanying Management’s Discussion and Analysis of Financial Condition and Results of Operations. In the accompanying consolidated financial statements, the statements of operations, stockholders’ equity, and cash flows reflecting Enhance Interactive results have been presented as the “Predecessor” for the year ended December 31, 2002 and the period of January 1, 2003 to February 28, 2003.

 

Presentation of Financial Reporting Periods

 

For purposes of our discussion, we have included the results of operations of the Predecessor, Enhance Interactive. The results of operations of TrafficLeader have been included as of the acquisition date of October 24, 2003. The comparative periods presented are the results of Enhance Interactive for the year ended

 

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December 31, 2002 (2002 period), compared to the combined results for the period of January 17, 2003 (inception) to December 31, 2003 and the results of Enhance Interactive for the period of January 1, 2003 to February 28, 2003 (2003 period). In the 2003 period, we have included the overlapping operating activities of Enhance Interactive and our operating activities for the period of January 17, 2003 (inception) through February 28, 2003. From January 17, 2003 (inception) through February 28, 2003, we were involved in business and product development, as well as financing and acquisition initiatives. During this period we had no revenues. Accordingly, our activities were different from the operating activities of Enhance Interactive.

 

Revenue

 

We currently generate revenue through our operating businesses. The primary sources of revenue, amounting to greater than 91% in all periods presented, are the performance-based advertising services, which include pay-per-click listings and paid inclusion. The secondary sources of revenue, amounting to less than 9% in all periods presented, are the search marketing services, which include advertising campaign management, conversion tracking and analysis and search engine optimization. We recognize revenue upon the completion of our performance obligation, provided that: (i) evidence of an arrangement exists, (ii) the arrangement fee is fixed and determinable, and (iii) collection is reasonably assured. We have no barter transactions.

 

In providing pay-per-click advertising services primarily through Enhance Interactive, we generate revenue upon our delivery of qualified click-throughs to our merchant advertisers. These merchant advertisers pay us a designated transaction fee for each click-through, which occurs when an online user clicks on any of their advertisement listings after it has been placed by us or by our distribution partners. Each click-through on an advertisement listing represents a completed transaction. The advertisement listings are displayed within our distribution network, which includes search engines, directories, destination sites and other targeted Web-based content. We provide priority of placement within our displayed advertisement listings based on the merchant advertiser’s price commitment for each click-through.

 

In our paid inclusion services delivered primarily through TrafficLeader, merchant advertisers pay for their Web pages and product databases to be crawled, or searched, and included in search engine and product shopping engine results within our distribution network. Generally, the paid inclusion results are presented separately on a Web page from the pay-per-click listings. For this service, revenue is generated when an online user clicks on a paid inclusion listing from search engine or product shopping engine results. Each click-through on an advertisement listing represents a completed transaction for which the merchant advertiser pays for on a per-click basis. The placement of a paid inclusion result within search engine results is largely determined by its relevancy, as determined by the search engine partner.

 

Merchant advertisers also pay us for our search marketing services, which are primarily delivered by TrafficLeader. Merchant advertisers pay us additional fees for such services as advertising campaign management, conversion tracking and analysis, and search engine optimization. Merchant advertisers generally pay us on a click-through basis, although in certain cases we receive a fixed fee for delivery of these services. In some cases we also deliver banner campaigns for select merchant advertisers, primarily through Enhance Interactive. We may also charge initial set-up or inclusion fees as part of our services. Total revenue from these services accounted for less than 9% of total revenue in all periods presented.

 

Banner advertising revenue (generated by Enhance Interactive) is primarily based on a fixed fee per click and is generated and recognized on click-through activity. In limited cases, banner payment terms are volume-based with revenue generated and recognized when impressions are delivered.

 

Non-refundable account set-up fees are paid by merchant advertisers and are recognized ratably over the longer of the term of the contract or the average expected merchant advertiser relationship period, which generally ranges from twelve months to more than two years.

 

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Other inclusion fees are generally associated with monthly or annual subscription-based services where a merchant advertiser pays a fixed amount to be included in our index of listings or our distribution partners’ indexes of listings. These subscription arrangements are recognized ratably over the service period.

 

We enter into agreements with various distribution partners to provide distribution for the URL strings and advertisement listings of our merchant advertisers. We generally pay distribution partners based on a percentage of revenue or a fixed amount per click-through on these listings. The level of click-throughs contributed by our distribution partners has varied, and we expect it will continue to vary, from quarter to quarter and year to year, sometimes significantly. Our growth will be impacted by our ability to increase our distribution, which impacts the number of Internet users who have access to our merchant advertisers’ listings and the rate at which our merchant advertisers are able to convert clicks from these Internet users into completed transactions, such as a purchase or sign up. Our growth also depends on our ability to continue to increase the number of merchant advertisers who use our services and the amount these merchant advertisers spend on our services.

 

We anticipate that these variables will fluctuate in the future, affecting our growth rate and our financial results. In particular it is difficult to project the number of click-throughs we will deliver to our merchant advertisers and how much merchant advertisers will spend with us, and it is even more difficult to anticipate the average revenue per click-through.

 

In addition, we believe we will experience seasonality. Our quarterly results have fluctuated in the past and may fluctuate in the future due to seasonal fluctuations in levels of Internet usage. It is generally understood that during the spring and summer months, Internet usage is lower than during other times of the year, especially in comparison to the fourth quarter of the calendar year. The extent to which usage may decrease during these off-peak periods is difficult to predict. Prolonged or severe decreases in usage during these periods may adversely affect our growth rate and results.

 

Service Costs

 

Service costs include network operations and customer service costs that consist primarily of costs associated with serving our search results, maintaining our Web sites, credit card processing fees, network fees, fees paid to outside service providers, and customer service. Customer service and other costs associated with providing our performance-based advertising and search marketing services and maintaining our Web site include depreciation of Web site and network equipment, colocation service charges of our Web site equipment, bandwidth, and software license fees, salaries of related personnel, stock-based compensation and amortization of intangible assets.

 

Service costs also include user acquisition costs that relate primarily to payments to our distribution partners for access to their user traffic. We enter into agreements of varying durations with distribution partners that integrate our services into their sites and indexes. The primary economic structure of our distribution partner agreements is a variable payment based on a specified percentage of revenue. These variable payments are often subject to minimum payment amounts per click-through. Other economic structures that to a lesser degree exist include:

 

  fixed payments, based on a guaranteed minimum amount of usage delivered;

 

  variable payments based on a specified metric, such as number of paid click-throughs; and

 

  a combination arrangement with both fixed and variable amounts.

 

We expense user acquisition costs under two methods: agreements with fixed payments are generally expensed at the greater of pro-rata over the term the fixed payment covers; or usage delivered to date divided by the guaranteed minimum amount of usage delivered.

 

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Agreements with variable payment based on a percentage of revenue, number of paid click-throughs or other metrics are generally expensed based on the volume of the underlying activity or revenue multiplied by the agreed-upon price or rate.

 

Sales and Marketing

 

Sales and marketing expenses consist primarily of payroll and related expenses for personnel engaged in marketing and sales functions; advertising and promotional expenditures; and cost of systems used to sell to and serve merchant advertisers.

 

Product Development

 

Product development costs consist primarily of expenses incurred in the research and development, creation and enhancement of our Internet site and services. Research and development expenses include compensation and related expenses, costs of computer hardware and software, and costs incurred in developing features and functionality of the services we offer. For the periods presented, substantially all of the product development expenses are research and development.

 

Product development costs are expensed as incurred or capitalized into property and equipment in accordance with the American Institute of Certified Public Accountants’ Statement of Position 98-1, “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use.” This statement requires that costs incurred in the preliminary project and post-implementation stages of an internal use software project be expensed as incurred and that certain costs incurred in the application development stage of a project be capitalized.

 

General and Administrative

 

General and administrative expenses consist primarily of payroll and related expenses for executive and administrative personnel, bad debt provision, facilities, professional services (including legal and insurance), and other general corporate expenses.

 

Acquisition-Related Retention Consideration

 

Acquisition-related retention consideration results from our contingent, earnings-based payment obligation to certain employees of Enhance Interactive for each of the calendar years 2003 and 2004, pursuant to the terms of the merger agreement. See subsection “Acquisitions” above. We shall have no obligation with respect to a year in the event that Enhance Interactive’s earnings before taxes do not exceed $3.5 million for that calendar year. The threshold determination is calculated separately for each of calendar years 2003 and 2004.

 

The contingent payment obligation is calculated based on the formula of 5.56% of Enhance Interactive’s earnings before taxes for each of the calendar years 2003 and 2004, up to a maximum payout cap of $1 million in the aggregate. See subsection “Acquisitions” above. To the extent we make any payments under this obligation, we will account for such amounts as compensation. For the 2003 calendar year, the retention consideration was approximately $283,000.

 

Stock-Based Compensation

 

Stock-based compensation consists of the following components:

 

  the intrinsic value of employee option and restricted stock issuances in cases where the fair value of the underlying stock was greater than the exercise price on the date of the grant;

 

  the fair value of non-employee option issuances; and

 

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  the amount by which the fair value of our Class B common stock exceeds the exercise price at the end of the period for certain options. We use variable accounting for the options to purchase 125,000 shares of our Class B common stock that were issued under our stock incentive plan. These options were being held in escrow as security for the indemnification obligations under the Enhance Interactive merger agreement, and were subject to forfeiture. We accounted for them as variable awards until the expiration of the agreed-upon escrow period on February 28, 2004.

 

Amortization of Identifiable Intangibles

 

Amortization of identifiable intangible assets relates to intangible assets identified in connection with the purchase of Enhance Interactive and, TrafficLeader. Intangible assets identified in connection with the purchase of Enhance Interactive were valued at $8.4 million at the acquisition date of February 28, 2003. Intangible assets identified in connection with the purchase of TrafficLeader were valued at $1.3 million at the acquisition date of October 24, 2003. The intangible assets have been identified as non-competition agreements, trade and domain names, distributor relationships, and merchant advertising customer base relationships and acquired technology. These assets are amortized over useful lives ranging from 12 to 42 months.

 

Provision for Income Taxes

 

For income tax purposes, we utilize the asset and liability method of accounting for income taxes. Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in results of operations in the period that includes the enactment date. A valuation allowance is recorded for deferred tax assets when it is more likely than not that such deferred tax assets will not be realized.

 

As of December 31, 2003, we had net operating loss carryforwards of $1.8 million, which will begin to expire in 2019. The Tax Reform Act of 1986 limits the use of net operating loss (NOL) and tax credit carryforwards in certain situations where changes occur in the stock ownership of a company. We believe that such a change has occurred, and that the utilization of the approximately $1.8 million of carryforwards is limited such that substantially all of these NOL carryforwards will never be utilized.

 

Accretion to Redemption Value of Redeemable Convertible Preferred Stock

 

Holders of Series A redeemable convertible preferred stock are entitled to receive annual cumulative dividends at the per annum rate of 8% of the original purchase price per share when and if declared by the board of directors. Upon conversion of the Series A redeemable convertible preferred stock either by optional conversion or by mandatory conversion upon a firm commitment initial public offering with gross proceeds of at least $20 million, all accumulated and unpaid dividends on the Series A redeemable convertible preferred stock, whether or not declared, since the date of issue up to and including the conversion date, shall be forgiven.

 

No holders of common stock will receive any dividends or distributions until the holders of the Series A redeemable preferred stock receive a dividend or distribution equal to all accrued but unpaid dividends on such preferred stock plus the per-share amount declared for the common stock on an as-converted basis.

 

We account for the difference between the carrying amount of the redeemable preferred stock and the redemption amount by increasing the carrying amount for periodic accretion using the interest method, so that the carrying amount will equal the redemption amount at the earliest redemption date.

 

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Results of Operations

 

Comparison of the year ended December 31, 2002 (2002 period), to the combined periods of January 17 (inception) to December 31, 2003, and of January 1 to February 28, 2003 (2003 period).

 

Revenue.    Revenue increased 128%, from $10.1 million in the 2002 period to $23.0 million in the 2003 period. This increase was primarily attributable to an increase in performance-based advertising services from $9.3 million in the 2002 period to $21.7 million in the 2003 period. Of this $12.4 million increase, 34% related to an increase in the number of merchant advertisers, while 66% related to an increase in the average revenue per merchant advertiser.

 

We believe the increase in revenue is primarily a result of the growth of our existing distribution partners, the increased number of searches and the resulting click-throughs performed by users of our service, and the addition of new distribution partners and merchant advertisers. Our distribution partners increased from approximately 290 in December 2002 to approximately 410 in December 2003. We also believe the foregoing factors, combined with our sales efforts and improved operational controls, have contributed to an increase in the number of merchant advertisers. $1.2 million of the increase in revenue in the 2003 period is also attributable to the acquisition of TrafficLeader in October 2003, which added 11 unique distribution partners and more than 280 merchant advertisers. TrafficLeader’s operating results were included in the 2003 period as of the acquisition date of October 24, 2003.

 

Our growth rate will depend, in part, on our ability to increase the number of click-throughs performed by users of our service, primarily through our distribution partners. If we do not renew our distribution partner agreements or replace traffic lost from terminated distribution agreements with other sources or if our distribution partners’ search businesses do not grow or are adversely affected, our revenue and results of operations may be materially and adversely affected. Our growth rate will also depend in part on our ability to increase the number and volume of transactions with merchant advertisers. We believe this is dependent in part on delivering high quality traffic that ultimately results in purchases or conversions for our merchant advertisers.

 

Expenses

 

Service Costs.    Service costs increased 106% from $6.3 million in the 2002 period to $13 million in the 2003 period. The net increase in costs was mainly attributable to an increase in payments to distribution partners of $6.2 million, an increase in credit card processing fees of $333,000, an increase in personnel costs of $171,000, a decrease in technology licensing costs of $104,000, and an increase in facility and other costs of $91,000. This net increase related to a greater number of searches, an increase in database and hardware capacity requirements as a result of an increase in our distribution partner base and corresponding number of searches, an increase in the number of personnel required to support our services and increased fees paid to outside service providers. Service costs represented 63% of revenue in the 2002 period and 57% of revenue in the 2003 period. As a percentage of revenue, the decrease in service costs for the 2003 period compared to the 2002 period was primarily a result of network operation expenses containing fixed costs and also not increasing at a higher rate than revenue. The decrease in the 2003 period was partially offset by the impact of $943,000 in service costs and the impact as a percentage of revenue resulting from the acquisition of TrafficLeader in October 2003. Since TrafficLeader’s user acquisition costs are higher as a percentage of revenue than Enhance Interactive, to the extent that TrafficLeader’s operations make up a larger percentage of future operations, we expect that service costs will increase as a percentage of revenue. We also expect that service costs will continue to increase in absolute dollars, since we anticipate expanding our operations.

 

Sales and Marketing.     Sales and marketing expense increased 55% from $1.8 million in the 2002 period to $2.8 million in the 2003 period. As a percentage of revenue, sales and marketing expenses were 18% in the 2002 period and 12% in the 2003 period. The increase in dollars was primarily related to an increase in personnel costs of $614,000, primarily due to an increase in the number of employees including $72,000 resulting from the acquisition of TrafficLeader in October 2003. The remaining increase is related to increases in outside marketing

 

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activities, rent, travel and other operating costs arising from operations in multiple jurisdictions. We expect that sales and marketing expenses will increase in absolute dollars in connection with any revenue increases, to the extent we expand our sales force, and to the extent we increase our marketing activities.

 

Product Development.    Product development expenses increased 77% from $812,000 in the 2002 period to $1.4 million in the 2003 period. As a percentage of revenue, product development expenses were 8% in the 2002 period and 6% in the 2003 period. As a percentage of revenue, the decrease in product development expenses in the 2003 period compared to the 2002 period was primarily a result of the allocation of product development expenses over a larger revenue base. The increase in dollars was primarily due to an increase in personnel costs of $461,000, primarily due to an increase in the number of employees, including $40,000 resulting from the acquisition of TrafficLeader in October 2003, and rent and other operating expenses of $163,000 arising from operations in multiple jurisdictions. We expect that product development expenses will increase in absolute dollars as we expect to increase the number of personnel and consultants to enhance our service offerings.

 

General and Administrative.    General and administrative expenses increased 205% from $977,000 in the 2002 period to $3.0 million in the 2003 period. As of percentage of revenue, general and administrative expenses were 10% in the 2002 period and 13% in the 2003 period. The increase in the dollars was due to an increase in personnel costs of $640,000, an increase in professional fees of $617,000, an increase in travel of $288,000, an increase in insurance of $74,000, an increase in bad debt expense of $126,000, and an increase in facility and other operating expenses of $257,000. Many of these costs and increases in costs as a percentage of revenue in the 2003 period result from operating in multiple jurisdictions commencing in 2003 and increased operating activity, including approximately $136,000 in general and administrative expenses from the acquisition of TrafficLeader in October 2003. We expect that our general and administrative expenses will increase in absolute dollars to the extent that we expand our operations and incur additional costs in connection with becoming a public company, such as professional fees and insurance.

 

Acquisition-Related Retention Consideration.    Acquisition-related retention consideration increased from zero in the 2002 period to $283,000 in the 2003 period. During the 2003 period, the components of acquisition-related retention consideration were service costs of $34,000, sales and marketing of $96,000, product development of $104,000 and general and administrative of $49,000. The acquisition-related retention consideration was calculated as part of the contingent, earnings-based payment obligation to certain employees of Enhance Interactive and is equal to 5.56% of Enhance Interactive’s earnings before taxes in excess of $3.5 million for the 2003 period of which $283,000, including $23,000 of employer-related payroll taxes, has been recorded in 2003. We accounted for this payment amount as compensation.

 

In addition, with respect to calendar year 2004, we will be obligated to pay additional acquisition-related retention consideration to certain employees of Enhance Interactive if Enhance Interactive has earnings before taxes in excess of $3.5 million. This acquisition-related retention consideration will be equal to 5.56% of Enhance Interactive’s earnings before taxes for the 2004 period. The acquisition-related retention consideration for the calendar years 2003 and 2004 is subject to an aggregate maximum of $1 million. We will account for any payment amount as compensation.

 

Stock-Based Compensation.    The amortization of stock-based compensation increased 493% from $365,000 in the 2002 period to $2.2 million in the 2003 period. During the 2002 period, the components of stock-based compensation were service costs of $3,000, sales and marketing of $149,000, product development of $57,000 and general and administrative of $156,000. The 2002 period amount related primarily to the January 2002 sale of 2,031,666 shares to employees for cash consideration totaling $10,000; $357,000 in stock-based compensation was recorded in connection with the share issuance based on the difference between the cash consideration and the estimated fair value. During the 2003 period, the components of stock-based compensation were service costs of $10,000, sales and marketing of $423,000, product development of $279,000 and general and administrative of $1.5 million. Amounts in the 2003 period related primarily to the vesting of stock options granted to employees in which the exercise price was less than the fair value of the shares at the date of grant, and $112,000 related to restricted stock issued to employees for future services in connection with the acquisition of

 

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TrafficLeader. The 2003 period also includes $781,000 of stock-based compensation for options to purchase 125,000 shares of Class B common stock, which were being held in escrow as security for the indemnification obligations under the Enhance Interactive merger agreement. These options were subject to forfeiture, until the expiration of the escrow period on February 28, 2004. Accordingly, we have accounted for these options as variable awards. Under variable plan accounting, compensation expense is measured quarterly as the amount by which the fair value of the shares of our Class B common stock covered by the option grant exceeds the exercise price and is recognized over the option’s vesting period. Increases or decreases in the fair value of our Class B common stock between the date of grant and the date of exercise result in a corresponding increase or decrease in the measure of compensation expense.

 

Amortization of Identifiable Intangibles.     Intangible amortization expense increased from zero in the 2002 period to $3 million in the 2003 period as a result of amortizing identifiable intangibles associated with the purchase of Enhance Interactive and TrafficLeader. Of the $3 million intangible amortization expense in the 2003 period, $123,000 was associated with the acquisition of TrafficLeader. During the 2003 period, the components of amortization of intangibles were service costs of $2.2 million, sales and marketing of $348,000, and general and administrative of $458,000. Our purchase accounting resulted in all assets and liabilities from our acquisition of Enhance Interactive and TrafficLeader being recorded at their estimated fair values on the acquisition dates of February 28, 2003 and October 24, 2003, respectively. For the period of February 28, 2003, through December 31, 2003, all goodwill, identifiable intangible assets and liabilities resulting from the Enhance Interactive and TrafficLeader acquisitions have been recorded in our financial statements. The identified intangibles amounted to $9.7 million, including $1.3 million associated with TrafficLeader, and are being amortized over a range of useful lives of 12 to 42 months. Our consolidated financial results for periods subsequent to the acquisition of Enhance Interactive are not comparable to the financial statements of Enhance Interactive presented for prior periods. Our future growth depends upon our ability to identify, structure and integrate acquisitions. We may acquire identifiable intangible assets as part of future acquisitions and if so, we expect that our intangible amortization will increase in absolute dollars.

 

Other Income.    Other income increased from $5,000 in the 2002 period to $76,000 in the 2003 period. Interest income and the adjustment to the fair value of the TrafficLeader redemption obligation account for primarily all of the increase. Interest income includes interest on cash balances. Interest income increased from $5,000 in the 2002 period to $47,000 in the 2003 period due to an increase in the average cash balance for the period resulting from the Series A redeemable convertible preferred stock financing.

