ITEM 1. BUSINESS
Except as otherwise required by the context, references in this report to the "Company," "Focal," "we," "us," or "our" refer to the combined business of Focal Communications Corporation and all of its subsidiaries. Unless otherwise indicated, the information in this Annual Report on Form 10-K gives effect to a recapitalization pursuant to which our Class A common stock, Class B common stock and Class C common stock were converted into a single class of common stock and a 500-for-1 stock split. Both the recapitalization and the stock split were effected on July 30, 1999.
This report contains trademarks of Focal, and may contain trademarks, tradenames and service marks of other parties.
Introduction
We are a national broadband communications provider that offers voice, data, and Internet infrastructure services to large communications-intensive users in major cities. We began operations in 1996, initiated service first in May 1997 and as of December 31, 2000 offered services in the following 20 markets:
As part of our expansion, we plan to offer services in four additional markets in 2001.
When we complete our expansion, the 24 markets in service will encompass a total of 56 metropolitan statistical areas. As of December 31, 2000, we had 435,272 lines installed and in service. This compares to 181,103 lines installed and in service as of December 31, 1999.
Our primary objective is to become the provider of choice to communications-intensive customers in our target markets for voice, data and Internet infrastructure services. Our sales and marketing efforts principally target Fortune 1000 companies and we had successfully penetrated approximately 40% of the Fortune 100 as of December 31, 2000. We also provide services to many of the leading network service providers in the nation.
We compete primarily on diversity, reliability, service, and price. Our primary competition is the Incumbent Local Exchange Carrier ("ILEC").
Our customers tend to be the largest, most sophisticated communications users in the country. We meet their demanding needs through our unique network architecture, the experience of our operations team, and our award winning back office systems. The superior performance of our network stems, in part, to our extensive interconnections with the ILEC in each of our markets. As of December 31, 2000, we had approximately 2,000 interconnections points. Our customers recognize the advantages of this design in assuring them the high throughput they need.
Most of our revenue is derived from the provision of switched voice and data services. Our customers have also asked for Internet access services that are as reliable as our local dial tone. To meet this demand, we launched a suite of services in 2000 based on a high speed Internet switching platform called the Focal Internet eXchange. These services take advantage of our current infrastructure and customer base to provide dedicated Internet access, colocation and private peering. These services are primarily targeted to both corporate accounts and network service providers.
We believe we were the first communications provider to employ the "smart- build" approach to network design. As such, we own and operate our switches, and initially lease, rather than own, transport capacity. As our customer traffic increases, it becomes economically attractive to own transport capacity in select markets. Accordingly, we signed agreements to acquire 9,730 local fiber transport miles in nine cities as of December 31, 2000. To support our service offerings, we have also leased approximately 23,000 DS-3 miles of long haul fiber transport capacity connecting each of our markets. Using these facilities, we are developing a nationwide ATM network to carry voice and data traffic.
Market Potential
We believe communications-intensive users in large metropolitan markets are not adequately supplied with highly reliable, local voice and data services. We also believe that these types of users will increasingly demand diversity in communications providers. As a result, we have chosen to initially do business only in large metropolitan markets with a high concentration of communications- intensive customers. We select our target geographical markets using several criteria:
. Sufficient market size
. Supportive state regulatory environment
. The existence of multiple fiber transport providers with extensive networks
We currently offer circuit-switched voice and data services, packet-switched data services, and high-speed Internet services. We believe the market potential in our target markets for these services is substantial.
The table below summarizes estimates from our market study regarding our current and planned markets. You should be aware that, with the exception of the "Operational Markets," the launch period shown in the second column is our current estimate of when we will begin providing services in our planned markets. These estimates are subject to change based upon numerous factors, including timely performance by third party suppliers and receipt of required regulatory approvals. You should also be aware that the markets targeted for launch in 2001 are preliminary and each may be replaced by other markets.
- -------- (1) This addressable market data does not include information for non-switched data and voice services. (2) Data for Northern Virginia are included in the data for Washington, D.C.
Strategy
Our objective is to become the provider of choice for broadband voice and data services to communication intensive users in our target markets. Our customer base already includes many leading companies such as:
Akamai Genuity Motorola Sony Compuserve IBM Nortel Networks United Earthlink Kraft Sears Stationers Wyeth
In total, Focal served approximately 40% of the Fortune 100 as of December 31, 2000.
We believe that our success is based on our superior network reliability, customer service, and sales force among other factors. The majority of our sales people bring significant industry experience and long standing customer relationships to the Company. Our back office support systems have won numerous awards including CIO Magazine's Top 100, which recognizes the companies with the leading information systems in the country.
Perhaps the best measure of customer satisfaction is our exceptional customer loyalty. We have had virtually zero customer related churn during the past several years. In fact, sales to the "same customer" grew by over 50% on a year over year basis. We also added a significant number of new customers during 2000 with the number of Telecom customers growing from 495 at the beginning of 2000 to 1,225 at the end of the year.
Our primary source of competition is the ILEC usually a Regional Bell Operating Company ("RBOC"). In addition to the above strengths, we also differentiate Focal from the competition by offering customers the ability to manage their local service on a national basis much like they do their long distance services. Despite our success, we still have a very low share of the local telecommunications market in the cities we serve, providing us with significant growth opportunities for the future.
Develop New Markets, Expand Geographic Coverage
Our six most established markets, accounted for 68% of our installed lines and 75% of our revenue for the three months ended December 31, 2000. This means that the remaining 14 markets, 70% of our current markets, have tremendous growth potential as they develop and perform more like our older markets. In addition to developing these more recent markets, Focal plans to expand into four new Tier 1 markets in 2001. This will bring our total markets served to 24 and our metropolitan statistical areas served to 56. Our first customers in a new market are usually existing customers that we serve in other locations.
Expand Service Offerings
We have responded to our customers' requests for additional services by offering new services that build on and leverage our existing infrastructure. This strategy reduces our start-up costs and required capital investment. The best example of this strategy is our high speed Internet access services based on the Focal Internet eXchange which was launched in September of 2000. This suite of services includes dedicated Internet access, colocation, private peering, and managed modems. As a result of our network architecture, our Internet access service provides measurably better performance than competitive offerings. We believe our strong presence in both the corporate and network services markets makes us a natural aggregation point for content providers, aggregators, and end-users.
Design a Capital-Efficient Network
By utilizing the "smart-build" approach to network design we believe we have optimized our return on invested capital. We do this by initially leasing, rather than owning, fiber capacity, concentrating our capital expenditures on switching facilities and information systems and acquiring fiber transport capacity as the volume and demands of our customer traffic warrants. Because of increased customer traffic volume in some of our
markets, we began acquiring our own fiber transport capacity in 1999. By continuing to use the "smart-build" approach to network and service deployment, we expect to reduce the time and money required to launch new markets and services, minimize the financial risk associated with underutilized networks and generate revenue and cash flow more quickly. We employ this same strategy for our suite of data services.
Maximize Network Utilization
We supplement our direct sales efforts with indirect sales to maximize the utilization of our network assets and systems infrastructure. To achieve this goal we actively utilize our VAR distribution channel. We provide services to VARs, such as managers of multi-dwelling units and companies that market bundled communications services to small- and medium-sized businesses. This enables us to increase the number of access lines served by our networks, driving network utilization. We also intend to pursue ways to maximize utilization rates for our Internet backbone. For example, we plan to sell unused upstream capacity to network service providers, content providers and application service providers as a way to maximize the utilization and efficiency of our network.
Networks
We utilize Nortel DMS-500 SuperNode digital central office switches for our existing markets, and currently plan to deploy similar switches in our additional markets. As we add customers in a market, it has generally been most cost-effective for us to use leased fiber transport capacity to connect our customers to our network. We have initially leased local network trunking facilities from the ILECs and metropolitan network providers in each of our markets in order to connect our switches to major ILEC central offices serving the central business district and outlying areas of business concentrations. Given the large volume of traffic that we generally carry, we are able to negotiate favorable transport rates and still offer our customers redundancy and diversity. In addition, we have designed our networks to maximize call completion and significantly reduce the likelihood of blocked calls, which helps us satisfy the needs of our high-volume customers. This "smart-build" approach is possible because there are multiple vendors of local fiber transport facilities in each of our large metropolitan markets, both current and planned. Our switch-based, leased transport network architecture has allowed us to:
. Reduce the time and money required to launch a new market
. Minimize financial risk associated with under-utilized networks
. Generate revenue and cash flow more quickly
We believe that the quantity of existing and planned fiber transport facilities available from numerous carriers will be sufficient to satisfy our need for local leased transport facilities and permit us to obtain these facilities at competitive prices for the foreseeable future. The fiber transport providers in our current and planned markets compete with each other for our business in order to maximize the return on their fixed-asset networks, which enables us to obtain competitive pricing. In addition, because each of our fiber transport capacity providers is a common carrier, they are required to make their transport services available to us on terms no less favorable than those provided to similar customers.
We own a portion of our local transport capacity because of increased volumes of customer traffic between our switches and specific ILEC central offices in some of our markets. We are a party to agreements for the acquisition of local fiber transport capacity covering a combined minimum of 10,800 fiber miles. As of December 31, 2000, we had activated our transport network in nine cities, comprising 9,730 fiber miles.
We have also employed a "smart-build" approach in developing our inter-city strategy. Initially, we resold long distance transmission service by buying minutes on a wholesale basis. We currently lease fiber optic transport capacity connecting our switches between each of our existing and planned markets that transports our calls from market to market over our own network and terminates the calls either directly at our customer's location or at the ILEC switch. For international calls, we have negotiated agreements with various international carriers for termination of our international calls throughout the world.
To implement our inter-city network, we have signed agreements with a number of carriers under which we have leased approximately 23,000 DS-3 miles of transport capacity connecting each of our existing and planned markets. This inter-city, DS-3 backbone network will initially be based on time division multiplexing technology and then we will transition the inter-city backbone to ATM technology. We believe the use of ATM switches will provide greater flexibility in creating and managing both data and voice services over the same physical network. We are currently able to price inter-city calls that remain on our network as if they were local calls--a service we call FocaLINC.
We are a party to a three year private line service agreement with MCI WorldCom providing for the lease of fiber transport capacity that will be used to connect our existing and planned markets. Under this agreement, we have agreed to pay total charges of at least $70 million for private line services, including existing private lines used within our markets to provide local service.
In order to support high-speed access to corporate LANs, we began in 1999 to deploy DSL technology in our key markets. We have obtained colocation space from the ILECs and we are installing DSL access multiplexers, or DSLAMs, in colocation cages in ILEC central offices located in densely populated regions. We had 292 ILEC central office colocations in service or under development as of December 31, 2000. Once installed, the DSLAMs terminate into an ATM switch, which transports high-speed data from end-users to Focal's corporate customers. These customers then manage the flow of this traffic onto their corporate LANs.
In connection with our data services, which include managed high-speed Internet access, colocation and peering services, we:
. Built a new Internet platform, called a Focal Internet eXchange. Each Focal Internet eXchange consists of a state-of-the art, fully-redundant, powerful Internet routing and switching infrastructure that enables us to provide high quality Internet access services to our customers. The local facilities are monitored by a centralized data network operations center, staffed 24 hours a day, seven days a week, and supported by trained technical resources in the field.
. Purchased transit services from multiple Tier-1 backbone providers in each of our markets. The transit services terminate in routers in our Focal Internet eXchanges, giving our customers direct access to multiple Internet backbones and allowing them to bypass congested, public interconnection points.
Products and Services
Voice Services
Inbound Services. Our basic, inbound service allows for the completion of calls to a new phone number we supply to our customer. Alternatively, local number portability, or LNP, allows us to provide inbound services using a customer's existing phone number. While LNP is occasionally unavailable and cumbersome to implement, it permits us to serve customers without altering their existing phone numbers. Consequently, we expect LNP to become increasingly useful to us in taking existing business from our primary competitors, the ILECs.
Direct inward dial service allows inbound calls to reach a particular station on a customer's phone system without operator intervention. We market direct inward dial service to our corporate customers as both a primary and backup service. As a primary service, the customer uses Focal numbers where a new line and number are needed, as when a customer hires a new employee. As a backup service, we can implement an alternative numbering plan for the customer in case the customer's primary service from the ILEC or another CLEC is interrupted.
Outbound Services. Our basic outbound services allow local and toll calls to be completed within a metropolitan region and long distance calls to be completed worldwide. This direct outward dial service is utilized by end-users in several ways. As a primary service, a customer uses Focal as a replacement for the ILEC
in placing calls to destinations within the region. In our least cost routing application, a customer can utilize our service in conjunction with its existing ILEC service to route calls using whichever carrier is least expensive for that particular type of call or time of day.
Other outbound applications include long distance overflow service in which we act as a backup to the customer's existing long distance carrier in order to optimize the number of direct, special access lines installed from the customer's premises to the long distance carrier's network.
Our FocaLINC service is designed to price inter-city calls that remain on our network as if they were local calls. This product provides a cost- effective way for our customers in one market to make calls to their offices in other Focal markets.
All of the services described above are commonly provisioned over a high- speed digital communications circuit called a T-1 facility and interface directly with our customers' private branch exchange or other customer-owned equipment. Direct interfacing averts our need to provide multiplexing equipment, which combines a number of communications paths onto one path, at the customer's location. This is possible due to the high call volume generated by the large communications-intensive customers we target. Our ability to directly interface with existing customer equipment further minimizes our capital investment and maximizes our overall return on capital.
Data Services
Access Services. Focal Virtual Office is designed to allow a corporate customer's employees to dial-in to the corporate customer's local area network using a telephone number in the employee's local calling area. This allows the employee to access the local area network for the price of a local call and enables our corporate customer to avoid the higher cost of maintaining region- wide 800 service for local area network access. In addition, our Virtual Office customers are able to use the Focal FinderTM service, an interactive tool placed on the customer's web site that automatically provides a telecommuting employee with the local calling number to be used for server access.
Focal Multi-Exchange Service, a variant of the Focal Virtual Office service marketed to network service providers, allows an network service provider's customers to cost-effectively access the network service provider's remote access servers. The combination of the multi-exchange service capacity and our high level of customer care has resulted in strong demand for our Multi- Exchange Service.
We are currently deploying DSL access services to provide high-speed, dedicated access to corporate LANs and the Internet. This service is being marketed to each of our targeted customer segments--large corporations, ISPs and VARs. DSL service is or will be available in a variety of speeds ranging from 144 kilobits per second to up to seven megabits per second. We believe DSL access service is a natural extension of the switched data services that we have provided since inception.
We offer our customers the ability to colocate equipment in our switching centers. Equipment colocation benefits the customer by allowing it to inexpensively house its data equipment without having to maintain secure, environmentally controlled space. We also offer them equipment maintenance services. These services are particularly well-suited to our network service provider customers, who frequently operate remote access servers and routers in conjunction with our switched services. As of December 31, 2000, we had over 138,000 square feet of customer colocation space available or under development.
Internet Services. As overall Internet usage has grown, it has placed tremendous demands on public networks and peering points. As traffic moves from one Internet backbone to another, it passes through a variety of interconnection points. Users frequently complain about delays, lost packets and other deterioration in service at these congested exchange points. At the same time, access speeds available to consumers and businesses continue to increase. New technology and faster modems are accelerating the speed at which users can access the Internet.
With these greater access speeds and as more and more companies begin to distribute content and applications over the Internet, demand for larger-sized files and more complex applications has increased. As a result, reliable Internet network performance has become essential to businesses and consumers. Erratic performance and lengthy delays, once an acceptable norm, have become unacceptable. For most, this means that fast, reliable and stable delivery of content and applications will become the new standard.
Our data services respond to the increased demand for high-speed Internet access and improved Internet content and services delivery. These services include managed high-speed Internet access, colocation and peering services. By building on our reputation as a premier provider of local access services data, we intend to expand the value proposition to our customers while satisfying their demand for additional data services.
Our managed high-speed Internet access services are principally targeted to our corporate and network service provider customer segments. These services provide high-quality access optimally routed over multiple Tier-1 Internet backbone networks. We buy Internet transit services from multiple Tier-1 backbone providers, terminating those connections on our routers in our switching centers. We believe that our aggregation of different providers and control over these routers allows us to provide a higher quality of service than our customers could otherwise afford. The service allows direct access to the leading global backbones with private peering connections to reach most of the Internet's top destinations, with availability of other backbones in case of a network failure or outage. We expect that this solution will continue to reduce many of the problems, namely packet loss and latency, that slow Internet services today, and continue to provide faster download speeds and increased reliability.
Our colocation services are targeted to customers who need to reach a high concentration of end-users. Following the installation of a Focal Internet eXchange, we will be able to offer an enhanced colocation environment to our customers. By colocating in a Focal facility, our colocation customers have the ability to improve the performance of content and application delivery by situating as close to the edge of the network as possible and reach customers of multiple network service providers from one location. Potential customers for this service include content replication and distribution services, streaming media hosting services, application service providers, unified messaging providers and companies providing downloads of software and other large files.