 

The adjustment to fair value of the redemption obligation went from zero in the 2002 period to $26,000 in the 2003 period. As of the date of acquisition of TrafficLeader, a redemption obligation was recorded at fair value in the amount of $81,000. The $26,000 adjustment reflects the decrease in the fair value of the obligation to $55,000 as of December 31, 2003.

 

Income Taxes.    The income tax benefit increased from $143,000 in the 2002 period to $860,000 in the 2003 period. The 2002 period effective tax rate benefit of 61% differed from the expected effective rate of 34% primarily due to reversing $208,000 of the valuation allowance on deferred tax assets and due to the effective rate impact of the $133,000 of non-deductible stock-based compensation during the 2002 period. During the 2002 period, Enhance Interactive determined that it was more likely than not, based on improved operating performance, that it would realize all of the available net deferred tax assets. The income tax effective rate was 32% in the 2003 period. This differed from the expected rate of 34% primarily due to state income taxes offset by non-deductible stock compensation amounts. The 2003 period was also impacted by the following factors:

 

  On February 28, 2003, and October 24, 2003 in connection with the purchase accounting for the respective acquisitions of Enhance Interactive and TrafficLeader, we recorded net deferred tax liabilities in the amount of approximately $3.5 million, including $456,000 associated with the acquisition of TrafficLeader, relating to the difference in the book basis and tax basis of its assets and liabilities.

 

  Approximately $3.6 million of these deferred tax liabilities, including $479,000 associated with the acquisition of TrafficLeader, related to the book basis versus tax basis of the identifiable intangible assets in the acquisitions totaling approximately $9.7 million.

 

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During the period of January 1 through February 28, 2003, as a result of a tax deduction from stock option exercises, Enhance Interactive recognized a tax-effected benefit of approximately $231,000, which was recorded as a credit to additional paid in capital.

 

Accretion to Redemption Value of Redeemable Convertible Preferred Stock.    The accretion to redemption value of preferred stock was $1,319,000 in the 2003 period. The accretion to the redemption value recorded during the period is based upon 6,724,063 shares of Series A preferred stock outstanding as of December 31, 2003 with a dividend rate of 8% per annum.

 

Net Income (Loss) Applicable to Common Stockholders.    Net loss applicable to common stockholders increased from $90,000 in the 2002 period to $3.2 million in the 2003 period. The increase was primary attributable to an increase in operating income offset by an increase of $3.0 million in amortization of intangible assets and an increase of $1.8 million in stock-based compensation.

 

Operating Income Before Amortization.    Our management believes that certain non-GAAP measures are helpful, when presented in conjunction with the comparable GAAP measures. The non-GAAP measures are not meant to replace or supercede the GAAP measures, but rather to supplement the information to present to the readers of the financial statements the same information as management considers in assessing the results of operations and performance.

 

When presenting non-GAAP measures we will present a reconciliation of the most directly comparable GAAP measure. These non-GAAP measures are consistent with how management views the results of operations in assessing performance.

 

We report Operating Income Before Amortization (“OIBA”) that is a supplemental measure to GAAP. This measure, among other things, is one of the primary metrics by which the company evaluates the performance of our business. Additionally, management uses adjusted OIBA which excludes acquisition-related retention consideration as we view this as part of the earn-out consideration from the transaction. Adjusted OIBA is the basis on which our internal budgets are based and by which management is currently evaluated. Management believes that investors should have access to, and we are obligated to provide, the same set of information that we use in analyzing our results. This non-GAAP measure should be considered in addition to results prepared in accordance with GAAP, but should not be considered in isolation, as a substitute for, or superior to, GAAP results. OIBA is defined as income (loss) from operations before (1) stock-based compensation expense and (2) amortization of intangible assets. This measure includes acquisition-related retention consideration resulting from the 2003 earn-out payment obligation from the Enhance Interactive acquisition. We provide and encourage investors to examine the reconciling adjustments between the GAAP and non-GAAP measures, which we discuss below.

 

We believe this measure is useful to investors because it represents our consolidated operating results, taking into account depreciation, which we believe is an ongoing cost of doing business, but excluding the effects of certain other non-cash expenses. OIBA has certain limitations in that it does not take into account the impact to our statement of operations of certain expenses including non-cash stock-based compensation associated with our employees and acquisition related accounting. We endeavor to compensate for the limitations of the non-GAAP measure presented by providing the comparable GAAP measure with equal or greater prominence, GAAP financial statements and detailed descriptions of the reconciling items and adjustments, including quantifying such items, to derive the non-GAAP measure.

 

The following are the non-cash expenses that are excluded from our non-GAAP measures:

 

  stock-based compensation consists of restricted stock and options expense, which relates mostly to restricted stock and options issued in connection with acquisitions. We view this expense as part of transaction costs which are not paid in cash. Stock-based compensation also includes the expense associated with certain employee stock options where on the date of grant the fair value of the underlying stock exceeded the exercise price.

 

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  amortization of intangible assets is a non-cash expense relating primarily to acquisitions. At the time of an acquisition, the intangible assets of the acquired company, such as distribution partner relationships and merchant advertiser customer relationships are valued and amortized over their estimated lives. While it is likely that we will have significant intangible amortization expense as we continue to acquire companies, we believe that since intangibles represent costs incurred by the acquired company to build value prior to the acquisition, they were part of transaction costs and will not be replaced with cash costs when the intangibles are fully amortized.

 

The following is a reconciliation of income (loss) from operations and net income (loss) applicable to common stockholders to the non-GAAP measure of operating income before amortization for the year ended December 31, 2002, the period of January 1, 2003 to February 28, 2003 and the period of January 17, 2003 (inception) to December 31, 2003.

 

     Predecessor Periods

     Successor Period

 
     Year ended
December 31,
2002


     Period from
January 1 to
February 28,
2003


    

Period from

January 17
(inception) to
December 31,
2003


 

Operating income before amortization (OIBA)

   $ 126,543      594,053      1,820,795  

Stock-based compensation

     (364,693 )    (38,981 )    (2,125,110 )

Amortization of intangible assets

     —        —        (3,023,408 )
    


  

  

Income (loss) from operations

     (238,150 )    555,072      (3,327,723 )

Other income:

                      

Interest income

     5,491      1,529      45,874  

Adjustments to fair value of redemption obligation

     —        —        25,500  

Other

     —        —        2,685  
    


  

  

Total other income

     5,491      1,529      74,059  
    


  

  

Income (loss) before provision for income taxes

     (232,659 )    556,601      (3,253,664 )

Income tax expense (benefit)

     (142,876 )    224,082      (1,084,312 )
    


  

  

Net income (loss)

     (89,783 )    332,519      (2,169,352 )

Accretion to redemption value of redeemable convertible preferred stock

     —        —        1,318,885  
    


  

  

Net income (loss) applicable to common stockholders

   $ (89,783 )    332,519      (3,488,237 )
    


  

  

 

Operating income before amortization (“OIBA”) increased from $127,000 in the 2002 period to $2.4 million in the 2003 period. The increase was primarily attributable to increased operating activity that resulted in an increase in revenue of $12.9 million offset by an increase in operating expenses of $10.6 million, excluding stock-based compensation expense and amortization of intangible assets.

 

Quarterly Results of Operations

 

The following tables set forth our unaudited quarterly results of operations data for the eight most recent quarters and periods ended December 31, 2003, as well as such data expressed as a percentage of our revenues for the

periods presented. The information in the tables below should be read in conjunction with our consolidated financial statements and the notes thereto included elsewhere in this prospectus. We have prepared this information on the same basis as the consolidated financial statements and the information includes all adjustments, consisting only of normal recurring adjustments, that we consider necessary for a fair statement of our financial position and operating results for the quarters/periods presented. Our quarterly operating results have varied substantially in the past and may vary substantially in the future. You should not draw any conclusions about our future results from the results of operations for any particular quarter or period presented.

 

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    Predecessor Periods

  Successor Periods

 
    Quarter
ended
March 31,
2002


    Quarter
ended
June 30,
2002


  Quarter
ended
Sept 30,
2002


    Quarter
ended
Dec 31,
2002


  Period from
Jan 1 to
Feb 28,
2003


  Period from
Jan 17
(inception)
to March 31,
2003


    Quarter
ended
June 30,
2003


    Quarter
ended
Sept 30,
2003


    Quarter
ended
Dec 31,
2003


 

Revenue

  $ 1,725,659     2,070,213   2,631,707     3,642,928   3,071,055   1,715,933     5,356,286     5,359,274     7,460,665  
   


 
 

 
 
 

 

 

 

Expenses:

                                                 

Service costs (1)

    1,098,184     1,310,469   1,755,041     2,170,479   1,732,813   883,280     2,955,535     2,967,206     4,486,049  

Sales and marketing (1)

    327,406     372,028   436,950     684,853   365,043   214,615     654,182     723,753     868,133  

Product development (1)

    128,969     157,811   202,350     322,543   144,479   104,947     354,927     384,248     447,300  

General and administrative (1)

    220,564     165,314   233,166     357,837   234,667   426,919     729,856     659,177     927,967  

Acquisition-related retention consideration (2)

    —       —     —       —     —     —       —       —       283,269  

Stock-based compensation (3)

    358,141     1,910   2,221     2,421   38,981   710,991     550,078     326,407     537,634  

Amortization of intangible assets (4)

    —       —     —       —     —     290,087     869,588     869,588     994,145  
   


 
 

 
 
 

 

 

 

Total operating expenses

    2,133,264     2,007,532   2,629,728     3,538,133   2,515,983   2,630,839     6,114,166     5,930,379     8,544,497  
   


 
 

 
 
 

 

 

 

Income (loss) from operations

    (407,605 )   62,681   1,979     104,795   555,072   (914,906 )   (757,880 )   (571,105 )   (1,083,832 )

Other income:

                                                 

Interest income

    106     686   1,732     2,967   1,529   3,092     13,479     16,931     12,372  

Adjustment to fair value of redemption obligation

    —       —     —       —     —     —       —       —       25,500  

Other

    —       —     —       —     —     —       —       —       2,685  
   


 
 

 
 
 

 

 

 

Total other income

    106     686   1,732     2,967   1,529   3,092     13,479     16,931     40,557  
   


 
 

 
 
 

 

 

 

Income (loss) before provision for income taxes

    (407,499 )   63,367   3,711     107,762   556,601   (911,814 )   (744,401 )   (554,174 )   (1,043,275 )

Income tax expense (benefit)

    —       —     (190,717 )   47,841   224,082   (323,092 )   (263,771 )   (196,368 )   (301,081 )
   


 
 

 
 
 

 

 

 

Net income (loss)

    (407,499 )   63,367   194,428     59,921   332,519   (588,722 )   (480,630 )   (357,806 )   (742,194 )

Accretion to redemption value of redeemable convertible preferred stock

    —       —     —       —     —     119,081     385,274     407,265     407,265  
   


 
 

 
 
 

 

 

 

Net income (loss) applicable to common stockholders

  $ (407,499 )   63,367   194,428     59,921   332,519   (707,803 )   (865,904 )   (765,071 )   (1,149,459 )
   


 
 

 
 
 

 

 

 


(1)   Excludes acquisition-related retention consideration, stock-based compensation and amortization of intangible assets

                                                 

(2)   Components of acquisition-related retention consideration:

                                                 

Service costs

  $ —       —     —       —     —     —       —       —       33,723  

Sales and marketing

    —       —     —       —     —     —       —       —       96,262  

Product development

    —       —     —       —     —     —       —       —       104,233  

General and administrative

    —       —     —       —     —     —       —       —       49,051  

(3)   Components of stock-based compensation:

                                                 

Service costs

  $ 2,350     241   285     285   190   —       —       —       9,776  

Sales and marketing

    145,602     920   1,074     1,073   715   128,993     99,861     87,720     105,297  

Product development

    56,238     210   315     315   37,710   69,769     95,108     38,348     37,855  

General and administrative

    153,951     539   547     748   366   512,229     355,109     200,339     384,706  

(4)   Components of amortization of intangible assets:

                                                 

Service costs

  $ —       —     —       —     —     215,087     644,588     644,588     712,694  

Sales and marketing

    —       —     —       —     —     29,167     87,500     87,500     143,951  

Product development

    —       —     —       —     —     —       —       —       —    

General and administrative

    —       —     —       —     —     45,833     137,500     137,500     137,500  

 

40


Table of Contents
    As A Percentage of Net Revenue

 
    Predecessor Periods

    Successor Periods

 
    Quarter
ended
March 31,
2002


    Quarter
ended
June 30,
2002


    Quarter
ended
Sept 30,
2002


    Quarter
ended
Dec 31,
2002


   

Period from

Jan 1 to
Feb 28,
2003


    Period from
Jan 17
(inception)
to March 31,
2003


    Quarter
ended
June 30,
2003


    Quarter
ended
Sept 30,
2003


    Quarter
ended
Dec 31,
2003


 

Revenue

  100.0 %   100.0 %   100.0 %   100.0 %   100.0 %   100.0 %   100.0 %   100.0 %   100.0 %
   

 

 

 

 

 

 

 

 

Expenses:

                                                     

Service costs (1)

  63.6     63.3     66.7     59.6     56.4     51.5     55.2     55.4     60.1  

Sales and marketing (1)

  19.0     18.0     16.6     18.8     11.9     12.5     12.2     13.5     11.6  

Product development (1)

  7.5     7.6     7.7     8.9     4.7     6.1     6.6     7.2     6.0  

General and administrative (1)

  12.8     8.0     8.9     9.8     7.6     24.9     13.6     12.3     12.4  

Acquisition-related retention consideration (2)

  —       —       —       —       —       —       —       —       3.8  

Stock-based compensation (3)

  20.8     0.1     0.1     0.1     1.3     41.4     10.3     6.1     7.2  

Amortization of intangible assets (4)

  —       —       —       —       —       16.9     16.2     16.2     13.3  
   

 

 

 

 

 

 

 

 

Total operating expenses

  123.6     97.0     99.9     97.1     81.9     153.3     114.1     110.7     114.5  
   

 

 

 

 

 

 

 

 

Income (loss) from operations

  (23.6 )   3.0     0.1     2.9     18.1     (53.3 )   (14.1 )   (10.7 )   (14.5 )

Other income:

                                                     

Interest income

  —       —       0.1     0.1     —       0.2     0.3     0.3     0.2  

Adjustment to fair value of redemption obligation

  —       —       —       —       —       —       —       —       0.3  

Other

  —       —       —       —       —       —       —       —       —    
   

 

 

 

 

 

 

 

 

Total other income

  —       —       0.1     0.1     —       0.2     0.3     0.3     0.5  
   

 

 

 

 

 

 

 

 

Income (loss) before provision for income taxes

  (23.6 )   3.1     0.1     3.0     18.1     (53.1 )   (13.9 )   (10.3 )   (14.0 )

Income tax expense (benefit)

  0.0     0.0     (7.2 )   1.3     7.3     (18.8 )   (4.9 )   (3.7 )   (4.0 )
   

 

 

 

 

 

 

 

 

Net income (loss)

  (23.6 )   3.1     7.4     1.6     10.8     (34.3 )   (9.0 )   (6.7 )   (9.9 )
   

 

 

 

 

 

 

 

 

Accretion to redemption value of redeemable convertible preferred stock

  —       —       —       —       —       6.9     7.2     7.6     5.5  

Net income (loss) applicable to common stockholders

  (23.6 )%   3.1 %   7.4 %   1.6 %   10.8 %   (41.2 )%   (16.2 )%   (14.3 )%   (15.4 )%
   

 

 

 

 

 

 

 

 

 

41


Table of Contents

For purposes of discussion, we have included the results of operations of the Predecessor, Enhance Interactive. The results of operations of TrafficLeader have been included since the acquisition date of October 24, 2003. The results of operations for the quarter ended March 31, 2003 as discussed below is based on the combined periods including our results from January 17, 2003 (inception) to March 31, 2003 and Enhance Interactive’s results from January 1, 2003 to February 28, 2003 (quarter ended March 31, 2003). From January 17, 2003 (inception) through February 28, 2003, we were involved in business and product development, as well as financing and acquisition initiatives and accordingly, our activities were different from the operating activities of Enhance Interactive. For further discussion of the presentation of Financial Reporting Periods, see page 30.

 

Revenue progressively increased in the quarters presented due primarily to an increase in the number of and growth of distribution partners, an increase in the number of merchant advertisers, and an overall increase in the number of searches and resulting click-throughs performed by users of our service. Revenue in the quarter ended December 31, 2003 also increased as a result of the acquisition of TrafficLeader.

 

Service costs increased in each quarter presented mainly as a result of increases each quarter in payments to distribution partners, costs of processing larger numbers of transactions, such as related credit card processing fees, and personnel and facility costs. Service costs generally decreased as a percentage of revenue in the 2003 quarters as compared to the 2002 quarters. The decrease in the percentage of revenue during this period is attributable to fixed network costs not increasing as revenue has grown, as well as economies of scale in our support and network infrastructure being realized, and certain variable costs having increased at a lower rate than revenue. Service costs increased as a percentage of revenue in the quarter ended December 31, 2003 primarily due to the acquisition of TrafficLeader in this period. TrafficLeader’s operations have a higher ratio of service costs to revenue than the operations of Enhance Interactive since user acquisition costs account for a higher ratio of its revenue.

 

Sales and marketing expense, product development expense, and general and administrative expense generally increased over the quarters presented, largely as a result of increases in personnel associated with selling, developing, and supporting our services. The increases in the 2003 quarters relative to the 2002 quarters are also related to increases in rent and other operating expenses arising from maintaining operations in multiple jurisdictions. The quarter ended December 31, 2003 was also impacted by the inclusion of TrafficLeader personnel in that period.

 

Stock-based compensation for the quarter ended March 31, 2002 was primarily related to the sale of shares to employees for cash consideration for amounts less than the estimated fair value. The stock-based compensation in the 2003 quarters related primarily to (i) employee stock options, for which the exercise price was less than the fair value on the date of grant, and (ii) the options to purchase 125,000 shares of Class B common stock held in escrow as security for the indemnification obligations under the Enhance Interactive merger agreement. The options held in escrow are accounted for as variable awards. Stock-based compensation increased in the quarter ended December 31, 2003 primarily due to amounts recognized for restricted shares issued to employees in connection with the acquisition of TrafficLeader.

 

Amortization of intangible assets expense in the initial three quarters of 2003 resulted from amortizing identifiable intangibles associated with the purchase of Enhance Interactive. Amortization of intangible assets expense increased in the quarter ended December 31, 2003 as a result of the additional amortization of identifiable intangibles associated with the purchase of TrafficLeader.

 

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Table of Contents
    Predecessor Periods

    Successor Periods

 
    Quarter
ended
March 31,
2002


    Quarter
ended
June 30,
2002


    Quarter
ended
Sept 30,
2002


    Quarter
ended
Dec 31,
2002


    Period from
Jan 1 to
Feb 28,
2003


    Period from
Jan 17
(inception)
to
March 31,
2003


    Quarter
ended
June 30,
2003


    Quarter
ended
Sept 30,
2003


    Quarter
ended
Dec 31,
2003


 

Operating income before amortization (OIBA) (1)

  $ (49,464 )   64,591     4,200     107,216     594,053     86,172     661,786     624,890     447,947  

Stock-based compensation

    (358,141 )   (1,910 )   (2,221 )   (2,421 )   (38,981 )   (710,991 )   (550,078 )   (326,407 )   (537,634 )

Amortization of intangible assets

    —       —       —       —       —       (290,087 )   (869,588 )   (869,588 )   (994,145 )
   


 

 

 

 

 

 

 

 

Income (loss) from operations

    (407,605 )   62,681     1,979     104,795     555,072     (914,906 )   (757,880 )   (571,105 )   (1,083,832 )

Other income:

                                                       

Interest income

    106     686     1,732     2,967     1,529     3,092     13,479     16,931     12,372  

Adjustment to fair value of redemption obligation

    —       —       —       —       —       —       —       —       25,500  

Other

    —       —       —       —       —       —       —       —       2,685  
   


 

 

 

 

 

 

 

 

Total other income

    106     686     1,732     2,967     1,529     3,092     13,479     16,931     40,557  
   


 

 

 

 

 

 

 

 

Income (loss) before provision for income taxes

    (407,499 )   63,367     3,711     107,762     556,601     (911,814 )   (744,401 )   (554,174 )   (1,043,275 )

Income tax expense (benefit)

    —       —       (190,717 )   47,841     224,082     (323,092 )   (263,771 )   (196,368 )   (301,081 )
   


 

 

 

 

 

 

 

 

Net income (loss)

    (407,499 )   63,367     194,428     59,921     332,519     (588,722 )   (480,630 )   (357,806 )   (742,194 )

Accretion to redemption value of redeemable convertible preferred stock

    —       —       —       —       —       119,081     385,274     407,265     407,265  
   


 

 

 

 

 

 

 

 

Net income (loss) applicable to common stockholders

  $ (407,499 )   63,367     194,428     59,921     332,519     (707,803 )   (865,904 )   (765,071 )   (1,149,459 )
   


 

 

 

 

 

 

 

 


(1) We report operating income before amortization (“OIBA”) that is a supplemental measure to GAAP. OIBA represents income (loss) from operations plus (1) stock-based compensation expense and (2) amortization of intangible assets. This measure, among other things, is one of the primary metrics by which we evaluate the performance of our business. Additionally, management uses adjusted OIBA which excludes acquisition-related retention consideration as we view this as part of the earn-out consideration from the transaction. Adjusted OIBA is the basis on which our internal budgets are based and by which management is currently evaluated. Management believes that investors should have access to, and we are obligated to provide, the same set of tools that we use in analyzing our results. This non-GAAP measure should be considered in addition to results prepared in accordance with GAAP, but should not be considered in isolation, as a substitute for, or superior to GAAP results. We believe this measure is useful to investors because it represents our consolidated operating results, taking into account depreciation, which we believe is an ongoing cost of doing business, but excluding the effects of certain other non-cash expenses.

 

OIBA has certain limitations in that it does not take into account the impact to our statement of operations of certain expenses including non-cash stock-based compensation associated with our employees and acquisition-related accounting. We endeavor to compensate for the limitations of the non-GAAP measure presented by providing the comparable GAAP measure with equal or greater prominence, GAAP financial statements and detailed descriptions of the reconciling items and adjustments, including quantifying such items, to derive the non-GAAP measure. This table provides a reconciliation of income (loss) from operations and net income (loss) applicable to common stockholders to the non-GAAP measure of operating income before amortization for the eight most recent quarters and/or periods ended December 31, 2003.

 

Liquidity and Capital Resources

 

We have financed our Company through the private sales of securities in January through May of 2003, which totaled approximately $20.3 million. Primarily from such proceeds, we have funded our business operations and the acquisitions of Enhance Interactive and TrafficLeader. The acquisition of Enhance Interactive resulted in $13.3 million in net cash consideration and the acquisition of TrafficLeader amounted to $3.2 million in net cash consideration. As of December 31, 2003, we had cash and cash equivalents of $6.0 million. As of December 31, 2003, we had contractual obligations of $836,000 of which $694,000 is for rent under our facility leases. In March 2004, we entered into a $2.3 million commitment for additional office space in Seattle, Washington, and this commitment extends through 2009. As of December 31, 2003, we had $21.4 million outstanding of Series A redeemable convertible preferred stock which are not included as components of

 

43


Table of Contents

stockholders’ equity because they are redeemable in certain events at the option of the holders, but are a part of our overall capital structure. If the offering is consummated under the terms presently anticipated, each of the outstanding shares of our Series A redeemable convertible preferred stock will automatically convert into one share of Class B common stock upon closing, and any accumulated dividends will be forgiven.

 

Net cash flow provided by operating activities was $1.5 million for the 2002 period and $3.3 million for the 2003 period. Cash was provided primarily from net income (losses) offset by non-cash amounts including depreciation and amortization of identifiable intangibles and stock-based compensation. The TrafficLeader acquisition, which occurred near the end of the 2003 period, contributed limited net cash flow to operations in the 2003 period. Accordingly, the operating cash flows were principally derived from Enhance Interactive’s operating activity.

 

Enhance Interactive working capital cash flows contribute to cash provided by operations, in large part as a result of the advance payment structure in place for most merchant advertisers. With respect to most of these merchant advertisers, we receive payment for pay-per-click advertising services prior to our delivery of the click-throughs. Our corresponding payments to the distribution partners who provide placement for the listings are generally made only after our delivery of a click-through. In most cases, the amount payable to the distribution partner will be calculated at the end of a calendar month, with a payment period following the delivery of the click-throughs. This payment structure results in a lag period between the receipt of the cash from the merchant advertisers and the payment to the distribution partners. These services constituted the majority of revenue in the 2003 period.

 

Nearly all of the TrafficLeader merchant advertisers are billed on a monthly basis following the month of our click-through delivery. This payment structure results in our advancement of monies to the distribution partners who have provided the corresponding placements of the listings. Merchant advertisers’ payments are generally received one to two weeks following payment to distribution partners. We expect that in future periods, if the paid inclusion service provided by TrafficLeader accounts for a greater percentage of our operating activity, working capital requirements will increase as a result.

 

Net cash flow used in investing activities was $334,000 for the 2002 period and $17.2 million for the 2003 period. Cash flow used in investing activities include capital expenditures for property and equipment and the acquisition of Enhance Interactive for $13.3 million in February 2003 and the acquisition of TrafficLeader for $3.2 million in October 2003. As a result of the Enhance Interactive and TrafficLeader acquisitions, we increased our property and equipment purchases for items such as network equipment and software, furniture, software and equipment for our personnel, and systems used to sell to and serve merchant advertisers. Purchases of property, plant and equipment for the period following the Enhance Interactive acquisition date of February 28, 2003 through December 31, 2003 totaled $466,000. As our operations increase, we expect property and equipment purchases will increase as we continue to invest in equipment and software for our systems and personnel.

 

Net cash flow provided by financing activities was $24,000 for the 2002 period and $20.3 million for the 2003 period. Cash flows from financing activities for the 2002 period relate to eFamily’s issuance of stock. Cash flows from financing activities for the 2003 period relate to proceeds from employees exercising stock options and proceeds from the sale of Class A and Class B common stock and Series A redeemable convertible preferred stock in the aggregate amount of $20.3 million.

 

For the 2003 period, the total aggregate Enhance Interactive contingent, earnings-based payment obligation is approximately $3.5 million. This payment obligation includes the earn-out consideration of approximately $3.2 million and the retention consideration of approximately $283,000, for the 2003 period. These amounts are payable on the earlier of (i) April 1, 2004 or (ii) three days after we have received gross proceeds of at least $20 million from an initial public offering.

 

For purposes of the calculations of the contingent earnings and revenue-based payment obligations for Enhance Interactive and TrafficLeader, we have allocated revenue based on the source of revenue. We attribute revenue

 

44


Table of Contents

from products and services originating with Enhance Interactive to Enhance Interactive, and likewise we attribute revenue from products and services originating with TrafficLeader to TrafficLeader. Consistent with that approach, we allocate revenues based on origination of merchant advertiser and distribution partner relationships and agreements.

 

Future contingent earnings- and revenue-based payment obligations related to the Enhance Interactive and TrafficLeader acquisitions, which will be determined in early 2005 for the 2004 calendar year, could significantly impact our cash flows and could significantly reduce our available cash and cash equivalents balances. These payment obligations are still subject to the aggregate maximums of $13.5 million, of which $3.5 million has been recorded in 2003, for Enhance Interactive and $1 million for TrafficLeader.

 

The following table summarizes our contractual obligations as of December 31, 2003, as well as an amount relating to a lease commitment entered into in February 2004 and the effect these obligations are expected to have on our liquidity and cash flows in future periods:

 

     Total

   Less than 1 year

   1-3 years

   4-5 years

   After 5 years

Contractual Obligations:

                          

Operating leases (A)

   $ 3,009,905    615,375    1,028,330    910,800    455,400

Other contractual obligations

     142,000    142,000    —      —       

Series A redeemable convertible preferred stock (B)

     34,800,000    —      —      —      34,800,000

Earn-out obligation associated with acquisition of Enhance Interactive (C)

     Up to 13,500,000    3,502,369    Up to 9,997,631    —      —  

Class B common stock subject to put redemption right (D)

     3,400,000    —      3,400,000    —      —  

Earn-out obligation associated with acquisition of TrafficLeader (E)

     Up to 1,000,000    Up to 1,000,000    Up to 1,000,000    —      —  
    

  
  
  
  

Total Contractual Obligations

     Up to $55,851,905    Up to 5,259,744    Up to 15,425,961    910,800    35,255,400
    

  
  
  
  

(A) Included in operating leases in the table above is a $2.3 million commitment for additional office space in Seattle, Washington that extends through 2009. We anticipate relocating from our current Seattle offices in the first half of 2004. We expect to record a charge in the first half of 2004 relating to the relocation of up to $350,000.

 

(B)

The Series A redeemable convertible preferred stock has redemption rights that will be eliminated upon the automatic conversion of the Series A redeemable convertible preferred stock into Class B common stock upon completion of the offering. Holders of Series A redeemable convertible preferred stock are entitled to receive cumulative dividends at the per annum rate of 8% of the original issue price per share when and if declared by the board of directors. The cumulative amount of preferred dividends in arrears is $1,317,000 or $0.20 per share at December 31, 2003. The board of directors has not declared any dividends as of December 31, 2003. Upon conversion of the Series A redeemable convertible preferred stock, either by optional conversion or by mandatory conversion upon an initial public offering, all accumulated and unpaid dividends on the Series A redeemable convertible preferred stock, whether or not declared, since the date of issue up to and including the conversion date, shall be forgiven. If dividends or other distributions are paid

 

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Table of Contents
 

on the Class B common stock, the holders of Series A redeemable convertible preferred stock are entitled to the preferential dividends above and are entitled to per share dividends equal to those declared or paid to holders of Class B common stock. At the election of the holders of at least a majority of the outstanding shares of Series A redeemable convertible preferred stock on each of the First Redemption Date (March 31, 2011), Second Redemption Date (March 31, 2012), Third Redemption Date (March 31, 2013) and Final Redemption Date (March 31, 2014), we shall redeem one-third of the number of shares of Series A redeemable convertible preferred stock held by such holders on each of the first three redemption dates and the remainder of any shares not already redeemed shall be redeemed on the final redemption date. The aggregate redemption amount is $21,489,000 at December 31, 2003.

 

(C) A contingent, earnings-based payment obligation may be owed to the former shareholders of Enhance Interactive. The payment obligation has two components, which consist of earn-out consideration and retention consideration.

 

The earn-out consideration is calculated based on the formula of 69.44% of Enhance Interactive’s earnings before taxes for each of the calendar years 2003 and 2004, up to an aggregate maximum payout cap of $12.5 million. In the event earnings before taxes do not exceed $3.5 million for 2003 or 2004, then no amount shall be payable for the related period. Any amounts payable will be accounted for as additional goodwill.

 

The retention consideration is calculated based on the formula of 5.56% of Enhance Interactive’s earnings before taxes for each of the calendar years 2003 and 2004, up to an aggregate maximum payout cap of $1 million. In the event earnings before taxes do not exceed $3.5 million for 2003 or 2004, then no amount shall be payable for the related period. Any amounts payable will be accounted for as compensation.

 

Based on the calculation for calendar year 2003, we have recorded a $3.5 million payment liability for the total 2003 earnings-based payment obligations, which will reduce the maximum aggregate obligation by the same amount.

 

(D) In the event we have not completed a firm commitment initial public offering with gross proceeds of at least $20 million prior to October 24, 2005, the former shareholders of TrafficLeader have the right to require us to redeem 425,000 shares of Class B common stock for $8 per share (for an aggregate redemption of $3.4 million), but only upon the affirmative vote of the holders of 75% of such shares. These shares were valued at $6.75 per share and the associated redemption right has a value of $55,000 at December 31, 2003, and will be reflected as a liability, until such time as a qualifying initial public offering occurs. Based upon the terms of the redemption right, we will mark the redemption right to fair value at each reporting period until such time as the redemption right expires or the shares are redeemed.

 

(E) A contingent, revenue-based payment obligation may be owed under the TrafficLeader acquisition agreement. The contingent revenue-based payment is conditioned on TrafficLeader having revenue in excess of $15 million for calendar year 2004. In the event that TrafficLeader meets the minimum revenue threshold, we will be obligated to pay an amount equal to 10% of each dollar in revenue above the $15 million threshold, up to a maximum payout cap of $1 million. Any amount payable will be accounted for as additional goodwill.

 

In the event on or prior to December 31, 2004, there is a change of control of TrafficLeader or of us, or both TrafficLeader’s CEO and CTO either resign for good reason or are terminated without cause, or we take any action prior to the end of December 31, 2004, which makes it impractical to calculate or reconstruct the earn out obligation, we will be obligated to pay the full amount of the $1 million contingent payment obligation.

 

We anticipate that we will need to invest working capital towards the development and expansion of our overall operations. We may make further acquisitions, which, in addition to the issuance of equity securities, could result in the reduction of our cash balances or the incurrence of debt. We have allocated approximately $12 million of the net proceeds from this offering to fund acquisitions. See “Use of Proceeds.” Furthermore, we expect that future capital expenditures may be higher than amounts recorded in the 2003 period if our operating activity continues to increase. In addition, TrafficLeader expenditures were only included in the 2003 period as of the

 

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Table of Contents

acquisition date of October 24, 2003. Future reporting periods will include all of TrafficLeader’s operating results for such periods. TrafficLeader’s operations have a higher ratio of service costs to revenue than the operations of Enhance Interactive.

 

Based on our operating plans, we believe that the proceeds from this offering, together with our existing resources and cash flows provided by operations, will be sufficient to fund our planned operations for at least twelve months from the date of this prospectus. However, additional equity and debt financing may be needed to support our Company needs. If additional financing is necessary, it may not be available; and if it is available, it may not be possible for us to obtain financing on satisfactory terms. Failure to generate sufficient revenue or raise additional capital could have a material adverse effect on our ability to continue as a going concern and to achieve our intended business objectives.

 

Critical Accounting Policies

 

The policies below are critical to our business operations and the understanding of our results of operations. In the ordinary course of business, we make a number of estimates and assumptions relating to the reporting of our results.

 

Our consolidated financial statements have been prepared with accounting principles generally accepted in the United States. The preparation of these consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses and the related disclosures of contingent assets and liabilities. We base our estimates on historical experience and on various assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

 

Our critical accounting policies relate to the following matters and are described below:

 

  Revenue;

 

  Goodwill and intangible assets;

 

  Stock-based compensation; and

 

  Allowance for doubtful accounts and merchant advertiser credits.

 

Revenue

 

We currently generate revenue through our operating businesses by delivering performance-based and search marketing services to merchant advertisers. The primary revenue driver has been performance-based advertising, which includes pay-per-click listings, delivered primarily through Enhance Interactive; and beginning in October 2003, paid inclusion, delivered primarily through TrafficLeader. For these particular services, revenue is recognized upon a user’s click-through of a merchant advertiser listing within our distribution network. Each click-through represents a completed transaction.

 

We have entered into agreements with various distribution partners in order to expand our distribution network, which includes search engines, directories, product shopping engines and other Web sites through which we distribute our merchant advertisers’ listings. We generally pay distribution partners based on a specified percentage of revenue or a fixed amount per click-through on these listings. We act as the primary obligor in these transactions, and we are responsible for providing customer and administrative services to the merchant advertiser. In accordance with EITF Issue No. 99-19, “Reporting Revenue Gross as a Principal Versus Net as an Agent,” the revenue derived from merchant advertisers who receive paid introductions through us as supplied by distribution partners is reported gross based upon the amounts received from the merchant advertiser.

 

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Goodwill and Intangible Assets

 

Goodwill represents the excess of the purchase price over the fair value of identifiable assets acquired and liabilities assumed in business combinations accounted for under the purchase method.

 

We apply the provisions of the Financial Accounting Standards Board’s (FASB) Statements of Financial Accounting Standards (SFAS) No. 142, “Goodwill and Other Intangible Assets,” (SFAS 142). Goodwill and intangible assets acquired in a purchase business combination and determined to have an indefinite useful life are not amortized, but instead tested for impairment at least annually in accordance with the provisions of SFAS 142. SFAS 142 also requires that intangible assets with definite useful lives be amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” (SFAS 144).

 

Goodwill not subject to amortization is tested annually for impairment, and is tested for impairment more frequently if events and circumstances indicate that the asset might be impaired. An impairment loss is recognized to the extent that the carrying amount exceeds the asset’s fair value. To date, no impairment charge has been taken for the goodwill related to our acquisitions of Enhance Interactive or TrafficLeader. If the fair value is lower than the carrying value, a material impairment charge may be reported in our financial results.

 

We review our long-lived assets for impairment in accordance with SFAS 144 whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets held and used is measured by a comparison of the carrying amount of an asset to estimated undiscounted future cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment is to be recognized by the amount by which the carrying amount of the assets exceeds fair value. Assets to be disposed of are separately presented on the balance sheet and reported at the lower of their carrying amount or fair value less costs to sell, and are no longer depreciated.

 

No impairment of our intangible assets has been indicated to date. To the extent such evaluation indicates that the useful lives of intangible assets are different than originally estimated, the amortization period is reduced or extended and, accordingly, the quarterly amortization expense is increased or decreased.

 

As a result of the significance of the goodwill and intangible asset carrying values, any impairment charges or changes to the estimated amortization periods could have a material adverse effect on our financial results.

 

Stock-Based Compensation

 

Our stock-based compensation plan is described more fully in Note 8 to the consolidated financial statements. We account for the plan under the recognition and measurement principles of APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations including FASB Interpretation No. 44, “Accounting for Certain Transactions involving Stock Compensation,” an interpretation of APB Opinion No. 25 issued in March 2000, to account for our employee stock options. Under this method, employee compensation expense is recorded on the date of grant only if the fair value of the underlying stock exceeded the exercise price. SFAS No. 123, “Accounting for Stock-Based Compensation,” established accounting and disclosure requirements using a fair value-based method of accounting for stock-based employee compensation plans.

 

As allowed by SFAS No. 123, we have elected to continue to apply the intrinsic value-based method of accounting described above for options granted to employees, and have adopted the disclosure requirements of SFAS No. 123. We recognize compensation expense over the vesting period utilizing the accelerated methodology described in Financial Accounting Standards Board Interpretation No. 28, “Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans.” We account for non-employee stock-based compensation in accordance with SFAS No. 123 and EITF No. 96-18.

 

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We use variable plan accounting to account for options to purchase 125,000 shares of our Class B common stock issued under our stock incentive plan that were held in escrow as security for the indemnification obligations under the Enhance Interactive merger agreement. These options were subject to forfeiture, until the expiration of the escrow period on February 28, 2004. Accordingly, we may be required to record a compensation charge on a quarterly basis, which will lower our earnings. Under variable plan accounting, compensation expense is measured quarterly as the amount by which the fair value of the shares of our Class B common stock covered by the option grant exceeds the exercise price and is recognized over the option’s vesting period. Increases or decreases in the fair value of our Class B common stock between the date of grant and the date of exercise result in a corresponding increase or decrease in the measure of compensation expense.

 

The amount of stock-based compensation to be recognized is derived based on our determination of the fair value of our Class B common stock. We determine the fair value of our Class B common stock based on several factors, including our operating performance, issuances of our convertible preferred stock, liquidation preferences of our preferred stock, and valuations of other publicly-traded companies.

 

The amount of compensation expense actually recognized in future periods could be lower than currently anticipated if unvested stock options for which deferred compensation has been recorded are forfeited. In addition, if we used different assumptions to determine the deemed fair value of our Class B common stock, we could have reported materially different amounts of stock-based compensation. We currently are not required to record stock-based compensation charges if the employee stock option exercise price or restricted stock purchase price equals or exceeds the deemed fair value of our common stock at the date of grant. Several companies have recently elected to change their accounting policies and begun to record the fair value of options as an expense. In addition, we understand that discussions of potential changes to applicable accounting standards are ongoing. If we had estimated the fair value of options on the date of grant using a Black-Scholes pricing model, and then amortized this estimated fair value over the vesting period of the options, our net income (loss) would have been adversely affected. See Note 1(m) to our consolidated financial statements for a discussion of how our net income (loss) would have been adversely affected.

 

Allowance for Doubtful Accounts and Merchant Advertiser Credits

 

Accounts receivable balances are presented net of allowance for doubtful accounts and merchant advertiser credits. The allowance for doubtful accounts is our best estimate of the amount of probable credit losses in our accounts receivable. We determine our allowance based on analysis of historical bad debts, advertiser concentrations, advertiser creditworthiness and current economic trends. We review the allowance for collectibility on a quarterly basis. Account balances are written off against the allowance after all reasonable means of collection have been exhausted and the potential recovery is considered remote. If the financial condition of our advertisers were to deteriorate, resulting in an impairment of their ability to make payments, or if we underestimated the allowances required, additional allowances may be required which would result in increased general and administrative expenses in the period such determination was made.

 

We determine our allowance for merchant advertiser credits and adjustments based upon our analysis of historical credits. Material differences may result in the amount and timing of our revenue for any period if our management made different judgments and estimates.

 

Related Party Transactions

 

For a description of our related party transactions see “Certain Relationships and Related Transactions.”

 

Recent Accounting Pronouncements

 

In November 2002, the Emerging Issues Task Force (EITF) reached a consensus on Issue No. 00-21 (EITF 00-21), “Revenue Arrangements with Multiple Deliverables.” EITF 00-21 addresses certain aspects of the accounting by a vendor for arrangements under which the vendor will perform multiple revenue generating

 

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activities. EITF 00-21 became effective for fiscal periods beginning after June 15, 2003. The adoption of EITF 00-21 has not had a material impact on our financial position and results of operations.

 

In May 2003, the FASB issued SFAS 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” The Statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). It is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. The adoption of this Statement did not have a material impact on our financial statements.

 

In December 2003, the SEC issued Staff Accounting Bulletin No. 104, “Revenue Recognition” (SAB No. 104), which revises or rescinds certain sections of SAB No. 101, “Revenue Recognition in Financial Statements” in order to make this interpretive guidance consistent with current authoritative accounting and auditing guidance and SEC rules and regulations. The changes noted in SAB No. 104 did not have a material effect on our financial position and results of operations.