We believe that our private peering points facilitate a more reliable exchange of traffic than is currently available. The current peering option for most of our network service provider customers is to exchange traffic at the public exchange points. These public exchange points are major bottlenecks in the transfer of data as congestion causes lost packets and delays. By managing a private peering environment for the exclusive use of our customers, we will be able to facilitate smoother exchanges of Internet traffic.
While we expect that each of our Internet services will stand on its own, the services are highly complementary. We believe that we will attract colocation customers because we offer convenient access to end-users of multiple network service providers. We believe we will attract network service provider and corporate customers not only because of our more reliable connectivity services, but also because of the ready access to content and applications that our customers may host in our facilities.
Advanced Services
CDR Express provides our VAR customers with automated delivery of daily call detail records, or CDRs, via the Internet. This system enables these customers to accurately bill their customers in a secure environment. CDR Express, as well as some other Focal products, are located in Your Domain--a section of our web site specifically dedicated to each customer. Your Domain enables our customers to access their most recent invoices, call detail records and the customer order entry forms. Your Domain is protected by a customer's user name and password. Your Domain can also inform customers of new product offerings being developed by us. Our Form View product, located in Your Domain, allows our customers to download order forms and other important documents through the Internet at their convenience.
Focal FLOW is an outbound service marketed to VARs that need to be able to switch outbound traffic among multiple long distance or international carriers. We partition our central office switch so VARs can utilize the core switching capability of our equipment at reasonable per minute or per port cost.
Sales and Marketing
Our primary objective is to satisfy the need for highly reliable communications services for communications-intensive users in the large metropolitan markets in which we operate by providing diverse, reliable and sophisticated services. We believe that we have a competitive advantage in satisfying this need since we are focused on delivering a specific set of innovative services to our target customers.
Diversity. Focal provides diversity to communications-intensive users by delivering highly reliable, local communications services as an alternative to the ILEC. This type of diversity already exists in other areas of communications services, such as long distance. Communications-intensive customers clearly embrace the benefits of diversity, particularly because redundancy minimizes the effects of facilities failures and maximizes competitive pricing. As a result, most of our target customers typically have multiple long distance providers, multiple equipment vendors and multiple local private-line providers. Because of our focused strategy, we believe that we are uniquely positioned to become the provider of choice for data and voice communications services for large, communications-intensive corporate users, VARs and network service providers. Our focused strategy is based on our ability to deliver the superior level of diverse, reliable and sophisticated services that our customers require.
Reliability. We provide reliable service to communications-intensive users, who are highly sensitive to the potential effects of facilities failures, by designing our networks around the same theme of diversity that we advocate for our customers. Although local services are perceived as simple, basic services, the delivery of highly reliable, local services requires sophisticated systems. We have engineered our switching and transport networks to meet the demanding traffic and reliability requirements of our target customers. Our network strategy is based on developing and operating a robust, reliable, high-throughput local network relative to the ILECs and other CLECs. Because we are a relatively new entrant to the markets we serve, we must meet or exceed the performance quality of the existing local networks in order to attract communications-intensive users to our networks. Unlike smaller users that tend to pre-qualify vendors based on price, we believe that communications-intensive users choose vendors based on the performance of their networks, and specifically, their reliability. As a result, the design and operation of our network are key success factors in our business development process.
We conducted extensive research to identify the best hardware for the high- volume users that we serve. As a result of this research, we selected Nortel DMS-500 SuperNode central office switches, which we have engineered to reduce significantly the likelihood of blocked calls and to maximize call completion. As such, our customers are unlikely to find themselves unable to complete or receive calls due to limitations inherent in our switches. We typically connect to a large number of switches in the ILEC's network. As of December 31, 2000, we had connected to a total of 1,975 ILEC switches. We believe this is a competitive advantage because it increases call completion even if a portion of the ILEC's trunking network becomes blocked. We optimize the configuration of our network by implementing overflow routing between the ILEC's network and ours, where available. Because the customer base of the ILECs and other CLECs is not typically as communications-intensive as ours, we specifically engineered our network to accommodate traffic volumes per customer far in excess of that which the ILECs or other CLECs typically experience. We believe that our design is unique among ILECs and CLECs and is attractive to our target customer base of communications-intensive users. In addition, we enhance our reliability by delivering service from our switches to customers over multiple fiber transport systems.
We have also implemented safeguards in our network design to maximize reliability. The DMS-500 SuperNode switch allows us to distribute customer traffic across multiple bays of equipment, thus minimizing the effects of any customer outage. In addition, these switches were engineered by Nortel Networks with fully redundant processors and memory in the event of a temporary failure. Similarly, we design our Focal Internet
eXchanges to achieve high levels of reliability by connecting each Focal Internet eXchange to at least three Internet backbone providers and by building two levels of redundancy into our switching and routing infrastructure at each Focal Internet eXchange. Our disaster prevention strategy includes service from multiple power sources where available, on-site battery backup and diesel generator power at each switching facility to protect against failures of our electrical service.
Sophistication. Our target customers are knowledgeable, sophisticated buyers of communications services that demand a high level of professionalism throughout a vendor's organization. We believe that the technical sophistication of our management and operations team has been a critical factor in our initial success and will continue to differentiate us from our competitors. Execution of our strategy of penetrating communications-intensive accounts requires a well-experienced team of sales professionals. As a result, attracting and retaining experienced sales professionals is important to our overall success. Our sales professionals' compensation is structured to retain these valuable employees through the grant of stock options and cash compensation incentives.
We divide our direct sales force into four groups:
. The corporate services group
. The data services group
. The network solutions group
. The government services group
The corporate services group is responsible for selling to large corporate users. Our sales strategy for these corporate customers is to initially complement the customer's service from the ILEC. After we build the service relationship, we anticipate increasing our overall penetration of the customer's local service. Over a period of time, we hope to dominate a corporate customer's local switched traffic. We emphasize the diversity, reliability and sophistication of our services in order to earn our place as the local provider of choice for our corporate customers.
The data services group is responsible for selling to network services providers, DSL providers and other data carriers, including ISPs. We are able to offer several innovative services such as environmentally conditioned colocation space, virtually non-blocking switching, transport facilities, firm installation times and high speed Internet access services based on our Focal Internet eXchange.
The network solutions group markets directly to VARs and other carriers by positioning us as a highly-reliable, responsive and cost-effective source of wholesale local communications services. We believe a wide array of communications service providers, including long distance companies, will seek to provide bundled communications services in the large metropolitan markets we target. We are well-positioned to be the provider of choice for re-bundled local service. Because we do not intend to directly distribute our services to residential or small- and medium-sized business customers, we believe that VARs and other carriers looking to purchase the local service portion of their bundled service offerings are more likely to purchase service from us rather than from other ILECs or CLECs that compete with them.
The government services group is a dedicated group of telecommunications professionals focused solely on meeting the demanding needs of telecom- intensive government customers. Our teams are highly experienced in the communications industry and understand the special requirements of the government sector.
Information Systems
Superior customer service is critical to achieving our goal of capturing market share. We are continually enhancing our service approach, which utilizes a trained team of customer sales and service representatives to coordinate customer installation, billing and service. Comprehensive support systems are also a critical
component of our service delivery. We have installed systems designed to address all aspects of our business, including service order, network provisioning, end-user and carrier billing, and trouble reporting. The efficiency of our operating processes contributes to our ability to rapidly initiate service to new accounts. Our installation desk follows a customer's order, ensuring the installation date is met. Additionally, our customer sales representatives respond to all other customer service inquiries, including billing questions and repair calls.
We are enhancing our systems and procedures for operations support, order provisioning and other back office systems in order to facilitate and streamline the processing of large order volumes and customer service. These systems are required to enter, schedule, provision and track a customer's order from the point of sale to the installation and testing of service. The existing systems currently employed by most ILECs, CLECs and long distance carriers generally require multiple entries of customer information to accomplish order management, provisioning, switch administration and billing. This process is not only labor intensive, but it creates numerous opportunities for errors in provisioning service and billing, delays in installing orders, service interruptions, poor customer service, increased customer turnover and significant added expenses due to duplicated efforts and decreased customer satisfaction.
We are currently using order management software to develop processes that allow us not only to enter customer orders onsite, via computer and/or over the Internet, but also to monitor the status of an order as it progresses through the service initiation process. This software supports the process by which we convert a customer to our network from the local exchange network of an ILEC or other carrier, including circuit design and work flow management.
Electronic Bonding with ILECs. In an effort to make the initiation of service for a customer more efficient, we have electronically bonded with several ILECs and third party service providers. Electronic bonding has improved our productivity by decreasing the period between the time of sale and the time a customer's line is installed. Electronic bonding allows us to access data from the ILEC, submit service requests electronically, and more quickly attend to errors in the local service request form because an order is bounced back if the ILEC determines that there is a mistake. As a result, we expect to be able to eventually substantially reduce the time required to switch service to us. Electronic bonding should also enable us to improve our ability to provide better customer care since we will more readily be able to pinpoint problems with a customer's order.
Electronic Bonding with Customers. We are also working toward the electronic bonding of that portion of the billing process in which we gather customer specific information, including their current service options, and the process of identifying and resolving customer service problems.
We believe automation of internal processes contributes to the overall success of a service provider and that billing is a critical element of any telephone company's operation. We deliver billing information in a number of media besides paper, including electronic files and Internet inquiry. Our Invoice Domain service allows customers to securely access and view their monthly invoices over the Internet. In addition, this service allows customers to download call detail records. Similarly, our VAR customers can download call records on a daily basis through our secure web site. This allows them to efficiently process invoices for their end-user customers.
Significant Relationships
We have no customers that accounted for more than 10% of our revenues during the three years ended December 31, 2000.
Competition
Portions of our industry are highly competitive. We face a variety of existing and potential competitors, including:
. The ILECs in our current and target markets
. Other voice and data CLECs
. Long distance carriers
. Potential market entrants, including cable television companies, VARs, electric utilities, microwave carriers, wireless telephone system operators and private networks built by large end-users
. Foreign carriers
. Internet infrastructure companies
Our primary competitor in each of our existing and planned markets is the ILEC. Examples include BellSouth, Verizon, Qwest, and SBC. These ILECs are generally required to file their prices with the state regulatory agencies in their service areas. Any price changes must be reflected in these filings. The ILECs have also generally been given the flexibility to respond to competition with lower pricing. In most cases, proposals for lower pricing must also be filed with the state utility commissions and the pricing must be made available to similarly situated customers. We believe this provides a disincentive for the ILECs to significantly vary or discount prices even in competitive situations. However, as a CLEC, similar obligations apply to us. See "--Regulation--State Regulation."
The ILECs offer a wider variety of services in a broader geographic area than ours and have much greater resources than we do. This may encourage an ILEC to subsidize the pricing for services with which we compete with the profits of other services in which the ILEC remains the dominant provider. We believe competition has limited the number of services dominated by ILECs. In addition, state regulators have exercised their enforcement powers in a way that makes it unlikely the ILECs would be able to successfully pursue this type of protective pricing strategy for an extended period.
In addition to competition from ILECs, we also face competition from a growing number of other CLECs. Although CLECs overall have only captured approximately 5% of total revenue of the U.S. local telecommunications market, we nevertheless compete to some extent with other CLECs in our customer segments. There are typically several other CLECs competing in each metropolitan market we serve or plan to enter. Examples of data and voice CLECs in our markets include Allegiance Telecom, Covad Communications Group, MCI WorldCom, XO Communications (formerly NEXTLINK Communications), Rhythms NetConnections and Teleport Communications Group, now a part of AT&T. In some instances, these CLECs have resources greater than ours and offer a wider range of services. Many of the CLECs in our markets target small- and medium- sized business customers, which differs from our target customer base of large, communications-intensive users.
The data services market is also extremely competitive. Our principal competitors in this market include Internet connectivity providers such as UUNET Technologies and Verio, private peering companies, such as InterNAP Network Services and Equinix, RBOCs that offer Internet access, global, national and local ISPs and companies that offer colocation services, such as Exodus Communications and AboveNet Communications. We also believe that new competitors will enter the data services market.
Some of the ILECs recently requested, among other things, that the FCC relax regulation of their provision of advanced data networks, which may also be used for voice traffic. While the FCC has denied those requests, it has initiated a rule-making that is intended to establish the procedures and safeguards necessary before these ILECs could, through separate subsidiary companies, provide these services on a largely deregulated basis. If adopted, these rules may provide additional opportunities for competition from these ILECs. SBC and Ameritech received authority from the FCC to create such a subsidiary in the FCC's approval of their merger. Bell Atlantic New York also received similar authority with the recent grant of its application to provide long-distance service in New York. The FCC recently released an order addressing, among other things, colocation rights of carriers offering advanced data services, but deferred action on the separate subsidiary issue. Bills have been introduced in Congress that would grant RBOCs permission to provide data services in areas where they are currently restricted from doing so. Although we cannot predict the outcome of any proposed or pending legislation, the
ability of RBOCs to provide data services on a broader basis could have a material adverse effect on us. In addition, the FCC recently acted to enable ISPs to buy DSL services in bulk from ILECs, which could result in additional competition for ISP business.
In addition to ILECs and other CLECs, we are competing with long distance carriers. A number of long distance carriers have introduced local telecommunications services to compete with us and the ILECs. These services include toll calling and other local calling services, which are often packaged with the carrier's long distance service. While we do not believe the packaging aspect of the service is particularly attractive to the communications-intensive customers we target, large long distance carriers enjoy certain competitive advantages due to their vast financial resources and brand name recognition. In addition, we believe there is a risk the long distance carriers may subsidize the pricing of their local services with profits from long distance services. We anticipate that the entry of some of the ILECs into the long distance market will reduce the risk of this type of activity by reducing the profitability of the long distance carrier's long distance minutes. Further, to the extent the long distance carrier purchases our service on a wholesale basis and rebundles it at a subsidized rate, we may benefit as the subsidized, wholesale service could result in higher market penetration than we would otherwise have achieved. In addition, we have displaced long distance carriers where the customer was dissatisfied with the quality of the long distance carrier's local service. We expect our reputation for exceptional service quality and customer care will continue to result in us displacing the long distance carrier as the primary alternative to the ILEC in competitive situations. In addition, we expect that some of our recent and proposed service offerings, which enable long distance calls to be priced like local calls, will increase our competitiveness.
We compete principally on the basis of the quality, sophistication and reliability of our service. See "--Sales and Marketing." We believe that the principal competitive factors in our markets are speed and reliability of service, quality of facilities, level of customer care and technical support, and the timing and market acceptance of new services and enhancements to existing services.
Regulation
The following summary of regulatory developments and legislation is not complete. It does not describe all present and proposed federal, state and local regulation and legislation affecting the telecommunications industry. Existing federal and state regulations are currently subject to judicial proceedings, legislative hearings and administrative proposals that could change, in varying degrees, the manner in which our industry operates. We cannot predict the outcome of these proceedings or their impact on the telecommunications industry or us.
Overview. Our services are subject to varying degrees of federal, state and local regulation. The decisions of regulatory bodies such as the FCC and state agencies are often subject to judicial review, which makes it difficult for us to predict outcomes in this area.
Federal Regulation. We must comply with the requirements of common carriage under the Communications Act of 1934. Comprehensive amendments to the Communications Act of 1934 were made by the Telecommunications Act of 1996, referred to as the Telecom Act, which substantially altered both federal and state regulation of the telecommunications industry. The purpose of this legislation was to foster increased competition in the telecommunications industry. Because implementation of the Telecom Act is subject to numerous federal and state policy rule-making and judicial review, we cannot predict with certainty what its ultimate effect on us will be.
Under the Telecom Act, any entity may enter a telecommunications market, subject to reasonable state safety, quality and consumer protection regulations. The Telecom Act makes local markets accessible by requiring the ILEC to permit interconnection to its network and establishing ILEC obligations with respect to:
. Colocation of equipment. This allows companies like us to install and maintain our own network equipment, including DSLAMs, ATM switches, and fiber optic equipment, in ILEC central offices.
. Interconnection. This requires the ILECs to permit their competitors to interconnect with ILEC facilities at any technically feasible point in the ILECs' networks.
. Reciprocal compensation. This requires the ILECs and CLECs to compensate each other for telecommunications traffic that originates on the network of one carrier and is sent to the network of the other.
. Resale of service offerings. This requires the ILEC to establish wholesale rates for services it provides to end-users at retail rates to promote resale by CLECs.
. Access to unbundled network elements. This requires the ILECs to unbundle and provide access to some components of their local service network to other local service providers. Unbundled network elements are portions of an ILEC's network, such as copper lines or "loops," that CLECs can lease in order to create their own facilities networks.
. Number portability. This requires the ILECs and CLECs to allow a customer to retain an existing phone number within the same local area even if the customer changes telecommunications services providers. All telecommunications carriers are required to contribute to the shared industry costs of number portability.
. Dialing parity. This requires the ILECs and CLECs to establish dialing parity so that all customers must dial the same number of digits to place the same type of call.
. Access to rights-of-way. This requires the ILECs and CLECs to establish non-discriminatory access to telephone poles, ducts, conduits and rights-of-way.