 

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BUSINESS

 

Company Overview

 

We provide technology-based services to merchants engaged in online transactions. Our objective is to be a leader in terms of growth, profitability, technological innovation, and business model innovation. We anticipate achieving our objectives through a combination of consolidation opportunities, growing those businesses we acquire, internal development initiatives and strategic relationships.

 

We believe there is a significant, long-term opportunity to capture market share of online transactions, and services that support online transactions, by building a profitable, diversified global company that provides a wide range of technology-based services to merchants, including: Web site infrastructure and development services; online payment and commerce infrastructure; promotional tools to market and sell products and services; and automated tools to manage and track online transaction. We intend to leverage the experience of our senior management to capture this opportunity, as they have substantial operational and strategic experience, including experience in building and managing public companies, executing acquisitions and forming strategic relationships.

 

Our current operating businesses are in the performance-based advertising and search marketing industries, primarily focused on helping merchants market and sell their products and services via the Internet. We currently provide our merchant customers with the following technology-based services: (1) performance-based advertising, including pay-per-click services, primarily through Enhance Interactive; and paid inclusion services, primarily through TrafficLeader; and (2) search marketing services, including advertising campaign management, conversion tracking and analysis, and search engine optimization, through TrafficLeader.

 

Enhance Interactive. Enhance Interactive provides performance-based advertising services to merchant advertisers, including pay-per-click services. Through Enhance Interactive’s pay-per-click service, merchant advertisers create keyword listings that describe their product or service, which are marketed to millions of consumers and businesses primarily through search engine or directory results.

 

TrafficLeader. TrafficLeader provides performance-based advertising and search marketing services to merchant advertisers, including paid inclusion, advertising campaign management, conversion tracking and analysis, and search engine optimization. Through TrafficLeader’s primary service, paid inclusion, TrafficLeader manages search-based advertising campaigns and services for merchant advertisers. TrafficLeader’s paid inclusion service helps merchant advertisers, who have hundreds or even thousands of products, reach prospective customers by first indexing their product databases and creating highly relevant product listings and then placing these listings in front of potential customers, primarily through search engines. Merchant advertiser’s product listings map directly to user search queries, which link to specific product or information pages when clicked. On behalf of merchant advertisers, TrafficLeader indexes these highly relevant listings into many of the Internet’s most-visited search engines, product shopping engines, and directories.

 

Collectively, our operating businesses distribute advertisements and paid listings through hundreds of partners, including search engines, directories, product shopping engines and other Web sites.

 

In support of our partners and merchants, we devote resources to developing and building proprietary technology-based products and services that we believe are innovative and provide a high degree of utility. Additionally, we continually evaluate opportunities to evolve existing technologies and business models, and we regularly consider possible acquisitions and strategic relationships.

 

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We were incorporated in Delaware on January 17, 2003. On February 28, 2003, we acquired eFamily together with its direct wholly-owned subsidiary Enhance Interactive. eFamily was incorporated in Utah on November 29, 1999, under the name FocusFilter.com, Inc. On October 24, 2003, we acquired TrafficLeader, which was incorporated in Oregon on January 24, 2000, under the name Sitewise Marketing, Inc.

 

From January 17, 2003 (inception) through February 28, 2003, we were involved in business and product development, as well as financing and acquisition initiatives. During this period we had no revenues.

 

Industry Overview

 

Internet-based transactions between consumers and merchants have grown rapidly in recent years. This growth is the result of decreasing price points of Internet access devices coupled with corresponding performance gains of such devices; a large installed base of personal computers in the workplace and homes; penetration of broadband technologies and increased Internet usage; and the emergence of compelling commerce opportunities and a growing awareness among consumers of the convenience and other benefits of online shopping.

 

Today’s consumers are becoming increasingly confident that they can find comprehensive product information and securely transact online. This, combined with merchants’ ability to more efficiently and effectively acquire and monetize customers, has led to a steady increase in online merchant transactions. We believe that the combination of these and other factors have significantly enhanced the effectiveness of the Internet as a mass commerce medium. We further believe that these characterizations are supported by the following industry estimates:

 

  Growing Internet Population and Internet Penetration Levels. Morgan Stanley estimates that global Internet users will grow at a compounded annual growth rate of 17% to 976 million by 2005 (representing 15% global population penetration), up from 609 million users at the end of 2002 (representing 10% global population penetration). Morgan Stanley also estimates that Internet users in North America will grow at a compounded annual growth rate of 11% to 242 million by 2005, up from 176 million users at the end of 2002.

 

  Large Number of Small Businesses Operating Online. According to International Data Corporation (IDC), by the end of 2007, 77% of the 8.5 million small businesses in the United States (defined as firms with under 100 employees that are not based at home) will have Web sites, compared to 62% of the 8 million small businesses in 2003.

 

  Growth of Electronic Commerce. Forrester Research believes that electronic commerce activity in the United States, fueled by a steady stream of new online shoppers and new product category sales, will grow at a compounded annual growth rate of 19% over the next five years to nearly $230 billion in 2008 (representing 10% of total retail sales in the United States).

 

  Growth of Online Advertising. U.S. Bancorp Piper Jaffray estimates that online advertising in the United States will grow at a compounded annual growth rate of 19% from $6.7 billion in 2003 to more than $15 billion in 2008 (representing approximately 6% of total advertising spending, compared to approximately 2% of total advertising spending in 2003).

 

  Growth of Performance-Based Advertising and Search Marketing. U.S. Bancorp Piper Jaffray estimates that the global market for performance-based advertising and search marketing, such as pay-per-click listings and paid inclusion, will grow at a compounded annual growth rate of 38% from approximately $1.4 billion in 2002 to approximately $7 billion in 2007.

 

  Growth in Certain Businesses that Support Online Merchants. According to IDC, the Web hosting market in the United States will grow at a compounded annual growth rate of 15% from more than $5.1 billion in 2002 to $10.4 billion in 2007.

 

Given the preceding global Internet user and online commerce trends, we believe there is a significant, long-term opportunity to capture market share of online transactions, and services that support online transactions, through

 

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building a profitable, diversified global company that provides a wide range of technology-based services to merchants, including: online payment infrastructure; automated tools and services to facilitate transactions; promotional tools to market goods and services; and automated tools to manage and track all aspects of online transactions. On an ongoing basis, we intend to evaluate points in the merchant transactions value chain that will provide the greatest opportunity for us to build and acquire offerings with the following characteristics: growth, scalability, profitability and defensibility.

 

Strategy

 

We intend to leverage our senior management’s experience, our financial and human resources, and our existing operating businesses to provide technology-based services for merchants engaged in online transactions. Key elements of our strategy include the following initiatives:

 

  Provide Quality Services in Support of Merchants and Partners. We believe that providing high quality services makes us more attractive to merchants and partners. In addition to selected strategic acquisitions, we intend to expand our offerings through internal development initiatives to provide merchants and partners additional, value-added services. Specifically, we intend to expand our services by providing systems and information that help merchant advertisers maximize the performance of online marketing budgets; and to partners by working with them to develop and market new products. For example, we currently offer services that optimize and enhance a merchant advertiser’s listing with a service that allows us to extract relevant product information from merchant advertisers’ sites to create separate listings, an analytics service that calculates the effectiveness of an advertising campaign, and optimization services to improve performance within algorithmic search engines. We have developed these services to meet the needs of our merchant advertisers, and we expect to continue to develop technologies as their needs and those of the market continue to evolve.

 

  Increase the Number of Merchants Served. By providing merchants a consistently high level of service, support and ability to achieve their targeted return-on-investment thresholds, we strive to build merchant loyalty and deliver long-term value. We intend to increase our merchants served through:

 

  direct sales force efforts for each of our operating companies, including strategic sales and telesales initiatives;

 

  referral arrangements with entities that can promote our services to potential merchants;

 

  trade show, seminar and conference attendance and sponsorships; and

 

  the acquisition of complementary operating businesses and services.

 

  Continue to Innovate and Develop Proprietary Technologies and Intellectual Property. In support of our partners and merchants, we are building additional, proprietary products and services that we believe are innovative and provide a high degree of utility. We intend to invest our resources in identifying potential offerings that create or evolve new products, technologies and/or business models. We intend to continue to file patents as appropriate to protect such proprietary products and business models. We are building and intend to continue to build new technologies that are in line with these objectives.

 

  Pursue Selective Acquisition and Consolidation Opportunities. We plan to selectively pursue strategic acquisition candidates. We apply rigorous evaluation criteria to acquisition candidates that are intended to help achieve our return-on-invested capital requirements, which we believe will translate into increased shareholder value. We do this through focusing on acquisition opportunities that represent a combination of the following characteristics:

 

  underleveraged and/or under-commercialized assets;

 

  opportunities for business model, product or service innovation and evolution;

 

  critical mass of transactions volume, merchants, revenue and/or profits;

 

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  revenue growth and expanding margins and operating profitability (or the characteristics to achieve significant scale and profitability); and

 

  an opportunity to enhance efficiencies and provide incremental growth opportunities for our operating businesses.

 

  Drive Increased Profitability through Revenue Growth and Operating Leverage. We are focused on achieving consistent growth in a manner that promotes profitability. Our operating structure, internal operating initiatives and strategic acquisition initiatives are concentrated on building businesses with profit margins that increase as our revenue increases. As such, we invest our resources in new initiatives only after planning and analysis that outline targeted return-on-invested-capital parameters.

 

  Develop New Markets. We will analyze opportunities and may seek to expand our technology-based services into new categories or new countries where our services can be replicated on a cost effective basis, or where the creation or evolution of a service may be appropriate. We anticipate utilizing various strategies to enter new markets, including: strategic relationships; acquiring products that address a new category or opportunity; acquiring country-specific properties; and creating joint venture relationships and internal initiatives where existing services can be extended internationally.

 

Operating Businesses

 

We currently deliver technology-based services through our operating companies, Enhance Interactive and TrafficLeader. Our current operating businesses are focused on supporting and building the businesses of our partners: our merchant advertisers focused on acquiring transactions and customers; and our distribution partners focused on building the number of advertisers and revenue opportunities within their networks. Specifically, our operating businesses deliver products and services in the performance-based advertising and search marketing industries, primarily focused on helping merchants market and sell their products and services via the Internet through the following technology-based services: (1) performance-based advertising, including pay-per-click services, primarily through Enhance Interactive; and paid inclusion, primarily through TrafficLeader; and (2) search marketing services, including advertising campaign management, conversion tracking and analysis, and search engine optimization, through TrafficLeader.

 

  Performance-Based Advertising, primarily including pay-per-click and paid inclusion services. Each of these services enables merchants to reach their target audience through search and directory results. The key difference between the common implementation of these services is whether payment by a merchant advertiser influences the rank of its listing within the applicable search or directory results.

 

  Pay-Per-Click Services. With pay-per-click services, merchant advertisers purchase keywords based on an amount they choose for a targeted placement, usually within search engine results. In this model, the advertiser drives pricing.

 

  Paid Inclusion Services. With paid inclusion services, merchant advertisers pay for their Web pages and product databases to be crawled, or searched, and indexed and included primarily within search engine and shopping engine results. Generally, the paid inclusion results are presented separately from the pay-per-click results. In this model, pricing is generally driven by the distribution partner, and does not affect placement in search results; rather, listings are generally ranked based on relevancy as determined by the partner search engine.

 

We believe that paid inclusion is an important complement to the algorithmic search technologies that determine the ranking of results within many of the major search engines (such as AltaVista, Ask Jeeves, Google and Inktomi), since merchant advertisers typically provide paid inclusion technology companies direct access to their internal product databases. Often, only once a paid inclusion company has crawled, replicated and optimized hundreds or thousands of individual product and informational Web pages for a merchant advertiser do links to these pages appear within search engine results. The indexing and subsequent listing of these Web pages made possible by paid inclusion companies enhances the overall relevancy of the search engines with which the company partners.

 

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  Search Marketing, designed for merchant advertisers who are focused on acquiring customers through search-based marketing methods, optimizing the performance of their campaigns through tracking and analyzing historical results, and refining their Web sites for increased relevance in algorithmic search engine indexes. These services include advertising campaign management, conversion tracking and analysis, and search engine optimization. We believe that businesses may benefit from the search marketing services we provide to enhance the performance of their advertising campaigns.

 

Enhance Interactive

 

Enhance Interactive provides performance-based advertising services, including pay-per-click listings, to merchant advertisers. Through Enhance Interactive, merchant advertisers market their products and services to millions of consumers and businesses through targeted pay-per-click listings that are primarily found in the form of search engine or directory results when a user searches for information, products or services. For the quarter ended December 31, 2003, Enhance Interactive processed more than 4 billion search queries. Enhance Interactive also delivers other advertising services such as banner advertising, branded advertisements that include a merchant advertiser logo associated with its advertisements (LogoLinks program), and paid inclusion services.

 

Merchant Advertising on Enhance Interactive. The pay-per-click results sold and distributed by the Enhance Interactive service are prioritized for users by the amount the merchant advertiser is willing to pay each time a user clicks on the merchant’s advertisement. Merchant advertisers pay Enhance Interactive when a click-through occurs on their advertisement.

 

Enhance Interactive provides services to thousands of merchant advertisers who want to drive consumers and customer leads to their Web sites. Potential merchant advertisers find Enhance Interactive directly, through contact by our telesales force, through direct sales efforts, through third-party referral programs, and through a variety of marketing activities that include trade shows, targeted mailings, e-mails and other promotional material sent directly to merchant advertisers, advertising agencies and search engine marketers.

 

When Enhance Interactive merchant advertisers submit advertisement listings to the Enhance Interactive service, Enhance Interactive reviews them for relevance and for conformity with our editorial guidelines. Merchant advertisers participate only in markets that are relevant to their Web site and product or service offerings. Enhance Interactive may also assist merchant advertisers in optimizing their advertisement campaigns by recommending relevant keywords available to them based on their Web sites and product or service offerings.

 

Distribution on Enhance Interactive. Enhance Interactive distributes merchant advertisements through hundreds of partners, including search engines, directories and other Web sites. The economic arrangements with Enhance Interactive’s distribution partners vary and may include:

 

  payment by Enhance Interactive based on a specified percentage of revenue generated;

 

  payment by Enhance Interactive based on a fixed click-through price; and

 

  combinations of the foregoing.

 

As of February 16, 2004, Enhance Interactive had arrangements for inclusion of its pay-per-click results and advertisements on four of the top 25 most visited Internet properties according to the December 2003 report of comScore MediaMetrix.

 

TrafficLeader

 

TrafficLeader provides performance-based advertising and search marketing services to merchant advertisers, including paid inclusion, advertising campaign management, conversion tracking and analysis, and search engine optimization.

 

 

Paid Inclusion. TrafficLeader’s paid inclusion program delivers targeted advertiser listings into some of the Internet’s most-visited search engines. Paid inclusion leverages proprietary technology to crawl and extract relevant product data and content from a merchant advertiser database and Web site, and create highly relevant, optimized Uniform Resource Locator (URL) strings and advertisement listings.

 

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Increased listing relevancy frequently translates into a better search experience for users, allowing them to find targeted results in response to their search queries; and better return-on-investment for merchant advertisers, as higher relevance typically leads to increased click-through rates and customer acquisition rates.

 

Once TrafficLeader’s technology has crawled, extracted, optimized and refined the merchant advertiser URL strings and advertisement listings, such strings and listings are automatically tagged and placed into partner search and directory indexes. These URL strings and listings map directly to user search queries, which link back to specific product pages when clicked. We believe that this process typically leads to high advertiser conversion rates or customer acquisitions. As TrafficLeader’s merchant advertisers typically have dynamically-updating product databases, TrafficLeader frequently refreshes merchant advertisers’ listings to ensure that the most up-to-date product information and/or content is available to TrafficLeader’s partners. Merchant advertiser URL strings and advertisement listings are typically ordered based on relevance to the user search query. Merchant advertisers pay TrafficLeader a fixed price for each click received on their URL string and advertisement listing.

 

Additionally, through leveraging proprietary technology, TrafficLeader analyzes an advertiser’s database as well as thousands to millions of actual, relevant user search queries to create additional, unique merchant advertiser listings that drive targeted traffic resulting in highly competitive conversion, or customer acquisition, rates. These additional, unique listings are generally included as part of TrafficLeader’s basic paid inclusion service.

 

  Search Engine Data Feed Creation. TrafficLeader also promotes a self-managed paid inclusion service, FeedWorks. FeedWorks is a technology-based service that extracts all relevant data from a merchant advertiser’s database and Web site, autonomously generates properly structured data feeds, and then provides the merchant advertiser with those feeds, which the merchant advertiser may then submit into search engine indexes.

 

  Conversion Tracking and Analysis. TrafficLeader’s Web analytics service, Real Performance Measurement (RPM), allows merchant advertisers to calculate the effectiveness of paid inclusion and performance-based advertising campaigns. Through RPM, merchant advertisers examine which URL strings and advertisement listings are converting to sales and which are not; and identify future opportunities based on this data.

 

  Advertising Campaign Management. TrafficLeader’s Preferred Placement program is an advertising campaign management service that continuously tracks, monitors and optimizes the placement of performance-based search advertising campaigns for merchant advertisers across a number of performance-based search advertising engines.

 

  Search Engine Optimization. TrafficLeader also offers search engine optimization services, Site Centric Services. Site Centric Services help merchant advertisers better organize and design their Web sites so their listings are optimized on the algorithmic search engines, such as AltaVista, Ask Jeeves (Teoma), Google, LookSmart (WiseNut), and Yahoo! (Inktomi).

 

Merchant Advertising on TrafficLeader. TrafficLeader primarily attracts merchant advertisers that have product databases, want to increase their online sales, and want to achieve target return-on-investment metrics. Potential merchant advertisers find TrafficLeader directly, through a variety of means, including contact by our direct sales staff, through marketing efforts such as trade shows or advertising, and through third-party referral programs.

 

Distribution on TrafficLeader. TrafficLeader distributes merchant advertiser URL strings and advertisement listings through distribution partners, including search engines and product shopping engines. The economic arrangements with TrafficLeader’s partners vary and may include:

 

  payment by TrafficLeader based on a specified percentage of revenue;

 

  payment by TrafficLeader based on a fixed click-through price; and

 

  combinations of the foregoing.

 

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For example, current agreements with certain Yahoo! subsidiaries contain mutual termination clauses and are primarily structured on a variable-payment basis, under which we make payments based on a specified percentage of revenue or based on the number of paid click-throughs.

 

As of February 16, 2004, TrafficLeader’s results appeared on a majority of the top 10 most visited Internet properties according to the December 2003 report of comScore MediaMetrix.

 

Sales, Business Development, Marketing, Advertising and Promotion

 

As of February 16, 2004, we had 39 full-time employee equivalents in our sales departments, including 32 at Enhance Interactive, and seven at TrafficLeader; 12 full-time employee equivalents in our business development departments, including seven at Enhance Interactive and four at TrafficLeader; and five full-time employee equivalents in our marketing departments, including four at Enhance Interactive. Our sales departments currently focus on adding new merchant advertisers to our operating businesses, while our business development departments are currently directed to service existing distribution partnerships and selectively add new distribution partners. Our marketing departments focus on promoting our operating businesses through affiliate relationships, press coverage, industry exposure, and trade shows. Our advertising and promotion of our services is broken into four main categories: direct sales, agency sales, online promotion, and referral agreements.

 

  Direct Sales: Our sales staff targets new merchant advertiser relationships through telesales efforts, direct marketing, and attendance and sponsorship at various trade shows and conferences.

 

  Agency Sales: Our agency program includes a group within the sales team that targets interactive agencies and other entities that service merchant advertisers. This sales group focuses on in-person and remote presentations of our services to agencies, and is also periodically engaged in various marketing initiatives at industry trade shows and conferences. Our agency agreements may include a combination of revenue sharing, performance-based fees and other costs.

 

  Online Promotion: We engage in certain advertising and direct marketing focused on acquiring new merchant advertisers and new distribution partners.

 

  Referral Agreements: We seek to build referral arrangements with entities that can promote our services to large numbers of potential advertisers. Our referral partner agreements are based on a combination of revenue sharing and performance-based fees.

 

We intend to continue our strategy of growing our merchant advertiser base through sales and marketing programs while being as efficient as possible in terms of our marketing and advertising costs. We continually evaluate our marketing and advertising strategies to maximize the effectiveness of our programs and their return on investment.

 

Information Technology and Systems

 

We have a proprietary technology platform for the purposes of managing and delivering advertisements to our partners. We also combine third party licenses and hardware to create an operating environment that focuses on quality products and services, with such features as automated online customer purchasing, real-time customer support and interactive reporting for customers and partners. We employ commercially available technologies and products distributed by various companies, including Cisco, Dell, Intel, Microsoft, Sun Microsystems and Veritas. We also utilize public domain software such as Apache, Linux, MySQL, Sun Microsystems Java, and Tomcat.

 

Our technology platform must be compatible with the systems used by our distribution partners, enabling us to deliver advertisement listings in rapid response to user queries made through such partners. We continue to build and innovate additional functionality to attempt to meet the quickly evolving demands of the marketplace. We devote significant financial and human resources to improving our merchant and partner experiences by continuing to develop our technology infrastructure. The cost of developing our technology solutions is included in the overall cost structure of our services and is not separately funded by any individual merchants or partners.