ILECs are required to negotiate in good faith with other carriers that request any or all of the arrangements discussed above. If a requesting carrier is unable to reach agreement with the ILEC within a prescribed time, either carrier may request arbitration by the applicable state commission. If an agreement still cannot be reached, carriers are forced to abide by the obligations established by the FCC and the applicable state commission.
We have entered into a number of interconnection agreements with the ILECs in our markets. We have existing interconnection agreements in each of our existing markets and in several of our planned markets. Several of the original interconnection agreements covering our existing markets, including the agreements covering Chicago and New York, have already expired. The expiration of these agreements has required us either to negotiate and arbitrate new interconnection terms with the ILECs, or to opt-in to other agreements. Pending conclusion of these negotiations and arbitrations, several existing interconnection agreements should continue to govern the payment of reciprocal compensation and other interconnection terms, while other renegotiated or arbitrated agreements may be given retroactive effect from the expiration date of the superceded agreement following the conclusion of negotiations and arbitrations.
The FCC is charged with establishing guidelines to implement the Telecom Act. In August 1996, the FCC released a decision, known as the Interconnection Decision, that established rules for the interconnection requirements outlined above and provided guidelines for interconnection agreements by state commissions. The U.S. Court of Appeals for the Eighth Circuit vacated portions of the Interconnection Decision. On January 25, 1999, the U.S. Supreme Court reversed the Eighth Circuit and upheld the FCC's authority to issue regulations governing pricing of unbundled network elements provided by the ILECs in interconnection agreements, including regulations governing reciprocal compensation, which are discussed in more detail below. In addition, the Supreme Court affirmed an FCC rule that allows requesting carriers to "pick and choose" the most attractive portions of existing interconnection agreements with other carriers. The Supreme Court did not, however, address other challenges raised about the FCC's rules at the Eighth Circuit because those challenges had not first been decided by the Eighth Circuit. In addition, the Supreme Court disagreed with the standard applied by the FCC for determining whether an ILEC should be required to provide a competitor with particular unbundled network elements.
The FCC adopted a new standard in November 1999 for analyzing unbundled network elements as required by the Supreme Court's order. Applying this standard to the existing network elements, the FCC concluded that ILECs would no longer be required to provide directory assistance and operator services as network elements, though they will continue to be available pursuant to tariff at different prices. The FCC also removed unbundled switching as an element in urban areas where the incumbents are also providing certain other combinations of elements in a non-discriminatory fashion. However the FCC declined, except in limited circumstances, to require ILECs to unbundle certain facilities used to provide high speed Internet access and other data services.
On July 18, 2000, the Eighth Circuit issued its order concerning the issues left unresolved by the Supreme Court. It vacated the FCC's rules regarding the discount on retail services that ILECs must provide to CLECs, the costing rules that must be applied in determining the price of unbundled network elements from ILECs, and the requirement that ILECs must provision combinations of UNEs that are not already combined. The Supreme Court will hear the latter two issues in its coming term. It is not possible to predict the outcome of that decision.
The Supreme Court's 1999 decision and the FCC's order on remand do not remove all uncertainty concerning the pricing terms and conditions of interconnection agreements. In particular, the Supreme Court's further review and ILEC appeals of the FCC's order on remand create contingencies. The resulting uncertainty makes it difficult to predict whether we will be able to continue to rely on our existing interconnection agreements or have the ability to negotiate acceptable interconnection agreements in the future.
In addition to requiring the ILECs to open their networks to competitors and reducing the level of regulation applicable to CLECs, the Telecom Act also reduces the level of regulation that applies to the ILECs, thereby increasing their ability to respond quickly in a competitive market. For example, the FCC has applied "streamlined" tariff regulation of the ILECs, which shortens the requisite waiting period before which tariff changes may take effect. These developments enable the ILECs to change rates more quickly in response to competitive pressures. The FCC has also adopted heightened price flexibility for the ILECs, subject to specified caps. If exercised by the ILECs, this flexibility may decrease our ability to effectively compete with the ILECs in our markets.
The Telecom Act also gives the FCC authority to determine not to regulate carriers if it believes regulation would not serve the public interest. The FCC is charged with reviewing its regulations for continued relevance on a regular basis. As a result of this mandate, a number of regulations that apply to CLECs have been and may in the future continue to be eliminated. We cannot, however, guarantee that any regulations that are now or will in the future be applicable to us will be eliminated.
In March 1999, the FCC issued an order requiring ILECs to provide unbundled loops and colocation on more favorable terms than had previously been available. The order permits colocation of equipment that could be used to more efficiently provide advanced data services such as high-speed DSL service, and requires less expensive "cageless" colocation. In the March order, the FCC deferred action on its previous proposal to permit ILECs to offer advanced data services through separate affiliates, free from some of the obligations of the Telecom Act. The D.C. Circuit vacated the FCC's rules regarding the colocation of equipment providing functionalities in addition to interconnection and access to UNEs, connections between colocating CLECs, and selection of colocation space. The FCC has not yet issued its order on remand from this decision.
In an August 1999 order, the FCC determined that advanced services are telecommunication services subject to regulation under Sections 251 and 252 of the Telecom Act. In the same order the FCC issued a notice of proposed rule making on terms for the provision of such services on a separate subsidiary basis. Permitting ILECs to provision data services through separate affiliates with fewer regulatory requirements could have a material adverse impact on our ability to compete in the data services sector. The FCC imposed conditions on the merger of SBC with Ameritech in October 1999 that permit the provisioning of advanced data services via separate subsidiaries pursuant to various requirements, some of which expire in the near term. The D.C. Circuit vacated the separate subsidiary requirement on January 29, 2001. We cannot predict whether these requirements will ultimately prove enforceable, nor whether they will deter anticompetitive behavior if they are enforceable.
Bell Atlantic's application for long distance service in New York has been approved subject to similar separate subsidiary provisions. These areas of regulation are subject to change through additional proceedings at the FCC or judicial challenge.
On December 9, 1999, the FCC released its line sharing order that requires ILECs to offer line sharing as an unbundled network element by June 6, 2000. Line sharing permits CLECs to use a customer's existing line to provide DSL services while the ILEC continues to use the same line to provide voice service. Prices for line sharing will be set by the states.
Reciprocal Compensation. Reciprocal compensation is the compensation paid by one carrier to complete particular calls on another local exchange carrier's network. Because a significant portion of our customers typically receive more calls than they make, we expect to receive more reciprocal compensation than we pay for calls that originate on our networks. As a result of the current regulatory environment and several trends in our business, which are discussed below, we expect our revenues from reciprocal compensation to decline significantly.
Some ILECs have refused to pay reciprocal compensation charges that they estimate are the result of inbound ISP traffic because they believe that this type of traffic is outside the scope of existing interconnection agreements. For example, Ameritech disputed a portion of the reciprocal compensation charges billed to it by us, which it believed were related to Internet charges. In March of 1998, the Illinois Commerce Commission ruled in favor of Focal and other CLECs regarding this dispute. In October 1998, Ameritech complied with the ruling and we received payment for past reciprocal compensation charges that represents substantially all of the disputed amounts. On June 18, 1999, the Seventh Circuit affirmed the Illinois Commerce Commission's order requiring the payment of reciprocal compensation for ISP- bound traffic. On August 19, 1999, the Seventh Circuit modified its prior order by providing that Ameritech is free to raise in state courts any state claims concerning reciprocal compensation, and by deferring any ruling on the petitions for rehearing pending the Court's resolution in other cases of procedural issues concerning the participation of state commissioners. Ameritech had previously filed such a state complaint which at its request had been held in abeyance pending the outcome of the federal case. On March 5, 2001, the Supreme Court granted certiorari to hear the issues pertaining to the participation of the state commissioners, and whether interconnection agreement enforcement actions may be appealed in federal court. We cannot predict the Supreme Court's ultimate order.
Some states in which our current and planned markets are located have ordered the ILECs to pay reciprocal compensation for Internet-related calls. The majority of states that have addressed the question have ruled that compensation is owed for this traffic. However, these states and other states that have not considered the issue to date may yet determine that no compensation is owed. A finding that reciprocal compensation is not payable for ISP traffic in California, Illinois, New York or Pennsylvania would have a material adverse effect on us.
In addition, on February 26, 1999, the FCC issued a declaratory ruling and Notice of Proposed Rulemaking concerning inbound ISP traffic. The FCC concluded in its ruling that ISP traffic is jurisdictionally mixed and largely interstate in nature, and also concluded that this traffic is not subject to the reciprocal compensation provisions of the Telecom Act. The FCC has requested comment as to what reciprocal compensation rules should govern this traffic upon expiration of existing interconnection agreements. The FCC also determined that no federal rule existed that governed reciprocal compensation for ISP traffic at the time existing interconnection agreements were negotiated and concluded that it would permit states to determine whether reciprocal compensation should be paid for calls to ISPs under existing interconnection agreements. On March 24, 2000, the D.C. Circuit vacated the FCC's finding that this traffic is not subject to reciprocal compensation provisions of the Telecom Act, and remanded this issue to the FCC for further examination. The Court did not address the jurisdictional issue, nor the authority of the states.
In light of the FCC's order and the court decision, state commissions, which previously addressed this issue and required reciprocal compensation to be paid for ISP traffic, may reconsider and may modify their prior
rulings. Several ILECs, including Ameritech, are seeking to overturn prior orders that they claim are inconsistent with the FCC's February 26, 1999 order. Relief sought could include repayment of reciprocal compensation amounts previously paid by the ILECs. Of the 32 state commissions that have considered the issue since the FCC's February 26, 1999 order, 25 of these states have upheld the requirement to pay reciprocal compensation for ISP- bound traffic. Only Massachusetts, New Jersey, South Carolina, Louisiana, Arizona, Colorado, and Iowa are not requiring reciprocal compensation for this traffic, at least pending negotiations and a further FCC decision. Missouri and Ohio are not requiring current payment, but are requiring a true-up based on the FCC's future decision. In addition, of the seven Federal District Courts and the three Courts of Appeals that have reviewed this issue on the merits to date, all have upheld state decisions requiring that reciprocal compensation be paid for ISP-bound traffic.
The New York Public Service Commission (the "NYPSC") determined that in certain circumstances, Verizon can pay a lower reciprocal compensation for calls terminated by a CLEC in excess of a ratio of three terminating minutes to each originating minute. The NYPSC also provided an opportunity to a CLEC having a ratio in excess of three-to-one, such as Focal, to demonstrate that its network is such that the higher rate should be applied. The NYPSC also permitted Verizon to file a tariff seeking to reduce the end office rate by thirty percent from its current level of $0.0034/MOU. Focal and other CLECs have protested this filing. Verizon has unilaterally reduced the reciprocal compensation rate in the New York market from July 1, 1999 on a going forward basis, which we have vigorously challenged in connection with the NYPSC proceeding described above. Verizon has also informed us that it intends to unilaterally escrow these payments in two smaller markets, New Jersey and Delaware.
Upon expiration of our existing interconnection agreements, we must negotiate new rates for reciprocal compensation with each carrier. Pending conclusion of these negotiations, the existing interconnection agreements are expected to continue to govern the payment of reciprocal compensation. We expect rates for reciprocal compensation will be lower under new interconnection agreements than under our existing agreements. A reduction in rates payable for reciprocal compensation could have a material adverse effect on us, as could any requirement to refund reciprocal compensation paid to date.
In addition to charging other carriers reciprocal compensation for terminating local traffic, Focal also collects access charges from carriers for originating and terminating interexchange traffic. Two interexchange carriers, AT&T and WorldCom, have stated that they will not pay the portion of Focal's traffic-sensitive access charges that exceed ILEC traffic-sensitive access charges. The Company is currently suing AT&T to recover these amounts.
In May 1997, the FCC released an order establishing a significantly expanded universal service regime to subsidize the cost of telecommunications service to high cost areas, as well as to low-income customers and qualifying schools, libraries, and rural health care providers. Providers of interstate telecommunications services, like us, as well as certain other entities, must pay for these programs. We are also eligible to receive funding from these programs if we meet certain requirements, but we are not currently planning to do so. Our share of the payments into these subsidy funds will be based on our share of certain defined telecommunications end-user revenues. Currently, the FCC is assessing such payments on the basis of a provider's revenue for the previous year. Various states are also in the process of implementing their own universal service programs. We are currently unable to quantify the amount of subsidy payments that we will be required to make and the effect that these required payments will have on our financial condition. Moreover, some of the FCC's universal service rules remain subject to judicial appeal and further FCC review including the FCC's 8% rule. The FCC's 8% rule provides that a carrier's international revenue is exempt from universal service assessment when its total interstate revenue represents 8% or less of its combined interstate and international revenue. Any court decision that has the effect of reducing the entities subject to universal service contributions could increase the contributions of the remaining entities that are subject to the rules. The FCC currently assesses universal service contributions based on prior year revenues; however, the FCC has initiated a rulemaking to reconsider this approach. Additional changes to the universal service program could increase our costs.
The FCC has made and is continuing to consider various reforms to the existing rate structure for charges assessed on long distance carriers for allowing them to connect to local networks. These reforms are designed to move these "access charges," over time, to lower, cost-based rate levels and structures. These changes will reduce access charges and will shift charges, which had historically been based on minutes-of-use, to flat-rate, monthly per line charges on end-user customers rather than long distance carriers. On August 5, 1999, the FCC adopted an order granting price cap local exchange carriers additional pricing flexibility, implementing certain access charge reforms, and seeking comment on others. The order provides certain immediate regulatory relief to price cap carriers and sets a framework of "triggers" to provide these companies with greater flexibility to set interstate access rates as competition increases. The order also initiated rulemaking to determine whether the FCC should regulate competitive local exchange carriers access charges. On February 2, 2001, the D.C. Circuit upheld the FCC rules regarding pricing flexibility. The FCC has recently granted pricing flexibility applications for switched access services provided by BellSouth in a number of cities in its service territory. The FCC also granted flexible pricing authority for dedicated transport and special access services provided by SBC entities in certain cities, and for dedicated transport and special access services provided by Verizon entities in certain cities. The manner in which the FCC continues to implement its approach to lowering access charge levels and a decision to regulate competitive local exchange carrier access rates could have a material effect on our ability to compete in providing interstate access services.
On May 31, 2000 the FCC adopted the proposal of the Coalition for Affordable Long Distance Service ("CALLS") that significantly restructures and, reduces in some respects, the interstate access charges of the RBOCs, AT&T, and Sprint. Among the more significant regulatory changes established by the CALLS Order, the RBOCs are required to reduce switched access charges to an average of $0.0055/minute. Price cap ILECs are additionally required to eliminate the presubscribed interexchange carrier charge ("PICC") as a separate charge and fold it into an increased subscriber line charge. AT&T and Sprint have committed in this proceeding to pass on access charge reductions to consumers, and to eliminate minimum monthly usage charges. Although the CALLS Order will not apply directly to CLECs, ILEC reductions in switched access charges may place some downward pressure on CLEC's to reduce their own switched access charges. In addition, IXCs other than AT&T and Sprint are not subject to the CALLS Order, but may seek to alter their offerings to conform to AT&T's and Sprint's commitments in this proceeding. A Petition for Reconsideration of the CALLS Order is currently before the FCC.
Tariff and Filing Requirements. Non-dominant carriers, including Focal, must file tariffs with the FCC listing the rates, terms and conditions of interstate and international services provided by the carrier. On October 29, 1996, the FCC adopted an order in which it eliminated the requirement that non-dominant interstate carriers maintain tariffs on file with the FCC for domestic interstate services. Accordingly, non-dominant interstate carriers, including Focal, no longer file interstate tariffs with the FCC for these services.
In addition, periodic reports concerning carriers' interstate circuits and deployment of network facilities also are required to be filed with the FCC. The FCC generally does not exercise direct oversight over cost justification and the level of charges for services of non-dominant carriers, although it has the power to do so. The FCC may also impose prior approval requirements on transfers of control and assignments of operating authorizations.
Fines or other penalties also may be imposed for violations of FCC rules or regulations. The FCC also requires that certified carriers like Focal notify the FCC of foreign carrier affiliations and secure a determination that such affiliations, if in excess of a specified amount, are in the public interest.
State Regulation. Most states regulate entry into the markets for local exchange and other intrastate services, and states' regulation of CLECs vary in their regulatory intensity. The majority of states require that companies seeking to provide local exchange and other intrastate services to apply for and obtain the requisite authorization from a state regulatory body, such as a state commission. This authorization process generally requires the carrier to demonstrate that it has sufficient financial, technical and managerial capabilities and that granting the
authorization will serve the public interest. As of December 31, 2000, we had obtained local exchange certification or were otherwise authorized to provide local exchange service in:
California Illinois Minnesota Pennsylvania Delaware Indiana Missouri Texas District of Maryland New Jersey Virginia Columbia Massachusetts New York Washington Florida Michigan Ohio Georgia
To the extent that an area within a state in which we provide service is served by a small or rural exchange carrier not currently subject to competition, we may not currently have authority to provide service in those areas at this time.
As a CLEC, we are and will continue to be subject to the regulatory directives of each state in which we are and will be certified. Most states require that CLECs charge just and reasonable rates and not discriminate among similarly situated customers. Some other state requirements include:
. The filing of periodic reports
. The payment of various regulatory fees and surcharges
. Compliance with service standards and consumer protection rules
States also often require prior approvals or notifications for certain transfers of assets, customers, or ownership of a CLEC and for issuances by certified carriers of equity securities, notes or indebtedness, although the terms of this offering do not require any prior approval. States generally retain the right to sanction a carrier or to revoke certifications if a carrier violates relevant laws and/or regulations. Delays in receiving required regulatory approvals could also have a material adverse effect on us. We cannot assure you that regulators or third parties will not raise material issues with regard to our compliance or non-compliance with applicable laws or regulations.
In most states, certificated carriers like us are required to file tariffs setting forth the terms, conditions, and prices for services which are classified as intrastate. In some states, the required tariff may list a range of prices for particular services, and in others, such prices can be set on an individual customer basis. We may, however, be required to file tariff addenda of the contract terms.
Under the Telecom Act, implementation of our plans to compete in local markets is and will continue to be, to a certain extent, controlled by the individual states. The states in which we operate or intend to operate have taken regulatory and legislative action to open local communications markets to various degrees of local exchange competition.
Local Regulation. We are also subject to numerous local regulations, such as building code requirements, franchise and local public rights of way. These regulations may vary greatly from state to state and from city to city.
Employees
As of December 31, 2000, we employed 1,130 full-time employees, none of whom were covered by a collective bargaining agreement. We believe that our future success will depend on our continued ability to attract and retain highly skilled and qualified employees. We believe that our relations with our employees are good.
ITEM 2.
ITEM 2. DESCRIPTION OF PROPERTY
We are headquartered in Chicago, Illinois and lease office space in a number of locations, primarily for network equipment installations and sales and administrative offices and cover approximately 796,000 square feet of leased space. These leases expire in years ranging from 2002 to 2015 and have varying renewal options. We also own approximately 13 acres of real property in Arlington Heights, Illinois. This property, which includes a 52,000 square foot building, houses our second Chicago-area switching center, national data center and national network operations center.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
With the exception of the matters discussed below, we are not aware of any material litigation against us. In the ordinary course of our business, we are involved in a number of regulatory proceedings before various state commissions and the FCC.
On September 16, 1997, we filed a complaint and request for temporary injunction against Ameritech Illinois with the Illinois Commerce Commission. The complaint claimed breach of the terms of the interconnection agreement between us and Ameritech Illinois because Ameritech Illinois refused to pay reciprocal compensation for our transport and termination of calls to our end- users that Ameritech Illinois believed were ISPs. In the interests of obtaining a more timely judgment, we withdrew our complaint without prejudice on October 17, 1997 and filed to intervene in a consolidated suit that included similar complaints against Ameritech Illinois by several other CLECs. On March 11, 1998, the Illinois Commerce Commission issued an order that required Ameritech Illinois to pay reciprocal compensation for calls made to ISPs. On March 15, 1998, Ameritech Illinois filed a motion with the Illinois Commerce Commission to stay the order pending an appeal, which was denied on March 23, 1998. On March 27, 1998, Ameritech Illinois filed suit in the United States District Court for the Northern District of Illinois seeking reversal of the Illinois Commerce Commission order. Ameritech Illinois also sought a stay of this order from the District Court, which was granted while the case was decided. On July 21, 1998, the District Court upheld the Illinois Commerce Commission's order, finding that calls to ISPs are local calls and therefore subject to the reciprocal compensation rules contained in the Telecom Act. The District Court stayed the decision to permit any party to appeal. Ameritech Illinois then appealed the decision to the U.S. Court of Appeals for the Seventh Circuit on August 25, 1998, and was denied a stay while the appeal is pending. In October 1998, Ameritech Illinois complied with the order and we received payment for past reciprocal compensation charges that represent substantially all of the disputed amounts. On June 18, 1999, the Seventh Circuit affirmed the Illinois Commerce Commission's order requiring the payment of reciprocal compensation for ISP-bound traffic. On August 19, 1999, the Seventh Circuit modified its prior order to permit Ameritech to raise in state courts any state claims concerning reciprocal compensation. On March 5, 2001, the Supreme Court agreed to hear the appeal pertaining to the participation of the state commissioners, and whether interconnection agreement enforcement actions may be appealed in federal court. We cannot predict the Supreme Court's ultimate order or its effect on our business or financial condition. See "Business--Regulation" for a description of federal rule-making and other developments affecting reciprocal compensation.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Focal did not submit any matter to a vote of its stockholders during the fourth quarter of 2000.
PART II
ITEM 5.
ITEM 5. MARKET FOR FOCAL'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS AND MARKET INFORMATION
Focal's common stock is traded on the Nasdaq National Market. Focal's ticker symbol is "FCOM." Focal completed the initial public offering of its common stock in August 1999. Prior to August 1, 1999, no established public trading market for the common stock existed.
The following table sets forth on a per share basis, the high and low bid information per share for our common stock as reported on the Nasdaq National Market for the periods indicated:
There were approximately 161 owners of record of Focal common stock as of February 28, 2001. This number excludes stockholders whose stock is held in nominee or street name by brokers and Focal believes that it has a significantly larger number of beneficial holders of common stock. A recently reported sale price of our common stock on the Nasdaq National Market is set forth on the front cover of this report.
Dividends
We have not paid any cash dividends on our common stock in the past and do not anticipate paying any cash dividends on our common stock in the foreseeable future. Any future determination to pay dividends will be at the discretion of our board of directors and will be dependent upon then existing conditions, including our financial condition, results of operations, contractual restrictions, capital requirements, business prospects, and other factors our board of directors deems relevant. In addition, our current financing arrangements effectively prohibit us from paying cash dividends for the foreseeable future.
Recent Sales of Unregistered Securities
Focal did not sell any equity securities during the period covered by this report that were not registered under the Securities Act of 1933 and that were not previously reported on Form 10-Q.
ITEM 6.
ITEM 6. SELECTED CONSOLIDATED FINANCIAL AND OPERATING DATA
The selected consolidated financial data presented below for the three years ended December 31, 2000, have been derived from our Consolidated Financial Statements and the accompanying notes related thereto. Our Consolidated Financial Statements for the three years ended December 31, 2000 have been audited by Arthur Andersen LLP, our independent public accountants. The balance sheet data as of December 31, 1996, 1997 and 1998 has been derived from our audited consolidated financial statements not included in this report. You should read the information in this table in conjunction with Item 7A, "Quantitative and Qualitative Disclosures About Market Risk", Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations," and our Consolidated Financial Statements and the accompanying notes related thereto appearing elsewhere in this report.
You should not assume that the results of operations above are indicative of the financial results we can achieve in the future. You should also keep the following matters in mind when you read this information:
. Non-cash compensation expense consists of:
-- charges totaling $0.1 million for 1996, $1.3 million for each of 1997 and 1998 and $2.5 million for 1999, which resulted from the vesting over time of shares of common stock issued to some of our executive officers in November 1996
-- charges of $1.8 million, $0.3 million, and $0.3 million for 1998, 1999 and 2000, respectively, which resulted from the vesting and cancellation of shares of common stock in connection with the September 30, 1998 amendment of vesting agreements with some of our executive officers
-- charges of $4.4 million in 1999 and $6.1 million in 2000, which resulted from our 1999 stock option grants to employees, directors and an outside consultant, and common stock issued to a director
. EBITDA represents earnings before interest, income taxes, depreciation and amortization and other non-cash charges, including non-cash compensation expense. EBITDA is not a measurement of financial performance under generally accepted accounting principles, is not intended to represent cash flow from operations, and should not be considered as an alternative to net loss applicable to common stockholders as an indicator of our operating performance or to cash flows as a measure of liquidity. We believe that EBITDA is widely used by analysts, investors and other interested parties in the telecommunications industry. EBITDA is not necessarily comparable to similarly titled measures for other companies.
. We count access lines as of the end of the period indicated and on a one-for-one basis using DS-0 equivalents.
. Data and Telecom services revenue information is not available for 1996, 1997 and 1998.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Overview
General. We provide voice, data and Internet infrastructure services to large, communications-intensive users in major cities. We began operations in 1996 and initiated service first in Chicago in May 1997. As of December 31, 2000 we offered service in a total of 20 markets, which encompass a total of 49 metropolitan statistical areas, or MSAs, and plan to serve 24 markets, or 56 MSAs, by the end of 2001. We believe our market expansion will allow us to reach a critical mass of geographic coverage and service capability for our target customer base of communications-intensive users. As of December 31, 2000, we had 435,272 lines in service.
In September 2000, we announced the launch of our first Focal Internet eXchange platform in our Chicago market. Our state-of-the-art Internet eXchange platforms provide high-speed, managed Internet access, colocation, and private peering services to large corporations, value-added resellers, network service providers, and content and application service providers. During the fourth quarter of 2000, we deployed Focal Internet
eXchanges in seven additional markets: New York; Northern New Jersey; Philadelphia; Washington D.C.; San Francisco; Oakland and San Jose. At the end of 2000, our Focal Internet eXchanges served eight markets. We intend to deploy a total of 36 Focal Internet eXchanges across our 24 planned markets.
Revenue. Data services revenue includes revenues from circuit switched lines sold to network service providers, DSL, colocation, and Internet infrastructure services. Telecom services revenue includes circuit switched lines sold to corporate and VAR customers. Our data and telecom services revenue is composed of monthly recurring charges, usage charges, and initial non-recurring charges. Monthly recurring charges include the fees paid by our customers for lines in service, additional features on those lines, and colocation space. Monthly recurring charges are derived only from end user customers. Usage charges consist of fees paid by end-users for each call made, fees paid by the ILEC and other CLECs as reciprocal compensation, and access charges paid by the IXCs for long distance traffic that we originate and terminate. Non-recurring revenues are typically derived from fees charged to install new customer lines and are deferred and amortized over estimated customer lives.
We earn reciprocal compensation revenue for calls made by customers of another local exchange carrier to our customers. Conversely, we incur reciprocal compensation expense to other local exchange carriers for calls by our customers to their customers. We expect the proportion of revenues represented by reciprocal compensation to decrease in the future as a result of the expiration and subsequent renegotiation of our existing interconnection agreements with the ILECs and the impact of recent and future regulatory developments.
Expenses. Our expenses are categorized as network expenses; selling, general and administrative; depreciation and amortization; and non-cash compensation expense. Network expenses are composed of leased transport charges, the cost of leasing space in ILEC central offices for colocating our transmission equipment, the costs of leasing our nationwide Internet network, reciprocal compensation payments and the cost of completing local and long distance calls. Leased transport charges are the lease payments we make for the use of fiber transport facilities connecting our customers to our switches and for our connection to the ILECs' and other CLECs' networks. Generally, we have been successful in negotiating lease agreements that match the duration of our customer contracts, thereby allowing us to avoid the risk of incurring expenses associated with transport facilities that are not being used by revenue generating customers.
Our strategy of initially leasing rather than building our own fiber transport facilities has resulted in our cost of service being a significant component of total cost. Accordingly, our network expenses may be higher on a relative basis compared to CLECs who own a higher percentage of their transport network. However, compared to these same companies, our capital expenditures will be significantly lower.
A key aspect of our "smart-build" strategy is that we only operate in Tier 1 markets which are served by multiple fiber providers. When traffic volumes grow sufficiently to justify investing in our own network, we have purchased our own fiber. As of December 31, 2000 we were operating our own fiber networks in nine of our markets with approximately 9,730 fiber miles in operation.
Selling, general and administrative expense ("SG&A") consists of network and customer care personnel costs, sales force compensation and promotional expenses as well as the cost of corporate activities related to regulatory, finance, human resources, legal, executive, and other administrative activities. We expect our sales expense to be lower as a percentage of revenue than that of our competitors because we have relatively high sales productivity associated with our strategy of serving communications-intensive customers. These customers generally utilize a large number of switched access lines relative to the average business customer, resulting in more revenue per sale. Further, fewer sales representatives are required to service the relatively smaller number of communications-intensive customers in a given region.
We record monthly non-cash compensation expense related to shares issued to some of our executive officers in November 1996, in connection with the September 30, 1998 amendments to vesting agreements with some of our executive officers, in connection with stock options granted to employees, an outside consultant,
and directors during 1999 and shares issued to a director during the first quarter of 1999. We will continue to record non-cash compensation expense in future periods relating to these events through the third quarter of 2003. See the notes to our Consolidated Financial Statements.
Quarterly Operating Results
The following table sets forth unaudited financial, operating and statistical data for each of the specified quarters of 2000 and 1999. The unaudited quarterly financial information has been prepared on the same basis as our Consolidated Financial Statements and, in our opinion, contains all normal recurring adjustments necessary to fairly state this information. The operating results for any quarter are not necessarily indicative of results for any future period.
- -------- (1) Quota bearing sales professionals. Does not include sales engineers or customers support personnel.
Year Ended December 31, 2000 Compared to Year Ended December 31, 1999
Our data services revenue increased 64% for the year ended December 31, 2000 to $159.0 million. Telecom services revenue increased 150% to $75.2 million for the year ended December 31, 2000. The increase in our data and telecom services revenue is primarily due to the generation of revenues from new markets that went into operation during 2000 and from a sequential increase in revenue from our more mature markets. In addition, we installed 254,169 lines during 2000, which exceeded the lines installed during the comparable period of 1999 by approximately 97% or 125,077 lines.
Network expenses totaled $89.7 million for the year ended December 31, 2000 compared to $29.9 million for the year ended December 31, 1999. This $59.8 million increase resulted from our expansion into new markets during 2000 and related costs for leased transport facilities, usage settlements, colocation and Internet network costs related to our Focal Internet eXchange platforms. Our gross margin was approximately 62% and 76% for the years ended December 31, 2000 and 1999, respectively. This decrease in our gross margin is a direct result of our market expansion, our effective reciprocal compensation per minute of use rate having declined between periods and due to initial network costs related to our Focal Internet eXchange platforms. SG&A expenses increased by $82.0 million to $155.5 million for the year ended December 31, 2000. This increase is the result of our expansion into new markets, the rollout of our Focal Internet eXchange platforms, and due to a corresponding increase in our employee base by 538 employees.
Depreciation and amortization increased from $23.8 million to $57.0 million in the comparative year to year periods. This $33.2 million increase is a result of our expansion into new markets, an increase in our fixed asset base for our existing markets, and due to the build-out of our nationwide network and Focal Internet eXchange platforms. Interest income was $20.3 million and $7.9 million for the years ended December 31, 2000 and 1999, respectively. This $12.4 million increase is primarily due to the receipt of $265.7 million in net proceeds from our 11 7/8% senior notes ("2000 Notes") offering completed in January 2000. Our net interest expense increased from $21.6 million during 1999 to $56.2 million for 2000. This net increase of $34.6 million is primarily due to an additional $31.8 million of interest expense charged relating to our outstanding 2000 notes which was partially offset by interest capitalized during the year ended December 31, 2000 totaling $9.4 million.
We incurred U.S. income tax expense of $0.6 million for 1999 compared to a tax benefit of $4.2 million in 2000. The tax benefit recorded for 2000 is the result of a net operating loss carryback for a refund of federal and state taxes paid.
Our six most established markets had $186.8 million in revenue, EBITDA of $94.0 million, and an EBITDA margin of 50% during 2000. We provide market specific information to provide insight into the life cycle performance of our older markets which are comprised of Chicago, New York, San Francisco, San Jose, Oakland, and Philadelphia.
Year Ended December 31, 1999 Compared to Year Ended December 31, 1998
Our total revenue for the year ended 1999 was $126.9 million compared to $43.5 million for the year ended 1998. This increase of 192% is primarily due to the generation of revenue from numerous markets during 1999 compared to revenues from primarily two markets, Chicago and New York, in the comparable period of 1998. We installed approximately 129,000 access lines during 1999, which exceeded the lines installed in the comparable period of 1998 by approximately 187% or 84,000 lines.
Network expenses totaled $29.9 million for the year ended December 31, 1999 compared to $5.1 million for the year ended December 31, 1998. This $24.8 million increase resulted from our rapid expansion into six new markets and related costs for leased transport facilities and usage settlements. Our gross margin was approximately 76% and 88% for the years ended December 31, 1999 and 1998, respectively. This decrease in our gross margin is a direct result of our effective reciprocal compensation per minute of use rate having declined between periods. SG&A expenses increased by $51.1 million to $73.5 million during the year ended December 31, 1999. This increase is the result of our planned expansion and due to a corresponding increase in our employee base by 359 employees.
Depreciation and amortization increased from $6.7 million to $23.8 million in the comparative year to year periods. This increase of $17.1 million is a result of our 1999 expansion into six new markets and due to our fixed asset base increase for our existing markets. Our 1999 capital expenditures of approximately $128.5 million (excluding $21.0 million of assets acquired under capital lease) were $64.3 million greater than that of the comparable period of 1998. Non-cash compensation expense was $7.2 million for the year ended December 31,
1999 compared to $3.1 million for comparable period in 1998. This $4.1 million increase in non-cash compensation expense is the result of September 30, 1998 amendments of vesting agreements with some of our executive officers, stock options granted to employees, an outside consultant, and directors during 1999, and stock issued to a director during the first quarter of 1999.