 

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In order to maintain a professional level of service and availability, we primarily rely upon third parties to provide hosting services, including hardware support and service, and network monitoring. Our servers are configured for high availability and large volumes of Internet traffic and are located in leased third-party facilities. Back-end databases make use of redundant servers and data storage arrays. We also have standby servers that provide for additional capacity as necessary. The facilities housing our servers provide redundant HVAC, power and Internet connectivity.

 

We continuously review ways to improve major aspects of our technology support and maintenance, including improving, upgrading and implementing business continuity plans, data retention initiatives, and backup and recovery processes.

 

Competition

 

Many of our potential competitors, as well as potential entrants into our target markets, have longer operating histories, larger customer or user bases, greater brand recognition and greater financial, marketing and other resources than we have. Many current and potential competitors can devote substantially greater resources than we can to promotion, Web site and systems development. In addition, currently and in the future as the use of the Internet and other online services increases, there will likely be larger, more well-established and well-financed entities that acquire companies relevant to our business strategy; and invest in or form joint ventures in categories or countries relevant to our business strategy; all of which could adversely impact our business. Any of these trends could increase competition, reduce the demand for any of our services and could have a material adverse effect on our business, operating results and financial condition.

 

We, as well as our operating companies, pursue a strategy that we believe allows us to work with all relevant companies in the industry, even those companies that some people or entities may perceive as our competitors. We intend to continue with a strategy that allows us to consider and pursue business arrangements with all companies in our industry.

 

We provide our services to: (i) merchant advertisers who acquire advertisement inventory through Enhance Interactive or TrafficLeader; (ii) partners who provide said inventory; and (iii) other intermediaries who may provide purchase and/or sales opportunities, including advertising agencies, search engine marketing companies and search engine optimization companies. Our operating businesses depend on maintaining and continually expanding their network of partners and merchants to generate transactions. As a result, we may compete with those who:

 

  sell performance-based advertising or search marketing services to merchants;

 

  aggregate or optimize advertising inventory for distribution through search engines, product shopping engines, directories, Web sites or other outlets; or

 

  provide destination Web sites or other distribution outlets that reach end users or customers of the merchants.

 

The industry defined by the sale of online advertising and marketing services is highly competitive. Although overall Internet advertising expenditures have increased in the last few years, the advertising industry has suffered in certain respects as many online businesses have ceased operations and many traditional businesses have scaled back their advertising budgets. In addition, we believe that today’s typical Internet advertiser is becoming more sophisticated regarding the different forms of Internet advertising, how to purchase Internet advertising in a cost-effective manner, and return-on-investment measurement. The competition for this pool of advertising dollars has also put downward pressure on pricing points, and online advertisers have demanded more effective means of reaching customers. We believe that these factors have contributed to the growth in performance-based advertising relative to certain other forms of online advertising and marketing, and as a result this sector has attracted many competitors.

 

 

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Due to the long-term growth trends in online advertising, these competitors, real and potential, range in size and focus. Our competitors may include such diverse participants as small referral companies, established advertising agencies, inventory resellers, search engines, and destination Web sites. To some extent, we may compete with our business partners, as we do with all other types of advertising sales companies and agencies. Furthermore, to a more limited extent, we may also compete with traditional offline media such as television, radio and print and direct marketing companies, for a share of merchant advertisers’ total advertising budgets. Although we pursue a strategy that enables us to work with most, if not all, of our competitors, there are no guarantees that all companies will view us as a potential partner.

 

We are also affected by the competition among destination Web sites that reach users or customers of search services. Several large media and search engine companies dominate this end of the transaction channel, although thousands of other smaller outlets are available to customers as well. User traffic among the media and search engine companies is concentrated among such larger participants as AOL, Google, Microsoft through MSN Search, and Yahoo! through FAST, Inktomi, Overture and Yahoo! Search. The online search industry continues to experience consolidation of major Web sites and search engines, which has the effect of increasing the negotiating power of these parties in relation to smaller providers. The major destination Web sites and distribution providers may have leverage to demand more favorable contract terms, such as pricing, renewal and termination provisions.

 

We expect competition to intensify in the future as new competitors can enter our market with little difficulty. The barriers to entering our market are relatively low. In fact, many current Internet and media companies presently have the technical capabilities and advertiser bases to enter the search marketing services industry. Further, if the consolidation trend continues among the larger media and search engine companies with greater brand recognition, the share of the market remaining for us and other smaller search marketing services providers could decrease, even though the number of smaller providers could continue to increase. These factors could adversely affect our competitive position and relatively small market share in the search marketing services industry.

 

Intellectual Property and Proprietary Rights

 

We seek to protect our intellectual property through existing laws and regulations and by contractual restrictions. We rely upon trademark, patent and copyright law, trade secret protection and confidentiality or license agreements with our employees, customers, partners and others to help us protect our intellectual property.

 

Our technologies involve a combination of proprietary rights, owned and developed by us, commercially available software and hardware elements that are licensed or purchased by us from various providers, including Cisco, Dell, Intel, Microsoft, Sun Microsystems and Veritas, and public domain software, such as Apache, Linux, MySQL, Sun Microsystems Java and Tomcat. We continue to develop additional technologies to update, supplement and replace existing components of the platform. We intend to protect these additional intellectual property rights through patent applications and trade secret enforcement.

 

Our policy is to apply for patents or for other appropriate statutory protection when we develop valuable new or improved technology. We currently do not have any registered patents. We have filed two patent applications with the U.S. Patent and Trademark Office for various aspects of our transaction technologies and services, with the following titles, numbers and descriptions:

 

  US Provisional Patent Application Serial Number 60/504,963, of Horowitz et al., entitled “Performance-Based Online Advertising System and Method,” was filed on September 23, 2003 and is currently pending. This patent application describes a system, method, and computer program product for implementing an online, performance-based service for advertisers that provides the ability for advertisers to purchase various advertising products.

 

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  US Provisional Patent Application Serial Number 60/523,688, of Horowitz et al., entitled “Online Advertising System and Method,” was filed on November 21, 2003 and is currently pending. This patent application describes an online advertising system, method, and computer program product configured to present an advertiser with keyword-driven pricing for advertisements.

 

The status of any patent involves complex legal and factual questions. The scope of allowable claims is often uncertain. As a result, we cannot be sure that any patent application filed by us will result in a patent being issued, nor that any patents issued in the future will afford adequate protection against competitors with similar technology; nor can we provide assurance that patents issued to us will not be infringed upon or designed around by others. Furthermore, the performance-based search advertising industry has been the subject of numerous patents and patent applications, which in turn has resulted in litigation. The outcome of this ongoing litigation or any future claims in this sector may adversely affect our business or financial prospects.

 

We have been issued registered trademarks in the United States covering certain goods and services for “TrafficLeader,” “Sitewise” and “Direct Search Inclusion.” We have applied for registered trademark status for “Marchex” and “Enhance Interactive.” We do not know whether we will be able to successfully defend our proprietary rights since the validity, enforceability and scope of protection of proprietary rights in Internet-related industries are uncertain and still evolving.

 

Government Regulation

 

We are subject to governmental regulation much like many other companies. There are still relatively few laws or regulations specifically addressed to the Internet. As a result, the manner in which existing laws and regulations should be applied to the Internet in general, and how they relate to our businesses in particular, is unclear in many cases. Such uncertainty arises under existing laws regulating matters, including user privacy, defamation, pricing, advertising, taxation, gambling, sweepstakes, promotions, content regulation, quality of products and services, and intellectual property ownership and infringement.

 

To resolve some of the current legal uncertainty, we expect new laws and regulations to be adopted that will be directly applicable to our activities. Any existing or new legislation applicable to us could expose us to substantial liability, including significant expenses necessary to comply with such laws and regulations, and could dampen the growth in use of the Internet in general.

 

Several new federal laws that could have an impact on our business have already been adopted. The Digital Millennium Copyright Act is intended to reduce the liability of online service providers for listing or linking to third party Web sites that include materials that infringe copyrights or rights of others. The Children’s Online Protection Act and the Children’s Online Privacy Protection Act are intended to restrict the distribution of certain materials deemed harmful to children and impose additional restrictions on the ability of online services to collect user information from minors. In addition, the Protection of Children from Sexual Predators Act requires online services providers to report evidence of violations of federal child pornography laws under certain circumstances.

 

The foregoing legislation may impose significant additional costs on our business or subject us to additional liabilities, if we were not to comply fully with their terms, whether intentionally or not. If we did not meet the safe harbor requirements of the Digital Millennium Copyright Act, we could be exposed to copyright actions, which could be costly and time-consuming. The Children’s Online Protection Act and the Children’s Online Privacy Protection Act impose fines and penalties to persons and operators that are not fully compliant with their requirements. The federal government could impose penalties on those parties that do not meet the full compliance practices of the Protection of Children from Sexual Predators Act. We intend to fully comply with the laws and regulations that govern our industry, and we employ internal resources and incur outside professional fees to establish, review and maintain policies and procedures to reduce the risk of noncompliance.

 

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We post our privacy policy and practices concerning the use and disclosure of any user data on our Web sites. Any failure by us to comply with posted privacy policies, Federal Trade Commission requirements or other domestic or international privacy-related laws and regulations could result in proceedings by governmental or regulatory bodies that could potentially harm our businesses, results of operations and financial condition. In this regard, there are a large number of legislative proposals before the U.S. Congress and various state legislative bodies regarding privacy issues related to our businesses. It is not possible to predict whether or when such legislation may be adopted, and certain proposals, if adopted, could harm our business through a decrease in user registrations and revenue. These decreases could be caused by, among other possible provisions, the required use of disclaimers or other requirements before users can utilize our services.

 

Employees

 

As of February 16, 2004, we employed a total of 170 full-time employee equivalents. We have never had a work stoppage, and none of our employees are represented by a labor union. We consider our employee relationships to be positive. If we were unable to retain our key employees or we were unable to maintain adequate staffing of qualified employees, particularly during peak sales seasons, our business would be adversely affected.

 

Properties

 

We do not own property. Our corporate offices are located at 2101 Fourth Avenue, Suite 1980, Seattle, Washington, and are comprised of approximately 8,453 square feet leased under sublease and lease agreements expiring in June 2006 and April 2004 respectively, at a combined monthly rental of $15,123. Our Enhance Interactive offices are located at 360 West 4800 North, Provo, Utah, and are comprised of approximately 13,050 square feet under a sublease agreement expiring in May 2005, at a monthly rental of $16,802. Additionally, our TrafficLeader offices are located at 2986 Crescent Avenue, Eugene, Oregon, and are comprised of approximately 6,725 square feet leased under sublease and lease agreements expiring in July 2004 and October 2004 respectively, at a combined monthly rental of approximately $9,572 per month.

 

In March 2004, we entered into a sublease agreement for additional office space in Seattle, Washington, and this commitment extends through 2009. The sublease agreement provides for the leasing of 11,400 square feet of office space at $16,150 per month, increasing to 26,788 square feet at $37,950 per month, over the term of the agreement ending in 2009.

 

Our information technology systems are hosted and maintained in third-party facilities under colocation services agreements. See “Information Technology and Systems.”

 

Legal Proceedings

 

We are not currently a party to any material legal proceeding and, to the best of our knowledge, none is threatened. From time to time, however, we may be subject to legal proceedings and claims in the ordinary course of business, including claims of alleged infringement of intellectual property rights, and a variety of claims arising in connection with our services.

 

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MANAGEMENT

 

Executive Officers and Directors

 

Our executive officers and directors, their ages and their positions are as follows.

 

Name


   Age

  

Position(s)


Russell C. Horowitz

   37    Chairman of the Board of Directors, Chief Executive Officer and Treasurer

Michael A. Arends

   33   

Chief Financial Officer

Ethan A. Caldwell

   35    Chief Administrative Officer, General Counsel and Secretary

Peter Christothoulou

   32   

Chief Strategy Officer

John Keister

   37   

President, Chief Operating Officer and Director

Walter Korman

   30   

Senior Vice President of Engineering

Victor Oquendo

   31   

Senior Vice President of Technology Operations

Dennis Cline (1) (2)

   43   

Director

Jonathan Fram (1) (2)

   47   

Director

Rick Thompson (1) (2)

   44   

Director


(1) Member of the Audit Committee.
(2) Member of the Nominating and Governance Committee.

 

Russell C. Horowitz. Mr. Horowitz is a founding officer and has served as the Chairman of our board of directors, Chief Executive Officer and Treasurer since our inception in January 2003. From January 2001 to December 2002, Mr. Horowitz and our founding officers jointly reviewed new business opportunities in the retail, media, finance and technology industries. Mr. Horowitz was previously a founder of Go2Net, a provider of online services to merchants and consumers, including online payment authorization technology, Web search and directory services and merchant web hosting, and served as its Chairman and Chief Executive Officer from its inception in February 1996 until its merger into InfoSpace, a provider of online services focused on Web search, online payment solutions for merchants, mobile infrastructure applications and content for wireless carriers, in October 2000, at which time Mr. Horowitz served as the Vice Chairman and President of the combined company through the merger integration process until January 2001. Additionally, Mr. Horowitz served as the Chief Financial Officer of Go2Net from its inception until May 2000. Prior to Go2Net, Mr. Horowitz served as the Chief Executive Officer and a director of Xanthus Management, LLC, the general partner of Xanthus Capital, a merchant bank focused on investments in early-stage companies, and was a founder and Chief Financial Officer of Active Apparel Group, now Everlast Worldwide. Mr. Horowitz received a B.A. in Economics from Columbia College of Columbia University.

 

Michael A. Arends. Mr. Arends has served as our Chief Financial Officer since May 2003. Prior to joining Marchex, Mr. Arends held various positions at KPMG since 1995, most recently as a Partner in KPMG’s Pacific Northwest Information, Communications and Entertainment assurance practice. Mr. Arends is a Certified Public Accountant and a Chartered Accountant and received a Bachelor of Commerce from the University of Alberta.

 

Ethan A. Caldwell. Mr. Caldwell is a founding officer and has served as our Chief Administrative Officer, General Counsel and Secretary since our inception in January 2003. From January 2001 to December 2002, Mr. Caldwell reviewed, together with the other founding officers, new business opportunities in the retail, media, finance and technology industries. Mr. Caldwell was previously Senior Vice President, General Counsel and Corporate Secretary of Go2Net, from November 1996, until its merger with InfoSpace in October 2000. Mr. Caldwell assisted in the integration of Go2Net with InfoSpace through December 2000. Mr. Caldwell received his J.D. from the University of Maryland and his B.A. in Political Science from Occidental College.

 

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Peter Christothoulou. Mr. Christothoulou is a founding officer and has served as our Chief Strategy Officer since our inception in January 2003. From January 2001 to December 2002, Mr. Christothoulou reviewed, together with the other founding officers, new business opportunities in the retail, media, finance and technology industries. Mr. Christothoulou was previously the Senior Vice President of Strategic Initiatives for Go2Net, focused on strategic acquisitions and investments, from January 2000 until its merger with InfoSpace in October 2000, at which time he served as the Senior Vice President of Corporate Strategy and Development of the combined company through the merger integration process until January 2001. Prior to Go2Net, Mr. Christothoulou was a Vice President in the Investment Banking Group of U.S. Bancorp Piper Jaffray, focused primarily on merger and acquisition advisory services for technology companies, and was with the investment banking firm from 1996 until January 2000. Mr. Christothoulou received a B.A. in Economics from the University of Washington.

 

John Keister. Mr. Keister is a founding officer and has served as our Chief Operating Officer and as a member of our board of directors since our inception in January 2003, and as our President since December 2003. From February 2001 to December 2002, Mr. Keister reviewed, together with the other founding officers, new business opportunities in the retail, media, finance and technology industries. Mr. Keister was previously a founder of Go2Net and served as its President from 1999 until its merger into InfoSpace in October 2000, at which time he served as Executive Vice President of the Consumer Division through the merger integration process until January 2001. He also served as a member of the board of directors of Go2Net and as its Chief Operating Officer from 1996 to 1999. Mr. Keister received B.A. degrees in Philosophy and in Diplomacy & World Affairs from Occidental College.

 

Walter Korman. Mr. Korman has been an executive in our technology organization since March 2003, and currently serves as Senior Vice President of Engineering. Mr. Korman was previously Director of Technology Mergers and Acquisitions at Go2Net from 1999 until its merger with InfoSpace in October 2000, after which he served as the combined company’s Senior Director of Operations Integration until June 2001. From 2001 to February 2003, he was a Software Engineer with Three Rings Design, an Internet games development company. Mr. Korman received a B.A. and M.S. in Computer Science from the University of California, San Diego.

 

Victor Oquendo. Mr. Oquendo is a founding officer and has been a leader of our technology organization since our inception in January 2003, and currently serves as Senior Vice President of Technology Operations. From January 2001 to January 2003, Mr. Oquendo reviewed, together with the other founding officers, new business opportunities in the retail, media, finance and technology industries. Mr. Oquendo was previously the Senior Vice President of Technology for Go2Net from 1998 until its merger with InfoSpace in October 2000, at which time he served as the combined company’s Senior Vice President of Technology Operations through the merger integration process until January 2001. Mr. Oquendo received a B.S. in Computer Science from the Rose-Hulman Institute of Technology.

 

Dennis Cline. Mr. Cline has served as a member of our board of directors since May 2003. Mr. Cline is currently the managing partner of DMC Investments, a firm he founded in 2000, which provides capital and consulting services to technology companies. From 1998 to 2000, Mr. Cline was the Chief Executive Officer of DirectWeb, a provider of a bundled solution of computer hardware and Internet access for consumers. Prior to DirectWeb Mr. Cline was a senior executive at Network Associates, a provider of computer security solutions. Mr. Cline received his J.D. from Rutgers School of Law and his B.A. from Rutgers University.

 

Jonathan Fram. Mr. Fram has served as a member of our board of directors since May 2003. Mr. Fram currently serves as a consultant to companies that provide media and voice services over the Internet. From May 2002 through December 2003, Mr. Fram was the CEO for Envivio, a privately-held company, where he remains a member of the board of directors, a provider of MPEG-4 broadcast and streaming solutions. From October 2001 to May 2002, Mr. Fram was the Acting CEO of Envivio while he was a consultant to France Telecom, Envivio’s majority shareholder at that time. From August 2000 to July 2001, Mr. Fram was the President and CEO of eVoice, an online voicemail and unified messaging provider, until its sale to America Online in July 2001. Prior

 

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to eVoice from July 1999 to August 2000, Mr. Fram was the President of Net2Phone, a provider of voice services over IP networks, until AT&T acquired a controlling interest in the company. Prior to Net2Phone, from 1991 to 1999, Mr. Fram was a General Manager at Bloomberg, responsible for the Television, Internet and Radio divisions. Mr. Fram received a B.S. degree in Electrical Engineering and Computer Science from Princeton University.

 

Rick Thompson. Mr. Thompson has served as a member of our board of directors since May 2003. Mr. Thompson has been the Vice President for the Extended Windows Platform Group at Microsoft since December 2002. From February 2001 to November 2002, Mr. Thompson was a business consultant to retail automotive, packaged goods and health and fitness companies, with a particular focus on providing product and market analysis services and management consulting. From May 2000 through January 2001, Mr. Thompson was the CFO and EVP for Product Development for Go2Net. Prior to Go2Net, from 1987 through 2000, Mr. Thompson was the Vice President of Hardware for Microsoft. Mr. Thompson received B.A. degrees in Economics and in French from Bates College.

 

Election of Directors and Officers

 

Our board of directors currently consists of the following five members: (i) Russell C. Horowitz (Chairman), (ii) John Keister, (iii) Dennis Cline, (iv) Jonathan Fram and (v) Rick Thompson. Messrs. Horowitz and Keister are the only management members of our board of directors and were selected as directors pursuant to a voting provision in the stockholders’ agreement that will automatically terminate upon the closing of this offering. Messrs. Cline, Fram and Thompson are independent directors as defined by the applicable rules of the National Association of Securities Dealers, Inc. listing standards. We refer to these directors as our “independent directors.” There are no family relationships among any of our directors and executive officers.

 

The directors are elected at each annual meeting of stockholders to serve until their successors have been duly elected and qualified, or until their earlier resignation or removal, if any. Executive officers are appointed by, and serve at the discretion of, the board of directors.

 

Board Committees

 

Audit Committee

 

The audit committee of our board of directors is comprised of Messrs. Cline, Fram and Thompson, each of whom is an independent director. The audit committee shall act pursuant to a formal charter adopted by the board, which will be available on our Web site. The audit committee reviews, with our independent auditors, the scope and timing of the auditors’ services, the auditors’ report on our consolidated financial statements following completion of the audit, and our internal accounting and financial control policies and procedures. In addition, the audit committee makes annual recommendations to the board of directors for the appointment of independent auditors for the ensuing year. The board has determined that each of the members of the audit committee qualifies as an “audit committee financial expert” as that term is defined in accordance with the Securities and Exchange Act of 1934 and the Sarbanes-Oxley Act of 2002 and that each also satisfies related NASDAQ finance or accounting experience requirements. Mr. Thompson currently serves as the chairman of the audit committee.