Interest income was $7.9 million and $6.5 million for the years ended 1999 and 1998, respectively. This increase of $1.4 million is primarily due to our cash, cash equivalents, and short-term investments increasing from $134.0 million at the end of 1998 to $188.1 million at the end of 1999. This increase is the result of our net proceeds of approximately $137 million raised in our August 1999 initial public offering. Interest expense increased from $16.1 million during 1998 to $21.6 million for 1999. This net increase of $5.5 million is due to an additional $4.6 million of amortization of our outstanding senior discount notes, $3.4 million of interest expense on our secured equipment term loan, and $1.1 million of non-cash interest expense relating to our capital lease obligation for dark fiber transport capacity. This increase of $9.1 million was partially offset by approximately $3.6 million of interest capitalized during 1999 in connection with the construction of our major facilities and networks.
We incurred U.S. income tax expense of $0.6 million for the year ended 1999 compared to $4.7 million in the same period of 1998. This decrease of $4.1 million in our tax expense between years is primarily due to the $18.5 million of additional pre-tax losses incurred during 1999 and the realization of a net operating loss at the end of 1999. We are obligated to pay federal and state income taxes due to the application of the alternative minimum tax.
Liquidity and Capital Resources
Our current business plan anticipates that we expand our existing networks and services, expand into four new markets in 2001, deploy our own fiber capacity in a majority of our markets, construct 36 Focal Internet eXchange platforms across our 24 planned markets, construct expanded colocation centers, and fund operating losses. We will require significant capital to fund this plan including the purchase and installation of voice and data switches, routers, equipment, infrastructure and fiber facilities and/or long- term rights to use fiber transport capacity. The implementation of this plan requires significant capital expenditures, a substantial portion of which will be incurred before significant related revenues from our new markets are expected to be realized. These expenditures, together with associated operating expenses, may result in our having substantial negative operating cash flow and substantial net operating losses for the foreseeable future, including 2001. Our current plan indicates we will turn EBITDA positive during 2001. In addition, our cash on hand and funds available under our Credit Facility (see below) provides over $300 million in liquidity as of December 31, 2000. Although we believe that our current plan, cost estimates and the scope and timing of our planned network build-out are reasonable, we cannot assure that actual costs or the timing of the expenditures, or that the scope and timing of our build-out, will be consistent with current estimates.
Our capital expenditures were approximately $309.6 million in 2000 compared to $128.5 million in 1999 (excluding $21.0 million of assets acquired under capital lease). This increase of $181.1 million primarily reflects capital spending for the build-out of our new and existing markets and for the construction of our nationwide network and Focal Internet eXchange platforms. We estimate that our capital expenditures in connection with our current business plan will be approximately $175 million to $200 million during 2001. The 2001 capital expenditures are expected to be made primarily for the build- out of four additional markets, the construction of Focal Internet eXchange platforms, the expansion of our existing markets and the activation of local dark fiber transport capacity in a number of our markets.
Our expectations of future capital requirements and cash flows from operations are based on current estimates. If our plans or assumptions change or prove to be inaccurate, we may be required to seek additional sources of capital or seek additional capital sooner than currently anticipated.
Net cash provided by operating activities for 2000 was $52.2 million, an increase of $33.6 million from the same period in 1999. This increase is primarily the result of a $33.2 million increase in depreciation and amortization, a $97.2 million increase in accounts payable and accrued liabilities, and an additional $2.8 million of amortization of our senior discount notes, which was offset by additional net losses of $83.5 million. Net cash provided by operating activities for 1999 was $18.6 million, a decrease of $3.9 million from the same period in 1998. This decrease is primarily the result of a $17.1 million increase in depreciation and amortization, a $4.1 million increase in non-cash compensation expense, and an additional $4.6 million of amortization of our senior discount notes, which was offset by additional net losses of $14.4 million and the increase in our 1999 accounts receivable exceeded 1998 by approximately $16.4 million.
Net cash used in investing activities was $309.9 million for 2000 compared to $130.6 million in 1999. This increase of $179.3 million is primarily the result of our 2000 expansion into four new markets and the continued expansion of our existing markets. Our capital expenditures of $309.6 million in 2000 exceeded 1999 by $181.0 million. Short-term investments primarily consist of debt securities, which typically mature between three months and one year. Net cash used in investing activities was $130.6 million for 1999 compared to $72.2 million in 1998. This increase of $58.4 million is primarily the result of our 1999 expansion into six new markets and the continued expansion of our existing markets. Our capital expenditures of $128.5 million in 1999 exceeded 1998 by $64.3 million. Short-term investments primarily consist of debt securities, which typically mature between three months and one year.
Net cash provided by financing activities for 2000 was $251.0 million, an increase of $86.9 million from 1999. This increase is primarily the net result of our proceeds from the issuance of our 2000 Notes in January 2000. Net cash provided by financing activities for 1999 was $164.1 million, a decrease of $9.3 million from 1998. This decrease is primarily the net result of our debt and equity proceeds between comparable periods.
On February 18, 1998, we received $150 million in gross proceeds from the sale of our 1998 Notes. The 1998 Notes will accrete to an aggregate stated principal amount of $270 million by February 15, 2003. As of December 31, 2000, the principal amount of the 1998 Notes had accreted to approximately $210.1 million. No interest is payable on the 1998 Notes prior to August 15, 2003. Thereafter, cash interest will be payable semiannually on August 15 and February 15 of each year. On August 2, 1999, we raised net proceeds of approximately $137 million in our initial public offering in which we sold 11,442,500 shares of our common stock at a price of $13 per share, which includes the underwriter's exercise of their over-allotment option to purchase 1,492,500 common shares at $13 per share. On January 12, 2000, we received approximately $265.7 million in net proceeds from our 2000 Notes offering completed in January 2000.
Our secured equipment term loans are solely for the purchase of telecommunications equipment and related software licenses and must be repaid over a five-year period from the date of the borrowing. As of December 31, 2000, there are no borrowings available to us under this facility and we had $35.5 million outstanding under this term loan facility. On August 25, 2000, we completed our $300 million Senior Secured Credit Facility (the Credit Facility). The Credit Facility consists of a seven year $150 million revolving credit facility and a seven year $150 million delayed draw term loan facility. The Credit Facility will be available, subject to certain financial and operating terms and conditions, and is intended to provide purchase money financing for the construction, acquisition, or improvements of telecommunications assets. The interest on amounts drawn is variable based on our leverage ratio, as defined in our Credit Facility. The initial commitment fee on the unused portion of the Credit Facility is 1.5% and will step down based on usage. We had not drawn down against the Credit Facility as of December 31, 2000. During February 2001, we borrowed approximately $8.0 million under the Credit Facility.
We have historically incurred net losses and have an accumulated deficit of $139.6 million and $33.7 million as of December 31, 2000 and 1999 respectively. The aggregate net proceeds totaling approximately $602.7 million that we received from the offering of our 1998 Notes, the August 1999 equity offering, the 2000 Notes and certain other financings, have funded a large portion of our operating losses and capital expenditures through December 31, 2000. We expect that our existing cash and investment balances, a portion of our Credit Facility, flexible "smart-build" success-based operating plans, and future cash flows (expected to be provided
from ongoing operations) will be sufficient to fund our operations and capital expenditure requirements into the second quarter of 2002. Our expectations of future capital requirements and cash flows from operations are based on current estimates. If plans or assumptions change or prove to be inaccurate, we may be required to seek additional sources of capital, seek additional capital sooner than currently anticipated, or modify our expansion plans.
The discussions under "Management's Discussion and Analysis of Financial Condition and Results of Operations" contain forward-looking statements. These statements are subject to a number of risks and uncertainties that could cause actual results to differ substantially from our projections. See "Information Regarding Forward-looking Statements" on page 2 of this report.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We are exposed to minimal market risks. We manage sensitivity of our results of operations to these risks by maintaining a conservative investment portfolio, which primarily consists of debt securities, typically maturing within one year, and entering into long-term debt obligations with appropriate pricing and terms. We do not hold or issue derivative, derivative commodity or other financial instruments for trading purposes. Financial instruments held for other than trading purposes do not impose a material market risk on us.
We are exposed to interest rate risk, as additional debt financing is periodically needed due to the large operating losses and capital expenditures associated with establishing and expanding our network coverage. The interest rate that we will be able to obtain on debt financing will depend on market conditions at that time, and may differ from the rates we have secured on our current debt.
While all of Focal's long-term debt bears fixed interest rates, the fair market value of our fixed rate long-term debt is sensitive to changes in interest rates. We have no cash flow or earnings exposure due to market interest rate changes for our fixed long-term debt obligations. The table below provides additional information about our 1998 Notes and 2000 Notes. For additional information about our long-term debt obligations, see our Consolidated Financial Statements and accompanying notes related thereto appearing elsewhere in this report.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The Company's Consolidated Financial Statements required by Item 8, together with the notes thereto and the report thereon of the independent public accountants dated February 9, 2000, are set forth on pages-F-19 of this report. The financial statement schedule listed under Item 14(a) 2, together with the report thereon of the independent public accountants dated February 9, 2001, are set forth on pages and of this report and should be read in conjunction with our Consolidated Financial Statements.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The table below contains information about the ages and positions of Focal's executive officers, selected key employees, and directors, as of February 28, 2001.
Robert C. Taylor, Jr. Robert Taylor is Chief Executive Officer and President for Focal Communications Corporation. He was appointed to this position in August 1996. Taylor is also Focal's co-founder and a director. Taylor is the Chairman of the Association for Local Telecommunications Services (ALTS), the nation's leading organization representing facilities- based competitive local exchange carriers (CLECs). In addition, Taylor sits on the board of directors for IPLAN Networks, a CLEC based in Argentina and Madison River Communications, an ILEC. With over 15 years of telecommunications experience, Taylor has held positions with MFS Communications, most recently as Vice President of Global Accounts, where he worked with the company's 50 largest customers and executed market development activities in Mexico and Canada. Prior to joining MFS in 1994, Taylor was one of the original senior executives at McLeod Communications Group. Taylor has also held management positions with MCI, Bellcore and Ameritech. Taylor received his M.B.A. from the University of Chicago Graduate School of Business and holds a Bachelor of Science degree in Mechanical Engineering.
John R. Barnicle. Mr. Barnicle has been Executive Vice President, Chief Operating Officer and a director since June 1996. Mr. Barnicle is a co-founder of Focal and is responsible for day-to-day operations, engineering, marketing and long-term planning. In 1996, Mr. Barnicle was Vice President of Marketing for MFS Telecom Companies, a subsidiary of MFS Communications. From 1994 to 1996, Mr. Barnicle was a Vice President of Duff & Phelps Credit Rating Company and before that held various marketing, operations and engineering positions with MFS Telecom (1992-1994) and Centel Corporation, a local exchange carrier (1986-1992). Mr. Barnicle received his M.B.A. with Distinction from DePaul University and holds a Bachelor of Science degree in Electrical Engineering.
Ronald Reising. Mr. Reising joined Focal in 2001 as Executive Vice President and Chief Financial Officer of Focal. He is responsible for the financial management of Focal and overseeing the finance, treasury and accounting functions. From 2000-2001, Mr. Reising was the chief financial officer of Derivion, a privately held electronic bill presentment and payment company based in Atlanta, Georgia. From 1991-2000, he held various international and domestic positions with Ameritech. His most recent appointment at Ameritech was in 1999 as
Chief Financial Officer of Bell Canada. In 1997, he was the Chief Financial Officer of Matav, the $1 billion national Hungarian telecommunications company in which Ameritech held a one-third-equity stake. Mr. Reising is a graduate of the Kellogg School of Management at Northwestern University and holds a bachelor's degree in economics from Lawrence University (Appleton, WI). Mr. Reising is also a Certified Public Accountant.
Renee M. Martin. Ms. Martin has been Senior Vice President, General Counsel and Secretary since March 1998. Ms. Martin is responsible for our legal and regulatory functions. From 1984 to 1998, Ms. Martin held various executive positions at Ameritech, most recently as Vice President and General Counsel Small Business Services, where she directed corporate legal resources to address contract negotiations, employment issues, regulatory affairs and litigation, and managed outside legal counsel. From 1982 to 1984, Ms. Martin was an attorney at the law firm of Cook and Franke, S.C. where she concentrated on general business and corporate law. Ms. Martin received her J.D. from the University of Wisconsin and holds a Bachelor of Arts degree in Journalism.
Anthony J. Leggio. Mr. Leggio, an Executive Vice President and President of Focal's Telecom Services Group, is responsible for the sales for Focal's business services organization, which includes corporate services, network solutions and the government services groups. Before joining Focal in 1997 as Regional Vice President Eastern Region, Mr. Leggio spent ten years, 1988 to 1997, with Sprint Corporation, holding a number of increasingly responsible sales management positions. Most recently, he served as Vice President of Sales, Eastern Region for Sprint PCS, where he led the planning, development, organization and implementation of the Fortune 1000 sales and support organization for Sprint's new wireless venture. Mr. Leggio received his MBA from St. Joseph's University and a B.S. in Marketing from Rowan College.
Michael L. Mael. Mr. Mael has been Executive Vice President and President, Focal Data Communications Group, since January 2000. Mr. Mael is responsible for developing and managing Focal's data services business. From 1997 until January 2000, he was Vice President, Applications and Web Services, at PSINet, where he developed and managed the company's global Web hosting business. From 1992 until 1997, Mr. Mael held various management positions at MCI Communications in finance, marketing, and business development, and was a member of the team that created MCI's Internet initiative. Mr. Mael received his BA from Brown University and his MBA from Stanford University.
Marie Allen. Ms. Allen is Senior Vice President of Human Resources. Ms. Allen is responsible for directing the strategic issues of employee retention and attraction for the company. She also is charged with maintaining Focal's valued corporate culture as the company moves into its next phase of growth. During her 15-year career, Ms. Allen has held senior management positions across various industries. From 1998 to 2000, she was Senior Vice President of Human Resources for Technology Solutions, Inc., a publicly traded, Chicago- based technology consulting firm. From 1996 to 1997, she was Vice President of Human Resources/Operations for NovaMed Eyecare Management, LLC, where she established a human resources function, and managed all aspects of recruitment, retention and issues related to organizational growth. In 1987 she founded The Allen Group, a human resource, training and organization development consulting firm, which she led until 1996.
Robert M. Junkroski. Mr. Junkroski has been Vice President and Treasurer since January 1999 and was Controller from January 1997 to January 1999. He is responsible for all our revenue assurance, audit, cash and risk management, customer credit, banking relationship and capital raising functions. From 1995 to 1997, Mr. Junkroski was Controller for Brambles Equipment Services, Inc., an equipment leasing company, where he was responsible for establishing and maintaining the divisional accounting, financial reporting and budgeting functions. From 1987 to 1995, Mr. Junkroski was Controller for Focus Leasing Corporation, an equipment leasing company, where he was responsible for the development and implementation of the accounting and financial reporting functions of several emerging companies. Mr. Junkroski is a Certified Public Accountant, received his M.B.A. with honors from Roosevelt University concentrating in Finance and Accounting and holds a Bachelor of Business Administration degree.
Gregory J. Swanson. Mr. Swanson has been Controller since January 1999 and is our principal accounting officer. He is responsible for all internal and external accounting and reporting functions. From June 1998 to December 1998, Mr. Swanson was Director of External Reporting for Allegiance Corporation, a health care manufacturing and distribution company. Before that he spent approximately nine years at Arthur Andersen LLP, a public accounting firm, where he was responsible for audit and business advisory services to technology and manufacturing companies. Mr. Swanson is a Certified Public Accountant and holds a Bachelor of Science degree in Accounting from the University of Southern California.
James E. Crawford, III. Mr. Crawford has served as a director of Focal since November 1996. From August 1992 to September 2000, he has been a general partner and then since September of 2000 a managing partner of Frontenac Company, a venture capital firm and stockholder of Focal. From February 1984 to August 1992, Mr. Crawford was a general partner of William Blair Venture Management Co., a venture capital fund. He was also a general partner of William Blair & Company, an investment bank and brokerage firm affiliated with William Blair Venture Management Co., from January 1987 to August 1992. Mr. Crawford serves as a director of Optika, Inc., ActionPoint, Inc., Allegiance Telecom and several private companies.
Todd A. Dagres. Mr. Dagres has been a general partner of Battery Ventures, a stockholder of Focal, since 1996. From 1994 to 1996, Mr. Dagres was a Principal and Senior Technology Analyst at Montgomery Securities focusing on the networking industry. Mr. Dagres serves on the Board of Trustees of Akamai Technologies, Convergent Networks, Inc., Edgix Corporation, Equipe Communications Corporation, Inventa Corporation, Alphion Corporation, Predictive Networks, Inc., RiverDelta Networks, Inc., and Storability, Inc.
John A. Edwardson. Mr. Edwardson has served as a director of Focal since February 1999. He became President and Chief Executive Officer of CDW Computer Services, Inc. in February 2001. Formerly, he was Chairman of Burns International Services Corp., a security services company, since June 1999, and President and Chief Executive Officer of Burns International since March 1999. From 1994 to 1998, Mr. Edwardson was President of UAL Corporation, the holding company for United Airlines, and also served as UAL's Chief Operating Officer from April 1995 through September 1998. He previously was Executive Vice President and Chief Financial Officer of Ameritech and held executive positions with Northwest Airlines. Mr. Edwardson also serves as a director of CDW and Household International, Inc.