 

Compensation Committee

 

Prior to the consummation of the offering, our board of directors shall establish a compensation committee comprised of at least two persons among Messrs. Cline, Fram and Thompson, each of whom is an independent director. The compensation committee will act pursuant to a formal charter to be adopted by the board, which will be available on our Web site. At such time, the compensation committee shall review and evaluate the compensation and benefits of all of our officers, including the compensation of our CEO, review general policy matters relating to compensation and employee benefits, and make recommendations concerning these matters to our board of directors. The compensation committee shall also administer our stock incentive plan and our employee stock purchase plan. For a more detailed description of our stock incentive plan, please see “Benefit Plans.”

 

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Nominating and Governance Committee

 

The nominating and governance committee is comprised of Messrs. Cline, Fram and Thompson, each of whom is an independent director. The nominating and governance committee shall act pursuant to a formal charter adopted by the board, which will be available on our Web site. The nominating and governance committee identifies individuals qualified to become board members, recommend to the board those persons to be nominated by the board of directors as directors at the annual meeting of stockholders, develop and recommend to the board a set of corporate governance principles applicable to our company and oversee the evaluation of the board and management. Mr. Fram currently serves as the chairman of the nominating and governance committee.

 

Our board of directors may establish other committees it deems necessary or appropriate from time to time.

 

Code of Conduct and Code of Ethics

 

We have adopted a code of conduct applicable to each of our officers, directors and employees, and a code of ethics applicable to our Chief Executive Officer and our senior financial officers, as contemplated by Section 406 of the Sarbanes-Oxley Act of 2002 and will include both codes on our Web site at www.marchex.com. We will disclose any amendments to, or waivers from, any provisions of either our code of conduct or our code of ethics on a Form 8-K filed with the Securities and Exchange Commission and on our Web site by posting such information within five days after such amendment or waiver.

 

Corporate Governance Guidelines

 

Prior to the consummation of the offering, our board of directors will adopt corporate governance guidelines to ensure effective corporate governance. These guidelines will also provide that our independent directors shall meet regularly (not less than two times per year) in executive session at which only our independent directors shall be present.

 

Compensation of Directors

 

Our directors currently do not receive cash compensation for their services as members of the board of directors. Directors are, however, reimbursed for the expenses they incur in attending meetings of the board of directors or board of director committees. We have granted a non-qualified stock option pursuant to our stock incentive plan to purchase 40,000 shares of our Class B common stock, at an exercise price of $3 per share and with vesting in equal annual increments on the first, second, third and fourth anniversaries of their respective dates of board service, to each of Messrs. Cline, Fram and Thompson.

 

Compensation Committee Interlocks and Insider Participation

 

No interlocking relationship exists between any proposed member of our compensation committee and any member of any other company’s board of directors or compensation committee. Members of the compensation committee will not receive additional compensation other than the compensation noted above that they received pursuant to becoming members of the board of directors. See “Security Ownership of Certain Beneficial Owners and Management” and “Certain Relationships and Related Transactions” for a summary of the holdings, rights and transactions of these members with respect to our shares of our Class B common stock.

 

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EXECUTIVE COMPENSATION

 

The following table sets forth the compensation earned by our Chief Executive Officer and our Chief Financial Officer for services rendered in all capacities during the period from our inception, January 17, 2003, to December 31, 2003. No other executive officer’s total annual salary and bonus for 2003 exceeds $100,000. We refer to these executives as our “named executive officers” elsewhere in this prospectus.

 

Summary Compensation Table

 

     2003 Compensation

   Long-term
Compensation


Name and Principal Position


   Salary

   Bonus

   All other
compensation


   Securities Underlying
Options


Russell C. Horowitz (Chief Executive Officer)(1)

   $ 39,712    0    *    0

Michael A. Arends (Chief Financial Officer)(2)

   $ 104,000    0    *    450,000

(1) Mr. Horowitz was not paid a salary for the period from January 17, 2003 (inception) through March 16, 2003, and his salary compensation commenced as of March 17, 2003.
(2) Mr. Arends joined Marchex as of May 1, 2003, and his salary compensation commenced as of that date.
* No other compensation in excess of the lesser of either $50,000 or 10% of total annual salary and bonus.

 

The following table sets forth information with respect to stock options granted to our named executive officers during the period from our inception, January 17, 2003, to December 31, 2003.

 

Option Grants

 

Name


   Number of
Securities
underlying
options granted


   Percentage of
Total Options
Granted to
Employees


    Exercise
Price Per
Share


   Expiration
Date


Russell C. Horowitz

   0    0 %   N/A    N/A
    
  

        

Michael A. Arends

   350,000    11.3 %   $3.00    5/1/2013
     100,000    3.3 %   IPO price    5/1/2013
    
  

        
     450,000    14.6 %         
    
  

        

 

The following table sets forth information regarding unexercised options held as of December 31, 2003, by our named executive officers. There was no public trading market for our Class B common stock as of December 31, 2003. Accordingly, these values have been calculated on the basis of an assumed initial public offering price of $6.50, which represents the middle of the filing range as of the date of this prospectus, less the applicable exercise price per share, multiplied by the number of shares issued or issuable, as the case may be, on the exercise of the option.

 

Aggregate Option Exercises/Option Values

 

    

Number of Shares
Acquired on
Exercise


   Number of Securities
Underlying
Unexercised Options At
December 31, 2003


   Value
of Unexercised In-the-
Money Options
At December 31, 2003


Name


  

Exercised


  

Value
Realized


   Exercisable

   Unexercisable

   Exercisable

   Unexercisable

Russell C. Horowitz

   N/A    N/A    N/A    N/A    N/A    N/A

Michael A. Arends

   N/A    N/A    33,333    416,667    116,667    1,108,335

 

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Employment Contract with Named Executive Officers

 

Russell C. Horowitz

 

We have entered into an Executive Employment Agreement with Russell C. Horowitz, our Chief Executive Officer, effective as of January 17, 2003. The agreement with Mr. Horowitz provides for an at-will employment term and an annual base salary of $50,000. Mr. Horowitz has signed our standard confidentiality agreement, which provides, among other things, that Mr. Horowitz will not compete with us for twelve months following termination of his employment.

 

Michael A. Arends

 

We have also entered into an Executive Employment Agreement with Michael A. Arends, our Chief Financial Officer, effective as of May 1, 2003. The agreement with Mr. Arends provides for an at-will employment term and an initial annual base salary of $156,000, which will be adjusted to $135,000 upon the closing of a qualified initial public offering with gross proceeds to us in excess of $20 million.

 

Under the agreement, Mr. Arends was granted a stock option to purchase 350,000 shares of Class B common stock at an exercise price of $3.00, subject to a four-year vesting schedule, 166,665 shares of which are designated as an incentive stock option and the remainder of which are designated as a non-qualified stock option. In addition, Mr. Arends was granted a non-qualified stock option to purchase 100,000 shares of Class B common stock at an exercise price equal to either the fair value one year from the date of the agreement or, if earlier, the initial public offering price, subject to a vesting schedule through October 31, 2007.

 

In the event that either (i) Russell C. Horowitz ceases to be a Marchex employee for any reason or (ii) a change in control occurs while Mr. Arends is employed by Marchex, all options or other equity awards held by Mr. Arends with respect to our Class B common stock shall become fully vested. For purposes of this provision, a change in control occurs if one person or entity acquires control of 50% or more of our common stock entitled to vote for directors, but does not occur as a result of an acquisition by Marchex or any corporation controlled by Marchex.

 

Mr. Arends has the right to a severance payment in the event of termination meeting certain conditions as set forth in the employment agreement, up to a maximum payment of one year’s salary.

 

Mr. Arends has signed our standard confidentiality agreement, which provides, among other things, that Mr. Arends will not compete with us for twelve months following termination of his employment.

 

Benefit Plans

 

Stock Incentive Plan. On January 17, 2003, we adopted our 2003 stock incentive plan. The plan provides for the granting of shares of Class B common stock to employees, directors, and consultants of Marchex, its affiliates and strategic partners and provides for the following types of option grants:

 

  incentive stock options within the meaning of Section 422 of the Internal Revenue Code (sometimes known as ISOs);

 

  non-statutory stock options, which are options not intended to qualify as ISOs (sometimes known as non-qualified options); and

 

  right to purchase shares pursuant to restricted stock purchase agreements.

 

Marchex has reserved 5,013,953 shares of Class B common stock for issuance under the plan. The plan also provides for annual increases in the number of shares available for issuance under the plan, on the first day of our fiscal year, equal to 5% of the outstanding shares of Class B common stock (including any shares of common stock issuable upon conversion of any outstanding capital stock) on such date. The total number of shares of

 

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Class B common stock for which options designated as ISO’s may be granted shall not exceed 8,000,000. As of December 31, 2003, options to purchase 3,089,600 shares of Class B common stock were outstanding. As of December 31, 2003, no options had been exercised under the plan.

 

At the discretion of the board, the plan administrator shall be either the full board of directors or a special committee of the board consisting of at least two members of the board. A majority of the members of the committee constitutes a quorum and any action may be taken by a majority of those present and voting at the meeting. The entire board of directors or the special committee administering the plan selects the participants who will receive awards and determines the terms and conditions of such awards. Grants of stock under the plan will be subject to the terms of an option agreement or stock grant agreement, each in a form approved by the plan administrator.

 

Pursuant to the plan, ISOs may only be granted to employees. No option designated as an ISO may be granted to any participant who owns stock totaling more than 10% of the voting power of all classes of our outstanding capital stock, unless the exercise price of such stock equals at least 110% of the fair value on the grant date and the term of the option does not exceed five years.

 

The plan will terminate automatically ten years from the date of adoption by the stockholders, on January 17, 2013, unless terminated sooner by the vote of the plan administrator or the requisite stockholder vote.

 

Employee Stock Purchase Plan. Our 2004 employee stock purchase plan, which will become effective on the first date that our Class B common stock is publicly traded as a result of this offering assuming we receive gross proceeds in excess of $20 million, was adopted by our board of directors and approved by our stockholders on February 15, 2004. This plan will be intended to qualify under Section 423 of the Internal Revenue Code and will permit eligible employees to purchase our Class B common stock for amounts up to 15% of their compensation in offering periods under the plan. Under the purchase plan, no employee will be permitted to purchase stock worth more than $25,000 in any calendar year, valued as of the first day of each offering period. We have authorized an aggregate of 300,000 shares of our Class B common stock for issuance under the purchase plan to participating employees.

 

The purchase plan will provide for offering periods which shall be determined by the board of directors. Eligible participants may purchase Class B common stock under the purchase plan at a price equal to the lesser of 85% of the fair value on the first day of an offering period and 85% of the fair value on the last day of an offering period.

 

401(k) Plan (Enhance Interactive). Our subsidiary, Enhance Interactive, sponsors a 401(k) plan covering its employees. The 401(k) plan is intended to qualify under Section 401(a) of the Internal Revenue Code of 1986, as amended, so that contributions to the 401(k) plan by employees or by Enhance Interactive and the investment earnings thereon, are not taxable to employees until withdrawn from the 401(k) plan, and so that contributions by Enhance Interactive, if any, will be deductible by Enhance Interactive when made. Under the 401(k) plan, employees may elect to reduce their current compensation by up to the plan’s prescribed annual limit and to have the amount of such reduction contributed to the 401(k) plan. The 401(k) plan permits, but does not require, additional matching and profit sharing contributions to the 401(k) plan by Enhance Interactive on behalf of all eligible participants in the 401(k) plan. To date, no matching or profit sharing contributions have been made by Enhance Interactive to the 401(k) plan.

 

401(k) Plan (TrafficLeader). Our subsidiary, TrafficLeader, sponsors a 401(k) plan covering its employees. The 401(k) plan is intended to qualify under Section 401(a) of the Internal Revenue Code of 1986, as amended, so that contributions to the 401(k) plan by employees or by TrafficLeader and the investment earnings thereon, are not taxable to employees until withdrawn from the 401(k) plan, and so that contributions by TrafficLeader, if any, will be deductible by TrafficLeader when made. Under the 401(k) plan, employees may elect to reduce their current compensation by up to the statutorily prescribed annual limit and to have the amount of such reduction contributed to the 401(k) plan. The 401(k) plan permits, but does not require, additional matching and non-

 

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elective contributions to the 401(k) plan by TrafficLeader on behalf of all eligible participants in the 401(k) plan. To date, no matching or non-elective contributions have been made by TrafficLeader to the 401(k) plan.

 

Limitations on Directors’ Liability and Indemnification Matters

 

As permitted by Delaware General Corporation Law, we have included in our certificate of incorporation a provision to eliminate the personal liability of our directors for monetary damages for breach or alleged breach of their fiduciary duties as directors, other than breaches of their duty of loyalty, actions not in good faith or which involve intentional misconduct, or transactions from which they derive improper personal benefit. In addition, our by-laws provide that we are required to indemnify our officers and directors under certain circumstances, including those circumstances in which indemnification would otherwise be discretionary, and we are required to advance expenses to our officers and directors as incurred in connection with proceedings against them for which they may be indemnified.

 

The limitations summarized above, however, do not affect our ability or the ability of our stockholders to seek non-monetary-based remedies, such as an injunction or rescission, against a director for breach of his fiduciary duty nor would such limitations limit liability under the federal securities laws. Our by-laws provide that we shall, to the extent permitted by Delaware law, indemnify and advance expenses to our currently acting and former directors, officers, employees and agents or director, officers, employees and agents of other corporations, partnerships, joint ventures, trusts or other enterprises if serving at our request arising in connection with their acting in such capacities.

 

At present, we are not aware of any pending or threatened litigation or proceeding involving our directors, officers, employees or agents in which indemnification would be required or permitted. We believe that our certificate of incorporation and by-law provisions are necessary to attract and retain qualified persons as directors and officers.

 

We have also entered into indemnification agreements with each of our directors and executive officers.

 

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SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS

AND MANAGEMENT

 

The following table sets forth information regarding the beneficial ownership of our common stock as of February 16, 2004 and as adjusted to reflect the sale of the Class B common stock offered hereby by:

 

  each person (or group of affiliated persons) who is known by us to own beneficially more than 5% of the outstanding shares of our common stock;

 

  each of our directors who own our common stock;

 

  each of our executive officers listed in the “Summary Compensation Table” who owns our common stock; and

 

  all directors and executive officers as a group.

 

Percentage of beneficial ownership is based on 20,279,063 shares of common stock outstanding as of February 16, 2004 (assuming the conversion of the outstanding convertible preferred stock), and 24,279,063 shares of common stock outstanding after completion of the offering. In computing the number of shares beneficially owned by a person and the percentage ownership of that person, shares of common stock subject to options held by that person that are currently exercisable or exercisable within 60 days of February 16, 2004, are deemed outstanding. These shares are not, however, deemed outstanding for the purposes of computing the percentage ownership of any other person. Except as otherwise noted below, the address for each beneficial owner listed below is c/o Marchex, Inc., 2101 Fourth Avenue, Suite 1980, Seattle, Washington 98121.

 

          Percentage of Shares
Outstanding


 

Name and Address of Beneficial Owner


   Number of
Shares Owned


   Before Offering

    After Offering

 

Russell C. Horowitz (1)

   9,525,040    47.0 %   39.2 %

Michael A. Arends (2)

   48,333    *     *  

John Keister (3)

   2,695,160    13.3 %   11.1 %

Rainwater River Authority, LLC (4)

   770,000    3.8 %   3.2 %

Twin Oaks Plateau, LLC (5)

   500,000    2.5 %   2.1 %

Dennis Cline (6)

   100,000    *     *  

Jonathan Fram

   0    0 %   0 %

Rick Thompson (7)

   1,158,333    5.7 %   4.8 %

All directors and executive officers as a group (10 persons) (8)

   15,762,492    77.5 %   64.8 %

 

Except as indicated in the footnotes below and except as subject to community property laws where applicable, the persons named in the table above have sole voting and investment power with respect to all shares of common stock shown as beneficially owned by them.

 

The table above does not include any shares that may be purchased in the offering.


 * Less than one percent of the outstanding shares of common stock.
(1) Includes: (i) 8,026,707 shares of our Class A common stock held by MARRCH Investments, LLC; (ii) 1,400,000 shares of our Class B common stock held by MARRCH Investments, LLC; and (ii) 83,333 shares of our Class B common stock held by Pemrose, LLC. Mr. Horowitz is the managing member of these entities and, as such, may be deemed to exercise voting and investment power over the shares held by all of these entities. It also includes 5,000 shares of our Class B common stock held in an Individual Retirement Account for the benefit of Mr. Horowitz and 10,000 shares of our Class B common stock.
(2)

Includes: (i) 33,333 shares of our Class B common stock issuable upon exercise of options; (ii) 4,500 shares of our Class B common stock; and (iii) 10,500 shares of our Class B common stock held by the Nicole

 

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Marie Arends 2003 Trust for the benefit of Nicole Marie Arends, the daughter of Mr. Arends, for which shares Mr. Arends disclaims beneficial ownership.

(3) Includes: (i) 2,000,167 shares of our Class A common stock; (ii) 6,160 shares of our Class B common stock held in an Individual Retirement Account for the benefit of Mr. Keister; (iii) 65,000 shares of our Class B common stock held in a Grantor Retained Annuity Trust, of which Mr. Keister is the grantor; and (iv) 623,833 shares of our Class B common stock.
(4) The David Horowitz Trust II is the sole member of Rainwater River Authority, LLC. The beneficiary of such trust is Mr. David M. Horowitz. The address for Rainwater River Authority, LLC is: 10900 NE 8th Street, Suite 900, Bellevue, Washington 98004.
(5) The David Horowitz Trust is the sole member of Twin Oaks Plateau, LLC. The beneficiary of such trust is Mr. David M. Horowitz. The address for Twin Oaks Plateau, LLC is: 10900 NE 8th Street, Suite 900, Bellevue, Washington 98004.
(6) Consists of 100,000 shares held by DMC Investments, LLC, a limited liability company of which Mr. Cline is the managing member.
(7) Consists of 1,158,333 shares of our Class B common stock.
(8) Includes an aggregate of: (i) 11,987,500 shares of our Class A common stock; (ii) 3,716,659 shares of our Class B common stock (including 10,500 shares for which beneficial ownership has been disclaimed); and (iii) 58,333 shares of our Class B common stock issuable upon exercise of options, of which options for the purchase of 33,333 shares of Class B common stock are exercisable at this time.

 

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CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

 

Transactions with Our Founding Officers

 

Russell C. Horowitz, Ethan A. Caldwell, Peter Christothoulou, John Keister and Victor Oquendo, our founding officers, were involved in our initial funding and by reason of such involvement would be deemed to be acting as promoters as such term is defined by Rule 405 of Regulation C under the Act. Following our inception, in January 2003, we issued an aggregate of 12,250,000 shares of our Class A common stock to these founding officers at a purchase price of $0.01 per share for a total purchase price of $122,500 and 1,000,000 shares of our Class B common stock for the benefit of Russell C. Horowitz individually or a Russell C. Horowitz–designated affiliated entity, at a purchase price of $0.01 per share for a total purchase price of $10,000. In connection with, and as part of, our preferred stock financing in February and May 2003, we issued an aggregate of 2,442,326 shares of our Series A redeemable convertible preferred stock to these founding officers at a purchase price of $3 per share for an aggregate purchase price of $7,326,980.

 

As part of our original organization, we purchased certain property and equipment from Russell C. Horowitz and an affiliated entity for approximately $57,000 and from Ethan A. Caldwell for approximately $4,000.

 

Private Placement Financing

 

In February and May 2003, we sold an aggregate of 6,724,063 shares of our Series A redeemable convertible preferred stock in a private placement at a purchase price of $3 per share for a total purchase price of $20,172,201 (this amount includes all investments, including investments of the executive officers and directors). Upon closing of this offering, all outstanding shares of preferred stock will automatically convert into Class B common stock and all share and per share amounts have been adjusted to reflect this conversion. The following table summarizes purchases, valued in excess of $60,000, of shares of our Series A redeemable convertible preferred stock by certain of our executive officers, directors, five-percent stockholders and certain of their family members or permitted transferees:

 

Investor


   Number of Shares
Purchased


   Aggregate Consideration

Ethan A. Caldwell

   50,000    $ 150,000

DMC Investments, LLC (1)

   100,000    $ 300,000

Rainwater River Authority, LLC (2)

   720,000    $     2,160,000

Donald J. Horowitz (3)

   171,200    $ 513,600

Entities affiliated with Russell C. Horowitz (4)

   1,488,333    $ 4,465,000

John Keister (5)

   706,993    $ 2,120,980

Marcia McGreevy Lewis (6)

   33,333    $ 100,000

Sylvia Mathews (7)

   150,000    $ 450,000

Victor Oquendo

   200,000    $ 600,000

Rick Thompson

   833,333    $ 2,500,000

(1) Dennis Cline, one of our directors, is the managing member of DMC Investments, LLC.
(2) The David Horowitz Trust II is the sole member of Rainwater River Authority, LLC. The beneficiary of such trust, Mr. David M. Horowitz, is the brother of Mr. Russell C. Horowitz.
(3) Mr. Donald J. Horowitz is Mr. Russell C. Horowitz’s father. These shares are held jointly with rights of survivorship with Lynda Horowitz.
(4) The record holders of these securities consist of: (i) MARRCH Investments, LLC and (ii) Pemrose, LLC. See footnote (1) in “Security Ownership of Certain Beneficial Ownership and Management” for a description of Mr. Horowitz’s relationship to these entities. It also includes 5,000 shares issued to an Individual Retirement Account for the benefit of Mr. Horowitz.
(5) Includes 6,160 shares issued to an Individual Retirement Account for the benefit of Mr. Keister and 65,000 shares issued to a Grantor Retained Annuity Trust, of which Mr. Keister is the grantor.