Kathleen A. Perone. Ms. Perone is a founding partner and managing director of Acappella Ventures L.L.C, a New Jersey-based venture capital firm that focuses on early stage telecom and technology infrastructure companies. From January 1998 to March 2000, Ms. Perone served as president of the North American division of Level 3 Communications, Inc., a leading communications and information services company, where she remains a consultant. From 1990 to 1998, Perone held a series of positions at MFS Communications: vice president and general manager; COO of MFS International; and president of two MFS divisions. Ms. Perone also is a director of Desktop News Corporation, REALTECH Systems, LighTrade and INFOCROSSING. She also serves on the advisory boards of TELLIUM and REALTECH.
James N. Perry, Jr. Mr. Perry has been a director of Focal since November 1996. From January 1993 to January 1999, he served as Vice President of Madison Dearborn Partners, Inc., and since January of 1999 has served as Managing Director of Madison Dearborn Partners, Inc. Previously, Mr. Perry served in various positions at First Capital Corporation of Chicago and its affiliates. Mr. Perry currently serves as a director or manager, as applicable, of Voicestream Wireless, CompleTel Holdings and Allegiance Telecom.
Andrew E. Sinwell. Mr. Sinwell has been a director of Focal since June 2000. He is a Managing Director of Madison Dearborn Partners, Inc., the general partner of Madison Dearborn Capital Partners, L.P., a stockholder of Focal. From 1994 to 1996, Mr. Sinwell was a Senior Policy Advisor at the Federal Communications Commission. Mr. Sinwell serves on the Board of Directors of Nextel Partners, Inc. and several privately-held companies.
Paul G. Yovovich. Mr. Yovovich has served as a director of Focal since March 1997. He is a private investor. Mr. Yovovich served as President of Advance Ross Corporation, an international transaction services and manufacturing company, from 1993 to 1996. He served in several executive positions with Centel Corporation from 1982 to 1992, where his last position was that of President of its Central Telephone Company unit. Mr. Yovovich also serves as a director of 3Com Corporation, APAC Customer Services, Inc., American Media Operations, Inc., and Lante Corporation.
How Our Directors Are Elected
The Board of Directors currently consists of nine members. The Board of Directors is divided into three classes of three members each. Each director serves a three-year term and one class is elected at each year's annual meeting of stockholders. Messrs. Barnicle, Crawford, and Yovovich are in the class of directors whose term will expire at our 2001 annual meeting of stockholders. Messrs. Edwardson, Perry, and Taylor are in the class of directors whose term will expire at our 2002 annual meeting of stockholders. Messrs. Dagres and Sinwell and Ms. Perone are in the class of directors whose term will expire at our 2003 annual meeting of stockholders. At each annual meeting of stockholders, successors to the class of directors whose terms expire at the meeting are elected to serve for three-year terms and until their successors are elected and qualified.
Our Board Committees
The Board has established four committees. They are the:
. Compensation Committee
. Stock Option Committee
. Audit Committee
. Nominating Committee
The Compensation Committee establishes salaries, incentives and other forms of compensation (except to the extent delegated to the Stock Option Committee) for our directors, executive officers and key employees and administers our equity incentive plans and other incentive and benefit plans. The members of the Compensation Committee are Mr. Crawford, Mr. Edwardson, Mr. Perry and Mr. Yovovich.
The Stock Option Committee grants stock options under the Company's 1998 Equity and Performance Incentive Plan (the "Plan") to employees who are not: (a) "covered employees" within the meaning of Section 162(m) of the Internal Revenue Code or who, in the Committee's judgment, are likely to be a covered employee at any time during the period a grant or award under the Plan to such person would be outstanding, (b) an officer or other person subject to Section 16 of the Securities Exchange Act of 1934, or (c) a vice president, senior vice president, or executive vice president. The members of the Stock Option Committee are Mr. Taylor and Mr. Barnicle.
The Audit Committee oversees the work of our independent auditors, reviews internal audit controls and evaluates conflict of interest issues. The members of the Audit Committee are Mr. Edwardson, Ms. Perone and Mr. Yovovich.
The Nominating Committee identifies nominees to stand for election to our Board of Directors. The members of the Nominating Committee are Mr. Taylor, Mr. Perry, Mr. Crawford and Mr. Yovovich.
Compensation of Our Directors
We currently pay our non-employee directors, other than designees of our institutional investors, in lieu of a cash retainer, annual director compensation in the form of an annual grant of stock options. The number of shares subject to each stock option granted to each of these directors on an annual basis is, as of 2001, equal to $120,000 divided by the option exercise price, which will be the fair market value per share on the date of grant. All directors are reimbursed for expenses incurred to attend Board of Directors or committee meetings.
In April 1997, Mr. Yovovich was granted an option to purchase 130,000 shares of our common stock under our 1997 Nonqualified Stock Option Plan (the "1997 Plan"). Ten percent of the shares covered by the option vested immediately and an additional 15% of the shares vest every six months thereafter. In January 1999, Mr. Yovovich was granted an additional option to purchase 20,000 shares of common stock under the 1997 Plan, which has the same vesting terms as his earlier grant. In February 2000, Mr. Yovovich was granted an additional option to purchase 1,349 shares of common stock under the 1997 Plan, which has the same vesting terms as his earlier grant. In February 1999, Mr. Edwardson was granted an option under our 1997 Plan to purchase 130,000 shares of our common stock on the same vesting terms as the options previously granted to Mr. Yovovich. In February 2000, Mr. Edwardson was granted an option to purchase 1,349 shares of common stock under the same vesting terms as the options previously granted. In August 2000, Ms. Perone was granted an option under our 1998 Plan to purchase 10,000 shares of our common stock on the same vesting terms as the options previously granted to Mr. Yovovich and Mr. Edwardson.
Potential Conflicts of Interest of Some of Our Directors
In addition to serving as members of our Board of Directors, Mr. Crawford, Mr. Sinwell, Mr. Dagres and Mr. Perry each serve as directors of other telecommunications services companies and other private companies. As a result, these four directors may be subject to conflicts of interest during their tenure on our Board of Directors. Accordingly, they may be periodically required to inform us and the other companies to which they owe fiduciary duties of financial or business opportunities. We do not currently have any standard procedures for resolving potential conflicts of interest relating to corporate opportunities or otherwise. Conflict of interest issues are reviewed by our Audit Committee.
Section 16(a) Beneficial Ownership Reporting Compliance
Section 16(a) of the Securities Exchange Act of 1934 requires our directors and officers and persons who own more than 10 percent of a registered class of our equity securities to file with the Securities and Exchange Commission initial reports of ownership and reports in changes in ownership in our common stock, and to furnish us with copies of all the reports they file. To our knowledge, based solely on a review of the copies of such reports furnished to us and written representations that no other Forms 5 were required, during the fiscal year ended December 31, 2000, all Section 16(a) filing requirements applicable to our directors, officers and greater than 10 percent beneficial owners were complied with, except that Mr. Crawford, a director, inadvertently failed to report acquisitions of our common stock on Forms 4 during May 2000, which acquisitions were subsequently reported on Forms 5.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The table below presents information about compensation earned by our Chief Executive Officer and each of our four other most highly compensated executive officers whose combined salary and bonus for 2000 exceeded $100,000 for services rendered in all capacities for our last three fiscal years. The officers listed in the following table are referred to as the Named Executive Officers:
- -------- (1) Does not include 2,500,000 shares of common stock issued to each of Mr. Taylor, Mr. Barnicle and Mr. Beatty in 1996 that were subject to time- vesting requirements set forth in their Employment Agreements, of which 500,000 shares vested in 1996, 1997 and 1998 and 1,000,000 shares vested in 1999. See "--Employment Agreements." Also does not include 1,838,943 shares of common stock issued to each of Mr. Taylor, Mr. Barnicle and Mr. Beatty in 1996 that were subject to performance-vesting requirements set forth in their Vesting Agreements with some of our institutional investors. Of these shares, 1,588,943 were canceled in connection with the September 30, 1998 amendments to the Vesting Agreements. The remaining 250,000 shares were subject to time-vesting requirements set forth in Restricted Stock Agreements signed at the time of the September 30, 1998 amendments to these Vesting Agreements. Of these shares, 137,500 held by Messrs. Taylor, Barnicle and Beatty remain subject to future vesting requirements. Based upon the closing price of our Common Stock on February 28, 2001, these 137,500 shares have an aggregate market value of $1,761,719. See "--Vesting Agreements." We do not anticipate paying any dividends on any of these shares. (2) Mr. Beatty resigned from Focal in February 2001. (3) Represents reimbursement of moving expenses.
Stock Option Grants
The table below provides information regarding stock options granted to the Named Executive Officers during the year ended December 31, 2000. None of the Named Executive Officers received stock appreciation rights, or SARs.
- -------- (1) The options granted to Mr. Taylor were granted under the 1998 Plan (as defined below). The 250,000 options were granted on June 1, 2000 and are comprised of 125,000 options that vest monthly over the 48 month vesting period; and 125,000 options that vest 25% per year based on Focal's common stock price meeting certain performance criteria. (2) The options granted to Mr. Barnicle were granted under the 1998 Plan. The 250,000 options were granted on June 1, 2000 and are comprised of 125,000 options that vest monthly over the 48 month vesting period; and 125,000 options that vest 25% per year based on Focal's common stock price meeting certain performance criteria. (3) The options granted to Mr. Leggio were granted under the 1998 Plan. The 50,000 options were granted on June 1, 2000 and are comprised of 25,000 options that vest 25% on the first anniversary date of the grant and 12.5% every six months thereafter; and 25,000 options that vest 25% per year based on Focal's common stock price meeting certain performance criteria. The remaining 7,500 options were granted on December 21, 2000 and vest 25% on December 21, 2002 and 12.5% every six months thereafter. (4) The options granted to Mr. Mael were granted under the 1998 Plan. The 50,000 options were granted on February 4, 2000 and vest 25% on the first anniversary date of the grant and 12.5% every six months thereafter. The 15,000 options were granted on June 1, 2000 and are comprised of 7,500 options that vest 25% on the first anniversary date of the grant and 12.5% every six months thereafter; and 7,500 options that vest 25% per year based on Focal's common stock price meeting certain performance criteria. The remaining 7,500 options were granted on December 21, 2000 and vest 25% on December 21, 2002 and 12.5% every six months thereafter. (5) Based on a ten-year option term and annual compounding, the 5% and 10% calculations are set forth in compliance with the rules of the Securities and Exchange Commission. The appreciation calculations do not take into account any appreciation in the price of the common stock to date and are not necessarily indicative of future values of stock options or the common stock.
Exercise of Stock Options and Year-End Values
The following table sets forth information regarding the number and value of unexercised stock options held by each of the Named Executive Officers as of December 31, 2000. None of the Named Executive Officers holds SARs.
- -------- (1) These shares represent shares issuable pursuant to stock options granted under our 1997 and 1998 Plan. See "the 1997 and 1998 Plan" below. (2) In accordance with the SEC's rules, values are calculated by subtracting the exercise price from the fair market value of the underlying common stock. For purposes of this table, fair market value is deemed to be $7.00, the closing price of our common stock reported for Nasdaq National Market on December 31, 2000. Based upon the closing price of our Common Stock on February 28, 20001, the exercisable and unexercisable options would have aggregate values equal to $119,376 and $977,146, respectively.
We established the Focal Communications Corporation 1997 Non Qualified Stock Option Plan (the "1997 Plan") effective February 27, 1997. The 1997 Plan is administered by the compensation committee of our Board of Directors (the "Board"). Options to purchase 6,927,650 shares were issued under the 1997 Plan and no further options will be granted under the 1997 Plan.
We adopted the Focal Communications Corporation 1998 Equity and Performance Incentive Plan (the "1998 Plan") on August 21, 1998. The total number of shares available under the 1998 Plan shall not exceed 12,050,000 shares. The Board and, with respect to non-executive employees, the stock option committee of our Board of Directors, has sole and complete authority to select participants and grant options, and other equity-based instruments for our common stock.
On August 21, 1998, we also adopted the 1998 Equity Plan for Non-Employee Directors of Focal Communications Corporation (the "1998 Non-Employee Plan"). The total number of shares available under the 1998 Non-Employee Plan shall not exceed 150,000 shares. The Board has sole and complete authority to select participants and grant options for our common stock, as defined in the 1998 Non-Employee Plan.
Employment Agreements
Focal is a party to identical Executive Stock Agreement and Employment Agreements ("Employment Agreements") with each of Mr. Taylor and Mr. Barnicle (the "Executive Investors"). The Employment Agreements provide that each Executive Investor will receive a minimum base salary of $120,000 (or any greater amount approved by a majority of the Board of Directors, including the Madison Dearborn designee and one of the Frontenac or Battery Ventures designees) and bonuses determined by the Board of Directors and based upon our achievement of performance goals set in advance of each year in the sole discretion of the Board of Directors. Unless he is terminated for cause, each Executive Investor is entitled for a period of between six and 12 months following termination of his employment with us (depending on the basis for termination) to continue to receive his salary and medical benefits, less any amounts the Executive Investor receives as compensation for other employment.
Pursuant to the Employment Agreements and in exchange for shares of common stock held by the Executive Investors prior to November 27, 1996:
. 2,500,000 shares of common stock subject to time-vesting requirements set forth in the Employment Agreements were issued to each of the Executive Investors on November 27, 1996
and
. 1,838,943 shares of common stock subject to performance-vesting requirements set forth in the Vesting Agreements (as defined below) were issued to each of the Executive Investors on November 27, 1996. Of these shares, 1,588,943 were canceled in connection with the September 30, 1998 amendments to the Vesting Agreements. The remaining 250,000 shares are subject to time-vesting requirements set forth in Restricted Stock Agreements signed on September 30, 1998. Of these shares, 137,500 shares issued to Messrs. Taylor, Barnicle and Beatty remained subject to future vesting requirements. See "--Vesting Agreements."
All of the 2,500,000 shares issued on November 27, 1996 that were subject to time-vesting requirements under the Employment Agreements have vested.
We entered into employment agreements with Mr. Mael and Mr. Leggio on substantially the same employment terms as the Executive Investors.
Each employment agreement requires the Executive Investor, or Mr. Mael or Mr. Leggio, as applicable, to assign to us all inventions developed in the course of employment, maintain the confidentiality of our proprietary information and refrain from competing with and soliciting employees from Focal during his or her employment and for a period of up to eighteen months after his or her termination. During this period, after any applicable severance pay period has expired, the Executive Investor, or Mr. Mael or Mr. Leggio, as applicable, is entitled to receive noncompetition compensation equal to his salary and medical benefits (net of any amounts he receives as compensation for other employment), unless he breaches his non-disclosure, non-compete or non-solicitation obligations.
Vesting Agreements
Pursuant to the original terms of three separate Vesting Agreements (the "Vesting Agreements"), each dated November 27, 1996, among Focal, the Executive Investors and each of our Institutional Investors, each of the Executive Investors was entitled to earn 1,838,943 shares of common stock if specified financial performance criteria were satisfied. If any of these shares of common stock vested, an equal number of shares of common stock held by the institutional investors would be forfeited by the Institutional Investors.
Pursuant to amendments to the Vesting Agreements, on September 30, 1998, the Vesting Agreements terminated and:
. The Institutional Investors collectively forfeited 2,500,000 shares of common stock
. The Executive Investors each forfeited 1,588,943 shares of common stock held by them (or a total of 6,355,770 shares for all Executive Investors)
. 250,000 shares of common stock held by each Executive Investor were vested and became subject to new time-vesting requirements based on periods of continuous service with us (the "Restricted Shares").
Twenty percent of the Restricted Shares immediately vested and the remaining Restricted Shares vest 10% on September 30, 1999, 15% on September 30, 2000, 20% on September 30, 2001 and 35% on September 30, 2002. The Executive Investors are entitled to voting, dividend and other ownership rights with respect to the Restricted Shares, but the Restricted Shares are subject to restrictions on transfer until they vest. Vesting of the Restricted Shares is accelerated under specified circumstances, including upon a Change in Control or the Executive Investor's death or disability. Change in Control has the same definition as in the 1997 Plan.
Compensation Committee Interlocks and Insider Participation
The Compensation Committee of the Board of Directors consists of four directors, Messrs. Crawford, Edwardson, Perry and Yovovich. None of our executive officers served as a member of the compensation committee of any other entity.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The table below sets forth information regarding beneficial ownership of our common stock as of February 28, 2001 for:
. Each of the Named Executive Officers
. Each of our directors
. All of our executive officers and directors as a group
. Each other person who we know beneficially owns 5% or more of our common stock
Unless otherwise noted, the address of each Named Executive Officer and director of Focal is 200 North LaSalle Street, Suite 1100, Chicago, Illinois 60601.