 

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(6) Ms. McGreevy Lewis is Mr. Keister’s mother.
(7) Ms. Mathews is Mr. Russell C. Horowitz’s mother. Includes 58,000 shares issued to an Individual Retirement Account for the benefit of Ms. Mathews.

 

In connection with the sale of the preferred stock, the investors were granted piggy-back registration rights, and we may therefore become obligated if requested after completing this offering to effect a registration under the Securities Act of 1933 of the shares of Class B common stock held by these investors upon the conversion of the preferred stock. See “Description of Capital Stock” for a more complete description of these registration rights.

 

We believe that we have executed all of the transactions set forth above on terms no less favorable to us than we could have obtained from unaffiliated third parties. It is our intention to ensure that all future transactions between us and our officers, directors and principal stockholders and their affiliates, are approved by a majority of the board of directors, including a majority of the independent and disinterested members of our board of directors, and are on terms no less favorable to us than those that we could obtain from unaffiliated third parties.

 

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DESCRIPTION OF CAPITAL STOCK

 

General

 

The following summary description of our capital stock is not intended to be complete and is subject, and qualified in its entirety by reference, to our certificate of incorporation, as amended and restated, and our bylaws. We have filed copies of each of these documents as exhibits to the registration statement of which this prospectus is a part.

 

The amended and restated certificate of incorporation will be adopted prior to the consummation of the offering. The following summary assumes the filing of the certificate of amendment to the certificate of incorporation.

 

Authorized and Outstanding Capital Stock

 

Upon the completion of this offering, Marchex will be authorized to issue 12,500,000 shares of Class A common stock, $0.01 par value per share, 125,000,000 shares of Class B common stock, $0.01 par value per share and 1,000,000 shares of undesignated preferred stock, $0.01 par value per share. All currently outstanding shares of Series A redeemable preferred stock will be converted into shares of Class B common stock at a conversion ratio of one-to-one upon the closing of this offering on a firm commitment basis with gross proceeds to Marchex of at least $20 million. The shares of Class A common stock are convertible on a one for one basis into shares of Class B common stock, but only upon the election of the individual holders. In the event that any shares of Class A are converted into shares of Class B, the number of outstanding Class A shares will be reduced on a one for one basis, and the number of Class B shares shall be increased on the same basis.

 

Prior to Completion of the Offering

 

As of February 16, 2004, assuming the mandatory conversion of all outstanding shares of the preferred stock, there were 20,279,063 shares of common stock outstanding that were held by 141 stockholders of record. Of these shares:

 

  11,987,500 shares were authorized as Class A common stock, and as of this date were held by five stockholders of record, and

 

  8,291,563 shares were authorized as Class B common stock, and as of this date were held by 136 stockholders of record.

 

As of February 16, 2004, we had options outstanding for the purchase an aggregate of 3,196,600 shares of Class B common stock of which 2,421,500 options are at a weighted average exercise price of $1.67 per share and 775,100 options will have an exercise price equal to the initial public offering price. These options were issued under our stock incentive plan, which is discussed in more detail below.

 

Upon Completion of the Offering

 

Our authorized capital stock, following the completion of this offering, will consist of shares of common stock and preferred stock:

 

  with 12,500,000 shares authorized as our Class A common stock, $0.01 par value per share, of which 11,987,500 will be outstanding and 262,500 will be held in treasury;

 

  with 125,000,000 shares authorized as our Class B common stock, $0.01 par value per share, of which 12,291,563 will be outstanding (12,891,563 shares if the underwriters’ over-allotment option is exercised in full). The representatives of the underwriters may also exercise warrants for the purchase of up to 120,000 shares of Class B common stock over a period commencing one year after the initial public offering date and ending five years from the initial public offering date for an exercise price of 130% of the initial public offering price; and

 

  with 1,000,000 shares as undesignated preferred stock, $0.01 par value per share, none of which will be outstanding.

 

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Common Stock

 

We have two classes of authorized common stock: Class A common stock and Class B common stock. Except with respect to voting rights, the Class A and Class B shares have identical rights. Holders of our Class A common stock are entitled to twenty-five votes for each share held and holders of our Class B common stock are entitled to one vote for each share held on all matters submitted to a vote of the stockholders, including the election of directors. Except as otherwise required by the laws of the State of Delaware, the holders of outstanding shares of Class A common stock and the holders of outstanding shares of Class B common stock vote as one class with respect to the election of directors and with respect to all other matters to be voted on by the stockholders of the Company.

 

Each share of Class A common stock is convertible, at the holder’s option, into one share of Class B common stock. Our Class B common stock is not convertible into our Class A common stock. Subject to the prior rights of any of our outstanding preferred stock to receive dividends and distributions, holders of our common stock are entitled to receive ratably any dividends that may be declared by the board of directors out of funds legally available and are entitled to receive, pro rata, all of our assets available for distribution to such holders upon liquidation, dissolution or winding up of the Company. The outstanding shares of Class A common stock and Class B common stock are, and the shares of Class B common stock to be issued upon completion of this offering will be, fully paid and non-assessable.

 

Preferred Stock

 

Upon the closing of this offering, all outstanding shares of Series A redeemable convertible preferred stock will be converted into 6,724,063 shares of Class B common stock based on the then-effective conversion ratio of one-to-one and the Series A redeemable preferred stock will automatically be retired. Thereafter, our board of directors will have the authority, without further action by the stockholders, to issue up to 1,000,000 shares of preferred stock, $0.01 par value, in one or more series. Our board of directors will also have the authority to designate the rights, preferences, privileges and restrictions of each such series, including dividend rights, dividend rates, conversion rights, voting rights, terms of redemption, redemption prices, liquidation preferences and the number of shares constituting any series. The issuance of preferred stock may have the effect of delaying, deferring or preventing a change in control of Marchex without further action by the stockholders. The issuance of preferred stock with voting and conversion rights may also adversely affect the voting power of the holders of Class B common stock. In certain circumstances, an issuance of preferred stock could have the effect of decreasing the market price of the Class B common stock. Upon the closing of this offering, no shares of preferred stock will be outstanding. Marchex currently has no plans to issue any shares of preferred stock.

 

Representatives’ Warrants

 

At the closing of this offering, we will sell warrants to purchase shares of our Class B common stock to the representatives for nominal consideration.

 

The representatives of the underwriters, or their designees, may exercise warrants for the purchase of up to 120,000 shares of Class B common stock over a period commencing one year after the initial public offering date and ending five years from the initial public offering date for an exercise price of 130% of the initial public offering price. We have reserved an equivalent number of shares of Class B common stock for issuance upon exercise of the warrants. The holders of the warrants will not possess any rights as a stockholder unless the warrants are exercised. The representatives’ warrants grant to the holders thereof certain rights of registration for the shares of Class B common stock issuable upon exercise thereof.

 

Stock Consideration in the Traffic Leader Acquisition

 

As partial consideration in the acquisition of TrafficLeader, Marchex issued an aggregate of 562,500 shares of Class B common stock to the former stockholders of TrafficLeader, 425,000 of which are fully vested on the date

 

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of grant and 137,500 of which are subject to vesting over time. Marchex is subject to continuing obligations under the agreement and plan of merger dated as of October 1, 2003, entered into by Marchex and TrafficLeader and its stockholders. We also refer to this agreement as the acquisition agreement. The shares issued in connection with the acquisition are subject to a stock transfer and restriction agreement dated as of October 24, 2003, between the former stockholders of TrafficLeader and Marchex.

 

The acquisition agreement and the stock transfer and restriction agreement provide that 137,500 shares of the total stock consideration are classified as “restricted equity consideration.” The restricted equity consideration is subject to a three year vesting schedule, with the first 16.67% vesting on the six month anniversary of the closing date and an additional 16.67% shall vest on the last day of each successive six month period over the next two and one half years. These shares of restricted equity consideration shall become fully vested in the event of an acceleration event as defined in the acquisition agreement with respect to Gerald Wiant and Bruce Fabbri, the former principal stockholders of TrafficLeader, and upon a “change of control” of Marchex with respect to all of the other stockholders who are identified in the stock transfer and restriction agreement. The restricted equity consideration granted to each of Gerald Wiant and Bruce Fabbri shall be subject to forfeiture in the event that their employment relationship with us terminates for any reason.

 

Pursuant to the acquisition agreement, Marchex is obligated to redeem 425,000 shares of Class B common stock at a price of $8 per share, in the event that Marchex has not effected the sale of shares of common stock in firm commitment underwritten public offering pursuant to an effective registration statement with at least $20 million of gross proceeds by October 24, 2005, upon the election of the holders of at least 75% of such shares.

 

With respect to the vested shares, the holders shall also have certain registration and drag along rights pursuant to the stock transfer and restriction agreement, as set forth in more detail below.

 

Registration Rights

 

After the completion of this offering, the holders of approximately 20,279,063 shares of our Class A and Class B common stock, or their permitted transferees, will be entitled to certain “piggy-back” rights with respect to registration of their shares, or “registrable securities,” under the Securities Act. These registration rights were granted pursuant to two separate agreements, the stockholders’ agreement entered into with investors as of January 23, 2003, and the stock transfer and restriction agreement entered into with the holders of those shares of Class B common stock which were issued in connection with the acquisition of TrafficLeader as of October 24, 2003. Of the total number of shares subject to registration rights, 19,716,563 shares of Class A and Class B common stock have rights under the January 2003 agreement, and 562,500 shares of Class B common stock have rights under the October 2003 agreement.

 

Under the terms of these agreements, if we determine to register any of our securities under the Securities Act in connection with a public offering for cash following this offering, either for our own account or for the account of other security holders exercising registration rights, the holders of these shares are entitled to notice of the registration and to include their shares of common stock in the registration upon request at our expense.

 

These “piggy-back” registration rights are not triggered in the case of certain excluded offerings such as registrations relating solely to employee benefit plans, Rule 145 transactions, common stock issuable upon the conversion of debt securities or any form that does not require substantially the same information that would be required to register these shares.

 

These “piggy-back” registration rights are subject to the right of the representatives of an offering to limit the number of shares included in such registration and underwriting. Each of the holders shall also be required to enter into the underwriting agreement for any offering including their shares. These agreements also provide that the holders of these registration rights if requested by the Company and the representatives shall not sell, transfer or otherwise dispose of their shares for 180 days following the closing of this offering.

 

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If our stockholders with registration rights cause a large number of securities to be registered and sold in the public market, those sales could cause the market price of our common stock to fall. If we were to initiate a registration and include registrable securities because of the exercise of registration rights, the inclusion of registrable securities could adversely affect our ability to raise capital.

 

We have agreed to certain “piggy-back” registration rights for the securities underlying the representatives’ warrants, which shall continue with respect to the shares for a period of five years from the first closing date of this offering.

 

Drag Along Rights

 

After the completion of this offering, the holders of approximately 13,555,000 shares of our Class A and Class B common stock, or their permitted transferees, will be entitled to drag along rights with respect to the sale of their shares. Of the total number of shares subject to these drag along rights, 12,992,500 shares of Class A and Class B common stock have rights under the January 2003 agreement, and 562,500 shares of Class B common stock have rights under the October 2003 agreement.

 

Under each of these agreements, the stockholders have drag along rights in the event that a majority of the voting power of a defined group of stockholders proposes to either:

 

  make a bona fide sale or exchange (in a business combination or otherwise) of all of the shares they hold to a third party who is not an affiliate or associate; or

 

  enter into a transaction pursuant to which we agree to merge with or into another entity or agree to sell all or substantially all of our assets.

 

For the holders who are party to the January 2003 agreement, those stockholders who hold a majority of the voting power of the outstanding securities subject to such agreement may effectuate the drag along right. For the holders who are party to the October 2003 agreement, those stockholders who hold a majority of the voting power of all of our outstanding securities may effectuate the drag along right.

 

Under each of these agreements, these majority stockholders have the right, exercisable upon 30 days’ notice to the other stockholders, subject thereto to require the other stockholders to sell or vote all of their shares of our common stock in favor of the subject transaction.

 

2003 Stock Incentive Plan

 

See “Executive Compensation—Benefit Plans” for a complete explanation of the plan.

 

2004 Employee Stock Purchase Plan

 

See “Executive Compensation—Benefit Plans” for a complete explanation of the plan.

 

Anti-Takeover Provisions Affecting Stockholders

 

Following this offering, our founding officers will control ninety-seven percent (97%) of the combined voting power of our outstanding common stock, which could be deemed to have an anti-takeover effect.

 

Our certificate of incorporation, as amended, provides that no director shall be personally liable to us or our stockholders for monetary damages for breach of fiduciary duty as a director notwithstanding any provision of law imposing such liability, provided that, to the extent provided by applicable law, the certificate of incorporation shall not eliminate the liability of a director for:

 

  any breach of the director’s duty of loyalty to us or our stockholders;

 

  acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law;

 

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  acts or omissions in respect of certain unlawful dividend payments or stock redemptions or repurchases; or

 

  any transaction from which such director derives improper personal benefit.

 

Our by-laws provide that we shall, to the extent permitted by Delaware law, indemnify and advance expenses to our currently acting and former directors, officers, employees and agents or director, officers, employees and agents of other corporations, partnerships, joint ventures, trusts or other enterprises if serving at our request arising in connection with their acting in such capacities. We have entered into indemnification agreements with each of our directors and executive officers.

 

We are subject to Section 203 of the Delaware General Corporation Law. Subject to specific exceptions, Section 203 prohibits a publicly held Delaware corporation from engaging in a “business combination” with an “interested stockholder” for a period of three years after the time the person became an interested stockholder, unless:

 

  the business combination, or the transaction in which the stockholder became an interested stockholder, is approved by our board of directors prior to the time the interested stockholder attained that status;

 

  upon consummation of the transaction that resulted in the stockholder becoming an interested stockholder, the interested stockholder owned at least 85% of the voting stock of the corporation outstanding at the time the transaction commenced, excluding those shares owned by persons who are directors and also officers and by employee stock plans in which employee participants do not have the right to determine confidentially whether shares held subject to the plan will be tendered in a tender or exchange offer; or

 

  at or after the time a person became an interested stockholder, the business combination is approved by our board of directors and authorized at an annual or special meeting of stockholders by the affirmative vote of at least two-thirds of the outstanding voting stock that is not owned by the interested stockholder.

 

“Business combinations” include mergers, asset sales and other transactions resulting in a financial benefit to the interested stockholder. Subject to various exceptions, in general an “interested stockholder” is a person who, together with his or her affiliates and associates, owns, or within three years did own, 15% or more of the shares of the corporation’s outstanding voting stock. These restrictions could prohibit or delay the accomplishment of mergers or other takeover or change in control attempts with respect to us and, therefore, may discourage attempts to acquire us.

 

In addition, our certificate of incorporation, as amended and restated, authorizes the board of directors to issue up to 1,000,000 shares of undesignated preferred stock, $0.01 par value per share. The preferred stock may be issued in one or more series, the terms of which may be determined at the time of issuance by our board of directors without further action by the stockholders. These terms may include voting rights, including the right to vote as a series on particular matters, preferences as to dividends and liquidation, conversion rights and redemption rights.

 

The provisions described above could have the effect of discouraging open market purchases of our Class B common stock because they may be considered disadvantageous by a stockholder who desires to undertake a business combination with us.

 

NASDAQ National Market Listing

 

We have applied to list our Class B common stock on the NASDAQ National Market and have reserved the trading symbol “MCHX.”

 

Transfer Agent and Registrar

 

The transfer agent and registrar for our Class B common stock is Mellon Investor Services LLC.

 

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MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

 

General

 

Market Information

 

Prior to this offering, there has been no public market for our Class B common stock.

 

Upon completion of this offering, we will have 12,291,563 shares of Class B common stock outstanding, assuming no exercise of the underwriters’ over-allotment option, and 12,891,563 shares of Class B common stock outstanding if the underwriters exercise their over-allotment option. Of these shares:

 

  the 4,000,000 shares of Class B common stock included in this offering, plus any shares issued upon exercise of the over-allotment option by the underwriters, will be freely tradable without restriction under the Securities Act, unless purchased by our “affiliates” as that term is defined in Rule 144 under the Securities Act; and

 

  the remaining 8,291,563 shares of Class B common stock that will be outstanding after this offering, and all of the shares of Class A common stock are “restricted securities” within the meaning of Rule 144.

 

Approximately 180 days after the date of this prospectus, we intend to file one or more registration statements on Form S-8 under the Securities Act to register the shares of Class B common stock to be issued under our stock incentive plan and our employee stock purchase plan and, as a result, all shares of Class B common stock acquired upon exercise of stock options and other equity-based awards granted under these plans will thereafter be freely tradable under the Securities Act unless purchased by our affiliates. These registration statements are expected to become effective upon filing.

 

Restricted securities generally may be sold only if they are registered under the Securities Act or are sold under an exemption from registration, including the exemptions provided by Rules 144 and 701 under the Securities Act, which are summarized below. Subject to the lock-up agreements described below, shares held by our affiliates that are not restricted securities may be sold subject to compliance with Rule 144 of the Securities Act without regard to the prescribed holding period under Rule 144.

 

The representatives have requested pursuant to the underwriting agreement the lock-up of shares held prior to this offering by officers, directors and holders of at least 1% of the outstanding shares for a period of 180 days after the consummation of this offering. In addition, for shares reserved for purchase in this offering by our officers, directors and employees, they will agree to such restrictions for a period of 180 days after the consummation of this offering. The representatives, may, in their sole discretion, permit early release of shares subject to the lock-up agreements. In considering any request to release shares subject to this lock-up agreement, the representatives will consider the possible impact of the release of the shares on the trading price of the stock sold in the offering. The representatives do not have any present intention or any understandings, implicit or explicit, to release any of the shares subject to the lock-up agreements prior to the expiration of the lock-up period.

 

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Securities Authorized for Issuance under Equity Compensation Plans

 

Equity Compensation Plan Information as of December 31, 2003:*

 

Plan category


   Number of securities to be
issued upon exercise of
outstanding options, warrants
and rights


   Weighted average exercise
price of outstanding options,
warrants and rights


   Number of
securities
remaining
available for future
issuance


Equity compensation plans approved by security holders**

   2,421,500
668,100
   $1.67 per share
initial public offering price
   910,400

Equity compensation plans not approved by security holders

   Not applicable    Not applicable    Not applicable
    
  
  

Total

   3,089,600    $1.67 to IPO price    910,400
    
  
  

* This table omits our 2004 employee stock purchase plan as such plan was not adopted by our board of directors until February 15, 2004 and was not approved by our stockholders until February 15, 2004. This plan will become effective on the date that the Class B common stock is publicly traded as a result of an initial public offering with gross proceeds in excess of $20 million pursuant to an effective registration statement.
** We have reserved 5,013,953 shares of Class B common stock for issuance under our 2003 stock incentive plan, of which an increase of 1,013,953 to the authorized number of shares available under the plan occurred on January 1, 2004 as a result of the “evergreen provision” under the plan. The “evergreen provision” provides for annual increases in the number of shares available for issuance under the plan, on the first day of our fiscal year, equal to 5% of the outstanding shares of Class B common stock (including any shares of common stock issuable upon conversion of any outstanding capital stock) on such date.

 

Holders

 

As of February 16, 2004, assuming the mandatory conversion of all outstanding shares of the preferred stock, there were 20,279,063 shares of common stock outstanding that were held by 141 stockholders of record. Of these shares:

 

  11,987,500 shares were authorized as Class A common stock, and as of this date were held by five stockholders of record; and

 

  8,291,563 shares were authorized as Class B common stock, and as of this date were held by 136 stockholders of record.

 

Rule 144

 

In general, under Rule 144 as currently in effect, a person who has beneficially owned shares for at least one year is entitled to sell in “brokers’ transactions” or to market makers, within any three-month period commencing 90 days after the date of this prospectus, a number of shares that does not exceed the greater of:

 

  one percent of the number of shares of Class B common stock then outstanding, approximately 242,791 shares immediately after the completion of this offering (248,791 shares if the underwriters’ over-allotment option is exercised in full); or

 

  the average weekly trading volume in our Class B common stock during the four calendar weeks preceding the required filing of a Form 144 with respect to such sale.

 

Sales under Rule 144 are generally subject to the availability of current public information about us. In addition, a person who is not deemed to have been an affiliate at any time during the 90 days preceding a sale and who has beneficially owned the shares proposed to be sold for at least two years would be entitled to sell those shares under Rule 144(k) without regard to the requirements described above.

 

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Rule 701

 

Rule 701 permits our directors, officers, employees or consultants who purchase shares pursuant to a written compensatory plan or contract to resell such shares in reliance upon Rule 144, but without compliance with certain restrictions. Rule 701 provides that affiliates may sell their Rule 701 shares under Rule 144 90 days after effectiveness of the registration statement of which this prospectus forms a part without complying with the holding period requirement and that non-affiliates may sell such shares in reliance on Rule 144 90 days after the effectiveness of such registration statement without complying with the holding period, public information, volume limitation or notice requirements of Rule 144. Those shares issuable upon the exercise of vested options will be saleable 180 days after the effectiveness of the registration statement, subject to the provisions of Rule 144.