- -------- * Less than 1% of the issued and outstanding shares of our common stock. (1) In accordance with the rules of the Securities and Exchange Commission, each beneficial owner's holding has been calculated assuming full exercise of outstanding warrants and options exercisable by the holder within 60 days after February 28, 2001, but no exercise of outstanding warrants and options held by any other person. Unless otherwise indicated below, the persons and entities named in the table have sole voting and sole investment power with respect to all shares beneficially owned by them, subject to applicable community property laws. (2) Includes 137,500 shares of common stock subject to vesting provisions contained in the executive's Restricted Stock Agreement. Also includes 965,385 shares of common stock held by Mistral Partner, L.P.,
a family limited partnership. Mr. Taylor exercises sole voting and investment power over shares held by this partnership. Also includes 79,000 shares of common stock held by Hylas Blind Selling Program Trust. Also includes 97,000 shares of common stock held by Mistral Blind Selling Program #1. Also includes 97,000 shares of common stock held by Mistral Blind Selling Program #2. Also includes 26,040 shares of common stock subject to options, which are exercisable within 60 days of February 28, 2001. (3) Includes 137,500 shares of common stock subject to vesting provisions contained in the executive's Restricted Stock Agreement. Also includes 350,000 shares of common stock held by JRB Partners, L.P., a family limited partnership. Mr. Barnicle exercises sole voting and investment power over shares held by this partnership. Also includes 48,000 shares of common stock held by John R. Barnicle Blind Selling Program Trust. Also includes 36,000 shares of common stock held by JRB Blind Program Selling Trust. Also includes 26,040 shares of common stock subject to options, which are exercisable within 60 days of February 28, 2001. (4) Mr. Reising joined Focal in February 2001 as Executive Vice President and Chief Financial Officer. (5) Consists of 17,180 shares of common stock and an additional 10,938 shares of common stock subject to options which are exercisable within 60 days of February 28, 2001. (6) Includes 150,000 shares of common stock subject to vesting provisions contained in the executive's Restricted Stock Agreement respectively. Also, consists of 12,500 shares of common stock subject to options which are exercisable within 60 days of February 28, 2001. (7) Mr. Perry, a director, owns no shares in his own name. Consists of shares of common stock owned by Madison Dearborn. See footnote 15 below. Mr. Perry's address is c/o Madison Dearborn Partners, Inc., Three First National Plaza, Suite 3800, Chicago, IL 60602. (8) Mr. Sinwell, a director, owns no shares in his own name. Consists of shares of common stock owned by Madison Dearborn. See footnote 15 below. Mr. Sinwell's address is c/o Madison Dearborn Partners, Inc., Three First National Plaza, Suite 3800, Chicago, IL 60602. (9) Mr. Crawford, a director, owns no shares in his own name. Consists of shares of common stock owned by Frontenac and 21,130 shares of common stock owned by Mr. Crawford's son. See footnote 16 below. Mr. Crawford's address is c/o Frontenac Company, 135 S. LaSalle Street, Suite 3800, Chicago, IL 60603. (10) Mr. Dagres, a director, owns no shares in his own name. Consists of shares of common stock owned by Battery Ventures. See footnote 17 below. Mr. Dagres's address is c/o Battery Ventures, 20 William Street, Wellesley, MA 02481. (11) Includes 161,716 shares of common stock and an additional 145,313 shares of common stock subject to options which are exercisable within 60 days of February 28, 2001. (12) Includes 160,000 shares of common stock and an additional 92,313 shares of common stock subject to options which are exercisable within 60 days of February 28, 2001. (13) Includes 6,000 shares of common stock and an additional 3,274 shares of common stock subject to options which are exercisable wihtin 60 days of February 28, 2001. (14) Includes 45,275,251 shares of common stock and an additional 390,561 shares of common stock subject to options which are exercisable within 60 days of February 28, 2001. (15) Consists of shares of common stock owned by Madison Dearborn. Messrs. Perry and Sinwell, directors of Focal, are principals of Madison Dearborn Capital Partners, Inc., the ultimate general partner of Madison Dearborn. Because of these positions, Messrs. Perry and Sinwell share voting and investment power with respect to the shares owned by Madison Dearborn. The address of Madison Dearborn is Three First National Plaza, Suite 3800, Chicago, IL 60602. See "Directors and Executive Officers of the Registrant--Potential Conflicts of Interest of Some of Our Directors." (16) Consists of shares of common stock owned by Frontenac. Mr. Crawford, a director, is a general partner of Frontenac Company, the general partner of Frontenac. Because of this position, Mr. Crawford shares voting and investment power with respect to the shares owned by Frontenac. The address of Frontenac is 135 S. LaSalle Street, Suite 3800, Chicago, IL 60603. See "Directors and Executive Officers of the Registrant-- Potential Conflicts of Interest of Some of Our Directors."
(17) Consists of shares of common stock owned by Battery Ventures. Mr. Dagres, a director, is a managing general partner of Battery Ventures. Because of this position, Mr. Dagres shares voting and investment power with respect to the shares owned by Battery Ventures. The address of Battery Ventures is 20 William Street, Wellesley, MA 02481. See "Directors and Executive Officers of the Registrant--Potential Conflicts of Interest of Some of Our Directors." (18) Mr. Beatty is a Named Executive Officer. He resigned from Focal in February 2001. Includes 137,500 shares of common stock subject to vesting provisions contained in the executive's Restricted Stock Agreement. Also includes 815,000 shares of common stock held by Coventry Court Partners, L.P., a family limited partnership. Mr. Beatty exercises sole voting and investment power over shares held by this partnership. Also includes 95,000 shares of common stock held by Coventry Court Partners Blind Selling Trust. Also includes 20,832 shares of common stock subject to options, which are exercisable within 60 days of February 28, 2001.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED PARTY TRANSACTIONS
The Stock Purchase Agreement and Stockholders' Agreement
We have entered into a Stock Purchase Agreement with some of our stockholders, dated as of November 27, 1996 and amended after that date. Pursuant to the Stock Purchase Agreement and additional related agreements, our existing stockholders were granted registration rights described below.
The Stock Purchase Agreement also requires us to:
. Deliver financial information to our institutional investors and certain of their transferees in a private sale of shares of common stock
. Provide access by our institutional investors, and certain of their transferees in a private sale of shares of common stock, to our physical properties, books and records
. Comply with the periodic reporting requirements under the Exchange Act to enable holders of "restricted shares" of common stock to sell those shares of common stock pursuant to Rule 144 under the Securities Act of 1933 or a short-form registration statement under the Securities Act of 1933.
See "Executive Compensation--Employment Agreements" and "--Vesting Agreements" for a more detailed discussion of the various provisions of the Employment Agreements and Vesting Agreements.
Registration Rights
Focal has granted registration rights to some holders of its common stock. These holders of common stock have the benefit of the following demand registration:
. Subject to minimum dollar amounts, Madison Dearborn may demand two registrations on Form S-1
. Frontenac and Battery may each demand one registration on Form S-1
. The holders of 8% of all shares of common stock subject to the registration agreement may demand an unlimited number of registrations on Form S-2 or Form S-3
In addition, stockholders that have been granted registration rights have unlimited "piggyback" registration rights under which they have the right to request that we register their shares of common stock whenever we register any of our securities under the Securities Act of 1933 and the registration form to be used may be used for the registration of their shares of common stock. These piggyback registration rights will not, however, be available:
. If the piggyback registration is in connection with an underwritten registration and the managing underwriter concludes that including shares of common stock owned by holders of "piggyback" registration rights would have an adverse impact on the marketing of the securities to be sold in the underwritten offering
. For registrations undertaken because of a demand registration
Some of Our Directors are also Directors of our Competitors
Some of our directors, who serve as representatives of the Institutional Investors, also serve on the boards of directors of companies with which we may compete or enter into agreements. Specifically, Mr. Crawford, and Mr. Perry are directors of Allegiance Telecom, a Dallas-based CLEC. Allegiance Telecom is one of our competitors. See "Directors and Executive Officers of the Registrant--Potential Conflicts of Interest of Some of Our Directors."
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) (1) Financial Statements
The consolidated financial statements of Focal Communications Corporation and Subsidiaries for the year ended December 31, 2000, together with the Report of Independent Public Accountants, are set forth on pages through of this report. The supplemental financial information listed and appearing hereafter should be read in conjunction with the consolidated financial statements included in the report.
(2) Financial Statement Schedules
The following are included in Part IV of this report for each of the years ended December 31, 1998, 1999 and 2000 as applicable:
Report of Independent Public Accountants
Schedule II--Valuation and Qualifying Accounts
Financial statement schedules not included in this report have been omitted either because they are not applicable or because the required information is shown in the consolidated financial statements or notes thereto, included in this report.
(3) The exhibits listed below are filed as part of this report:
EXHIBIT INDEX
- --------
* Portions of this exhibit have been omitted pursuant to a request for confidential treatment, and the omitted portions have been filed separately with the Securities and Exchange Commission. + Management contract or compensatory plan.
(b) Reports on Form 8-K. The Company did not file any reports on Form 8-K during the period covered by this report.
(c) Financial Statement Schedules. The financial statement schedules filed as part of this Annual Report on Form 10-K are as specified in item 14(a)(2) herein.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, there unto duly authorized.
Focal Communications Corporation
/s/ Robert C. Taylor, Jr. By: _________________________________ Robert C. Taylor, Jr. President and Chief Executive Officer March 30, 2001
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant in the capacities and on the dates indicated. Each Director whose signature appears below authorizes and appoints Robert C. Taylor, Jr., John R. Barnicle and Renee M. Martin, or any of them, as his attorney-in-fact to sign and file on his behalf any and all amendments to this report.
EXHIBIT INDEX
- --------
* Portions of this exhibit have been omitted pursuant to a request for confidential treatment, and the omitted portions have been filed separately with the Securities and Exchange Commission. + Management contract or compensatory plan.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
FOCAL COMMUNICATIONS CORPORATION AND SUBSIDIARIES INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Board of Directors of Focal Communications Corporation:
We have audited the accompanying consolidated balance sheets of FOCAL COMMUNICATIONS CORPORATION AND SUBSIDIARIES (a Delaware corporation) as of December 31, 2000 and 1999, and the related consolidated statements of operations, stockholders' equity and cash flows for each of the three years in the period ended December 31, 2000. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States. 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 Focal Communications Corporation and Subsidiaries as of December 31, 2000 and 1999, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2000, in conformity with accounting principles generally accepted in the United States.
ARTHUR ANDERSEN LLP
Chicago, Illinois February 9, 2001
FOCAL COMMUNICATIONS CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
As of December 31, 2000 and 1999 (Dollars in thousands, except share amounts)
The accompanying notes are an integral part of these consolidated financial statements.
FOCAL COMMUNICATIONS CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
For the Three Years Ended December 31, 2000 (Dollars in thousands, except share amounts)
The accompanying notes are an integral part of these consolidated financial statements.
FOCAL COMMUNICATIONS CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
For the Three Years Ended December 31, 2000 (Dollars in thousands, except common shares)
The accompanying notes are an integral part of these consolidated financial statements.
FOCAL COMMUNICATIONS CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the Three Years Ended December 31, 2000 (Dollars in thousands, except share amounts)
The accompanying notes are an integral part of these consolidated financial statements.
FOCAL COMMUNICATIONS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except share amounts)
1. ORGANIZATION AND OPERATIONS
Focal Communications Corporation began operations on May 31, 1996. Focal Communications Corporation and Subsidiaries is a national broadband communications provider in the United States and offers a range of voice, data and Internet infrastructure services to larger, communications-intensive users in major cities.
2. SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation
The 2000 and 1999 consolidated financial statements include the accounts of all our wholly owned subsidiaries. All material intercompany transactions and balances have been eliminated in consolidation.
Basis of Accounting
The accompanying consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles ("GAAP").
Use of Estimates and Assumptions
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Concentration of Suppliers
We currently lease our transport capacity from a limited number of suppliers and are dependent upon the availability of fiber transmission facilities owned by those suppliers. We are currently vulnerable to the risk of renewing favorable supplier contracts, timeliness of the supplier in processing our orders for customers and we are at risk to regulatory agreements that govern the rates to be charged to us.
Financial Instruments
We consider all liquid interest-earning investments with a maturity of three months or less at the date of purchase to be cash equivalents. Short- term investments primarily consist of debt securities, which typically mature between three months and one year from the purchase date and are held to maturity and valued at amortized cost, which approximates fair value. The carrying value for current assets and current liabilities as of December 31, 2000 and 1999 reasonably approximates fair value due to the nature of the financial instrument and the short maturity of these items. Fair value for our long-term debt is based on market quotes, where available or by discounting expected cash flows at the rates currently offered to us for debt of the same remaining maturities. The fair value of our long-term debt is approximately $295,000 and $176,850 as of December 31, 2000 and 1999, respectively.
FOCAL COMMUNICATIONS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Revenue Recognition
Revenue is recognized as we provide services to our customers. Monthly recurring charges include fees paid by customers for lines in service, additional features on those lines and colocation space. These charges are billed monthly, in advance, and are fully earned during the month. Usage charges and reciprocal compensation charges are billed in arrears and are fully earned when billed. Initial, non-recurring fees are deferred and amortized over estimated customer lives.
Depreciation and Amortization
Depreciation is provided on a straight-line basis over the estimated useful lives of the assets as follows:
When depreciable assets are replaced or retired, the amounts at which such assets were carried are removed from the respective accounts and charged to accumulated depreciation and any gains or losses on disposition are recorded currently in the consolidated statements of operations.
Maintenance and repairs are charged to expense as incurred, while major replacements and improvements are capitalized.
Impairment of Long-Lived Assets
We periodically assess the recoverability of the carrying cost of our long- lived assets based on a review of projected undiscounted cash flows related to the asset held for use. If assets are determined to be impaired, then the asset is written down to its fair value based on the present value of the discounted cash flows of the related asset or other relevant measures (quoted market prices, third-party offers, etc.). Based on our review, management does not believe that an impairment of the long-lived assets has occurred.
Income Taxes
We account for income taxes using the liability approach pursuant to which deferred income tax assets and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities, using enacted tax rates currently in effect. State and local taxes may be based on factors other than income.
Segment Information
In 1998, we adopted SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information which requires a "management approach"" to segment information. The management approach designates the internal reporting that is used by management for making operating decisions and assessing performance as the source of our reportable segments. We operate in a single industry segment, "Communication Services." Operations are managed and financial performance is evaluated based on the delivery of multiple communications services to customers over fiber networks.
FOCAL COMMUNICATIONS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Software Costs
Certain costs incurred in the development of internal use software are capitalized and amortized over their appropriate useful lives.
Reclassifications
Certain prior-year amounts have been reclassified to conform to the 2000 and 1999 presentation. These changes had no impact on our previously reported financial position or our results of operations.
3. PROPERTY, PLANT AND EQUIPMENT
Long-lived assets are stated at cost, which includes direct costs and capitalized interest, and are depreciated once placed in service using the straight line method. Interest capitalized in 2000 and 1999 amounted to $9,374 and $3,633, respectively.
Property, plant and equipment consists of the following:
4. LONG-TERM DEBT
In February 1998, we completed our offering of $270 million stated principal amount at maturity of our 12.125% senior discount notes due 2008 (the 1998 "Notes"), resulting in gross proceeds of $150,028. The 1998 Notes bear interest at the rate of 12.125% per annum (computed on a semi-annual Note equivalent basis) with an effective interest rate of approximately 11.09% and 11.81% for 2000 and 1999, respectively. Prior to February 15, 2003, interest accrues but is not payable in cash.
From February 15, 2003, interest on the stated principal amount at maturity of the 1998 Notes will be payable in cash semiannually on August 15 and February 15 of each year, beginning on August 15, 2003. Total interest expense for the 1998 Notes was $23,296 in 2000 and $20,713 in 1999.
FOCAL COMMUNICATIONS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
The 1998 Notes are senior unsecured obligations of Focal's ranking pari passu in right of payment with all other existing and future senior indebtedness of ours, if any, and will rank senior in right of payment to all existing and future subordinated indebtedness of Focal's, if any. Holders of secured indebtedness of Focal's, however, will have claims that are prior to the claims of the holders of the 1998 Notes with respect to the assets securing such other indebtedness. The 1998 Notes will be effectively subordinated to all existing and future indebtedness and other liabilities of our subsidiaries (including accounts payable).
The 1998 Notes are redeemable, at our option, in whole or in part, at any time or from time to time, on or after February 15, 2003, at 106.063% of their stated principal amount at maturity, plus accrued and unpaid current interest, declining ratably to 100% of their stated principal amount at maturity, plus accrued and unpaid current interest, on or after February 15, 2006.
The Notes indenture contains certain covenants which, among other things, restrict our ability and certain of our subsidiaries to incur additional indebtedness (and, in the case of certain subsidiaries, issue preferred stock), pay dividends or make distributions in respect of Focal's or such subsidiaries' capital stock, make other restricted payments, enter into sale and leaseback transactions, incur liens, cause encumbrances or restrictions to exist on the ability of certain subsidiaries to pay dividends or make distributions in respect of their capital stock, issue and sell capital stock of certain subsidiaries, enter into transactions with affiliates, sell assets, or amalgamate, consolidate, merge or sell or otherwise dispose of all or substantially all of their property and assets. These covenants are subject to exceptions and qualifications. We were in compliance with these covenants as of December 31, 2000.
On January 12, 2000, we received net proceeds of approximately $265,700 from the issuance of our $275,000 11 7/8% senior notes due 2010 ("2000 Notes"). The 2000 Notes bear interest at a rate of 11.875% per annum payable on July 15 and January 15, commencing July 15, 2000 with an effective interest rate of 11.71% for 2000. The 2000 Notes are not secured by any of our assets and rank equally in right of payment with all our unsubordinated and unsecured indebtedness. The 2000 Notes are senior in right of payment to all of our future subordinated indebtedness. We may elect to redeem all or part of the 2000 Notes at any time from time to time, on or after January 15, 2005 at specified redemption prices. In addition, at any time and from time to time prior to January 15, 2003 we may redeem in the aggregate up to 35% of the initially outstanding aggregate principal amount of the 2000 Notes with the proceeds from one or more registered underwritten primary public offerings of common stock at a price of 111.875% of the principal amount of the 2000 Notes.
On August 25, 2000, we completed our $300,000 Senior Secured Credit Facility (the Credit Facility). The Credit Facility consists of a seven year $150,000 revolving credit facility and a seven year $150,000 delayed draw term loan facility. The Credit Facility will be available, subject to certain financial and operating terms and conditions, and is intended to provide purchase money financing for the construction, acquisition, or improvements of telecommunications assets. The interest on amounts drawn is variable based on our leverage ratio, as defined in the Credit Facility. The initial commitment fee on the unused portion of the Credit Facility is 1.5% and will step down based on usage. We have not drawn down against the Credit Facility as of December 31, 2000.
We utilized a secured equipment term loan (the "Facility") from a third party with a maximum borrowing level of $50,000. The Facility provided for, among other things, equipment drawdowns through December 30, 1999, and requires repayment based on 60 equal monthly installments of principal and interest for each drawdown. All drawdowns under the Facility bear interest at the five-year swap rate percent plus additional basis points, as defined in the Facility. The effective interest rate for the drawdowns under the Facility was approximately 9.82% and 9.68% for 2000 and 1999, respectively. The Facility provides for certain restrictive
FOCAL COMMUNICATIONS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
financial and non-financial covenants. Among other things, these covenants require the maintenance of minimum cash flow and revenue levels. We were in compliance with these covenants as of December 31, 2000. Total interest expense was $ 3,958 for 2000 and $3,374 for 1999.
Long-term debt at December 31, 2000 and 1999, consists of the following:
Aggregate maturities of long-term debt outstanding, excluding obligations under capital lease, as of December 31, 2000, are as follows:
5. STOCK OPTIONS/STOCK PURCHASE PLAN
We established the Focal Communications Corporation 1997 Non Qualified Stock Option Plan (the "1997 Plan") effective February 27, 1997. The 1997 Plan is administered by the compensation committee of our Board of Directors (the "Board"). Options to purchase 6,927,650 shares were issued under the 1997 Plan and no further options will be granted under the 1997 Plan.
We adopted the Focal Communications Corporation 1998 Equity and Performance Incentive Plan (the "1998 Plan") on August 21, 1998. The total number of shares available under the 1998 Plan shall not exceed 12,050,000 shares. The Board and, with respect to non-executive employees, the stock option committee of our Board of Directors, has sole and complete authority to select participants and grant options, and other equity-based instruments for our common stock.
FOCAL COMMUNICATIONS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
On August 21, 1998, we also adopted the 1998 Equity Plan for Non-Employee Directors of Focal Communications Corporation (the "1998 Non-Employee Plan"). The total number of shares available under the 1998 Non-Employee Plan shall not exceed 150,000 shares. The Board has sole and complete authority to select participants and grant options for our common stock, as defined in the 1998 Non-Employee Plan.
Under our stock option plans, the Board has complete discretion in determining vesting periods and terms of each participant's options granted. The options granted to participants under our stock option plans typically vest at 25% on the first-year anniversary from grant date and vesting at 12.5% every six months for the remainder of vesting years. The term of each option has a life of 10 years. In addition, the plans provide for accelerated vesting upon certain events, as defined.
On October 1, 2000, we established the Focal Communications Corporation 2000 Employee Stock Purchase Plan ("ESPP"). The ESPP is intended to give employees a convenient means of purchasing shares of Focal Common Stock through payroll deductions. Each participating employee's contributions will be used to purchase shares for the employee's share account as promptly as practicable after each 6 month period. The cost per share will be 85% of the lower of the closing price of our Common Stock on the Nasdaq National Market on the first or the last day of the 6 month period. We began the Stock Purchase Plan October 1, 2000. We have 375,000 shares of Common Stock reserved for issuance under the Stock Purchase Plan at December 31, 2000. As of December 31, 2000, participants have contributed $1,932, which will be used to purchase approximately 152,831 shares at March 31, 2001.
The following summarizes option activity:
FOCAL COMMUNICATIONS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
The following table summarizes information about fixed stock options outstanding at December 31, 1998, 1999 and 2000:
We have chosen to account for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board Opinion ("APB") No. 25, "Accounting for Stock Issued to Employees." Under APB No. 25, the exercise price of the employee stock options equals the fair value of the underlying stock on the date of grant and no compensation expense is recorded. We have adopted the disclosure only provisions of the SFAS No. 123, "Accounting for Stock-Based Compensation."
We utilized the Black-Scholes option pricing model to estimate the fair value of options at the date of grant during 2000, 1999 and 1998. Had we adopted SFAS No. 123, pro forma net loss and basic and diluted net loss per share of Common Stock would have been approximately $(131,204) and $(2.17), $(27,487) and $(.55), $(8,603) and $(.20), for the three years ended December 31, 2000, respectively. The pro forma disclosure is not likely to be indicative of pro forma results which may be expected in future years because of the fact that options vest over several years, compensation expense is recognized over the vesting period and additional awards may also be granted.
The Black-Scholes option model estimated the weighted average fair value at the date of grant of options granted in 2000, 1999, and 1998 to be approximately $24.99, $5.76, and $2.23 per option, respectively. The remaining contractual life of all options was approximately nine years. Principal assumptions used in applying the Black-Scholes model were as follows:
FOCAL COMMUNICATIONS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
6. EQUITY TRANSACTIONS
During 1999, we granted 3,570,775 stock options to employees, directors, and an outside consultant. Giving effect to our initial public offering, the fair market value of our common stock exceeded the exercise price for 3,192,500 of the total stock options granted. In addition, we also sold 150,000 shares of common stock to a director during 1999, which was retrospectively determined to be at a price below the fair market value. Total non-cash compensation related to these 1999 transactions of approximately $20,776 will be recognized, of which $1,505 was initially recorded during 1999 on the dates of each respective transaction and the remaining $19,271 will be ratably charged to operations over the respective vesting periods for the stock option grants. Total non-cash compensation related to the grant to a consultant was charged to operations over the consultant's service period through November 1999 in accordance with SFAS No. 123.
On August 2, 1999, we sold 9,950,000 shares of our common stock in an IPO at a price of $13 per share, which resulted in net proceeds of approximately $119 million. In connection with the IPO, our Board of Directors and stockholders authorized: (1) a recapitalization of our existing Class A common stock, Class B common stock, and Class C common stock into a single class of common stock; (2) an increase in the number of authorized shares of common stock to 100,000,000 and the authorization of 2,000,000 shares of preferred stock; and (3) a 500 for-one stock split.
On August 19, 1999 pursuant to the terms of the underwriting agreement, among us and our underwriters, our underwriters elected their option to purchase an additional 1,492,500 shares of our common stock at $13 per share which resulted in additional net proceeds to us of approximately $18 million.
During January 2000, we granted 150,000 shares of restricted stock to an executive in connection with an employment agreement. The restricted stock granted resulted in total non-cash compensation of approximately $6,000 which will be ratably charged to operations over a three year vesting period.
7. INCOME TAXES
For the year ended December 31, 2000 we recorded an income tax benefit of $4,205. For the year ended December 31, 1999 and 1998, we recorded an income tax provision of $600 and $4,660, respectively. The deferred tax consequences related to the original issue discount interest accrued and other temporary differences in reporting items for financial statement and income tax purposes are recognized, if appropriate. Realization of future tax benefits related to the deferred tax assets is dependent on many factors, including our ability to generate future taxable income. Management has considered these factors and has concluded that a full valuation allowance for financial reporting purposes is required for the deferred tax assets for these periods.
FOCAL COMMUNICATIONS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
The income tax provision (benefit) for the three years ended December 31, 2000, consists of the following:
Our federal income tax provision (benefit) at the statutory tax rate is reconciled below to our overall provision (benefit) for income taxes for the year ended December 31, 2000 and 1999:
The income tax effect of temporary differences comprising the net deferred tax assets and tax liabilities as of December 31, 2000 and 1999 consists of the following:
As of December 31, 2000, we had a net operating loss carryforward ("NOL") of approximately $98,000 for tax purposes which will be available to offset future taxable income. This NOL will expire in 2015. We have recognized $3,726 of this NOL as of December 31, 2000 due to the realization of a federal and state tax refund.
FOCAL COMMUNICATIONS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
8. LOSS PER SHARE
We compute basic earnings per common share based on the weighted average number of shares of common stock outstanding for the period. This calculation excludes certain unvested shares of common stock held by our executives. Diluted earnings per common share are adjusted for the assumed exercise of dilutive stock options and unvested shares of common stock. Since the adjustments required for the calculation of diluted weighted average common shares outstanding are anti-dilutive, this calculation has been excluded from the loss per share calculation for the three years ended December 31, 2000. Our basic and diluted weighted average number of shares outstanding at December 31, 2000, 1999, and 1998 are as follows:
9. EMPLOYEE BENEFIT PLAN
We have a 401(k) Plan (the "Plan") covering substantially all eligible employees. Under the Plan, participants may make pretax contributions from 1% to 15% of eligible earnings, as defined. We may elect to contribute to the Plan at our discretion. In February, 1998, we elected to match 30% of the first 10% that an employee contributes to the Plan. Our matching contributions totaled approximately $1,059, $430 and $145 for 2000, 1999, and 1998, respectively.
10. COMMITMENTS AND CONTINGENCIES
Under the terms of various short- and long-term contracts, we are obligated to make payments for office rents and for leasing components of our communications network through 2021. The office rent contracts provide for certain scheduled increases and for possible escalation of basic rentals based on a change in the cost of living or on other factors. We expect to enter into other contracts for additional components of our communications network, office space, other facilities, equipment and maintenance services in the future.
A summary of such fixed commitments at December 31, 2000, are as follows:
FOCAL COMMUNICATIONS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Rent expense under operating leases for office rent and rent for leasing components of our communications network was approximately $12,184, $5,093, $1,522 for 2000, 1999, and 1998, respectively.
During 1999, we entered into agreements with carriers for the acquisition of indefeasible rights of use for dark fiber transport capacity for a minimum of 10,800 fiber miles. The terms of the agreements are for 20 years with a total minimum commitment of approximately $71 million. One of these agreements has been accounted for as a capital lease (Note 4). We also signed an agreement with a carrier for the lease of fiber transport capacity for a five year term and a minimum commitment of $70 million. We have committed to $10 million in year one; $13.2 million in year two; and $15.6 million for each of the remaining three years of the agreement.
We are party to a products purchase agreement with a vendor that expires December 31, 2002. This agreement requires us to place orders for certain network products in a minimum aggregate amount over the term of the agreement of $75 million.
11. STOCK PURCHASE AGREEMENT
On November 27, 1996, we entered into a Stock Purchase Agreement (the "Agreement") with Institutional Investors and Executives ("Investors"), as defined. The Agreement resulted in 39,692,000 shares of Class A Common Stock, par value $.01 per share being issued for an aggregate purchase price of $25,800. Subsequent to the closing of the Agreement, we sold 461,500 shares of Class A Common shares for a purchase price of $300 to Designees (as defined in the Agreement) of the Institutional Investors.
As part of the Agreement, the existing Common Stock held by the Executives was converted into newly issued Class B Common and Class C Common shares (the "Exchange"). The closing of the Exchange and issuance of Class B Common and Class C Common shares took place simultaneously with the initial closing of the issuance of Class A Common shares under the Agreement. In connection with this transaction, compensation expense totaling approximately $5,200 will be charged to income over the vesting period of the Class B Common shares issued that did not vest immediately. Total non-cash compensation expense of $1,300, and $2,492 was recorded for 1998 and 1999, respectively.
We amended certain vesting agreements of the Executives and Institutional Investors on September 30, 1998, which effected the cancellation of 6,355,500 shares of our Class C Common Stock then outstanding, cancellation of 2,500,000 shares of the Company's Class A Common Stock held by certain institutional shareholders and the conversion of 1,000,000 shares of the Company's Class C Common Stock into Class B Common Stock. The new converted Class B Common Stock is subject to certain restrictions, and was issued to our executives (founding shareholders) in satisfaction of the obligations of Focal and such shareholders set forth in certain vesting agreements as defined in the Agreement. In connection with such transactions, non-cash compensation expense totaling approximately $4,000 will be charged to income over the vesting period of the restricted Class B Common shares issued. Total non-cash compensation expense relating to this matter of $1,770, $326 and $272 was recorded for the three years ended December 31, 2000, respectively. During 2000, a total of 175,000 shares of our common stock (new Class B shares prior to recapitalization) were cancelled as a result of the resignation of an Executive.
In connection with our IPO that was completed on August 2, 1999 (Note 6), our Board of Directors and stockholders authorized, among other things, a recapitalization of our existing Class A common stock, Class B common stock, and Class C common stock into a single class of common stock.
A summary of the Company's Class A and B Common Stock before our recapitalization on August 2, 1999 is as follows:
Class A Common--A total of 50,000,000 shares are authorized, of which 37,687,000 were issued and outstanding as of December 31, 1998. Institutional Investors, as defined, who hold Class A Common shares
FOCAL COMMUNICATIONS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
had the right to put the shares to us at fair market value but the Agreement was amended and the put right was replaced by a provision which would require us to voluntarily liquidate. The Class A Common Stock held by Institutional Investors have demand registration rights; all Class A Common stockholders have voting rights, piggyback registration rights, participate in earnings and dividends and other preference features, as defined.
Class B Common--A total of 17,500,000 shares have been authorized and 11,000,000 shares are issued and outstanding as of December 31, 1998. Class B Common stockholders have demand registration rights, voting rights, piggyback registration rights, participate in earnings and dividends and other preference features, as defined. The Class B Common issued upon the Exchange will vest 20% on the closing of the Agreement and 20% on each of the four anniversaries of the closing date of the Agreement. Accelerated vesting will occur on the dates of certain (as defined) events: (a) qualified sale of the Company; (b) qualified reorganization; and (c) public offering of the Company's stock. The vesting of the Class B Common accelerated by an additional 20% in connection with our IPO on August 2, 1999 (Note 6). For the Class B Common converted from Class C Common, the Restricted Stock Agreement ("RSA") provides, among other things, vesting of 20% at the closing of the RSA (September 30, 1998), 10%, 15%, 20% and 35% on each of the consecutive anniversaries of the closing of the RSA, respectively, with immediate vesting upon a Change in Control, as defined in the RSA.
12. SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Cash paid for interest and non-cash investing and financing activities for the three years ended December 31, 2000 was as follows:
13. SEGMENT INFORMATION
We currently operate solely in the United States and are organized primarily on the basis of strategic geographic operating segments that provide communications services in each respective geographic region. All of our geographic operating segments have been aggregated into one reportable segment, "Communications Services," for the year end as of December 31, 2000 and 1999.
The accounting policies of the segments are the same as those described in the "Summary of Significant Accounting Policies." Our chief operating decision maker views earnings before interest, taxes, depreciation and amortization ("EBITDA") as the primary measure of profit and loss. The following represents information about revenues and EBITDA which excludes non-cash compensation, total assets and capital expenditures for the Communications Services reportable segment as of and for the years ended December 31, 2000, 1999 and 1998:
FOCAL COMMUNICATIONS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
The following reconciles total segment EBITDA to our consolidated net loss before income taxes for the three years ended December 31, 2000:
The following reconciles our total segment assets to our consolidated total assets as of December 31, 2000 and 1999:
14. SELECTED QUARTERLY INFORMATION (UNAUDITED)
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Board of Directors of Focal Communications Corporation:
Our audits were made for the purpose of forming an opinion on the consolidated financial statements taken as a whole. The schedule of Valuation and Qualifying Accounts as of and for the three years ended December 31, 2000, is presented for purposes of additional analysis and is not a required part of the consolidated financial statements of Focal Communications Corporation and Subsidiaries. Such information has been subjected to the auditing procedures applied in the audits of the consolidated financial statements and, in our opinion, is fairly stated in all material respects in relation to the consolidated financial statements taken as a whole.
ARTHUR ANDERSEN LLP
Chicago, Illinois February 9, 2001
Schedule II
FOCAL COMMUNICATIONS CORPORATION AND SUBSIDIARIES
VALUATION AND QUALIFYING ACCOUNTS