 

Registration of Shares

 

We have entered into a stockholders’ agreement with certain of our investors and a stock transfer and restriction agreement with the former stockholders of TrafficLeader, each of which provide our stockholders with “piggy-back” registration rights. See “Description of Capital Stock—Registration Rights.”

 

We have agreed to certain “piggy-back” registration rights for the securities underlying the representatives’ warrants. See “Underwriting.”

 

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UNDERWRITING

 

Under the terms and subject to the conditions contained in an underwriting agreement dated the date of this prospectus, the underwriters named below, for whom Sanders Morris Harris Inc. and National Securities Corporation are acting as representatives, have severally agreed to purchase, and we have agreed to sell to them, severally, the number of shares indicated below:

 

Name


   Number of Shares

Sanders Morris Harris Inc.

    

National Securities Corporation

    
      
    

Total

    
    

 

The underwriting agreement provides that the obligations of the several underwriters to pay for and accept delivery of the shares of Class B common stock offered hereby are subject to a number of conditions, including the receipt by the representatives of the legal opinions of their counsel and our counsel, officer’s certificates and a letter from our independent auditors, and to certain other conditions, including the conditions that no stop order suspending the effectiveness of the registration statement be in effect and no proceedings for such purpose are threatened by the Securities and Exchange Commission. The underwriters are obligated to take and pay for all of the shares of Class B common stock offered hereby (other than those covered by the over-allotment option described below) if any are purchased.

 

Over-Allotment Option

 

We have granted to the underwriters an option, exercisable for 30 days from the date of this prospectus, to purchase up to an aggregate of 600,000 additional shares of our Class B common stock at the public offering price listed on the cover page of this prospectus, less underwriting discounts and commissions. The underwriters may exercise this option solely for the purpose of covering over-allotments, if any, made in connection with the offering of the shares of our Class B common stock offered by this prospectus. To the extent this option is exercised, all purchases shall be made by the representatives for the representatives’ accounts unless representatives elect to purchase less than all of additional shares, in which case the remaining additional shares not purchased by the representatives shall be purchased for the account of each underwriter (other than representatives) in the same proportion as the number of shares of firm stock set forth opposite such underwriter’s name in the above table bears to the total number of shares of firm stock purchased by all underwriters (other than representatives).

 

Directed Share Program

 

At our request, the underwriters have reserved for sale, at the initial public offering price, up to 600,000 shares for our officers, directors, employees, consultants and others having a relationship with us. The number of shares of our Class B common stock available for sale to the general public will be reduced to the extent these reserved shares are purchased. Any reserved shares that are not purchased by these persons will be offered by the underwriters to the general public on the same basis as the other shares in this offering.

 

Commissions and Discounts

 

The following table shows the per-share and total underwriting discounts and commissions to be paid to the underwriters by us in connection with this offering. The underwriting discounts and commissions have been determined through negotiations between the underwriters and us, and have been calculated as a percentage of the offering price. These amounts are shown assuming both no exercise and full exercise of the over-allotment option.

 

     Per Share

   No Exercise

   Full Exercise

Public offering price (1)

   $ 6.50      $ 26,000,000    $ 29,900,000

Underwriting discounts & commissions

   $ 0.325    $ 1,300,000    $ 1,495,000

Proceeds, before expenses, to us (2)

   $ 6.175    $ 24,700,000    $ 28,405,000

(1) Based on the middle of the filing range on the date of this prospectus.
(2) We estimate the expenses of this offering will be approximately $1,400,000.

 

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The underwriters propose to offer the shares of Class B common stock directly to the public at the initial public offering price per share set forth on the cover page of this prospectus and to selected dealers at such price less a concession not in excess of $             per share. The underwriters may allow, and these dealers may re-allow, a concession not in excess of $             per share to certain other dealers. After this offering, the public offering price, concession and re-allowance may be changed by the representative.

 

We have agreed to pay to the representatives the maximum amount of $50,000 to account for the representatives’ direct expenses in connection with this offering on a non-accountable basis, of which $25,000 has been paid by us and the balance shall be paid upon the first closing date. Subject to our written pre-approval, additional direct expenses of the representatives shall be paid up to a maximum of $50,000.

 

Representatives’ Warrants

 

In connection with this offering, we have agreed to sell warrants to the representatives for $100.00. The representatives’ warrants are for the account of the representatives or their designees, which will be limited to their officers, directors and employees, to purchase 120,000 shares of our Class B common stock. The shares issuable upon exercise of the representatives’ warrants will be in all respects identical to the shares offered to you. No holder of the representatives’ warrants will possess any rights as a shareholder unless the warrants are exercised. The representatives’ warrants contain a cashless exercise provision and provide for adjustment in the number of shares issuable upon exercise thereof as a result of certain subdivisions and combinations of the common stock. The representatives’ warrant will be limited to a term of five years from the first closing date and will become exercisable only commencing 12 months after the first closing date at a per share exercise price equal to 130% of the initial public offering price per share set forth on the cover page of this prospectus. The one-year restriction on the exercise of the representatives’ warrants is pursuant to Rule 2710(c)(7)(A) of the NASD Conduct Rules. The representatives’ warrants may not be sold, assigned, transferred, pledged or hypothecated except to the representatives’ designees for a period of one year from the completion of the offering.

 

The representatives’ warrants are not redeemable by us. In addition, we have agreed to certain “piggy-back” registration rights for the securities underlying the representatives’ warrants which shall continue with respect to the shares for a period of five years from the first closing date.

 

Any profit realized by the representatives on the sale of the securities issuable upon exercise of the representatives’ warrants may be deemed to be additional underwriting compensation. During the term of the representatives’ warrants, the holders thereof are given the opportunity to profit from a rise in the market price of our Class B common stock. We may find it more difficult to raise additional equity capital while the representatives’ warrants are outstanding. At any time at which the representatives’ warrants are likely to be exercised, we may be able to obtain additional equity capital on more favorable terms.

 

Lock-up Agreements

 

The representatives have requested pursuant to the underwriting agreement the lock-up of shares held prior to this offering by officers, directors and holders of at least 1% of the outstanding shares for a period of 180 days after the consummation of this offering. In addition, for shares reserved for purchase in this offering by our officers, directors and employees, they will agree to such restrictions for a period of 180 days after the consummation of this offering. The representatives, may, in their sole discretion, permit early release of shares subject to the lock-up agreements.

 

Indemnification

 

We and the underwriters have agreed to indemnify each other against certain liabilities, including liabilities under the Securities Act of 1933, as amended, and to contribute to payments which the indemnified party may be required to make in respect thereof. We and the underwriters are each aware that, in the opinion of the Securities and Exchange Commission, such indemnification is against public policy as expressed in the Securities Act of 1933, as amended, and is, therefore, unenforceable.

 

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Stabilizing Transactions, Short Positions and Penalty Bids

 

In order to facilitate the offering of the Class B common stock, the underwriters may engage in transactions that stabilize, maintain or otherwise affect the price of our Class B common stock in accordance with Regulation M under the Securities Exchange Act of 1934.

 

  Stabilizing transactions permit bids to purchase the underlying security so long as the stabilizing bids do not exceed a specified maximum.

 

  Over-allotment involves sales by the underwriters of shares in excess of the number of shares the underwriters are obligated to purchase, which creates a syndicate short position. The short position may be either a covered short position or a naked short position. In a covered short position, the number of shares over-allotted by the underwriters is not greater than the number of shares which they may purchase in the over-allotment option. In a naked short position, the number of shares involved is greater than the number of shares in the over-allotment option. The underwriters may close out any short position by either exercising their over-allotment option and/or purchasing shares in the open market.

 

  Syndicate covering transactions involve purchases of the Class B common stock in the open market after the distribution has been completed in order to cover syndicate short positions. In determining the source of shares to close out the short position, the underwriters will consider, among other things, the price of shares available for purchase in the open market as compared to the price at which they may purchase shares through the over-allotment option. If the underwriters sell more shares than could be covered by the over-allotment option—a naked short position—that position can only be closed out by buying shares in the open market. A naked short position is more likely to be created if the underwriters are concerned that there may be downward pressure on the price of the shares in the open market after pricing that could adversely affect investors who purchase in the offering.

 

  Penalty bids permit the representatives to reclaim a selling concession from a syndicate member when the common stock originally sold by the syndicate member is purchased in a stabilizing or syndicate covering transaction to cover syndicate short positions.

 

  In passive market making, market makers in the Class B common stock who are underwriters or prospective underwriters may, subject to limitations, make bids for or purchases of the Class B common stock until the time, if any, at which a stabilizing bid is made.

 

These stabilizing transactions, syndicate covering transactions and penalty bids may have the effect of raising or maintaining the market price of the Class B common stock or preventing or retarding a decline in the market price of the Class B common stock. As a result, the price of the Class B common stock may be higher than the price that might otherwise exist in the open market. These transactions may be effected on the Nasdaq National Market or otherwise and, if commenced, may be discontinued at any time.

 

Determination of Offering Price

 

Prior to this offering, there has been no public market for our Class B common stock. Consequently, the public offering price of our Class B common stock will be determined by negotiation between the representatives of the underwriters and us.

 

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LEGAL MATTERS

 

The validity of the shares of Class B common stock offered hereby will be passed upon for us by Nixon Peabody LLP. A partner with the law firm of Nixon Peabody LLP beneficially owns 30,000 shares of Class B common stock.

 

EXPERTS

 

The consolidated financial statements of the Predecessor to Marchex, Inc. as of December 31, 2002 and February 28, 2003 and of Marchex, Inc. and subsidiaries as of December 31, 2003, and for the year ended December 31, 2002, the period from January 1, 2003 through February 28, 2003, and the period from January 17, 2003 (inception) through December 31, 2003 and the financial statements of Sitewise Marketing, Inc. as of December 31, 2002 and September 30, 2003, and for the year ended December 31, 2002 and the nine month period ended September 30, 2003 have been included herein in reliance upon the reports of KPMG LLP, independent auditors, appearing elsewhere herein, and upon the authority of said firm as experts in accounting and auditing.

 

DISCLOSURE OF COMMISSION POSITION ON INDEMNIFICATION FOR SECURITIES ACT LIABILITIES

 

Insofar as indemnification for liabilities arising under the Securities Act may be permitted to directors, officers and controlling persons of the small business issuer pursuant to the foregoing provisions, or otherwise, the small business issuer has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy and, is therefore, unenforceable.

 

WHERE YOU CAN FIND MORE INFORMATION

 

We have filed a registration statement on Form SB-2 with the Securities and Exchange Commission, or SEC, for the Class B common stock we are offering by this prospectus. This prospectus does not contain all of the information set forth in the registration statement or in the exhibits and schedules thereto. For further information with respect to Marchex and our Class B common stock, we make reference to the registration statement and to the exhibits and schedules filed therewith. Statements contained in this prospectus, relating to the contents of any contract or any other document referred to are not necessarily complete, and in each instance, reference is made to the copy of such contract or other document filed as an exhibit to the registration statement, each such statement being qualified in all respects by such reference.

 

A copy of the registration statement may be inspected by anyone without charge at the SEC’s principal office in Washington, D.C., and copies of all or any part of the registration statement may be obtained from the Public Reference Section of the SEC, 450 Fifth Street, N.W., Washington, D.C. 20549, upon payment of certain fees prescribed by the SEC. Please call the SEC at 1-800-SEC-0330 for further information on the operation of the public reference rooms. The SEC maintains a web site that contains reports, proxy and information statements and other information regarding registrants that file electronically with the SEC. The address of the Web site is www.sec.gov.

 

Upon completion of the offering, we will be subject to the information reporting requirements of the Securities Exchange Act of 1934, as amended and, in accordance therewith, will file reports, proxy statements and other information with the SEC.

 

We intend to furnish our stockholders with annual reports containing financial statements audited by our independent public accountants and to make available to our stockholders quarterly reports for the first three fiscal quarters of each fiscal year containing unaudited interim financial information.

 

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INDEX TO FINANCIAL STATEMENTS

 

     Page

Marchex, Inc.

    

Independent Auditors’ Report

   F-2

Consolidated Balance Sheets of the Predecessor to Marchex, Inc. as of December 31, 2002, and February 28, 2003, and of Marchex, Inc. and subsidiaries as of December 31, 2003

   F-3

Consolidated Statements of Operations for the year ended December 31, 2002, period from January 1, 2003 to February 28, 2003 (Predecessor periods), and the period from January 17, 2003 (inception) to December 31, 2003 (Successor period)

   F-4

Consolidated Statements of Stockholders’ Equity for the year ended December 31, 2002, period from January 1, 2003 to February 28, 2003 (Predecessor periods), and the period from January 17, 2003 (inception) to December 31, 2003 (Successor period)

   F-5

Consolidated Statements of Cash Flows for the year ended December 31, 2002, period from January 1, 2003 to February 28, 2003, (Predecessor periods), and the period from January 17, 2003 (inception) to December 31, 2003 (Successor period)

   F-6

Notes to Consolidated Financial Statements

   F-7

Sitewise Marketing, Inc. (d.b.a. TrafficLeader)

    

Independent Auditors’ Report

   F-33

Balance Sheets as of December 31, 2002 and September 30, 2003

   F-34

Statements of Operations for the year ended December 31, 2002 and nine month period ended September 30, 2003

   F-35

Statements of Stockholders’ Equity for the year ended December 31, 2002 and nine month period ended September 30, 2003

   F-36

Statements of Cash Flows for the year ended December 31, 2002 and nine month period ended September 30, 2003

   F-37

Notes to Financial Statements

   F-38

Unaudited Pro Forma Condensed Consolidated Financial Statements

   F-47

Unaudited Pro Forma Condensed Consolidated Statements of Operations for the year ended December 31, 2003

   F-49

Notes to Unaudited Pro Forma Condensed Consolidated Financial Statements

   F-50

 

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Table of Contents

Independent Auditors’ Report

 

The Board of Directors and Stockholders

Marchex, Inc.:

 

We have audited the accompanying consolidated balance sheets of the Predecessor to Marchex, Inc. as of December 31, 2002 and February 28, 2003 and of Marchex, Inc. and subsidiaries as of December 31, 2003 and the related consolidated statements of operations, stockholders’ equity and cash flows for the years ended December 31, 2002, the period from January 1, 2003 through February 28, 2003 (Predecessor periods), and the period from January 17, 2003 (inception) through December 31, 2003 (Successor period). These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

 

We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Predecessor to Marchex, Inc. and Marchex, Inc. and its subsidiaries, as of December 31, 2002, February 28, 2003 and December 31, 2003 and the results of their operations and their cash flows for the Predecessor periods and Successor period in conformity with accounting principles generally accepted in the United States of America.

 

/s/    KPMG LLP

 

Seattle, Washington

February 16, 2004, except as to note 15(a),

which is as of March 18, 2004

 

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Table of Contents

MARCHEX, INC. AND SUBSIDIARIES

 

Consolidated Balance Sheets

 

    Predecessor Periods

    Successor Period

   

December 31,

2003

Pro Forma


 
   

December 31,

2002


   

February 28,

2003


   

December 31,

2003


   
                      (unaudited)  

Assets

                         

Current assets:

                         

Cash and cash equivalents

  $ 1,494,300     1,820,763     6,019,119        

Accounts receivable, net

    489,664     538,213     1,627,730        

Other receivables

    —       1,137     384        

Prepaid expenses

    30,014     49,615     117,596        

Income tax receivable

    —       —       290,939        

Deferred tax assets

    89,920     117,645     263,193        

Other current assets

    39,211     46,159     24,190        
   


 

 

     

Total current assets

    2,143,109     2,573,532     8,343,151        

Property and equipment, net

    473,793     494,087     994,793        

Deferred tax assets

    52,956     32,187     —          

Other assets

    9,435     9,435     409,878        

Goodwill

    —       —       17,252,999        

Identifiable intangible assets, net

    —       —       6,701,791        
   


 

 

     

Total assets

  $ 2,679,293     3,109,241     33,702,612        
   


 

 

     

Liabilities and Stockholders’ Equity

                         

Current liabilities:

                         

Accounts payable

  $ 1,294,877     891,124     2,842,229        

Accrued payroll and benefits

    128,301     257,000     252,642        

Accrued expenses and other current liabilities

    118,581     107,015     1,031,850        

Deferred revenue

    736,594     812,385     848,958        

Earn-out liability payable

    —       —       3,525,995        
   


 

 

     

Total current liabilities

    2,278,353     2,067,524     8,501,674        

Deferred tax liabilities

    —       —       1,829,687        

Deferred revenue

    27,682     27,541     38,993        

Other non-current liabilities

    2,993     4,085     2,274        

Fair value of redemption obligation

    —       —       55,250        
   


 

 

     

Total liabilities

    2,309,028     2,099,150     10,427,878        

Series A redeemable convertible preferred stock, $0.01 par value. Authorized 8,500,000; ($21,489,395 aggregate liquidation preference and redemption value at December 31, 2003) issued and outstanding 6,724,063 shares at December 31, 2003; (no shares issued and outstanding on pro forma basis)

    —       —       21,440,402     —    
Commitments, contingencies, and subsequent events                          

Stockholders’ equity:

                         

Predecessor Periods:

                         

Common stock, no par value. Authorized 35,000,000 shares;

                         

Class A: 30,496,112 authorized through February 28, 2003; 23,355,421 and 24,894,319 issued and outstanding at December 31, 2002 and February 28, 2003, respectively

    398,774     696,815     —       —    

Class B: 4,503,888 authorized through February 28, 2003 4,503,888 issued and outstanding at December 31, 2002 and February 28, 2003

    1,419,986     1,419,986     —       —    

Successor Period:

                         

Common stock, $.01 par value. Authorized 46,500,000 shares;

                         

Class A: 12,500,000 authorized; 12,250,000 issued and 11,987,500 outstanding at December 31, 2003

    —       —       122,500     122,500  

Class B: 34,000,000 authorized; issued and outstanding 1,567,500 at December 31, 2003, including 137,500 of restricted stock; (8,291,563 issued and outstanding on pro forma basis)

    —       —       15,675     82,916  

Additional paid-in capital

    —       —       6,716,734     28,089,895  

Deferred stock-based compensation

    (9,266 )   —       (1,532,340 )   (1,532,340 )

Accumulated deficit

    (1,439,229 )   (1,106,710 )   (3,488,237 )   (3,488,237 )
   


 

 

 

Total stockholders’ equity

    370,265     1,010,091     1,834,332     23,274,734  
   


 

 

 

Total liabilities and stockholders’ equity

  $ 2,679,293     3,109,241     33,702,612     33,702,612  
   


 

 

 

 

See accompanying notes to consolidated financial statements.

 

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Table of Contents

MARCHEX, INC. AND SUBSIDIARIES

 

Consolidated Statements of Operations

 

    Predecessor Periods

  Successor Period

 
   

Year ended

December 31,

2002


   

Period from

January 1 to

February 28,

2003


 

Period from

January 17

(inception) to

December 31,

2003


 

Revenue

  $ 10,070,507     3,071,055     19,892,158  
   


 
 


Expenses:

                   

Service costs (1)

    6,334,173     1,732,813     11,292,070  

Sales and marketing (1)

    1,821,237     365,043     2,460,683  

Product development (1)

    811,673     144,479     1,291,422  

General and administrative (1)

    976,881     234,667     2,743,919  

Acquisition-related retention consideration (2)

    —       —       283,269  

Stock-based compensation (3)

    364,693     38,981     2,125,110  

Amortization of intangible assets (4)

    —       —       3,023,408  
   


 
 


Total operating expenses

    10,308,657     2,515,983     23,219,881  
   


 
 


Income (loss) from operations

    (238,150 )   555,072     (3,327,723 )

Other income:

                   

Interest income

    5,491     1,529     45,874  

Adjustment to fair value of redemption obligation

    —       —       25,500  

Other

    —       —       2,685  
   


 
 


Total other income

    5,491     1,529     74,059  
   


 
 


Income (loss) before provision for income taxes

    (232,659 )   556,601     (3,253,664 )

Income tax expense (benefit)

    (142,876 )   224,082     (1,084,312 )
   


 
 


Net income (loss)

    (89,783 )   332,519     (2,169,352 )

Accretion to redemption value of redeemable convertible preferred stock

    —       —       1,318,885  
   


 
 


Net income (loss) applicable to common stockholders

  $ (89,783 )   332,519     (3,488,237 )
   


 
 


Basic and diluted net loss per share applicable to common stockholders

              $ (0.26 )

Shares used to calculate basic and diluted net loss per share

                13,259,747  

Pro forma basic and diluted net loss per share applicable to common stockholders (unaudited)

              $ (0.18 )

Shares used to calculate pro forma basic and diluted net loss per share (unaudited)

                19,011,093  

(1)   Excludes acquisition-related retention consideration, stock-based compensation and amortization of intangible assets

                   

(2)   Components of acquisition-related retention consideration:

                   

Service costs

  $ —       —       33,723  

Sales and marketing

    —       —       96,262  

Product development

    —       —       104,233  

General and administrative

    —       —       49,051  

(3)   Components of stock-based compensation:

                   

Service costs

  $ 3,161     190     9,776  <